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I. Summary Working Capital Management Working capital management is concerned with the problems that arise in managing the Current assets ( CA), current liabilities (CL) and the interrelationships between them. Its Operational goal is to manage the CA & CL in such a way that a satisfactory/acceptable level of net working capital (NWC) is maintained.
There are two concepts of working capital (WC): gross and net. The gross WC means the total CA and CL
The NWC is necessary due to non synchronous nature of expected cash inflow and required cash outflow. The more predictable the cash inflows are, the less NWC will be required and vice‐versa. The NWC represent the liquidity position of a firm.
The NWC has a bearing on liquidity, profitability and risk of becoming technically insolvent in general, the greater is the NWC, the higher is the liquidity, the lower is the risk and the Profitability, and vice‐versa. The trade‐off in between profitability and risk is an important Element in the evaluation of the level of NWC of a firm.
The need of working capital (WC) arises from the cash/operation cycle of a firm. It refers to The length of time required to complete the following the sequence of events: conversion of Cash into inventory, inventory into receivables and receivables into cash. The opening cycle Creates the need for working capital and its length in terms time‐span required to complete the cycle is the major determinant of the firm’s working capital needs.
II. Summary of Cash Management Cash is the ready currency to which all liquid assets can be reduced.
Near cash implies marketable securities viewed the same way as cash because of their high liquidity.
Marketable securities are short‐term interest earning money market instruments used by firms to obtain a return on temporary idle funds.
Motives for holding cash Transaction motive is for holding cash/near cash to meet routine cash requirements to finance transaction in the normal course of business. Precautionary motive is motive for holding cash/near‐cash as cushion to meet unexpected contingencies/demand for cash. Speculative motive is motive for holding cash/near‐cash to quickly take advantage of opportunities typically outside the normal course of business. Compensating motive is a motive for holding cash to compensate banks for providing certain services or loans.
The basic objectives of cash management are two‐fold:(a) to meet the cash disbursement needs (payment schedule), and (b) to minimize funds committed to cash balances. These are conflicting and mutually contradictory and the task of cash management is to reconcile.
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Meeting Payment Schedule : in the normal course of business, firms have to make payments of cash on a continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a constant inflow of cash through collections from debtors. Minimizing Funds Committed to Cash Balances : The second objective of cash management is to minimize cash balances. In minimizing the cash balances, two conflicting aspects have to be reconciled. A high level of cash balances will, as shown above, ensure prompt payment together with all the advantages. But it is also implies that large funds will remain idle, as cash non earning asset and the firm will have to forego profits. A low level cash balances, on the other hand, may mean failure to meet the payment schedule. The aim of cash management, therefore, should be to have an optimal amount of cash balances. III. Summary of Receivables Management The term receivables is defined as ‘debt owned to the firm by customers arising from sale of goods and services in thee ordinary course of business ‘. When a firm makes an ordinary sale of goods or services and does not receive payment, the firm grants trade credit and creates accounts receivables which could collected in the future. Receivables management is also called trade credit management. Thus, accounts receivable represent an extension of credit to customers, allowing them a reasonable period of time in which to for the goods received.
Costs associated with the extension of credit and accounts receivable are: Collection cost is the administrative cost incurred in collecting receivables. Capital cost is the cost of the use of additional capital to support credit sales which alternatively could have been employed elsewhere. Delinquency cost : arising out of failure of customers to pay on due date. Default cost: are the over dues that cannot be recovered.
Credit policy is the determination of credit standards and credit analysis
IV. Summary of Inventory Management The basic responsibility of the financial manager is to make sure the firm’s cash flows are managed efficiently. Efficient management of inventory should ultimately result in the maximization of the owner’s wealth. It implies that while the management should try to pursue the financial objective of turning inventory as quickly as possible, it should at the same time ensure sufficient inventories to satisfy the production and sales demands.
Ordering cost: is the fixed cost of placing and receiving an inventory order.
Carrying costs: The second board category of costs associated with inventory are the carrying costs. They are involved in maintaining or carrying inventory. The cost of holding inventory may be divided into two categories:
1. Those that arise due to the storing of inventory. The main components of this category of carrying costs are (i) storage cost, that is, tax, depreciation, insurance, maintenance of the building, utilities and janitorial
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services; (ii)insurance of inventory against and theft; (iii)deterioration in inventory because of pilferage, fire, technical obsolescence, style obsolescence and price decline; (iv)serving costs, such as labor for handling inventory, clerical and accounting costs.
The Opportunity Cost Funds: This consists of expenses in raising funds(interest on capital)to finance the acquisition of inventory. If funds were not locked up; in inventory, they would have
Earned a return. This is the opportunity cost of financial cost component of the cost. The carrying costs and the inventory size are positively related and more in the same direction. if the level of inventory increases, the carrying costs also increase and vise‐versa. The sum of the order and carrying costs represents and total cost of inventory . this is compared with the benefits arising out of inventory to determine the optimum level of inventory.
Lead time: is time normally taken in receiving delivery after placing orders with suppliers.
Safety stocks : implies extra inventories that can be drawn down when actual lead time and/or usage rates are greater than expected.
V. Summary of Leverage Leverage : is the employment of an asset/source of finance for which firm pays fixed cost/fixed return.
Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed returns. As a result , the earnings available to the share holders/owners are affected as also their risks. There are three types of leverage, namely, operating, financial and combined.
Leverage associated with asset acquisition or investment activities is referred to as the operating leverage. It refer to the firms ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits (EBIT) and results in more than a proportionate change (+/‐) in EBIT with change in the sales revenue.
Degree in operational leverage (DOL) is computed in two ways : (i) Percentage change in EBIT/Percentage change in sales and (ii) (Sales – Variable costs)/EBIT or Contribution/EBIT
The operating leverage is favorable when increase in sales volume has a positive magnifying effect on EBIT. It is unfavorable when decrease in sales volume has a negative magnifying effect on EBIT. Therefore, high DOL is good when sales revenues are rising and bad when they are falling.
The DOL is measure of the business/operating risk of the firm. Operating risk is the risk of the firm not being able to cover its fixed operating costs. The larger is the magnitude of such cost, the larger is the volume of sales required to recover them. Thus, the DOL, depends on fixed operating costs.
Financial leverage is related to the financing activities of a firm. It results from the presence of fixed financial charges (such as interest on debts and dividend on preference shares). Since such financial expenses do not vary with the operating profits, financial leverage is concerned with the effect of changes in EBIT on the earnings available to equity‐holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share(EPS).
The degree of financial leverage (DFL) can be computed in the following ways: (i)
DFL=Percentage change in EPS/Percentage change EBIT.
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(ii) (iii)
DFL= EBIT/(EBIT‐I), when debt is used. DFL =EBIT/(EBIT – I – Dp/(1 – t)), when debt as well as preference capital is used.
Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to the equity‐holders. When a firm earns more on the assets purchased with the funds than the fixed cost of their use, the financial leverage is favorable. Unfavorable leverage occurs when the firm does not earn as much as funds cost.
High fixed financial costs increase the financial leverage and, thus, financial risk. The financial risk refers to the risk of the firm not being able to cover its fixed financial costs. In case of default, the firm can be technically forced into liquidation. The larger is the amount of fixed financial costs, the larger is EBIT required to recover them. Thus, the DFL depends on fixed financial costs.
To devise an appropriate capital structure, the amount of EBIT under various financing plans should be related to EPS. The EBIT‐EPS analysis EPS is a widely‐used method of examining the effect of financial leverage /use of debt. A financial alternative that ensures the largest EPS is preferred, given the level of EBIT.
Financial break‐evens point (BEP) represents a point at which before‐tax earnings are equal to the firm’s fixed financial obligations. Symbolically, is computed as follows: (I + Dp + Dt)/(1 – t)). In other words, at financial BEP, EPS is zero.
The EBIT level at which the EPS is the same for two alternative financial plans is known as the indifference point/level. Beyond the indifference level of EBIT, the benefits of financial leverage begin to operate with respect to EPS.
Combined leverage (DCL) is the product of operating and financial leverage. It indicates the effect that changes in sales will have on EPS. Symbolically, it can be computed by the following methods:
(i) DCL = DOL X DFL (ii) DCL = PERCENTAGE CHANGE IN EPS/PERCENTAGE CHANGE IN SALES (iii) DCL = (SALERS – VARIABLE COSTS)/(EBIT – 1) Combined leverage is a measure of the total risk of the firm. To keep the risk within manageable limits, a firm which has high degree of operating leverage should have low financial leverage and vice‐versa. EBIT‐EPS analysis/approach is an approach for selecting capital structure that maximizes earning per share (EPS) over the expected range of earnings before interest and taxes.
VI. Summary of Capital Structure Theories Capital structure refer to the mix or proportion of different sources of finance (debt and equity) to total capitalization. A firm should select such a financing‐mix which maximizes its value/the shareholders’ wealth (or minimizes its overall cost of capital). Such a capital structure is referred to as the optimum capital structure.
Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital and valuation. The four important theories are: (i) Net income (NI) approach and (ii)Net operating income(NOI) approach, (iii) Modigliani and Miller (MM) approach and
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ASSUMPTIONS
1. There are only two sources of funds used by a firm: perpetual debt and ordinary shares. 2. There are no corporate taxes. This assumption is removed later. 3. The dividend/payout ratio is 100%. That is total earnings are paid out as dividend to the shareholders and there are no retained earnings. 4. The total assets are given and do not change. The investment decisions are, in other words, assumed to be constant. 5. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debts and reduce the equity capital. 6. The operating profits(EBIT) are not expected to grow. 7. All inventories are assumed to have the same subjective probability distribution of the future expected EBIT for a given firm. 8. Business risk is constant over time and is assumed to be independent of its capital structure. 9. Perpetual life of the firm. Definitions AND SYMBOLS: In addition to the above assumptions, we shall make use of some symbols in our analysis of capital structure theories: S= total market value of equity B= total market value of debt I= total interest payments V= total market value of the firm (V=S +B) S = (EBIT‐I)/Ke or EBT/Ke
Net income (NI) approach
According to the NI approach, capital structure is relevant as its affects the cost of capital and valuation of the firm.
The core of this approach is that as the ratio of less expensive source of funds (i.e., debt) increases in the capital structure, the cost of capital (ko) decreases and valuation (V) of the firm increases.
With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure and which the (ko) would be the lowest, the v of the firm the highest and market price per share the maximum.
Net operating income(NOI) approach
The NOI approach is diametrically opposite to the NI approach. The essence of this approach is the capital structure decision of a corporate does not effect its cost of capital and valuation, and hence, irrelevant.
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The main argument of NOI is that and increase in the proportion of debt in the capital structure would lead to an increase in the financial risk of the equity holders. To compensate for the increased risk, they would require a higher rate of return (ke) on their investment. As a result, the advantage of the lower cost of debt would exactly be neutralized by the increase in the cost of equity. The cost of debt has two components: (i) explicit, represented by rate of interest, and (ii) implicit, represented by the increased in the cost of equity capital. Therefore, the real cost of debt and equity would be the same and there is nothing like an optimum capital structure.
As per NOI, V = EBIT/Ko
S = V‐B
Modigliani and Miller Approach
Modigliani and Miller (MM) concur with NOI and provide a behavioral justification for the irrelevance of capital structure.
They maintain that the cost of capital and value of the firm do not change with a change of leverage. They contend that the total value of homogeneous firms that differ only in respect of leverage cannot be different because of the operations of arbitrage.
The arbitrage refer to the switching over operations, that is, the investors switch over from over‐valued firm (levered firm) to the undervalued firms (unlevered). The essence of arbitrage is that the investors (arbitragers) are able to substitute personal or home‐made leverage for corporate leverage. The switching operation drives the total value of the two homogeneous firms equal.
The basic premises of (MM) approach, in practice, are of doubtful validity. As a result, the arbitrage process is impeded. To the extent, the arbitrage process is imperfect, it implies that the capital structure matters.
The MM contend that with corporate taxes, debt has a definite advantage as interest paid on debt is tax‐ deductible and leverage will lower the overall cost of capital. The value of the levered firm(V1) would exceed the value of the unlevered firm(Vu) by an amount equal to levered firm’s debt multiplied by tax rate.
Factors impacting Capital Structure Decision
A host of factors, both quantitative and qualitative including subjective judgment of financial managers, have a bearing of the determination of an optional capital structure of a firm. They are not only highly complex but also conflicting in nature and, therefore, cannot fit entirely into a theoretical frame work. Moreover the weights assigned to various factors also vary widely according to conditions in the economy, the industry and the company itself. Therefore, a corporate should attempt to evolve an appropriate capital structure, given the facts of the particular case.
The key factors relevant to designing an appropriate capital structure are, (i) profitability, (ii) liquidity, (iii) control, (iv) leverage ratios in industry, (v) nature of industry, (vi) consultation with investment banks/lenders, (vii) commercial strategy, (viii) timing, (ix) company characteristics and (x) tax planning. PROFITABILITY ASPECT: Keeping in view the primary objective of financial management of maximizing the market value of the firm, the EBIT‐EPS analysis should be considered logically by the first step in the
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direction of designing a firm’s capital structure. Given the objective of financial management to maximize the share holders wealth, a corporate should carryout profitability analysis in terms of determining the amount of EBIT Indifference point at which its MPS is identical under two proposed financial plans. In general, the higher the level of EBIT than the indifference point and the lower the probability of its downward fluctuation, the greater is the amount debt that can be employed by a corporate. LIQUIDITY ASPECT : EBIT‐EPS analysis and coverage ratios are very useful in making explicit the impact of leverage on EPS and on the firm’s ability to meet its commitments at various levels of EBIT. But the EBIT/ interest ratio is less than a perfect measure to analyse the firm’s ability to service fixed charges because the firms ability to do so depends on the total payments required, that is, interest and principal, in relation to the cash flow available to met them. Therefore, the analysis of the cash flow ability of the firm to the service fixed charges is an important exercise to be carried out in capital structure planning in addition to profitability analysis.
Coverage ratio can also be used to judge the adequacy of EBIT to meet the firm’s obligations to pay financial charges, interest on loan, preference dividend and repayment of principal. A higher ratio implies that the firm can go for larger proportions of debt in it capital structure.
Another major to determine the adequacy of cash flow to meet the fixed obligations in cash budget. A cash budget should be prepared for a range of possible cash inflows with a probability attached to each of them. Since the probability of various cash flow pattern is known, the firm can determine the level of debt it can employ and still remain within an insolvency limit tolerable to the management. The impact of alternative debt policies should also be examined under adverse circumstances/recession conditions. To retain control over management, a firm would prefer use of debt to equity. A debt equity ratio of firm should be similar to those of other companies in the industry. In case sales are subject to wide fluctuations, a firm should employ less debt. Firm subject to keen competition should prefer a greater proportion of equity. The corporate in industry groups which are at their infancy should rely more on equity capital. Investment analysts/ bankers/institutional investors understand the capital market better as well as requirements of investors/lenders. Their opinion is also useful in designing capital structure.
An appropriate capital structure should provide room for flexibility not in obtaining funds but also in refunding them.
Public issues of share as well as debt capital should be made at time when the state of economy as well as capital market is idle to provide the funds. For instance, it will be useful to postpone borrowings if decline in interest rates is expected in the future.
The characteristics for company, inter‐alia, in terms of size in credit standing are decisive in determining in its capital structure. While large firms enjoying the high credit standing among investors are in a better position to obtain funds from the sources of their choice, the relatively small firms, new firms and firms having poor credit standing have limited option in this regard.
The choice of and appropriate debt policy involves trade ‐off between tax benefits and cost of financial distress. Moreover, the management should consider the implicit cost of the tax subsidy in using debt.
VII. Beta Estimation
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Beta (β) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole
Beta is also referred to as systematic risk. The risk inherent to the entire market or entire market segment. Also known as "un‐diversifiable risk"
An asset has a Beta of zero if its returns change independently of changes in the market's returns. A positive beta means that the asset's returns generally follow the market's returns, in the sense that they both tend to be above their respective averages together, or both tend to be below their respective averages together. A negative beta means that the asset's returns generally move opposite the market's returns: one will tend to be above its average when the other is below its average.[
In other words, beta greater than 1 means that return of a security are more volatile as compared to the market returns. If the beta is less than 1 then it means that return of a security are less volatile as compared to the market returns
Formula for calculating beta β = N∑XM ‐ ∑X∑M N∑M2 – (∑M)2
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