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UNIT-II
FINANCING DECISION
INTRODUCTION
Business requires finance for many purposes. First a large sum of money has to be spent on investigating the soundness of a business scheme before it is taken up for implementation. If the scheme is large and is organized as a joint stock company, drafting and printing of necessary documents, registration of the company etc. involve expenses. All these have to be done before the commencement of business. Secondly in the case of a manufacturing organization a factory building has to be erected and machinery installed before production can be undertaken. Thirdly, money is needed to purchase raw materials semi-finished parts and miscellaneous stores and to pay the workers. Finally the procurement of money itself involves some expense. It is incurred on advertising, preparation of documents, maintenance of books and staff for the purpose, payment of interest, creation of funds for repayment and so on.
SOURCES OF FINANCE OF A BUSINESS Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern. Sources of finance state that, how the companies are mobilizing finance for their requirements. The companies belong to the existing or the new which need sum amount of finance to meet the long-term and short-term requirements such as purchasing of fixed assets, construction of office building, purchase of raw materials and day-to-day expenses. Sources of Finance may be classified as: (I) Long term Sources and (II) Short term Sources.
(I) LONG TERM SOURCES: When the finance mobilized with large amount and the repayable over the period will be more than five years, it may be considered as long-term sources. Share capital, issue of debenture, long-term loans from financial institutions and commercial banks come under this kind of source of finance. Long-term source of finance needs to meet the capital expenditure of the firms such as purchase of fixed assets, land and buildings, etc. Long-term sources of finance include: (a) Equity Shares (b) Preference Shares (c) Debenture (d) Public Deposits (e) Retained Earnings (f) Term Loans (g) Loans from Financial Institutions (h) Lease and Hire Purchase (a) Equity Shares : Equity Shares also known as ordinary shares, which means, other than preference shares. Equity shareholders are the real owners of the company. They have a control over the management of the company. Equity shareholders are eligible to get dividend if the company earns profit. Equity share capital cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the value of unpaid value of shares. Features of Equity Shares Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income left after paying fixed rate of dividend to preference shareholder. The earnings or the income available to the shareholders is equal to the profit after tax minus preference dividend. 3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the right to get the claims on assets. These rights are only available to the equity shareholders. 4. Right to control: Equity shareholders are the real owners of the company. Hence, they have power to control the management of the company and they have power to take any decision regarding the business operation. 5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of voting right power; they can change or remove any decision of the business concern. Equity shareholders only have voting rights in the company meeting and also they can nominate proxy to participate and vote in the meeting instead of the shareholder. (b) Preference Shares The parts of corporate securities are called as preference shares. It is the shares, which have preferential right to get dividend and get back the initial investment at the time of winding up of the company. Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights. Features of Preference Shares The following are the important features of the preference shares: 1. Maturity period: Normally preference shares have no fixed maturity period except in the case of redeemable preference shares. Preference shares can be redeemable only at the time of the company liquidation. 2. Residual claims on income: Preferential sharesholders have a residual claim on income. Fixed rate of dividend is payable to the preference shareholders. 3. Residual claims on assets: The first preference is given to the preference shareholders at the time of liquidation. If any extra Assets are available that should be distributed to equity shareholder. 4. Control of Management: Preference shareholder does not have any voting rights. Hence, they cannot have control over the management of the company. (c) Debentures A Debenture is a document issued by the company. It is a certificate issued by the company under its seal acknowledging a debt. According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge of the assets of the company or not.” **Features of Debentures
- Maturity period:** Debentures consist of long-term fixed maturity period. Normally, debentures consist of 10–20 years maturity period and are repayable with the principle investment at the end of the maturity period. 2. Residual claims in income: Debenture holders are eligible to get fixed rate of interest at every end of the accounting period. Debenture holders have priority of claim in income of the company over equity and preference shareholders. 3. Residual claims on asset: Debenture holders have priority of claims on Assets of the company over equity and preference shareholders. The Debenture holders may have either specific change on the Assets or floating change of the assets of the company. Specific change of Debenture holders are treated as secured creditors and floating change of Debenture holders are treated as unsecured creditors. 4. No voting rights: Debenture holders are considered as creditors of the company. Hence they have no voting rights. Debenture holders cannot have the control over the performance of the business concern.
(II) SHORT TERM SOURCES:
After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short-term funds may even lead to closure of business. Short-term finance serves following purposes It facilitates the smooth running of business operations by meeting day to day financial requirements.
- It enables firms to hold stock of raw materials and finished product.
- With the availability of short-term finance goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business.
- Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.
- Short-term funds are also required to allow flow of cash during the operating cycle. Operating cycle refers to the time gap between commencement of production and realization of sales. Sources of Short-term Finance There are a number of sources of short-term finance which are listed below: a) Trade credit b) Bank credit c) Commercial Papers d) Customers’ Advances e) Inter-corporate Deposits (ICDs) f) Short-term Unsecured Debentures (a) Trade Credit: Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance. (b) Bank Credit: Credit facility provided by commercial banks to meet the short-term and working capital requirements has been important short term sources of finance in India. The bank credit, in general, is a short, term financing, say, for a year or so. This short-term financing to business firm is regarded as self-liquidating in the sense that the uses to which the borrowing firm is expected to put the funds are ordinarily expected to generate cash flows adequate to repay the loan within a year. Further, these loans are called self-liquidating because the bank’s motive to provide finance is to meet the seasonal demand, e.g., to cover the seasonal increase in inventories or receivables. In principle, the bank credit is intended to carry the firm through seasonal peaks in financing need. The amount of credit extended by a bank may be referred to as a credit limit which denotes the maximum limit of loan which the firm can avail from the bank. Sometimes, the bank may approve separate limits for peak season and non-peak season. (c) Commercial Papers: Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period, generally, varying from a few days to a few months. For example, in India, the maturity period of CP varies between 15 days to 1 year while in some other countries, the maturity period may go up to 270 days. It is a money market instrument and generally purchased
by commercial banks, money market mutual funds and other financial institutions desirous to invest their funds for a short period. (d) Customers’ Advances: Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers’ advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short- term requirements with the help of customers’ advances. (e) Inter-corporate Deposits (ICDs) Sometimes, the companies borrow funds for a short-term period, say up to six months, from other companies which have surplus liquidity for the time being. The ICDs are generally unsecured and are arranged by a financier. The ICDs are very common and popular in practice as these are not marred by the legal hassles. The convenience is the basic virtue of this method of financing. There is no regulation at present in India to regulate these ICDs. Moreover, these are not covered by the Section 58A of the Companies Act, 1956, as the ICDs are not for long term. The transactions in the ICD are generally not disclosed as the borrowing under the ICDs imply a liquidity shortage of the borrower. The rate of interest on ICDs varies depending upon the amount involved and the time period. The entire working of ICDs market is based upon the personal connections of the lenders, borrowers and the financiers. (f) Short-term Unsecured Debentures: Companies have raised short-term funds by the issue of unsecured debentures for periods upto 17 months and 29 days. The rate of interest on these debentures may be higher than the rate on secured long-term debentures. It may be noted that no credit rating is required for the issue of these debentures because as per the SEBI guidelines, the credit ratings required for debentures having maturity period of 18 months or more. The use of unsecured debentures as a source of short-term financing, however, depends upon the state of capital market in the economy. During sluggish period, the companies may not be in a position to issue these debentures. Moreover, only established firms can issue these debentures as new company will not find favour from the investors. Another drawback of this source is that the company pro-cures funds from retail investors instead of getting a lump-sum from one source only. Further, that the issue of securities in capital market is a time consuming process and the issue must be planned in a proper way.
COST OF CAPITAL
Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm. Meaning of Cost of Capital Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders. Definitions The following important definitions are commonly used to understand the meaning and concept of the cost of capital.
Average and Marginal Cost Average cost of capital is the weighted average cost of each component of capital employed by the company. It considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc. Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when the company goes for further raising of finance. Historical and Future Cost Historical cost is the cost which as already been incurred for financing a particular project. It is based on the actual cost incurred in the previous project. Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience. Specific and Combine Cost The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of capital. It is very useful to determine the each and every specific source of capital. The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to understand the total cost associated with the total finance of the firm. MEASUREMENT OF COST OF CAPITAL It refers to the cost of each specific sources of finance like:
- Cost of equity
- Cost of debt
- Cost of preference share
- Cost of retained earnings (A) Cost of Equity Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”. Cost of equity can be calculated from the following approach: - Dividend price (D/P) approach - Dividend price plus growth (D/P + g) approach - Earning price (E/P) approach Dividend Price Approach The cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares. Dividend price approach can be measured with the help of the following formula:
D Ke = P Where, Ke = Cost of equity capital D = Dividend per equity share P = Net proceeds of an equity share Dividend Price Plus Growth Approach The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following formula:
D
Ke = + g P Where, Ke = Cost of equity capital D = Dividend per equity share g = Growth in expected dividend P = Net proceeds of an equity share Earning Price Approach Cost of equity determines the market price of the shares. It is based on the future earning prospects of the equity. The formula for calculating the cost of equity according to this approach is as follows. E Ke = × 100 P Where, Ke = Cost of equity capital E = Earning per share P = Net proceeds of an equity share. (B) Cost of debt: Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable. It may be calculated with the help of the following formula. Kd = R (1 – t) Where, Kd = Cost of debt capital t = Tax rate R = Debenture interest rate (C) Cost of Preference Share Capital Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share. There are two types of preference shares irredeemable and redeemable. Cost of redeemable preference share capital is calculated with the help of the following formula: Dp Kp = × 100 P Where, Kp = Cost of preference share Dp = Fixed preference dividend P = Net proceeds of a Preference Share (D) Cost of Retained Earnings Retained earnings are one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital. Cost of retained earnings can be calculated with the help of the following formula: Kr =Ke (1 – t) (1 – b) Where, Kr=Cost of retained earnings Ke=Cost of equity
1. Level of Interest Rates: The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital. 2. Tax Rates: Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital. Marginal Cost of Capital The weighted average cost to a company for raising additional funds is called Marginal Cost of Capital. The marginal cost of capital depends on the current cost of individual sources of capital (common stock, retained earnings, preferred stock, and debt) and the proportions in which the sources will be used. This cost is stated as a percentage and is compared to the return that is expected to be earned on a proposed investment. The marginal weights represent the proportion of various sources of funds to be employed in raising additional funds. MCC shall be equal to WACC, when a firm employs the existing proportion of capital structure and some cost of component of capital structure. But in practice WACC may not be equal to Marginal cost of capital due to change in proportion and cost of various sources of funds used in raising new capital. The MCC ignores the long-term implications of the new financing plans. Hence, WACC should be preferred to maximize shareholders wealth in the long-term.
CAPITAL STRUCTURE
Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level of capital, it will earn high profit and they can provide more dividends to its shareholders. Meaning of Capital Structure Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. The term capital structure refers to the relationship between the various long-term source financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure is the important decision of the financial management because it is closely related to the value of the firm. Capital structure is the permanent financing of the company represented primarily by long-term debt and equity. Definition of Capital Structure The following definitions clearly initiate, the meaning and objective of the capital structures. According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources”. According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”. According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”. According to the definition of R.H. Wessel, “The long term sources of fund employed in a business enterprise”. Financial Structure The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to which total funds are available to finance the total assets of the business.
Financial Structure = Total liabilities Or Financial Structure = Capital Structure + Current liabilities. The following points indicate the difference between the financial structure and capital structure. Financial Structure Capital Structure
- It includes both long-term and short-term sources of funds
- It includes only the long-term sources of funds.
- It means the entire liabilities side of the balance sheet.
- It means only the long-term liabilities of the company.
- Financial structures consist of all sources of capital.
- It consist of equity, preference and retained earning capital.
- It will not be more important while determining the value of the firm
- It is one of the major determinations of the value of the firm.
Optimum Capital Structure
The ratio between debt and equity is named leverage. It has to be optimized as high leverage can bring a higher profit but create solvency risk. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. Management must therefore identify the “optimal mix” of financing – the capital structure that results in maximum value. The optimum capital structure has been expressed by Ezra Solomon in the following words: “Optimum leverage can be defined as that mix of debt and equity which will maximize the value of a company, i.e., the aggregate value of the claims and ownership interests represented on the credit side of the balance sheet.” Capital structure policy involves a choice between risk and expected return. The optimal capital structure strikes a balance between these risks and returns and thus examines the price of the stock. The pattern of capital structure of a firm has to be planned in such a way that the owner’s interest is maximized. There may be three fundamental patterns of capital structure in a firm:
- Financing exclusively by equity stock.
- Financing by equity and preferred stock.
- Financing by equity, preferred stock and bonds.
GUIDING PRINCIPLES OF CAPITAL STRUCTURE Which of the above patterns would be most suited to the company can be decided in the light of the fundamental principles. The guiding principles of capital structure decision are:
1. Cost principle: According to this principle ideal pattern of capital structure is one that tends to minimize cost of financing and maximize the earnings per share. Cost of capital is subject to interest rate at which payments have to be made to suppliers of funds and tax status of such payments. 2. Risk principle: This principle suggests that such a pattern should be devised so that the company does not run the risk of brining on a receivership with all its difficulties and losses. Risk principle places relatively greater reliance on common stock for financing capital requirements of the corporation and forbids as far as possible the use of fixed income bearing securities.
market, investors may move out of equities. Similarly, if the interest rate on bonds and other long-term instruments is affected due to the government’s policy, it will also influence companies’ decisions.
- Cost of Capital: The cost of raising funds depends on the expected rate of return for the suppliers. This rate depends on the risk borne by investors. Ordinary shareholders face the maximum risk as they don’t get a fixed rate of dividend. They get paid after preference shareholders receive their dividends. The company has to pay interest on debentures under all circumstances. It attracts more investors to opt for debentures and bonds. CAPITAL STRUCTURE THEORIES There are different viewpoints on the impact of the debt-equity mix on the shareholder’s wealth. There is a viewpoint that strongly supports the argument that the financing decision has major impact on the shareholder’s wealth, while according to others, the decision about the financial decision is irrelevant as regards maximization of shareholder’s wealth. A great deal of controversy has developed over whether the capital structure of a firm as determined by its financing decision affects its cost of capital. Traditionalists argue that the firm can lower its cost of capital and increase the market value per share by the judicious use of leverage. Modigliani & Miller, on the other hand, argue that in the absence of taxes and other market imperfections, the total value of the firm and its cost of capital are independent of capital structure. There are four major theories explaining the relationship between capital structure, cost of capital and value of the firm:
- Net Income Approach
- Net Operating Income Approach
- Traditional Approach
- Modigliani-Miller Approach There are certain underlying assumptions made in order to present the theories in a simple manner. The assumptions are as follows:
- The firm employs only two types of capital- debt and equity.
- There are no corporate taxes. This assumption is removed later.
- The firm pays 100% of its earnings as dividend.
- The firm’s total assets are given and they do not change, i.e. the investment decisions are assumed to be constant.
- The firm’s total financing remains constant.
- The operating earnings are not expected to grow.
- The business risk remains constant and is independent of capital structure and financial risk.
- All investors have the same subjective probability distribution of the future expected operating earnings for a given firm.
- The firm has a perpetual life. 1. Net Income Approach Net Income approach suggested by the Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm. According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm. Net income approach is based on the following three important assumptions:
- There are no corporate taxes.
- That the total capital requirement of the firm is given and remains constant.
- The cost debt (Kd) is less than the cost of equity (Ke)
- Both Kd and Ke remains constant and increase in financial leverage i.e. use of more and more debt financing in the capital structure does not affect the risk perception of the investors. On the other hand, if the proportion of debt financing in the capital structure is reduced or say when the financial leverage is reduced, the weighted average cost of capital (Ko) of the firm will increase and the total value of the firm will decrease. The Net Income (NI) Approach showing the effect of leverage on overall cost of capital has been presented in the following figure:
Cost of Capital (%) Ke(Cost of Equity)
Ko (Overall Cost of Capital)
Kd (Cost of Debt)
Degree of Leverage Figure 2.1: Net Income Approach: Effect of Leverage of Cost of Capital
The figure 2.1 shows that the Kd and Ke are constant for all levels of leverages i.e., for all levels of debt financing. As the debt proportion or the financial leverage increases, the WACC, Ko decreases as the Kd less than Ke. This result in the increase in value of the firm. In the Figure 4. it may be noted that Ko will approach Kd as the debt proportion increases. However, Ko will never touch Kd as there cannot be a 100% debt firm. Some element of equity must be there. However, if the firm is 100% equity firm, then the Ko is equal to Ke. The rate of decline in Ko depends upon the relative position of Kd and Ke. Under NI approach, the firm will have to maximum value capital structure at a point where Ko is minimized. With a judicious use of the debt and equity, a firm can achieve an optimum capital structure. This optimal capital structure is one at which the WACC, Ko, is minimum resulting in the maximum value of the firm. The total market value of a firm on the basic of Net Income Approach can be ascertained as below: V = S+D Where, V = Value of firm S = Market value of equity Market value of the equity can be ascertained by the following formula: EBIT S = Ke Where, EBIT = Earnings available to Equity Shareholder Ke = Cost of equity/Equity Capitalization Rate D = Market Value of Debt
2. Net Operating Income (NOI) Approach:
Another modern theory of capital structure, suggested by Durand. This is just the opposite to the Net Income approach. According to this approach, Capital Structure decision is
3. Traditional Approach It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate approach. According to the traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of capital up to certain level of debt. Traditional approach states that the Ko decreases only within the responsible limit of financial leverage and when reaching the minimum level, it starts increasing with financial leverage. Assumptions Capital structure theories are based on certain assumption to analysis in a single and convenient manner: 1. There are only two sources of funds used by a firm; debt and shares. 2. The firm pays 100% of its earning as dividend. 3. The total assets are given and do not change. 4. The total finance remains constant. 5. The operating profits (EBIT) are not expected to grow. 6. The business risk remains constant. 7. The firm has a perpetual life. 8. The investors behave rationally. Under the traditional approach, the cost of debt, Kd is assumed to be less than the cost of equity, Ke. In case of 100% equity firm, Ko is equal to the Ke but when (cheaper) debt is introduced in the capital structure and the financial leverage increases, the Ke remains same as the equity investors expect a minimum leverage in every firm. The Ke does not increase even with increase in leverage. The argument for Ke remaining unchanged may be that up to a particular degree of leverage, the interest charge may not be large enough to pose a real threat to the dividend payable to the shareholders. This constant Ke and Kd makes the Ko to fall initially. Thus it shows that the benefits of cheaper debts are available to the firm. But this position does not continue when leverage is further increased. The increase in leverage beyond a limit increases the risk of the equity investors also and as a result the Ke also starts increasing. However, the benefits of use of debt may be so large that even after offsetting the effects of increase in Ke, the Ko may still go down or may become constant for some degree of leverages. However, if the firm increases the leverage further, then the risk of the debt investor may also increase and consequently the Kd also starts increasing. The already increasing Ke and the now increasing Kd makes the Ko to increase. Therefore, the use of leverage beyond a point will have the effect of increase in the overall cost of capital of the firm and thus results in the decrease in value of the firm. Figure 4.3 illustrate this approach graphically.
Ke (Cost of Equity)
Cost of Capital (%) Ko (Overall Cost of Capital)
Kd (Cost of Debt)
Degree of Leverage Figure 2.3: The NOI Approach: Effect of Leverage of Cost of Capital
The above figure suggests that there is a range of capital structure in which the cost of capital (Ke) is the minimum and the value of the firm is maximum. There are many variations of traditional approach, but all the supporters of the traditional approach agree that the cost of capital declines and the value of firm increases with use of debt in capital structure.
4. Modigliani and Miller Approach This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble to that of Net Operating Income Approach. 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. Modigliani and Miller Approach further states that the market value of a firm is affected by its future growth prospect apart from the risk involved in the investment. The theory stated that value of the firm is not dependent on the choice of capital structure or financing decision of the firm. If a company has high growth prospect, its market value is higher and hence its stock prices would be high. If investors do not see attractive growth prospects in a firm, the market value of that firm would not be that great Modigliani and Miller approach is based on the following important assumptions:
- There is a perfect capital market.
- There are no retained earnings.
- There are no corporate taxes.
- The investors act rationally.
- The dividend payout ratio is 100%.
- The business consists of the same level of business risk. Value of the firm can be calculated with the help of the following formula: EBIT (l t) Ke Where EBIT = Earnings before interest and tax Ko = Overall cost of capital t = Tax rate
Ke (Cost of Equity)
Cost of Capital (%) Ko (Overall Cost of Capital)
Kd (Cost of Debt)
Degree of Leverage Figure 2.4: MM Approach: Effect of Leverage of Cost of Capital)
The above figure indicates that as per the MM Approach, as we increase the proportion of debt in our capital structure, overall cost of capital comes down but at the same time company becomes financially risky, which result in increase in expectations of shareholders which leads to
The company may use finance or leverage or operating leverage, to increase the EBIT and EPS. Operating Leverage The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis. Operating leverage can be calculated with the help of the following formula: C OL = OP Where, OL = Operating Leverage C = Contribution EBIT = Earnings before Interest and Taxes Operating leverage may be favorable or unfavorable. High degree of operating leverage indicates higher degree of risk. It is good when revenues are rising and bad when they are falling. Operating risk is the risk of the firm not being able to cover its fixed operating costs. The larger the magnitude, the larger the volume of sales required to cover all fixed costs. Before going to work out the problems, there is a need to know how to compute the earnings available to the equity shareholders from the sales revenue. Uses of Operating Leverage Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.
- If any change in the sales, it will lead to corresponding changes in profit.
- Operating leverage helps to identify the position of fixed cost and variable cost.
- Operating leverage measures the relationship between the sales and revenue of the company during a particular period.
- Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.
- Operating leverage describes the over all position of the fixed operating cost. The following format clearly gives a picture about the calculation of earnings available to the ordinary shareholders.
Particulars Amount ( ) Sales Revenue (Units Sold × S.P Per Unit) ×××× Less: Variable Cost (Units Produced × CPU) ×××× Contribution ×××× Less: Fixed Cost ×××× Earnings before Interest and Taxes (EBIT) ×××× Less: Interest (^) ×××× Earnings before Taxes (EBT) ×××× Less: Taxes ×××× Earnings after Taxes (EAT) (^) ×××× Less: Preference Dividend ×××× Earnings available to Equity Shareholders ××××
Financial Leverage Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”. Financial leverage may be favorable or unfavorable depends upon the use of fixed cost funds. Favorable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage. Unfavorable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage. Financial leverage can be calculated with the help of the following formula: EBIT FL = EBT Where, FL = Financial leverage EBIT = Earnings before Interest and Taxes EBT = Earnings before tax. Uses of Financial Leverage
- Financial leverage helps to examine the relationship between EBIT and EPS.
- Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
- Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
- Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.
- If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.
DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE
Features of Difference Operating Leverage Financial Leverage 1.Definition/Arises Operating Leverage arises from the cost structure
Financial Leverage arises from the capital Structure. 2.Determination It is determined by the relationship between Sales and EBIT
It is determined by the relationship between EBIT and EPS. 3.Risk Degree of Operating leverage creates Business Risk.
Degree of financial leverage creates financial Risk.
- Formula Used DOL=Sales-VC/EBIT DFL=EBIT/EBIT-I
- Affects It affects the sales and EBIT IT affects the EBIT and EPS.
- Use/Fulcrum In operating leverage the fulcrum is the fixed cost.
In financial leverage the fulcrum is the fixed interest charges that must be paid to service the long term debt.
