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Week 3

The document discusses financing decisions in strategic financial management, focusing on capital structure theory and its implications for shareholder value. It outlines key facets of financing decisions, including capital structure, financing instruments, methods, and distribution policy, while contrasting debt and equity financing. Additionally, it highlights the Modigliani and Miller theorem, critiques its assumptions, and presents tools for analyzing capital structure, emphasizing the importance of factors like asset structure, revenue stability, and management attitudes.

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Week 3

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Strategic Financial Management:

Managing for Shareholder Value

Professor Prasanna Chandra
Week 3: Financing Decisions

Introduction and Capital Structure Theory

Welcome to session three, financing decisions. The outline of the session is given here.
Financing decisions versus investment decisions, facets of financing decisions, capital structure
decision, financing instruments, methods, markets, pricing and timing, distribution policy. You
will find more detailed coverage of financing decisions in my book, Financial Management
Theory in Practice.

Financing decisions are comparatively easier than investment decisions for the following
reasons. Financing decisions are made in capital markets, which are approximately perfect.
Investment decisions, however, are made in real markets, which are characterized by a lot of
imperfections. While making financial decisions, you can observe the value of similar financial
assets.While making investment decisions, you have to estimate the value of these assets. There
are very few opportunities in the realm of financing where NPV is significantly different from
zero. There are many opportunities in the realm of investments where NPV can be significantly
higher than zero or significantly lower than zero.

We will discuss four broad facets of financing decision,

1. Capital structure - what should be the debt equity ratio of the firm?

2. Instruments - Which specific instruments of financing should the firm use?

3. Methods, markets, pricing, and timing - Which methods of issuance should the firm
use? Which market should the firm tap? What should be the pricing of instruments? At
what time should the firm approach the market?

4. Distribution policy - What should be the dividend policy or share buyback policy of the
firm?

Before we look at the debt equity choice the firm let us understand the key differences between
debt and equity. Debt has a fixed claim. Debt interest is tax deductible. Debt enjoys high
priority. Debt has a fixed maturity. Debt does not entail dilution of management control.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 3: Financing Decisions

Equity has a residual claim. Equity dividend is not tax deductible. Equity has a low priority in
a financially troubled situation. Equity has an infinite life. Equity enables management control.
We have a wide range of instruments ranging from pure debt to pure equity and a lot of hybrid
securities in between.

Franco Modigliani and Merton Miller wrote a paper in 1958, which appeared in American
Economic Review. In this paper, they argued that leverage does not matter. This was a seminal
contribution. Many consider this to be the beginning of modern finance. In fact, both Franco
Modigliani and Merton Miller became Nobel laureates in economics subsequently. The
assertion that leverage does not matter was considered as a bombshell assertion challenging
the traditional belief in finance that leverage policy did matter.

In very simple terms their argument is that the value of a firm depends on the cash flows from
assets and not on how these cash flows are distributed between debt and equity. The cash flows
of a firm are distributed between debt and equity. The manner in which this distribution takes
place according to Modigliani and Miller has no bearing whatsoever on the value of the firm.

Of course, their argument is based on a number of simplifying assumptions. The key

simplifying assumptions are listed here, perfect capital market, there are no transaction costs,
The market reflects intrinsic value. Rational investors. Investors make rational assessment
about cash flows. They are not subject to any behavioral biases.

Rational managers. Managers deploy capital very rationally. Managers don't squander capital
over uneconomic projects. Managers faithfully serve the interest of investors. Homogeneous
expectations. All investors in the marketplace have identical expectations. Equivalent risk
classes. Firms can be divided into different classes. Within each class, firms have equal risk.
Absence of taxation. There is no taxation, corporate or personal. These are indeed very very
stringent assumptions in the real world these assumptions are rarely if ever fulfilled.

While the Modigliani and Miller theorem is valid under the assumptions made by them, critics
of Modigliani and Miller theory have argued that in the real world most of those assumptions
are not satisfied. In the real world firms and investors pay taxes. Bankruptcy costs can be high.

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 3: Financing Decisions

If a firm is on the verge of bankruptcy, it incurs substantial bankruptcy costs, which are
deadweight costs. Agency costs exist. Managers don't faithfully serve the interest of
shareholders and other investors. Often managers pursue their own interest at the expense of
the interest of investors. Managers tend to prefer a certain sequence of financing.

Managers prefer internal equity, then they go for debt, and then they finally look at external
equity. Informational asymmetry exists. There is a lot of informational asymmetry. Managers
know much more about the prospects of the firm than investors, and they utilize that
informational advantage to serve their own interests.

Personal and corporate leverage are not perfect substitutes. Modigliani and Miller assume that
whether a company resorts to financial leverage or investors resort to financial leverage, it
doesn't make any difference. In the real world, 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 on debt is a tax deductible expense. Dividend payment is not a tax deductible expense.
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
many operating inefficiencies, which reduce the value of the firm.

Agency costs arise because managers are often interested in promoting their interest rather than
the interest of investors. In a highly levered firm, that motivation may be stronger because
managers know that upside is enjoyed by them, whereas downside is borne by investors. The
combined effect of these three imperfections is captured in a trade off model, which is
represented on this graph.

On this axis is the debt equity ratio of the firm. On this axis is the value of the firm. This is the
value of the unlevered firm. This is the value of a levered firm when we consider only the tax
advantage as we have seen higher the leverage greater the tax advantage. However, beyond a
certain point financial distress costs and agency costs kick in and as financial leverage increases
these costs increase. So, we find that the tax advantage of debt is nullified gradually by financial

distress cost and agency cost. It appears that there is a debt equity ratio at which the value of
the firm is maximized.

Checklist for Capital Structure Decisions.

- Asset Structure: If the assets of the firm are highly tangible, the firm can employ more
debt. If the assets of the firm are highly intangible, the firm cannot employ much debt
because lenders look for tangible security.

- Stability of Revenues: If the revenues are fairly stable the firm can employ more debt.
If revenues are highly volatile, firm cannot use much debt.

- Operating leverage: If the operating fixed costs are high and operating leverage is high,
the firm cannot superimpose high financial leverage because total leverage would
become unmanageable.

- Growth rate: If the growth rate of the firm is very high, it may have to rely more on
equity financing.

- Profitability: Profitable firms tend to use more of internally generated equity and less
of debt.

- Taxes: Firms which have a high corporate tax rate have a greater incentive to use debt.
Firms which have have very minimal corporate tax rate, have much less incentive to
use debt control.

- Control: If the incumbent management doesn't want to share control with outside
investors, then it would rely more on debt.

- Attitude of management: Some managements have an aversion to debt, so they have a

zero debt policy. Infosys, for example, has a zero debt policy. Microsoft also perhaps
has a zero debt policy.

- Attitude of lenders and rating agencies: Corporate managements have to be sensitive

to what lenders look for, what rating agencies look for, because they must have a
favorable equation with lenders and rating agencies. So, they will have to respect the
expectations of lenders and rating agencies.

In summary, debt makes more sense for firms which have tangible assets, low business risk,
high corporate tax, and fewer growth options. Equity makes more sense for firms which have
intangible assets, high business risk, no tax, and valuable growth options.

Tools of Capital Structure – I

There doesn't seem to be a neat formula for determining the optimal capital structure. However,
an effective capital structure can be developed using certain tools. The important tools are

EBIT - EPS analysis. EBIT stands for Earnings Before Interest Tax. EPS is Earnings Per Share.

ROI - ROE Analysis. ROI stands for Return on Investment. ROE stands for Return on Equity.

ROE - ROIC Analysis. ROE is Return on Equity. ROIC is Return on Invested Capital.

Analysis of Operating Financial and Total Leverages.

Ratio Analysis.

Earnings per share in practice is a very important financial metric. Managements are often
sharply focused on this metric. Sometimes they are obsessed with this metric. So they are likely
to ask a question like this. What happens to EPS for different levels of EBIT under alternative
capital structures? The relationship between EBIT and EPS is shown below.

EPS is equal to EBIT. EBIT, which is also referred to as operating profit, minus interest,
multiplied by 1 minus tax rate. So, this whole is profit after tax. EBIT minus interest is profit
before tax, and 1 minus tax applied to that gives profit after tax. Profit after tax divided by
number of outstanding shares gives earnings per share.

Under alternative capital structures, interest differ and number of outstanding shares differ. To
understand how EPS behaves under alternative financing plans. Let us look at an example.

A company currently has an all equity capital structure. It has issued 1 million equity shares of
10 rupees each and its capital is rupees 10 million. It requires additional capital of rupees 10
million for an expansion project. It is considering two options. It can issue 1 million equity
shares at 10 rupees each. Alternatively, it can raise rupees 10 million by way of debt, carrying
an interest rate of 14%.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 3: Financing Decisions

After the expansion plan, the EBIT of the company can vary between 2 million and 4 million.
As far as EBIT variation is concerned, it remains the same under both the financing options.
What happens under equity financing?

EBIT is 2 million, EBIT is 4 million. We'll look at how EPS behaves with variations in EBIT.
If EBIT is 2 million, interest is nil because the company is an all equity finance company. Profit
before tax is 2 million. Taxes are assumed to be 50%, so taxes would be 1 million. Profit after
tax, 1 million. Number of equity shares under this financing plan would go up from the current
1 million to 2 million, so EPS would be 0.50.

If EBIT is 4 million, Then profit before taxes, 4 million. Taxes, 2 million. Profit after taxes, 2
million. Number of equity shares is 2 million. EPS would be 1 rupee.

Under debt financing, there is a debt burden of 1. 4 million. When EBIT is 2 million. Interest
is 1. 4 million. Profit before tax is 600, 000. Taxes are 300, 000. Profit after tax is 300, 000.
Under debt financing, number of equity shares remains at 1 million, so earnings per share is
profit after tax by 1 million, which is 0.30.

If EBIT is 4 million, this is the picture. Interest is 1. 4 million. Profit before tax is 2. 6 million.
Taxes are 1. 3 million. Profit after tax is 1. 3 million. Number of equity shares is 1 million. So
EPS is 1.30.

We find that under equity financing, EPS varies between 0.5 and 1. Under debt financing, EPS
varies between 0.3 and 1. 3. In general, under debt financing, EPS has a larger variation.
compared to its variation under equity financing.

If both these EBIT levels are equally probable, then expected EPS here is 0.75 and expected
EPS here is 0.80. This is the kind of general relationship we find. The expected EPS would be
more under debt financing, but variation of EPS will also be more under debt financing.

Break even EBIT level, the EBIT indifference point between two alternative financing plans
can be obtained by solving the following equation for EBIT star.

EBIT star represents the break even EBIT level. EBIT star minus EBIT, Interest under
financing plan 1 multiplied by 1 minus tax rate divided by number of equity shares under
financing plan 1 is equal to EBIT star minus interest under financing plan 2 multiplied by 1
minus tax rate divided by number of outstanding equity shares under financing plan 2.

What is the relationship between ROIC and ROE? ROE is Profit after tax divided by equity
ROIC is NOPAT divided by invested capital or NOPAT divided by the sum of equity and debt
because invested capital is simply equity plus debt. ROE is profit after tax divided by equity
which is NOPAT. PBIT minus interest multiplied by 1 minus t divided by equity.

The numerator of this ratio can be expressed in this manner. PBIT multiplied by 1 minus t
minus i multiplied by 1 minus t. PBIT multiplied by 1 minus t is nothing but NOPAT. So, PBIT
multiplied by 1 minus T can be expressed as the product of ROIC and the sum of equity plus
debt. This is what I have done here, PBIT multiplied by 1 minus T is expressed in this manner.

Interest is rate of interest multiplied by debt. So, I multiplied by 1 minus t can be expressed as
rd multiplied by 1 minus t. When we simplify this ratio we get ROIC plus within brackets
ROIC minus r multiplied by 1 minus t the whole bracket closed multiplied by debt equity ratio.

This is a very useful and elegant equation in finance which says return on equity is equal to
return on invested capital plus the difference between return on invested capital and post tax
cost of debt multiplied by debt equity ratio. Here is a numerical example that illustrates the
formula discussed just now.

A company has total assets of 200 million It has 100 million of equity 100 million of debt.So,
debt equity ratio is one. The profit loss account of the firm is shown here. Revenues 300 million,
profit before interest and tax 40 million, interest burden 10 million interest is 10 percent Of
total debt of 100 million, profit before tax is 30 million, tax at the rate of 30 percent is 9 million
profit after tax is 21 million.

Given these numbers we find that return on equity is profit after tax 21 million divided by
equity of 100 million, so, return on equity is 21 percent return.

Return on invested capital is NOPAT divided by invested capital NOPAT is profit before
interest and tax multiplied by 1 minus tax rate.

Invested capital is 200, so ROIC works out to 14%. Cost of debt in pre tax terms is 10%, tax
rate is 30%, so post tax cost of debt is 7%. Debt equity ratio is 1 to 1. Return on equity is equal
to ROIC plus ROIC minus small r times 1 minus t, the whole multiplied by debt equity ratio as
per the formula discussed just now.

In this equation, let us look at the numbers on the right hand side, ROIC is 14%, ROIC is 14%.
Post tax cost of debt is 7%. Debt equity is 1. So this works out to 21%, which is what we started
with. This is an illustration of the formula given just now. Here is a solved problem.

Alpha company has an ROIC of 12%, a post tax cost of debt of 7%. If Alpha wants to an ROE
of 18%, what should be its debt equity ratio? The required ROE of 18 percent is put on the left
hand side. On the right hand side, we have ROIC plus ROIC minus post tax cost of debt
multiplied by the debt equity ratio. Solving this for debt equity ratio, we find that the 1.2 will
ensure that the firm achieves an ROE of 18 percent.

How is the return on equity related to return on investment which is also referred to as earning
power return on investment is PBIT divided by total assets or PBIT divided by equity plus debt.
Return on Equity is profit after tax divided by equity. Profit after tax is profit before interest in
tax, minus interest multiplied by one minus tax rate.

In the numerator of this ratio, PBIT can be expressed as the product of ROI and the sum of E
plus D. So, PBIT has been expressed as E plus D times ROI, interest is simply interest rate R
multiplied by debt divided by equity the whole multiplied by 1 minus T. This simplifies itself
to return on investment plus ROI minus R multiplied by debt equity the entire thing multiplied
by 1 minus tax rate.

So, return on equity is equal to earning power plus earning power minus cost of debt multiplied
by debt equity ratio, the whole multiplied by one minus tax rate. So, return on equity is a

function of earning power, effect of leverage, and tax factor. To understand how ROE behaves
in relation to changes in ROI, under alternative capital structures, let us consider an example.

A firm requires a capital of 200 million. It is considering two capital structures. In this capital
structure, it employs debt and equity in equal proportions. So, equity will be 100 million, debt
will be 100 million. In this capital structure, it does not employ debt. It relies entirely on equity.
So equity will be 200 million.

What happens when ROI is 5%? What happens when ROI is 15 percent under this capital
structure? When ROI is 5%, PBIT would be 10 million. PBIT is simply capital multiplied by
ROI. In this capital structure, there is An interest burden of 10 million, 100 million of debt will
carry an interest rate of 10%. PBT is zero. Tax is zero. Profit after tax is zero. So, return on
equity is zero percent.

When ROI is 15 percent, PBIT is 30 million. Interest remains at 10 million. PBIT is 20 million.
Tax, given a tax rate of 25 percent, will be 5 million. Profit after tax would be 15 million.
Return on equity would be 15 percent. 15 million divided by 100 million.

Under this capital structure, when ROI is 5%, PBIT is 10 million. There's no interest because
it is an all equity cap structure. PBT is 10 million. Tax, given a tax rate of 25 percent is 2.5
million. Profit after tax is 7.5 million. Return on equity is 7.5 divided by 200, so it is 3.75%.
When ROI is 15%, PBIT is 30 million, interest is nil, profit before tax is 30 million, tax is 7.5
million. 5 million. Return on equity is 22. 5 divided by 200, so it is 11. 25 percent.

So, we find that in an all equity capital structure, return on equity varies less compared to how
it varies in a leveraged capital structure. Here, ROE varies between 2 and 15% here, ROE varies
between 3.75% and 11.25%.

Here is a solved problem. Magnos company is an average cost of 38% and a tax rate of 25%.
The ROI is 14%. What financial average ratio should the company adopt? If it's target? ROE
is 15%. We set up this equation target, ROE, 15%. ROI is given as 14 percent. Cost of debt is
8 percent. Debt equity ratio is unknown.

The whole multiplied by 1 minus 0. 25, which is a tax rate. Solving this equation for the debt
equity ratio, we find that the debt equity ratio is 1. This means that if this company employs a
equity ratio of 1, it can achieve at target ROE of 15%.

Tools of Capital Structure – II

The three concepts of leverage - operating leverage, financial leverage, and total leverage. To
understand these concepts of leverage, let us look at the income statement structure. Sales, less
variable costs, less fixed operating costs, profit before interest and tax, less interest on debt,
profit before tax, less tax, profit after tax, less preferred dividend, equity earning.

Operating leverage stems from the existence of fixed operating costs. Financial leverage stems
from the existence of fixed financing costs. Total leverage stems from the existence of fixed
operating costs and fixed financing costs. Let us consider some important relationships
obtaining on the income statement.

Profit before interest and tax is equal to quantity multiplied by unit contribution margin which
is the difference between unit selling price and unit variable cost minus fixed cost. Profit after
tax is profit before interest and tax minus interest the whole multiplied by 1 minus tax rate.
Earnings per share is defined as profit after tax by number of outstanding share. Profit after tax
is given by this expression and n is the number of outstanding share.

If we express PBIT in this form, if we express PBIT as quantity multiplied by P minus V minus
F. Then, in the numerator of this ratio, we have Q multiplied by P minus V minus F minus I,
the whole multiplied by 1 minus T. This is divided by N to get earnings per share.

In order to concretize our understanding of various measures of leverage, we will look at a

numerical example, Modern Enterprises manufactures and sells a product called Fixit, which
sells at 1000 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. 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. Namely, 50,000 and 60,000 is shown below.

When quantity is 50,000, sales are 50 million because unit selling price is 1,000. Variable costs
are 20 million because unit variable cost is 400. Contribution is 30 million. Fixed operating
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 3: Financing Decisions

costs are given as 20 million. PBIT is 10 million. Interest is given as 4 million. PBT is 6 million.
Tax is 1. 8 million because the tax rate is 30 percent. Profit after tax is 4.2 million. Since 1
million shares are outstanding, earnings per share is 4.2.

When quantity sold is 60,000 units, sales are 60 million. Variable costs are 24 million.
Contribution is 36 million. Fixed operating costs are 20 million. Profit before interest and taxes
16 million, interest is 4 million, profit before tax is 12 million, tax is 3.6 million, profit after
tax is 8.4 million, and earnings per share is 8.4.

We find that a 20 percent increase in sales leads to a 60 percent increase in PBIT and a 100
percent increase in earnings per share.

What do we find when you look at the previous table? We find that at 20 percent change in
quantity leads to a 60 percent change in PBIT. When quantity changes from 50,000 to 60,000,
there is a 20 percent change. In response to that, PBIT increases from 10 million to 16 million.
So, a 20 percent change in quantity leads to a 60 percent change in PBIT.

DOL is defined as percentage change in PBIT divided by percentage change in Q.

Mathematically, DOL is equal to contribution divided by PBIT. In our example, DOL is 30
million, which is a contribution, divided by PBIT, which is 10 million. So, DOL is 3. That is
why a 20 percent increase in units says leads to a 60 percent increase in PBIT.

Let us now look at the degree of financial leverage or DFL. DFL is percentage change in PBT
divided by percentage change in PBIT. Mathematically, DFL is equal to PBIT divided by PBT.
I am not showing the mathematical derivations. If you are interested in the mathematical
derivation, you can consult my book Financial Management Theory and Practice, 10th edition.

In our example, DFL is equal to PBIT which is 10 million divided by PBT which is 6 million.
So, DFL works out to 1. 67. Finally, we have DTL or Degree of Total Leverage which is
defined as percentage change in PBT divided by percentage change in Quantity.
Mathematically, DTL is equal to contribution divided by profit before tax.

In our example, contribution is 30 million, profit before tax is 6 million, so, DTL works out to
5. DTL may be expressed as a product of DOL and DFL. DOL is 3, DFL is 1.67, so DTL is 5.
That is why we found that 20% change in quantity led to a 100% change in profit after tax
lenders.

Credit rating agencies and companies usually employ certain ratios to determine the soundness
of the capital structure. The important ratios are interest coverage ratio. This is defined as
earnings before interest in taxes divided by interest on debt. An interest coverage ratio of 5, or
6 or 7 or 8, is considered to be fairly satisfactory. If this coverage ratio falls below 3, it is a
matter of concern.

Cash flow coverage ratio is defined as earnings before interest in taxes plus depreciation plus
other non cash charges the whole divided by interest on debt plus loan repayment installment
divided by one minus tax rate.

Remember loan repayment installment has to come out of profit after tax so an adjustment of
this kind is made if a company has a loan repayment obligation of 100 million and its effective
tax rate is 25 percent, then it must have a pre tax amount of 133.3 million.

On 133.3 million it would pay 25 percent by your taxes so the tax liability will work out to 33.
3 million leaving it with a profit after tax of 100 million which is sufficient to meet loan
repayment installment obligation.

To judge the debt capacity of a project, lenders in India commonly use a ratio called debt
service coverage ratio. The ratio is defined as profit after tax plus depreciation plus interest on
long term loans plus lease repayment obligations. The entire thing is submitted over the loan
period divided by interest on long term loans plus loan repayment obligation plus lease rentals.
The entire thing is submitted over the life of the loan.

The key norms of financing used by lenders in India are:

1. generally, the debt equity ratio should not exceed one to one for service companies, two to
one for manufacturing companies, and four to one for infrastructure companies.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 3: Financing Decisions

2. Secured loans should normally have a fixed asset coverage ratio of 1. 25 to 1.

3. The annual debt service coverage ratio should be at least 1. 5.

4. The total outside liabilities to total net worth should not exceed 3 to 1.

5. Current liabilities, including working capital borrowings, are not more than 75 percent of
current assets.

Comparative analysis, a common approach to analyzing the capital structure of a firm, is to

compare its debt equity ratio to the average debt equity ratio of the industry to which the firm
belongs.

Since, the firms in industry may differ on factors like operating risk, profitability, and tax status,
it makes sense to control for differences in these variables.

Instruments of Financing – I

Hello learners and welcome back. There are three broad kinds of financing instruments, equity
instruments, hybrid instruments, and debt instruments. The important equity instruments are
listed here.

Equity shares represent the most important source of finance. Equity shares make sense to an
issuer who wants to share risk, income, and control. Equity shares appeal to an investor who
wants to share income, control and risk. Look at the sequence as per the issuer is concerned.
The issuer is primarily interested in sharing risk As far as the investor is concerned the investor
is primarily interested in sharing income.

Non voting equity shares and differential voting right equity shares carry no voting right or
limited voting, but enjoy a higher rate of dividend. These instruments appeal to an issuer who
wants to avoid dilution of control. They appeal to an investor who wants a higher dividend by
foregoing voting rights.

Global depository receipts and American depository receipts are equity instruments for raising
finances internationally. They appeal to an issuer who wants to get a better price and build
some brand equity internationally. They appeal to an investor who wants to have exposure to
Indian equities.

Hybrid instruments have some features of equity and some features of debt. The important
hybrid instruments are preference shares, convertible debentures, and foreign currency
convertible bonds.

Preference shares carry a fixed rate of dividend and are redeemable after a certain time.
Preference shares ordinarily do not carry any voting right. The dividend on preference shares
is payable from profit after tax. Preference shares lie between equity and dividend. The
dividend rate in preference shares is usually higher than the dividend rate on equity.

Preference shares make sense to an issuer who has exhausted debt capacity but is unwilling to
issue equity. Preference shares make sense to an investor who wants a higher dividend income
and lower risk.

Convertible debentures are ventures which are convertible into equity at the option of the
investor. For example, a company may show a convertible debenture for 100 rupees. The
debenture may be convertible into two equity shares of 50 each. At the option of the investor
between three years and seven years convertible debentures normally carry an interest rate
which is lower than the interest rate on straight debentures because the investor enjoys the
possibility of significant capital appreciation if the equity shares rise over a period of time.

Convertible debentures make sense to an issuer who seeks to contain costs in bad times but
does not mind incurring higher costs in good times. Convertible debentures make sense to an
investor who seeks downside protection with upside potential. Remember, the investor enjoys
downside protection, if the equity shares do not rise, the investor can retain the instrument as a
straight debt instrument, which is redeemable after some time.

Foreign currency convertible bonds are convertible bonds or convertible debentures issued in
foreign markets. Debt instruments have proliferated. There is a mind boggling range of debt
instruments in practice. For our purposes, the most important debt instruments are plain vanilla
bonds, floating rate bonds, deep discount bonds, callable bonds, and puttable bonds.

Plain vanilla bonds are bonds which carry a fixed nominal rate of interest and a fixed maturity
period. These bonds make sense to an issuer who wants a fixed nominal cost and maturity.
They make sense to an investor who wants a fixed nominal return and maturity.

Floating rate bonds are bonds which carry an interest rate that is linked to some benchmark
rate. Internationally, a popular benchmark rate is LIBOR or London Inter Bank Offering Rate.
In India, a popular benchmark rate is MIBOR or Mumbai Inter Bank Offering Rate. Generally
the benchmark rate is linked to inflation rate, so floating rate bonds earn a return which is more
or less protected in real time. Floating rate bonds appeal to an issuer who wants fixed real costs.
They appeal to an investor who wants a fixed real return.

Deep discount bonds or zero coupon bonds are bonds which are issued at a steep discount over
their par value. For example, a company may issue a deep discount bond which has a par value
of rupees 100. The issue price may be rupees 50. The redemption period is after six years. The
bond does not carry any interest rate, that is why it is called a zero coupon bond.

An investor who invests 50 rupees would get 100 rupees after six years. These bonds appeal to
an issuer who wants to finance long gestation projects and avoid paying periodic interest. They
appeal to an investor who wants to enjoy capital growth and avoid reinvestment risk. The
investor does not get any periodic interest payment. So there is no reinvestment risk.

Callable bonds are bonds which can be prematurely redeemed by the issuing company. These
bonds usually carry an interest rate higher than the interest rate applicable on straight
debentures. These bonds have an appeal to an issuer who wants the flexibility of redeeming
bonds prematurely by paying slightly high interest rate. They appeal to investors who want
slightly high interest rate at the risk of premature redemption.

Puttable bonds bonds, which can be prematurely redeemed at the option of the investor. These
bonds usually carry an interest rate which is slightly lower than the normal interest rate because
the investor enjoys the right of premature redemption. These bonds appeal to issuers who want
to reduce interest costs at the risk of premature redemption. They appeal to investors who want
the benefit of premature redemption and are willing to sacrifice some interest for that.

The general principle to be followed in designing debt instruments is to ensure that the cash
flow obligations associated with debt instruments are matched with the cash flows generated
by the assets and projects of the firm.

So, a careful assessment has to be made of cash flows that would be generated from the assets
of the firm. What would be the duration of these cash flows? What would be the currency mix
of these cash flows? What would be the effect of inflation uncertainty on these cash flows,
what would be the growth patterns of these cash flows? What would be the nature of cyclicality
of these cash flows?

Based on such an assessment, debt instruments had to be designed, the duration and maturity
of debt instruments, the currency denominations of debt instruments, the fixed versus floating
character of debt instruments, the straight versus convertible nature of debt instruments and
other special features of debt instruments should always be matched with the cash flows that
are generated by the assets and projects of the firm. Since, we have such a wide range of debt
instruments, many lay people have great difficulty in understanding the character of these
instruments.

I am reminded of a story. A lady in New York had deposited the portfolio for bonds with the
bank for custody. One day she called the bank manager and said, have you collected interest
on my bonds? The bank manager looked at her portfolio and found that it had several kinds of
bonds. Bonds meant for redemption, bonds meant for conversion, and so on.

And so he asked the lady, is she referring to bonds which are meant for redemption or is she
referring to bonds which are meant for conversion? Lady did not understand the terms
redemption or conversion in the context of bonds. She shot back and said, am I speaking to the
first city bank or the first Baptist church? Redemption, conversion are all spiritual terms and
bonds have acquired a spiritual aura.

To determine whether a new security is advantageous to the firm, the corporate treasurer must
ask the following questions.

1. What differences are there between the new security and its closest comparable conventional
security?

2. Does the new security reallocate risk efficiently?

3. Does the new security reduce issuance costs?

4. Does the new security lower the tax burden?

5. Does the new security reduce agency costs?

6. Does the new security enhance the liquidity for the investors?

7. Does the new security impose more or less restrictions?

8. How payments on the new security will, will vary with changes in interest rates, exchange
rates, commodity prices, or some other economic variable.

Thus, the key factors to be considered are risk allocation, issuance cost, tax, agency cost,
liquidity, restrictive covenants, impact of economic variables.

Hence, designing innovative securities is always a challenging and interesting exercise.

Instruments of Financing – II

Hello, learners, and welcome back. Leasing has emerged as a supplementary source of finance.
A lease represents a contractual arrangement whereby the lessor grants the lessee the right to
use an asset in return for periodical lease rental payments. Leases may be classified into two
types, finance leases and operating leases.

A finance lease or capital lease is essentially a form of borrowing. It's salient features are:

1. it is an intermediate term to long term, non cancellable arrangement.

2. it is fully amortized during the primary lease period.

3. the lessee is responsible for maintenance, insurance, and taxes.

An operating lease is a lease other than a finance lease. It's salient features are:

1. the lease term is significantly less than the economic life of the equipment.

2. the lessor usually provides you operating know how and insures and maintains the
equipment.

For financing infrastructure projects such as airports, seaports, metro railway systems and so
on. Project finance has emerged as an important modality of financing. The key features of
project finance are:

1. The project is set up as a separate company, which is granted a concession by the

government for a specified period of time.

2. The sponsor company or the promoter company takes a very substantial equity stake in
the project and enjoys the overall responsibility for managing the project.

3. The project company enters into comprehensive contractual arrangements with various
parties such as contractors, suppliers, and customers.

4. The project company employs a high debt equity ratio with lenders having no recourse
or limited recourse to the sponsor company.

The relationship between the project SPV and various parties is shown in this diagram.

The project SPV receives equity from the sponsors or the promoters, gets concession or license
agreement from the government, enters into an insurance contract with insurance companies,
O&M contract with O&M operator, EPC contract with EPC contractor, debt contract with
lenders, TRA escrow agreement with TRA agent, off tech contracts with users and so on.

The distinctive feature of project finance is a web of contractual arrangements designed to

distribute various risks inherent in the project to parties best qualified to appraise and control
them. It represents an efficient way of allocating and managing risks.

Here is an illustration. GVK industry sponsored GVK power. The project company to set up a
power project. GVK Power entered into the following contracts with various parties.

A turnkey execution contract with ABB Switzerland and O&M contract with CMS
Corporation, a power purchase agreement with Andhra Pradesh state electricity board, a loan
agreement with IFC, ADB and Indian financial institutions.

Securitization has been an important financial innovation. Securitization involves packaging a

designated pool of assets, mortgage loans, consumer loans, higher purchase receivables, and
so on. And issuing securities which are collateralized by the underlying assets and their
associated cash flow stream. Securities backed by mortgage loans are referred to as mortgage
backed securities. Securities backed by other assets are called asset based securities.

Securitization involves the following steps. Seasoning - The issuing company identifies the
receivables to be securitized. Credit enhancement - The issuing company may enhance the
creditworthiness of the pool of receivables in some way or the other. Transferred to a special
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
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Strategic Financial Management:
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Professor Prasanna Chandra
Week 3: Financing Decisions

purpose vehicle - the receivables are transferred to a special purpose vehicle. Issuance of
securities - The special purpose vehicle issues securities against the pool of receivables that is
transferred to it. Payment by SPV - The SPV makes payment to the issuing company.

Methods, Markets, Pricing and Timing

Hello learners and welcome back. There are three ways of issuing securities, public issue, rights
issue, private placement. A public issue involves selling securities to general public. A rights
issue involves selling securities to existing shareholders on a preemptive basis. A private
placement involves selling securities to a group of select investors not exceeding 200.

How do the three methods of issuing securities compare? Amount that can be raised is large in
a public issue and moderate in a rights issue and private placement. Cost of issue is high in a
public issue because a public issue in entails a lot of formalities and a great deal of marketing
expenditure.

Cost of issue is negligible in rights issue and private placement. Dilution of control takes place
in a public issue and private placement. There is no dilution of control in a rights issue, because
it is made to existing shareholders on a pro rata basis. Degree of underpricing is large in a
public issue.

In a public issue, investors are always concerned with informational asymmetry and they ask
for some kind of a discount to get interested in subscribing to the issue. Degree of underpricing
is irrelevant in a rights issue and very small in a private placement. Market perception is
negative for a public issue and neutral for a rights issue and private placement was market
perception negative for a public issue.

The market believes that management knows much more about the company and management
is likely to approach the market when the market is buoyant. So, market perception of a public
issue is somewhat negative.

Indian firms can raise funds in three markets. Domestic market, which is regulated by SEBI.
Euro market, also called as offshore market or international market, is a market which lies
outside the regulatory purview of national regulators. Foreign domestic market is the domestic
market in countries such as US, UK and Japan. Let us look at how these three markets compare
in terms of several factors.

Access - Access to the domestic capital market is relatively easy. Access to the Euro market is
somewhat restricted. Access to the foreign domestic markets such as the U.S. market is highly
restricted because they impose a lot of onerous conditions on companies.

Market size - Domestic capital market is relatively small. Euro market or international market
is very large. Foreign domestic market in countries such as U. S., U. K., and Japan is very large.

Cost of issue is rather high in the domestic capital market. Cost of issue is low in the Euro
market. Cost of issue is low in the foreign domestic market.

Disclosure and transparency - Disclosure and transparency requirements are relatively less
onerous in India, more onerous in the Euro market, even more onerous in the markets of
developed countries such as the US and UK.

Prices or rates - Domestic market may not offer such attractive prices or rates. Euro market
offers more attractive prices or rates. Foreign domestic markets of developed countries offer
even more attractive prices or rates.

Indian firms can raise foreign currency finance in various ways. Foreign currency term loans
from financial institutions, export credit schemes, external commercial borrowings, euro
issues, issues in foreign domestic markets.

As far as pricing and timing concern, three guidelines seem to be relevant.

1. Decouple financing and investment decisions. Smart moves on financing and

investment side of the business often do not synchronize. So when conditions in the
financial markets are favorable, it may be advisable to raise money and wait till good
opportunities arise for organic investment or inorganic investment.

2. Never be greedy. If the conditions in the capital market are favourable, companies may
have an inclination to wait a little longer so that they can raise money when the market
touches its zenith. This may be like chasing a chimera.When conditions are favorable,
raise money.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
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Strategic Financial Management:
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Professor Prasanna Chandra
Week 3: Financing Decisions

3. Ensure inter-generational Equity. There is a tendency on the part of some companies to

price their shares very aggressively when the market is buoyant. They overprice their
share. When they do so, they hurt new investors and benefit existing investors.
Sometimes companies may underprice their security. When they do so, they benefit
new investors at the expense of existing investors. As far as possible, the firm should
try to ensure inter-generational equity. Firms which follow a policy of interg-
enerational equity have loyal investors who remain with the firm for a very long time.

Features of Euro currency loans. A euro currency is simply a deposit of currency in a bank
outside the country of the currency. For example, a euro dollar is a dollar deposit in a bank
outside the US. The main features of euro currency loans, which represent the principal form
of external commercial borrowings are syndication. These loans are provided by a group of
lenders, floating rate, the loans carry a floating rate of interest. Interest period is usually three
months, six months, or 12 months.

Currency option, the borrower has the option of designating the currency. Repayment and
prepayment, the borrower can repay the loan as per the original terms of contract or prepay the
loan according to the borrower's convenience.

Euro issues - Euro issues are issues of bonds and equities in the euro market. The principal
mechanisms used by Indian companies are Depository Receipts mechanism and Euro
Convertible Issues. The former represents indirect equity investment while the latter is debt
with an option to convert it into equity.

Issues in foreign domestic markets. Indian firms can also issue bonds and equities in the
domestic capital market of a foreign country. Reliance Industries Limited, for example, issued
bonds in the U. S. domestic capital market. Such bonds are called Yankee Bonds. Infosys, for
example, tapped the U. S. equity market by issuing American Depository shares.

It is instructive to look at the triggers for some of the major financial innovations. Euro bonds
were stimulated by a 30 percent withholding tag on interest payment on bonds in the U. S. Zero
coupon bonds were a response to a mistake committed by the Internal Revenue Service in the

U. S. They allowed interest on simple interest principle rather than this compound interest
principle.

For example, if a company issued a zero coupon bond for 100 $ and the bond had a face value
of 200 Sand a maturity of seven years, it meant that the compound interest rate on the bond
was 10%. So, effectively the interest for year one would be 10 percent of 100 $, the amount
collected by the firm.

The IRS, however, allowed the company to claim a reduction of 14 $ because they said 200$
is the maturity value, 100 $ is issuance price, seven years is the maturity period. This stimulated
a lot of companies to issue zero coupon bonds because they could claim greater tax benefit in
terms of present value of tax benefits.

Financial futures emerged when the Bretton Woods system of fixed exchange rate was
abandoned. Paper currency, a major financial innovation, was invented by ingenious
Americans when the British government imposed a prohibition on colonial North America
from minting coins.

Eurodollar market was a response to regulation Q in the U.S. which imposed ceiling on interest
rate on time deposits. Financial swaps, a major financial innovation, emerged when the British
government imposed restriction on dollar financing by British firms and sterling financing by
non British firms.

The innovations that we have discussed were a response to taxes and regulations. Here is a
memorable quote attributed to Merton Miller, a Nobel laureate in economics. “Taxes and
regulations are the grains of sand that spur the oyster to produce the pearls of financial
innovation.”

Financing Guidelines and Financing Strategies

Hello learners, and welcome back. The key financing guidelines are:

1. Maintain flexibility - A firm must maintain sufficient reserve borrowing power to meet
uncertainties and contingencies.

2. Contain total risk - If the degree of operating leverage is high, the firm should not have
a high degree of financial leverage. Otherwise, the degree of total leverage may become
unmanageable.

3. Enhance return on equity - By judiciously employing debt, a firm can enhance return
on equity.

4. Minimize dilution of control - Managements are often interested in ensuring that control
is not diluted.

5. Finance proactively - Smart moves on financing and investment side do not

synchronize. S,o a firm should finance proactively, not reactively.

Often these considerations are somewhat conflicting. So, a firm has to take a balanced view of
various factors in hammering out its financing strategy. There seems to be a pecking order of
financing which goes as follows: Internal finance, debt finance, external equity finance.

Firms first rely on internal finance which is available by way of retained earnings. This is
internally available. The firm doesn't have to negotiate with external suppliers of capital. The
firm does not have to offer any explanation. It is a very convenient form of finance for the firm
taps first.

After tapping internal finance, if it requires additional funds it relies primarily on debt finance
because often there is a disinclination to raise external equity and dilute the control that is
exercised by the present promoter after it has used its debt capacity to the extent it considers
reasonable, it looks at external equity finance.
© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
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Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 3: Financing Decisions

Given the pecking order financing, there is no well defined targeted equity ratio as there are
two kinds of equity, internal and external. While the internal equity is at the top of the pecking
order, the external equity is at the bottom. The sources of financing over the life cycle of the
firm are shown here.

Startup stage, savings, friends and relatives, angel investors, venture capital, growth stage 1,
private sale of shares, local banks, private equity, asset based loans or leases, growth stage 2,
initial public offer, money center banks and or finance companies, asset based loans or leases.
maturity stage, commercial paper, bond issues, follow on share issues, money center banks and
finance companies, asset based loans or leases.

Let us look at the financing strategy of Reliance Industries and Tata Steel. Reliance has been
very successful in its financing strategy. I have written a short case on its financing strategy.
Here is the gist of the case. Think big. Right from the beginning, Dhirubhai Ambani thought
of world class plants and facilities.

When Reliance was setting up a grassroots refinery in Jamnagar, the initial project size was six
million. As the formulation progressed, the project size was raised to 12, 15, 18, 24, and finally
33. They set up the largest grassroot refinery in the world. I say, look at this surname, Ambani.
Ambani is a combination of ambition plus money.

They have unlimited ambition for raising money for mega projects. Dedicate a team to treasury
management. When they realize the importance of treasury management, they brought Alok
Agarwal from Bank of America and created an internal treasury group, which developed a very
steady relationship with its merchant bankers.

They instituted a very innovative practice of preparing the offer document on a weekly basis.
Normally when a company goes to capital market it takes several weeks or months to prepare
the offer document because companies make infrequent trips to capital market. Reliance
realized that conditions in capital market are dynamic so it must be in a state of perennial
readiness, so it has to be set up a practice where the offer document is prepared or updated on
a weekly basis.

This has enabled Reliance to tap opportunities in the capital market domestically and
internationally. No wonder it has been the first to raise money by way of a GDR issue, by way
of a euro convertible bond issue, by way of Yankee bonds. In the U. S. capital market they
issued bonds which are called Yankee bonds.

Initially, they issued bonds which had a maturity of 10 years, then, they issued bonds which
had a maturity of 25 years, then they finally issued bonds which had a maturity of 100 years.
The first company from the Asia Pacific region to raise Yankee bonds which had a maturity of
100 years. They de linked financing and investing.

They realized that smart moves on financing and investment side do not synchronize. So they
began financing proactively. They always thought in international terms and they used dollar
as currency for internal communication and dialogue. Ensure that primary market investors
earn. Dhirubhai Ambani realized in late 70s that he had to cultivate, the loyalty of small
investors.

So, he gave an assurance of some kind to investors that. If they subscribe to the primary issues
of Reliance, they would not have cause for regret. Even Mukesh Ambani has been able to give
an informal assurance of that kind. At some point of time when Reliance realized that
institutional investors had become important, they started to a regular communication dialogue
with institutional investors and today they have a number of institutional investors who have
great faith in the company, deepen the market for its debt in order to ensure that the market for
its debt instrument was deepened. They made sure in many cases that additional issues were
almost identical to existing issues.

De leveraged in a timely manner, Reliance raised substantial sums of money for its retail
venture and telecom venture, and its balance sheet was considered by many to be over
leveraged, assuaging the concern of investors. Reliance started it's deleveraging exercise in a
timely manner and effected a very successful deleveraging process in 2020.

As a result, Reliance has become a zero net debt company, a great achievement for a company
of its size and complexity. Here are some glimpses of the financing prowess of Reliance.

Reliance was the first company in history to be accorded better than sovereign ratings. In
January 2013, Reliance issued 800 million dollars senior perpetual notes with the company
having the option to redeem them from time to time.

This landmark deal represents the first ever U. S. dollar senior fixed for life non deferable
perpetual issuance out of Asia and the lowest coupon achieved for a US dollar senior perpetual
issuance globally to date. By 31-03-2013 Reliance had total debt of 13. 3 billion dollars over
91 percent being denominated in foreign currencies.

It had cash and cash equivalents of 15.3 billion dollars. Its gross debt equity ratio was 0.4 and
its net debt equity ratio was zero. Reliance built relationship with more than 100 banks and
financial institutions. It received a credit rating from Moody's which was above India's
Sovereign Credit Rating.

Subsequently, Reliance raised a lot of money for its JIO venture and retail venture. There was
a concern about excessive leverage. To alleviate the concern, Reliance resorted to the largest
ever rights issue in India and the largest private placement. As a result, its net debt is now again
zero.

Alok Agarwal, CFO, Reliance Industries Limited says financing decisions are guided by
factors like market capitalization, earnings per share, return on equity, debt equity ratio, and
interest cover.

Tata Steel, too, has raised substantial sums of money in India and abroad for its acquisitions
and greenfield investments. In its financing strategy, Tata Steel endeavours to raise cost
efficient funds for the growth plans the company, be an investment grade company in the long
term. Provide financial flexibility in the balance sheet, focus on EPS accretion, comply with
the expectations of various lenders in terms of financial covenants.

Distribution Policy – I

Hello, learners, and welcome back. What should be the distribution policy of the firm?
According to the traditional view, a firm must be very generous in dividend payment because
shareholders value a rupee of dividends more than a rupee of retained earnings. This argument
has been challenged by Franco Modigliani and Merton Miller in their seminal Contribution
1961. They argued that the dividend policy of a firm did not matter. Their view is captured in
this diagram.

According to them, when a firm gives dividends, shareholders enjoy current income. And when
a firm retains earnings, shareholders enjoy capital appreciation because retained earnings
augment net worth and enhance earning power, irrespective of how earnings are split between
dividends and retained earnings.

Package of current income and capital appreciation has the same value. Franco Modigliani got
Nobel Prize in economics in 1985. Subsequently, I had the good fortune of interviewing him
at MIT and I asked him, how did he arrive at this argument? He said, this is a very simple and
straightforward application of a fundamental intuition from macroeconomics.

He was essentially a macroeconomist. Merton Miller also got a Nobel Prize in Economics.
Franco Modigliani and Merton Miller are regarded as founding fathers of modern corporate
finance. The Modigliani and Miller hypothesis is based on a number of assumptions:

1. investors are indifferent between dividends and capital gains.

2. there is no informational asymmetry between investors and managers.

3. there are no agency costs, managers are rational and they promote the interest of
shareholders. Investment and dividend decisions are independent.

4. there are no taxes.

5. there are no flotation costs.

Obviously these are very restrictive assumptions. In the real world, they are not satisfied. So,
in the real world, it seems that dividend policy matters. There are several imperfections in the
real world which seem to suggest that dividend policy matters.

1. Investors often have a preference for dividends over capital gain.

2. There may be informational asymmetry. Managers know much more about the prospects of
the firm than investors know.

3. Agency costs exist. Managers may not serve the interests of investors.

4. Taxes exist. There are taxes on dividends. There are taxes on capital gain. And these tax
rates may be different.

5. Flotation costs are incurred by firms when they go to raise finances.

The dividend payout policy of a firm depends largely on the market imperfections and the
firm's position in its life cycle. If we ignore taxes, the major imperfections are flotation costs,
agency costs, and informational asymmetry. As far as, the stage of a firm in its life cycle is
concerned, the firm may be in infancy stage, rapid growth stage, maturity stage, and decline
stage.

When a firm is in infancy stage, flotation costs are very high, agency costs are low,
informational asymmetry is very high. The implied dividend policy is NIL or negligible
dividends.

In a rapid growth stage, flotation costs are moderate. Agency costs are moderate informational
asymmetries. Moderate implied dividend policies, low dividend payout policy

In the maturity stage, flotation costs are low. Agency costs a high informational asymmetries
following the implied dividend policies, increasing dividend payout.

In the decline stage, flotation costs are low. Agency costs are very high informational,
asymmetry low. The implied dividend policies, generous dividend payout.

A conference board survey in the US revealed that five considerations or guidelines influence
dividend policy.

1. the company's earnings record in its future prospects.

2. the company's record of continuity or regularity of dividend payment.

3. the need to maintain a stable rate of dividends per share.

4. the company's cash flow, present cash position, and the anticipated need for funds.

5. the needs and expectations of the investors of the common stock.

John Lintner of Harvard university surveyed corporate dividend behavior, and he found that

1. Firm set long run target payout ratios.

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

3. Dividends tend to follow earnings but have a smoother path.

4. Dividends are sticky in nature.

Lintner expressed corporate dividend behavior in the form of the following model.

Dt is equal to cr EPSt plus 1 minus t dt minus 1; where Dt is dividend per share for year t, c is
adjustment rate, r is target payout rate, EPSt is earnings per share for year t. And Dt minus 1 is
dividend per share for year t minus 1.

Essentially, dividend per share for a year is a weighted function of EPS of that year and
dividend per share for the previous year. The weights assigned are cr here and 1 c here. c is an
adjustment rate and r is a target payout rate. Here is a numerical example.

For Kinematic Limited has earnings per share of Rs. 4 for year T. Its dividend per share for
year T minus 1 was Rs. 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 Kinematic
Limited for year T? If the Lintner Model F star applies to it.

According to the Lintner's model, kinematics dividend per share for year t would be 0.5 into 0.
6 multiplied by rupees 4 plus 0.5 multiplied by rupees 1.5. It is Rupees 1. 95.

The key considerations in formulating the dividend policy are:

1. investment decisions have the greatest impact on value creation.

2. external equity is more expensive than internal equity.

3. most promoters are averse to dilute their stake.

4. there is a limit to debt financing.

5. dividend decision has a signaling value.

I have participated in the dividend decision in several companies over time. These are the
guidelines that have served me well.

1. Don't pay dividends at the expense of positive NPV projects. Positive NPV projects enhance
the value of the firm, so dividends should not be paid at the expense of positive NPV projects.

2. Minimize the need to sell external equity. External equity is more expensive than internal
equity. and external equity entails dilution of control. So minimize the need to sell external
equity.

3. Define a target plowback ratio and a target dividend payout ratio along with a target debt
equity ratio. The target plowback ratio and target dividend payout ratio are complementary.
The target plowback ratio is 0.7. Target dividend payout ratio would be 0.3. The plowback
ratio may be established in this manner: growth rate of the firm divided by return on equity if
the growth rate in revenues and assets is 12 percent and return on equity is 15 percent, then the
plowback ratio would be 0.8 which means the payout ratio would be 0. 2.

4. Accept temporary departures from the targets.

5. Avoid dividend cuts. Dividends have a very important signaling value. A dividend cut is
perceived very negatively. Unless the circumstances are very extenuating, dividend cuts should
be avoided.

6. Issue bonus shares periodically.

I have a simple rule of thumb. A firm must issue bonus shares in the ratio 1 to 1 when the
reserves and surplus are four times the paid up capital.

Distribution Policy – II

Hello learners, and welcome back. A bonus issue represents capitalization of free reserves built
out of the genuine profits or share premium collected in cash only. In the wake of a bonus issue,
the shareholder's proportional ownership remains unchanged, the book value per share, the
earnings per share, and the market price per share decrease, but the number of shares increases.

What are the accounting effects of a bonus issue? The effects of a bonus issue on the equity
portion of the balance sheet is shown here. Part A shows equity portion before bonus issue.
Paid up capital is 10 million. Reserves and surplus are 30 million. Paid up capital consists of 1
million shares of rupees 10 Each fully paid up.

The company decides to give a bonus issue with the ratio 1 to 1, so the Equity portion after a
bonus issue of one to one looks like this paid up share capital increases from 10 million to 20
million because number of equity shares now increases from 1 million to 2 million. Reserves
and surplus decline from 30 million to 20 million. Essentially a portion of reserves and
surpluses capitalized.

Most of the companies in India have effected stock splits. In a stock split, the par value per
share is reduced and the number of shares is increased proportionately. The effects of a stock
split on the equity portion of the balance sheet are shown here.

Equity portion before stock split: paid up share capital 5,500,000. Thousand shares of rupees
10 each fully paid up, reserves and surplus are rupees 10 million. The firm thus a stock split in
the ratio 5 to 1, which means one share of 10 rupees each fully paid, will be converted into 5
shares of rupees 2 each fully paid.

As a result, the equity portion after the stock split in the ratio 5 to 1 looks like this. Paid up
share capital remains at 5 million. But the number of shares goes up from 500,000 to 2.5
million. The paid up value per share decreases from rupees 10 to rupees 2. Reserves and surplus
remain at 10 million.

Here is a summary comparison of a bonus issue and a stock split. The par value of the share is
unchanged. The par value of the share is reduced. A part of reserves is capitalized. There is no
capitalization of reserves. The shareholders proportional ownership remains unchanged. The
shareholders proportional ownership remains unchanged.

The book value per share, the earnings per share, and the market price per share decline. The
book value per share, the earnings per share, and the market price per share decline. The market
price per share is brought within the popular trading range. The market price per share is
brought within a more popular trading range.

In addition to or in lieu of dividends, a firm may do a share buyback. It represents another

modality of distribution. Share buybacks, referred to as equity repurchases or stock repurchase
in the U. S., have become possible in India since 1998. Over a period of time, they have gained
in popularity. Firms like TCS and Infosys have done several share buybacks.

In India, corporates can choose two methods of share buyback, open market purchase method
or the tender method. Under the open market purchase method, the company announces it's
decision to buy shares in the open market they stipulate the maximum price at which they will
buy shares. They also announce the number of shares that they are willing to buy from the open
market.

Under the tender method, the company fixes a price and then sends a letter to all its shareholders
saying that it is willing to buy up to a certain number of shares at the predetermined price. For
example, a company may send a letter to a shareholder saying that the company wants to buy
100 million shares directly from them at a price of rupees 400 per share. If more shares are
tendered by shareholders, then the company will accept shares on a pro rata basis.

There are five common reasons for choosing buybacks over dividends. Undervaluation - if the
shares of a firm are undervalued it makes sense to buy back the shares rather than pay
dividends. Taxes - Often buybacks are more tax friendly for investors. Flexibility - buybacks
provide management greater flexibility in distribution compared to dividend payment because
when a firm pays dividends there is an expectation on the part of investors that dividends would

be continued in future. Stock options - when a firm has issued stock options which lead to
equity dilution, buybacks counter potential equity dilution. Enhancing promoter's stake - When
promoters don't participate in a buyback, their equity stake in the firm is enhanced after the
buyback.

Buybacks in India are subject to several regulations.

1. a company can buy back 10 percent of its shares annually with a board resolution. Beyond
that, a special resolution of shareholders is required, which means 75 percent of shareholders
by value have to vote in favor of the buyback.

2. The post buyback debt equity ratio should not exceed 2 to 1.

3. The buyback should not exceed 25 percent of the total paid up capital and free reserves.

4. After completing a buyback program, a company should not make a further issue of equity
share within a period of six months, except in certain permitted cases.

5. The buyback process has to be handled by a qualified investment banker duly appointed by
the company.

The key guidelines that emerge from our discussion are as follows:

1. Monitor developments - Capital market conditions are dynamic. So, a firm should monitor
the developments in the capital market both domestic capital market and international capital
market. And benefit from opportunities that arise from time to time

2. Follow the FRICT principle - FRICT is an acronym that stands for Flexibility, Risk, Income,
Control, and Taxes. Of course, these considerations can be conflicting and a firm should take
a balanced view.

3. Match operating cash flows to debt cash flows - The firm must design its debt instruments
in such a way that the debt servicing burden is matched with the operating cash flows of the
firm.

4. Design innovative instruments - After the enactment of SEBI, firms have freedom in
designing instruments and pricing instruments. Many firms have used this flexibility to design
innovative instruments.

5. Set target payout ratio judiciously - A firm must set the target payout ratio in such a manner
that retained earnings are adequate to meet the equity requirement of the firm. Internal equity
is cheaper than external equity. Internal equity does not entail dilution of control. So the
plowback ratio and the payout ratio had to be judiciously worked out.

6. Return money to shareholders when the firm does not have worthwhile projects - If the firm
does not have positive NPV projects, it should return money to shareholders. When a company
has a lot of surplus money, there is a tendency on the part of management to squander money
on uneconomic projects. Management may pursue their pet projects to preside over a big
empire. Such a tendency has to be curbed.

Financing Decisions – Module Summary

Hello, learners, and welcome back. Let us sum up our discussion. Financing decisions are
relatively easier compared to investment decisions. Several tools are available for developing
an effective capital structure.

Earnings before interest and tax, earnings per share analysis, return on equity, return on
invested capital analysis, return on equity, return on investment analysis, analysis of leverages,
ratio analysis.

EPS is equal to EBIT minus interest multiplied by 1 minus tax rate the whole divided by
number of outstanding shares.

Return on equity is equal to return on invested capital plus return on invested capital minus pre
tax cost of debt multiplied by 1 minus tax rate the whole multiplied by debt equity ratio.

Return on equity is equal to return on investment plus the difference between return on
investment and pre tax cost of debt, the whole multiplied by debt equity ratio. The entire thing
multiplied by one minus tax rate.

Degree of operating leverage is equal to contribution divided by profit before interest and tax.

Degree of financial leverage is profit before interest and tax divided by profit before tax.

Degree of total leverage is contribution divided by profit before tax.

The key financing guidelines applicable to Financial structure are the Frick principle. There is
a pecking order of financing.

There are three markets in which securities can be issued domestic market euro market or
offshore market and foreign domestic market.

Dividend decisions have an important signaling value A bonus issue involves capitalization of
free reserves.

In a stock split, par value per share is reduced and number of shares is increased
proportionately.

A share buyback involves repurchase of shares by a company. In India, companies choose

either the open market purchase method or the tender method.

Thank you.

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course on Swayam. No part of this document, including any
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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)
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 1: Strategic Financial Management:
Managing for Shareholder Value

PRACTICE QUESTIONS

Week 3

FINANCING DECISIONS

DP - 1A company’s present capital structure consists of 20,000,000 shares of equity stock. It

requires
100,000,000 of external financing for which it is considering three alternatives .
Alternative A - Issue 5,000,000 equity shares of 10 par at 20 each
Alternative B - Issue 3,000,000 equity shares of 10 par at 20 each and 4,000,000 preference
shares of 10 par carrying 11 percent dividend
Alternative C - Issue 1,000,000 equity shares of 10 par at 20 each and Rs.80 million of
debentures carrying 14 percent interest rate.
The company’s tax rate is 40 percent.

a) What is the EPS – PBIT equation for the three alternative?

b) What is the EPS – PBIT indifference point for alternatives A & B?

DP – 2. Vintex Limited has a target ROE of 20 percent. The debt – equity ratio of the firm is
1.2 and its pre tax cost of debt is 12 percent. What ROI should the company plan to earn if its
tax rate is 30 percent?

DP – 3. Ram Company sells a product for 800 per unit. The variable cost is 400 per unit.
Fixed operating costs (F) are 2,000,000. Fixed interest costs (I) is 300,000. What is the degree
of operating leverage (DOL), degree of financial leverage (DFL), and the degree of total
leverage (DTL), at quantity (Q) which is 6,000.

PP-1. Nanda Enterprises has a target ROE of 18 percent. The financial leverage ratio for the
firm is 0.7 and its tax rate is 50 percent. What ROI should the company plan to earn? The
cost of debt is 12 percent.

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course format on Swayam. No part of this document, including
any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Strategic Financial Management:
Managing for Shareholder Value
Professor Prasanna Chandra
Week 1: Strategic Financial Management:
Managing for Shareholder Value

Answer:

DP -1 –
(a)
A: EPS = [(PBIT – 0) (1 – .4)]/25,000,000
B: EPS = [(PBIT – 0) (1 – .4) – 4,400,000]/23,000,000
C: EPS = [(PBIT – 11,200,000) (1 – .4)]/21,000,000

(b) 91,666,667

DP 2. 19.53% ,

DP 3 – DOL = 6.0, DFL = 4, DTL = 24

PP 1- 24.47%

© All Rights Reserved. This document has been authored by Prof Prasanna Chandra and is permitted for use only within the course "Strategic
Financial Management: Managing for Shareholder Value " delivered in the online course format on Swayam. No part of this document, including
any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.

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