ADVANCED STRATEGIC FINANCIAL MANAGEMENT

ADVANCED STRATEGIC FINANCIAL MANAGEMENT

(MCM4EF04)

STUDY MATERIAL

ELECTIVE COURSE

IV SEMESTER

M.Com. (2019 Admission)

UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION

CALICUT UNIVERSITY P.O. MALAPPURAM - 673 635, KERALA

190620

School of Distance Education University of Calicut

Study Material IV Semester

M.Com. (2019 Admission) Elective Course MCM4EF04: ADVANCED STRATEGIC FINANCIAL MANAGEMENT

Prepared by:

SHAKKEELA CHOLASSERI Guest Faculty Department of Commerce and Management Studies MES Mampad College.

Scrutinized by:

Dr. AFEEFA CHOLASSERI Guest Faculty, Department of Commerce & Management Studies, Central University of Kerala

DISCLAIMER

"The author(s) shall be solely responsible

for the content and views

expressed in this book".

CONTENTS

Module Title Page No.

I Financial Goals & strategy 1 - 38

II Financial Strategy For Capital

Structure

39 - 89

III Lease financing strategy 90 - 119

IV Merger strategy 120 - 152

V Take over strategy 153 - 192

MCM43F04: Advanced Strategic Financial Management

School of Distance Education, University of Calicut 1

MODULE 1

FINANCIAL GOALS AND STRATEGY

Financial Management is a vital activity in any

organization. It is the process of planning, organizing,

controlling and monitoring financial resources with a view to

achieve organizational goals and objectives. It is an ideal

practice for controlling the financial activities of an

organization such as procurement of funds, utilization of

funds, accounting, payments, risk assessment and every other

thing related to money.. It also includes applying management

principles to the financial assets of an organisation, while also

playing an important part in fiscal management. Financial

management provides pathways to attain goals and objectives

in an organisation. The main duty of a financial manager is to

measure organisational efficiency through proper allocation,

acquisition and management.

Strategic financial management aims at controlling and

looking at all the finances of the company to achieve the

desired targets and earn the desired profits for the company.

The function of Strategic financial management starts from

detecting the number of funds required for the business, then

looking for the means or the ways through which these funds

are raised at cheaper rates so that the financial requirement of

the business are fulfilled. In other words, it can also be termed

as applying principles of management to the financial

resources of an organisation.

Meaning of Strategic Financial Management

Strategic financial management is a term used to

describe the process of managing the finances of a company to

meet its strategic goals. It is a management approach that uses

different techniques and financial tools to devise a strategic

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plan. Strategic financial management ensures that the strategy

chosen is implemented to achieve the desired goals.

Strategic financial management means not only

managing a company's finances but managing them with the

intention to succeed—that is, to attain the company's goals and

objectives and maximize shareholder value over time.

Strategic financial management is about creating profit

for the business and ensuring an acceptable return on

investment (ROI). Financial management is accomplished

through business financial plans, setting up financial controls,

and financial decision making.

The purpose of strategic financial management is to

identify the possible strategies capable of maximizing the

organization's market value. Also, it ensures that the

organization is following the plan efficiently to attain the

desired short-term and long-term goals and maximize value for

the shareholders.

Features of Strategic Financial Management

1. It focuses on long-term fund management, taking into

account the strategic perspective.

2. It promotes profitability, growth, and presence of the

firm over the long term and strives to maximize the

shareholders‘ wealth.

3. It can be flexible and structured, as well.

4. It is a continuously evolving process, adapting and

revising strategies to achieve the organization‘s

financial goals.

5. It includes a multidimensional and innovative approach

for solving business problems.



6. It helps develop applicable strategies and supervise the

action plans to be consistent with the business

objectives.

7. It analyzes factual information using analytical

financial methods with quantitative and qualitative

reasoning.

8. It utilizes economic and financial resources and focuses

on the outcomes of the developed strategies.

9. It offers solutions by analyzing the problems in the

business environment.

10. It helps the financial managers to make decisions

related to investments in the assets and the financing of

such assets.

Importance of Strategic Financial Management

The approach of strategic financial management is to

drive decision making that prioritizes business objectives in

the long term. Strategic financial management not only assists

in setting company targets but also creates a platform for

planning and governing plans to tackle challenges along the

way. It also involves laying out steps to drive the business

towards its objectives.

The purpose of strategic financial management is to identify

the possible strategies capable of maximizing the

organization‘s market value. Also, it ensures that the

organization is following the plan efficiently to attain the

desired short-term and long-term goals and maximize value for

the shareholders. Strategic financial management manages the

financial resources of the organization for achieving its

business objectives.

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FINANCIAL GOALS AND STRATEGY

One of the primary responsibilities of any major

corporation is to clear the company‘s financial goals as a

tangible focus for its business mission and strategy. These goals

are imposed by shareholders through stock market responses to

company performance. In practice, they are deeply rooted in the

company‘s values and political philosophy, and they draw

persuasive power from the depth of that view. Despite this

power, and because a company‘s financial goals are so visible

and tangible, they often become the focal point for tension and

dispute at the higher levels of the organization.

A financial goal is a target to aim for when managing

your money. It can involve saving, spending, earning or even

investing. Creating a list of financial goals is vital to creating a

budget. All corporate goals that affect the flow of funds within a

company are the result of both explicit and implicit trade-offs

among competing interests.

Financial strategy aims to maximize the financial value

of a firm. Financial strategy can provide competitive advantage

through low costs funds. In any financial strategy, achieving

the desirable debt equity ratio by borrowing for long

term financial needs and generating cash flow internally is a

crucial issue.

In a study of large American corporations, Donaldson

has identified several characteristics of a company‘s financial

goal systems:

1. Companies are not always governed by the maximum

profit criterion.

2. Financial priorities change according to the changes in

the economic and competitive environment.

3. Competition sets the constraints within which a

company can attain its goal.



4. Managing a company‘s financial goal system is a

continuous process of balancing different priorities in a

manner that the demand for and supply of funds

reconciled.

5. A change in any goal cannot be effected without

considering the effect on other goals.

6. Financial goals are changeable and unstable ,and

therefore, managers find it difficult to understand and

accept the financial goal system.

Corporate managers in India consider the following

four financial goals as the most important

1. Ensuring fund availability

2. Maximizing growth

3. Operating profit before interest and taxes

4. Return on investment.

In recent times more and more companies in India give

important to shareholder value creation.

SHAREHOLDER VALUE CREATION

Shareholder value is the financial worth owners of a

business receive for owning shares in the company. An

increase in shareholder value is created when a company earns

a return on invested capital. The term, shareholder value was

originated by Alfred Rappaport in 1986. The main goal for a

company is to increase the wealth of its shareholders (owners)

by paying dividends and/or causing the stock price to increase.

Shareholder value is the value enjoyed by a shareholder

by possessing shares of a company. Increasing the shareholder

value is of prime importance for the management of a

company. So the management must have the interests of

shareholders in mind while making decisions. The higher the



shareholder value, the better it is for the company and

management.

For this to happen, management must exercise efficient

decision making so as to earn/increase profits, thereby

increasing shareholder value. On the other hand, faulty

decision making using unfair tactics might damage shareholder

value.

Value creation means creating value for shareholders.

Value creation should be the focus of all the metrics. When

organization creates value for shareholders, it means that they

are creating value for all the stake holders.

Shareholder value is the value delivered to the equity

owners of a corporation due to management's ability to

increase sales, earnings, and free cash flow, which leads to an

increase in dividends and capital gains for the shareholders.

A company‘s shareholder value depends on strategic

decisions made by its board of directors and senior

management, including the ability to make wise investments

and generate a healthy return on invested capital. If this value

is created, particularly over the long term, the share

price increases and the company can pay larger cash dividends

to shareholders. Mergers, in particular, tend to cause a heavy

increase in shareholder value.

Creating value for shareholders is now extensively

recognized corporate objective. The interest in value creation

has been motivated by several developments.

1. Capital markets are becoming progressively global.

Investors can willingly shift investments to higher yielding,

often foreign, opportunities.

2. Institutional investors, which usually were inactive

investors, have begun exerting influence on corporate

managements to create value for shareholders.

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3. Corporate governance is instable, with owners now

demanding liability from corporate managers.

Manifestations of the increased assertiveness of

shareholders include the need for executives to justify their

compensation levels, and well-publicized lists of

underperforming companies and overpaid officials.

4. Business press is highlighting shareholder value creation in

performance rating exercises.

5. More focus is to link top management compensation to

shareholder returns.

Approaches for Measuring Shareholder Value

The measures available to management and

shareholders to appraise a firm's value-creation performance

can be categorized into three groups.

1. The Marakon Approach

This model was developed by Marakon Associates, an

International Management Consulting firm known for its work

in the field of value-based management in 1978. According

to Marakon model, a firm‘s value is measured by the ratio of

its market value to the book value. An increase in this ratio

depicts an increase in the value of the firm, and a reduction

reflects a reduction in the firm‘s value. According to the

Marakon model, the market-to-book values ratio is function of

thee return on equity, the growth rate of dividends, and cost of

equity.

This measure examines the difference between the

Return On Equity (ROE)and required return on equity (cost of

equity) as the source of value creation. This measure is a

variation of the Enterprise Value(EV) measures(measure of

companies total value).. Inspite of using capital as the entire

base and the cost of capital for calculating the capital charge,

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this measure uses equity capital and the cost of equity to

calculate the capital (equity) charge.

Similarly, it uses economic value to equity holders (net

of interest charges) instead of total firm value. For an all equity

firm, both EV and the equity spread technique will offer

identical values because there are no interest charges and debt

capital to consider. Even for a firm that relies on some debt,

the two measures will lead to identical insights provided there

are no extraordinary gains and losses, the capital structure is

stable, and a proper re-estimation of the cost of equity and debt

is conducted.

A market is favourable only if the equity spread and

economic profit earned by the average competitor is positive.

If the average competitor's equity spread and economic profit

are negative, the market is unappealing.

2. Alcar Approach

The Alcar group Inc. a management and Software

Company, has established an approach to value-based

management which is based on cut-rate cash flow analysis. In

this structure, the importance is not on annual performance but

on valuing expected performance. The inferred value measure

is similar to valuing the firm based on its future cash flows and

is the method most closely related to the DCF/NPV

framework. In this approach, one guesses future cash flows of

the firm over a reasonable horizon, allocates a continuing

(terminal) value at the end of the horizon, estimates the cost of

capital, and then estimates the value of the firm by calculating

the present value of these estimated cash flows.

This technique of valuing the firm is same to that

followed in calculating NPV in a capital-budgeting context.

Since the computation reaches at the value of the firm, the

implied value of the firm's equity can be determined by



subtracting the value of the current debt from the estimated

value of the firm. This value is the implied value of the equity

of the firm.

To evaluate whether the firm's management has created

shareholder value, one subtracts the implied value at the

beginning of the year from the value estimated at the end of

the year, adjusting for any dividends paid during the year. If

this difference is positive, management can be said to have

created shareholder value.

Under this approach following are the determinants of

Shareholders Value :

1. Rate of sales growth

2. Operating profit margin

3. Income tax rates

4. Working capital investment

5. Fixed capital investment

6. Cost of capital

7. Value growth duration

The Alcar approach has been accepted by financial

experts for two main reasons:

1. It is theoretically good as it utilize the discounted cash flow

framework.

2. Alcar have made available computer software to popularize

their approach.

However, the Alcar approach has some drawbacks such

as In the Alcar approach, profitability is measured in terms of

profit margin on sales. It is generally documented that this is

not a good index for comparative purposes. Fundamentally a

verbal model, it is unnecessarily burdensome. Therefore it

requires a fairly involved computer programme.



3. Mckinsey Approach:

The McKinsey model, developed by leading

management consultants McKinsey & Company, is a

comprehensive approach to value-based management. This

approach is based on the discounted cash flow principle,

which is a direct measure of value creation. McKinsey Model

of Value Based Management focuses on the identification

of key value drivers at various levels of the organization,

and places emphasis on these value drivers in all the areas,

i.e. in setting up of targets, in the various management

processes, in performance measurement, etc. Value based

management is a model that allow managers to run a business

focusing on the creation, improvement, and delivery of value.

According to Copeland, Roller and Murrin, value-

based management is ―an approach to management whereby

the company‘s overall aspirations, analytical techniques,

and management processes are all aligned to help the

company maximize its value by focusing management

decision-making on the key drivers of value‖.

According to McKinsey Model of Value Based

Management, the key steps in maximizing the value of a firm

are as follows:

1. Identification of value maximization as the supreme goal

2. Identification of the value drivers

3. Development of strategy

4. Setting of targets

5. Deciding upon the action plans

6. Setting up the performance measurement system

Value Based Management works on the approach and

philosophy that enables and supports the management of the

organization to create the maximum value. It mainly focuses



on the maximization of the value of the shareholders of the

company.

Main steps in the McKinsey approach to value-based

maximization are as under:

1 .Make certain the supremacy of value maximization

2. Find the value drivers

3. Establish appropriate managerial processes

4. Implement value-based management philosophy

In recent times more companies are focusing on

shareholder‘s value creation. These companies adopted various

methods of measuring shareholder value like shareholder value

added (SVA), market value added (MVA) and economic value

added (EVA) .

Shareholder Value Added

Shareholder value added (SVA) is a measure of the

operating profits that a company has produced in excess of its

funding costs, or cost of capital. The basic calculation is net

operating profit after tax (NOPAT) minus the cost of capital,

which is based on the company's weighted average cost of

capital.

Shareholder value added = Net operating profit after

tax(NOPAT) - Cost of capital

NOPAT is an operating performance measure after

taking account of taxation, but before any financing costs.

Interest is totally excluded from NOPAT as it appears

implicitly in the capital charge. NOPAT also requires further

equity-equivalent adjustments. Capital costs include both the

cost of debt finance and the cost of equity finance . The cost of

these sources of finance is reflected by the return required by

the funds provider, be they a lender or a shareholder. This

capital cost is referred to as the Weighted Average Cost of

https://www.accountingtools.com/articles/net-operating-profit-after-tax-definition-and-usage.html


https://www.accountingtools.com/articles/2017/5/4/cost-of-capital-definition



Capital (WACC) and is determined having regard to the

relative capital structure of the business.

Shareholder value added is a measure of the

incremental value of a business to those who have invested in

it. In essence, the calculation shows the amount of additional

earnings that a company is generating for its investors that is in

excess of its cost of funds. It provides more relevant

information than the net profit figure normally reported by a

business, since net profit alone does not take into account the

cost of funds.

Illustration: 1

A company has a net operating profit of 15,00,000. Applicable

tax rate for the company is 35%. The company‘s capital

amounts to 6,00,000.

Solution :

Shareholder value added = Net operating profit after tax - Cost

of capital

Net operating profit after tax = Profit Before Interest and Tax

× (1-Tax)

Shareholder Value Added (SVA) = 15,00,000 × (1 – 0.35) –

6,00,000 = 3,75 ,000

Market Value Added

Market value added represents the wealth generated by a

company for its shareholders since its foundation. Market

value of the firm‘s share is a measurement of the shareholders

wealth. It is the shareholder‘s appraisal of the firm‘s efficiency

in employing their capital. It equals the amount by which the

market value of the company's stock exceeds the total capital

invested in a company (including capital retained in the form

of undistributed earnings).

Market Value Added = Market Value – Invested Capital

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Another simplest formula for computing MVA, is market

value of share minus book value of share holder‘s equity:

MVA = Market Value of Shares – Book Value of

Shareholders‘ Equity

To find the market value of shares, simply multiply the

outstanding shares by the current market price per share. If a

company offers owns preferred and ordinary shares, then the

two are summed together to find the total market value. Market

value is also referred to as the ‗enterprise value‘. It is the total

of firm‘s market value of debt and market value of equity.

Market value added is calculated in two ways.First for

the perspective of common shareholders and it equals the

excess of market capitalization over total common

shareholders equity.

Market Value Added = Market capitalization - Total Common

Shareholder‘s Equity ie.

Total Shares Outstanding × Current Market Price – Total

Common Shareholders Equity

Second for the perspective of all investors ie. Both share

holder and debt holders, market value added equals the market

value of the company minus sum of the book value of equity

and debt.

Market value added for all investors =

Market Value Added = Market Value of the Company − (Book

Value of Equity + Book Value of Debt)

A company‘s MVA is an indication of its capacity to increase

shareholder value over time. A high MVA is evidence of

effective management and strong operational capabilities. A

low MVA can mean the value of management‘s actions and

investments is less than the value of the capital contributed by

shareholders. A negative MVA means the management's

https://www.investopedia.com/terms/c/contributed-capital.asp



actions and investments have diminished and reversed the

value of capital contributed by shareholders.

In other words, a high MVA means the company is generating

enough wealth so it will continue to attract investors. It then

means that it will continue to expand its operations, earn more

profit, and stay ahead of its competitors. It indicates that the

company is generating enough money to cover the cost of

capital.

Illustration :2

Consider Company XYZ whose shareholders‘ equity amounts

to 750,000. The company owns 5,000 preferred shares and

100,000 common shares outstanding. The present market value

for the common shares is 12.50 per share and 100 per share for

the preferred shares. Calculate MVA .

Solution:

Calculation of MVA :

Market Value of Common Shares = 100,000 × 12.50

= 1,250,000

Market Value of Preferred Shares = 5,000 × 100 = 500,000

Total Market Value of Shares = 1,250,000 + 500,000

= 1,750,000

Therefore, Market Value Added = 1,750,000 – 750,000 =

1,000,000.

Illustration: 3

Calculate the market value added using the following

information:

Total number of shares issued 20,000,000

Number of shares held as treasury stock 1,100,000

Current share price 35.5

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Total invested capital plus retained earnings 453,503,000

Cost of treasury stock 39,050,000

Assume that the market value of debt equals its book value.

Solution:

Number of Shares Outstanding = 20,000,000 − 1,100,000 =

18,900,000

Market Capitalization = 18,900,000 × 35.5 = 670,950,000

Total Shareholders' Equity

= Total Invested Capital + Retained Earnings − Cost of

Treasury Stock

= 453,503,000 − 39,050,000 = 414,453,000

Market Value Added for Shareholders = 670,950,000 −

414,453,000 = 256,497,000

Market Value Added for all Investors

= Market Value of Equity − Total Shareholders' Equity +

Market Value of Debt − Book Value of Debt

= 256,497,000 + 0 = 256,497,000

Market – to- Book Value (M/BV)

Another measure of shareholders value creation is the market

to book value approach. This compares a firm's book value to

its market value. A company's book value is calculated by

looking at the company's historical cost, or accounting value.

A firm's market value is determined by its share price in the

stock market and the number of shares it has outstanding,

which is its market capitalization. It helps investors to find a

company's value by comparing the firm's book value to its

market value.

Book value is the net value of a firm's assets found on its

balance sheet, and it is roughly equal to the total amount all

https://www.investopedia.com/terms/m/marketcapitalization.asp



shareholders would get if they liquidated the company.

Market value is the company's worth based on the

total value of its outstanding shares in the market,

which is its market capitalization. Market value tends to be

greater than a company's book value since market value

captures profitability, intangibles, and future growth prospects.

Market value is calculated by multiplying a company's

outstanding shares by its current market price.

The formula to calculate the market to book ratio is divide a

company's market capitalization by its book value.

Market to Book Ratio = Market Capitalization / Book Value

OR

Market to Book Ratio = Market Price per Share / Book Value

per Share

Market Capitalization = Outstanding shares × Market price of

each share

Book Value per Share = Total Shareholders‘ Equity / Total

number of Shares outstanding

Illustration: 4

Assume a corporation having a share price of Rs.5 in the stock

market. It has 2,000,000 outstanding shares. As per the balance

sheet, the book value is, say, Rs.4,000,000

Calculate market to book value ratio.

Market to Book Value Ratio = 5 × 2,000,000 / 4,000,000 = 2.5

Illustration: 5

Company X, whose publicly traded stock price is Rs.20 and it

has 100,000 outstanding equity shares. The book value of the

company is Rs.1,500,000. Calculate M B ratio.

Market-to-book value ratio = 20 × 1 00 000 / 1,500,000 =

2,000,000/1,500,000 = 1.33



Here, the market perceives a market value of 1.33 times the

book value to company X.

Economic Value Added(EVA)

Economic Value Added is a valuable tool to measure

the wealth produced by a company for its equity shareholders.

It can be said that it is a measure of residual income after

meeting the necessary requirements for funds. Consulting firm

Stern Steward has created the idea of Economic Value Added.

EVA aid managers in their decision-making by incorporating

two basic concepts of finance. The first is that the objective of

any business is to maximize the value created for the

company‘s shareholders. Second, the value of a company is

dependent on the extent to which shareholders expect earnings

to be greater than or less than the cost of capital.

A continuous increase in EVA will result in an increase

in the market value of the company. EVA has been adopted by

many companies including Coca Cola Inc, DuPont, AT&T,

Quaker Oats and General Motors The reason so many

companies have adopted the EVA and have realized financial

benefits are due to the advantages of its use. EVA highlights

the areas of the company that create value. This enables

managers to take decisions on increasing the efficiency of their

capital and operations by focusing work on areas with higher

productivity. EVA-based financial management gives

managers superior information, motivation, empowerment and

accountability to ensure that their decisions create the greatest

amount of shareholder value.

EVA is the performance measure most directly linked

to the creation of shareholder wealth over a period of time.

EVA gives manager superior information and superior

motivation to make decisions that will create the greatest

shareholder private enterprise. EVA is used to identify firms

those are creating value for shareholders. Favorable changes in

https://www.mbaknol.com/financial-management/economic-value-added-eva-definition-calculation/

https://www.mbaknol.com/financial-management/economic-value-added-eva/



stock prices will increase stock prices as the equity holder‘s

residual claim decreases, while debt holders should realize

capital gains on their securities through credit upgrades. EVA

also can be used to design value and growth-oriented

investment strategies.

EVA is the net operating profit after tax (NOPAT)

minus the capital charge of a company. The NOPAT of a

company is defined as the operating profit after taxes have

been deducted. It is the return on the company‘s total capital

invested. The capital charge is an appropriate charge for the

opportunity cost of all capital invested in a company. The

information required to calculate a company‘s EVA is

obtained from a company‘s income statement and balance

sheet

A company can increase its EVA in the following

ways.

• Increasing NOPAT by increasing operating income

• Reducing the capital charge by reducing the company‘s

capital and cost of capital

Computation of Economic Value Added

Economic Value Added is fundamentally the surplus

left after making an appropriate charge for capital employed in

the business. It may be calculated by using following equation.

EVA = NOPAT – (WACC ×Total capital employed)

Where , NOPAT = Net Operating Profits After Tax

WACC = Weighted Average Cost of Capital

Total Capital employed or invested capital = Equity + long-

term debt at the beginning of the period

Net Operating Profit After Tax (NOPAT)

NOPAT is a profit before interest and taxes (PBIT) minus tax

https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/



without any adjustments for interest. It can also be calculated

as profit after tax plus after tax interest.

NOPAT = PBIT (1 – T) = Profit After Tax (PAT) +

Interest (1 – T)

In terms of return on invested capital (ROIC), the formula of

EVA can be written as follows:

EVA = Invested Capital × (ROIC - WACC)

The formula to calculate ROIC is

ROIC takes into account four key components:

operating income, tax rates, book value, and time. The ROIC

formula is net operating profit after tax (NOPTAT) divided by

invested capital. Companies with a steady or improving return

on capital are unlikely to put significant amounts of new

capital to work.

Illustration :6

Following details have been taken from the Income Statement

of Anand & Son‘s.

Calculate NOPAT .

Sales 2,00,000

Cost of goods sold 50,000

Labour 30,000

Administration expenses 20,000

Interest 10,000

Tax rate 30%

Solution:

Net Income is calculated using the formula given below



(1) NOPAT = PBIT (1 – T)

Profit before interest and tax(PBIT) = Sales – COGS –

Labour – Administration Expenses

= 2,00,000 - 50,000 – 30,000 – 20000 = 1,00,000

Tax rate = 0.30

NOPAT = 1,00,000(1 – .30) = 1,00,000 × 0.70 = 70,000

OR

(2) NOPAT = Profit After Tax (PAT) + Interest (1 – T)

PAT = 1,00,000 – 10,000 -27,000 = 63,000

NOPAT = 63,000 -- 10,000 (1 - .30)

NOPAT = 63,000 + 7,000 = 70,000

Illustration :7

ABC Ltd has generated 150,000 in total revenue along with

the following expenses.

Cost of goods sold 70,000

Interest expenses 10,000

Depreciation 25,000

Tax rate 20%, Calculate NOPAT.

Solution :

PBIT = Total Revenue - Cost of Goods Sold - depreciation

1,50,000 - 70,000 -25,000 = 55,000

NOPAT = PBIT (1- T) = 55,000 × 0.80 = 44,000

Weighted Average Cost of Capital ( WACC ) :

The weighted average cost of capital is a calculation of

a firm's cost of capital in which each category of capital is

proportionately weighted. All sources of capital, including

common stock, preferred stock, bonds, and any other long-

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https://www.investopedia.com/terms/w/weighted.asp



term debt, are included in a WACC calculation.

Weighted Average Cost of Capital ( WACC ) = [(E/V) x

Ke] +[(D/V) x Kd x (1 – Tc)]

E = Market value of the company‘s equity

D = Market value of the company‘s debt

V = Total market value of the company [E + D]

Ke = Cost of Equity

Kd = Cost of Debt

Tc = Tax rate

WACC is calculated by multiplying the cost of each capital

source (debt and equity) by its relevant weight, and then

adding the products together to determine the value. In the

above formula, E/V represents the proportion of equity-based

financing, while D/V represents the proportion of debt-based

financing.

Illustration :8

Calculate WACC

Market Value of Equity = 63,989

Value of Debt = 6,533

Cost of Equity = 7.20%

Cost of Debt = 1.52%

Tax rate = 30.82%

WACC = E/V × Ke + D/V × Kd × (1 – Tax Rate)

WACC = (63,989/(63,989+6,533)) x 7.20% +

(6,533 /(63,989+6,533)) x 1.52% x (1-0.3082)

WACC = 6.63%



Illustration :9

Calculate WACC for both Companies.

Particulars Company A Company B

Market Value of Equity (E)

Market Value of Debt (D)

Cost of Equity (Re)

Cost of Debt (Rd)

Tax Rate (Tax)

300000

100000

4%

6%

35%

500000

100000

5%

7%

35%

Weighted Average Cost of Capital of Company A

= 3/5 × 0.04 + 2/5 × 0.06 × 0.65 = 0.0396 = 3.96%.

Weighted Average Cost of Capital of Company B

= 5/6 × 0.05 + 1/6 × 0.07 × 0.65 = 0.049 = 4.9%.

Now we can say that Company A has a lesser cost of capital

(WACC) than Company B.

Illustration: 10

Calculate the weighted average cost of capital (WACC) of AB

Ltd;

Market Value of Equity = Rs.86,319.8

Market Value of Debt (Fair Value of Debt) = Rs.3814

Cost of Equity = 7.50%

Cost of Debt = 2.72%

Tax rate = 32.9%

Weighted average cost of capital

= (86,319.8/90133.8) x 7.50% + (3814/90133.8) x 2.72%

x (1-0.329) = 7.26%

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Total Capital employed or invested capital

Capital employed, also known as funds employed, is

the total amount of capital used for the acquisition of profits by

a firm or project. It can be calculated in two ways:

Capital Employed = Total Assets – Current Liabilities

Where:

Total Assets are the total book value of all assets.

Current Liabilities are liabilities due within a year.

OR

Capital Employed = Fixed Assets + Working Capital

Where:

Fixed Assets, also known as capital assets, are assets that

are purchased for long-term use and are vital to the

operations of the company. Examples are property, plant,

and equipment (PP&E).

Working Capital is the capital available for daily

operations and is calculated as current assets minus current

liabilities.

Illustration:11

Calculate Capital Employed for the following:

Current assets 1,00,000

Non - Current assets 3,50,000

Current liability 50,000

Non- current liability 1,25,000

Solution:

Capital Employed = 1,00,000 + 3,50,000 – 50,000 = 4,00,000

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Accounting adjustments for EVA Calculation

Now since we have understood the basics of EVA

calculation, let us go a bit further to understand what can be

some of the real-life accounting adjustments involved

especially at the Operating Profit level:

1 .Long-term expenses : There are certain expenses that can

be classified as long-term expenses such as research and

development, branding of a new product, re-branding of old

products. These expenses may be incurred in a given period of

time but generally have an effect over and above a given year.

These expenses should be capitalized while EVA calculation

as they generate wealth over a period of time So these

expenses added to net operating profit and to capital

employed.

2. Depreciation : It is divided in to two for easy

understanding such as accounting depreciation and economic

depreciation. Accounting depreciation is one which is

calculated as per Accounting policies and procedures. In

contrast, economic depreciation is one that takes into account

the true wear and tear of the assets and should be calculated as

per the usage of assets rather than a fixed useful life. Add

accounting depreciation and deduct economic depreciation to

net operating profit and the difference in value should be

adjusted from the capital employed.

3. Non-cash expenses : These are expenses that do not affect

the cash flow of a given period.

EVA Example: Foreign exchange contracts are

reported at fair value as on the reporting date. Any loss

incurred is charged to the Income Statement. This loss does not

lead to any cash outflow and should be added back to the Net

Operating Profit.and also added to capital employed by adding

it to Retained Earnings.

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4. Non-cash incomes: Similar to non-cash expenses, there are

non-cash incomes which do not affect the cash flow of a given

period. These should be subtracted from the Net Operating

Profit. And also from capital employed by subtracting it from

Retained Earnings

5. Provisions: While calculating accounting profits, various

provisions are created, such as deferred tax provisions,

provision for doubtful debts, provision for expenses, allowance

for obsolete inventory, etc. These are provisional figures and

do not actually affect the economic profit. In fact, these

provisions are generally reversed on the first day of the next

reporting period. It should be add to net operating profit as

well as capital employed.

6. Taxes : Tax should also be calculated on actual cash

outflow rather than the mercantile system where all accruals

are taken into account, and only then tax is deducted. Tax is

supposed to be deducted after calculating Net Operating Profit.

So it is directly deducted, and no other adjustments are

required.

Advantages of EVA

EVA is frequently regarded as a single, simple measure that

gives a real picture of shareholder wealth creation. In addition

to motivate managers to create shareholder value and to be a

basis for management compensation, there are further practical

advantages that value based measurement systems can offer:

1. It helps managers to make better investment decisions,

identify improvement opportunities and consider long–term

and short-term benefits for the Company;

2. . It helps to give a clear picture of wealth creation as

compared to other financial measures used for analysis.

3. It is comparatively simple to understand.

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4. It helps to develop a relationship between the use of capital

and Net Operating Profit. This can be analyzed to make the

most out of opportunities and also make appropriate

improvements wherever necessary.

5. It measures the quality of managerial decisions and indicates

the value growth in the future.

6. It is very easy to compute EVA, extracting the data from

both the income statement and the balance sheet and adjusting

it.

Disadvantages of EVA:

1. There are a lot of assumptions involved in calculating the

Weighted Average Cost of Capital. It is not easy to

calculate the cost of equity, which is a key aspect of

WACC. On account of this, there are chances that EVA

itself can be perceived to be different for the same

organization, and for the same period as well

2. Apart from the WACC, there are other adjustments also

which are required to the Net Operating Profit After Tax.

All non-cash expenses need to be adjusted. This becomes

difficult in case of an organization with multiple business

units and subsidiaries.

3. A comparative analysis is difficult with Economic Value

Added (EVA) on account of the underlying assumptions of

WACC.

4. EVA is calculated on historical data, and future predictions

are difficult.

Illustration: 12

QRS Ltd‘s earnings before interest and taxes for the

financial year 2020 amounted to 5,130 Lakhs. Applicable tax

rate is 35%. 60% of the company's assets are financed by debt

which has an after tax cost of 3.8%, while 40% is financed by



equity with a cost of 9.8%. Their average total capital

employed over the period amounted to 50,420 Lakhs. Find

Economic Value Added.

Solution:

Economic Value Added = NOPAT − WACC × Capital

Employed

NOPAT = EBIT × (1 − Tax Rate) = 5,130 Lakhs × (1 − 35%)

= 3,334 Lakhs

WACC = 0.6 × 3.8% + 0.4 × 9.8% = 6.2%

Economic Value Added = 3,334 − 6.2% × 50,420 = 208 Lakhs

Illustration:13

Calculate EVA for the following:

Equity 20000

Debt 10000

NOPAT 70000

Cost of debt 8%

Cost of equity 10%

Tax rate 30%

Solution :

WACC = [(E/V) x Ke] +[(D/V) x Kd x (1 – Tc)]

= [ 20000 / 30000 × 10% ] + ×10000/30000 × 8%

× (1- 30%)

= 6.667% + 1.867% = 8.53%

Calculation of Economic Value Added :

Economic Value Added (EVA) = Net Operating Profit After

Tax – (Capital Invested * WACC)

= 70,000 – ( 30,000 × 8.53%)

= 70,000 – 2,559 = = 67,441



Illustration: 14

XYZ Company had the following results in the last financial

year:

Balance sheet (Rs.in thousands)

Assets Amounts Liabilities Amounts

Current assets:

Cash &cash

equivalents Accounts

recievables

Inventories

Other current assets

Long term assets:

Plant

Goodwill

Other longterm assets

1200

3840

7650

410

23250

7100

3500

Current liabilities:

Short- term debt

Accounts payables

Accruals

Long term

liabilities:

Long term debt:

Other long term

liabilities

Preferred stock

Common stock

Retained earnings

4630

5680

1890

7000

550

1720

19850

5630

Total 46950 Total 46950

STATEMENT OF INCOME

Net revenue

Cost of sale

Gross profit

Research and development

General expenses

45680

32540

13140

1350

2730



Operating income

Interest

Earning before tax

Provision for tax

Net income

9060

1610

7450

2100

5350

The weighted average cost of capital is 14.35%.

Solution:

Operating income of Rs.9,060,000 and provision for taxes of

Rs.2,100,000.

NOPAT = Rs.9,060,000 – Rs.2,100,000 = Rs.6,960,000

The amount of invested capital is equal to total assets of Rs.

46,950,000 less noninterest-bearing liabilities: accounts

payable of Rs.5,680,000 and accruals of Rs.1,890,000.

Invested capital = 46,950,000 - 5,680,000 - 1,890,000 =

39,380,000

Thus, the economic value added of XYZ Company is

EVA = 6,960,000 - 39,380,000 × 14.35% = Rs.1,308,970

So, the economic profit generated by XYZ Company covers

the cost of capital provided by investors.

Illustration: 15

If EBIT = 250,000 ; Tax rate = 25% ; WACC = 10%; Total

Capital = 1,000,000;

EVA = 250,000 × (1-0.25) – 0.1 × 1,000,000) = Rs. 87500

The EVA equals 87,500, which means that the firm had

created a wealth of Rs.87,500 to it's share holders



Illustration: 16

Gama Ltd. has existing assets in which it has capital invested

of Rs.150 crores. The After Tax Operating Income is Rs.20

crores & Company has a Cost of Capital of 12%. Estimate the

Economic Value Added of the firm.

Solution:

Capital Employed = 150 crores

NOPAT = 20 crores

WACC 12%

EVA = NOPAT – (WACC × Capital employed)

= 20 Crore - (12% × 150)

= 2 Crore .

Illustration: 17

The following information is available of a concern. Calculate

Economic Value Added

12% Debt Rs.2,000 crores

Equity capital Rs. 500 crores

Reserves and Surplus `Rs.7,500 crores

Risk-free rate 9%

Beta factor 1.05

Market rate of return 19%

Equity (market) risk premium 10%

Operating profit after tax Rs 2,100 crores

Tax rate 30%

Solution:

Cost of Debt (Kd)= 12%



Cost of Equity(Ke)= Risk free rate +(Beta ×Market Risk

Premium)

= 9% +1.05(19%-9%)=19.5%

Debt equity ratio(as given in the question) 20% & 80%

WACC= [(Ke) × Equity %] + (Kd) × Debt% × (1- Tc)

= (19.5 × 80%) + (12 × 20%) × (1- .30)

= 17.28%

Operating Profit before tax `2100 crores

EVA = NOPAT – Cost of Capital Employed

= [(` 2100 cr.) – (17.28%) × `10,000 cr.]

= Rs.2100 cr. – `1728 cr.

= Rs.372 cr.

MANAGERIAL IMPLICATIONS OF SHAREHOLDERS

VALUE CREATION

The shareholder value approach is based on the

assumption that a principal and agent relationship exists

between the shareholders and the management. As an agent of

share holders, management is charged with the responsibility

of creating wealth for the shareholders. Shareholders assume

management to produce value over and above the costs of

resources consumed, including the cost of using capital. If

dealers of capital do not receive good return to compensate

them for the risk they are taking, they will take out their capital

for better revenues, since value will be lost.

GROWTH RATIOS

Growth ratios can give an indication of how fast your business

is growing. For example, one type of growth ratio is sales

percentage, which compares current sales to those of the



previous year. Net income percentage takes sales growth a step

further by showing profit after subtracting operating costs.

Growth rate is the amount in which the value of an

investment, asset, portfolio or business increases over a

specific period. The growth rate provides you with important

information about the value of an asset or investment as it

helps you understand how that asset or investment grows,

changes and performs over time. This information can help

you predict the future revenue of a specific asset or investment.

Growth rate is helps to make predictions about future

growth. Growth rate can be used to represent the performance

of a business and its expected future growth.

INTERNAL GROWTH RATE (IGR)

The internal growth rate (IGR) refers to the sales

growth rate that can be supported with no external financing.

As such, the company is funding its operations solely

from retained earnings. A company‘s maximum internal

growth rate is the highest level of business operations that can

continue to fund and grow the company.

An internal growth rate (IGR) is the highest level

of growth achievable for a business without obtaining outside

financing. A firm's maximum internal growth rate is the level

of business operations that can continue to fund and grow the

company without issuing new equity or debt. The internal

growth rate is an important measurement for startup companies

and small businesses because it measures a firm's ability to

increase sales and profit without issuing more stock (equity) or

debt.

Formula to calculate the Internal Growth Rate is:

Internal Growth Rate = ( ROA × Retention Ratio)/(1-( ROA×

Retention Ratio)

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Retention Ratio is the rate of earnings which a company

reinvest in its business. In other words, once all the dividend

etc. is paid to shareholders, the left amount is the retention

rate.

Retention Ratio = 1 – Dividend Payout Ratio

Return on assets (ROA) is an indicator of how

profitable a company is relative to its total assets. ROA is best

used when comparing similar companies or by comparing a

company to its own previous performance.

Formula to calculate the Return on Asset is:

ROA = Net Income / Total Assets

Illustration: 18

Calculate the internal growth rate using the following

information.

Total assets 2,00,000

Net income 20,000

Dividend paid 4000

Solution:

Dividend Payout Ratio = Dividends Paid / Net Income

4,000/ 20,000 × 100 = 20%


Retention Ratio = 1 – 20%

Retention Ratio = 80%

ROA = Net income / Total Assets

ROA = 20,000 / 2,00,000

ROA = 10%

Therefore,




Retention Ratio)

= (0.10 × 0.80) / (1- ( 0.10 × 0.80) = 8.69%

Illustration: 19

An extract of financial statement of AB Ltd; are as follows,

Calculate IGR.

Total Asset : 61691000

Net Income : 4364000

Dividend Pay Out Ratio : 32.65%

Solution:


= 1 - 32.65% = 67.35%

ROA = Net income / Total Assets

= 4364000/61691000 = 7.07 %


Retention Ratio)

= (0.0707 × .6735) / (1- 0.0707 ×0. 6735)

= 4.99%

Illustration: 20

A company‗s ROA is 20% and payout ratio is 60%, Calculate

internal growth rate.

Solution:

Internal Growth Rate=( ROA × Retention Ratio) /

(1-( ROA× Retention Ratio)

Retention Ratio = 1- Dividend Payout Ratio

= 1- 0.60 = 0.40



Internal Growth Rate= (0.20 × 0.40) / (1- ( 0.20 × 0.40)

= 7.36%

Sustainable Growth Rate (SGR)

The sustainable growth rate (SGR) is the maximum

rate of growth that a company can sustain without having to

finance growth with additional equity or debt. The SGR

involves maximizing sales and revenue growth without

increasing financial leverage. Achieving the SGR can help a

company prevent being over-leveraged and avoid financial

distress.

To find out SGR the following formula can be used

Sustainable Growth Rate = Return on Equity × (1 − Dividend

Payout Ratio)

First, obtain or calculate the return on equity (ROE) of

the company. ROE measures the profitability of a company by

comparing net income to the company's shareholders'

equity.Then, subtract the company's dividend payout

ratio from 1. The dividend payout ratio is the percentage of

earnings per share paid to shareholders as dividends. Finally,

multiply the difference by the ROE of the company.

ROE = Net Income / Shareholders‘ Equity

Companies with high SGRs are usually effective in

maximizing their sales efforts, focusing on high-margin

products, and managing inventory, accounts payable, and

accounts receivable.Sustaining a high SGR in the long-term

can prove difficult for companies for several reasons, including

competition entering the market, changes in economic

conditions, and the need to increase research and development.

Illustration :21

Consider the following and calculate Sustainable

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Growth Rate:

ROE: 21.3% , Dividend Payout Ratio: 40.3

Solution:

SGR = Return on Equity × (1−Dividend Payout Ratio)

= 0.213 × (1 - 0.403)

= 12. 7 %

Review Questions:

Short answer questions

1. What is strategic financial management?

2. What you meant by financial goal ?

3. Explain shareholders value creation.

4. What is MVA ?

5. Write a short note on Market –to- Book Value.

6. Explain EVA.

7. Explain growth ratio.

8. What is internal growth rate ?

9. What is sustainable growth rate ?

10. What is NOPAT ?

11. What is WACC ?

Short essay questions

12. Explain the characteristics of strategic financial

management.

13. Explain the importance of strategic financial

management.

14. Describe the characteristics of a company‘s financial

goal systems.



15. What do you meant by shareholders value creation?

16. Write a brief note about Marakon Approach for

measuring shareholde‘rs value.

17. Explain Alcar Approach.

18. Write about McKinsey Approach.

19. Elucidate the calculation process of EVA.

20. Point out the advantages of EVA

21. Expound the term IGR.

22. Differentiate IGR and SGR.

23. Describe managerial implications of shareholders value

creation.

24. Clear up accounting adjustments for EVA Calculation

Long essay questions

25. Explain shareholders value creation. Why it is

extensively recognized as corporate objective ?

26. Discuss various approaches for Measuring Shareholder

Value.

27. What is economic value added?. How is it calculated?

What are its advantages and disadvantages.

Practical problems

1. Calculate EVA for the following:

Equity 17000

Debt 7000

NOPAT 63700

Cost of debt 8%

Cost of equity 12%

Tax rate 30%



(Answer – WACC - 10.13% , EVA- 61268 )

2. Bharat Ltd. has Rs.100 crore worth of common equity on its

balance sheet, and 50 lakhs shares of stock outstanding. The

company‘s market value added (MVA) is Rs.24 crores. What

is the company‘s stock price?

(stock price Rs.248)



MODULE II

FINANCIAL STRATEGY FOR

CAPITAL STRUCTURE

The capital structure is the particular combination

of debt and equity used by a company to finance its overall

operations and growth.

Equity capital arises from ownership shares in a

company and claims to its future cash flows and profits. Debt

comes in the form of bond issues or loans, while equity may

come in the form of common stock, preferred stock,

or retained earnings. Short-term debt is also considered to be

part of the capital structure.

Both debt and equity can be found on the balance sheet.

Company assets, also listed on the balance sheet, are purchased

with this debt and equity. Capital structure can be a mixture of

a company's long-term debt, short-term debt, common stock,

and preferred stock. A company's proportion of short-term debt

versus long-term debt is considered when analyzing its capital

structure.

When analysts refer to capital structure, they are most

likely referring to a firm's debt-to-equity (D/E) ratio, which

provides insight into how risky a company's borrowing

practices are. Usually, a company that is heavily financed by

debt has a more aggressive capital structure and therefore

poses a greater risk to investors. This risk, however, may be

the primary source of the firm's growth.

Debt is one of the two main ways a company can raise

money in the capital markets. Companies benefit from debt

because of its tax advantages; interest payments made as a

result of borrowing funds may be tax-deductible. Debt also

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allows a company or business to retain ownership, unlike

equity. Additionally, in times of low interest rates, debt is

abundant and easy to access.

Equity allows outside investors to take partial

ownership in the company. Equity is more expensive than

debt, especially when interest rates are low. However, unlike

debt, equity does not need to be paid back. This is a benefit to

the company in the case of declining earnings. On the other

hand, equity represents a claim by the owner on the future

earnings of the company

Debt to Equity Ratio

Debt to Equity ratio is the ratio of the total long

term debt and equity capital in the business .A company‘s ratio

of debt to equity should support its business strategy. A capital

structure decision is characterized as a choice of that

combination of debt and equity which maximizes the market

value of the firm. The debt-equity ratio is a measure of the

relative contribution of the creditors and shareholders or

owners in the capital employed in business.

Debt to Equity Ratio = Total Debt / Shareholders‘ Equity

The debt-to-equity (D/E) ratio is used to evaluate a

company's financial leverage and is calculated by dividing a

company‘s total liabilities by its shareholder equity. The Debt

to Equity ratio (also called the ―debt-equity ratio‖, ―risk ratio‖,

or ―gearing‖), is a leverage ratio that calculates the weight of

total debt and financial liabilities against total shareholders‘

equity.

Meaning and Definition of Leverage

Leverage results from using borrowed capital as a

funding source when investing to expand the firm's asset base

and generate returns on risk capital. Leverage is an investment

strategy of using borrowed money—specifically, the use of

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various financial instruments or borrowed capital—to increase

the potential return of an investment. Leverage can also refer

to the amount of debt a firm uses to finance assets.

Leverage is the use of debt (borrowed capital) in order

to undertake an investment or project. The result is to multiply

the potential returns from a project. At the same time, leverage

will also multiply the potential downside risk in case the

investment does not pan out. When one refers to a company,

property, or investment as "highly leveraged," it means that

item has more debt than equity.

The concept of leverage is used by both investors and

companies. Investors use leverage to significantly increase the

returns that can be provided on an investment. They lever their

investments by using various instruments, including options,

futures, and margin accounts. Companies can use leverage to

finance their assets. In other words, instead of issuing stock to

raise capital, companies can use debt financing to invest in

business operations in an attempt to increase shareholder

value.

Types of Leverage:

Leverage are the three types:

(i) Operating leverage ,

(ii) Financial leverage and

(iii) Combined leverage

1. Operating Leverage:

Operating leverage refers to the use of fixed operating

costs such as depreciation, insurance of assets, repairs and

maintenance, property taxes etc. in the operations of a firm.

But it does not include interest on debt capital. Higher the

proportion of fixed operating cost as compared to variable

cost, higher is the operating leverage, and vice versa.

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Operating leverage may be defined as the ―firm‘s ability to use

fixed operating cost to magnify effects of changes in sales on

its earnings before interest and taxes.

Operating leverage occurs when a firm incurs fixed

costs which are to be recovered out of sales revenue

irrespective of the volume of business in a period. In a firm

having fixed costs in the total cost structure, a given change in

sales will result in a disproportionate change in the operating

profit or EBIT of the firm.

If there is no fixed cost in the total cost structure, then

the firm will not have an operating leverage. In that case, the

operating profit or EBIT varies in direct proportion to the

changes in sales volume.

Operating leverage is associated with operating risk or

business risk. The higher the fixed operating costs, the higher

the firm‘s operating leverage and its operating risk. Operating

risk is the degree of uncertainty that the firm has faced in

meeting its fixed operating cost where there is variability of

EBIT.

The formula used to compute operating leverage is:

A high degree of operating leverage is welcome when

sales are rising i.e., favourable market conditions, and it is

undesirable when sales are falling. Because, higher degree of

operating leverage means a relatively high operating fixed cost

for recovering which a larger volume of sales is required.

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The degree of operating leverage is also obtained by

using the following formula:

Degree of operating leverage (DOL)

= Percentage change in profit

Percentage Change in sales

The value of degree of operating leverage must be

greater than 1. If the value is equal to 1 then there is no

operating leverage

Illustration 1:

A firm sells its product for Rs. 5 per unit, has variable

operating cost of Rs. 3 per unit and fixed operating costs of Rs.

10,000 per year. Its current level of sales is 20,000 units. What

will be the impact on profit if (a) Sales increase by 25% and

(b) decrease by 25%?

(a) A 25% increase in sales (from 20,000 units to 25,000 units)

results in a 33 1/3% increase in EBIT (from Rs. 30,000 to Rs.

40,000).

(b) A 25% decrease in sales (from 20,000 units to 15,000




units) results in a 33 1/3% decrease in EBIT (from Rs. 30,000

to Rs. 20,000).

The above illustration clearly shows that when a firm

has fixed operating costs an increase in sales volume results in

a more than proportionate increase in EBIT. Similarly, a

decrease in the level of sales has an exactly opposite effect.

The former operating leverage is known as favourable

leverage, while the latter is known as unfavorable.

2. Financial Leverage:

Financial leverage is primarily concerned with the

financial activities which involve raising of funds from the

sources for which a firm has to bear fixed charges such as

interest expenses, loan fees etc. These sources include long-

term debt (i.e., debentures, bonds etc.) and preference share

capital. Long term debt capital carries a contractual fixed rate

of interest and its payment is obligatory irrespective of the fact

whether the firm earns a profit or not.

As debt providers have prior claim on income and

assets of a firm over equity shareholders, their rate of interest

is generally lower than the expected return in equity

shareholders. Further, interest on debt capital is a tax

deductible expense. These two facts lead to the magnification

of the rate of return on equity share capital and hence earnings

per share. Thus, the effect of changes in operating profits or

EBIT on the earnings per share is shown by the financial

leverage.

According to Gitman financial leverage is ―the ability

of a firm to use fixed financial charges to magnify the effects

of changes in EBIT on firm‘s earnings per share‖. In other

words, financial leverage involves the use of funds obtained at

a fixed cost in the hope of increasing the return to the equity

shareholders.



Favourable or positive financial leverage occurs when a

firm earns more on the assets/ investment purchased with the

funds, than the fixed cost of their use. Unfavorable or negative

leverage occurs when the firm does not earn as much as the

funds cost. Thus shareholders gain where the firm earns a

higher rate of return and pays a lower rate of return to the

supplier of long-term funds. The difference between the

earnings from the assets and the fixed cost on the use of funds

goes to the equity shareholders. Financial leverage is also,

therefore, called as ‗trading on equity‘.

Financial leverage is associated with financial risk.

Financial risk refers to risk of the firm not being able to cover

its fixed financial costs due to variation in EBIT. With the

increase in financial charges, the firm is also required to raise

the level of EBIT necessary to meet financial charges. If the

firm cannot cover these financial payments it can be

technically forced into liquidation.

The formula used to compute Financial leverage is :

Financial leverage = Percentage change in EPS / Percentage

change in EBIT

OR

Increase in EPS / EPS / Increase in EBIT/EBIT

Degree of Financial leverage (DFL) = EBIT / EBT

The value of degree of financial leverage must be

greater than 1. If the value of degree of financial leverage is 1,

then there will be no financial leverage. The higher the

proportion of debt capital to the total capital employed by a

firm, the higher is the degree of financial leverage and vice

versa.



Again, the higher the degree of financial leverage, the

greater is the financial risk associated, and vice versa. Under

favourable market conditions (when EBIT may increase) a

firm having high degree of financial leverage will be in a better

position to increase the return on equity or earning per share.

Illustration 2:

One-up Ltd. has Equity Share Capital of Rs. 5,00,000

divided into shares of Rs. 100 each. It wishes to raise further

Rs. 3,00,000 for expansion-cum-modernisation scheme.

The company plans the following financing

alternatives:

(i) By issuing Equity Shares only.

(ii) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000

through Debentures @ 10% per annum.

(iii) By issuing Debentures only at 10% per annum.

(iv) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000

by issuing 8% Preference Shares.

You are required to suggest the best alternative giving

your comment assuming that the estimated earnings before

interest and taxes (EBIT) after expansion is Rs. 1,50,000 and

corporate rate of tax is 35%.



In the above example, we have taken operating profit

(EBIT = Rs. 1,50,000) constant for alternative financing plans.

It shows that earnings per share (EPS) increases with the

increase in the proportion of debt capital (debenture) to total

capital employed by the firm, the firm‘s EBIT level taken as

constant.

Financing Plan I does not use debt capital and, hence,

Earning per share is low. Financing Plan III, which involves

62.5% ordinary shares and 37.5% debenture, is the most

favourable with respect to EPS (Rs. 15.60). The difference in

Financing Plans II and IV is due to the fact that the interest on

debt is tax-deductible while the dividend on preference shares

is not.

Hence, financing alternative III should be accepted as

the most profitable mix of debt and equity by One-up Ltd.

Company.




3. Combined Leverage:

Operating leverage shows the operating risk and is

measured by the percentage change in EBIT due to percentage

change in sales. The financial leverage shows the financial risk

and is measured by the percentage change in EPS due to

percentage change in EBIT.

Both operating and financial leverages are closely

concerned with ascertaining the firm‘s ability to cover fixed

costs or fixed rate of interest obligation, if we combine them,

the result is total leverage and the risk associated with

combined leverage is known as total risk. It measures the

effect of a percentage change in sales on percentage change in

EPS.

The combined leverage can be measured with the help

of the following formula:

Combined Leverage = Operating leverage x Financial leverage

= % Change in EPS / % Change in sales

OR, alternatively Degree of Combined Leverage = DOL× DFL

Contribution / EBIT × EBIT / EBT = Contribution / EBT

The combined leverage may be favourable or

unfavorable. It will be favourable if sales increase and

unfavorable when sales decrease. This is because changes in

sales will result in more than proportional returns in the form

of EPS. As a general rule, a firm having a high degree of

operating leverage should have low financial leverage by

preferring equity financing, and vice versa by preferring debt

financing.

If a firm has both the leverages at a high level, it will

be very risky proposition. Therefore, if a firm has a high

degree of operating leverage the financial leverage should be

kept low as proper balancing between the two leverages is



essential in order to keep the risk profile within a reasonable

limit and maximum return to shareholders.

Leverage effect and shareholders risk

The risk of a firm is influenced by the use of leverage.

At an ideal level of financial leverage, a company‘s return on

equity increases because the use of leverage increases stock

volatility, increasing its level of risk which in turn increases

returns. However, if a company is financially over-leveraged a

decrease in return on equity could occur. Financial over-

leveraging means incurring a huge debt by borrowing funds at

a lower rate of interest and using the excess funds in high risk

investments. If the risk of the investment outweighs the

expected return, the value of a company‘s equity could

decrease as stockholders believe it to be too risky.

The variability of EBIT and EPS distinguish between

two types of risks operating risk and financial risk.

Operating Risk : can be defined as variability of EBIT or

return on assets. Incurrence of fixed operating costs in the

firm‘s income stream increases the business risk or operating

risk. It increases the variability of operating income due to

change in sales revenue and change in expenses (fixed &

variable). Operating risk is an unavoidable risk.

Financial Risk: The variability of EPS caused by the usage

of financial leverage is called financial risk.Employment of

debt in the capital structure increases the financial risk. It

increases the variability of the returns to the shareholders. So

leverage and risk are directly related. Financial risk is an

avoidable risk if the firm decides not to use any debt in capital

structure.

If a firm increases the proportion of debt capital in its

capital structure, fixed charges increase and there is a chance

to the firm not being able to meet these fixed charges . If the



firm continues to lever itself, the probability of cash

insolvency increases. Hence any decision to use debt or

preferred stock in the capital structure of the firm means that

the equity shareholders of the firm are exposed to financial

risk.

Illustration: 3

Calculate the Degree of Operating Leverage (DOL),

Degree of Financial Leverage (DFL) and the Degree of

Combined Leverage (DCL) for the following firms and

interpret the results.

Particulars Firm A Firm B Firm C

Output (units)

Fixed costs

Variable cost per unit

Interest on borrowing funds

Selling price per unit

60000

7000

0.20

4000

0.60

15000

14000

1.50

8000

5.00

100000

1500

0.02

----

0.10

Solution:

Particulars Firm A Firm B Firm

C

Outputs (units)

Selling price per unit

Variable cost per unit

Contribution per unit

Total contribution (unit x

contribution per unit)

Less fixed cost

60000

0.60

0.20

0.40

24000

7000

15000

5.00

1.50

3.50

52500

14000

100000

0.10

0.02

0.08

8000

1500



EBIT

Less interest

PBT

Degree of operating

leverage (Contribution

/EBIT)

Degree of financial

leverage (EBIT / PBT)

Degree of combined

leverage (contribution /

PBT)

17000

4000

13000

24000/

17000

= 1.41

17000/

13000

= 1.31

24000

/3000

= 1.85

38500

8000

30500

52500/

38500

= 1.38

38500/

30500

= 1.26

52500/30500

= 1.72

6500

---

6500

8000/

6500

1.23

6500/

6500

= 1.00

8000/

6500

= 1.23

Interpretation:

High operating leverage combined with high financial

leverage represents risky situation. Low operating leverage

combined with low financial leverage will constitute an ideal

situation. Therefore, firm M is less risky because it has low

fixed cost and low interest and consequently low combined

leverage.

Illustration :4

A firm has sales of Rs. 10,00,000, variable cost of Rs.7,00,000

and fixed costs of Rs. 2,00,000 and debt of Rs.5,00,000

at 10% rate of interest. What are the operating, financial and

combined leverages? It the firm wants to double its Earnings



before interest and tax (EBIT), how much of a rise in sales

would be needed on a percentage basis?

Solution:

Statement of Existing Profit

Sales ` 10,00,000

Less : Variable Cost 7,00,000

Contribution 3,00,000

Less : Fixed Cost 2,00,000

EBIT 1,00,000

Less : Interest

@ 10% on 5,00,000 50,000

Profit before tax (PBT) 50,000

Operating Leverage = Contribution / EBIT =

3,00,000 /1,00,000 = 3

Financial Leverage = EBIT / PBT = 1,00,000 / 50,000 = 2

Combined Leverage = Contribution / PBT = 3,00,000 /50,000

= 6

Statement of Sales needed to double the EBIT

Operating leverage is 3 times i.e., 33-1/3% increase in

sales volume cause a 100% increase in operating profit or

EBIT. Thus, at the sales of ` 13,33,333, operating profit or

EBIT will become ` 2,00,000 i.e., double the existing one.

Working note:

Sales 13,33,333

Variable Cost (70%) 9,33,333

Contribution 4,00,000



Fixed Costs 2,00,000

EBIT 2,00,000

Illustration :5

XYZ and Co. has three financial plans before it, Plan I,

Plan II and Plan III. Calculate operating and financial leverage

for the firm on the basis of the following information and also

find out the highest and lowest value of combined leverage:

Production 800 Units

Selling Price per unit ` 15

Variable cost per unit ` 10

Fixed Cost :

Situation A ` 1,000

Situation B ` 2,000

Situation C ` 3,000

Capital Structure Plan I, Plan II Plan III

Equity Capital Rs. 5,000 , Rs. 7,500, Rs. 2,500

12% Debt Rs.5,000 Rs. 2,500 Rs. 7,500

Solution:

Calculation of Operating Leverage:

Particulars Situation

A

Situation

B

Situation

C

Number of unit sold

Sales @ Rs.15

Variable cost @Rs. 10

Contribution

Fixed cost

800

12000

8000

4000

1000

800

12000

8000

4000

2000

800

12000

8000

4000

3000



EBIT

Operating leverage =

Contribution / EBIT

3000

1.33

2000

2.00

1000

4.00

Calculation of Financial Leverage:

Particulars Plan I Plan II Plan III

Situation .A

EBIT

Less : Interest @ 12%

Profit before Tax

Financial Leverage

(EBIT/Profit before Tax)

Situation B

EBIT


Profit before Tax

Financial Leverage


Situation C

EBIT


Profit before Tax

Financial Leverage


3,000

600

2,400

1.25

2,000

600

1,400

1.43

1,000

600

400

2.5

3,000

300

2,700

1.11

2,000

300

1,700

1.18

1,000

300

700

1.43

3,000

900

2,100

1.43

2,000

900

1,100

1.82

1,000

900

100

10



Calculation of Combined Leverage:

Particulars Situation A Situation B Situation C

Plan I

Plan II

Plan III

1.66

1.48

1.90

2.86

2.36

3.64

10

5.72

40

Interpretation: The highest combined leverages is there when

financial plan III is implemented in situation C; and lowest

value of combined leverage is attained when financial plan II is

implemented in situation A.

Illustration :6

The selected financial data for A, B and C companies for the

year ended March, 2020 are as follows:

Particulars A B C

Variable expenses as a % Sales

Interest

Degree of Operating leverage

Degree of Financial leverage

Income tax rate

66.67

200

5 : 1

3 : 1

50%

75

300

6 : 1

4 : 1

50%

50

1,000

2 : 1

2 : 1

50%

Prepare Income Statements for A, B and C companies.

Solution:

For Company A, the DFL is 3 : 1 (i.e., EBIT : PBT)

and it means that out of EBIT of 3, the PBT is 1 and the

remaining 2 is the interest component. Or, in other words, the

EBIT : Interest is 3:2. Similarly, for the operating leverage of

6:1 (i.e., Contribution : EBIT) for Company B, it means that

out of .Contribution of 6, the EBIT is 1 and the balance 5 is

fixed costs. In other words, the Fixed costs: EBIT is 5:1. This



information may be used to draw the statement of sales and

profit for all the three firms as follows:

Statement of Operating Profit and Sales

Particulars A B C

Financial leverage (EBIT/PBT)

or, EBIT/Interest

Interest

EBIT

[ 200×3/2; 300×4/3;

1,000×2/1 ] Operating leverage

= (Cont./EBIT) i.e., Fixed

Exp./EBIT

Variable Exp. to Sales

Contribution to Sales

Fixed costs 300×4/1 400×5/1

2,000×1/1

Contribution = (Fixed cost +

EBIT)

Sales

3 : 1

3 : 2

200

300

5 : 1

4: 1

66.67%

33.33%

1,200

1,500

4,500

4 : 1

4 : 3

300

400

6 : 1

5: 1

75%

25%

2,000

2,400

9,600

2 : 1

2 : 1

1,000

2,000

2 : 1

1: 1

50%

50%

2,000

4,000

8,000

Income Statement for the year ended 31.03.20

Particulars A B C A B C

Sales

Variable cost

Contribution

Fixed Costs

EBIT

4000

3000

1500

1200

300

9600

7200

2400

2000

400

8000

4000

4000

2000

2000



Interest

PBT

Tax at 50%

Profit after Tax (PAT)

Operating leverage

(Cont./EBIT)

Financial leverage

(EBIT/PBT)

Combined leverage

200

100

50

50

5

3

15

300

100

50

50

6

4

24

1000

1000

500

500

2

2

4

CAPITAL STRUCTURE PLANNING AND POLICY

When developing a capital structure strategy, it's in the

interest of the financial leaders of a company to familiarize

themselves with the types of capital available to make more

tactical decisions about their company's capital structure, better

positioning them to accomplish both short-term and long-term

goals.

The risk of a firm is influenced by the use of leverage.

Incurrence of fixed operating costs in the firm's income stream

increases the business risk or operating risk. Similarly,

employment of debt in the capital structure increases the

financial risk. It increases the variability of the returns to

the shareholders.

Every time when the funds are to be procured, financial

manager has to choose the most profitable source of finance

after considering the merits and demerits of different sources

of finance.

FACTORS AFFECTING CAPITAL STRUCTURE

Capital structure refers to the way a firm chooses to

finance its assets and investments through some combination



of equity, debt, or internal funds. It is in the best interests of a

company to find the optimal ratio of debt to equity to reduce

their risk of insolvency, continue to be successful and

ultimately remain or to become profitable. The factors

influencing the capital structure or determinants of capital

structure are discussed as follows:

1. Financial Leverage or Trading on Equity: The use

of long term fixed interest bearing debt and preference share

capital along with equity share capital is called financial

leverage or trading on equity. If the assets financed by debt

yield a return greater than the cost of the debt, the earnings per

share will increase without an increase in the owners‘

investment. Similarly, the earnings per share will also increase

if preference share capital is used to acquire assets. But the

leverage impact is felt more in case of debt because (i) the cost

of debt is usually lower than the cost of preference share

capital, and (ii) the interest paid on debt is a deductible charge

from profits for calculating the taxable income while dividend

on preference shares is not. The EBIT-EPS analysis is one

important tool in the hands of the financial manager to get an

insight into the firm‘s capital structure management. He can

consider the possible fluctuations in EBIT and examine their

impact on EPS under different financing plans.

2. Growth and Stability of Sales: The capital structure

of a firm is highly influenced by the growth and stability of its

sales. If the sales of a firm are expected to remain fairly stable,

it can raise a higher level of debt. Stability of sales ensures that

the firm will not face any difficulty in meeting its fixed

commitments of interest payment and repayments of debt.

Similarly, the rate of growth in sales also affects the capital

structure decision.

3. Cost of Capital: . Cost of capital refers to the

minimum return expected by its suppliers. The expected return

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depends on the degree of risk assumed by investors. A high

degree of risk is assumed by shareholders than debt-holders.

The capital structure should provide for the minimum cost of

capital. Measuring the costs of various sources of funds is a

complex subject and needs a separate treatment. it is desirable

to minimize the cost of capital, cheaper sources should be

preferred. The main sources of finance for a firm are equity

share capital, preference share capital and debt capital. Debt is

a cheaper source of funds than equity. The tax deductibility of

interest charges further reduces the cost of debt. The

preference share capital is cheaper than equity capital, but is

not as cheap as debt is. Thus, in order to minimize the overall

cost of capital, a company should employ a large amount of

debt.

4. Risk: There are two types of risk that are to be

considered while planning the capital structure of a firm viz

(i) business risk and (ii) financial risk. Business risk refers to

the variability to earnings before interest and taxes. Business

risk can be internal as well as external. Internal risk is caused

due to improper products mix non availability of raw

materials, incompetence to face competition, absence of

strategic management etc. internal risk is associated with

efficiency with which a firm conducts it operations within the

broader environment thrust upon it. External business risk

arises due to change in operating conditions caused by

conditions thrust upon the firm which are beyond its control

e.g. business cycle.

5. Cash Flow: One of the features of a sound capital

structure is conservation. Conservation does not mean

employing no debt or a small amount of debt. Conservatism is

related to the assessment of the liability for fixed charges,

created by the use of debt or preference capital in the capital

structure in the context of the firm‘s ability to generate cash to

meet these fixed charges. The fixed charges of a company

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include payment of interest, preference dividend and principal.

The amount of fixed charges will be high if the company

employs a large amount of debt or preference capital.

Whenever a company thinks of raising additional debt, it

should analyse its expected future cash flows to meet the fixed

charges. It is obligatory to pay interest and return the principal

amount of debt. A firm which shall be able to generate larger

and stable cash inflows can employ more debt in its capital

structure as compared to the one which has unstable and lesser

ability to generate cash inflow. Debt financial implies burden

of fixed charge due to the fixed payment of interest and the

principal. Whenever a firm wants to raise additional funds, it

should estimate, project its future cash inflows to ensure the

coverage of fixed charges.

6. Nature and Size of a Firm: Nature and size of a firm

also influence its capital structure. All public utility concern

has different capital structure as compared to other

manufacturing concern. Public utility concerns may employ

more of debt because of stability and regularity of their

earnings. On the other hand, a concern which cannot provide

stable earnings due to the nature of its business will have to

rely mainly on equity capital. The size of a company also

greatly influences the availability of funds from different

sources. A small company may often find it difficult to raise

long-term loans. If somehow it manages to obtain a long-term

loan, it is available at a high rate of interest and on

inconvenient terms. The highly restrictive covenants in loans

agreements of small companies make their capital structure

quite inflexible. The management thus cannot run business

freely. Small companies, therefore, have to depend on owned

capital and retained earnings for their long-term funds. A large

company has a greater degree of flexibility in designing its

capital structure. It can obtain loans at easy terms and can also

issue ordinary shares, preference shares and debentures to the

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public. A company should make the best use of its size in

planning the capital structure.

7. Control: Whenever additional funds are required by a

firm, the management of the firm wants to raise the funds

without any loss of control over the firm. In case the funds are

raised though the issue of equity shares, the control of the

existing shareholder is diluted. Hence they might raise the

additional funds by way of fixed interest bearing debt and

preference share capital. Preference shareholders and

debenture holders do not have the voting right. Hence, from

the point of view of control, debt financing is recommended.

But, depending largely upon debt financing may create other

problems, such as, too much restrictions imposed upon

imposed upon by the lenders or suppliers of finance and a

complete loss of control by way of liquidation of the company.

8. Flexibility: Flexibility means the firm‘s ability to

adapt its capital structure to the needs of the changing

conditions. The capital structure of a firm is flexible if it has no

difficulty in changing its capitalisation or sources of funds.

Whenever needed the company should be able to raise funds

without undue delay and cost to finance the profitable

investments. The company should also be in a position to

redeem its preference capital or debt whenever warranted by

future conditions. The financial plan of the company should be

flexible enough to change the composition of the capital

structure. It should keep itself in a position to substitute one

form of financing for another to economise on the use of

funds.

9. Requirement of Investors: The requirements of

investors is another factor that influence the capital structure of

a firm. It is necessary to meet the requirements of both

institutional as well as private investors when debt financing is



used. Investors are generally classified under three kinds, i.e.

bold investors, cautions investors and less cautions investor.

10. Capital Market Conditions (Timing): Capital Market

Conditions do no remain the same for ever sometimes there

may be depression while at other times there may be boom in

the market is depressed and there are pessimistic business

conditions, the company should not issue equity shares as

investors would prefer safety.

11. Marketability: Marketability here means the ability of

the company to sell or market particular type of security in a

particular period of time which in turn depends upon -the

readiness of the investors to buy that security. Marketability

may not influence the initial capital structure very much but it

is an important consideration in deciding the appropriate

timing of security issues. At one time, the market favors

debenture issues and at another time, it may readily accept

ordinary share issues. Due to the changing market sentiments,

the company has to decide whether to raise funds through

common shares or debt. If the share market is depressed, the

company should not issue ordinary shares but issue debt and

wait to issue ordinary shares till the share market revives.

During boom period in the share market, it may not be possible

for the company to issue debentures successfully. Therefore, it

should keep its debt capacity unutilised and issue

ordinary shares to raise finances.

12. Inflation: Another factor to consider in the financing

decision is inflation. By using debt financing during periods of

high inflation, we will repay the debt with dollars that are

worth less. As expectations of inflation increase, the rate of

borrowing will increase since creditors must be compensated

for a loss in value. Since inflation is a major driving force

behind interest rates, the financing decision should be

cognizant of inflationary trends.

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13. Floatation Costs: Floatation costs are incurred when

the funds are raised. Generally, the cost of floating a debt is

less than the cost of floating an equity issue. This may

encourage a company to use debt rather than issue ordinary

shares. If the owner‘s capital is increased by retaining the

earnings, no floatation costs are incurred. Floatation cost

generally is not a very important factor influencing the capital

structure of a company except in the case of small companies.

14. Legal Considerations: At the time of evaluation of

different proposed capital structure, the financial manager

should also take into account the legal and regulatory

framework. For example, in case of the redemption period of

debenture is more than 18 months, then credit rating is

required as per SEBI guidelines. Moreover, approval

from SEBI is required for raising funds from capital market

whereas; no such approval is required- if the firm avails loans

from financial institutions. All these and other regulatory

provisions must be taken into account at the time of deciding

and selecting a capital structure for the firm.

FINANCIAL OPTIONS AND THE VALUE OF A FIRM

An option gives its owner the right to either buy or sell

an asset at the exercise price but the owner is not obligated to

exercise (buy or sell) the option. When an option reaches its

expiration date without being exercised, it is rendered useless

with no value. Options are used to either provide investors

with the means to speculate on both positive and negative

market movements of securities or help manage the risk of

adverse financial market conditions and potentially offset

losses.

There are two types of options: Call option and put

option , both of which can be purchased to speculate on the

direction of stocks or stock indices, or sold to generate income.

https://www.mbaknol.com/financial-management/securities-and-exchange-board-of-india-sebi/



Call options : are financial contracts that give the option

buyer the right, but not the obligation, to buy a stock,

bond, commodity or other asset or instrument at a specified

price ( strike prise) within a specific time period. The stock,

bond, or commodity is called the underlying asset. A call

buyer profits when the underlying asset increases in price. Call

options allow the option holder to purchase an asset at a

specified price before or at a particular time.

If the market price of the stock rises above the option‘s

strike price, the option holder can exercise their option, buying

at the strike price and selling at the higher market price in

order to lock in a profit. On the other hand, options only last

for a limited period of time. If the market price does not rise

above the strike price during that period, the options expire

worthless.

Put options : are opposites of calls in that they allow

the holder to sell an asset at a specified price before or at a

particular time. Put options are traded on various underlying

assets, including stocks, currencies, bonds, commodities,

futures, and indexes. A put option can be contrasted with a call

option, which gives the holder the right to buy the underlying

at a specified price, either on or before the expiration date of

the options contract.

Holder of a call speculates that the value of the

underlying asset will move above the exercise price (strike

price) before expiry. Conversely, a holder of a put option

speculates that the value of the underlying asset will move

below the exercise price before expiry

Basic terms relating to call and put options:

1.. Expiration date: The date when the options contract

becomes void. It‘s the due date for you to do something with

https://www.investopedia.com/terms/c/commodity.asp

https://www.investopedia.com/terms/u/underlying-asset.asp

https://www.investopedia.com/terms/c/calloption.asp

https://www.investopedia.com/terms/c/calloption.asp



the contract, and it can be days, weeks, months or years in the

future.

2. Strike price, or exercise price: The price at which you can

buy or sell the stock if you choose to exercise the option.

3 Premium: Option premium is the non-refundable amount

paid upfront by the option buyer to the option seller The

premium consists of:

Intrinsic value: The value of an option based on the

difference between a stock‘s current market price and the

option‘s strike price.

Time value: The value of an option based on the amount of

time before the contract expires. Time is valuable to investors

because of the possibility that an option‘s intrinsic value will

increase during the contract‘s time frame.

Factors affecting value of an option

1. Underlying Price

The value of calls and puts are affected by changes in

the underlying stock price in a relatively straightforward

manner. When the stock price goes up, calls should gain in

value because you are able to buy the underlying asset at a

lower price than where the market is, and puts should decrease.

Likewise, put options should increase in value and calls should

drop as the stock price falls, as the put holder gives the right to

sell stock at prices above the falling market price.

2 Strike Price (exercise price)

That pre-determined price at which to buy or sell is

called the option's strike price or exercise price. If the strike

price allows you to buy or sell the underlying at a level which

allows for an immediate profit buy disposing of that

transaction in the open market, the option is in-the-money (for

https://www.investopedia.com/terms/s/strikeprice.asp



example a call to buy shares at $10 when the market price is

currently $15, you can make an immediate $5 profit).

3. Time to Expiration

The effect of time is easy to conceptualize but takes

experience before understanding its impact due to the

expiration date. Time works in the stock trader's favor because

good companies tend to rise over long periods of time. But

time is the enemy of the buyer of the option because, if days

pass without a significant change in the price of the

underlying, the value of the option will decline. In addition, the

value of an option will decline more rapidly as it approaches

the expiration date. Conversely, that is good news for the

option seller, who tries to benefit from time decay, especially

during the final month when it occurs most rapidly.

4. Interest Rates

Like most other financial assets, options prices are

influenced by prevailing interest rates, and are impacted by

interest rate changes. Call option and put option premiums are

impacted inversely as interest rates change: calls benefit from

rising rates while puts lose value. The opposite is true when

interest rates fall.

5. Volatility

Volatility is the difference recorded in day-to-day stock

prices. It is also referred to as swings that affect a stock‘s

prices. The more volatile stocks are more frequently subject to

a varying strike price level as compared to their non-volatile

counterparts. With big moves, the chances are higher to make

money and the investor shifts out of the Blue sphere. Thus

options on volatile stocks are definitely more expensive than

the less or non-volatile ones. It is always prudent to remember,

therefore, that even the minutest of changes in volatility

estimates impact options prices substantially. Volatility is

https://www.investopedia.com/terms/t/timedecay.asp



more often viewed as an estimate and using just an estimate

and future volatility particularly, makes it virtually impossible

to correctly calculate the right option value.

6. Dividends :

When the stock trades and yet, its holder gets

no dividends, the situation is termed ex-dividend and the price

of the stock gets diminished by the amount of dividend

payable. With rising dividends, put values increase while call

values decrease.

7. Option Type:

The option value depends on its type. There are

basically two types: Put or Call. The difference clearly hinges

on which side you exactly stand of the market or trade. This is

probably the simplest variable comprehensible to the average

trader.

DIVIDEND POLICY AND VALUE OF THE FIRM

Shareholders are the owners of the company. They

expect some return on the capital invested in the company and

it is called dividend. The dividend refers to that part of the

profits which is distributed by the company among its

shareholders. The investors are interested in earning maximum

return on their investments and to maximize their wealth. On

the other hand, the company needs to provide funds to finance

its long term growth. Dividend Policy of a firm thus affects

both the long term financing and the wealth of the

shareholders.

Meaning of Dividend

The Dividends are the proportion of revenues paid to

the shareholders. The amount to be distributed among the

shareholders depends on the earnings of the firm and is

decided by the board of directors.

https://www.angelbroking.com/share-market/dividends



Types of Dividend

1. Cash Dividend:

It is one of the most common types of dividend paid in

cash. The shareholders announce the amount to be disbursed

among the shareholder on the ―date of declaration.‖ Then on

the ―date of record‖, the amount is assigned to the shareholders

and finally, the payments are made on the ―date of payment‖.

The companies should have an adequate retained earnings and

enough cash balance to pay the shareholders in cash.

2. Scrip Dividend:

Under this form, a company issues the transferable

promissory note to the shareholders, wherein it confirms the

payment of dividend on the future date.A scrip dividend has

shorter maturity periods and may or may not bear any interest.

These types of dividend are issued when a company does not

have enough liquidity and require some time to convert its

current assets into cash.

3. Bond Dividend:

The Bond Dividends are similar to the scrip dividends,

but the only difference is that they carry longer maturity period

and bears interest.

4. Stock Dividend/ Bonus Shares:

These types of dividend are issued when a company

lacks operating cash, but still issues, the common stock to the

shareholders to keep them happy.The shareholders get the

additional shares in proportion to the shares already held by

them and don‘t have to pay extra for these bonus shares.

Despite an increase in the number of outstanding shares of the

firm, the issue of bonus shares has a favorable psychological

effect on the investors.



5. Property Dividend:

These dividends are paid in the form of a property

rather than in cash. In case, a company lacks the operating

cash; then non-monetary dividends are paid to the investors.

The property dividends can be in any form: inventory, asset,

vehicle, real estate, etc. The companies record the property

given as a dividend at a fair market value, as it may vary from

the book value and then record the difference as a gain or loss.

6. Liquidating Dividend:

When the board of directors decides to pay back the

original capital contributed by the equity shareholders as

dividends, is called as a liquidating dividend. These are usually

paid at the time of winding up of the operations of the firm or

at the time of final closure

DIVIDEND POLICY

The Dividend Policy is a financial decision that refers

to the proportion of the firm‘s earnings to be paid out to the

shareholders. Here, a firm decides on the portion of revenue

that is to be distributed to the shareholders as dividends or to

be ploughed back into the firm. A company should formulate a

sound dividend policy considering certain factors.

Determinants of dividend policy :

Some of the most important determinants of dividend

policy are:

1. Type of Industry:

Industries that are characterised by stability of earnings

may formulate a more consistent policy as to dividends than

those having an uneven flow of income. For example, public

utilities concerns are in a much better position to adopt a

relatively fixed dividend rate than the industrial concerns.



2. Age of Corporation:

Newly established enterprises require most of their

earning for plant improvement and expansion, while old

companies which have attained a longer earning experience,

can formulate clear cut dividend policies and may even be

liberal in the distribution of dividends.

3. Extent of share distribution:

A closely held company is likely to get consent of the

shareholders for the suspension of dividends or for following a

conservative dividend policy. But a company with a large

number of shareholders widely scattered would face a great

difficulty in securing such assent. Reduction in dividends can

be affected but not without the co-operation of shareholders.

4. Need for additional Capital:

The extent to which the profits are ploughed back into

the business has got a considerable influence on the dividend

policy. The income may be conserved for meeting the

increased requirements of working capital or future expansion.

5. Business Cycles:

During the boom, prudent corporate management

creates good reserves for facing the crisis which follows the

inflationary period. Higher rates of dividend are used as a tool

for marketing the securities in an otherwise depressed market.

6. Changes in Government Policies:

Sometimes government limits the rate of dividend

declared by companies in a particular industry or in all spheres

of business activity.

7. Trends of profits:

The past trend of the company‘s profit should be

thoroughly examined to find out the average earning position



of the company. The average earnings should be subjected to

the trends of general economic conditions. If depression is

approaching, only a conservative dividend policy can be

regarded as prudent.

8. Taxation policy:

Corporate taxes affect dividends directly and

indirectly— directly, in as much as they reduce the residual

profits after tax available for shareholders and indirectly, as the

distribution of dividends beyond a certain limit is itself subject

to tax. At present, the amount of dividend declared is tax free

in the hands of shareholders.

9. Future Requirements:

Accumulation of profits becomes necessary to provide

against contingencies (or hazards) of the business, to finance

future- expansion of the business and to modernise or replace

equipments of the enterprise. The conflicting claims of

dividends and accumulations should be equitably settled by the

management.

10. Cash Balance:

If the working capital of the company is small liberal

policy of cash dividend cannot be adopted. Dividend has to

take the form of bonus shares issued to the members in lieu of

cash payment.

11. Control Objectives:

When a company pays high dividends out of its

earnings, it may result in the dilution of both control and

earnings for the existing shareholders. As in case of a high

dividend pay-out ratio, the retained earnings are insignificant

and the company will have to issue new shares to raise funds

to finance its future requirements.



Importance of dividend policy

Following are some of the reasons for which dividend

policy is essential in every business organization:

1. Develop Shareholders’ Trust: When the company has a

constant net earnings percentage, it secures a stable market

value and pays suitable dividends. The shareholders also feel

confident about their investment decision, in such an

organization.

2. Influence Institutional Investors: A fair policy means a

strong reputation in the financial market. Thus, the company‘s

strong market position attracts organizational investors who

tend to leverage a higher sum to the company.

3. Future Prospects: The fund adequacy for next project

undertaking and investment opportunities is planned, decides

its dividend policy such that to avoid illiquidity.

4. Equity Evaluation: The value of stocks is usually

determined through its dividend policy since it signifies the

organizational growth and efficiency.

5. Market Value Stability of Shares: A suitable dividend

policy means satisfied investors, who would always prefer to

hold the shares for the long term. This leads to stability and a

positive impact on the stocks‘ market value.

6. Market for Preference Shares and Debentures: A

company with the proficient dividend policy may also borrow

funds by issuing preference shares and debentures in the

market, along with equity shares.

7. Degree of Control: It helps the organization to exercise

proper control over business finance. Since, the company may

land up with a shortage of funds for future opportunities, if the

company distributes maximum profit as dividends.



8. Raising of Surplus Funds: It also creates organizational

goodwill and image in the market because of which the

company becomes capable of raising additional capital.

9. Tax Advantage: The tax rates are less on the qualified

dividends, which are received as a capital gain when compared

to the percentage of income tax charged.

Dividend and value of the firm

On the relationship between dividend and the value of

the firm different theories have been advanced. They are as

follows:

1. Irrelevance Theory : According to irrelevance theory

dividend policy do not affect value of firm, thus it is called

irrelevance theory. Residual Theory Modigliani & Miller

Approach ( MM Approach)

2. Relevance Theory : According to relevance theory dividend

policy affects value of firm, thus it is called relevance theory.

Walter‘s Model & Gordon‘s Model

1. Miller and Modigliani theory on Dividend Policy

Miller and Modigliani have argued that firm‘s

dividend policy is irrelevant to the value of the firm.

According to this approach, the market price of a share is

dependent on the earnings of the firm on its investment and not

on the dividend paid by it. Earnings of the firm which affect its

value, further depends upon the investment opportunities

available to it. 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. 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.

According to MM, under a perfect market condition,



the dividend policy of the company is irrelevant and it does not

affect the value of the firm. ―Under conditions of perfect

market, rational investors, absence of tax discrimination

its dividend policy may have no influence on the market price

of shares‖. M – M‘s hypothesis of irrelevance is based on

certain assumptions.

Assumptions of Miller and Modigliani Hypothesis

1. The firm operate in a perfect capital market: 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.

Valuation Formula

Modigliani – Miller‘s valuation model is based on the

assumption of same discount rate / rate of return applicable to

all the stocks.

MM approach can be proved with the help of the

following formula :

Po =

P1 can be calculated with the help of the following formula:



P1 = Po * (1 + Ke ) – D1

Where,

P1 = market price of the share at the end of a period

Po =market price of the share at the beginning of a period

Ke = cost of capital

D = dividends received at the end of a period

Value of firm can be determined as follows :

V = (n+ m ) × P1

Where,

n = number of share outstanding at the beginning of the period

(No. of existing shares)

m = number of shares to be issued (ie additional shares to be

issued)

P1 = market price at the end of the period.

Number of shares to be issued can be determined as follows :

Number of additional equity shares to be issued

m =

I = investment required

E = earnings expected

n = number of share outstanding at the beginning

D1 = dividend to be paid at the end of the year


Illustration: 7

Anu Ltd. Currently has 10,00,000 equity shares

outstanding. Current market price per share is Rs. 100, the net

income for the current year is Rs. 3,00,00,000 and investment



budget is Rs. 4,00,00,000. Cost of equity is 10%. The

company is contemplating declaration of dividend @ Rs. 5 per

share. Assuming MM approach.

a) Calculate market price per share if dividend declared

and if is not declared.

b) How many equity shares are to be issued under both

the options.

Solution:

Po =

= P1 = Po × (1 + Ke ) – D1

Po = current market price of the share = 100

D1 = expected dividend at the end of the year = 5

Ke = cost of equity = 10%

P1 = expected price for the share at the end of the year = ?

a) i. when dividend is declared:

P1 = 100 × (1+0.10) – 5 = 110-5 = Rs.105

ii. when dividend is not declared:

P1 = 100 × (1+0.10) – 0 = 110 – 0 = Rs.110

b) calculation of number of additional equity shares to be

issued:

Number of additional equity shares to be issued

m =

I = investment required

E = earnings expected

n = number of share outstanding at the beginning

D1 = dividend to be paid at the end of the year




i ) when dividend declared:

m =

= 1,42,587 shares

ii) when dividend is not declared:

m =

= 90,909 shares

Illustration: 8

Good Luck Co. Ltd. has 5,000 outstanding shares

selling at Rs100 each. The firm has net profits of Rs.50,000

and wants to make new investments of Rs.1,00,000 during the

period. The firm is also thinking of declaring a dividend of

Rs.6 per share at the end of the current fiscal year. The firm‘s

opportunity cost of capital is 10%. What should be the value

of firm if i) dividend is not declared ii) a dividend is declared

.Assume MM approach

Solution:

I. Calculation of Value of firm when dividends are

paid:

i) Market price of the share

P1 = 100 (1+ 0.10) – 6 = Rs104

ii) Number of shares to be issued by the

company

m = 1,00,000 – (50,000 – 5,000 x 6) /104

= (1,00,000 – 20,000) / 104

= 769.23

iii) Value of firm

V = (n + m) × P1



= (5000 +769.23 ) × 104

= 6,00,000 approx

II. When dividend not paid :

i) Market price of the share

P1 = 100(1+ 0.10) – 0 = Rs. 110

ii) Number of shares to be issued by the

company.

m = 1,00,000 – (50,000 – 0) /110

= 454.54

iii) Value of firm

V = (n + m) × P1

= (5,000 + 454.54) × 110

= 6,00,000 approx

Thus ,whether dividend are paid or not ,the value of the firm

remains the same Rs.6,00,000

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

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.

According to this model, a firm can maximizethe

market value of its share and value of thefirm by adopting a

dividend policy as follows:

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.

Walters formula for calculating market value is :

P =

Where,

P = market price per share

D = dividend per share (E – D) = Retained earnings per

share

r = internal rate of return



ke = cost of capital

E = earning per share

Illustration :9

The earnings per share of a company is Rs. 10 and the

rate of capitalization applicable to its 10 per cent. The

company has three options of paying dividend i.e. (i) 50%, (ii)

75% and (iii)100% . Calculate the market price of the share as

per Walter‘s model if it can earn a return of (a) 15, (b) 10 and

(c) 5 per cent on its retained earnings.

Solution:

P =

1) r = 15% , 2) r = 10% , 3) r = 5% 4) r = 0 %

Interpretation ; when r = 15% and Ke = 10 , the market value

of share is highest ie Rs. 150,in case of zero dividend payout

ratio. When r (10%) = Ke(10%) , the d/p ratio has no effect on

the market price of the share,the market value remains at



Rs.100.When r(5%) < Ke,(10%), the market value of share is

highest(Rs.100), in case of d/p ratio 100%.

Illustration: 10

Following are the details of three companies A Ltd., B Ltd.

and C Ltd.

A Ltd; B Ltd; C Ltd;

r = 20%

𝑘e = 15%

E = Rs 8

r = 15%

𝑘e = 15%

E = Rs 8

r = 10%

𝑘e = 15%

E = Rs 8

Calculate the value of an equity share of each of these

companies applying Walter‘s Model when D/P ratio is (a) 40%

(b) 70% (c) 90%.

Solution: Value of an Equity Share as per Walter‘s Model

X Ltd. is a ―growth firm‖ , Where r > 𝑘e . Therefore, to

maximize the market price, the company needs to retain all its

earnings, otherwise its price will decline.

Y Ltd. is a ―normal firm‖, where r = 𝑘e . In this case D/P ratio

does not have any impact on the value of the firm and it‘s

share price.



Z Ltd. is a ―declining firm‖. The rate of return is less than the

cost of capital i.e., r < 𝑘e . Therefore, to maximize the market

price of the share, the company should distribute all its

earnings as dividend. The value of the share is increasing when

we increase the payout ratio from 40% to 90%.

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

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.

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

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 =

Where, P = price of a share

E = Earnings per share

b = retention ratio

1-b = proportion of earnings distributed as dividends

Ke = capitalization rate (cost of capital)

br = growth rate

Illustration: 11

Assuming that cost of equity is 11% rate of return on



investment is 12%; and earning per share is Rs 15. Calculate

price per share by Gordon model, if dividend payout ratio is

10% and 30%.

Solution:

According to gardon‘s model : P =

P=market price of equity share.

E= earnings per share.

b=retention ratio or (1-payout ratio).

r=rate of return on investment .

Ke=cost of equity capital .

br =growth rate of the firm .

When D/P ratio is 10% , P =

=1.5÷0.002

= Rs. 750

when D/P ratio is 30% P =

=4.5÷0.026

= Rs. 173.08

Illustration ;12

The following information is available in respect of Alpha

Ltd.

Earning Per Share = Rs. 10 ,Cost of Equity( ke) = 20% .

Find out market price of the share under different Rate of

Return r=25% r=20% r=15% , if retention ratio 100%, 50% ,

25% and 0%

Solution:

Rate of Return r=25% r=20% r=15%

Cost of equity k=20% k=20% k=20%



EPS E=Rs. 10 E=Rs. 10 E=Rs. 10

if b = 100 ie 1.0

10(1-1) / 0.20

(1×0.25)

= 0

10(1-1) / 0.20 -

(1×0.20)

= 0

10(1-1)/0.20-

(1×0.15)

= 0

if b = 0.5 10(1-0.5) / 0.20-

(0.5×0.25)

=66.67

[10(10.5)]/[0.20-

(0.5×0.20)]

= 50

10(1-0.5)/0.20-

(0.5×0.15)

= 40

If b = 0.25 10(1-0.25) / 0.20

-

(0.25×0.25)

= 54.5

10(1-0.25) / 0.20

-(0.25×0.20)

= 50

10(1-0.25) /

0.20 -

(0.25×0.15)

= 46.2

If b = 0 10(1-0) / 0.20 -

(0×0.25)

= 50

10(1-0) / 0.20 -

(0×0.20)

= 50

10(1-0) / 0.20 -

(0×0.15)

= 50

Interpretation :When r > k, the market value of a share

increases as the dividend payout ratio decreases. When r = k,

the market value of a share does not change with the change in

the dividend payout ratio. When r < k, the market value of

share increases as the dividend payout ratio increases.

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.

Review Questions:

I. Short answer questions:

1. Explain capital structure.

2. What is leverage ?

3. Explain financial leverage.

4. What you meant by operating leverage ?

5. How we calculate combined leverage ?

6. What is operating risk ?

7. Write about financial risk .

8. Describe earning per share.

9. Explain call option.

10. Explain put option.

11. Differentiate cash dividend and property dividend.

12. What is scrip dividend ?

13. Explain dividend policy.

14. Explain irrelevance concept of dividend.

15. Write four assumption on M.M. Approach.

16. What is relevance concept of dividend ?

II. Short essay questions:

17. Write a note about leverage effect and shareholders

risk.



18. What are the strategies kept in mind while forming a

capital structure ?

19. Explain major types of dividend.

20. What are the factors affecting value of an option ?

21. Explain the determinants of dividend p[policy.

22. Write the importance of dividend policy.

23. Explain Modigliani & Miller – irrelevance theory.

24. What is Walter‘s model of dividend policy?

25. Explain Gordon‘s model of dividend policy.

III. Long essay questions:

26. Discuss the effect of leverage on shareholders risk and

return.

27. Describe about financial option and value of firm.

28. Explain relevance theory of dividend policy.

29. Give a detailed explanation on MM Theory.

Practical Problems :

1. Aurora Ltd. Has 50,000 outstanding shares. The current

market price per share is Rs. 100 each. It hopes to make

a net income of Rs. 5,00,000 at the end of current year.

The company‘s Board is considering a dividend of Rs.5

per share at the end of the current financial year The

company need to raise Rs. 10,00,000 for an approved

investment expenditure. The company belongs to a risk

class for which the capitalization rate is 10%. Show

how the M.M. Approach affects the value of firm if the

dividend are paid or not.

(Answer : 7143 shares& value 60,00,015 ,4545 shares

& value 59,99,950)



2. Babu & Co. earn Rs. 8 per share having capitalization

rate of 10% and has a return on @ 20%. According

to Walter‘s model, what should be the price per share at

25% dividend payout ratio ? Is this optimum payout

ratio as per Walter‘s Model?

(Answer : 140, it is not the optimum payout ratio)

3. Casino Ltd. provide the following information,

determine the value of its share (Gordon model).

Rate of return on investment - Rs.12, Earning Per

Share - Rs.20, Capitalisation rate – 15% ,Dividend

payout ratio – 60%

(Answer – Rs.117.65)



MODULE – III

LEASE FINANCIAL STRATEGY

Many business owners and financial officers consider

leasing is an effective strategy offering flexibility, convenience

and control for managing finances that provides immediate

cash-flow benefits, simplifies equipment upgrades, may bring

significant tax advantages, and helps achieve short- and long-

term company goals.

LEASING CONCEPTS

A lease is a contract outlining the terms under which

one party agrees to rent property owned by another party. It

guarantees the lessee, also known as the tenant, use of an asset

and guarantees the lessor, the property owner or landlord,

regular payments for a specified period in exchange. Both the

lessee and the lessor face consequences if they fail to uphold

the terms of the contract.

Leases are legal and binding contracts that set forth the

terms of rental agreements in real estate and real and personal

property. These contracts stipulate the duties of each party to

effect and maintain the agreement and are enforceable by each.

For example, a residential property lease includes the address

of the property, landlord responsibilities, and tenant

responsibilities, such as the rent amount, a required security

deposit, rent due date, consequences for breach of contract, the

duration of the lease, pet policies, and any other essential

information.

Meaning of Lease

Lease financing is one of the important sources of

medium- and long- term financing where the owner of an

asset gives another person, the right to use that asset against

https://www.investopedia.com/terms/l/lessee.asp

https://www.investopedia.com/terms/l/lessor.asp

https://www.investopedia.com/terms/s/security-deposit.asp

https://www.investopedia.com/terms/s/security-deposit.asp



periodical payments. The owner of the asset is known as lessor

and the user is called lessee. The periodical payment made by

the lessee to the lessor is known as lease rental. Under lease

financing, lessee is given the right to use the asset but the

ownership lies with the lessor and at the end of the lease

contract, the asset is returned to the lessor or an option is given

to the lessee either to purchase the asset or to renew the lease

agreement.

Different Types of Lease:

Depending upon the transfer of risk and rewards to the

lessee, the period of lease and the number of parties to the

transaction, lease financing can be classified into two

categories. Finance lease and operating lease.

I. Finance Lease:

Financial leasing is a contract involving payment over

a longer period. It is a long-term lease and the lessee will be

paying much more than the cost of the property or equipment

to the lessor in the form of lease charges. It is irrevocable. In

this type of leasing the lessee has to bear all costs and the

lessor does not render any service. It is the lease where the

lessor transfers substantially all the risks and rewards of

ownership of assets to the lessee for lease rentals. In other

words, it puts the lessee in the same condition as he/she would

have been if he/she had purchased the asset. Finance lease has

two phases: The first one is called primary period. This is non-

cancellable period and in this period, the lessor recovers his

total investment through lease rental. The primary period may

last for indefinite period of time. The lease rental for the

secondary period is much smaller than that of primary period.

Features of Finance Lease:

1. A finance lease is a device that gives the lessee a right to

use an asset.



2. The lease rental charged by the lessor during the primary

period of lease is sufficient to recover his/her investment.

3. The lease rental for the secondary period is much smaller.

This is often known as peppercorn rental.

4. Lessee is responsible for the maintenance of asset.

5. No asset-based risk and rewards is taken by lessor.

6. Such type of lease is non-cancellable; the lessor‘s

investment is assured.

II. Operating Lease:

Lease other than finance lease is called operating lease.

In an operating lease, the lessee uses the asset for a specific

period. The lessor bears the risk of obsolescence and incidental

risks. There is an option to either party to terminate the lease

after giving notice. In this type of leasing lessor bears all

expenses, lessor will not be able to realize the full cost of the

asset and specialized services are provided by the lessor. This

kind of lease is preferred where the equipment is likely to

suffer obsolescence.

Here risks and rewards incidental to the ownership of

asset are not transferred by the lessor to the lessee. The term of

such lease is much less than the economic life of the asset and

thus the total investment of the lessor is not recovered through

lease rental during the primary period of lease. In case of

operating lease, the lessor usually provides advice to the lessee

for repair, maintenance and technical knowhow of the leased

asset and that is why this type of lease is also known as service

lease.

Features of Operating Lease:

1. The lease term is much lower than the economic life of the

asset.



2. The lessee has the right to terminate the lease by giving a

short notice and no penalty is charged for that.

3. The lessor provides the technical knowhow of the leased

asset to the lessee.

4. Risks and rewards incidental to the ownership of asset are

borne by the lessor.

5. Lessor has to depend on leasing of an asset to different

lessee for recovery of his/her investment.

III. Sale and Leaseback:

It is a sub-part of finance lease. Under a sale and

leaseback arrangement, a firm sells an asset to another party

who in turn leases it back to the firm. The asset is usually sold

at the market value on the day. The firm, thus, receives the

sales price in cash, on the one hand, and economic use of the

asset sold, on the other.

The firm is obliged to make periodic rental payments to

the lessor. Sale and leaseback arrangement is beneficial for

both lessor and lessee. While the former gets tax benefits due

to depreciation, the latter has immediate cash inflow which

improves his liquidity position.

In fact, such arrangement is popular with companies

facing short-term liquidity crisis. However, under this

arrangement, the assets are not physically exchanged but it all

happens in records only.

This is nothing but a paper transaction. Sale and lease

back transaction is suitable for those assets, which are not

subjected to depreciation but appreciation, say for example,

land.

IV. Leveraged Leasing:

A special form of leasing has become very popular in

recent years. This is known as Leveraged Leasing. This is



popular in the financing of ―big-tickets‖ assets such as aircraft,

oil rigs and railway equipments. In contrast to earlier

mentioned three types of leasing, three parties are involved in

case of leveraged lease arrangement – Lessee, Lessor and the

lender.

Leveraged leasing can be defined as a lease

arrangement in which the lessor provides an equity portion

(say 25%) of the leased asset‘s cost and the third-party lenders

provide the balance of the financing. The lessor, the owner of

the asset is entitled to depreciation allowance associated with

the asset.

V. Direct Leasing:

A firm acquires the use of an asset that it does not

already own. A direct lease may be arranged from the

manufacturer supplier directly or through the leasing company.

In the first case the manufacturer/supplier himself act as the

lessor while in the second case the lessee firm arranges the

purchase of the asset for the leasing company [lessor]from the

manufacturer or the supplier and also enters into an agreement

with the lessor for the lease of the asset.

VI. Straight Lease and Modified Lease :

Straight lease requires the lessee firm to pay lease

rentals over the expected service life of the asset and does not

provide for any modifications to the terms and conditions of

the basic lease. Modified lease on the other hand provides

several options to the lessee during the lease period. For

example, the option of terminating the lease may be providing

by either purchasing the asset or returning the same.

VII. Primary and Secondary Lease [ Front ended and Back

Ended Lease]

Under primary and secondary lease, the lease rentals

are charged in such a manner that the lesser recovers the cost



of the asset and acceptable profit during the initial period of

the lease and then a secondary lease is provided at nominal

rentals. In simple words, the rentals charged in the primary

period are much more than that of the secondary period. This

form of lease arrangement is also known as front ended and

back ended scheme.

Difference between the Operating and Financial Lease

Topics Operating Lease Financial Lease

Definition

Operating lease is

short term lease

used to finance

assets & is not fully

amortized over the

life of the asset.

A financial lease is the

lease used in connection

with long term assets &

amortizes the entire cost

of the asset over the life

of the lease.

Duration Short term leasing Long term leasing

Cost The lessor pays the

maintenance cost.

Lessee pays the

maintenance cost.

Cancel &

Changeable

Cancelable lease &

It is a changeable

lease contract.

Non-cancelable lease &

It is not a changeable

lease contract.

Risk lessor bears the risk

of the asset.

The lessee bears the risk

of the asset.

Purchase At the end of the

asset is hot

At the end of the

contract, the asset is



purchasable. purchasable.

Renew It is a renewable

contract.

It is not a renewable

contract.

Also called

Service lease, short

term lease,

cancelable lease.

A capital lease, long

term lease, non-

cancelable lease.

Advantages of Lease Financing :

Lease financing has following advantages

A. To Lessor:

The advantages of lease financing from the point of

view of lessor are summarized below

1. Assured Regular Income:

Lessor gets lease rental by leasing an asset during the

period of lease which is an assured and regular income.

2. Preservation of Ownership:

In case of finance lease, the lessor transfers all the risk

and rewards incidental to ownership to the lessee without the

transfer of ownership of asset hence the ownership lies with

the lessor.

3. Benefit of Tax:

As ownership lies with the lessor, tax benefit is enjoyed

by the lessor by way of depreciation in respect of leased asset.

4. High Profitability:

The business of leasing is highly profitable since the

rate of return based on lease rental, is much higher than the

interest payable on financing the asset.



5. High Potentiality of Growth:

The demand for leasing is steadily increasing because it

is one of the cost efficient forms of financing. Economic

growth can be maintained even during the period of

depression. Thus, the growth potentiality of leasing is much

higher as compared to other forms of business.

6. Recovery of Investment:

In case of finance lease, the lessor can recover the total

investment through lease rentals.

B. To Lessee:

The advantages of lease financing from the point of

view of lessee are discussed below:

1. Use of Capital Goods:

A business will not have to spend a lot of money for

acquiring an asset but it can use an asset by paying small

monthly or yearly rentals.

2. Tax Benefits:

A company is able to enjoy the tax advantage on lease

payments as lease payments can be deducted as a business

expense.

3. Cheaper:

Leasing is a source of financing which is cheaper than

almost all other sources of financing.

4. Technical Assistance:

Lessee gets some sort of technical support from the

lessor in respect of leased asset.

5. Inflation Friendly:

Leasing is inflation friendly, the lessee has to pay fixed

amount of rentals each year even if the cost of the asset goes

up.



6. Ownership:

After the expiry of primary period, lessor offers the

lessee to purchase the assets— by paying a very small sum of

money.

Disadvantages of Lease Financing :

Lease financing suffers from the following

disadvantages

A. To Lessor:

1. Unprofitable in Case of Inflation:

Lessor gets fixed amount of lease rental every year and

they cannot increase this even if the cost of asset goes up.

2. Double Taxation:

Sales tax may be charged twice:

First at the time of purchase of asset and second at the

time of leasing the asset.

3. Greater Chance of Damage of Asset:

As ownership is not transferred, the lessee uses the asset

carelessly and there is a great chance that asset cannot

be useable after the expiry of primary period of lease.

4. High Risk of Obsolescence:

The Lessor has to bear the risk of obsolescence as there

are rapid technological changes.

B. To Lessee:

1. Compulsion:

Finance lease is non-cancellable and even if a company

does not want to use the asset, lessee is required to pay the

lease rentals.



2. Ownership:

The lessee will not become the owner of the asset at the

end of lease agreement unless he decides to purchase it.

3. Costly:

Lease financing is more costly than other sources of

financing because lessee has to pay lease rental as well as

expenses incidental to the ownership of the asset.

4. Understatement of Asset:

As lessee is not the owner of the asset, such an asset

cannot be shown in the balance sheet which leads to

understatement of lessee‘s asset.

LEASING AND BUYING

Leasing will allow you an option to immediately get

hold of the asset you want to use without paying a hefty

amount. It‘s like buying a phone. And for leasing, you would

pay lesser money for the asset per month than if you would

have bought the asset. In leasing, you would receive another

benefit. You would also be able to save taxes (depending on

the place you‘re located at)

Buying will allow you to own the asset. If you take a

loan from the bank, a bank will own the asset until the amount

is paid off. But for buying an asset, you need to pay more per

month than if you would have leased the asset. Buying an asset

also allows you to pay less insurance premium than leasing an

asset.

A newly starting business, can take an asset on lease in

the beginning since it would cost less and an existing business

wish to expand the business and think that owning an asset,

better to buy the asset.

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Differences between Buying and Leasing

Basis of

difference Leasing Buying

Meaning

Leasing allows the

owner to use the

asset immediately

without paying huge

amount..

Buying allows the

owner to use the asset

not only for immediate

need but also for a

long-term purpose

Risk Lies with lessor Lies with buyer /

owner

Amount per

month Usually lower. Usually higher

The matter of

selling .

Once your lease is

over, you don‘t need

to worry about

selling the asset..

If you don‘t like the

asset after the

purchase, you need to

find a new buyer to

sell off the asset.

Tax savings

In leasing, you would

be able to save more

taxes.

In buying, you would

be able to save fewer

taxes (there can be an

exception).

Parties Lessor and lessee . Buyer and seller.

Down

payment

Down payment in

terms of leasing is

quite low or no down

payment.

You need to pay a

down payment of

10%-20% of the asset

immediately.

Long-term

Loan

There‘s no question

of a long-term loan.

In a normal scenario,

you need to take a

long-term loan from

the bank/financial

institution.



CASH FLOW CONSEQUENCES OF A FINANCIAL

LEASE

There are cash flow consequences in case of finance

lease. It is a way of normal financing for a company. Suppose,

a firm finds it financially worthwhile to acquire an equipment

costing Rs. 500 lac. The life of the equipment is say 10 years.

Instead of buying the equipment, there is another option

available for the company. It can lease the equipment for 10

years for lease rental of Rs 110 lac. Now assume, company

will have to provide for the maintenance, insurance and

other operating expenses related to use of the assets. Company

is using straight line method for depreciation which is 14%.

The tax rate is 35 per cent. So the consequences of the lease as

compared to buying option are as follows –

The company can acquire the asset immediately. The cash

saved is equivalent to cash inflow. This means there is cash

inflow of Rs 500 lac.

Depreciation is a deductible expense which saves tax. The

tax shield is equal to the amount of depreciation each year

multiplied by tax rate. When the organisation takes leases,

it loses the depreciation tax shield.

So, tax shield lost = 50 × 0.35 = 17.5 lac.

There is a cash out flow of Rs. 110 lac per year as lease

payments. But these payment will yield tax shield of Rs

110 × 0.35 that is 38.5 lac per year. Hence the after tax

lease payments would be Rs 110 – 38.5 = 71.5 lac per year.

However, the tax shield is available only when

company pays taxes. In case, it did not, then depreciation is

worth noting for it.

https://www.cashstock.in/operating-expenses-definition/

https://www.cashstock.in/depreciation-definition/



Financial Evaluation of Leasing:

1. Lessee’s Point of View:

(Lease or Buy/Lease or Borrow Decisions):

Once a firm has evaluated the economic viability of an

asset as an investment and accepted/selected the proposal, it

has to consider alternate methods of financing the investment.

However, in making an investment, the firm need not own the

asset. It is basically interested in acquiring the use of the asset.

Thus, the firm may consider leasing of the asset rather

than buying it. In comparing leasing with buying, the cost of

leasing the asset should be compared with the cost of financing

the asset through normal sources of financing, i.e., debt and

equity.

Since, payment of lease rentals is similar to payment of

interest on borrowings and lease financing is equivalent to debt

financing, financial analysts argue that the only appropriate

comparison is to compare the cost of leasing with that of cost

of borrowing. Hence, lease financing decisions relating to

leasing or buying options primarily involve comparison

between the cost of debt-financing and lease financing.

The evaluation of lease financing decisions from the point

of view of the lessee involves the following steps:

(i) Calculate the present value of net-cash flow of the buying

option, called NPV (B).

(ii) Calculate the present value of net cash flow of the leasing

option, called NPV (L)

(iii)Decide whether to buy or lease the asset or reject the

proposal altogether by applying the following criterion:

(a) If NPV (B) is positive and greater than the NPV (L),

purchase the asset.



(b) If NPV (L) is positive and greater than the NPV (B), lease

the asset.

(c) If NPV (B) as well as NPV (L) are both negative, reject the

proposal altogether.

Since many financial analysts argue that the lease

financing decisions arise only after the firm has made an

accept-reject decision about the investment; it is only the

comparison of cost of leasing and borrowing options.

The following steps are involved in such an analysis:

(i) Determine the present value of after-tax cash outflows

under the leasing option.

(ii) Determine the present value of after-tax cash outflows

under the buying or borrowing option.

(iii)Compare the present value of cash outflows from leasing

option with that of buying/borrowing option.

(iv) Select the option with lower presented value of after-tax

cash outflows.

Illustration 1:

A limited company is interested in acquiring the use of an

asset costing Rs. 5,00,000. It has two options:

(i) To borrow the amount at 18% p.a. repayable in 5 equal

installments or

(ii) To take on lease the asset for a period of 5 years at the year

end rentals of Rs. 1,20,000.

The corporate tax is 50% and the depreciation is

allowed on w.d.v. at 20%. The asset will have a salvage of Rs.

1,80,000 at the end of the 5th year.

You are required to advise the company about lease or

buy decision. Will decision change if the firm is allowed to

claim investment allowance at 25%?



Note::

(1) The present value of Re. 1 at 18% discount factor is:

1st year – .847

2nd year – .718

3rd year – .609

4th year – .516

5th year – .437

(2) The present value of an annuity of Re. 1 at 18% p.a. is

Rs.3.127.

Solution:

I. Calculation of loan installment:

Loan Installment =

=

= 159898

II. Schedule of loan payment

Year

Loan

balance at

beginning

of the

year

Loan

Instalment

Interest

Payment

Principal

Payment

Loan

balance

at the

end of

the

year

1

2

3

4

5

(Rs.)

500000

430102

347622

250296

135451

(Rs.)

159898

159898

159898

159898

159898

(Rs.)

90000

77418

62572

45053

24447

(Rs.)

69898

82480

97326

114845

135451

(Rs.)

430102

347622

250296

135451

NIL



III. Calculation of Present Value of after-tax cash outflows

under Borrowing/Buying option

Year

Loan Instal-ment

(Rs)

Tax Saving on

Net Cash

Outflow

(Rs)

P.V.Factor

at 18%

P.V. of after

Tax net Cash

Outflow

(Rs)

Interest

(Rs)

Dep.(after-Tax)

(Rs)

Total

(Rs)

2 3 4=2-3 5 6

1

2

3

4

5

159898

159898

159898

159898

159898

45000

38709

31286

22527

12224

50000

40000

32000

25600

20480

95000

78709

63286

48127

32704

64898

81189

96612

111771

127194

.847

.718

.609

.516

.437

54969

58294

58837

57.674

55584

TOTAL: 285358

Total present value of cash out flow = 285358

Less P.V.of salvage at the end of

5th

year (180000× .437) = 78660

206698

IV. Calculation of Present Value of after-tax cash outflows

under lease option

Year

end

Lease

rental

Tax

savings

on lease

rent

After-

Tax

cash

outflows

P.V.

Annuity

factor at

18%

Total

P.V. of

cash

outflows

1-5

(RS)

120000

(RS)

60000

(RS)

60000

(RS)

3.127

(RS)

187620

(v) Evaluation:

As the present value of after-tax cash outflows under

the leasing option is lesser than the present value of after-tax



cash outflows of the buying option, it is advisable to take the

asset on lease.

(vi) Decision if Investment Allowance is allowed:

In case Investment Allowance is allowed on purchase of

asset the total of present value of net cash outflows will

decrease by the present value of tax

savings on investment allowance as below: investment

allowance:

(allowed at the end of 1st year ) 5,00,000 × 25/100

Tax Savings (50%)

PV factor at the end of 1st year

PV of Tax savings on investment allowance

(62500 x 0.847)

hence, P.V of cash outflows in buying option shall be =

Rs.2,06,684 - 52938

1,25,000

62500

0.847

52938

1,53,746

In that case, the P.V. of cash outflows under buying

option shall be lesser than the P.V. of cash outflows under

leasing option .It is advisable the company should buy the

asset.

Working note :

Calculation of Depreciation :

1st year 5,00,000 x 20% = 1,00,000

2nd

year 4,00,000 x 20% = 80,000

3rd

year 3,20,000 x 20% = 64,000

4th

year 25,600 x 20% = 51,200

5th

year 204800 x 20% = 40960



Financial Evaluation of Leasing:

2. Lessor’s Point of View:

The financial viability of leasing out an asset from the

point of view of lessor can be evaluated with the help of the

two time adjusted methods of capital budgeting:

(a) Present Value Method

(b) Internal Rate of Return Method.

(a) Present Value Method:

This method involves the following steps:

(i) Determine cash outflows by deducing tax advantage of

owning an asset, such as investment allowance, if any.

(ii) Determine cash inflows after-tax

(ii) Determine the present value of cash outflows and after tax

cash inflows

(iv) Decide infavour of leasing out an asset if P.V. of cash

inflows exceeds the P.V. of cash outflows. i.e., if the NPV is

+ve , leasing out an asset is favourable otherwise in case

N.P.V. is -ve, the lessor would lose on leasing out the asset.

Illustration : 2

From the information given below, you are required to

advise about leasing out of the asset:

Cost of equipment - Rs. 400000

Average cost of capital to the lessor - 12%

Depreciation (allowable) - 20% on original cost

Expected life of asset - 5 years

Salvage value - nil

Lease rent payable at the end of each of 5 years - Rs. 150000



Corporate tax (applicable to lessor) - 50%

P.V.of an Annuity of Re. 1 for 5 years at 12% is Rs . 3.605

Solution:

Calculation of cash outflow (Rs)

Cost of equipment

Less: tax advantage , if any

Cash Outflow

400000

nil

400000

Calculation of after –tax cash inflows (Rs)

lease rental

less: depreciation

earnings before tax (EBT)

less : tax at 50%

earnings after tax (EAT)

add : depreciation

cash inflows after tax

150000

80000

70000

35000

35000

80000

115000

Calculation of present value of cash outflows

year

(Rs.)

0

cash outflows

(Rs)

400000

P.V. discount

factor at 12%

1.00

P.V. of cash

outflows

(Rs.)

400000



Calculation of P.V. of Cash inflows

Year

1-5

Cashflows after

tax

(Rs.)

115000

P.V.. Annuity

discount factor

at 12%

3.605

P.V. of

Cash

inflows

(Rs)

414575

Calculation of Net Present Value Rs

present value of cash inflows

less: P.V. of cash outflows

Net Present Value of cash flows

414575

400000

14575

Since the present value of cash inflows is more than the

present value of cash outflows or says N.P.V. is positive, it is

desirable to lease out the asset.

(b) Internal Rate of Return Method:

The internal rate of return can be defined as that rate of

discount at which the present value of cash- inflows is equal to

the present value of cash outflows.

It can be determined with the help of the following

mathematical formula:

C = A1/(1+r) + A2/(1+r)2 + A3/(1+r)

3 + … … … … + An/(1+r)

n

Where,

C = Initial Outlay at time Zero.

A1, A2, … … … An = Future net cash flows at different

periods.

2,3 …….. , = Numbers of years



r = Rate of discount of internal rate of return.

The Internal rate of return can also be determined with the help

of present value tables.

The following steps are required to practice the internal rate of

return method:

(1) Determine the future net cash flows for the period of the

lease. The net cash inflows are estimated future net cash flows

for the period of the lease. The net cash inflows are estimated

future earnings, from leasing out the asset, before depreciation

but after taxes.

(2) Determine the rate of discount at which the present value of

cash inflows is equal to the present value of cash outflows.

This may be determined as follows:

(a) When the annual net cash flows are equal over the life

of the asset:

Firstly, find out Present Value Factor by dividing initial

outlay (cost of the investment) by annual cash flow, i.e.,

Present Value Factor = Initial Outlay/Annual Cash Flow.

Then, consult present value annuity tables with the number of

year equal to the life of the asset and find out the rate at which

the calculated present value factor is equal to the present value

given in the table.

Illustration 3:

Initial outlay Rs 50000

Life of the asset 5 years

Estimated annual cash – flows Rs 12.500

Calculate the internal rate of return Rs 12500

Solution:

Present value factor

=

= 4



Consulting present value annuity tables for 5 years

periods at present value factor of 4 Internal rate of return

= 8% approx.(as seen from the table that at 8% for 5 year

period , the present value is 3.9927 which is nearly equal to 4.)

(b) When the annual cash flows are unequal over the life of

the asset:

In case annual cash flows are unequal over the life of

the asset, the internal rate of return cannot be determined

according to the technique suggested above. In such cases, the

internal rate of return is calculated by hit and trial and that is

why this method is also known as hit and trial yield method.

Under this method ,

IRR = L +

× (H –L)

Where, L = lower discount rate

H = higher discount rate

P1 = present value at lower discount rate

P2 = Present value at higher discount rate

Q = net cash outlay

We may start with any assumed discount rate and find

out the total present value of all the cash flows by consulting

present value tables.

The so calculated total present value of cash inflows as

compared with the present value of cash outflows which is

equal to the cost of the initial investment where total

investment is to be made in the beginning. The rate, at which

the total present value of all cash inflows equals the initial

outlay, is the internal rate of return. Several discount rates may

have to be tried until the appropriate rate is found.

The calculation process may be summed up as follows.



(i) Prepare the cash flow table using an arbitrary assumed

discount rate to discount the net cash flow to the present value.

(ii) Find out the Net Present Value by deducting from the

present value of total cash flows calculated in (i) above the

initial cost of the investment.

(iii) If the Net Present Value (NPV) is positive, apply higher

rate of discount.

(iv) If the higher discount rate still gives a positive net present

value, increase the discount rate further until the NPV becomes

negative.

(v) If the NPV is negative at this higher rate, the internal rate

of return must be between these two rates:

(3) Accept the proposal if the internal rate of return is higher

than or equal to the minimum required rate of return, i.e. the

cost of capital or cut off rate.

(4) In case of alternative proposals select the proposal with the

highest rate of return as long as the rates are higher than the

cost of capital or cut-off rate.

Illustration 4:

Initial Investment – Rs. 60,000

Life of the Asset – 4 years

Estimated Net Annual Cash Flows:

1st year 15000

2nd

year 20000

3rd

year 30000

4th

year 20000

Compute the internal rate of return and also advise the lessor

about the leasing out decision if his expected minimum rate of

return is 15%.



Note: Present Value Factor at various rates of discount.

year 10% 12% 14% 15% 16%

1

2

3

4

909

.826

.751

.683

.892

.797

.711

.635

.877

.769

.674

.592

.869

.743

.657

.571

.862

.756

.640

.552

Schedule showing P.V. cash flows at various discount rates

Year

Annual Cash Flows

Rs.

Discount rate 10%

12% 14% 15%

P.V.F P.V.F Rs.

P.V.F P.V. Rs

P.V.F. P.V. P.V.F. P.V. Rs

1 2 3 4

15000 20000 30000 20000

.909

.826

.751

.683

13635 16520 22530 13660

.892

.797

.711

.635

13380 15940 21330 12700

.877

.769

.674

.592

13155 15380 20220 11840

.869

.756

.657

.571

13035 15120 19710 11420

66345 63350 60595

59285

P.V.F = Present Value Factor, P.V.= Present Value

(1) The present value of cash flows at 14% rate of discount is

Rs. 60,595 and at 15% rate of discount it is t 59,285. So the

initial cost of investment which is Rs. 60,000 falls in between

these two discount rates. At 14% the NPV is+ 595 but at 15%

the NPV is – 715, we may say that IRR = 14.5% (approx).

[Calculation : IRR = 14 +

× (15 –14) =14.5%]

(2) As the IRR is less than the minimum required rate of

return, the lessor should not lease out the asset.

EQUIVALENT LOAN METHOD

The lessee might evaluate the lease using the

equivalent loan method, which involves comparing the net

savings at Time 0 if the asset is leased with the present value



of the incremental costs of leasing over the term of the lease. If

the Time 0 savings is greater than the present value of the

incremental costs, there is an advantage to leasing.

Equivalent loan is the loan which a firm may take and

has the same cash flow commitment as the lease. It means that

in terms of payment obligations of the firm, the lease and

equivalent loan have identical effect. Thus, equivalent loan can

be defined as that amount of loan which would produce the

firms commitment for cash flow exactly same as that of lease.

The evaluation of financial lease by equivalent loan method

involves the following steps:-

1. Determine the periodic cash flows from leasing

2. Calculate equivalent loan which these periodic cash flows

can service

3. Compare the amount of equivalent loan with the amount of

lease finance. If the amount of lease finance is more than

the value of equivalent loan, it would be better to finance

the asset by leasing, otherwise loan would be a better

option

METHOD OF COMPUTING LEASE RENTALS

The following steps are involved in computing lease

rentals:-

1. Determine the cost of the asset which includes the actual

purchase price and expenses like freight, insurance, taxes

and installation, etc.

2. Determine the cash flows to the lessor on account of

ownership of the asset. These include tax advantage

provided by depreciation and investment allowance.

3. Calculate the present value of cash flows as determined in

step 2.



4. Subtract the present value of cash flows of ownership

advantage from the cost of the asset determined in step 1 so

as to determine the minimum required net recovery

through lease rentals.

5. Calculate the post-tax lease rentals by dividing the

minimum required net recovery through lease rentals by

present value factor of annuity.

6. Compute the pretax lease rentals by adjusting the post-tax

lease rentals for the tax factor.

Illustration: 5

ABC Leasing is considering to lease out an equipment

costing Rs. 10,00,000 for five years, which is the expected life

of the equipment, and has an estimated salvage value of Rs.

1,00,000. Sunny Leasing can claim a depreciation of 20% on

w.d.v. of the asset but is not eligible for investment allowance.

The firm falls under a tax rate of 50% and the minimum post-

tax required rate of return is 12%. You are required to calculate

the lease rental which the firm should charge.

Note:(1) Present Value Factor at 12% discount rate is as

below:

Year 1 = .893; Year 2= .797; Year 3 = .712; Year 4 = .636 and

Year 5 = .567

(2) Annuity Discount Factory at 12% for 5 years = 3.605.



Solution:

(III): Calculation of Present Value of Cash Flow :

Year Cash Flows

(Rs)

P.V. Factor

at 12%

P.V. of Cash

Flolw

(Rs)

1.

2.

3.

4.

5.

100000

80000

64000

51200

140960

.893

.797

.712

.636

.567

Total

89300

63760

45568

32563

79924

311115

(IV): minimum required net recovery through lease rentals:

MRLR = Rs. 1000000-311115

= Rs. 688885

(V): Post- Tax Lease Rental (PTLR) =

= Rs.191092



(VI) Pre- tax lease rental (LR) = 1,91,092×100÷50 =Rs.

3,82,184

ie lease rent expressed in terms of lease financing

= 3,82,184 × 1000 ÷ 10,00,000 ×1 ÷12 = 31.85 per thousand

per month .

Review Questions :


1. What is lease ?

2. Explain parties of lease.

3. What do you meant by financial lease?

4. What is operating lease?

5. Explain sale and lease back.

6. What is leveraged lease ?

II. Short essay questions:

7. What are the different types of lease ?

8. Explain cash flow consequences of lease.

9. Distinguish between the Operating and Financial

Lease.

10. Explain the benefits of leasing to the lessor.

11. What are the merits and demerits of leasing to the

lessee.

12. Differentiate buying and leasing.

III. Long essay questions:

13. What you understand by leasing ? State its advantages

and disadvantages.

14. Discuss various methods of evaluating leasing

proposal.



Practical Problems :

1: A company is interested in acquiring the use of an asset

costing Rs.1000000, it has two options (a) to borrow the

amount at 10% p.a. repayable in 5 equal instalments ,or (b) to

take asset on lease for a period of 5 years at yearly rentals of

rs.240000 ( payable at the end of each year ) . The corporate

tax is 50% and the depreciation is allowed on writtern down

value at 20% . The asset will have a salvage value of

Rs.300000 at the end of the 5th

year. Advice the company

regarding lease or buy decisions.

(Not to take asset on lease)

2: A project with an initial investment of Rs. 100000 generates

cash inflows of Rs. 50000 ; Rs. 40000; Rs. 30000 with life of 3

years . What will be the internal rate of return ?

(IRR = 10.65%)

3: X Ltd. is considering purchase of a computer for Rs. 30000 ;

life 3 years with no scrap value . It can purchase from its own

funds or borrows at 12% p.a. , principal repayable at Rs. 10000

p.a. purchase of this machine will result in a savings of labour

costs of Rs. 16000 p.a. X Ltd. wants 10% return. Tax rate is

30% . Evaluate the proposal P.V. factor = 0.909, 0.826, 0.751 .

(Company should not go for borrowing option)

4: Sunitha Equipments private ltd. Is considering to purchase

an equipment. The company can either borrow the necessary

funds through 9% or can arrange to have the equipment

through lease by paying the rentals of Rs. 24000. The cost of

equipment is Rs. 100000 and would attract capital allowances

at 25% on a reducing balance over its five –year life. The

corporate tax is 33%. You are expected to evaluate the two

options .

( Take the equipment on lease )



5. Manu trading company is having effective tax rate of 50%

and a discounting rate of 15%. it has two offers to purchase

the equipment .

Option 1 :

(a) Borrow the loan from a bank to the cost of the equipments

Rs.1000.

(b) Loan is repayable in 5 years.

(c) Interest in charged at 14%.

Option 2

(a) Lease the asset by paying the rentals of rs, 300 per year.

(b) The cost of the lease is r s. 1000.

(c) The lease period for 5 years.

(d) The rate of depreciation applicable in 15%.

Evaluate the proposal and guide the company (leasing is

cheaper than borrowings)



MODULE IV

MERGER STRATEGY

Restructuring a corporate entity is often a necessity

when the company has grown to the point that the original

structure can no longer efficiently manage the output and

general interests of the company. The restructuring is seen as a

positive sign of growth of the company and is often welcome

by those who wish to see the corporation gain a larger market

share. The idea of corporate restructuring is to allow the

company to continue functioning in some manner. Even when

corporate raiders break up the company and leave behind a

shell of the original structure, there is still usually a hope, what

remains can function well enough for a new buyer to purchase

the diminished corporation and return it to profitability.

Corporate restructuring may also take place as a result

of the acquisition of the company by new owners. The

acquisition may be in the form of a leveraged buyout, a hostile

takeover, or a merger of some type that keeps the company

intact as a subsidiary of the controlling corporation.

Merger and acquisition strategies are devised in

accordance with the policy of the organization. Some may

prefer to diversify or to expand in a specific field of business,

while some others may wish to strengthen their research

facilities etc. The merger and acquisition strategies may differ

from company to company and also depend a lot on the policy

of the respective organization. However, merger and

acquisition strategies have got some distinct process, based on

which, the strategies are devised.

Meaning of Merger

A merger is an agreement that unites two existing

companies into one new company. A merger is a fusion of two

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or more entities, and it is a process in which the identity of one

or more entities is lost.It is the combination of one or more

corporations and other business entities into a single business

entity, the joining of two or more companies to achieve greater

efficiencies of scale and productivity.

A merger takes place when; two or more organizations

merge, and their operations are absorbed by a news

organization.

A merger is a strategy through which two or more

organizations agree to integrate their operations on a relatively

co-equal basis because they have resources and capabilities

that together may create a stronger competitive advantage.

In the business world, a merger is a combination of two

or more companies. When combined, a new company is

created. After having been merged, the companies lose their

independent identities. The partnering-companies are

dissolved.

Their assets and liabilities are combined. New

shares/stocks are issued for the new company created after the

merger. Therefore, they can never operate a business with their

previous names independently.

Mergers and acquisitions are commonly done to

expand a company‘s reach, expand into new segments, or

gain market share. All of these are done to

increase shareholder value. Often, during a merger, companies

have a no-shop clause to prevent purchases or mergers by

additional companies

In merger 2 or more than 2 entities are involved. Two

entities are:

Merging Company: The entity which transfers its assets to

other entity.

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Merged Company: The entity to which all the assets are

transferred by the merging company.

Merger and an Acquisition

Mergers and Acquisitions are part of strategic

management of any business. It involves consolidation of two

businesses with an aim to increase market share, profits and

influence in the industry. Mergers and Acquisitions are

complex processes which require preparing, analysis and

deliberation. There are a lot of parties who might be affected

by a merger or an acquisition, like government agencies,

workers and managers. Before a deal is finalized all party

needs to be taken into consideration, and their concerns should

be addressed, so that any possible hurdles can be avoided.

‗Mergers and Acquisitions‘ is a technical term used to

define the consolidation of companies. When two companies

are combined to form a single unit, it is known as merger,

while an acquisition refers to the purchase of company by

another one, which means that no new company is formed, but

one company has been absorbed into another. Mergers and

Acquisitions are important component of strategic

management, which comes under corporate finance. The

subject deals with buying, selling, dividing and combining

various companies. It is a type of restructuring, with the aim to

grow rapidly, increase profitability and capture a greater

proportion of a market share.

The main difference between a merger and an

acquisition is that a merger is a form of legal consolidation of

two companies, which are formed into a single entity, while an

acquisition happens when one company is absorbed by another

company, which means that the company that is purchasing the

other company continues to exist. In the recent years, the

distinction between the two has become more and more

blurred, as companies have started doing joint ventures.

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Sometimes acquirer wants to keep the name of the acquired

company, as it has goodwill value attached to it.

A merger is the combination of two similarly sized companies

combined to form a new company, such as Exxon Mobil or

BBVA Compass. An acquisition occurs when one company

clearly purchases another and becomes the new owner. This

was the case with Amazon's acquisition of Whole Foods,

Google buying Motorola, or CVS purchasing Aetna.

Types of Merger

1. Congeneric/Product extension merger

Such mergers happen between companies operating in

the same market. The merger results in the addition of a new

product to the existing product line of one company. As a

result of the union, companies can access a larger customer

base and increase their market share.

In this type, it is a combining of two or more

companies that operate in the same market or sector with

overlapping factors, such as technology, marketing, production

processes, and research and development (R&D). A product

extension merger is achieved when a new product line from

one company is added to an existing product line of the other

company. When two companies become one under a product

extension, they are able to gain access to a larger group of

consumers and, thus, a larger market share. An example of a

congeneric merger is Citigroup's 1998 union with Travelers

Insurance, two companies with complementing products.

2. Conglomerate merger

Conglomerate merger is a union of companies

operating in unrelated activities. The union will take place only

if it increases the wealth of the shareholders. This is a merger

between two or more companies engaged in unrelated business

activities. The firms may operate in different industries or in

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different geographical regions. A pure conglomerate involves

two firms that have nothing in common. A mixed

conglomerate, on the other hand, takes place between

organizations that, while operating in unrelated business

activities, are actually trying to gain product or market

extensions through the merger.

Companies with no overlapping factors will only merge

if it makes sense from a shareholder wealth perspective, that is,

if the companies can create synergy, which includes enhancing

value, performance, and cost savings. A conglomerate merger

was formed when The Walt Disney Company merged with the

American Broadcasting Company (ABC) in 1995.

3. Market extension merger

This type of merger occurs between companies that sell

the same products but compete in different markets.

Companies that engage in a market extension merger seek to

gain access to a bigger market and, thus, a bigger client base.

To extend their markets, Eagle Bancshares and RBC Centura

merged in 2002. Companies operating in different markets, but

selling the same products, combine in order to access a larger

market and larger customer base.

4. Horizontal merger

A horizontal merger occurs between companies

operating in the same industry. The merger is typically part of

consolidation between two or more competitors offering the

same products or services. Such mergers are common in

industries with fewer firms, and the goal is to create a larger

business with greater market share and economies of

scale since competition among fewer companies tends to be

higher. The 1998 merger of Daimler-Benz and Chrysler is

considered a horizontal merger.

Companies operating in markets with fewer such

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businesses merge to gain a larger market. A horizontal merger

is a type of consolidation of companies selling similar products

or services. It results in the elimination of competition; hence,

economies of scale can be achieved.

5. Vertical merger

When two companies that produce parts or services for

a product merger, the union is referred to as a vertical merger.

A vertical merger occurs when two companies operating at

different levels within the same industry's supply

chain combine their operations. Such mergers are done to

increase synergies achieved through the cost reduction, which

results from merging with one or more supply companies. One

of the most well-known examples of a vertical merger took

place in 2000 when internet provider America Online (AOL)

combined with media conglomerate Time Warner.

A vertical merger occurs when companies operating in

the same industry, but at different levels in the supply chain,

merge. Such mergers happen to increase synergies, supply

chain control, and efficiency.

6. Forward Merger

It is a merger when the entity mergers itself with the

buyer. This kind of merger helps in increasing the profit of the

firm.

7. Reverse Merger

a type of merger in which private companies acquire a

public company by exchanging the majority of its shares with

a public company, thereby effectively becoming a subsidiary

of a publicly-traded company. It is also known as reverse IPO,

or Reverse Take Over (RTO)

Procedure of Merger

It involves the following steps:

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1. Examination of object clauses

The first step for the merger of companies is to

examine the object clauses. The examination of object clauses

of the memorandum of association must be conducted to check

and search if the power to amalgamate is available to form a

new company. If such clauses do not exist necessary approvals

from the Board of directors, shareholders and company law

board are required.

2. Intimation to stock exchanges

The stock exchanges where amalgamation and

amalgamated companies are listed should be informed about

amalgamation or merger proposal. From time to time, copies

of all notices, resolutions and orders should be properly

communicated in good faith as to give correct information to

the concerned stock exchanges.

3. Approval of the draft merger proposal by the respective

boards

The proposal of draft merger should be approved by the

board of directors of both the companies. It is necessary for the

board of each company to pass the resolutions giving

directions to its directors or executives to continue the matter

further.

4. Application to high courts

Once the approval of the draft merger approval is

confirmed by the respective board of directors an application

for merger and amalgamation can be filed with the tribunal or

High court of the state where its registered office is situated

.So that it convene the meetings of the respective shareholders

and creditors to pass the merger proposal.

5. Joint Application

When more than one company is involved in any type



of scheme or proposal like merger then it is the discretionary

power of the company to file a Joint Application. In practice,

the application is generally filed by the transferee company.

The Company makes an application to the National Company

Law Tribunal of relevant territorial jurisdiction

6.. Dispatch of notice to shareholders and creditors

A notice and explanatory note of the meeting approved

by the NCLT should be dispatched by each company to its

shareholders and its creditors with the purpose to call upon the

meeting in order to get 21 days in advance. The notice of the

meeting should be published at least in two newspapers. An

affidavit should also be filed with NCLT giving information

that notice has been dispatched by each company to

shareholders and creditors and that the same has been

published in two newspapers.

7. Holding of meetings of shareholders and creditors

In order to pass the scheme of merging the companies

and to work upon it a meeting of shareholders should be held

by each company in which at least 75 percent of shareholders

in each class must vote either in person or by proxy must

approve the scheme of merging the companies. In the same

way, another meeting of creditors of the company must be held

in the same manner to pass the scheme of merging the

company. Section 391(2) states that ¾ of the majority should

be passed i.e a special resolution for the approval of the

scheme of merger.

8. Petition to the High Court for confirmation and passing

of HC orders

Once the scheme of merging the companies is passed

by the shareholders and creditors then a petition has to be filed

to honourable High Court by the companies which are

involved in merging the companies for confirming the scheme

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of merging the companies. The High Court will decide a date

for the hearing. A notice has to be published in two

newspapers (one ernacular and one English) stating that the

scheme of the merger is approved. After hearing of the High

Court the parties involved in merger companies state that the

scheme is fair, reasonable and in bonafide intention, the High

Court must give its verdict approving the scheme. The High

Court is authorized to modify the scheme and pass orders

accordingly.

9. Filing the order with the registrar

A true certified copy of the High Court order must be

filed with the registrar of companies within the time specified

by the High Court.

10. Transfer of assets and liabilities

After the order is passed by the Honourable High

Court, then there would be the transfer of liabilities and assets

to the merged company which is the third company which will

be formed after merging two companies.

11. Issue of shares and debentures

Once the merged company is formed, then the shares

and debentures must be issued by the company which will be

listed on the stock exchange.

Advantages of a Merger

1. Increases market share

When companies merge, the new company gains a

larger market share and gets ahead in the competition.

2. Reduces the cost of operations

Companies can achieve economies of scale, such as

bulk buying of raw materials, which can result in cost

reductions. The investments on assets are now spread out over

a larger output, which leads to technical economies.

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3. Avoids replication

Some companies producing similar products may

merge to avoid duplication and eliminate competition. It also

results in reduced prices for the customers.

4. Expands business into new geographic areas

A company seeking to expand its business in a certain

geographical area may merge with another similar company

operating in the same area to get the business started.

5. Prevents closure of an unprofitable business

Mergers can save a company from going bankrupt and

also save many jobs.

Disadvantages of a Merger

1. Raises prices of products or services

A merger results in reduced competition and a larger

market share. Thus, the new company can gain a monopoly

and increase the prices of its products or services.

2. Creates gaps in communication

The companies that have agreed to merge may have

different cultures. It may result in a gap in communication and

affect the performance of the employees.

3. Creates unemployment

In an aggressive merger, a company may opt to

eliminate the underperforming assets of the other company. It

may result in employees losing their jobs.

4. Prevents economies of scale

In cases where there is little in common between the

companies, it may be difficult to gain synergies. Also, a bigger

company may be unable to motivate employees and achieve

the same degree of control. Thus, the new company may not be

able to achieve economies of scale.

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VALUATION UNDER MERGERS AND ACQUISITION

Investors in a company that are aiming to take over

another one must determine whether the purchase will be

beneficial to them. In order to do so, they must ask themselves

how much the company being acquired is really worth.

Naturally, both sides of a Mergers and Acquisition

[MERGERS] deal will have different ideas about the worth of

a target company: its seller will tend to value the company at

as high of a price as possible, while the buyer will try to get the

lowest price that he can. There are, however, many legitimate

ways to value companies. The most common method is to look

at comparable companies in an industry, but deal makers

employ a variety of other methods and tools when assessing a

target company. A few of them are as follows:-

1. Comparative Ratios :

The following are two examples of the many

comparative metrics on which acquiring companies may base

their offers.

i) Price-Earnings Ratio (P/E Ratio) :

With the use of this ratio, an acquiring company makes

an offer that is a multiple of the earnings of the target

company. Looking at the P/E for all the stocks within the same

industry group will give the acquiring company good guidance

for what the target‘s P/E multiple should be.

ii) Enterprise-Value-to-Sales Ratio (EV/Sales) :

With this ratio, the acquiring company makes an offer

as a multiple of the revenues, again, while being aware of the

price-to-sales ratio of other companies in the industry. The

calculation of EV-to-sales is simply the enterprise value of the

company divided by its sales.



2. Replacement Cost :

In few cases, acquisitions are based on the cost of

replacing the target company. For the sake of simplicity,

suppose the value of a company is simply the sum of all its

equipment and staffing costs. The acquiring company can

literally order the target to sell at that price, or it will create a

competitor for the same cost. Naturally, it takes a long time to

assemble good management, acquire property and get the right

equipment. But this method of establishing a price certainly

wouldn‘t make much sense in a service industry where the key

assets - people and ideas - are hard to value and develop.

3. Discounted Cash Flow (DCF) :

A key valuation tool in M&A, discounted cash flow

analysis determines a company‘s current value according to its

estimated future cash flows. Forecasted free cash flows (net

income + depreciation/amortization - capital expenditures -

change in working capital) are discounted to a present value

using the company‘s weighted average costs of capital

(WACC). Admittedly, DCF is tricky to get right, but few tools

can rival this valuation method.

In order to apply DCF technique , the following

information is required:

1. The time period for the evaluation of deal is determined. It

depends upon the period for which the benefits of merger

are expected to be available to the combined firm.

2. Secondly, the after tax cash flows (without merger) of the

acquiring firm over the evaluation period is calculated.

3. The discount rate is determined

4. The present value of the cash flows (arrived in step 2) of

the acquiring firm without merger using the discount rate

determined above is calculated.



5. Then the post merger cash flows ( after tax) of the

combined firm is calculated. The cash flows consist of the

cash flows of both merging firms and the merged firm and

reflect the benefits of synergy that accrue to the firms on

account of merger.

6. The ownership position of the shareholders of acquiring

firm in the merged firm (combined) firm is determined. For

this purpose the following model is applied:

OP =

Where,

NA= number of outstanding equity shares of firm A (the

merged/acquiring firm before merger.

NB=number of outstanding equity shares of firm B (the

merging /acquired firm) before the merger

ER= exchange ratio representing the number of shares of firm

A exchanged for every share of Firm B.

The denominator in the above model denotes the total number

of outstanding shares post –merger in the combined firm. The

numerator denotes the number of shares of the acquiring firm.

Hence, the model denotes the fraction of shares that the

shareholders of acquiring firm hold in the combined firm.

Finally, calculate NPV of the merged proposal from the point

of view of A(acquiring firm) as follows:

NPV(A) = OP[PV(CF)]-PV(A)

Where,

NPV(A)=NPV of the merger proposal from the point of view

of shareholders of

A, acquiring firm.

OP= ownership position of the shareholder of firm A in the



combined firm [CF]

PV(CF) = PV of the cash flows of the combined firm.

PV(A)= PV of the cash flows of firm (A), without the merger

Swap Ratio

A swap ratio is a ratio at which an acquiring company

will offer its own shares in exchange for the target company's

shares during a merger or acquisition. When two companies

merge or when one company acquires another, the transaction

does not have to be an outright purchase of the target

company's shares with cash. It can involve a stock conversion,

which is basically an exchange rate, described through the

swap ratio.

A swap ratio tells the shareholders of a target company

how many shares of the acquiring company's stock they will

receive for every one share of target company stock they

currently own. For example, if an acquiring company offers a

swap ratio of 2:1, it will provide two shares of its own

company for every one share of the target company. To arrive

at the appropriate swap ratio, companies analyze a variety of

financial metrics, such as book value, earnings per share,

dividends, and debt levels, as well as other factors, such as the

reasons for the merger or acquisition. The swap ratio aims to

be a purely financial metric but can waver away from a purely

financial perspective through negotiations.

Swap ratios are important because they aim to ensure

that the shareholders of the companies are not impacted by the

merger or acquisition and that the shareholders maintain the

same value as they did before, with the hopes of further growth

through the synergies of a merged company.

Divestiture

A divestiture is the partial or full disposal of a business

unit through sale, exchange, closure, or bankruptcy. A



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divestiture most commonly results from a management

decision to cease operating a business unit because it is not

part of a core competency. A divestiture may also occur if a

business unit is deemed to be redundant after a merger or

acquisition, if the disposal of a unit increases the sale value of

the firm, or if a court requires the sale of a business unit to

improve market competition.

A divestiture is the disposition or sale of an asset by a

company, a way to manage its portfolio of assets. As

companies grow, they may find they are in too many lines of

business and they must close some operational units to focus

on more profitable lines. Many conglomerates face this

problem. Companies may also sell off business lines if they are

under financial duress. For example, an automobile

manufacturer that sees a significant and prolonged drop in

competitiveness may sell off its financing division to pay for

the development of a new line of vehicles. Divested business

units may be spun off into their own companies rather than

closed in bankruptcy or a similar outcome. Companies may be

required to divest some of their assets as part of the terms of a

merger. Governments may divest some of their interests in

order to give the private sector a chance to profit.

Financial impact of Merger

Mergers and acquisitions are strategic decisions leading

to the maximization of a company‘s growth by enhancing its

production and marketing operations. They have become

popular in the recent times because of the enhanced

competition, breaking of trade barriers, free flow of capital

across countries and globalization of business as a number of

economies are being deregulated and integrated with other

economies. A number of motives are attributed for the

occurrence of mergers and acquisitions.

(i) Synergies through Consolidation : Synergy implies a

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situation where the combined firm is more valuable than the

sum of the individual combining firms. It is defined as ‗two

plus two equal to five‘ (2 + 2 = 5) phenomenon. Synergy refers

to benefits other than those related to economies of scale.

Operating economies are one form of synergy benefits. But

apart from operating economies, synergy may also arise from

enhanced managerial capabilities, creativity, innovativeness,

R&D and market coverage capacity due to the

complementarily of resources and skills and a widened horizon

of opportunities. An undervalued firm will be a target for

acquisition by other firms. However, the fundamental motive

for the acquiring firm to takeover a target firm may be the

desire to increase the wealth of the shareholders of the

acquiring firm. This is possible only if the value of the new

firm is expected to be more than the sum of individual value of

the target firm and the acquiring firm. For example, if A Ltd.

and B Ltd. Decide to merge into AB Ltd. then the merger is

beneficial if

V (AB) > V (A) +V (B)

Where

V (AB) = Value of the merged entity

V (A) = Independent value of company A

V (B) = Independent value of company B

Igor Ansoff (1998) classified four different types of synergies.

These are :

(a) Operating synergy :

The key to the existence of synergy is that the target

firm controls a specialized resource that becomes more

valuable when combined with the bidding firm‘s resources.

The sources of synergy of specialized resources will vary

depending upon the merger.



In case of horizontal merger, the synergy comes from

some form of economies of scale which reduce the cost or

from increase market power which increases profit margins

and sales. There are several ways in which the merger may

generate operating economies. The firm might be able to

reduce the cost of production by eliminating some fixed costs.

The research and development expenditures will also be

substantially reduced in the new set up by eliminating similar

research efforts and repetition of work already done by the

target firm. The management expenses may also come down

substantially as a result of corporate reconstruction. The

selling, marketing and advertisement department can be

streamlined. The marketing economies may be produced

through savings in advertising (by reducing the need to attract

each other‘s customers), and also from the advantage of

offering a more complete product line (if the merged firms

produce different but complementary goods), since a wider

product line may provide larger sales per unit of sales efforts

and per sales person. When a firm having strength in one

functional area acquires another firm with strength in a

different functional area, synergy may be gained by exploiting

the strength in these areas.

In a vertical merger, a firm may either combine with its

supplier of input (backward integration)and/or with its

customers (forward integration). Such merger facilitates better

coordination and administration of the different stages of

business stages of business operations-purchasing,

manufacturing and marketing – eliminates the need for

bargaining (with suppliers and/or customers), and minimizes

uncertainty of supply of inputs and demand for product and

saves costs of communication.

(b) Financial synergy :

Financial synergy refers to increase in the value of the



firm that accrues to the combined firm from financial factors.

There are many ways in which a merger can result into

financial synergy and benefit. A merger may help in:

• Eliminating financial constraint

• Deployment surplus cash

• Enhancing debt capacity

• Lowering the financial costs

• Better credit worthiness

Financial Constraint : A company may be constrained to

grow through internal development due to shortage of

funds. The company can grow externally by acquiring

another company by the exchange of shares and thus,

release the financing constraint.

Deployment of Surplus Cash : A different situation may

be faced by a cash rich company. It may not have enough

internal opportunities to invest its surplus cash. It may

either distribute its surplus cash to its shareholders or use it

to acquire some other company. The shareholders may not

really benefit much if surplus cash is returned to them

since they would have to pay tax at ordinary income tax

rate. Their wealth may increase through an increase in the

market value of their shares if surplus cash is used to

acquire another company. If they sell their shares, they

would pay tax at a lower, capital gains tax rate. The

company would also be enabled to keep surplus funds and

grow through acquisition.

Debt Capacity : A merger of two companies, with

fluctuating, but negatively correlated, cash flows, can bring

stability of cash flows of the combined company. The

stability of cash flows reduces the risk of insolvency and

enhances the capacity of the new entity to service a larger



amount of debt. The increased borrowing allows a higher

interest tax shield which adds to the shareholders wealth.

Financing Cost : The enhanced debt capacity of the

merged firm reduces its cost of capital. Since the

probability of insolvency is reduced due to financial

stability and increased protection to lenders, the merged

firm should be able to borrow at a lower rate of interest.

This advantage may, however, be taken off partially or

completely by increase in the shareholders risk on account

of providing better protection to lenders.Another aspect of

the financing costs is issue costs. A merged firm is able to

realize economies of scale in flotation and transaction costs

related to an issue of capital. Issue costs are saved when

the merged firm makes a larger security issue.

Better credit worthiness : This helps the company to

purchase the goods on credit, obtain bank loan and raise

capital in the market easily.RP Goenka‘s Ceat Tyres sold

off its type cord division to Shriram Fibers Ltd. in 1996

and also transfer‘s its fiber glass division to FGL Ltd.,

another group company to achieve financial synergies.

(c) Managerial synergy :

One of the potential gains of merger is an increase in

managerial effectiveness. This may occur if the existing

management team, which is performing poorly, is replaced by

a more effective management team. Often a firm, plagued with

managerial inadequacies, can gain immensely from the

superior management that is likely to emerge as a sequel to the

merger. Another allied benefit of a merger may be in the form

of greater congruence between the interests of the managers

and the shareholders. A common argument for creating a

favorable environment for mergers is that it imposes a certain

discipline on the management. If lackluster performance

renders a firm more vulnerable to potential acquisition,



existing managers will strive continually to improve their

performance.

(d) Sales synergy :

These synergies occurs when merged organization can

benefit from common distribution channels, sales

administration, advertising, sales promotion and warehousing.

The Industrial Credit and Investment Corporation of India Ltd.

(ICICI) acquired Tobaco Company, ITC Classic and Anagram

Finance to obtain quick access to a well dispersed distribution

network.

(ii) External and Internal Growth : A company may expand

and/or diversify its markets internally or externally. If the

company cannot grow internally due to lack of physical and

managerial resources, it can grow externally by combining its

operations with other companies through mergers and

acquisitions. Mergers and acquisitions may help to accelerate

the pace of a company‘s growth in a convenient and

inexpensive manner.

(iii) Market Share : A merger can increase the market share

of the merged firm. The increased concentration or market

share improves the profitability of the firm due to economies

of scale. The acquisition of Universal Luggage by Blow Plast

is an example of limiting competition to increase market

power. Before the merger, the two companies were competing

fiercely with each other leading to a severe price war and

increased marketing costs. As a result of the merger,Blow Plast

has obtained a strong hold on the market and now operates

under near monopoly situation.

(iv) Purchase of assets at bargain price : Mergers may be

explained by the opportunity to acquireassets, particularly

land, mined rights, plant and equipment at lower cost than

would be incurred if they were purchased or constructed at



current market prices. If market prices of many stocks have

been considerably below the replacement cost of the assets

they represent, expanding firm considering constructing plants

developing mines, or buying equipment.

(v) Increased external financial capability : Many mergers,

particularly those of relatively small firms into large ones,

occur when the acquired firm simply cannot finance its

operations. This situation is typical in a small growing firm

with expanding financial requirements. The firm has exhausted

its bank credit and has virtually no access to long term debt or

equity markets. Sometimes the small firms have encountered

operating difficulty and the bank has served notice that its

loans will not be renewed. In this type of situation, a large firm

with sufficient cash and credit to finance the requirements of

the smaller one probably can obtain a good situation by

making a merger proposal to the small firm. The only

alternative the small firm may have is to try to interest two or

more larger firms in proposing merger to introduce completion

into their bidding for the acquisition.

(vi) Increased managerial skills : Occasionally, a firm will

have good potential that it finds itself unable to develop fully

because of deficiencies in certain areas of management or an

absence of needed product or production technology. If the

firm cannot hire the management or develop the technology it

needs, it might combine with a compatible firm that has the

needed managerial personnel or technical expertise. Any

merger, regardless of the specific motive for it, should

contribute to the maximization of owner‘s wealth.

(vii) Reduction in tax liability : Under Income Tax Act, there

is a provision for set-off and carry forward of losses against its

future earnings for calculating its tax liability. A loss making

or sick company may not be in a position to earn sufficient

profits in future to take advantage of the carry forward



provision. If it combines with a profitable company, the

combined company can utilize the carry forward loss and save

taxes with the approval of government. In India, a profitable

company is allowed to merge with a sick company to set-off

against its profits the accumulated loss and unutilized

depreciation of that company. A number of companies in India

have merged to take advantage of this provision.

(viii) Economies of Scale : Economies of scale arise when

increase in the volume of production leads to a reduction in the

cost of production per unit. Merger may help to expand

volume of production without a corresponding increase in

fixed costs. Thus, fixed costs are distributed over a large

volume of production causing the unit cost of production to

decline. Economies of scale may also arise from other

indivisibilities such as production facilities, management

functions and management resources and systems. This

happens because a given function, facility or resource is

utilized for a large scale of operation.

Other Impacts

Impacts on Employees

Mergers and acquisitions may have great economic

impact on the employees of the organization. In fact, mergers

and acquisitions could be pretty difficult for the employees as

there could always be the possibility of layoffs after any

merger or acquisition. If the merged company is pretty

sufficient in terms of business capabilities, it doesn't need the

same amount of employees that it previously had to do the

same amount of business. As a result, layoffs are quite

inevitable. Besides, those who are working, would also see

some changes in the corporate culture. Due to the changes in

the operating environment and business procedures, employees

may also suffer from emotional and physical problems.



Impact on Management

The percentage of job loss may be higher in the

management level than the general employees. The reason

behind this is the corporate culture clash. Due to change in

corporate culture of the organization, many managerial level

professionals, on behalf of their superiors, need to implement

the corporate policies that they might not agree with. It

involves high level of stress.

Impact on Shareholders

Impact of mergers and acquisitions also include some

economic impact on the shareholders. If it is a purchase, the

shareholders of the acquired company get highly benefited

from the acquisition as the acquiring company pays a hefty

amount for the acquisition. On the other hand, the shareholders

of the acquiring company suffer some losses after the

acquisition due to the acquisition premium and augmented

debt load.

Impact on Competition

Mergers and acquisitions have different impact as far

as market competitions are concerned. Different industry has

different level of competitions after the mergers and

acquisitions. For example, the competition in the financial

services industry is relatively constant. On the other hand,

change of powers can also be observed among the market

players.

Dilution

Dilution occurs when a company issues new shares that

result in a decrease in existing stockholders' ownership

percentage of that company. When a company issues

additional shares of stock, it can reduce the value of existing

investors' shares and their proportional ownership of the

company. This common problem is called dilution. It is a risk

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that investors must be aware of as shareholders and they need

to take a closer look at how dilution happens and how it can

affect the value of their shares.

Merger and dilution effect on EPS.

Normally, the primary goal of a merger model is to find

out if the acquiring company can increase its EPS after the deal

goes through There are many reasons why EPS might go up

after an M&A deal. The synergy between the two firms might

result in increased economies of scale or scope. The target

company's capital or research and development tools may lead

to future gains in productivity or revenue generation. In any

case, the financial analysts are looking for a sum value that is

greater than the individual components. Generally acquisition

will increase the acquiring company's earnings per share

(EPS). Accretive acquisitions tend to be favorable for the

company's market price because the price paid by the acquiring

firm is lower than the boost that the new acquisition is

expected to provide to the acquiring company's EPS. A

momentary increase in EPS does not necessarily mean that the

deal will be a long-term success.

Due to dilution the reduction in shareholders' equity

positions through the issuance or creation of new shares.

Dilution also reduces a company's earnings per share (EPS),

which can have a negative impact on share prices. Dilution can

occur when a firm raises additional equity capital, though

existing shareholders are usually disadvantaged.

Merger and dilution effect on business control

When merger and acquisition occurs the shareholders

of both companies may experience a dilution of voting power

due to the increased number of shares released during the

merger process. This phenomenon is prominent in stock-for-

stock mergers, when the new company offers its shares in


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exchange for shares in the target company, at an agreed-

upon conversion rate. Shareholders of the acquiring company

experience a marginal loss of voting power, while shareholders

of a smaller target company may see a significant erosion of

their voting powers in the relatively larger pool of

stakeholders.

It also reduces the voting power of the shareholders.

With the increase in the number of shares, each existing

shareholder owns a smaller percentage of the company,

resulting in a decrease in the value of each share. For example,

assume that a company issues 200 shares to 200 independent

shareholders, with each shareholder having 1% ownership in

the company. If the company issues 200 more shares to 200

other shareholders, the ownership of each shareholder reduces

to 0.5%.

Illustration :1

Company X is considering the purchase of company Y.

The following are the financial data of the two companies:

Company X Company Y

Number of Shares 4,00,000 1,00,000

Earnings per Share (EPS) ì 6.00 ì 4.50

Market Value Per Share ì 30.00 ì 20.00

Assuming that the management of the two companies has

agreed to exchange shares in proportion to:

(i) The relative earnings per share of the two firms;

(ii) 4 shares of company X for every 5 shares held in company

Y.

You are required to illustrate and comment on the impact of

merger on the EPS.

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Solution:

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Comments:

When the exchange ratio is 4:5, the impact of merger

on EPS is dilution of Rs. 0.063 per share on the earnings per

share for the shareholders of the acquiring company and

accretion in the EPS of the acquired firm amounting to

Rs.0.312 per share. However, for a more reliable analysis of

the impact of merger on EPS, the growth rate of the two

companies should also have been considered.

Illustration :2

Sunny Lamps Ltd. is taking over Moon Lamps Ltd. As

per the understanding between the managements of the two

companies, shareholders of Moon Lamps Ltd. would receive

0.7 shares of Sunny Lamps Ltd. for each share held by them.

The relevant data for the two companies are as follows:

Ignoring the economies of scale and the operating synergy,

you are required to calculate:

(i) Premium paid by Sunny Lamps Ltd., to the shareholders of

Moon Lamps Ltd,

(ii) Number of shares after the merger;

(iii) Combined EPS;

(iv) Combined P/E ratio;

(v) Market value per share; and

(vi) Total market capitalisation after the merger.




Solution:

Illustration: 3

XYZ Ltd. is considering merger with ABC Ltd. XYZ

Ltd.‘s shares are currently traded at Rs. 25. It has 2,00,000

shares outstanding and its profits after taxes (PAT) amount to

Rs. Rs. 4,00,000. ABC Ltd. has 1,00,000 shares outstanding.

Its current market price is Rs. 12.50 and its PAT are Rs.

1,00,000. The merger will be effected by means of a stock





swap (exchange). ABC Ltd. has agreed to a plan under which

XYZ Ltd. will offer the current market value of ABC Ltd.‘s

shares:

(i) What is the pre-merger earnings per share (EPS) and P/E

ratios of both the companies?

(ii) If ABC Ltd.‘s P/E ratio is 8, what is its current market

price? What is the exchange ratio? What will XYZ Ltd.‘s

post-merger EPS be?

(iii) What must the exchange ratio be for XYZ Ltd.‘s that pre

and post-merger EPS to be the same?

Solution:

(i) Pre-merger EPS and P/E ratios of XYZ Ltd. and ABC Ltd.

Particulars XYZ Ltd.. ABC Ltd.

Profits after taxes

Number of shares outstanding

EPS (Earnings after tax/No. of

shares)

Market price per share

P/E Ratio (times)

4,00,000

2,00,000

2

23.00

12.50

1,00,000

1,00,000

1

12.50

12.50

(ii) Current market price of ABC Ltd., if P/E ratio is 8 = Rs. 1

× 8 = Rs. 8

Exchange ratio = Rs. 25/8 = 3.125

Post merger EPS of XYZ Ltd.=

=216

(iii) Desired exchange ratio

Total number of shares in post-merged company

=

. = 5,00,000/2 = 2,50,000



Number of shares required to be issued = 2,50,000 – 200,000

= 50,000

Therefore, the exchange ratio is = 50,000/ 1,00,000 = 0.50

Illustration: 4

The following information is provided related to the acquiring

firm M Limited and the target firm N Limited :

Particulars M Ltd; N Lmtd;

Profits after tax (PAT)

Number of shares

Outstanding P/E ratio

(times)

Rs. 2,000 lakhs

200 lakhs

10

Rs. 400 lakhs

100 lakhs

5

Calculate:

(i) What is the swap ratio based on current market price?

(ii) What is the EPS of Mark Limited after acquisition?

(iii) What is the expected market price per share of Mark

Limited after acquisition, assuming P/E ratio of Mark

Limited remains unchanged?

(iv) Determine the market value of the merged firm.

(v) Calculate gain/loss for shareholders of the two

independent companies after acquisition.

Solution:

EPS before acquisition

M Ltd. = Rs. 2,000 lakhs/200 lakhs = Rs.10

N Ltd. = Rs. 400 lakhs/100 lakhs = Rs. 4

Market price of share before an acquisition = EPS × P.E. ratio

M Ltd. = Rs. 10 × 10 = Rs. 100

N Ltd. = Rs. 4 × 5 = Rs. 20



(i) Swap Ratio based on Current Market Prices= Rs. 20/Rs.

100 = 0.2 i.e. 1 share of M Ltd. for 5 shares of N Ltd.

Number of shares to be issued = 100 lakhs × 0.20 = 20 lakhs

(ii) EPS after Acquisition =

= Rs. 10.91

(iii) Expected market price per share of M Ltd. after an

acquisition after assuming P/E ratio of M

Ltd. remains unchanged = Rs. 10.91 × 10 = Rs. 109.10

(iv) Market Value of Merged Firm = Rs. 109.10 × 220 lakh

shares = Rs. 240.02 crores

(v) Gain from the Merger (Rs. Crores)

Post-merger market value of merged firm

Less : Pre-merger market value:

M Ltd. 200 lakhs × Rs. 100 = 200 crores

N Ltd. 100 lakhs × Rs. 20 = 20 crores

Gain from merger .

240.02

220.00

20.02

Gain to shareholders of M Ltd. and N Ltd. (Rs. Crores)

Particulars M Ltd. N Ltd

Post-merger value

Less: Pre-merger

value

Gain to shareholders

218.20

200.00

18.20

21.82

20.00

1.82

Review questions:

Short questions:

1. What is Merger?



2. Explain Horizontal merger.

3. What is vertical merger ?

4. What is Conglomerate merger ?

5. What is Congeneric merger ?

6. What is Forward merger ?

7. Explain Swap ratio.

8. What do you meant by Divestiture?

9. What is Dilution ?

Short essay questions:

10. Explain different type of merger.

11. Write a note about the procedure of merger.

12. What are the advantages of merger ?

13. Explain impact of merger and acquisition.

14. Discuss merger and dilution effect of merger.

15. How merger and dilution effect on business control?

Long essay questions:

16. Define merger. Explain briefly its types and procedures.

17. Explain impact of merger on various aspects of an

organisation.

Practical problems:

1. A Ltd. is intending to acquire X Ltd. by merger and the

following information is available in respect of the companies :

Particulars A Ltd B Ltd

Number of equity shares

Earnings after tax (Rs.)

Market value per share (Rs.)

1000000

5000000

42

600000

1800000

28



Calculate :

(i) What is the present EPS of both the companies?

(ii) If the proposed merger takes place, what would be the

new earning per share of A Ltd. ? Assume that the merger

takes place by exchange of equity shares and the exchange

ratio is based on the current market price.

[Answer : EPS A &b - Rs.5&Rs.3, EPS after merger Rs.4.86]

2. Company X is contemplating the purchase of Company Y,

Company X has 3,00,000 shares having a market price of Rs.

30 per share, while Company Y has 2,00,000 shares selling at

Rs. 20 per share. The EPS are Rs. 4.00 and Rs. 2.25 for

Company X and Y respectively. Managements of both

companies are discussing two alternative proposals for

exchange of shares as indicated below :

(i) in proportion to the relative earnings per share of two

Companies.

(ii) 5 share of Company X for one share of company Y (5 : 1).

You are required : (i) to calculate the Earnings Per Share (EPS)

after merger under two alternatives; and (ii) to show the impact

on EPS for the shareholders of two companies under both

alternatives

[Answer : X Ltd before &after merger Rs.4 and Y Ltd Rs.

2.25(before) and 4(after) EPS when share exchange ratio 5:1

is Rs. 4.125, impact on shareholder increase EPS X Ltd and

decrease EPS of Y Ltd].



MODULE – V

TAKEOVER STRATEGY

Modern markets demand that operating businesses are

well endowed with abilities to effectively outperform

competing businesses. A successful business, at least from the

perspective of the modern market, must be marked by efficient

production, effective marketing and high sales and turnovers.

However, it is quite challenging to ensure that a business has

all these abilities without proper investment. Therefore,

businesses usually opt to take over other businesses in order to

facilitate the efficiency with which they produce, the

effectiveness with which they market their products and

services and to increase their sales and turnovers.

Logically, taking over another business comes with the

opportunity of increasing the abilities of the business.

Takeovers come with ready alternative measures that can be

used to sort out some management or business issues that

previously hampered the attainment of the maximum potential

of the acquiring company. The additional abilities of the

acquired business can be used to enhance those of the

acquiring business. The additional departments and sections

availed by the acquired firm should offer the acquiring firm

some additional space to effectively manage and utilize

management resources in order to enhance the abilities of the

acquiring business.

Mergers and takeovers (or acquisitions) are very

similar corporate actions. They combine two previously

separate firms into a single legal entity. Significant operational

advantages can be obtained when two firms are combined and,

in fact, the goal of most mergers and acquisitions is to improve

company performance and shareholder value over the long-

term.

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Meaning of Takeover

A takeover, or acquisition, is usually the purchase of a

smaller company by a larger one. It can produce the same

benefits as a merger, but it doesn't have to be a mutual

decision.

A takeover occurs when one company makes a

successful bid to assume control of or acquire another.

Takeovers can be done by purchasing a majority stake in the

target firm. Takeovers are also commonly done through

the merger and acquisition process. In a takeover, the company

making the bid is the acquirer and the company it wishes to

take control of is called the target.

Takeovers are typically initiated by a larger company

seeking to take over a smaller one. They can be voluntary,

meaning they are the result of a mutual decision between the

two companies. In other cases, they may be unwelcome, in

which case the acquirer goes after the target without its

knowledge or some times without its full agreement.

In corporate finance, there can be a variety of ways for

structuring a takeover. An acquirer may choose to take

over controlling interest of the company‘s outstanding shares,

buy the entire company outright, merge an acquired company

to create new synergies, or acquire the company as a

subsidiary

Types of takeovers

Friendly takeover

Under this takeover the acquirer purchases

a controlling interest in the target only after rounds of

negotiations and a final agreement with the latter. The bid is

finalized based on the approval of the majority shareholders.

As the name suggests, a friendly takeover occurs when


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the target company is happy about the arrangement. In other

words, its directors and shareholders have approved the offer.

The bidder tells the target‘s board of directors about its

intention and makes an offer. The board then advises its

shareholders to accept the offer. Subsequently, the friendly

takeover goes ahead.

A welcome or friendly takeover will usually be

structured as a merger or acquisition. These generally go

smoothly because the boards of directors for both companies

usually consider it a positive situation. Voting must still take

place in a friendly takeover. However, when the board of

directors and key shareholders are in favor of the takeover,

takeover voting can more easily be achieved.

Hostile takeover

An unwelcome or hostile takeover can be quite

aggressive as one party is not a willing participant. The

acquiring firm can use unfavorable tactics such as a dawn raid,

where it buys a substantial stake in the target company as soon

as the markets open, causing the target to lose control before it

realizes what is happening.

The target firm‘s management and board of directors

may strongly resist takeover attempts by implementing tactics

such as a poison pill, which allows the target‘s shareholders to

purchase more shares at a discount to dilute the potential

acquirer‘s holdings and voting rights.

In a hostile takeover situation, the target company does

not want the bidder to acquire it. This can only really happen

in a publicly-listed company because the directors are not

typically majority shareholders. The bidder does not back

always off if the board of a publicly-listed company rejects the

offer. If the bidder still pursues the acquisition, it becomes a

hostile takeover situation. Sometimes there may also be a

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hostile takeover situation if the bidder announces its firm

intention to make an offer, and then immediately makes the

offer directly – thus, not giving the board time to get

organized. If the bidder can divide board and or shareholder

opinion, it has a better chance of succeeding. There are five

different ways that a hostile takeover situation can play out.

Bailout Takeover:

A bailout takeover refers to a scenario where the

government or a financially stable company takes over control

of a weak company with the goal of helping the latter regain its

financial strength. The goal of the bailout takeover is to help

turn around the operations of the company without liquidating

its assets. The acquiring entity achieves this by developing a

rescue plan and appointing a manager to spearhead the

recovery while protecting the interests of the investors

and shareholders.

This is intended to bail out the sick companies and

allow them to rehabilitate as per official schemes approved by

the leading financial institution.

Reverse Takeover:

A reverse takeover happens when a private company

takes over a public one. The acquiring company must have

enough capital to fund the takeover. Reverse takeovers provide

a way for a private company to go public without having to

take on the risk or added expense of going through an initial

public offering (IPO).

Horizontal takeover: of one company by another company in

the same industry. The main purpose behind this kind of

takeover is achieving the economies of scale of increasing the

market share. Example takeover of Hutch by Vodafone.

Vertical takeover: Takeover by one company with its

suppliers or customers. The former is known as Backward


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integration and later is known as forward integration- takeover

of Sona Steering Ltd by Maruti Udyog Ltd. is a backward

takeover. The main purpose behind this kind of takeover is

reduction in costs.

Conglomerate takeover: Takeover of one company operating

in totally different industries. The main purpose of this kind of

takeover is diversification.

Backflip Takeover: A backflip takeover bid occurs when the

acquirer becomes the subsidiary of the target company. The

takeover is termed a ―backflip‖ due to the fact that the target

company is the surviving entity and the acquiring company

becomes the subsidiary of the merged company. A common

motive behind a backflip takeover offer is for the acquiring

company to take advantage of the target‘s stronger brand

recognition or some other significant marketplace edge.

This acquirer turns itself into a subsidiary of the target

company to retain the brand name of the smaller yet well-

known company. In this way, the larger acquirer can operate

under a well-established brand and gain its market share.

Creeping takeover

This takeover occurs when one company slowly

increases its share ownership in another. Once the share

ownership gets to 50% or more, the acquiring company is

required to account for the target‘s business through

consolidated financial statement reporting. The 50% level can

thus be a significant threshold, particularly since some

companies may not want the responsibilities of controlling

ownership. After the 50% threshold has been breached, the

target company should be considered a subsidiary.

TAKEOVER PROCEDURES

The law relating to takeovers is contained in both the

Companies Act, 2013 and the Securities and Exchange Board

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of India Regulations, 2011 (SEBI Takeover Code). Securities

and Exchange Board of India (substantial acquisition of shares

and Takeovers) Regulations, 2011 is the primary piece of Law

which regulates Takeovers of Listed Companies in India

The Companies Act, 2013 deals with the power of a

company to acquire shares of another company, generally

(section 186), and specifically, in relation to acquiring from

persons who did not sell or have not agreed to sell shares held

by them, notwithstanding approval of the scheme or contract

for acquisition of the shares by shareholders owning 90% and

over of the shares (sections 235 and 236). The company being

acquired could be either a public quoted company or a private

limited company.

The takeover procedures are as follows:

1. Appointment of a merchant banker:

Before making any public announcement of offer

referred to in regulation 10 or regulation 11 or regulation 12,

the acquirer shall appoint a merchant banker in Category I

holding a certificate of registration granted by the Board, who

is not an associate of or group of the acquirer or the target

company

2. Public Announcement :

A public announcement is an announcement made in

the newspapers by the acquirer primarily disclosing his

intention to acquire shares of the target company from existing

shareholders by means of an open offer for not less than 20%

of shares. Public Announcement is made to ensure that the

shareholders of the target company are aware of an exit

opportunity available to them.

The disclosures in the announcement include:-

The offer price, number of shares to be acquired from the

public,



Identity of acquirer,

Purpose of acquisition,

Future plans of acquirer, if any, regarding the target

company,

Change in control over the target company, if any,

The procedure to be followed by acquirer in accepting the

shares tendered by the shareholders and

The period within which all the formalities pertaining to

the offer would be completed.

3. No misleading information :

The public announcement of the offer or any other

advertisement, circular, brochure, publicity material or letter of

offer issued in relation to the acquisition of shares shall not

contain any misleading information.

4. Timing of the public announcement of offer :

The acquirer is required to make the P.A within four

working days of the entering into an agreement to acquire

shares or deciding to acquire shares/ voting rights of target

company or after any such change or changes as would result

in change in control over the target company.

In case of indirect acquisition or change in control, the

PA shall be made by the acquirer within three months of

consummation of such acquisition or change in control or

restructuring of the parent or the company holding shares of or

control over the target company in India.

5. Escrow Account :

Before making the Public Announcement, the acquirer

has to open an escrow account in the form of cash deposited

with a scheduled commercial bank or bank guarantee in favour

of the Merchant Banker or deposit of acceptable securities with



appropriate margin with the Merchant Banker. The Merchant

Banker is also required to confirm that firm financial

arrangements are in place for fulfilling the offer obligations.

The escrow amount shall be 25% of the consideration if offer

size is less than Rs. 100 cr. and 10% for excess of

consideration above Rs. 100 cr.

6. Letter of offer :

A draft letter of offer is required to be filed with SEBI

within 14 days from the date of Public Announcement. The

following also need to file along with the draft:-

1. A filing fee of Rs.50,000/- per letter of offer (payable by

Cheque / Demand Draft)

2. A due diligence certificate

3. Registration details

The letter of offer shall be despatched to the

shareholders not earlier than 21 days from its submission to the

Board.

7. Specified date:

The public announcement shall specify a date, which

shall be the specified date for the purpose of determining the

names of the shareholders to whom the letter of offer should be

sent: However such specified date shall not be later than the

thirtieth day from the date of the public announcement.

8. Minimum Offer Price and Payments made :

It is not the duty of SEBI to approve the offer price,

however it ensures that all the relevant parameters are taken in

to consideration for fixing the offer price and that the

justification for the same is disclosed in the offer document.

The offer price shall be the highest of:-

1. Negotiated price under the agreement.



2. Price paid by the acquirer or PAC with him for acquisition if

any, including by way of public rights/ preferential issue

during the 26-week period prior to the date of the PA. -

Average of weekly high & low of the closing prices of shares

as quoted on the Stock exchanges, where shares of Target

company are most frequently traded during 26 weeks prior to

the date of the Public Announcement

3. In case the shares of target company are not frequently

traded, then the offer price shall be determined by reliance on

the parameters, like: the negotiated price under the agreement,

highest price paid by the acquirer or PAC

4. Acquirers are required to complete the payment of

consideration to shareholders who have accepted the offer

within 30 days from the date of closure of the offer.

5. In case the delay in payment is on account of non-receipt of

statutory approvals and if the same is not due to willful default

or neglect on part of the acquirer, the acquirers would be liable

to pay interest to the shareholders for the delayed period in

accordance with Regulations. Acquirer(s) are however not to

be made accountable for postal delays.

If the delay in payment of consideration is not due to

the above reasons, it would be treated as a violation of the

Regulations.

9. Safeguards incorporated so as to ensure that the

Shareholders get their payments:

The regulations provide for opening of escrow account. In

case, the acquirer fails to make payment, Merchant Banker has

a right to forfeit the escrow account and distribute the proceeds

in the following way.

1/3 of amount to target company

1/3 to regional Stock Exchanges, for credit to investor

protection fund etc.



1/3 to be distributed on pro rata basis among the shareholders

who have accepted the offer.

10. General obligations of the acquirer :

The public announcement of an offer to acquire the shares of

the target company shall be made only when the acquirer is

able to implement the offer.

-- Within 14 days of the public announcement of the offer, the

acquirer shall send a copy of the draft letter of offer to the

target company at its registered office address, for being placed

before the board of directors and to all the stock exchanges

where the shares of the company are listed.

--The acquirer shall ensure that the letter of offer is sent to all

the shareholders (including non-resident Indians) of the target

company, whose names appear on the register of members of

the company as on the specified date mentioned in the public

announcement, so as to reach them within 45 days from the

date of public announcement.

-- The date of opening of the offer shall be not later than the

[fifty fifth] day from the date of public announcement.

-- The offer to acquire shares from the shareholders shall

remain open for a period of 20 days.

11. Revision of offer :

The acquirer who has made the public announcement

of offer may make upward revisions in his offer in respect of

the price and the number of shares to be acquired, at any time

up to seven working days prior to the date of the closure of the

offer. However such upward revision of offer shall be made

only upon ;

(a) making a public announcement in respect of such changes

or amendments in all the newspapers in which the original

public announcement was made;



(b) simultaneously with the issue of such public

announcement, informing the Board, all the stock exchanges

on which the shares of the company are listed, and the target

company at its registered office;

(c) increasing the value of the escrow account as provided

under sub-regulation (9) of regulation 28.

12. Withdrawal of offer :

The offer once made cannot be withdrawn except in the

following circumstances:

-- Statutory approval(s) required have been refused

-- The sole acquirer being a natural person has died

--Such circumstances as in the opinion of the Board merits

withdrawal.

13. Exemptions :

The following transactions are however exempted from

making an offer and are not required to be reported to SEBI:

1. Allotment to underwriter pursuant to any underwriting

agreement;

2. Acquisition of shares in ordinary course of business by;

3. Regd. Stock brokers on behalf of clients;

4. Regd. Market makers;

5. Public financial institutions on their own account;

6 . Banks & FIs as pledges

7. Acquisition of shares by way of transmission on

succession or by inheritance;

8. Acquisition of shares by Govt. companies;

9. Acquisition pursuant to a scheme framed under section 18

of SICA 1985; of arrangement/ restructuring including



amalgamation or merger or de-merger under any law or

Regulation Indian or Foreign;

10. Acquisition of shares in companies whose shares are not

listed;

11. However, if by virtue of acquisition of shares of unlisted

company, the acquirer acquires shares or voting rights

(over the limits specified) in the listed company, acquirer

is required to make an open offer in accordance with the

Regulations.

14. Penalties :

The Regulations have laid down the general obligations

of acquirer, target company and the Merchant Banker. For

failure to carry out these obligations as well as for failure / non

compliance of other provisions of the Regulations, the

Regulations have laid down the penalties for non compliance.

These penalties may be

a) forfeiture of the escrow account,

b) directing the person concerned to sell the shares acquired

in violation of the regulations,

c) directing the person concerned not to further deal in

securities,

d) levy monetary penalties,etc.

e) directing transfer of any proceeds or securities to the

Investors Protection Fund of a recognised stock

exchange;

Reasons for Undertaking Takeovers

There are many reasons why a firm may decide to

undertake a takeover as part of its strategy, including to

Increase market share



Acquire new skills

Access economies of scale

Secure better distribution

Acquire intangible assets (brands, patents, trade marks)

Spread risks by diversifying

Overcome barriers to entry to target markets

Defend itself against a takeover threat

Enter new segments of an existing market

Eliminate competition

IMPORTANT PROVISIONS AND IMPLICATIONS OF

SEBI NEW CODE, 2011

The Securities and Exchange Board of India (―SEBI‖)

had been mulling over reviewing and amending the existing

SEBI (Substantial Acquisition of Shares and Takeovers)

Regulations, 1997 (―Takeover Code of 1997‖) for quite some

time now. A Takeover Regulations Advisory Committee was

constituted under the chairmanship of Mr. C. Achuthan

(―Achuthan Committee‖) in September 2009 to review the

Takeover Code of 1997 and give its suggestions.

The Achuthan Committee provided its suggestions in

its report which was submitted to SEBI in July 2010. After

taking into account the suggestions of the Achuthan

Committee and feedback from the interest groups and general

public on such suggestions, the SEBI finally notified the SEBI

(Substantial Acquisitionof Shares and Takeovers) Regulations,

2011 (―Takeover Code of 2011‖) on 23 September 2011. The

Takeover Code of 2011 will be effective from 22 October

2011. The Takeover Code of 2011 adheres to the framework

and principles of the Takeover Code of 1997 but the changes it



brings about are significant. Some of the most important

amendments are discussed below:

1. Initial Threshold Limit for Triggering of an Open Offer:

Under the Takeover Code of 1997, an acquirer was

mandated to make an open offer if he, alone or through

persons acting in concert, were acquiring 15% or more of

voting right in the target company. This threshold of 15% has

been increased to 25% under the New Takeover Code of 2011.

Therefore, now the strategic investors, including private equity

funds and minority foreign investors, will be able to increase

their shareholding in listed companies up to 24.99% and will

have greater say in the management of the company. An

acquirer holding 24.99% shares will have a better chance to

block any decision of the company which requires a special

resolution to be passed. The promoters of listed companies

with low shareholding will undoubtedly be concerned about

any acquirer misutilising it.

However, at the same time, this will help the listed

companies to get more investments without triggering the open

offer requirement as early as 15%, therefore making the

process more attractive and cost effective.

2. Creeping acquisition :

The Takeover Code of 1997 recognised creeping

acquisition at two levels from 15% to 55% and from 55% to

the maximum permissible limit of 75%. Acquirers holding

from 15% to 55% shares were allowed to purchase additional

shares or voting rights of up to 5% per financial year without

making a public announcement of an open offer. Acquirers

holding from 55% to 75% shares were required to make such

public announcement for any additional purchase of shares.

However, in the latter case, up to 5% additional shares could

be purchased without making a public announcement if the



acquisition was made through open market purchase on stock

exchanges or due to buyback of shares by the listed company.

The Takeover Code of 2011 makes the position

simpler. Now, any acquirer, holding more 25% or more but

less than the maximum permissible limit can purchase

additional shares or voting rights of up to 5% every financial

year, without requiring making a public announcement for

open offer. The Takeover Code of 2011, also lays down the

manner of determination of the quantum of acquisition of such

additional voting rights. This would be beneficial for the

investors as well as the promoters, and more so for the latter,

who can increase their shareholding in the company without

necessarily purchasing shares from the stock market.

3. Indirect acquisition:

The Takeover Code of 2011, clearly lays down a

structure to deal with indirect acquisition, an issue which was

not adequately dealt with in the earlier version of the Takeover

Code. Simplistically put, it states that any acquisition of share

or control over a company that would enable a person and

persons acting in concert with him to exercise such percentage

of voting rights or control over the company which would have

otherwise necessitated a public announcement for open offer,

shall be considered an indirect acquisition of voting rights or

control of the company.

It also states that wherever,

(a) the proportionate net asset value of the target company as a

percentage of the consolidated net asset value of the entity or

business being acquired;

(b) the proportionate sales turnover of the target company as a

percentage of the consolidated sales turnover of the entity or

business being acquired; or



(c) the proportionate market capitalisation of the target

company as a percentage of the enterprise value for the entity

or business being acquired; is more than 80% on the basis of

the latest audited annual financial statements, such indirect

acquisition shall be regarded as a direct acquisition of the

target company and all the obligations relating to timing,

pricing and other compliance requirements for the open offer

would be same as that of a direct acquisition.

4. Voluntary Offer:

A concept of voluntary offer has been introduced in the

Takeover Code of 2011, by which an acquirer who holds more

than 25% but less than the maximum permissible limit, shall

be entitled to voluntarily make a public announcement of an

open offer for acquiring additional shares subject to their

aggregate shareholding after completion of the open offer not

exceeding the maximum permissible non-public shareholding.

Such voluntary offer would be for acquisition of at least such

number of shares as would entitle the acquirer to exercise an

additional 10% of the total shares of the target company. This

would facilitate the substantial shareholders and promoters to

consolidate their shareholding in a company.

5. Size of the Open Offer

The Takeover Code of 1997, required an acquirer,

obligated to make an open offer, to offer for a minimum of

20% of the ‗voting capital of the target company‘ as on

‗expiration of 15 days after the closure of the public offer‘. The

Takeover Code of 2011, now mandates an acquirer to place an

offer for at least 26% of the ‗total shares of the target

company‘, as on the ‗10th working day from the closure of the

tendering period‘.

The increase in the size of the open offer from 20% to

26%, along with increase in the initial threshold from 15% to



25%, creates a unique situation under the Takeover Code of

2011. An acquirer with 15% shareholding and increasing it by

another 20% through an open offer would have only got a 35%

shareholding in the target company under the Takeover Code

of 1997. However, now an acquirer with a 25% shareholding

and increasing it by another 26% through the open offer under

the Takeover Code of 2011, can accrue 51% shareholding and

thereby attain simple majority in the target company.

These well thought out figures clearly shows the

intention of the regulator to incentivize investors acquiring

stakes in a company by giving them an opportunity of attaining

simple majority in a company.

6. Important exemptions from the requirement of open

offer:

Inter-se transfer - The Takeover Code of 1997 used to

recognize inter se transfer of shares amongst the following

groups –

(a) group coming within the definition of group as defined in

the Monopolies and Restrictive Trade Practices Act, 1969

(b) relatives within the meaning of section 2(77) of the

Companies Act, 2013

(c) Qualifying Indian promoters and foreign collaborators who

are shareholders, etc.

The catagorisation of such groups have been amended in the

Takeover Code of 2011 and transfer between the following

qualifying persons has been termed as inter se transfer:

(a) Immediate relatives

(b) Promoters, as evidenced by the shareholding pattern filed

by the target company not less than three years prior to the

proposed acquisition

(c) a company, its subsidiaries, its holding company, other



subsidiaries of such holding company, persons holding not less

than 50% of the equity shares of such company, etc.

(d) persons acting in concert for not less than three years prior

to the proposed acquisition, and disclosed as such pursuant to

filings under the listing agreement.

To avail exemption from the requirements of open offer under

the Takeover Code of 2011, the following conditions will have

to be fulfilled with respect to an inter se transfer:

If the shares of the target company are frequently traded – the

acquisition price per share shall not be higher by more than

25% of the volume-weighted average market price for a period

of 60 trading days preceding the date of issuance of notice for

such inter-se transfer – If the shares of the target company are

infrequently traded, the acquisition price shall not be higher by

more than 25% of the price determined by taking into account

valuation parameters including, book value, comparable

trading multiples, etc.

Rights issue – The Takeover Code of 2011 continues to

provide exemption from the requirement of open offer to

increase in shareholding due to rights issue, but subject to

fulfilment of two conditions:

(a) The acquirer cannot renounce its entitlements under such

rights issue; and

(b) The price at which rights issue is made cannot be higher

than the price of the target company prior to such rights issue.

Scheme of arrangement – The Takeover Code of 1997 had a

blanket exemption on the requirement of making an open offer

during acquisition of shares or control through a scheme of

arrangement or reconstruction. However, the Takeover Code

of 2011 makes a distinction between where the target company

itself is a transferor or a transferee company in such a scheme

and where the target company itself is not a party to the



scheme but is getting affected nevertheless due to involvement

of the parent shareholders of the target company. In the latter

case, exemption from the requirement of making an open offer

would only be provided if

(a) the cash component is 25% or less of the total consideration

paid under the scheme, and

(b) post restructuring, the persons holding the entire voting

rights before the scheme will have to continue to hold 33% or

more voting rights of the combined entity.

Buyback of shares – The Takeover Code of 1997 did not

provide for any exemption for increase in voting rights of a

shareholder due to buybacks. The Takeover Code of 2011

however provides for exemption for such increase. In a

situation where the acquirer‘s initial shareholding was less

than 25% and exceeded the 25% threshold, thereby

necessitating an open offer, as a consequence of the buyback,

The Takeover Code of 2011 provides a period of 90 days

during which the acquirer may dilute his stake below 25%

without requiring an open offer.

Whereas, an acquirer‘s initial shareholding was more than 25%

and the increase in shareholding due to buyback is beyond the

permissible creeping acquisition limit of 5% per financial year,

the acquirer can still get an exemption from making an open

offer, subject to the following:

(a) such acquirer had not voted in favour of the resolution

authorising the buyback of securities under section 77A of

the Companies Act, 1956;

(b) in the case of a shareholder resolution, voting was by way

of postal ballot;

(c) the increase in voting rights did not result in an acquisition

of control by such acquirer over the target company .In case

the above conditions are not fulfilled, the acquirer may, within



90 days from the date of increase, dilute his stake so that his

voting rights fall below the threshold which would require an

open offer.

7. Other important changes

Following are few other important amendments that

have been brought about in the Takeover Code of 2011:

Definition of ‗share‘ – The Takeover Code of 1997 excluded

‗preference shares‘ from the definition of ‗shares‘ vide an

amendment of 2002. However, this exclusion has been

removed in the Takeover Code of 2011 and therefore now

‗shares‘ would include, without any restriction, any security

which entitles the holder to voting rights.

Non-compete fees– As per the Takeover Code of 1997, any

payment made to the promoters of a target company up to a

maximum limit of 25% of the offer price was exempted from

being taken into account while calculating the offer price.

However, as per the Takeover Code of 2011, price paid for

shares of a company shall include any price for the shares /

voting rights / control over the company, whether stated in the

agreement or any incidental agreement, and includes ‗control

premium‘, ‗non-compete fees‘, etc.

Responsibility of the board of directors and independent

directors – The general obligations of the board of directors of

a target company under the Takeover Code of 1997 had given

a discretionary option to the board to send their

recommendations on the open offer to the shareholders and for

the purpose the board could seek the opinion of an independent

merchant banker or a committee of independent directors.

The Takeover Code of 2011, however, makes it mandatory for

the board of directors of the target company to constitute a

committee of independent directors (who are entitled to seek

external professional advice on the same) to provide written



reasoned recommendations on such open offer, which the

target company is required to publish.

TAKEOVER DEFENCES

Takeover defences include all actions by managers to

resist having their firms acquired. Attempts by target managers

to defeat outstanding takeover proposals are overt forms of

takeover defenses. Resistance also includes actions that occur

before a takeover offer is made which make the firm more

difficult to acquire. The intensity of the defences can range

from mild to severe. Mild resistance forces bidders to

restructure their offers, but does not prevent an acquisition or

raise the takeover price substantially. Severe resistance can

block takeover bids, thereby giving the present managers of

the target firm veto power over acquisition proposals.

An analysis of takeover defences can be examined with

the wealth effects of takeovers. A takeover substantially

increases the wealth of shareholders to target company.

Historical estimates of the stock price increases of target firms

are about 20 percent in mergers and about 30 percent in tender

offers. More recently, in many cases, premiums have exceeded

50 percent. There is no need of much analysis to determine

that the right to sell a share of stock for 50 percent more than

its previous market price benefits target shareholders.

Takeover resistance can benefit the shareholders.

Stockholders are concerned about the market value of the firm.

The market value of any firm is the sum of, which two

components ; the value of the firm conditional on retaining the

same management team ; and the expected change in value of

the firm from a corporate control change , which equals the

probability of a takeover times the change in value from a

takeover

Market value of the firm = value of the firm with current



managers x Probability of a control change x change in the

value from a control change

Stock holders are concerned about how takeover

defences affect all three components of value; the value of the

firm under current managers, the probability of an acquisition,

and the offer price if a takeover bid occurs. While takeover

defences may lower the probability of being acquired, they

may also increase the offer price. Furthermore, takeover

defences can affect the value of the firm even if it is not

acquired, that is, the value with its current management team.

There are several ways to defend against a hostile takeover.

Pre-offer Takeover Defence

These are the following types of pre-offer defensive

measures:

Poison Pill

The term poison pill refers to a defense strategy used

by a target firm to prevent or discourage a potential hostile

takeover by an acquiring company. Potential targets use this

tactic in order to make them look less attractive to the potential

acquirer. Although they're not always the first and best way to

defend a company, poison pills are generally very effective.

The target company gives its shareholders the right to buy the

stocks of the target company at a large discount to the stock‘s

market price.

There are two types of poison pill strategies—the flip-

in and flip-over.

Flip-in poison pill strategy involves allowing the

shareholders, except for the acquirer, to purchase additional

shares at a discount. This right to purchase is given to the

shareholders before the takeover is finalized and is often

triggered when the acquirer amasses a certain threshold

percentage of shares of the target company.

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Flip-Over Poison Pill

A flip-over poison pill strategy allows stockholders of

the target company to purchase the shares of the acquiring

company at a deeply discounted price if the hostile takeover

attempt is successful.

Poison Put

A poison put is a takeover defense strategy in which

the target company issues a bond that investors can redeem

before its maturity date. A poison put is a type of poison pill

provision designed to increase the cost a company will incur in

order to acquire a target company. The target company gives

its bondholders the right to sell the bonds back to the company

at a pre-determined redemption price, which is generally above

or at the par value.

Golden Parachutes

Golden parachutes are additional compensations to the

target‘s top management in the case of termination of its

employment following a successful hostile acquisition. Since

these compensations decrease the target‘s assets, this defense

reduces the amount the acquirer is willing to pay for the

target‘s shares. This defense may thus harm shareholders. It,

however, effectively deters hostile takeovers. Compensation

arrangements are made between the target and the senior

management. The managers have the right to leave the

company with huge exit payouts if there is any change in the

corporate control.

Restrictive Takeover Laws

The companies can incorporate themselves in the states

where the law helps them to defend hostile takeovers.

Staggered Board

Under this strategy, the target company‘s board of

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directors is divided into three groups of equal sizes. Each

group can be elected in a staggered way for the three-year

term. This arrangement will deter an acquirer as he can win

only one-third of the directors in a year.

Restricted Voting Rights

Under this measure, shareholders who have acquired a

large percentage of stocks recently are restricted to vote.

Supermajority Voting Provisions

Through this provision, a higher majority, say 85%, of

the shareholders, need to approve the transaction, instead of

standard 51%.

Fair Price Amendments

Through such amendments, the target company does

not allow mergers where an offer is below a threshold value.

The goal of the fair price provision is to discourage hostile

takeovers by making the acquisition more expensive. The

provision also protects minority stockholders who may be

offered a lower price for their shares than shareholders who

own a significant percentage of the company‘s stock.

Post-Offer Takeover Defence Mechanism

These are the following types of post-offer defensive

measures:

Greenmail

Greenmail is a buyout by the target of its own shares

from the hostile acquirer with a premium over the market

price, which results in the acquirer‘s agreement not to pursue

obtaining control of the target in the near future. The taxation

of greenmail used to present a considerable obstacle for this

defense. Plus, the statute may require a shareholder approval of

repurchase of a certain amount of shares at a premium. This is

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mostly accompanied by another clause prohibiting the acquirer

to make another attempt for a specific time period.

‘Crown Jewel’ Defence

The crown jewel defense strategy involves selling the

most valuable assets of a target company to a third party or

spinning off the assets into a separate entity. The main goal of

the crown jewel defense strategy is to make the target

company less attractive to the corporate raider. The

management of the target company can identify the major

motivation behind the deal i.e a specific subsidiary or

an asset and sell it off to another party.

‗Pac-man’ Defence

The Pac-Man defense occurs when a target company

attempts to acquire its potential acquirer when a takeover bid

has already been received. Just as the acquirer is attempting to

buy up a controlling amount of shares in the target company,

the target likewise begins buying up shares of the acquirer in

an attempt to obtain a controlling interest in the acquirer.

The target company can make a counter-offer to take

over the acquiring company and defend itself. However, other

defensive measures can‘t be used later if the company decides

to use this strategy.

‗Just Say No’ Defence

The easiest way is to decline the offer. If the acquiring

company tries the bear hug or even a tender offer, the

management of the target company should explain to the

shareholders and the board of directors why the deal is not the

best for the company.

Litigation

When a target company receives an offer, it can start a

litigation process against the acquirer. The success of the

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process depends on factors such as anti-competition laws in the

jurisdiction or the presence of sufficient evidence. Even if the

chances of success are low, the litigation process can still be

employed to delay a potential hostile takeover. During this

time, a target company may develop a more thorough

defensive strategy. The management can allege the violation of

securities law and file a court case against the acquirer.

Share Repurchase

The target company can acquire its stocks from any

shareholders by using a share repurchase. This can lead to an

increase in the cost for the acquirer.

Leveraged Recapitalization

The target company uses a huge amount of debt to

finance the share repurchases. However, not all shares are

repurchased.

White Knight Defence

The board of the target company looks for a third party

that has a better fit with the company to buy the target

company in place of the hostile acquirer. The third party is

referred to as ‗White Knight‘. A white knight defense is seen

as beneficial to shareholders, particularly when management

has exhausted all other options to avoid a takeover.

White Squire Defence

The white squire defense is a variation of the white

knight defense. The board of the target company asks a third

party to buy a substantial but a minority stake in the target

company. This stake would be enough to obstruct the takeover

with no need to sell the company.

PROS AND CONS OF TAKEOVERS

Takeovers come with a host of advantages and

disadvantages regardless of the perspective one views them

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from. Although these advantages and disadvantages tend to

vary from one case to the next, there are some that tend to

reoccur in almost all cases. These will be listed below starting

with the advantages then the disadvantages:

Advantages (Pros) Of Takeovers

1. They often come with a positive impact on sales/revenues.

Takeovers often see an increase in sales/revenue of the

acquiring company. The main reason behind this may be

due to the increased yields of products and services and

improved marketing abilities that come with the acquired

firm.

2. They enable a business to venture into new markets

without necessarily having to face all the procedural issues

involved. This is made possible due to the fact that

acquiring a business operating in a different market will

avail the opportunity of conducting business in that new

market easily than when starting a new business in that

market.

3. Takeovers have the ability to reduce business competition

in the market. Regardless of the market share of the

acquired business, every new takeover ensures that there is

less competition. Takeovers guarantee an increased market

share for the acquiring business which in turn translates to

reduced competition and improved market performance.

4. Takeovers bring about an increased brand portfolio. In

addition to the brand portfolio of the acquiring business,

the business being taken over will bring with it its brand

portfolio which will increase the brand portfolio of the new

business after the takeover. Increased brand portfolio will

encourage sales as there is a high probability of attracting

new buyers to the new business.



5. Takeovers offer a window to improve business efficiency

and improve business abilities in the market. With

acquisition of the new business, it is possible to easily

eliminate synergies and redundancies from the business.

Takeovers bring about an easy way to eliminate jobs and

posts with overlapping responsibilities and duties. This is

attained during the restructuring and adjustment period

when operations are streamlined and integrated after the

takeover.

Disadvantages (Cons) of Takeovers

1. Upon takeovers, there is a likelihood that employee

productivity will reduce. There are two main explanations

for this incidence. First, the culture clashes of the two

merging companies may work to negate the results of

employee productivity. Secondly, issues pertaining to job

insecurity will most likely affect the productivity of

employees towards negative levels.

2. There is always an undeniable and unavoidable conflict

between the management of the acquiring firm and the

management of the acquired firm. This often results into

hostile takeovers which often delay success of the acquired

firm in the market. It calls for quite a significant chunk of

investment to effectively avoid such a conflict and

guarantee timely success in the market after the takeover.

3. Takeovers bring about a notion of a single firm controlling

a large section of the products in the market, a precedent to

a monopoly. The reduced competition brought about by a

firm taking over other firms leads to a situation where

consumers are deprived of choices of products to choose

from due to the in-existence of competition in the market.

DISTRESS RESTRUCTURING STRATEGY

Corporate distress, including the legal processes of



corporate insolvency reorganization and liquidation, is a

sobering economic reality reflects the corporate demise. Many

theorists stated that each firm is unavoidably exposed to ups

and downs during its development and corporate collapse is

not an unexpected event . Corporate distress is reversible

process through adopting restructuring strategies. Companies

undergo a distressed financial situation usually share a series

of common patterns which make it problematic to estimate a

possible outcome of this situation

There are numerous causes for failure of companies.

The most important among them is related to management.

The vital cause of corporate upheaval is usually simply

running out of cash, but there are a variety of means-related

reasons that contribute to bankruptcies and other distressed

conditions in which firms find themselves.

These causes are as under:

1. Chronically sick industries (such as agriculture, textiles,

department stores).

2. Deregulation of major industries (i.e., airlines, financial

services, health care, and energy).

3. High real interest rates in certain periods.

4. International competition.

5. Congestion within an industry.

6. Increased leveraging of corporate.

7. Comparatively high new business formation rates in certain

periods.

Some of these reasons are understandable for corporate

distress such as high interest rates, overleveraging, and

competition. Deregulation eliminates the protection of a

regulated industry and promotes larger numbers of entering



and exiting firms. Competition is far greater in a deregulated

environment, such as the airline industry

When any firm undergo financial distress, it cannot

typically meet its debt repayment obligations using its liquid

assets. Unless there is an unexpected recovery of performance,

the distressed firm is likely to default on its debt. This could

result in a formal bankruptcy filing, a dismissal of the

management, and possibly, liquidation of the firm. To evade

this, firms typically respond to financial distress by either

reorganisation assets through fire sales, mergers, acquisitions

and capital expenditures reductions or liabilities by

restructuring debt-both bank loans and public debt

Restructuring strategy:

In case of corporate distress, there is a need of

corporate restructuring as a company needs to improve its

efficiency and profitability and it requires expert corporate

management. When the companies are distressed, the

government may intervene and support them to recover and

revive. For this, firstly the company has to declare the sick

unit, in accordance with the compliances of sick industry

company‘s act 1985. Company is vested in the hands of board

of industrial and financial reconstruction. In the best interest of

company, the board may revive it, rehabilitates it or sell off the

unit. Company must follow restructuring to generate funds .In

broad sense, corporate restructuring refers to the changes in

ownership, business mix, assets mix and alliances with a view

to enhance the shareholder value. Hence, corporate

restructuring may involve ownership restructuring, business

restructuring and assets restructuring.

Purpose of Corporate Restructuring:

1. To enhance the shareholder value, the company should

continuously evaluate its Portfolio of businesses, Capital



mix, Ownership & Asset arrangements to find

opportunities to increase the shareholder‘s value.

2. To focus on asset utilization and profitable investment

opportunities.

3. To reorganize or divest less profitable or loss making

businesses/products.

4. The company can also augment value through capital

Restructuring, it can innovate securities that help to reduce

cost of capital.

Types of Corporate Restructuring strategies:

1. Mergers / Amalgamation: It is a process by which at least

two companies combined to establish single firm. It is a

merger with a direct competitor and hence expands as the

firm's operations in the same industry. Horizontal mergers

are designed to accomplish economies of scale and result

in reduce rivals in the industry. Vertical Merger is a merger

which occurs upon the combination of two companies

which are operating in the same industry but at different

stages of production or distribution system.

2. Acquisition and Takeover: Takeovers and acquisitions

are common process in business area. A takeover is a

distinct form of acquisition that happens when a company

takes control of another company without the acquired

firm‘s agreement. Takeovers that occur without permission

are commonly called hostile takeovers. Acquisitions

happen when the acquiring company has the permission of

the target company‘s board of directors to purchase and

take over the company.

3. Divesture: Divesture is a transaction through which a firm

sells a portion of its assets or a division to another

company. It involves selling some of the assets or division

for cash or securities to a third party which is an outsider.



Divestiture is a form of contraction for the selling

company. It is a means of expansion for the purchasing

company. It represents the sale of a segment of a company

(assets, a product line, a subsidiary) to a third party for

cash and or securities.

4. Demerger (spin off / split up / split off): It is a type of

corporate restructuring policy in which the entity's business

operations are segregated into one or more components. A

demerger is often done to help each of the segments

operate more smoothly, as they can focus on a more

specific task after demerger. Spinoffs are a way to offload

underperforming or non-core business divisions that can

drag down profits. Split-off is a transaction in which some,

but not all, parent company shareholders receive shares in

a subsidiary, in return for relinquishing their parent

company's share. Split-up is a transaction in which a

company spins off all of its subsidiaries to its shareholders

and ceases to exist.

5. Joint Ventures: Joint ventures are new enterprises owned

by two or more contributors. They are typically formed for

special purposes for a certain period. It is a combination of

subsets of assets contributed by two (or more) business

entities for a specific business purpose and a limited

duration. Each of the venture partners continues to exist as

a separate firm, and the joint venture represents a new

business enterprise. It is a contract to work jointly for a

period of time. Each member expects to gain from the

activity but also must make a contribution.

6. Buy back of Securities: Buy Back of Securities is

significant process for Companies who wants to decrease

their Share Capital.

7. Franchising: Franchising is also effective restricting

strategy. It is an arrangement where one party (franchiser)



grants another party (franchisee) the right to use trade

name as well as certain business systems and process, to

produce and market goods or services according to certain

specifications.

8. A leverage buyout (LBO) is any acquisition of a company

which leaves the acquired operating entity with a greater

than traditional debt-to-worth ratio.

A corporate restructuring strategy involves the

dismantling and renewal of areas within an organization that

needs special attention from the management. The procedure

of corporate reformation often ensues after buy-outs, corporate

attainments, takeovers or bankruptcy. Basically, organizational

reorganisation involves making numerous transformation to

the organizational setup. These changes have great impact on

the flow of authority, responsibility and information across the

organization. The causes for restructuring differ from

diversification and growth to lessening losses and cutting

down costs. Organizational restructuring may be done because

of external factors such as amalgamation with some other

company, or because of internal factors such as high employee

costs. Restructuring strategy is about decreasing the manpower

to retain employee costs under control.

DEMERGER

A demerger is a form of corporate restructuring in

which the entity's business operations are segregated into one

or more components. It is the reverse of a merger or

acquisition. It is a valuable strategy for companies that want to

refocus on their most profitable units, reduce risk, and create

greater shareholder value. It is also a good strategy for

separating out business units that are underperforming and

creating a drag on overall company performance.

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De-merger allows a large company, such as a

conglomerate, to split off its various brands or business units to

invite or prevent an acquisition, to raise capital by selling off

components that are no longer part of the business's core

product line, or to create separate legal entities to handle..

A demerged company is said to be one whose

undertakings are transferred to the other company, and the

company to which the undertakings are transferred is called the

resulting company. The demerger can take place in any of the

following forms:

Spin Off

Spin-off: It is the divestiture strategy wherein the

company‘s division or undertaking is separated as an

independent company. Once the undertakings are spun-off,

both the parent company and the resulting company act as a

separate corporate entities.

When a company creates a new independent company

by selling or distributing new shares of its existing business,

this is called a spinoff. A spinoff is a type of divestiture. A

company creates a spinoff expecting that it will be worth more

as an independent entity. A spinoff is also known as a spin

out or starbust.

A parent company will spin off part of its business if it

expects that it will be lucrative to do so. The spin off will have

a separate management structure and a new name, but it will

retain the same assets, intellectual property, and human

resources. The parent company will continue to provide

financial and technological support in most cases.

A spinoff may occur for various reasons. A company

may conduct a spinoff so it can focus its resources and better

manage the division that has more long-term potential.

Businesses wishing to streamline their operations often sell

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less productive or unrelated subsidiary businesses as spinoffs.

For example, a company might spin off one of its mature

business units that are experiencing little or no growth so it can

focus on a product or service with higher growth prospects.

Split-up

A business strategy wherein a company splits-up into

one or more independent companies, such that the parent

company ceases to exist. Once the company is split into

separate entities, the shares of the parent company is

exchanged for the shares in the new company and are

distributed in the same proportion as held in the original

company, depending on the situation.

Split-Off

In a split-off, shareholders in the parent company are

offered shares in a subsidiary, but the catch is that they have to

choose between holding shares of the subsidiary or the parent

company. A shareholder has two choices: (a) continue holding

shares in the parent company or (b) exchange some or all of

the shares held in the parent company for shares in the

subsidiary. Because shareholders in the parent company can

choose whether or not to participate in the split-off,

distribution of the subsidiary shares is not pro rata as it is in the

case of a spin-off.

A split-off is generally accomplished after shares of the

subsidiary have earlier been sold in an initial public

offering (IPO) through a carve-out. Since the subsidiary now

has a certain market value, it can be used to determine the

split-off's exchange ratio.

To induce parent company shareholders to exchange

their shares, an investor will usually receive shares in the

subsidiary that are worth a little more than the parent company

shares being exchanged.

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Carve-Out

In a carve-out, the parent company sells some or all of

the shares in its subsidiary to the public through an initial

public offering (IPO).

Since shares are sold to the public, a carve-out also

establishes a net set of shareholders in the subsidiary. A carve-

out often precedes the full spin-off of the subsidiary to the

parent company's shareholders. For such a future spin-off to be

tax-free, it has to satisfy the 80% control requirement, which

means that no more than 20% of the subsidiary's stock can be

offered in an IPO.

Sell-Off

Sell-off is the rapid selling of securities such as stocks,

bonds and commodities. The increase in supply leads to a

decline in the value of the security. A sell-off may occur for

many reasons, such as the sell-off of a company's stock after a

disappointing earnings report, or a sell-off in the broad market

when oil prices surge, causing increased fear about the energy

costs that companies will face.

All financial trading instruments have sell-offs. They

are a natural occurrence from profit-taking and short-selling.

Healthy price uptrends require periodic sell-offs to replenish

supply and trigger demand. Minor sell-offs are considered

pullbacks. Pullbacks tend to hold support at the 50-period

moving average. However, when a sell-off continues on an

extensive basis, it can be signs of a potentially dangerous

market reversal.

Corrections tend to be more aggressive, usually testing

the 200-period moving average. The death cross is a popular

sell-off signal in which the daily 50-period moving average

forms a crossover down through the daily 200-period moving

average.



LEVERAGED BUYOUT ( LBO)

A leveraged buyout (LBO) is the acquisition of another

company using a significant amount of borrowed money to

meet the cost of acquisition. The assets of the company being

acquired are often used as collateral for the loans, along with

the assets of the acquiring company. The purpose of leveraged

buyouts is to allow companies to make large acquisitions

without having to commit a lot of capital.

In an LBO, there is usually a ratio of 90% debt to 10%

equity. Because of this high debt/equity ratio, the bonds issued

in the buyout are usually are not investment grade and are

referred to as junk bonds. Further, many people regard LBOs

as an especially ruthless, predatory tactic. This is because it

isn't usually sanctioned by the target company. Further, it's

seen as ironic in that a company's success, in terms of assets on

the balance sheet, can be used against it as collateral by a

hostile company.

Reasons for LBOs

LBOs are conducted for three main reasons. The first is

to take a public company private; the second is to spin-off a

portion of an existing business by selling it; and the third is to

transfer private property, as is the case with a change in small

business ownership. However, it is usually a requirement that

the acquired company or entity, in each scenario, is profitable

and growing.

Leveraged buyouts have had a notorious history,

especially in the 1980s, when several prominent buyouts led to

the eventual bankruptcy of the acquired companies. This was

mainly due to the fact that the leverage ratio was nearly 100%

and the interest payments were so large that the company's

operating cash flows were unable to meet the obligation. One

of the largest LBOs on record was the acquisition of Hospital



Corporation of America (HCA) by Kohlberg Kravis Roberts &

Co. (KKR), Bain & Co. and Merrill Lynch in 2006. The three

companies paid around $33 billion for the acquisition of HCA.

ADVANTAGES OF LBO:

1. Responsibility to pay interest and repay the debt, forces the

management to perform better which results in increased

productivity.

2. Restructuring and use of the acquired firm‘s asset saves the

costs Economies of scale

3. For better performance technology is updated and large

amounts of production leads to economies of scale.

4. Because of huge Debt; payments of dividends are not

necessary.

5. Tax shield: Because of debt financing, there are

interest tax shields which increases cash flow to

the shareholders.

DISADVANTAGES OF LBO:

1. There are uncertainties associated with financials.

2. Because of high leverage, there will be inappropriate

investment policy

3. If the cash flow is low and an inability to pay principal and

debt, can lead to bankruptcy of the firm.

4. Carrying out LBO deal can be dangerous to the companies

which are vulnerable to competition.

5. High debt payment may affect company‘s credit rating.

MANAGEMENT BUYOUT (MBO)

Management buyout (MBO) is a type of acquisition

where a group led by people in the current management of a

company buy out majority of the shares from existing

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shareholders and take control of the company.

For example, company ABC is a listed entity where the

management has a 25 per cent holding while the remaining

portion is floated among public shareholders. In the case of an

MBO, the current management will purchase enough shares

outstanding with the public so that it can end up holding at

least 51 per cent of the stock.

In a management buyout, the business‘s current

management team buys out the current owner. Business

owners often prefer MBOs if they are retiring or if a majority

shareholder wants to leave the company. They‘re also useful

for large enterprises that want to sell divisions that are

underperforming or that aren‘t essential to their strategy. The

buyers enjoy a greater financial incentive when the business

succeeds than they would have if they remained employees.

Management buyouts have many advantages, in

particular the continuity of operations. When the management

team does not change, the owner can expect a smoother

transition with business continuing to operate profitably.

Review questions:


1. Define takeover.

2. What is friendly takeover?

3. What is Hostile takeover?

4. Explain Reverse Takeover.

5. What is Backflip Takeover?

6. Explain Bailout Takeover.

7. Explain Creeping takeover.

8. Write a short note on takeover defence.



9. What do you meant by demerger?

10. What do you meant by restructuring strategy?

11. What is sell-off?

12. What is spin off?

13. Explain leveraged buy out..

II. Short Essay questions:

14. What are the various types of takeover strategy?

15. Explain the purpose of restructuring strategy.

16. Explain various types of Corporate Restructuring

strategies.

17. Reasons for Undertaking Takeovers

III. Long Essay questions:

18. What is take over? Explain the procedures of takeover.

19. Discuss important provisions and implications of SEBI

new code

20. Write a short note on defensive mechanism of takeover

Additional reading :

*Financial Management , I.M. Pandey

*Financial Management, Shashi . K. Gupta & Neeti Gupta.

Online sources :

* https://www.businessmanagementideas.com/strategic-

management/financial-strategy

*https://hbr.org/1985/05/financial-goals-and-strategic-

consequences.

*Https://efinancemanagement.com/dividend-

decisions/modigliani-miller-theory-on-dividend- policy

*https://www.civilserviceindia.com/subject/Management/notes

/management-of-corporate-distress-and-restructuring-

strategy.html

https://www.businessmanagementideas.com/strategic-

https://hbr.org/1985/05/financial-goals-and-strategic-consequences

https://hbr.org/1985/05/financial-goals-and-strategic-consequences

https://efinancemanagement.com/dividend-decisions/modigliani-miller-theory-on-dividend-%20policy

https://efinancemanagement.com/dividend-decisions/modigliani-miller-theory-on-dividend-%20policy

https://www.civilserviceindia.com/subject/Management/notes/management-of-corporate-distress-and-restructuring-strategy.html



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ADVANCED STRATEGIC FINANCIAL MANAGEMENT