Finance End Term Questions

1. “The concept of finance function has changed and keeps changing

along with the evolution of the content of finance as a business
management activity.” Elucidate.

The continually rising globalization, emerging markets, competition as well

as legislation and compliance requirements make businesses more complex,
resulting in greater pressure on finance function.
Amidst the rising complexity of the business environment, it is expected to
deliver quality information. The contribution to organizational performance
gains more prominence as the organization continues its expansion
activities.
The word finance originates from the French and is subsequently adopted by
English-speaking regions to refer to the ‘management of money’. ‘Finance’,
today, is more than just a word; it has emerged into a highly significant
professional and academic discipline.

Traditional approach
Traditionally, finance itself in any organization aimed to achieve optimal use
of the limited financial resources. The scope of finance is mostly confined to
the procurement of funds by business houses to address financial needs.
Earlier, finance as a function remained focused on funding activities and
involved extensive decision making around financial instruments,
investment houses and practices. This period (the mid-1950s) is referred to
as corporation finance. Under this approach, finance as a function
emphasizes more on managerial aspects of business and stretches the
responsibilities of a finance manager to include all decision-making
associated with the efficient use of resources.
A modern day finance manager should possess a balanced blend of
management skills, financial expertise, administrative ability, technological
knowledge, communication skills and decision-making skills.
 Modern Approach
Under this approach, finance as a function emphasizes more on managerial
aspects of business and stretches the responsibilities of a finance manager to
include all decision-making associated with the efficient use of resources.
A modern day finance manager should possess a balanced blend of
management skills, financial expertise, administrative ability, technological
knowledge, communication skills and decision-making skills.

2. “The wealth maximization approach provides an appropriate criteria

for proper financial decision making.” Explain

1. Wealth Maximization Objective Recognizes The Time Value Of Money

Time value of money is an important concept in financial decision making.
Wealth maximization goal recognizes this concept. According to this concept, all
cash flows generated over the life of the project are discounted back to present
value using required rate of return as discount rate, and the decision is based on the
present value of future returns.

2. Consideration Of Risk
Wealth maximization objective also considers the risks associated to the streams of
future cash flows. The risk is taken care of by using appropriate required rate of
return to discount the future streams of cash flows. Higher the risk, higher will be
the required rate of return and vice versa.

3. Efficient Allocation of Resources

Shareholders wealth maximization objective provides guideline for firm's decision
making and also promotes an efficient allocation of resources in the economic
system. Resources are generally allocated taking into consideration the expected
return and risk associated to a course of action. The market value of stock itself
reflects the risk return trade-off associated to any investor in the capital market. In
other words, shareholder wealth , maximization considers the riskiness of the
income stream. Therefore, if a firm makes financing decisions considering market
price of share maximization, it will raise necessary capital only when
the investment ensures the economic use of capital. In the absence of pursuing the
goal of shareholders wealth maximization, there is danger of sub-
optimal allocation of resources in an economy that leads to inadequate capital
formation and low rate of economic growth.

4. Residual Owners
Shareholders are residual claimants in earnings and assets of the company.
Therefore, if shareholders wealth is maximized, then all others with prior claim
than shareholders could be satisfied.

5. Emphasis On Cash Flow

Wealth maximization objective uses cash flows rather than accounting profit as the
basic input for decision making. The use of cash flows is less ambiguous because it
represents means profit after tax plus non-cash outlays to all

Core Concepts

Working Capital Management–Meaning & concept, factors affecting working capital

requirements, cash management, receivables management, inventory management

Questions that probe understanding of concepts and application of learning

1. What is working capital? Discuss the factors that need to be considered while estimating
the working capital requirements of a business firm.

Working capital is the capital of a business which is used in its day-to-day trading operations,
calculated as the current assets minus the current liabilities.

Working capital is a measure of both a company's efficiency and its short-term financial health.
Working capital is calculated as:

Working Capital = Current Assets - Current Liabilities

The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has
enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C
(working capital). While anything over 2 means that the company is not investing excess assets.
Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "net working capital".

Factor to be considered are :

1. Length of Operating Cycle:
The amount of working capital directly depends upon the length of
operating cycle. Operating cycle refers to the time period involved
in production. It starts right from acquisition of raw material and
ends till payment is received after sale.
The working capital is very important for the smooth flow of
operating cycle. If operating cycle is long then more working capital
is required whereas for companies having short operating cycle, the
working capital requirement is less.

2. Nature of Business:
The type of business, firm is involved in, is the next consideration
while deciding the working capital. In case of trading concern or
retail shop the requirement of working capital is less because length
of operating cycle is small.
The wholesalers as compared to retail shop require more working
capital as they have to maintain large stock and generally sell goods
on credit which increases the length of operating cycle. The
manufacturing company requires huge amount of working capital
because they have to convert raw material into finished goods, sell
on credit, maintain the inventory of raw material as well as finished
goods.

3. Scale of Operation:
The firms operating at large scale need to maintain more inventory,
debtors, etc. So they generally require large working capital whereas
firms operating at small scale require less working capital.

4. Business Cycle Fluctuation:

 During boom period the market is flourishing so more demand,
more production, more stock, and more debtors which mean more
amount of working capital is required. Whereas during depression
period low demand less inventories to be maintained, less debtors,
so less working capital will be required.

5. Seasonal Factors:
The working capital requirement is constant for the companies which are
selling goods throughout the season whereas the companies which are selling
seasonal goods require huge amount during season as more demand, more
stock has to be maintained and fast supply is needed whereas during off
season or slack season demand is very low so less working capital is needed.

6. Technology and Production Cycle:

If a company is using labour intensive technique of production then more
working capital is required because company needs to maintain enough cash
flow for making payments to labour whereas if company is using machine-
intensive technique of production then less working capital is required
because investment in machinery is fixed capital requirement and there will
be less operative expenses.

7. Credit Allowed:
Credit policy refers to average period for collection of sale proceeds. It
depends on number of factors such as creditworthiness, of clients, industry
norms etc. If company is following liberal credit policy then it will require
more working capital whereas if company is following strict or short term
credit policy, then it can manage with less working capital also.

8. Credit Avail:
Another factor related to credit policy is how much and for how long period
company is getting credit from its suppliers. If suppliers of raw materials are
giving long term credit then company can manage with less amount of
working capital whereas if suppliers are giving only short period credit then
company will require more working capital to make payments to creditors.

9. Operating Efficiency:
The firm having high degree of operating efficiency requires less amount of
working capital as compared to firm having low degree of efficiency which
requires more working capital.

10. Availability of Raw Materials:

If raw materials are easily available and there is ready supply of raw
materials and inputs then firms can manage with less amount of working
capital also as they need not maintain any stock of raw materials or they can
manage with very less stock.

11. Level of Competition:

If the market is competitive then company will have to adopt liberal credit
policy and to supply goods on time. Higher inventories have to be maintained
so more working capital is required. A business with less competition or with
monopoly position will require less working capital as it can dictate terms
according to its own requirements.

12. Inflation:
If there is increase or rise in price then the price of raw materials and cost of
labour will rise, it will result in an increase in working capital requirement.

13. Growth Prospects:

Firms planning to expand their activities will require more amount of
working capital as for expansion they need to increase scale of production
which means more raw materials, more inputs etc. so more working capital
also.

2. “Management of cash flows plays a very important role in cash management”. Discuss

Cash flow is of vital importance to the health of a business. One saying is: “revenue is vanity,
cash flow is sanity, but cash is king”. What this means is that whilst it may look better to have
large inflows of revenue from sales, the most important focus for a business is cash flow.
Many businesses may continue to trade in the short- to medium-term even if they are making a
loss. This is possible if they can, for example, delay paying creditors and/or have enough money
to pay variable costs. However, no business can survive long without enough cash to meet its
immediate needs.
Cash comes into the business (cash inflows), mostly through sales of goods or services and flows
out (cash outflows) to pay for costs such as raw materials, transport, labour, and power. The
difference between the two is called the net cash flow. This is either positive or negative. A
positive cash flow occurs when a business receives more money than it is spending. This enables
it to pay its bills on time.
A negative cash flow means the business is receiving less cash than it is spending. It may struggle
to pay immediate bills and need to borrow money to cover the shortfall. The distinction between
cash flow and profit is shown in the example. In accounting, negative figures are shown in
brackets.

Liquidity
Businesses aim to provide greater financial returns than the level of interest earned by simply
placing the cash in a bank. They can also hold too much cash. Cash does not earn anything so
holding too much cash could mean potential losses of earnings. The cash situation is referred to
as the liquidity position of the business. The closer an asset is to cash, the more 'liquid' it is. A
deposit account at a bank or stock that can easily be sold are liquid. Assets such as buildings are
the least liquid. Liquid assets are those that are most easily turned into cash.
Cash flow is always important, but especially when it is not easy to obtain credit. When the
economy is in recession, financial service providers are reluctant to lend money. Borrowing also
becomes more expensive as interest rates are raised to partially offset the risk of borrowers not
paying back loans.

Controlling cash is essential and management accountants deal with a range of cash
issues:
  ensuring that sufficient cash is available for investment by not tying up cash
in stock unnecessarily
 putting procedures in place for chasing up outstanding debts
 controlling different levels of cash outflows in relation to the size of the
business.

For example, a car repair garage buys parts and tyres whilst a hairdresser buys shampoos,
equipment and pays for power. In each case, if the business has cash problems it may be slow
to pay its bills to suppliers. This creates further cash problems which spread throughout the
economy. If small suppliers are not paid they may go out of business. This in turn may affect
businesses further up the ladder.

Core Concepts

Capital Structure–Meaning & Concept, capital structure theories, factors affecting capital
structure decisions, EBIT-EPS analysis

Questions that probe understanding of concepts and application of learning

1. What do you mean by capital structure? Explain the factors affecting the capital structure.

The capital structure is how a firm finances its overall operations and growth by using
different sources of funds. Debt comes in the form of bond issues or long-term notes
payable, while equity is classified as common stock, preferred stock or retained
earnings. Short-term debt such as working capital requirements is also considered to be
part of the capital structure.

1. Cash Flow Position:

The decision related to composition of capital structure also depends upon the
ability of business to generate enough cash flow.

The company is under legal obligation to pay a fixed rate of interest to

debenture holders, dividend to preference shares and principal and interest
amount for loan. Sometimes company makes sufficient profit but it is not
able to generate cash inflow for making payments.

The expected cash flow must match with the obligation of making payments
because if company fails to make fixed payment it may face insolvency.
Before including the debt in capital structure company must analyse properly
the liquidity of its working capital.

2. Interest Coverage Ratio (ICR):

It refers to number of time companies earnings before interest and taxes
(EBIT) cover the interest payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities
whereas lower ICR means less borrowed fund securities.

3. Debt Service Coverage Ratio (DSCR):

It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest
on debt but DSCR takes care of return of interest as well as principal
repayment.

If DSCR is high then company can have more debt in capital structure as
high DSCR indicates ability of company to repay its debt but if DSCR is less
then company must avoid debt and depend upon equity capital only.

4. Return on Investment:
Return on investment is another crucial factor which helps in deciding the
capital structure. If return on investment is more than rate of interest then
company must prefer debt in its capital structure whereas if return on
investment is less than rate of interest to be paid on debt, then company
should avoid debt and rely on equity capital. This point is explained earlier
also in financial gearing by giving examples.

5. Cost of Debt:
If firm can arrange borrowed fund at low rate of interest then it will prefer
more of debt as compared to equity.

6. Tax Rate:
High tax rate makes debt cheaper as interest paid to debt security holders is
subtracted from income before calculating tax whereas companies have to
pay tax on dividend paid to shareholders. So high end tax rate means prefer
debt whereas at low tax rate we can prefer equity in capital structure.

7. Cost of Equity:
Another factor which helps in deciding capital structure is cost of equity.
Owners or equity shareholders expect a return on their investment i.e.,
earning per share. As far as debt is increasing earnings per share (EPS), then
we can include it in capital structure but when EPS starts decreasing with
inclusion of debt then we must depend upon equity share capital only.

8. Floatation Costs:
Floatation cost is the cost involved in the issue of shares or debentures. These
costs include the cost of advertisement, underwriting statutory fees etc. It is a
major consideration for small companies but even large companies cannot
ignore this factor because along with cost there are many legal formalities to
be completed before entering into capital market. Issue of shares, debentures
requires more formalities as well as more floatation cost. Whereas there is
less cost involved in raising capital by loans or advances.

9. Risk Consideration:
Financial risk refers to a position when a company is unable to meet its fixed
financial charges such as interest, preference dividend, payment to creditors
etc. Apart from financial risk business has some operating risk also. It
depends upon operating cost; higher operating cost means higher business
risk. The total risk depends upon both financial as well as business risk.

If firm’s business risk is low then it can raise more capital by issue of debt
securities whereas at the time of high business risk it should depend upon
equity.

10. Flexibility:
Excess of debt may restrict the firm’s capacity to borrow further. To maintain
flexibility it must maintain some borrowing power to take care of unforeseen
circumstances.

11. Control:
The equity shareholders are considered as the owners of the company and
they have complete control over the company. They take all the important
decisions for managing the company. The debenture holders have no say in
the management and preference shareholders have limited right to vote in the
annual general meeting. So the total control of the company lies in the hands
of equity shareholders.

12. Regulatory Framework:

Issues of shares and debentures have to be done within the SEBI guidelines
and for taking loans. Companies have to follow the regulations of monetary
policies. If SEBI guidelines are easy then companies may prefer issue of
securities for additional capital whereas if monetary policies are more
flexible then they may go for more of loans.

13. Stock Market Condition:

There are two main conditions of market, i.e., Boom condition. These
conditions affect the capital structure specially when company is planning to
raise additional capital. Depending upon the market condition the investors
may be more careful in their dealings.

During depression period in the market business is slow and investors also
hesitate to take risk so at this time it is advisable to issue borrowed fund
securities as these are less risky and ensure fixed
repayment and regular payment of interest but if there is Boom period,
business is flourishing and investors also take risk and prefer to invest in
equity shares to earn more in the form of dividend.

14. Capital Structure of other Companies:

Some companies frame their capital structure according to Industrial norms.
But proper care must be taken as blindly following Industrial norms may lead
to financial risk. If firm cannot afford high risk it should not raise more debt
only because other firms are raising.

2. What are capital structure theories? Explain various capital structure theories with the
help of diagram.
 In financial management, capital structure theory refers to a systematic approach to financing
business activities through a combination of equities and liabilities. Competing capital structure
theories explore the relationship between debt financing, equity financing and the market value of
the firm.

Theories of Capital Structure

Net Income (NI) Approach:

According to NI approach a firm may increase the total value of the
firm by lowering its cost of capital.

When cost of capital is lowest and the value of the firm is greatest, we
call it the optimum capital structure for the firm and, at this point, the
market price per share is maximised.

he same is possible continuously by lowering its cost of capital by the

use of debt capital. In other words, using more debt capital with a
corresponding reduction in cost of capital, the value of the firm will
increase.

The same is possible only when:

(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes; and

(iii) The use of debt does not change the risk perception of the
investors since the degree of leverage is increased to that extent.

Since the amount of debt in the capital structure increases, weighted

average cost of capital decreases which leads to increase the total value
of the firm. So, the increased amount of debt with constant amount of
cost of equity and cost of debt will highlight the earnings of the
shareholders.
The degree of leverage is plotted along the X-axis whereas Ke, Kw and
Kd are on the Y-axis. It reveals that when the cheaper debt capital in
the capital structure is proportionately increased, the weighted
average cost of capital, Kw, decreases and consequently the cost of debt
is Kd.
Thus, it is needless to say that the optimal capital structure is the
minimum cost of capital if financial leverage is one; in other words,
the maximum application of debt capital.

The value of the firm (V) will also be the maximum at this point.

2. Net Operating Income (NOI) Approach:

Now we want to highlight the Net Operating Income (NOI) Approach
which was advocated by David Durand based on certain assumptions.

They are:
(i) The overall capitalisation rate of the firm Kw is constant for all
degree of leverages;
(ii) Net operating income is capitalised at an overall capitalisation rate
in order to have the total market value of the firm.

Thus, the value of the firm, V, is ascertained at overall cost

of capital (Kw):
V = EBIT/Kw (since both are constant and independent of leverage)
(iii) The market value of the debt is then subtracted from the total
market value in order to get the market value of equity.

S–V–T

(iv) As the Cost of Debt is constant, the cost of equity will be

Ke = EBIT – I/S
The NOI Approach can be illustrated with the help of the
following diagram:

Under this approach, the most significant assumption is that the Kw is

constant irrespective of the degree of leverage. The segregation of debt
and equity is not important here and the market capitalises the value
of the firm as a whole.
Thus, an increase in the use of apparently cheaper debt funds is offset
exactly by the corresponding increase in the equity- capitalisation rate.
So, the weighted average Cost of Capital Kw and Kd remain unchanged
for all degrees of leverage. Needless to mention here that, as the firm
increases its degree of leverage, it becomes more risky proposition and
investors are to make some sacrifice by having a low P/E ratio.

3. Traditional Theory Approach:

It is accepted by all that the judicious use of debt will increase the
value of the firm and reduce the cost of capital. So, the optimum
capital structure is the point at which the value of the firm is highest
and the cost of capital is at its lowest point. Practically, this approach
encompasses all the ground between the Net Income Approach and
the Net Operating Income Approach, i.e., it may be called
Intermediate Approach.

The traditional approach explains that up to a certain point, debt-

equity mix will cause the market value of the firm to rise and the cost
of capital to decline. But after attaining the optimum level, any
additional debt will cause to decrease the market value and to increase
the cost of capital.

In other words, after attaining the optimum level, any additional debt
taken will offset the use of cheaper debt capital since the average cost
of capital will increase along with a corresponding increase in the
average cost of debt capital.

Thus, the basic proposition of this approach are:

(a) The cost of debt capital, Kd, remains constant more or less up to a
certain level and thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises
gradually up to a certain level and thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level
remains unchanged more or less and thereafter rises after attaining a
certain level.
The traditional approach can graphically be represented
under taking the data from the previous illustration:

It is found from the above that the average cost curve is U-shaped.
That is, at this stage the cost of capital would be minimum which is
expressed by the letter ‘A’ in the graph. If we draw a perpendicular to
the X-axis, the same will indicate the optimum capital structure for the
firm.

Thus, the traditional position implies that the cost of capital is not
independent of the capital structure of the firm and that there is an
optimal capital structure. At that optimal structure, the marginal real
cost of debt (explicit and implicit) is the same as the marginal real cost
of equity in equilibrium.

For degree of leverage before that point, the marginal real cost of debt
is less than that of equity beyond that point the marginal real cost of
debt exceeds that of equity.

Core Concepts

Dividend Policy– Meaning & Concepts, types of dividend policy, types of dividends,
theories of dividend policy decisions.

Questions that probe understanding of concepts and application of learning

1. Define dividend policy. Explain various types of dividend policies and state giving
reasons, about which type of dividend policy a good company should follow.

Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will
pay out to shareholders. Some evidence suggests that investors are not concerned with a
company's dividend policy since they can sell a portion of their portfolio of equities if they want
cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an
issuance of dividends should have little to no impact on stock price. That being said, many
companies do pay dividends, so let's look at how they do it.

Types of Dividend policy

1.) Regular dividend policy: in this type of dividend policy the investors get dividend at usual
rate. Here the investors are generally retired persons or weaker section of the society who want
to get regular income. This type of dividend payment can be maintained only if the company has
regular earning.
Merits of Regular dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.
2) Stable dividend policy: here the payment of certain sum of money is regularly paid to the
shareholders. It is of three types:
a) Constant dividend per share: here reserve fund is created to pay fixed amount of dividend in
the year when the earning of the company is not enough. It is suitable for the firms having stable
earning.
b) Constant pay out ratio: it means the payment of fixed percentage of earning as dividend
every year.
c) Stable rupee dividend + extra dividend: it means the payment of low dividend per share
constantly + extra dividend in the year when the company earns high profit.
Merits of stable dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.
3) Irregular dividend: as the name suggests here the company does not pay regular dividend to
the shareholders. The company uses this practice due to following reasons:
 Due to uncertain earning of the company.
 Due to lack of liquid resources.
 The company sometime afraid of giving regular dividend.
 Due to not so much successful business.
4) No dividend: the company may use this type of dividend policy due to requirement of funds
for the growth of the company or for the working capital requirement.

2. Discuss in brief various dividend policy theories with their assumptions and limitations.

1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost
always affects the value of the enterprise. His model shows clearly the
importance of the relationship between the firm’s internal rate of return (r)
and its cost of capital (k) in determining the dividend policy that will
maximise the wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;

3. All earnings are either distributed as dividend or reinvested internally

immediately.

4. Beginning earnings and dividends never change. The values of the

earnings pershare (E), and the divided per share (D) may be changed in the
model to determine results, but any given values of E and D are assumed to
remain constant forever in determining a given value.

5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as

follows:
P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is the
sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all
equity firm under different assumptions about the rate of return. However, the
simplified nature of the model can lead to conclusions which are net true in
general, though true for Walter’s model.
The criticisms on the model are as follows:
1. Walter’s model of share valuation mixes dividend policy with investment
policy of the firm. The model assumes that the investment opportunities of
the firm are financed by retained earnings only and no external financing debt
or equity is used for the purpose when such a situation exists either the firm’s
investment or its dividend policy or both will be sub-optimum. The wealth of
the owners will maximise only when this optimum investment in made.

2. Walter’s model is based on the assumption that r is constant. In fact

decreases as more investment occurs. This reflects the assumption that the
most profitable investments are made first and then the poorer investments
are made.

The firm should step at a point where r = k. This is clearly an erroneous

policy and fall to optimise the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it

changes directly with the firm’s risk. Thus, the present value of the firm’s
income moves inversely with the cost of capital. By assuming that the
discount rate, K is constant, Walter’s model abstracts from the effect of risk
on the value of the firm.

2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth
rate (g) = br is constant forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful

value for the share.

According to Gordon’s dividend capitalisation model, the market value of a

share (Pq) is equal to the present value of an infinite stream of dividends to
be received by the share. Thus:

The above equation explicitly shows the relationship of current earnings (E,),
dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of
capital (k), in the determination of the value of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is
irrelevant as it does not affect the wealth of the shareholders. They argue that
the value of the firm depends on the firm’s earnings which result from its
investment policy.

Thus, when investment decision of the firm is given, dividend decision the
split of earnings between dividends and retained earnings is of no
significance in determining the value of the firm. M – M’s hypothesis of
irrelevance is based on the following assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is appropriate
for all securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical
for all shares. As a result, the price of each share must adjust so that the rate
of return, which is composed of the rate of dividends and capital gains, on
every share will be equal to the discount rate and be identical for all shares.

Thus, the rate of return for a share held for one year may be calculated
as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market
price per share at time 1 and D is dividend per share at time 1. As
hypothesised by M – M, r should be equal for all shares. If it is not so, the
low-return yielding shares will be sold by investors who will purchase the
high-return yielding shares.

This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue
until the differentials in rates of return are eliminated. This discount rate will
also be equal for all firms under the M-M assumption since there are no risk
differences.

From the above M-M fundamental principle we can derive their valuation
model as follows:

Multiplying both sides of equation by the number of shares outstanding (n),

we obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value
of the firm at time 0 will be

The above equation of M – M valuation allows for the issuance of new

shares, unlike Walter’s and Gordon’s models. Consequently, a firm can pay
dividends and raise funds to undertake the optimum investment policy. Thus,
dividend and investment policies are not confounded in M – M model, like
waiter’s and Gordon’s models.

Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks
practical relevance in the real world situation. Thus, it is being criticised on
the following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.

3. According to M-M’s hypothesis the wealth of a shareholder will be same

whether the firm pays dividends or not. But, because of the transactions costs
and inconvenience associated with the sale of shares to realise capital gains,
shareholders prefer dividends to capital gains.

4. Even under the condition of certainty it is not correct to assume that the
discount rate (k) should be same whether firm uses the external or internal
financing.

If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.

5. M-M argues that, even if the assumption of perfect certainty is dropped

and uncertainty is considered, dividend policy continues to be irrelevant. But
according to number of writers, dividends are relevant under conditions of
uncertainty.
Core Concepts

Cost of Capital–Meaning & concept, Computation of cost for different source of capital,
weighted average cost of capital

Questions that probe understanding of concepts and application of learning

1. Define cost of capital. Discuss in detail the steps involved in computation of WACC.

Ans : Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment with equal
risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given
investment.

Steps for calculating the weighted Average Cost of capital

 Calculate the market share of firm equity by multiplying the total number of share
into price per share. This figure indicates by the E in the formula
 Calculate the market value –not the book value- of the company debt by the
number of bonds by the price per bond. This figure indicates by ‘D’.
2. Write note on :
 Cost of debt capital
The primary cost of capital is the cost the firm has to pay to raise the debts from
the outside world. For example the Interest rate paid on loans is considered to be
the cost of debt capital as interest has to be paid for the raising the loan. Dividend
is another cost of the debt capital.
Cost of Debt can be calculate before tax and after tax both
Before tax
Cost of debt = coupons rate of bonds
After tax
Cost of debt = coupons rate of bonds (1-tax)

 Cost of preference share capital

Cost of preference share capital is that part of the cost of capital in which we
calculate the amount payable to the preference shareholder in form of dividend
with the fixed rate.
Formula
Cost of share capital = Amount of preference dividend/ Preference share capital

In case of adjustments
 Kp = D/NP
D= annual preference dividend
NP = Par value pref. shares – discount – floation cost
Or
NP = Par value Preference share + premium

Cost of redeemable Pref. shares

D + (m.v – n.p)/n
½ (m.v + n.p)
Where
n is the number of years
m.v is maturity value

 Opportunity cost of retained earnings

Cost of retained earnings (ks) is the return stockholders require on the company's common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf),
which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate
of return on the market (rm).

The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk.
Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained
earnings.

Formula 11.3

b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the
 interest rate of the firm's long-term debt and add a risk premium (typically three to five
percentage points):

Formula 11.4

ks = long-term bond yield + risk premium

c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach".
Using the dividend-growth model, you can rearrange the terms as follows to determine ks.

Formula 11.5
ks = D1 + g;
P0

where:
D1 = next year's dividend
g = firm's constant growth rate
P0 = price
Typically, you must also estimate g, which can be calculated as follows:

Formula 11.6

g = (retention rate)(ROE) = (1-payout rate)(ROE)

 Weighted Average cost of capital

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all
its security holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital.
Importantly, it is dictated by the external market and not by management. The WACC represents the minimum
return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers
of capital, or they will invest elsewhere.[1]
Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible
debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental
subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate
different returns. The WACC is calculated taking into account the relative weights of each component of
the capital structure. The more complex the company's capital structure, the more laborious it is to calculate
the WACC.