MAHATMA
GANDHI UNIVERSITY KOTTAYAM
MBA-SECOND
SEMESTER
Course
No CC09 -FINANCIAL
MANAGEMENT
(Internal Evaluation Marks 40 External Evaluation Marks 60 Total Marks 100)
Module I
Financial Management - Scope -
Role of Financial Management in Business-Time value of money-Risk and Return-
Risk diversification.
Module II
Long-term investment decisions –
Capital budgeting, Different techniques –Traditional and modern methods (DCF
method) – Capital Rationing – Risk Analysis in Capital budgeting – An overview
of Cost of Capital.
Module III
Financing decisions – Operating,
Financial and combined leverage – Capital Structure – Meaning and importance-
Theories of capital structure – Net income, Net operating income and MM
approach (Hypothesis).
Module IV
Dividend decisions – Dividend
policy (Walter Gordon and MM approach) – Types of Dividend- Legal and
Procedural aspects of payment of Dividend.
Module V
An overview of Working Capital
Management – Inventory, Cash and Receivable
management and Management of
surplus – Working Capital Financing and Long term Financing, Current
Liabilities Management – size and sources- Money Market – Banks – Regulation of
Working Capital Finance in India.
References
1. Van Horne James, Financial
Management Policy, Prentice Hall India
2. I M Panday, Financial
Management, Vikas Publications, New Delhi.
3. Prasanna Chandra, Financial
Management, Tata Mc Graw Hill, New Delhi.
4. Khan M Y& Jain P K, Financial
Management, Tata Mc Graw Hill, New Delhi.
5. Lawerence J Gitman, Principles
of Managerial Finance, Pearson Education
limited. New Delhi.
6. James C Vanhorne, John M
Wachowicz Jr, Fundamentals of Financial
Management, Pearson
Education Limited, New Delhi.
LEVERAGES
The term leverage is used to describe the
firm’s ability to use fixed cost assets or funds to magnify the returns to its
owner. James horn has defined leverage as the employment of an asset or funds
for which the firm pays a fixed cost or fixed return. Thus according to
him leverage results as a result of the firms employing an asset or source of
funds, which has a fixed cost or return. The former may be termed as fixed
operating cost, while later may be termed as fixed financial cost. It should be
noted that fixed cost or return is the fulcrum of leverage. If a
firm is not required to pay fixed cost or fixed return there will be no
leverage. The fixed cost and fixed return remains constant irrespective
of the changes in volume of out put or sales. Thus the employment of an asset
or source of funds for which the firm has to pay a fixed cost or return has a
considerable influence on the earnings available of equity shareholders. The
fixed cost or return acts as the fulcrum and the leverage magnifies the
influence. It must however be noted that higher is the degree of leverage higher
is the risk and higher the return to the owners.
Types of
Leverage
1.Operating
leverage
2.Financial
leverage and
3.Composite
leverage.
Operating Leverage
The operating leverage may be defined as the firm’s ability to use
fixed operating cost to magnify the effects of changes in sales on its earning
before interest and taxes (EBIT). It means that the extend to which the
fixed costs are used in the activity of a firm. When fixed cost items like
rent, salary, depreciation etc. are employed to magnify earnings it is called
the use of operating leverage. The firm is said to have a high degree of
operating leverage, if it employs a greater amount of fixed cost and small
amount of variable cost. On the other hand a firm will have a low
operating leverage when it employs a great amount of variable cost and smaller
amount of fixed cost. Thus the degree of fixed element in the cost structure,
operating leverage in a firm is a function of three factors.
1.
The amount of fixed cost.
2.
The contribution and
3.
The volume of sales.
Of course there will be no
operating leverage if there are no fixed operating costs.
Favorable and un favorable operating
leverage.
Operating leverage may be favorable or
unfavorable. In case the contribution (Sales –Variable Cost) exceeds the fixed
cost; there is favorable operating leverage. In a reverse case the operating
leverage will be termed as unfavorable.
Computation
Degree of
operating leverage (DOL) = Contribution / Operating profit
Contribution = Sales – Variable
cost OR
Contribution = Earning Before
Interest and Tax (EBIT) + Fixed Cost
Operating profit means Earning
Before Interest and Tax (EBIT) OR
Operating profit = Sales –
Variable Cost – Fixed Cost OR
Operating profit =
Contribution – Fixed Cost
Degree of
operating leverage (DOL) = % change in profit
%
change in sales
The
degree of operating leverage may be defined as percentage change in the profit
resulting from a percentage change in the sales that is degree of operating
leverage.
Financial Break Even
Point = Fixed Cost / P/V ratio
P/V ratio = Contribution
/ Sales
Margin of Safety = Operating
profit / Contribution
Utility
The operating
leverage indicates the impact of change in sales on operating income. If a firm
has a high degree of operating leverage, a small change in sales will have a
large effect on operating profit. In other words the operating profit of such a
firm will increase at a faster than the increase in sales. Similarly the
operating profit of such a firm will suffer a greater loss as compared to
reduction in sales.
Generally the
firms’ do not like to operate under condition of a high degree of operating
leverage, this is a very risky situation where a small drop in sales can be
excessively damaging to the firms effort to achieve profitability.
Financial Leverage or Trading on equity
The
use of the fixed charge sources of funds, debentures and preference capital
along with the owner’s equity in the capital structure is described as
financial leverage or gearing or trading on equity. The use of the term
trading on equity is derived from the fact that it is the owner’s equity that
is used as a basis to raise debt, i.e. the equity that is traded up on. Financial leverage is concerned with the
effect of changes in EBIT on the earnings available to the equity shareholders.
Financial
leverage is defined as “the ability of a firm to use fixed financial cost to
magnify the effect of changes in EBIT on the earnings per share (EPS).”
In other words financial leverage involves the use of funds obtained at a fixed
cost in the hope of increasing the return to the shareholders. Financial leverage helps to increase the
ordinary shareholders earnings without increasing their investment in the
company. This is possible if the company earns more than there fixed
cost. Consequently the EPS or the rate of return on equity increases.
Favorable and un favorable financial
leverage.
Financial
leverage may be favorable or unfavorable when the EPS increases due to the use
of debt in the capital structure it is called +ve or favorable financial
leverage. Unfavorable or –ve financial leverage occurs when the EPS decreases
because of the use of debt in the capital structure.
Significance of financial leverage
Financial
leverage is employed to plan the ratio between debt and equity so that EPS is
improved. Following are the significance of financial leverage.
1
Planning of capital structure
The capital structure is concerned with the
raising of long-term funds both from shareholders and long-term creditors. A
financial manager has to decide about the ratio between fixed capital funds and
equity share capital. The effects of borrowing on the cost of capital and
financial risk have to be discussed before selecting a financial capital
structure.
2. Profit planning
The
EPS is affected by the degree of financial leverage. If the profitability of
the concern is increasing, then fixed cost funds which help in increasing the
availability of profit for equity shareholders. There fore financial leverage
is important for profit planning.
Limitations of financial leverage or
Trading on equity
Following are the important
limitations:
1.Double
edged weapon
Trading on equity is double-edged
weapon. It can be successfully employed to increase the earning of the
shareholders only when the rate of earnings of the company is more than fixed
rate of interest in long-term borrowings. On the other hand it does note earn
as much as the cost of interest on long term borrowings, then it will work
adversely and hence cannot be employed.
2.Beneficial
only to company having stability of earnings
Financial leverage is beneficial
only to the companies having regular and stable earnings. This is so because
interest on long-term debt is a recurring burden on the company and a company
having irregular income cannot pay interest on its borrowings during lean
years.
3.Increase
risk and rate of interest.
Another limitation of
financial leverage is on account of the fact that every rupee of extra debt increases
the risk and hence the rate of interest on subsequent loans also goes on
increasing. It becomes difficult for the company to obtain further debts
without offering extra securities and higher rate of interest reducing their
earnings.
4. Restrictions from financial institutions.
The
financial institutions also impose restrictions on companies, which resort to
excessive trading on equity because of the risk factor and to maintain a
balance in the capital structure of the company.
Measures of Financial
Leverage
Financial Leverage measures
the degree of the use of debt and other fixed cost source of fund to finance
the assets, the firm has acquired. The use of debt has a magnifying effect on
the EPS. It can be said that the higher the proportion of debt in the capital
structure the higher is the Financial Leverage and
vice versa. Broadly speaking Financial Leverage can
be measured in two ways;
1. Stock terms 2. Flow terms.
1.Stock
terms
a. A
simple ratio of debt to equity or
b.
By the ratio of long-term debt + preference share to total capitalization.
Each of these measures indicates the
relative proportions of the fund to the total funds of the firm on which it is to pay fixed Financial Leverage.
2.Flow
terms
The Financial Leverage can be measured either by
a. The ratio of EBIT to
interest payment or
b. The ratio of cash
flows to interest payments popularly called the debt service capacity or coverage. These coverage ratios are
useful to the suppliers of the funds as they assess the degree of
risk associated with lending to the firm.
In
general higher the stock ratio and lower the flow ratio the grater the risk and
vice versa.
Computation
EBIT - EPS Analysis
The
EBIT – EPS analysis as a method to study the effect of leverage, essentially
involves the comparison of alternative method of financing under various
assumptions of EBIT. A firm has the choice to raise funds for financing
its investment proposal from different sources in different proportions. For
e.g.: it can,
1. Exclusively use of equity
capital.
2. Exclusively use of
preference capital.
3. Exclusively use of
debt.
4. Use a combination of equity
and preference share capital.
5. Combination of equity and
debt.
6. Combination of equity debt
and preference capital in different proportions.
The choice of the combination of
the various sources would be one, which given the level of earnings before
interest and taxes would ensure the largest EPS.
Degree of financial leverage
Degree of Financial Leverage (D F L) = E B I T
E B T
EBIT = Earning before interest and tax
EBT
= Earning before tax but after interest
OR
Degree of financial
leverage (DFL) = %change
in EPS
% change in EBIT
The degree of financial leverage
may be defined as percentage change in the EPS resulting from a percentage
change in the EBIT.
Point of indifference
Equivalency point refers
to that level of EBIT at which EPS remains the same irrespective of debt equity
mix. At this level of EBIT the rate of return on capital employed is
equal to the cost of debt and this is also known as break even level of EBIT
for alternative financial plans.
The indifference point can be determined by using the following
equation;
(X-I1)(1-T1)-PD1 = (X-I2)(1-T2)-PD2
S1 S2
Where,
X = EBIT at the indifference point
N1 = Number or amount of equity shares out standing, if only equity
shares are issued.
N2 =
Number or amount of equity shares out standing, if both equity shares and
debentures are issued or both equity shares and
preference shares are issued or both preference shares and debentures are
issued.
T1 = Corporate income tax of first alternative.
T2 = Corporate income tax of second alternative.
I1 = The amount of interest on debenture of first alternative.
I2 = The amount of interest on debenture of second alternative.
PD1 = The amount of dividend on preference share capital of first
alternative.
PD2 = The amount of dividend on preference share capital of second
alternative.
Composite Leverage
Composite
leverage is the combination of operating and financial leverage. It is also
known as combined leverage. The composite leverage represents the
effect of a given change in the sales revenue on the EPS. It affects the total
risk of the firm. If a company employs a high level of operating and financial
leverage, even a small change in the level of sales will have dramatic effect
on EPS. Both financial and operating leverage magnify the revenue of the firm.
The composite leverage focuses attention on the entire income of the concern.
The management before using the composite leverage should properly assess the
risk factor. To keep the risk within manageable limits, a firm which has high
degree of operating leverage will be advised to have low financial leverage and
vice versa.
Computation
Degree of Composite Leverage (D.C.L)
= Operating Leverage X Financial Leverage
OR
Degree of Composite Leverage (D.C.L) = C X EBIT
EBIT EBT
i.e. = Contribution / Earnings Before Tax
Degree of Composite Leverage (C.L) = % change in EBIT X % change in EPS
% change in sales % change in EBIT
i.e. = % change in EPS
% change in sales
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