ACAD-EDGE

EDITION 3
Corporate Finance
Table of Contents
Investment Decision ................................................................................................................................................ 3
Capital budgeting ................................................................................................................................................. 3
Weighted Average Cost of Capital (WACC) ................................................................................................. 3
Capital Budgeting Methods ............................................................................................................................ 4
EXCEL Notes ............................................................................................................................................................ 7
Cash Flow Estimation .......................................................................................................................................... 8
Cash Flow Estimation for Expansion Projects ............................................................................................. 8
Cash Flow Estimation for Replacement Projects ......................................................................................... 9
Mutually Exclusive Projects with Unequal Lives .......................................................................................... 9
Risk Analysis and Optimal Capital Budget ...................................................................................................... 11
Types of Project Risk..................................................................................................................................... 11
Working Capital Management .......................................................................................................................... 11
Financing Decisions ............................................................................................................................................... 13
Capital Structure ................................................................................................................................................ 13
Cost of Equity ................................................................................................................................................. 13
Cost of Debt .................................................................................................................................................... 14
Sources of Capital ......................................................................................................................................... 15
Risk ...............................................................................................................................................................................16
Business Risk:................................................................................................................................................ 16
Financial Risk ................................................................................................................................................. 17
Degree of operating leverage (DOL): .......................................................................................................... 17
Degree of Financial Leverage (DFL): .......................................................................................................... 17
Degree of total leverage (DTL) ..................................................................................................................... 18
Theories of Capital Structure ................................................................................................................................ 18
Net Income Approach ........................................................................................................................................ 18
Net Operating Income Approach ..................................................................................................................... 19
Modigliani Miller Theory .................................................................................................................................... 19
Traditional Theory .............................................................................................................................................. 19
Dividend Decision .................................................................................................................................................. 20
Dividend Policy ................................................................................................................................................... 20
Dividend Irrelevance Theory ............................................................................................................................ 20
Bird-in-the-Hand Theory ............................................................................................................................... 20
Tax Preference Theory ................................................................................................................................. 20
Information Content or Signalling Theory ................................................................................................... 21
Clientele Effect ............................................................................................................................................... 21
Residual Dividend Model .............................................................................................................................. 21

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 Investment Decision
Investing decisions are the decisions relating to the asset composition of the firm.
Assets represent investment or uses of the funds that the firm makes in expectation of
earning a return for its investors. Broadly these assets can be long term/fixed assets or
current assets. Thus, we have two branches under this. Capital budgeting for fixed
assets and working capital management for current assets.
Capital budgeting decision are often considered more crucial. They have a direct
bearing on the long-term profitability of the business, are irreversible in the short run
and involves huge amount of cash. The main idea under this decision to invest projects
which gives return greater than the cost. We use different methods to evaluate a project
or asset like net present value, internal rate of return, payback period etc.
Factors like the risk involved in the project which is reflected in the rate of return and
the amount of cash flow that it will help generate are two most important factors
affecting our decision.
Working capital deals with management of current assets which might not contribute
directly towards earning but their existence is necessary for efficient and optimum
utilization of fixed assets. It includes cash management, inventory management, and
receivables management.

Capital budgeting
Capital Budgeting (or investment appraisal) is the planning process used to determine
a firm's long-term investments such as new machinery, replacement machinery, new
plants, new products, and research and development projects.

It involves the following major steps-

1. Estimate the cost of capital
2. Forecast the project cash flows
3. Use one of the capital budgeting techniques to determine the feasibility of the
project.

Importance of capital Budgeting

1. Firstly, the capital resources available to a firm are limited, and the success of a
firm largely depends on how well it uses the limited resources available to it.
Capital Budgeting helps a manager to select the most profitable avenues for the
investment of the scarce resources of the company
2. Secondly, Capital budgeting is usually used in evaluating Capital projects, which
are Long-term investment projects requiring relatively large sums to acquire, develop,
improve, and/or maintain a capital asset (such as land, buildings, dykes, roads). The
outlays on these projects can be so big that the future of corporations may be decided
by capital budgeting decisions. Reversal of capital budgeting decisions cannot be done
at a low cost; hence mistakes in the selection of capital projects can be very costly.
3. Thirdly, many other corporate decisions also have scope for the application of
capital budgeting principles, as adopted for the specific case. Examples of such areas
of application are investments in working capital, mergers and acquisitions, leasing
and bond refunding.

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 4. Fourthly, the valuation principles in capital budgeting are quite similar to those
used in portfolio management and security analysis. Thus, the diverse use of capital
budgeting methods extends to these areas also.
5. Fourthly, the focus of capital budgeting is on ultimately maximizing shareholder
value. Thus, correct capital budgeting decisions have payoffs for a number of
stakeholders in the company.

Basic Capital Budgeting Principals

- Cash flows are the basis for decisions. Accounting concepts, such as net income,
are not the basis for decisions.
- Timing of cash flows is crucial due to the fact that provided money can earn
interest, any amount of money is worth more the sooner it is received.
- Cash flows are based on opportunity costs. Here we consider what the increase in
cash flows is due to the investment, with respect to the cash flows without the
investment.
- Cash flows are adjusted for tax payments, i.e. after-tax cash flows are taken.
- Financing costs are not accounted for: A company can finance its Capital projects
from various sources. The major sources are Debt and Equity. Each of these
different sources has a cost of raising and using the funds associated with them.
However, while evaluating capital projects, we do not take them into account.
Instead, the operating cash flows are focused on and the costs of debt (and other
capital) are reflected in the discount rate (explained below)
- Cash flows are recorded only when they actually occur and not when work is
undertaken or a liability is incurred.

Process of capital budgeting

We will try to understand this process while using an example. Suppose a firm XYZ &
Co. has enough funds and now has decided to invest in Capital projects. The process it
will follow is:

Step One: Generating Ideas- Generation of investment ideas can be from anywhere.
All levels of the organization- from the top to the bottom, from departments to
functional areas- can contribute by generating fresh investment ideas. Ideas can also be
generated from outside the company. In our example, the firm can increase its existing
production capacity, expand its product line by setting up an additional factory, invest
in some other business, etc

Step Two: Analyzing Individual Proposals- In the next step XYZ & Co. would gather
adequate, reliable information in order to first forecast future cash flows from each
proposed project and then evaluate their profitability. In this stage, the non-profitable
proposals are screened away and the remaining are moved on to next stage

Step Three: Planning the Capital Budget- Next, the profitable proposals are organized
after taking into account two key considerations:

- The match between the proposal and the company’s overall strategic objectives,
- The duration and timing of the project.

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 Since companies have various financial and other resource constraints, the proposals
usually have to be scheduled on a priority-basis.

Suppose XYZ & Co. identifies two potential profitable investments as investing in a
different business and expanding its existing production facility. The option of
investing in a different business is forecasted to generate a better profitability, but the
money would be locked in for a long period and one of the company’s goals is to
become a market leader in its existing market. In such a situation, the option of
expanding its existing production facility would be ranked highest and undertaken
first.

Step Four: Monitoring and Post-auditing- Post-auditing capital projects are as

important as selecting and implementing them. Firstly, it serves to monitor the analysis
and forecasts that the capital budgeting process is based on. Overly optimistic forecasts
can be detected and such systematic errors rectified. Secondly, the negative deviation
between actual performance and expectations can be corrected by taking adequate
measures, wherever possible, which in turn improves business operations. Lastly,
sound ideas for future investments may be evolved during post-auditing current
investments.

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of
capital. This has been used by many firms in the past as a discount rate for financed projects, as
the cost of financing (capital) is regarded by some as a logical discount rate (required rate of
return) to use. Weighted Average Cost of Capital is the minimum return a firm must earn on
existing assets to keep its stock price constant and satisfy its creditors and owners.
Corporations raise money from two main sources: equity and debt. Thus, the capital structure of
a firm comprises three main components: preferred equity, common equity and debt (typically
bonds and notes). The WACC takes into account the relative weights of each component of the
capital structure and presents the expected cost of new capital for a firm.

WACC =𝑾𝒅 (𝟏 − 𝒕) ∗ 𝑹𝒅 + 𝑾𝒆 ∗ 𝑹𝒆 + 𝑾𝒑 ∗

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where,
Wd = Weight of debt portion in value of corporation t = Tax Rate
Rd= cost of debt (rate)
We = Weight of equity portion in value of corporation Re= cost of internal equity (rate)
Rp= cost of Preference Shares (rate)
Wp = Weight of preference portion in value of corporation

When is the WACC the appropriate discount rate for evaluating a proposed investment
project?

Example: A firm is considering a project that costs $28 million and will result in initial after-tax
cash savings of $5 million at the end of the first year. These savings will grow at the rate of 5%
per year. The firm has a D/E ratio of 0.5, a cost of equity of 29.2% and a cost of debt of 10%.
The firm is in the 34% corporate tax bracket. The cost- saving proposal is closely related to the
firm's core business, so it is viewed as having the same risk as the overall firm. Using the NPV
investment rule, should the firm take on the project?

V D
= +1
E E
Hint: V = D + E. this implies

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 Why are financing costs not included in project cash flows?

Financing cost is irrelevant in determining relevant costs for capital budgeting. The
definition for a relevant cost is: Any future cash flows that are incurred due to accepting the
project. As financing costs (interest expenses, coupons, etc) may be incurred due to accepting
the project we do not include them in operating cash flows rather they will usually enter the
NPV calculation via the r. Here is a simple example how the WACC accomplishes this
function.
Market Values ($’s)
Project Value 200 75 Debt (D)
125 Equity (E)
200 Project Value

The project generates perpetual after tax cash flows of $20 which are similar in risk to the
existing business, the return on equity is 12.83%, the return on debt is 8% and the marginal tax
rate is 34%. First calculate the NPV of the project assuming the new project will not alter the
existing firm capital structure.
125 75
WACC = 0.1283 + 0.08(1 − 0.34) = 0.1000
200 200

NPV = −200 + 20
=0
0.1000

You are indifferent to investing in this project (in other words you have the breakeven r) but
how does the return to shareholders on this project relate to the return on equity?

184

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 Calculate the expected dollar return to the shareholders. The expected equity income is
the yearly cash flow minus the tax shield of debt.

Exp(equityincome) = C − DrD (1 − C ) = 20 − (75)(0.08)(1 − 0.34) = 16.04

16.04
E(equityreturn) = = 0.1283
125

You can see that the return on equity and the E(equity return) are the same. So, the
interest expense is accounted for in the WACC, not the operating cash flows and at the
breakeven r, the two returns on equity are identical.

Capital Budgeting Methods

Many formal methods are used in capital budgeting, including the techniques such as:

Payback Period
It is the number of years it takes to recover the initial cost of the project. You must be given a
minimum number of years for a project to be accepted. This criterion ignores the time value of
money and any cash flows beyond the payback period.

For Example: If we look at a project that has net cash flow as depicted in the table below,

We can calculate the cumulative cash flow as shown in the table below.

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From this table we see that we are able to recover our investments somewhere in the 5th year.
The exact time during which the invested amount is regained can be calculated by assuming the
cash flow to be uniformly distributed across the year as shown below.

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 Discounted Payback Period

The discounted payback period partially addresses the shortcomings in the payback period
method. It takes the cumulative discounted cash flows from the project into consideration while
calculating the number of years it takes to recover the original investment. Thus, it takes the
time value of money and risk of the project into account, but this method also ignores the cash
flows that occur after the discounted payback period is reached. For a project with negative
NPV, there will not be any discounted payback period since it never recovers its original
investment. The discounted payback period must be greater than the payback period without
discounting.
It is the number of years it takes to recover the initial investment in present value terms. The
discount rate used is the project’s cost of capital. This method incorporates the time value of
money but still ignores any cash flows beyond the discounted payback period.
For Example, In the case given above if we take the discount rate to be 10%, the discounted
cash flow is given as
Cumulative
Year Cash Flow Discounted Cash Flow
CF
0 $(5000) $(5000) $(5000)
1 800.00 727.27 (4272.73)
2 900.00 818.18 (3454.55)
3 1500.00 1363.64 (2090.91)
4 1200.00 1090.91 (1000.00)
5 3200.00 2909.09 1909.09

= 4 + 1000/2909.09
= 4.343

Net Present Value (NPV)

NPV is an indicator of how much value an investment or project adds to the value of the firm.
Each cash inflow/outflow is discounted back to its PV. Then they are summed. It can be

Calculated according to the formula,

Where
t - time of the cash flow
n - total time of the project
r - discount rate (the rate of return that could be earned on an investment in the financial markets
with similar risk.)
CFt - the net cash flow (the amount of cash) at time t.
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With a particular project, if NPV is a positive value, the project is in the status of discounted
cash inflow in the time of t. If NPV is a negative value, the project is in the status of discounted
cash outflow in the time of t.

Appropriately risked projects with a positive NPV are acceptable. This does not necessarily
mean that they should be undertaken since NPV at the cost of capital may not account for
opportunity cost, i.e. comparison with other available investments. In financial theory, if there
is a choice between two mutually exclusive alternatives, the one yielding the higher NPV
should be selected. The following sums up the NPVs in various situations.

If NPV > 0
It means the investment would add value to the firm and the project may be accepted.

If NPV < 0
The investment would subtract value from the firm. The project should be rejected.

If NPV = 0
The investment would neither gain nor lose value for the firm. We should be indifferent in the
decision whether to accept or reject the project. This project adds no monetary value.
Decision should be based on other criteria, e.g. strategic positioning or other factors not
explicitly included in the calculation. However, NPV = 0 does not mean that a project is only
expected to break even, in the sense of undiscounted profit or loss (earnings). It will show net
total positive cash flow and earnings over its life.

EXAMPLE: Suppose a company is considering an investment of $70 million in a capital

project that will return after-tax cash flows of $20 million per year for the next three years
plus another $30 million in year 4. The required rate of return is 10 percent.

Here, the NPV would be

NPV= 20/1.1 + 20/1.1^2 +20/1.1^3 + 30/1.1^4 – 70

= 70.2274 – 70 = $0.2274 million.

Thus the investor’s wealth is expected to increase by a net of $0.2274 million. This
indicates the decision rule for NPV:

Invest if NPV > 0

Do not invest if NPV < 0

Positive NPV investments increase investor wealth whereas negative NPV investments
decrease it. Many investments have cash outflows that occur not only at time zero, but also
at future dates. In this case, all cash outflows are taken as negative inflows and discounted

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at the required rate of return just as in the case of positive cash inflows at different points
of time.

Internal Rate of Return

The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether
they should make investments. It is an indicator of the efficiency of an investment (as opposed
to NPV, which indicates value or magnitude). The IRR is the annualized effective compounded
return rate which can be earned on the invested capital, i.e. the yield on the investment.
A project is a good investment proposition if its IRR is greater than the rate of return that could
be earned by alternative investments (investing in other projects, buying bonds, even putting the
money in a bank account). Thus, the IRR should be compared to an alternative cost of capital
including an appropriate risk premium.
Mathematically the IRR is defined as any discount rate that results in a net present value of zero
of a series of cash flows.

To find the internal rate of return, find the IRR that satisfies the following equation:

Where,
n- total time of the project
CFi-Cash flow generated in the ith year
IRR – Internal Rate of Return to be calculated

The IRR method should not be used in the usual manner for projects that start with an initial
positive cash inflow (or in some projects with large negative cash flows at the end), for example
where a customer makes a deposit before a specific machine is built, resulting in a single
positive cash flow followed by a series of negative cash flows (+ ). In this case the usual, IRR
decision rule needs to be reversed.

In the above example given for NPV, the IRR is the discount rate that solves the following
equation:

Algebraically, this equation would be very difficult to solve. Normally, trial and error
method is resorted to, systematically plugging various discount rates until one, the IRR,
satisfies the equation. But financial calculators and spreadsheet software have routines that
calculate IRR easily, so the trial and error method can be avoided. The IRR is 10.14
percent here.
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 The decision rule for the IRR is to invest if the IRR exceeds the

required rate of return for a project:

Invest if IRR > r

Do not invest if IRR < r

Profitability Index
Profitability index identifies the relationship of investment to payoff of a proposed project. The
ratio is calculated as follows:
Profitability Index = (PV of future cash flows) / (PV Initial investment)
Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value
Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it
allows you to clearly identify the amount of value created per unit of investment, thus if you are
capital constrained you wish to invest in those projects which create value most efficiently first.
NB Statements below this paragraph assume the cash flow calculated DOESN'T include the
investment made in the project. Where investment costs are included in the computed cash flow
a PV>0 simply indicates the project creates more value than the cost of capital which is
determined by the Weighted Average Cost of Capital (WACC).
A ratio of one is logically the lowest acceptable measure on the index. Any lower value would
indicate that the project's PV is less than the initial investment. As values on the profitability
index increase, so does the financial attractiveness of the proposed project. Rules for selection
or rejection of a project:
If PI > 1 then accept the project if PI < 1 then reject the project.

PI indicates nothing but the value received when we invest one unit of currency. Although the
PI not used as often as the NPV and IRR, it is sometimes considered better for Capital
Rationing; because unlike NPV, it takes the size of the project also in account. Therefore it is a
useful tool for ranking projects because it allows you to quantify the amount of value created
per unit of investment.

EXCEL Notes

Calculation of NPV in Excel

Function- NPV (rate, value1, [value2],…)
Rate - The rate of discount over the length of one period.
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Value- Each cash flow is to be specified at the end of the period over which the discount rate r
applied. The values of cash flow should be in chronological order.

Remarks-
• If there is an additional cash flow at the start of the first period, it should be added to the
value returned by the NPV function.
• The primary difference between PV and NPV is that PV allows cash flows to begin
either at the end or at the beginning of the period. Unlike the variable NPV cash flow
values, PV cash flows must be constant throughout the investment.
• If an argument is an array or reference, only numbers in that array or reference are
counted. Empty cells, logical values, text, or error values in the array or reference are
ignored.

Calculation of IRR in Excel

IRR (values, [guess])

Values- An array or a reference to cells that contain numbers for which you want to calculate
the internal rate of return. Values must contain at least one positive value and one negative
value to calculate the internal rate of return. IRR uses the order of values to interpret the order
of cash flows.

Guess- An optional parameter which takes a number as input that you guess is close to the
result of IRR.

Remarks
• Since the process of finding IRR is an iterative one, the guess value is taken as the
starting point. If no argument is provided, the guess starts at 10% IRR.
• IRR cycles through the calculation until the result is accurate within 0.00001 percent. If
IRR can't find a result that works after 20 tries, the #NUM! error value is returned.

Cash Flow Estimation

The key topics here are the definitions of cash flow and the basic computations for expansion
and replacement projects. For either type of project we need to calculate the initial outlay (at t
= 0), the annual incremental after-tax operating cash flows (t = 1... n), and any additional
terminal year cash flows (t = n).

Cash Flow Estimation for Expansion Projects

For an expansion project, the cash flows need to be considered under the following three heads-

1) Net initial outlay – this may include the following-

1. Purchase Price,
2. Transportation and installation costs,
3. Additional costs such as training,
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 4. Required increase in net working capital.

2) Annual after-tax operating cash flows (OCF)

This needs to be calculated for each year of operation apart from the terminal year and for the
terminal year as well. This is done as-

Operating Cash Flow for Project Life- Incremental revenue

- Incremental costs
- Depreciation increase on project Incremental
earnings before taxes
- Tax on incremental EBT Incremental
earnings after taxes
+ Depreciation increase Annual Operating Cash
Flow

3) Terminal Year Non-Operating Cash Flow-

For calculating the terminal year non-operating cash flow, add the after-tax salvage value of the
assets and any recapture of net working capital to the final year’s after-tax operating cash flow.

Then, by performing one of the capital budgeting techniques, the feasibility of the expansion
project can be evaluated.

Cash Flow Estimation for Replacement Projects

For a replacement project a process similar to the expansion one is to be followed with some
modifications:

1) Initial Outlay
The tax implications of the sale of assets can increase or decrease cash flow. If the sale price is
greater than the carrying cost (book value) of the asset, tax must be paid on the gain and this
decreases the after-tax sale proceeds. If the sale price is less than the book value, then taxes are
reduced (and cash flow increased) by the tax rate times the amount of the loss.

Hence, the initial outlay is calculated in a manner similar to the process in the above case but
the only difference is proceeds of the sale of the existing asset are deducted and taxation on
gains (losses) are added (deducted) Annual after-tax operating cash flows (OCF)
This is calculated according to the method shown in the above case. The change in depreciation
due to the replacement and the incremental income, revenue and taxation values are those
derived out of the replacement rather than expansion.

2) Terminal Year Non-Operating Cash Flow-

Replacement projects apply the same approach as an expansion project.
If the new equipment has an expected life equal to the remaining life of the equipment to be

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replaced, then a positive NPV or IRR> project cost of capital is sufficient to decide to replace
the existing assets.

Some points to remember in estimating incremental after-tax cash flows:

• Ignore sunk costs (any costs that are unaffected by the accept/reject decision).
• Ignore any financing costs associated with asset purchase (financing costs are included
in the project cost of capital or WACC).
• Include any effects on the cash flows for other firm products (externalities).
• Include the opportunity cost (actual cash flows lost) of using any existing firm assets for
the project.
• Shipping and installation costs are included in the initial cost used to calculate the
annual depreciation for new assets.

Mutually Exclusive Projects with Unequal Lives

For mutually exclusive projects with unequal lives the fact that the longer-lived project has a
higher NPV is not sufficient to justify its acceptance. There are two approaches to put the
projects on an equal basis time wise.

1. The replacement chain approach - Assume that the shorter project will be repeated until the
total number of years is equal to the years for the longer project. Let us consider two projects
that have the cash flows as given in the table below-

We project the cash flows as if we repeated the 3-year project at the end of Year 3 and sum the
cash flows to create a 6-year project for comparison as shown in the table below-

We can then directly compare the NPV of the repeated project to the project with an expected
life of six years and accept the one with the greater NPV (as long as the NPV is positive).

2. The equivalent annual annuity (EAA) approach - An alternative to the replacement chain
approach is to convert the NPV for each project into an equivalent annual payment and select
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the project with the greater (positive) equivalent annual payment.

A three-step process is followed to evaluate the two projects under this method-

1. We first determine the net present value of the two projects individually.
2. Taking the negative of net present value as the present value and the future value as 0 for
the given time period and the WACC, we estimate the early cash flows that are known as
equivalent annual annuity.

Another method for calculating the same can be by using the formula for EAA as

𝑟 ∗ 𝑁𝑃𝑉
𝐶=
(1 − (1 +
𝑟)−𝑛)

Where,
C=Equivalent Annuity Cash Flow (EAA)
r=discount rate per period
n=no. of periods
NPV= Net Present Value
3. Compare the EAA values of the two projects and select the one with the higher value of
EAA.

Risk Analysis and Optimal Capital Budget

Types of Project Risk
1) Stand-alone risk - Unique to individual project, standard deviation of the project’s returns
can be used to gauge the significance of this risk.
2) Corporate risk - Project’s contribution to the firm’s total risk, effect on the standard
deviation of the firm’s returns by the particular project
3) Market (beta) risk - Systematic (beta) risk of a project, effect of the project on the firm’s
beta with respect to the market.
Techniques for estimating the stand-alone risk of a capital investment
1. Sensitivity analysis - Involves changing a variable such as sales volume, sales price, an input
cost, or the assumed cost of capital, and recalculating the NPV. The project with the greater
percentage change in NPV for a given variable change is the riskier project.
2. Scenario analysis - Calculate the NPV for “base-case,” worst-case (low sales, low price, etc.),
and a best-case scenario and assign probabilities to each of these outcomes. Then calculate
the standard deviation of the NPV as you would with any probability model.
3. Monte Carlo simulation - Use assumed probability distributions for the key variables in the
NPV calculation, draw random values for these variables and calculate NPV (thousands of
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 times), and use the distribution of NPVs to estimate the expected NPV and the standard

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 deviation of NPV as a measure of stand-alone risk.

Using the SML in Capital Budgeting

When a project’s risk differs from that of a firm’s average risk project, rather than using the
firm’s cost of common equity in calculating the WACC (discount rate) for evaluating a capital
project, we can use the beta of a project. This will generate a WACC (discount rate) that is
specific to the project and is based on the project’s market/beta risk. The project beta can be
estimated by:
1. The pure-play method -Use the beta of a traded single-product company in the same line
of business as the capital project.
2. The accounting beta method - Regress the ROA of similar past projects on the average
ROA for a (market) portfolio of firms to estimate the project beta.

Working Capital Management

Working Capital Management is concerned with the problems that arise in attempting to
manage the current assets, the current liabilities and the interrelationship that exist between
them. The Goal of Working Capital Management is to manage the firm’s current assets and
liabilities in such a way that a satisfactory level of working capital is maintained. This is so
because if a firm cannot maintain a satisfactory level of working capital, it is likely to become
insolvent and may even be forced into bankruptcy. The current assets should be large enough to
cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current
assets must be managed efficiently in order to maintain the liquidity of the firm while not
keeping too high a level for anyone of them. Each of the short-term sources of financing must
be continuously managed to ensure that they are obtained and used in best possible way. This
interaction between current assets and current liabilities is, therefore the main theme of theory
of working capital management.
There are two concepts of Working Capital: Gross and Net
1) Gross Working Capital: It means the current assets which represent the proportion of
investment that circulates from one form to another in the ordinary conduct of business.
2) Net Working Capital: It is the difference between current assets and current liabilities
or alternatively the portion of current assets financed with long-term funds.
Concept of Zero Working Capital
The Zero Working Capital (ZWC) concept of Net Working Capital differs from the commonly
used concept of working capital (CA-CL). The ZWC is given by the formula:

𝑍𝑊𝐶 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠

The rational is that the inventories and receivables are the major constituents of current assets
which affect sales. Further, supplier finance inventories through account payable.
There are financial benefits of reducing the working capital. First, it results in a one-time
release of cash flow. Second, the release of cash flow enhances the firm’s earnings. Put
differently, permanent reduction in working capital funds results in financial cost (savings in
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capital costs). The zero working capital concept forces the corporates to produce and deliver
faster. With low inventories, storage cost as well as loss due to obsolete inventories are also
minimized, leading to another set of savings in operating costs.
Negative Working Capital is it bad?
Whether low or even negative working capital is a sign of alarm or not completely depends
upon the Cash Conversion Cycle of the industry. A lot of times it happens that the Credit Period
availed is much more than the Credit Period given. In this specific business it is possible to
have a negative working capital. But having a negative working capital also depicts an ever-
looming Default Risk. Negative Working Capital is often observed in Industry with negative
cash conversion cycle and especially in conglomerates where one business unit if required can
use the assets of other unit in case of emergency.

Determining the Finance Mix

As we have read above, Working Capital in a way is to determine how the Current Assets shall
be financed. There are three basic approach to determine an appropriate financing mix.
1) Hedging or Matching Approach: Under this approach the Current Assets are classified
into two classes.
a. Those which are required in a certain amount for a given level of operation.
Hence, do not vary over time.
b. Those which fluctuates over time.
The rational is to invest the fixed component from the Long-Term Liabilities and the
variable component from the Current Liabilities.
2) Conservative Approach: Under this approach the estimated part of the current assets is
financed via long term liabilities and the unexpected or emergency component is
financed via Current Liabilities.
3) Trade off between Hedging and Conservative Approach: The two approaches
discussed above have their own limitations and advantages. The hedging approach is
associated with low NWC and High profits but the risk is also high. The Conservative
Approach is associated with high NWC and low profits but the risk is also low.
According to this theory the manager should strike a balance between these two
extremes to arrive at an optimum level of NWC with desirable level of risk and
maximum profitability.

Financing Decisions
Financing decisions deal with the financing pattern of the firm. As firms make decisions
concerning where to invest their resources during investing decisions, they have also to decide
how they should raise resources. Now there are two main sources of financing any firm, the
shareholder’s funds or borrowed funds. The key distinction between these sources lies in the
fixed commitments created by borrowed funds to pay interest and principal amount. They are
always repayable and you need to service them periodically due to which they are less risky and
demands less rate of return vis-à-vis your shareholders fund. They contribute towards
increasing the financial risk of the firm and therefore in spite of being cheaper, a firm never
goes for 100% debt.
Shareholder’s funds include equity, preference and the accumulated profits. Preference share
has lesser risk compared to equity due to repayment of capital and right to dividend before

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equity.
Thus, financing decision takes into account the cost of raising funds from different sources and
then on the basis of that decides an optimum capital mix of debt-equity for the firm so that their
overall cost of capital can be minimized. Also, they use cheaper source of funding like debt to
trade on equity which is possible only when my ROI > cost of debt.

Capital Structure
Capital Structure refers to some combination of equity, debt and hybrid securities that is used to
finance a company’s assets. A firm's capital structure is then the composition or 'structure' of its
liabilities.

Optimal Capital Structure:

The optimal capital structure is that proportion of debt and equity capital that do both of the
following:
• Minimize the weighted average cost of capital.
• Maximize the firm’s stock price

Cost of Equity

Ke= Rf+ Beta (Rm-Rf)

Determinants of Beta.
1. Product type
Industry effects- the best value of a firm depends upon the sensitivity of the demand of
the products and services and of its costs to macroeconomic factors that affect the
overall markets. Like cyclical companies have higher betas than non-cyclical. Firms
with discretionary products have higher betas than less discretionary ones.
2. Operating leverage effects
It refers to the proportion of the total costs of the firm that are fixed. Other things
remaining equal, higher operating leverage results in greater earnings variability which
in turn leads to higher betas.
3. Financial leverage
As firms borrow, they create fixed costs in the form of interest payments that make their
earnings to equity investors more volatile. This increased earning volatility increases the
equity betas.

Regression beta is actually the top down approach to beta which is not that trustworthy as it is
based on one aspect of history. Now betas of a portfolio is always the market value weighted
average of the betas of the individual investments in that portfolio. Bottom up beta is estimated
by following a process which is: - find out the businesses that a firm operates in. then find the
unlevered betas of other firms in these businesses. Take the weighted average (by sales or
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operating income) of these unlevered betas. And finally lever them up using the debt-equity
ratio of the firm. So, bottom-up beta approach is better than top-down one as the standard error
of the beta estimate will be much lower. The betas can reflect the current (and even expected
future) mix of businesses that the firms is in rather than the historical mix. The law of large
numbers is the average of a hundred bad numbers can be a really good number so an average
of a hundred bad regression betas can actually give you a good beta for a business so one reason
for preference of bottom up betas is they're more precise.

For estimating betas for non-traded assets, the conventional approaches do not work as there are
no stock prices or historical returns that can be used to compute the regression betas. Thus, using
bottom up approach is the only option for them. But one thing to remember is that beta
measures the risk added to a diversified portfolio. The owners of the most private firms are not
diversified. Therefore, using beta to arrive at a cost of equity for a private firm will under/over
estimate the cost of equity.
Also, we need to adjust beta to reflect total risk rather than market risk. This adjustment is a
relatively simple one, since the R squared of the regression measures the portfolio of the risk
that is market risk.
Total beta= market beta/ correlation of the sector with the market.

Cost of Debt

The cost of capital is a composite cost to the firm of raising financing to fund its projects. In
addition to equity, firms can raise capital from debt as well. Debt is that source of funding
which involves commitment to make fixed payments in future and these fixed payments are tax
deductible. Also, failure to make the payment can lead to default or loss of control of the firm to
the party to whom payments are due. Thus, debts add to the financial risk of the firm. Thus,
debt is any interest-bearing liability whether short term or long term and can be operating or
capital in nature.
Just like equity has its cost, similarly debt has a cost. So, the cost of debt is the rate at which
you can borrow money long term.

HOW TO CALCULATE COD

If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on the long
term, straight bonds can be used as the interest rate. Also, COD is to be estimated in the same
currency as the cost of equity and the cash flows in the valuation.
If the firm is rated, use the rating and a typical default spread on bonds with that rating to
estimate the cost of debt. But if the firm is not rated and has recently borrowed long term loans
from bank, use that interest rate or you can estimate the synthetic rating for the company and
use that rating to arrive at a default spread and a cost to debt.
Talking about how to calculate this synthetic rating. The rating can be estimated using the
financial characteristics of the firms and for that we can use the interest coverage ratio i.e.
EBIT/interest expenses. On the basis of the interest coverage ratio of companies that I have data
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on, I will make a lookup table and then use this ratio to find out the rating for a non-rated
company. But be careful as synthetic ratings reflect only interest coverage ratio and do not
allow for sector-wide biases in ratings.
In the end, remember that market companies carry two burdens of risk on the shoulder, one is
their own risk that is company default spread and the other is the country default risk
Sources of Capital

Common stock/ equity shares

A share of common stock provides an ownership interest in the company, along with voting
rights and possible dividends. The entire equity share capital of the firm is divided into smaller
units called shares. Holders of common stock are the last to be paid if the company liquidates.
Dividends are not guaranteed and may be suspended if the company struggles financially. To
account for this risk, the dividend yield is higher than the rate paid on preferred shares.

Differential Equity shares.

Common stock may be divided into classes with different number of votes per share. These
classes are typically designated as Class A, Class B, Class C, etc. on the stock market. They are
termed as differential equity shares. They can be traded in the market like normal shares though
in India they aren’t very popular.

Rights issue
A rights issue is an invitation to existing shareholders to purchase additional new shares in the
company in proportion to the number of shares they already possess. They can accept the offer,
reject the offer or sell their right to another investor. For example, 1:4 rights issue means an
existing investor can buy one extra share for every four shares already held by him/her. Usually
the price at which the new shares are issued by way of rights issue is less than the prevailing
market price of the stock, i.e. the shares are offered at a discount.

Warrants
It is a derivative instrument issued by the company itself by keeping its own stock as the
underlying asset, it therefore gives the holder the right to buy the stock at a fixed price on the
expiry date. One thing to be noted, it can be issued only by public limited companies and that to
against fully paid up shares only.

Sweat Equity shares

Sweat equity shares means such equity shares as are issued by a company to its directors or
employees at a discount or for consideration, other than cash, for providing their know-how or
making available rights in the nature of intellectual property rights or value additions, by
whatever name called.

Bonus shares
Bonus shares are additional shares given to the current shareholders without any additional cost,

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based upon the number of shares that a shareholder already owns. These are company's
accumulated earnings which are not given out in the form of dividends, but are converted into
free shares. Thus, they are a way of converting your reserves and surplus into equity share
capital. The number of shares in the market increases leading to more trading. Market
capitalization of the firm doesn’t change.

Preference shares
They give ownership, but does not include voting rights. Preference shares Holders have the
right to receive dividends before equity holders and are paid before them during liquidation.
They can be of different types like convertible where the shareholder has the option of
converting his shares to common stock. It could be compulsory conversion also. Then it could
be redeemable or irredeemable ones. Though in India, a company can’t issue irredeemable.
Preference shares. If you own cumulative preferred shares, you will be entitled to retroactive
payment of any suspended dividends. Lastly Participating preferred stock pays an increased
dividend when the company is profitable.

Debentures
A debenture is a medium to long-term debt instrument used by large companies to borrow
money from public at a fixed rate of interest. They are typically bonds that are not secured by
specific property or collateral usually but are paid before equity or preference shareholders
during liquidation. They are debt securities that can be traded on a stock exchange

Bond
A bond is a fixed income investment in which an investor loans money to an entity (typically
corporate or governmental) which borrows the funds for a defined period of time at a variable
or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign
governments to raise money and finance a variety of projects and activities

Risk
In Finance, Risk is the uncertainty associated with any investment. It also refers to the
possibility that an investment’s actual return will be different than expected. Risk includes the
possibility of losing some or all of the original investment. Risks can be classified as:

Business Risk:
Business risk is the uncertainty about a firm’s future Return on Assets (ROA). This is the most
important consideration when a firm determines its optimal capital structure. Major factors
affecting business risk are:
1) Variability in the demand of its products (sales)
2) Variability of output price charged by the firm

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 3) Variability of input prices for inputs used by the firm
4) Ability to pass along changes in input prices in output prices.
5) Operating leverage (proportion of total costs that are fixed costs)

There are two types of business risk:

• Systematic Risk - Systematic risk refers to the chance an entire market or
economy will experience a downturn or even fail. Economic crashes, recessions,
wars, interest rates and natural disasters are common sources of systematic risk.
Any business operating in the market is exposed to these risks, and the amount of
systematic risk does not vary between businesses in the same market. Therefore,
there is little small business owners can do to decrease their exposure to systematic
risk.
• Unsystematic Risk - Unsystematic risk describes the chance a specific company
or line of business will experience a downturn or even fail. Unlike systematic risk,
unsystematic risk can vary greatly from business to business. Sources of
unsystematic risk include the strategic, management and investment decisions a
small business owner faces every day. Investors decrease their exposure to
unsystematic risk by diversifying their portfolio and holding ownership in a variety
of companies operating in a variety of industries.

Financial Risk
Financial risk refers to the chance a business's cash flows are not enough to pay creditors and
fulfill other financial responsibilities. The level of financial risk, therefore, relates less to the
business's operations themselves and more to the amount of debt a business incurs to finance
those operations. Taking on higher levels of debt or financial liability therefore increases a
business's level of financial risk.

Degree of operating leverage (DOL):

The degree of operating leverage is an efficiency ratio that shows how well companies use their
fixed and variable costs to general net income. It refers to the extent of fixed costs in a
company's overall cost structure. Companies with higher fixed costs compared with variable
costs are considered to have more leverage because the higher fixed costs require more initial
production in order to break even.

It can be computed as:

At a particular sales level,

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 Degree of Financial Leverage (DFL):
The degree of financial leverage (DFL) is the leverage ratio that sums up the effect of an
amount of financial leverage on the earning per share of a company.

The degree of financial leverage is useful for figuring out the fate of net income in the future,
which is based on the changes that take place in the interest rates, taxes, operating expenses and
other financial factors.
DFL at a particular level of sales is:

Degree of total leverage (DTL):

The Degree of Combined Leverage (DCL) is the leverage ratio that sums up the combined
effect of the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL)
has on the Earning per share or EPS given a particular change in sales.

Theories of Capital Structure

Net Income Approach
The Net Income (NI) approach to an optimal capital structure states that the total value of the
firm changes with a change in the financial leverage. The NI approach holds true under certain
assumptions. For example, the NI approach assumes that the cost of debt is lower than the cost
of equity. Therefore, an increase in the proportion of debt in the capital structure would result in
a decrease in the firm’s average cost of capital. A lower cost of capital would result in an
increase in the value of the firm. The NI approach can be used to determine a firm’s optimum
capital structure, where the value of the firm is highest and the cost of the capital is lowest.

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Net Operating Income Approach
According to this approach the firm cannot change its cost of capital accordingly as it changes
the capital structure, since the cost of equity is linearly rising and the cost of debt is fixed. Thus
the Cost of capital is constant.

The Net Operating Income (NOI) approach states that the proportion of debt and equity in the
firm’s structure does not have any impact on the firm’s value or its cost of capital. The NOI
approach assumes that while the cost of debt is constant for all levels of leverage, the cost of
equity increases linearly with financial leverage. This increase is explained by the increase in
the financial risk to the firm as it increases the proportion of debt in its capital structure. Cost of
equity increases because the shareholders expect a higher rate of return to cover the risk of
increase in leverage. Therefore, according to the NOI approach, there cannot be any optimum
capital structure for a firm.

Modigliani Miller Theory

Modigliani and Miller advocates capital structure irrelevancy theory. This suggests that the
valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly
leveraged or has lower debt component in the financing mix, it has no bearing on the value of a
firm.
The first proposition, also referred to as the debt irrelevance theorem, states that the value of a
firm is unaffected by its capital structure. The second proposition states that the required rate of

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return on equity increases as the firm’s debt equity ratio increases. This exactly offsets the less
expensive funds represented by debt.

Traditional Theory
The theory that an optimal capital structure exists, where the WACC is minimized and market
value is maximized. This is midway between the NI approach and the NOI approach. In this the
cost of equity changes as the firm becomes more and more leveraged and hence there is just one
optimal capital structure. At the optimal capital structure, the marginal cost of real debt will
equal the real cost of equity.

Dividend Decision

Dividend decision deals with the appropriation of after-tax profits. These profits are available to
be distributed among the shareholders or can be retained by the firm for reinvestment within the
firm. The profits which are not distributed are impliedly retained in the business. Paying out
more to the owners in the form of dividends satisfy their expectations but has other implications
like less funds for reinvestment to finance growth of the firm. Therefore, dividend is majorly
depended on two factors: - reinvestment opportunities available with the firm and the
opportunity rate of return of the shareholders. More the opportunities, less the dividend.
Similarly, if by reinvesting the money I am earning more return in comparison to my cost of
equity, then also retained earnings will be more.
Apart from this, finance manager needs to decide whether to distribute cash dividend or bonus
share (stock dividends). In a way, the earning retained by the firm will help them grow and
enable them to give better gains in the future in the form of capital gains.
Under dividend decision, the firm needs to decide its dividend policy and its effect on the value
of firm. One school of thought says that dividend effects the value ie. Relevance theory given
by Walter and Gordon and other says that it doesn’t called the irrelevance theory and given by
Modigliani and Miller.

Dividend Policy
There are three theories about dividend/payout policy, which can be summarized as: Investors
don’t care, investors prefer higher payouts, and investors prefer lower payouts.

Dividend Irrelevance Theory

Modigliani and Miller (MM) demonstrate that if markets are ―perfect or frictionless, a firm’s
dividend policy has no effect on the firm’s weighted average cost of capital or the value of the
firm. The intuition for this result is that with perfect markets, shareholders can effectively create
their own ―homemade dividend policy, either buying shares with ―excess dividends or selling
shares to generate ―dividend income.

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 Bird-in-the-Hand Theory
This theory is based on the idea that dividends (in the hand) are more valuable to investors than
future capital gains (in the bush), which are less certain. The implication is that an increase in
the payout ratio increases the value of equity, which decreases the cost of equity capital and
increases firm value.

Tax Preference Theory

Under this theory lower payout ratios are preferred because dividends are taxed as received and
at a higher rate than capital gains, which are only taxed when shares are eventually sold. The
implication is that a decrease in the payout ratio increases the value of equity, which decreases
the cost of equity capital and increases firm value.

Information Content or Signalling Theory

When a firm cuts its dividend, it is taken as a sign that the current dividend cannot be
maintained and that management believes that future earnings prospects are not good, resulting
in a drop in the stock price as investors revise their expectations about future earnings growth
downward.
When a firm raises its dividend, it sends the opposite signal about management’s views about
future earnings, and the stock price rises.

Clientele Effect
High payout stocks will attract income-oriented investors and low payout stocks will attract
capital gains-oriented investors. Since there are costs associated with switching from one stock
to another, firms should maintain a stable dividend/dividend policy so as not to alienate their
clientele (current shareholders).

Residual Dividend Model

A residual dividend policy requires that a firm fund all positive NPV projects from earnings and
pay out only the unused (residual) earnings as dividends.

The steps are:

• Identify the optimal capital budget.
• Determine the amount of equity needed to finance that capital budget for a given
capital structure.
• Meet equity requirements to the maximum extent possible with retained earnings.
• Pay as dividends any ―residual‖ earnings that remain.

Since earnings and positive NPV investment opportunities both vary from year to year,
following a residual dividend policy will lead to uncertainty about future dividends and possibly
alienate a firm’s dividend clientele as defined above. However, projecting earnings and optimal
capital expenditures over a period of five years or more can be an appropriate way to estimate
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the optimal or target dividend payout ratio.

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