FM_prof sango notes
Transcript of FM_prof sango notes
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Sandeep Gokhale
Jamnalal Bajaj InstituteUniversity of Mumbai
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References
Financial Management
Authors :• Khan & Jain• Prasanna Chandra• I.M.Pandey• S.C.Kuchhal• Maheshwari
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Syllabus
• Ratio Analysis• Fund & Cash flow analysis• Cost of Capital• Working Capital Mgmt.• Means of Financing• Capital Budgeting• Dividend Structuring
• Bonus Shares• Share Holder Value
Measurement
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FINANCIAL MANAGEMENT
Objective: Create share holder value Methodology: Capturing of value at all Levels.
Business Process restructuring
Enterprise resource management.Vertically integrated operations.
Customer relationship Management
Sustained up scaling of operations
Effectiveness: Proximity of gross profit to net profit
Maximisation of EVA
EV / EBIDTA multiple
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Financial Management – an Overview
Business environment
Planning Policies&Decisions
(Management Accounting)
Restructuring
Resource Mobilisation
Treasury
Control&Information
( Audit & Taxation)
Valuation Technique
FinancialMarkets
Investor WishList
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Environmental scan
Economy : Convertibility of Local Currency
GDP / Industrial growth rate
Scalability of Operations
FDI – Incoming / outgoing
Inflation rate / Fiscal deficit
Trade surplus/deficits
Balance of payment status
WTO Implications
Emerging markets scenario
Gross national income distribution
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Government Policy : Industrial policy
Government programmes and projects
Tax regime
Subsidies, incentives and concessions
Exim policies / VAT
Government Expenditure
Lending considerations of financialinstitutions and commercial banks
Infrastructure Development
Rating of Govt paper
Agricultural policies
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Technology: Emergence of new technologies.
Access to technical Up gradation
Level of obsolescence.
Socio Demographic : Population trends
Age shifts in population
Educational profile.Attitudes toward consumption and investment
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Competition : Number of players in the industry and their market share.
Duty barrier and status of international costand volume positioning.
Degree of homogeneity and differentiationamong products.
Entry barriers for new capacities.
Comparison with substitute products.
Unorganised sector operations.
Marketing polices and practices.
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ORGANISATIONAL INTERFACE OF FINANCE
Areas Interface
Corp planning: Long term financial goals in terms of assets, sales,profits,dividends etc.
Expansion, new projects diversifications
takeovers , mergers,disinvestments.
Internal generation, tax planning.
Operations: Integrating functional plans.
Working capital management
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Areas Interface
Control: Budgetary control of all divisions
Variance analysis
Marketing: Credit norms
Cost analysis of decisions like discounts , premium pricing,product promotion etc.
Manufacturing: Budgeting for manufacturing operations.
Product mix decisions.
Personnel: Budgeting for personnel & administrative
function.
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FINANCIAL FUNCTION
Money Mgmt Accounting Control Advisory Role
Resource
Mobilisation
Financial
Accounting
Budget s Project
Financing
Working CapitalMgmt
CostAccounting
VarianceAnalysis
Pricing
Investment
Mgmt
MgmtAccounting
Profit Center Div. Policy
Valuation of Assets
Cost Center
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Financial Decision Areas
• Investment analysis• Working capital management• Sources and cost of funds
• Determination of capital structure• Dividend policy• Analysis of risks & returns• Treasury - interest / exchange rate swaps
• Restructuring of operations / term debt profile• Equity buyback / Bonus
• To result in shareholder wealth maximisation
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PROFIT AND LOSS ACCOUNT
For the Period 1st April to March 31st
Income: Gross sales from Goods & Services
Less: Excise Duty
Net Sales
Other Income
Non operating IncomeTotal Income
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Expenditure : Raw materials consumed
Manufacturing expenses
Administrative expensesSelling expenses
WIP +FG adjustment
PBIDT (Gross Profit)Less: Interest
Less Depreciation
PBT (Operating Profit)
Less: Tax
PAT (net profit)
Gross cash accruals : PAT + Depn
Net cash accruals : GCA - Dividend
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THE BALANCE SHEET
For the year ended March 31st 00...
Liabilities : Equity share capital
Reserves & Surplus
Term loan
Debentures
Fixed deposits
Other unsecured loans
Commercial bank borrowings
Creditors
Other current liabilities
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Assets: Gross fixed assets
Less: Acc. Depn
Net Block Investments
Currents Assets: RM Stock
WIPF.G.Stock
Debtors
Cash in bank Loans & Advances
Misc.. expenditure
Deferred expenditure
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RATIO ANALYSIS
Principal tool for analysis
Inter firm comparison
Intra firm comparison
Industry analysis
Responsibility accounting
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TYPES OF FINANCIAL RATIOS
Liquidity
Leverage
Turnover
Profitability / Valuation
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LIQUIDITY RATIOS
Current Ratio: Current assets
Current liabilities
Acid test ratio: C.A- Inventories
Current liabilities
Cash position ratio: Cash in bank + hand
Current liabilities
Inventory to G.W.C: Inventory
Current assets
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LEVERAGE RATIOS
Debt / Equity ratio: Long term debt
Net worth
Borrowing / Assets: 1 - Net worth
Total Assets
Fixed asset / Networth : Fixed Assets Net worth
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Capital gearing ratio: Capital entitled to fixed return
Capital not entitled to fixed return
Debt. Service coverage ratio: PBDIT - Tax
Interest + Annual installment
Interest coverage ratio: PBDIT - Tax
Interest
F. Asset coverage ratio: Gross fixed asset - Acc. Depn
LT Secured liabilities
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ACTIVITY RATIOS
Total asset turnover: Net salesTotal assets
Fixed asset turnover: Net salesFixed assets
Inventory turnover: Net salesInventory
activity
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Debtors turnover: Credit sales
Avg. debtor
Collection period: Avg. debtor * 365
CR. Sales
Creditors Turnover: Credit purchase
Avg.. Creditors
Payment period: Avg. Creditor * 365
Net sales
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PROFITABILITY / VALUATION RATIOS
Gross profit ratio: PBDIT / SalesEBITDA / Sales
NOPLAT : Net operating profit less adjusted
Tax
ROSE: PAT - Pref. Div
Net worth
Return on CAP. Employed: PBIT
Total Lia - Creditors – Provisions
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Book value per share: Net Worth
NO of Equity Shares
EV / EBITDA: Enterprise value / Gross profit
Earning per share: PAT - Pref Div
No. of Equity shares
Price Earning ratio: Market price
Earnings per share
Pay out ratio: Dividend paid
Profit after Tax
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USERS OF FINANCIAL RATIOS
Lenders of funds for appraising credit worthiness for long term / short
term lending decisions.
Valuations in investment / disinvestment decisions.
Financial analyst / Mutual Funds / Investment Bankers.
Management for operational short / long term planning.
Credit Rating Agencies
Tax authorities
A O S O A O A A S S
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LIMITATIONS OF RATIO ANALYSIS
A ratio in absolute terms has no meaning. It has to be compared.
•Inter firm comparison.
•Companies resort to window dressing of Balance sheets.
•Operating and accounting practices differ from company tocompany.
•Consolidation of group / subsidiary companies figures.
E.G. Changes in Depreciation methods
Inventory Valuation
Treatment of contingent liabilities.
Valuation of investments.
Conversion or transaction of foreign exchange items.
FUND FLOW ANALYSIS
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FUND FLOW ANALYSIS
It is a statement indicating the methods by which a company has beenfinanced and the uses to which it has applied its funds over a period of
time.
It provide an insight into the movement of funds and helps inunderstanding the changes in the structure of asset & liabilities.
Provides information as to how funds are raised and utilised.
Determines need for funds and helps in deciding finance mix
Determines financial consequences of business decisions.
Free cash flow generation ability and Utilisation of the same.
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FUND MANAGEMENT
Mobilisation Requirement
Quantum Source Cost
Normal
Capitalexpenditure
Incremental
Working capital
New
Investments
Equity Buy back
FUND FLOW OCCASIONS
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FUND FLOW OCCASIONS
Sources Uses
Funds from operations Loss from operations
Sale of fixed assets Increase in fixed assets
Increase in liabilities Redemption of liabilities
Sale of securities Purchase of securities
Decrease in W.C Increase In W.C
Cash Dividends, Equity buy back
FUND FLOW
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FUND FLOW
Assets Uses of funds
Liabilities Uses of funds
Assets Source of funds
Liabilities Source of funds
Comparison of balance sheets of consecutive years .
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TYPES OF FUND FLOW STATEMENTS
OVERALL FUND FLOW
OPERATIONAL FUND FLOW
WORKING CAPITAL BASED FUND FLOW
(ONLY STS/STU STATEMENT)
COST OF CAPITAL
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COST OF CAPITAL
Aggregate of the liabilities raised by a company is the total capitalemployed in business.
Different sources have different cost and tax implications.
Cost of capital
It is a single rate (weighted average ) for a finance mix.
It is computed on a post - tax basis since cost of different sourceshave different tax implications
E.g.. Interest on debt capital enjoys tax shield while dividend paidon equity has no tax shield.
COC is used as a discounting rate in DCF analysis.
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RELEVANCE OF COC
•Used as a hurdle rate in DCF analysis.
•Wt. Average cost of capital
•Marginal cost of capital
K0 = Ki + Ke
K0 = WT. Average cost of capital
Ki = Cost of debt capital
Ke = Cost of equity capital
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COST OF CAPITAL
Consists of three components:
•Risk less cost of a particular type of finance (rj)
•Business risk premium(b)
•Finance risk premium(f)
K0 = rj + b + f
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RELATIONSHIP BETWEEN WEIGHTED AVERAGECOST AND MARGINAL COST OF CAPITAL
•Degree of leverage
•Cost of instruments
•Tax Rate / Treatment
WACOC : K0 = Ki1 + Ke1
MCOC : K0 = Ki + Ke1
METHODS OF COMPUTATION OF COST OF
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METHODS OF COMPUTATION OF COST OFEQUITY
ROI approach
Ke = PAT - pref. div + non tax shield portion of depn
Equity block (E + R +S + acc depn)
Market capitalisation approach
Ke = D/P + G
D = Dividend per share G = Growth rate = b*r
P = Market price per share
b= % Retained earnings = PAT - Dividends / PAT
r = % Return on “b” = PAT - Pref div / Net worth
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Capital Asset Pricing model
Ke = Rf +beta ( Rf – Rm)
Rf = risk free rate of returnBeta = stock relationship with a index
Rm = Market expectations of return ( Bloomberg base )
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•If ROI approach is used to determine Ke then book value to be
considered as weights.If market capitalization approach is usedthen market value to be considered as weights.
•All cost to be considered on a post tax basis.
•The market capitalization approach is superior to the ROIapproach since the parameters are market determined andfuturistic as compared to the ROI approach.
•The CAPM approach is a further refinement which also includes premium for risk
•In loss making companies minimum cash flow approach is used.
•Cost of equity could be benchmarked with return onguilts,market risk and portfolio risk ( Asset Beta )
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WORKING CAPITAL MANAGEMENT
Objective: Optimise current asset deployment.
Advantages: Lower interest cost.Inventory holding cost reduced.
Disadvantages: Interruption in production.Stock out to customers.
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WORKING CAPITAL
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WORKING CAPITAL
Current assets comprise of stocks of raw materials, work in progress,finished goods, and receivables.
Gross working capital = total current assets.
Net working capital = CA - CL
Objective is to optimse asset requirement and funding the same at
minimal cost.
Working capital
requirementPermanentcomponent
Variable
component )
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OPERATING CYCLE TIME
Time required for rolling or rotation of current assets.
Date of receipt RM issued to Throughput time
of RM production Dept
Collection of Despatched to consumers Converted to FG
Receivables
FACTORS INFLUENCING WORKING CAPITAL
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FACTORS INFLUENCING WORKING CAPITALREQUIREMENTS
• Nature of business
•Manufacturing process
•Competitive forces in raw material & finished goods segment.
•Infrastructural support.
•Through put time
•Seasonality in demand
•Shelf life of RM / Finished product
•Customer relationship management
CREDIT MANAGEMENT
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CREDIT MANAGEMENT
•Terms of payment Cash against delivery
Consignee basis
Proforma invoice
Letter of creditAdvances
Suppliers / Buyers LOC
•Credit policy variables Credit standards
Credit period
Cash Discounts
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•Credit evaluation Character
Capacity
Capital
Collateral
Macro conditions
•Control of accounts Days sales outstanding
receivables Ageing schedule (in days)Collection matrix
Average collection period
RECEIVABLES MANAGEMENT
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RECEIVABLES MANAGEMENT
•Credit standards Collection cost
Average collection period
Bad debts
Level of incremental sale•Credit terms
•Collection policies
•Factoring
CASH MANAGEMENT
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Cash budgets : Quarterly / monthly / weekly
Operating cash inflow/ outflow items:
Cash inflow Cash outflow
Cash sales Accounts payable
Collection of receivables R.M purchase
Salary
factory expenseAdministration/selling exp.
Taxes / Duties
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WORKING CAPITAL FINANCING
•Cash accruals
•Trade credit
•Commercial bank borrowings
Cash credit limit
WCTL
Bill discounting
Letter of credit
Bank guarantee
•Public deposits
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•Short term / medium term loans from FI’s Banks
•Debentures for working capital
•Commercial Paper.•Euro Commercial Borrowings
•Inter Corporate deposits
•Trade credit notes ( commodity exchanges )•Factors
RBI CREDIT AUTHORISATION SCHEME
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1969 Dahejia committee .. recommended nationalisation of
banks
1974 Tandon committee
To curb excessive credit and inflation
•Industry wise norms for eligible current assets.
•MPBF to be determined on the basis of following:
Method 1: 5% of (CA-CL) to be financed from LTSBalance would be MPBF.
Method : 5% of CA to be financed from LTS fromthe balance CL to be deducted to
determine MPBF .
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Method 3: 5% of core current assets from LTS .
•All borrowers were immediately put under method 1 of lending andexcessive CBB converted into WCTL.
•Structured reporting to banks.
•Penal interest provisions.
FAST TRACK APPROCH
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•Credit monitoring arrangement (CMA) instead of CAS.
• Norms for Eligible current assets for computing MPBF will be the industry average.
• No prior approval of RBI required.
•Lesser dependence on bank finance.
1997: Concept of maximum permissible bank finance (MPBF)abolished to ensure efficient credit delivery mechanism ”
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Implications:
Banks free to determine credit limits
Consortium finance abolished
Tandon method - (CR > 1.33) diluted .
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Projected Balance Sheet Method
Applicable to all borrowers engaged in manufacturing,services and trading activities whose fund based limit is inexcess of rs 5 lacs and below rs 00 lacs.
Under the PBS method ,assessment of working capital will be carried out in a flexible manner with examination of allrelevant parameters and the borrower will submit the sameas per the following forms:
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Projected Balance Sheet Method
• Form 1 : Particulars of existing Long / short termdebts,borrowings from NBFC’S ,ICD’,Leasing etc
• Form : Operating statements
• Form 3 : Analysis of balance sheet
• Form 4 : Comparative statement of CA/CL.
• Form 5 : Fund flow statement.
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Cash Budget Method
• Used for assessing WC requirements of seasonal industries andconstruction activities.
• The required finance is quantified from the projected cash flows andnot from projected values of assets and liabilities
• Assessment of the cash budget,projected profitability,liquidity,Leverage and fund flow are done.
• The cash budget analysis is also used to sanction adhoc workingcapital limits.
• WC limits are determined on the ‘Cash Gap’ .• Takes into consideration fluctuations in fund requirement over a
period of time.No strict norms for inventory levels.Temporaryslippage's allowed.
Long Term Financing
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Long Term Financing
Basis of evaluation
Availability
•Flexibility
•Cost
Availability : should be available at the point / time when requiredFlexibility : certain instruments are user/ application specific
Cost : to be evaluated on a post tax basis
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SOURCES OF TERM FINANCE
•Term loans from all India financial institutions
•State level financial institutions
•Debentures: NCD
PCD
OFCD
•Fixed Deposits
•Equity share capital
•Equity share capital with differential rights as to dividend,voting or otherwise
•Preference share capital
•Mutual Funds
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•Retained earnings
•Exchangeables•Venture Capital
•Deferred payment gurantees
•Leasing
•External commercial borrowings
•Depository receipts
•Floating interest rate Debt.
•Securitisation of future receivables
•Derivative linked bonds
FINANCIAL / INVESTMENT INSTITUTIONS
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They are major source of long term debt funds for financing:
•Fixed Assets
•Margin money for working capital
Indian FI’s
IDBI / ICICI / IFCI / IIBI
Foreign Institutions
Sectoral Institutions
HDFC / IL&FS / HUDCO / IDFC
Universal Banks
ICICI Bank
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Investment institutions
GIC & Subsidiaries
UTI
LIC
Investment Banks• 3 State level financial institutions (IDC’s)
• 3 State level financial institutions (MSFC)
SFC’s can fund upto 90 LacsSIDC’s can fund upto 150 Lacs
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Features: Interest rate is based upon the primelending rate + project risk.
Basic interest rate linked to inflation rate
Project risk / company risk depends on the credit-rating.
Security Hypothecation & mortgage
Collateral
Covenants
Moratorium period
Repayment schedule / Amortisation schedule
Convertibility option only in the event of default.
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GUIDE LINES FOR KEY RATIOS
DCSR > 1.8 TIMES
D/E 1:5:1
Promoters contribution : 0 - 5%
CR: > 1.33
Banks
Participate in Long term financing on conditions similar to FI’showever are able to offer funds at lower cupon rates.
Debentures:
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•Approval from SEBI mandatory if public issue is proposed
•Debentures used to finance margin money not to exceed more than0% of N.W.C
•Convertibility clause terms to be specified at issuance time.
•Credit rating mandatory
•Types of Debentures:
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NCD
FCD
PCDOCD
•Coupon rate depends on terms of issue.
Other features
• No TDS for interest paid upto Rs 500 per annum
•Redemption premium
•Listing on stock exchanges
•Fully secured
•Call and put options
Advantages from Issuer’s point of view:
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•Lower cost due to low risk and tax deductibility of interest payment.
• No / limited dilution of control•Offer stable return to investors having fixed maturity
and subsequently redemption/ conversion to equity
• No increase in equity base during non conversion period
Fixed deposits
•Limit on quantum : 5% of networth
•Cost : 8-11% depending on maturity period & risk
•unsecured
EQUITY SHARE CAPITAL
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•Authorised , issued, subscribed and paid up
•Par value, issue price, book value, market value
•Residual claims on Income /Assets
• No upper limit•Costliest sources of finance
•Entails permanent servicing by way of dividends without taxshield
•Voting rights/ Control in management/ Limited liability
•Under preview of SEBI and SEB guidelines
•Buy Back allowed
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Equity investments in foreign cos allowed to resident indian
shareholder in the event foregin co has 10% stake in indian co.•For Listing on exchanges atleast 10% to be offered to the public
by way of a prospectus
Issuance of Non-Voting & differential rights shares allowed
•Debentures on conversion becomes equity share capital.
•For Listing on BSE/ NSE the paid up Equity capital should be atleast Rs 10 Cr. and for the other exchanges atleast Rs5 Cr
EVALUATION OF ESC
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EVALUATION OF ESC
Company’s point of view
AdvantagesRepresents almost permanent capital
Does not involve any fixed obligation for servicing
Enhances credit worthiness of the company to secure additionaldebt.
Disadvantages
High cost of capital
Dividends paid on profit after tax further subjected to dividenddistribution tax of 1 .5%
High flotation cost
Dilution of control (Treasury issue)
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Retained earnings
Made up of Accumulated depreciation and retained profits.
Represent the internal sources of finance available to thecompany.
Availability : Level of profitability / payout ratio
Cost : Identical to ESC.
Flexibility : High
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Disadvantages
High opportunity costLimitation on amount
Bonus issue may capitalisereserves
Advantages
Reinvestment of profit may be convenient to many shareholders.
No dilution of control since Co. Relies on retained earnings
No flotation cost/ Losses on account of underpricing.
Proceeds could be used in a subsequent buyback.
.
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Leasing
Ownership of asset with lessor (depreciation to be claimed belessor)
Wet leasePromoters contribution not necessary
Off balance sheet item (borrowing power unaffected)
Flexibility in lease rentalsLease rent (principle + interest) is tax deductive).
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CAPTAL BUDGETING
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•Capital investment decision
Capital investments involve increase in the fixed assets of a
company.(Expansion / diversification / Green field / takeover / merger)
•Characteristics of investments
Capital outlay needs to be made up front returns come later
Certain amount of risk is involved
Capital investment tend to be indivisible. (difficult to phase out).
•Financial techniques
The purpose of financial techniques is to enable the making of investment acceptance / rejection decisions.
Non financial factors in project appraisal
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Market
Technical
Infrastructure
Ecological
Economic
Influence of non - financial factors
Financial projections
Gestation period
Profitability
Life of project / Terminal value
Sensitivity analysis
NON FINANCIAL FACTORS DETERMINING
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NON FINANCIAL FACTORS DETERMINING
FINANCIAL VIABILITY OF PROJECTS
Market factors
Present and future size of the marketPresent and future demand and supply situation
Achievable market shareSelling & distribution channels
Technical factors
Level of Technological obsolence
Plant locationScales of operation
Raw material & utilities consumption norms
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Ecological factors
Pollutant levels
Treatment of effluent
Environmental impact of the project
Economic factors
Social cost benefit analysis
Economic rate of protection
Domestic resource cost
Protection enjoyed by industry.
FINANCIAL TECHNIQUES IN CAPITALBUDGETING
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BUDGETING
Return on investment
AVG ROI = PBIT
(over 10 yrs) Total Inv.
Advantages
Simple to calculate and easy to understand
Maximisation of shareholders wealth and maximising the market value of investments.
.DisadvantagesTime value of money not considered
It is a concept based on profit and not cash
No objective criterion for acceptance / Rejection decision.
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Payback period
It is the time required to get back the original investmentcompanies going through liquidity crisis /for small investments willuse the pay back period method.
Disadvantages
Cash inflows / Outflows after payback Period are ignored.Time value for money is ignored
Discounted cash flow (DCF)
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Discounted cash flow (DCF)
Cash inflow and outflow for the entire life of the project isconsidered.
It considers time value for money as a result earnings in earlier years have higher value than earned in later years.
IRR Method
IRR is that rate of discount at which the net present value of cashflows equals net present value of cash outflows.
If IRR > COC Investment is support worthy.
NPV method
Using COC discount the netflows
If NPV is + VE investment is support worthy. .
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Comparison of elementsElements Payback NPV IRR
Net investment. Comparable comparable Comparable
Subsequentinvestment
Possible to userough approx.
Exact timing Exact timing
Recovery of terminal value
Not Possible Specificeconomic impact
Specificeconomic impact
Accounting profit
Roughapproximation
Not relevant Not Relevant
Operating cashflow
Approximationof pattern
Not relevant Not relevant
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CONCEPTS IN CAPITAL BUDGETING
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•Life of project
Physical
Market
Techno efficient
•Incremental principle
Sunk / Allocated costs to be ignored
Only incremental cash flows to be considered
•Evaluation of post tax basis since COC is on a post tax basis
•Principle of separation of “Finance” from “Investment “ decision.
Financing cost (interest) to be ignored.
•Effect of tax shield on the company as a whole to be considered
PROJECT COST COMPONENTS
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Land
Civil Construction
Plant & Machinery
Misc Fixed Assets
Erection and commissioning
Technical Know how fees
Preliminary & preoperative expenses
Contingencies
Total Capital Cost
Margin money for working capital
Total project cost
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PROJECT CASH FLOWS
Cash outflows Capital expenditureMargin money
Normal capital expenditure
Cash inflow Net cash accruals
Salvage value
Recovery of WC
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NPV vs IRR conflict
• NPV is technically superior to IRR and is also able to handleselection of mutually exclusive projects.
• The decision rule for the NPV assumes that cash flows resultingduring the life cycle of the project have an opportunity cost equal tothe discount rate used.
• The decision rule for the IRR assumes that such resulting cash flowshave an opportunity cost equal to IRR which generated them.
• NPV approach provides an absolute measure that fully represents the
value from the project to a company.• IRR by contrast provides a % figure from which the benefits in
terms of wealth creation cannot be grasped.
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Capital Budgeting Sensitivity Analysis
• Monte Carlo Simulation
• Break even analysis
• Decision tree analysis
• Expected value Criterion
• Under different scenarios
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Share holder value creation
• Cash Dividends• Stock Dividends• Bonus Shares
• Bonus Debentures-issued from free reserves• Equity Buy back / Secondary Listing• Stock Split• Synergic Investments• Synergic Acquisitions• Disinvest out of unrelated businesses• Shares of holding co. with fungibility
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DIVIDEND STRUCTURING
Appropriation of PAT towards Dividend pay out and Reserves
Payout ratio = Dividend paid / PAT
Retention ratio = PAT - Dividend paid / PAT
Dividend rate (%) could be high but payout could be low.
Dividend rate will be depended upon the PAT, Payout ratio andEquity base.
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Factors influencing dividend policy
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Factors influencing dividend policy
•If the appetite for funds is high due to increase in level of exsistingoperation or due to major capital investment plan then a highretention policy will be adopted.
•A closely held company having major capital investment planswill follow a low pay out policy so that internal accruals could actas a major source of finance in the future thereby reducingdependence on infusion of fresh equity.
•Tax implications
Company has to pay 1 .5% distribution tax.Recipient of dividendtax exempted in the shareholders hands..
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•Restriction in loan agreement / government regulations / FI’s onon payment of dividend during the currency of the loan.
•Legal requirement under Companies act.
•Liquidity position : Higher PAT does not necessarily meanhealthy liquidity. A strained liquidity position would force a policyof low payout.
•Stability in the rate of dividend : companies usually follow a policy of gradually rising or stable dividend policy and not directlylink it with PAT.
•Generally the Indian corporate sector follows a payout policy of 30% . The retention ratio keeps increasing so as to counter inflation, floatation cost, help in Equity buyback etc.
BONUS SHARESBonus share are issued to existing share holders as a result of
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Bonus share are issued to existing share holders as a result of capitalization of reserves.
In the wake of a bonus issue
The shareholders proportional ownership remains unchanged
The book value, market price, E.P.S decreases.
Fallout of a bonus issue
• Normally the Ex-bonus price comes down by the proportion of bonus given with a mark up of approximately 30 - 35%•More active trading in stock exchanges.
•The nominal rate of dividend tends to decline this may dispel theimpression of profiteering.•Shareholders regard a bonus issue as a firm indication that the
prospects for the company are good.•Capital gains tax exemptions with indexation available for bonusissue
GUIDELINES FOR ISSUE OF BONUS SHARES
I S it h g b d f I di
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Issuer : Security exchange board of India
Bonus issue should be made from capitalisation of free reserves
built out of genuine profits and share premium.Reserves created byrevaluation of assets, statutory reserves etc. are not allowed for capitalisation
Bonus issue greater than 1:1 allowed
Residual reserve test: residual reserves after the proposedcapitalisation should be at least 40% of the increased capital For computation all contingent liabilities, statutory reserves andrevaluation reserves to be excluded.
Yield test: 30% of the average P.B.T for the last 3 years shouldgive a return of at least 10% on the enhanced capital.
Bonus in lieu of dividend is not permitted