LESSON - 1

FINANCIAL GOALS AND STRATEGY

LEARNING OBJECTIVES :
 To make the students understand the financial goals and strategy.
 To know about strategic Financial Management
 Able to prepare Strategic Financial Planning
 To understand the financial goals
 To know about key financial goals
 Able to establish financial goals for business

STRUCTURE :

1.1 Introduction to Strategic Financial Management

1.2 Features of SFM
1.3 Functions of Strategic Financial Management
1.4 Strategic Financial Planning Process
1.5 Advantages of SFM
1.6 Disadvantages of SFM
1.7 Introduction to Financial goals
1.8 Importance of financial goals
1.9 Characteristics of Financial goals
1.10 Financial goals for business
1.11 Examples of financial goals
1.12 Key Financial Goals
1.13 Summary
1.14 Technical Terms
1.15 Self-Assessment Questions
1.16 Suggested Readings

1.1 INTRODUCTION :

The term strategic financial management is a combination of two terms viz. strategy
and finance. Strategy, by definition, implies a long-term perspective. Hence, as explained
above strategic financial management is about the management of the finances of any
company in such a manner that it enables the meeting of the long-term goals. The assumption
here is that the company has a clear idea of what its long-term financial goals are. This is
because, in the absence of such knowledge, it is impossible to make any long-term decisions.

Traditional financial management emphasizes that any project which provides a

positive net present value must be accepted. However, strategic financial management has a
different opinion in this case. Strategic financial management realizes that many projects can
have a positive net present value. However, the company may not have the capital to go
through with all the projects. Hence, some projects may need to be prioritized over others. In
such cases, simply prioritizing the projects with the maximum net present value may not be
feasible. This is where strategic financial management comes into play. It helps companies
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select the most optimal projects, which will give them the maximum probability of meeting
their long-term objective.

That strategic financial management helps companies identify projects which may
appear to be sub-optimal in the short run but may actually be the most optimal in the long
run. It changes the lens through which the company views its operations as well as its
finances.

1.2 FEATURES OF STRATEGIC FINANCIAL MANAGEMENT :

1. It focuses on long-term fund management, taking into account the strategic
perspective.
2. It promotes profitability, growth, and presence of the firm over the long term and
strives to maximize the shareholders’ wealth.
3. It can be flexible and structured, as well.
4. It is a continuously evolving process, adapting and revising strategies to achieve the
organization’s financial goals.
5. It includes a multidimensional and innovative approach for solving business
problems.
6. It helps develop applicable strategies and supervise the action plans to be consistent
with the business objectives.
7. It analyzes factual information using analytical financial methods with quantitative
and qualitative reasoning.
8. It utilizes economic and financial resources and focuses on the outcomes of the
developed strategies.
9. It offers solutions by analyzing the problems in the business environment.
10. It helps the financial managers to make decisions related to investments in the assets
and the financing of such assets.

1.3 FUNCTIONS OF STRATEGIC FINANCIAL MANAGEMENT :

Strategic financial management encompasses the entire spectrum of financial

activities performed by any organization. Some of the key decisions which are enabled by
strategic financial management have been mentioned below.

Decisions Regarding Capital Investments : The point of view of strategic financial

management makes organizations view their capital investment decisions in a new light. For
example, the recent 15-20 years have seen the emergence of asset-light businesses.

For instance, Uber, Airbnb, Facebook are all leaders in their own industries.
However, they own very few assets. Companies that use strategic financial management to
make decisions about their long-term assets would have noticed this trend earlier than other
companies. Hence, they would have invested in making long-term commitments towards
illiquid assets which may end up providing a sub-optimal return in the long run.

It is strategic financial management that sensitizes the organization about the

effectiveness of its decision when a broader time frame is considered. It is no coincidence
that companies which place a higher emphasis on strategic financial management have
invested heavily in the digitization of their business even though it might be eating into their
profits in the short run.
Strategic Financial Management 1.3 Financial Goals and Strategy

Decisions Regarding Location :

Companies that take a strategic point of view about their investments also use
different methods to select where they will locate their business.
For example, many American companies have been located in China in the past.
However, if the decision were to be made now, fewer companies would choose to locate in
China. This is because of the continuous tensions and trade wars between the two countries.

This is what makes long-term location in China a riskier proposition than locating in
another country that may be slightly more expensive in the short run but less prone to trade
wars in the future.

Decisions Regarding Mergers and Acquisitions : Strategic financial management helps

companies take a careful look at their business models. It is during this deep dive that
companies often discover whether organic growth is best for them or whether they too can
choose the inorganic way. The guiding principle remains the same.

If the company can absorb the costs of acquiring another company and add value in
the long run, such an acquisition would be justified. However, strategic financial
management ensures that companies keep their long-term goals in mind before taking a
decision regarding an acquisition. The bottom line is that strategic financial management is
not a new technique of modelling financial data for making business decisions. In most cases,
the tools and models used are the same. The change lies in the manner in which these results
are interpreted. The long-term point of view changes how appealing each option looks and
may influence the one which gets selected.

1.4 THE STRATEGIC FINANCIAL PLANNING PROCESS :

The strategic financial planning process is different in the sense that it combines the
functions of strategy formulation as well as financial planning. For many years, these two
processes have been considered to be separate in most organizations around the world.
Strategic financial planning merges these processes and created a hybrid approach.

In a broad sense, strategy formulation refers to the market in which the company
decides to place itself. This means that the company decides to sell some products and
services and excludes all other products and services. This decision in turn decides the
opportunities that the company has as well as the competition that it is likely to face.

Using strategic financial planning to place a company in a strategically advantageous

position has more benefits than having an ordinary strategic position and then competing.
This long-term view of where the company sees itself a few years from now is kept in mind
while making strategic financial decisions.

1. Scanning the External Environment : The first step in the strategic financial
planning process is scanning the external environment. This simply means that the
organization pays close attention to social, political, demographic, and more
importantly technological changes happening in the environment.
The organization tries to understand what the business environment will look
like in the future. It tries to make an educated guess about the type of competition
they will be facing and what competitive advantage will they have vis-a-vis their
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competitors. This process is done in the due course of strategic management as well.
However, in the strategic financial management process, there is a lot of emphasis on
numbers. Decisions are based on quantifiable information instead of being based on
intuition.
2. Internal Introspection : The second step is for the company to clearly know its
capabilities and shortcomings. The company needs to take a just and unflinching look
at what its competitive advantage is today. The next step is for them to realize that
this competitive advantage will change with the passage of time. A decision has to be
made regarding whether the company should continue on the same course that it is on
today, or whether it should change its strategic priorities and build a new competitive
advantage.
Internal introspection can be challenging for many companies due to the
paucity of relevant data. However, some resources should be spent in acquiring this
data if it aids in the final decision-making. After all, the strategic priorities which the
firm sets as a result of this exercise are likely to continue in the long run and will
shape the financial future of the firm.
3. Clear and Compelling Goals : The process requires the creation of clear and
compelling goals for the organization. In theory, mission and vision statements are
present in every organization. However, in reality, they are often ignored. Also, the
vision statements tend to be vague and can be used to include almost any line of
business. This is done purposely to provide the organization with flexibility.
However, it can work out to be disadvantageous in the long run. Also, these goals are
generally set up at corporate level goal alignment meetings. Hence, the head office is
generally under pressure from various departments to include their goals in the
strategic goals as well.

The end result is a list of goals that dilute the focus of the organization. The
entire process can end up being political if the senior management is not cognizant of
the fact and does not try to steer the company in the right direction.

This is where strategic financial management is different. It clearly advocates

that the organization should limit the number of strategic goals. The emphasis is on
selecting a narrow set of goals and excluding everything else. The logic is that if the
vast resources of the firm are concentrated on a narrow number of goals, then the firm
will gain absolute superiority in such areas. On the other hand, vague and ambiguous
strategic statements can be detrimental to the strategic financial management
objective.
4. Management’s Vision Aligned with the Company’s Vision : In an ideal scenario,
the strategic vision of the management needs to be aligned with the strategic vision of
the board of directors. However, it does not happen in practice in several
organizations. This is the case particularly when a company undergoes a change in
the top leadership. The new management often wants to bring in changes. However, it
is the responsibility of the board of directors to ensure that the vision of the
management stays aligned with the overall vision.

The fact of the matter is that management can change over a period of time.
However, the company will remain for a longer period of time. The management
should adapt to the company’s strategic vision and not vice versa. Even if the new
management wants to bring in changes, they should be deliberated and brought in
through the right channel.
Strategic Financial Management 1.5 Financial Goals and Strategy

There are a few steps in the strategic financial planning process that need to be followed
rigorously. In the short run, they might seem to be unnecessary. However, in the long run,
they provide tremendous clarity and as a result, the company is able to organize its resources
in order to obtain the best possible results.

1.5 ADVANTAGES OF STRATEGIC FINANCIAL MANAGEMENT :

The field of strategic financial management has become increasingly popular in the
past few years. This has been because of the various advantages that accrue to the
practitioners of this philosophy. In this article, we will have a closer look at some of the
important advantages which result from following this philosophy.
a) Aligns The Vision of the Board and the Management: The biggest advantage
of strategic financial management is that it ensures that all the stakeholders are on
the same page. In companies where strategic financial management is not
practiced, it is common for the board of directors to have a different vision for the
future of the company as compared to the management of the firm. Strategic
financial management makes it mandatory for all the parties to spell out their
vision for the future in clear terms. The free cash flow generated by the firm must
then be utilized to meet these commonly agreed-upon strategic goals. Strategic
financial management helps streamline the actions of various stakeholders in the
company. This might seem obvious. However, in reality, companies can be large
and complex and often work in ways that can be counterproductive. This is where
strategic financial management comes in handy.
b) Common Framework: Strategic financial management helps in setting up
common goals. These common goals are then cascaded to lower levels of the
organization. The employees are encouraged to think about achieving strategic
objectives instead of innovating in ad-hoc ways. This common framework guides
the distribution of various resources which are controlled by the organization.
This helps align short-term resource allocation with long-term strategic goals.
c) Guides Innovation and Technology Adoption: In the modern world, companies
are required to make huge investments in technology. Information technology
companies are amongst the biggest and most strategically important partners to
big multinational corporations. Since such a large amount of money is going to be
spent towards building information technology resources, it is imperative that the
resources be built in a strategic manner.
d) This is where strategic finance comes into the picture. The discipline of strategic
finance forces the company to envision itself a couple of decades into the future.
The company is forced to think about the type of technology that they want to
have in order to become a market leader. Investments in information technology
are not considered on a piecemeal basis. Instead, they are considered to be part of
a larger system that will emerge a few years later. David Ogilvy famously said
that advertisements must not be considered to be an expense. Instead, they must
be considered to be an investment towards building the company’s brand in the
long term. The same philosophy can be applied to information technology-related
spending within companies.
e) Strategic finance makes the priorities of the company clear. Once these
priorities are explained to the workforce, they can then use their domain
knowledge in order to bring in rapid innovation.
f) Helps Create Buy-In: Strategic financial management sensitizes the higher
management of the company towards the need to bring in change. Once this has
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been done, the managers and the board of directors become more receptive to
change. This helps create buy-in once new projects are presented. In the absence
of strategic financial management, the board of directors would be more likely to
support the status quo. Strategic financial management sensitizes the management
to the fact that change is inevitable and that it can be pleasant if brought about
voluntarily instead of being forced upon by market realities.
g) Aligns Performance Management Goals: Strategic financial management helps
to align the various departments of the organization. The human resource
department is also included in this exercise. This is because the firm can only
further its strategic objectives if the people are inclined to do so. It is the job of
the human resource department to use funds in order to motivate employees to
achieve the firm’s long-term financial goals. Hence, strategic financial
management also encourages the firm to build a system of performance
management wherein people who help achieve strategic goals are compensated
fairly.
h) Improved Focus on Competitive Landscape: Lastly, the discipline of strategic
financial management makes the company more focused on the competition. In
the absence of strategic financial management, the firm is unlikely to benchmark
its performance with that of its peers. The focus on competitive strategy and the
continuous scanning of the corporate environment makes firms better prepared to
meet market challenges. Companies that follow strategic financial management
conduct simulations on how the competitive landscape can change and how these
changes would impact their performance. This helps them build an organization
that is more versatile, resilient and can therefore survive competitive pressures.

1.6 DISADVANTAGES OF STRATEGIC FINANCIAL MANAGEMENT :

There is no philosophy in the management domain which has not been criticized. The
strategic financial management philosophy is no exception. Although it has been proven that
there are numerous benefits to implementing this framework of decision making, there are
some associated costs as well. This is because of the various disadvantages that accompany
the implementation of strategic financial management.
In this article, we will have a look at some of the common disadvantages which are
associated with this philosophy.
1. Expensive: Developing a strategy is not an easy task. It cannot be done by
operational managers who run the day-to-day operations of a firm. In order to develop
a long-term financial strategy and to align it with the overall strategy of the company,
managers with different skill sets need to be hired. These managers must have an
overall understanding of how strategic thought has evolved over the past few years
and how it is likely to evolve in the future. There are very few personnel who have
this skill set. Hence, they are expensive to hire. Besides, these personnel will also
need access to research reports and data in order to discharge their duties effectively.
All these things cost money. Hence, only organizations that have deep pockets can
actually afford to implement strategic financial management.
2. Time Consuming: The designing of the financial strategy of an organization is not
the task that can be performed by a single department. The behaviors and objectives
of the entire organization need to be aligned in order for the strategy to be effective.
This means that the implementation of strategic finance requires time from line
managers, the human resources department, the marketing department, and other such
departments within the organization. Companies where strategic management has
Strategic Financial Management 1.7 Financial Goals and Strategy

been implemented often complain that this philosophy takes away a lot of their time
and hence the daily productivity of employees is negatively impacted. Since strategic
financial management is an ongoing exercise, companies must budget for extra hours
that their employees will have to spend if they want the implementation to be truly
successful.
3. Less Accuracy: The entire philosophy of strategic financial management is based on
making predictions about events that are far away in the future. Typically, strategic
financial management makes decisions based on their perception of how the external
environment will be two decades from the current date. The problem with strategic
management is that the future does not unfold as the organization has expected.
Hence, a lot of the time, the strategy created by this function gets invalidated.
However, it must be understood that organizations are not looking at an absolute
competitive advantage. Instead, they are trying to obtain a relative competitive
advantage. Therefore, companies that engage in strategic financial planning are better
than companies that do not. This gives them a competitive advantage and justifies the
existence of the field even though the absolute accuracy rate of their predictions may
not be as impressive.
4. Uncertain External Environment: In a previous article, we have already studied
that the strategic environment is not static. Over the past six decades, the world has
seen at least four different schools of strategic thought. All of these schools of
thought were quite different from one another. Hence, companies had to adapt to
these changing strategies. The adaptation process was not simple or cheap.
Companies had to sell off companies which they had earlier acquired. This process of
first buying and then selling off companies proved to be quite expensive for some
companies. Similarly, the excessive focus on data and technology which is being
displayed by the current school of strategic thought may become obsolete in a few
years from now. The rapidly changing external environment and the inability of
strategic financial management to keep up with the speed of change make it a
disadvantage for many organizations.
5. Conflicting Goals: The major issue with strategic management is that a lot of the
time, short-term goals conflict with long-term goals. In theory, the answer is simple
and the organization must focus on the long-term goals of organization. However, in
practice, this is easier said than done. Companies often face a lot of pressure from
their shareholders to deliver results every quarter. Any negative signal in the short-
run results of the company leads to a collapse in the share price of the firm. Hence,
strategic financial managers do not have the freedom to perform their tasks. They
cannot take tough decisions since it might hurt the company in the short run.
Management and board of directors are wary of any decision which causes a drop in
their share price and hence does not give full freedom to strategic financial managers.
6. Impedes Flexibility: Lastly, strategy is about choosing certain goals. If certain goals
are chosen, that also automatically means that certain other goals have been excluded.
The exclusion of these goals limits the agility of an organization. It has been observed
that organizations which follow strategic financial management are less flexible as
compared to their peers. This means that they take longer to change in response to a
change in the external environment.
The above-mentioned points make it clear that there are some significant disadvantages to
strategic financial management. However, the advantages are even more significant. This is
why many companies continue to use the strategic financial management framework to guide
them while making long-term decisions.
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1.7 INTRODUCTION TO FINANCIAL GOALS :

Business financial goals can help businesses increase their productivity and impact
the success of an organisation. Establishing the right financial goals can allow companies to
manage expenses and track progress effectively. Knowing how to establish the right goals
can be essential if you're responsible for financial goals in an organisation.

Business financial goals refer to an organization’s economic objectives. To be

successful, it's essential a business can self-sustain financially. Financial goals can help
measure a company's progress or help to accelerate growth. They can also help employees
understand their role in reaching those goals so everyone understands their impact and value
at a company.

Financial goals typically relate to a fixed timeline, either short-term or long-term. For
example, a short-time goal may be to make enough profit to invest in a specific piece of
equipment that is likely to benefit an organisation. In contrast, a longer-term goal may be to
reach a particular profit margin throughout a set period. It's crucial for financial goals to be
clear, measurable and achievable. Setting goals can help teams to develop specific plans to
achieve them, helping with prioritization, accountability, innovation and teamwork.

1.8 IMPORTANCE OF FINANCIAL GOALS :

Financial objectives are important because they help businesses plan for growth, track
progress and improve the organization’s success. Goals can influence how a company
operates, including decision-making. There can be many financial goals, which depend on
the products or services a company offers, its current needs and how it operates. Financial
goals can also change over time. For example, a business may change its goals if they wish to
focus on a new strategy, or it may increase targets if they meet a financial goal. It's typical for
companies to have more than one financial goal.

1.9 CHARACTERISTICS OF FINANCIAL GOALS :

Goals are the quantitative expressions of company’s mission and strategy and are set
by its long-term planning system as a trade-off among conflicting and competing interests. In
a study of twelve large American Corporations, Donaldson has identified

Several characteristics of a company’s financial goals system.

 Companies are not always governed by the maximum profit criterion.
 Financial priorities change according to the changes in the economic and competitive
environment.
 Competition sets the constraints within which a company can attain its goals.
 Managing a company’s financial goals system is a continuous process of balancing
different priorities in a manner that the demand for and supply of funds in reconciled.
 A change in any goal cannot be affected without considering the effect on other goals.
 Financial goals are changeable and unstable, and therefore managers find it difficult
to understand and accept the financial goals system.

In practice the financial goals system boils down to the management of flow of funds.
The objectives of growth and return can assume different priorities during the life cycle of a
company. For fulfilling its desire of attaining high growth, a company may have to sacrifice
Strategic Financial Management 1.9 Financial Goals and Strategy

superior return. Similarly, it may be able to achieve maximum return by constraining its
growth. For supporting its growth target, a company needs to ensure adequate supply of
funds which require trade-offs among the company’s dividend or debt policies or various
sources of funds. A financial goal system of low pay out and high debt will provide a
profitable firm an opportunity to sustain a high level of sales growth.

1.10 FINANCIAL GOALS FOR A BUSINESS :

Consider following these steps if you're looking to establish financial goals in your role.
1. Start with the business strategy : When develop financial goals for a business, it's
helpful to step back from the organisation's daily activities and take an objective look at the
organisation. Understand from senior leaders or business owners where they want the
business to be in the future and learn about what it's likely to take to get there. Connecting
the financial goals to the overall business strategy is essential.
2. Consider the long-term outlook : Once understand the company's strategic goals,
consider how can align financial goals with a long-term outlook. For example, if the CEO
has a clear vision for the organisation in 10 years, consider the financial plans to meet that
vision. For instance, if the CEO wants to be the leading financial planning organisation in
Western Australia, consider the required financial goals to hit that target, such as a specific
annual turnover.
3. Adapt for the short-term :After considered long-term goals, look at how can achieve
them by breaking them down into short-term financial goals. For example, if target turnover
is $500,000 and the current turnover is $250,000, setting a realistic timeline to get there is
essential. If select a five-year goal, know the target if the turnover increase is $50,000 in the
first year. Consider incorporating SMART goals, which stand specific, measurable,
achievable, relevant and time-bound.
4. Prioritise goals : Once have a list of actionable short-term goals, it's essential to prioritise
these and sort out which ones to address first. One way to do this is by identifying goals that
are easy to achieve and completing these first, which can help to build momentum and
motivation with your team. For example, if one of the financial objectives is to reduce
expenses, it may consider setting up a working group with operations to understand any
wasteful or unnecessary spending that can reduce to help boost the current revenue.
5. Review budget : When setting financial goals, keeping track of the budget is important.
Monitoring spending can be essential to meeting financial goals, ensuring expenses are at
appropriate levels and won't negatively impact the organisation from reaching its financial
goals. Depending on role in the organisation, may work closely with other teams, such as
procurement or provide guidance or training to managers responsible for spending or setting
budgets. In addition to understanding the afford to achieve the goals, educating others within
the organisation may be necessary.
6. Monitor financial goals : Once established the budget, keep track of the progress.
Consider the best tools or processes can introduce to help the monitor progress. If not
responsible for spending, working closely with other teams and asking them to regularly
provide details on their forecast vs actual spending can be useful. By monitoring the budget
regularly, it can help to ensure to meet the longer-term goals.
1.11 EXAMPLES OF FINANCIAL GOALS :

Here are some examples to consider that may help you when creating financial goals:
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Boosting revenue : Many companies focus on increasing revenue as one of their most
important financial goals. Revenue is what makes a business successful and allows it to
grow. Many organisations focus on percentages rather than assigning a specific dollar value
when setting these types of goals.
Example: A major retail operator wishes to increase overall business revenue by 20% in the
next five years. The finance manager can monitor performance by setting shorter-term annual
revenue goals, such as a 5% increase in year one. Using short-term goals allows managers to
track if the organisation is likely to meet the long-term goal and adapt or amend the strategy
or tactics for boosting revenue where necessary.
Increasing profit margins : Another objective that can be common in some businesses is to
increase profit margins from sales. Profit margins refer to how much a sale makes after
considering expenses, in contrast to revenue, which is the general amount of profit a business
makes. One way to increase profit margins is to lower expenses, such as streamlining
operations or assessing supplier costs. If the expenses are already as low as possible, another
option is typically to increase the product or service cost.
Example: A distribution company undertakes an audit to determine if it can streamline any
processes to improve workflow. The audit identifies three tasks that currently sit with
different people, which one person could manage effectively. They adapt their workflow to
improve efficiency and help reduce overall costs.
Optimising pricing : Price optimisation involves analysing customer and market data to
determine the optimal price point for an organisation's product or service. The goal is to find
the best price to attract customers, boost sales and increase profits. Depending on the
products or services a business provides, a business can set the price in line with what
customers are willing to pay or at a fair market price in comparison to competitors.
Example: A luxury car brand is set to launch a new model that is generating a lot of
customer excitement. They undertake a market review to determine the price customers
expect and are willing to pay for the new model. Besides pricing the car to cover costs for
production, they use this research to help set the price for the car.
Maintaining financial stability : This financial goal can help businesses to continue through
a challenging time when the focus is on surviving rather than profits. The goal is to ensure
the business doesn't lose profits but maintains the current level of profitability. The short-
term goal is that the company may meet its financial obligations to set long-term goals in the
future, focusing on growth and profitability.
Example: A popular restaurant is experiencing financial difficulty because of ongoing
construction works next door, affecting outdoor dining availability and noise levels. The
finance manager chases outstanding debts, pays off any debts in full to reduce interest and
reduces the variety on the menu to help cut costs. When the construction finishes, the
restaurant switches its goal back to focusing on generating revenue and business growth.
Earning a return on investments : This goal is typically a long-term business goal because
investments usually take time to see positive returns. Businesses typically invest in physical
property and equipment or other assets, such as bonds or stocks. When investing in physical
property, it's essential that companies ensure the revenue generated justifies the initial
purchase cost.
Example: A small business owner decides to invest in stocks and bonds after a strong year.
The return on investment is determined by capital gains and interest, which makes the
investment a good choice to offer them flexibility if other, more profitable investment
Strategic Financial Management 1.11 Financial Goals and Strategy

opportunities become available or they need to access cash for their business fast.

1.12 KEY FINANCIAL GOALS :

Corporate Managers in India consider the following four financial goals as the most
important. The financial goals which a company may be expected to pursue can be
categorised into four groups (see box). In a study of 57 Indian companies, it was found that
each company sets multiple goals for itself. For example, in the first group of goals the most
preferred one is the maximization of operating profit before interest and taxes, as many as 24
companies (42%) have ranked it either in the first or second place. All other goals get low
preferences in this group. In the second group, the maximization of return on investment gets
the highest priority. The maximization of growth in sales is preferred by a large number of
companies in different degree in the third group of goals. Similarly, in the fourth group, a
significant number of companies consider funds availability as an important [Link] results
reveal that goals which depend on market determined variables get low priority in the
financial decisions of Indian companies. In fact, companies seem to define a financial goal in
terms of the variable over they have control.
Maximising the level Maximising the ratio of
1. Book Value of net worth 1. Price-earnings
[Link] value of per share 2. Market rate of return
[Link] flow per share 3. Return on investment
[Link] profit before interest 4. Net profit to net worth
and tax 5. Net profit margin
KEY FINANCIAL
GOALS6. Market share
Maximisig the growth in
1. Earning per share
Ensuring the funds are available
2. Total assets
3. Sales

The four relative important goals pursued by companiesare:

 Ensuring fund availability

 Maximizing growth
 Operating profit before interest and taxes
 Return on Investment
Managers prefer to achieve higher sales growth even at the cost of low profitability. They do
notin practice aim to maximize the market value of their companies’ shares while making
financial decisions
1.13 SUMMARY :
After studied this lesson the student able to understand what is Strategy Financial
Management, its planning process, advantages and disadvantages of SFM, Introduction to
financial goals, business financial goals and key financial goals.

1.14 TECHNICAL TERMS :

 Strategy: Strategy is an action that managers take to attain one or more of the
organization’s goals. Its is a general direction set for the company and its various
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components to achieve a desired state in the future. Strategy results from the detailed
strategic planning process.
 Finance: Finance is the process of channeling these funds in the form of credit, loans,
or invested capital to those economic entities that most need them or can put them to
the most productive use. The institutions that channel funds from savers to users are
called financial intermediaries. They include commercial banks, savings banks,
savings and loan associations, and such nonbank institutions as credit unions,
insurance companies, pension funds, investment companies, and finance companies.
 Management: It is how businesses organize and direct workflow, operations, and
employees to meet company goals. The primary goal of management is to create an
environment that lets employees work efficiently and productively. A solid
organizational structure serves as a guide for workers and establishes the tone and
focus of their work.
 Financial goal : A financial goal is a scientifically defined financial milestone that
you plan to achieve or reach. Financial goals comprise earning, saving, investing and
spending in proportions that match your short-term, medium-term or long-term plans.
 Short-Term Planning : Short-term planning is usually considered to take 12 months
or less. Your daily, weekly, monthly, even quarterly and yearly goals all can be filed
under “short-term goals.” They are stepping stones that will help to reach big
goal(s).That type of planning requires to look at the current situation and fix potential
issues as soon as possible. Sometimes “as soon as possible” takes a day, sometimes 6
months, depending on the complexity of the issue.

1.15 SELF-ASSESSMENT QUESTIONS :

1. What is meant by Strategic Financial Management
2. What is the Strategic planning process
3. What are the advantages and disadvantages of SFM
4. What is meant by financial goals
5. What are the financial goals for business
6. What are the Key financial goals.

1.16 SUGGESTED READINGS :

1. Van Horn, JC, Financial Management and Policy, Prentice Hall,New Delhi
2. PG Godbole, Mergers, Acquisitions and Corporate Restructuring, Vikas, NewDelhi
3. Weaver, Strategic Corporate Finance, Cengage,ND
4. Weston JF, Chung KS & Heag SE., Mergers, Restructuring & Corporate Control,
Prentice Hall.
5. GP Jakarthiya, Strategic Financial Management, Vikas, NewDelhi
6. Coopers & Lybrand, Strategic Financial: Risk Management, Universities Press
(India)Ltd.
7. Robicheck, A, and Myers, S., Optimal Financing Decisions, Prentice HallInc.
8. James [Link], RiskL The New Management Imperative in Finance, A JaicoBook.

Dr. [Link]
 LESSON-2
SHAREHOLDERS VALUE CREATION
LEARNING OBJECTIVES :
 To make the students understand the concept of shareholders value creation.
 To know about shareholders value
 To understand the calculation of shareholders value
 Able to understand the examples of shareholders value creation
 To understand the determinants of shareholders value creation

STRUCTURE :
2.1 Introduction to Shareholder Value
2.2 Features of Shareholders Value
2.3 Concept of Shareholders value
2.4 Calculation of shareholders value
2.5 Examples of Shareholders value
2.6 Introduction shareholders value creation
2.7 Determinants of shareholders value creation
2.8 Introduction to Market Value Added
2.9 Definition of Market Value Added
2.10 Determinants of Market Value Added
2.11 Example for Market Value Added
2.12 Advantages of MVA
2.13 Disadvantages of MVA
2.14 Introduction Market to Book Value Ratio
2.15 Process of M/BV Ratio
2.16 Determinants of M/BV Ratio
2.17 Interpretation of M/BV Ratio
2.18 Examples of M/BV Ratio
2.19 Advantages and Disadvantages of M/BV Ratio.
2.20 Summary
2.21 Technical Terms
2.22 Self-Assessment Questions
2.23 Suggested Readings

2.1 INTRODUCTION TO SHAREHOLDER VALUE :

Shareholder value is the value delivered to the equity owners of a corporation, thanks
to management’s ability to increase sales, earnings, and free cash flow, which leads to an
increase in dividends and capital gains for shareholders.

A company’s shareholder value depends on strategic decisions that its board of

directors and senior management make, including the ability to make wise investments and
generate a healthy return on invested capital. If this value is created, particularly over the
Centre for Distance Education 2.2 Acharya Nagarjuna University

long term, then the share price increases and the company can pay larger cash dividends to
shareholders. Mergers, in particular, tend to cause a large increase in shareholder value.

Shareholder value can become a hot-button issue for corporations, as the creation of
wealth for shareholders does not always or equally translate to value for the corporation’s
employees or customers.

2.2 FEATURES OF SHAREHOLDERS VALUE :

 Shareholder value is the value given to stockholders in a company based on the firm’s
ability to sustain and grow profits over time.

 Increasing shareholder value also increases the total amount in the stockholders’
equity section of the balance sheet.
 A well-managed firm maximizes the use of its assets.

 The maxim about increasing shareholder value is, in fact, a myth or misconception, as
there exists no legal duty for management to maximize corporate profits.

2.3 CONCEPT OF SHAREHOLDERS VALUE :

Shareholder value is the financial worth owners of a business receive for owning
shares in the company. An increase in shareholder value is created when a company earns
a return on invested capital (ROIC) that is greater than its weighted average cost of capital
(WACC). Put more simply, value is created for shareholders when the business increases
profits.

Shareholders value: where, ROIC > WACC

The market value of the shareholders’ equity is directly observable from the capital
markets, In theory, the market value should be equal the warranted economic value of the
firm. The true economic value of a firm or business or division or project or any strategy
depends on the cash flows and the appropriate discount rate (commensurate with the risk of
cash flows).

2.4 CALCULATION OF SHAREHOLDERS VALUE :

Shareholder value is the return of an investment in a given company. Shareholder

value is created when a company's returns exceed its cost of doing business. When a
company's management team employs smart business decisions and is able to increase its
earnings, share price, and dividends, shareholder value increases.

Making money on an investment is every investor's goal, so it's important to know

how to calculate your shareholder value. Fortunately, it can be done in four easy steps.
Strategic Financial Management 2.3 Shareholders Value Creation

1. Derive the individual equity holder value : To calculate an individual's shareholder

value, we start by subtracting a company's preferreddividends from its net income.
Preferred dividends are dividends paid to holders of preferred stock. Net income is a
company's total earnings minus operating and non-operating expenses, depreciation,
interest, and taxes.
If a company has a net income of ₹ 1 billion and pays out ₹ 200 million in preferred
dividends, then it has ₹ 800 million in income available to shareholders.
2. Derive earning per share : Calculate the company's earnings by share by dividing the
company's available income by its total number of shares outstanding. If a company has
400 million shares outstanding, then we can divide ₹ 800 million by 400 million to get
an earnings per share of ₹ 2.
3. Add stock price to EPS : Add the stock price to the earnings per share. If our
company's stock is selling at ₹ 40 per share, then add ₹ 40 and the earnings of ₹ 2 per
share to arrive at ₹ 42.
4. Multiply by total no. of shares held by individual equity holder : Now multiply the
above total by the number of shares held by an individual shareholder. If a shareholder
owns 10 shares, then their individual shareholder value is ₹ 420.

Example :

Subtract the company's preferred dividends, which it has promised to preferred

shareholders, from its net income. For example, if a company has a net income of ₹ 80,000
one year and must distribute ₹ 20,000 of it to preferred shareholders, subtract ₹ 20,000 from
₹ 80,000 to get ₹ 60,000. This is the income available to share holders. Divide the income
by the total number of outstanding shares. For example, if the company has issued 15,000
shares, divide ₹ 60,000 by 15,000, to get ₹ 4. This is the value of earnings per share. Add the
stock price to this value. For example, if the stock sells at ₹ 25 per share, add ₹ 4 to ₹ 25 to
get ₹ [Link] the earnings per share by the number of shares that the shareholder owns.
For example, if the investor owns 20 shares, multiply ₹ 29 by ₹ 20, to get ₹ 580. This is the
Centre for Distance Education 2.4 Acharya Nagarjuna University

shareholder value.

2.6 INTRODUCTION TO SHAREHOLDER VALUE CREATION :

Shareholders Value creation is at the core of every successful business success. It

involves turning resources into something valuable through hard work. In the realm of
economics, it’s a comprehensive concept encompassing the creation of tangible products
and services. It refers to the process of generating additional value for stakeholders, going
beyond the initial investment or input.

It also involves investments in capital goods and intellectual property assets. In

essence, value creation is about making more out of what the have, and it’s central to the
success of any organization.

It’s important to highlight that the concept of shareholders value creation extends
beyond just seeking profit. It encompasses a wider range of aspects, such as improving
products and services, fostering stronger customer relationships, driving innovation, and
making positive contributions to both the community and the environment.

At its core, grasping the meaning of value creation is closely tied to sustainability.
Businesses need to continuously innovate and adapt to changing market conditions. This
entails streamlining operations, refining products, and promoting a culture of excellence.
Organizations must consistently aim to enhance their value creation strategies

2.7 DETERMINATION OF SHAREHOLDER VALUE CREATION :

To create value, management must have thorough understanding of the performance

variables that drive the value of the business. These are known as key-value drivers. There
are two reasons for understanding these variables. First, the organization cannot act directly
on value. It has to act on things it can influence, such as customer satisfaction, cost, and
capital expenditures. Secondly, it is through these drivers of value that senior management
learns to understand the rest of the organization and to establish a dialogue for goal
accomplishment. A value driver is any variable that considerably affects the value of the
organization. Though value drivers need to be organized so that management can recognise
which have the greatest impact on value and assign responsibility for their performance to
individuals who can help the organization to meet its targets.

To determine the shareholder value creation there is a number of approaches to

determining the shareholders’ value creation whether it is diluted or appreciated.

APPROACHES FOR MEASURING SHAREHOLDER VALUE :

The measures available to management and shareholders to appraise a firm's value-creation
performance can be categorized into three groups. In first type, measurement includes those
assessments which depend on mainly on the financial statements produced by the firm, but
require an estimation of the cost of capital and other adjustments to traditional income
statements and balance sheets to reveal operating cash flows and an appropriate capital base.
These can be named value-creation measures.
The second type of measures, it includes those that rely entirely on stock market data
and, thus, are mainly applicable to exchange listed companies. These can be labelled as
wealth-reaction measures. These measures concentrate on the impact on shareholder wealth
 Strategic Financial Management 2.5 Shareholders Value Creation

and use that as an indirect measure of annual (or periodic). In the category of measures, there
are hybrid value/wealth-creation measures and require both financial statement and stock
market data.
Company differences in financial sophistication, internal reporting capabilities, and business
characteristics create a need for tailored value measurement approaches. The practices differ
along a number of dimensions, including:
1. The simplicity/accuracy trade-off implied in each.
2. Management's ability to understand and control the measures.
3. The complexity required for implementation

The above table shows the different approaches to determine the shareholders’ value creation.
Out of those important methods are discussed below and following lesson.

2.8 INTRODUCTION TO MARKET VALUE ADDED :

 Market Value Added (MVA) is the best final measure of a Company’s performance.
Stewart states that MVA is a cumulative measure of corporate performance and that it
represents the stock market’s assessment from a particular time onwards of the net
present value of all a Company’s past and projected capital projects. MVA is
calculated at a given moment, but in order to assess performance over time, the
difference or change in MVA from one date to the next can be determined to see
whether the value has been created or destroyed.
 Market value added represents the wealth generated by a company for its shareholders
since inception. It equals the amount by which the market value of the company's
stock exceeds the total capital invested in a company (including capital retained in the
Centre for Distance Education 2.6 Acharya Nagarjuna University

form of undistributed earnings).

 Since the main goal of a for-profit organization is to maximize shareholders' wealth,
market value added is an important measure to analyze how much value a company
has added to the wealth of its shareholders. Higher market value added is better.
 The aim of a company’s managers is to maximize value in order to do value creation.
The aim is not to maximize the value of a company, which can be easily
accomplished by contributing additional inputs of capital. MVA increases when the
invested capital earns a rate of return greater than the cost of capital.

2.9 DEFINITION :

According to Stern Stewart, if the total market value of a company is more than the
amount of capital invested in it, the company has managed to create shareholder value. If the
market value is less than the capital invested, the company has destroyed shareholder value

2.10 DETERMINATION OF MARKET VALUE ADDED :

MVA is derived by deduction the book value of the firm from its market
capitalization. The book value of the firm is equity share capital plus reserves and surplus,
minus any revaluation reserve and miscellaneous expenses. Market value of the firm can be
determined dividing Earning Before Interest and Taxes (EBIT) by weighted average cost of
capital. The market value added (MVA) indicates the shareholders value creation. MVA is
determined as difference between the total market value of the company and book value the
economic capital, also named invested capital

Market value Added = Market value of the firm – Book value of the firm
(Number of common shares outstanding x share price) + (Number of preferred shares
outstanding x share price) - Book value of invested capital
(or)
MVA means wealth generated by Company for its providers of Finance.
Add: Market value of Equity
Add: Market value of Preference
Add: Market value of Debenture
Less: Book value of (Equity + PSH + Long Term Debt) = MVA
(or)
MVA = Current market value of debt and equity – Economic book value
(Where, Economic Book Value = Share capital + Free Reserves + Debt)

2.11 EXAMPLES OF MARKET VALUE ADDED :

1. Example: consider Company XYZ whose shareholders’ equity amounts to ₹ 750,000. The
company owns 5,000 preferred shares and 100,000 common shares outstanding. The present
market value for the common shares is ₹ 12.50 per share and ₹ 100 per share for the preferred
shares.

Sol :
MVA=MV-BV
Market Value of Common Shares = 100,000shares * ₹ 12.50per share = ₹ 1,250,000
Market Value of Preferred Shares = 5,000shares * ₹ 100per share = ₹ 500,000
Total Market Value of Shares = ₹ 1,250,000 + ₹ 500,000 = ₹ 1,750,000
Strategic Financial Management 2.7 Shareholders Value Creation

Using the figures obtained above

MVA=MV-BV
Market Value Added = ₹ 1,750,000 – 750,000 = ₹ 1,000,000

1. EXAMPLE : COMPUTATION OF MVA

The stockholders' equity of ABC Company shows a total of ₹ 852,000 (share capital,
additional paid-in capital, and retained earnings). It has 100,000 common shares and 5,000
preference shares outstanding.
The common shares currently have a market value of ₹ 18.50 per share. Preferred shares are
currently selling at ₹ 120 per share. Compute for the market value added.
Sol:

MVA= MV-BV
MV of common shares = 100,000 x ₹ 18.50 = ₹18,50,000
MV of preferred shares = 5,000 x ₹ 120 = 6,00,000

Total market value of stocks = ₹ 1,850,000 + ₹ 600,000

Total market value of stocks = ₹ 24,50,000
Market value of stocks - Book value of stockholders'
MVA=
equity
= ₹ 24,50,000- ₹ 852,000
MVA= 15,98,000/-
The higher the MVA, the better. Investors apparently want their invested capital to grow. In
fact, one of the main goals of a firm is maximization of shareholders' wealth by increasing the
stock price.

[Link] :
Calculate the market value added using the following information:
Total number of shares issued 20,000,000
Number of shares held as treasury stock 1,100,000
Current share price 35.5
Total invested capital plus retained earnings ₹ 453,503,000
Cost of treasury stock ₹ 39,050,000
Assume that the market value of debt equals its book value.
Solution
Number of Shares Outstanding = 20,000,000 − 1,100,000 = 18,900,000
Market Capitalization = 18,900,000 × ₹ 35.5 = ₹ 670,950,000
Total Shareholders' Equity

= Total Invested Capital + Retained Earnings − Cost of Treasury Stock

= ₹ 453,503,000 − ₹ 39,050,000 = ₹ 414,453,000

Market Value Added for Shareholders = ₹ 670,950,000 − ₹ 414,453,000 = ₹ 256,497,000

 MARKET VALUE ADDED CALCULATION EXAMPLE

XYZ Company has 3,970,000 shares of common stock outstanding at a current market price
of ₹ 7.83. The company’s long-term debt is represented by a bond issue with a fixed annual
coupon rate of 12.75%. This bond issue will mature in the next 3 years, and the current
required rate of return on bonds with a similar risk is 14.25%.
Centre for Distance Education 2.8 Acharya Nagarjuna University

Balance sheet, US ₹in thousands

Sol: MVA FOR SHAREHOLDERS

MVA=MV – BV

MV= 39,70,000*7.83=3,10,85,100/-
BV= 2,54,80,000

MVA=31085100-25480000 = 56,05,100/-

1. MVA FOR ALL INVESTORS :

MVEQUITY+MVPSH+MVDEBT-INVESTED CAPITAL
MV OF LONGTERM DEBT:
MV

70,00,00*12.75%

₹ 892,500 ₹ 892,500 ₹ 892,500 + ₹ 7,000,000

PV = 1+ 2+ = ₹ 6,757,247.60
(1 + 0.1425) (1 + 0.1425) (1 + 0.1425)3
Invested capital = Current Assets-(Current liabilities except short term debt)+Non-Current
Assets - Deferrable Tax Liability

₹ 13,060,000 - (₹ 5,680,000 + ₹ 1,890,000 + ₹ 1,230,000) + ₹ 34,200,000 - ₹ 800,000 = ₹

37,660,000
Strategic Financial Management 2.9 Shareholders Value Creation

MVA=MV-BV

MV= (Total Equity+ Short term debt + Long term debt + other long-term Liabilities)

MV = (₹ 31085100 + ₹ 4,630,000 + ₹ 6,757,247.60 + ₹ 550,000) =43,022,347

MVA = MV-BV

43,022,347 - ₹ 37,660,000 = ₹ 5,362,347.60

As an example, the investor relations officer of Cud Farms is preparing a press release
that reveals the increase in market value added since the new management team was
hired. The analysis is based on the following information:
Prior Year Current Year
Number of common shares outstanding 5,000,000 5,700,000

Common stock price ₹ 4.00 ₹ 4.20

Number of preferred shares outstanding 400,000 375,000
Preferred share price ₹ 11.00 ₹ 11.30
Book value of invested capital ₹ 18,000,000 ₹ 20,625,000
The market value added for the prior year is calculated as follows:
Sol: MVA = MV – BV
(5,000,000 Common shares x ₹ 4.00 price) + (400,000 Preferred shares x ₹ 11.00 price) -
₹ 18,000,000 Equity book value
= ₹ 6,400,000 Market value added
The market value added for the current year is calculated as follows::
(5,700,000 Common shares x ₹ 4.20 price) + (375,000 Preferred shares x ₹ 11.30 price) -
₹ 20,625,000 Equity book value
= ₹ 7,552,500 Market value added

2.12 ADVANTAGES OF MARKET VALUE ADDED (MVA) :

 Makes companies more attractive to potential investors : Investors will always

prefer companies with higher MVA because it shows the firm’s ability to create
wealth for its stockholders. In other words, a high MVA shows that the
organization is healthy and succeeding – a factor that signals a high probability of
generating significant returns later on. So, for investors who are not interested in
high-return investments, a firm with a high MVA seems like a safe option.
 Boosts the survival chances of a company : In the corporate world, nothing is
100% sure. A company could be making billions of profits one minute and
declaring bankruptcy the next time. However, for a company to register a high
MVA, its likelihood to thrive is certainly high.
 It promotes high returns for investors : There are benefits for individuals who
have already invested their money. For example, a business with a high added
market value has shown to be successful for present investors and has produced
considerable returns.
 Anticipate Positive News : A corporation can anticipate positive news and
Centre for Distance Education 2.10 Acharya Nagarjuna University

significant investor interest in the future with such a reputation among investors
in the business sector, ensuring a certain level of success and profitability.
A high MVA means the company is generating enough wealth so it will continue to
attract investors. It then means that it will continue to expand its operations, earn more
profit, and stay ahead of its competitors.

2.13 LIMITATIONS OF MARKET VALUE ADDED :

1. MVA does not take into account the opportunity costs of the invested capital.
2. MVA does not take into account the interim cash returns to shareholders.
3. Market Value Added (MVA) cannot be calculated at divisional (Strategic Business
Unit) level and cannot be used for privately held companies.

2.14 MARKET VALUE TO BOOK VALUE RATIO (OR) (PRICE TO BOOK

RATIO):

Introduction :
The Market to Book ratio (also called the Price to Book ratio), is a financial valuation
metric used to evaluate a company’s current market value relative to its book value.

The market to book ratio is typically used by investors to show the market’s
perception of a particular stock’s value. It is used to value insurance and financial companies,
real estate companies, and investment trusts. It does not work well for companies with mostly
intangible assets. This ratio is used to denote how much equity investors are paying for each
rupee in net assets.

The market to book ratio is calculated by dividing the current closing price of the stock by the
most current quarter’s book value per share.

The market value is the current stock price of all outstanding shares (i.e. the price that the
market believes the company is worth).

The book value is the amount that would be left if the company liquidated all of its assets and
repaid all of its liabilities. The book value equals the net assets of the company and comes
from the balance sheet. In other words, the ratio is used to compare a business’s net assets
that are available in relation to the sales price of its stock.

2.15 PROCESS OF MARKET TO BOOK VALUE RATIO :

The formula calculation is done by using the following steps:
Step 1: Firstly, collect the current market value of the stock, which is easily available from
the stock market. Now, collect the number of outstanding shares of the company and
determine the market capitalization by multiplying the current stock price and the number of
outstanding shares.

Market capitalization = Current stock price * Number of outstanding shares.

Step 2: Next, determine the total book value or the net worth of the company from its balance
sheet. Net worth can be computed by deducting total liabilities, preferred stock,
and intangible assets from total assets of the company.
Strategic Financial Management 2.11 Shareholders Value Creation

Total book value = Total assets – Total liabilities – Preferred stock – Intangible assets
Step 3: Finally, the calculation can be completed by dividing the market capitalization by the
total book value of the company, as shown below.

Market to Book ratio = Market capitalization / Total book value

2.16 DETERMINATION OF THE MARKET TO BOOK VALUE(M/B) :

The market value of a firm’s share is the present value of the expected stream of
dividend per share (DIV). DIV depends on the firm’s pay-out ratio (1-b) and the earning
growth (g). Earnings growth depends on the retention ratio (b) and the return on equity
(ROE):
g=b × ROE
The stream of DIV is discounted at the cost of equity (ke). The market value per share (M) is
given as follows:
∞ ∞
DIV EPSt(1 − b)
M=∑ t
=∑ (1)
(1 + ke) (1 + ke)t
t=1 t=1
In Equation (1), DIV (dividend per share ) is expected to grow at a constant rate, g. That is,
DIV
t
= DIVt-1 (1+g) = DIV0(1 + g)
If we assume an infinite time period (n=∞), then Equation (1) can be simplified as follows:
DIV EPS1(1 − b)
M= = (2)
ke − g ke − g
Since EPS1 is the product of the book value of firm’s share and its return on equity (i.e.,
EPS1=ROE ×B), Equation (2) can be written as follows.
ROE (1 − b)B
M= (3)
ke − g
Dividing both sides of Equation (3) by B (book value per share), we obtain M/B equation as
follows:
M ROE − g
= (4)
B ke − g
The time horizon, n may be assumed to be finite. Then Equation (4) becomes as follows.
M ROE − g 1+g 1+g
=[ ] [1 − ( ) n] + [ ]n (5)
B ke − g 1 + ke 1 = Ke
We can notice from equation (4) or (5) that the following are the determinants of the
M/B ratio.

Determinants of the M/B ratio:

Economic profitability or spread: The magnitude of the spread between return on equity
and the cost of equity, i.e., ROE – ke determines the M/B ratio.
Growth: Growth depends on the firm’s retention ratio (b) and the return on equity, (ROE).
Given the firm’s ROE, higher the retention ratio, higher will be the growth rate. However, a
higher growth rate does not necessarily increase the shareholder value. It will accelerate the
M/B ratio oly when on equity is greater than the firm’s cost of equity (ROE>ke). Growth will
have a negative effect on value if the cost of equity is more than the return on
equity(ke>ROE). Thus, a firm, should be economically profitable (i.e., ROE>ke) for growth
to be of value to the shareholders growth is detrimental from the value perspective when the
firm is economically unprofitable (i.e., ROE<ke).
Centre for Distance Education 2.12 Acharya Nagarjuna University

Investment Period: The number of yeares over which the future investment will grow also
determines the market value. In Equation (4) the time horizon, n is assumed infinite while
Equation (5) assumes a finite time period.

The Market to Book formula is:

Market Capitalization / Net Book Value (or)
Share Price / Net Book Value per Share

where, Net Book Value = Total Assets – Total Liabilities

Total book value = Total assets – Total liabilities – Preferred stock – Intangible assets

2.17 INTERPRETATION OF THE RATIO :

 A low ratio (less than 1) could indicate that the stock is undervalued (i.e. a bad
investment), and a higher ratio (greater than 1) could mean the stock is overvalued
(i.e. it has performed well). Many argue the opposite and due to the discrepancy of
opinions, the use of other stock valuation methods either in addition to or instead of
the Price to Book ratio could be beneficial for a company.
 A low ratio could also indicate that there is something wrong with the company. This
ratio can also give the impression that you are paying too much for what would be left
if the company went bankrupt.
 The market-to-book ratio helps a company determine whether or not its asset value is
comparable to the market price of its stock. It is best to compare Market to Book
ratios between companies within the same industry.

2.18. EXAMPLE PROBLEMS

[Link] Calculation of Price to Book Ratio in Excel

The Price to Book ratio (or Market to Book ratio) can easily be calculated in Excel if the
following criteria are known: share price, number of shares outstanding, total assets, and total
liabilities. From there, market capitalization and net book value can be calculated. Market
Cap is equal to share price times shares outstanding. Net Book Value is equal to Total Assets
minus Total Liabilities.
Strategic Financial Management 2.13 Shareholders Value Creation

As above the example, all assumptions or hard codes are in blue font, and all formulas are in
black.
Stock 1 has a high market capitalization relative to its net book value of assets, so its Price to
Book ratio is 3.9x.
Stock 2 has a lower market cap than its book value of equity, so its Market to Book ratio is
0.9x.

2. EXAMPLE
Assume there is a company X whose publicly traded stock price is ₹ 20 and it has
100,000 outstanding equity shares. The book value of the company is ₹ 1,500,000.
Sol: Market-to-book value ratio = 20* 1 00 000 / 1,500,000 = 2,000,000/1,500,000 =
1.33
Here, the market perceives a market value of 1.33 times the book value to company X
3. EXAMPLE :
Let us take the example of David, who intends to invest in the furniture company ABC Ltd,
which is a publicly traded company. ABC Ltd has 10,000 outstanding shares that are trading
at $50 per share. The company reported a net worth of $300,000 on their balance sheet as on
the last day of the previous accounting period. Calculate the market to book ratio for ABC
Ltd.
Sol: Given, Total book value = $300,000
Below is the data for the calculation of ABC Ltd.
Therefore, market capitalization can be calculated as
Market Capitalization = Current stock price * Number of outstanding shares
= $50 * 10,000
Market Capitalization = $500,000
Therefore, the ratio for ABC Ltd can be calculated as,
= $500,000 / $300,000
= 1.67
A ratio of more than one indicates that the investors value the company more than its book
value.
4. Example :
Let us now take the example of Apple Inc. As on March 1, 2019, the current market value of
each share of Apple Inc. stood at $174.97 and 4,745,398,000 number of outstanding shares.
The latest reported net worth of the company stood at $118,255,318,160. Calculate the
market to book ratio for Apple Inc.
Sol:
Given, Total book value = $118,255,318,160
Below is data for the calculation of Apple Inc.
Therefore, market capitalization can be calculated as
Market capitalization = Current stock price * Number of outstanding shares
= $174.97 * 4,745,398,000
Market Capitalization = $830,302,288,060
Therefore, the ratio for Apple Inc. can be calculated as,
= $830,302,288,060 / $118,255,318,160
= 7.02
A high ratio simply justifies the investors’ confidence in the brand of Apple Inc. and its
future growth prospects.
Centre for Distance Education 2.14 Acharya Nagarjuna University

2.19 ADVANTAGES OF MARKET TO BOOK VALUE RATIO :

 Book value is a cumulative amount that is usually positive even the P/E multiple is
negative because of negative earnings. Ergo M/BV can be used when P/E can not
 Book value is more stable than EPS, so it may be more useful than P/E when EPS is
volatile
 For marked to market firm assets, M/BV is more useful the P/E multiple
 Sometimes M/BV is useful in valuing companies that are expected to go out of
business
Disadvantages of Market to Book Value:
 First disadvantage shall come to mind through the asset value. Value of intangibles
are not captured in assets, such as the brand value of Coca-Cola, or the human capital
of service companies.
 M/BV is misleading when there are significant differences in the asset intensity of
production methods among the firms
 Differences in accounting methods, such as US GAAP and IFRS can lead to different
asset values. That makes the comparison harder
 Inflation and technological change can cause the book and market value of assets to
differ significantly. So the book value is not an accurate measure of the value of
shareholders investments

2.20 SUMMARY :

After studied this lesson the student should be able to know about what is shareholder
value how would be creates the value and different approaches to measuring the shareholder
value creation and its important methods of Market Value Added and Market to book value.

2.21 TECHNICAL TERMS :

 Shareholder: A shareholder is a person, company, or institution that owns at least

one share of a company’s stock or in a mutual fund. Shareholders essentially own the
company, which comes with certain rights and responsibilities. This type of
ownership allows them to reap the benefits of a business’s success.
 Shareholders Value: Shareholder value is the value enjoyed by a shareholder by
possessing shares of a company. It is the value delivered by the company to the
shareholder. Increasing the shareholder value is of prime importance for the
management of a company. So the management must have the interests of
shareholders in mind while making decisions. The higher the shareholder value, the
better it is for the company and management.
 Market value added (MVA): It is a calculation that shows the difference between
the market value of a company and the capital contributed by all investors, both
bondholders and shareholders. In other words, it is the market value of debt and
equity minus all capital claims held against the company.
 Market Value: Market value (also known as OMV, or "open market valuation") is
the price an asset would fetch in the marketplace, or the value that the investment
community gives to a particular equity or business.
 Book Value: In accounting, book value is the value of an asset according to its
balance sheet account balance. For assets, the value is based on the original cost of the
asset less any depreciation, amortization or impairment costs made against the asset.
Traditionally, a company's book value is its total assets [clarification needed] minus
intangible assets and liabilities. However, in practice, depending on the source of the
Strategic Financial Management 2.15 Shareholders Value Creation

calculation, book value may variably include goodwill, intangible assets, or both. The
value inherent in its workforce, part of the intellectual capital of a company, is always
ignored. When intangible assets and goodwill are explicitly excluded, the metric is
often specified to be tangible book value.
 The retention ratio: It(also known as the net income retention ratio or plowback
ratio) is the ratio of a company’s retained income to its net income. The retention ratio
measures the percentage of a company’s profits that are reinvested into the company
in some way, rather than being paid out to investors as dividends.

2.22 SELF-ASSESSMENT QUESTIONS :

1. What is Shareholders value creation and how to calculate it.

2. What are approaches of Shareholders value measurement
3. What is Market value added and explain its advantages and disadvantages.
4. What is Market to Book Value and explain its process.
5. Explain the advantages and disadvantages of M/BV
6. The stock of company XYZ is trading at 6/- per share and there are 100 shares
outstanding.

Balance Sheet for company XYZ(as on 31st December, 2015)

Liabilities Amt Assets Amt
Accounts payable 500 Cash 1,000
Current Long-Term Debt 500 Accounts Receivable 5,00
Total Current Liabilities _______ Inventory 5,00
Long-Term Debt 1,000 ______
Total liabilities 500 Total Current Assets 2,000
Owner equity _______ Intangible assets 200
Preferred stock 1,500
1000
200

Calculate the Market to book value ratio.

2.23 SUGGESTED READINGS :

1. Van Horn, JC, Financial Management and Policy, Prentice Hall, New Delhi
2. PG Godbole, Mergers, Acquisitions and Corporate Restructuring, Vikas, NewDelhi
3. Weaver, Strategic Corporate Finance, Cengage,ND
4. Weston JF, Chung KS &Heag SE., Mergers, Restructuring & Corporate
Control, Prentice Hall.
5. GP Jakarthiya, Strategic Financial Management, Vikas, NewDelhi
6. Coopers & Lybrand, Strategic Financial: Risk Management, Universities Press (India)

Dr. [Link]
 LESSON - 3
FINANCIAL OPTIONS AND VALUE OF THE FIRM
LEARNING OBJECTIVES :
After studying this lesson, you will be able to:
 To make the students understand the financial options and value of the firm
 Explain the meaning of financial options and value of the firm.
 Identify the different options and source to procure financial resources.
 Acquaint with the concept of Value of the firm.
 Depict various computation methods for value of the firm.

STRUCTURE :
3.1 Introduction
3.2 Finance Sources / Options
3.2.1 Long term Security Finance
3.2.2 Ownership Securities
3.2.3 Creditor ship Securities
3.2.4 Medium term Finance
3.2.5 Short term Finance
3.3 Financial Management - Value of the firm
3.3.1 Capital Structure Value of the firm
3.3.2 ENIT – EPS Analysis Value of the firm
3.3.3 Financial Mix Value of the firm
3.3.4 Dividend decisions Value of the firm
3.4 Financial Options and Value of the firm
3.5 Value of the firm–Computation Methods
3.5.1 . Book Value
3.5.2 Discounted Cash flow
3.5.3 Market Capitalization
3.5.4 Enterprise Value
3.5.5 EBITDA
3.5.6 Present value of a growing perpetuity formula
3.6 Summary
3.7 Self assessment questions
3.8 Suggested readings

3.1 INTRODUCTION :
In our present day economy, finance is defined as the provision of money at the time
when it is required. Every enterprise, whether bit, medium or small, need finance to carry on
its operations and to achieve its targets. In fact, fiancé is so indispensable today that it is
righty said that it is the life blood on an enterprise. Without adequate fiancé, no enterprise can
possibly accomplish its objects.
Capital required for a business can be classified under two main categories, viz.,
i. Fixed Capital, and
Centre For Distance Education 3.2 Acharya Nagarjuna University

ii. Working Capital.

Every business needs funds for two purposes – for it establishment and to carry out its
day-to-day operations. Long-term funds are required to create production facilities through
purchases of fixed assets such as plant, machinery, land, building, furniture, etc. Investment
in these assets represents that part of firm’s capital which is blocked on a permanent or fixed
basis and is called fixed capital. Funds are also needed for short-term purposes for the
purchase of raw materials, payment of wages and other day-to-day expenses, etc., these funds
are known as working capital
The various financial options of raising long-term funds include issue of shares,
debenture, pouching back of profits and loans from financial institutions, etc. The short-term
requirements of funds can be met from commercial banks, trade credit, installment credit,
advance, factoring or receivable credit, accruals, deferred incomes, and commercial paper,
etc.
3.2 FINANCIAL OPTIONS/SOURCES :
Sources of finance mean the ways for mobilizing various terms of finance to the
industrial concern. Sources of finance state that, how the companies are mobilizing finance
for their requirements. The companies belong to the existing or the new which need sum
amount of finance to meet the long-term and short-term requirements such as purchasing of
fixed assets, construction of office building, purchase of raw materials and day-to-day
expenses. Sources of finance may be classified under various categories according to the
following important heads:
3.2.1 Long Term Security Finance :
If the finance is mobilized through issue of securities such as shares and debenture, it is
called as security finance. It is also called as corporate securities. This type of finance plays a
major role in the field of deciding the capital structure of the company.
Characters of Security Finance Security finance consists of the following important
characters:
 Long-term sources of finance.
 It is also called as corporate securities.
 Security finance includes both shares and debentures.
 It plays a major role in deciding the capital structure of the company.
 Repayment of finance is very limited.
 It is a major part of the company’s total capitalization.
Types of Security Finance Security finance may be divided into two major types:
 Ownership securities or capital stock.
 Creditor ship securities or debt capital.

3.2.2 Ownership Securities :

The ownership securities also called as capital stock is commonly called as shares. Shares
are the most Universal method of raising finance for the business concern. Ownership capital
consists of the following types of securities.
a) EQUITY SHARES
b) PREFERENCE SHARES
c) NO PAR STOCK
Strategic Financial Managements 3.3 Financial Options and Value…

d) DEFERRED SHARES
e) CREDITORSHIP SECURITIES
f) DEBENTURES
g) RETAINED EARNINGS

a) EQUITY SHARES :
Equity Shares also known as ordinary shares, which means, other than preference shares.
Equity shareholders are the real owners of the company. They have a control over the
management of the company. Equity shareholders are eligible to get dividend if the company
earns profit. Equity share capital cannot be redeemed during the lifetime of the company. The
liability of the equity shareholders is the value of unpaid value of shares.
FEATURES OF EQUITY SHARES
Equity shares consist of the following important features:

a) Maturity of the shares: Equity shares have permanent nature of capital, which has
no maturity period. It cannot be redeemed during the lifetime of the company.
b) Residual claim on income: Equity shareholders have the right to get income left after
paying fixed rate of dividend to preference shareholder. The earnings or the income
available to the shareholders is equal to the profit after tax minus preference dividend.
c) Residual claims on assets: If the company wound up, the ordinary or equity
shareholders have the right to get the claims on assets. These rights are only available
to the equity shareholders.
d) Right to control: Equity shareholders are the real owners of the company. Hence,
they have power to control the management of the company and they have power to
take any decision regarding the business operation.
e) Voting rights: Equity shareholders have voting rights in the meeting of the company
with the help of voting right power; they can change or remove any decision of the
business concern. Equity shareholders only have voting rights in the company
meeting and also they can nominate proxy to participate and vote in the meeting
instead of the shareholder.
f) Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is
the legal right of the existing shareholders. It is attested by the company in the first
opportunity to purchase additional equity shares in proportion to their current holding
capacity.
g) Limited liability: Equity shareholders are having only limited liability to the value of
shares they have purchased. If the shareholders are having fully paid up shares, they
have no liability.
b) PREFERENCE SHARES
The parts of corporate securities are called as preference shares. It is the shares, which
have preferential right to get dividend and get back the initial investment at the time of
winding up of the company. Preference shareholders are eligible to get fixed rate of dividend
and they do not have voting rights. It means a preference shareholder enjoys two rights over
equity shareholders :(a) right to receive fixed rate of dividend and (b) right to return of
capital. After settling the claims of outsiders, preference shareholders are the first to get their
dividend and then the balance will go to the equity shareholders. However, the preference
shareholders do not have any voting rights in the annual general body meetings of the
company.
Centre For Distance Education 3.4 Acharya Nagarjuna University

Preference shares may be classified into the following major types:

a) Cumulative preference shares: Cumulative preference shares have right to claim
dividends for those years which have no profits. If the company is unable to earn
profit in any one or more years, C.P. Shares are unable to get any dividend but they
have right to get the comparative dividend for the previous years if the company
earned profit
b) Non-cumulative preference shares: Non-cumulative preference shares have no right
to enjoy the above benefits. They are eligible to get only dividend if the company
earns profit during the years. Otherwise, they cannot claim any dividend.
c) Redeemable preference shares: When, the preference shares have a fixed maturity
period it becomes redeemable preference shares. It can be redeemable during the
lifetime of the company. The Company Act has provided certain restrictions on the
return of the redeemable preference shares.
d) Irredeemable Preference Shares: Irredeemable preference shares can be redeemed
only when the company goes for liquidator. There is no fixed maturity period for such
kind of preference shares.
e) Participating Preference Shares Participating preference shareholders have right to
participate extra profits after distributing the equity shareholders.
FEATURES OF PREFERENCE SHARES
 Maturity period: Normally preference shares have no fixed maturity period except in
the case of redeemable preference shares. Preference shares can be redeemable only at
the time of the company liquidation.
 Residual claims on income: Preferential shareholders have a residual claim on
income. Fixed rate of dividend is payable to the preference shareholders.
 Residual claims on assets: The first preference is given to the preference
shareholders at the time of liquidation. If any extra Assets are available that should be
distributed to equity shareholder.
 Control of Management: Preference shareholder does not have any voting rights.
Hence, they cannot have control over the management of the company.
c) NO PAR SHARES :
When the shares are having no face value, it is said to be no par shares. The company
issues this kind of shares which is divided into a number of specific shares without any
specific denomination. The value of shares can be measured by dividing the real net worth of
the company with the total number of shares. Value of no. per share =the realnetworth/Total
no. Of shares
d) DEFERRED SHARES :
Deferred shares also called as founder shares because these shares were normally
issued to founders. The shareholders have a preferential right to get dividend before the
preference shares and equity shares. According to Companies Act 1956 no public limited
company or which is a subsidiary of a public company can issue deferred shares. These
shares were issued to the founder at small denomination to control over the management by
the virtue of their voting rights.
3.2.3 Creditor ship Securities :
Creditor ship Securities also known as debt finance which means the finance is
mobilized from the creditors. Debenture and Bonds are the two major parts of the Creditors
hip Securities.
Strategic Financial Managements 3.5 Financial Options and Value…

a) DEBENTURES :
Debenture is a document issued by the company. It is a certificate issued by the company
under its seal acknowledging a debt. Debentures are the loans taken by the company. It is a
certificate or letter issued by the company under its common seal acknowledging the receipt
of loan. A debenture holder is the creditor of the company. Debenture holder is entitled to a
fixed rate of interest on the debenture amount. Payment of interest on debenture is the first
charge against profits. Apart from the loans from financial institutions, a company may raise
loans through debentures. This is an additional source of long-term finance. The payment of
interest and principal amounts on these debentures is subject to the terms and conditions of
issue of debentures.
Types of Debentures it may be divided into the following major types:
a. Unsecured debentures: Unsecured debentures are not given any security on assets
of the company. It is also called simple or naked debentures. This type of debentures
is traded as unsecured creditors at the time of winding up of the company.
b. Secured debentures: Secured debentures are given security on assets of the
company. It is also called as mortgaged debentures because these debentures are
given against any mortgage of the assets of the company.
c. Redeemable debentures: These debentures are to be redeemed on the expiry of a
certain period. The interest is paid periodically and the initial investment is returned
after the fixed maturity period.
d. Irredeemable debentures: These kinds of debentures cannot be redeemable during
the life time of the business concern.
e. Convertible debentures: Convertible debentures are the debentures whose holders
have the option to get them converted wholly or partly into shares. These debentures
are usually converted into equity shares.
Conversion of the debentures may be:
 Non-convertible debentures
 Fully convertible debentures
 Partly convertible debentures

FEATURES OF DEBENTURES :
a. Maturity period: Debentures consist of long-term fixed maturity period. Normally,
debentures consist of 10–20 years maturity period and are repayable with the
principle investment at the end of the maturity period.
b. Residual claims in income: Debenture holders are eligible to get fixed rate of
interest at every end of the accounting period. Debenture holders have priority of
claim in income of the company over equity and preference shareholders.
c. Residual claims on asset: Debenture holders have priority of claims on Assets of
the company over equity and preference shareholders. The Debenture holders may
have either specific change on the Assets or floating change of the assets of the
company. Specific change of Debenture holders are treated as secured creditors and
floating change of Debenture holders are treated as unsecured creditors.
d. No voting rights: Debenture holders are considered as creditors of the company.
Hence they have no voting rights. Debenture holders cannot have the control over
the performance of the business concern.
Centre For Distance Education 3.6 Acharya Nagarjuna University

b) RETAINED EARNINGS :
Retained earnings are another method of internal sources of finance. Actually is not a
method of raising finance, but it is called as accumulation of profits by a company for its
expansion and diversification activities. Retained earnings are called under different names
such as; self finance, inter finance, and plugging back of profits. According to the Companies
Act 1956 certain percentage, as prescribed by the central government (not exceeding 10%) of
the net profits after tax of a financial year have to be compulsorily transferred to reserve by a
company before declaring dividends for the year. Under the retained earnings sources of
finance, a part of the total profits is transferred to various reserves such as general reserve,
replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
3.2.4 Medium-Term Finance :
Medium-term finance refers to such sources of finance where the repayment is
normally over one year and less than three years. This is normally utilized to buy or lease
motor vehicles, computer equipment, or machinery whose life is less than three years. The
sources of medium term finance are as given below:

a) Bank Loans : Bank loans are extended at a fixed rate of interest. Repayment of the loan
and interest are scheduled at the beginning and are usually directly debited to the current
account of the borrower. These are secured loans.
b) Hire-Purchase : It is a facility to buy a fixed asset while paying the price over a long
period of time. In other words, the possession of the asset can be taken by making a down
payment of a part of the price and the balance will be repaid with a fixed rate of interest in
agreed number of installments. The buyer becomes the owner of the asset only on payment of
the last installment. The seller is the owner of the asset till the last installment is paid. In case
there is any default in payment, the seller can reserve the right of collecting back the asset.
Today, most of the consumer durables such as cars, refrigerators, TVs and so on, are sold on
hire-purchase basis. It provides an opportunity to keep using the asset much before the full
price is paid.
c) Leasing or Renting : Where there is a need for fixed assets, the asset need not be
purchases. It can be taken on lease or rent for specified number of years. The company who
owns the asset is called lesser and the company which takes the asset on leas is called lessee.
The agreement between the lesser and lessee is called a lease agreement. On the expiry of the
lease agreement, the owner takes the asset back into his custody. Under lease agreement,
ownership to the asset never passes. Only possession of the asset passes from lesser to the
lessee. Lease is not a loan. But when the business wants a certain asset for a short/medium
period, lease can significantly reduce the financial requirements of the business to buy the
asset.
d) Venture Capital : This form of finance is available only for limited companies. Venture
capital is normally provided in such projects where there is relatively a higher degree of risk.
For such projects, finance through the conventional sources may not be available. Many
banks offer such finance through their merchant banking divisions, or specialist banks which
offer advice and financial assistance. The financial assistance may take the form of loans and
venture capital. In the case of viable or feasible projects, the merchant banks may participate
in the equity also. In return, they expect one or two (depending up on the volume of funs
pumped in) director positions on the board to exercise the control on the company matters.
The funds, so provided by the venture capital, can be used for acquiring another company or
launching a new product or financing expansion and growth.
Strategic Financial Managements 3.7 Financial Options and Value…

3.2.5 Short-Term Finance :

a) Commercial Paper (CP) : It is a new money market instrument introduced in India in
recent times. CPs are issued usually in large denominations by the leading, nationally
reputed, highly rated and credit worthy, large manufacturing and finance companies in the
public and private sector. The proceeds of the issue of commercial paper are used to finance
current transactions and seasonal and interim needs for funds. Reliance Industries is one of
the early companies which are issued Commercial Paper.
b) Bank Overdraft : This is a special arrangement with the banker where the customer can
draw more than what he has in this savings/current account subject to a maximum limit.
Interest is charged on a day-to-day basis on the actual amount overdrawn. This source is
utilized to meet the temporary shortage of funds.
c) Trade Credit : This is a short-term credit facility extended by the creditors to the debtors.
Normally, it is common for the traders to buy the material and other supplies from the
suppliers on credit basis. After selling the stocks, the traders pay the cash and buy fresh
stocks again on credit. Sometimes, the suppliers may insist on the buyer to sign a bill (bill of
exchange). This bill is called bills payable.
d) Debt Factoring or Credit Factoring : Debt Factoring is the arrangement with factor
where the trader agrees to sell its accounts receivable or debtors at discount to the specialized
dealers called factors. In the case of Credit Factoring, the trader agrees to sell his accounts
payables (at premium).
e) Advance from Customers : It is customary to collect full or part of the order amount from
the customer in advance. Such advances are useful to meet the working capital needs. Short-
term deposited from the customers, sister companies and outsiders. It is normal to find the
supermarkets and trading organizations inviting deposits of six months to one year duration.
As an incentive, such deposit holders may be given 5-10 precept discounts on the purchases.
f) Internal funds : Internal funds are generated by the firm itself by way of secret reserve,
depreciation provisions, taxation provision, and retained profits and so on and these can be
utilized to meet the urgencies.
3.3 VALUE OF THE FIRM :
The concept of valuation lies at the root of corporate financial decisions. Unless and
until the finance manager is aware of the concept of valuation, it is difficult for him to
evaluate whether the different financial decisions have actually added to the corporate wealth.
Such an evaluation is significant not just for the finance manager. The other parties related to
the company, viz., the shareholders and the creditors would also like to know the value of the
company insofar.
 A firm’s value, also known as Firm Value (FV), Enterprise Value (EV) is an
economic
 concept that reflects the value of a business. It is the value that a business is worthy of
 at a particular date. Theoretically, it is an amount that one needs to pay to buy/take
over
 a business entity. Like an asset, the value of a firm can be determined on the basis of
 either book value or market value. But generally, it refers to the market value of a
 company. EV is a more comprehensive substitute for market capitalization and can be
 calculated by following more than one approach.
 A firm’s value, also known as Firm Value (FV), Enterprise Value (EV) is an
economic
Centre For Distance Education 3.8 Acharya Nagarjuna University

 concept that reflects the value of a business. It is the value that a business is worthy of
 at a particular date. Theoretically, it is an amount that one needs to pay to buy/take
over
 a business entity. Like an asset, the value of a firm can be determined on the basis of
 either book value or market value. But generally, it refers to the market value of a
 company. EV is a more comprehensive substitute for market capitalization and can be
 calculated by following more than one approach.
3.3.1 Capital Structure - Value Of The Firm :
Focusing on the theoretical relationship between capital structure, cost of capital and
valuation, has shown that although the empirical evidence is not conclusive, theoretically a
judicious combination of debt and equity does affect the cost of capital as also the total value
of the firm. There is, in other words, an optimum capital structure. The capital structure is
said to be optimum when the marginal real cost (explicit as well as implicit) of each available
source of financing is identical. With an optimum debt and equity mix, the cost of capital is
minimum and the market price per share (or total value of the firm) is maximum. The use of
debt in capital structure or financial leverage has both benefits as well as costs. While the
principal attraction of debt is the tax benefit, its cost is financial distress and reduced
commercial profitability. The term financial distress includes bankruptcy. The problem of
financial distress will magnify with an increase in financial leverage. Beyond a certain point,
the expected cost of financial distress will outweigh the tax benefit. A firm is, thus, concerned
with a trade-off between risk and return emanating from the use of debt. A proper balance
between the two is, therefore, called for.
Given the objectives of maximization of shareholder’ wealth, the need or an optimal
capital structure cannot, therefore, be overemphasized. In operational terms, every firm
should try to design such a capital structure. But the determination of an optimum capital
structure is a formidable task. It should be clearly understood that identifying the precise
percentage of debt that will maximize price per share is almost impossible. It is possible,
however, to determine the approximate proportion of debt to use in the financial plan in
conformity with the objective of maximizing share price or total value of the firm.
In theory, one can speak of an optimum capital structure, but, in practice, it is very
difficult to design one. There are significant variations among industries as also among
individual companies within the same industry in respect of capital structure. There is so
because there are host f factors, both quantitative and qualitative, including subjective
judgment of financial managers which determine the capital structure of a firm. These factors
are highly complex and cannot fit entirely into a theoretical framework. From the operational
standpoint, therefore, what should be attempted is an appropriate capital structure. It may be
noted, at the outset, that is certain common, and often, conflicting considerations involved in
determining the methods of financing assets because the position of each company is
different. Accordingly, the weight given to various factors also varies widely, according to
conditions in the economy, the industry and the company itself.
Above all, the freedom of management to adjust the mix of debt and equity in
accordance with these criteria is limited by the availability of the various types of debt to
have an appropriate capital structure, but the debt may not be available to the company
because the suppliers of the funds may think that it will involve too much financial risk for
them. However, the plans of that management ultimately makes in the light of these
considerations often involve a compromise between the desires and conditions imposed by
Strategic Financial Managements 3.9 Financial Options and Value…

the suppliers of funds. Moreover, none of the factors by itself is completely satisfactory. But,
collectively, they provide sufficient information fort taking rational decisions.
3.3.2 EBIT – EPS Analysis Value of the firm:
The EBIT-EPS approach to capital structure is a tool businesses use to determine the
best ratio of debt and equity that should be used to finance the business' assets and operations.
At its core, the EBIT-EPS approach is a way to mathematically project how a balance sheet's
structure will impact a company's earnings. To understand how the EBIT-EPS method works,
first we must understand the two primary metrics involved, EBIT and [Link] refers to a
company's earnings before interest and taxes. These metric strips out the impact of interest
and taxes, showing an investor or manager how a company is performing excluding the
impacts of the balance sheet's composition. In terms of EBIT, it doesn't matter if a company
is overloaded with debt or has no loans at all. EBIT will be the same either [Link] stands
for earnings per share, which is the profit the company generates including the impact of
interest and tax obligations. EPS is particularly helpful to investors because it measures
profits on a per share basis. If a company's total profit is soaring but its profit per share is
declining, that's a bad thing for the investor owning a fixed number of shares. EPS captures
this dynamic in a simple, easy to understand way.
The ratio between these two metrics can show investors and management how the bottom
line results, the company's EPS, relates to its performance independent of its capital structure,
its EBIT. For example, let's say a company wants to maintain stable EPS but is considering
taking out a new loan to grow its balance sheet. In order for EPS to remain stable, the
company's EBIT must also increase at least as much as the new interest expense from the
debt. If EBIT increases the same as the next interest expense, then EPS should remain stable,
assuming no change in taxes.
Illustration: 01
ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new factory expects
to yield annual earnings before interest and tax (EBIT) of Rs.5,00,000. In choosing financial
plan, ABC Ltd., has an objective of maximizing earnings per share (EPS). The company
proposes to issuing ordinary shares and raising debit of Rs. 3,00,000 and Rs.10,00,000 of Rs.
15,00,000. The current market price per share is Rs. 250 and is expected to drop to Rs. 200 if
the funds are borrowed in excess of Rs. 12,00,000. Funds can braised at the following rates.

a) up to Rs. 3,00,000 at 8%.

b) over Rs. 3,00,000 to Rs. 15,000,00 at 10%.
c) over Rs. 15,00,000 at 15%.
Assuming a tax rate of 50% advice the company.
Solution:
Earnings before Interest and Tax (BIT) less Interest Earnings Before Tax less: Tax@50%.

Alternatives
Particulars
I II III
Debt raising Rs.3,00,000 Rs.10,00,000 Rs.15,00,000
Earnings Before Interest & Tax 5,00,000 5,00,000 5,00,000
Less: Interest 24,000 1,00,000 2,25,000
Earnings After Interest 4,76,000 4,00,000 2,75,000
Centre For Distance Education 3.10 Acharya Nagarjuna University

Less: Tax Rate 50 % 2,38,000 2,00,000 1,37,500

Earnings After Tax 2,38,000 2,00,000 1,37,500
27,00,000 20,00,000 15,00,000
Market Price per share 250 250 200
No. of Equity shares 10,800 8,000 7,500
Earnings available to equity share holders 2,38,000 2,00,000 1,37,500
Earnings Per Share 22.03 25 18.33

The secure alternative which gives the highest earnings per share is the best. Therefore the
company is advised to revise Rs. 10,00,000 through debt amount Rs. 20,00,000 through
ordinary shares.
Illustration: 02
Compute the market value of the firm, value of shares and the average cost of capital from
the following information.
Net operating income Rs. 1,00,000
Total investment Rs. 5,00,000
Equity capitalization Rate:
(a) If the firm uses no debt 10%
(b) If the firm uses Rs. 25,000 debentures 11%
(c) If the firm uses Rs. 4,00,000 debentures 13%
Assume that Rs. 5,00,000 debentures can be raised at 6% rate of interest whereas. 4,00,000
debentures can be raised at 7% rate of interest.
Solution
Computation of market value of firm value of shares and the average cost of capital.

Alternatives
(a) No Debt (b) (c)
Particulars Rs.2,50,000 Rs.4,00,000
6% 7%
Debentures Debentures
Earnings Before Interest & Tax 1,00,000 1,00,000 1,00,000
Less: Interest --- 15,000 28,000
Earnings Available to equity shareholders 1,00,000 85,000 72,000
Equity Capitalization Rate 10 % 11 % 13 %
100 100 100
Market value of shares 10,000x 10,000x 10,000x
10 11 13
Rs.10,00,000 Rs.7,72,727 Rs.5,53,846

Market Value of the firm 10,00,000 10,27,727 9,53,846

Average Cost of Capital 1,00,000 1,00,000 1,00,000

x100 x100 x100

Strategic Financial Managements 3.11 Financial Options and Value…

10,00,000 10,27,727 9,53,846

EBIT/V 10 % 9.78 % 10.48 %

Comments
From the above data, if debt of Rs. 2,50,000 is used, the value of the firm increases and the
overall cost of capital decreases. But, if more debt is used to finance in place of equity i.e.,
Rs. 4,00,000 debentures, the value of the firm decreases and the overall cost of capital
increases.
3.3.3. Financial Mix – Value of the firm :
The capital structure should be examined from the view point of its impact on the
value of the firm it can be legitimately expected that if the capital structure decision effects
the total value of the firm, a firm should select such a financing-mix as will maximize that
shareholders wealth such a capital structure is referred to as the optimal capital structure the
optimum capital structure may be defined as the capital structure or combination debt and
equity that lead to the maximum value of the firm.
The importance of an appropriate capital structure is thus obvious. There is a view
point that strongly supports the close relationship between leverage and value of the firm.
There is a equally strong body of opinion which beliefs that financing-mix or the combination
of debt and equity as no impact on the shareholders wealth and the decision on financial
structure is irrelevant. In other words, there is nothing such as optimum capital structure.
In theory capital structure can affect the value of a company by affecting either its
expected earnings or the cost of capital or both. While it is true that financing-mix cannot
affect the total operating earnings of a firm, as they are determined by the investment
decisions, it can affect the share of earnings belonging to the ordinary shareholders. The
capital structure decision can influence the value to the firm through the earnings available to
the shareholders. But the leverage can largely influence the value of the firm through the cost
of capital. In exploring the relationship between leverage and value of a firm we are
concerned with the relationship between leverage and cost of capital from the stand point of
valuation.
Illustration: 03
(a) A Company expects a net income of Rs. 1,00,000. It has Rs. 2,50,000, 8% debentures.
The equality capitalization rate of the company is 10%. Calculate the value of the firm and
overall capitalization rate according to the net income approach(ignoring income tax).
(b) If the debenture debts are increased to Rs. 4,00,000. What shall be the value of the firm
and the overall capitalization rate?
Solution
(a) Capitalization of the value of the firm
Rs.
Net income 1,00,000
Less: Interest on 8% Debentures of Rs. 2,50,000 20,000
Earnings available to equality shareholders 80,000
Equity capitalization rate 10%

80,000
= × 100
Centre For Distance Education 3.12 Acharya Nagarjuna University

10

Market value of equity = 8,00,000

Market value of debentures = 2,50,000
Value of the firm = 10,50,000
Calculation of overall capitalization rate
Earnings EBIT
Overall cost of capital (Ko) =
Value of the firm V

1,00,000
= ×100
10,50,000

= 9.52%
(b) Calculation of value of the firm if debenture debt is raised to Rs. 3,00,000.

Rs.
Net income 1,00,000
Less: Interest on 8% Debentures of Rs. 4,00,000 32,000
Equity Capitalization rate 68,000
10%
100
Market value of equity = 68,000 ×= 6,80,000
10

= 6,80,000

Market value of Debentures = 4,00,000

Value of firm = 10,80,000
1,00,000
Overall cost of capital =×10
10,80,000

= 9.26%
Thus, it is evident that with the increase in debt financing, the value of the firm has increased
and the overall cost of capital has increased.
Illustration: 04
XYZ expects a net operating income of Rs. 2,00,000. It has 8,00,000, 6% debentures. The
overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization
rate (Cost of Equity) according to the net operating income approach. If the debentures debt
is increased to Rs. 10,00,000. What will be the effect on volume of the firm and the equity
capitalization rate?
Solution
Net operating income = Rs. 2,00,000
Overall cost of capital = 10%

Market value of the firm (V)

Strategic Financial Managements 3.13 Financial Options and Value…

EBIT
=
K0
100
= 2,00,000×= Rs. 20,00,000
10

Market value of the firm =Rs. 20,00,000

Less: market value of Debentures = Rs. 8,00,000
12,00,000

Equity capitalization rate (or) cost of equity (Ke)

EBIT – I
=
V–D
Where,
V = value of the firm
D = value of the debt capital

2,00,000 – 48,000
= X100
20,00,000 – 8,00,000

= 12.67%
If the debentures debt is increased to Rs. 10,00,000, the value of the firm shall remain
changed to Rs. 20,00,000. The equity capitalization rate will increase as follows:

EBIT – I
=
V–D

2,00,000 – 60,000
= X100
20,00,000 – 10,00,000

1,40,000
= X 100
10,00,000
= 14 %
Illustration :05
There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any
debt in its financing, while B has Rs. 2,50,000 , 6% Debentures in its financing. Both the
firms have earnings before interest and tax of Rs. 75,000 and the equity capitalization rate is
10%. Assuming the corporation tax is 50%, calculate the value of the firm.
Solution
The market value of firm A which does not use any debt.
Centre For Distance Education 3.14 Acharya Nagarjuna University

EBIT
Vu=
K0
75,000
==75,000×100/10
10/100
= Rs. 7,50,000
The market value of firm B which uses debt financing of Rs. 2,50,000
Vt= Vu + t
Vu = 7,50,000, t = 50% of Rs. 2,50,000
= 7,50,000 + 1,25,000
= Rs. 8,75,000.
3.3.4 Dividend Decisions – Value Of The Firm :
Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount
of profit to be treated as retained earnings for financing its long term growth. Hence, dividend
decision plays very important part in the financial management. Dividend decision consists of
two important concepts which are based on the relationship between dividend decision and
value of the firm.
There are conflicting views regarding the impact of dividend decision on the value of a firm.
According to one school of thought, dividend decision does not affect the share holders
wealth and hence the valuation of the firm. On the other hand, according to other school of
thought, dividend decision materially affects the shareholders wealth and also the valuation
of the firm.
1. The Irrelevance concept of Dividend of the Theory of Irrelevance.
2. The Relevance concept of Dividend of the Theory of Relevance.
Illustration: 06
Z Ltd., has risk allying firm for which capitalization rate is 12%. It currently has outstanding
8,000 shares selling at Rs. 100 each. The dividend for the current financial year is Rs. 7 per
share. The company expects to have a net income of Rs. 69,000 and has proposal formatting
new investments of Rs. 1,60,000. Show that under the MM hypothesis the payment of
dividend does not affect the value of the firm.
Solution
(a) Value of the firm when dividends are paid. Price of the shares at the end of the current
financial year.

P1 = Po (1+Ke) – D1
= 100 (1 + .12) – 7
= 100×1.12 – 7
P1 = Rs. 105
(b) Number of shares to be issued.
I – (TE – nD)
S=
P1
1,60,000 – (69,000-(8000x7))
=
105
Strategic Financial Managements 3.15 Financial Options and Value…

1,60,000-13,000
=
105
= 1,47,000/105 = 1400 shares
The MM hypothesis explained in another firm also assumes that investment required
by the firm on account of payment of dividends is finance out of the issue of equity shares.

I – (TE – nD)
S=
M1
S = Value of the firm can be calculated as follows.

(N + S) M1 – (1-TE)
nPo =
1 + Ke
nPo = Value of the firm
TE = Total Earnings
M1= Market Price at the end of the period
Ke= Cost of capital
D = Dividend paid at the end of the year (or) period
N = Number of shares outstanding at the beginning of the period.

(N + S) M1 – (1-TE)
nPo =
1 + Ke

8,000+1,400x105 – (1,60,000-69,000)
=
1 + 12 %

9,400x105 – 91,000
=
1 + 12 %

= 8,00,000

Illustration: 07
From the following information supplied to you, ascertain whether the firm is following an
optional dividend policy as per Walter’s Model?
Total Earnings Rs. 2,00,000
No. of equity shares (of Rs. 100 each 20,000)
Dividend paid Rs. 1,00,000
P/E Ratio 10
Return Investment 15%
The firm is expected to maintain its rate on return on fresh investments. Also find out what
should be the E/P ratio at which the dividend policy will have no effect on the value of the
share? Will your decision change if the P/E ratio is 7.25 and interest of 10%?
Centre For Distance Education 3.16 Acharya Nagarjuna University

Solution
Earnings 2,00,000
EPS = = = Rs. 10
No. of Shares 20,000

= P / E Ratio = 10

Earnings 2,00,000
EPS = = = Rs. 10
No. of Shares 20,000
Total Dividends paid
EPS =
No. of Shares
1,00,000
= = Rs. 5
20,000

The value of the share as per Walter’s Model is

D + r /Ke (E-D)
P=
Ke
5 + 015 /.10 (10-5)
P=
0.10
5 + 7.5
=
0.10
= Rs. 12.5

DPS
Dividend Payout =
0.10
5/10x100 = 60%
r > Ke therefore by distributing 60 % of earnings, the firm is not following an optional
dividend policy. In this case, the optional dividend policy for the firm would be to pay zero
dividend and the Market Price would be:

5 +0.15/.10 (10-0)
P=
0.10

5 + 15
=
.10

= 20/0.10
P= Rs.200.
Strategic Financial Managements 3.17 Financial Options and Value…

So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25
instead of 10 then the Ke = 1=0.138 and in this case Ke> r and the MP of the share is 7.25.
.15
5+ (10-5)
.138
P= .138
.138
= 5 + 5.435

P = Rs.75.62
Illustration: 08

The earnings per share of a company are Rs. 80 and the rate of capitalization applicable to the
company is 12%. The company has before it an option of adopting a payment ratio of 25%
(or) 50%(or) 75%. Using Walter’s formula of dividend payout, compute the market value of
the company’s share of the productivity of retained earnings (i) 12% (ii) 8%(iii) 5%.

Solution :
E = 10 and Ke=12%=0.12
As per Walter’s Model, the market price of a share is
D + r /Ke (E-D)
P=
Ke
(A) If payout ratio is 25 %
(i) r = 12% =0.12, D = 25% of 10 = Rs.2.50

2.5 +0.12 /.12 (10-2.50)

P=
0.12
2.50 + 7.50
=
0.12

= 10/0.12
= Rs. 83.33

R = 8 % =0.08
R = 8 % =0.08, D = 25% of 10 = Rs.2.50
2.5 +0.08 /.12 (10-2.50)
P=
0.12
2.50 + 5
=
0.12
= 7.50/0.12
= Rs. 62.5
Illustration: 09
Centre For Distance Education 3.18 Acharya Nagarjuna University

From the following data, calculate the MP of a share of ABC Ltd., under (i) Walter’s
formula; and (ii) Dividend growth model.
EPS = Rs. 10 DPS = Rs. 6
Ke = 18% r = 25%
retention ratio (b) = 45%
Solution:

(i) Walter’s Model

D + r (EPS-DPS)
P=
Ke
6 + .25 (10-6)
=
.18
6 + 5.56
=
.18
11.56
=
.18
= 64.22
(ii) Dividend Growth Model:
E(1-b)
P=
Ke–br

10 (1-0.45)
P=
0.18 – (0.45x0.25)

10 x 0.55
=
0.18 – 0.1125

5.5
=
0.18 – 0.1125

= Rs. 81.48

Illustration: 10
Raja company earns a rate of 12% on its total investment of Rs. 6,00,000 in assets. It has
6,00,000 outstanding common shares at Rs. 10 per share. Discount rate of the firm is10% and
it has a policy of retaining 40% of the earnings. Determine the price of its share using
Gordon’s Model. What shall happen to the price of the share if the company has payout of
60% (or) 20%?
Solution
According to Gordon’s Model, the price of a share is
Strategic Financial Managements 3.19 Financial Options and Value…

E (1-b)
P=
Ke– br
Given: E = 12% of Rs. 10=Rs. 1.20
r = 12%=0.12
K = 10%=0.10
t = 10%=0.10
b = 40%=0.40
Put the values in formula
1.20 (1- 0.40)
P=
10– (0.40x0.12)
1.20 x (0.60)
P=
10– (0.048)
0.72
P=
0.052
P = 13.85

If the firm follows a policy of 60 % payout then b=20% =0.20

1.20 (1 x 0.20)
The Price is P=
0.10 – (.2 x .12)

= 0.05
r = 4% = 0.04, D = 25% of 10 = 2.50

0.04/0.12 (10 – 2.50)

=2.50 +
0 .12

5
= = Rs.41.67
0.12

If payout ratio is 50%, D=50% of 10 = Rs.5

0.12/0.12 (10 – 5)
=2.50 +
0 .12

10
= = Rs.83.33
0.12
r = 8% = 0.08, D = 50% of 10 =5
Centre For Distance Education 3.20 Acharya Nagarjuna University

5+ 0.8/0.12 (10 – 5)
=
0 .12
5+ 3.33
=
0 .12
8.33
= = Rs.69.42
0 .12
r = 4 % = 0.04, D = 50% of 10 =5

0.04
= 5+ (10 - 5)
0.12
5+1.67
= = Rs.55.58
0.12

C) If payout ratio is 75%

D = 75% of 10 = 7.50
i) r = 12% = 0.12, D=75% of 10 =7.50

7.50+0.12 (10-7.50)
0.12
P=
0.12
7.50 + 2.50
= = Rs.83.33
0.12

ii) r = 8% = 0.08, D=75% of 10 =7.50

7.50+0.08 (10-7.50)
0.12
P=
0.12
7.50 + 1.67
= = Rs.76.42
0.12

iii) r = 4% = 0.04, D = 75% of 10 = 7.50

7.50+0.04 (10-7.50)
0.12
P=
0.12
Strategic Financial Managements 3.21 Financial Options and Value…

7.50 + 0.83
=
0.12

8.3 3
= Rs.69.42
0.12

1.20x 0.80
=
0.10-0.024

0.96
= =Rs.12.63
0.076
If the payout is 20% the value of b=0.60 and the price of the share is

1.20 ( 1- 0.60 )
=
0.10 – (0.80 x 0.12)

1.20 x 0.40
=
0.10-0.096

0.48
= = Rs.120.
0.0004

3.4 FINANCIAL OPTIONS AND VALUE OF THE FIRM :

In finance, valuation is the process of determining the present value (PV)of an asset by the
one who is authorized to do so called the value. Items that are usually valued are a financial
asset or liability. Valuations can be done on assets(for example, investments in marketable
securities such as stocks, options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for
many reasons such as investment analysis, capital budgeting, merger and acquisition
transactions, financial reporting, taxable events to determine the proper tax liability, and in
litigation.
Valuation of financial assets is done using one or more of these types of models:
1. Absolute value models that determine the present value of an asset's expected future
cash flows. These kinds of models take two general forms: multi-period models such
as discounted cash flow models or single-period models such as the Gordon model.
These models rely on mathematics rather than price observation.
2. Relative value models determine value based on the observation of market prices of
similar assets.
3. Option pricing models are used for certain types of financial assets (e.g., warrants, put
options, call options, employee stock options, investments with embedded options
Centre For Distance Education 3.22 Acharya Nagarjuna University

such as a callable bond) and are a complex present value model. The most common
option pricing models are the Black–Schools-Merton models and lattice models.
Common terms for the value of an asset or liability are market value, fair value, and intrinsic
value. The meanings of these terms differ. For instance, when an analyst believes a stock's
intrinsic value is greater (less) than its market price, an analyst makes a "buy" ("sell")
recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and
vary among analysts. The International Valuation Standards include definitions for common
bases of value and generally accepted practice procedures for valuing assets of all types.

3.5. VALUE OF THE FIRM –COMPUTATION METHODS :

One way to calculate a business’s valuation is to subtract liabilities from
assets. However, this simple method doesn’t always provide the full picture of a company’s
value. This is why several other methods exist. Here’s a look at six business valuation
methods that provide insight into a company’s financial standing, including book value,
discounted cash flow analysis, market capitalization, enterprise value, earnings, and the
present value of a growing perpetuity formula.
3.5.1 Book Value :
One of the most straightforward methods of valuing a company is to calculate its book
value using information from its balance sheet. Due to the simplicity of this method,
however, it’s notably unreliable. To calculate book value, start by subtracting the company’s
liabilities from its assets to determine owners’ equity. Then exclude any intangible assets.
The figure you’re left with represents the value of any tangible assets the company owns. As
Harvard Business School Professor Mihir Desai mentions in the online course Leading with
Finance, balance sheet figures can’t be equated with value due to historical cost accounting
and the principle of conservatism. Relying on basic accounting metrics doesn't paint an
accurate picture of a business’s true value.
3.5.2 Discounted Cash Flows :
Another method of valuing a company is with discounted cash flows. This technique is
highlighted in the Leading with Finance as the gold standard of valuation.
Discounted cash flow analysis is the process of estimating the value of a company or
investment based on the money, or cash flows, it’s expected to generate in the future.
Discounted cash flow analysis calculates the present value of future cash flows based on the
discount rate and time period of analysis.
Discounted Cash Flow =Terminal Cash Flow / (1 + Cost of Capital) # of Years in the Future
The benefit of discounted cash flow analysis is that it reflects a company’s ability to generate
liquid assets. However, the challenge of this type of valuation is that its accuracy relies on the
terminal value, which can vary depending on the assumptions you make about future growth
and discount rates.
3.5.3 Market Capitalization :
Market capitalization is one of the simplest measures of a publicly traded company's
value. It’s calculated by multiplying the total number of shares by the current share price.
Market Capitalization = Share Price x Total Number of Shares
One of the shortcomings of market capitalization is that it only accounts for the value
of equity, while most companies are financed by a combination of debt and equity. In this
case, debt represents investments by banks or bond investors in the future of the company;
Strategic Financial Managements 3.23 Financial Options and Value…

these liabilities are paid back with interest over time. Equity represents shareholders who own
stock in the company and hold a claim to future profits.
3.5.4 Enterprise Value :
The enterprise value is calculated by combining a company's debt and equity and then
subtracting the amount of cash not used to fund business operations.
Enterprise Value = Debt + Equity – Cash
To illustrate this, let’s take a look at three well-known car manufacturers: Tesla, Ford, and
General Motors (GM).
In 2016, Tesla had a market capitalization of $50.5 billion. On top of that, its balance sheet
showed liabilities of $17.5 billion. The company also had around $3.5 billion in cash in its
accounts, giving Tesla an enterprise value of approximately $64.5 billion.
Ford had a market capitalization of $44.8 billion, outstanding liabilities of $208.7 billion, and
a cash balance of $15.9 billion, leaving an enterprise value of approximately $237.6 billion.
Lastly, GM had a market capitalization of $51 billion, balance sheet liabilities of $177.8
billion, and a cash balance of $13 billion, leaving an enterprise value of approximately
$215.8 billion.
While Tesla's market capitalization is higher than both Ford and GM, Tesla is also financed
more from equity. In fact, 74 percent of Tesla’s assets have been financed with equity, while
Ford and GM have capital structures that rely much more on debt. Nearly 18 percent of
Ford's assets are financed with equity, and 22.3 percent of GM's.
3.5.5 EBITDA :
 When examining earnings, financial analysts don't like to look at the raw net income
profitability of a company. It’s often manipulated in a lot of ways by the conventions
of accounting, and some can even distort the true picture.
 To start with, the tax policies of a country seem like a distraction from the actual
success of a company. They can vary across countries or time, even if nothing
actually changes in the company’s operational capabilities. Second, net income
subtracts interest payments to debt holders, which can make organizations look more
or less successful based solely on their capital structures. Given these considerations,
both are added back to arrive at EBIT (Earnings Before Interest and Taxes), or
“operating earnings.”
 In normal accounting, if a company purchases equipment or a building, it doesn't
record that transaction all at once. The business instead charges itself an expense
called depreciation over time. Amortization is the same thing as depreciation but for
things like patents and intellectual property. In both instances, no actual money is
spent on the expense.
3.5.6 Present Value of a Growing Perpetuity Formula :
One way to think about these ratios is as part of the growing perpetuity equation. A
growing perpetuity is a kind of financial instrument that pays out a certain amount of money
each year—which also grows annually. Imagine a stipend for retirement that needs to grow
every year to match inflation. The growing perpetuity equation enables you to find out
today’s value for that sort of financial instrument. The value of a growing perpetuity is
calculated by dividing cash flow by the cost of capital minus the growth rate.
Value of a Growing Perpetuity = Cash Flow / (Cost of Capital - Growth Rate)
Centre For Distance Education 3.24 Acharya Nagarjuna University

So, if someone planning to retire wanted to receive $30,000 annually, forever, with a discount
rate of 10 percent and an annual growth rate of two percent to cover expected inflation, they
would need $375,000—the present value of that arrangement.
What does this have to do with companies? Imagine the EBITDA of a company as a
growing perpetuity paid out every year to the organization’s capital holders. If a company can
be thought of as a stream of cash flows that grow annually, and you know the discount rate
(which is that company’s cost of capital), you can use this equation to quickly determine the
company’s enterprise value. To do this, you’ll need some algebra to convert your ratios.
For example, if you take Tesla with an enterprise to EBITDA ratio of 36x, that means
the enterprise value of Tesla is 36 times higher than its EBITDA. If you look at the growing
perpetuity formula and use EBITDA as the cash flow and enterprise value as what you’re
trying to solve for in this equation, then you know that whatever you’re dividing EBITDA by
is going to give you an answer that is 36 times the numerator.
To find the enterprise value to EBITDA ratio, use this formula: enterprise value
equals EBITDA divided by one over ratio. Plug in the enterprise value and EBITDA values
to solve for the ratio.
Enterprise Value = EBITDA / (1 / Ratio)
In other words, the denominator needs to be one thirty-sixth, or 2.8 percent. If you
repeat this example with Ford, you would find a denominator of one-fifteenth, or 6.7 percent.
For GM, it would be one-sixth, or 16.7 percent. Plugging it back into the original equation,
the percentage is equal to the cost of capital.
3.6 SUMMARY :
In financial management, capital structure theory refers to systematic approach to
financing business activities through a combination of equities and liabilities. There are
several competing capital structure theories, each of which explores the relationship between
debt financing, equity financing, and the market value of the firm slightly differently. Sources
of finance mean the ways for mobilizing various terms of finance to the industrial concern.
Sources of finance state that, how the companies are mobilizing finance for their
requirements. Capital structure refers to the mix or proportion of different sources of finance
(debt and equity) to total capitalization. A firm should select such a financing mix which
maximizes its value /the shareholders’ wealth. Such capital structure refers to optimal capital
structure.
3.7 SELF ASSESSMENT QUESTIONS :
1. Explain the various sources of financing.
2. What is meant by security financing?
3. What is debt financing?
4. Discuss the relationship between capital structure and the value of the firm?
5. Discuss the relationship between dividend policy and the value of the firm?
6. Explain the relation between financial options and value of the firm?
3.8 SUGGESTED READINGS :
 [Link], Financial Management, Vikas Publisher.
 [Link], Financial Management, Tata McGraw Hill.
 Khan & Jain, Financial Management, Tata McGraw Hill.

Dr. [Link]
 LESSON – 4
MANAGERIAL IMPLICATION OF
SHAREHOLDERS VALUE CREATION
LEARNING OBJECTIVE :
 To make the students understand the managerial implications of Shareholders Value
Creation
 Able to understand the shareholders’ value creation
 Able to know about the managerial implications of SVC
STRUCTURE :
4.1 Concept of Implication of Shareholder Value Creation
4.2 Determinants of Shareholder Value Creation
4.3 Approaches for Measuring Shareholder Value
4.4 Drivers To Shareholder Value Creation
4.5 Shareholder value management cycle
4.6 Frame work of Shareholders value creation in companies
4.7 Advantages of Shareholder Value Analysis
4.8 Disadvantages of Shareholder Value Analysis
4.9 Managerial Implications Of Shareholder Value
4.10 Summary
4.11 Technical Terms
4.12 Self-Assessment Questions
4.13 Suggested Readings
4.1 CONCEPT OF IMPLICATION OF SHAREHOLDER VALUE CREATION :
Several economic theorists asserted that value is created when management produces
revenues over and above the economic costs to generate these revenues. Costs come from
four sources such as worker wages and benefits; material, supplies, and economic devaluation
of physical assets; taxes; and the opportunity cost of using the [Link] this value-based
view, value is only created when revenues surpass all costs including a capital charge. This
value accumulates typically to shareholders because they are the residual owners of the firm.
Shareholders assume management to produce value over and above the costs of resources
consumed, including the cost of using capital.
If dealers of capital do not receive good return to compensate them for the risk they
are taking, they will take out their capital for better revenues, since value will be lost. A
company that is destroying value will always fight to attract further capital to finance growth
since it will be constrained by a share price that stands at a discount to the underlying value
of its assets and by higher interest rates on debt or bank loans demanded by creditors.
Shareholder value creation infers continued creation of shareholder wealth through annual
dividend receipts and share price appreciations. Wealth creation is defined as the changes in
the wealth of shareholders on a periodic (annual) basis.
Applicable to exchange-listed firms, changes in shareholder wealth are inferred
mostly from changes in stock prices, dividends paid, and equity raised during the period.
Since stock prices reveal investor anticipations about future cash flows, creating wealth for
shareholders needs that the firm undertake investment decisions that have a positive net
Centre for Distance Education 4.2 Acharya Nagarjuna University

present value (NPV).Though these terms are used interchangeably, there is some difference
between value creation and wealth creation. The value standpoint is based on measuring
value directly from accounting-based information with some adjustments, while the wealth
viewpoint depends mainly on stock market information. For a publicly traded firm, these two
concepts are alike when management provides all relevant information to capital markets,
and the markets consider and have confidence in management.
Shareholder value: (Source: Banerjee, Banerjee Bhabotosh, 1977)
The company cannot create shareholder value

 If they disregard important constituencies, they must have good relationship with
customers, employees, suppliers, government and so on. This is a form of corporate
social responsibility, within an overall framework of shareholder wealth
maximization. There are many reasons for measuring and managing shareholder
value:
 Capital markets are becoming progressively international. Investors can voluntarily
shift investments to higher yielding, often foreign, opportunities.
 Corporate governance is instable, with owners now demanding accountability from
corporate executives. Exhibitions of the increased assertiveness of shareholders
include the necessity for executives to rationalise their compensation levels, and well-
publicized lists of underperforming companies and overpaid executives.
 Managers are concerned with self-preservation. Well-publicized hostile takeovers
have served notice to all levels of management that weak financial performance is
unacceptable and may precipitate a fight for corporate control. This potential loss of
control has motivated many executives to better understand the importance of
measuring and managing shareholder expectations.

4.2 DETERMINANTS OF SHAREHOLDER VALUE CREATION :

To create value, management must have thorough understanding of the performance variables
that drive the value of the business. These are known as key-value drivers. There are two
reasons for understanding these variables. First, the organization cannot act directly on value.
It has to act on things it can influence, such as customer satisfaction, cost, and capital
expenditures. Secondly, it is through these drivers of value that senior management learns to
understand the rest of the organization and to establish a dialogue for goal accomplishment.
A value driver is any variable that considerably affects the value of the organization.
Though value drivers need to be organized so that management can recognise which have the
greatest impact on value and assign responsibility for their performance to individuals who
can help the organization to meet its targets.
Strategic Financial Management 4.3 Managerial Implication of…

1.3 Approaches for Measuring Shareholder Value

The measures available to management and shareholders to appraise a firm's value-

creation performance can be categorized into three groups. In first type, measurement
includes those assessments which depend on mainly on the financial statements produced by
the firm, but require an estimation of the cost of capital and other adjustments to traditional
income statements and balance sheets to reveal operating cash flows and an appropriate
capital base.
These can be named value-creation measures.
The second type of measures, it includes those that rely entirely on stock market data and,
thus, are mainly applicable to exchange listed companies. These can be labelled as wealth-
creation measures. These measures concentrate on the impact on shareholder wealth and use
that as an indirect measure of annual (or periodic). In the category of measures, there are
hybrid value/wealth-creation measures and require both financial statement and stock market
data.

Company differences in financial sophistication, internal reporting capabilities, and business

characteristics create a need for tailored value measurement approaches. The practices differ
along a number of dimensions, including:

1. The simplicity/accuracy trade-off implied in each.

2. Management's ability to understand and control the measures.
3. The complexity required for implementation
1. The Equity Spread
Another measure of shareholder value creation is the equity spread proposed by Marakon
Associates. This measure reflects the difference between the ROE and required return on
equity (cost of equity) as the source of value creation. This measure is a variation of the EV
measures (Hussey, 2007). Marakan Associates, an international management-consulting firm
created in 1978, has done revolutionary work in the area of value-based management. This
measure contemplates the difference between the ROE and required return on equity (cost of
equity) as the source of value creation. This measure is a variation of the EV measures.
Centre for Distance Education 4.4 Acharya Nagarjuna University

Instead of using capital as the entire base and the cost of capital for calculating the capital
charge, this measure uses equity capital and the cost of equity to calculate the capital (equity)
charge. Congruently, it uses economic value to equity holders (net of interest charges) instead
of total firm value. For an all equity firm, both EV and the equity spread technique will offer
identical values because there are no interest charges and debt capital to consider. Even for a
firm that relies on some debt, the two measures will lead to identical insights provided there
are no extraordinary gains and losses, the capital structure is stable, and a proper re-
estimation of the cost of equity and debt is conducted.
In Marakan model, shareholder wealth creation is measured as the difference between the
market value and the book value of a firm's equity. According to the Marakon model, the
market-to-book values ratio is function of thee return on equity, the growth rate of dividends,
and cost of equity. For an all-equity firm, both EV and the equity-spread method will offer
same values because there are no interest charges and debt capital to consider. Even for a
firm that relies on some debt, the two measures will lead to identical insights provided there
are no extraordinary gains and losses, the capital structure is stable, and a proper re-
estimation of the cost of equity and debt is conducted.
A market is favourable only if the equity spread and economic profit earned by the average
competitor is positive. If the average competitor's equity spread and economic profit are
negative, the market is unappealing.
2. Alcar Approach
The Alcar group Inc. a management and Software Company, has established an approach to
value-based management which is based on cut-rate cash flow analysis. In this structure, the
importance is not on annual performance but on valuing expected performance. The inferred
value measure is similar to valuing the firm based on its future cash flows and is the method
most closely related to the DCF/NPV framework. In this approach, one guesses future cash
flows of the firm over a reasonable horizon, allocates a continuing (terminal) value at the end
of the horizon, estimates the cost of capital, and then estimates the value of the firm by
calculating the present value of these estimated cash flows. This technique of valuing the firm
is same to that followed in calculating NPV in a capital-budgeting context. Since the
computation reaches at the value of the firm, the implied value of the firm's equity can be
determined by subtracting the value of the current debt from the estimated value of the firm.
This value is the implied value of the equity of the firm.
To evaluate whether the firm's management has created shareholder value, one subtracts the
implied value at the beginning of the year from the value estimated at the end of the year,
adjusting for any dividends paid during the year. If this difference is positive, management
can be said to have created shareholder value.
The Alcar approach has been accepted by financial experts for two main reasons:
1. It is theoretically good as it utilize the discounted cash flow framework.
2. Alcar have made available computer software to popularize their approach.
3. There are numerous steps for assessing shareholder value:
4. Predict the operating annual cash flows over the planning period.
5. Discount the forecasted operating cash flow stream using weighted average cost of
capital.
6. Estimate the residual value of business plan/strategy at the end of the period and find
its present value. The residual value can be calculated by dividing Perpetuity cash
flows by Cost of capital.
7. Calculate the total shareholder value, which is equal to Present value of operating
cash flows plus Present value of Residual value minus Market value of Debt.
Strategic Financial Management 4.5 Managerial Implication of…

8. Establish the pre-strategy value through similar process.

9. Pre strategy value = Cash flows before decision making/Cost of Capital - Market
Value of Debt.
10. Calculate the value created by the strategy.
However, the Alcar approach has some drawbacks such as In the Alcar approach,
profitability is measured in terms of profit margin on sales. It is generally documented that
this is not a good index for comparative purposes. Fundamentally a verbal model, it is
unnecessarily burdensome. Therefore it requires a fairly involved computer programme.

3. Mckinsey Approach:
McKinsey & Company, profitable international consultancy firm has developed an
approach to value-based management which has been very well enunciated by Tom
Copeland, Tim Koller, and Jack Murrian of McKinsey & Company. They stated that
"Properly executed, value based management is an approach to management whereby the
company's overall aspirations, analytical techniques, and management processes are all
aligned to help the company maximize its value by focusing decision making on the key
drivers of value.
Main steps in the McKinsey approach to value-based maximization are as under:
 Make certain the supremacy of value maximization
 Find the value drivers
 Establish appropriate managerial processes
 Implement value-based management philosophy
4. The Discount Cash Flow Approach :
Actual economic value of a firm or a business or a project or any strategy depends on
the cash flows and the suitable discount rate (commensurate with the risk of cash flow).
There are various techniques for calculating the present value of a firm or a business/division
or a project.
The first method uses the weighted average cost of debt and equity (WACC) to discount the
net operating cash flows. When the value of a project with an estimated economic life or of a
firm or business over a planning horizon is calculated, then an estimate of the terminal cash
flows or value will also be made. Thus, the economic value of a project or business is:
Economic Value = Present Value of net operating cash flows + Present value of terminal
value
The second method of calculating the economic value explicitly incorporates the value
created by financial leverage. The steps that are involved in this method of estimation of the
firm's total value are as follows:

1. Estimate the firm's unlevered cash flows and terminal value.

2. Determine the unlevered cost of capital.
3. Discount the unlevered cash flows and terminal value by the unlevered cost of capital.
4. Calculate the present value of the interest tax shield discounting at the cost of debt.
5. Add these two values to obtain the levered firm's total value.
6. Subtract the value of debt from the total value to obtain the value of the firm's shares.
Centre for Distance Education 4.6 Acharya Nagarjuna University

7. Divide the value of shares by the number of shares to obtain the economic value per
share.
The third method to determine the shareholder economic value is to calculate the value of
equity by discounting cash flows available to shareholders by the cost of equity. The present
value of equity is given as below:
Economic value of equity = Present value of equity cash flows + Present value of terminal
investment.
4.4 DRIVERS TO SHAREHOLDER VALUE CREATION :
In order to maximize shareholder value, there are three main strategies for driving
profitability in a company: (1) revenue growth, (2) increasing operating margin, and (3)
increasing capital efficiency. We will discuss in the following sections the major factors in
boosting each of the three measures.
Revenue Growth : For any goods and services businesses, sales revenue can be improved
through the strategies of sales volume increase or sales price inflation.
Increasing Sales Volume : A company would want to retain its current customers and keep
them away from competitors to maintain its market share. It should also attract new
customers through referrals from existing customers, marketing and promotions, new
products and services offerings, and new revenue streams.
Raising Sales Price : A company may increase current product prices as a one-time strategy
or gradual price increases throughout several months, quarters, or years to achieve revenue
growth. It can also offer new products with advanced qualities and features and price them at
higher ranges.
Ideally, a business can combine both higher volume and higher prices to significantly
increase revenue.
Operating Margin : Besides maximizing sales, a business must identify feasible approaches
to cost reductions leading to optimal operating margins. While a company should strive to
reduce all its expenses, COGS (Cost of Goods Sold) and SG&A (Selling, General, and
Administrative) expenses are usually the largest categories that need to be efficiently
managed and minimized.
Cost of Goods Sold (COGS) : When a company builds a good relationship with its
suppliers, it can possibly negotiate with suppliers to reduce material prices or receive
discounts on large orders. It may also form a long-term agreement with the suppliers to
secure its material source and pricing.
Many companies use automation in their manufacturing processes to increase
efficiency in production. Automation not only reduces labor and material costs, but also
improves the quality and precision of the products and, thus, largely reduces defective and
return [Link] management is the process by which activities associated with returns and
reverse logistics are managed. It is an important factor in cost reduction because a good
return management process helps the company manage the product flow efficiently and
identify ways to reduce undesired returns by customers.
Selling, General, and Administrative (SG&A) Expenses : SG&A is usually one of the
largest expenses in a company. Therefore, being able to minimize them will help the
company achieve an optimal operating margin. The company should tightly control its
marketing budget when planning for next year’s spending. It should also carefully manage its
Strategic Financial Management 4.7 Managerial Implication of…

payroll and overhead expenses by evaluating them periodically and cutting down on
unnecessary labor and other costs.
Shipping cost is directly associated with product sales and returns. Therefore, good
return management will help reduce the cost of goods sold as well as logistics costs.
Capital Efficiency : Capital efficiency is the ratio between dollar expenses incurred by a
company and dollars that are spent to make a product or service, which can be referred to as
ROCE (Return on Capital Employed) or the ratio between EBIT (Earnings Before Interest
and Tax) over Capital Employed. Capital efficiency reflects how efficiently a company is
deploying its cash in its operations.
ROCE=EBIT/CAPITAL EMPLOYED : Capital employed is the total amount of capital a
company uses to generate profit, which can be simplified as total assets minus current
liabilities. A higher ROCE indicates a more efficient use of capital to generate shareholder
value, and it should be higher than the company’s capital cost.
Property, Plant, and Equipment (PP&E) : To achieve high capital efficiency, a company
would first want to achieve a high return on assets (ROA), which measures the company’s net
income generated by its total [Link] time, the company might also shift to developing
proprietary technology, which is a system, application, or tool owned by a company that
provides a competitive advantage to the owner. The company can then profit from utilizing
this asset or licensing the technology to other companies. Proprietary technology is an
optimal asset to possess because it increases capital efficiency to a great extent.
Inventory : Inventory is often a major component of a company’s total assets, and a
company would always want to increase its inventory turnover, which equals net sales
divided by average inventory. A higher inventory turnover ratio means that more revenues
are generated given the amount of inventory. Increasing inventory turnover also reduces
holding costs, consisting of storage space rent, utilities, theft, and other expenses. It can be
achieved by effective inventory management, which involves constant monitoring and
controlling of inventory orders, stocks, returns, or obsolete items in the [Link]
buying efficiency can be greatly improved by using the Just-in-time (JIT) system. Costs are
only incurred when the inventory goes out and new orders are being placed, which allows
companies to minimize costs associated with keeping and discarding excess inventory.
4.5 SHAREHOLDER VALUE MANAGEMENT CYCLE :
A successful implementation of shareholder value management means that the firm selects a
strategy that maximizes the expected shareholder value, finds the highest valued use for all
assets bases performance evaluation and incentive compensation on shareholder value added
and returns cash to shareholders when value creating investments do not exist
Centre for Distance Education 4.8 Acharya Nagarjuna University

It is a ongoing process of the organisation to enhance the value

of the shareholders.

4.6 FRAME WORK OF SHAREHOLDERS VALUE CREATION IN COMPANIES:

In highly volatile and complicated marketplace, it is import to create shareholder value

which can lead to firm's success. Shareholder value is a business concept, and referred as
shareholder value maximization or as the shareholder value model, which suggests that the
ultimate measure of a company's achievement is the extent to which it augments
shareholders. It became popular during the 1980s. This notion is used in several ways:

 To refer to the market capitalization of a company.

 To refer to the model that the main goal for a company is to increase the wealth of its
shareholders (owners) by paying dividends and/or causing the stock price to increase.
4.6 FRAMEWORK FOR SHAREHOLDERS VALUE CREATION
 Strategic Financial Management 4.9 Managerial Implication of…

There is more pressure on corporate directors to measure, manage and report the creation of
shareholder value regularly. In the emergent field of shareholder value analysis, various
measures have been developed that claim to measure the creation of shareholder value and
wealth. Value creation means creating value for shareholders.
Value creation should be the focus of all the metrics. When organization creates value
for shareholders, it means that they are creating value for all the stake holders.

Creating value for shareholders is now extensively recognized corporate objective. The
interest in value creation has been motivated by several developments.

1. Capital markets are becoming progressively global. Investors can willingly shift
investments to higher yielding, often foreign, opportunities.
2. Institutional investors, which usually were inactive investors, have begun exerting
influence on corporate managements to create value for shareholders.
3. Corporate governance is instable, with owners now demanding liability from corporate
managers. Manifestations of the increased assertiveness of shareholders include the need
for executives to justify their compensation levels, and well-publicized lists of
underperforming companies and overpaid officials.
4. Business press is highlighting shareholder value creation in performance rating exercises.
5. More focus is to link top management compensation to shareholder returns.

4.7 ADVANTAGES OF SHAREHOLDER VALUE ANALYSIS :

Shareholder value analysis has numerous benefits as the management of a company should
first consider the interest and the advantage of the shareholders, before it meets any decision.

The Advantages of Shareholder Value Analysis are as under:

 It provides a long-term financial view on which to base strategic decisions.

 It provides a universal approach that is not subject to the particular accounting policies
that are adopted. It is therefore internationally applicable and can be used across
sectors.
 It forces the organization to focus on the future and its customers, in particular the
value of future cash flows.

4.8 DISADVANTAGES OF SHAREHOLDER VALUE ANALYSIS :

Disadvantages of the shareholder value analysis are as under:

 One major drawback of the tendency of corporations to focus on maximizing

shareholder value is that it can lead to poor or unsustainable business practices.
 Another disadvantage of shareholder value analysis is that estimation of future cash
flows, a key component of SVA can be very difficult to complete precisely. This can
lead to incorrect or misleading figures forming the basis of strategic decisions.
Development and implementation of the system can be long and difficult.
Centre for Distance Education 4.10 Acharya Nagarjuna University

 Management of shareholder value requires more complete information than

traditional measures.
 It has been observed that companies which concentrate on maximizing shareholder
value might lose focus on what customers want, or might do things that are not
optimal for customers.
 Other harmful effect of shareholder value maximization is that it can unhappy
employees. The lower corporation's costs, the more profit it stands to make if its total
revenue is constant, so corporations can benefit from cutting employee benefits and
wages. If domestic labour is not inexpensive enough or not productive enough,
businesses can outsource labour to foreign workers who are willing to work for lower
wages.

4.9 MANAGERIAL IMPLICATIONS OF SHAREHOLDER VALUE :

The Shareholder value approach is based on the assumption that a principal-agent
relationship exists between the shareholders and the management. As shareholders’ agent,
management is charged with the responsibility of creating wealth for shareholders. Therefore,
all management actions and strategies should be guided by SVC.

The foundation of SVC is the notion that the shareholder value depends on the future
cash flows and their risk. The cost of capital, accounting for the timing and risk of future cash
flows, is used to determine the present value of cash flows. We should note that SVC
emphasizes the present value of future cash flows rather than earnings. Earnings suffer from
accounting policy biases and subjectivism. They are not directly linked to value.
The SVC approach helps to strengthen the competitive position of the firm by
focusing on wealth creation. It provides objective and consistent framework of evaluation and
decision-making across all functions, departments and units of the firm. It can be easily
implemented since cash flow data can be obtained by suitably adapting the firm’s existing
system of financial projection and planning.
SVC takes a long-term perspective and focuses on valuation. A number of companies
in India use the DCF analysis to evaluate projects. They accept those projects which are
expected to generate internal rate of return higher than the cost of capital, or a positive net
present value of future cash flows when discounted at the cost of capital. More and more
corporate managers now realise the strong need for the extensive adoption of SVC in realise
the strong need for the extensive adoption of SVC in evaluating all management actions,
projects, business strategies and overall strategic planning.

SVC can be used to evaluate the consequences of strategies pursued by the company.
At the business unit or division level, it is used to evaluate the alternative competitive
strategies, to identify the key business factors that impact SVC and to set performance targets
that are consistent with value creation. At the corporation level, it is used to evaluate the
contribution of the strategic combination of businesses that will create maximum value, to
identify products or businesses for divestiture and to mergers and acquisition activities.
The following steps are involved in using SVC based on DCF approach for strategic analysis
and planning
Strategic Financial Management 4.11 Managerial Implication of…

STEP-I: Evaluate the current position of each division assuming that there will not
be any significant changes from the current strategy.
STEP-II: Estimate the business unit’s net operating cash flows from the current
strategy over the planning horizon, make explicit assumptions about sales growth, operating
profit margin, tax rate, changes in working capital and additional capital expenditure needed
to sustain the existing strategies.
STEP-III: Estimate the unlevered cost of capital (Ku) of the business unit. The
unlevered beta of an independent company similar to the business unit can be used for
calculating the business unit’s cost of capital.
STEP-IV: Estimate the terminal or the residual value of post-planning period. Make
appropriate assumptions about the post-planning growth of cash flows keeping in mind the
nature of competition.
STEP-V: Calculate the present value of net operating cash flows and terminal value
at the cost of capital
STEP-VI: Calculate the present value of interest tax shield at the cost of debt. If the
amount of debt is not directly observable, then use the debt ratio of similar independent firms
to determine the business unit’s amount of debt.
STEP-VII: Add the present values of net operating cash flows, terminal value and
interest tax shield to obtain the total value of the business.
STEP- IX: Subtract the value of debt from the total value to calculate the shareholder
value.
STEP-X: Repeat the above mentioned steps to calculate the shareholder value if the
Centre for Distance Education 4.12 Acharya Nagarjuna University

business until follows a new strategy. The difference between the shareholder value created
(or destroyed). Go for new strategy if a positive value is created for the shareholder.
STEP- XI: Strategic plans of all business units should be integrated into the corporate
strategic plan. SVC approach should be utilised to exploit the synergy between various units.
The focus should be on maximising the overall shareholder value rather than treating
business units as absolutely autonomous and working at cross purposes.
DCF approach is easily amenable for evaluating long term projects and business
strategies. However, tracking the operating performance more frequently, EVA approach is
operationally more feasible. EVA, after making appropriate adjustments, is closer to cash
flows. It is the experience of a large number of adopters of EVA that higher EVA leads to
higher market value of shares.
4.10 SUMMARY :
After studied this students should be able to understand the concept shareholders value
creation, drivers of shareholders creation, framework of shareholders value creation,
Shareholders management cycle, advantages and disadvantages of shareholders analysis and
implications of shareholders value creation.
4.11 TECHNICAL TERMS :
 Shareholder: A shareholder is a person, company, or institution that owns at least
one share of a company’s stock or in a mutual fund. Shareholders essentially own the
company, which comes with certain rights and responsibilities. This type of
ownership allows them to reap the benefits of a business’s success.
 Shareholders Value: Shareholder value is the value enjoyed by a shareholder by
possessing shares of a company. It is the value delivered by the company to the
shareholder. Increasing the shareholder value is of prime importance for the
management of a company. So the management must have the interests of
shareholders in mind while making decisions. The higher the shareholder value, the
better it is for the company and management.
 Profitability: is essential to developing your business and entrepreneurial
competencies. It's also essential when pursuing a career in accounting or finance.
Profitability is a measure of a business's profit relative to its expenses. In other words,
it's an organisation's ability to generate income It by using resources that it has
available, such as people, time and equipment. Profit ability is the primary goal of all
companies. Because it's the money that business ventures generate through their
activities, it enables those ventures to grow, develop new products or enter new
markets.
 Financial stability: It can be defined as “a condition in which the financial system is
not unstable". It can also mean a condition in which the three components of the
financial system -- financial institutions, financial markets and financial infrastructure
-- are stable. ‘Stability of financial institutions’ refers to a condition in which
individual financial institutions are sound enough to carry out their financial
intermediation function adequately, without assistance from external institutions
including the government.
 Value creation: It is the process of turning resources into something valuable with
work. In economics, it is a broad term that includes the production of tangible goods
and services. It also includes investment in capital goods and intellectual property
products.
Strategic Financial Management 4.13 Managerial Implication of…

4.12 SELF-ASSESSMENT QUESTIONS :

1. What is meant by shareholders value creation
2. Explain the concept of shareholders value creation
3. What are the drivers shareholders value creation
4. What are the advantages and disadvantages of shareholders value analysis in
organisation
5. What are approaches to measure the shareholders value in organisations
6. What are the managerial implications of shareholders value creation

4.13 SUGGESTED READINGS :

1. Van Horn, JC, Financial Management and Policy, Prentice Hall,New Delhi
2. PG Godbole, Mergers, Acquisitions and Corporate Restructuring, Vikas, NewDelhi
3. Weaver, Strategic Corporate Finance, Cengage,ND
4. Weston JF, Chung KS &Heag SE., Mergers, Restructuring &
Corporate Control, Prentice Hall.
5. GP Jakarthiya, Strategic Financial Management, Vikas, NewDelhi
6. Coopers & Lybrand, Strategic Financial: Risk Management, Universities Press
(India)Ltd.
7. Robicheck, A, and Myers, S., Optimal Financing Decisions, Prentice HallInc.
8. James [Link], RiskLThe New Management Imperative in Finance, A
JaicoBook.

Dr. [Link]
 LESSON - 5

LEVERAGE EFFECT AND SHAREHOLDERS’ RISK

LEARNING OBJECTIVES :
After studying this lesson, you will be able to:
 To make the students understand the leverage effect and shareholder’s risk.
 Explain the meaning of financial leverage.
 Identify the relationship between risk and leverage.
 Compare the operating leverage and financial leverage.
 Acquaint with the concept of working capital leverage and total leverage.

STRUCTURE
5.1 Introduction
5.2 Definitions
5.3 Concept of leverage
5.4 Types of leverage
5.4.1 Operating leverage
5.4.2 Financial leverage
5.4.3 Combined leverage
5.5 Difference between operating leverage and financial leverage
5.6 Working capital leverage
5.7 Effects of leverage on shareholder’s return
5.8 Risk and leverage
5.9 Relationship between financial risk and financial leverage
5.10 Summary
5.11 Glossary
5.12 Self assessment questions
5.13 Lesson end exercise
5.14 Suggested readings

5.1 INTRODUCTION :
The term leverage, in general, refers to a relationship between two inter-related
variables. It refers to an increased means of accomplishing some purpose. Leverage is used to
lifting heavy objects, which may not be otherwise possible. In the financial point of view,
leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to
its shareholders. With reference to a business firm, these variables may be costs, output, sales
revenue, EBIT, Earnings Per share (EPS) etc. In financial analysis, the leverage reflects the
responsiveness or influence of one financial variable over some other financial variable.
Thus, leverage refers to relationship between two variables as reflected in a unit change in
one variable consequent upon a unit change in another variable. In financial management
Operating leverage, financial leverage and Combined Leverage is calculated. The Operating
relationship establishes the relationship between sales and EBIT. It measures the effect of
change in sales revenue on the level of EBIT. Operating leverage appears as a result of fixed
cost. The financial leverage measures the responsiveness of the EPS for given change in
EBIT. The financial leverage appears as a result of fixed financial charge i.e. interest and
preference dividend. Combined leverage may also be ascertained to measures the % change
Centre for Distance Education 5.2 Acharya Nagarjuna University

in EPS for a % change in the sales. Financial leverage measures the extent to which the cost
of project has been funded by borrowed money as compared to owner’s equity. EBIT –EPS
Analysis indicates the projected EPS for different financial plans. In Leverage analysis the
relationship between two interrelated variables is established.
5.2 DEFINITIONS :
Leverage is an investment strategy of using borrowed money—specifically, the use of
various financial instruments or borrowed capital—to increase the potential return of an
investment. Leverage can also refer to the amount of debt a firm uses to finance assets. The
employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed
return is called leverage. Various authors have defined leverage in different ways.
 According to James C. Van Home, ‘Leverage refers to the use of fixed cost in an
attempt to increase (or lever up) profitability’.
 In the words of J. E. Walter, ‘Leverage may be defined as percentage return on
equity and the net rate of return on total capitalization’.
 Ezra Solomon defined leverage as ‘the ratio of net returns on shareholders equity and
the net rate of return on total capitalization’.
 According to S. C. Kuchhal, the term leverage ‘is used to describe a firm’s ability to
use fixed cost bearing assets or funds to magnify the return to its owners’.
Thus leverage implies the use of fixed cost in an attempt to increase profitability. It can b
defined as; leverage is the responsiveness of firm’s return to fluctuations in revenue and
operating income, and the ability of a firm to magnify the influence resulting in higher return.

5.3 CONCEPT OF LEVERAGE :

The leverage may be defined as the % change in one variable divided by the %
change in some other variable or variables. Impliedly, the numerator is the dependent
variable, say X, and the denominator is the independent variable, say Y. The leverage
analysis thus, reflects as to how responsiveness is the dependent variable to a change in the
independent variables.
James Horne defined leverage as, the employment of an asset or fund for which the firm
pays a fixed cost or fixed return.

% Change in the dependent variable

Leverage =
% Change in the Independent variable

For example, A firm increased its sales promotion expenses from Rs 5,000 to Rs.
6,000 i.e. an increase of 20%. This resulted in the increase in no. Of unit sold from 200 to 300
i.e. an increase of 50%.
The leverage may be defined as = 0.50/0.20= 6.5
This means that % increase in number of unit sold is 6.5 times that of % increase in
sales promotion expenses. The operating profit of a firm is a direct consequence of the sales
revenue of the firm and in turn operating profit determines the profit available to the equity
shareholders. The functional relationship between the sales revenue and the EPS can be
established through operating profit (EBIT) as follow:
Strategic Financial Management 5.3 Leverage Effect and...

Sales Revenue EBIT

-Variable costs - Interest
Contribution Profit before tax
-Fixed Costs - Tax
EBIT Profit after Tax (EPS)

The left hand side sows that the level of EBIT depends upon the level of sales revenue
and the right hand side shoes that the level of profit after tax or EPS depends upon the level
of EBIT. The relationship between Sales revenue and EBIT is defined as operating leverage
and the relationship between EBIT and EPS is defined as financial leverage. The direct
relationship between sales revenue and EPS can also be established by combining the
operating leverage and financial leverage and is defined as the Composite leverage. Thus,
leverage can be classified into three major headings according to the nature of the finance
mix of the company.

The company may use financial leverage or operating leverage, to increase the EBIT and
EPS. The various types of leverages are explained below:

5.4 TYPES OF LEVERAGE :

5.4.1 Operative Leverage :

The leverage associated with investment activities is called as operating leverage. It is
caused due to fixed operating expenses in the company. Operating leverage may be defined
as the company’s ability to use fixed operating costs to magnify the effects of changes in
sales on its earnings before interest and taxes. Operating leverage consists of two important
costs viz., fixed cost and variable cost. When the company is said to have a high degree of
operating leverage if it employs a great amount of fixed cost and smaller amount of variable
cost. Thus, the degree of operating leverage depends upon the amount of various cost
structure.
Whenever, the % change in EBIT resulting from given % change in sales is greater
than the % change in sales, the OL exists and the relationship is known as the DOL (Degree
of Operating Leverage). This means that as long as the DOL is greater than 1, there is an OL.
The OL emerges as result of existence of fixed element in the cost structure of the firm. The
OL, therefore, may be defined as firm’s position or ability to magnify the effect of change in
sales over the level of EBIT. The level of fixed costs, which is instrumental in bringing this
magnifying effect, also determines the extent of this effect. Higher the level of fixed costs in
relation to variable costs, greater would be the DOL. The DOL may, at any particular sales
volume, also be calculated as a ratio of contribution to the EBIT.
Operating leverage can be determined with the help of a break even analysis.
Centre for Distance Education 5.4 Acharya Nagarjuna University

Operating leverage can be calculated with the help of the following formula:

Contribution
Operating Leverage =
Operating Profit (EBIT)

Degree of operating leverage :

When the sale increases or decreases, the EBIT also changes. The operating leverage
measures the relationship between the sales revenue and the EBIT or in other words, it
measures the effect of change in sales revenue on the level of EBIT. The degree of operating
leverage may be defined as percentage change in the operating income (EBIT) resulting from
a percentage change in the sales. It can be calculated with the help of the following formula:

Percentage change in EBIT

DOL =
Percentage Change in Sales
For example, ABC Ltd. sells 1000 unit @ Rs.10 per unit. The cost of production is
Rs.7 per unit and the whole of the cost is variable in nature. The profit of the firm is 1,000 x
(Rs.10 – Rs.7) = Rs.3,000. Suppose, the firm is able to increase its sales level by 40%
resulting in total sales of 1400 units. The profit of the firm would now be 1400 x (Rs.10 –
Rs.7) = Rs. [Link] operating leverage of the firm is

Percentage change in EBIT

DOL =
Percentage Change in Sales

RS.1200
3000
DOL=
Rs. 4000
10,000
=1
The Operating Leverage of 1 denotes that the EBIT level increases or decreases in
direct proportion to the increase or decrease in sales level. This is due to fact that there is no
fixed costs and total cost is variable in nature. Thus, impliedly, the profit level i.e. the EBIT
varies in direct proportion to the sales level. So EBIT varies in direct proportion to sales
level.
Thus, on the basis of the above analysis, the OL may be interpreted as follows:

1. The OL is the % change in EBIT as a result of 1% change in sales. OL arises as a

result of fixed cost in the cost structure. If there is no fixed cost, there will be no OL
and the % change in EBIT will be same as % change in sales.
2. A positive DOL means that the firm is operating at a level higher than the breakeven
level and both the EBIT and sales will vary in the same direction.
3. A negative DOL means that the firm is operating at a level lower than the breakeven
level; and the EBIT will be negative.
Strategic Financial Management 5.5 Leverage Effect and...

Significance and uses of operating leverage :

Operating leverage is one of the techniques to measure the impact of changes in sales
which lead for change in the profits of the company. If any change in the sales, it will lead to
corresponding changes in profit. Operating leverage helps to identify the position of fixed
cost and variable cost. Operating leverage measures the relationship between the sales and
revenue of the company during a particular period. Operating leverage helps to understand
the level of fixed cost which is invested in the operating expenses of business activities. It
describes the overall position of the fixed operating cost.
Analysis of operating leverage of a firm is very useful to the financial manger. It tells
the impact of changes in sales on operating income. A firm having higher DOL (Degree of
operating Leverage) can experience a magnified effect on EBIT for even a small change in
sales level. Higher DOL can dramatically increase the operating profits. But if there is decline
in sales level, EBIT may be wiped-out and a loss may be operated. As explained earlier, the
operating leverage depends on fixed costs. If the fixed costs are higher, the higher would be
firm’s operating leverage and its operating risks. Higher operating leverage indicates that the
break-even point would be reached at a high level of sales. Also, in the case of higher
operating leverage, the margin of safety would be low. Therefore, it is preferred to operate
sufficiently above break-even point to avoid the danger of fluctuations in sales and profits.
Operating Leverage explains the effect of change in sales on EBIT. When there is
high operating leverage, a small rise in sales will result in a larger rise in EBIT. But if there is
small drop in sales, EBIT will fall dramatically or may even be wiped off. Thus, existence of
high operating leverage reflects high-risk situation. As the operating leverage reaches its
maximum near break-even point, the firm can protect itself from the dangers of operating
leverage and the consequent operating risk by operating sufficiently above the break-even
point.
5.4.2 Financial Leverage :
A leverage activity with financing activities is called financial leverage. Financial
leverage represents the relationship between the company’s earnings before interest and taxes
(EBIT) or operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The
use of long-term fixed interest bearing debt and preference share capital along with share
capital is called financial leverage or trading on equity”.
Financial leverage may be favorable or unfavorable depends upon the use of fixed
cost funds. Favorable financial leverage occurs when the company earns more on the assets
purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive
financial leverage. Unfavorable financial leverage occurs when the company does not earn as
much as the funds cost. Hence, it is also called as negative financial leverage.

In other words, the Financial Leverage (FL) measures the relationship between the EBIT and
the EPS and it reflects the effect of change in EBIT on the level of EPS. The FL measures the
responsiveness of the EPS to a change in EBIT and is defined as the % change in EPS
divided by the % change in EBIT. Symbolically,

Operating Profit (EBIT)

Financial Leverage =
Profit before Tax
Centre for Distance Education 5.6 Acharya Nagarjuna University

Hence, the FL may be defined as a % increase in EPS that is associated with a given
% increase in the level of EBIT. The increase in EPS of the firm may be more than
proportionate for increase in the level of EBIT. In other words, the effect of increase or
decrease in EBIT is magnified on the level of EPS. The existence of fixed financing charge is
instrumental to bring this magnifying effect and also determines the extent of this effect.
Higher the level of fixed financial charge, greater would be the FL.
Degree of financial leverage :
Degree of financial leverage may be defined as the percentage change in taxable profit as a
result of percentage change in earnings before interest and tax (EBIT). This can be calculated
by the following formula:

Percentage change in Taxable Income

DFL =
Percentage change in Operating Income

Alternative definition of financial leverage :

According to Gitmar, “financial leverage is the ability of a firm to use fixed financial
changes to magnify the effects of change in EBIT and EPS”.

Percentage change in EPS

DFL =
Percentage change in EBIT
On the basis of above analysis, the Financial Leverage can be interpreted as:
a) The Financial Leverage is a % change in EPS as result of 1% change in EBIT. The FL
emerges as a result of fixed financial cost (in the form of interest and preference
dividend). If there is no fixed financial liability, there will be no FL. In such a case the
% change in EPS will be same as % change in EBIT.
b) A positive FL means that the firm is operating at a level of EBIT which is higher than
the financial break-even level and both the EBIT and EPS will vary in the same
direction as the EBIT changes.
c) A negative FL means that the firm is operating at a level lower than the financial
break-even level and the EPS will be negative.
Significance and uses of financial leverage :
a. Planning of capital structure: the capital structure is concerned with the raising of
long term funds both from the shareholders and long term creditors. A financial
manager has to decide about the ratio between fixed cost funds and equity share
capital. The effects of borrowing on cost of capital and financial risk have to be
discussed before selecting a final capital structure.
b. Profit planning: the EPS is affected by the degree of financial leverage. If the
profitability of the concern is increasing ten the fixed cost funds will help in
increasing the availability of profits for equity shareholders. Financial leverage is
important for profit planning.
Thus, financial leverage helps to examine the relationship between EBIT and EPS.
Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT. Financial leverage locates the correct profitable financial decision regarding
Strategic Financial Management 5.7 Leverage Effect and...

capital structure of the company. Financial leverage is one of the important devices which is
used to measure the fixed cost proportion with the total capital of the company. If the firm
acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per
share and return on equity capital will decrease. The impact of financial leverage can be
understood with the help of the following exercise.
Financial BEP :
It is the level of EBIT which covers all fixed financing costs of the company. It is the level of
EBIT at which EPS is zero.
Indifference Point :
It is the point at which different sets of debt ratios (percentage of debt to total capital
employed in the company) gives the same EPS.

5.4.3 Combined Leverage :

The Combined Leverage (CL) is not a distinct type of leverage analysis, rather it is a
product of the OL and the FL. Both the financial and operating leverage magnify the revenue
of the firm. Operating leverage reflects the income which is the result of the production. On
the other hand, the financial leverage of the result of financial decisions.
The composite leverage focuses the attention on the entries income of the concern.
The risk factor should be properly assessed by the management before using the composite
leverage. The high financial leverage may be offset against low operating leverage vice versa.
Combined leverage is also called as composite leverage or total leverage. Combined leverage
expresses the relationship between the revenue in the account of sales and the taxable
income. The CL may be defined as the % change in EPS for a given % change in the sales
level and may be calculated as follows:

Degree of combined leverage :

The percentage change in a firm’s earning per share (EPS) results from one percent change in
sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of
financial leverage (DFL) at a particular level of sales.

Percentage change in EPS

Degree of Combined leverage =
Percentage change in Sales
The Combined Leverage is interpreted as:
a. The Combined Leverage is the % change in EPS resulting from a 1% change
in sales level.
b. A positive CL means that the leverage is being computed for a sales level
higher than the break-even level and both the EPS and sales will vary in the
same direction.
c. A negative CL means that the leverage is being calculated for a sales level
lower than the financial break-even level and EPS will be negative.
Illustration 5.1: Calculate the Degree of Operating Leverage (DOL), Degree of Financial
leverage (DFL) and the Degree of Combined Leverage (DCL) for the following firms and
interpret the results.
Centre for Distance Education 5.8 Acharya Nagarjuna University

Firm A Firm B Firm C

Output (units) 60,000 15,000 1,00,000

Fixed Costs (Rs) 7,000 14,000 1,500
Variable cost per unit (Rs.) 0.20 1.50 0.02
Interest on borrowed funds 4,000 8,000 -----
Selling price per unit (Rs) 0.60 5.00 0.10

Solution:

Firm A Firm B Firm C

Output (units) 60,000 15,000 1, 00,000
Selling price per unit (Rs) 0.60 5.00 0.10
Variable cost per unit (Rs.) 0.20 1.50 0.02
Contribution per unit 0.40 3.50 0.08
Total Contribution Rs.24,000 Rs.52,500 Rs.8,000
Less fixed costs 7,000 14,000 1,500
EBIT 17,000 38,500 6,500
Less Interest 4,000 8,000 -----
Profit
Degree before Tax
of Operating Leverage 13,000 30,500 6,500

Contribution/EBIT 24,000/17,000 52,500/38,000

8,000/6,500
= 5.41 =5.36 = 5.23

Degree of Financial Leverage :

EBIT/PBT 17,000/13,000 38,500/30,500
6,500/6,500
= 5.31 = 5.26 = 5.00
Degree of Combined Leverage :

Contribution/ EBIT 24,000/13,000 52,500/30,500

8,000/6,500
= 5.85 = 5.72 = 5.23

Illustration 5.2: A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed
costs of Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating,
financial and combined leverages? If the firm wants to double its earnings before interest and
tax (EBIT), how much of a rise in sales would be needed on a percentage basis?
Solution:
Statement of Existing Profit :
Strategic Financial Management 5.9 Leverage Effect and...

Sales Rs.10,00,000
Less Variable cost 7,00,000
Contribution 3,00,000
Less fixed cost 2,00,000
EBIT 1,00,000
Less Interest @ 10% on 5,00,000 50,000
Profit after Tax 50,000
Operating leverage Contribution/ EBIT = 3,00,000/1,00,000 = 3
Financial Leverage EBIT/PBT = 1,00,000/50,000 = 2
Combined Leverage = 3x 2= 6

Statement of sales needed to double EBIT :

Operating Leverage is 3 times i.e. 33 – 1/3% increase in sales volume causes a 100% increase
in operating profit or EBIT. Thus, at the sales of Rs. 13,33,333, operating profit or EBIT will
become Rs. 2,00,000 i.e. double existing one.
Verification:

Sales Rs.13,33,333
Variable cost (70%) 9,33,333
Contribution 4,00,000
Fixed Costs 2,00,000
EBIT 2,00,000

Illustration 5.3: The balance sheet of Well Established Company is as follows:

Liabilities Amount Assets Amount

Equity share capital 60,000 Fixed Assets 1,50,000
Retained Earnings 20,000 Current Assets 50,000
10% long term debt 80,000
Current Liabilities 40,000
2,00,000
The company’s total assets turnover ratio is 3, its fixed operating costs are2,00,000

Rs.1,00,000 and its variable operating cost ratio is 40%. The income tax rate is 50%.
Calculate the different types of leverages given that the face value of share is Rs.10.
Solution: Total Assets Turnover Ratio = Sales / Total Assets
3 = Sales/2,00,000
Centre for Distance Education 5.10 Acharya Nagarjuna University

Sales 6,00,000
Variable Operating Cost (40%) 2,40,000
Contribution 3,60,000
Less Fixed Operating Cost 1,00,000
EBIT 2,60,000
Less interest (10%of 80,000) 8,000
PBT 2,52,000
Tax at 50% 1,26,000

PAT 1,26,000
Number of shares 6,000
EPS Rs.21
Degree of Operating Leverage = Contribution/EBIT
= 3,60,000/2,60,000 = 1.38
Degree of Financial leverage = EBIT / PBT
= 2,60,000/2,52,000 = 1.03
Degree of Combined Leverage =1.38 x 1.03 = 1.42

Illustration 5.4: The following information is available for ABC & Co.

EBIT Rs. 11,20,000

Profit before Tax 3,20,000
Fixed Costs 7,00,000

Calculate % change in EPS if the sales are expected to increase by 5%.

Solution: In order to find out the % change in EPS as a result of % change in sales, the
combined leverage should be calculated as follows:
Operating Leverage = Contribution/ EBIT
= Rs.11,20,000 + Rs. 7,00,000/11,20,000
= 5.625
Financial Leverage = EBIT / Profit before Tax
= Rs. 11,20,000/3,20,000
= 7.5

Combined Leverage = Contribution/ Profit before Tax = OL x FL

= 5.625 x 7.5 = 5.69
Strategic Financial Management 5.11 Leverage Effect and...

The combined leverage of 5.69 implies that for 1% change in sales level, the % change in
EPS would be 5.69% So, if the sales are expected to increase by 5%, then the % increase in
EPS would be 5 x 5.69 = 28.45%.

Illustration 5.5: The data relating to two companies are as given below:

Company A Company B
Capital Rs.6,00,000 Rs.3,50,000
Debentures Rs. 4,00,000 Rs. 6,50,000
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 Rs. 250
Fixed costs per annum Rs.7,00,000 Rs.14,00,000
Variable cost per unit 10 75

You are required to calculate the Operating leverage, Financial leverage and Combined
Leverage of two companies.

Solution: Computation of Operating leverage, Financial Leverage and Combined leverage

Company A

Company B
Output (units) per annum 60,000
15,000
Selling price/unit Rs.30
250
Sales Revenue 18,00,000
37,50,000
Less variable costs
@ Rs.10 and Rs.75 6,00,000
11,25,000
Contribution 12,00,000
26,25,000
Less fixed costs 7,00,000
14,00,000
Illustration EBIT
5.6: X Corporation has estimated that for a new product its break-even point is
5,00,000
2,000 units if the item is sold for Rs. 14 per unit, the cost accounting department has currently
12,25,000
identified variable cost of Rs. 9 per unit. Calculate the degree of operating leverage for sales
volume of 2,500
Less Interestand
units 3,000onunits.
@ 12% What do you infer
debentures from the degree of operating
48,000
leverage at the sales volume of 2,500 units and 3,000 units and their difference if any?
78,000
PBT 4,52,000
11,47,000
DOL = Contribution/EBIT 12,00,000/5,00,000
Centre for Distance Education 5.12 Acharya Nagarjuna University

Solution: Statement of Operating Leverage

Particulars 2500 units 3000 units

Sales @ Rs.14 per unit 35,000 42,000
Variable cost 22,500 27,000
Contribution 12,500 15,000
Fixed Cost (2,00 0 x (Rs.14 – 9) 10,000 10,000
EBIT 2,500 5,000
Operating Leverage
= Contribution/ EBIT 12,50 0/2,500 15,000/5,000
=5 =3

Illustration 15.7: The following data is available for XYZ Ltd.

Sales Rs. 2,00,000
Less: Variable cost 60,000
Contribution 1,40,000
Fixed Cost 1,00,000
EBIT 40,000
Less Interest 5,000
Profit before tax 35,000
Find out:
a. Using concept of financial leverage, by what percentage will the taxable income
increase, if EBIT increases by 6 %.
b. Using the concept of operating leverage, by what percentage will EBIT increase if
there is 10% increase in sales and,
c. Using the concept of leverage, by what percentage will the taxable income increase if
the sales increase by 6%. Also verify the results in view of the above figures.
Solution:
(i) Degree of Financial Leverage:

FL = EBIT/Profit before Tax = 40,000/35,000 = 5.15

If EBIT increases by 6%, the taxable income will increase by 5.15 x 6 = 6.9% and it may be
verified as follows:

EBIT (after 6% increase) Rs. 42,400

Less Interest 5,000
Profit before Tax 37,400
Increase in taxable income is Rs. 2,400 i.e 6.9% of Rs. 35,000
(ii) Degree of Operating Leverage:

OL = Contribution / EBIT = 1,40,000/40,000 = 7.50

Strategic Financial Management 5.13 Leverage Effect and...

If sale increases by 10%, the EBIT will increase by 7.50 x 10 = 35% and it may be verified as
follows:
Sales (after 10% increase) Rs. 2,20,000
Less variable expenses @ 30% 66,000
Contribution 1,54,000
Less Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is Rs. 14,000 i.e 35% of Rs. 40,000
(iii) Degree of Combined leverage
CL = Contribution/ Profit before tax = 1,40,000/35,000 = 4

If sales increases by 6%, the profit before tax will increase by 4x6= 24% and it may be
verified as follows:

Sales (after 6% increase) Rs. 2,12,000

Less Variable expenses@ 30% 63,600
Contribution 1,48,400
Less Fixed cost 1,00,000
EBIT 48,400
Less Interest 5,000
Profit before tax 43,400

Increase in Profit before tax is Rs. 8,400 i.e 24% of Rs. 35,000

5.5 DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL

LEVERAGE :

Sl.
Operating leverage Financial leverage
No.
Operating leverage is associated with Financial leverage is associated with
5. investment activities of the company. financing activities of the company.

Operating leverage consists of fixed Financial leverage consists of operating

6. operating expenses of the company. profit of the company.

It represents the ability to use fixed It represents the relationship between

7. operating cost. EBIT and EPS

Operating leverage can be calculated leverage can be calculated by

8. by Financial

A percentage change in the profits A percentage change in taxable profit is

resulting from a percentage change in the result of percentage change in EBIT.
5. the sales is called as degree of
operating leverage.

Trading on equity is not possible while Trading on equity is possible only when
6. the company is operating leverage. the company uses financial leverage
Centre for Distance Education 5.14 Acharya Nagarjuna University

Operating leverage depends upon fixed Financial leverage depends upon the
7.
cost and variable cost. operating profits.
Tax rate and interest rate will not Financial leverage will change due to tax
8. affect the operating leverage. rate and interest rate.

5.6 WORKING CAPITAL LEVERAGE :

One of the new models of leverage is working capital leverage which is used to locate the
investment in working capital or current assets in the company. Working capital leverage
measures the sensitivity of return in investment of charges in the level of current assets.

Percentage change in ROI

Working Capital Leverage =
Percentage change in Working Capital

If the earnings are not affected by the changes in current assets, the working capital leverage
can be calculated with the help of the following formula.

CA
Working Capital Leverage =
TA + DCA

where, CA = Current Assets, TA = Total Assets , DCA = Changes in the level of Current
Assets.
5.7 EFFECTS OF LEVERAGE ON SHAREHOLDERS’ RETURNS :
Financial plan is one of the vital decisions of a firm because a financial plan affects
the market value, cost of capital and shareholders return of a firm. The Proportion of Debt to
Equity in the financial plan of a firm is called leverage. Since optimal debt ratio influences a
firm’s market value and shareholder’s return, different firms use different debt ratio at
different levels to maximize market value and shareholders return. Leverage has statistically
significant effect on the shareholders’ return and proper management of leverage can
maximize the value of EPS.
Operating leverage effect : % Change in EBIT is more than % Change in sale If %
change of earnings before interest and tax is more than % change in sale, this operating
leverage will effect ROE positively because at this level, per unit fixed cost will decrease and
small increase in sale will boost EBIT. If EBIT will increase, ROE will also increase.
Operating Leverage indicates, how will EBIT change if sales changes. 2:1 ratio of operating
leverage means 100% increase in sales will increase EBIT by 200%. As interest is fixed cost,
so ROE will increase.
i. Situation: High operating leverage: Too high operating leverage is not good, it
may be highly risky.
ii. Situation: Low operating leverage: Low operating leverage may be useful
when sale market is fluctuating.
Strategic Financial Management 5.15 Leverage Effect and...

Operating leverage effect : % Change in EBIT is less than % Change in sale Now we see
the second face when % changes of EBIT is less than % changes in sales, it means 200%
increase in sales will increase EBIT by only 100% if operating leverage is 1:6. This situation
is less effective for enhancing ROE.
Effect of financial leverage on ROE :If we have to check real effect of leverage on ROE,
we have to study financial leverage. Financial leverage refers to the use of debt to acquire
additional assets. Financial leverage may decrease or increase return on equity in different
conditions.
i. Situation: High financial leverage: Financial over-leveraging means incurring a
huge debt by borrowing funds at a lower rate of interest and utilizing the excess
funds in high risk investments in order to maximize returns.
ii. Situation: Low financial leverage: Financial low-leveraging means incurring a
low debt by borrowing funds. It may affect positively, if decrease the value of
bought asset with this low debt.

5.8 RISK AND LEVERAGE :

Risk is the probability that the future revenue streams of a firm shall show a variation
from the expected figures. The variation is normally on the negative or the lower side because
a positive variation reduces the investment risk and a reduction of risk is always welcome.
For linkage with leverage, we can divide risk into two broad categories, i.e. business risk and
financial risk. Business risk pertains to risks associated with day to day operations of the
firm. For example, decisions made regarding purchase of raw materials, manufacturing
expenses and administrative expenses, etc. change the business risk profile of the firm. These
decisions have an impact upon the operational profitability of the firm, i.e. the profits before
interest and taxes. Financial risk, on the other hand, is associated with introduction of fixed
interest bearing debt obligations in the capital structure of the firm. These obligations create a
prior charge on EBIT before distribution of post tax profits among the owners.
5.9 RELATIONSHIP BETWEEN FINANCIAL RISK AND FINANCIAL
LEVERAGE :
As the financial leverage increases, the breakeven point of the company increases and
the company now has to sell more of its product (or service) in order to break even. High
financial leverage increases the risk to banks and other lenders because of the higher
probability of bankruptcy and the risk to stockholders because greater losses may be incurred
if the company goes bankrupt. Increase in financial leverage, increases the risk to
stockholders because the higher leverage will cause greater volatility in earnings and greater
volatility in the stock price.
5.10 SUMMARY :
Capital Structure of a firm is a reflection of the overall investment and financing strategy of
the firm. It shows how much reliance is being placed by the firm on external sources of
finance and how much internal accruals are being used to finance expansions. Optimal capital
structure means arrangement of various components of the structure in tune with both the
long-term and short term objectives of the firm. The four Capital Structure Theories are—Net
Income Approach, Net Operating Income Approach, Traditional Approach and Modigliani
Miller Approach. – Net income approach provides that the cost of debt capital, Kd and the
cost of equity capital Ke remains unchanged when the degree of leverage, varies. –Net
Operating Income approach states that cost of the capital for the whole firm remains constant,
irrespective of the leverage employed in the firm. Traditional Approach to capital structure
Centre for Distance Education 5.16 Acharya Nagarjuna University

advocates that there is a right combination of equity and debt in capital structure, at which
market value of the firms is maximum. – Modigliani and Miller have restated the net
operating income position in terms of three basic propositions: Proposition I – The total value
of a firm is equal to its expected operating income divided by the discount rate appropriate to
its risk class. Proposition II – The expected yield on equity, Ke is equal to Ko plus a
premium. Proposition III – The cut off rate for investment decision making for a firm in a
given risk class is not affected by the manner in which the investment is financed.
5.11 GLOSSARY :
 Operating leverage: It increases as the ratio of fixed costs to variable costs increases.
 Variable cost: Costs that change with the level of production.
 Breakeven point: The level of sales where a company’s revenues equal its cost.
Profit is zero at this point.
5.12 SELF ASSESSMENT QUESTIONS :
1. Distinguish between operating leverage and financial leverage.
2. Explain the concept of financial leverage.
3. Examine the impact of financial leverage on the EPS. Does the financial Leverage
always increase the EPS?
4. How operating leverage and financial leverage can be measured?

5.13 LESSON END EXERCISE :

1. Is there any relationship between risk and leverage? Explain.
2. Define working capital leverage.
3. Discuss the relation between debt financing and finical leverage.
5.14 SUGGESTED READINGS :
1. [Link], Financial Management, Vikas Publisher.
2. [Link], Financial Management, Tata McGraw Hill.
3. Khan & Jain, Financial Management, Tata McGraw Hill.

Dr. Zia Ur Rehman