KMBN204(FINANCIAL MANAGEMENT AND CORPORATE

FINANCE)
UNIT-1
INTRODUCTION OF FINANCE
What Is Finance?
Finance is a term for matters regarding the management, creation, and study of money and
investments. It involves the use of credit and debt, securities, and investment to finance
current projects using future income flows. Because of this temporal aspect, finance is
closely linked to the time value of money, interest rates, and other related topics.
Finance can be broadly divided into three categories:
 Public finance
 Corporate finance
 Personal finance

 Finance is a term broadly describing the study and system of money, investments,
and other financial instruments.
 Finance can be divided broadly into three distinct categories: public finance,
corporate finance, and personal finance.
 More recent subcategories of finance include social finance and behavioral finance.
 The history of finance and financial activities dates back to the dawn of civilization.
Banks and interest-bearing loans existed as early as 3000 BC. Coins were being
circulated as early as 1000 BC.
 While it has roots in scientific fields, such as statistics, economics, and mathematics,
finance also includes non-scientific elements that liken it to an art.

 Finance is the process of managing every money-related activity of businesses, people, and
governments
Key Finance Terms
Here are some key financial terms one should know:
 Assets: Assets refer to all resources a business has with an economic value. This
includes current assets , fixed assets , tangible assets , intangible assets, operating assets ,
and non-operating assets.

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 Liabilities: Liabilitiesrefer to all financial obligations that an entity is responsible for,
including debt. Current liabilities must be paid within the same year, whereas non-current
liabilities are long-term (eg: leases, mortgages, and business loans).
 Balance Sheet: A balance sheet is a document that outlines all assets minus all liabilities to
arrive at the entity’s total net worth. People do this to determine their personal net worth.
(assets like income, investments, and property minus liabilities like mortgage and student
loans)
 Accounts Receivable:Accounts Receivable(A/R) is the amount all clients owe to a business,
usually in invoices. This represents all the income.
 Cash Flow: Cash flow is the overall movement of money into and out of your business each
month and is compiled into a cash flow statement to determine the entity’s ability to pay its
bills reliably.
 Profit and Loss: A business must intake more income than expenses to maintain profits.
Otherwise, they will incur losses. The document aggregating and analyzing all profit and loss
is an income statement.
 Net Profit: This is also referred to as net operating income or the bottom line and refers to
the total amount a business has earned or lost at the end of each reporting period (usually one
month).
 Time Value of Money: Time Value of Money is a concept that essentially means that a dollar
today is worth more than a dollar tomorrow. Due to compoundinginterest, inflation, and the
function of money in our economy, the present value of money today is always worth more
than its future value.
Role of a Financial Manager
Financial activities of a firm is one of the most important 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 should maintain a far sightedness in order to ensure that
the funds are utilized in the most efficient manner.
His/Her actions directly affect the Profitability, growth and goodwill of the firm.
Following are the main functions of a Financial Manager:
1. Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and
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.
2. Allocation of Funds
Once 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
1. The size of the firm and its growth capability
2. Status of assets whether they are long-term or short-term
3. Mode by which the funds are raised

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 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.
A healthy mix of variable and fixed factors of production can lead to an increase in the
profitability of the firm.
Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production.
An opportunity cost must be calculated in order to replace those factors of production
which has gone thrown wear and tear. If this is not noted then these fixed cost can
cause huge fluctuations in profit.
Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager.
When securities are traded on stock market there involves a huge amount of risk
involved. Therefore a financial manger understands and calculates the risk involved in
this trading of shares and debentures.
Its on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst share holders as
dividend instead invest in the business itself to enhance growth.
The practices of a financial manager directly impact the operation in capital market.

Wealth Maximization vs
Profit Maximization
Wealth Maximization consists of activities that manage
the financial resources to increase the stakeholders’
value. In contrast, Profit Maximization consists of the
activities that manage the financial resources intending
to increase the Company’s profitability.

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Financial Decisions

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Financial decisions are the decisions taken by managers about an organization’s finances.
These decisions are of great significance for the organization’s financial well-being. The
financial decisions pertaining to expenditure management, day-to-day capital management,
assets management, raising funds, investment, etc. The assets and liabilities of the
organisation are affected by financial decisions. Undertaking efficient financial decisions can
lead to immense revenue over a long term period. Investment decisions are significantly
immense decisions. Besides this, financing and dividend are also essential aspects of financial
decisions. Keep on reading to know more about it, including the various factors affecting
financial decisions.
Investment Decisions
Investment decisions pertain to how managers must invest in various securities, instruments,
assets etc. These decisions are considered more important than financing and dividend
decisions.
Here, the decision is taken regarding how investment should occur in different asset classes
and which ones to avoid. It also involves whether to go for short term or long term assets.
This decision is taken under the organizational requirements.
This decision in financial management is concerned with allocation of funds raised from
various sources into acquisition assets or investment in a project.
The scope of investment decision includes allocation of funds towards following
areas:
i. Expansion of business
ii. Diversification of business
iii. Productivity improvement
iv. Product improvement
v. Research and Development
vi. Acquisition of assets (tangible and intangible), and
vii. Mergers and acquisitions.
Further, Investment decision not only involves allocating capital to long term assets but
also involves decisions of utilizing surplus funds in the business, any idle cash earns no
further interest and therefore not productive. So, it has to be invested in various as
marketable securities such as bonds, deposits that can earn income.
Most of the investment decisions are uncertain and a complex process as it involves
decisions relating to the investment of current funds for the benefit to be achieved in
future. Therefore while considering investment proposal it is important to take into
consideration both expected return and the risk involved. Thus, finance department of an
organization has to decide to allocate funds into profitable ventures so that there is safety
on investment and regular returns is possible.

Financing Decisions
Managers take these decisions to facilitate financing for the organisation. The relation of
financing decisions is to raise equity while reducing debt as much as possible. Often, they are
taken in light of the investment decisions.
These decisions must be taken continuously as the organisation needs funds regularly.
Financing decisions should not be very rigid to allow room for manoeuvre if an emergency
arises or the economic situation changes suddenly.
All organizations irrespective of type of business must raise funds to buy the assets
necessary to support operations.
Thus financing decisions involves addressing two questions:
I. How much capital should be raised to fund the firm’s operations (both existing &
proposed?)

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 II. What is the best mix of financing these investment proposals?
The choice between the use of internal versus external funds, the use of debt versus
equity capital and the use of long-term versus short-term debt depends on type of source,
period of financing, cost of financing and the returns thereby. Prior to deciding a specific
source of finance it is advisable to evaluate advantages and disadvantages of different
sources of finance and its suitability for purpose.
Efforts are made to obtain an optimal financing mix, an optimal financing indicates the
best debt-to-equity ratio for a firm that maximizes its value, in simple words, and the
optimal capital structure for a company is the one which offers a balance between cost
and risk.

Dividend Decision
After making a profit, an organisation has to decide how much reward to give to its
shareholders. This reward must be given to them in return for their investment in the
company’s stock. Giving too little can cause a loss of trust and confidence of shareholders in
the organisation. However, giving too much would reduce the profit margin of the
organisation. So, an optimum balanced dividend decision must be taken in this situation.
These decisions involve how many profit portions to hand over to the shareholders in
dividends. It also consists of the timing of giving dividends to the shareholders. An excessive
delay in giving dividends would be bad for the reputation of the organisation in the eyes of
the shareholders and the public.
4. Working Capital Decisions:
In simple words working capital signifies amount of funds used in its day-to-day trading
operations. Working capital primarily deals with currents assets and current liabilities.
Infact it is calculated as the current assets minus the current liabilities. One of the key
objectives of working capital management is to ensure liquidity position of a firm to
avoid insolvency.
The following are key areas of working capital decisions:
i. How much inventory to keep?
ii. Deciding ratio of cash and credit sales
iii. Proper management of cash
iv. Effective administration of bills receivables and payables
v. Investment of surplus cash.
The principle of effective working capital management focuses on balancing liquidity
and profitability. The term liquidity implies the ability of the firm to meet bills and the
firm’s cash reserves to meet emergencies. Whereas the profitability means the ability of
the firm to obtain highest returns within the funds available. In order to maintain a
balance between profitability and liquidity forecasting of cash flows and managing cash
flows is very important.

Factors Affecting Financial Decisions

Let’s look at the factors affecting investment, financing, and dividend decisions.
Factors Affecting Investment Decisions:
 Capital budgeting- The evaluation of investment proposals must occur by techniques of
capital budgeting. This means considering factors like rate of return, interest rate, investment
amount, etc.
 Cash flows of the project- A proper estimation must be made of the expected cash receipts
and payments during the entire tenure of an investment proposal.
 Rate of return- The expected returns from an investment proposal must be considered.
 Factors Affecting Financing Decision:

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 Cost- The cost of raising funds varies from one source to another. For example, equity is
generally more expensive than debt.
 Cash flow position- A good cash flow position means ease in using borrowed funds.
 Economic condition- Finances can be raised easily during an economic boom, while a
recession makes it hard to raise finances.
 Risk- The risk associated with various financing sources is not the same. Borrowed funds
involve more risk than the owner’s fund as interest.
 Flotation cost- This is the cost involved in issuing securities like expenses on the prospectus,
the fee of underwriting, and the commission or brokerage.
 Factors affecting Dividend Decision:
 Preference of shareholders- Shareholders’ preferences must be considered when deciding the
dividend amount. If this amount falls too below the shareholders’ expectations, the
organisation’s reputation will be affected. This is a risk that every organisation must avoid.
 Earnings- High dividend rate can be declared by organisations with stable earnings.
 Dividends stability- Organizations try to stabilise dividends as much as follows. As such, no
altering in dividend share should occur due to small or minor changes.
 Taxation policy- A high tax on dividends would mean that organisations would do lower
dividend payouts generally. The situation would be reversed if tax rates were lower.
 Growth prospects- If the estimated growth prospects of the organisation are good shortly, the
number of dividends will be low.
 Cash flow- When declaring dividends, an organisation must ensure that it has sufficient cash
available. As such, the organisation’s cash flow position is a crucial factor to consider.
Conclusion
Financial decisions are the decisions that managers of an organisation make about the
finances. These decisions play a huge role in the financial well-being of an organisation.
There are three types of financial decisions- investment, financing, and dividend. Managers
take investment decisions regarding various securities, instruments, and assets. They take
financing decisions to ensure regular and continuous financing of the organisations. The
dividend decision has to do with the correct amount of reward to its shareholders. Finally,
read the various factors affecting financial decisions.

CORPORATE FINANCE
Corporate finance is a subfield of finance that deals with how corporations address funding
sources, capital structuring, accounting, and investment decisions.
Corporate finance is often concerned with maximizing shareholder value through long- and
short-term financial planning and the implementation of various strategies. Corporate
finance activities range from capital investment to tax considerations.
Corporate finance refers to planning, developing and controlling the capital structure of a
business. It aims to increase organizational value and profit through optimal decisions on
investments, finances as well as dividends. It focusses on capital investments aimed at
meeting the funding requirements of a business to attain a favorable capital structure.
 Corporate finance is the process of obtaining and managing finances in order to optimize a
company’s growth and value for its shareholders.
 The concept focusses on investment, financing and dividend principle.
 The main functional areas are capital budgeting, capital structure, working capital
management and dividend decisions. For example, judging whether to invest in debt or equity
as a medium to raise funds for the business is the primary focus of capital structure decisions.
 Going over the risk-return aspect of investment alternatives, ensuring working capital
management, etc. are some aspects of this branch of finance.

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  Corporate finance is concerned with how businesses fund their operations in order to
maximize profits and minimize costs.
 It deals with the day-to-day demands on business cash flows as well as with long-
term financing goals (e.g., issuing bonds).
 Corporate finance also deals with monitoring cash flows, accounting, preparing
financial statements, and taxation.
 Determining whether or not to issue a dividend is another corporate finance activity.
 Corporate finance jobs can pay attractive salaries.

SCOPE OF CORPORATE FINANCE

The most crucial role of corporate finance is to cater to the financial needs of businesses and
resolve financial issues. Here is why sound knowledge of corporate finance is of utmost
importance for every business:
The scope/ importance of corporate finance can be classified as follows:
 Decision Making:
There are several decisions that have to be done on the basis of available capital and limited
resources. If an organization has to start a new project, then it has to consider whether it
would be financially viable and if it would yield profits. So while investing in a new project
or a new venture, a company has to consider several things like availability of finances, the
time taken for its completion, etc. and then makes decisions accordingly.
 Research and Development: In order to survive in a volatile market for a long duration, a
business organization needs to continuously research the market and develop new products to
appeal the consumers. It may even have to upgrade its old products to compete with new
vendors in the market. Some companies employ people to conduct market surveys on a large
scale; prepare questionnaire for consumers; do market analysis, while other may outsource
this work to others. All these activities would require financial support.
 Fulfilling Long Term and Short Term Goals: Every organization has several long term goals
in order to survive in the market. The short term goals may include paying the salaries of
employees, managing the short term assets, acquiring corporate finances like bank drafts,
trade credit from suppliers, purchase of raw materials for production etc. Some long term
goals would include acquiring bank loans and paying them off; increasing the customer base
for the company etc.
 Depreciation of Assets: When you invest in a new software or a new equipment, you would
require to keep aside some amount to maintain it and upgrade it in the long run. Only then
you could be assured that it would yield good results over a period of time. In the fast
changing times of today, if this is not done, you might end up losing business if you do not
have finances for it.
 Minimizing Cost of Production: Corporate finance helps in minimizing the cost of
production. With the rising cost of prices of raw materials and labor, the management has to
come up with innovative measures to minimize the cost of production. In many organizations
that spend a lot of money on large scale production, deploy professionals for this purpose.
These people tend to buy quality products from vendors who offer it at lowest possible rates.
For example, a products based software company might buy software from a vendor that sells
it at a lower rate than an internationally acclaimed company selling the same thing.
 Raising capital: When an organization has to invest in a new venture, it is very important
that it has to raise capital. This cab be done by selling bonds and debentures, stocks of the
company taking loans from the banks etc. All this can be done only by managing corporate
finances in a proper manner.
 Optimum Utilization of Resources: The resources available to organizations may be limited.
But if they are utilized efficiently, they can yield good results. For example, a business

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organization needs to know the amount of money it can spend on its employees and how
much hike should be given to them. The proper management of corporate finance would also
help in utilizing its profits in such a manner that would help in increasing them; for example,
investing in government bonds, keeping up with the latest technology trends to increase
efficiency.
 Efficient Functioning: A smooth flow of corporate finance would enable businesses to
function in a proper manner. The salaries of employees would be paid on time, loans would
be cleared in time, purchase raw materials can be done when required, sales and promotion
for existing products and launch of new products, etc.
 Expansion and Diversification: Before an organization decides to expand or diversify in to
a new arena, it has to consider various aspects like the capital available, risks involved, the
amount to be invested for purchase of new equipment etc. All this can be done by experts and
this would be very beneficial for the organization.
 Meeting Contingencies: Running a business involves talking several risks. Not all risks can
be foreseen. Although you can transfer some of these risks to third parties by buying an
insurance policy, you cannot have every contingency covered by your insurer. You would
have to keep some amount aside to tide over these situations.
Corporate finance plays a very important role in the overall functioning, growth and
development of a business. In India, finance advisors help entrepreneurs and businesses by
providing them with vital information through market research and analysis. This helps then
to make decisions, expand their business, and survive in a competitive market in the long run.
Therefore, the management of corporate finance is very important for profitable as well as
non-profitable organizations.
Corporate Governance

Corporate governance is the system of rules, practices, and processes by which a firm is
directed and controlled. Corporate governance essentially involves balancing the interests of
a company's many stakeholders, such as shareholders, senior management executives,
customers, suppliers, financiers, the government, and the community.
Since corporate governance provides the framework for attaining a company's objectives, it
encompasses practically every sphere of management, from action plans and internal
controls to performance measurement and corporate disclosure.
 Corporate governance is the structure of rules, practices, and processes used to direct
and manage a company.
 A company's board of directors is the primary force influencing corporate
governance.
 Bad corporate governance can cast doubt on a company's operations and its ultimate
profitability.
 Corporate governance covers the areas of environmental awareness, ethical behavior,
corporate strategy, compensation, and risk management.
 The basic principles of corporate governance are accountability, transparency,
fairness, responsibility, and risk management.
Benefits of Corporate Governance
 Good corporate governance creates transparent rules and controls, provides guidance
to leadership, and aligns the interests of shareholders, directors, management, and
employees.
 It helps build trust with investors, the community, and public officials.
 Corporate governance can provide investors and stakeholders with a clear idea of a
company's direction and business integrity.
 It promotes long-term financial viability, opportunity, and returns.

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  It can facilitate the raising of capital.
 Good corporate governance can translate to rising share prices.
 It can lessen the potential for financial loss, waste, risks, and corruption.
 It is a game plan for resilience and long-term success.
The Principles of Corporate Governance
While there can be as many principles as a company believes make sense, some of the more
well-known include the following.
Fairness
The board of directors must treat shareholders, employees, vendors, and communities fairly
and with equal consideration.
Transparency
The board should provide timely, accurate, and clear information about such things as
financial performance, conflicts of interest, and risks to shareholders and other stakeholders.
Risk Management
The board and management must determine risks of all kinds and how best to control them.
They must act on those recommendations to manage them. They must inform all relevant
parties about the existence and status of risks.
Responsibility
The board is responsible for the oversight of corporate matters and management activities. It
must be aware of and support the successful, ongoing performance of the company. Part of
its responsibility is to recruit and hire a CEO. It must act in the best interests of a company
and its investors.
Accountability
The board must explain the purpose of a company's activities and the results of its conduct.
It and company leadership are accountable for the assessment of a company's capacity,
potential, and performance. It must communicate issues of importance to shareholders.
Corporate Governance Models
The Anglo-American Model
This model can take various forms, such as the Shareholder Model, the Stewardship Model,
and the Political Model. However, the Shareholder Model is the principal model.
The Shareholder Model is designed so that the board of directors and shareholders are in
control. Stakeholders such as vendors and employees, though acknowledged, lack control.
Management is tasked with running the company in a way that maximizes shareholder
interest. Importantly, proper incentives should be made available to align management
behavior with the goals of shareholders/owners.
The model accounts for the fact that shareholders provide the company with funds and may
withdraw that support if dissatisfied. This can keep management working efficiently and
effectively.
The board should consist of both insiders and independent members. Although traditionally,
the board chairman and the CEO can be the same person, this model seeks to have two
different people hold those roles.
The success of this corporate governance model depends on ongoing communications
between the board, company management, and the shareholders. Important issues are
brought to shareholders' attention. Important decisions to be made are put to shareholders for
a vote.
U.S. regulatory authorities tend to support shareholders over boards and executive
management.

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The Continental Model
Two groups represent the controlling authority under the Continental Model. They are the
supervisory board and the management board.
In this two-tiered system, the management board is comprised of company insiders, such as
its executives. The supervisory board is made up of outsiders, such as shareholders and
union representatives. Banks with stakes in a company also could have representatives on
the supervisory board.
The two boards remain completely separate. The size of the supervisory board is determined
by a country's law. It can't be changed by shareholders.
National interests have a strong influence on corporations with this model of corporate
governance. Companies can be expected to align with government objectives.
This model also considers stakeholder engagement of great value, as they can support and
strengthen a company’s continued operations.
The Japanese Model
The key players in the Japanese Model of corporate governance are banks, affiliated entities,
major shareholders called Keiretsu (who may be invested in common companies or have
trading relationships), management, and the government. Smaller, independent, individual
shareholders have no role or voice.
Together, these key players establish and control corporate governance.
The board of directors is usually comprised of insiders, including company executives.
Keiretsu may remove directors from the board if profits wane.
The government affects the activities of corporate management via its regulations and
policies.
In this model, corporate transparency is less likely due to the concentration of power and the
focus on interests of those with that power.
How to Assess Corporate Governance
As an investor, you want to select companies that practice good corporate governance in the
hope of avoiding losses and other negative consequences such as bankruptcy.
You can research certain areas of a company to determine whether or not it's practicing good
corporate governance. These areas include:
 Disclosure practices
 Executive compensation structure (whether it's tied only to performance or also to
other metrics)
 Risk management (the checks and balances on decision-making)
 Policies and procedures for reconciling conflicts of interest (how the company
approaches business decisions that might conflict with its mission statement)
 The members of the board of the directors (their stake in profits or conflicting
interests)
 Contractual and social obligations (how a company approaches areas such as climate
change)
 Relationships with vendors
 Complaints received from shareholders and how they were addressed
 Audits (the frequency of internal and external audits and how issues have been
handled)
Types of bad governance practices include:
 Companies that do not cooperate sufficiently with auditors or do not select auditors
with the appropriate scale, resulting in the publication of spurious or noncompliant
financial documents
 Bad executive compensation packages that fail to create an optimal incentive for
corporate officers

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  Poorly structured boards that make it too difficult for shareholders to oust ineffective
incumbents
Be sure to include corporate governance in your due diligence before making an investment
decision.
Importance of corporate governance
The corporate governance is an emerging concept which came into light in the world in 2002
when the U.S. introduced the Sarbanes- Oxley Act, and in India, its importance was
highlighted after Satyam Fraud and Kingfisher Airlines loss.
So get prevention from such losses in future, corporate governance is introduced and have the
following importance:
 It will help in maximize value, sustainability and long-term benefits.
 It also ensures good citizenship awareness.
 It helps in developing ethical behaviour in the corporation.
 It also helps in developing sound corporate governance practices.
Objectives of corporate governance
The objectives of corporate governance are as follows-
Social responsibility: All Stakeholders should be accountable to the whole section as a
collective responsive policymaker. In a diverse society, every section should have its
ideological representation from which the policy could be framed. This is analogous to the
cabinet form of government in which ministers are collectively responsible to the public’.
Transparency: All the work carried out by executive should be in the public domain for
better grievance redressal and timely disposal of complaints.
Apex executive authorities should consult general public experts on public matters and place
them in timely manners for greater accountability like Shillong Declaration in India.
Work Culture: To implement and make a bureaucracy that is ideologically thought for
public welfare with maximum participation of every section of society evenly, including the
marginalized section.
This policymakers consult and work in timely bounded manners to resolve matters related to
minimum government maximum governance. An ideal public employer is one who disburses
their duties without any discrimination to anyone.
Citizen charter for public welfare is a type of governance mechanism which is single point
reach out the guidance of the concerned authority towards the public.
Economic Goal-One of major goal is to secure economic justice for every involved section
like universal basic income, minimum wages, work-life balance etc.
Economic justice is also one for job security social security in which people are able to cope
with market volatility and the seasonal changes that affect the market and employment trends.
Social Cohesion: It also acts as a binding force for inclusive growth for all. Many central
sponsored schemes are already implemented in this sector by our government.
Marginalized sections are the worst affected person foe which representation is very low. SC
& ST, Women, OBC, LGBTQ are often targeted, but a binding force with cooperation for
stakeholders is needed for their welfares also.
Corporate governance initiatives in India
In India, the Ministry of Corporate Affairs and Securities and Exchange Board of India take
initiatives for corporate governance. The first formal regulatory framework for certain
companies, specifically for corporate governance, was established by the SEBI in February
2000 on the recommendations of Kumarmangalan Birla Committee report.
SEBI is also maintaining the standards of corporate governance through various laws. Some
of them are Securities Contracts (Regulation) Act, 1956.
In 2002, the Ministry of Corporate affairs appointed Naresh Chandra Committee to examine
various issues related to corporate governance.

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Ethical issues with corporate governance in India
Not only law and board making are sufficient for establishing corporate governance. The
correct implementation is also necessary for effectively inculcating the ethics of corporate
governance. There are some issues associated with corporate governance in India:
 Conflict of interest
 Weak board
 Ownership and management separation
 Independent directors
 Executive compensation
Conflicts Of Interest: Sometimes, the interest of the administrative board and management
board are different, which causes conflicts and become a barrier in establishing corporate
governance in the organization.
Weak Board: Another issue is the weak board of the corporation which have less or no
diversity of experiences and implementing policies and management. For example, in the
case of Insolvency Leasing and financial services, no red flag was raised by any board
member.
Ownership And Management Separation: the management and owner of the firm
corporate are different, which causes a difference in interest and sometimes in powers also
which is responsible for hindrance of the progress of corporate.
Independent Directors: the governing body can check for the partisanship of the directors
that is they are independent of accountability and can frame rules according to the favouring
policies towards their own interests.
Executive Compensation: There are minimal restraint and less accountability from which
the compensated efforts are not disbursed properly to the policymakers. Executive boards do
not provide enough transparency to showcase proper mode of working in their course of
action.
Conclusion
The corporate governance is an emerging practice which includes the balancing of the
interest of the company’s stakeholders and the interest of the community.
Corporative governance has 4Ps – people, purpose, process and performance. There are
various ethical issues associate with the corporate governance in India like the conflict in the
interest, weak board, executive compensation etc.
There are various initiatives taken by the government in order to promote corporate
governance which is mainly done by the Ministry of Corporate Affairs and SEBI.
What Is Agency Theory?
Agency theory refers to a principle that focuses on the relationship between principals and
their agents. The principal is a superior entity, and they delegate work to the entity known as
agents. Michael C. Jensen and William Meckling popularized the agency theory concept.

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 In a business scenario, shareholders are the principals, and company executives are the
agents. In a political context, elected representatives are the agents, and their constituents are
the principals. The theory points to the conflict of interest and priorities between principals
and agents. Conflict occurs when they are engaged in achieving a specific goal and agents act
on behalf of the principal.
 Agency theory definition portrays it as a principle that focuses on the relationship between
principals and their agents. Michael C. Jensen and William Meckling popularized the
concept.
 A company’s board of directors and the CEO is an example of a principal-agent relationship
where the board of directors is the principal, and the CEO is the agent.
 It can be applied to resolve disputes between principals and agents. However, it also has
disadvantages like narrow focus and a limited set of presumptions.
Principal Agency Theory Explained
The agency theory analyses the issues and solutions surrounding task delegation from
principals to agents. The principals appoint the agents to perform specific duties. Agents are
given authority to complete the duties or work assigned. The issues arise because of
conflicting interests and information asymmetry between the principal and agent. The theory
discusses setting up agency relationships to minimize the likelihood of disputes and other
problems between agents and principals.
The types of agency theory can be positivist and principal agency theory:
 Positivist studies have concentrated on defining scenarios in which the principal and agent
are likely to have divergent aims and then detailing the governance frameworks that restrict
the agent’s self-serving or self-interest conduct. For example, the agent is more likely to
operate in the principal’s best interests when the agreement between the principal and agent is
outcome-based, or the principal has information to verify the agent’s actions.
 The principal-agent researchers focus on the principal-agent relationship and interaction to
create the ideal contract between the principal and the agent. Also, a behavior-based contract
is the most effective since the principal purchases the agent’s conduct in this situation. Also,
Because the agent is thought to be more risk-averse than the principal, an outcome-based
contract would unduly pass the risk to the agent.

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 Types Of Agency Theory Relationship
Some of the important types are:
1. Shareholders and Company Executives
In this relationship, the company executives serve as the agents and the shareholders as the
principal. Investors, in this case, are the shareholders who fund the companies run by
company executives. Furthermore, the actions taken by the company’s management will
determine the potential impact on the investment. Therefore, the firm management must
make wise decisions.
2. Board of Directors and CEO
The CEO (agent) serves the board of directors (principal). The board of directors would
support the CEO if he can make profitable decisions. On the other side, the relationship
between the board of directors and the CEO might be problematic if the choice made by the
CEO hurts the company’s financial situation.
3. Investor and Fund Manager
The fund manager is the agent, while the investor is the principal. The investor gives the fund
manager a fee, a percentage of the fund’s average assets under management (AUM). In this
scenario, the fund manager allocates the money per the investor’s preferences. If the fund
manager can assist the investors in gaining profits above average, they can develop a close
relationship. Alternatively, if the fund manager reports a loss or profits lower than expected,
the relationship between the investor and the fund manager would be affected.
Examples
Let us look at the agency theory examples to understand the concept better:
Example #1
Employees are agents, while employers are the principals in agency theory. Employees are
hired in a company to work toward the organization’s goals. However, the increasing number
of corporate scams affects employer and employee relationships. Employees violate the
organization’s ethics, which results in significant financial and reputational damage.
Sometimes the damage done by corrupt employees is irreversible, and an organization
ultimately has to wind up the business.
Example #2
The way a country’s government functions is among the most prevalent examples of agency
theory. The people choose political representatives to govern the nation in a way that best
serves their interests. Representatives of various political parties promise voters that they will
bring reforms in line with the interests of the country’s citizens. However, voters feel
deceived when their elected officials do not fulfill guaranteed promises. Here, the electorate
serves as the principal and chooses the public servants as their agents.
Advantages & Disadvantages
Advantages
 It resolves the disputes between the agents and the principals
 The incentives motivate the agents, reducing losses to the firm or the organization.
 Another strategy to cut agency loss is compensating agents according to performance.
 Conflict is less likely to arise if there is transparency between the principals and the agents.
Disadvantages
 Its limited behavioral presumptions and theoretical focus are one of its drawbacks. A larger
spectrum of human motivations is ignored by agency theory since it primarily emphasizes
self-interested and opportunistic human behavior.
 Procedures defending shareholders’ interests may interfere with implementing strategic
choices and limit collective activities. Hence, control mechanisms recommended based on
agency theory are not only expensive but also commercially unsuccessful.

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 The theory has been criticized for oversimplifying organizational conflict and for the
mathematical complexity necessary to find answers to the agency problem.
Corporate Valuation Model

In the field of finance, corporate valuation is the process of determining the value of a
business entity. It is an important aspect of corporate finance, used for a wide variety of
purposes. Valuation is essential for mergers and acquisitions, where a sound decision has to
be made whether and at what price to acquire a company. The value of a company could be
different for sellers and buyers, so valuation is integral part of the negotiation process. It is
also crucial for the effective management of a company, for identifying its value-generating
units, and formulating strategies for growth. Initial public offerings, portfolio management,
and tax assessment are also areas that involve a lot of corporate valuation.
Asset-Based Valuation
Asset-based valuation model derives the value of a company by determining the fair market
value of its assets. Assets are an important factor in revenue generation. Every company with
active business and operations has a set of assets and liabilities. Assets can be tangibles
like property, plant & equipment (PPE) or intangibles like copyrights and trademarks.
The basic concept implies that the value of the total company equity is equivalent to the value
of the total company assets (tangible and intangible) minus the value of the total company
liabilities (recorded and contingent). An analyst can use different techniques to value an
asset. For example, they can follow balance sheet values, replacement values, or fair market
values.
It is a generally accepted business valuation method. The method is flexible and complex at
the same time. The provision to add off-balance-sheet items like contingent assets or
liabilities explains its flexibility. The market worth of tangible assets is easily estimated using
book value. However, estimating the value of intangible assets makes the method complex.
As a result, this method may necessitate more data, analyst effort, and associated
expenditures than alternative valuation approaches.
Asset-Based Valuation Methods

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 #1 – Asset Accumulation Valuation
The asset accumulation valuations methods resemble the balance sheet equation; that is, the
difference between the value of assets and liabilities gives the company’s equity value or net
worth. The method considers all the assets and liabilities, even the items not present on the
balance sheet. For example, it includes the values of intangible assets like trademarks and
contingent liabilities, which usually appear in the footnotes to the financial statements.
#2 – Excess Earnings Valuation
Excess earnings valuation method recommended by IRS Rev. Rul. 68–609 combines asset-
based and income-based models aggregating asset and income information. The IRS ruling
also states that the technique “should not be used if there is better evidence available from
which the value of intangibles can be determined.” The method uses two capitalization
rates to identify tangible vs. intangible assets returns. So, a combination of the tangible and
intangible asset values contributes to evaluating the company’s overall value.
Various studies suggest that the excess earnings method is a feasible valuation alternative for
privately held firms, lacking analyst monitoring. The difficulty in estimating two
capitalization rates, on the other hand, acts as a disincentive to broader usage in business
valuation.
Examples
To find the value using an asset-based approach, an analyst start this valuation procedure
with an audited balance sheet. All entity assets and liability accounts are subject to
revaluation to the valuation assignment standard of value. To prepare a revalued balance
sheet, the analyst identifies and capitalizes all of the entity’s assets and liabilities. This
process includes all of the assets and liabilities that are already recorded on the entity’s
balance sheet and not recorded on the entity’s balance sheet.
Based on the values in the revalued balance sheet in line with the fair market value:
 Total assets: $107 billion
 Total liabilities: $60 billion
 Value: Total assets – Total liabilities = $107 – $60 = $47 billion
Consider another asset-based valuation example where the book value of assets is $50,000
(current assets, fixed assets, and other assets like investment in subsidiaries); the
corresponding total derived after adding the fair market value of each item in the asset list is
$76,000. The fair market value of intangible assets is $10,000. So, the value of the total
assets is $86,000. The book value or fair market value of current and long-term liabilities is
$33,000. In the next step, add $7,000 as the value of contingent liabilities; the total liabilities
are $40,000. Finally, the total owner’s equity is derived by deducting liabilities from assets,
$46,000.
Pros and Cons
Pros
 It is the most preferred method in a critical context like liquidation and M&A.
 It follows simple mathematical formulas.
 Consider off-balance-sheet items.
Cons
 Having innumerable assets does not point to the profitability of the business.
 Valuing the intangible assets requires attention to detail and making the overall process
complex.
 The method does not include the earnings of the company.
 Requires revaluation to derive the fair market value.
EARNINGS APPROACH
This is another common method of valuation and is based on the idea that the actual value of
a business lies in the ability to produce revenue in the future. There are a lot of methods of

17
valuation under the earning value approach, but the most common one is capitalizing past
earnings.
What is ‘Capitalization of Earnings or Capitalizing Past Earning?’
Capitalization of earnings is determined by calculating the NPV (Net present value) of the
expected future cash flows or profits. The estimate here is found by taking the future earnings
of the company and dividing them by a cap rate (capitalization rate).
In short, this is an income-valuation approach that lets us know the value of a company by
analyzing the annual rate of return, the current cash flow and the expected value of the
business.
Still not sure how this works? Let’s look at a detailed explanation to give you a better idea.
Detailed Explanation of ‘Capitalization of Earnings’
This approach of the capitalization of earnings, being one of the conventional methods of
valuation, helps investors figure out the possible risks and return of acquiring a company.
Finding a Capitalization Rate
Finding out the capitalization rate for a company includes knowledge of the different kinds of
industries and businesses, as well as a significant amount of research. Normally, the rates
used for small businesses are 20% to 25%, which is the ROI (return on investment) that every
buyer looks for while choosing which business to acquire.
As the ROI doesn’t normally include the owner’s salary, this amount has to be separate from
the ROI calculations. Let us take for instance a small business that earns about $200,000
every year and pays the owner a FMV (fair market value) of $50,000. The remaining
$150,000 is used as income for valuation purposes.
As soon as all the variables are known, the calculation of the capitalization rate is obtained
with a simple formula. The formula is operating income divided by the purchase price. At
first, the thing to be determined is the annual gross income of the investment.
After this, the operating expenses has to be subtracted to find out the total operating income.
Then this value is divided by the investment’s/property’s purchase cost to find out the
capitalization rate.
Disadvantages of Capitalization of Earnings Method
There isn’t one perfect method to determine a company’s value, which is why assessing a
company’s future earnings has some drawbacks. At first, the method used to predict the
future earnings might give an inaccurate figure, which would eventually result in less than
expected generated profits.
In addition to this, exceptional circumstances can occur that eventually compromises the
earnings, and affect the valuation of the investment. Further, a business that has just entered
the market might lack adequate information for finding out an accurate valuation of the
company.
The buyer has to know all about the desired ROI and the acceptable risks, as the
capitalization rate has to be reflected in the risk tolerance, market characteristics of the buyer,
and the expected growth factor of the business. For instance, if a buyer is not aware of the
targeted rate, he might pass on a more suitable investment or overpay for an investment.
Capitalization of Earnings Example
Let’s take an example of a company that for the last ten years, has earned and had cash flows
of about $500,000 every year. As per the predictions of the company’s earnings, the same
cash flow would continue for the foreseeable future. The expenses for the business every year
is about $100,000 only. Hence, the company makes an income of $400,000 every year.
To figure out the value of the business, an investor analyses other risk investments that have
the same kind of cash flows. The investor now recognizes a $4 million Treasury bond that
returns about 10% annually, or $400,000. From this, the investor can determine that the value
of the business is around $4,000,000. This is because it is a similar investment concerning

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risks and rewards. This would be a method in determining similar investments for the value
of a company.

Earning based Valuation Model

Earnings-based business valuation methods value your company by its ability to be profitable
in the future. It is best to use earnings-based valuation methods for a company that is stable
and profitable. There are two main approaches:
Capitalization of Earnings
The Capitalization of Earnings method assumes the calculations for a single time period will
continue and calculates future profitability based on cash flow, annual ROI, and expected
value.
Capitalization of earnings is determined by calculating the NPV (Net present value) of the
expected future cash flows or profits. The estimate here is found by taking the future earnings
of the company and dividing them by a cap rate.
In short, this is an income-valuation approach that lets us know the value of a company by
analyzing the annual rate of return, the current cash flow and the expected value of the
business.
Disadvantages of Capitalization of Earnings Method
There isn’t one perfect method to determine a company’s value, which is why assessing a
company’s future earnings has some drawbacks. At first, the method used to predict the
future earnings might give an inaccurate figure, which would eventually result in less than
expected generated profits.
In addition to this, exceptional circumstances can occur that eventually compromises the
earnings, and affect the valuation of the investment. Further, a business that has just entered
the market might lack adequate information for finding out an accurate valuation of the
company.
The buyer has to know all about the desired ROI and the acceptable risks, as the
capitalization rate has to be reflected in the risk tolerance, market characteristics of the buyer,
and the expected growth factor of the business. For instance, if a buyer is not aware of the
targeted rate, he might pass on a more suitable investment or overpay for an investment.
Multiple of Earnings
The Multiple of Earnings method, like Capitalization of Earnings, values a business by its
future profitability. However, this method calculates a company’s worth by assigning a
multiplier to its current revenue. The appropriate multiplier varies widely depending on the
specific industry, current market trends, and economic climate.
Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty
is directly tied to the identity of the business owner.
Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the
percentage of business that might be lost under a change of ownership.
Concept of Risk and Return (Including Capital Asset Pricing Model)
After investing money in a project a firm wants to get some outcomes from the project. The
outcomes or the benefits that the investment generates are called returns. Wealth
maximization approach is based on the concept of future value of expected cash flows from a
prospective project.
So cash flows are nothing but the earnings generated by the project that we refer to as returns.
Since fixture is uncertain, so returns are associated with some degree of uncertainty. In other
words there will be some variability in generating cash flows, which we call as risk. In this
article we discuss the concepts of risk and returns as well as the relationship between them.
CONCEPT OF RISK

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A person making an investment expects to get some returns from the investment in the future.
However, as future is uncertain, the future expected returns too are uncertain. It is the
uncertainty associated with the returns from an investment that introduces a risk into a
project. The expected return is the uncertain future return that a firm expects to get from its
project. The realized return, on the contrary, is the certain return that a firm has actually
earned.
Elements of Risk
Various components cause the variability in expected returns, which are known as elements
of risk. There are broadly two groups of elements classified as systematic risk and
unsystematic risk.
(i) Systematic Risk
Business organizations are part of society that is dynamic. Various changes occur in a society
like economic, political and social systems that have influence on the performance of
companies and thereby on their expected returns. These changes affect all organizations to
varying degrees. Hence the impact of these changes is system-wide and the portion of total
variability in returns caused by such across the board factors is referred to as systematic risk.
These risks are further subdivided into interest rate risk, market risk, and purchasing power
risk.
(ii) Unsystematic Risk
The returns of a company may vary due to certain factors that affect only that company.
Examples of such factors are raw material scarcity, labour strike, management inefficiency,
etc. When the variability in returns occurs due to such firm-specific factors it is known as
unsystematic risk. This risk is unique or peculiar to a specific organization and affects it in
addition to the systematic risk. These risks are subdivided into business risk and financial
risk.
Measurement of Risk
Quantification of risk is known as measurement of risk.
Two approaches are followed in measurement of risk
(i) Mean-variance approach, and
(ii) Correlation or regression approach.
CONCEPT OF RETURN
Return can be defined as the actual income from a project as well as appreciation in the value
of capital. Thus there are two components in return—the basic component or the periodic
cash flows from the investment, either in the form of interest or dividends; and the change in
the price of the asset, commonly called as the capital gain or loss.
The term yield is often used in connection to return, which refers to the income component in
relation to some price for the asset. The total return of an asset for the holding period relates
to all the cash flows received by an investor during any designated time period to the amount
of money invested in the asset.
It is measured as
Total Return = Cash payments received + Price change in assets over the period /Purchase
price of the asset. In connection with return we use two terms—realized return and expected
or predicted return. Realized return is the return that was earned by the firm, so it is historic.
Expected or predicted return is the return the firm anticipates to earn from an asset over some
future period.
CAPITAL ASSET PRICING MODEL – (CAPM)
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance
for pricing risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.

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The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf + βi (ERm – Rf)
ERi = Expected return of investment
Rf = Risk-free rate
βi = Beta of the investment
ERm = Expected return of market
(ERm – Rf) = Market risk premium
Portfolio Tools: Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security. Below is an illustration of the CAPM concept.
CAPM Formula and Calculation
CAPM is calculated according to the following formula:

Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)
The CAPM formula is used to calculate the expected return on investable asset. It is based on
the premise that investors have assumptions of systematic risk (also known as market risk or
non-diversifiable risk) and need to be compensated for it in the form of a risk premium – an
amount of market return greater than the risk-free rate. By investing in a security, investors
want a higher return for taking on additional risk.

Expected Return
The “Ra” notation above represents the expected return of a capital asset over time, given all
of the other variables in the equation. The expected return is a long-term assumption about
how an investment will play out over its entire life.
Risk-Free Rate
The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-year
US government bond. The risk-free rate should correspond to the country where the
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investment is being made, and the maturity of the bond should match the time horizon of the
investment. Professional convention, however, is to typically use the 10-year rate no matter
what, because it’s the most heavily quoted and most liquid bond.
The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall
market. In other words, it is the stock’s sensitivity to market risk. For instance, if a
company’s beta is equal to 1.5 the security has 150% of the volatility of returns of the market
average. However, if the beta is equal to 1, the expected return on a security is equal to the
average market return. A beta of -1 means security has a perfect negative correlation with the
market.
Market Risk Premium
From the above components of CAPM we can simplify the formula to reduce “expected
return of the market minus the risk-free rate” to be simply the “market risk premium”. The
market risk premium represents the additional return over and above the risk-free rate, which
is required to compensate investors for investing in a riskier asset class. Put another way, the
more volatile a market or an asset class is, the higher the market risk premium will be.
Why CAPM is Important
The CAPM formula is widely used in the finance industry by various professions such as
investment bankers, financial analysts, and accountants. It is an integral part of the weighted
average cost of capital (WACC) as CAPM calculates the cost of equity.
WACC is used extensively in financial modeling. It can be used to find the net present value
(NPV) of the future cash flows of an investment and to further calculate its enterprise value
and finally its equity value.
Conventional and DCF Method, Inflation and Capital Budgeting
CONVENTIONAL CASH FLOW
Conventional cash flow is a series of inward and outward cash flows over time in which there
is only one change in the cash flow direction. A conventional cash flow for a project or
investment is typically structured as an initial outlay or outflow, followed by a number of
inflows over a period of time. In terms of mathematical notation, this would be shown as -, +,
+, +, +, +, denoting an initial outflow at time period 0, and inflows over the next five periods.
Discount cash flow (DCF) Method
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analyses use future free cash flow projections and discounts
them, using a required annual rate, to arrive at present value estimates. A present value
estimate is then used to evaluate the potential for investment. If the value arrived at through
DCF analysis is higher than the current cost of the investment, the opportunity may be a good
one.
Types of DCF Techniques:-
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal
Rate of Return [IRR].
(A) Net Present Value Techniques [NPV]:
Net Present Value may be defined as the excess of present value of project cash inflows
[stream of benefits] over that of outflows [cash outlays]. The cash flows of a project are
discounted at some desired rate of return, which is mostly equivalent to the cost of capital.
(B) Internal Rate of Return [IRR]:-
The Internal Rate of Return may be defined as that rate of interest when used to discount the
cash flows of an investment, reduce its NPV to zero. Or it is the
rate of discount, which equates the aggregate discounted benefits with aggregate discounted
costs.

22
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted
Rate of Return Method’. This method is used when the cost of investment and the annual
cash inflows are known but the discount rate [rate of return] is not known and is to be
calculated.
INFLATION AND CAPITAL BUDGETING
Inflation and capital budgeting are closely related and at no cost capital budgeting can be
completed without taking into account inflation. All of us know, that inflation causes our
purchasing power to decline. So, if we buy an asset for USD5000 today, it is probable that the
same asset can be bought for USD10,000 after a couple of years. However, it is assumed that
the project cost as well as net revenues increase in a proportionate manner with inflation. For
this reason, in reality rates of inflation are not taken into account. But this is not true always,
inflation does affect capital budgeting. Inflation and capital budgeting are bound to affect
cash flows .
Effects of Inflation and Capital Budgeting
Inflation affects discount rates and cash flows. There are two factors on which inflation acts.
They are discount rate and cash flow.
 Cash flows:
Mathematical representation,
Let us assume that r refers to the revenues; t refers to the tax rate; c is the cost and d is the
depreciation. By arranging the above variables in a formula the following is obtained.
(r-c) (1-t) + d = (r-c) (1-t) + dt
Inflation affects (r-c) (1-t), which is on the right side of the equation. But Inflation does not
impact dt. The reason can be attributed to the fact that historical costs determine depreciation
costs. This implies that inflation has a tendency to decrease the value of real rate of return.
Studies reveal that Net cash flow is more as compared to real cash flows provided we do not
take inflation into account.
(II) Discount rates:
Discount rates refer to the rate of return, which is the required rate or the target rate. The
project cost is inflation adjusted. This adjustment is usually done in the premiums. The
required rate or the target rate of return for the investors ought to be the same as real inflation
return together with the expected inflation rate.
Mathematical representation of discount rate:
Let us assume that RNT is inflation in nominal terms(required). RR is the real rate of
inflation , p is the expected rate of inflation.
The equation is:
RNT = RR + p
We already know that inflation adjusts itself in the premiums. Hence, rate of inflation ought
to be highlighted in the cash flows also.
Discounted cash-flow Techniques
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analyses use future free cash flow projections and discounts
them, using a required annual rate, to arrive at present value estimates. A present value
estimate is then used to evaluate the potential for investment. If the value arrived at through
DCF analysis is higher than the current cost of the investment, the opportunity may be a good
one.
Types of DCF Techniques:
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal
Rate of Return [IRR].
(A) Net Present Value Techniques [NPV]:

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Net Present Value may be defined as the excess of present value of project cash inflows
[stream of benefits] over that of outflows [cash outlays]. The cash flows of a project are
discounted at some desired rate of return, which is mostly equivalent to the cost of capital.

(B) Internal Rate of Return [IRR]:

The Internal Rate of Return may be defined as that rate of interest when used to discount the
cash flows of an investment, reduce its NPV to zero. Or it is the
rate of discount, which equates the aggregate discounted benefits with aggregate discounted
costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted
Rate of Return Method’. This method is used when the cost of investment and the annual
cash inflows are known but the discount rate [rate of return] is not known and is to be
calculated.
Arbitrage Pricing Theory
The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s
returns can be forecast using the linear relationship between the asset’s expected return and a
number of macroeconomic factors that affect the asset’s risk. This theory was created in 1976
by the economist, Stephen Ross. Arbitrage pricing theory offers analysts and investors a
multi-factor pricing model for securities based on the relationship between a financial asset’s
expected return and its risks.
The theory aims to pinpoint the fair market price of a security that may be temporarily
mispriced. The theory assumes that market action is less than always perfectly efficient, and
therefore occasionally results in assets being mispriced – either overvalued or undervalued –
for a brief period of time. However, market action should eventually correct the situation,
moving price back to its fair market value. To an arbitrageur, temporarily mispriced securities
represent a short-term opportunity to profit virtually risk-free.
The APT is a more flexible and complex alternative to the Capital Asset Pricing Model
(CAPM). The theory provides investors and analysts with the opportunity to customize their
research. However, it is more difficult to apply, as it takes a considerable amount of time to
determine all the various risk factors that may influence the price of an asset.
Assumptions in the Arbitrage Pricing Theory
The Arbitrage Pricing Theory operates with a pricing model that factors in many sources of
risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM) which only takes into
account the single factor of the risk level of the overall market, the APT model looks at
several macroeconomic factors that, according to the theory, determine the risk and return of
the specific asset.
These factors provide risk premiums for investors to consider because the factors carry the
systematic risk that cannot be eliminated by diversification of an investment portfolio.

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The APT suggests that investors will diversify their portfolios, but that they will also choose
their own individual profile of risk and returns based on the premiums and sensitivity of the
macroeconomic risk factors. Risk-taking investors will exploit the differences in expected
and real return on the asset by using arbitrage.
Arbitrage in the APT
The APT suggests that the returns on assets follow a linear pattern. An investor can leverage
deviations in returns from the linear pattern using the arbitrage strategy. Arbitrage is a
practice of the simultaneous purchase and sale of an asset, taking advantage of slight pricing
discrepancies to lock in a risk-free profit for the trade.
However, the APT’s concept of arbitrage is different from the classic meaning of the term. In
the APT, arbitrage is not a risk-free operation – but it does offer a high probability of success.
What the arbitrage pricing theory offers traders is a model for determining the theoretical fair
market value of an asset. Having determined that value, traders then look for slight deviations
from the fair market price, and trade accordingly. For example, if the fair market value of
stock A is determined, using the APT pricing model, to be $13, but the market price briefly
drops to $11, then a trader would buy the stock, based on the belief that further market price
action will quickly “correct” the market price back to the $13 a share level.
Mathematical Model of the APT
The Arbitrage Pricing Theory can be expressed as a mathematical model:

Where:
E(rj) – Expected return on asset
rf – Risk-free rate
ßn – Sensitivity of the asset price to macroeconomic factor n
RPn – Risk premium associated with factor n
The beta coefficients in the APT are estimated by using linear regression. In general,
historical securities returns are regressed on the factor to estimate its beta.
Factors in the APT
The APT provides analysts and investors with a high degree of flexibility regarding the
factors that can be applied to the model. The factors, and how many of them are used to
analyze a given security, are subjective choices made by the individual market analyst or
investor. Therefore, two different investors using the APT to analyze the same security may
have widely varying results when it comes to their actual trading. Even among the most
devoted advocates of the theory, there is no consensus agreement of finance professionals and
academics on which factors are best for predicting returns on securities.
However, Ross suggests that there are some specific macroeconomic factors that have proven
most reliable as price predictors. These include sudden changes in inflation and GNP,
corporate bond premiums, and shifts in the yield curve. Some other commonly used factors in
the APT are GDP, commodities prices, market indices levels, and currency exchange rates.
Although a bit complex to work with, and something that requires time and practice to
become adept at using, the Arbitrage Pricing Theory is an analytical tool that investors can
use to evaluate their portfolio holdings from a basic value investing perspective, looking to
identify securities that may be temporarily mispriced, well below or above their fair market
value.
Economic Value Added
Economic value added (EVA) is a financial measurement of the return earned by a firm that
is in excess of the amount that the company needs to earn to appease shareholders. In other

25
words, it is a measure of an organization’s economic profit that takes into account the
opportunity cost of invested capital and ultimately measures whether organizational value
was created or lost.
EVA compares the rate of return on invested capital with the opportunity cost of investing
elsewhere. This is important for businesses to keep track of, particularly those businesses that
are capital intensive. When calculating economic value added, a positive outcome means that
the company is creating value with its capital investments.
Conversely, a negative outcome would mean that the company is destroying value with its
capital investments and the capital would be better spent elsewhere. Businesses can use
economic value added to assess managerial performance as it serves as a measure of value
creation for shareholders.
The EVA formula is calculated using the following equation:
EVA = NOPAT – (Capital x Cost of Capital)
EVA = NOPAT – (WACC * capital invested)
Where NOPAT = Net Operating Profits After Tax
WACC = Weighted Average Cost of Capital
Capital invested = Equity + long-term debt at the beginning of the period
and (WACC* capital invested) is also known as finance charge
Components of EVA:
These three components of EVA are described below:
(i) NOPAT:
NOPAT is defined as follows:
(Profits before interest and taxes) (1- tax rate)
(ii) Cost of capital:
Providers of capital (shareholders and lenders) want to be suitably compensated for investing
capital in the firm. The cost of capital reflects what they expect.
The formula employed for estimating cost of capital is:
Cost of capital = (Cost of equity) (Proportion of equity in the capital employed) + (Cost
of preference) (Proportion of preference in the capital employed) + (Pre-tax cost of
debt) (1- tax rate) (Proportion of debt in the capital employed)
(iii) Capital employed:
To obtain capital employed, we have to make adjustments to the ‘accounting’ balance sheet
to derive the ‘economic book value’ balance sheet. These adjustments are meant to reflect the
economic value of assets in place of value determined by historical cost.
Example
Paul is the CFO of an organization in Boston. In order to assess the organization’s value
creation or destruction, Paul would like to calculate economic value added for 2015. The
organization’s NOPAT is $3,500,000, cost of capital is 5%, and the organization employed
1,000,000 in capital in 2015.
By plugging the values into the EVA calculation above, we can compute the value that Paul
needs:
$3,500,000 – ( 1,000,000 x 5% ) = $3,450,000
Paul’s organization had a total added value amount of $3,450,000 in 2015.
Advantages of EVA:
(i) EVA is a tool which helps to focus managers’ attention on the impact of their decisions in
increasing shareholders’ wealth.
(ii) EVA is a good guide for investors; as on the bias of EVA, they can decide whether a
particular company is worth investing money in or not.
(iii) EVA can be used as a basis for valuation of goodwill and shares.

26
(iv) EVA is a good controlling device in a decentralised enterprise. Management can apply
EVA to find out EVA contribution of each decentralised unit or segment of the company.
(v) EVA linked compensation schemes (for both operatives and managers) can be developed
towards protecting (or rather improving) shareholders’ wealth.
Earned Value Analysis: Planned Value (PV), Earned Value (EV), Cost Variance (CV),
Schedule Variance (SV)
Earned Value Analysis (EVA) is an industry standard method of measuring a project’s
progress at any given point in time, forecasting its completion date and final cost, and
analyzing variances in the schedule and budget as the project proceeds. It compares the
planned amount of work with what has actually been completed, to determine if the cost,
schedule, and work accomplished are progressing in accordance with the plan. As work is
completed, it is considered “earned”.
Planned Value (PV)
This is the first element of earned value management. Planned Value is the approved value of
the work to be completed in a given time.
According to the PMBOK Guide, “Planned Value (PV) is the authorized budget assigned to
work to be accomplished for an activity or WBS component.”
You must calculate Planned Value before actually doing the work; it also serves as a baseline.
The total Planned Value for the project is known as Budget at Completion (BAC). Planned
Value is also called Budgeted Cost of Work Scheduled (BCWS).
Formula for Planned Value (PV)
The formula to calculate Planned Value is simple. Multiply the planned percentage of the
completed work by the project budget. That will give you the Planned Value.
Planned Value = (Planned % Complete) X (BAC)
Earned Value (EV)
This is the third and last element of earned value management. Earned Value is the work
actually completed to date. It shows you the value that the project has produced if it were
terminated today.
According to the PMBOK Guide, “Earned Value (EV) is the value of work performed
expressed in terms of the approved budget assigned to that work for an activity or WBS
component.”
Although all three elements have their significance, Earned Value is the most useful because
it shows you how much value you have earned from the money you have spent to date,
management is always looking for this information.
Earned Value is also known as Budgeted Cost of Work Performed (BCWP).
Aspirants often get confuse Planned Value and Earned Value. Planned Value shows you how
much value you expected to earn within a given time, while Earned Value shows how much
value you have actually earned.
Formula for Earned Value (EV)
The formula to calculate the Earned Value is simple. Multiply the actual percentage of the
completed work by the project budget.
Earned Value = % of completed work X BAC (Budget at Completion).
Cost Variance (CV)
A cost variance is the difference between the cost actually incurred and the budgeted or
planned amount of cost that should have been incurred. Cost variances are most commonly
tracked for expense line items, but can also be tracked at the job or project level, as long as
there is a budget or standard against which it can be calculated. These variances form a
standard part of many management reporting systems. Some cost variances are formalized
into standard calculations. The following are examples of variances related to specific types
of costs:

27
  Direct material price variance
 Fixed overhead spending variance
 Labor rate variance
 Purchase price variance
 Variable overhead spending variance
Schedule Variance (SV)
Schedule variance is an indicator of whether a project schedule is ahead or behind and is
typically used within Earned Value Management (EVM). Schedule Variance can be
calculated by subtracting the Budgeted Cost of Work Scheduled (BCWS) from the Budgeted
Cost of Work Performed (BCWP). The BCWS measures the budget for the entire project and
the BCWP measures the cost of actual work done. The difference is the schedule variance.
Time Value of Money
The time value of money (TVM) is the concept that money available at the present time is
worth more than the identical sum in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also sometimes referred to as present
discounted value.
The time value of money draws from the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money’s potential to
grow in value over a given period of time. For example, money deposited into a savings
account earns a certain interest rate, and is therefore said to be compounding in value.
Basic Time Value of Money Formula
Depending on the exact situation in question, the TVM formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has
additional or less factors. But in general, the most fundamental TVM formula takes into
account the following variables:
 FV = Future value of money
 PV = Present value of money
 i = interest rate
 n = number of compounding periods per year
 t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [1 + (i / n)] (n x t)
There are five (5) variables that you need to know
1. Present value (PV)– This is your current starting amount. It is the money you have in
your hand at the present time, your initial investment for your future.
2. Future value (FV)– This is your ending amount at a point in time in the future. It
should be worth more than the present value, provided it is earning interest and
growing over time.
3. The number of periods (N)– This is the timeline for your investment (or debts). It is
usually measured in years, but it could be any scale of time such as quarterly,
monthly, or even daily.
4. Interest rate (I)– This is the growth rate of your money over the lifetime of the
investment. It is stated in a percentage value, such as 8% or .08.
5. Payment amount (PMT)– These are a series of equal, evenly-spaced cash flows.

28
Opportunity Cost, Time Value of Money

Opportunity costs
Opportunity costs represent the benefits an individual, investor or business misses out on
when choosing one alternative over another. While financial reports do not show opportunity
cost, business owners can use it to make educated decisions when they have multiple options
before them.
The term “opportunity cost” comes up often in finance and economics when trying to choose
one investment, either financial or capital, over another. It serves as a measure of an
economic choice as compared to the next best one. For example, there is an opportunity cost
of choosing to finance a company with debt over issuing stock.
Opportunity cost cannot always be fully quantified at the time when a decision is made.
Instead, the person making the decision can only roughly estimate the outcomes of various
alternatives, which means imperfect knowledge can lead to an opportunity cost that will only
become obvious in retrospect. This is a particular concern when there is a high variability of
return. To return to the first example, the foregone investment at 7% might have a high
variability of return, and so might not generate the full 7% return over the life of the
investment.
The concept of opportunity cost does not always work, since it can be too difficult to make a
quantitative comparison of two alternatives. It works best when there is a common unit of
measure, such as money spent or time used.
Opportunity cost is not an accounting concept, and so does not appear in the financial records
of an entity. It is strictly a financial analysis concept.
How is Opportunity Cost Calculated?
In financial analysis, the opportunity cost is factored into the present when calculating Net
Present Value formula.

NPV Formula
Where:
NPV: Net Present Value
FCF: Free cash flow
r: Discount rate

29
n: Number of periods
When presented with mutually exclusive options, the decision-making rule is to choose the
project with the highest NPV. However, if the alternative project gives a single and
immediate benefit, the opportunity costs can be added to the total costs incurred in C0. As a
result, the decision rule then changes from choosing the project with the highest NPV into
undertaking the project if NPV is greater than zero.
Financial analysts use financial modeling to evaluate the opportunity cost of alternative
investments
Application of Opportunity Cost
For example, assume a firm discovered oil in one of its lands. A land surveyor determines
that the land can be sold at a price of $40 billion. A consultant determines that extracting the
oil will generate an operating revenue of $80 billion in present value terms if the firm is
willing to invest $30 billion today. The accounting profit would be to invest the $30 billion to
receive $80 billion, hence leading to an accounting profit of $50 billion. However, the
economic profit for choosing to extract will be $10 billion because the opportunity cost of not
selling the land will be $40 billion.
Time Value of Money (TVM)
The time value of money (TVM) is the concept that money available at the present time is
worth more than the identical sum in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also sometimes referred to as present
discounted value.
The time value of money draws from the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money’s potential to
grow in value over a given period of time. For example, money deposited into a savings
account earns a certain interest rate and is therefore said to be compounding in value.
Further illustrating the rational investor’s preference, assume you have the option to choose
between receiving $10,000 now versus $10,000 in two years. It’s reasonable to assume most
people would choose the first option. Despite the equal value at time of disbursement,
receiving the $10,000 today has more value and utility to the beneficiary than receiving it in
the future due to the opportunity costs associated with the wait. Such opportunity costs could
include the potential gain on interest were that money received today and held in a savings
account for two years.
Basic TVM Formula
Depending on the exact situation in question, the TVM formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has
additional or less factors. But in general, the most fundamental TVM formula takes into
account the following variables:
 FV = Future value of money
 PV = Present value of money
 i = interest rate
 n = number of compounding periods per year
 t = number of years
Based on these variables, the formula for TVM is.
FV = PV x [ 1 + (i / n) ] (n x t)
Startup
 A startup is a company that's in the initial stages of business.
 Founders normally finance their startups and may attempt to attract outside
investment before they get off the ground.

30
  Funding sources include family and friends, venture capitalists, crowdfunding, and
loans.
 Startups must also consider where they'll do business and their legal structure.
 Startups come with high risk as failure is very possible but they can also be very
unique places to work with great benefits, a focus on innovation, and great
opportunities to learn.
What are the Different Ways Businesses can Find Start-up
Funds?
1. Funding from Personal Savings

Funding from personal savings is the most common type of funding for small businesses. The
two issues with this type of funding are 1) how much personal savings you have and 2) how
much personal savings are you willing to risk.

In many cases, entrepreneurs and business owners prefer OPM, or “other people’s money.”
The four funding sources below are all OPM sources.
2. Business Loans

Debt financing is a fancy way of saying “loan.” Credit unions and banks offer funding that
you must repay over time with interest. This can come in the form of a personal loan, a
traditional business loan, or different loans based on the type of asset you need to purchase
(e.g., for equipment, land, or vehicles).

You must prove to the lender that the likelihood of you paying back the bank loans is high,
and meet any requirements they have (e.g., having collateral in some cases). With a bank
loan, you do not need to give up equity. However, once again, you will have to pay interest
along with the principal.
3. Friends & Family

A big source of funding for entrepreneurs is friends and family. They can provide funding in
the form of debt (you must pay it back), equity (they get shares in your company), or even a
hybrid (e.g., a royalty whereby they get paid back via a percentage of your sales).

Friends and family are a great source of funding since they generally trust you and are easier
to convince than strangers. However, there is the risk of losing their money. And you must
consider how your relationship with them might suffer if this happens.
4. Angel Investors

Angel investors are generally wealthy individuals like friends and family members; you just
don’t know them (yet). At present, there are about 250,000 private angel investors in the
United States that fund more than 30,000 small businesses each year.

Most of these angel investors are not members of angel groups. Rather they are business
owners, executives and/or other successful individuals that have the means and ability to fund
deals that are presented to them and which they find interesting.

Networking is a great way to find an angel investor for your business.

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 5. Venture Capital

Venture capital funding is a suitable option for businesses that are beyond the startup period,
as well as those who need a larger amount of venture capital for expansion and increasing
market share. Venture capitalists and VC firms are professional investors that are more
involved with business management, and they play a significant role in setting milestones,
targets, and giving advice on how to ensure greater success.

Venture capitalists invest in new businesses and medium-sized businesses they believe are
likely to go public or be sold for massive future business profits. Specifically, they want to
fund companies that have the ability to be valued at $100 million or more within five years.
They also go through an expensive and lengthy process of deciding on the best business to
invest their venture funds. Hence, the application process and approval usually takes several
months.

What Is Interest?
Interest is the monetary charge for the privilege of borrowing money. Interest expense or
revenue is often expressed as a dollar amount, while the interest rate used to calculate
interest is typically expressed as an annual percentage rate (APR). Interest is the amount of
money a lender or financial institution receives for lending out money. Interest can also refer
to the amount of ownership a stockholder has in a company, usually expressed as a
percentage.
Types of Interest Rate

 Simple interest. ...

 Compound interest. ...
 Effective Interest. ...
 Fixed interest. ...
 Variable interest. ...
 Real interest. ...
 Accrued interest.
Simple Interest

This rate, otherwise known as “nominal” or “regular” interest, is your basic interest rate. This
is the straightforward calculation of how much you owe without correcting for any other
factors such as time, inflation or payment schedule.
S.I. = [(Principal (P) × Time (T) × Rate (r)) / 100]
Compound Interest

This refers to when a product calculates your interest on a periodic basis, then adds that to the
principal. It’s often referred to as “interest on interest.” It is different from simple interest in
that the rate at which your interest is calculated and the rate at which your interest accrues are
different.

Techniques of Time Value of Money

Discounting or Present Value Method

32
The current value of an expected amount of money to be received at a future date is known as
Present Value. If we expect a certain sum of money after some years at a specific interest
rate, then by discounting the Future Value we can calculate the amount to be invested today,
i.e., the current or Present Value.

Hence, Discounting Technique is the method that converts Future Value into Present Value.
The amount calculated by Discounting Technique is the Present Value and the rate of interest
is the discount rate.

Compounding or Future Value Method

Compounding is just the opposite of discounting. The process of converting Present Value
into Future Value is known as compounding.

Future Value of a sum of money is the expected value of that sum of money invested after n
number of years at a specific compound rate of interest.

33
Differences:

The points of differences between compounding and discounting are as follows:

Difference # Compounding
 The process of converting the Present Value into Future Value is known as
compounding.
 Interest rate is used to calculate the Future Value or the compounded value.
 Higher the interest rate greater will be the future or the compounded value.

Future Value is always greater than the Present Value provided the interest rate is positive –

FV = PV (1 + r)n

Difference # Discounting
 The process of converting Future Value in Present Value terms is known as
discounting.
 Discount rate is used to calculate the Present Value.
 Higher the discount rate lower will be the Present Value.
 Present Value is always less than the Future Value –

Every finance manager has to take three important Financial Management decisions such as –
the Investment Decision, Financing decision and the Dividend decision. Finance manager has
to take all these decisions keeping in mind the value maximization or the wealth
maximization objective of Financial Management.

So a finance manager before taking a financial decision should keep in mind the objective of
value maximization. In case of an Investment Decision, where return is fixed and assured it is
said to be risk-free investment, for example, 10% Reserve Bank of India Bonds, government

34
bonds, keeping money in deposit accounts offered by public sector banks, etc. In this case,
the probability of the return is 1 and hence no risk is associated with it.

Again for taking Investment Decisions for investing in shares of a company, the risk
associated with mutual funds needs to be considered as in this type of investment the return
varies which is neither fixed nor assured.

Share market is volatile and the return varies depending on certain macro level factors and
company-specific factors such as capital depreciation, fluctuating dividend rate due to profit
fluctuation, fund crisis, etc.

So, two aspects are involved in any financial decision one the risk and another return. Both
these two factors vary from one decision to another. A proper balance or trade-off between
risk and return is required to maximize the return by minimizing the risk and, thereby,
achieving the goal of maximizing the market value to shares.

1.Rajiv took a loan of Rs. 7000 from a bank at 10% as a rate of interest. Find the
interest he has to pay at the end of one year.
Solution: Here, sum borrowed, P = 7000
Rate of interest, R = 10%
This means if he borrowed Rs. 100, he had to pay Rs. 10 as interest. So, for Rs. 7000, the
interest he has to pay for one year is 7000×10/100 = Rs. 700.
So, at the end of the year, the amount he has to pay back = 7000 + 700 = Rs. 7700

2. Let the sum invested in Scheme A be Rs. x and that in Scheme B be Rs.(12800 – x).
Then, [x . 14 . 2]/100 + [(12800 – x) . 11 . 2]/100 = 3508
28x – 22x = 350800 – (12800 × 22)
6x = 69200

35
x = 11533.33
So, the sum invested in Scheme B = Rs. (12800 – 11533.33) = Rs. 1266.67.
A lender claims to be lending at simple interest, but he adds the interest every 6 months
in the calculation of the principal. The rate of interest charged by him is 8%. What will
be the effective rate of interest?
Solution:
Let the sum be Rs. 100.
Then,
Simple interest for 1st 6 months = Rs. [100 × 8 × 1]/[100 × 2] = Rs. 4
Simple interest for last 6 months = Rs. [104 × 8 × 1]/[100 × 2] = Rs.4.16
So, amount at the end of 1 year = Rs. (100 + 4 + 4.16) = Rs. 108.16
Effective rate = (108.16 – 100) = 8.16%
Example 3: A town has a population of 20,000. The population increases by 10% per year.
What will be the population after 2 years?
Solution:
Here, R = 10/100
P = 20000
T=2
Population after 2 years will be = P[1 + (R/100)]T
= 20000[1 + (10/100)]2
= 20000(1.1)2
= 24200.
Example 4: The time required for a sum of money to amount to five times itself at 16%
simple interest p.a. will be:
Solution:
Let the sum of money be Rs. x and the time required to amount to five times itself be t years.
So, the interest in ‘t’ year should be Rs. 4x.
In case of simple interest, we know,
(P × T × r)/100 = SI
Where, P = Principal amount, T = Duration in years, i = Interest rate per year, SI = Total
simple interest
Then,

⇒ t × (16/100) = 4
x × t × 16% = 4x

⇒ t = 400/16 = 25
∴ The required time = 25 years.
Example 5: The rate of simple interest per annum at which a sum of money doubles itself in
16⅔ years is:

36
Solution:
Let the principal amount be P.
Now, the amount A after 16⅔ years is doubled.
Hence, amount is 2P.
I = P × R × T/100
Where,
P = principal amount
R = rate of interest
T = time in years = 162/3 = 50/3
I = simple interest
Amount A = I + P
According to question,
A = P + (P × R × T/100)
2P = P + (P × R × T/100)
P = P × R × T/100
R = 100/T
R = 100 × 3/50
R = 6%
Example 6: In which year will the amount on a sum of Rs. 800 at 20% compounded half-
yearly exceed Rs.1000?
Solution:
Let the time taken for this amount to reach Rs. 1000 be X.
The important thing to note is that this sum is compounded half-yearly. Hence, we use the
formula:*****
Where, A = Amount
P = Principal
r = Interest rate
m = No. of periods within a year
T = No. of years

∴�<�(1+[��∗100]��)
We need to obtain T such that the RHS should be greater than the LHS:

In this case,
A = 1000
P = 800
r = 20%
m = 2 (since it is half-yearly)
Substituting these values, we have
1000<800(1+202×100)2�=800(11/10)2�
1000/800<(121100)�

37
⇒ 1.25 < (1.21)T
Now, we need to use trial and error to check for the values of T.
For T = 1, 1.25 > 1.21; hence, the condition is not satisfied.
For T = 2, 1.25 < 1.4641, hence the condition is met.
Therefore, it is the second year in which the amount would be greater than Rs. 1000.
Example 7: In how many years will a sum of Rs. 4,000 yield a simple interest of Rs. 1,440 at
12% per annum?
Solution:
We know that the formula for simple interest:
SI = [P × R × T] / 100
Where,
SI = Simple Interest = 1440
P = Principal = 4000
T = Time = ?
R = Rate of Interest = 12%

⇒ 1440 = [4000 × 12 × T] / 100

Substituting the values in the formula

⇒ 1440 = 480T
⇒ T = 1440/480 = 3 yrs

KMBN204
UNIT-4
MEANING OF DIVIDEND
Dividend refers to a reward, cash or otherwise, that a company gives to its shareholders.
Dividends can be issued in various forms, such as cash payment, stocks or any other form. A
company's dividend is decided by its board of directors and it requires the shareholders'
approval.
 A dividend is the distribution of corporate earnings to eligible shareholders.
 Dividend payments and amounts are determined by a company's board of directors.
 The dividend yield is the dividend per share, and expressed as a percentage of a
company's share price.
 Many companies do not pay dividends and instead retain earnings to be invested
back into the company.

What Is a Dividend Policy?

A dividend policy is the policy a company uses to structure its dividend payout to
shareholders. Some researchers suggest the dividend policy is irrelevant, in theory, because
investors can sell a portion of their shares or portfolio if they need funds.
Dividend policy is the guideline for dividend distribution drafted by the board of directors of
the company. The policy includes parameters for sharing profits with the shareholders. It
also includes how often and in which form the dividends are to be distributed.

38
TYPES OF DIVIDEND

A company decides dividends based on multiple factors. However, the payment of dividends can
happen in terms of cash, stock, property or scrip. Following are the different types of dividends:
 Cash Dividend: Cash dividends are the most common and popular form of dividend payouts.
The company issues a dividend to all shareholders. The cash dividend amount is deposited
into the bank account of the shareholder as per their shareholding.
 Stock Dividend: Through stock dividend payouts, a company issues additional shares to its
common shareholders without any consideration. When a company issues less than 25% of
the previously issue, then the dividend is a stock dividend. On the other hand, it is a stock
split when the company issues more than 25% of the last issue.
 Property Dividend: A company sometimes issues a non-monetary dividend to its
shareholders. The company records the property dividend against the current market price
of the asset. The market price of the asset can be either higher or lower than the book value.
Therefore, the company records the transaction as either a profit or loss.
 Scrip Dividend: In a scenario where the company does not have enough dividends, it may
issue a promissory note. A promissory note that is indicating to pay dividends at a later date.
Essentially, this creates note payables for the company.

Types of Dividend Policies

Companies follow different patterns for paying out dividends. The patterns depend on the type of
dividend policy chosen by them. There are four different types of dividend policy that companies
usually follow, and they are:
 Stable Dividend Policy
A stable dividend policy involves fixing a certain amount of dividend that the shareholders
periodically receive. Even if the company incurs a loss, the amount of dividend does not change.
 Regular Dividend Policy
In a regular dividend policy, the company fixes a certain percentage of dividend from the company’s
profits. When the profits are high, the dividend payment will automatically be high. While the profits
are low, the dividend payment will remain low. Experts usually considers this to be the most
appropriate policy for paying dividends and creating goodwill.
 Irregular Dividend Policy
In an irregular dividend policy, the dividend payment solely depends on the company’s decision. If
the company decides to pay a dividend to the shareholders, then the shareholders get the dividend.
The decision solely depends on the company’s priorities. If the company has a new project to fund,
then it may decide to retain the profits within the company instead of distributing it.
 No Dividend Policy
In no dividend policy, the company always retains the profits and doesn’t distribute them to its
shareholders. Usually, growth-oriented companies follow the no dividend policy. The strategy might
suit companies who aim for growth. However, it may discourage investors who are looking for
sustainable income in the long term.

Factors Affecting Dividend Policy

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The following are the factors that affect the dividend policy:
 Profitability: The profitability of a company is one of the major factors that affect the
dividend policy. Companies will declare dividends only if they make profits. The profits also
determine how much dividends the company shall distribute to its shareholders.
 Dividend Payment History: A company with a good dividend payment history will continue
to maintain its dividend payments in the future. Many investors invest in such stocks to earn
regular dividends.
 Availability of Fund and Growth: Companies retain their profits to fund their growth and
expansion plans. If there are enough retained earnings, companies tend to distribute their
profits to shareholders by giving dividends.Dividend Trends: To attract and retain
shareholders, companies may issue dividends to keep up with the industry trend.
 Business Cycles
When the company experiences a boom, it is prudent to save up and make reserves for
dips. Such reserves will help a company to maintain dividends even in depressing markets
to plow back and attract more shareholders.
 Changes in Government Policies
There could be a change in a company’s dividend policy due to the imposed changes by the
government. The Indian government had put temporary restrictions on companies to pay
dividends during 1974-75.
 Leverage
A company having more leverage in its financial structure and, consequently, more interest
payments may decide on a low dividend payout to increase its net worth and to make sure

40
that it can make payment of financial charges even in case of earnings of the company are
falling. Whereas a company utilizing more of its own financing will prefer high dividends.
 Future Financial Requirements / Reinvestment Opportunity
The dividend payout will also depend on the future requirements for the additional capital.
A company having profitable investment opportunities is justified in retaining its earnings.
However, a company with no capital requirements should opt for a higher dividend.
 The Extent of Share Distribution
A company with a large number of shareholders will have a difficult time getting them to
agree to a conservative policy. On the other hand, a closely held company has more chances
of succeeding in finalizing conservative dividend payouts.
 Different Shareholders’ Expectations
Another factor that impacts the policy is the diversity in the type of shareholders a company
has. A different group of shareholders will have different expectations. A retired shareholder
will have a different requirement vis-a-vis a wealthy investor. The company needs to clearly
understand the different expectations and formulate a successful dividend policy.
Psychologically, a cash dividend will give more satisfaction to shareholders in comparison to
capital appreciation.
 Ownership Structure
The ownership structure of a company also impacts the policy. A company with a higher
promoter’s holdings will prefer a low dividend payout as paying out dividends may cause a
decline in the value of the stock. Whereas high institutional ownership will favor a high
dividend payout as it helps them increase control over the management.
 Age of Corporation
Newly formed companies will have to retain a major part of their earnings for further
growth and expansion. Thus, unlike established companies, they have to follow a
conservative policy that can pay higher dividends from their reserves.
 Type of Industry
The nature of the industry to which the company belongs has an important effect on the
dividend policy. Industries where earnings are stable may adopt a consistent dividend policy
as opposed to the industries where earnings are uncertain and uneven. They are better off
having a conservative approach to dividend payout.

DIVIDEND THEORY/ MODELS

A major decision area of Financial management is the dividend policy decision in the sense
that the firm has to choose between distributing the profits to the shareholders and
ploughing them back into the business. The selection would be influenced by the effect on
the objective of Financial Management of maximising shareholder’s wealth. The firm should
pay dividend if the payment will lead to the maximisation of the wealth of the owners and if
not then the firm should retain profits to finance investment programmes. The relationship
between dividends and value of the firm should, therefore, be the decision criterion. There
are conflicting opinions regarding the impact of dividends on the valuation of a firm.
According to one school of thought, dividends are irrelevant so that the amount of dividend
paid has no effect on the valuation of a firm. (IRRELEVANCE THEORY)
On the other hand certain theories consider the dividend decision as relevant to the value of
the firm measured in terms of the market price of the shares. (RELEVANCE THEORY)

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IRRELEVANCE OF DIVIDENDS:
GENERAL VIEW: The argument supporting the irrelevance of dividends to valuation is that the
dividend policy of a firm is a part of its financing decision. As a part of the financing decision, the
dividend policy of the firm is a residual decision and dividends are a passive residual. It implies that
when a firm has sufficient investment opportunities, it will retain the earnings to finance them.
Conversely, if acceptable investment opportunities are inadequate, the implication is that the
earnings would be distributed to the shareholders. The test of adequate acceptable investment
opportunities is the relationship between the return on the investments (r) and the cost of capital
(k). As long as (r) exceeds (k), a firm has acceptable investment opportunities. That dividend are
irrelevant, or are passive residual, is based on the assumption that the investors are indifferent
between dividend and capital gains. So long as the firm is able to earn more than the
equitycapitalisation rate (ke ), the investors would be content with the firm retaining the earnings. In
contrast, if the return is less than the (ke ), investors would prefer to receive the earnings i.e.
dividends.

Miller and Modigliani theory on Dividend

Policy
Definition: According to Miller and Modigliani Hypothesis or MM Approach, dividend
policy has no effect on the price of the shares of the firm and believes that it is the
investment policy that increases the firm’s share value.
The investors are satisfied with the firm’s retained earnings as long as the returns are more
than the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at
which the earnings, dividends or cash flows are converted into equity or value of the firm. If

42
 the returns are less than “Ke” then, the shareholders would like to receive the earnings in
the form of dividends.
Miller and Modigliani have given the proof of their argument, that dividends have no
effect on the firm’s share price, in the form of a set of equations, which are explained in
the content below:
Assumptions of Miller and Modigliani Hypothesis

1. There is a perfect capital market, i.e. investors are rational and have access to all the
information free of cost. There are no floatation or transaction costs, no investor is large
enough to influence the market price, and the securities are infinitely divisible.
2. There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
3. It is assumed that a company follows a constant investment policy. This implies that there is
no change in the business risk position and the rate of return on the investments in new
projects.
4. There is no uncertainty about the future profits, all the investors are certain about the
future investments, dividends and the profits of the firm, as there is no risk involved.

Criticism of Miller and Modigliani Hypothesis

1. It is assumed that a perfect capital market exists, which implies no taxes, no flotation, and
the transaction costs are there, but, however, these are untenable in the real life situations.
2. The Floatation cost is incurred when the capital is raised from the market and thus cannot
be ignored since the underwriting commission, brokerage and other costs have to be paid.
3. The transaction cost is incurred when the investors sell their securities. It is believed that in
case no dividends are paid; the investors can sell their securities to realize cash. But
however, there is a cost involved in making the sale of securities, i.e. the investors in the
desire of current income has to sell a higher number of shares.
4. There are taxes imposed on the dividend and the capital gains. However, the tax paid on the
dividend is high as compared to the tax paid on capital gains. The tax on capital gains is a
deferred tax, paid only when the shares are sold.
5. The assumption of certain future profits is uncertain. The future is full of uncertainties, and
the dividend policy does get affected by the economic conditions.
Thus, the MM Approach posits that the shareholders are indifferent between the dividends
and the capital gains, i.e., the increased value of capital assets.

Walter’s Model

Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends
are relevant and have a bearing on the firm’s share prices. Also, the investment policy
cannot be separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal
rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy
affects the overall value of the firm. The efficiency of dividend policy can be shown through
a relationship between returns and the cost.

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 If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. The firms
with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
 If r<K, the firm should pay all its earnings to the shareholders in the form of dividends,
because they have better investment opportunities than a firm. Here the payout ratio is
100%.
 If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent
towards how much is to be retained and how much is to be distributed among the
shareholders. The payout ratio can vary from zero to 100%.

Assumptions of Walter’s Model

1. All the financing is done through the retained earnings; no external financing is used.
2. The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes
in the investments.
3. All the earnings are either retained or distributed completely among the shareholders.
4. The earnings per share (EPS) and Dividend per share (DPS) remains constant.
5. The firm has a perpetual life.

Criticism of Walter’s Model

1. It is assumed that the investment opportunities of the firm are financed through the
retained earnings and no external financing such as debt, or equity is used. In such a case
either the investment policy or the dividend policy or both will be below the standards.
2. The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of
return (r) is constant, but, however, it decreases with more investments.
3. It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic
since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
Note: Here, the cost of capital (K) = Cost of equity (Ke), because no external source of
financing is used.

Gordon’s Model
Definition: The Gordon’s Model, given by Myron Gordon, also supports the doctrine that
dividends are relevant to the share prices of a firm. Here the Dividend Capitalization
Model is used to study the effects of dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and
prefers certain returns to uncertain returns. Therefore, they put a premium on a certain
return and a discount on the uncertain returns. The investors prefer current dividends to
avoid risk; here the risk is the possibility of not getting the returns from the investments.
But in case, the company retains the earnings; then the investors can expect a dividend in
future. But the future dividends are uncertain with respect to the amount as well as the
time, i.e. how much and when the dividends will be received. Thus, an investor would
discount the future dividends, i.e. puts less importance on it as compared to the current
dividends.
According to the Gordon’s Model, the market value of the share is equal to the present
value of future dividends. It is represented as:
P = [E (1-b)] / Ke-br

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 Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate

Assumptions of Gordon’s Model

1. The firm is an all-equity firm; only the retained earnings are used to finance the investments,
no external source of financing is used.
2. The rate of return (r) and cost of capital (K) are constant.
3. The life of a firm is indefinite.
4. Retention ratio once decided remains constant.
5. Growth rate is constant (g = br)
6. Cost of Capital is greater than br

Criticism of Gordon’s Model

1. It is assumed that firm’s investment opportunities are financed only through the retained
earnings and no external financing viz. Debt or equity is raised. Thus, the investment policy
or the dividend policy or both can be sub-optimal.
2. The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of
returns is constant, but, however, it decreases with more and more investments.
3. It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in
the real life situations, as it ignores the business risk, which has a direct impact on the firm’s
value.
Thus, Gordon model posits that the dividend plays an important role in determining the
share price of the firm.

Bird in Hand Argument

(Dividends and Uncertainty)

Gordon revised this basic model later to consider risk and uncertainty. Gordon’s model, like
Walter’s model, contends that dividend policy is relevant. According to Walter, dividend
policy will not affect the price of the share when R = K. But Gordon goes one step ahead and
argues that dividend policy affects the value of shares even when R=K. The crux of Gordon’s
argument is based on the following 2 assumptions.

(i) Investors are risk averse and

(ii) They put a premium on a certain return and discount (penalise) uncertain return.

The investors are rational. Accordingly they want to avoid risk. The term risk refers to the
possibility of not getting the return on investment. The payment of dividends now
completely removes any chance of risk. But if the firm retains the earnings the investors can
expect to get a dividend in the future. But the future dividend is uncertain both with respect
to the amount as well as the timing. The rational investors, therefore prefer current

45
dividend to future dividend. Retained earnings are considered as risky by the investors. In
case earnings are retained, therefore the price per share would be adversely affected. This
behaviour of investor is described as “Bird in Hand Argument”. A bird in hand is worth two
in bush. What is available today is more important than what may be available in the future.
So the rational investors are willing to pay a higher price for shares on which more current
dividends are paid. Therefore the discount rate (K) increases with retention rate.

Differences Between Interim and Final Dividends

A company pays an interim dividend before its profits are declared during its Annual General
Meeting (AGM). The company's board of directors declare the interim dividend and final dividend.
Companies distribute interim dividends from their retained earnings. A company's retained earnings
are whatever's left of its profits after paying direct and indirect costs and taxes. Like the Indian
mining company, Vedanta announced an interim dividend of ₹18.5 per share in May
2023. Conversely, the final dividend gets paid after the company has declared its financial results.
Companies can pay an interim dividend for part of a financial year (spread across one or two
quarters). However, final dividends always occur annually. A company has the right to cancel the
interim dividends once announced, but it cannot withdraw the final dividends.

What are the benefits of a dividend policy?

The dividend policy equally benefits the company and the shareholders in the following ways:
For companies:
 Shareholders exhibit more trust in a company that pays periodic dividends over a non-
dividend-paying company.
 Regular dividend payments attract investors who want to invest in robust businesses and
earn a steady income through dividends.
For shareholders:
 The dividend policy clearly and transparently states the terms of dividend distribution
between the shareholders and the company.
 Shareholders of a dividend stock can earn dual income.

Dividend Decision

Definition: The Dividend Decision is one of the crucial decisions made by the finance
manager relating to the payouts to the shareholders. The payout is the proportion
of Earning Per Share given to the shareholders in the form of dividends.
The companies can pay either dividend to the shareholders or retain the earnings within the
firm. The amount to be disbursed depends on the preference of the shareholders and the
investment opportunities prevailing within the firm.

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The optimal dividend decision is when the wealth of shareholders increases with the
increase in the value of shares of the company. Therefore, the finance department must
consider all the decisions viz. Investment, Financing and Dividend while computing the
payouts.
If attractive investment opportunities exist within the firm, then the shareholders must be
convinced to forego their share of dividend and reinvest in the firm for better future
returns. At the same time, the management must ensure that the value of the stock does
not get adversely affected due to less or no dividends paid out to the shareholders.
The objective of the financial management is the Maximization of Shareholder’s Wealth.
Therefore, the finance manager must ensure a win-win situation for both the shareholders
and the company.

UNIT-2

Opportunity Cost
Opportunity costs represent the benefits an individual, investor or business
misses out on when choosing one alternative over another. While financial
reports do not show opportunity cost, business owners can use it to make
educated decisions when they have multiple options before them.
The term “opportunity cost” comes up often in finance and economics when
trying to choose one investment, either financial or capital, over another. It
serves as a measure of an economic choice as compared to the next best one.
For example, there is an opportunity cost of choosing to finance a company with
debt over issuing stock.
Opportunity cost cannot always be fully quantified at the time when a decision
is made. Instead, the person making the decision can only roughly estimate the
outcomes of various alternatives, which means imperfect knowledge can lead to
an opportunity cost that will only become obvious in retrospect. This is a
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particular concern when there is a high variability of return. To return to the
first example, the foregone investment at 7% might have a high variability of
return, and so might not generate the full 7% return over the life of the
investment.
The concept of opportunity cost does not always work, since it can be too
difficult to make a quantitative comparison of two alternatives. It works best
when there is a common unit of measure, such as money spent or time used.
Opportunity cost is not an accounting concept, and so does not appear in the
financial records of an entity. It is strictly a financial analysis concept.

Cost of Capital
Cost of capital (COC) is the cost of financing a project that requires a business
entity to look into its deep pockets for funds or borrowings. Businesses and
investors use the cost of employing capital to account for and justify the equity
or debt funding required for such projects.
Cost of capital is the minimum rate of return or profit a company must earn
before generating value. It’s calculated by a business’s accounting department
to determine financial risk and whether an investment is justified.

Importance of Cost of Capital

The cost of capital is very important concept in the financial decision

making. Cost of capital is the measurement of the sacrifice made by investors
in order to invest with a view to get a fair return in future on his investments as
a reward for the postponement of his present needs. On the other hand from the
point of view of the firm using the capital, cost of capital is the price paid to the
investor for the use of capital provided by him. Thus, cost of capital is reward
for the use of capital. The progressive management always likes to consider
the importance cost of capital while taking financial decisions as it’s very
relevant in the following spheres:

1. Designing the capital structure: The cost of capital is the significant

factor in designing a balanced and optimal capital structure of a firm.
While designing it, the management has to consider the objective
of maximizing the value of the firm and minimizing cost of capital.
Comparing the various specific costs of different sources of capital,
the financial manager can select the best and the most economical source
of finance and can designed a sound and balanced capital structure.
2. Capital budgeting decisions: The cost of capital sources as a very useful
tool in the process of making capital budgeting decisions. Acceptance or
rejection of any investment proposal depends upon the cost of capital. A

48
 proposal shall not be accepted till its rate of return is greater than the cost
of capital. In various methods of discounted cash flows of capital
budgeting, cost of capital measured the financial performance and
determines acceptability of all investment proposals
by discounting the cash flows.
3. Comparative study of sources of financing: There are various sources
of financing a project. Out of these, which source should be used at a
particular point of time is to be decided by comparing costs of different
sources of financing. The source which bears the minimum cost of capital
would be selected. Although cost of capital is an important factor in such
decisions, but equally important are the considerations of retaining
control and of avoiding risks.
4. Evaluations of financial performance: Cost of capital can be used
to evaluate the financial performance of the capital projects. Such as
evaluations can be done by comparing actual profitability of the project
undertaken with the actual cost of capital of funds raise to finance the
project. If the actual profitability of the project is more than the actual
cost of capital, the performance can be evaluated as satisfactory.
5. Knowledge of firms expected income and inherent risks: Investors can
know the firms expected income and risks inherent there in by cost of
capital. If a firms cost of capital is high, it means the firms present rate of
earnings is less, risk is more and capital structure is imbalanced, in such
situations, investors expect higher rate of return.
6. Financing and Dividend Decisions: The concept of capital can be
conveniently employed as a tool in making other important financial
decisions. On the basis, decisions can be taken regarding dividend policy,
capitalization of profits and selections of sources of working capital.

In sum, the importance of cost of capital is that it is used to evaluate new

project of company and allows the calculations to be easy so that it has
minimum return that investor expect for providing investment to the company.

Components of Cost of Capital

The three components of cost of capital are:

1. Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or
redeemable.
(a) Debt issued at par: The computation of cost of debt issued at par is
comparatively an easy task. It is the explicit interest rate adjusted further for the
tax liability of the company. It may be computed according to the following
formula:
Kd = I/NP,…………….Before tax
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Kd= (I/NP)*1-t………………after tax
Where,
 Kd = Cost of debt;
 T = Marginal tax rate;
 R = Debenture interest rate.
The tax is deducted out of the interest payable, because interest is treated as an
expense while computing the firm’s income for tax purposes. However, the tax
adjusted rate of interest should be used only in those cases where the “earning
of the firm before interest and tax” (EBIT) is equal to or exceed the interest. In
case, EBIT is in negative, the cost of debt should be calculated before adjusting
the interest rate for tax.
(b) Debt issued at premium or discount: In case the debentures are issued at
premium or discount, the cost of debt should be calculated on the basis of net
proceeds realized on account of issue of such debentures or bonds. Such cost
may further be adjusted keeping in view the tax applicable to the company. Cost
of debt can be calculated according to the following formula:
Kd= I(1-T)/NP
Where,
 Kd = Cost of debt after tax.
 I = Annual interest payment.
 NP = Net proceeds of loans or debentures.
 T = Tax rate.
2. Cost of Preference Capital
The computation of the cost of preference capital however poses some
conceptual problems. In case of borrowings, there is legal obligation on the firm
to pay interest at fixed rates while in case of preference shares, there is no such
legal obligation. Hence, some people argue that dividends payable
on preference share capital do not constitute cost. However, this is not true. This
is because, though it is not legally binding on the company to pay dividends on
preference shares, it is generally paid whenever the company makes sufficient
profits. The failure to pay dividend may be better of serious concern from the
point of view of equity shareholders. They may even lose control of the
company because of the preference shareholders getting the legal right to
participate in the general meetings of the company with equity shareholders
under certain conditions in the event of failure of the company to pay them their
dividends. Moreover, the accumulation of arrears of preference dividends may
adversely affect the right of equity shareholders to receive dividends. This is
because no dividend can be paid to them unless the arrears of preference
dividend are cleared. On account of these reasons the cost of preference capital
is also computed on the same basis as that of debentures. The method of its
computation can be put in the form of the following equation:
Kp=Dp/Np
Where,
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  Kp = Cost of preference share capital
 Dp = Fixed preference dividend
 Np = Net proceeds of preference shares.
In case of redeemable preference shares, the cost of capital is the discount rate
that equals the net proceeds of sale of preference shares with the present value
of future dividends and principal repayments.
3. Cost of Equity Capital
The computation of the cost of equity capital is a difficult task. Some people
argue, as observed in case of preference shares, that the equity capital does not
involve any cost. The argument put forward by them is that it is not legally
binding on the company to pay dividends to the equity shareholders. This does
not seem to be a correct approach because the equity shareholders invest money
in shares with the expectation of getting dividend from the company. The
company also does not issue equity shares without having any intention to pay
them dividends. The market price of the equity shares, therefore, depends upon
the return expected by the shareholders.
Conceptually cost of equity share capital may be defined as the minimum rate
of return that a firm must earn on the equity financed portion of an investment
in a project in order to leave unchanged the market price of such shares.
From the preceding discussion, it is implied that in order to find out the cost of
equity capital, one must be in a position to determine what the shareholders as a
class expect from their investment in equity shares. This is a difficult
proposition because shareholders as a class are difficult to predict or quantify.
Different authorities have conveyed different explanations and approaches.
In order to determine the cost of equity capital, it may be divided into new
equity and existing equity. The following are some of the appropriate according
to which the cost of equity capital can be worked out:
(a) Dividend price (D/P) approach
According to this approach, the investor arrives at the market price of an equity
shares by capitalizing the set of expected dividend payments. Cost of equity
capital has therefore been defined as “the discount rate that equates the present
value of all expected future dividends per share with the net proceeds of the
sale (or the current market price) of a share”.
In other words, the cost of equity capital will be that rate of expected dividends
which will maintain the present market price of equity shares.
This approach rightly emphasizes the importance of dividends, but it ignores the
fact that the retained earnings have also an impact on the market price of the
equity shares. The approach therefore does not seem to be very logical.
The cost of new equity can be determined according to the following formula:
Ke =D/NP
Where,
 Ke= Cost of equity capital;
 D= Dividend per equity share;

51
  NP = Net proceeds of an equity share.
In case of existing equity shares, it will be appropriate to calculate the cost of
equity on the basis of market price of the company’s shares. In the present case,
it can be calculated according to the following formula:
Ke = D/MP
Where,
 Ke= Cost of equity capital;
 D= Dividend per equity share;
 MP = Market price of an equity share.
(b) Dividend price plus growth (D/P + g) approach
According to this approach, the cost of equity capital is determined on the basis
on the expected dividend rate plus the rate of growth in dividend. The rate of
growth in dividend is determined on the basis of the amount of dividends paid
by the company for the last few years. The computation of cost of capital
according to this approach can be done by using the following formula:
Ke = (D/NP) + g
Where,
 Ke = Cost of equity capital;
 D= Expected dividend per share;
 NP = Net proceeds of per share;
 g= Growth in expected dividend.
It may be noted that in case of existing equity shares, the cost of equity capital
can also be determined by using the above formula. However, the market price
(MP) should be used in place of net proceeds (NP) of the shares as given above.
(c) Earning price (E/P) approach
According to this approach, it is the earning per share which determines the
market price of the shares. This is based on the assumption that the shareholders
capitalize a stream of future earnings (as distinguished from dividends) in order
to evaluate their share holdings. Hence, the cost of capital should be related to
that earnings percentage which could keep the market price of the equity shares
constant. This approach, therefore, takes into account both dividends as well as
retained earnings. However, the advocates of this approach differ regarding the
use of both earnings and the market price figures. Some simply use of current
earning rate and the current market price of the share of the company for
determining the cost of capital. While others recommend average rate of
earnings (based on the earnings of the past few years) and the average market
price (calculated on the basis of market price for the last few years) of equity
shares.
The formula for calculating the cost of capital according to the approach is as
follows:
Ke =E/NP
Where
 Ke= Cost of equity capital;

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  D= Earnings per share;
 NP = Net proceeds of an equity share.
However, in case of existing equity shares, it will be appropriate to use market
price (MP) instead of net proceeds (NP) for determining the cost of capital.
(d) Realized Yield Approach
According to this approach, the cost of equity capital should be determined on
the basis of the returns actually realized by the investors in a company on their
equity shares. Thus, according to this approach the past records in a given
period regarding dividends and the actual capital appreciation in the value of the
equity shares held by the shareholders should be taken to compute the cost of
equity capital.
This approach gives fairly good results in case of companies with stable
dividends and growth records. In case of such companies, it can be assumed
with reasonable degree of certainty that the past behavior will be repeated in the
future also.

Cost of Retained Earnings

Retained earnings represent a company's cumulative profits or earnings that
have not been paid out as cash dividends to shareholders. Retained earnings can
be reinvested back into the company. However, there's an opportunity cost with
retained earnings, particularly if not utilized properly or if it sits unused, which
can limit a company's growth.
 Retained earnings represent a company's cumulative profits that have not
been paid out as cash dividends to shareholders.
 There's an opportunity cost with retained earnings if not utilized properly
or if it sits unused, which can limit a company's growth.
 Companies typically calculate the opportunity cost of retained earnings
by averaging the results of three separate calculations.

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Composite Cost of Capital
Composite cost of capital is also referred to as weighted average cost of capital
(WACC). It is a calculation of a company's cost of capital that involves the
proportional weighting of each category of capital. It takes into account all
sources of capital, such as common and preferred stock, bonds, and other forms
of long-term debt. Composite cost of capital can be used for a variety of
purposes, from calculating economic value added to determining whether a
certain investment is feasible.

What is the WACC Formula?

The calculation used for WACC includes cost of equity and cost of debt, along
with additional economic components commonly used by businesses.
Here is how those components are broken down in a WACC formula.
• E = Market value of the business’s equity
• V = Total value of capital (equity + debt)
• Re = Cost of equity
• D = Market value of the business’s debt

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 • Rd = Cost of debt
• T = Tax rate
Once you have those numbers, here’s how to calculate WACC:
WACC = (E/V x Re) + ((D/V x Rd) x (1-T))
To use the WACC formula, you need to first multiply the costs of each financial
component and include that component’s proportional rate. Once you’ve arrived
at those figures, multiply them by the company’s corporate tax rate. The
resulting figure gives you the company’s weighted average cost of capital.

Cash Flows as Profit and Components of Cash Flows

Cash flow and profit are two different financial parameters, but when you’re
running a business, you need to keep track of both. Here’s how they’re
different, why they’re both important and how they intersect with other
corporate issues, especially when a company grows rapidly.
Cash Flow
Cash flow is the money that flows in and out of the firm from operations and
financing and investing activities. It’s the money you need to meet current and
near-term obligations. But there are two things to keep in mind about cash flow:
A Business Can Be Profitable and Still Not Have Adequate Cash Flow
In the worst case, insufficient cash flow in a profitable business can send it into
bankruptcy. For example, you’re making widgets and selling them at a profit.
But your product goes through a long sales chain and some of your biggest and
most important wholesale customers don’t pay on invoices for 120 days. This
sounds extreme, but many large US corporations in the 21st century don’t pay
an account payable for three or four months from the receipt of the invoice.
Since you’re the little guy, the suppliers of materials you need to make those
widgets often want to be paid either upon receipt or in 15 or 30 days. Ironically,
if you’re caught between suppliers who want their money now and buyers
who’re slow to pay, a successful product with increasing sales can create a real
cashflow crisis. Even though your unit sales are increasing and profitable, you
won’t get paid in time to pay your suppliers and meet payroll and other
operational expenses. If you’re unable to meet your financial obligations in a
timely way, your creditors may force you into bankruptcy at a period when sales
are growing rapidly.
Your Sales May Be Growing and the Money Keeps Pouring In, but That
Doesn’t Mean You’re Making a Profit
If you borrow money to solve the cash flow problem, for instance, the rising
debt costs that result can raise your costs above the breakeven point. If so,
eventually your cash flow will dry up and eventually your business will fail.
Profit
Profit, also called net income, is what remains from sales revenue after all the
firm’s expenses are subtracted. It’s obvious in principle that a business cannot
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long survive unless it is profitable, but sometimes, as with cash flow, the very
success of a product can raise expenses. It may not be immediately apparent that
this is a problem. In other cases, you may be aware of the problem, but believe
that by reducing production costs you can restore profitability in time to avoid a
crisis. Unfortunately, unless you have a clear understanding of all the relevant
cost data, you may not act effectively or promptly enough to make the firm
profitable again before it runs out of money.
Components of Cash Flows
(i) Cash Flow from Operating Activities
The net amount of cash coming in or leaving from the day to day business
operations of an entity is called Cash Flow from Operations. Basically it is the
operating income plus non-cash items such as depreciation added. Since
accounting profits are reduced by non-cash items (i.e. depreciation and
amortization) they must be added back to accounting profits to calculate cash
flow.
Cash flow from operations is an important measurement because it tells the
analyst about the viability of an entities current business plan and operations. In
the long run, cash flow from operations must be cash inflows in order for an
entity to be solvent and provide for the normal outflows from investing and
finance activities.
(ii) Cash Flow from Investing Activities
Cash flow from investing activities would include the outflow of cash for long
term assets such as land, buildings, equipment, etc., and the inflows from the
sale of assets, businesses, securities, etc. Most cash flow investing activities are
cash out flows because most entities make long term investments for operations
and future growth.
(iii) Cash Flow from Finance Activities
Cash flow from finance activities is the cash out flow to the entities investors
(i.e. interest to bondholders) and shareholders (i.e. dividends and stock
buybacks) and cash inflows from sales of bonds or issuance of stock equity.
Most cash flow finance activities are cash outflows since most entities only
issue bonds and stocks occasionally.

What is a Capital Budgeting

Capital budgeting is the process of making investment decisions in long term
assets. It is the process of deciding whether or not to invest in a particular
project as all the investment possibilities may not be rewarding.

Thus, the manager has to choose a project that gives a rate of return more than
the cost financing such a project. That is why he has to value a project in terms
of cost and benefit.

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Following are the categories of projects that can be examined using capital
budgeting process:

 The decision to buy new machinery

 Expansion of business in other geographical areas
 Replacement of an obsolete equipment
 New product or market development etc

Thus, capital budgeting is the most important responsibility undertaken by

a financial manager. This is because:

1. It involves the purchase of long term assets and such decisions may
determine the future success of the firm.
2. These decisions help in maximizing shareholder’s value.
3. Principles applicable to capital budgeting process also apply to other
corporate decisions like working capital management.

Process of Capital Budgeting

Following are the steps of capital budgeting process:

 Idea Generation
The most important step of the capital budgeting process is generating good
investment ideas. These investment ideas can come from a number of sources

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like the senior management, any department or functional area, employees, or
sources outside the company.
 Analyzing Individual Proposals
A manager must gather information to forecast cash flows for each project in
order to determine its expected profitability. This is because the decision to
accept or reject a capital investment is based on such an investment’s future
expected cash flows.
 Planning Capital Budget
An entity must give priority to profitable projects as per the timing of the
project’s cash flows, available company resources, and a company’s overall
strategies. The projects that look promising individually may be undesirable
strategically. Thus, prioritizing and scheduling projects is important because of
the financial and other resource issues.
 Monitoring and Conducting a Post Audit
It is important for a manager to follow up or track all the capital budgeting
decisions. He should compare actual with projected results and give reasons as
to why projections did not match with actual performance. Therefore, a
systematic post-audit is essential in order to find out systematic errors in the
forecasting process and hence enhance company operations.

Techniques of Capital Budgeting

Capital budgeting techniques are the methods to evaluate an investment
proposal in order to help the company decide upon the desirability of such a
proposal. These techniques are categorized into two heads : traditional methods
and discounted cash flow methods.

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 A. Traditional Methods
Traditional methods determine the desirability of an investment project based
on its useful life and expected returns. Furthermore, these methods do not take
into account the concept of time value of money.

 Pay Back Period Method

Payback period refers to the number of years it takes to recover the initial cost
of an investment. Therefore, it is a measure of liquidity for a firm. Thus, if an
entity has liquidity issues, in such a case, shorter a project’s payback period,
better it is for the firm.
It is refers to the period within which entire amount of investment is
expected to be recovered in form of Cash.
Situation 1: Uniform Cash Receipts:

Situation 2: Unequal Cash Receipts:

Step 1: Calculate Cumulative Cash Inflow
Step 2: Calculate Payback Period

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  Discounted Payback Period : It is refers to the period within which
entire amount of investment is expected to be recovered in form of
Discounted Cash.
Step 1: Calculate Cumulative Discounted Cash Inflow
Step 2: Calculate Discounted Payback Period

 Average Rate of Return Method (ARR)

Accounting/Average Rate of Return (ARR): ARR is the rate of return in
terms of average book profit on investment. It can be calculated by using
one of the following three methods:

Formula 1: ARR (Total Investment Basis) = × 100

Formula 2: ARR (Average Investment Basis) = × 100

Formula 3: ARR (Annual

Basis):
Step 1: Calculate Annual Rate of Return =
Step 2: Calculate Average Rate of Return of Annual ARR in Step 1
Note:
Average Investment = ½ × (Initial Investment + Salvage) + Additional
Working Capital (If Any)
Or
Average Investment = (½ × Depreciable Investment) + Salvage +
Additional Working Capital

B. Discounted Cash Flow Methods

As mentioned above, traditional methods do not take into the account time
value of money. Rather, these methods take into consideration present and
future flow of incomes. However, the DCF method accounts for the concept that
a rupee earned today is worth more than a rupee earned tomorrow. This means
that DCF methods take into account both profitability and time value of money.

 Net Present Value Method (NPV)

NPV is the sum of the present values of all the expected incremental cash flows
of a project discounted at a required rate of return less than the present value of
the cost of the investment.
In other words, NPV is the difference between the present value of cash inflows
of a project and the initial cost of the project. As per this technique, the projects
whose NPV is positive or above zero shall be selected.
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The net present value of a project is the amount, in current value of
amount, the investment earns after paying cost of capital in each period.
NPV = PV of Inflow – PV of Outflow/Initial Investment Or
NPV = (PI – 1) × PV of Outflow/Initial Investment

 Profitability Index (PI)/Desirability Factor (DF)/Present Value

Index Method:
PI = PV of Inflow ÷ PV of Outflow/Initial investment Or

Note: PI technique is useful:

 In case of Capital Rationing with indivisible projects
 In case of equal NPV under mutually exclusive projects

 Internal Rate of Return (IRR)

Internal Rate of Return refers to the discount rate that makes the present value
of expected after-tax cash inflows equal to the initial cost of the project.
In other words, IRR is the discount rate that makes present values of a project’s
estimated cash inflows equal to the present value of the project’s estimated cash
outflows.
Internal rate of return refers to the actual rate of return generated by the
project. Internal rate of return for an investment proposal is the discount
rate that equates the present value of the expected cash inflows with the
initial cash outflow.

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Situation 1: One Point Inflow & Outflow:

Situation 2: Multiple Point Inflow (Unequal Cash) & Outflow:

Step 1: Calculate one positive and one negative NPV by using
random discount rate

Where,
L = Lower Discount Rate
H = Higher Discount Rate
NPV L = NPV at Lower Discount Rate
NPV H = NPV at Higher Discount Rate
Situation 3: `Multiple Point Inflow (Equal Cash) & Outflow:

Step 1: `Calculate PVIFA at IRR: PVIFA IRR =

Step 2: `Calculate IRR on the basis of PVIFA table:
(a) If matched in table : Matched PVIFA rate is IRR
(b) If not matched then have to use interpolation: IRR

 Modified Internal Rate of Return (MIRR) The MIRR is

obtained by assuming a single outflow in the zero year and the
terminal cash inflow.
Step 1: Calculate cumulative compounded value of intermediate cash
inflow by using cost of capital as rate of compounding.

 Profitability Index
Profitability Index is the present value of a project’s future cash flows divided
by initial cash outlay. Thus, it si closely related to NPV. NPV is the difference
between the present value of future cash flows and the initial cash outlay.
Whereas, PI is the ratio of the present value of future cash flows and initial cash
outlay.
PI = PV of future cash flows/CF0 = 1 + NPV/CF0

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Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV is
negative, PI will be less than 1. Therefore, based on this, if PI is greater than 1,
accept the project otherwise reject.

 Replacement Decision: Decision in respect of replacement of an

existing working machine with new one having higher production
capacity or lower operating cost or both.
Step 1: Calculate Initial Outflow:
Particulars INR

Purchase Cost of New Machine XXX

Less: Sale Value of Old Machine (XXX)

Less: Tax Saving on Loss on Sale of Old Machine (XXX)

Add: Tax Payment on Profit on Sale of Old XXX

Machine

Add: Increase In Working Capital XXX

Less: Decrease in Working Capital (XXX)

Initial Outflow XXX

Step 2: Calculate Incremental CFAT.
Step 3: Calculate Incremental Terminal Value (net of tax).
Step 4: Calculate Incremental NPV and Take Replacement Decision.

 Capital Rationing : Capital rationing refers to the process of

selection of optimal combination of projects out of many subject to
availability of funds.
Situation 1 : Projects are Divisible:
Step 1: Calculate PI of all the available projects
Step 2: Give Rank to all projects on the basis of PI
Step 3: Select Projects on the basis of Rank
Situation 2: Projects are Indivisible:
Step 1: Calculate all possible combinations
Step 2: Select combination of projects having higher combined NPV

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Decision Under Various Techniques

Techniques Yes No

ARR ARR ≥ Desired Return ARR < Desired Return

Traditional Payback Payback ≤ Desired Payback > Desired

Payback Payback

Discounted Payback Payback ≤ Desired Payback > Desired

Payback Payback

NPV NPV ≥ 0 NPV < 0

PI PI ≥ 1 PI < 1

IRR IRR ≥ Cost of Capital IRR < Cost of Capital

MIRR MIRR ≥ Cost of Capital MIRR < Cost of Capital

Special Points:

 Sunk Cost and Allocated Overheads are irrelevant in Capital
Budgeting.
 Opportunity Cost is considered in Capital Budgeting.
 Working Capital introduced at the beginning of project (cash
outflow) and recover (cash inflow) at the end of the project
life.
 Running Cost : Always Cash Cost.

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  Operating Cost : Variable Cost plus Fixed Cost (Including
Depreciation) subject to operating cost must be >
Depreciation.
 Depreciation : Only as per Tax is relevant.
 If nothing is specified: Depreciation as per books is assumed
to be depreciation as per tax and Losses can be carry
forwarded for tax benefit.

Excel Application in Analyzing Project

Excel is a commonly used tool for all sorts of things: making to-do lists,
analyzing data, managing projects, planning events, budget calculations, you
name it. It’s often the first go-to tool for managing projects, given its handy grid
format and its ability to formulate and filter data to make sense of it.

Excel can be challenging for certain aspects of project management. That’s why
we’ve created this guide to help you get the most out of the tool.

How to Start a Project in Excel?

Whether you’re starting a large, formal project or a small one, you generally
lead with a list. It can be helpful to open up Excel as a tool to sketch out the
rough beginnings of your to-do lists and key dates and people needed to
accomplish the project. The grid in Excel offers a natural logic, helping to
define what tasks need to follow others, culminating in a final finished project.

Excel’s formulas are also obvious benefits when you’re defining column data
like project budgets, and its more advanced features like pivot tables are great
ways to visualize data in a spreadsheet.

Excel is useful for starting projects and developing a breakdown of tasks

(sometimes called a Work Breakdown Structure). Here’s what you need to do to
get started:

 First, you should have defined your project’s goals and deliverables in
your project charter or Statement of Work. Once you have that, you can
create a document in Excel to begin planning the project.
 Start with a Task Tracking or Project Tracking template (see our list of
starter templates).
 Add tasks and prioritize individually as well as add target start and end
dates.

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  Create distinctions between larger task activities and subtasks by rolling
up some rows underneath a larger task.
 Define the planned duration of each task (how long is it supposed to
take?)
 Assign the task to an individual responsible for completing that task.
 Save and share! You now have the beginnings of a project plan that you
can share with your team. It’s important to invite others to contribute so
they can see their role in the overall effort and share in the sense of
accomplishment when tasks are marked off as completed.

Once you’ve started with the Task Tracking list, you can explore the other
project management templates we have created for you. These can help with
different phases and aspects of your project to help you ensure its successful
delivery all the way through.

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