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W L OM

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Financial managementscoperole

of financial management in business

time value of money risk and

returnrisk diversification

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FINANCIAL MANAGEMENT:-

Financial Management means planning,organizing, directing and controlling the

financial activities such as procurementand utilization of funds of theenterprise. It means applying generalmanagement principles to financial

resources of the enterprise.

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Objectives of Financial Management

The financial management is generally concerned withprocurement, allocation and control of financial resources of aconcern. The objectives can be-To ensure regular and adequatesupply of funds to the concern.

To ensure adequate returns to the shareholders which will dependupon the earning capacity, market price of the share, expectations ofthe shareholders.

To ensure optimum funds utilization. Once the funds are procured,they should be utilized in maximum possible way at least cost.

To ensure safety on investment, i.e, funds should be invested in safeventures so that adequate rate of return can be achieved.

To plan a sound capital structure-There should be sound and faircomposition of capital so that a balance is maintained between debtand equity capital.

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Functions of Financial Management

Estimation of capital requirements

Choice of sources of funds

Investment of funds

Disposal of surplus

Management of cash

Financial controls

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Investment of funds:

The finance manager has to decide to allocate funds into profitable

ventures so that there is safety on investment and regular returns is possible.

Disposal of surplus:

The net profits decision have to be made by the finance manager. This can

be done in two ways:

*Dividend declaration - It includes identifying the rate of dividends and other

benefits like bonus.

*Retained profits - The volume has to be decided which will depend upon

expansional, innovational, diversification plans of the company.

Management of cash:Finance manager has to make decisions with regards to cash

management. Cash is required for many purposes like payment of wages and

salaries, payment of electricity and water bills, payment to creditors, meeting

current liabilities, maintainance of enough stock, purchase of raw materials, etc.

Financial controls:The finance manager has not only to plan, procure and utilize the funds

but he also has to exercise control over finances. This can be done through many

techniques like ratio analysis, financial forecasting, cost and profit control, etc.

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FINANCIAL PLANNING:-

Financial Planning is the process of estimating the capital required

and determining its competition. It is the process of framing financial policies

in relation to procurement, investment and administration of funds of an

enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

Determining capital requirements- This will depend upon factors like cost of current and

fixed assets, promotional expenses and long- range planning. Capital requirements have

to be looked with both aspects: short- term and long- term requirements.

Determining capital structure- The capital structure is the composition of capital, i.e.,the relative kind and proportion of capital required in the business. This includes

decisions of debt- equity ratio- both short-term and long- term.

Framing financial policies with regards to cash control, lending, borrowings, etc.

A finance manager ensures that the scarce financial resources are maximally utilized in

the best possible manner at least cost in order to get maximum returns on investment.

f l l

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Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures,

programmes and budgets regarding the financial activities of a concern. This

ensures effective and adequate financial and investment policies. The importancecan be outlined as-

Adequate funds have to be ensured.Financial Planning helps in ensuring a

reasonable balance between outflow and inflow of funds so that stability is

maintained.

Financial Planning ensures that the suppliers of funds are easily investing incompanies which exercise financial planning.

Financial Planning helps in making growth and expansion programmes which

helps in long-run survival of the company.

Financial Planning reduces uncertainties with regards to changing market trends

which can be faced easily through enough funds.

Financial Planning helps in reducing the uncertainties which can be a hindrance

to growth of the company. This helps in ensuring stability an d profitability in

concern.

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FINANCE DECISIONS

Investment Decision

One of the most important finance functions is to intelligently allocate capital to

long term assets. This activity is also known as capital budgeting. It is important toallocate capital in those long term assets so as to get maximum yield in future.

Following are the two aspects of investment decision

a.Evaluation of new investment in terms of profitability

b.Comparison of cut off rate against new investment and prevailing investment.

Financial Decision

Financial decision is yet another important function which a financial manger

must perform. It is important to make wise decisions about when, where and how

should a business acquire funds. Funds can be acquired through many ways and

channels. Broadly speaking a correct ratio of an equity and debt has to be maintained.

This mix of equity capital and debt is known as afirmscapital structure. A firm tends to

benefit most when the market value of a companysshare maximizes this not only is a

sign of growth for the firm but also maximizes shareholders wealth.

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Dividend Decision

Earning profit or a positive return is a common aim of all the businesses.

But the key function a financial manger performs in case of profitability is to decide

whether to distribute all the profits to the shareholder or retain all the profits or

distribute part of the profits to the shareholder and retain the other half in the

business. Its the financial managers responsibility to decide a optimum dividend

policy which maximizes the market value of the firm. Hence an optimum dividend

payout ratio is calculated. It is a common practice to pay regular dividends in case of

profitability Another way is to issue bonus shares to existing shareholders.

Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid

insolvency. Firms profitability, liquidity and risk all are associated with the

investment in current assets. In order to maintain a tradeoff between profitabilityand liquidity it is important to invest sufficient funds in current assets. But since

current assets do not earn anything for business therefore a proper calculation must

be done before investing in current assets. Current assets should properly be valued

and disposed of from time to time once they become non profitable. Currents assets

must be used in times of liquidity problems and times of insolvency.

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FINANCIAL MANAGER

Financial activities of a firm is one of the mostimportant and complex activities of a firm. Therefore in

order to take care of these activities a financial manager

performs all the requisite financial activities.

A financial manger is a person who takes care of all

the important financial functions of an organization. The

person in charge must ensure that the funds are utilized in

the most efficient manner. His actions directly affect the

Profitability, growth and goodwill of the firm.

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main functions of a Financial Manager:

Raising of Funds

In order to meet the obligation of the business it is important to have enough cashand liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a

financial manager to decide the ratio between debt and equity. It is important to maintain a

good balance between equity and debt.

Allocation of FundsOnce the funds are raised through different channels the next important function is to

allocate the funds. The funds should be allocated in such a manner that they are optimally used.

In order to allocate funds in the best possible manner the following point must be considered

These financial decisions directly and indirectly influence other managerial activities. Hence

formation of a good asset mix and proper allocation of funds is one of the most important activity

Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning

is important for survival and sustenance of any organization. Profit planning refers to proper

usage of the profit generated by the firm. Profit arises due to many factors such as pricing,

industry competition, state of the economy, mechanism of demand and supply, cost and output.

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WEALTH MAXIMIZATION

A process that increases the current net value of business or shareholder

capital gains, with the objective of bringing in the highest possible return.

The wealth maximization strategy generally

involves making sound financial investment decisions which takeinto consideration any risk factors that would compromise or outweigh the

anticipated. benefits.

Wealthmaximization is a financial management technique that

concentrates its focus on increasing the net worth of a company or firm. This

approach says, more traditional method of management that seeks out increasedprofits above all other pursuits. Those who pursue this technique also seek out

profits, but they concern themselves with cash flow, earnings per share of

shareholders, and the social value of any financial initiatives as well

http://www.wisegeek.com/what-is-cash-flow.htmhttp://www.wisegeek.com/what-is-cash-flow.htmhttp://www.wisegeek.com/what-is-cash-flow.htm

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TIME VALUE OF MONEYThe time value of money is the principle that a certain

currency amount of money today has a different buying

power value than the same currency amount of money in thefuture. The value of money at a future point of time would

take account of interestearned or inflationaccrued over a

given period of time.

http://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Interest

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There are mainly three ways for accounting

for the time value of money:* Simple interest

* Compounding

* Discounting

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Compounding:-The ability of an asset to generate earnings, which are thenreinvested in order to generate their own earnings. In other

words, compounding refers to generating earnings from previousearnings.Also known as "compound interest".

The process of earningintereston a loanor other fixed-incomeinstrument where the interest can itself earn interest. That is,interest previously calculated is included in the calculation of

future interest.Compound interest is interest paid on an investment during thefirst period is added to the principal; then, during the secondperiod, interest is earned on the new sum

http://financial-dictionary.thefreedictionary.com/Earningshttp://financial-dictionary.thefreedictionary.com/Interesthttp://financial-dictionary.thefreedictionary.com/Loanhttp://financial-dictionary.thefreedictionary.com/Loanhttp://financial-dictionary.thefreedictionary.com/Interesthttp://financial-dictionary.thefreedictionary.com/Earnings

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Simple Interest

Interest is earned only on principal.

Example: Compute simple interest on $100

invested at 6% per year for 3 years.

1st year interest is $6.00

2nd year interest is $6.00

3rd year interest is $6.00

Total interest earned: $18.00

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DIS OUNTING

The process of determining the present value of

a payment or a stream of payments that is to be

received in the future. Given the time value ofmoney, a dollar is worth more today than it

would be worth tomorrow given its capacity to

earn interest. Discounting is the method used to

figure out how much these future payments are

worth today.

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RISK

Risk means the chance of loss.

The chance that an investments

actual return will be different than

expected. Risk includes the

possibility of losing some or all ofthe original investment.

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Sources of risk

The essence of risk in aninvestment is the variation in its

returns.The variation in risk is caused by anumber of factors.

These factors may be internal orexternal.

continues.

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External factors means the factors

which are beyond the control ofbusiness.

Internal factors means the factors

which can be controlled by the

organization.

The risk caused by external factors

is called systematic risk.

The risk caused by internal factors

is called unsystematic risk.

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REASONS :-

economic changes

political changestechnological changes

stock price

social changes

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TYPES OF SYSTEMATIC RISK

A. INTEREST RATE RISKS

B. MARKET RISK

C. PURCHASING POWER RISK

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INTEREST RATE RISK

This type of risk is affect to debt securities like

debentures or bonds.

Debt securities have normally a coupon rate of

interest and it is equal to the interest rate

prevailing in the market when these securities

are issued.

Some times, the interest rate prevailing in the

economy will be changed , but the coupon rate

will not be changed.

These variations in bond prices caused due to

the variations in interest rates is known as

interest rate risk.

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MARKET RISK

Market risk of shares may move upward or

downward.

General rise in price is called bullish trend and fall

in price is called bearish trend.These changes may reflect in the sensitive index of

BSE or nifty.

The stock market is seen to be volatile. This

volatility leads to variations in the returns ofinvestors in shares. These variations in return caused

by the volatility of the stock market is referred to as

the market risk.

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PURCHASING POWER RISK

Inflation results in reducing

purchasing power o f money.thus inflation causes a variation in

thee purchasing power of the returnsfrom an investment.

This is known as purchasing powerrisk.

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Inflation may be caused by two

reasons:-

Sometimes demand is increasing

but supply cannot be increased, priceof the goods increases.

Rise in cost of production leads to

increase in price of product.

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UNSYSTEMATIC RISK.

Risk caused due to some

factors which are controlled

by the organization is called

unsystematic risk.

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REASONS :-

Scarcity of raw materials

Labour stike

Inefficiency of management

Financial pattern

Operating environmentWork overloading

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TYPES OF UNSYSTEMATIC

RISK

A. BUSINESS RISKB. FINANCIAL RISK

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USINESS RISK

Every company operates within a

particular operating environment.The operating cost may be fixed cost

or variable cost. Too much fixed cost

adversely affects the working ofcompany. It leads to total decline of

revenue.

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FINANCIAL RISK

Financial risk is a function of financial leverage. It

means the use of debt in the capital structure.

The presence of debt in the capital structure

creates fixed payment to be made whether the

company makes profit or loss. This fixed interest

payment creates more variability in the EPS

available to equity shareholders. The variabilityin EPS due to the presence of debt in the capital

structure of a company is called financial risk.

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RISK AND RETURNRisk is the chance that an investment's actual return will be different than

expected. Technically, this is measured in statistics by standard deviation. Risk

means you have the possibility of losing some, or even all, of our original

investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High

levels of uncertainty (high risk) are associated with high potential returns.

The risk/return tradeoffis the balance between the desire for the lowest possible

risk and the highest possible return. This is demonstrated graphically in the chart

below. A higher standard deviation means a higher risk and higher possible return.

http://www.investopedia.com/terms/r/riskreturntradeoff.asphttp://www.investopedia.com/terms/r/riskreturntradeoff.asp

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DIVERSIFICATION OF RISK

Diversification is a risk-management technique that mixes a wide variety ofinvestments within a portfolio in order to minimize the impact that any one security will

have on the overall performance of the portfolio.

Diversification essentially lowers the risk of your of portfolio. There are three main

practices that can help to ensure the best diversification:

Spread portfolio among multiple investment vehiclessuch as cash, stocks, bonds,mutual funds, and perhaps even some real estate

Vary the risk in your securities.If you are investing in equity funds, then consider large

cap as well as small cap funds. And if you are investing in debt, you could consider both

long term and short term debt. It would be wise to pick investments with varied risk

levels; this will ensure that large losses are offset by other areasVary your securities by industry.This will minimize the impact of specific risks of certain

industries

Diversification is the most important component in helping you reach your long-range

financial goals while minimizing your risk. At the same time, diversification is not an

ironclad guarantee against loss. No matter how much diversification you employ,

investing involves taking on some sort of risk.

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Long term investment decision capital

budgeting different techniques

traditional and modern methods of

capital budgeting capital rationing

risk analysis in capital rationing an

overview of cost of capital

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Investment Decision

The investment decision of a firm is generally

known as capital budgeting or capital

expenditure decisions.

It defines the investment of current funds

most efficiently in long-term assets as an

anticipation of expected flow of benefits over

a series of years.

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Importance of Investment Decision

Growth

Risk

Funding

Irreversibility

Complexity

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Capital Budgeting

Capital budgeting is the process of making

investment decisions in capital expenditure.

It involves planning and control of capital

expenditure.

It is the process of deciding whether or not to

commit the recourse to a particular long term

project whose benefit are to be realized over along period of time.

Characteristics / needs/

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Characteristics / needs/

importance of capital budgeting

Exchange of current funds for thebenefit to be achieved in future.

Future benefits.

Invested in long term non- flexibleactivities.

Investment of huge funds.

Difficulties in investment decisions.

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Factors Influencing Capital Budgeting

Availability of funds

Structure of capital

Taxation Policy

Government PolicyLending Policies of Financial Institutions

Immediate need of the Project

Earnings

Capital ReturnEconomic Value of the Project

Working Capital

Accounting Practice

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Capital budgeting process

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STAGES IN CAPITAL BUDGETING

1. Identification Stagedetermine which types of capitalinvestments are necessary to accomplish organizational

objectives and strategies

2. Search StageExplore alternative capital investments

that will achieve organization objectives3. Information-Acquisition Stageconsider the expected

costs and benefits of alternative capital investments

4. Selection Stagechoose projects for implementation

5. Financing Stageobtain project financing

6. Implementation and Control Stageget projects underway and monitor their performance

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Kinds of capital budgeting

1. Accept reject decision:-

It relates to independent projects which do not compete with oneanother. This decisions are mainly based on minimum return oninvestment.

2.Mutually exclusive project decision:-

It relates to the decisions about depend projects. In such a wayacceptance of one project causes rejection of another.

3.Capital rationing decision:-

Here the total capital should be allocated to several profitableprojects according to their nature. Simply limited capital shouldbe rationed to several projects.

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Cash inflow

The cash inflow of a company is simply the total

money earned by that company.

The cash inflow can include interest or money made

on investments, sales, or any other operating activitythat can result in a monetary profit.

Cash inflow minus cash outflow will yield the take-

home profit of a business.

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Payback Method

This method is based on the principal that everycapital expenditure pays itself back within acertain period out of the additional earningsgenerated from the capital assets.

It measures the period of time for the originalcost of a project to be recovered from theadditional earnings of the project.

Under this method various investment proposalsare ranked according to the length of their pay

back period in such a manner that the investmentwith a shorter payback period is preferred to theone which has longer pay back period.

It is also known as pay out period/ pay off period.

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PBP= Cash out flow

annual cash inflow

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Net Present Value Method

It s the modern method of evaluatinginvestment proposal method take intoconsideration the time value of money andattempts to calculate the return on

investment by introducing the factor of timeelement.

It recognizes the fact that a rupee earnedtoday is worth more than the same rupee

earned tomorrow.

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Limitations of NPV method

Estimating cash flowit is difficult to obtain

the estimates of cash flows due to uncertainty.

Measuring discount rateit is difficult to

precisely measure the discount rate.

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Discounted Cash Flows

Discounted Cash Flow (DCF) Methods

measure all expected future cash inflows and

outflows of a project as if they occurred at a

single point in time

The key feature of DCF methods is the time

value of money (interest), meaning that a

dollar received today is worth more than adollar received in the future

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Discounted Cash Flows (continued)

DCF methods use the Required Rate of Return (RRR),

which is the minimum acceptable annual rate of return

on an investment.

RRR is the return that an organization could expect toreceive elsewhere for an investment of comparable risk

RRR is also called the discount rate, hurdle rate, cost of

capital or opportunity cost of capital

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Three-Step NPV Method

1. Draw a sketch of the relevant cash inflows and

outflows

2. Convert the inflows and outflows into present

value figures using tables or a calculator3. Sum the present value figures to determine the

NPV. Positive or zero NPV signals acceptance,

negative NPV signals rejection

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NPV Method Illustrated

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Internal Rate of Return (IRR) Method

The IRR Method calculates the discount rate at

which the present value of expected cash

inflows from a project equals the present

value of its expected cash outflows.

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IRR Method

Analysts use a calculator or computer program to

provide the IRR

Trial and Error Approach:

Use a discount rate and calculate the projects NPV. Goal: find

the discount rate for which NPV = 0

1. If the calculated NPV is greater than zero, use a higher discount

rate

2. If the calculated NPV is less than zero, use a lower discount rate

3. Continue until NPV = 0

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Comparison NPV and IRR Methods

IRR is widely used

NPV can be used with varying RRR

NPV of projects may be combined for

evaluation purposes, IRR cannot

Both may be used with sensitivity analysis

(what-if analysis)

Relevant Cash Flows in

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Relevant Cash Flows in

DCF Analysis

Relevant cash flows are the differences in

expected future cash flows as a result of

making an investment Categories of Cash Flows:

1. Net Initial Investment

2. After-tax cash flow from operations

3. After-tax cash flow from terminal disposal of an

asset and recovery of working capital

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Net Initial Investment

Three Components:

1. Initial Machine Investment

2. Initial Working Capital Investment

3. After-tax Cash Flow from Current Disposal of

Old Machine

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Cash Flow from Operations

Two Components:

1. Inflows (after-tax) from producing and selling

additional goods or services, or from savings

in operating costs. Excludes depreciation,handled below:

2. Income tax cash savings from annual

depreciation deductions

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Types of capital rationingExternal capital rationing

Occurs usually due to the imperfection of capital market.

There are two kinds of reasons for capital rationing -

external and internal.

When a business is unable to borrow funds from outsidesources, it is an external reason for capital rationing. A firm

may be unable to borrow funds because of internal financial

shortages, substandard operating performance, unfavorable

credit conditions or when it introduces a new, untestedproduct. Banks are particularly reluctant to lend to small

businesses and individuals with a less-than-satisfactory

performance.

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Internal capital rationing Occurs due to the self-imposed restrictions by the

management.

In a privately-owned company, management may want to

limit growth of business to have a stronger hold on thebusiness. In larger companies, upper management mayspecify spending limits for each department, following acomprehensive corporate strategy. Internal reasons also

include human resource constraints, in which the companymay not have adequate middle management personnel tocover expansion.

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Computation of cost of capital

A . Computation of cost of specific source offinance

B . Computation of weighted average cost of

capital.

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Computation of cost of specific

source of finance

Computation of each specific sources

like DEBT, PREFERENCE SHARECAPITAL, EQUITY SHARE CAPITAL and

RETAINED EARNINGS.

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Meaning and importanceTheories of

capital structureNet incomeNet

operating incomeMM approach

l

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Capital structure

Capital structure of a company refers to thecomposition of its capitalization and it includesall long term capital sources i.e., loans,

reserves, shares and bonds.

the Capital structure of business can be

measured by the ratio of various kinds ofpermanent loan and equity capital to totalcapital.

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pt ma cap ta structure

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The OCM can be defined as that capital structure or combination of debt and equitythat leads to the maximum value of the firm

OCM maximises the value of the company and hence the wealth of its owners andminimise the companys cost of capital.

the following consideration should be kept in mind while maximising the value of thefirm in achieving the goal of the optimal capital structure:

1. If ROI is higher the fixed cost of funds, the company should prefer to raise thefunds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPSand MV of the firm.

2. If debt is used as a source of finance, the firm saves a considerable amount inpayment of tax as interest is allowed as a deductible expense in computation oftax.

3. It should also avoid undue financial risk attached with the use of increased debt

financing4. The Capital structure should be flexible.

Point of indifference/ Range of earningsThe earnings per share equivalent point or point of indifference

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The earnings per share, equivalent point or point of indifference

refers to that EBIT, level at which EPS remains the same

irrespective of Different alternatives of Debt-Equity mix. At this

level of EBIT, the rate of return on capital employed is equal to

the cost of debt and this is also known as the break-even level

of EBIT for alternative financial plans

Capital Gearing

CG means the ratio between the various types of securities in the

capital structure of the company. A company is said to e high-

gear when it has proportionately higher/larger issue of Debtand PS for raising the LT resources. Whereas low-gear stands for

a proportionately large issue of equity shares.

Leverage

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everage

Leverage-an Increased means of accomplishing some

purpose

In financial management, it is the firms ability to use fixed

cost assets or funds to increase the returns to its owners;

Financial leverage- the use of long term fixed income

bearing debt and preference share capital along with theequity share capital is called financial leverage or trading

on equity

A Firm is known to have a favourable leverage if its earnings

are more than what debt would cost. On the contrary, ifit does not earn as much as the debt costs then it will be

known as an unfavourable leverage.

I t f fi i l l

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Impact of financial leverage

When the d/f b/w the earnings from assets financed byfixed cost funds and cost of these funds are distributed to

the equity stockholders, they will get additional earnings

without increasing their own investment. Consequently,

the EPS and the Rate of return on ESC will go up.

On the contrary, if the firm acquires fixed cost funds at a

higher cost than the earnings from those assets then the

EPS and return on equity capital will decrease.

Significance of financial leverage

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Significance of financial leverage

Planning of capital structure

Profit planning

Limitations of FL/ trading on equity

Double-edged weapon Beneficial only to companies having stability in

earnings

Increases risk and rate of interest

Restriction from financial instruments

O ti l

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Operating leverage

Operating leverage results from the presence of fixed coststhe help in magnifying net operating income fluctuations

flowing from small variations in revenue.

The changes in sales are related to changes in the revenue.

The fixed costs do not change with the changes in sales,

any increase in sales, FC remaining the same, will

magnify operating revenue

OL shows the ability of a firm to use fixed operating cost to

increase the effect of change in sales and the charges in

fixed operating income.

A measurement of the degree to which a firm or project incurs acombination of fixed and variable costs.

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1. A business that makes few sales, with each sale providing a veryhigh gross margin, is said to be highly leveraged. A business that

makes many sales, with each sale contributing a very slight margin, is

said to be less leveraged. As the volume of sales in a business

increases, each new sale contributes less to fixed costs and more to

profitability.

2. A business that has a higher proportion of fixed costs and a lower

proportion of variable costs is said to have used more operatingleverage. Those businesses with lower fixed costs and higher variable

costs are said to employ less operating leverage.

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C bi d l

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Combined leverage

The OL affects the income which is the resultof production. On the other hand, FL is theresult of financial decisions. The CL focusesattention on the entire income of the concern

This leverage shows the relationship betweena change in sales and the correspondingvariation in taxable income.

Working capital leverage

This leverage measures the sensitivity of ROI ofchanges in the level of current assets.

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ROI ROE Approach

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ROIROE Approach

This approach analyses the relationshipbetween the ROI and ROE for different levels

of financial leverage.

ROIreturn on investment

ROE- return on equity

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Assumptions of Capital Structure

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p p

Theories

Firm uses only two sources of funds: perceptual riskless debt andequity;

There are no corporate or income: or personal tax;

The dividend payout ratio is 100% [There are no retained earnings];

There is no change in the total assets.

There is no change in capitalThe firms operating profits (EBIT) are not expected to grow;

The business risk is remained constant

The firm has perpetual life

Definitions used in Capital Structure

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Definitions used in Capital Structure

E = Total Market Value of Equity.

D = Total Market Value of Debt.

V = Total Market Value of the Firm.

I = Annual Interest payment.

NI = Net Income.

NOI = Net Operating Income.

Ee = Earning Available to Equity Shareholder.

he weighted average cost of capital (WACC)is the ratethat a company is expected to pay on average to all its

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that a company is expected to pay on average to all itssecurity holders to finance its assets.

The WACC is the minimum return that a company mustearn on an existing asset base to satisfy its creditors,owners, and other providers of capital, or they willinvest elsewhere. Companies raise money from anumber of sources: common equity, preferred stock,

straight debt, convertible debt, exchangeabledebt, warrants, options, pension liabilities, executivestock options, governmental subsidies, and so on.Different securities, which represent different sources

of finance, are expected to generate different returns.The WACC is calculated taking into account the relativeweights of each component of the capital structure. Themore complex the company's capital structure, the

more laborious it is to calculate the WACC.

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Net Income (NI) Approach

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According to NI approach, if the financialleverage increases, the weighted average cost

of capital decreases and the value of the firm

and the market price of the equity sharesincreases. Similarly, if the financial leverage

decreases, the weighted average cost of

capital increases and the value of the firm andthe market price of the equity shares

decreases.

Assumptions of NI approach

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Assumptions of NI approach

There are no taxes

The cost of debt is less than the cost of equity.

The use of debt does not change the risk

perception of the investors

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Net Income Approach

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Net Income Approach

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Net Operating Income Approach

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Net Operating Income Approach

There is no relation between capital structure and Ko and V.

Assumptions:

(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of

leverage.

(ii) The market capitalises the total value of the firm as a whole and noimportance is given for split of value of firm between debt and equity;

(iii) The market value of equity is residue [i.e., Total value of the firm minus market

value of debt)

(iv) The use of debt funds increases the received risk of equity investors, there by ke

increases

(v) The debt advantage is set off exactly by increase in cost of equity.(vi) Cost of debt (Ki) remains constant

(vii) There are no corporate taxes.

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Formula used for NOI Approach

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Formula used for NOI Approach

Value of the Firm [V] = EBIT / Ko

Market Value of Equity [E] = VD

Cost of Equity/ Equity Capitalization Rate [Ke]

= Ee / E or EBITI / V - D

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Assumptions

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Assumptions

a. Information is available at free of costb. The same information is available for all investors

c. Securities are infinitely divisible

d. Investors are free to buy or sell securities

e. There is no transaction costf. There are no bankruptcy costs

g. Investors can borrow without restrictions as the sameterms on which a firm can borrow

h. Dividend payout ratio is 100 percenti. EBIT is not affected by the use of debt

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