Elementary Corporate Finance CBCFB3T04

Syllabus topics (RTMNU)

• Definition, Meaning, Scope, Importance and Evolution of Corporate Finance (Financial Management)
• Objectives of Financial Management: Profit Maximization, Wealth Maximization
• Financial Decisions: Factors influencing financial decisions
• Functional areas of financial management
• Functions of a finance manager
• Financial Planning: Objectives, Characteristics, Steps of a Sound Financial Plan

Definition, Meaning, Scope, Importance and Evolution of Corporate Finance (Financial Management)

Corporate finance means the way a company raises money (funds), uses that money in assets and projects, and shares the profit with its owners. In India the same subject is usually called Financial Management.

Other definitions:

• Howard and Upton: Financial management is the application of planning and control functions to the finance function.
• Solomon (Ezra Solomon): Financial management is concerned with the efficient use of an important economic resource, namely capital funds.

Scope of financial management (what it covers):

1. Investment decision – in which fixed assets and projects to invest (capital budgeting) and how much to keep in current assets (working capital).
2. Financing decision – from where to raise funds: shares, debentures, loans; and in what mix (capital structure).
3. Dividend decision – how much profit to pay as dividend and how much to retain.
4. Liquidity decision – keeping enough cash to pay bills on time without keeping idle cash.
5. Financial analysis and control – ratio analysis, budgets, cost control.

Importance:

1. Every business activity needs money; finance is called the "life blood" of business.
2. Helps raise funds at the lowest cost and at the right time.
3. Ensures funds are used in profitable projects only.
4. Maintains liquidity, so the firm can pay suppliers, workers and lenders.
5. Increases the value of the firm and the wealth of shareholders.
6. Helps in growth, expansion, mergers and survival in hard times.

Evolution (three phases):

Objectives of Financial Management: Profit Maximization, Wealth Maximization

1. Profit maximisation: the firm should take decisions that increase its profit.

• Merits: profit is a test of efficiency; it is needed for survival and growth; easy to understand.
• Criticism: (a) "profit" is vague – gross or net, short-run or long-run? (b) ignores the time value of money (₹1 today is worth more than ₹1 after a year); (c) ignores risk; (d) may ignore social responsibility.

2. Wealth maximisation (value maximisation): the firm should take decisions that increase the market value of its shares, i.e. the net present value (NPV) of its future cash flows.

• Uses cash flows, not accounting profit.
• Considers time value of money by discounting.
• Considers risk through the discount rate.
• Benefits shareholders, and indirectly lenders, employees and society.

Financial Decisions: Factors influencing financial decisions

The three main financial decisions are investment, financing and dividend decisions (some books add the liquidity decision).

Factors influencing financial decisions:

1. Cost – cost of each source of funds (interest, dividend expectation).
2. Risk – more debt means more fixed interest burden and more risk.
3. Cash flow position – strong cash flow allows more debt and higher dividend.
4. Size and nature of business – a steel plant needs more fixed capital than a trading firm.
5. Control – new equity shares dilute control of existing owners; debt does not.
6. Capital market conditions – in a boom equity is easy to raise; in a slump debt is preferred.
7. Government policies and taxation – interest is tax deductible; SEBI and RBI rules.
8. Return expected and growth plans – growth firms retain more profit.

Functional areas of financial management, functions of a finance manager

Functional areas: (1) determining the amount of funds required, (2) raising funds from suitable sources, (3) investment of funds in fixed and current assets, (4) cash management, (5) profit planning and dividend distribution, (6) financial control through budgets and ratios.

Functions of a finance manager:

A. Executive (main) functions

1. Estimating capital requirement – for fixed assets and working capital.
2. Deciding capital structure – mix of equity, preference and debt.
3. Choosing sources of funds – shares, debentures, bank loans, public deposits.
4. Investment of funds – using capital budgeting methods (payback, NPV, IRR).
5. Disposal of surplus – dividend vs retained earnings.
6. Cash management – right amount of cash at the right time.
7. Financial control – budgets, ratio analysis, cost control, internal audit.

B. Routine (incidental) functions – record keeping, preparing reports, handling cash receipts and payments, safe custody of documents, dealing with banks.

Financial Planning: Objectives, Characteristics, Steps of a Sound Financial Plan

Objectives: (1) ensure funds are available when needed; (2) avoid both shortage and surplus of funds; (3) keep a proper balance between owned and borrowed funds; (4) keep the cost of capital low; (5) plan for growth and expansion; (6) reduce uncertainty.

Characteristics of a sound financial plan:

1. Simplicity – a simple capital structure with few types of securities.
2. Foresight – considers present and future needs.
3. Flexibility – can increase or reduce funds when needed.
4. Liquidity – enough current assets to pay current liabilities.
5. Optimum use of funds – no over- or under-capitalisation.
6. Economy – minimum cost of raising funds.
7. Control – existing owners keep control.
8. Intensive use and contingency provision for emergencies.

Steps in financial planning:

1. Set financial objectives (short-term and long-term).
2. Estimate the total funds required (fixed + working capital).
3. Decide the capital structure (debt–equity mix).
4. Select the sources of finance.
5. Frame financial policies (cash, credit, dividend, borrowing).
6. Prepare financial procedures, budgets and forecasts.
7. Review and revise the plan regularly.

Likely exam questions

1. (Long, 8/16 marks) Define financial management. Explain its scope and importance, and trace the evolution of corporate finance from the traditional to the modern approach.
2. (Long, 8/16 marks) Compare profit maximisation and wealth maximisation as objectives of financial management. Why is wealth maximisation considered superior?
3. (Short, 4 marks) State the functions of a finance manager.
4. (Short, 4 marks) What are the factors influencing financial decisions?
5. (Short, 4 marks) State the characteristics of a sound financial plan.

Syllabus topics (RTMNU)

• Introduction and Classification of Sources of Finance
• Features, Advantages and Disadvantages of the following Ownership Securities: Equity Shares
• Preference Shares (Types)
• Shares with Differential Rights
• Sweat Equity Shares
• Debentures (Types)
• Internal Financing: Retained Earnings
• Depreciation as a source of funds
• Loan Financing: Types of Short-Term and Long-Term Loans
• Concept of Venture Capital
• Seed Capital
• Bridge Finance
• Lease Financing
• Euro Issues

Introduction and Classification of Sources of Finance

A company needs funds to buy machines, buildings, raw materials and to pay daily expenses. The places from where it gets these funds are called sources of finance.

Equity Shares

Equity shares are shares which do not carry any preferential right for dividend or repayment of capital. Equity shareholders are the real owners of the company.

Features: (1) permanent capital, repaid only on winding up; (2) dividend is not fixed, paid only if profit is left after preference dividend; (3) voting rights; (4) residual claim on income and assets; (5) limited liability; (6) freely transferable if listed.

Advantages: no fixed burden of dividend; permanent capital; no charge on assets, so assets remain free for borrowing; increases creditworthiness.

Disadvantages: highest cost of capital (dividend not tax deductible, high issue expenses); dilution of control on new issue; over-capitalisation risk; shareholders bear highest risk.

Preference Shares (Types)

Preference shares carry two preferential rights: (a) dividend at a fixed rate before equity dividend, and (b) return of capital before equity on winding up.

Types:

1. Cumulative – unpaid dividend of a year is carried forward and paid later.
2. Non-cumulative – unpaid dividend lapses.
3. Participating – share in surplus profit after equity dividend.
4. Non-participating – only fixed dividend.
5. Convertible – can be converted into equity shares.
6. Non-convertible – cannot be converted.
7. Redeemable – repaid after a fixed period. Under the Companies Act 2013 (Section 55) a company cannot issue irredeemable preference shares; normally they must be redeemed within 20 years (infrastructure projects may get longer).

Advantages: fixed dividend, so equity holders keep surplus (trading on equity); no voting rights normally, so no loss of control; no charge on assets; dividend can be skipped in a bad year.

Disadvantages: dividend is not tax deductible, so costlier than debt; cumulative dividend arrears become a burden; must be redeemed.

Shares with Differential Rights

These are equity shares with different voting or dividend rights from ordinary equity shares (DVR shares) – e.g. fewer votes but higher dividend. Allowed under Section 43 of the Companies Act 2013 and the related rules. Example: Tata Motors issued 'A' Ordinary shares (DVR) in 2008 with lower voting rights and slightly higher dividend.

• Advantages: promoters keep control while raising money; investors who want income, not votes, get more dividend.
• Disadvantages: less popular, less liquid, usually trade at a discount; governance concerns.

Sweat Equity Shares

Sweat equity shares are equity shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing know-how, intellectual property rights or value additions (Section 54, Companies Act 2013).

• Advantages: rewards and retains talent without paying cash; employees become owners.
• Disadvantages: dilution of existing holding; valuation of know-how is difficult; needs special resolution.

Debentures (Types)

A debenture is a document issued under the company's seal acknowledging a debt, carrying fixed interest and repayable on a fixed date. Debenture holders are creditors, not owners.

Types: secured and unsecured; redeemable and irredeemable; convertible (fully/partly) and non-convertible (NCDs); registered and bearer; first and second (by priority of charge); zero-coupon/deep-discount bonds.

Advantages: interest is tax deductible, so cheapest source; no dilution of control; trading on equity increases return to equity holders; suitable when earnings are stable.

Disadvantages: fixed interest is a burden even in loss; repayment on maturity; assets are charged; too much debt increases financial risk.

Internal Financing: Retained Earnings, Depreciation as a source of funds

Retained earnings (ploughing back of profits): the part of net profit not distributed as dividend and kept for reinvestment, shown as reserves and surplus.

• Merits: no issue cost; no dilution of control; no fixed burden; helps in growth and in absorbing losses; makes the company self-reliant.
• Demerits: shareholders get less dividend; possible misuse or over-capitalisation; available only to profitable firms.

Depreciation as a source of funds: depreciation is a non-cash expense. It reduces profit (and tax) but no cash goes out. So the cash equal to depreciation stays inside the business and can be used to replace assets. Hence in cash-flow terms Funds from operations = Net profit + Depreciation. Strictly, depreciation does not create cash; it retains cash by reducing tax and dividend.

Loan Financing: Types of Short-Term and Long-Term Loans

Short-term loans (up to 1 year): cash credit, bank overdraft, discounting of bills of exchange, trade credit, working capital demand loan, commercial paper, advances from customers.

Long-term loans: term loans from banks and financial institutions (SIDBI, NABARD, EXIM Bank), loans from State Financial Corporations, public deposits (medium term), External Commercial Borrowings (ECBs).

Concept of Venture Capital, Seed Capital, Bridge Finance, Lease Financing, Euro Issues

• Venture capital: equity or equity-linked finance given to new, high-risk, high-growth businesses (start-ups) by venture capital funds, along with management help. Example: Flipkart was backed by venture capital funds in its early years.
• Seed capital: very first small amount of money to convert an idea into a business – for research, prototype and market study. Often given by founders, angel investors or schemes like the Startup India Seed Fund Scheme.
• Bridge finance: short-term loan to meet a temporary gap until long-term funds (sanctioned term loan or public issue proceeds) are received.
• Lease financing: the owner of an asset (lessor) gives the right to use it to another (lessee) for periodic lease rentals. The lessee uses the asset without buying it. Types: financial lease and operating lease.
• Euro issues: raising funds from foreign markets in foreign currency, e.g. GDR (Global Depository Receipts, listed in Luxembourg/London), ADR (American Depository Receipts, listed in USA – e.g. Infosys ADRs on NYSE), FCCB (Foreign Currency Convertible Bonds) and ECBs.

Likely exam questions

1. (Long, 8/16 marks) What are sources of finance? Classify them. Explain the features, advantages and disadvantages of equity shares and debentures.
2. (Long, 8/16 marks) Explain retained earnings and depreciation as internal sources of finance. Also explain the concepts of venture capital, seed capital, bridge finance and Euro issues.
3. (Short, 4 marks) State the different types of preference shares.
4. (Short, 4 marks) What are sweat equity shares?
5. (Short, 4 marks) Distinguish between equity shares and debentures.

Syllabus topics (RTMNU)

• Meaning, Concept and Definition and Significance of Cost of Capital
• Computation of Cost of Capital: Cost of Debt
• Cost of Preference Capital
• Cost of Equity Share Capital
• Cost of Retained Earnings
• Computation of Weightage Average Cost of Capital
• Marginal Cost of Capital
• Leverages: Types, Importance and Computation of Leverages

Meaning, Concept, Definition and Significance of Cost of Capital

Cost of capital is the minimum rate of return a company must earn on its investments so that the market value of its shares does not fall. It is the price the company pays for using funds from shareholders and lenders.

Significance:

1. Capital budgeting – used as the discount rate for NPV; a project is accepted only if its return (IRR) is more than the cost of capital.
2. Capital structure – helps choose the mix of debt and equity with minimum overall cost.
3. Choosing sources of finance – compare the cost of each source.
4. Performance evaluation – actual return is compared with the cost of capital.
5. Dividend and working capital decisions also use it.

Cost of Debt

Interest is a tax-deductible expense, so the real (after-tax) cost of debt is lower than the interest rate.

Illustration 1: A company issues 10% irredeemable debentures of ₹100 each at 5% discount (₹95). Tax rate 30%. Find K_d.

Solution: I = ₹10; I (1 − t) = 10 × 0.70 = ₹7; NP = ₹95.
K_d = 7 ÷ 95 × 100 = 7.37%

Illustration 2: 12% debentures of ₹100 each are issued at ₹96, redeemable at ₹104 after 5 years. Tax rate 30%. Find K_d.

Solution: I (1 − t) = 12 × 0.70 = ₹8.40; (RV − NP) ÷ n = (104 − 96) ÷ 5 = ₹1.60; (RV + NP) ÷ 2 = (104 + 96) ÷ 2 = ₹100.
K_d = (8.40 + 1.60) ÷ 100 × 100 = 10%

Cost of Preference Capital

Preference dividend is paid out of profit after tax, so no tax adjustment is made.

Illustration 3: 11% preference shares of ₹100 each issued at ₹95 (net), redeemable at ₹105 after 5 years. Find K_p.

Solution: D = ₹11; (105 − 95) ÷ 5 = ₹2; (105 + 95) ÷ 2 = ₹100.
K_p = (11 + 2) ÷ 100 × 100 = 13%

Cost of Equity Share Capital

Equity has no fixed dividend, so its cost is the return shareholders expect. Common methods:

• Dividend price approach: K_e = D₁ ÷ P₀
• Dividend growth (Gordon) approach: K_e = D₁ ÷ P₀ + g (use NP instead of P₀ for a new issue)
• Earnings price approach: K_e = EPS ÷ Market price
• CAPM: K_e = R_f + β (R_m − R_f)

Illustration 4: Market price of an equity share is ₹50. Expected dividend next year D₁ = ₹5; growth rate 5%. Find K_e. Also find the cost of a new issue if flotation cost is ₹2 per share.

Solution: K_e = 5 ÷ 50 + 0.05 = 0.10 + 0.05 = 15%. New issue: NP = 50 − 2 = ₹48; K_e = 5 ÷ 48 + 0.05 = 0.1042 + 0.05 = 15.42%.

Cost of Retained Earnings

Retained earnings belong to equity shareholders. If the company keeps profit instead of paying dividend, shareholders lose the chance to invest it elsewhere (opportunity cost). So K_r = K_e (without flotation cost). If personal tax (t_p) and brokerage (b) are given: K_r = K_e (1 − t_p)(1 − b).

Weighted Average Cost of Capital

WACC (K_o) is the average of the costs of all sources, each weighted by its proportion in total capital. Weights may be book value or market value weights.

Illustration 5: Compute WACC from the following (book values):

Check by amounts: 75,000 + 28,000 + 10,000 + 14,000 = ₹1,27,000; 1,27,000 ÷ 10,00,000 = 12.70%.

Marginal Cost of Capital

Marginal cost of capital (MCC) is the cost of raising one more rupee (the additional funds) of new capital. It is the weighted cost of the new funds only. MCC rises when cheap sources are used up – e.g. after retained earnings are exhausted the firm must issue new equity with flotation cost, so the cost goes up. Example: if the firm above raises ₹2,00,000 more, half by new equity at 15.42% and half by debt at 7.37%, MCC = 0.5 × 15.42 + 0.5 × 7.37 = 11.40% (rounded).

Leverages: Types, Importance and Computation of Leverages

Leverage means the use of fixed costs (fixed operating costs or fixed interest) to magnify the effect of a change in sales on profits.

Importance: shows business and financial risk; helps plan capital structure (high OL firms should keep FL low); shows how much EPS will change for a given change in sales; useful in profit planning.

Illustration 6: A firm sells 1,00,000 units at ₹20. Variable cost ₹12 per unit, fixed cost ₹3,00,000. It has 10% debt of ₹20,00,000. Tax 30%. Compute OL, FL and CL.

OL = 8,00,000 ÷ 5,00,000 = 1.6; FL = 5,00,000 ÷ 3,00,000 = 1.67; CL = 8,00,000 ÷ 3,00,000 = 2.67 (= 1.6 × 1.67). Meaning: a 10% rise in sales will raise EBT (and EPS) by about 26.7%.

Likely exam questions

1. (Long, 8/16 marks) Define cost of capital and explain its significance. How is the cost of debt, preference capital, equity and retained earnings computed?
2. (Long, 8/16 marks) A company has: Equity capital ₹6,00,000 (cost 16%), Retained earnings ₹2,00,000 (cost 15%), 10% Preference capital ₹2,00,000, Debentures ₹4,00,000 (after-tax cost 7%). Compute the weighted average cost of capital using book value weights.
3. (Short, 4 marks) Sales ₹10,00,000, variable cost ₹6,00,000, fixed cost ₹2,00,000, interest ₹50,000. Calculate operating, financial and combined leverage.
4. (Short, 4 marks) Explain marginal cost of capital.
5. (Short, 4 marks) A company issues 9% irredeemable debentures of ₹100 at par. Tax rate 30%. Find the cost of debt.

Syllabus topics (RTMNU)

• Concept, Importance and Factors Determining Capital Structure
• Theories of Capital Structure: Net Income Approach
• Net Operating Income Approach
• The Traditional Approach
• Modigliani and Miller Approach
• Dividend Policy: Concept
• Dividend Models: Walters Model
• Gordon’s Model
• Modigliani and Miller Model

Concept, Importance and Factors Determining Capital Structure

Capital structure is the mix of long-term sources of funds – equity shares, preference shares, retained earnings and debentures/long-term loans – used by a company.

Importance: (1) affects the cost of capital; (2) affects the value of the firm and share price; (3) decides financial risk; (4) uses trading on equity to raise EPS; (5) affects control and flexibility.

Factors determining capital structure:

1. Trading on equity – if return on investment is higher than the interest rate, debt raises EPS.
2. Cost of capital – debt is cheaper because interest is tax deductible.
3. Stability of earnings and cash flow – stable firms (e.g. power utilities) can take more debt.
4. Risk – business risk and financial risk together should not be too high.
5. Control – promoters who want control prefer debt.
6. Flexibility – keep some borrowing capacity for the future.
7. Size, nature and age of firm, capital market conditions, legal rules (SEBI, RBI), tax rate.

Theories of Capital Structure: Net Income Approach

Given by David Durand. Assumptions: K_d and K_e remain constant, K_d < K_e, no taxes. Since cheap debt replaces costly equity, more debt lowers WACC and raises the value of the firm. So capital structure is relevant; optimum is (almost) 100% debt.

Illustration 1: EBIT ₹2,00,000; 10% debt ₹5,00,000; K_e 12.5%. Find V and K_o. What if debt rises to ₹8,00,000?

More debt → V up, K_o down. This proves the NI approach.

Net Operating Income Approach

Also by Durand. K_o and K_d are constant. When debt increases, equity becomes riskier and K_e rises just enough to keep K_o the same. So the value of the firm does not depend on capital structure (irrelevance). Every capital structure is optimum.

Illustration 2: Same firm, EBIT ₹2,00,000; K_o 12.5%; 10% debt.

Value stays ₹16,00,000; only K_e rises.

The Traditional Approach

A middle path between NI and NOI. Up to a certain level of debt, K_e rises only slightly, so K_o falls and V rises. Beyond that point both K_e and K_d rise sharply, so K_o rises. Hence the K_o curve is U-shaped and there is an optimum capital structure at its lowest point. (Diagram in words: x-axis debt/equity, y-axis cost; K_d flat then rising, K_e slowly then sharply rising, K_o saucer-shaped.)

Modigliani and Miller Approach

MM (1958), without taxes: In perfect markets the value of a firm is independent of its capital structure: V_L = V_U. Assumptions: perfect capital market, no taxes, no transaction cost, investors can borrow at the same rate as firms, same business risk class, 100% payout.

Arbitrage process: if a levered firm's value is higher than an identical unlevered firm, investors sell shares of the overvalued firm, borrow personally (home-made leverage) and buy shares of the undervalued firm, earning the same income with less investment. This buying and selling continues until both values become equal.

MM with taxes (1963): interest is tax deductible, so debt gives a tax shield. V_L = V_U + t × D.

Illustration 3: Unlevered firm value ₹20,00,000; a similar firm has ₹10,00,000 debt; tax 30%. V_L = 20,00,000 + 0.30 × 10,00,000 = ₹23,00,000.

Dividend Policy: Concept

Dividend policy decides how much of the net profit is paid to shareholders as dividend and how much is retained. Payout ratio = DPS ÷ EPS; retention ratio (b) = 1 − payout ratio. Types: stable, irregular, no-dividend policy.

Dividend Models: Walters Model

James E. Walter: dividend policy is relevant. It depends on the relation between the firm's return on investment (r) and cost of equity (k_e).

• r > k_e (growth firm): retain all, payout 0% is optimum.
• r = k_e (normal firm): dividend does not matter.
• r < k_e (declining firm): pay 100%.

Illustration 4: E = ₹10, r = 15%, k_e = 12%. Find P at payout ₹0, ₹4, ₹10.

Since r > k_e, price is highest at zero payout.

Gordon's Model

Myron Gordon: dividend is relevant; investors prefer a "bird in hand" (present dividend) to uncertain future gains.

Illustration 5: E = ₹10, r = 15%, k_e = 12%. Retention 40%: P = 6 ÷ (0.12 − 0.06) = ₹100. Retention 60%: P = 4 ÷ (0.12 − 0.09) = ₹133.33. Growth firm → more retention, higher price.

Modigliani and Miller Model

MM (1961): in perfect markets dividend policy is irrelevant; value depends on earning power. Whatever shareholders gain in dividend they lose in a lower ex-dividend price.

Illustration 6: 1,00,000 shares, P₀ ₹100, k_e 10%, earnings ₹10,00,000, investment ₹15,00,000, proposed dividend ₹5.

Value is the same either way, proving irrelevance.

Likely exam questions

1. (Long, 8/16 marks) What is capital structure? Explain the factors determining capital structure, and discuss the Net Income and Net Operating Income approaches.
2. (Long, 8/16 marks) EPS of a company is ₹8, rate of return on investment is 15% and cost of equity is 10%. Using Walter's model, find the market price of share when the payout ratio is 0%, 50% and 100%, and state the optimum payout.
3. (Short, 4 marks) Explain the Modigliani–Miller approach to capital structure and the arbitrage process.
4. (Short, 4 marks) EBIT ₹3,00,000, 10% debt ₹10,00,000, cost of equity 15%. Find the value of the firm and overall cost of capital under the Net Income approach.
5. (Short, 4 marks) Explain Gordon's dividend model.