VI SEMESTER

ADVANCED FINANCIAL
MANAGEMENT
Course Outcomes:
On successful completion of the course, the students’ will be able to
a) Understand and determine the overall cost of capital.
b) Comprehend the different advanced capital budgeting
techniques.
c) Understand the importance of dividend decisions.
d) Evaluate mergers and acquisition.
e) Enable the ethical and governance issues in financial
management
 Module No. 1:
Cost of Capital and Capital Structure Theories
14 Hours
• Cost of Capital: Meaning and Definition
• Significance of Cost of Capital
• Types of Capital
• Computation of Cost of Capital – Specific Cost – Cost of Debt – Cost
of Preference Share Capital – Cost of Equity Share Capital –
Weighted Average Cost of Capital – Problems.
• Theories of capital structures: The Net Income Approach, The Net
Operating Income Approach, Traditional Approach and MM
Hypothesis – Problems.
 Module No. 2:
Risk Analysis in Capital Budgeting 14 Hours
• Risk Analysis
• Types of Risks
• Risk and Uncertainty
• Techniques of Measuring Risks
• Risk adjusted Discount Rate Approach
• Certainty Equivalent Approach
• Sensitivity Analysis
• Probability Approach
• Standard Deviation and Co-efficient of Variation
• Decision Tree Analysis – Problems.
 Module No. 3:
Dividend Decision and Theories 14 Hours
• Introduction
• Dividend Decisions: Meaning
• Types of Dividends
• Types of Dividends Polices
• Significance of Stable Dividend Policy
• Determinants of Dividend Policy
• Dividend Theories:
• Theories of Relevance – Walter’s Model and Gordon’s Model and
• Theory of Irrelevance – The Miller-Modigliani (MM) Hypothesis -
Problems.
 Module No. 4:
Mergers and Acquisitions 10 Hours
• Meaning
• Reasons
• Types of Combinations
• Types of Merger
• Motives and Benefits of Merger
• Financial Evaluation of a Merger
• Merger Negotiations
• Leverage buyout
• Management Buyout
• Meaning and Significance of P/E Ratio.
• Problems on Exchange Ratios based on Assets Approach, Earnings Approach and Market
Value Approach and
• Impact of Merger on EPS, Market Price and Market capitalization.
 Module No. 5:
Ethical and Governance Issues 8 Hours
• Introduction to Ethical and Governance Issues
• Fundamental Principles,
• Ethical Issues in Financial Management,
• Agency Relationship,
• Transaction Cost Theory,
• Governance Structures and Policies,
• Social and Environmental Issues,
• Purpose and Content of an Integrated Report
 Module No. 1:
Cost of Capital and Capital Structure Theories
14 Hours
 Cost of Capital: Meaning

• Is the minimum rate of return expected by its investors

• It is the weighted average cost of various sources of finance used by a
firm
• The capital used by the firm may be –
• Debt
• Preference capital
• Retained earnings
• Equity shares
• A decision to invest in a particular project depends upon the cost of
capital of the firm or the cutoff rate which is the minimum rate of
return expected by investor.
 Cost of Capital: Definition
James C Van Horne – Defines cost of capital as, “a cut-off rate for the
allocation of capital to investments of projects. It is the rate of return on a
project that will leave unchanged the market price of the stock”.

Solomon Ezra - “Cost of capital is the minimum required rate of earnings

or the cut-off rate of capital expenditure”

Hampton, John J. – “the rate of return the firm requires from investment in
order to increase the value of the firm in the market place”
 Significance of Cost of Capital
1. Designing the capital structure:

• The cost of capital is the significant factor in designing a balanced and

optimal capital structure of a firm.

• While designing it, the management has to consider the objective of

maximizing the value of the firm and minimizing cost of capital.

• Comparing the various specific costs of different sources of capital, the

financial manager can select the best and the most economical source
of finance and can designed a sound and balanced capital structure.
 2. Capital budgeting decisions:

• The cost of capital sources as a very useful tool in the process of making capital
budgeting decisions.

• Acceptance or rejection of any investment proposal depends upon the cost of

capital.

• A proposal shall not be accepted till its rate of return is greater than the cost of
capital.

• In various methods of discounted cash flows of capital budgeting, cost of capital

measured the financial performance and determines acceptability of all investment
proposals by discounting the cash flows.
 3. Comparative study of sources of financing:

• There are various sources of financing a project.

• Out of these, which source should be used at a particular point of time is to

be decided by comparing costs of different sources of financing.

• The source which bears the minimum cost of capital would be selected.

• Although cost of capital is an important factor in such decisions, but equally

important are the considerations of retaining control and of avoiding risks.
 4. Evaluations of financial performance:

• Cost of capital can be used to evaluate the financial performance of the

capital projects.

• Such as evaluations can be done by comparing actual profitability of the

project undertaken with the actual cost of capital of funds raise to
finance the project.

• If the actual profitability of the project is more than the actual cost
of capital, the performance can be evaluated as satisfactory.
 5. Knowledge of firms expected income and inherent risks:

• Investors can know the firms expected income and risks

inherent there in by cost of capital.

• If a firms cost of capital is high, it means the firms present rate

of earnings is less, risk is more and capital structure is
imbalanced, in such situations, investors expect higher rate of
return.
 6. Financing and Dividend Decisions:

• The concept of capital can be conveniently employed as a

tool in making other important financial decisions.
• On the basis, decisions can be taken regarding dividend
policy, capitalization of profits and selections of sources of
working capital.
 Types of Capital

1. Debt
2. Equity
3. Preference
4. Retained Earnings
 Computation of Cost of Capital - Cost of Debt

• Debt which comprises debentures essentially represents

borrowed funds.

• Interest is payable compulsorily, even if the company is

incurring losses.

• As the interest paid is treated as a business expense, there is a

benefit accruing out of tax benefit.

• Debt is categorised as: Redeemable and Irredeemable Debt

1. Cost of Irredeemable Debentures
• Companies are not allowed to issues irredeemable debentures
• All the debentures are redeemable within a maximum period of 5 years
• When Basel II norms applied to the banks requiring higher capital computed on the
basis of risk weightage assigned to the assets, most of the Indian banks needed to
raise capital
• As pure equity or pure debt securities have problems of their own,
• RBI allowed them to raise hybrid securities in the form of perpetual bonds or
debentures
• These debentures can continue forever on the balance sheet of the bank
• They are redeemable at the option of the bank
• The debenture holder has no option to demand the redemption.
• Therefore, such bonds get the status of irredeemable debt.
 Calculation of Cost of Irredeemable Debt

𝑰(𝟏−𝑻)
Kd= 𝑿𝟏𝟎𝟎
𝑷

Where,
Kd= cost of debenture
I = Interest payable per debenture
T = Marginal rate of tax
P = Net Proceeds received from the issue of debenture
Illustration I

In June 2019, UCO bank raised Rs 200 crore by issue

of perpetual bonds carrying 10% coupon rate. They

were issued at par and having a face value of Rs. 100.

applicable tax rate was 30%. Calculate cost of debt.

Illustration 2

Cosoms Ltd. Issues 15% debentures of Rs.

100 each at a discount of 10% applicable
tax rate was 40%. Calculate the cost of
debentures.
Illustration 3

Inarc Oil Issued debentures of Rs. 100 each a

discount of 5%, carrying Interest at 12%. If the
company is in 30% Tax Bracket, calculate the cost of
debenture assuming issue expenses of 10% of the
face value of debenture
Illustration 4
Andhra Bank is planning to issue 12% Perpetual
Debentures of Rs. 100 each. Tax rate applicable to the
bank is 30%. Issue expenses are estimated to be 10%
of net sale proceeds of the issue of debentures. What
will be the cost of debenture when it is issues (a) at
par (b) at a discount of 10% and (c ) at a 20%
premium.
Computation of Cost of Redeemable Debt

𝑰 𝟏−𝑻 +(𝑹−𝑷)/𝒏
Kd= 𝑿𝟏𝟎𝟎
(𝑹+𝑷)/𝟐

Where,
Kd = Cost of Redeemable Debt
I = Interest per debt
P = Net amount realized per debt
R = Redemption value
N = Redemption period
Illustration 5

A company issues at par debentures of Rs. 100

redeemable after a period of 5 years. The
debentures carry interest at 15%. If applicable tax
rate is 40%, calculate the cost of debt.
Illustration 6
V P Ltd. Issued 10,000 debentures of Rs. 50 each, carrying interest at
10% per annum. These were redeemable after 5 years at a 10%
premium. The issue expenses amounted to 5% of net proceeds of sale.
Applicable tax rate is 30%

Calculate cost of debt if the issue is made

(a) At par

(b) At a premium of 5%

(c) At a discount of 10%

Illustration 7

A company issues Rs. 10,00,000, 10% redeemable debentures

at a discount of 5%. The cost of floatation amounts to Rs.
30,000. the debentures are redeemable after five years.
Calculate before tax and after tax cost of debt, assuming a tax
rate of 50%.
 Illustration 8
Details of Redeemable debentures of 4 different companies are given below. Issue
expenses are given as a percentage of net sale proceeds. Debentures of all the
companies are redeemable after five years and carry a uniform interest rate of 15%.

Company FV Discount Premium Issue Expense Tax Rate Redemption

(RS) (%) (%) (%) (%) Premium (%)

A 100 10 - 5 30 10
B 10 - 20 10 40 20
C 100 - 20 15 0 10
D 100 10 - 10 20 Nil

Calculate cost of debentures of each company.

 Computation of Cost of Capital Cost of Preference Share Capital

• Preference shares are better than equity shares because they carry fixed rate of dividend

• If it is non-cumulative, it is as good as equity shares, as there is no need to pay dividend during

the years of loss making.

• In case of cumulative preference shares, payment of dividend can be postponed to profit making
years - In this respect, it is better than debentures and bonds

• Debentures/Bonds are better than preference shares by resulting in lower tax liability dividend
paid on preference shares it not allowed as business expense, while calculating the tax liability.

• Preference shares may be redeemable or irredeemable.

• In India, irredeemable preference shares are not allowed - Hence, it can only mean the preference
shares the redemption date of which is not announced at the time of issue of share.

• They are compulsorily repayable within a maximum period of 20 years.

 Irredeemable Preference Shares
• When the preference shares do not have any specific date of redemption, we
call them irredeemable preference shares.

• The cost is calculated by the formula used for calculating cost of equity shares
under dividend yield method.

• However preference shares are not traded on the stock exchange usually.

• Therefore, we do not have a market price.

• P represents net proceeds from the issue as in case of cost of equity of

companies making a new issue of shares.
Calculation of Cost of irredeemable Preference shares

𝑫
Kp= 𝑿𝟏𝟎𝟎
𝑷

Where,
Kp = Cost of Preference Share
D = Dividend Per Share

P = Net Proceeds Per Share

Illustration 9

Zen Motors Ltd. Issues 12% irredeemable preference shares of

Rs. 100 each on 15-06-2020. Calculate the cost of preference
shares if it is

1. At par

2. At a discount of 10%

3. At a premium of 20%
Illustration 10

On July 1, 2019, Financial Maverick Ltd. Issued 1,00,000

preference shares of Rs. 10 each at a discount of 20%. The
dividend was payable at 14%. The share issues expenses
amounted to 15% of face value of the share. Calculate the
cost of preference shares.
Illustration 11

Zoom Tak TV Ltd. Issues convertible preference shares of

Rs. 100 each at a premium of Rs. 400 per share. Dividend
was payable at 15%. The floating expenses of the shares
amounted to 10% of the issue price. Calculate the cost of
preference shares.
Illustration 12

Normal Operations Ltd. Issued 1 lakh preference

shares for a net amount of Rs. 45 lakh. Dividend
payable on these shares amounted to Rs. 8 lakh per
annum. The total share issue expenses amounted to
Rs. 3 lakh. Calculate cost of preference shares.
 Redeemable Preference Shares

• Redeemable preference shares carry the tag of redemption

date at the time of issue of the shares.

• If any problem mentions the date of redemption, they are

assumed to be redeemable

• If not, they are regarded as irredeemable

 Calculation of Cost of redeemable Preference shares

𝑫+(𝑹−𝑷)/𝒏
Kp= 𝑿𝟏𝟎𝟎
(𝑹+𝑷)/𝟐

Where,
Kp = Cost of Redeemable Preference Share
D = Dividend per share
P = Net amount realized per share
R = Redemption value
n = Redemption Period
Illustration 13

X Ltd. Issued 15% preference shares of Rs. 100 each on Jan 10,
2006. they were redeemable at par after 5 years. Calculate the cost
of preference shares

i. If it is issued at par

ii. If it is issued at a discount of 10%

iii. Is it is issued at a premium of 25%

Illustration 14

Viking Construction Ltd. Issued 50,000 preference shares of Rs. 100

each redeemable after 5 years at a premium of 20%. Dividend
payable @13%. Calculate the cost of preference shares

i. If they are issued at par

ii. If they are issued at 10% discount

iii. If they are issued at 10% premium

Illustration 15

P A Ltd. Issued 10,000 preference shares Rs. 100 each. They are
redeemable after 5 years at a premium of 5% and carry a dividend
of 12%. Share issue expenses amounted to Rs. 20,000.

Calculate the cost of preference shares

a. If issued at par

b. If issued at 5% discount

c. If issued at 5% premium
 Computation of Cost of Capital - Cost of Equity
• It is the annual cost payable by the company on its equity shares
• Originally it was considered to be dividend per share divided by the face
value of the shares
• The dividend is declared at a certain percentage on the face value of the
shares
• Therefore, this was a dividend divided by face value of the shares.
• Subsequently many other factors entered into its computation.
• The simplicity and certainty of computation are lost in the process of
considering these different factors.
 Models of computation of cost of equity

I. Dividend Yield Method

II. Dividend Growth Method
III. Earning – Price Ratio Method
 I. Dividend Yield Method
• This method involves dividing the dividend per share by the market
price of the equity shares
• This method is based upon the idea that cost of capital is the return the
market expects on its investment in equity shares of the company
• The return to the shareholders is the cost of capital to the company
𝑫
Ke= 𝑿𝟏𝟎𝟎
𝑷
Where,
ke = Cost of Equity
D = Dividend per share
P = Market Price
Illustration 16

Show off Ltd. Issued 1 lakh ordinary shares of Rs. 10

at a discount of 10%. Share issue expenses amounted
to Rs. 50,000. it expected to pay dividend at 17% for
the current year. Calculate cost of equity.
Illustration 17

C Ltd. Issued 50,000 equity shares of Rs. 10 each at a

premium of 20%. The share issue expenses are
estimated to be 10% of total sale proceeds. Calculate
the cost of equity share if the company is planning to
declare dividend @ 13.5% for the current year
Illustration 18

In December 2019, ICICI Bank Ltd. Issued equity shares through

the book building route. The cut-off price was determined at Rs.

500/ share for an equity share of Rs.10 face value. It is planning

to declare 85% dividend for the year 2019-20. calculate the cost

of equity shares assuming issue expenses at 30% of issue price

(Cut-off Price).
• Cut-off price means the investor is ready to pay whatever price is
decided by the company at the end of the book building process.
Retail investor has to pay the highest price while placing the bid at Cut-
Off price. If company decides the final price lower than the highest price
asked for IPO, the remaining amount is return to the retail investor.

• Book building is a systematic process of generating, capturing, and

recording investor demand for shares. Usually, the issuer appoints a major
investment bank to act as a major securities underwriter or bookrunner.
Illustration 19
RI issued 26,20,000 equity shares of Rs. 10 each through book building
open between Nov. 28, 2019 to Dec. 1, 2019. the price band was Rs.
145-165.
After the closure of book running, the cut-off price was fixed at Rs.
150/-. It expected to pay dividend at 100% for the year 2019-20. if
shares issue expenses amount to 20% of the cut-off price, calculate the
cost of equity shares.
 Illustration 20
The details of four companies that accessed the primary capital market
during 2019-20 are given below. Calculate their cost of equity.
SL. Company Face Value Issue Price Issue Expenses (as Estimated %
No. (Rs) (Rs) a % of issue price) of Dividend
1 A Bank 10 100 10% 35%
2 B Bank 10 110 20% 20%
3 C Bank 10 30 20% 30%
4 D Bank 10 190 30% 40%
Illustration 21
From the following data relating to 3 steel companies, calculate
their cost of equity.
Sl. Company Face Value Dividend Market Price
No. (Rs.) (%) (Rs.)
1 Jindal Stainless Steel Ltd. 2 120 78
2 Steel Authority of India 10 33 67
3 Tata Steel Ltd. 10 130 510
Illustration 22
The relevant data relating to certain Indian Pharmaceutical
companies are given below. Calculate the cost of equity shares.
Sl. No. Company Face Value Dividend % Market Price
1 Cadila Health Care 5 120 620
2 Cipla 2 175 225
3 Dr. Reddy Labs 5 100 1100
4 Matrix Laboratories 2 60 228
5 Nicholas Piramal 2 150 177
6 Ranbaxy Laboratories 5 50 431
7 Wockhardt 5 100 390
8 Zandu Pharma 100 50 2800
9 Dabur Pharma 1 10 59
10 Amrutanjan 10 35 211
 II Dividend Growth Method
• This is based on Gordon’s Dividend growth model
• If there is constant growth in the earnings and dividend, it is reasonable
to expect it in the future also.
• Therefore, to the usual cost of capital as a percentage, we add growth in
earning or dividends as percentage.

𝑫
Ke= 𝑿𝟏𝟎𝟎 + 𝑮
Where, 𝑷
Ke = Cost of Equity Share
D = Dividend Per Share
P = Market Price
G= Growth in Earning as a Percentage
Illustration 23
Nippo Batteries Ltd. Declared 200% dividend for the year
2019-20 on its equity shares of Rs. 10 face value. The price of
the share was Rs. 340. if it’s expecting a growth in the
earnings for the next year at 12% calculate the cost of equity
shares for the company.
Illustration 24
Asian Paints Ltd. Declared 95% dividend on its equity shares of Rs. 10
for the year 2019-20. the market price ruled at Rs. 410 per share. It
expected a growth rate of 8%

On the other hand, Berger Paints Ltd. For the same year declared 70%
dividend on its equity shares of Rs. 2 face value. The market price
ruled at Rs. 68. It expected a growth rate of 10%.

Calculate the cost of equity shares of each of the company.

Illustration 25

The following 4 companies were engaged in polyester packaging.

They furnish the details for the year 2019-20. calculate their cost of
equity shares.
Sl. Company Face Value Dividend % Market Expected
No. Rs. Price Rs. Growth Rate %
1 Cosmo Films 10 40 83 3
2 Ecoplast 10 15 19 6
3 Garware Polyester 10 10 40 5
4 Polyplex Corporation 10 80 115 8
Illustration 26
The financial Details of 8 Fertilizer Companies for the year 2019-20 are
given below along with expected growth rates. Calculate their cost of
equity shares.
Sl. Company Face Dividend Market Estimated
No. Value Rs. % Price Rs. Growth rate %
1 Chambal 10 18 34 4
2 Coromandel 2 85 77 6
3 EID Parry 2 225 281 8
4 Gujarat 10 38 103 5
Narmada
5 Godavari 10 20 78 5
6 Gujarat State 10 15 190 6
7 National 10 10 34 4
8 Zuari 10 18 234 7
 III Earning –Price Ratio Method
(Inverse PE Ratio Method)
• Both dividend Yield and Dividend Growth Method suffer when dividend declared is Zero.

• Many a time dividend is totally ignored by the investor.

• The shareholder is more interested in knowing the Earning Per Share (EPS).

• He is indifferent to the percentage of it declared as dividend.

• Therefore, EPS is compared with market price to arrive at cost of equity shares.

• This is nothing but reciprocal of PE ratio.

𝑬𝑷𝑺
Ke= 𝑿𝟏𝟎𝟎
𝑷
• This method is superior in that even if dividend declared is zero, we calculate either the
cost of equity shares or market price.
Illustration 27
For the year ended 31-03-2019. Bilpower Ltd. Achieved an EPS of Rs.
8.30. The market price was Rs. 170.30 calculate the cost of equity
shares.
Illustration 28
The EPS and Market Price of the four companies comprising the
abrasives industry in India are given below.

Sl. No. Company EPS Rs. Market Price Rs Face Value Rs

1 A 3.90 144.25 2
2 B 25.60 590 10
3 C 3.30 19.75 1
4 D 35.80 692.40 10
Illustration 29
The EPS for the year 2018-19 and market price as on 22-05-2020 of
eight tata group companies are given below. Calculate the cost of
equity shares of each company.
Sl. No. Company Face Value Rs. EPS Rs. Market Price Rs.
1 Tata Chemicals 10 13.90 222.50
2 Tata Coffee 10 16.10 299.85
3 Tata Tea 10 21.80 683.00
4 Tata Elxsi 10 11.00 206.65
5 Tata Metaliks 10 18.20 160.25
6 Tata Sponge 10 14.40 109.60
7 Indian Hotels 10 14.90 1024.90
8 Voltas 10 13.10 991.95
 Weighted Average Cost of Capital

• Weighted Average Cost of Capital represents cost of capital of the firm.

• It represents the average cost at which the company was able to raise
long term funds.

• Naturally, it represents both owned funds and borrowed funds.

𝑬𝑿𝑲𝒆+𝑫𝑿𝑲𝒅+𝑷𝑿𝑲𝒑
Kw= 𝑿𝟏𝟎𝟎
𝑬+𝑫+𝑷
Illustration 30
S G Ltd. Furnishes the following details of its capital structure.

i. Equity share capital Rs.800,000 with the cost of equity shares

at 10%

ii. Preference share capital of Rs. 500,000 with the cost of

preference shares at 12%

iii. Debentures of Rs. 600,000 with the cost of debt at 14%

Calculate the weighted average cost of capital of the company

Illustration 31
The capital structure of a company and the cost of specific sources
of funds are as below. Calculate the weighted average cost of capital.

Source of Funds Book-Value Specific Cost

Debentures 150,000 5%
Preference Shares 50,000 9%
Equity Shares 200,000 15%
Illustration 32
Fresh Farm Products Ltd. Had the following capital structure.

1. Equity shares of Rs. 10 each amounting to Rs. 300,000. the market price of
the share was Rs. 75 and the dividend was at 40%

2. 15% preference shares of Rs. 100 each redeemable after 10 years at 10%
premium. Total preference shares capital was Rs. 200,000.

3. Rs. 400,000 worth of 14% debentures of Rs. 100 each redeemable at 5%

premium after 5 years. The applicable tax rate was 30%

Calculate the cost of capital of the company (Weighted average cost of capital)
Illustration 33
The following information has been extracted from the balance sheet of
Fusion Limited as on 31-12-2019.
Equity share capital Rs. 400
12% debentures Rs. 400
18% Term Loans Rs. 1200
a) Determine the weighted average cost of capital of the company, if it
had been paying dividend at a consistent rate of 20% per annum
b) What difference will it make, if the current price of the Rs. 100 share
is Rs. 160
c) Determine the effect of income tax on the cost of capital under both
the premises (tax rate is 40%)
Illustration 34
Assuming that the firm pays tax at 50% rate, compute the after tax cost of
capital in the following cases:
1. A 8.5% preference share sold at par
2. A perpetual (irredeemable) bond, at par, compound rate of interest
being 7%
3. A 10 year, 8% Rs. 1000 per bond, sold at Rs. 950, less 4% underwriting
commission, redeemable at par
4. A preference share selling at a current market price of Rs.100 with a
8.5% dividend and a redemption price of Rs. 110, if the company
redeems it in 5 years
5. A common share selling at a current market price of Rs. 100 and
paying a current dividend of Rs. 9 per share which is expected to grow
at the rate of 8%.
Illustration 35
A ltd. Has the following capital structure:
Equity share capital (200,000 share) Rs.40,00,000
6% Preference shares Rs. 10,00,000
8% Debentures Rs. 3,00000
The market price of the company’s equity shares is Rs. 20. it is expected
that the company will pay a current dividend of Rs. 2 per share, which
will grow at 7% forever. The tax rate may be presumed at 50%. You are
required to compute the following.
a. A weighted average cost of capital based on existing capital structure
b. The new weighted average cost of capital if the company raised an
additional Rs. 20,00,000 debt by issuing 10% debentures. This would
result in increasing the expected dividend to Rs. 3 and leave the
growth unchanged, but the price of the share will fall to Rs. 15 per
share
Illustration 36
For the year ended 30-09-2019, JK Industries had the following capital
structure.
a. 13.50 Lakhs equity share of Rs. 10 each. Dividend for the year was 30%
and the market value per share was Rs. 50
b. 7 lakh 14% cumulative redeemable preference shares of Rs. 10 each.
These were redeemable after 8 years at 10% premium. Original issue
expenses amounted to 5% of the face value of shares.
c. 180,000 redeemable debentures of Rs. 10 each carrying 15% interest.
No issue expense were there as they were privately placed. However,
they were issued at a discount of 10%. The company was in 40% tax
bracket. These were redeemable after 4 years at a premium of 5%.
Calculate the cost of each of the above in order to calculate the
weighted average cost of capital
Illustration 37
Assuming that the firm pays tax a rate. Compute the after tax cost of
capital in the following cases.
1) A 12.5% preference share sold at par
2) A perpetual (irredeemable) bond, sold at par, compound rate of
interest being 7%
3) A 10 year, 14% Rs 1000 per bond, sold at Rs. 900, less 5%
underwriting commission, redeemable at par
4) A preference share sold at Rs. 100 with a 11% dividend and a
redemption price of Rs. 110, if the company redeems it in 4 years
5) A common share selling at a current market price of Rs. 100 and
paying a current dividend of Rs. 22, per share, which is expected to
grow at the rate of 10%
Illustration 38
Bhushan steel and strips Ltd. Had the following secured debentures of
their balance sheet as at 31-03-2019.
The company was in 30% tax bracket.
10 lakh 13% debentures of Rs. 10 each redeemable after 4 years at a
premium of 10%. These ere originally issued at par with issue expenses
at 10% of the face value
15 lakh 12.5% debentures of Rs. 10 each redeemable after 5 years at par.
These were originally issued at a discount 5% with no issue expenses
50 lakh 11.8% debentures of Rs. 10 each redeemable after 3 years at
premium of 10% These were originally issued at a 10% discount with
5% face value as expenses.
Calculate weighted average cost of debentures.
Illustration 39
The following information has been extracted from the balance sheet of
Vision Ltd. As on 31-12-2019
Equity share capital Rs. 500
12% debentures Rs. 500
18% Term Loans Rs. 800
Determine the weighted average cost of capital of the company. If it had
been paying dividend at a consistent rate of 30% per annum
What difference will it make if the current price of the Rs. 100 share is Rs.
200
Determine the effect of income tax on the cost of capital under both the
premises (Tax Rate is 30%)
Illustration 40
A Ltd. Has the following capital structure.
Equity share capital (3,00,000 shares) Rs. 30,00,000
6% Preference shares Rs. 20,00,000
8% Debentures Rs. 40,00,000
The market price of the company’s equity share is Rs. 30 it is expected
that the company will pay a current dividend of Rs. 5 per share, which
will grow at 20% forever. The tax rate may be presumed at 35%. You are
required to compute the following
A weighted average cost of capital based on existing capital structure
The new weighted average cost of capital, if the company raised an
additional Rs. 20,00,000 debt by issuing 1% debentures. This would
result in increasing the expected dividend to Rs. 8 and leave the growth
unchanged, but the price of the share will fall to Rs. 15 per share.
CAPITAL STRUCTURES
Meaning of Capital Structure

• Capital Structure plays a crucial role in determining the

profitability of an organization.

• Weston & Brigham Defines capital structure as, “The permanent

financing of the firm represented by long-term debt, preferred

stock and net worth”.

Theories of capital structures
• The existence of the optimum capital structure is not accepted by all financial experts.

• There are two extreme views on the existence of the optimum capital structure.

• As per one school of thought the capital structure influences the value of the firm
and cost of capital and hence there exists an optimum capital structure.

• On the other hand, the other school of thought advocates that capital structure has
no relevance and it does not influence the value of the firm and cost of capital.

• Reflecting these views, different theories of capital structure have been developed in
the theory of business finance.

• The main contributors to these theories are David Durand, Ezra Solomon, Modigliani
and Miller.
 The Net Income Approach (NIA)

• Suggested By David Durand in 1959

• Which suggest that capital structure effects Weighted Average Cost of

Capital

• According to this approach, a firm can increase its value or lower the
overall cost of capital by increasing the proportion of debt in the
capital structure.
Net Income Approach [NIA] - Assumptions

1. There are only 2 sources of funds such as DEBT and EQUITY

2. There are no retained earnings. It implies that entire profit are
distributed among the shareholders
3. There are no corporate tax
4. The cost of debt is lesser than cost of equity or equity capitalization
rate
5. Cost of debt and cost of equity remains constant at all level of debt
equity mix
 Ke = Cost of Equity
Cost of Capital

15%
Ko = Overall Cost of Capital

10%
Cost of Debt

Financial Leverage
Value of the Firm under Net Income Approach [NIA]
Step I: Computation of Market Value of Equity (E):
𝑬𝑩𝑻
E=
𝑲𝒆
Step II: Computation of Market Value of Debt (D):
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
D=
𝑲𝒅
Step III: Computation of Value of the Firm:
V = E+D
Step IV: Computation of Overall Cost of Capital (K):
𝑬𝑩𝑰𝑻
K= 𝑿100
𝑽
Illustration 1

SD Company Ltd. Is expecting an annual earning before the

payment of interest and tax is ₹ 2,00,000. The company in its
capital structure has ₹ 8,00,000, 10% debentures. The cost of
equity or equity capitalization rate is 12.5%. You are required
to calculate the value of firm according to Net Income
Approach and also compute overall cost of capital
Illustration 2
A company expects to earn Net Operating Income of ₹
3,60,000 annually. It has ₹ 12,00,000, 10% debentures,
Equity Capitalization rate of the company is 12%. What
would be the Value of the Company and also calculate
the Overall cost of capital using Net Income Approach.
Illustration 3
A company expected annual Net Operating Income
[EBIT] is ₹ 50,000. The Company has ₹ 2,00,000 10%
debentures, the equity capitalization rate of the
company is 12.5%. Assuming no taxes find out the
value of the firm under Net Income Approach and
also calculate the overall cost of capital
Illustration 4
Firm S and D are identical in all respect including risk
factors except for debt equity mix. S has issued 6%
debentures of ₹10,00,000, D has issued only equity. Both
the firms earn 30% before and interest and tax on their
total asset of ₹25,00,000. Assume tax rate of 50% and
capitalization of 20% for all equity company. You are
requested to compute the value of 2 firms using N.I.A.
Illustration 5
A company Expects to earn Net Operating Income of
₹7,00,000 annually. It has ₹23,00,000 10%
Debenture. Equity Capitalization rate of the company
is 14%. What would be the value of the company also
calculate overall cost of capital.
The Net Operating Income Approach

• According to this approach changes in the capital structure of a

company doesn’t effect the market value of the firm and the

overall cost of capital remain constant irrespective of method of

financing.
 Assumptions of Net Operating Income Approach
• There are no corporate taxes

• Cost of debt remains constant at all level of debt

• Overall cost of capital remains constant

• Value of the firm depends on expected net operating income and overall
capitalization rate or the opportunity cost of capital

• Net operating income of the firm is not affected by the degree of financial leverage.

• The operating risk or business risk does not change with the change in debt equity
mix.

• WACC does not change with the change in financial leverage

 Ke = Cost of Equity

Ko = Overall Cost of Capital

Cost of Capital

15%

10%
Cost of Debt

Financial Leverage
 Calculation
1. Calculation of Value of the Firm:
𝑬𝑩𝑰𝑻
V=
𝑲𝒐

2. Calculation of Value of Debt:

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
D=
𝑲𝒅

3. Calculation of Value of Equity:

S= V-D

4. Calculation of Cost of Equity:

𝑬𝑩𝑻
Ke= X100
𝑺
Illustration 6

A company has an Annual Net Operating

Income of ₹3,60,000. The company has
₹14,00,000, 12% debentures. The overall cost
of capital of the company is 14%. What would
be the value of the firm or company? Also
calculate equity capitalisation rate.
Illustration 7

A company has an annual Net Operating Income of

₹90,000 the company has ₹3,00,000, 10%
debentures the overall cost of capital of the company
is 12% what would be the value of the company?
Also calculate equity capitalization rate as per Net
Operating Income Approach.
Illustration 8
A company and B company are identical in every aspect except that

company A uses debt while company B doesn’t. the company A has

₹9,00,000 debentures carrying 10% interest. Both the company earns

20% operating income on their total asset of ₹15,00,000. the

capitalization rate is 15% you are required to compute the value of the

firms using NIA and NOIA.

Illustration 9
The firm P and Q are identical in all respect including risk factor
except for debt equity mix. Firm P has issued 10% debentures of
₹12,00,000 while Q has issued only equity. Both the firm earn 30%
before interest and tax on their total asset of ₹ 12,50,000. Assuming
a tax rate of 50% and capitalisation rate of 20% for all equity
company. you are required to compute the value of 2 firms using Net
Income Approach and Net Operating Income Approach.
Illustration 10

The firm A and B are identical in all respect including risk factor except

for debt equity mix. Firm A has issued 12% debentures of ₹ 15,00,000

while B has issued only equity. Both the firms earn 30% before

interest and tax on their total asset of ₹25,00,000 assuming a tax rate

of 50% and capitalization rate of 20% for all equity. You are required

to compute the value of 2 firms using NI and NOI approach.

 Illustration 11

A company expects a Net Income of ₹ 1,00,000 it has ₹5,00,000

6% Debenture. The overall capitalization rate is 10% calculate
the value of the firm and the equity capitalization rate (cost of
equity) according to the NOI approach.

If the debt is increased to ₹ 7,50,000 what will be effect on the

value of the firm and the equity capitalisation rate.
Illustration 12

A company expects Net Income of ₹80,000 it has ₹

2,00,000, 8% debentures. The equity capitalization rate
of the company is 10% calculate the value of the firm
and overall capitalization rate (ignoring tax) if the
debentures debt is increased to ₹ 3,00,000 what shall be
the value of the firm and overall capitalization rate.
Illustration 13
The firm D and S are identical in all respect including risk factor except
for debt equity mix. Firm A has issued 10% debentures of ₹ 22,00,000
while B has issued only equity. Both the firms earn 40% before
interest and tax on their total asset of ₹35,00,000 assuming a tax rate
of 30% and capitalization rate of 25% for all equity firm. You are
required to compute the value of 2 firms using NI and NOI approach.
Traditional Approach
• The traditional approach was propounded by Ezra Soloman in 1963

• This approach is the compromise between NI approach and NOI approach.

• The traditional approach rejects both extreme prepositions of relevance approach of NI theory
and irrelevance approach of NOI theory.

• This approach neither assumes constant cost of equity (ke) and declining Weighted
Average Cost of Capital (WACC) like NI approach nor increasing cost of equity and
constant cost of debt (kd) and over all cost of capital (ko) like NOI approach.

• Under traditional approach WACC decreases only up to a certain level of financial leverage
and starts increasing beyond this level.

• At the judicious mix of debt and equity as of optimum capital structure weighted average cost
of capital is minimum and the market value of the firm is maximum.
Three stage of capital structure under traditional approach

1. The value of the firm may first increase with moderate leverage
when WACC is decreasing.

2. Reach the maximum value when WACC is minimum.

3. Then starts declining with higher financial leverage when WACC

start increasing.
Assumptions Under Traditional Approach

1. Cost of debt (kd) remains stable with an increase in the debt ratio to a
certain limit after which it begins to grow.

2. Cost of equity (ke) remains stable or grows slightly with an increase in

the debt ratio to a certain limit after which it begins to grow rapidly.

3. Weighted average cost of capital decreases to some degree with an

increase in the debt ratio and then begins to grow.

4. Cost of equity is larger than the cost of debt at any capital structure, i.e.,
ke>kd at any value of debt ratio.
Value of the Firm under Traditional Approach
Step I: Computation of Market Value of Equity (E):
𝑬𝑩𝑻
E=
𝑲𝒆

Step II: Computation of Value of the Firm:

V = E+D

Step III: Computation of Overall Cost of Capital (K):

𝑬𝑩𝑰𝑻
Ko= 𝑿100
𝑽
Illustration 13
Compute the market value of the firm, value of shares and the average cost of capital
from the following information:
Net Operating Income ₹ 200000
Total Investment ₹ 1000000
Equity Capitalisation Rate:
a) if the firm uses no debt 10%
b) if the firm uses ₹ 400000 debentures 11%
c) if the firm uses ₹ 600000 debentures 13%
Assume that ₹ 400000 debentures can be raised at 5% rate of interest whereas ₹
600000 debentures can be raised at 6% rate of interest.
Illustration 14
A company’s current net operating income (EBIT) is ₹ 800000. the company
has ₹ 20 lakhs of 10% debt outstanding. Its equity capitalisation rate is 15%.
The company is considering to increase its debt by raising additional ₹ 10
lakhs and to utilise these funds to retire the amount of equity. However, due to
increased financial risk, the cost of entire debt is likely to increase to 12% and
the cost of equity to 18%.

You are required to compute the market value of the company using traditional
model and also make recommendations regarding the proposal.
Illustration 15

EBIT = Rs. 200,000

Presently 100% equity finance with Ke = 16%.

Introduction of debt to the extent of Rs. 300,000 @ 10% interest rate or Rs.
500,000 @ 12%.

For case I, Ke = 18% and for case II, Ke = 21%.

Find the value of firm and the WACC Calculate Value of firm, total value of
equity and WACC
Modigliani – Miller (MM) Hypothesis

• According to MM Approach cost of capital is independent of capital structure

and financial leverage does not affect the overall cost of capital and hence there
is no optimum capital structure.

• MM theory is just similar to NOI approach with a basic difference.

• The basic difference is that the NOI approach is purely abased on definitional
term, explaining the concept without behavioral justification,

• whereas M.M. Approach provides behavioral justification in favor of the theory.

• This theory was proposed by Modigliani and Miller in the year 1963
MM approach is identical with Net Operating Income approach if

• taxes are ignored (theory of irrelevance).

• when corporate taxes are assumed to exist, their hypothesis is similar

to the Net Income Approach (theory of relevance).
Assumptions – MM Approach – in the absence of taxes
i) Capital markets are perfect where individuals and companies can
borrow unlimited funds at the same rate of interest.

ii) Stock markets are perfectly competitive.

iii) There is no corporate tax

iv) There is no transaction cost.

v) Investors are free to buy and sell securities.

vi) Investors behave rationally.

vii) Dividend payout ratio is 100% and there are no retained earnings.
 Calculation
1. Firms Total Market Value:
𝑬𝑩𝑰𝑻
V=
𝑲𝒆

2. Calculation of Value of Equity:

S= V-D

3. Firms Leverage Cost of Equity:

Cost of Equity+(Cost of Equity –Cost of Debt)
Illustration 16
The following information is available regarding Mid Air Enterprises:
i) Mid Air currently has no debt, it is an all equity company
ii) Expected EBIT = ₹24Lakhs. EBIT is not expected to increase overnight, so Mid Air is in no growth situation
iii) There are no taxes, so T= 0 percent
iv) Mid Air pays out all its income as dividends
v) If Mid Air begins to use debt, it can borrow at the rate Kd = 8%. This borrowing rate is constant and it is
independent of the amount of debt. Any money raised by selling debt would be used to retire common stock,
so Mid Air’s assets would remain constant.
vi) The risk of Mid Air’s assets and thus its EBIT, is such that its shareholders require a rate of return Ke = 12%, if
no debt is used.
Using MM approach without corporate taxes and assuming a debt of ₹1 Crore, you are required to:
a) Determine the firm’s total market value
b) Determine the firm's value of equity
c) Determine the firm’s leverage cost of equity
Assumptions – MM Approach – corporate taxes assumed to exist

• Value of the firm will increase or the cost of capital will decrease with the

use od debt on account of deductibility of interest charges for tax purpose.

• Thus, optimum capital structure can be achieved by maximising the debt

mix in the equity of a firm

Calculations

𝑬𝑩𝑰𝑻
The Value of Unlevered Firm Vu= (1-t)
𝑲𝒐

The Value of Levered Firm VL =Vu+tD

Cost of levered equity KeL = Keu – [Keu –Kd](1-T)

Illustration 17

A company has earnings before interest and taxes of ₹1,00,000. it

expects a return on its investment at a rate of 12.5%. You are

requited to find out the total value of the firm according to the

MM theory
Illustration 18
There are two firms X and Y which are exactly identical except
that X does not use any debt in its financing, while Y has
₹1,00,000 5% debentures in its financing. Both the firms have
EBIT of ₹25,000 and the equity capitalisation rate is 10%.
Assuming the corporation tax of 50% calculate the value of the
firm using MM approach.
Arbitrage Process
• The market value of the firm which uses debt content in its capital structure, is higher than the market value of
firm which does not use debt.

• According to MM theory, this situation can not remain for a long period because of the arbitrage process.

• As the investor in Company which has debt content can earn a higher rate of return on their investment with
lower financial risk, they will sell their holdings of shares of that company and invest in equity company.

• Further, equity holding company does noy use any debt in its capital structure, the financial risk to the investors
will be less, thus, they will engage in personal leverage by borrowing additional finds equivalent to their
proportionate share in debt holding company’s debt at the same rate of interest and invest the borrowed funds
also in equity company.

• The arbitrage process will continue till the prices of shares of debt mix company fall and that of equity company
rise so as to make the market value of the 2 firms identical.

• However, in the arbitrage process, such investors who switch their holdings will gain
Illustration 19
The following is the data regarding two companies A and B belonging to
the same equivalent risk class:
Company A Company B
No of Ordinary Shares 100000 150000
8% Debentures 50000 NIL
Market Price Per Share 1.30 1.00
Profit Before Interest 20000 20000

All profits after paying debenture interest are distributed as dividends

You are required to explain how under MM approach, an investor holding
10% of shares in Company A will be better off in switching his holding to
Company B
Illustration 20
Companies A and B belong to the same business risk class. Average Net
Operating Income Before Interest of Each company is ₹100 Lakhs. Other related
information is given below:
Company A Company B
Market Value of Equity 400 Lakhs 120 Lakhs
Market Value of Debt - 200 Lakhs
Total Market Value 400 Lakhs 320 Lakhs

Rate of interest on debentures is 15% p.a. and the same is considered to be

certain by all the investors.
(a) In case the total market value of the two companies are not in equilibrium,
explain the process by which equilibrium is restored to according to MM
approach.
(b) If the cost of equity is 27.78% for company A in equilibrium, what will it be
for company B
Illustration 21
Compute the equilibrium values and capitalisation rates of equity of the
companies A and B on the basis of the following data assume that:
a) There is no income tax, and
b) The equilibrium value of average cost of capital is 8.5%
Company A Company B
V 250 300
D 0 150
S 250 150
EBIT 25 25
I 0 9
EBT 25 16
Ke 10% 10.7%
Leverage D/V 0 0.5
Ko 10% 8.33%
MM Model proposition
• Value of a firm is independent of the capital structure.

• Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate
rate (i.e. WACC).

• Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT / Expected WACC

• As per MM, identical firms (except capital structure) will have the same level of earnings.

• As per MM approach, if market values of identical firms are different, ‘arbitrage process’ will
take place the difference will mitigate.

• In the ‘arbitrage process’ investors will switch their securities between identical firms (from
levered firms to un-levered firms) and receive the same returns from both firms.
Illustration 21
In considering the most desirable capital for a company the following
estimates of the cost of debt and equity (after tax) have been made at a
various level of debt equity mix.
Use of Debt as a percentage in total capital Cost of Debt Cost of Equity
00 6.0 10.0
10 6.0 10.0
20 6.0 10.0
30 6.0 10.0
40 6.0 16.0
50 9.0 20.0
60 10.0 24.0

You are required to calculate optimal debt equity for the company by
calculating composite cost of capital (Overall Cost of capital)
 Solution
Debt % Equity % Cost of Debt Cost of Equity WACC
00 100 6.0 10.0 10
10 90 6.0 10.0 9.6
20 80 6.0 10.0 9.2
30 70 6.0 10.0 8.8
40 60 6.0 16.0 12
50 50 9.0 20.0 14.5
60 40 10.0 24.0 15.6

Therefore, the optimal debt-equity mix for the company is still 30% debt and 70%
equity, as it yields the minimum WACC of 8.8%.
 Module No. 2:

Risk Analysis in Capital Budgeting

14 Hours
Content
• Risk Analysis
• Types of Risks
• Risk and Uncertainty
• Techniques of Measuring Risks
• Risk adjusted Discount Rate Approach
• Certainty Equivalent Approach
• Sensitivity Analysis
• Probability Approach
• Standard Deviation and Co-efficient of Variation
• Decision Tree Analysis – Problems.
Risk Analysis
• Risk analysis is applicable to various aspects of life and is fundamental to a wide variety of

academic disciplines, from the physical and social sciences to the humanities.

• It is a complex procedure that involves identifying and analyzing potential issues that could

negatively impact key business initiatives or project.

• There are different types of risk analysis, including quantitative risk analysis, which involves

building a risk model using simulation or deterministic statistics to assign numerical values to

inputs.

• Overall, risk analysis is a proven way of identifying and assessing factors that could

negatively affect the success of a business or project.

Risk

• Risk is the potential for undesirable outcomes or loss associated

with a particular action, decision, or event.

• In various contexts, including finance, business, and project

management, risk encompasses the uncertainty of achieving

desired outcomes and the possibility of adverse consequences.

Reason for adjustment of Risk in Capital Budgeting Decision

Main reason for considering risk in capital budgeting decision are as follows:

1. There is an opportunity cost involved while investing in a project for

the level of risk. Adjustment of risk is necessary to help the decision as
to whether the return out of the project are proportionate with the risks
borne and whether it is worth investing in the project over investment
options available.

2. Risk adjustment is required to know the real value of the cash inflows.
Higher risk will lead to higher risk premium and also expectation of
higher return.
 Uncertainty
• Uncertainty refers to the lack of certainty or sureness regarding the
outcomes or consequences of an event.

• It represents a condition where there is ambiguity or unpredictability,

and the probabilities of different possible outcomes are not known with
precision.

• In the context of measurement, uncertainty means the range of possible

values which the true value of the measured quantity may lie.
Risk and Uncertainty
• Risk involves known and • Uncertainty pertains to situations
where the future outcomes are not
measurable factors with
known or measurable.
quantifiable probabilities.
• It involves a lack of information or
• It refers to the probability of an unpredictability, making it
event occurring and can be challenging to assign probabilities.
managed or mitigated through • Uncertainty is often associated with
various strategies, such as uncharted territories that are
exceptionally difficult to quantify.
hedging or diversification.
Difference between Risk and Uncertainty
While risk can be quantified and managed, uncertainty is challenging to assess and prepare for
future events in the context of financial management, the differences between risk and
uncertainty are as follows:
Risk Uncertainty
Risk involves known potential outcomes and while uncertainty involves unknown potential
their likelihoods outcomes and their probabilities
Risk is considered amenable to being while uncertainty belongs to uncharted
quantified, such as using implied volatility territory that is exceptionally difficult to
from options markets to assess the downside quantify
potential
Risk can be measured and quantified through whereas uncertainty cannot be measured in
theoretical models, and potential outcomes are quantitative terms, as the future events are
known unpredictable, and the outcomes are unknown.
Types of Risks
1. Market Risk: Also known as systematic risk or non- diversifiable risk,
market risk stems from the fact that the value of investments can fluctuate
due to macroeconomic factors.
2. Project-Specific Risk: These risks are unique to a particular project or
investment and may arise from factors such as managerial deficiencies,
errors in cash flow estimation, or unexpected events.
3. Competitive or Competition Risk: This risk arises from the actions of
competitors that may materially affect the expected cash flows of a project or
investment.
4. Industry-Specific Risk: These risks affect all firms in a specific industry and
can be grouped into technological risk, commodity risk, and legal risk.
 Types of Risks
5. International Risk: This risk is associated with factors such as changes in
international political scenarios, inflation, interest rates, and general economic
conditions that can impact the operations of firms.
6. Credit Risk: The possibility of loss due to the failure of a borrower to repay a loan or
meet contractual obligations.
7. Operational Risk: Risks arising from internal processes, systems, people, or
external events that can impact the organization's operations.
8. Strategic Risk: The potential for losses resulting from poor business decisions,
inadequate implementation of strategies, or external factors affecting the
organization's strategy.
9. Liquidity Risk: The risk of not being able to meet short term financial obligations
due to insufficient liquid assets.
10. Event Risk: Uncertainties related to unexpected events, such as natural disasters,
political instability, or technological failures, impacting business operations.
Risk Analysis

• Risk analysis is a crucial process that involves identifying, assessing, and

mitigating potential risks that may impact business initiatives,
investments, or projects.

• It involves understanding uncertainty, quantifying the uncertainty,

running models, and analyzing results.

• It is a complex procedure that involves identifying and analyzing

potential issues that could negatively impact key business initiatives or
projects.
 Significance of Risk Analysis in Capital Budgeting
Risk analysis plays a crucial role in capital budgeting, influencing decision-making and
ensuring the success of long- m investments.

1. Informed Decision-Making: Risk analysis provides a comprehensive understanding of

potential risks associated with capital investments, enabling informed decision-making.

2. Measurement of Risks: It allows for the measurement and quantification of various risks
involved in capital projects, helping businesses assess the impact on returns and
profitability.

3. Identification of Variables: Through risk analysis, all Variables influencing profit margins,
such as costs and revenues, are thoroughly examined, providing a holistic view of potential
outcomes.
 Significance of Risk Analysis in Capital Budgeting
4. Barrier Identification: It helps identify barriers and benefits related to risk
analysis methods, aiding firms in assessing the feasibility of capital investments.

5. Actionable Information: Risk analysis provides actionable information, allowing

companies to exploit knowledge about long-term investments and make strategic
adjustments.

6. Relationship with Capital Budgeting: Risk is inherent in capital budgeting, and

understanding this relationship is essential to ensure that chosen actions lead to
favorable outcomes.
 Significance of Risk Analysis in Capital Budgeting
7. Quantifying uncertainty: Risk analysis goes beyond traditional methods that rely on single-
point estimates, instead assessing the likelihood of various potential outcomes and their financial
impacts. This enables a more comprehensive understanding of the risks involved.

8. Improving decision-making: By understanding the range of potential outcomes and their

probabilities, decision-makers can make more informed choices about which projects to pursue
and how to structure them to mitigate risks.

9. Aligning risk appetite with investment decisions: Risk analysis helps ensure that investments
align with a company's overall risk tolerance. This reduces the likelihood of taking on projects
that could jeopardize financial stability.

10. Identifying potential problems early: Proactive risk analysis can uncover potential problems or
challenges early in the planning process, allowing for adjustments or contingency plans to be
made.
Techniques of Measuring Risks
Risk measurement is crucial in finance and investment to assess and
manage potential uncertainties. Several techniques are employed to
quantify risk:

1. Standard Deviation: This measures the dispersion of returns from

their mean, indicating the volatility of an investment.

2. Alpha: Alpha assesses the excess return of an investment compared to

its expected return, providing insights into its performance relative to
the market.
Techniques of Measuring Risks
3. Beta Coefficient: Beta measures an investment's sensitivity to market

movements, indicating its risk in relation to the broader market.

4. R-squared (R2): R-squared gauges the proportion of an asset's

variability explained by its benchmark, helping to understand the

reliability of the benchmark in predicting the asset's performance.

5. Value at Risk (VaR): VaR estimates the maximum potential loss within

a given confidence level, offering a quantified measure of downside risk.

Techniques of Measuring Risks
6. Sharpe Ratio: Sharpe ratio evaluates the risk-adjusted return of an
investment, considering both the return and the risk involved.

7. Coefficient of Variation (CVaR): CVaR measures the risk of an

investment by assessing the expected shortfall beyond a certain
confidence level.

8. Discount Rate Method: This method involves adjusting future cash

flows by applying a discount rate, considering the time value of money
as a measure of risk.
Techniques of Measuring Risks

9. Range Analysis: An early method, range analysis assesses risk by

analyzing the range of possible outcomes

10. Expected Value: Expected value calculates the average pf possible

outcome, providing a measure of central tendency in risk management.

Risk adjusted Discount Rate Approach
• Risk Adjusted Discount Rate (RADR) approach is a method used in finance to account
for risk when evaluating potential investments or projects.

• This methodology adjusts the discount rate used in discounted cash flow (DCF)
analysis to reflect the level of risk involved.

• The RADR reflects the correlation between risk and return, signifying the
required return on investment while considering the level of risk associated with
the investment.

• By incorporating the risk-adjusted discount rate, investors can make more informed
decisions by aligning the discount rate with the specific risk profile of the investment.
Risk adjusted Discount Rate Approach How it works:
1. Determine the risk-free rate: This is the rate of return you could earn on a risk-free
investment, such as a government bond.

2. Estimate the risk premium: This is an additional return that investors demand to
compensate for the risk of a particular investment.

3. Add the risk premium to the risk-free rate: This yields the RADR, which is used to
discount future cash flows to their present value.

By using a higher discount rate for riskier projects, RADR ensures that these projects must
generate higher projected returns to be considered worthwhile.

This helps decision- makers account for risk when comparing different investment options and
allocate resources more effectively.
Illustration 1
Balaji Enterprise Ltd is investing 100 lakhs in a project. The risk-
free rate of return is 7%. Risk premium expected by the
Management is 7%. The life of the project is 5 years. Following are
the cash flows that are estimated over the life of the project.
Year Cash flow (₹ in Lakhs)
1 25
2 60
3 75
4 80
5 65
Illustration 2
An investment will have an initial outlay of ₹100000. it is expected to
generate cash inflows as under:
Year Cash inflow (₹)
1 40000
2 50000
3 15000
4 30000

Risk free rate of interest is 10%. Risk premium is 10% (the risk
characterising the project).
a) Compute the NPV using risk free rate
b) Compute NPV using risk adjusted discount rate
Illustration 3
A firm is considering an investment in a project with an expected life of 3
years. It requires an initial investment of ₹35,000. the firm estimates the
following cash flows in each of the next three years
After tax cash inflow Probability
5000 0.2
10000 0.3
30000 0.3
50000 0.2
Assuming a risk adjusted required rate of return (after taxes) of 20% is
appropriate for the investment projects of this level of risk, compute the risk
adjusted NPV
Illustration 4
Determine the risk adjusted net present value of the following projects:
X Y Z
Net Cash Outflow 210000 120000 100000
Life of the Project 5 Years 5 Years 5 Years
Annual Cash Inflows 70000 42000 30000
Coefficient of Variation 1.2 0.8 0.4

The Company selects the risk adjusted rate of discount on the basis of the coefficient of
variation:
Coefficient of Variation 0.00 0.4 0.8 1.2 1.6 2.0 >2.0
Risk Adjusted Discount 10% 12% 14% 16% 18% 22% 25%
Rate
P.V Factor 1 to 5 Years at 3.791 3.605 3.433 3.274 3.127 2.864 2.689
Risk adjusted Discount
Rate
Illustration 5
Following information have been retrieved from the finance department of
AL-Corp Finance Ltd. Relating to Project X Y and Z:
X Y Z
Net Cash Outflow 420000 2400000 2000000
Life of the Project 5 5 5
Annual Cash Inflows 140000 840000 600000
Coefficient of Variation 2.0 0.8 1.6

You are required to determine the risk adjusted net present value of the
projects considering that the company selects risk adjusted rate of discount
on the basis of the coefficient of variation.
Coefficient of Variation 0.00 0.4 0.8 1.2 1.6 2.0 >2.0
Risk Adjusted Discount Rate 8% 10% 12% 14% 16% 20% 22%
P.V Factor 1 to 5 Years at Risk adjusted 3.992 3.790 3.604 3.433 3.274 2.990 2.863
Discount Rate
Certainty Equivalent Approach
A concept used in decision theory and finance to evaluate risky choices.

It refers to the guaranteed amount of money or certain outcome that an individual would
consider equivalent to the value of a risky prospect.

It’s a method in finance to account for risk by adjusting uncertain future cash flows to
their “Guaranteed” equivalents, reflecting a decision maker's risk aversion.

This allows for comparing risky projects more directly to safer ones.

This approach is based on the assumptions that individuals have different levels of risk
tolerance, and it is used to assess and compare options with varying levels of risk and
uncertainty.
Certainty Equivalent Approach
The certainty equivalent is calculated by dividing the expected return by one plus the risk
premium and it plays a crucial role in various areas of finance, including capital
budgeting, portfolio management, insurance and actuarial science.

It is a powerful tool that aids in decision making under uncertainty, allowing for the
evaluation of risk by adjusting the expected payoff of the uncertain investment.

The concept of certainty equivalent is essential for determining premiums in insurance

and is used to value uncertain future cash flows, providing a more accurate valuation in
actuarial science.

Overall, the certainty equivalent approach provides a quantitative method for making
informed financial decisions under conditions of risk and uncertainty.
Certainty Equivalent Approach

Certainty Equivalent:
Capital Budgeting:
The guaranteed Calculation:
amount of money Certainty Equivalent
Risk Aversion: Certainty Equivalent is is used to evaluate
someone would accept
today instead of a The degree to which often estimated by projects with
risker, potentially someone dislikes dividing the expected uncertain cash flows.
higher amount in the uncertainty and cash flow by (1+Risk Future cash flows are
future. prefers guaranteed Premium), where the replaced with their
outcomes risk premium reflects certainty equivalents,
CE = EXPECTED CASH risk aversion. making projects more
FLOWS/(1+Risk comparable.
Premium)
Illustration 6
ABC ltd. Has a project at its disposal with an expected cash flow of ₹100,
and a risk premium of 0.10 (due to risk aversion). Compute its certainty
Equivalent.
Illustration 7
The following table presents 5 years cash inflows of Rao Enterprises. The
certainty coefficient for the cash flows also given which presents the
probability of the occurrence of cash flows:
Year Cash Inflow Certainty Coefficient
1 100000 0.9
2 250000 0.7
3 90000 0.5
4 120000 0.6
5 50000 0.2
The Initial investment is 300000 and the discount rate is 9% annually.
With the help of a certainty equivalent method find out the NPV and
anlyse it.
Illustration 8
ABC inc has an investment proposal at its disposal. If investment
proposal costs 45,00,000 and risk free rate is 5%, calculate net
present value under certainty equivalent technique.
Year Cash Inflow Certainty Coefficient
1 1000000 0.9
2 1500000 0.85
3 2000000 0.82
4 2500000 0.78
Illustration 9
Alpha Beta Company employs a certainty equivalent approach in the
evaluation of risky investments. The capital budgeting department of
the company has developed the following information regarding a new
project
Year Cash Inflow Certainty Coefficient
0 (200000) 1.0
1 160000 0.8
2 140000 0.7
3 130000 0.6
4 120000 0.4
5 80000 0.3

The firm uses riskless rate of interest on government securities at 6%.

Should the project be accepted?
Sensitivity Analysis
• It is a technique used to understand how changes in input variables
effect the output of a model, providing a comprehensive picture of
potential outcomes.

• It is a crucial technique within risk analysis, that helps assess how

uncertainty in input variables affects the overall risk of a project or
decision.

• It involves systematically changing input values to observe how the

output, typically a measure of risk, varies in response.
Key applications in Risk analysis
Identifying critical risk drivers: Pinpointing which input
variable have the most significant impact on risk, guiding attention
and resources.

Quantifying risk exposure: Assessing the potential range of

outcomes and the likelihood of adverse events occurring

Evaluating risk mitigation strategies: Testing the effectiveness

of different approaches to reducing risk by observing their impact
on output.
Enhancing decision – making: By understanding the sensitivity
of risk to various factors, decision makers can make more informed
choices that consider uncertainty and potential outcomes.
Sensitivity Analysis

• Breakeven Analysis: This will provide information

about the effect of EBIT on factors like direct cost to
the project such as labour, material, and overhead
expenses

• Range: Under this method the project manager

Sensitivity Analysis can determines the optimistic timing, the pessimistic
be done under two timing and expected timing of the project. Range is the
difference between optimistic and pessimistic gap.
forms: Higher the rage higher the risk and vice-versa.
Analysis of Sensitivity Factor on EBIT Basis
• Calculate EBIT = Sales-VC-FC
• EBIT on Sales = EBIT/Sales X 100
• EBIT on Material = EBIT/Material X 100
• EBIT on Labour = EBIT/Labour X 100
• EBIT on Fixed Cost = EBIT/Fixed Cost X 100
Illustration 10
Sahana Ltd. a component manufacturing company presents the
following operating details:

Sales 1000 Units @ ₹20 per unit

Material Cost ₹14 per unit

Labour Cost ₹4 per unit

Fixed Cost ₹1000

Calculate EBIT and make a sensitivity analysis out of that.

Analysis of Sensitivity Factor on Range Basis

• Calculate EBIT

• Calculate ROI = EBIT/C X 100

• Calculate Range = Highest ROI – Lowest ROI

Illustration 11
Plama Ltd. Company presents the following facts:
Sales 20000 units @ ₹ 10 per unit
Material Cost at ₹ 4 per unit
Wages ₹ 2 per unit
Fixed Cost ₹ 10,000
Capital Employed ₹100,000
Calculate return on investment
Also calculate the range of ROI for the following Situation
Material Cost Goes up by 25%
Labour Cost increases by 20%
Sales declines by 20%
Fixed Cost increases by 25%
Illustration 12
A Ltd. Co. presents the following:
Number of units sold 25000
Selling price per unit ₹ 20
Material Cost per unit ₹ 8
Labour Cost per unit ₹ 9
Fixed Cost ₹ 30,000
Calculate Operating Profit.
Determine the effect of following possibilities on operating profit if
i) 10% decline in sales price
ii) 20% increase in material cost
iii) 20% increase in fixed cost
Illustration 13
An uncertainty prevailing in the acceptance of the project. To make the
right decision, the range of the return on investment for different
forecasted figures is needed. Help the company by calculating the range
in return in return on investment.
Forecasted Figures Optimistic Expected Pessimistic
Sales 40000 30000 30000
Variable Cost as % of sales 15% 20% 25%
Fixed Cost 12000 13000 15000
Capital Employed 44000 45000 60000
 Probability Approach
• Also known as Probabilistic Risk Assessment (PRA)

• It is a quantitative method that uses probability distribution to assess risks

and uncertainties in a system or process.

• The probability approach in risk analysis is a systematic and comprehensive

methodology to evaluate risks associated with various situations, projects,

or investments.
 Probability Approach
• It is based on the concept of probabilistic risk assessment, which addresses three
basic questions:
• What can go wrong with the studied technological entity or stressor, or what
are the initiators or initiating events that lead to adverse outcomes?
• What and how severe are the potential detriments, or the adverse
consequences that the technological entity (or the ecological system in the
case of a different context) leads to? and
• How likely to occur are these undesirable consequences, or what are their
probabilities or frequencies?
Illustration 14
Possible net cash flows of Projects A and B at the end of the first year
and their probabilities are given as below. Discount rate is 10 per cent.
For both the project initial investment is ₹10,000. From the following
information, calculate the expected net present value for each project.
Sate which project is preferable?
Possible Cash Flow Probability Cash Flow Probability
Event Project A Project A Project B Project B
A 8000 0.10 24000 0.10
B 10000 0.20 20000 0.15
C 12000 0.40 16000 0.50
D 14000 0.20 12000 0.15
E 16000 0.10 8000 0.10
Illustration 15
Probabilities for net cash flows for 3 years of a project are as follows:
Year 1 Year 2 Year 3
Cash flow Probability Cash flow Probability Cash flow Probability
4000 0.1 2000 0.2 2000 0.3
6000 0.2 9000 0.3 4000 0.4
6000 0.3 6000 0.4 10000 0.2
8000 0.4 8000 0.1 8000 0.1

Calculate the expected net cash flows. Also calculate net present value of
the project using expected cash flows using 10 per cent discount rate.
Initial investments ₹15,000.
Standard Deviation and Co-efficient of Variation

• Standard deviation and coefficient of variation are

two commonly used measures in risk analysis.

Standard Deviation and Co-efficient of Variation

• Standard deviation:

• Measures the dispersion of data from its expected value and is

commonly used to measure the historical volatility associated

with an investment.

• It is a statistical measure of the degree of variation or risk in a set

of data points around the mean.

Standard Deviation and Co-efficient of Variation

• Coefficient of variation (CV)

• Is the ratio of the standard deviation to the mean, and it is a useful

statistic for comparing the degree of variation from one data series to

another, even if the means are drastically different from one another.

• In finance, the CV allows investors to determine how much volatility, or

risk, is assumed in comparison to the amount of return expected from

investments,
Standard Deviation and Co-efficient of Variation
• Both measures are important in investment selection and portfolio
management, as they help investors understand the risk-to-reward ratio of
different investments.

• The lower the ratio of the standard deviation to mean return or the coefficient
of variation, the better the risk-return tradeoff.

• These measures are used in conjunction with other risk management

techniques, such as Sharpe ratio, beta, value at risk (VaR), conditional value at
risk (CVaR), and R-squared, to provide a comprehensive picture of the potential
risks and returns associated with an investment.
Formulas

• Standard Deviation of the project under non-probabilistic

situation:

• Standard Deviation of the project under probabilistic situation

(Multiply the (X-µ)2 with p
𝑆𝐷
• Co-efficient of variance = 𝑋100
µ
Illustration 16
From the following details of two projects calculate their standard
deviation, variance and co-efficient of variance:
Possible Events Cash flows (₹)
Project Gold Dust Project Star Dust
I 40000 46000
II 30000 32000
III 24000 28000
IV 16000 4000
V 10000 10000
Illustration 17
Calculate coefficient of variation based on the following information
Project Alpha Project Beta
NPV Estimate Probability NPV Estimate Probability
15000 0.2 15000 0.1
12000 0.3 12000 0.4
6000 0.3 6000 0.4
3000 0.2 3000 0.1
i) Compute the expected NPV of Projects
ii) Compute the Risk attached to each project i.e., standard deviation of
each probability distribution
iii) Compute the profitability index of each project
iv) Identity which project do you recommend? State with reason
Illustration 18
From the following information, ascertain which project is riskier on the
basis of standard deviation and also calculate co-efficient of variation.
Project T Project M
Cash Flows Probability Cash flows Probability
2000 0.1 2000 0.1
4000 0.3 4000 0.2
6000 0.2 6000 0.4
8000 0.2 8000 0.2
10000 0.2 10000 0.1
Illustration 19
A Company is considering 2 mutually exclusive projects X and Y. Project X
Costs ₹3,00,000 and Project Y costs ₹3,60,000. You have been given below the
net present value, probability distribution for each project.

Project X Project Y
NPV Estimate Probability NPV Estimate Probability
30000 0.1 30000 0.2
60000 0.4 60000 0.3
120000 0.4 120000 0.3
150000 0.1 150000 0.2
i) Compute the expected net present value of both the project
ii) Compute the Risk attached to each project
iii) Which project do you consider risker and why?
Decision Tree Analysis
• A powerful tool in risk management
• Enabling organisations to make informed choices by visualising potential
outcomes and consequences.
• It provides a structure approach to assess risks, facilitating informed
decision making based on a comprehensive evaluation of potential
outcomes
• Decision tree analysis involves constructing a graphical representation
resembling a tree question node and branching out into different
decision paths, eventually leading to various outcomes
• By quantifying probabilities and weighing potential risks, decision tree
analyse the consequences of their choices.
• This technique is particularly useful for evaluating complex decision
scenarios and identifying high risk areas, thus enabling organisations to
assess and address potential risks effectively.
Decision Tree Analysis

• Decision tree analysis (DTA) involves creating a tree like diagram that
represents:
• Decision points (Branches): Representing the different choices or
options available.
• Chance Events (Nodes): Representing uncertain events or outcomes
that could occur.
• Outcomes (Leaves): Representing the final results of each decision
path
Illustration 20
A company has made following estimates of the CFAT of the proposed
project. The company use decision tree analysis to get clear of projects cash
flow. The project cost ₹80,000 and the expected life of the project is 3 years.
The Net Cash inflow are:
In year 1 there is 0.4 probability that CFAT will be ₹50,000 and 0.6
probability that CFAT will be ₹60,000.
The probabilities assigned to CFAT for the year 2 are as follows:
If CFAT is ₹50,000 If CFAT is ₹60,000
₹ Probability ₹ Probability
24000 0.2 50000 0.5
40000 0.4 44000 0.5
32000 0.3 60000 0.1
Illustration 21
A businessman has two options to sell his products. He can set up a show
room in a city or can sell from his factory outlet. Setting up a showroom
will cost ₹6,00,000 with a 55% probability of success.
if the showroom succeeds, he can gross a net profit of ₹10,00,000 per
year. if fails, he can close the show room and rent it out for an annual rent
of ₹3,60,000 for the rest of the year. the probability of getting rent is
40%.
If he sells from the factory outlet, he has to incur ₹3,00,000 as renovation
charges. The chance of successful selling here is 45% with the net profit
of ₹ 5,50,000 per year.
a. What would your advice the businessman to do?
b. Advice a businessman on how a decision tree helps him to make
decisions.
 Illustration 22
A restaurateur has 3 projects in hand. He can only take up one project at a time. The project is to take up a fast food

corner at an investment of ₹600,000 where the chances of success will be 0.75 with the cash inflow of ₹ 9,00,000. If fails

the cash inflow of ₹150,000 is expected from salvage from furniture and utensils.

The second project is to open an expresso coffee shop with an investment of ₹8,00,000 where there will be definite

success with an inflow of ₹9,00,000.

The third project is to open an ice cream parlour with an investment of ₹10,00000. the chances of success are 0.8 with

an inflow of ₹12,00,000. if failed an inflow of ₹30,00,000 is expected from salvage value.

If there is success, the restaurateur will decide to start a fast-food kiosk with an investment of ₹4,00,000 where by he

can expect high demand with 0.8 probability and ₹5,00,000 inflow, medium demand with 0.15 probability and cash

inflow of ₹4,00,000 and low demand with 0.5 probability with a cash outflow of ₹1,00,000.

All the amounts adjusted to current value. You are expected to draw a decision tree and a payoff table and thereby

advice the restaurateur about the best course of action.

 Module No. 3

Dividend Decision
and
Theories
14 Hours
Content
• Introduction
• Dividend Decisions: Meaning
• Types of Dividends
• Types of Dividends Polices
• Significance of Stable Dividend Policy
• Determinants of Dividend Policy
• Dividend Theories:
• Theories of Relevance – Walter’s Model and Gordon’s Model and
• Theory of Irrelevance – The Miller-Modigliani (MM) Hypothesis -
Problems.
 Introduction
• The major decisions of financial management of any business are investment,
financing, and dividend decisions.

• The dividend decision is also an integral part of financing decision.

• When a company earns profits, it must decide as to how much of the profit should be
distributed by way of dividend to the shareholders and how much to be retained for
future purpose.

• These retained earnings are the internal sources of finance to the company.

• Thus, the earnings available to shareholders are equal to the dividends plus retained
earnings.
 Introduction
• The success of any business firm rests not only on the optimal utilization of funds but also on efficient
management of income earned from its business operations.

• The distribution of fair amount of dividend to shareholders, provision for sufficient reserves to finance
future opportunities and to absorb the shocks of business and provision of adequate resources for
retiring old bonds and redeeming other debts call for effective management of income.

• The efficient management of income strengthens the financial position of the business enterprise and
enables the firm to withstand seasonal fluctuations and oscillations.

• It also helps in enlisting the support of the shareholders in future and finally facilitates in raising funds
from different avenues of capital market.

• As such the dividend decision is one of the most important areas of decision making for a finance
manager.
Dividends
Dividends are regular payments made by a company to its shareholders as a way
to distribute a portion of its profits. When a company generates earnings, it may
choose to allocate a portion of those profits to shareholders in the form of
dividends. These payments can be made in cash, additional shares of stock, or
other assets.
Dividends serve as a reward for shareholders who have invested in the company,
providing them with a tangible return on their investment. They are typically paid
out quarterly or annually, depending on the company’s financial performance and
dividend policy. Dividends are an essential component of many investors’
strategies, as they offer a steady stream of income and can contribute to long-term
wealth accumulation.
Types of Dividends
1. Cash Dividend
This is a common type of dividend that companies distribute to their
shareholders in the form of cash payments. When a company generates profits,
it may choose to distribute a portion of those profits back to its shareholders as
cash dividends. They are typically paid on a per-share basis, meaning that
shareholders receive a certain amount of cash for each share they own.
Example, if a company declares a cash dividend of Rs. 10 per share and an
investor owns 100 shares, they would receive a cash payment of Rs. 10*100 =
Rs. 1,000. Cash dividends are usually paid out regularly, such as quarterly, semi-
annually, or annually, depending on the company’s dividend policy.
Types of Dividends
2. Stock Dividend

Stock dividends are a type of dividend payment in which a company distributes

additional shares of its own stock to existing shareholders instead of cash. These
are often used by companies to conserve cash while still rewarding shareholders.

Example, if a company announces a 10% stock dividend and an investor owns

100 shares, they would receive an additional 10 shares (10% of 100 shares) as a
stock dividend. As a result, the investor’s total number of shares would increase to
110. The value of each share may decrease proportionally to account for the new
shares issued.
Types of Dividends
3. Property Dividend

Property dividends are a type of dividend payment in which a company distributes assets or property to
its shareholders instead of cash or additional shares. Instead of receiving cash or stock, shareholders
receive tangible or intangible assets, such as inventory, real estate, intellectual property, or subsidiary
company shares.

Property dividends are less common than cash or stock dividends and are typically issued when a
company has excess assets that can be distributed among its shareholders. This type of dividend allows
the company to monetize its assets or transfer ownership of certain assets to its shareholders.

Example, a real estate development company may distribute properties or rental units to its
shareholders as property dividends. Shareholders would then become owners of those properties and
may choose to sell, lease, or retain them as per their discretion.
Types of Dividends
4. Scrip Dividend
Scrip dividends are quite similar to stock dividends. In this, instead of additional
shares, the shareholder will be getting scrips or vouchers that can be redeemed
with shares on the market. They are a type of dividend payment in which a
company issues additional shares of its own stock to its shareholders instead of
cash or property. Instead of receiving a cash payout, shareholders receive
additional shares of the company’s stock based on their existing shareholding.
For instance, if a company declares a scrip dividend of 10% and a shareholder
owns 1,000 shares of the company, the shareholder would receive an additional
100 shares (10% of 1,000 shares) as a scrip dividend. The shareholder can hold
on to these additional shares or choose to sell them in the market.
 Types of Dividends
5. Liquidating Dividend

Liquidating dividends are given by a company when it is in the process of liquidating its assets
and winding up its operations and therefore, cannot pay in the form of other dividends. Unlike
regular dividends that are paid out of a company’s profits, liquidating dividends are paid from the
company’s remaining assets after all debts and liabilities have been settled.

It’s important to note that liquidating dividends is typically subject to specific legal and regulatory
requirements. The distribution of assets must follow the prescribed procedures outlined by the
applicable laws and regulations governing the liquidation process.

Example, if a company decides to liquidate and has Rs. 10 million in assets remaining after
paying off all debts and liabilities, it may distribute these assets as liquidating dividends to its
shareholders.
Types of Dividends – on the basis of declaration
• Final Dividend: Declaration is done in annual general meeting. This is
declared after the preparation of all the financial statement. Managers
are well aware about the net profit and financial health of the
organization.

• Interim Dividend: Dividend is declared before the annual general

meeting ant of the time during financial year. Generally it is declared
along with mid quarterly results of the companies.
Dividends Policy

• A dividend policy can be defined as the dividend distribution guidelines

provided by the board of directors of a company.

• It sets the parameter for delivering returns to the equity shareholders, on

the capital invested by them in the business.

• While taking such decisions, the company has to maintain a proper

balance between its debt and equity composition.
Significance of Stable Dividend Policy

• A business with a stable dividend policy pays out a steady dividend

every given period, regardless of the volatility in the market.

• The exact amount of dividends that are paid out depends on the long-
term earnings of the company.

• The dividend’s growth is in line with the company’s long-term earnings.

Significance of Stable Dividend Policy

1.Investor Confidence: A stable dividend policy instills confidence among investors as it

signals financial stability and predictability. Investors, particularly income-oriented

investors such as retirees or pension funds, often rely on dividends for a steady stream of

income. A consistent dividend payout reassures them of the company's financial health and

its ability to generate consistent profits.

2.Market Perception: A stable dividend policy can enhance the company's image in the

market. It portrays the company as mature, reliable, and committed to shareholder returns.

This positive perception can attract new investors and potentially boost the company's stock

price.
Significance of Stable Dividend Policy

3. Reduced Volatility: By committing to a stable dividend policy, companies may reduce

stock price volatility. Investors seeking stable income are more likely to hold onto their

shares, even during periods of market turbulence, if they expect consistent dividend

payments. This stability in shareholder base can contribute to a more stable stock price.

4. Discipline in Capital Allocation: Maintaining a stable dividend policy imposes discipline

on management in terms of capital allocation. It encourages management to prioritize

investments that generate sustainable cash flows and long-term profitability. This can lead

to more prudent decision-making and efficient use of resources.

Significance of Stable Dividend Policy
5. Signaling Mechanism: A stable dividend policy can serve as a signaling mechanism to investors.

When a company announces a change in its dividend policy, it may signal changes in its future

prospects, financial condition, or management's confidence in the business. Therefore, maintaining

stability in dividend payments can prevent misinterpretation or undue speculation about the

company's performance.

6. Tax Considerations: In some jurisdictions, there may be tax advantages associated with stable

dividend policies. For example, investors may prefer receiving qualified dividends, which are taxed

at a lower rate in many countries. By maintaining a stable dividend policy, companies can help

investors plan their tax liabilities more effectively.

Significance of Stable Dividend Policy
1. Earning Stability
2. Cash Flow Generation
3. Profitability
4. Industry Characteristics
5. Growth Prospects
6. Capital Expenditure Requirements
7. Debt Level and Financial Leverage
8. Tax Consideration
9. Share holders base
10. Management Philosophy
11. Historical Dividend Payments
12. Regulatory Environment
Dividend Theories/ Models
• Dividend models consider whether there is any relation between
dividend policy and market value of the shares.
• They consider the impact of dividend and retained earnings on the
value of the firm.
• There are two schools of thought-
• First school of thought argues that dividend is relevant for the
valuation of the firm or market price of the shares.
• The models of Walter and Gordon belong to this school
• The second school of thought, argue that dividend paid is not relevant
either for the market price of the shares or the valuation of the firm.
• The Modigliani-Miller pair belongs to the second school.
 Walter’s Model
• James Walter published an article in Journal of Finance in 1963 under
the title “Dividend Policy: its Influence on the value of the Firm”

• He argued that dividend policy does affect the value of an enterprise

• Based on the relation between cost of capital and return on investment

• He classified the firms into three groups:

• Growth
• Decline
• Normal
 Growth firm

• The Return on Investment, is more than cost of capital.

• The firm’s earning capacity is far more than the return the shareholder
will be getting on other investments (reflected by cost of capital)

• Therefore, it is only logical and prudent that money is retained in the

firm itself.

• Therefore, the Dividend pay-out ratio should be zero.

 Declining Firm
• The cost of capital is more than the return on investment

• It means the shareholder can get a better return, if he invests the money
in other forms of investment

• The shareholders will be able to generate better return than the

company.

• The company can as well pay out 100% of the earnings as dividend

• Retention ratio is Zero

 Normal firm

• Where the return on investment is equal to cost of capital

• It makes no difference whether the surplus is in the hands of the

company or in the hands of the shareholder

• The company can decide upon any percentage of dividend based on

other relevant factors.

 Walter’s Model - Assumptions

• There are only two sources of finance: equity and retained earnings. Other
forms like preference shares and debentures or bonds do not exist in the
capital structure

• The Return of investment is constant from one year to another

• The cost of capital is also assumed to be constant from one year to another

• The firm has an infinite life

 Formula
Market Price of the Shares

𝑫 + 𝑹 (𝑬 − 𝑫)
___________
𝑷= 𝒌
𝒌
P= Market Price of Equity
R = Rate of Return
E = Earning Per Share
K = Cost of Capital
D= Dividend Per Share
 Calculation of Dividend Per Share

• The dividend declared can be given either as a percentage or payout

ratio.

• Where it is a percentage, the face value of the share is multiplied by

the percentage in order to calculate the dividend per share.

• If the face value is not given, it is assumed to be Rs. 10.

• In case it is given as a percentage of payout ratio, then the EPS must

be multiplied by the percentage in order to get the dividend per
share.
Illustration 1
Company A has achieved on EPS of Rs. 30 for the year 2019-20. what is the
dividend per share if
(a) a 20% dividend is declared on the share of Rs. 10 face value
(b) dividend payout ratio is 20%

Solution:
Dividend per share = Face Value X Percentage
= Rs. 10X20% = Rs. 2
Dividend per share = EPS X Percentage of Payout ratio
= Rs. 30X20% = Rs. 6
Illustration 2
The National Sports Company with earnings per shares of Rs.
7.50 is capitalised at 12% and has a return on Investment of
15%. What would be the optimum payout and the price of the
shares at this payout according to Walter’s Model.
Solution:

As the company has a return on investment at 15%, which is higher than

the cost of capital at 12%, it is a growth firm. According to Walter’s Model
the dividend payout should be zero. At zero payout, the market price of the
share is.
P = D+R [(E-D)/k]/k
P = 0+.15[(7.50-0)/.12]/.12
P = Rs. 78.13
Illustration 3
The earning per share of a company are Rs. 10. It has an internal rate of
return of 15% and the capitalisation rate of its risk class is 12.5%. If
walter’s model is used:

(i) What should be the optimum payout ratio of the firm?

(ii) What would be the price of the share at this payout?

(iii) How shall the price of the share be affected if 20% payout ratio was
employed?
Solution:
(i) As the company has a return on investment at 15% which is higher
than the cost of capital at 12.5%, it is a growth company. According to
Walter’s model, the dividend payout should be Zero.
(ii) At Zero Payout the market price of the share is,
P = 0+.15 [(10-0)/.125]/.125
P = Rs. 96
(iii) If 20% was employed on the share of Rs. 10, the dividend per share is,
Rs. 2 (10X20%)
P = 2+.15[(10-2)/.125]/.125
P = Rs. 92.80
The market value has come down, as it is the highest at zero percent
payout, any more dividends will only result in reducing the market
price as per Walter’s Model.
Illustration 4
SD Chemicals Ltd. Achieved an EPS of Rs. 5 per share on its equity with a

face value of Rs. 10 for the year 2018-19. it achieved a Return on

Investment at 15% with the cost of capital at 10%. The board of directors

recommended a dividend of Rs. 3 per share. Calculate the market value of

share of the firm.

Illustration 5
For the year 2018-19, S Ltd. Achieved an EPS at Rs.8. its cost of capital is

15% and rate of return is 20%. Determine its market price when the

dividend pay-out ratio is (a) 0% (b) 25% (c) 50% or (d) 100%.
 Illustration 6
Consider the following data:

Growth Firm Normal Firm Declining Firm

Rate of Return 20% 15% 10%
Capitalisation Rate 15% 15% 15%
EPS Rs.4 Rs.4 Rs.4

Calculate the market price of shares of the firms if the pay-out ratio is
25%, 50% or 75% also comment on it
Comment:

• For the growth firm, the market price keeps declining with increasing
pay-out ratio. Therefore, optimum pay-out ratio is zero.

• For the normal firm, the market price remains the same for any pay-out
ratio

• For the declining firm, the market price keeps increasing with
increasing pay-out ratio. Therefore, the optimum pay-out ratio is 100%
Illustration 7
Earning per share Rs. 12

Internal Rate of Return 15%

Capitalisation rate of its risk class 10%

If walter’s model is used

1. What should be the optimum pay-out ratio of the firm?

2. What would be the price of the share at this pay-out ratio?

3. How shall the price of the share be affected if 40% pay-out was employed?
Illustration 8

The following data relate to three sugar companies. Using Walter’s model,
calculate the market price of their shares

Bajaj Barlarmpur KCP Sugar

EPS Rs. 10 Rs. 5 Rs. 30
Return on Investment 35% 32% 45%
Div. Pau-out Ratio 4% 20% 5%
Cost of Capital 9% 9% 9%
Illustration 9

Maruthi Udyog Ltd. Achieved an EPS of Rs. 25 for the year 2018-19. the

return on investment was 21% while the cost of capital was 7.5%. If the

dividend pay-out ratio is 8% calculate the market price of the equity shares

of the Company. What will be the impact on the share price, if the pay-out

ratio is increased to 20%.

 Criticisms of Walter’s Model

• The assumption that only equity shares and retained earnings are on the capital
structure of the company holds good only for zero debt companies. Generally, software
companies alone have zero debt capital structure. In most other cases, debt and hybrid
securities are there on the capital structure.

• The assumption that return on investment is constant is also wrong. Plenty of

production factor, marketing factors, taxation and many other factors change the
return on investment. Many a time, it does not remain constant even coincidentally.

• Cost of Capital also rarely remains constant. Only, when the companies are able to
manage the affairs with internal accruals, cost of capital may be same from one year to
another in the long-run, cost of capital does change.
 Gordon Model

• Dividend Capitalization Model

• Subscribed to the relevance concept of Walter

• He maintained that the dividend declared had an impact on the value of

shares

• He varied from Walter in advocating that the growth in the dividend

affected valuation of shares.
 Gordon’s Model Assumptions
1. Only retained earning and equity shares are on the capital structure of
the company

2. The Rate of Return of the company is constant from one year to

another

3. The Cost of Capital also remains constant from one year to another

4. Taxes do not exist on dividend or on capital gains

5. The firm has a perpetual life

 Formula
Calculation of Market Value

𝑬(𝟏 − 𝒃)
𝑷=
(𝒌𝒆 − 𝒃𝑹)
Where
P = Market Price of Share
E = EPS
b = Retention Ratio
R = Rate of Return
(1-b) = Dividend Pay Out Ratio
Illustration 10

ABC Co Ltd had an EPS of Rs. 15, Cost of Capital at 16%, dividend pay-out

ratio at 40% and a return on Investment at 20%. Calculate the market

price of its share.

Illustration 11

XYZ Co. Ltd. Achieved an EPS of Rs. 20 for the year 2005-6. its cost of equity

was 15% and rate of return was 18%. The dividend pay-out ratio was 20%.

Calculate market price of the share using Gordon’s model. What will be the

share price, if the pay-out ratio was increased to 50%.

Illustration 12
A company had an EPS of Rs. 25. its rate of return was 15% while
the cost of equity was 14% using Gordon’s Dividend model,
calculate the market price of the equity share of the company, if
dividend pay-out ratio is 25%, 30% and 40%.
Illustration 13
From the particulars given below relating to three companies,
calculate the market price of the shares of the companies using
Gordon’s Dividend model
G Ltd. N Ltd. D Ltd.
Return on Investment 20% 15% 10%
Cost of Equity 15% 15% 15%
EPS Rs.8 Rs. 8 Rs. 8
Retention Ratio 25% 25% 25%
Illustration 14
Using Gordon’s Dividend Model, Calculate share prices of the following
companies:

RoI CoE EPS D-Pay-Out Ratio

Can Fin Home Ltd. 15% 15% Rs. 10 25%
LIC Housing Finance 14% 12% Rs. 16 32%
Illustration 15
The following seven companies are selected for having the same return on
investment at 12% and the same EPS at Rs 20. However, their cost of
capital and dividend pay-out ratio are different at the figures shown below
Company Dividend Pay-out (%) Cost of Equity (%)
A 10 16
B 20 15
C 30 14
D 40 13
E 50 12
F 60 11
G 70 10
Using Gordon’s Dividend model, determine their share prices.
 Gordon’s Model Defects

1. The share price cannot be calculated if the dividend pay-out ratio is

zero. If it’s zero. The numerator becomes zero

2. For highly successful companies cost of equity is negligible because of

high share price and a small dividend. This will make the denominator

negative.
 Modigliani Miller Model (Irrelevance)

• Under certain assumptions (no taxes, perfect markets, and no information

asymmetry), the dividend policy of a firm should not affect its market
value.

• Investors can create their desired cash flows by selling shares, and the
value of the firm is determined by its investment policy.

• This theory challenged the traditional belief that dividend policy

influences firm value. for growth oriented companies this theory is very
much beneficial.
Assumptions of MM approach
• All the investors are rational and do not take the decisions based on
emotions or sentiments

• All the price sensitive information is available to all the investors at the
same time

• That the securities are infinitely divisible

• Individual cannot influence the same share price

Formula
P1 = P0 (1+Ke)-D
Where,
P1 = Price at the End
P0 = Price at the Beginning
Ke = Cost of Equity
D = Dividend per share
Illustration 16

Emerson Electric Ltd. Had 1000 equity shares of ₹100 each.

During financial year, its cost of equity was 20%. Using Miller

Modigliani model, decide what will be the price of the share, if no

dividend declared? If a dividend of ₹10 per share is declared,

what will be the share price?

Illustration 17
Two software companies A ltd. And B Ltd. Had equity shares
priced at ₹130 each. During the financial year 2022-23, each one
made a net profit of 200 crores. Cost of equity is the same for
both the companies at 11%. A ltd. decides to declare a dividend at
10 per share and B ltd. decided not to declare any dividend.
Illustration 18
Apply MM hypothesis and determine the share prices of the following:

Company Face Price of Share before Dividend Cost of Net Profit

Value declaring Dividend per Share Equity (in Crores)
P 10 1600 12 3 126
Q 10 621 6 4 108
R 10 182 3 5 12
S 10 1163 22 2 310
T 10 4923 40 1 5
Additional Problems
Illustration 20
An EPS at Rs. 96, Return on Investment at 20%, Cost of Equity at 9% were

the financial hall marks of Grasim Industries Ltd. It proposed a dividend at

Rs. 16 per share.

a. What is its share price under Walter’s dividend model?

b. What will be the share price if the dividend is increased to Rs. 20 per

share or reduced to Rs. 10 per share?

Illustration 21
Three Reliance Group Companies present their financial for 2018-19 as
shown below
Company EPS Return on Cost of Divided
(Rs.) Investment Equity
Reliance Energy 22 10 5.5 4.70
Reliance Capital 4.50 7.5 2 3.00
Reliance 53.00 21 10 7.50

Calculate their share prices based on Walter’s Dividend Model

Illustration 22
Using the following data, calculate the share prices based on Gordon’s
dividend theory.

Gr Ltd. NO Ltd. DE Ltd.

Return on Investment 24% 19% 13%
Cost of Equity 18% 19% 15%
EPS Rs. 9 Rs. 6 Rs. 4
Retention Ratio 30% 30% 30%
Illustration 23
A Company had an EPS of Rs. 23. its rate of return was 18% while the
cost of equity was 10%. Using Gordon’s model, calculate the market
price of the equity share of the company, if dividend pay-out is

a) 20% b) 35% and c) 50%

Illustration 24
Using Gordon’s dividend model, calculate the share prices of the following
companies

Return on Cost of EPS Dividend

Investment Equity Pay-out
Can Fin Homes Ltd. 18% 18% Rs. 12 35%

LIC Housing Fin. Ltd. 16% 11% Rs. 14 28%

Illustration 25
From the particulars given below relating to 5 companies calculate
market price of the shares of the companies using Gordon’s dividend
model

M Ltd. N Ltd. O Ltd. P Ltd. Q Ltd.

Return on 19% 14% 13% 11% 20%
Investment
Cost of Equity 14% 14% 14% 14% 14%
EPS Rs. 9 Rs. 9 Rs. 9 Rs. 9 Rs. 9
Retention Ratio 30% 30% 30% 30% 30%
Illustration 26
Pidilite Industries Ltd. Manufacturer of Fevicol & other brands of adhesives,
provides its financials for the year 2019-20 (Face value of the share Rs. 1)

EPS Rs. 2.80; Return on Investment 21.9%; Cost of Equity 15%. The company
announced a dividend resulting in a pay-out ratio at 35% using Gordon’s model

a) Calculate the share price of the company

b) What will be the change in the price if the Dividend pay-out ratio is
increased to 50%, 60% and 80%
Illustration 27
A certain number of companies achieved an EPS of Rs. 20 each with a rate
of return at 14%. Calculate the share prices of the companies using the
below given data as per Gordon’s Dividend model
Company Dividend Pay-Out Ratio Equity
A 10 20
B 20 19
C 30 18
D 40 17
E 50 16
F 60 15
Illustration 29
Details of three companies are:

A B C
Rate of Return 18% 16% 14%
Cost of Equity 12% 16% 16%
Earning Per Share Rs. 10 Rs. 10 Rs. 10

Following the Walter’s dividend model, calculate the share prices of

companies for a dividend pay-out ratio at 40%, 60%, 80% and 100%
Illustration 30
Three companies Present the following financial details
X Y Z
Return on Investment 30% 25% 20%
EPS Rs. 16 Rs. 12 Rs. 8
Cost of Equity 18% 25% 22%
Using Walter’s Dividend model, calculate the share prices for 0%, 25%,
50% and 75% pay-out ratio
Illustration 31
Three companies achieved an EPS at Rs. 8 each with cost of capital at
12% each. The first company achieved a rate of return at 20% while the
second company achieved 12% and the third company achieved 10%

Based on Gordon’s model, calculate the share prices for

20%, 40%, 50%, 55% and 60% retention ratio.

Illustration 33
The following seven companies are selected for having the same Return
on Investment at 13% and the same EPS at Rs. 21. However, their cost of
capital and Dividend pay-out ratio are different at the figures shown
below:
Company Dividend Pay-Out Ratio (%) Cost of Equity (%)
A 12 16
B 22 15
C 32 14
D 44 13
E 55 12
F 68 11
Using Gordon’s dividend model, determine their share prices.
Illustration 34
The following seven engineering companies undertake turn-key projects in
India. Their financials for 2022-23 are given below. All the companies have
₹10 as the Face Value of shares of a company.
Company Price per share Dividend Per share Cost of equity
ABC 264 1.50 4.4
DEF 823 7.50 2.4
GHI 813 1.20 2.2
JKL 130 0.30 2.3
MNO 168 1.00 5.9
PQR 251 4.50 4.14
STU 840 5.00 2.1

Using MM hypothesis calculate the market price of shares after the

declaration of dividend.
 Module No. 4:

Mergers and Acquisitions

10 Hours
Content
• Meaning
• Reasons
• Types of Combinations
• Types of Merger
• Motives and Benefits of Merger
• Financial Evaluation of a Merger
• Merger Negotiations
• Leverage buyout
• Management Buyout
• Meaning and Significance of P/E Ratio.
• Problems on Exchange Ratios based on Assets Approach, Earnings Approach
and Market Value Approach and
• Impact of Merger on EPS, Market Price and Market capitalization.
Meaning of Merger
• Merger and acquisition (M&A) refer to the processes by which
companies consolidate their assets, operations, and management
structures.

• A merger is the combination of two companies to form a new entity. In a

merger, both companies cease to exist separately, and a new
organization is created.
Types of Merger
• Merger can be achieved through various methods, including:

• Horizontal Merger: Combining two companies in the same industry and at the same stage of
production, often competitors.

• Vertical Merger: Joining two companies at different stages of production within the same industry,
such as a manufacturer merging with a supplier.

• Conglomerate Merger: Uniting companies in unrelated businesses, diversifying the combined

company's activities and risk.

• Congeneric merger: involves companies that operate in the same general industry but offer
different products or services that are related in terms of technology, marketing, or distribution
channels. These mergers are undertaken to achieve synergies through combining complementary
products, expanding market reach, and leveraging existing customer bases.
Horizontal Merger:

• The merger between Sprint and T-Mobile in 2020. Both companies were in the

telecommunications industry and combined to better compete with larger

rivals like Verizon and AT&T.

• The merger between Vodafone India and Idea Cellular in 2018. Both

companies were major players in the Indian telecommunications sector. Their

merger created Vodafone Idea Limited, one of the largest telecom operators in

India, aimed at competing more effectively with Reliance Jio.

Vertical Merger:

• The acquisition of MGM Studios by Amazon in 2021. Amazon, primarily an e-

commerce and cloud computing giant, acquired MGM Studios, a major player in

content creation, to enhance its Prime Video streaming service.

• The acquisition of Zee Entertainment Enterprises Ltd (ZEEL) by Sony Pictures

Networks India (SPNI) in 2021. This vertical merger combined Sony’s

distribution capabilities with Zee's strong content creation, forming a more

robust entity in the media and entertainment sector.

Conglomerate Merger:

• The merger between International Flavors & Fragrances Inc. (IFF) and
DuPont's Nutrition & Biosciences unit in 2021. This merger combined
IFF's capabilities in flavors and fragrances with DuPont's expertise in
nutrition and biosciences, bringing together businesses from different
sectors.
• The merger between Tata Steel and Bhushan Steel in 2018. Tata Steel, a
leading steel manufacturer, acquired Bhushan Steel, which operated in a
related but different segment of the steel industry, expanding its
production capacity and market reach.
Congeneric Merger

• The acquisition of ARM Holdings by NVIDIA in 2020.

• ARM Holdings: A leading semiconductor intellectual property (IP) company, specializing in designing and
licensing technology for microprocessors and other semiconductor components used in a wide range of
devices, including smartphones, tablets, and IoT devices.

• NVIDIA: A leading graphics processing unit (GPU) manufacturer and technology company, known for its
GPUs used in gaming, artificial intelligence (AI), and data centers.

• The merger between Just Dial and Reliance Retail Ventures Limited (RRVL) in 2021.
• Just Dial: A leading local search engine and business directory service provider in India, offering
information on various businesses, products, and services across different categories.

• Reliance Retail Ventures Limited (RRVL): A subsidiary of Reliance Industries Limited (RIL), one of India's
largest conglomerates, operating in various sectors, including retail, telecommunications, and energy.
Meaning of Acquisition
• An acquisition occurs when one company purchases another
company. The acquired company may become a subsidiary of
the acquiring company or may be completely absorbed and
cease to exist.
Types of Acquisition/Combinations

• Acquisitions can be friendly or hostile:

• Friendly Acquisition: The target company agrees to be acquired, and

the transaction proceeds smoothly.

• Hostile Acquisition: The acquiring company goes directly to the

shareholders or fights to replace management to get the acquisition
approved against the wishes of the target company's management.
Friendly Acquisition

• The acquisition of Slack Technologies by Salesforce in 2021. This was a friendly

acquisition where Slack agreed to be acquired by Salesforce, aiming to create a

unified platform for business communication and collaboration.

• The acquisition of Flipkart by Walmart in 2018. This was a friendly acquisition

where Flipkart's management and shareholders agreed to the deal. Walmart

aimed to strengthen its presence in the fast-growing Indian e-commerce market

through this acquisition.

Hostile Acquisition

• The attempted hostile takeover of Unilever by Kraft Heinz in 2017. Kraft Heinz
made an unsolicited bid to acquire Unilever, which was rejected by Unilever's
board. Although Kraft Heinz eventually withdrew the offer, it remains a
significant recent example of a hostile acquisition attempt.

• The attempted hostile takeover of Mindtree by Larsen & Toubro (L&T) in 2019.
L&T made an unsolicited bid to acquire a significant stake in Mindtree, an IT
services and consulting company. Despite resistance from Mindtree’s
management, L&T successfully acquired a controlling stake, marking a notable
example of a hostile takeover in India.
Reasons
Companies pursue M&A for various strategic reasons, including:

1. Growth: Expanding market reach, customer base, and product lines.

2. Synergies: Reducing costs and increasing efficiencies by combining

operations.

3. Diversification: Entering new markets or industries to spread risk.

4. Competitive Advantage: Increasing market share and reducing

competition.
Motives of Merger
1.Strategic Growth: Mergers can facilitate rapid expansion into new markets,
regions, or product lines, helping companies achieve growth objectives more
quickly than through organic means.

2.Synergy: Merging companies can combine their resources, capabilities, and

operations to achieve synergies, such as cost savings, revenue enhancements,
and operational efficiencies.

3.Market Power: Mergers can increase market share, enhance competitive

positioning, and strengthen bargaining power with suppliers and customers,
allowing companies to exert greater influence in their industries.
Motives of Merger
4. Diversification: Companies may pursue mergers to diversify their

revenue streams, reduce dependence on specific markets or products,

and spread risk across different business segments or geographies.

5. Technology and Innovation: Mergers can provide access to new

technologies, research and development capabilities, and intellectual

property, enabling companies to innovate and stay competitive in fast-

evolving industries.
Motives of Merger
6. Vertical Integration: Companies may merge with suppliers or

customers to vertically integrate their operations, streamline supply

chains, and capture value across multiple stages of the production or

distribution process.

7. Economies of Scale: Mergers can lead to economies of scale by reducing

per-unit costs through increased production volumes, shared resources,

and greater efficiency in operations.

Benefits of Merger
1.Increased Market Share: Mergers can enable companies to capture a larger share of the
market, boosting revenue and profitability.

2.Cost Savings: Merging companies can eliminate duplicate functions, consolidate

operations, and achieve cost efficiencies, resulting in lower operating expenses and
improved margins.

3.Revenue Growth: Mergers can create opportunities for cross-selling, upselling, and
expanding into new customer segments or geographic markets, driving top-line growth.

4.Enhanced Competitive Positioning: Mergers can strengthen a company's competitive

position by combining complementary strengths, capabilities, and resources, making it
more resilient to competitive pressures.
Benefits of Merger
5. Access to Resources and Expertise: Merging companies can leverage
each other's resources, talent pool, technologies, and market knowledge,
enabling faster innovation and market penetration.

6. Shareholder Value Creation: Successful mergers can create value for

shareholders through increased profitability, growth prospects, and market
valuation.

7. Risk Mitigation: Diversification achieved through mergers can reduce

business risk by spreading exposure across different markets, products,
and economic cycles.
Financial Evaluation of a Merger
1. Valuation Methods:

1. Discounted Cash Flow (DCF): Estimates the present value of future cash
flows generated by the merged entity, considering factors such as growth
rates, capital expenditures, and discount rates.

2. Comparable Company Analysis (CCA): Compares financial metrics (e.g.,

revenue, EBITDA) of the target company with similar publicly traded
companies to estimate its value.

3. Precedent Transaction Analysis (PTA): Reviews past merger and acquisition

transactions in the same industry to assess the potential valuation of the
target company.
Financial Evaluation of a Merger
2. Financial Ratios and Metrics:

• Price/Earnings (P/E) Ratio: Compares the price of a company's shares to its earnings
per share, providing insight into its valuation relative to its profitability.

• Enterprise Value (EV) to Earnings Before Interest, Taxes, Depreciation, and

Amortization (EBITDA) Ratio: Measures a company's valuation relative to its
earnings before certain expenses, providing a measure of its operating performance.

• Debt-to-Equity Ratio: Assesses the target company's leverage and financial risk by
comparing its debt to its equity.

• Return on Investment (ROI): Calculates the return generated from the investment in
the merger, considering factors such as synergies, cost savings, and revenue growth.
Financial Evaluation of a Merger
3. Synergy Analysis:

• Cost Synergies: Identifies potential cost savings resulting from eliminating

duplicate functions, consolidating operations, and optimizing efficiencies.

• Revenue Synergies: Estimates potential revenue growth opportunities from

cross-selling, upselling, expanding market reach, and accessing new customer
segments.

• Strategic Synergies: Evaluates the strategic benefits of the merger, such as

combining complementary strengths, accessing new technologies, and
enhancing competitive positioning.
Financial Evaluation of a Merger
4. Risk Assessment:

• Integration Risks: Considers the challenges and costs associated with integrating
operations, systems, cultures, and personnel of the merging companies.

• Market Risks: Analyzes potential risks related to market conditions, industry trends,
regulatory changes, and competitive dynamics.

• Financial Risks: Assesses risks related to financing the merger, including debt levels,
interest rates, and capital structure considerations.

5. Sensitivity Analysis:

• Scenario Analysis: Evaluates the impact of different scenarios, assumptions, and variables
on the financial outcomes of the merger, helping identify key drivers and uncertainties.
Merger Negotiations
Merger negotiations are a critical phase in the merger and acquisition
(M&A) process, where the terms of the deal are discussed and finalized
between the acquiring and target companies.

Successful negotiations require careful planning, communication, and

strategic decision-making.
Key steps and considerations in merger negotiations:

1. Preparation:
• Define Objectives: Clearly outline the strategic objectives and desired
outcomes of the merger for both parties.

• Assess Value: Conduct thorough valuation analysis to determine the fair value
of the target company and set realistic expectations.

• Gather Information: Obtain comprehensive information about the target

company, including financials, operations, market position, and potential
synergies.
Key steps and considerations in merger negotiations:

2. Establish Communication:
• Engage Advisors: Hire experienced M&A advisors, such as
investment bankers, lawyers, and financial analysts, to assist in
negotiations and provide expertise.
• Open Dialogue: Initiate discussions with the target company's
management and stakeholders to gauge interest, address concerns,
and establish rapport.
Key steps and considerations in merger negotiations:
3. Negotiation Strategy:
Identify Priorities: Determine key negotiation priorities, such as price,
terms, governance structure, integration plans, and employee retention.
Create Leverage: Identify sources of leverage, such as competing offers,
regulatory considerations, or strategic alternatives, to strengthen
negotiating position.
Maintain Flexibility: Remain open to alternative deal structures, creative
solutions, and compromises to overcome differences and reach a mutually
beneficial agreement.
Key steps and considerations in merger negotiations:

4. Due Diligence:
• Conduct Due Diligence: Thoroughly review the target company's
operations, financials, contracts, legal matters, and risks to identify
potential issues and mitigate uncertainties.
• Share Information: Provide access to relevant information and data
to facilitate due diligence by the acquiring company and its advisors.
Key steps and considerations in merger negotiations:
5. Negotiation Process:
• Define Terms: Outline the proposed terms of the deal, including offer
price, payment structure, timing, governance, and post-merger integration
plans.
• Negotiate Terms: Engage in negotiations to address differences,
negotiate concessions, and reach agreement on key terms and conditions.
• Document Agreement: Draft a non-binding term sheet or letter of intent
outlining the agreed-upon terms as a basis for further negotiations and
formal agreements.
Key steps and considerations in merger negotiations:
6. Finalization:
• Legal Documentation: Prepare and negotiate legal documents, such as the
merger agreement, purchase agreement, and disclosure documents, with
assistance from legal counsel.

• Regulatory Approval: Obtain necessary regulatory approvals and clearances

required for the merger, complying with antitrust, competition, and other
regulatory requirements.

• Closing: Execute final agreements, complete transaction closing, and transfer

ownership of the target company's shares or assets to the acquiring company.
Key steps and considerations in merger negotiations:

7. Communication and Integration:

• Stakeholder Communication: Communicate the merger agreement
to employees, customers, suppliers, shareholders, and other
stakeholders, addressing concerns and highlighting benefits.
• Integration Planning: Develop a comprehensive integration plan to
facilitate the smooth transition of operations, systems, personnel,
and cultures post-merger.
Leverage buyout
A leverage buyout (LBO) is a transaction where a company, typically a
private equity firm, acquires another company using a significant amount
of debt to finance the purchase.

The acquired company's assets and cash flows serve as collateral for the
debt, which is often repaid using the target company's future cash flows
or through asset sales.
Leverage buyout
• A recent example of a leveraged buyout in India is the acquisition of
BigBasket by Tata Group's digital arm, Tata Digital, in 2021.
• Tata Digital, a subsidiary of Tata Group, sought to strengthen its
presence in the fast-growing e-commerce and grocery delivery
market in India.
• BigBasket, one of India's leading online grocery platforms, presented
an attractive opportunity for Tata Digital to expand its digital
ecosystem and compete more effectively with other players in the
sector.
Management Buyout
A Management Buyout (MBO) is a transaction in which the existing
management team of a company, often with the assistance of external
financing from private equity investors or lenders, acquires a controlling
stake or all of the ownership interest in the company from its current
owners, which could be other shareholders or a parent company.
Management Buyout
• The acquisition of Cafe Coffee Day (CCD) by its management team led by its former CEO, VG
Siddhartha, in 2019.

• VG Siddhartha, the founder of CCD, led the management team in a bid to take the company
private through an MBO. CCD, one of India's largest coffee chain operators, faced financial
challenges and shareholder pressures, prompting Siddhartha and the management team to
pursue ownership of the company.

• The acquisition of Mindtree Limited by its management team along with Larsen & Toubro (L&T)
in 2019.

• Mindtree, an Indian multinational information technology and outsourcing company, faced

a hostile takeover bid from L&T, a leading Indian conglomerate. In response, the
management team of Mindtree, led by its founders and senior executives, collaborated with
L&T to orchestrate an MBO to retain control of the company.
Meaning of P/E Ratio.
• The Price-to-Earnings (P/E) ratio is a commonly used financial metric that
compares a company's current stock price to its earnings per share (EPS). It
is calculated by dividing the market price per share of the company's stock by
its earnings per share.
• The P/E ratio provides insight into how the market values a company's stock
relative to its earnings.
• A higher P/E ratio typically indicates that investors are willing to pay more
for each unit of earnings, suggesting that the company may be overvalued or
expected to grow at a faster rate.
• A low P/E ratio may suggest that the stock is undervalued.
Formula for P/E Ratio.

Market Price per Share

P/E Ratio =
Earnings per Share
 Significance of P/E Ratio
1. Investment Decision Making: The P/E ratio is a key factor considered by

investors when making investment decisions. It helps investors assess the

attractiveness of a company's stock as an investment opportunity relative to its

earnings and growth prospects.

2. Market Timing: Changes in the P/E ratio over time can provide insights into

market sentiment and investor behavior. For example, a rising P/E ratio may

signal increasing optimism and bullish sentiment, while a declining P/E ratio

may indicate growing concerns and bearish sentiment.

 Significance of P/E Ratio
3. Risk Assessment: The P/E ratio can be used as a risk assessment tool to evaluate the

level of risk associated with investing in a particular stock. A high P/E ratio may imply

higher risk, as investors are paying a premium for future growth expectations, while a

low P/E ratio may suggest lower risk but also potential undervaluation.

4. Benchmarking: The P/E ratio serves as a benchmark for evaluating a company's

stock valuation relative to historical levels, industry averages, and market indices. By

comparing the current P/E ratio with historical trends and industry peers, investors

can gauge whether the stock is trading at a premium or discount.

 Significance of P/E Ratio
5. Long-Term Investing: While the P/E ratio provides insights into short-term

market sentiment and valuation, it is also relevant for long-term investors who

focus on fundamental analysis and value investing principles. Long-term

investors may use the P/E ratio as one of several factors to assess the intrinsic

value and growth potential of a company's stock.

 Impact of Merger on EPS
1. EPS Dilution or Accretion:

• Dilution: If the acquiring company pays a premium for the target company or
issues additional shares to finance the acquisition, EPS may be diluted for
existing shareholders. This means that the combined company's earnings are
spread over a larger number of shares, resulting in a decrease in EPS.

• Accretion: Conversely, if the merger generates cost synergies, revenue

enhancements, or operational efficiencies that increase earnings without a
proportional increase in the number of shares outstanding, EPS may be accretive.
In this case, EPS increases due to the merger, benefiting existing shareholders.
 Impact of Merger on EPS
2. Merger Accounting:

• Purchase Price Allocation: The allocation of the purchase price to the assets and
liabilities of the acquired company can impact future earnings. If the purchase price
exceeds the fair value of the acquired company's net assets, the excess amount is
recorded as goodwill and may result in future amortization expenses, which could
reduce EPS.

• Restructuring Charges: Merger-related restructuring charges, such as severance

payments, integration costs, or impairment charges, can impact EPS in the short term.
These charges may reduce earnings immediately following the merger but could lead to
long-term benefits if they result in cost savings or revenue enhancements.
 Impact of Merger on EPS
3. Changes in Capital Structure:

• Issuance of New Shares: If the acquiring company issues new shares to

finance the merger, the increase in the number of shares outstanding can

dilute EPS, as earnings are divided among a larger shareholder base.

• Debt Financing: If the merger is financed through debt, the interest

expense associated with the debt may reduce earnings, thereby impacting

EPS. However, if the merger generates sufficient cash flows to service the

debt and support future growth, the impact on EPS may be mitigated.
Impact of Merger on EPS
4. Integration Synergies:

• Cost Synergies: If the merger results in cost synergies, such as

operational efficiencies, economies of scale, or overhead reductions,
the combined company's earnings may increase, leading to accretive
EPS.
• Revenue Synergies: Similarly, if the merger generates revenue
synergies, such as cross-selling opportunities, expanded market
reach, or product diversification, the combined company's earnings
may grow, potentially increasing EPS over time.
Impact of Merger on EPS
5. Timing and Execution:

• Integration Challenges: The timing and successful execution

of post-merger integration initiatives can impact EPS. Delays or
difficulties in integrating operations, systems, or cultures may
delay the realization of synergies and affect earnings.
Impact of Merger on Market Price
1. Premium Paid:

Positive Impact: If the acquiring company offers a premium price for the

target company's shares, it can lead to an immediate increase in the

target company's stock price. Shareholders of the target company may

view the premium as favorable and be willing to sell their shares at a

higher price.
Impact of Merger on Market Price
2. Perceived Synergies:

• Positive Impact: If the merger is expected to result in significant synergies, such as

cost savings, revenue growth, or market expansion opportunities, investors may

perceive the combined entity as more valuable, leading to an increase in the stock

price of both the acquiring and target companies.

• Negative Impact: Conversely, if investors are skeptical about the potential

synergies or if integration challenges are anticipated, it could lead to uncertainty

and a decline in the stock prices of the merging companies.

Impact of Merger on Market Price
3. Market Reaction:

• Initial Reaction: The initial market reaction to a merger announcement can be

volatile. Depending on investor sentiment, market expectations, and the perceived

strategic rationale behind the merger, the stock prices of the involved companies

may experience significant fluctuations in the short term.

• Long-Term Impact: Over the long term, the impact of a merger on stock prices may

depend on the ability of the combined entity to deliver on its promises, achieve

synergies, and execute its strategic plans effectively.

Impact of Merger on Market Price
4. Regulatory Approval:

Uncertainty: Regulatory approval processes, particularly in mergers

involving large companies or companies operating in regulated

industries, can introduce uncertainty and volatility into the stock prices

of the merging companies. Delays or challenges in obtaining regulatory

approvals may impact investor confidence and stock prices.

Impact of Merger on Market Price
5. Integration Challenges:

• Risk Factors: Integration challenges, such as cultural differences,

operational disruptions, or strategic misalignments, can negatively impact
investor perception and confidence in the success of the merger, leading to
downward pressure on stock prices.

• Successful Integration: Conversely, if the merging companies successfully

navigate integration challenges and achieve their synergy targets, it can
enhance investor confidence and support higher stock prices over time.
Impact of Merger on Market Price
6. Market Conditions:

• Overall Market Sentiment: Market conditions,

macroeconomic factors, and industry trends can influence
investor behavior and stock prices independently of the
merger itself. A favorable market environment may support
higher stock prices for the merging companies, while adverse
market conditions could exert downward pressure.
Impact of Merger on Market capitalization
1. Immediate Market Reaction:

• Target Company: The market capitalization of the target company often increases
immediately following the announcement of a merger, especially if the acquiring company
offers a premium over the target’s current market price. This premium reflects the
additional value that the acquirer believes the target company will bring.

• Acquiring Company: The market capitalization of the acquiring company may experience
volatility. While the initial reaction can vary, it often depends on investor perception of the
merger’s strategic fit, the price paid, and the expected synergies. If the market views the
merger favorably, the acquirer's market cap might increase. Conversely, if the market
perceives the acquisition as overvalued or risky, the market cap could decrease.
Impact of Merger on Market capitalization
2. Long-term Impact:

• Synergies and Integration: If the merger achieves the anticipated synergies, such as
cost reductions, increased revenue, or enhanced market position, the combined entity’s
market capitalization could increase over the long term. Successful integration leading
to improved financial performance can positively affect investor confidence and market
value.

• Operational Challenges: Conversely, if the merger faces significant integration

challenges, such as cultural clashes, operational disruptions, or failure to realize
synergies, the market capitalization of the combined entity could suffer. Persistent
issues can erode investor confidence and negatively impact market value.
Impact of Merger on Market capitalization
3. Financial Structure:

• Share Issuance: In stock-for-stock mergers, the acquiring company issues new

shares to the target company’s shareholders. This increases the number of shares
outstanding, potentially diluting the existing shareholders' equity. The overall effect
on market capitalization will depend on how the market values the new shares
relative to the anticipated benefits of the merger.

• Debt Financing: If the acquisition is financed through debt, the additional financial
leverage can impact investor perception. While moderate leverage can amplify
returns and potentially increase market cap, excessive debt can raise concerns
about financial stability, potentially leading to a decrease in market capitalization.
Impact of Merger on Market capitalization
4. Market Sentiment and Economic Conditions:

• Investor Sentiment: The overall sentiment of investors toward mergers and

acquisitions (M&A) activity can influence market capitalization. Positive sentiment
and a favorable market environment can lead to an increase in market cap, whereas
a negative sentiment or a bearish market can have the opposite effect.

• Economic Conditions: Broader economic conditions, such as interest rates,

economic growth, and industry trends, can also impact how a merger affects market
capitalization. In a strong economic climate, mergers are often viewed more
positively, potentially boosting market cap. During economic downturns, even
strategically sound mergers might struggle to maintain market value.
Impact of Merger on Market capitalization
Accretive Merger: If a merger is expected to be accretive to earnings
(i.e., it increases the EPS of the acquiring company), it can lead to an
increase in market capitalization. This usually happens when the
acquired company has a higher growth rate or profit margins that
contribute positively to the combined entity.

Dilutive Merger: If a merger is dilutive to earnings (i.e., it decreases the

EPS of the acquiring company), it can lead to a decrease in market
capitalization. This might occur when the acquiring company pays a
significant premium or if the target company has lower profit margins.
Exchange Ratio
• An exchange ratio is a key component in mergers and acquisitions,
particularly in stock-for-stock transactions.

• It determines the number of shares of the acquiring company that

shareholders of the target company will receive for each share they
hold in the target company.

• The exchange ratio can significantly impact the perceived fairness and
attractiveness of a merger deal for both sets of shareholders.
Problems on Exchange Ratios based on Assets Approach
Assets Approach:

• Focuses on the valuation of the underlying assets of both companies.

• The exchange ratio is determined by comparing the total assets values or net asset
values.

• The formula for the exchange ratio using the assets approach is:

Total Assets of Traget Comapny

Exchange ratio =
Total Assets of A𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲

• This approach provides a comprehensive view of the companies asset bases.

• It can be particularly relevant when the value of tangible or intangible assets is a

significant driver of values.
Illustration 1
Based on the information given below determine the exchange ratio based
on Net Asset Value:
T Ltd. (Acquirer) C Ltd. (Target)
Fixed Assets 150 100
Current Assets 100 50
13% Debentures 100 40
Creditors 100 10
Problems on Exchange Ratios based on Earnings Approach
• Earning approach involves using earnings metrics, such as earnings per
share (EPS), to establish the exchange ratio.

• The formula for the exchange ratio using the earnings approach is:

EPS of Traget Comapny

Exchange ratio =
EPS of A𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
• This method provides a perspective based on the earnings generating
capacity of the companies.

• Historical or projected earnings may be used, and it is particularly relevant

when earnings are a primary driver of value
Illustration 2
Determine the exchange ratio in case of below merger, based on EPS
proportion:

Thumps Up Ltd. (Acquirer) 7 Up Ltd (Target)

PAT 6700000 5450000

No. of Shares 100000 50000

Problems on Exchange Ratios based on Market Value Approach
• Market value approach considers the market prices of the acquiring company and
target companies’ stocks.
• The exchange ratio is determined by comparing the market capitalisations or stock
prices.
• The formula for the exchange ratio using the market capitalisation approach is :
Market Capitalisation of Traget Comapny
Exchange ratio =
Market Capitalisation of A𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
or
Market Price of Traget Comapny
Exchange ratio =
Market Price of A𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
• This approach reflects the real time valuation of the companies in the stock market.
• However, it may be influenced by short term market fluctuations.
Illustration 3
Determine the Exchange ratio in case of below takeover based on
Market Price.

Market price of D Ltd. (Acquiring Co.) Rs. 83

Market price of P Ltd. (Target Co.) Rs. 44

Illustration 4
Determine the Exchange Ratio in case of below takeovers based on
Market Price.
Dosa Ltd. (Acquirer) Puri Ltd. (Target)
P/E Ratio 5 Times 10 Times
Profit After Tax ₹20 Lacs ₹12.5 Lacs
No of Shares 100000 50000
Illustration 5
Shanthi Ltd. Wishes to take over Mahesh Ltd. The financial details of the two
companies are as under:
Particulars Shanthi Mahesh
Equity Shares (₹10 per share) 100000 50000
Share Premium Account 2000
Profit and Loss Account 38000 4000
Preference Shares 20000
10% Debentures 15000 5000
Total 173000 61000
Fixed Assets 122000 35000
Net Current Assets 51000 26000
Maintainable Annual Profit After Tax
For Equity Share Holders 24000 15000
Market Price per Equity Shares 24 27

What offer do you think Shanthi Ltd. Could make to Mahesh Ltd. In terms of
Exchange Ratio, based on (a) Net Asset Value (b) Earning Price Ratio (c) Market
Price
Illustration 6
Nandi Ltd. Is considering the acquisition of Heri Ltd. With Stock. Relevant
financial information is as below:
Particulars Nandi Ltd. Heri Ltd.
Present Earnings (in thousands) ₹ 4000 ₹ 1000
Common Shares (in thousands) 2000 800
Earning Per Share ₹2 ₹ 1.25
Price Earning Ratio 12 8

Nandi Ltd. Plans to offer a premium of 20% over the market price of Heri
Ltd.
i) What is the ratio of Exchange of stock?
ii) How many New shares will be issues?
Illustration 7

Based on the below data, calculate pre merger EPS for both companies and
Post Merger EPS of acquiring Company.

Exchange Ratio – 0.5 shares of acquiring company Bhat Ltd. To be given to

shareholders of Target Company SLV Ltd. For Every one share of SLV Ltd.
Held by them

Profit After Tax of Bhat LTd. ₹25,00000 profit after tax of SLV Ltd.
₹4500000

No. of outstanding equity shares of Bhat Ltd. 250000 no. of outstanding

equity shares of SLV Ltd. 180000
 Module No. 5

Ethical and Governance Issues

8 Hours
CONTENT

• Introduction to Ethical and Governance Issues

• Fundamental Principles,

• Ethical Issues in Financial Management,

• Agency Relationship,

• Transaction Cost Theory,

• Governance Structures and Policies,

• Social and Environmental Issues,

• Purpose and Content of an Integrated Report

Introduction to Ethical and Governance Issues
• Ethical and governance issues are crucial considerations in the realm of business, technology, and
society.

• These issues encompass a range of topics related to how organizations and individuals should
conduct themselves, ensuring their actions align with moral principles and regulatory standards.

• Ethical and governance issues are crucial considerations in the realm of business, technology, and
society.

• These issues encompass a range of topics related to how organizations and individuals should
conduct themselves, ensuring their actions align with moral principles and regulatory standards.

• Understanding and addressing ethical and governance issues are essential for the sustainable
success of any organization. By fostering a culture of integrity, accountability, and transparency,
organizations can build trust with their stakeholders, mitigate risks, and contribute positively to
society.
Fundamental Principles

The fundamental principles of ethics and governance serve as the

cornerstone for ethical behavior and effective governance in
organizations.

These principles provide a framework for decision-making and conduct,

ensuring that actions are aligned with moral values and regulatory
expectations.
Ethical Principles

1. Integrity: Integrity involves being honest and having strong moral

principles. Ensure all actions and communications are truthful and
adhere to ethical standards. Avoid deceit and maintain consistency in
ethical conduct.

2. Objectivity: Objectivity requires impartiality and freedom from bias.

Make decisions based on facts and evidence without allowing
personal feelings, prejudices, or external pressures to influence
judgment.
Ethical Principles

3. Professional Competence and Due Care: Maintain professional

knowledge and skill at the required level and act diligently.
Continuously update skills and knowledge to provide competent
services. Perform duties thoroughly and in accordance with applicable
standards and regulations.

4. Confidentiality: Respect and protect confidential information

acquired during professional work. Do not disclose information
without proper authorization, unless legally obligated. Ensure that
confidential information is not used for personal gain.
Ethical Principles

5. Professional Behavior: Comply with relevant laws and regulations

and avoid actions that discredit the profession. Uphold the reputation
of the profession through ethical behavior. Avoid activities that might
harm the profession's integrity or public trust.
Governance Principles

1. Accountability: Being responsible for actions and decisions to

stakeholders. Establish clear roles and responsibilities within the
organization. Ensure that individuals and teams are answerable for
their performance and decisions.

2. Transparency: Openness in communication and decision-making

processes. Provide clear, accessible, and accurate information to
stakeholders. Disclose relevant details about operations, financial
performance, and governance practices.
Governance Principles

3. Fairness: Treat all stakeholders equitably and impartially. Implement

policies that ensure fair treatment in hiring, promotion, compensation, and
other business practices. Address conflicts of interest to maintain
impartiality.

4. Responsibility: Acknowledge and act on the impact of decisions and

actions on stakeholders and the environment. Incorporate sustainable
practices into business operations. Engage in corporate social
responsibility initiatives and consider the long-term effects of decisions.
Governance Principles

5. Independence: Freedom from undue influence or bias in decision-

making. Ensure that governance structures, such as boards and

committees, are independent and free from conflicts of interest.

Encourage objective oversight and evaluation of management.

Ethical Issues in Financial Management

• Ethical issues in financial management are critical as they directly

impact the integrity, transparency, and trustworthiness of financial
practices within organizations.

• These issues can have significant consequences for stakeholders,

including investors, employees, customers, and the broader community.
 Ethical Issues in Financial Management

1. Financial Reporting and Transparency

Misrepresentation of Financial Statements:

Financial statements must accurately reflect the organization's financial position. Misrepresenting or

manipulating financial data to present a more favorable view than reality is unethical and can mislead

stakeholders.

Earnings Management:

This involves manipulating accounting methods to achieve desired financial outcomes, such as meeting

earnings targets. While not always illegal, it is considered unethical as it distorts true financial

performance.
Ethical Issues in Financial Management
2. Insider Trading

• Insider trading involves using non-public, material information to trade in

the stock market. This practice is illegal and unethical as it gives unfair

advantage and undermines market integrity.

• It erodes investor confidence and trust in financial markets, leading to

potential financial losses for ordinary investors and damaging the

organization’s reputation.
Ethical Issues in Financial Management
3. Conflict of Interest

• Personal Gain vs. Organizational Interest: Conflicts arise when

financial managers prioritize personal gain over the organization’s best
interests. Examples include accepting gifts from suppliers or engaging in
transactions that benefit oneself at the expense of the organization.

• Duty of Loyalty: Financial managers must act in the best interest of

their organization and avoid situations where personal interests could
compromise their professional judgment.
Ethical Issues in Financial Management
4. Fraud and Embezzlement

• Asset Misappropriation: This includes theft of company assets, such as

cash, inventory, or intellectual property. It is a direct violation of trust and

legal standards.

• Financial Fraud: Creating false invoices, forging documents, or falsifying

expense reports to misappropriate funds is unethical and illegal.

 Ethical Issues in Financial Management
5. Compliance and Regulatory Issues

• Adhering to Laws and Regulations: Financial managers must ensure

compliance with all relevant laws and regulations, including tax laws, securities

regulations, and anti-money laundering laws. Ignoring or circumventing these

regulations is unethical and can lead to severe penalties.

• Ethical Dilemmas in Taxation: Aggressive tax avoidance strategies that exploit

loopholes, while legal, may be considered unethical if they contravene the spirit

of the law and fairness.

Ethical Issues in Financial Management
6. Responsible Financial Management

• Risk Management: Ethical financial management involves identifying

and managing risks responsibly. Over-leveraging or engaging in high-risk
financial practices for short-term gains can be unethical if it endangers
the organization’s long-term stability.

• Investment Decisions: Decisions should be made based on sound

financial principles and in the best interest of stakeholders. Avoiding
investments in harmful industries (e.g., tobacco, arms) reflects ethical
considerations.
Ethical Issues in Financial Management

7. Corporate Social Responsibility (CSR)

• Sustainable Financial Practices: Ethical financial management includes

considering the environmental and social impacts of financial decisions.
Investing in sustainable projects and ensuring fair labor practices align with
ethical standards.

• Philanthropy and Community Engagement: Ethical financial managers

advocate for allocating resources towards community development and
charitable activities, reflecting a commitment to societal well-being.
Agency Relationship

• An agency relationship is a fundamental concept in financial

management, business, and law, where one party, the principal,
delegates authority to another party, the agent, to act on their behalf.

• This relationship is central to many organizational and financial

activities and is governed by both legal and ethical considerations.
 Key Components of Agency Relationship
1. Principal: The principal is the party who delegates authority to the agent to act on their
behalf. In a business context, principals are often shareholders or business owners.

2. Agent: The agent is the party who is authorized to act on behalf of the principal. In
businesses, agents can be managers, executives, or employees.

3. Authority: The principal grants authority to the agent to perform specific tasks or make
decisions. This authority can be broad or limited, depending on the terms of the agency
agreement.

4. Fiduciary Duty: The agent owes a fiduciary duty to the principal, which includes acting in
the principal's best interest, maintaining loyalty, and avoiding conflicts of interest.
Types of Agency Relationships

1. Employer-Employee Relationship: Employees act as agents of their

employer, performing tasks and making decisions within the scope of their
employment.

2. Corporate Governance: Executives and managers act as agents for the

shareholders, making decisions to enhance shareholder value.

3. Financial Advisors: Financial advisors act as agents for their clients,

providing advice and managing investments in the clients' best interests.

4. Real Estate Agents: Real estate agents act on behalf of property owners or
buyers to sell or purchase property.
Ethical and Governance Issues in Agency Relationships
1. Conflict of Interest: Agents must avoid situations where their personal interests conflict with those of the
principal. For example, a manager should not benefit personally from a business deal at the expense of the
company.

2. Information Asymmetry: Agents often have more information than principals, which can lead to situations
where agents might not act in the principal's best interest. Transparency and effective communication are
crucial to mitigate this issue.

3. Moral Hazard: When agents do not bear the full consequences of their actions, they may take risks that are
not in the best interest of the principal. For example, a manager might undertake risky projects to achieve
short-term gains, knowing that the negative consequences will be borne by the shareholders.

4. Principal-Agent Problem: This arises when the goals of the principal and the agent are not aligned.
Mechanisms such as performance-based incentives, monitoring, and contractual agreements can help align
their interests.
Mitigating Ethical and Governance Issues
1. Incentive Alignment: Aligning the incentives of agents with the goals of the principal, such as through
performance-based bonuses or stock options, can motivate agents to act in the principal’s best
interests.

2. Monitoring and Oversight: Establishing robust monitoring systems, such as internal audits, oversight
committees, and regular reporting, helps ensure that agents act ethically and in accordance with the
principal’s goals.

3. Clear Contracts and Policies: Clearly defined contracts and policies outlining the roles,
responsibilities, and ethical expectations of agents can prevent misunderstandings and unethical
behavior.

4. Training and Ethical Leadership: Providing training on ethical behavior and fostering a culture of
integrity and accountability can encourage agents to act ethically.
Transaction Cost Theory

• Transaction Cost Theory (TCT) is a key concept in economics and

organizational theory that examines the costs associated with economic
exchanges.

• It provides insights into why firms exist, how they are structured, and
how they manage their operations.

• This theory was prominently developed by Ronald Coase and later

expanded by Oliver Williamson.
Key Concepts of Transaction Cost Theory
1. Transaction Costs:
Transaction costs are the costs incurred in making an economic exchange. These
include costs of searching for information, negotiating and enforcing contracts, and
monitoring and ensuring compliance.
Types of Transaction Costs:
• Search and Information Costs: Costs involved in finding the right product or
service and gathering relevant information.
• Bargaining and Decision Costs: Costs associated with negotiating and reaching
an agreement.
• Policing and Enforcement Costs: Costs of ensuring that the terms of the
agreement are met and taking action if they are not.
Key Concepts of Transaction Cost Theory
2. Bounded Rationality:
• Bounded rationality refers to the limitations of human cognitive
abilities in processing information and making decisions. It suggests
that individuals and organizations cannot foresee all possible
outcomes or gather all necessary information.
• Due to bounded rationality, contracts are often incomplete, leading to
potential disputes and the need for mechanisms to handle unforeseen
contingencies.
Key Concepts of Transaction Cost Theory
3. Opportunism:

• Opportunism is the self-interest seeking behavior of individuals or

firms, often involving deceit or manipulation.

• Opportunism can lead to increased transaction costs as parties try to

safeguard themselves against potential exploitation through detailed

contracts and monitoring mechanisms.

Key Concepts of Transaction Cost Theory
4. Asset Specificity:

• Asset specificity refers to investments that are highly specialized and

cannot be easily repurposed for other uses without significant loss of

value.

• High asset specificity increases transaction costs because it creates a

dependency between the parties involved, leading to potential hold-up

problems where one party may exploit the situation.

Why Firms Exist According to TCT

• Firms exist to minimize transaction costs. When transaction costs are

high in the open market due to factors like asset specificity, bounded

rationality, and opportunism, it becomes more efficient to organize

transactions within a firm (hierarchy) where these costs can be better

managed and controlled.

• Within firms, hierarchies and control mechanisms can reduce the costs

associated with negotiating and enforcing contracts repeatedly.

Governance Structures in Transaction Cost Theory
1. Markets: Transactions occur through price mechanisms and contracts between
independent parties. Suitable for exchanges with low transaction costs and low
asset specificity.

2. Hierarchies (Firms): Transactions are managed internally through managerial

oversight and administrative controls. Suitable for exchanges with high transaction
costs, high asset specificity, and significant risks of opportunism.

3. Hybrid Structures: Arrangements such as long-term contracts, joint ventures, and

strategic alliances that combine elements of both market and hierarchy. Suitable for
situations where transaction costs are moderate and some level of collaboration
and control is beneficial.
Implications of TCT for Business Strategy
1. Make or Buy Decisions: Firms must decide whether to produce in-house (make)
or outsource (buy) based on the comparative transaction costs. High transaction
costs favor in-house production, while low transaction costs favor outsourcing.
2. Contract Design: Contracts should be designed to minimize transaction costs,
considering factors like asset specificity and potential for opportunism. Incomplete
contracts should include clauses for handling disputes and unforeseen
contingencies.
3. Vertical Integration: Firms may choose vertical integration (owning different
stages of production or supply chain) to reduce transaction costs associated with
market exchanges. Vertical integration helps manage high asset specificity and
reduce the risk of opportunism.
Governance Structures and Policies

• Governance structures and policies are essential frameworks that guide

the direction, control, and administration of organizations.

• They ensure that organizations operate ethically, efficiently, and in

alignment with their strategic objectives.

• Governance structures define the hierarchy, roles, and responsibilities

within an organization.

• These structures ensure effective decision-making, accountability, and

oversight.
Key components of Governance Structures
1. Board of Directors: The board of directors is the highest governing body responsible for overseeing the
organization’s overall direction and management. Setting strategic goals, appointing and evaluating the CEO,
ensuring financial integrity, and compliance with laws and regulations.

2. Executive Management: Executive management, led by the CEO, is responsible for the day-to-day
operations and implementation of the board’s strategic directives. Managing resources, executing policies,
and achieving organizational goals.

3. Committees: Committees, such as audit, risk, and compensation committees, assist the board by focusing on
specific areas. Providing specialized oversight, making recommendations to the board, and ensuring
compliance with specific governance policies.

4. Shareholders: Shareholders are the owners of the organization and have the right to vote on key issues,
such as electing board members. Participating in annual meetings, approving major decisions, and providing
input on strategic directions.

5. Advisory Boards: Advisory boards provide non-binding strategic advice and expertise to the board of
directors or management. Offering insights on industry trends, potential risks, and strategic opportunities.
 Key Governance policies

1. Code of Ethics: Establishes standards of ethical behavior for employees, management, and
board members. Guidelines on integrity, honesty, conflict of interest, confidentiality, and
compliance with laws.

2.Conflict of Interest Policy: Prevents personal interests from interfering with professional
duties. Disclosure requirements, procedures for managing conflicts, and consequences for
violations.

3.Whistleblower Policy: Encourages reporting of unethical or illegal activities without fear of

retaliation. Reporting procedures, protections for whistleblowers, and investigation processes.
 Key Governance policies
4. Risk Management Policy: Identifies, assesses, and mitigates risks that could impact the
organization’s objectives. Risk assessment methodologies, risk appetite, mitigation strategies,
and monitoring mechanisms.

5. Audit and Compliance Policy: Ensures financial integrity and compliance with laws and
regulations. Internal and external audit procedures, compliance checks, and reporting
requirements.

6. Board Governance Policy: Defines the roles, responsibilities, and processes for the board of
directors. Board composition, election procedures, meeting protocols, and performance
evaluation.

7. Diversity and Inclusion Policy: Promotes a diverse and inclusive workplace. Recruitment
practices, anti-discrimination guidelines, and training programs.
Importance of Governance Structures and Policies
1. Accountability: Ensures that decision-makers are held responsible for their
actions and that there is a clear chain of command.

2. Transparency: Promotes openness in the organization’s operations and

decision-making processes, building trust with stakeholders.

4. Ethical Conduct: Establishes a culture of integrity and ethical behavior,

reducing the risk of misconduct and legal issues.
Importance of Governance Structures and Policies
4. Risk Management: Identifies and mitigates potential risks, safeguarding
the organization’s assets and reputation.

5. Strategic Direction: Provides a framework for setting and achieving

strategic goals, ensuring long-term sustainability and success.

6. Stakeholder Confidence: Enhances the confidence of investors,

employees, customers, and other stakeholders by demonstrating sound
governance practices.
Social and Environmental Issues

• Social and environmental issues are increasingly important

considerations for organizations in today's globalized and
interconnected world.

• Addressing these issues is essential for sustainable development and

for maintaining the trust and support of stakeholders, including
customers, employees, investors, and the broader community.
 Social Issues
1.Labor Practices

1. Fair Wages and Benefits: Ensuring that employees receive fair compensation and
benefits is fundamental. This includes complying with minimum wage laws, providing
health benefits, and ensuring safe working conditions.

2. Workplace Safety: Implementing rigorous safety standards to prevent accidents and

injuries at work.

3. Child Labor: Prohibiting the use of child labor in any part of the supply chain and
ensuring compliance with international labor standards.

4. Diversity and Inclusion: Promoting a diverse and inclusive workplace where all
employees have equal opportunities for growth and advancement, regardless of gender,
race, ethnicity, sexual orientation, or disability.
Social Issues

2. Human Rights
1.Respecting Human Rights: Adhering to international human rights
standards and ensuring that business operations do not infringe on the
rights of individuals.
2.Supply Chain Management: Monitoring and ensuring that suppliers and
partners also comply with human rights standards, avoiding complicity in
abuses.
Social Issues
3. Community Engagement
1.Corporate Social Responsibility (CSR): Engaging in CSR initiatives that
contribute to the social and economic development of the communities in
which the organization operates.
2.Philanthropy: Supporting charitable causes and nonprofit organizations
through donations, volunteer programs, and other forms of support.
Social Issues

4. Health and Well-being

1.Employee Wellness Programs: Implementing programs that support
the physical and mental health of employees, such as fitness programs,
counseling services, and flexible working arrangements.
2.Product Safety: Ensuring that products and services are safe for
consumers and comply with relevant safety standards and regulations.
 Environmental Issues
1.Sustainability

1. Resource Management: Efficiently using resources such as water, energy, and raw
materials to minimize waste and reduce environmental impact.

2. Renewable Energy: Investing in renewable energy sources, such as solar and wind power,
to decrease reliance on fossil fuels and reduce carbon footprint.

2.Pollution and Waste Management

1. Emission Reduction: Implementing measures to reduce greenhouse gas emissions and

other pollutants. This includes adopting cleaner production processes and technologies.

2. Waste Reduction: Minimizing waste generation through recycling, reusing materials, and
adopting circular economy principles.
 Environmental Issues
3. Climate Change
1. Mitigation and Adaptation: Developing strategies to mitigate the impact of
climate change and adapt to its effects. This includes reducing carbon emissions,
enhancing energy efficiency, and preparing for climate-related risks.
2. Carbon Footprint: Measuring and reducing the organization’s carbon footprint
through various initiatives, such as improving energy efficiency and offsetting
emissions.
4. Biodiversity and Ecosystems
1. Conservation Efforts: Supporting conservation projects and initiatives to protect
biodiversity and restore ecosystems.
2. Sustainable Sourcing: Ensuring that raw materials are sourced sustainably, such
as using certified sustainable timber, palm oil, and other resources.
 Importance of Addressing Social and Environmental Issues
1.Reputation and Brand Value

1. Organizations that proactively address social and environmental issues often enjoy
enhanced reputation and brand loyalty. Consumers are increasingly favoring brands that
demonstrate a commitment to ethical and sustainable practices.

2.Regulatory Compliance

1. Compliance with social and environmental regulations is essential to avoid legal

penalties, fines, and other regulatory actions. Staying ahead of regulatory changes can
also provide a competitive advantage.

3.Risk Management

1. Identifying and mitigating social and environmental risks helps prevent disruptions and
potential crises that could harm the organization’s operations and reputation.
 Importance of Addressing Social and Environmental Issues
4. Investor Confidence

1. Many investors now consider environmental, social, and governance (ESG) factors
when making investment decisions. Organizations that address these issues can
attract and retain responsible investors.

5. Employee Engagement and Retention

1. A commitment to social and environmental responsibility can enhance employee

morale, attract top talent, and improve retention rates. Employees want to work
for organizations that align with their values.
Integrated Report

• An integrated report is a comprehensive document that communicates an

organization's strategy, governance, performance, and prospects in the

context of its external environment, aiming to show how the organization

creates value over the short, medium, and long term.

• It combines financial and non-financial information, providing a holistic

view of the organization’s activities and their impact on various

stakeholders.
Purpose and Content of an Integrated Report
1.Holistic View of Value Creation:
Provides a comprehensive understanding of how an organization creates value over time,
considering financial, environmental, social, and governance aspects.
2.Stakeholder Communication:
Enhances communication with stakeholders, including investors, employees, customers,
suppliers, regulators, and the community, by offering a transparent view of the organization’s
operations and strategy.
3.Strategic Insight:
Offers insights into the organization’s strategy, business model, and how it leverages
resources and relationships to achieve its objectives.
4.Accountability and Stewardship:
Demonstrates the organization’s commitment to accountability and stewardship of financial,
social, and environmental resources.
5.Decision-Making Support:
Provides useful information that supports better decision-making by stakeholders, fostering
trust and confidence in the organization.
Content of an Integrated Report
1.Organizational Overview and External Environment:
• Description of the organization’s mission, vision, values, culture, ownership, and
structure.
• Overview of the external environment, including economic, social, environmental,
and regulatory factors that influence the organization.
2.Governance:
• Information about the organization’s governance structure, including the roles and
responsibilities of the board of directors and executive management.
• Description of governance practices, policies, and processes that ensure
accountability and ethical behavior.
3.Business Model:
• Explanation of the organization’s business model, including key activities, products
or services, value propositions, and the resources and relationships it relies on.
Content of an Integrated Report
4. Strategy and Resource Allocation:
• Outline of the organization’s strategic objectives, priorities, and initiatives.
• Discussion on how resources are allocated to achieve strategic goals and create
value.
5. Performance:
• Comprehensive analysis of financial and non-financial performance, including key
performance indicators (KPIs).
• Assessment of the outcomes related to strategic objectives and the impact on
various capitals (financial, manufactured, intellectual, human, social and
relationship, and natural).
6. Outlook:
• Forward-looking information about the organization’s prospects, risks, and
opportunities.
• Discussion on the potential impact of future trends and developments on the
organization’s strategy and performance.
Content of an Integrated Report
7. Risks and Opportunities:
1. Identification and evaluation of key risks and opportunities that could affect the
organization’s ability to create value.
2. Strategies for managing risks and capitalizing on opportunities.
8. Stakeholder Relationships:
1. Information on how the organization engages with its stakeholders and the
outcomes of these engagements.
2. Discussion on stakeholder expectations and how they influence the organization’s
strategy and decision-making.
9. Basis of Preparation and Presentation:
1. Explanation of the reporting framework and principles used in the preparation of
the integrated report.
2. Disclosure of materiality considerations, assumptions, and methodologies used in
compiling the report.
Benefits of an Integrated Report
1.Enhanced Transparency and Accountability:
• Provides a clear and comprehensive view of the organization’s performance and strategic
direction, fostering greater accountability to stakeholders.
2.Improved Stakeholder Engagement:
• Facilitates better communication and engagement with stakeholders by addressing their
information needs and expectations.
3.Better Decision-Making:
• Supports informed decision-making by providing relevant and integrated information
about the organization’s performance, risks, and opportunities.
4.Sustainable Business Practices:
• Encourages the adoption of sustainable business practices by highlighting the
interconnections between financial performance and environmental, social, and
governance (ESG) factors.
5.Competitive Advantage:
• Enhances the organization’s reputation and credibility, potentially leading to competitive
advantages in attracting investment, customers, and talent.
Prepared by,
Dr Sunil D Souza
Faculty of Commerce
St. Philomena’s College (Autonomous) Mysore - 15