STRATEGIC FINANCIAL MANAGEMENT:

Managing For Shareholder Value

Week 3 – Financing Decisions

Contents:

Financing Decisions Capital Structure and Firm Value - Tools for Developing an
Effective Capital Structure - Financing Instruments - Methods of Offering - Markets-
Pricing and Timing - Raising Foreign Currency Finance - Dividend Policy and Firm
Value- Distribution Policy - Project Finance- Miscellaneous Topics.

STUDY PLAN

Week 3: FINANCING DECISIONS

• Watch Videos: Financing Decisions
• Study
➢ Reading – Week 3

• Solve the Practice Questions Pertaining to Week 3

READING WEEK 3: FINANCING DECISIONS
This reading is organized in seven sections as follows:

• Key Points Relating to Sources of Finance

• Key Points Relating to Financial Strategy
• Tools for Development an Effective Capital Structure
• Financing Instruments, Project Finance, and Securitisation
• Dividend Policy and Firm Value
• Financing Strategy of Reliance Industries

1. KEY POINTS RELATING TO SOURCES OF FINANCE

• The two broad sources of finance available to a firm are: shareholders’ funds
(equity funds) and loan funds (debt funds).
• Equity capital represents ownership capital as equity shareholders
collectively own the firm. Equity shareholders enjoy the rewards as well as
bear the risk of ownership.
• The rights of equity shareholders consist of: (i) the right to residual income,
(ii) the right to control, (iii) the pre-emptive right to purchase additional
equity shares issued by the firm, and (iv) the residual claim over assets in the
event of liquidation.
• Preference capital represents a hybrid form of financing—it partakes some
characteristics of equity and some attributes of debentures.
• The internal accruals of a firm consist of depreciation charges and retained
earnings.
• Term loans represent a source of debt finance which is generally repayable in
less than 12 years. They are employed to finance acquisition of fixed assets
and working capital margin.

2.KEY POINTS RELATING TO FINANCING STRATEGY

• The important considerations in planning the capital structure of a firm are:

earnings per share, risk, control, flexibility, and nature of assets.
• A firm should use more equity when (a) the corporate tax rate applicable to
the firm is negligible, (b) business risk exposure is high, (c) dilution of control
is not an important issue, (d) the assets of the firm are mostly intangible, and
(e) valuable growth options exist.
• A firm should use more debt when: (a) the corporate tax rate applicable to the
firm is high, (b) business risk exposure is low, (c) dilution of control is an
important issue, (d) the assets of the firm are mostly tangible, and (e) the firm
has few growth options.
 • The market for financial securities may be divided into two segments: the
primary market and the secondary market. New issues are made in the
primary market whereas outstanding issues are traded in the secondary
market.
• There are three ways in which a company may raise finances in the primary
market: (i) public issue, (ii) rights issue, and (iii) private placement.
• A firm planning to raise finances may tap one or more of the following capital
markets: Indian capital market, euro capital market, and foreign domestic
capital market.
• Since the market price and intrinsic value may diverge in real life situations,
pricing and timing are important issues. Remember the following guidelines
while resolving these issues: (i) Decouple financing and investment decisions.
(ii) Never be greedy. (iii) Ensure inter-generational fairness.
• The key considerations influencing a firm’s dividend policy are: earnings
prospects, funding requirements, dividend record, liquidity position,
shareholder preference, and control.
• Bonus shares are issued to existing shareholders as a result of the
capitalisation of reserves.
• In a stock split, the par value per share is reduced and the number of shares is
increased proportionately.
• Given the dominant role of ‘lead steers’, a company should bear in mind the
following guidelines while communicating with the market: (i) Deemphasise
creative accounting. (ii) Avoid financial hype. (iii) Cut ‘lead steers’ into the
planning process.
• Corporate governance is concerned basically with the agency problem that
arises from the separation of finance and management. To build a healthy,
mutually beneficial, long-term relationship with its investors, it behoves on
every company to improve the standard of its corporate governance.

3.CAPITAL STRUCTURE AND FIRM VALUE

Franco Modigliani and Merton Miller (MM, hereafter) wrote a paper in 1958 which
appeared in American Economic Review. In this paper they argued that leverage does
not matter. In very simple terms their argument is that the value of a firm depends on
the cash flows of the assets and not on how the cash flows are distributed between
debt holders and shareholders.
MM argument is based on a number of simplifying assumptions.

• The capital market is perfect.

• Investors are rational.

• Managers are rational.

• Investors have homogeneous expectations.

 • Firms can be grouped into equivalent risk classes.

• There are no taxes.

• Corporate and personal leverage are perfect substitutes.

While the MM theory is valid under the assumptions made by them, critics of their
theory have argued that in the real world most of their simplifying assumptions are
not satisfied.
The following imperfections characterize the real world:

• Firms and investors pay taxes.

• Bankruptcy costs can be high.

• Agency costs exist.

• Managers tend to prefer a certain sequence of financing.

• Informational asymmetry exists.

• Personal and corporate leverage are not perfect substitutes.

The three most important imperfections in the real world are : taxes, financial
distress costs, and agency costs. Interest in debt is a tax- deductible expense whereas
dividend payment is not. So, financial leverage enhances the value of the firm because
it generates tax advantage.
Financial leverage, however, can lead to financial distress. A financially distressed
firm suffers from many operating inefficiencies which reduce the value of the firm.
Agency costs arise because managers are often interested in promoting their
interests rather than the interest of investors. In a highly levered firm, that motivation
may be stronger because managers know that the upside is enjoyed by them whereas
downside is suffered by investors.
The combined effect of these imperfections is captured in a tradeoff model captured
in Exhibit 1.
Exhibit 1 Tradeoff Model

4.TOOLS FOR DEVELOPMENT AN EFFECTIVE CAPITAL STRUCTURE

Even though it is difficult to determine the optimal capital structure, it is relatively
easy to find an effective capital structure. The following tools are helpful in this task.
ROI – ROE Analysis
Suppose a firm, Korex Limited, which requires an investment outlay of 100 million, is
considering two capital structures:

While the average cost of debt is fixed at 10 percent, the ROI (defined as PBIT
divided by total assets) may vary widely. The tax rate of the firm is 50 percent.
Based on the above information, the relationship between ROI and ROE (defined as
equity earnings divided by net worth) under the two capital structures, A and B,
would be as shown in Exhibit 2. Graphically the relationship is shown in Exhibit 3.
Exhibit 2 Relationship Between ROI and ROE Under Capital

Structures A and B

Exhibit 3 Relationship Between ROI and ROE Under Alternative Capital Structures

Looking at the relationship between ROI and ROE we find that:

• The ROE under capital structure A is higher than the ROE under capital
structure B when ROI is less than the cost of debt.
• The ROE under the two capital structures is the same when ROI is equal to
the cost of debt. Hence the indifference (or breakeven) value of ROI is equal
to the cost of debt.
• The ROE under capital structure B is higher than the ROE under capital
structure A when ROI is more than the cost of debt.

The influence of ROI and financial leverage on ROE is mathematically as follows:

ROE = [ROI + (ROI – r) D/E] (1 – t) (1)
where ROE is the return on equity, ROI is the return on investment, r is the cost of
debt, D/E is the debt-equity ratio, and t is the tax rate.
This may be derived as follows:
 Applying the above equation to Korex Limited when its D/E ratio is 1, we may
calculate the value of ROE for two values of ROI, namely, 15 percent and 20 percent.
ROI = 15%
ROE = [15 + (15 – 10) 1] (0.5) = 10.0%
ROI = 20 percent
ROE = [20 + (20 – 10) 1] (0.5) = 15.0%
These results, as expected, are in conformity with our earlier analysis.
Analysis of Leverages
Leverage arises from the existence of fixed costs. There are two kinds of leverage, viz,
operating leverage and financial leverage. Operating leverage arises from the firm’s
fixed operating costs such as salaries, rent, depreciation, insurance, property taxes,
and advertising outlays. Financial leverage arises from the firm’s fixed financing
costs such as interest on debt.
To understand the two basic types of leverage and the total (or combined) leverage
and their effects, it is helpful to look at an example. Modern Enterprises manufactures
and sells a product called Fixit which sells at 1,000 per unit. The variable operating
costs per unit are 400. The fixed operating costs are 20 million. The fixed interest
burden of the company is 4 million and the income tax rate applicable to the company
is 30 percent. The company has 1 million outstanding shares. The income statement
of the company, for two levels of sales, viz., 50,000 and 60,000, is shown in Exhibit4.
Exhibit 4 Income Statement

In the above example, a 20 percent increase in unit sales leads to a 60 percent

increase in PBIT, thanks to the existence of 20,000,000 of fixed operating costs. Put
differently, fixed operating costs magnify the impact of change in sales. Note that the
magnification works in the reverse direction as well. For example, in the above
example, a 20 percent decline in unit sales from 50,000 to 40,000 will lead to a 60
percent fall in PBIT (10,000,000 to 4,000,000). You can verify this yourself.
The sensitivity of PBIT to changes in unit sales (Q) is referred to as the degree of
operating leverage (DOL). Formally, it is defined as:
Percentage change in PBIT
DOL =
Percentage change in Q
Mathematically,
Contribution
DOL =

PBIT In our example,

30,000,000
DOL = = 3.0
10,000,000
That is why, a 20 percent increase in unit sales, leads to a 60 percent increase in PBIT.
While operating leverage arises from the existence of fixed operating costs,
financial leverage stems from the existence of fixed interest expenses. When a firm
has fixed interest expenses, 1 percent change in PBIT leads to more than 1 percent
change in profit before tax (PBT) or profit after tax (PAT) or earnings per share (EPS).
Looking at Exhibit 4, we find that a 60 percent increase in PBIT (from 10,000,000 to
16,000,000) leads a 100 percent increase in PBT (from 6,000,000 to 12,000,000). The
sensitivity of PBT to changes in PBIT is referred to as the degree of financial
leverage (DFL).
Formally, it is defined as:
Percentage change in PBIT
DFL =
Percentage change in PBIT

Mathematically,
Contribution
DTL =
Profit before tax
Note that DTL is simply the product of DOL and DFL

DTL = DOL x DFL

Contribution PBIT
= x
PBIT PBT

Contribution
=
PBT
In our example ,
30,000,000
DTL = =5
6,000,000
Ratio Analysis
Traditionally, firms have looked at certain ratios to assess whether they have a
satisfactory capital structure. The commonly used ratios are: interest coverage ratio,
cash flow coverage ratio, debt service coverage ratio, and fixed assets coverage ratio.
A Checklist
The following factors have a bearing on the capital structure decision.

1. Asset Structure Tangible-intensive firms that have more assets which are
acceptable as security to lenders have higher financial leverage. Intangible
intensive firms that have fewer assets that are acceptable as security to
lenders have lower financial leverage.

2. Stability of Revenues Firms whose revenues are relatively stable can assume
more debt compared to firms with volatile revenues.

3. Operating Leverage Other things being equal, a firm with lower operating
leverage can employ more financial leverage and vice versa.

4. Growth Rate Rapidly growing firms need more external capital. Since
external equity is costly and it entails dilution of promoter stake, such firms
tend to rely more on debt.
 5. Profitability Highly profitable firms tend to use relatively little debt. The
reason for this is simple. Thanks to their high profitability, firms like
Hindustan Unilever and Infosys have adequate internally generated funds for
meeting their investment needs. So, they require very little debt.

6. Taxes Interest on debt is a tax-deductible expense. Hence, other things being

equal, higher a firm’s tax rate, the greater the incentive to use debt.

7. Control When management is concerned about the dilution of its equity stake
in the firm, it prefers debt to external equity.

8. Attitude of Management As there is no precise method for determining the

optimal capital structure, managerial attitude plays an important role. Some
managements are aggressive and willing to use more debt; others are
conservative and use little debt.

9. Attitude of Lenders and Rating Agencies Apart from what its own analysis
suggests, managements listen to what lenders and rating agencies say. After
all, the ability of a firm to raise debt depends on the attitude of lenders and
rating agencies.

5.FINANCING INSTRUMENTS, PROJECT FINANCE, AND SECURITISATION

Financing Instruments
A variety of instruments are available for raising long-term finance. The
important ones are as follows:
Equity and Equity – Related Instruments Debt Instruments

▪ Equity shares ▪ Plain vanilla bonds

▪ Non- voting equity shares ▪ Floating rate bonds

▪ Preference shares ▪ Deep discount bonds

▪ Convertible bonds ▪ Bonds with embedded options (call and

put)

Primary Rationale The primary rationale or appeal of different instruments from

the point of view of the issuer and the investor is as follows:
Security Issuer Investor

▪ Equity shares Wants to share risk, income, Wants to share income, risk
and control and control
▪ Non- voting equity shares Wants to avoid dilution of Wants higher dividend by
control foregoing voting rights
▪ Preference shares Has exhausted debt capacity, Wants tax – sheltered dividend
but is unwilling to issue equity. income with low risk
 ▪ Convertible debentures Seeks to contain costs in bad Seeks downside
times but does not mind protection with upside
incurring higher costs in good potential
times
▪ Plain vanilla bonds Wants a fixed nominal costs Wants a fixed nominal returns
and maturity period and maturity period
▪ Floating rate bonds Wants fixed real cost Wants fixed real return
▪ Deep discount bonds (or Wants to finance long Wants to enjoy capital growth
zero coupon bonds) gestation projects and avoid and avoid reinvestment risk
paying periodic interest
▪ Callable bonds Wants the flexibility of Wants slightly higher interest
redeeming bonds prematurely, rate at the risk of premature
by paying redemption
slightly higher interest
▪ Puttable bonds Wants to reduce interest cost Wants the flexibility of earlier
at the risk of premature redemption by accepting a
redemption lower interest rate

Project Finance

Project finance involves raising funds for a capital investment project that can be
economically separated from its sponsor. The suppliers of funds depend primarily on
the cash flows of the project to service their loans and provide return on their equity
investment in the project.
While project finance has assumed great significance for infrastructure projects
from 1970s onward, it has a long history. Indeed venture-by-venture financing for
projects with finite life was the norm in commerce until the 17th century.
Features of Project Finance The key features of project finance, which appears to
be the principal arrangement for private sector participation in infrastructure
projects, are as follows:

● The project is set up as a separate company which is granted a concession

by the government.

● The sponsor company which promotes the project usually takes a

substantial stake in the equity of the project and enjoys the overall
responsibility for running the project.

● The project company enters into comprehensive contractual

arrangements with various parties like contractors, suppliers, and
customers.

● The project company employs a high debt-equity ratio, with lenders

having no recourse or limited recourse to the sponsor company or to the
government in the event of default.
The above features distinguish project finance from conventional direct financing.
In the latter, the projects are generally not set up as separate companies; the loans
are granted by the lenders against the balance sheet of the sponsor; the contractual
arrangements are not very comprehensive and ironclad; the lenders have recourse to
the assets of the sponsor; and the debt-equity ratios are not as high as those found in
the case of project finance.
Securitisation
Securitisation involves packaging a designated pool of assets (mortgage loans,
consumer loans, hire purchase receivables, and so on) and issuing securities which
are collateralised by the underlying assets and their associated cash flow stream.
Securitisation is originated by a firm that seeks to liquefy its pool of assets. Securities
backed by mortgage loans are referred to as mortgage-backed securities; securities
backed by other assets are called asset-based securities.
The key steps involved in securitization are:

1. Seasoning
2. Credit enhancement
3. Transfer to a special purpose vehicle (SPV)
4. Issuance of securities
5. Payment by SPV

6.DIVIDEND POLICY AND FIRM VALUE

Since the principal objective of financial management is to maximise the value of the
firm, a key question of interest to us is: What is the relationship between dividend
policy and firm value?
Miller and Modigliani (MM, hereafter) have advanced the view that the value of a
firm depends solely on its earnings power and is not influenced by the manner in
which its earnings are split between dividends and retained earnings. This view,
referred to as the MM “dividend irrelevance” theorem, is presented in their
celebrated 1961 article. In this article MM constructed their argument on the
following assumptions.
• Capital markets are perfect and investors are rational: information is
freely available, transactions are instantaneous and costless, securities
are divisible, and no investor can influence market prices.

• Floatation costs are nil.

• There are no taxes.

• Investment opportunities and future profits of firms are known with

certainty (MM drop this assumption later).

• Investment and dividend decisions are independent.

The substance of MM argument may be stated as follows: If a company retains

earnings instead of giving it out as dividends, the shareholder enjoys capital
appreciation equal to the amount of earnings retained. If it distributes earnings by
way of dividends instead of retaining it, the shareholder enjoys dividends equal in
value to the amount by which his capital would have appreciated had the company
chosen to retain its earnings. Hence, the division of earnings between dividends and
retained earnings is irrelevant from the point of view of the shareholders.

Implications of Real world Imperfections While the MM dividend irrelevance is

valid in the perfect world, the real world is characterised by the following
imperfections, which makes the distribution policy relevant.

• Investor preference for dividends

• Transaction costs

• Informational asymmetry

• Agency costs

Corporate Dividend Behaviour

Is there a pattern to corporate dividend behaviour? The classic answer to this
question was provided by John Lintner1 in 1956. Lintner's survey of corporate
dividend behaviour is captured in four stylised facts:

1. Firms set long-run payout ratios. Mature firms with fairly stable earnings have
higher payout ratios whereas rapidly growing firms have lower payout ratios.

2. Managers are concerned more about the change in the dividend than the
absolute level of dividend.

3. Dividends tend to follow earnings, but dividends follow a smoother path than
earnings. Transitory changes in earnings are not likely to have an impact on
dividend payment.

4. Dividends are sticky in nature because managers are reluctant to effect

dividend changes that may have to be reversed. They are particularly
concerned about having to pull back an increase in dividend.

Lintner expressed corporate dividend behaviour in the form of the following model:

where Dt is the dividend per share for year t, c is the adjustment rate, r is the target
payout ratio, EPSt is the earnings per share for year t, and Dt–1 is the dividend per
share for year t – 1.
Let us look at an example. Kinematics Limited has earnings per share of 4.00 for
year t. Its dividend per share for year t–1 was 1.50. Assume that the target payout
ratio and the adjustment rate for this firm are 0.6 and 0.5, respectively. What would
be the dividend per share for Kinematics Limited for year t if the Lintner model
applies to it?
 Kinematics dividend per share for year t would be:
0.5 x 0.6 x 4.00 + 0.5 x 1.5 = 1.95
The Lintner model shows that the current dividend depends partly on current
earnings and partly on previous year’s dividend.

7.FINANCING STRATEGY OF RELIANCE INDUSTRIES

Reliance Industries Limited (Reliance, hereafter) has in arguably been the most
successful company in the Indian private sector in raising finances for its ambitious
projects from time to time. It seems to have mastered the knack of obtaining finances
at attractive terms for supporting its aggressive investment plans. The key
ingredients of its financing strategy are briefly discussed below.
Think Big Reliance has an all-consuming passion to be the biggest and the best. As
someone has remarked: Ambani = Ambition + Money
Dedicate a Team to Treasury Management Reliance has a team dedicated to treasury
management. It continually assesses the developments in various markets to identify
financing opportunities.
Develop a Steady Relationship with the Merchant Bankers Reliance’s principal
merchant banker is Merrill Lynch, a world leader. It has developed a steady
relationship with it over time. Remember that the capabilities and support of the
merchant banker are essential for raising finances.
Be in a State of Readiness Speed is the essence of financing. The treasury team of
Reliance keeps a draft prospectus which is updated on a weekly basis. A rating is also
kept ready. Once Reliance decides on a financing option it hardly wastes any time,
thanks to its perennial readiness
Be the First Reliance has a number of firsts to its credit. It has been the first Indian
company to issue Global Depository Receipts, to privately place a large chunk of
equity shares with financial institutions at a price close to the prevailing market price,
to go for a syndicated eurocurrency loan, to make a Eurobond issue, to issue 20-year
Yankee bonds, 50-year Yankee bonds, and even 100-year Yankee bonds. (Yankee
bonds are dollar denominated bonds issued in the U.S. capital market by foreign
borrowers).
Delink Financing and Investment Decisions Opportunities for smart moves on
investment and financing sides of the business often do not synchronise. Hence it
makes sense to decouple investment and financing decisions. Reliance seems to be
doing this. It raises finances whenever the market conditions are favourable
irrespective of whether it has immediate investment projects on hand or not.
Think International Aware of the compulsions of globalisation, Reliance believes in
thinking in international terms. It is the first Indian company to appoint an
international firm of auditors and to get the ratings from Moody’s and S & P. It uses
the language of “the dollar” extensively.
Ensure that the Primary Market Investor is Adequately Rewarded Reliance is rightly
credited as the company which has promoted the equity cult in India. It seems to have
followed the motto: “Protect the interest of those who participate in the primary
issues of the company.” Even though many investors who bought Reliance in the
secondary market may have lost money, primary market investors have not.
Cultivate the Institutional Investors In 1994 individual investors held more than 50
percent of the equity of Reliance. Anticipating the institutionalisation of the capital
market, Reliance has taken initiatives to encourage greater institutional participation
in its equity and has succeeded immensely in that endeavour.
Deepen the Market for its Debt When a company fragments its debt financing over
several issues, the market for its debt may lack depth. In a bid to overcome this
problem, Reliance issued ` 300 crore worth of zero coupon bonds in August 1999
which were identical to an outstanding issue made a few months earlier. The
idea was to avoid fragmentation of issue.
Deleverage in a Timely Manner Reliance had raised large amounts of debt for its mega
investments in telecom, retail, and other businesses. When investors expressed
concern over the same, Reliance deleveraged in a timely manner and turned zero net
debt company in 2020.

( Adapted from Prasanna Chandra Financial Management, Theory and Practice, 10th
edition, McGraw Hill)