FINANCIAL

MANAGEMENT ( FM)

HAND BOOK
EDITION 2
CS EXECUTIVE NEW SYLLABUS

REVISE ENTIRE FM IN JUST TWO HOURS

By

Prof. RAJ AWATE (Always with u )

Instagram – raj_awate_

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INSPIRE ACADEMY

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RAJ AWATE ( always with U ) Faculty of CMA and FM 8888881719, 7447447339
Finance may be1.defined
Scope as an
andart Objectives
or a science of of
managing money.
Financial Management

✓ Financial management comprises the forecasting, planning, organizing, directing, coordinating and
controlling of all activities relating to acquisition and application of the financial resources of an
undertaking in keeping with its financial objective.
Financial Management as procurement of funds and their effective utilisations in the business;
✓ Types of decision : investment, financing and dividend decisions
✓ Investment decision :
- Investment ordinarily means utilisation of money for profits or returns
- Capital budgeting is a major technique of investment decision making process.
- Investment decisions and capital budgeting are considered as synonymous in the business
world.
- investment decisions are used in following areas:
capital budgeting
cost of capital
measuring risk
management of liquidity and current assets
expansion and contraction involving business failure and re-organisations
buy or hire or lease an asset.
✓ Financing decision :
- next step in financial management for executing the investment decision once taken.
- Financing decisions are concerned with the determination of how much funds to procure
from amongst the various options available i.e. the financing mix or capital structure.
- important area of financing decision making, aims at
maximising returns on investment
minimising the risk.
- The risk and return analysis is a common tool for investment and financing decisions
✓ Dividend decision:
- financial manager must decide whether the firm should distribute all profits or retain them or
distribute a portion and retain the balance
- Factors playing important role in dividend policy –
market price of shares
the trend of earning
the tax position of the shareholders
cash flow position

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 requirement of funds for future growth
restrictions under the Companies Act.
✓ A fair decision criterion should follow the following two fundamental principles
(1) the “Bigger and Better” principle- It means bigger benefits are preferable to smaller ones;
(2) “A Bird in Hand is Better than Two in the Bush” principle- It means early benefits are
preferable to later benefits.
✓ Objectives of financial management:

a)Profit maximisation;

b) Shareholder Wealth maximisation.

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 ✓ Profit Maximization goal:

Drawback/limitations :

Advantages Disadvantages / Limitations

a) Must for survival of business, else, Capital is lost.a) The term “Profit” is vague.
b) Essential for growth and development ofb)
business. c) Higher the profits, higher the risks involved.
c) Impact on society through factor payments. d)
d) Profit-making firms only can pursue sociale) It ignores time pattern of returns.
obligations. f) It ignores social and moral obligations of the
e) business.

✓ Wealth maximization:
(a) It is consistent with the object of maximizing owner’s economic welfare.
(b) It focuses on the long run picture.
(c) It considers risk.
(d) It recognizes the value of regular dividend payments.
(e) It takes into account time value of money.
(f) It maintains market price of its shares.

✓ Difference :

Profit Maximization Wealth Maximization

Does not consider the effect of future cash Recognises the effect of all future cash
flows, dividend decisions, EPS, etc. flows, dividends, BPS, etc.
A Firm with Profit Maximization objective A Firm with Wealth Maximization objective
may refrain from payment of dividend to may pay regular dividends to its
its Shareholders. Shareholders.
Ignores time pattern of returns. Recognises the time pattern of returns.
Focus on Short-Term. Focus on Medium / Long Term
Does not consider the effect of uncertain/ Recognises the risk-return relationships.
risk.

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 Comparatively easy to determine the Offers no clear or specific relationship
relationship between financial decisions and between financial decisions and share
Profits market prices.

✓ Economic value added (EVA) is the after tax cash flow generated by a business minus the cost of
the capital it has deployed to generate that cash flow.
EVA = (Operating Profit) – (A Capital Charge)
EVA = NOPAT – (Cost of Capital x Capital)

✓ EVA will increase if:

- Operating profits grow without employing additional capital i.e., through greater efficiency.
- Additional capital is invested in the projects that give higher returns than the cost of procuring
new capital
- Unproductive capital is liquidated
✓ Risk return trade off : A particular combination of risk and return where both are optimized may
be known as Risk-return trade off and at this level of risk-return, the market price of the shares
will be maximised.
✓ Liquidity : is defined as ability of the business to meet its short-term obligations. It shows the
quickness with which a business/company can convert its assets into cash to pay what it owes in
the near future.
Current Ratio which is the ratio of current assets to current liabilities, is widely used by corporate
units to judge ability to discharge short-term liabilities covering the period upto one year.
✓ Responsibilities of the financial manager –

- Forecasting of Cash Flow

- Raising Funds

- Managing the Flow of Internal Funds

- To Facilitate Cost Control

- To Facilitate Pricing of Product, Product Lines and Services

- Forecasting Profit

- Measuring Required Return

- Managing Assets

- Managing Funds

✓ Finance Functions/ Finance Decisions :

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 Value of a firm will depend on various finance functions/decisions. It can be expressed as:
V= f (I,F,D)

The finance functions are divided into long term and short term functions/ decisions.

a)Long term Finance decision-

a. Investment decisions (I)
b. Financing decisions (F)
c. Dividend decisions (D)

b) Short term Finance decision- It includes working capital management

✓ Three Stages of Evolution of Financial Management-

- The Traditional Phase- During this phase, financial management was considered necessary only
during occasional events such as takeovers, mergers, expansion, liquidation, etc.
- Transitional Phase- During this phase, the day-to-day problems that financial managers faced were
given importance. The general problems related to funds analysis, planning and control were given
more attention in this phase.
- Modern Phase- Modern phase is still going on. The scope of financial management has greatly
increased now. It is important to carry out financial analysis for a company.

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 2 Type of Financing and Cost of capital

✓ Financial Needs : All financial needs of business can be grouped into following three categories:
- Long term financial needs- This category includes where funds are required for more than 5-
10 years. E.g. investment in building, machinery, land etc.
- Medium term financial needs- This category includes where funds are required for more than
one year but not more than 5 years. E.g. Advertisement campaign
- Short-term financial needs- This requires to finance current assets like stock, debtors, cash
etc.

✓ Classification of financial sources :

Source of Finance based on Basic Sources –

a. External Sources –
i. Share Capital – Equity Shares & Preference Shares
ii. Debt or Borrowed Capital- Debentures & Loan from financial institutions.
b. Internal Sources –Retained earnings

Source of Finance based on Maturity of payment-

a. Long term-

• Share Capital
• Retained earnings
• Debentures/Bonds of different types
• Loans from Financial Institutions
• Loan from State Financial Corporation
• Loan from commercial banks
• Venture capital funding
• Asset securitisation

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b. Medium-term

• Preference shares
• Debentures/Bonds
• Public deposits
• Medium term loan from banks
• Lease financing/Hire purchase financing
• External commercial borrowings
• Euro issues

c. Short-term

• Trade Credit
• Accrued expenses and deferred income
• Short term loans like working capital loans from commercial banks
• Fixed deposits for a period of 1 year or less

✓ The cost of capital :

- the cost of a company's funds (both debt and equity),
- from an investor's point of view "the shareholder's required return on a portfolio company's
existing securities"
- Cost of capital is used to evaluate new projects of a company and it is the minimum return
that investors expect for providing capital to the company.
- For an investment to be worthwhile, the expected return on capital must be greater than the
cost of capital.
- The cost of capital is the rate of return that capital could be expected to earn in an alternative
investment of equivalent risk.

✓ There are four main factors which mainly determine the cost of Capital of a firm :
- General economic conditions
- marketability of the firm’s securities (market conditions)
- operating and financing conditions within the company
- amount of financing needed for new investments.

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✓ Contollable factors -There are factors affecting cost of capital that the company has control over

and includes Capital Structure Policy, Dividend Policy, Investment Policy etc.

Uncontrollable factors - There are some factors affecting cost of capital that the company has

not control over and these factors includes Level of Interest Rates, Tax Rates.

✓ Cost of Debt is calculated after tax because interest payments are tax deductible for the firm.

Cost of capital is denoted by the term Kd.

Cost of Redeemable Debt:

𝐼 [1 − 𝑡 ] + [𝑅𝑉 − 𝑁𝑃 ]/𝑁) / ([𝑅𝑉 + 𝑁𝑃]/2)

Cost of Irredeemable Debt:

𝐈 × [𝟏 − 𝒕])/(𝑵𝑷)

Kd after taxes = Kd (1 – tax rate)

✓ Cost of preference shares :

- Irredeemable preference shares are those shares issuing by which the company has no
obligation to pay back the principal amount of the shares during its lifetime. The only liability
of the company is to pay the annual dividends. The cost of irredeemable preference shares is:

Kp (cost of pref. share) = Annual dividend

Market price

– Redeemable preference shares are those shares which have a fixed maturity date at which

they would be redeemed. The cost of redeemable preference shares is calculated by under given

formulae.

=D+(RV-SV)/N

Cost of Redeemable preference shares = Kp (RV+SV)/2

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✓ cost of equity capital : is the minimum rate of return that a company must earn on the equity
financed portion of its investments in order to maintain the market price of the equity share at
the current level.

- CAPM model : This is a popular approach to estimate the cost of equity. According to the SML,
the cost of equity capital is:

Ke = Rf + ß (Rm -Rf) Where:

Ke = Cost of equity Rf = Risk-free rate

Rm = Equity market required return

ß = beta- Systematic Risk Coefficient.

- Bond Yield Plus Risk Premium Approach :This approach is a subjective procedure to estimate
the cost of equity. In this approach, a judgmental risk premium to the observed yield on the
long-term bonds of the firm is added to get the cost of equity.

Cost of equity = Yield on long-term bonds + Risk Premium.

- Dividend Growth Model Approach

P0 =D1/(Ke-g)

Ke= D1/P0+ g. here

P0 = Current price of the stock D1= Expected dividend at the end of year 1

Ke = Equity shareholders' required rate of

return g = Growth rate

- Earnings-Price Ratio approach : Ke = E

1 / P0

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✓ The weighted average cost of capital (WACC), as the name implies, is the weighted average of

the costs of different components of the capital structure of a firm. WACC is calculated after

assigning different weights to the components according to the proportion of that component in the

capital structure.

✓ The following format may be adopted for computation of WACC:

Component Amount Proportion Individual Multiplication

or % cost
Debt (kd) W1 Kd Kd× W1

Preference capital (kp) W2 Kp Kp ×W2

Retained earnings (ke) W3 Ke Ke × W3

Equity capital (ke) W4 Ke Ke × W4

Total (ko) Ko = WACC = total of

above

✓ Importance of WACC :

- Securities analysis employ WACC all the time when valuing and selecting investments.
- In discounted cash flow analysis WACC is used as a hurdle rate against which to assess return
on investment capital performance.
- It also plays a key role in economic value added (EVA) calculations.
- Investors use WACC as a tool to decide whether to invest

✓ Marginal Cost of Capital (MCC) can be defined as the cost of additional capital introduced in the

capital structure since we have assumed that the capital structure can vary according to changing

requirements of the firm.

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 3 PROJECT FINANCE

✓ Project decisions are taken by the management with basic objective to maximize returns on the

investment being made in a project.

✓ Project report is a working plan for implementation of project proposal after investment decision by

a company has been taken.

✓ Project appraisal should be analyzed for determining the project objects, accuracy of method and

measurement, objective of the proposal, reliability of data and project statements.

✓ A careful balance has to be stuck between debt and equity. A debt equity ratio of 1:1 is considered

ideal but it is relaxed up to 1.5:1 in suitable cases.

✓ Economic Rate of Return is a rate of discount which equates the real economic cost of project

outlay to its economic benefits during the life of the project.

✓ Domestic Resource Cost measures the resource cost of manufacturing a product as against the cost

of importing/exporting it. The output from any project adds to domestic availability implying a

notional reduction in imports to the extent of output of the project or an addition to exports if the

product is being exported.

✓ Effective Rate of Protection attempts to measure the net protection provided to a particular stage

of manufacturing

✓ The Loan agreement is an agreement expressed in writing and entered into between the borrower

and the lender bank, institution or other creditors. It envisages a relationship taking into account

the commitment made at that time and the conduct of the parties carrying legal sanctions.

✓ Loan syndication involves obtaining commitment for term loans from the financial institutions and

banks to finance the project. Basically it refers to the services rendered by merchant bankers in

arranging and procuring credit from financial institutions, banks and other lending and investment

organization or financing the client project cost or working capital requirements

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✓ In Social Cost-Benefit Analysis, a project is analyzed from the point of view of the benefit it will

generate for the society as a whole.

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 4 DIVIDEND POLICY

✓ Dividend Policy :

The term ‘dividend’ refers to that portion of profit (after tax) which is distributed among the owners/shareholders
the firm.

✓ Four types of dividend policy :

1) Regular dividend policy: in this type of dividend policy the investors get dividend at usual rate. Here,
the investors are usually persons who want to get regulary incomes. This type of dividend payment can
be maintained only if the company has regular earning.

2)Stable dividend policy: Here the payment of certain sum of money is regularly made to the
shareholders. It is of three types:

a) Constant dividend per share: In this case, reserve fund is created to pay fixed amount of
dividend in the year when the earning of the company is not enough. It is suitable for the firms having
stable earning.

(b) Constant payout ratio: Under this type the payment of fixed percentage of earning is paid as
dividend every year.

(c) Stable rupee dividend + extra dividend: Under this type, there is payment of low dividend per
share constantly + extra dividend in the year when the company earns high profit. The extra dividend
may be considered as a “bonus” paid to the shareholders as a result of usually good year for the firm.
This additional amount of dividend may be paid in the form of cash or bonus shares, subject to the
firm’s liquidity position.

3)Irregular dividend: as the name suggests here the company does not pay regular dividend to the

shareholders. The company uses this practice due to following reasons:

– Due to uncertain earning of the company.

– Due to lack of liquid resources.

– The company is sometime afraid of giving regular dividend.

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 – Due to uncertainty of business.

4) No dividend: the company may use this type of dividend policy due to requirement of funds for the

growth of the company or for the working capital requirement.

✓ Types of dividend :

- Cash Dividend

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid

periodically out the business concern’s EAIT (Earnings after interest and tax).

- Stock Dividend :Stock dividend is paid in the form of the company stock due to raising of more
finance. Under this type, cash is retained by the business concern. Stock dividend may be bonus
issue. This issue is given only to the existing shareholders of the business concern.
- Bond Dividend :Bond dividend is also known as script dividend. If the company does not have
sufficient funds to pay cash dividend, the company promises to pay the shareholder at a future
specific date with the help of issue of bond or notes.
- Property Dividend :Altrnative to cash or stock dividend, a property dividend can either include
shares of a subsidiary company or physical assets such as inventories that the company holds.
The dividend is recorded at the market value of the asset provided. It will be distributed under
exceptional circumstances. This type of dividend is not prevalent in India.

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1) Theories on Dividend Policies

a) Walter Approach: This approach shows how dividend can be used to maximize the share price.
The relationship between dividend and share price on the basis of Walter’s formula is shown below:

R
𝐷 + Ke (𝐸 − 𝐷)
P0 =
𝐾𝑒

Where,

Po = Market price of Equity share.

D = Dividend per share paid by the Firm.

R = Rate of return on investment of the Firm.

Ke = Cost of Equity share capital

E = Earnings per share of the Firm.

Explanation: The formula explains why market prices of shares of growth companies are high even

though the dividend paid out is low. It also explains why the market price of shares of certain

companies which pay higher dividends and retain very low profits is also high.

b) Gordon Growth Model: This model explicitly relates the market value of the firm to dividend policy.

𝐸 (1 − b)
P0 =
𝐾𝑒 − 𝑔

Where,

Po = Market price of Equity share.

E = Earnings per share of the Firm.

B = Retention Ration (1 – Pay-out ratio),

R = Rate of return on Investment of the Firm.

Ke = Cost of Equity share capital, and

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 Br = g i.e., Growth rate of the firm

Explanation: The formula given by Gordon shows where the rate of return is greater than the discount rate (Ke),
share price increases and vice-versa. In case the both are equal; the price remains unchanged.

c) Modigliani and Miller (MM) Approach: Modigliani and Miller Hypothesis is in support of the irrelevance of divide
means firm’s dividend policy has no effect on value of shares.

𝐏𝟏 = 𝑷𝟎 (𝟏 + 𝑲𝒆 ) − 𝑫

Where,

Po = Market price of Equity share today/now.

D = Dividend per share

P1 = Market price of Equity share at end of year 1

Ke = Cost of Equity share capital

Explanation: Due to reduction in the price of a share when it goes ‘ex-dividend’, the value of a

shareholder’s wealth is always the same irrespective of the amount of dividend declared.

A shareholder can always sell his portion of equity to realize the dividend income.

2) Determinants of Dividend Policy

i) Legal
ii) Financial needs of the company
iii) Economic Constraints
iv) Nature of Business Conducted by a Company
v) Existence of the Company
vi) Type of Company Organization
vii) Market Conditions
viii) Financial Arrangement
ix) Change in Government Policies

3) Stability of Dividend
a) Constant Dividend Pay-out Ratio
b) Steady Dividend Per Share

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 c) Steady Dividends plus Extra

4) Dividend Policy is determined by the Board of Directors having taken into consideration a number of
factors which include legal restrictions imported by the Government to safeguard the interest of various
parties or the constituents of the company.

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 5 WORKING CAPITAL

✓ Meaning and Concept of Working Capital

In accounting term working capital is the difference between the current assets and current liabilities.

Working Capital = Current Assets – Current Liabilities

✓ Nature of working capital

The term working capital refers to current assets which may be defined as

i) Those which are convertible into cash or equivalents within the normal operating cycle

of the firm, and

ii) Those which are required to meet day to day operations.

The term working capital may be used in two different ways:

1. Gross Working Capital (or Total Working Capital)

2. Net Working Capital

✓ Factors determining working capital requirement

1. Basic Nature of Business

2. Business Cycle Fluctuations
3. Seasonal Operations
4. Market Competitiveness
5. Credit Policy
6. Supply Conditions

✓ Need for adequate working capital

The need and importance of adequate working capital for day to day operations can hardly be underestimated.

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 Every firm must maintain a sound working capital position otherwise its business activities may be adversely affected.

✓ Working capital Policy and management

Two broad policy alternatives, in this respect, are:

a) A conservative current Asset financing policy

b) An aggressive current Asset Financing Policy

✓ Types of working capital needs

1) Initial working capital

2) Regular working capital
3) Fluctuating working capital
4) Reserve margin working capital
5) Permanent and Temporary Working Capital
6) Long Term working capital
7) Short term working capital
8) Gross Working Capital
9) Net Working Capital

✓ Estimation and calculation of working capital

A firm must estimate in advance as to how much net working capital will be required for the smooth operations

of the business. Only then, it can bifurcate this requirement into permanent working capital and temporary

working capital. This bifurcation will help in deciding the financing pattern i.e.,

how much working capital should be financed from long term sources and how much be financed from short term

sources.

There are different approaches available to estimate the working capital requirements of a firm as follows:

1) Working Capital as a Percentage of Net Sales

a) To estimate total current assets as a % of estimated net sales.
b) To estimate current liabilities as a % of estimated net sales, and
c) The difference between the two above, is the net working capital as a % of net sales.

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2) Working Capital as a Percentage of Total Assets or Fixed Assets
3) Working Capital based on Operating Cycle

✓ Banking norms and macro aspect of working capital management

1) Norms for inventory and receivables

2) Bank lending
a) Working Capital Gap:
75% of the working capital gap will be financed by the bank i.e. Total Current Assets
Less: Current Liabilities other than Bank Borrowings.
Less: 25% of Working Capital gap from long-term sources.

b) Alternatively, the borrower has to provide for a minimum of 25% of the total current assets
out of long-term funds and the bank will provide the balance. The total current liabilities
inclusive of bank borrowings will not exceed 75% of the current assets:
Maximum Bank Borrowing permissible:
Total Current Assets
Less: 25% of current assets from long-term sources.
Less: Current liabilities other than Bank borrowings

c) The third alternative is also the same as the second one noted above except that it excludes
the permanent portion of current assets from the total current assets to be financed out of the

long-term funds, viz.

Maximum Bank Borrowing permissible=

Total Current Assets
Less: Permanent portion of current assets
Real Current Assets
Less: 25% of Real Current Assets
Less: Current Liabilities other than Bank Borrowings.

Thus, by following the above measures, the excessive borrowings from banks will be gradually eliminated and the
funds could be put to more productive purposes.

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 The above methods may be reduced to equation as under :
1st Method : PBC = 75/100 WCG
2nd Method : PBC = TCA – [(25/100 TCA) + OCL]
3rd Method : PBC = TCA – [CRA + 25/100 (TCA – CRA) + OCL]
Where,
PBC stands for Working Capital Gap
TCA stands for Total Current Assets
OCL Stands for Other Current Liabilities.
(i.e. Current Liabilities other than Bank Borrowings)
CRA stands for Amount required to finance Core Assets.

3) Style of credit
4) Information system
5) Follow up
6) Norms of Capital Structure

✓ Factors affecting the cash needs

It has already been said that the financial manager has to achieve a trade-off between liquidity and

profitability and in doing so he should note that there are various factor which will determine the amount

of cash balance to be kept by the firm. Some of these factors are as follows:

a. Cash Cycle
b. Cash Inflows and Cash Outflows
c. Cost of Cash Balance
d. Other Considerations

✓ Types of inventories

i) Finished Goods
ii) Work-in-Progress
iii) Raw Materials

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✓ Inventory management

1) Transactionary Motive
2) Precautionary Motive
3) Speculative Motive

✓ Costs of receivables

1. Cost of Financing
2. Administrative Cost
3. Delinquency Costs
4. Cost of Default by Customers

✓ Benefits of receivables

1. Increase in Sales
2. Increase in Profit
3. Extra Profit

✓ The operating cycle is the length of time between the company’s outlay on raw materials,
wages and other expenditures and the inflow of cash from the sale of the goods. In a manufacturing
business, operating cycle is the average time that raw material remains in stock less the period of
credit taken from suppliers, plus the time taken for producing the goods, plus the time the goods
remain in finished inventory, plus the time taken by customers to pay for the goods.

Operating Cycle = R + W + F + D – C

Where,R = Raw material storage period W= Work-in-progress holding period

F = Finished goods storage period D = Receivables (Debtors) collection period.

C = Credit period allowed by suppliers (Creditors).

✓ Working capital leverage may refer to the way in which a company’s profitability is affected in part
by its working capital management.

✓ Funds flow represent movement of all assets particularly of current assets because of movement in
fixed assets is expected to be small except at times of expansion or diversification.

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✓ Cash management means management of cash in currency form, bank balance and reality
marketable securities.

✓ There are various technical tools used in inventory management such as ABC analysis, Economic
Order Quantity (EOQ) and inventory turnover analysis.
✓
✓ ABC analysis is based on paid to those item which account for a larger value of consumption
rather than the quantity of consumption.

important technique of inventory control on selective basis.

Category % in total % in total Extent of control
value quantity
A 70% 10% Constant and strict control
B 20% 20% Need periodic review not strict as excessive.
C 10% 70% Little control

✓ Economic order quantity ( EOQ ) : size of order which should be placed so that overall cost
2 ×Annual requirement ×cost per order
is minimum. EOQ = √ carrying cost p.u.p.a.

Annual ordering cost = cost per order * Number of orders

Where, number of orders = AR / order size

Annual carrying cost = carrying cost p.u.pa. * Average inventory

Where, average inventory = order size /2

✓ Inventory level :
Reorder level ( ROL) : It shows level of stock at which order must be placed.

ROL = Maximum lead time * Maximum consumption rate

= Safety stock + Avg lead time * Avg consumption rate

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 Minimum level = ROL– Avg lead time * Avg consumption rate

Maximum level = ROL + ROQ – Min lead time time * Min consumption rate

maximum level+Minimum level ROQ

Average level = 2
= minimum level + 2

Danger level = emergency lead time * normal consumption rate

✓ Factoring is a type of financial service which involves an outright sale of the receivables of a firm

to a financial institution called the factor which specializes in the management of trade credit.

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 6 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

✓ Investment may be defined as a conscious act on the part of a person that involves deployment of

money in securities issued by firms with a view to obtain a target rate of return over a specified

period of time.
✓
✓ Investment is conscious act of deployment of money in securities issued by firms. Speculation also

involves deployment of funds but is not backed by a conscious analysis of pros and cons.
✓
✓ Speculation also involves deployment of funds but it is not backed by a conscious analysis of pros

and cons.
✓
✓ Both gambling and betting are games of chance in which return is dependent upon a particular

event happening.
✓
✓ Risk in security analysis is generally associated with the possibility that the realized returns will

be less than the returns that were expected.

✓
✓ Risk can be classified under two main groups :
systematic risk and unsystematic risk.

✓ Systematic risk :

- Those forces that are uncontrollable, external and broad in their effect are called sources of

systematic risk.

- Systematic risk is due to the influence of external factors on an organization.

- Such factors are normally uncontrollable from an organization’s point of view.

- Systematic risk is a macro in nature as it affects a large number of organizations operating under

a similar stream or same domain. It cannot be planned by the organization.

Types :

1. Interest rate risk :Interest-rate risk is the variation in the single period rates of return caused by the
fluctuations in the market interest rate. It particularly affects debt securities as they carry the fixed
rate of interest.

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2. Market risk :Market risk is associated with consistent fluctuations seen in the trading price of any
particular shares or securities.

3. Purchasing power or inflationary risk :Purchasing power risk is also known as inflation risk. It is so,
since it emanates (originates) from the fact that it affects a purchasing power adversely. It is not
desirable to invest in securities during an inflationary period.

✓ Unsystematic Risk :

- Unsystematic risk is due to the influence of internal factors prevailing within an organization.

- Such factors are controllable, internal factors which are peculiar to a particular industry or firm/(s).

- It may be because of change in management, labour strikes which will impact the returns of only

specific firms which are facing the problem.

- It is a micro in nature as it affects only a particular organization.

Types :
Business or liquidity risk,
Financial or credit risk

✓ Return is the primary motivating force that drives investment. It represents the reward for

undertaking investment.

✓ The main objective of security analysis is to appraise are intrinsic value of security.

✓ The Fundamental approach suggests that every stock has an intrinsic value which should be equal

to the present value of the future stream of income from that stock discounted at an appropriate

risk related rate of interest.

✓ Technical approach suggests that the price of a stock depends on supply and demand in the market

place and has little relationship with its intrinsic value.

✓ Efficient Capital Market Hypothesis (ECMH) is based on the assumption that in efficient capital

markets prices of traded securities always fully reflect all publicly available information concerning

those securities.

✓ Performance of a company is intimately related to the overall economic environment of the country

because demand for products and services of the company would under normal circumstances be

directly related to growth of the country’s economy.

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✓ Industry level analysis focuses on a particular industry rather than on the broader economy.

✓ Dow Jones theory shows that share prices demonstrate a pattern over four to five years and these

patterns can be divided into primary, secondary and minor trends.

✓ \Charts and Indicators are two major tools of Technical Analysis.

✓ Portfolio management refers to managing efficiently the investment in the securities by

professionals for both small investors and corporate investors who may not have the time and skills

to arrive at sound investment decisions.

✓ Portfolio Analysis seeks to analyze the pattern of return emanating from a portfolio of securities.

✓ Risk means that the return on investment would be less than the expected rate. Risk is a

combination of possibilities because of which actual returns can be slightly different or greatly

different from expected returns.

✓ Portfolio theory was originally proposed by Harry Markowitz in 1950s, and was the first formal

attempt to quantify the risk of a portfolio and develop a methodology for determining the optimal

portfolio.

✓ As per Markowitz Model, a portfolio is efficient when it yields highest return for a particular level

of risk or minimizes risk for a specified level of expected return.

✓ Covariance and correlation are conceptually analogous in the sense that both of them reflect the

degree of comovements between two variables.

✓ According to Sharpe Index Model, return on a security is correlated to an index of securities or

an index or an economic indicator like GDP or prices and the return for each security can be given

by: Ri = ai +ßi RM + ei

✓ Capital Asset Pricing Model provides that if adding a stock to a portfolio increases its standard

deviation, the stock adds to the risk of the portfolio. This risk is the un-diversified risk that can

not be eliminated.

✓ Beta is the measure of the non- diversifiable or systematic risk of an aaet relative to that of the

market portfolio.

Beta = Non- Diversifiable risk of asset or portfolio

Risk of market portfolio

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 –The sharpe ratio is a risk adjusted measure of return that is often used to evaluate the performance
of a portfolio.

– EVA measures the firm’s ability to earn more than the true cost of capital.

– EVA combines the concept of residual income with the idea that all capital has a cost,
which means that it is a measure of the profit that remains after earning a required rate of
return on capital

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 7 CAPITAL BUDGETING

✓ Capital budgeting refers to long-term planning for proposed capital outlays and their financing.
Thus, it includes both raising of long-term funds as well as their utilisation.
✓ basic feature of capital budgeting decisions are:

- current funds are exchanged for future benefits;

- there is an investment in long-term activities; and
- the future benefits will occur to the firm over series of years

✓ Types of capital budgeting decisions (i) the accept-reject decisions; (ii) mutually exclusive

decisions; and (iii) capital rationing decisions.

Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the
proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment
proposals which yield a rate of return greater than cost of capital are accepted and the others are
rejected. Under this criterion, all the independent prospects are accepted.

Mutually exclusive decisions: It includes all those projects which compete with each other in a way
that acceptance of one precludes the acceptance of other or others. Thus, some technique has to be
used for selecting the best among all and eliminates other alternatives.

Capital rationing decisions: Capital budgeting decision is a simple process in those firms where fund is
not the constraint, but in majority of the cases, firms have fixed capital budget. So large number of
projects compete for these limited budget. So the firm ration them in a manner so as to maximise the
long run returns. Thus, capital rationing refers to the situations where the firm have more acceptable
investments requiring greater amount of finance than is available with the firm. It is concerned with
the selection of a group of investment out of many investment proposals ranked in the descending order
of the rate of return.

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1) Capital Budgeting: When a business makes a capital investment (assets such as equipment, building,
land etc.) it incurs a cash outlay in the expectation of future benefits. Out of different investment
proposals available to a business, it has to choose a proposal that provides the best return and the
return equals to, or greater than, that required by the investors.

2) Importance of capital budgeting decision:

a) Cost
b) Time
c) Irreversibility
d) Complexity
e) Risk and Uncertainly involved in appraisal
f) Substantial expenditure
g) Long time period

3) Basic financial factors are used in project evaluation technique:

a) Initial Investment: The equals the cash outflow at the initial stage, net of salvage value of old machinery if any.

Initial Investment = Cost of New Asset purchased Less Sale Value of old assets if any.

b) Cash Flow After Taxes (CFAT): This equals the cash inflows generated by the projects at various point of
time.

CFAT = PAT (Profit After Tax) + Depreciation and other amortizations.

c) Project life: The time period during which the project generates positive Cash Flow After Taxes is called
project life. Project life may be finite or infinite.

d) Terminal inflows: Amount expected to be realized at the end of project life. If nothing is mentioned in
the problem, assume working capital will be recovered in full.

e) Time Value of Money: the value of money differs at different point of time. So the present value of further
cash flows will be computed by discounting the same at the appropriate discount rate.

f) Discount Rate: It represents the cut-off rate for capital investment evaluation.

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 g) PV Factor and Annuity Factor Tables: For the purpose of discounting future cash flows, the PV factor

(Present Value Factor) and Annuity Factor tables are used. The utility of tables is as under:
• In case of uniform Cash Flows during the project life: Annuity Factor at the end of the project life.
• In case of different Cash Flows during the project life: PV Factors for each year.

4) Tax shield: Tax Shield = Loss Adjusted x Tax Rate.

5) Depreciation: Depreciation is not an item of cash flows; hence it is not considered in cash flow analysis.

However, Depreciation is relevant in capital budgeting on account of depreciation tax shield. Tax shield on

depreciation is an item of cash flow and hence must be recognized.

Depreciation Tax Shield = Depreciation x Tax Rate.

6) Types of Investment Proposal

a) Cost Reduction Proposals
b) Income Maintaining Proposals
c) Income Increasing Proposals
d) Research and Development
7) Classification of proposal
a) Independent proposals:
b) Contingent or dependent proposals
c) Mutually Exclusive proposals

8) Method of ranking investment proposals

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 Payback Period
Traditional or

Capital budgeting techniques

Non-discounting Accounting Rate of
Return

Net Present Value

Profability Index

Time-adjusted Internal Rate of Return

or Discount
cash flows Modified Internal Rate of
Return

Discounted Payback

Equivalent Annualised
Benefit / Cost Method

9) Pay Back Period - Payback period refer to the period in which the project will generate the necessary cash to recoup
the initial investment.

In case of even cash flows:

Initial Investment
Payback Period =
Annual Cash Inflow

Where
Annual cash flows = Estimated cash inflows resulting from the proposed investment (i.e. net income on account
of investment before depreciation but after taxation)

Sr. no. Particulars Decision

1) Payback period < cut-off period predetermines by management Accept

2) Payback period > cut-off period predetermines by management Reject

3) Payback period = cut off period predetermine by management Accept

Suitability of using Payback Period of Medhod :

Payback period method may be successfully applied in the following circumstances:

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 - where the firms suffers from liquidity problem and is interested in quick recovery of fund than
profitability
- high external financing cost of the project
- for projects involving very uncertain return; and political and economic pressures.

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10) Discounted payback period: When the payback period is computed after discounting the cash flows by
a predetermine rate, it is called as the ‘Discounted payback period’. It is computed as under:

11) Payback reciprocal: It is a reciprocal of payback period. It is calculated as follows

Payback Reciprocal:
Annual Cash Inflow
=
Inital Investment

12) Average rate of return: According to this method, the capital investment proposals are judged on the basis of
their relative profitability. For this purpose, capital employed and expected income are determined
according to commonly accepted accounting principles and practices over the entire economic life
of the project and then the average yield is calculated.

Average Annual NetEarnings Annual Average Net Earnings

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑡𝑚𝑒𝑛𝑡
∗ 100 OR 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝐼𝑛𝑣𝑒𝑡𝑚𝑒𝑛𝑡
∗ 100

Where,

a) The term “Average annual net earning” is the average of the earning (after depreciation and tax) over the whole of
the economic life. One may calculate “Average annual net earning s” before tax. Such rate is known as
pre-tax accounting rate of return.

b) The amount of “Average Investment” is calculated as follows:

Original investment − Scrap value
+ 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
2

ARR > Minimum rate of return (cut off rate)

and Reject the project if

ARR < Minimum rate of return (cut off rate)

Suitability of using ARR Method:

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 If the project life is not long, then the method can be used to have a rough assessment of the internal

rate of return. The present method is generally used as supplementary tool only.

13) Discounted cashflow method - An investment is essential outlay of funds in anticipation of future returns.
The presence of time as a factor in investment is fundamental rather than incidental to the purpose of
evaluation of investments.

there are three discounted cash flow methods for evaluating capital investment proposals i.e.

Net Present Value Method

Internal Rate of Return Method

Profitability Index or Benefit Cost (B/C) Ratio Method.

14) NPV - The net present value is the difference between present value of benefits and present value of costs.
𝑵𝑷𝑽 = PV of Cash Inflows − Present Value of Cash Outflow

Sr. No. Particulars Decision

A) NPV > Zero Accept
B) NPV < Zero Reject
C) NPV = Zero Accept

Suitability of NPV Method:

Net present value is the most suitable method in those circumstances where availability of resources is
not a constraint. The management authority can accept all those projects having Net Present Value
either Zero or positive. This method shall maximise shareholders wealth and market value of share which
is the sole aim of any business enterprise.

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15) The internal rate of return refers to the rate which equates the present value of cash inflows and
present value of cash outflows. In other words, it is the rate at which net present value of the
investment is zero.

Decision Rule :

If Internal Rate of Return i.e.

r > k (cut off rate) Accept the investment proposal

r < k Reject the investment proposal

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16) Profitability Index is defined as the rate of present value of the future cash benefits at the required
rate of return to the initial cash outflow of the investment. symbolically, Profitability Index is expressed
as :

Profitability index = PV of Future cash flows

Initial cash investment

17) If a choice must be made, the Net Present Value Method generally is considered to be superior

theoretically because:

- It is simple to operate as compared to internal rate of return method;

- It does not suffer from the limitations of multiple rates;

- The reinvestment assumption of the Net Present Value Method is more realistic than internal

rate of return method.

Some prefer Internal rate of return method on the following grounds:

- It is easier to visualise and to interpret as compared to Net Present Value Method.

- It suggests the maximum rate of return and even in the absence of cost of capital, it gives
fairly good idea of the projects profitability
- . On the other hand, Net Present Value Method may yield incorrect results if the firm’s cost
of capital is not calculated with accuracy.
- The internal rate of return method is preferable over Net Present Value Method in the
evaluation of risky projects.

18) Capital rationing :

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 - The firm may put a limit to the maximum amount that can be invested during a given period
of time, such as a year. Such a firm is then said to be resorting to capital rationing.
- A firm with capital rationing constraint attempts to select the combination of investment
projects that will be within the specified limits of investments to be made during a given
period of time and at the same time provide greatest profitability.

19) Risk adjusted discount rates method is used in investment and budgeting decisions to cover time

value of money and the risk. The use of risk adjusted discount rate is based on the concept that

investors demands higher returns from the risky projects. The required return of return on any

investment should include compensation for delaying consumption equal to risk free rate of return, plus

compensation for any kind of risk taken on.

20)Decision tree technique is another method which many corporate units use to evaluate risky proposals.
A decision tree shows the sequential outcome of a risky decision. A capital budgeting decision tree
shows the cash flows and net present value of the project under differing possible circumstances.

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 7 CAPITAL STRUCTURE

✓ Capital Structure is the combination of capitals from different sources of finance.

✓ The capital of a company consists of equity shareholders fund, preference share capital and long-
term external debts.

✓ Types of capital structure -

1) Horizontal capital structure - In a Horizontal capital structure, the firm has zero debt components in the structure
mix. The structure is quite stable. Expansion of the firm takes in a lateral manner, i.e. through equity or retained
earning only.

2) Vertical capital structure - In a vertical capital structure, the base of the structure is formed by equity share
capital. This base serves as the foundation on which the super structure of preference share capital and debt is
built. The Incremental addition in the capital structure is almost entirely in the form of debt. Quantum of retained
earnings is low and the dividend pay-out ratio is quite high.

3) Pyramid shaped capital structure - A pyramid shaped capital structure has a large proportion of consisting of equity
capital and retained earnings which have been ploughed back into the firm over a considerably large period of time.
The cost of share capital and the retained earnings of the firm is usually lower than the cost of debt. This structure
is indicating of risk averse conservative firms.

4) Inverted pyramid shaped capital structure - Such a capital structure has a small component of equity capital,
reasonable level of retained earnings but an ever-increasing component of debt. All the increases in the capital
structure in the recent past have been made through debt only.

✓ The significance of the capital structure is discussed below:

1. It reflects the firm’s strategy

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2. It is an indicator of the risk profile of the firm

3. It acts as a tax management tool

4. It helps to brighten the image of the firm

✓ Capital structure Vs financial structure :

Sr. CAPITAL STRUCTURE FINANCIAL STRUCTURE

No.
1) Capital structure of a company refers to types Financial Structure refers to the balance
of long term financing included in the capital between all the company’s liabilities and its
equities. Financial structure thus concerns the
entire “Liability” side of the Balance Sheet.
2) Debt, common stock, preferred stock, retained Financial structure on the other hands also
earnings and reserves. includes short term debt and accounts
payables.
3) It represents source of funding. It represents financial obligation of company.
4) It includes both long-term & short-term It includes only long-term sources of funds.
sources of funds.
5) It means the entire liabilities side of the It means only long-term liabilities of the
balance sheet. company.
6) It will not be more important while It is one of the major determinations of the
determining the value of the firm. value of the firm.
7) Capital structure relates to long term capital Financial structure involves creation of both
deployment for creation of long term assets. long term and short-term assets.
8) Capital structure is the core element of the The financial structure of a firm is considered
financial structure. Capital structure can exist to be a balanced one if the amount of current
without the current liabilities and in such liabilities is less than the capital structure net
cases, capital structure shall be equal to the of outside debt because in such cases the
financial structure. But we cannot have a long-term capital is considered sufficient to
situation where the firm has only current pay current liabilities in case of sudden loss
liabilities and no long-term capital. of current assets.

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✓ A sound or appropriate capital structure should have the following features:

- Return: it should generate maximum returns to the shareholders without adding additional

cost to them.

- Risk:

- Flexibility: The capital structure should be flexible. It should be possible for a company to
adapt its capital structure with a minimum cost and delay if warranted by a changed situation.
- Capacity: The capital structure should be determined within the debt capacity of the company
and this capacity should not be exceeded.
- Control: The capital structure should involve minimum risk of loss of control of the company.

✓ An optimal capital structure is the best debt to equity ratio for a firm that maximises its
value. The optimal capital structure for a company is one that offers a balance between the
ideal debt to equity range and minimises the firm’s cost of capital.

✓ There are basically four approaches to capital structure decision:

Net Income Approach

Net Operating Income Approach

Traditional Approach

Modigliani Miller (MM) Approach

✓ NI Aprroach :

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 - According to this approach there is a relationship between capital structure and the value of
the firm and therefore, the firm can affect its value by increasing or decreasing the debt
proportion in the overall financial mix.
- The Net Income Approach makes the following assumptions:

The total capital requirement of the firm is given and remains constant.

Cost of debt (Kd) is less than cost of equity (Ke).

Both Kd and Ke. remain constant and increase in financial leverage i.e., use of more and more
debt financing in the capital structure does not affect the risk perception of the investors.

✓ NOI approach :

- Net operating income approach is opposite to the Net income approach. According to NOI
Approach, the market value of the firm depends upon the net operating profit or EBIT and
the overall cost of capital. The financing mix or the capital structure is irrelevant and does
not affect the value of the firm.
- The NOI Approach makes the following assumptions:

The investors see the firm as a whole and thus capitalize the total earnings of the firm to

find the value of the firm as a whole.

The overall cost of capital KO, of the firm is constant and depends upon the business risk
which also is assumed to be unchanged.

The cost of debt, Kd, is also taken as constant.

There is no taxes.

✓ The traditional approach to capital structure advocates that there is a right combination of
equity and debt in the capital structure, at which the market value of a firm is maximum. As
per this approach, debt should exist in the capital structure only up to a specific point, beyond
which, any increase in leverage would result in the reduction in value of the firm.

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 It means that there exists an optimum value of debt to equity ratio at which the
Weighted Average Cost of Capital (WACC) is the lowest and the market value of the firm is the
highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises
to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market
value of the firm starts a downward movement.

Assumptions under traditional approach:

The rate of interest on debt remains constant for a certain period and thereafter with an increase

in leverage, it increases.

The expected rate by equity shareholders remains constant or increase gradually. After that, the
equity shareholders starts perceiving a financial risk and then from the optimal point and the
expected rate increases speedily.

On the basis of these assumptions, the MM model derived that:

a. The total value of the firm is equal to the capitalized value of the operating earnings of the firm. The capitaliz
is to be made at a rate appropriate to the risk class of the firm.
b. The total value of the firm is independent of the financing mix. i.e. the financial leverage.
c. The cut-off rate for the investment decision of the firm depends upon the risk class to
which the firm belongs, and thus is not affected by the financing pattern of these investments.

✓ The Arbitrage Process: The arbitrage process refers to undertaking by a person of two related
actions or steps simultaneously in order to derive some benefit e.g. buying by a speculator in one
market and selling the same at the same time in some other market; or selling one type of
investment and investing the proceed in some other investment. The profit or benefit from the
arbitrage process may be in any form increased income from the same level of investment or
same income from lesser investment. This arbitrage process has been used by MM to testify
their hypothesis of financial leverage, cost of capital and value of the firm.

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✓ MM MODEL WITHOUT TAXES:

1. That the firm’s capital structure is irrelevant.

2. The WACC is the same no matter what mixture of debt and equity is used to finance the firm.
3. The value of the levered firm is equal to the value of the unlevered firm, and
4. Cost of equity, ke = k0 + (ko-k) D/E. It implies that the cost of Equity raises as the firm increases
its use of debt.

✓ MM MODEL WITH TAXES:

1. The value of the levered firm is equal to the value of unlevered firm + the present value of the
interest tax shield, i.e, VL = Vu + D (t) So, debt financing is advantageous, and it increases the
value of the firm.
2. The WACC of the firm decreases, as the firm relies more and more on debt financing.
3. The cost of Equity, ke = ko + ko – kd) (D/E) (i-t) or = k0 + (ko – k) [D (l-t)/E] where, ko is the
WACC of the unlevered firm.

✓ EBIT- EPS relationship –

One widely used means of examining the effect of leverage is to analyse the relationship between
earnings before interest and taxes (EBIT) and earnings per share (EPS). The use of EBIT –
EPS analysis indicates to management the projected EPS for different financial plans. Generally,
management wants to maximise EPS if doing so also satisfies the primary goal of financial
management - maximisation of the owner’s wealth as represented by the value of business, i.e.
the value of firm’s equity. If the firm attempts to use excessive amounts of debt, shareholders
( who are risk - averters) may sell their shares, and thus its price will fall. While the use of
large amount of debt may result in higher EPS, it may also result in a reduction in the price of
the firm’s equity. The optimum financial structure for a firm (that is, the use of debt in
relationship of equity and retained earnings as sources of financing) should be the one which
maximises the price of the equity.

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 8 LEVERAGE

✓ the term ‘leverage’ means sensitiveness of one financial variable to change in another. Use of
one financial variable to create an impact on other financial variable

✓ operating leverage is defined is defined as the “firm’s ability to use fixed operating costs to
magnify effects of changes in sales on its earnings before interest and taxes.”

(a) Explanation: a change in sales will lead to a change in profit i.e. earnings before interest
and taxes (EBIT). The effect of change in sales on EBIT is measured by operating leverage.
Since fixed costs remain the same irrespective of level of output, percentage in EBIT will be
higher than increase in sales.
(b) Measurement : The degree of operating leverage (DOL) is measured by (expressed in times)

% change in EBIT or contribution

% change in sales EBIT

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 • Impact of fixed costs: DOL depends on fixed costs. If fixed costs are higher, DOL is
higher and vice-versa.
• Effect of high DOL: if DOL is high, it implies that fixed costs are high, Due to the
high, hence the break even pint (no profit – no loss situation) would be reached at a
higher level of sales. Due to the high break-even point, the margin of safety and
profits would low. This means that the operating risks are higher hence a low DOL is
preferred.
• A high DOL means that profits (EBIT) may be wiped off. Even for a marginal
reduction in sales. Hence it is preferred to operate sufficiently above break-even point
to avoid the danger of fluctuations in sales and profits.

𝒇𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕 𝒇𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕

(c) Operating breakeven point = or
𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 𝑷𝑽 𝒓𝒂𝒕𝒊𝒐

✓ the degree of financial leverage (DFL) is measured by : (expressed in times)

% change in EPS
DFL = % change in EBIT

EBIT
= …… it is used when there are no preference shares
EBT

EBIT
= PREF.div … used when there are preference shares
EBIT−INT−
1−tax rate

(a) Significance:

• Effect on EPS: DFL measures the impact of change in EBIT (operating income) on
EPS (earnings per share).supposes DFL of a firm is 4 times, it implies that 1% change
in EBIT will lead to 4% change in EPS. Hence, if EBIT increases by 10% EPS increases
by 10% × 4= 40%. Also, if EBIT decreases by say 5% EPS, fall by 20%
• Indicator of financial risk

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(b) Impact of fixed financial charges:
DFL depends on the magnitude of interest and fixed financial charges. If these costs are
higher, DFL is higher and vice-versa.

Effect of high DFL: if DFL is high, it implies that fixed interest charges are high. This means
that the financial risks are higher. The DFL is considered to be favourable or advantageous to
the firm, when if earns more on its total investments that what it pays towards debt capital.
In other words, DFL is advantageous only if return on capital employed (ROCE) is greater than
rate of interest on debt.

Financial BEP – it is that level of EBIT at which EPS is zero.

𝑃𝐷
Financial break-even point = 1+ 1−𝑇𝐴𝑋 𝑅𝐴𝑇𝐸
Where, I= interest, PD = pref. dividend

Important points about financial leverage :

1) DFL is UNDEFINED AT FIANCIAL BEP.

2) DFL is negative below financial BEP.
3) DFL is positive above financial BEP
4) DFL decreases as EBIT increase, because the risk reduces.
5) Each, level of EBIT has different DFL.
6) When there is no interest and preference dividend, DFL = 1

✓ the degree of combined leverage (DCL) is measured as DOL × DFL

Therefore,
𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
DCL = 𝑬𝑩𝑻
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
= 𝒑𝒓𝒆𝒇.𝑫𝒊𝒗
𝑬𝑩𝑰𝑻−𝑰𝒏𝒕−
𝑰−𝒕𝒂𝒙 𝒓𝒂𝒕𝒆

✓ Working capital leverage measures the sensitivity of return in investment of charges in the level

of current assets.

RAJ AWATE ( always with U ) Faculty of CMA and FM 8888881719, 7447447339

 Working Capital Leverage = Percentage Change in ROI

Percentage Change in Working Capital

If the earnings are not affected by the changes in current assets, the working capital leverage can

be calculated with the help of the following formula.

where, CA = Current Assets TA = Total Assets DCA = Changes in the level of Current Assets

RAJ AWATE ( always with U ) Faculty of CMA and FM 8888881719, 7447447339

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744 744 733 9
LiVE
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