Corporate finance - WordPress.com · 2014-02-10 · EBIT- EPS analysis 43 Dividend and share repurchase Procedural aspects of paying dividend 46 Issuing securities Public offering

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Corporate Finance

CREATED BY ADNAN ARSHAD

(Lecturer)

Govt. College University Faisalabad

CONTACT NO: 0301-7120098

EMAIL: [email protected]

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BRIEF CONTENTS

Topics

Page No

Goal and function of finance

Function of finance. investment decision , finance decision

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Concept in valuation

time value of money, present value, bond return , dividend discounting

model , measuring risk

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Market risk and return

Efficient financial markets, security portfolio, capital assets pricing model

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Investment in assets and required return

Administrative framework, method of evaluation , NPV vs IRR, inflation

capital budgeting

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Theory of capital structure

Cost of capital, capital structure, taxes,

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Making capital structure decision

EBIT- EPS analysis

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Dividend and share repurchase

Procedural aspects of paying dividend

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Issuing securities

Public offering security

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Fixed income financing and pension liability

Feature of debt , types of debt financing, proffered stock

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Corporate finance CHAPTER 1

Goal and function of finance

Definition of finance

The finance function is the process of acquiring and utilizing funds of a business.

Financing consists of the raising, providing, managing of all the money, capital or funds

of any kind to be used in connection with the business

Financial Management: The process of managing the financial resources, including accounting and financial reporting, budgeting, collecting accounts receivable, risk management, and insurance for a business

Major functions of financial management: 1. Accounting:

Typically includes: (a) planning the program within delegated limits; (b) developing, revising, and/or adapting accounting systems; (c) executing day-to-day ledger maintenance and related operations for the classification and other recording of financial transactions; (d) analyzing the results and interpreting the effects of transactions upon the financial resources of the organization; (e) applying accounting concepts to solve problems, render advice, or to meet other needs of management; and (f) managing the total accounting program, including supervision of subordinate accountants, accounting technicians, voucher examiners, payroll clerks, and other similar supporting personnel. 2. Budgeting: Typically includes: (a) the formulation -- developing instructions, calls for estimates, preparing estimates, reviewing and consolidating estimates; (b) the presentation -- either within the organization or at hearings (within the agency, at the budget bureau, or subcommittee); and (c) the execution -- funds control, program adjustments, review of reports and preparation of reports. 3. Managerial-Financial Reporting:

. Managerial-financial reporting is the process of providing appropriate data to key officials at all levels of management for the purpose of helping to achieve the

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most effective program and financial management. Stress is placed on aiding in the making of management decisions. Normally, much of such data will be of a financial character, developed from the accounting and the budget systems; however, frequently data will be a combination of both financial and non-financial information and, in some cases, the data may be entirely non-financial in nature. In its ideal form, the data are so integrated as to represent a single total data system. Since in good managerial-financial reporting, concern is given to the development of the systems that will provide the essential data, one of the normal responsibilities of the Financial Manager is the development, revision and/or adaptation of the managerial-financial reporting system.

Function of finance

1 -Investment decision.

One of the most important long term decisions for any business relates to investment.

Investment is the purchase or creation of assets with the objective of making gains in the

future. Typically investment involves using financial resources to purchase a machine/

building or other asset, which will then yield returns to an organisation over a period of

time.

Decisions basically concerned with the process of acquiring funds. May be from own

sources (Equity Capital) or loan sources ( Debt Capital).

These decisions are concerned with answers to the following questions

1. what is the scale of the investment - can the company afford it?

2. How long will it be before the investment starts to yield returns? 3

3. How long will it take to pay back the investment?

4. What are the expected profits from the investment?

5. Could the money that is being ploughed into the investment yield higher returns

elsewhere?

2-Financing decisions

Decisions concerning the liabilities and stockholders' equity side of the firm's balance

sheet, such as a decision to issue bonds.

Concerned with utilisation of funds. These decisions relate to the selection of the assets in

which funds should be invested. From the asset perspective these decisions are—

• Capital Budgetting decisions

• Working Capital Management

Capital budgeting decision

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Capital budgeting is the process by which the financial manager decides whether to

invest in specific capital projects or assets. In some situations, the process may entail in

acquiring assets that are completely new to the firm. In other situations, it may mean

replacing an existing obsolete asset to maintain efficiency.

During the capital budgeting process answers to the following questions are sought:

What projects are good investment opportunities to the firm?

From this group which assets are the most desirable to acquire?

How much should the firm invest in each of these assets?

Working capital management

Working capital management involves the relationship between a firm's short-term assets

and its short-term liabilities. The goal of working capital management is to ensure that a

firm is able to continue its operations and that it has sufficient ability to satisfy both

maturing short-term debt and upcoming operational expenses. The management of

working capital involves managing inventories, accounts receivable and payable, and

cash.

3- Asset management

management refers to the professional management of investments such as stocks and

bonds, along with real estate. Typically, asset management is only practiced by the very

wealthy, as the services of a professional firm can demand considerable sums of money,

and successful asset management usually requires a large and diverse portfolio.

Numerous professional firms and investment banks offer asset management services,

which are often handled by a team of financial professionals for the best results. The

firms handling the largest accounts are based in the United States, although several

venerable European firms also work with high volume accounts.

Typically, the investor meets with an asset management team before surrendering control

of the assets to discuss goals and investment styles. In general, the team works with the

investor to set realistic goals to grow the investor's wealth and measure the performance

of the team. The investor also usually expresses directions as to what type of investment

style he would prefer the team to engage in. For example, single young investors

sometimes choose less conservative investment schemes than older individuals or

couples. Meetings with the asset management team are held on a regular basis so that the

investor can be apprised of progress and kept up to date.

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CHAPTER 2

Time value of money

The idea that money available today is worth more than the same amount of money in the

future,

Time value of money is the concept of measuring the value of money over time.

Why do we care, because value of money changes with time and it‘s crucial to analysis of

a real estate investment to be able to measure and solve for those changes.

Everyone knows that money deposited in a savings account will earn interest. Because of

this, the sooner it starts earning interest, the better. For example, assuming a 5% interest

rate, a $100 investment today will be worth $105 in one year ($100 multiplied by 1.05).

Conversely, $100 received one year from now is worth only $95.24 today ($100 divided

by 1.05), assuming a 5% interest rate.

There are two components

Present value

Present value defines what a dollar is worth today.

The current worth of a future sum of money or stream of cash flows given a specified rate

of return. Future cash flows are discounted at the discount rate, and the higher the

discount rate, the lower the present value of the future cash flows. Determining the

appropriate discount rate is the key to properly valuing future cash flows, whether they be

earnings or obligations

PV = FV/ (1+i) ⁿ

Annuity

An annuity is a cash flow, either income or outgoings, involving the same sum in

each period.

An annuity is the payment or receipt of equal cash flows per period for a specified

amount of time. For example, when a company set aside a fixed sum each year to

meet a future obligation, it is using annuity.

The time period between two successive payments is called ‗payment period‘ or

‗rent period‘.

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A = P [ (1+i)ⁿ - 1 / (1+i) ]

A = Annual or future value which is the sum of the compound amounts of all payments

P = Amount of each instalment

i = Interest rate per period

n = Number of periods

Present value of ordinary annuity

The present value of an ordinary annuity is the sum of the present value of a series of

equal periodic payments. An annuity where the first payment is delayed beyond one year,

the annuity is called a ‗deferred annuity‘.

PVA = R [ 1 – (1+i)ⁿ / i ]

Present value of perpetuity

A perpetuity is a financial instrument that promises to pay an equal cash flow per period

forever, that is, an infinite series of payments and principal amount never be repaid. The

present value of perpetuity is calculated with the following formula:

Present value of annuity due

The Present Value of an Annuity Due is identical to an ordinary annuity except that each

payment occurs at the beginning of a period rather than at the end. Since each payment

occurs one period earlier, we can calculate the present value of an ordinary annuity and

then multiply the result by (1 + i).

PVAD = R [ 1 – (1+ i)ⁿ /I ] × ( 1 + i)

Future value

The future value of a sum of money invested at interest rate i for one year is given by:

FV = PV ( 1 + i )

where

FV = future value

PV = present value

i = annual interest rate

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If the resulting principal and interest are re-invested a second year at the same interest

rate, the future value is given by:

FV = PV ( 1 + i ) ( 1 + i )

In general, the future value of a sum of money invested for n years with the interest

credited and re-invested at the end of each year is:

FV = PV ( 1 + i )ⁿ

Future value of ordinary annuity

The future value of an annuity is simply the sum of the future value of each payment. The

equation for the future value of an annuity due is the sum of the geometric sequence:

FV = R [ (1+ i)ⁿ - 1 / i]

Future value of annuity due

FV = R [ (1+ i)ⁿ - 1 / i] × (1 + i)

Valuation of long term security

We are concern with the valuation of firm long term securities bonds, preferred stock,

and common stock

This value is the present value of the cash flow stream provided to the investor,

discounted at a required rate of return appropriate for the risk involved

There are different types of securities

1- Bond valuation A bond is a long-term debt instrument issued by a corporation or government.

A bond is a security that pays a stated amount of interest to the investor, period after

period, until it is finally retired by the issuing company

Terms of bond

Face value

The maturity value (MV) [or face value] of a bond is the stated value. In the case of a

U.S. bond, the face value is usually $1,000.

Coupon rate

The bond‘s coupon rate is the stated rate of interest; the annual interest payment divided

by the bond‘s face value.

Discount rate

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The discount rate (capitalization rate) is dependent on the risk of the bond and is

composed of the risk-free rate plus a premium for risk

Types of bond

Perpetual bond

A perpetual bond is a bond that never matures. It has an infinite life. These are indeed

rare but they help to illustrate the valuation technique in its simplest form

Present value of bond would simply be equal to the capitalized value of an infinite stream

of interest payment

Example

Bond P has a $1,000 face value and provides an 8% annual coupon. The appropriate

discount rate is 10%. What is the value of the perpetual bond?

I = $1,000 ( 8%) = $80.

kd = 10%.

V = I / kd [Reduced Form]

= $80 / 10% = $800.

Non zero coupon paying bond

A non-zero coupon-paying bond is a coupon paying bond with a finite life. If the bond

has a finite maturity then we must not only consider the interst stream but also the

terminal or maturity value ( face value ) in the valuing bond the valuation equation for a

such a bond that pays interest at the end of each years

(1 + kd)1

(1 + kd)2

(1 + kd)V = + + ... +

I I I

= t=1

or I (PVIFA kd, )

V = II / kkdd [Reduced Form]

(1 + kd)t

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Bond C has a $1,000 face value and provides an 8% annual coupon for 30 years. The

appropriate discount rate is 10%. What is the value of the coupon bond?

V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30) = $80 (9.427) + $1,000 (.057)

[Table IV] [Table II]

= $754.16 + $57.00 = $811.16.

Zero coupon bond

A zero coupon bond is a bond that pays no interest but sells at a deep discount from its

face value; it provides compensation to investors in the form of price appreciation

= MV (PVIFkd, nn)

Bond Z has a $1,000 face value and a 30 year life. The appropriate discount rate is 10%.

What is the value of the zero-coupon bond?

V = $1,000 (PVIF10%, 30)

= $1,000 (.057)

= $57.00

2 -Preferred stock valuation

Preferred Stock is a type of stock that promises a (usually) fixed dividend, but at the

discretion of the board of directors. Preferred Stock has preference over common stock

in the payment of dividends and claims on assets.

The payment of preferred stock is similar to an annuity, so the valuation model of a

preferred stock is

V = Dp / Kp

Example

Stock PS has an 8%, $100 par value issue outstanding. The appropriate discount rate is

10%. What is the value of the preferred stock?

Dp = $100 ( 8% ) = $8.00.

Kp = 10%.

(1 + kd)1

(1 + kd)2

(1 + kd)nn V = + + ... +

I I + MV I

= nn

t=1 (1 + kd)

t

I

V = I (PVIFA kd, nn) + MV (PVIF kd, nn)

(1 + kd)nn +

MV

(1 + kd)nn

V = MV

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V = Dp / kp = $8.00 / 10%

= $80

3 -Common stock valuation Common stock is the security that represent the ultimate ownership (and risk) position in

a corporation

The difficult issues of valuation: uncertainty and payment of stock dividend, different

risk levels, etc.

Unlike bond and preferred stock cash flow which are contractually stated much more

uncertainty surrounds the future stream of return connected with common stock

Are the dividend foundation

The value of a share of common stock can be viewed as the discounted value of all

expected cash dividends provided by issuing firm until the end of time

Case 1: hold the stock for a long time

Dt is a cash dividend

Ke is the investor required return

• Case 2: hold the stock for a short time (e.g., 2 years)

• Note: D1, D2…Dn and P2 are all estimates

P2 expected sale price

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Chapter 3

Concept in valuation

Dividend discounting models

A procedure for valuing the price of a stock by using predicted dividends and discounting

them back to present value. The idea is that if the value obtained from the DDM is higher

than what the shares are currently trading at, then the stock is undervalued.

In other words, it is used to evaluate stocks based on the net present value of the future

dividends.

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There are 3 models used in the dividend discount model:

zero-growth model

zero growth which assumes that all dividends paid by a stock remain the same; Since the

zero-growth model assumes that the dividend always stays the same, the stock price

would be equal to the annual dividends divided by the required rate of return. Stock‘s

Intrinsic Value = Annual Dividends / Required Rate of Return

This is basically the same formula used to calculate the value of a perpetuity, which is a

bond that never matures, and can be used to price preferred stock, which pays a dividend

that is a specified percentage of its par value. A stock based on the zero-growth model

can still change in price if the capitalization rate changes, as it will if perceived risk

changes, for instance.

Example—Intrinsic Value of Preferred Stock

If a preferred share of stock pays dividends of $1.80 per year, and the required rate of

return for the stock is 8%, then what is its intrinsic value?

Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50.

the constant-growth model, (gordon growth model )

constant growth model which assumes that dividends grow by a specific percent

annually;

The constant-growth DDM (Gordon Growth model, because it was popularized by

Myron J. Gordon) assumes that dividends grow by a specific percentage each year, and is

usually denoted as g, and the capitalization rate is denoted by k.

Constant-Growth Rate DDM Formula

Intrinsic Value = D1

──────

k – g

D1 = Next Year‘s Dividend

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k = Capitalization Rate

g = Dividend Growth Rate

The constant-growth model is often used to value stocks of mature companies that have

increased the dividend steadily over the years. Although the annual increase is not always

the same, the constant-growth model can be used to approximate an intrinsic value of the

stock using the average of the dividend growth and projecting that average to future

dividend increases.

Example—Calculating Next Year‘s Stock Price Using the Constant-Growth DDM

If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually,

then what will be the price of the stock next year, assuming a required rate of return of

12%?

Next Year‘s Stock Price = $4 x 1.06 / (12% - 6%) = 4.24 / 0.06 = $70.67

This Year‘s Stock Price = $4 / 0.06 = 66.67

Growth Rate of Stock Price = $70.67 / $66.67 = 1.06 = Dividend Growth Rate

Note that if both the capitalization rate and dividend growth rate remains the same every

year, then the denominator doesn‘t change, so the stock‘s intrinsic value will increase

annually by the percentage of the dividend increase. In other words, both the stock price

and the dividend amount will increase by the constant-growth factor, g.

variable-growth model, (multi stage growth model )

variable growth model which typically divides growth into 3 phases: a fast initial phase,

then a slower transition phase that ultimately ends with a lower rate that is sustainable

over a long period.

Variable-growth rate models (multi-stage growth models) can take many forms, even

assuming the growth rate is different for every year. However, the most common form is

one that assumes 3 different rates of growth:

an initial high rate of growth, a transition to slower growth, and lastly, a sustainable,

steady rate of growth.

Basically, the constant-growth rate model is extended, with each phase of growth

calculated using the constant-growth method, but using 3 different growth rates of the 3

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phrases. The present values of each stage are added together to derive the intrinsic value

of the stock.

Sometimes, even the capitalization rate, or the required rate of return, may be varied if

changes in the rate are projected.

Measuring risk

Variation in return is called risk . uncertainty in return is called risk

Chance that actual return on investment will be different from the expected return.

This includes the possibility of losing some or all of the original investment. Risk is

usually measured by calculating the standard deviation of the historical returns or average

returns of a specific investment. Many companies now allocate large amounts of money

and time in developing risk management strategies to help manage risks associated with

their business and investment dealings. A key component of the risk management process

is risk assessment, which involves the determination of the risks surrounding a business

or investment.

Expected risk return trade off

The principle that potential return rises with an increase in risk. Low levels of uncertainty

(low risk) are associated with low potential returns, whereas high levels of uncertainty

(high risk) are associated with high potential returns. According to the risk-return

tradeoff, invested money can render higher profits only if it is subject to the possibility of

being lost

Risk free rate of return

The theoretical rate of return of an investment with zero risk. The risk-free rate represents

the interest an investor would expect from an absolutely risk-free investment over a

specified period of time.

Variation in return is called risk . uncertainty in return is called risk

Chance that actual return on investment will be different from the expected return.

This includes the possibility of losing some or all of the original investment. Risk is

usually measured by calculating the standard deviation of the historical returns or average

returns of a specific investment. Many companies now allocate large amounts of money

and time in developing risk management strategies to help manage risks associated with

their business and investment dealings. A key component of the risk management process

is risk assessment, which involves the determination of the risks surrounding a business

or investment.

Market risk

Change in price of security is called market risk

Political risk

Risk face due to political instability in country

Financial risk

The risk face by the business due to more debts used in the business

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International risk and currency risk

The risk face due to exchange the rates of the currency is called currency risk and

exchange rate risk

Individual security analysis

Return = E(R) = ∑ R×P

E(R) = expected return

R= expected return on different time period

P= probability

Risk = S.D= √∑[R-E(R)]² × p

Portfolio risk

Risk reflects the chance that the actual return on an investment may be very different than

the expected return. One way to measure risk is to calculate the variance and standard

deviation of the distribution of returns.

If the answer of correlation of the portfolio is positive it means that the security in that

portfolio are depend on each other and this portfolio is a very risky. Portfolio if the

answer of correlation is negative it mean that the securities in that not depend on each

other and this portfolio is a less risky portfolio

Portfolio Variance and Standard Deviation

The variance/standard deviation of a portfolio reflects not only the variance/standard

deviation of the stocks that make up the portfolio but also how the returns on the stocks

which comprise the portfolio vary together. Two measures of how the returns on a pair of

stocks vary together are the covariance and the correlation coefficient.

The Covariance between the returns on two stocks can be calculated using the following

equation:

where

s12 = the covariance between the returns on stocks 1 and 2,

N = the number of states,

pi = the probability of state i,

R1i = the return on stock 1 in state i,

E[R1] = the expected return on stock 1,

R2i = the return on stock 2 in state i, and

E[R2] = the expected return on stock 2.

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The Correlation Coefficient between the returns on two stocks can be calculated using the

following equation:

where

r12 = the correlation coefficient between the returns on stocks 1 and 2,

s12 = the covariance between the returns on stocks 1 and 2,

s1 = the standard deviation on stock 1, and

s2 = the standard deviation on stock 2

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Chapter 4

Market efficiency

Market efficiency that prices on traded assets (e.g., stocks, bonds, or property) already

reflect all available information, and instantly change to reflect new information.

Stages of market efficiency

There are three stages of market efficiency

Weak form efficiency

One of the most historical types of information used in assessing security values in

market data, which refers to all past price information. If security price are determined in

market that is weak form efficient, historical price and volume data should already be

reflected in current price should be of no value in predicting future price changes .t

Test of usefulness of price data are called weak form tests of EMH (efficient market

hypotheses). If the weak form of EMH is true past price changes should be unrelated to

future price change.

Semi strong efficiency

A more comprehensive level of market efficiency involves not only known and publicly

available market data, but all publicly known and available data such as earning,

dividend, and stock split announcements, new product developments, financing

difficulties and accounting changes. A market that quickly incorporates all such

information into prices is said to show semi strong efficiency

Strong form of market efficiency

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The most stringent form of market efficiency is strong form which asserts that stock

prices fully reflect all information, public and non public . If market is strong form

efficient no group of investors should be able to earn, over reasonable period of time.

Abnormal rates of return by using publicly available information in a superior manner

Efficient Market Hypothesis (EMH)

Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in

any given time, the prices on the market already reflect all known information, and also

change fast to reflect new information.

Therefore, no one could outperform the market by using the same information that is

already available to all investors, except through luck.

Market risk and return

Capital assets pricing model

A model that describes the relationship between risk and expected return and that is used

in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways:

time value of money and risk. The time value of money is represented by the risk-free (rf)

rate in the formula and compensates the investors for placing money in any investment

over a period of time. The other half of the formula represents risk and calculates the

amount of compensation the investor needs for taking on additional risk. This is

calculated by taking a risk measure (beta) that compares the returns of the asset to the

market over a period of time and to the market premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on a

risk-free security plus a risk premium. If this expected return does not meet or beat the

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required return, then the investment should not be undertaken. The security market line

plots the results of the CAPM for all different risks (betas).

Security market line

The relation between an asset’s risk premium and its market beta is called the “Security Market Line” (SML). K = Rf + ( Km – Rf ) β

K security market line

Rf = risk free rate

Km = expected return on market portfolio

The graph below depicts the SML. Note that the slope of the SML is equal to (E[Rm] -

Rf) which is the market risk premium and that the SML intercepts the y-axis at the risk-

free rate.

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In capital market equilibrium, the required return on an asset must equal its expected

return. Thus, the SML equation can also be used to determine an asset's required return

given its Beta.sumption of capital assets pricing model

The Beta (Bi)

The beta for a stock is defined as follows:

where

sim = the Covariance between the returns on asset i and the market portfolio and

s2m = the Variance of the market portfolio.

Note that, by definition, the beta of the market portfolio equals 1 and the beta of the risk-

free asset equals 0.

An asset's systematic risk, therefore, depends upon its covariance with the market

portfolio. The market portfolio is the most diversified portfolio possible as it consists of

every asset in the economy held according to its market portfolio weight.

Assumption of CAPM

The CAPM is simple and elegant. Consider the many assumptions that underlie the

model. Are they valid?

Zero transaction costs.

The CAPM assumes trading is costless so investments are priced to all fall on the capital

market line.

Zero taxes.

The CAPM assumes investment trading is tax-free and returns are unaffected by taxes.

Yet we know this to be false: (1) many investment transactions are subject to capital

gains taxes, thus adding transaction costs; (2) taxes reduce expected returns for many

investors, thus affecting their pricing of investments; (3) different returns (dividends

versus capital gains, taxable versus tax-deferred) are taxed differently, thus inducing

investors to choose portfolios with tax-favored assets; (4) different investors (individuals

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versus pension plans) are taxed differently, thus leading to different pricing of the same

assets.

Homogeneous investor expectations.

The CAPM assumes invests have the same beliefs about expected returns and risks of

available investments. But we know that there is massive trading of stocks and bonds by

investors with different expectations.

Available risk-free assets.

The CAPM assumes the existence of zero-risk securities, of various maturities and

sufficient quantities to allow for portfolio risk adjustments. But we know even Treasury

bills have various risks: reinvestment risk -- investors may have investment horizons

beyond the T-bill maturity date; inflation risk -- fixed returns may be devalued by future

inflation; currency risk -- the purchasing power of fixed returns may diminish compared

to that of other currencies. (Even if investors could sell assets short -- by selling an asset

she does not own, and buying it back later, thus profiting from price declines -- this

method of reducing portfolio risk has costs and assumes unlimited short-selling ability.)

Borrowing at risk-free rates.

The CAPM assumes investors can borrow money at risk-free rates to increase the

proportion of risky assets in their portfolio. We know this is not true for smaller, non-

institutional investors. In fact, we would predict that the capital market line should

become kinked downward for riskier portfolios (ß > 1) to reflect the higher cost of risk-

free borrowing compared to risk-free lending.

Beta as full measure of risk.

The CAPM assumes that risk is measured by the volatility (standard deviation) of an

asset's systematic risk, relative to the volatility (standard deviation) of the market as a

whole. But we know that investors face other risks: inflation risk -- returns may be

devalued by future inflation; and liquidity risk -- investors in need of funds or wishing to

change their portfolio's risk profile may be unable to readily sell at current market prices.

Moreover, standard deviation does not measures risk when returns are not evenly

distributed around the mean (non-bell curve). This uneven distribution describes our

stock markets where winning companies, like Dell and Walmart, have positive returns

(35,000% over ten years) that greatly exceed losing companies' negative returns (which

are capped at a 100% loss).

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Chapter 5

Investment in assets and required return

Administrative framework

There are following steps involve in administrative framework

1- Generation of investment proposal

2- Estimation of cash flow for the proposals

3- Evaluation of cash flow

4- Selection of project based on acceptance criterion

5- Continual revaluation of investment project after their acceptance

Method of evaluation ( also called capital budgeting technique )

1- payback period

2- internal rate of return

3- net present value

4- profitability index

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chapter 6

Difference between NPV and IRR

NPV IRR

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NPV is a mathematical tool which uses the

discounting process,

NPV is calculated in terms of currency

NPV Method is preferred over other

methods since it calculates additional

wealth

NPV is used to evaluate the project.

Formula of NPV is

NPV care about the reinvestment o the

inflow from the project

The internal rate of return method is also

known as the yield method. The IRR IRR

of a project/investment is defined as the

rate of discount at which the present value

of cash inflows and present value of cash

outflows are equal

IRR is expressed in terms of the percentage

return a firm expects the capital project to

return;

IRR method does not preferred over other

methods since it can not calculate

additional wealth.

The IRR Method cannot be used to

evaluate projects

Formula of IRR

ICO = CF1 / (1+IRR) 1 + CF2 / (1+IRR)2

+--------+CFn /(1+IRR)n

The IRR does not care about the

reinvestment of the inflows from the

project.

Capital budgeting

Definitions " Capital: Fixed assets used in production

" Budget: Plan of in- and outflows during some period

24

" Capital Budget: A list of planned investment (i.e., expenditures on fixed assets)

outlays for different projects.

" Capital Budgeting: Process of selecting viable investment projects.

"

Technique of capital budgeting

Pay back period:

In this technique, we try to figure out how long it would take to recover the invested

capital through positive cash flows of the business. Reverting back to the cafe example,

an initial investment of Rs. 200,000 is required to start the business; Rs 10,000 per month

are expected to be earned for the first year, and Rs 20,000 would be earned every month

in the second year.

Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000

per month, which make Rs. 120,000 for the year (twelve months). Since you had invested

Rs. 200,000 initially of which Rs. 120,000 have been recovered in the first year, you are

still Rs.80, 000 short of recovering your initial investment. In the second year, you would

be earning Rs. 20,000 per month, so the remaining Rs. 80,000 can be recovered in the

next four months. We can say that the initial invested capital can be recovered in 16

months, or the payback period for this investment is 16 months. The shorter the payback

period of a project, the more an investor would be willing to invest his money in the

project. While the payback period is a simple and straightforward method for analyzing a

capital budgeting proposal, it has certain limitations. First and the foremost problem is

that it does not take into account the concept of time value of money. The cash flows are

considered regardless of the time in which they are occurring. You must have noticed that

we have not used any interest rate while making calculation.

Advantages Of Payback Period

• It is easy to understand and apply. The concept of recovery is familiar to every

decision-maker.

• Business enterprises facing uncertainty - both of product and technology - will

benefit by the use of payback period method since the stress in this technique is

on early recovery of investment. So enterprises facing technological obsolescence

and product obsolescence - as in electronics/computer industry - prefer payback

period method.

• Liquidity requirement requires earlier cash flows. Hence, enterprises having high

liquidity requirement prefer this tool since it involves minimal waiting time for

recovery of cash outflows as the emphasis is on early recumbent of investment.

Disadvantages Of Payback Period

• The time value of money is ignored. For example, in the case of project

• A Rs.500 received at the end of 2nd and 3rd years are given same weight age. Broadly

a rupee received in the first year and during any other year within the payback period is

given same weight. But it is common knowledge that a rupee received today has higher

value than a rupee to be received in future.

• But this drawback can be set right by using the discounted payback period method. The

discounted payback period method looks at recovery of initial investment after

considering the time value of inflows.

25

Management Science-II Prof

• Another important drawback of the payback period method is that it ignores the cash

inflows received beyond the payback period. In its emphasis on early recovery, it often

rejects projects offering higher

total cash inflow.

Return on Investments:

The concept of return on investment loosely defined, as there are a number of ratios that

can be used to analyze return on investment. However, in capital budgeting it implies the

annual average cash flow a business is making as a percentage of investment. In other

words, it is an average percentage of investment recovered in cash every year.

The formula for return on investment is as follows:

ROI= (∑CF/n)/ IO

Return on Investment is also very easy to calculate, but like payback period, it does not

take into account the time value of money concept.

A high ROI ratio is considered better and 90% is a very good rate of return but before

deciding whether or not this project should be taken up,

Accounting Rate Of Return – Advantages

• It Is Easy To Calculate.

• The Percentage Return Is More Familiar To The Executives.

Accounting Rate Of Return – Disadvantages

• The definition of cash inflows is erroneous; it takes into account profit after tax

only. It, therefore, fails to present the true return.

• Definition of investment is ambiguous and fluctuating. The decision could be biased

towards a specific project, could use average investment to double the rate of

return and thereby multiply the chances of its acceptances.

Net Present Value (NPV):

NPV is a mathematical tool which uses the discounting process, something that we have

found missing in the aforementioned capital budgeting techniques. The formula for

calculating NPV is as follows:

NPV =

Where,CF1=cash flows occurring in different time periods

ICO= Initial cash outflow

i=discount /interest rate

n=year in which the cash flow takes place

Initial cash outflow, being an outflow, is always expressed as a negative figure.

26

NPV is considered one of the most popular capital budgeting criteria. The disadvantage

with the

NPV is that it is difficult to calculate since these calculations are based on too many

estimates.

In order to calculate the NPV we need to forecast the future cash flows and sales; the

discount factor is also an estimate. If the NPV of a project is more than zero, it should be

accepted. If two or more projects under contemplation, then the one with the higher NPV,

should be accepted. When a company invests in projects with positive NPV, they raise

the shareholders‘ wealth or company‘s value. This would also increase the market value

added and the economic value added for the firm.

Probability Index:

It is quite similar to the NPV in terms of concept and calculation. Profitability index

may be defined as the ratio of the present value of future cash flows to the initial

investment.

The profitability index can be calculated using the following formula.

PI = CF1/ (1+ K) 1 + CF2 /(1+ K) 2 +-----------+ CFn1+ K) n / ICO

NPV method, would also be acceptable on the profitability index criteria.

So for as accept reject decision are concerned all the three discounted cash flow (DCF)

methods lead to same decision. But in case of ranking mutually exclusive project some

time there will be conflict decision between NPV and IRR. In such situations a choice has

to be made between these methods. Since PI is a relative ranking method, this fits most

suitably for valuating mutually exclusive projects

Therefore, the project is acceptable. Notice that we have taken into consideration the

annualized

return. The same can be calculated using the monthly returns with a slight adjustment in

the formula as we have studied in the previous lectures. If there were two or more

projects that need ranking, the one with the highest profitability index would be

acceptable.

Let us now talk about the fifth and the final capital budgeting criteria of our course,

known as Internal

Internal Rate of Return (IRR):

The internal rate of return method is also known as the yield method. The IRR IRR of a

project/investment is defined as the rate of discount at which the present value of cash

inflows and present value of cash outflows are equal. IRR can be restated as the rate of

discount, at which the present value of cash flow (inflows and outflows) associated with a

project equal zero.

let at be the cash flows (inflow or outflow) in period t

then IRR of the project is found out by solving for the value of 'r' in the following

equation:

• Where t = 0,1,2......

• .... n years

ICO = CF1 / (1+IRR) 1 + CF2 / (1+IRR)2 +--------+CFn /(1+IRR)n

The capital budgeting process

27

There‘re following step involve in capital budgeting process

Strategic planning

A strategic plan is the grand design of the firm and clearly identifies the business the firm

is in and where it intends to position itself in the future. Strategic planning translates the

firm‘s corporate goal into specific policies and directions, sets priorities, specifies the

structural, strategic and tactical areas of business development, and guides the planning

process in the pursuit of solid objectives. A firm‘s vision and mission is encapsulated in

its strategic planning framework.

There are feedback loops at different stages, and the feedback to ‗strategic planning‘ at

the project evaluation and decision stages This feedback may suggest changes to the

future direction of the firm

Identification of investment opportunities

The identification of investment opportunities and generation of investment project

proposals is an important step in the capital budgeting process. Project proposals cannot

be generated in isolation. They have to fit in with a firm‘s corporate goals, its vision,

mission and long-term strategic plan. Of course, if an excellent investment opportunity

presents itself the corporate vision and strategy may be changed to accommodate it. Thus,

there is a two-way traffic between strategic planning and investment opportunities.

These investments normally represent the strategic plan of the business firm and, in turn,

these investments can set new directions for the firm‘s strategic plan.

Some firms have research and development (R&D) divisions constantly searching for and

researching into new products, services and processes and identifying attractive

investment opportunities. Sometimes, excellent investment suggestions come through

informal processes such as employee chats in a staff room or corridor.

Preliminary screening of projects

Generally, in any organization, there will be many potential investment proposals

generated. Obviously, they cannot all go through the rigorous project analysis process.

Therefore, the identified investment opportunities have to be subjected to a preliminary

screening process by management to isolate the marginal and unsound proposals, because

it is not worth spending resources to thoroughly evaluate such proposals. The preliminary

screening may involve some preliminary quantitative analysis and judgments based on

intuitive feelings and experience.

Financial appraisal of projects

This stage is also called quantitative analysis, economic and financial appraisal, project

evaluation, or simply project analysis. This project analysis may predict the expected

future cash flows of the project, analyze the risk associated with those cash flows,

develop alternative cash flow forecasts, examine the sensitivity of the results to possible

changes in the predicted cash flows, subject the cash flows to simulation and prepare

alternative estimates of the project‘s net present value.

Thus, the project analysis can involve the application of forecasting techniques, project

evaluation techniques, risk analysis and mathematical programming techniques such as

linear programming. While the basic concepts, principles and techniques of project

evaluation are the same for different projects, Financial appraisal will provide the

28

estimated addition to the firm‘s value in terms of the projects‘ net present values. If the

projects identified within the current strategic framework of the firm repeatedly produce

negative NPVs in the analysis stage, these results send a message to the management to

review its strategic plan.

Qualitative factors in project evaluation

When a project passes through the quantitative analysis test, it has to be further evaluated

taking into consideration qualitative factors. Qualitative factors are those which will have

an impact on the project, but which are virtually impossible to evaluate accurately in

monetary terms. They are factors such as:

_ the societal impact of an increase or decrease in employee numbers

_ the environmental impact of the project

_ possible positive or negative governmental political attitudes towards the project

_ the strategic consequences of consumption of scarce raw materials

_ positive or negative relationships with labor unions about the project

_ possible legal difficulties with respect to the use of patents, copyrights and trade or

brand names

_ impact on the firm‘s image if the project is socially questionable.

The accept/reject decision

NPV results from the quantitative analysis combined with qualitative factors form the

basis of the decision support information. The analyst relays this information to

management with appropriate recommendations. Management considers this information

and other relevant prior knowledge using their routine information sources, experience,

expertise, ‗gut feeling‘ and, of course, judgment to make a major decision – to accept or

reject the proposed investment project.

Project implementation and monitoring

Once investment projects have passed through the decision stage they then must be

implemented by management. During this implementation phase various divisions of the

firm are likely to be involved. An integral part of project implementation is the constant

monitoring of project progress with a view to identifying potential bottlenecks thus

allowing early intervention. Deviations from the estimated cash flows need to be

monitored on a regular basis with a view to taking corrective actions when needed.

Post-implementation audit

Post-implementation audit does not relate to the current decision support process of the

project; it deals with a post-mortem of the performance of already implemented projects.

An evaluation of the performance of past decisions, however, can contribute greatly to

the improvement of current investment decision-making by analyzing the past ‗rights‘

and ‗wrongs‘.The post-implementation audit can provide useful feedback to project

appraisal or strategy formulation.

Inflation The rate at which the general level of prices for goods and services is rising, and,

subsequently, purchasing power is falling. As inflation rises, every dollar will buy a

29

smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of

gum will cost $1.02 in a year.

Measuring inflation is a difficult problem for government statisticians

In North America, there are two main price indexes that measure inflation:

Consumer Price Index (CPI) - A measure of price changes in consumer goods and

services such as gasoline, food, clothing and automobiles. The CPI measures price

change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau

of Labor Statistics.

Producer Price Indexes (PPI) - A family of indexes that measure the average change

over time in selling prices by domestic producers of goods and services. PPIs measure

price change from the perspective of the seller. U.S. PPI data can be found at the Bureau

of Labor Statistics.

CAUSES OF INFLATION

Inflation is caused when the aggregate demand exceeds the aggregate supply

of goods and services. We analyze the factors which lead to increase in demand and

the shortage of supply.

Factors Affecting Demand

Both Keynesians and monetarists believe that inflation is caused by increase in the

aggregate demand. They point towards the following factors which raise it.

1. Increase in Money Supply. Inflation is caused by an increase in the supply of

money which leads to increase in aggregate demand. The higher the growth rate of the

nominal money supply, the higher is the rate of inflation. Modern quantity theorists

do not believe that. true inflation starts after the full employment level. This view is

realistic because all advanced countries are faced with high levels of unemployment

and high rates of inflation.

2. Increase in Disposable Income. When the disposable income of the people

increases, it raises their demand for goods and services. Disposable income may

increase with the rise in national income or reduction in taxes or reduction in the

saving of the people.

3. Increase in Public Expenditure. Government activities have been expanding

much with the result that government expenditure has also been increasing at a

phenomenal rate, thereby raising aggregate demand for goods and services.

Governments of both developed and developing countries are providing more

facilities under public utilities and social services, and also nationalizing indus tries

and starting public enterprises with the result that they help in increasing aggregate

demand.

30

4. Increase in Consumer Spending. The demand for goods and services increases

when consumer expenditure increases. Consumers may spend more due to

conspicuous consumption or demonstration effect. They may also spend more when

they are given credit facilities to buy goods on hire-purchase and installment basis.

5. Cheap Monetary Policy. Cheap monetary policy or the policy of credit

expansion also leads to increase in the money supply which raises the demand for

goods and services in the economy. When credit expands, it raises the money income

of the borrowers which, in turn, raises aggregate demand relative to supply, thereby

leading to inflation. This is also known as credit-induced inflation.

6. Deficit Financing. In order to meet its mounting expenses, the government

resorts to deficit financing by borrowing from the public and even by printing more

notes. This raises aggregate demand in relation to aggregate supply, thereby leading

to inflationary rise in prices. This is also known as deficit-induced inflation.

7. Expansion of the Private Sector. The expansion of the private sector also tends to

raise the aggregate demand. For huge investments increase employment arid income,

thereby creating more demand far goods and services. But it takes time for the output

to enter the market.

8. Black Money. The existence of black money in all countries due to corruption,

tax evasion etc. increases the aggregate demand. People spend such unearned money

extravagantly, thereby creating unnecessary demand for commodities. This tends to

raise the price level further.

9. Repayment of Public Debt. Whenever the government repays its past internal

debt to the public, it leads to increase in the money supply with the public. This tends

to raise the aggregate demand for goods and services.

10. Increase in Exports. When the demand for domestically produced goods

increases in foreign countries, this raises the earnings of industries producing export

commodities. These, in turn, create more demand for goods and services within

the economy.

Factors Affecting Supply

Factors Affecting Supply

There are also certain factors which operate on the opposite side and tend to

reduce the aggregate supply. Some of the factors are as follows:

31

1. Shortage of Factors of Production. One of the important causes affecting

the supplies of goods is the shortage of such factors as labour, raw materials,

power supply, capital etc. They lead to excess capacity and reduction in indus -

trial production.

2. Industrial Dispute. In countries where trade unions are powerful, they also

help in curtailing production. Trade unions resort to strikes and if they happen to

be unreasonable from the employers' viewpoint and are prolonged, they force the

employers to declare lock-outs. In both cases, industrial production falls, thereby

reducing supplies of goods. If the unions succeed in raising money wages of their

members to a very high level than the productivity of labour, this also tends to

reduce production and supplies of goods.

3. Natural Calamities. Drought or floods is a factor which adversely affects

the supplies of agricultural products. The latter, in turn, create shortages of food

products and raw materials, thereby helping inflationary pressures.

4. Artificial Scarcities. Artificial scarcities are created by hoarders and specu-

lators who indulge in black marketing. Thus they are instrumental in reducing

supplies of goods and raising their prices.

5. Increase in Exports. When the country produces more goods for export

than for domestic consumption, this creates shortages of goods in the domestic

market. This leads to inflation in the economy.

6. Lop-sided Production. If the stress is on the production of comfort,

luxuries, or basic products to the neglect of essential consumer goods in the

country, this creates shortages of consumer goods. This again causes inflation.

7. Law of Diminishing Returns. If industries in the country are using old

machines and outmoded methods of production, the law of diminishing returns

operates. This raises cost per unit of production, thereby raising the prices of

products.

8. International Factors. In modern times, inflation is a worldwide pheno-

menon. When prices rise in major industrial countries, their effects spread to

almost all countries with which they have trade relations. Often the rise in the

price of a basic raw material like petrol in the international market leads to rise

in the price of all related commodities in a country.

MEASURES TO CONTROL INFLATION

32

We have studied above that inflation is caused by the failure of aggregate

supply

to equal the increase in aggregate demand. Inflation can, therefore, be controlled

by increasing the supplies and reducing money incomes in order to control

aggregate demand. The various methods are usually grouped under three heads:

Monetary measures, fiscal measures and other measures.

1. Monetary Measures

Monetary measures aim at reducing money incomes.

(a) Credit Control. One of the important monetary measures is monetary

policy. The central bank of the country adopts a number of methods to control

the quantity and quality of credit. For this purpose, it raises the bank rates, sells

securities in the open market, raises the reserve ratio, and adopts a number of

selective credit control measures, such as raising margin requirements and

regulating consumer credit.

Monetary policy may not be effective in controlling inflation, if inflation

is due to cost-push factors. Monetary policy can only be helpful in controlling

inflation due to demand-pull factors.

(b) Demonetization of Currency. However, one of the monetary measures is

to demonetize currency of higher denominations. Such a measure is usually

adopted when there is abundance of black money in the country.

(c) Issue of New Currency. The most extreme monetary measure is the issue

of new currency in place of the old currency. Under this system, one new note is

exchanged for a number of notes of the old currency. The value of bank deposits

is also fixed accordingly. Such a measure is adopted when there is an excessive

issue of notes and there is hyperinflation in the country. It is very effective

measure. But is inequitable for its hurts the small depositors the most.

2. Fiscal Measures

Monetary policy alone is incapable of controlling inflation. It should, there-

fore, be supplemented by fiscal measures. Fiscal measures are highly effective

for controlling government expenditure, personal consumption expenditure, and

private and public investment. The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure. The government should reduce

unnecessary expenditure on non-development activities in order to curb infla tion.

This will also put a check on private expenditure which is dependent upon

government demand for goods and services. But it is not easy to cut government

expenditure. Though economy measures are always welcome but it becomes

33

difficult to distinguish between essential and non-essential expenditure. There-

fore, this measure should be supplemented by taxation.

(b) Increase in Taxes. To cut personal consumption expenditure, the rates of

personal, corporate and commodity taxes should be raised and even new taxes

should be levied, but the rates of taxes should not be so high as to discourage

saving, investment and production. Rather, the tax system should provide larger

incentives to those who save, invest and produce more. Further, to bring more

revenue into the tax-net, the government should penalize the tax evaders by imposing

heavy fines. Such measures are bound to be effective in controlling inflation. To

increase the supply of goods within the country, the government should reduce import

duties and increase export duties.

(c) Increase in Savings. Another measure is to increase savings on the part of the

people. This will tend to reduce disposable income with the people, and hence

personal consumption expenditure. But due to the rising cost of living, people are not

in a position to save much voluntarily. Keynes, therefore, advocated compulsory

savings or what he called `deferred payment' where the saver gets his money back

after some years. For this purpose, the government should float public loans carrying

high rates of interest, start saving schemes with prize money, or lottery for long

periods, etc. It should also introduce compulsory provident fund, provident fund-cum-

pension schemes, etc. compulsorily. All such measures to increase savings are likely

to be effective in controlling inflation.

(d) Surplus Budgets. An important measure is to adopt anti-inflationary budgetary

policy. For this purpose, the government should give up deficit financing and instead

have surplus budgets. It means collecting more in revenues and spending less.

(e) Public Debt. At the same time, it should stop repayment of public debt and

postpone it to some future date till inflationary pressures are controlled within the

economy. Instead, the government should borrow more to reduce money supply with

the public.

Like the monetary measures, fiscal measures alone cannot help in controlling

inflation. They should be supplemented by monetary, non-monetary and non fiscal

measures.

3. Other Measures

The other types of measures are those which aim at increasing aggregate supply

and reducing aggregate demand directly.

(a) To Increase Production. The following measures should be adopted to increase

production:

34

(i) One of the foremost measures to control inflation is to increase the

production of essential consumer goods like food, clothing, kerosene oil, sugar,

vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on

preferential basis to increase the production of essential commodities.

(iii) Efforts should also be made to increase productivity. For this purpose,

industrial peace should be maintained through agreements with trade unions, binding

them not to resort to strikes for some time.

(iv) The policy of rationalization of industries should be adopted as a long-

term measure. Rationalization increases productivity and production of industries

through the use of brain, brawn and bullion.

(v) All possible help in the form of latest technology, raw materials, financial

help, subsidies, etc. should be provided to different consumer goods sectors to

increase production.

(b) Rational Wage Policy. Another important measure is to adopt a rational wage

and income policy. Under hyperinflation, there is a wage-price spiral. To control this,

the government should freeze wages, incomes, profits, dividends, bonus, etc. But such

a drastic measure can only be adopted for a short period and by antagonizing both

workers and industrialists. Therefore, the best course is to link increase in wages to

increase in productivity. This will have a dual effect. It will control wage and at the

same time increase productivity, and hence production of goods in the economy.

(c) Price Control. Price control and rationing is another measure of direct control to

check inflation. Price control means fixing an upper limit for the prices of essential

consumer goods. They are the maximum prices fixed by law and anybody charging

more than these prices is punished by law. But it is difficult to administer price

control.

(d) Rationing. Rationing aims at distributing consumption of scarce goods so as to

make them available to a large number of consumers. It is applied to essential

consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise

the prices of necessaries and assure distributive justice. But it is very inconvenient for

consumers because it leads to queues, artificial shortages, corruption and black

marketing. Keynes did not favour rationing for it "involves a great deal of waste, both

of resources and of employment."

___________________________________

35

Chapter -8

Cost of capital

―It is rate of return to our stock holder and bond against our IRR‖

The required return necessary to make a capital budgeting project, such as building a new

factory, worthwhile

The cost of capital determines how a company can raise money

Component of cost of capital

There are three component of cost of capital

Cost of debt capital

Cost of equity capital

Cost of preferred stock capital

Cost of debt capital

The effective rate that a company pays on its current debt. This can be measured in either

before- or after-tax returnsA company will use various bonds, loans and other forms of

debt, so this measure is useful for giving an idea as to the overall rate being paid by the

company to use debt financing.

Before the tax cost of debt

Before the tax cost of debt is derived by solving for the discount rate kd that equal to

market price of the debt issue with the present value of interest plus principal payments

and by then adjusting the explicit cost obtained for the tax deductibility of interest

payments

Po = It + Pt

---------

( 1 + Kd)

Po is the current market price of debt issue

∑ denotes the summation for period 1 through n

It is the interest payment in period t

Pt payment of principal in period t

Kd discount rate

After the tax cost of debt

After the cost of debt which denote by Ki

Ki = Kd ( 1- t)

Where Kd remains as previously used and t is now defined as the company marginal tax

rate because interest charged are tax deductible to the issuer the after the tax cost of debt

is substantially less than the before tax cost

36

Cost of equity capital

The cost of equity capital is equal to the required rate of return on equity-supplied capital.

n financial theory, the return that stockholders require for a company. The traditional

formula for cost of equity (COE) is the dividend capitalization model

Ke = (D1 / Po ) +g

There are two model

Capital assets pricing model

A model that describes the relationship between risk and expected return and that is used

in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways:

time value of money and risk. The time value of money is represented by the risk-free (rf)

rate in the formula and compensates the investors for placing money in any investment

over a period of time. The other half of the formula represents risk and calculates the

amount of compensation the investor needs for taking on additional risk. This is

calculated by taking a risk measure (beta) that compares the returns of the asset to the

market over a period of time and to the market premium (Rm-rf).

Dividend discounting model

it is used to evaluate stocks based on the net present value of the future dividends.

There are 3 models used in the dividend discount model:

zero-growth model

37

zero growth which assumes that all dividends paid by a stock remain the same; Since the

zero-growth model assumes that the dividend always stays the same, the stock price

would be equal to the annual dividends divided by the required rate of return. Stock‘s

Intrinsic Value = Annual Dividends / Required Rate of Return

the constant-growth model, (gordon growth model )

constant growth model which assumes that dividends grow by a specific percent

annually;

Intrinsic Value = D1

──────

k – g

D1 = Next Year‘s Dividend

k = Capitalization Rate

g = Dividend Growth Rate

The constant-growth model is often used to value stocks of mature companies that have

increased the dividend steadily over the years. Although the annual increase is not always

the same, the constant-growth model can be used to approximate an intrinsic value of the

stock using the average of the dividend growth and projecting that average to future

dividend increases

Cost of preferred stock capital

Required rate of return on investment of the preferred shareholders of company .

Kp = Dp / Po

Dp = expected dividend per share

Po = per share market price of the stock

38

Weighted average cost of capital

The weighted average cost of capital (WACC) is the rate that a company is expected to

pay on average to all its security holders to finance its assets.

All capital sources - common stock, preferred stock, bonds and any other long-term debt -

are included in a WACC calculation. All else help equal, the WACC of a firm increases

as the beta and rate of return on equity increases, as an increase in WACC notes a

decrease in valuation and a higher risk.

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

Or

Cost of capital = Kx (Wx)

Where Kx is after tax cost of xth method of financing

Wx is weight

Limitations of WACC

1.Weighting System

Marginal Capital Costs

―Marginal Cost of Capital (MCC) Schedule is a graph that relates the firm‘s weighted

average cost of each dollar of capital to the total amount of new capital raised.‖

―The marginal cost of capital (MCC) is the cost of the last dollar of capital raised,

essentially the cost of another unit of capital raised.‖

Some sources of capital are more expensive than others; for example, low-grade

subordinated debt would be more expensive to raise (require a higher interest rate)

than unsubordinated debt. Because capital must be raised to finance a new project, the

marginal cost of capital should be the Hurdle Rate used in discounted cash flow

present value analysis, not the average cost of capital.

39

Flotation Costs

Flotation costs are the costs associated with issuing securities such as underwriting, legal,

listing, and printing fees.

a. Adjustment to Initial Outlay

One approach which we refer to as the adjustment to initial outlay method treats the

flotation costs of financing as an addition to initial cash outlay for project according to

this procedure the net present value of project is computed according to

NPV = CFt / (1 + K) t - (ICO + flotation cost)

CFt = project cash flow at time t

ICO = initial cash out lay

K = firm cost of capital

b. Adjustment to Discount Rate

A second more traditional approaches calls for an upward adjustment of cost of capital

when flotation cost are present. This method which we refer to as the adjustment to

discount rate procedure. under this procedure each component cost of capital would be

recalculated by finding the discount rate equates the present value of cash flows to the

suppliers of capital with the net proceed of a security issue rather than the security market

price

Capital structure

Capital structure refers to the combination or mix of debt and equity which a company

uses to finance its long term operations.

Debt comes in the form of bond issues or long-term notes payable, while equity is

classified as common stock, preferred stock or retained earnings. Short-term debt such as

working capital requirements is also considered to be part of the capital structure.

Capital structure theories

There are following theories

Net operating income approach

40

A theory of capital structure in which the weighted average cost of capital and total value

of the firm remain constant leverage is changed .

Concept of Leverage

Leverage (or gearing) is the ratio of loan capital plus bank and other borrowings to

capital employed (the funds that are used to operate the business).

Ke = E/S

E = O-I

S= V-B

V = O/Ko

O = net operating income

Ko = overall capitalization rate

V = total value of firm

B = market value of debt

S = market value of stock

Example the firm has 1000 $ in debt at 10 percent interest that the expected annual net

operating income is 1000 $ and that the overall capitalization rate Ko is 15 percent

calculate value of firm

E = O-I = 1000-100 = 900

S = V – B = 1000/15 – 1000 = 5667 $

Ke = 900 $ / 5667 $ = 15.88%

Net operating income or NOI is used in two very important real estate ratios. It is an

essential ingredient in the Capitalization Rate (Cap Rate) calculation that is used to

estimate the value of income producing properties. Another important ratio that is used to

evaluate income producing properties is the Debt Coverage Ratio or DCR. The NOI is a

key ingredient in this important ratio also.

It is also an essential part of an income property's Income Statement and Cash Flow

Statement. It is therefore important to understand how the Net Operating Income is

calculated

Net income approach

41

Assumptions of the NI Approach

There are no corporate taxes

The cost of debt is less than the cost of equity

The debt content does not change the risk perception of the investors

Traditional approach

A theory of capital structure in which there exits an optimal capital structure and where

management can increase the total value of the firm through the judicious use of financial

leverage

This approach suggest that the firm can initially lower its cost of capital and raise its total

value through increasing leverage

Assumption

1. Cost of debt remain less constant but after certain limit it start increasing.

2. Similarly cost of equity also remain less constant and increase after certain limit

3. Total cost of capital decrease up to certain point, then become constant & then

start decreasing.

4. The company pays out all its earnings as dividends

5. The leverage of the company can be changed immediately by issuing debt to

purchase shares, or by issuing shares to repurchase debt

Miller and modigilani approach

42

Assumption

a) A perfect capital market exists in which

investors have the same information

Upon which they act rationally

To arrive to the same expectations about future earnings and risks

c) There are no taxes or transaction costs

d) Debt is risk-free and freely available at the same cost to investors and companies

alike.

e) Homogeneous expectation

In 1958 Modigliani and Miller proposed

MM Proposition I

The total market value of a company, in the absence of tax will be determined by two

factors

1 Total earnings of the company

2. The level of operating risk attached to those earnings(The total market value would be

computed by discounting the total earnings at a rate that is appropriate to the level of

operating risk. The WACC)

Thus the capital structure has no effect on the

MM justified their approach by the use of arbitrage.

MM Proposition II

1. The cost of debt remains unchanged as the level of leverage increases

2. The cost of equity rises in such a way as to keep the WACC constant.

Factor affecting the capital structure

1. Size of Business

43

2. Form of Business Organisations

3. Stability of Earnings

4. Degree of Competition

5. Stage of Life Cycle

6. Credit Standing

7. Corporation Tax

8. State Regulations

9. State of Capital Market

10. Attitude of Management

11. Trading on Equity

12. Interest Coverage Ratio

13. Cash Flow Ability of the Company

14. Cost of Capital

15. Floatation Costs

16. Control

17. Flexibility

18. Leverage Ratios for other Firms

19. Consultation with Invt. Banker & Lenders

20. General Level of Business Activity

Taxes

Definition: Sums imposed by a government authority upon persons or property to pay for

government services

Effects of taxes

Corporate taxes

If your business is organized as a C corporation, you'll be paid a salary like other

employees. Any profit the business makes will accrue to the corporation, not to you

personally. At the end of the year, you must file a corporate income tax return. Corporate

tax returns may be prepared on a calendar- or fiscal-year basis. If the tax liability of the

business is calculated on a calendar year, the tax return must be filed with the IRS no

later than March 15 each year; however, the corporation may file a request for extension

of due date.

Reporting income on a fiscal-year cycle is more convenient for most businesses because

they can end their tax year in any month they choose. A corporation whose income is

primarily derived form the personal services of its shareholders must use a calendar-year

end for tax purposes. In addition, most Subchapter S corporations are required to use

calendar-year ends.

Uncertainty of tax shield benefit

If taxable income should be low or turn negative the tax shield benefir from debt are

reduced or even eliminated. If the firm should go bankrupt and liquidate the future tax

44

saving associated with debt would stop together. As financial leverage increase the

uncertainty associated with the interest tax shield benefit become more and more

important issue

Corporate plus personal taxes

With the combination of corporate taxes and personal taxes on both debt and stock

income the present value of interest tax shield benefit will likely be lowered however the

general consensus is that personal taxes act to reduce but not eliminate the corporate tax

advantage associated with debt

Sales Taxes

Sales taxes are levied by many cities and states at varying rates. Most provide specific

exemptions, as for certain classes of merchandise or particular groups of customers.

Service businesses are often exempt altogether. Contact your state and/or local revenue

offices for information on the law for your area so that you can adapt your bookkeeping

to the requirements.

Levying taxes on all states would present no major difficulties, but since this is not the

case, your business will have to identify tax-exempt sales from taxable sales. Then you

can deduct tax-exempt sales from total sales when filing your sales tax returns each

quarter. Remember, if you fail to collect taxes that should have been collected, you can

be held liable for the full amount of uncollected tax, plus penalties and interest.

Taxes on Proprietorships, Partnerships and Corporations

The first tax issue business owners face is the legal form of your business. You can be a

sole proprietor, a general partner, or the head of your corporation. Your choice has a big

impact on your tax liability, so make sure to get your CPA's advice first.

Sole Proprietorship Taxes

A sole proprietorship is a one-owner business, which has many or few employees. This

form of organization is simple and requires no fancy legal work. You name your business

in accordance with licensing laws, you apply for a federal EIN number if you have

employees, and you're all set. A sole proprietor's income is included on his or her

personal tax return.

Suppose a husband and wife file a joint return. The husband has his own business, while

the wife works part-time for the government and makes $25,000 a year. The husband's

gross income from his business was $100,000, and his business made $20,000 in profits

after business expenses were deducted. His $20,000 profit is included on the individual

return, along with his wife's $25,000. The business income is considered personal income

45

for the sole proprietor, and there are no special business-income taxes other than self-

employment taxes.

Social Security (FICA) Tax

The Federal Insurance Contributions Act, or FICA, provides for a federal system of old-

age, survivors, disability and hospital insurance. The old-age, survivors, and disability

insurance part is financed by the Social Security tax. The hospital insurance part is

financed by the Medicare tax.

FICA requires employers to match and pay the same amount of Social Security tax as the

employee does. Charts and instructions for Social Security deductions come with the IRS

payroll forms. Congress has mandated requirements for depositing FICA and withholding

taxes, and failure to comply with these regulations subjects a business to substantial

penalties. Four different reports must be filed with the IRS regarding payroll taxes (both

FICA and income taxes) that you withhold from your employees' wages:

1. Quarterly return of taxes withheld on wages (Form 941);

2. Annual statement of taxes withheld on wages (Form W-2);

3. Reconciliation of quarterly returns of taxes withheld with annual statement of taxes

withheld (Form W-3);

4. Annual Federal Unemployment Tax return (Form 940).

______________________________________

Chapter -9

Making capital structure decision

EBIT and EPS analysis

EBIT - Earnings Before Interest and Taxes. Accountants like to use the term Net

Operating Income for this income statement item, but finance people usually refer to it as

EBIT. Either way, on an income statement, it is the amount of income that a company

has after subtracting operating expenses from sales (hence the term net operating

income). Another way of looking at it is that this is the income that the company has

before subtracting interest and taxes (hence, EBIT).

EAT - Earnings After Taxes. Accountants call this Net Income or Net Profit After

Taxes, but finance people usually refer to it as EAT.

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EPS - Earnings Per Share. This is the amount of income that the common stockholders

are entitled to receive (per share of stock owned). This income may be paid out in the

form of dividends, retained and reinvested by the company, or a combination of both.

Calculation of EBIT

Sales : xxxxx

(-)V.C : xxx

=Contribution : xxxxx

(-)F.C : xxxx

=EBIT {Earning Before Interest and Taxes}

Calculation EPS

EBIT : xxxxx

(-)INTERSET : xxx

=EBT : xxxxx

(-)TAX : xx

=Earning for ESH : xxxxx

(÷) No. of E.S : xxx

= EPS {Earning Per Share} xxx

Q: The present capital structure of Gupta Co. ltd. is:

4000, 5% Debentures of Rs 100 each Rs 4,00,000

2000, 8% P. Shares of Rs 100 each Rs 2,00,000

4000, Equity shares of Rs 100 each Rs 4,00,000

Rs 10,00,000

The present earning of the company before interest & taxes are 10% of the invested

capital every year. The company is in need of Rs 2,00,000 for purchasing a new

equipment and it is estimated that additional investment will also produce 10% earning

before interest & taxes every year.

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The company has asked your advice as to whether the requisite amount be obtained in the

form of 5% Debenture or 8% P. Shares

Or equity shares of Rs 100 each to be issued at par. Examine the problem in all its

bearing and advice firm if the Corporate tax rate is 50%.

Particulars

Present

i

Debenture

ii

P. Share

iii

Eq. Share

EBIT

(-)Interest

1,00,000

20,000

1,20,000

30,000

1,20,000

20,000

1,20,000

20,000

EBT

(-)Tax 50%

80,000

40,000

90,000

45,000

1,00,000

50,000

1,00,000

50,000

EAT

(-)P.

Dividend

40,000

16,000

45,000

16,000

50,000

32,000

50,000

16,000

ESH

(÷) No. of

Equity

Shares

24,000

4,000

29,000

4,000

18,000

4,000

34,000

6,000

EPS

Change in

EPS

Rs 6.00

-

Rs 7.25

+1.25

Rs 4.50

-1.50

Rs 5.67

-0.33

Cash flow ability to service debt

Page 442 (book financial management) (chapter 16) (operating and financial

leverage )

__________________________________________

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Chapter 10

Procedural aspect of paying dividend

What Does Dividend Policy Mean?

The policy a company uses to decide how much it will pay out to shareholders in

dividends.

Procedural aspect of paying dividend

There are following procedure of paying dividend

1- declaration date

2- Ex-dividend date

3- Date of record

4- Date of payment

Declaration date

The date on which the next dividend payment is announced by the directors of a

company. This statement includes the dividend's size, ex-dividend date and payment date.

It is also referred to as the "announcement date".Once it is authorized, the dividend is

known as a declared dividend and it becomes the company's legal liability to pay it.

Example

The declaration date of all listed stock options in the U.S. is on the third Friday of the

listed month. If there is a holiday on the Friday then the declaration date falls on the third

Thursday.

Record date

The date by which a corporate shareholder must be registered in order to be eligible to

receive dividends or to vote on company business.

The record date is the date on which you must be a holder of the stock (i.e., a shareholder

or unit holder) in order to receive the dividends for the upcoming payment date.

Example

This means that if you purchased the stock and the transaction is fully settled in your

brokerage account by February 10th, then you will receive the dividends or distributions

on your most recent purchase on the upcoming payment date (which is usually 7-10 days

later).

Shareholders of record on the record date also receive the annual, semi-annual and other

stockholder voting materials from the record date onwards. Thus, you might receive

some of these in the mail (or your inbox) before you‘ve received the dividend.

Ex-dividend date

The first day of trading when the seller, rather than the buyer, of a stock will be entitled

to the most recently announced dividend payment. The length of time ensuing between

the ex-dividend date and the date of actual payment may be up to a month. If you sell

your stock before the ex-dividend date, you also are selling away your right to the stock

49

dividend. Your sale includes an obligation to deliver any shares acquired as a result of the

dividend to the buyer of your shares, since the seller will receive an I.O.U. or "due bill"

from his or her broker for the additional shares

Date of payment

The date on which a bill is due.

The date on which a dividend will be paid to stockholders or on which interest will be

paid to bondholders by the issuers' paying agents.

The legal payment due date is the date specified in the contract.

The actual payment date is the date the payment is initiated by the payor unless specified

otherwise in the contract.

___________________________________________

Chapter 11

Issuing securities

Public offering securities The sale of equity shares or other financial instruments by an organization to the public in

order to raise funds for business expansion and investment. Public offerings of corporate

securities in the U.S. must be registered with and approved by the SEC and are normally

conducted by an investment underwriter.

Generally, any sale of securities to more than 35 people is deemed to be a public offering,

and thus requires the filing of registration statements with the appropriate regulatory

authorities. The offering price is predetermined and established by the issuing company

and the investment bankers handling the transaction. The term public offering is equally

applicable to a company's initial public offering, as well as subsequent offerings.

Method of public offering of security

There are two methods of public offering securities

1- Traditional underwriting

When investment banking institution buys a security issue it underwriters the sale of the

issue by giving company a check for the purchase price at that time company is reviled of

the risk of not being able to sell the issue at the established price if the issuer dose not sell

well because of an adverse turn in the market or because it is over priced

Best effort offering

An underwriting in which an investment bank, acting as an agent, agrees to do its best to

sell the offering to the public, but does not buy the securities outright and does not

guarantee that the issuing company will receive any set amount of money. Less common

than a firm commitment offering. When an investment bank is hired to underwrite

securities of a company, there are other types of offerings, including the most common,

firm commitment. With a firm commitment offering, the investment bank guarantees the

number of securities it will sell and guarantees its commitment by purchasing the shares

themselves, even if they cannot sell them. The shares that the investment bank is unable

to sell cannot be returned to the company.

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Making a market

Underwriter will make a market for a security after it is issued. in first public offering of

common stock making market is important to investor. In making market the underwriter

maintains a position in stock quotes bid and asked prices, and stand ready to buy and sell

it at those prices. These quotations are based on underlying supply and demand condition

2- Self registration

The distinguish feature of traditional underwriting is that the registration process with

securities and exchange commission take at least several weeks to complete. Large

corporation whose securities are listed on an exchange are able to shortcut the registration

process under rule 415

Flotation cost

Flotation costs are the costs associated with issuing securities such as underwriting, legal,

listing, and printing fees.

a. Adjustment to Initial Outlay

One approach which we refer to as the adjustment to initial outlay method treats the

flotation costs of financing as an addition to initial cash outlay for project according to

this procedure the net present value of project is computed according to

c. Adjustment to Discount Rate

A second more traditional approaches calls for an upward adjustment of cost of capital

when flotation cost are present. This method which we refer to as the adjustment to

discount rate procedure. under this procedure each component cost of capital would be

recalculated by finding the discount rate equates the present value of cash flows to the

suppliers of capital with the net proceed of a security issue rather than the security market

price

________________________________

Chapter 12

Definition of debt financing Debt financing is basically money that you borrow to run your business.

You can think of debt financing as being divided into two categories, based on the type of

loan you are seeking: long term debt financing and short term debt financing.

Long Term Debt Financing usually applies to assets your business is purchasing, such

as equipment, buildings, land, or machinery. With long term debt financing, the

scheduled repayment of the loan and the estimated useful life of the assets extends over

more than one year.

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Short Term Debt Financing usually applies to money needed for the day-to-day

operations of the business, such as purchasing inventory, supplies, or paying the wages of

employees. Short term financing is referred to as an operating loan or short term loan

because scheduled repayment takes place in less than one year. A line of credit is an

example of short term debt financing.

Feature of debt

High yield bonds

A high paying bond with a lower credit rating than investment-grade corporate bonds,

Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds

pay a higher yield than investment grade bonds.

Based on the two main credit rating agencies, high-yield bonds carry a rating of 'BBB' or

lower from S&P, and 'Baa' or lower from Moody's. Bonds with ratings above these levels

are considered investment grade. Credit ratings can be as low as 'D' (currently in default),

and most bonds with 'C' ratings or lower carry a high risk of default; to compensate for

this risk, yields will typically be very high.

Also known as "junk bonds"

Bond ratings

A grade given to bonds that indicates their credit quality. Private independent rating

services such as Standard & Poor's, Moody's and Fitch provide these evaluations of a

bond issuer's financial strength, or its the ability to pay a bond's principal and interest in a

timely fashion.

Bond ratings are expressed as letters ranging from 'AAA', which is the highest grade, to

'C' ("Junk"), which is the lowest grade. Different rating services use the same letter

grades, but use various combinations of upper- and lower-case letters to differentiate

themselves.

Sinking fund

Fund set aside by a corporation or government agency for the purpose of periodically

redeeming bonds, debentures, and preferred stocks. The fund is accumulated from

earnings, and payments into the fund may be based on either a fixed percentage of the

outstanding debt or a fixed percentage of profits. Sinking funds are administered

separately from the corporation's working funds by a trust company or trustee. The

purpose of a sinking fund is to assure investors that provision has been made for the

repayment of bonds at maturity.

Floating rate notes

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money

market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a

rate that remains constant.

52

A note with a variable interest rate. The adjustments to the interest rate are usually made

every six months and are tied to a certain money-market index. Also known as a

"floater".

These protect investors against a rise in interest rates (which have an inverse relationship

with bond prices), but also carry lower yields than fixed notes of the same maturity. It's

essentially the same concept as a adjustable-rate mortgage, except FRNs are investments

(not debt).

Types of debt financing

1 Working Capital Loan:

It is the most popular short-term financing option. It is meant to meet the working needs

like the purchase of raw material, payment of wages and other administrative expenses,

financing inventories, managing internal cash-flows, supporting supply chains, funding

production and marketing operations. Most banks provide these against collaterals.

Companies who borrow from banks are subjected to the discipline of maintenance of

proper accounts and regular repayments of loans. They are subjected to periodical

monitoring through a reporting structure of financial and other statements and also

through analysis of cash flows routed through the banks.

2. Overdraft:

The other short-term debt option is the overdraft facility, by way of which a company

opens a current account with a bank and can overdraw money up to an agreed limit. In

this case, you pay interest only for the time you use the money.

3. Factoring:

The bank buys the customer‘s account receivables in domestic and international trade,

assuming the responsibility of collecting them from the party who owes money.

4. Commercial Papers (CPs):

It is a debt instrument issued by companies at a discount on the face value. Banks,

individuals and mutual funds usually buy commercial papers.

5. Term loans:

Term loans are mostly taker to buy assets and grow business. These loans are term

based, which may vary from three to ten years. The amount, the tenure and interest rates

may vary depending upon the risk profile of the company. Term loans are either asset-

backed or cash-flow backed. In the case of asset-backed term loans, lender institutions

seek assets of the company as collaterals while issuing loans. In the case of cash-flow

53

backed loans, banks carefully scrutinize the balance sheets of a company to study its

cash-flow capability.

6. Syndicated loans:

Syndicated loans are large capital loans raised by big corporations from a group of banks.

These are aimed at acquiring domestic or international companies. In this case, one bank

acts as a lead bank.

7. Project Finance:

Large and long-term infrastructure projects require huge amounts amount of funding both

in the form of debt and equity. In project financing, lenders (banks) rely on the assets

created for the project as security and the cash-flow generated by the project as source of

funds for repaying their dues. These projects include building of roads, dams; ports etc

are sensitive to regulatory and political policies and tariffs.

8. Debentures:

This is a long-term debt instrument issued by a company with the acknowledgement that

it would repay the money at a certain rate of interest to the buyer. These are not shares,

thus the buyer can stake no claim in the share of the company.

9. Inter-corporate deposits:

This is a short-term help provided by one corporate with surplus funds to another in need

of funds. The major disadvantage to lenders is that the money is locked in for the certain

period of time.

10. Personal loans:

Entrepreneurs also take personal loans from banks and financial institutions to fund their

projects.

11 Secured Debt

Secured lenders look for repayment in one of two ways: normal repayment from cash

flow, or liquidation of the assets held as security. When a secured lender looks at your

company, they are looking for enough historical cash flow to pay the loan payment AND

enough tangible security (land, buildings or equipment) to fully repay the loan advance,

plus interest and expenses.

Secured debt is the cheapest to obtain because it is relatively low risk for the lender. It is

also the most widely available. Secured loans can include operating lines of credit, term

loans and mortgages. Lenders include banks, term lenders, asset-based lenders,

franchisers, factoring companies, sales and leaseback sources, export-related sources and

equipment leasing companies.

12 Subordinated Debt

Also known as participating debt, junior debt, mezzanine debt and quasi-equity. Banks

will provide subordinated debt in situations where there is insufficient tangible security to

cover the loan if your historical cash flow is more than sufficient to service future

payments of principal and interest, as well as future capital expenditures to maintain the

54

physical plant in its present condition. Lenders look for a debt service coverage ratio of at

least 1.5 to 1.

Lenders enhance their rate of return by charging bonus interest, or a royalty on sales, or

by participating in the available cash flow. They may request an option or warrants for

common shares in your company.

Because of the higher risk, subordinated debt has higher fees and rates of interest than

secured debt.

13 Unsecured Term Loans

Unsecured loans are granted only to firms with projected and historical financial data to

prove ability to repay. They usually require you to put up 30% to 50% of the funds

needed, depending on the type of business.

14 Real Estate Financing

These include commercial or industrial mortgages for up to 75% of the appraised value of

your property, for terms of 10 to 20 years.

Preferred stock Preferred Stock is a type of stock that promises a (usually) fixed dividend, but at the

discretion of the board of directors. Preferred Stock has preference over common stock

in the payment of dividends and claims on assets.

The payment of preferred stock is similar to an annuity, so the valuation model of a

preferred stock is

V = Dp / Kp

Example

Stock PS has an 8%, $100 par value issue outstanding. The appropriate discount rate is

10%. What is the value of the preferred stock?

Dp = $100 ( 8% ) = $8.00.

Kp = 10%.

V = Dp / kp = $8.00 / 10%

= $80

Types of preferred stock

In addition to the straight preferred, as just described, there is great diversity in the

preferred stock market. Additional types of preferred stock include:

Prior Preferred Stock –

Many companies have different issues of preferred stock outstanding at the same time

and one of them is usually designated to be the one with the highest priority. If the

company has only enough money to meet the dividend schedule on one of the preferred

issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred

55

have less credit risk than the other preferred stocks but it usually offers a lower yield than

the others.

Preference Preferred Stock –

Ranked behind the company's prior preferred stock (on a seniority basis), are the

company's preference preferred issues. These issues receive preference over all other

classes of the company's preferred except for the prior preferred. If the company issues

more than one issue of preference preferred, then the various issues are ranked by their

relative seniority. One issue is designated first preference, the next senior issue is the

second and so on.

Convertible Preferred Stock –

These are preferred issues that the holders can exchange for a predetermined number of

the company's common stock. This exchange can occur at any time the investor chooses

regardless of the current market price of the common stock. It is a one way deal so one

cannot convert the common stock back to preferred stock.

Cumulative preferred stock – If the dividend is not paid, it will accumulate for future

payment.

Exchangeable preferred stock –

This type of preferred stock carries the option to be exchanged for some other security

upon certain conditions.

Participating Preferred Stock –

These preferred issues offer the holders the opportunity to receive extra dividends if the

company achieves some predetermined financial goals. The investors who purchased

these stocks receive their regular dividend regardless of how well or how poorly the

company performs, assuming the company does well enough to make the annual

dividend payments. If the company achieves predetermined sales, earnings or

profitability goals, the investors receive an additional dividend.

Perpetual preferred stock – This type of preferred stock has no fixed date on which

invested capital will be returned to the shareholder, although there will always be

redemption privileges held by the corporation. Most preferred stock is issued without a

set redemption date.

Putable preferred stock –

These issues have a "put" privilege whereby the holder may, upon certain conditions,

force the issuer to redeem shares.

Monthly income preferred stock – A combination of preferred stock and subordinated

debt.

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Non-cumulative preferred stock –

Dividend for this type of preferred stock will not accumulate if it is unpaid. Very

common in TRuPS and bank preferred stock, since under BIS rules, preferred stock must

be non-cumulative if it is to be included in Tier 1 capital.

___--____________________________________________________-____

THE END

Fahad - MBA IV contact number -03338366266

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Corporate finance - WordPress.com · 2014-02-10 · EBIT- EPS analysis 43 Dividend and share repurchase Procedural aspects of paying dividend 46 Issuing securities Public offering