CU-BCOM-SEM-IV-Financial Management-Second Draft

 The basis of our model is earnings before interest and taxes (EBIT). In contrast to classical firm valuation methods based on free cash flows after taxes, such an approach allows us to treat all claimants to EBIT consistently, namely the government (taxes), bondholders (interest), and shareholders (dividends). 9.4 COST OF PREFERENCE CAPITAL Preference shares, or preferred stock as they are known in the United States, are a class of shares that entitle the holder to preferences over those of the company’s ordinary shares. The most usual preference concerns dividend rights, but other provisions may sometimes be included. They are non-equity shares, but are also described sometimes as equity. They are not debt instruments although they trade similar to certain types of debt, and often the preference share market making desk is located within the bond division of a bank. Preference shares rank below debt instruments in the event of a wind-up of a company, but above ordinary shares. They have a long history; the market in preference shares was well established in both the United Kingdom and United States in the nineteenth century. The main types of preference share are fixed-dividend, adjustable-rate and auction market preference shares. These main variations will be reviewed later in the chapter. Preference shares may be defined as shares which provide their holders an entitlement to receive a dividend, but only up to a specific limit, which is usually a fixed amount every year. They may also give their holders a limited right to participate in any surplus in the event of a winding up, should there be a liquidation and sale of the company’s assets. Preference shares may also be redeemable on fixed terms or on terms dictated by the issuing company. Despite their name however preference shares are similar to debt capital and this is why it is necessary to review their characteristics here. However preference shares are not debt, but are a form of ownership in a company, despite the fact that most forms of preference stocks do not grant their holders a voting right. The instruments might be fairly described as a peculiar cross between shares and bonds, and share some but not all characteristics of both. For example certain preference shares are unlike ordinary shares in that if a dividend is not paid in one year, it will accumulate and must be paid before ordinary share dividends. Unlike bonds however a failure to pay dividends is not a default, although there are several negative implications associated with such an action. They are similar to bonds in that they do not entitle holders a vote in the company (usually, as long as the dividend is paid), although voting rights are usually granted if a dividend is not paid. The preference share market making desk in a bank is usually situated in the fixed interest division, rather than in the equity division. This reflects that the valuation of preference shares fluctuates with the yield curve. In this chapter we introduce the different types of preference shares, and how they differ from conventional fixed income securities. In the US and UK there is wide variety of preference shares in the market and we are only able to review them here; interested readers may wish to consult the references listed in the bibliography. 151 CU IDOL SELF LEARNING MATERIAL (SLM)

The majority of borrowers in the US domestic market are financial institutions. In the UK domestic market the instrument has been more popular with non-financial corporates, although banks have also been large-volume issuers. During the period 1983–1993 over $81 billion was raised in the US preferred market, of which around 62% was by financial companies. It shows the level of issuance in the US market during this period. Preference shares are purely a corporate financing instrument and credit ratings for individual share issues are as important as they are for corporate bonds. In the US domestic market, ratings are issued by four ratings firms, known as “nationally recognised statistical rating organisations” or NRSROs, which are Standard & Poor’s, Moody’s, Duff and Phelps and Fitch Investors Service. The ratings issued by the NRSROs, although outwardly similar to the ratings for corporate bonds in some cases, need to be assessed differently however; this is because preferred stock should be analysed within the range of other preference shares, distinct from debt issues. An annual preference dividend is payable, usually on a semi-annual basis, as a fixed percentage amount of the nominal value of the share. Unlike the interest payable on a conventional bond though, which is paid out of the pre-tax profits of the issuing company, preference share dividends are paid out post-tax profits. The dividend on a preference share must be paid before any dividend can be paid to ordinary equity shareholders. The primary differentiating feature of preference shares compared to ordinary shares is the treatment of the dividend that is payable by them, which are at a fixed rate or variable rate. The dividend paid by a conventional preference share is at a fixed rate of the face value, or a fixed cash value per share. The dividend must be paid before any can be paid on ordinary shares; for the majority of preference shares the dividend is in cash. During the bull market of the mid1980s up to the crash of October 1987, some preference shares in the US market paid dividends in the form of more shares. These were known as PIKs preferred stock. There are also preference shares that pay a variable rate dividend in the US market. Generally these pay a dividend that is adjusted or re-set quarterly at a fixed spread to the Treasury yield curve. The spread, known as the dividend reset spread, will lie above or at the level of one of three points on the yield curve, which are the threemonth maturity point, the 10-year point and the 30- year point. Instead of using the redemption yield at these points, the adjusted dividend is based on the Treasury constant maturity (TCM) yield, which is calculated by the Federal Reserve. This means that the adjusted dividend is not a pure short- or long-term yield but a composite of the two. Variable rate preferred stock in the US is known as adjustable-rate preferred stocks or ARPS. They are singular instruments in that they are neither money market paper nor long-dated bonds. They possess some of the attributes of ordinary shares however, in that they do not exhibit the “pull to par” effect of bonds with a fixed maturity. However they are related to the debt market yield curve and their value will fluctuate with this. In the United Kingdom the coupon rate of preference dividend is shown net of tax, as the amount of dividend that shareholders will receive in cash. The gross pre-tax dividend is this 152 CU IDOL SELF LEARNING MATERIAL (SLM)

net amount plus a tax credit for the amount of income tax deducted. If the tax credit is 25%, the gross dividend is multiplied by 100/75 of the net dividend. Preference shares do not, as a rule, entitle holders to a vote in the running of the company. This is perhaps the chief difference between preference shares and ordinary shares. The general understanding is that, because preference shareholders receive a regular and fixed dividend, they do not require voting rights. This is not always the case, and certain issues do entitle holders to a vote. For example the preferred stock of Southern California Edison, a US utility company, carries with it varying levels of voting rights. The cumulative preferred stockholders each have six votes per share, while the $100 cumulative preferred stock entitles its holders to two votes per share. The votes may use cumulatively in the case of the election of company directors. The general exception is when preference shares are in arrears after the non-payment of a dividend. In the US market if more than four dividends have not been paid, which in most cases would be over a two-year period, preference shares are allotted voting rights, sometimes just to be used in the election or re-election of directors. Where this provision is included in the terms of the share issue, they are known as contingent voting stock, because the right to vote is contingent on the preference shareholders not receiving the dividends to which they entitled. When a dividend arrear(s) has been paid off, the voting rights will cease. Such provisions are common, sometimes because of regulatory requirements. The New York Stock Exchange for example, states that non-voting preferred stock must be contingent voting stock otherwise it cannot be listed on the exchange. The other type of voting power that is often carried by preference shares relates to specific corporate actions that may affect the standing or value of the shares themselves. For instance preference shareholders may be entitled to vote on proposals to increase the authorised amount of any class of stock that would rank ahead of the preference shares, in terms of dividends or rights to assets in the event of a liquidation. The shareholders may also be entitled to give their approval on a merger or consolidation, the results of which might adversely affect the rights and preferences of the preference shares. Shares that have this privilege written into their terms is known as vetoing stock. However this veto power is usually available only if the preference shares are in dividend arrears, and will be removed if the arrears are paid off. 9.5 SUMMARY  A sinking fund provision in a preference share issue will operate in a similar fashion to a sinking fund with a bond. It will provide for the periodic redemption of a proportion of the issue, most commonly on an annual basis. For example, the sinking fund may pay off 5% of the original number of shares each year. Preference shares that are callable and also have sinking finds may set different dates when the two features are applicable, so that the sinking fund may come into operation after the stock ceases to be callable. Sinking fund payments may be made in shares of stock 153 CU IDOL SELF LEARNING MATERIAL (SLM)

purchased in the open market or by the call of the required number of shares at the sinking fund call price, which is normally par or another stated value. As with the payment of dividends, the failure to make a sinking fund payment is not considered a default, unlike with a bond, and the company could not be placed in bankruptcy. Certain preferred issues have purchase funds. These are essentially optional on the part of the issuer because it will have to use its best efforts to retire a portion of the shares at periodic intervals if they can be purchased in the open market, or otherwise through a tender, at below the redemption price. If the shares are trading above the purchase price, the purchase fund cannot operate. A purchase fund can act as a floor for the price of the shares, at a time of high dividend yields, but would not operate in a low yield environment.  The gross yield that investors expect from preference shares and bonds of the same issuing company was historically the same, although liquidity considerations meant that the yield on preference shares would be slightly higher. The yield on preference shares in the UK market is now considerably higher than in the bond market, as a result of tax changes introduced by the Labour government in 1997.2 This has resulted in there being no real advantage to a UK company in raising capital in the preference share market, which may well become illiquid in the near future. For the purposes of analysis, let us consider an historical example that illustrates the considerations involved, which would apply in other markets.  In the UK domestic market preference shares are traded in the same way as ordinary shares that is, they are listed on an exchange. Trading is on the exchange via its dealing system. Domestic issues of preference shares can be relatively small size, and they are often issued as part of a company financial re-structuring or through a private placement to a small group of investors. In 1996 the Bank of Ireland issued conventional preference shares to raise part of the financing required in its take-over of the Bristol & West building society. The preference shares were also used to pay some of the membership of the building society, who were entitled to a share of the society’s reserves in return for giving up ownership of it.  In the US under half of all publicly issued preference shares are listed on the NYSE or the American Stock Exchange, with the remainder trading in the OTC market. The normal unit of trading is 100 shares but this is not universal and some issue trade in lots of 10 shares. It is possible to deal in odd-lots of shares. Listing an issue may lead to a lower dividend yield for an issuer if it improves its marketability. This is more significant if the issue itself is a relatively large size one. Dealing via an exchange system also makes an issue more transparent in the market. In international markets companies usually issue redeemable convertible preference shares, which are regarded as part of the Euro convertibles market, together with convertible bonds and equity warrant bonds. 154 CU IDOL SELF LEARNING MATERIAL (SLM)

 The investment community could soon be mourning the death of the £5 billion market in preference shares, a form of corporate debt that was highly popular in the Seventies. Fund managers and market makers say the trade in preference shares has all but stopped. Many believe “press” will be allowed to wither on the vine, as issuing companies and investors switch to more tax-efficient types of debt. Press differ from corporate bonds in that the income is distributed in the form of a dividend rather than interest. Should the issuer collapse, press rank below other classes of secured and unsecured debt, but ahead of ordinary stock. Some preference shares have limited voting rights. The reasons for the market’s decline are multiple. Changes to company taxes and the rapid emergence of a market in sterling-denominated corporate bonds have both played their part. In addition, problems of illiquidity have been compounded by the generally depressed state of the UK fixed-interest market.  Without doubt, the biggest blow to press came with the Chancellor of the Exchequer’s decision to abolish the dividend tax credit when he reformed advance corporation tax in his maiden Budget in 1997. Overnight, the value of preference shares dropped 20 per cent for one of the stock’s biggest group of buyers: gross investors. Press thus lost much of their appeal for pension funds which criticised the ACT changes as a Maxwell-style raid on the savings of the elderly. Retail investors, however, were given a stay of execution: they can still obtain a dividend credit of 10 per cent for the next five years so long as they hold the stock through a personal equity plan (Pep) or individual savings account (Isa). The ACT changes triggered a gradual move to corporate bonds, a market now conservatively valued at £150 billion in the UK. Many managers of unit trusts have already adjusted the balance of their portfolios to reflect this.  “We have not bought press for two years,” said Ian Dickson, manager of the Henderson Preference & Bond unit trust, which at £228 million is one of the biggest retail funds in the sector. “Preference shares were the great story of the late 1970s, but they no longer stack up against corporate bonds. You are not getting paid for the additional risk.” Mr Dickson said that his fund was 80 per cent invested in press just a couple of years ago. Today, that weighting has shrunk to 20 per cent. By way of illustration, Mr Dickson points to the yield on the preference shares of Bank of Scotland, one of the bigger issuers in this market. The yield is 6.8% with the 10 per cent dividend tax credit, falling to 6 per cent for a net investor.  The bank’s own long-dated bonds pay 6.6 per cent, effectively on a net basis. Issuers have also begun to snub the market. Hugh Everitt, director of corporate bonds at CGU, the insurance and fund management group, said the number of issues on the market was 400 two years ago. Today, there are only 250. A two-tier market has evolved, with only the larger issuing companies – typically financial services companies – offering reasonable levels of liquidity to investors. The last issue of any 155 CU IDOL SELF LEARNING MATERIAL (SLM)

significance was when Halifax paid £750 million for Birmingham Midshires Building Society earlier this year. Members received a package of preference shares, although most have cashed in the stock already. 9.6 KEYWORDS  Derivatives: A complex investment that is largely unregulated, especially when compared with stocks and bonds. They are securities whose value is derived from some other variable, such as interest rates or foreign currencies, and can be used to reduce risk or increase returns. Derivatives are rarely used and significantly restricted in most states.  Development District: A special taxing district created to finance the costs of infrastructure improvements necessary for the development or redevelopment of land of high priority to the county. These districts are often designated for areas that the county’s long-range master plan recommends significant development.  Development Impact Fee: A payment of money imposed upon new property developments as a condition of approval from the county. Development impact fees pay for a proportionate share of the cost of improvements needed to serve new growth and development.  Disbursement: Expenditure or a transfer of funds to another accounting entity within the county’s financial system. Total disbursements equal the sum of expenditures and transfers.  Double-barrelled Bond: A bond secured by the pledge of more than one source of repayment, often project revenue and taxing power. 9.7 LEARNING ACTIVITY 1. Create a session on debt. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on preference capital. ___________________________________________________________________________ ___________________________________________________________________________ 9.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 156 CU IDOL SELF LEARNING MATERIAL (SLM)

1. What is preferred stock? 2. Define weighted average cost of capital. 3. What is operating leverage? 4. Define financial leverage. 5. Write the main aim of financial decisions. Long Questions 1. Explain the theories of cost of capital. 2. Elaborate the advantages of cost of capital. 3. Illustrate the disadvantages of cost of capital. 4. Discuss on the Significance cost of debt. 5. Examine the cost of preference capital. B. Multiple Choice Questions 1. Which form of market efficiency states that current prices fully reflect the historical sequence of prices? a. Weak b. Semi-strong c. Semi-strong d. Flexible 2. Which form of market efficiency states that current prices fully reflect all publicly available information? a. Weak b. Semi-strong c. Semi-strong d. Flexible 3. Which is concerned with the acquisition, financing, and management of assets with some overall goal in mind? a. Financial management b. Profit maximization c. Agency theory d. Social responsibility 157 CU IDOL SELF LEARNING MATERIAL (SLM)

4. Which is the employment of an asset is sources of fund for which the firm has to pay a fixed cost or fixed return? a. Financial management b. Profit maximization c. Asset management d. Leverage 5. Which is the minimum required rate of earnings or the cut off rate of capital expenditure a. Cost of capital b. Working capital c. Equity capital d. None of these Answers 1-c, 2-a, 3-b, 4-a, 5-d 9.9 REFERENCES References  Cook, D, O. & Tang, T. (2010). Macroeconomic conditions and capital structure adjustment speed. Journal of Corporate Finance.  Corbett, J. & Jenkinson, T. (1996). The financing of industry, 1970-89: an international comparison. Journal of Japanese and International Economies.  DeAngelo, H. &Matulis, R, W. (1980). Optimal capital structure under corporate and personal taxation. Journal of Financial Economics. Textbooks  De Jong, A. Kabir, R. & Nguyen, T, T. (2008). Capital structure around the world: the roles of firm and country specific determinants. Journal of Banking and Finance.  Delcoure, N. (2007). The determinants of capital structure in transitional economies. International Review of Economics and Finance.  De Miguel, A. & Pindado, J. (2001). Determinants of capital structure: new evidence from Spanish panel data. Journal of Corporate Finance. 158 CU IDOL SELF LEARNING MATERIAL (SLM)

Website  https://www.researchgate.net/publication/301194439_Preference_Shares_and_Preferr ed_Stock/link/5f8065c5a6fdccfd7b53247d/download  https://egyankosh.ac.in/bitstream/123456789/16092/1/Unit-5.pdf  https://www.lh-ag.com/wp-content/uploads/2018/06/6_Preference-Shares-as-a- Source-of-Capital-by-Ong-Eu-Jin-and-Christine-Chan-Ee-Yin.pdf 159 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-10 COST OF CAPITAL PART II STRUCTURE 10.0 Learning Objective 10.1 Introduction 10.2 Cost of Equity Capital 10.3 Retained Earnings 10.4 Weighted Average Cost of Capital 10.5 Significance Cost of Debt 10.6 Cost of Preference Capital 10.7 Summary 10.8 Keywords 10.9 Learning Activity 10.10 Unit End Questions 10.11 References 10.0 LEARNING OBJECTIVE After studying this unit, you will be able to  Explain the concept of cost of equity capital.  Illustrate the concept of retained earnings.  Explain the weighted average cost of capital. 10.1 INTRODUCTION As mentioned in the introduction, a main application of calculating the cost of debt within the presented framework could be a situation in which the cost of equity is already given. In this subsection, we consider a firm that maintains an exogenous financing strategy, keeping the initial leverage ratio constant. We assume that the firm has already carried out a reasonable estimate for the cost of equity. According to the constant-leverage strategy, using the WACC to value the firm or a project of the firm is adequate. To calculate the WACC, the cost of debt must be estimated. For this, the firm uses the approach presented in this paper, although the model deviates from its actual policy, as the model assumes a financing policy with a time varying leverage ratio. In the following, we analyse whether the cost of debt thus derived is a reasonable approximation in this situation. The true cost of debt is calculated within a 160 CU IDOL SELF LEARNING MATERIAL (SLM)

simulation study. The company has issued a perpetual bond which pays interest at a fixed rate i, as assumed in the model. The EBIT flow is modelled according to Eq. (1) on a yearly basis, which gives new values for debt and equity at the end of each period. If the EBIT and thus the asset value fall, the debt ratio increases. To retain the initial leverage ratio, the firm redeems part of the debt. Conversely, if the asset value rises, the firm takes on new debt at a coupon rate according to fair market conditions. Figure 10.1: Cost of Capital The firm defaults if the asset value breaches the initial bankruptcy threshold B. By repeating the simulation many times (we run 50,000 paths, each until either bankruptcy or a final date T ¼ 100 is reached), we obtain a flow of expected payments to bondholders (including interests, redemptions, and new debt issues) for the successive periods. The actual cost of debt is the internal rate of return of this payment flow. We analyse this ‘‘true’’ cost of debt compared to the approximate cost of debt obtained by the model. The base data for the firm are the same as in Sect. 3, where the corporate interest rate varies between 3 and 7%. Figure 6 shows the results. For corporate interest rates up to about 5.5%, the deviations are fairly small, remaining below 0.2%. For higher rates, deviations can become larger—at a corporate interest rate of 7%, the model gives a cost of debt of 4.9%, whereas the true value is 5.5%. The reason for this underestimation of the actual cost of debt lies in the financing policy: a high initial corporate interest rate goes hand in hand with a high initial leverage ratio and thus a high level of default risk. The constant-leverage policy reduces the effects of default risk for bondholders, as parts of the outstanding debt are redeemed in full when the bankruptcy threshold approaches. These early redemptions increase the expected return for bondholders and thus the cost of debt. Nonetheless, using the cost of debt obtained by the model seems to be a reasonable approximation in most cases. The constant-leverage policy makes the WACC method an appropriate choice for the valuation of the firm or single projects of the firm. To 161 CU IDOL SELF LEARNING MATERIAL (SLM)

analyse the effect of the approximation on the final outcome, the value of a cash flow, we consider a perpetual flow of 1 in each period to be discounted with the WACC. The perspective is thus internal, looking at a new project within the firm. Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm's cost of debt and cost of equity blended together. The cost of capital metric is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the mode of financing used. It refers to the cost of equity if the business is financed solely through equityor to the cost of debt if it is financed solely through debt. `Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the weighted average cost of capital (WACC). Cost of capital represents a hurdle rate that a company must overcome before it can generate value, and it is used extensively in the capital budgeting process to determine whether a company should proceed with a project. The cost of capital concept is also widely used in economics and accounting. Another way to describe the cost of capital is the opportunity cost of making an investment in a business. Wise company management will only invest in initiatives and projects that will provide returns that exceed the cost of their capital. Cost of capital, from the perspective of an investor, is the return expected by whoever is providing the capital for a business. In other words, it is an assessment of the risk of a company's equity. In doing this, an investor may look at the volatility (beta) of a company's financial results to determine whether a certain stock is too risky or would make a good investment. A firm's cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital. Each category of the firm's capital is weighted proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on the company's balance sheet, including common and preferred stock, bonds, and other forms of debt. 10.2 COST OF EQUITY CAPITAL The growing competition among companies at the market and the strong connectivity among individual economies can be considered as most significant effects of globalization. The negative consequences of these effects are showed especially with arrival of the financial and economic crisis in 2008, which caused deeper financial or existential problems in some companies. According to these problems, there arise up an increasing pressure on examination of business performance. So, we can ask the question how we could evaluate companies and their performance as efficiently as possible under these conditions. There are several traditional (e.g. indicators of liquidity, activity, profitability, etc.) or modern (e.g. 162 CU IDOL SELF LEARNING MATERIAL (SLM)

EVA, MVA, NPV, CFROI, etc.) indicators of business performance, which bring a more dynamic and realistic image about company but not only about its performance but also about competitive position on the market. Thanks to the simplicity of calculation, not only Slovak companies tend to use traditional indicators for measure of business performance. The main deficiency of traditional indicators may be considered disregard of risk, the impact of inflation as well as the time value of money which leads to the question about accuracy of the calculations and their explanatory value of business performance. Due to above facts, we decided to explore the possibility of using selected modern indicators for measure of business performance. In business practice, the most widely used model for measuring a business performance is model EVA (Economic Value Added). The problem within EVA may be the calculation of opportunity cost of capital, which is one of the most examined components of business costs. Therefore, within our research we focused just on the indicator opportunity cost of capital and we examine the main differences between the calculation with CAPM model and Build-up model. The first part of this paper is focused on the theoretical definition of selected models with emphasis on their computational feature that can we discover significant differences between these two models. In the next part, we introduce the examined sample as well as the criteria that we set within selection process. Due to the large volume of data, we present in section Research sample and results the example of calculation of opportunity cost of capital with using CAPM model and Built-up model (the calculation was performed on randomly selected company from our sample). In the final part, we present our obtained concludes. Company and its transformation processes are influenced by a number of macroeconomics and microeconomics factors, which impacts reflected in the results of business. This raises the question, how we could evaluate the company which is undertaking these factors as well as how we could measure its performance. The concept of business performance is perceived by different views as the ability of company to achieve the desired effects or outcomes in measurable unitsor as the rate of achievement by individuals, groups, organizations or processes (European Foundation for Quality management).When we examine a business performance it is necessary to monitor not only the financial components, but also non-financial components of companies such as the work efficiency of employees, their motivation, etc. In terms of comparison the company with competitors or interest of investor, it is important not only to monitor business performance, but also its measurement. Based on the measurement we are able to evaluate company in terms of its performance. We can use a several indicators of business evaluation e.g. qualitative or quantitative indicators, traditional or modern indicators, etc. In our research, which is focused on the evaluation of business performance within the engineering industry in Slovakia, we decided to use a most used model of calculation of business performance – EVA. However, when we used this model we discovered a problem with variable approach how to calculate the opportunity cost of equity capital. In the next part of this section, we introduce a two models that we used for calculation. 163 CU IDOL SELF LEARNING MATERIAL (SLM)

Based on our research we can conclude that the best way how to calculate the opportunity cost of equity capital is calculation by Build-up model. This method reflected not only external risks but also internal risks of companies which is very important factor. However, the big disadvantage of this model is that quantification is based on the subjective assessment of the analyst as well as the fact that risk additional charges are often estimated only according to the financial statements. Foreign studies confirmed that this model is not applicable for all businesses and for each sector or industry. If the company decided to use the CAPM model, it must consider very carefully what type of bonds should be used for determining the risk-free rate of return. The most ideal way would be to set bonds at the beginning and the end of the examined year or average of these two issues. However, in some countries, as well as in Slovakia, it is very difficult because not all countries have developed capital market. In the concept of CAPM model we recommended to use for calculation the 30-years US bonds. We realized, that utilization of US bonds within calculation in Slovak market is not the best way how to expressed the opportunity cost of equity capital as well as how to evaluate the business performance. However, we think that modern indicators are the better way how to calculate cost of equity than traditional indicators which are not as flexible and efficient as modern indicators. We are convinced that the best option how to express the business performance is the combination of financial and non-financial factors. Because of that, we continue with our research and we examine the non-financial factors within the engineering industry on the Slovak market. 10.3 RETAINED EARNINGS Finance is a constant requirement for every growing business. There are several sources of finance from where a business can acquire finance or capital which it requires. But, the finance manager cannot just choose any of them indifferently. Every type of finance has different pros and cons in terms of cost, availability, eligibility, legal boundaries, etc.. So choosing the right source of finance is a challenge. Internal sources of Finance are the sources of finance or capital which are generated by the business itself in its normal course of operations. There is no outside dependency for catering the need of capital. Like an individual, companies too, set aside a part of their profit to meet future requirements. The portion of profits not distributed among the shareholders but retained and used in the business is called Retained Earnings. It is also known as ploughing back of profit, retained capital or accumulated earnings. In other words, Retained Earnings are the profits that have been reinvested in the business instead of being paid out as dividends. The Retained Earnings are considered as the backbone of the financial structure of the corporate sector and it represents that portion of divisible profits which is not paid out as dividend. 164 CU IDOL SELF LEARNING MATERIAL (SLM)

Useful for expansion and diversification Retained earnings are most useful to expansion and diversification of the business activities. Economical sources of finance Retained earnings are one of the least costly sources of finance since it does not involve any flotation cost as in the case of raising of funds by issuing different types of securities. No fixed obligation If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest. Increase the share value When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance. So, the value of the share will increase. Improper utilization of funds If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless spending of funds. Over capitalization Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance. Leads to monopolies Excessive use of retained earnings leads to monopolistic attitude of the company. Dissatisfaction among shareholders Retained earnings do not allow shareholders to enjoy full benefit of the actual earnings of the company. This creates not only dissatisfaction among the shareholders but also adversely affect the market value of shares. The retained earningsof a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that period, the net income (or net loss) at that point is transferred from the Profit and Loss Account to the retained earnings account. If the balance of the retained earnings account is negative it may be called accumulated losses, retained losses or accumulated deficit, or similar terminology. Any part of a credit balance in the account can be capitalised, by the issue of bonus shares, and the balance is available for distribution of dividends to shareholders, and the residue is carried forward into the next period. Some laws, including those of most states in the United States require that dividends be only paid out of the positive balance of the retained earnings account at the time that payment is to be made. This protects creditors from a company being 165 CU IDOL SELF LEARNING MATERIAL (SLM)

liquidated through dividends. A few states, however, allow payment of dividends to continue to increase a corporation’s accumulated deficit. This is known as a liquidating dividend or liquidating cash dividend. In accounting, the retained earnings at the end of one accounting period is the opening retained earnings in the next period, to which is added the net income or net loss for that period and from which is deducted the bonus shares issued in the year and dividends paid in that period. If a company is publicly held, the balance of retained earnings account that is negatively referred to as \"accumulated deficit\" may appear in the Accountant's Opinion in what is called the \"Ongoing Concern\" statement located at the end of required SEC financial reporting at the end of each quarter. Retained earnings are reported in the shareholders' equity section of the corporation's balance sheet. Corporations with net accumulated losses may refer to negative shareholders' equity as positive shareholders' deficit. A report of the movements in retained earnings is presented along with other comprehensive income and changes in share capital in the statement of changes in equity. Due to the nature of double-entry accrual accounting, retained earnings do not represent surplus cash available to a company. Rather, they represent how the company has managed its profits (i.e. whether it has distributed them as dividends or reinvested them in the business). When reinvested, those retained earnings are reflected as increases to assets (which could include cash) or reductions to liabilities on the balance sheet. A company is normally subject to a company tax on the net income of the company in a financial year. The amount added to retained earnings is generally the after tax net income. In most cases in most jurisdictions no tax is payable on the accumulated earnings retained by a company. However, this creates a potential for tax avoidance, because the corporate tax rate is usually lower than the higher marginal rates for some individual taxpayers. Higher income taxpayers could \"park\" income inside a private company instead of being paid out as a dividend and then taxed at the individual rates. To remove this tax benefit, some jurisdictions impose an \"undistributed profits tax\" on retained earnings of private companies, usually at the highest individual marginal tax rate. The issue of bonus shares, even if funded out of retained earnings, will in most jurisdictions not be treated as a dividend distribution and not taxed in the hands of the shareholder. Retaining earnings by a company increases the company's shareholder equity, which increases the value of each shareholder's shareholding. This increases the share price, which may result in a capital gains tax liability when the shares are disposed. 166 CU IDOL SELF LEARNING MATERIAL (SLM)

10.4 WEIGHTED AVERAGE COST OF CAPITAL Weighted Average Cost of Capital is the average of the costs of specific sources of capital employed by a company, properly weighted by the proportion the various sources of capital in the company’s capital structure. In simple, Weighted Average Cost is nothing but average cost of the specific cost of various sources of finance. Compute the specific cost of each source of capital ( i.e. cost of Equity Capital Ke, Cost of Preference Capital Kp, Cost of Debenture Capital Kd and/ or cost of Retained Earnings ). Assign weight to each specific source of fund weights can be assigned to each specific source of fund on the basis of historical weights method or marginal weights method. a. Historical weights method: under this method, weights are assigned on the basis of the proportion of funds already employed by the company. Here book value weights or market value weights can be used. book value weights are readily available from the published financial statements of the company generally companies set their capital structure on the basis of book value and also their capital structure analysis is also done on the basis of book value. It is more convenient to be used whereasmarket values of securities are realistic as they give us the values of securities that are close to the actual amount raised from sale of securities. Also while calculating cost of capital we normally consider the prevailing market price. However it is difficult to determine the market value because of frequent fluctuations. Use of market values as weights helps the company's equity capital gain greater importance. Marginal weights Method - under this method, specific cost or sources are assigned weight in the proportion of funds to be raised from each source to the total funds to be raised. In other words, the proportion of each source of capital to the proposed total capital will be the basis of weight .this method the new project to be financed wholly by raising fresh capital. In truth, not even the chairman of the Federal Reserve Board knows how to identify a firm’s precise optimal capital structure or how to measure the effects of capital structure changes on stock prices and the cost of capital. In practice, capital structure decisions must be made using a combination of judgment and numerical analysis. The weighted average cost of capital (WACC) is an invaluable tool for use by financial managers in capital budgeting and business valuation analyses, and consequently, is a key topic in financial management courses. A continuing need exists for improved methods of teaching and learning this important topic. In a survey of 392 CFOs Graham and Harveyfind that financial executives readily use business school techniques like net present value (NPV) and the capital asset pricing model (CAPM), but are much less likely to follow capital structure guidance from academia. Graham and Harveysuggest an explanation for this behaviour might be that business schools are better at teaching capital budgeting and the cost of capital than at teaching capital structure. 167 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 10.2: Weighted Average cost of capital Citing this need for better capital structure teaching methods, Hulloffers a pedagogical spreadsheet application of the capital structure decision-making process for a firm issuing debt to retire equity. Continuing the effort to produce improved teaching methods for capital structure, our purpose in this paper is to describe pedagogy that includes an experiential process for students to explore alternative mixes of debt and equity in the firm’s capital structure and to observe the impact of their choices upon WACC and common stock price. The traditional approach to estimating the cost of invested capital is to compute a WACC using point estimates of each input. In reality however, there is uncertainty associated with these inputs. Some of the parameters in the WACC, such as the unlevered beta and market risk premium, are not known with certainty due to their stochastic nature or because they are not under the firm’s control. These variable inputs can add to the variability of WACC results. An approach to estimating WACC that explicitly addresses this uncertainty is to identify and quantify the uncertainty in individual WACC parameter estimates, then describe the uncertainty around the expected WACC via Monte Carlo simulation. This paper describes use of both the traditional and Monte Carlo approaches as a means for students to i. Investigate and better understand the relationship between debt and equity in the capital structure, WACC, and firm value and ii. Appreciate the impact on estimated WACC of uncertainty and variability in its components. The remainder of this paper is organized as follows: The next section describes the basic spreadsheet model as used by students. Input and output variables are defined, terminology is 168 CU IDOL SELF LEARNING MATERIAL (SLM)

given, and key relationships among variables are explained. The following section describes the use of Monte Carlo simulation to help students understand the effects of uncertainty on the calculated WACC and how the effect is influenced by the degree of leverage used. The penultimate section discusses student learning objectives and assessment, and the final section offers some concluding remarks. In this section we present a student-friendly spreadsheet model based on relatively simple scenario analysis. The spreadsheet can be used in class to introduce students to the calculation of weighted average cost of capital, and to help them better understand how changes in the mix of debt and equity affect the firm’s cost of capital and overall corporate valuation. Scenarios are descriptions of different future states of an organization's environment. Scenario analysis has long been used in the business worldand by 1980 the technique was being applied by half of Fortune 1000 companies. Its use has continued to grow with the increased uncertainty, globalization, and complexity in the business environment. The base spreadsheet modelappears. This model is one that assumes addition of debt occurs within a context of company recapitalization, that is, the exchange of one form of financing for another. An example would be removing common shares from the company's capital structure and replacing them with bonds. A reverse example would be when a company issues stock in order to buy back debt securities, thus increasing its proportion of equity capital compared to its debt capital. The model maintains total initial capital (book value) constant - additional debt is taken on through several alternative scenarios in which common equity is proportionally decreased. This approach isolates and emphasizes the risk/return trade-offs inherent in placing additional debt in the capital structure. Students begin in Scenario 1by creating a capital structure of their choosing. They enter values for the amount of debt, the amount of preferred stock equity, the firm’s unlevered beta, and other inputs. Since total capital remains constant, the amount of common stock equity (book value) is calculated as Total capital less the sum of Long Term Debt and Preferred Stock. Of course the market value of equity will be different in each scenario and will depend on the WACC and the Firm Value. Upon entering values for debt a student can immediately see the effect on the WACC and firm’s stock price. Students can create up to six capital structure combinations (scenarios). In Scenarios 2 through 6 students test each of those alternatives with increasingly larger amounts of debt, and investigate the effect of that increased leverage on WACC and firm value. The firm value is measured by the present value of future Free Cash Flows to the Firm (FCFF). Most inputs are common for all scenarios (1-6). Only the amounts financed by debt are allowed to vary by scenario since the purpose of this exercise is for students to see how different capital structure combinations can affect WACC. The rest of the numbers that appear on the spreadsheet are calculated results, based on user inputs. The large number of inputs provides the student with considerable flexibilities and adds increased realism to the 169 CU IDOL SELF LEARNING MATERIAL (SLM)

learning experience. The Cost of debt (row 8) is calculated in a way that reflects the fact that higher financial leverage leads to an increased probability of default, higher bond interest rates and multiple symptoms of financial distress. The issue of financial distress cost as related to WACC is summarized well by Almeida and Philippon. The risk of bankruptcy for highly-levered companies will rise precisely when it is most disadvantageous: when it is harder to liquidate assets and more costly to raise new capital. Bond investors seem to be aware of these risks, and have usually demanded significant risk premia to hold debt securities issued by highly-levered firms. But since standard valuations of bankruptcy costs ignore these economy-wide risks, corporate managers who follow this practice will underestimate the actual expected costs of debt and may end up with excessive leverage in their capital structure. The formulas in cells C8:H8 calculate the cost of debt as the risk free rate of interest plus the model’s built-in yield spread. The spread depends on the company’s bond rating (AAA, BB, etc.), and reflects the higher risk associated with higher debt levels. Table 1 shows the bond rating criteria of Standard &Poor’s Rating Services. 10.5 SIGNIFICANCE COST OF DEBT The cost of capital is the company's cost of using funds provided by creditors and shareholders. A company's cost of capital is the cost of its long-term sources of funds: debt, preferred equity, and common equity. Ezra Solomon defines “Cost of capital is the minimum required rate of earnings or cut-off rate of capital expenditure”. According to Mittal and Agarwal “the cost of capital is the minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price”. According to Khan and Jain, cost of capital means “the minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged”. Maximisation of the Value of the Firm For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital. There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue financial risk. Capital Budgeting Decisions Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the discount rate used in evaluating the desirability of the investment project. In the internal rate of return method, the project will be accepted if it has a rate of return greater than the cost of capital. In calculating the net present value of the expected future cash flows from the project, the cost of capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for allocating the firm’s investible funds in the most optimum manner. For this reason, cost of capital is 170 CU IDOL SELF LEARNING MATERIAL (SLM)

also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return etc. Management of Working Capital In management of working capital the cost of capital may be used to calculate the cost of carrying investment in receivables and to evaluate alternative policies regarding receivables. It is also used in inventory management also. Dividend Decisions Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be formulated according to the nature of the firm— whether it is a growth firm, normal firm or declining firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm, respectively. Determination of Capital Structure Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the proportion of debt and equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimised. Evaluation of Financial Performance The concept of cost of capital can be used to evaluate the financial performance of top management. This can be done by comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital. The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose you borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the lender for the use of her money. Since Congress allows you to deduct from your income the interest you paid, how much does this dollar of debt really cost you? It depends on your marginal tax rate -- the tax rate on your next dollar of taxable income. Why the marginal tax rate? Because we are interested in seeing how the interest deduction changes your tax bill. We compare taxes with and without the interest deduction to demonstrate this. Suppose that before considering interest expense you have $2 of taxable income subject to a tax rate of 40 percent. Your taxes are $0.80. Now suppose your interest expense reduces your taxable income by $0.10, reducing your taxes from $2.00 x 40 percent = $0.80 to $1.90 x 40 percent = $0.76. By deducting the $0.10 interest expense, you have reduced your tax bill by $0.04. You pay out the $0.10 and get a benefit of $0.04. In effect, the cost of your debt is not $0.10, but $0.06. Let Ki represent the cost of debt per year before considering the tax deductibility of interest, kd represent the cost of debt after considering tax deductibility of interest, and t be the marginal tax rate. 171 CU IDOL SELF LEARNING MATERIAL (SLM)

10.6 COST OF PREFERENCE CAPITAL Preference shares as the term implies are the shares that rank at a priority above the equity shares. These shares contain a preferential right to receive the dividend as are declared by the company on first priority order. During the course of dividend declaration, these shareholders are entitled to receive the dividend first as against the normal equity shareholder. The preference shareholders not only have a preferential right to receive a dividend on the preliminary basis but they also have preferential right to receive the proceeds that are realized from the sale of the company’s assets during the course of liquidation of the company after payments having been made to the secured creditors of the company. As per explanation(ii) to section 42 of the Companies Act, 2013, the term preference shares mean and includes that part of the share capital the holders of which have a preferential right overpayment of dividend (fixed amount or rate) and repayment of share capital in the event of winding up of the company. Preference shares generally pay a higher rate of dividend however at a fixed rate or a fixed amount as a dividend. The preference shareholders are also privileged and entitled to receive all dividends i.e. current as well as an accrued dividend at priority before equity shareholders. It is evident to highlight that a company can issue preference shares only if these shares form part of the authorized share capital of the company as per the Memorandum of Association. It is important to verify the Articles of Association as to whether they grant authorization to issue preference shares. In the scenario where the Memorandum of Association or the Articles of Association of the company do not bestow the requisite power to issue preference share then in such a state, necessary amendments would be required to be made in these documents prior to issuing such preference shares. It is widely known that the equity shareholders are regarded as the owners of the company. The equity holders have the major decision-making power in their hands while granting limited decision-making power to the preference shareholders.  There is no legal obligation on the firm to pay a dividend to the preference shareholders.  The redemption of preference shares is not distressful for a firm since the shares are redeemed out of the profits and through the issue of fresh shares (preference shares and equity shares).  The preference capital is considered as a component of net worth and hence the creditworthiness of the firm increases.  Preference shareholders do not enjoy the voting rights, and thus, there is no dilution of control. 172 CU IDOL SELF LEARNING MATERIAL (SLM)

 It is very expensive as compared to the debt-capital because unlike debt interest, preference dividend is not tax deductible.  Although, there is no legal obligation to pay the preference dividends, when the payment is made it is done along with the arrears.  The preference shareholder can claim prior to the equity shareholders, in case the dividends are being paid or at the time of winding up of the firm.  If the company does not pay or skips the preference dividend for some time, then the preference shareholders could acquire the voting rights. The preference capital is similar to the equity in the sense: the preference dividend is paid out of the distributable profits, it is not obligatory on the part of the firm to pay the preference dividend, these dividends are not tax-deductible. The portion of the preference capital resembles the debentures: the rate of dividend is fixed, preference shareholders are given priority over the equity shareholders in case of dividend payment and at the time of winding up of the firm, the preference shareholders do not have the right to vote and the preference capital is repayable. 10.7 SUMMARY  While scenario analysis is a powerful and useful tool, one serious limitation is that it does not explicitly consider probability and uncertainty. Several of the inputs to the model discussed in the previous section have uncertain values. An approach to estimating expected WACC that explicitly addresses this uncertainty is to apply Monte Carlo simulation5 . Use of this tool is growing in the finance arena. For example, Rosickydescribes the use of Monte Carlo Simulation in making capital budget decisions, and Chang and Dasguptashow how Monte Carlo Simulation can be used in capital structure research. In this section, we describe how students use Monte Carlo simulation to understand how and to what extent the uncertain variables affect their estimates of the WACC, and how important the effect of uncertainty is for various debt-equity combinations. In a nutshell, students first identify the sources of uncertainty in estimating WACC parameters, then quantify the uncertainty around the estimation of each WACC parameter, and finally aggregate and quantify the uncertainty around the expected WACC via Monte Carlo simulation.  Monte Carlo simulation is a numerical approach used to solve problems or reveal more information about a situation by repeated random sampling. It can be thought of as artificially creating a chance event or series of related events (for example, a process) many independent times, and observing a summary or distribution of results. The estimated parameters of that distribution will be in error by some amount. One 173 CU IDOL SELF LEARNING MATERIAL (SLM)

can never know the exact size of this error because the true value of the quantity estimated is unknown.  One can show however, that the parameter estimate obtained from a simulated process or calculation is a consistent estimator of the true parameter. For example, as the number of random sample trials is increased, the half-width interval and corresponding standard error related to the estimated mean become smaller such that one has an asymptotically valid confidence interval for the mean. Typically, a model is prepared in which selected inputs are designated as having a distribution of values rather than point (single) values. This is done with those inputs which are not known with certainty. With tools available today almost any probability distribution can be assigned to an input of the model.  When the distribution is unknown, the one that represents the best fit to the available data can be used. In a given trial, a random value from each input variable’s distribution is selected and calculation of outputs is performed with those random values. After thousands of trials, the model outputs can be plotted as a frequency distribution that shows not only the most likely outcome, but also a range of possible outcomes, and the probability of those outcomes.  The simulation results remain estimates whose accuracy is defined by user inputs, but assuming the model is reasonably correct, the results can be more informative than alternative single-point estimates, or even scenario sets, that may be otherwise produced. If input variables exhibit correlation, this can also be modelled. The Monte Carlo simulation models were constructed using the Crystal Ball® software package. Students have access to this software in our school’s financial lab.  In general, the nominal or quoted rate on a security is composed of the risk-free rate plus compensation for risk. The Real Risk-Free Rate, denoted here as rRF*, is the interest rate that would exist on a security that had no risk, including no inflation risk. This may be thought of as a US Treasury security in a world without inflation. The nominal rate, denoted here as rRF, is equal to the risk-free component plus an inflation premium, i.e., rRF = rRF* + IP. Brigham & Houstoncite the difficulty of measuring the Real Risk-Free rate but say most experts think that rRF* has fluctuated in the range of 2 to 4 percent in recent years. Accordingly, we adopted that range and elected to use a triangular distribution with minimum of 2 percent and a maximum of 4 percent to represent the Real Risk-Free rate.  The market risk premium is the premium investors require to hold an average stock compared to the least risky or risk-free investment, typically taken as a US Treasury bond. The size of the premium is a function both of the investor’s risk aversion and how risky the investor perceives the market to be. The market risk premium is not 174 CU IDOL SELF LEARNING MATERIAL (SLM)

known with certainty, and so it must be estimated. Of course, estimates vary depending upon the source. 10.8 KEYWORDS  Encumbrance: An accounting commitment that reserves appropriated funds for a future expenditure. The total of all expenditures and encumbrances for a department or agency in a fiscal year, or for a capital project, may not exceed its total appropriation. The commitments relate to unperformed contracts for goods or services.  Enterprise Fund: A fund established to finance and account for the acquisition, operation, and maintenance of governmental facilities and services that are wholly or partially supported by user charges/ fees. Examples include liquor control and parking facilities.  Excise Tax: A tax levied on the purchase of a particular commodity.  Expendable Trust Funds: Accounting entities for assets the county does not own but must use for certain purposes, such as escrow deposits held by the county and retiree group insurance reserves.  Expenditure: A decrease in the net financial resources of the county generally due to the purchase of goods and services, the payment of salaries and benefits, and the payment of debt service. 10.9 LEARNING ACTIVITY 1. Create a session on weighted average cost of capital. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on retained earnings. ___________________________________________________________________________ ___________________________________________________________________________ 10.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is equity capital? 2. What is preference capital? 175 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Define the term the cost of debt? 4. Define the term preference capital? 5. Write the main aim of preference capital? Long Questions 1. Explain the advantages of preference capital. 2. Elaborate the disadvantages of preference capital. 3. Examine the advantages of cost of capital. 4. Discuss on the disadvantages of cost of capital. 5. Illustrate the cost of equity capital. B. Multiple Choice Questions 1. Which of the following is the first step in capital budgeting process? a. Final approval b. Screening the proposal c. Implementing proposal d. Identification of investment proposal 2. Which term does refer to the period in which the project will generate the necessary cash flow to recoup the initial investment? a. Internal return b. Payback period c. Discounting return d. Accounting return 3. What is a mutually exclusive project can be selected as per payback period? a. Less b. More c. More than 5 years d. None of these 4. What its profitability index is more than if the project can be selected? a. 1% b. 3% c. 5% d. 10% 176 CU IDOL SELF LEARNING MATERIAL (SLM)

5. What is Initial outlay 50,000, life of the asset 5 yrs., estimated annual cash flow 12,500, IRR = a. 5% b. 6% c. 8% d. 10% Answers 1-a, 2-d, 3-b, 4-a, 5-a 10.11 REFERENCES References  Demirguc-Kunt, A. & Detragianche, E. (1999). Financial liberalisation and financial fragility, World Bank Conference on Development Economics, World Bank.  Demirguc-Kunt, A. & Maksimovic, V. (1996). Stock market development and firm financing choices. World Bank Economic Review.  Demirguc-Kunt, A. & Maksomovic, V. (1998). Law, finance and firm growth. The Journal of Finance. Textbooks  Demirguc-Kunt, A. & Levine. R. (1996). Stock market development and financial intermediaries: stylized facts. The World Bank Economic Review.  De, Kock. G, P, C. (1985). Final report of the commission of inquiry into the monetary system and monetary policy in South Africa. Pretoria: Government Printer.  Dhillon, U, S. & Johnson, H. (1994). The effect of dividend changes on stock and bond prices. The Journal of Finance. Website  file:///C:/Users/Sony/Downloads/JFE-Article-Karagiannidis.pdf  https://www.srcc.edu/sites/default/files/Eco(hons.)_BCH%202.4(b)_GE- FINANCE_RuchikaChoudhary-converted.pdf  https://en.wikipedia.org/wiki/Retained_earnings 177 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-11 LEVERAGE STRUCTURE 11.0 Learning Objective 11.1 Introduction 11.2 Leverages 11.2.1 Financial 11.2.2 Operating 11.2.3 Combined Leverage 11.3 Measurement 11.4 Effect on Profit 11.5 Summary 11.6 Keywords 11.7 Learning Activity 11.8 Unit End Questions 11.9 References 11.0 LEARNING OBJECTIVE After studying this unit, you will be able to  Explain the concept offinancial leverages.  Explain the concept of operating leverages.  Illustrate the effect on profit. 11.1 INTRODUCTION In the arena of financing decisions, the capital structure decision assumes greater significance. As it deals with debt equity composition of the organization, the resultant risk and return for shareholders is of utmost concern for finance managers. If the borrowed funds are more than owners’ funds, it results in increase in shareholders’ earnings. At the same time, it also increases the risk of the organization. In a situation where the proportion of the equity funds is more than the proportion of the borrowed funds, the return as well as risk of the shareholders will be very low. This underlines the importance of having an optimal capital structure where risk and return to shareholders be matched. The effect of capital structure where risk and return to shareholders may judiciously help the finance managers to 178 CU IDOL SELF LEARNING MATERIAL (SLM)

decide their short term and long term strategiesThe behaviour and application of leverage helps in examining the whole issue in right perspective. In finance leverage (or gearing in the United Kingdom and Australia) is any technique involving using debt (borrowed funds) rather than fresh equity (value of owned assets minus liabilities) in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples — hence the provenance of the word from the effect of a leverin physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. Leveraging enables gains to be multiplied. On the other hand, losses are also multiplied, and there is a risk that leveraging will result in a loss if financing costs exceed the income from the asset, or the value of the asset falls. While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face bankruptcy or default during a business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% if the stock declines 20%also in this case the involved subject might be unable to refund the incurred significant total loss. Risk may depend on the volatility in value of collateral assets. Brokers may demand additional funds when the value of securities held declines. Banks may decline to renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called- in. This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices. It means that as market price falls, leverage goes up in relation to the revised equity value, multiplying losses as prices continue to go down. This can lead to rapid ruin, for even if the underlying asset value decline is mild or temporarythe debt-financing may be only short-term, and thus due for immediate repayment. The risk can be mitigated by negotiating the terms of leverage, by maintaining unused capacity for additional borrowing, and by leveraging only liquid assetswhich may rapidly be converted to cash. There is an implicit assumption in that account, however, which is that the underlying leveraged asset is the same as the unleveraged one. If a company borrows money to modernize, add to its product line or expand internationally, the extra trading profit from the additional diversification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures (high risk) and 179 CU IDOL SELF LEARNING MATERIAL (SLM)

puts the rest in a low-risk money-market fund, he or she might have the same volatility and expected return as an investor in an unlevered low-risk equity-index fund. Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels. So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly levered hedge funds have less return volatility than unlevered bond fundsand normally heavily indebted low-risk public utilities are usually less risky stocks than unlevered high- risk technology companies. Before the 1980s, quantitative limits on bank leverage were rare. Banks in most countries had a reserve requirement, a fraction of deposits that was required to be held in liquid form, generally precious metals or government notes or deposits. This does not limit leverage. A capital requirement is a fraction of assets that is required to be funded in the form of equity or equity-like securities. Although these two are often confused, they are in fact opposite. A reserve requirement is a fraction of certain liabilities (from the right hand side of the balance sheet) that must be held as a certain kind of asset (from the left hand side of the balance sheet). A capital requirement is a fraction of assets (from the left hand side of the balance sheet) that must be held as a certain kind of liability or equity (from the right hand side of the balance sheet). Before the 1980s, regulators typically imposed judgmental capital requirementsa bank was supposed to be \"adequately capitalized,\" but these were not objective rules. Figure 11.1: Leverage National regulators began imposing formal capital requirements in the 1980sand by 1988 most large multinational banks were held to the Basel I standard. Basel I categorized assets 180 CU IDOL SELF LEARNING MATERIAL (SLM)

into five risk buckets, and mandated minimum capital requirements for each. This limits accounting leverage. If a bank is required to hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to 1. While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for all off-balance sheet risks (there was a clumsy provisions for derivatives, but not for certain other off-balance sheet exposures) and it encouraged banks to pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to solid companies or ones near bankruptcy, and the requirement for government loans was zero). Figure 11.2: Leverage Analysis 11.2 LEVERAGES Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunistic. The poor performance of many banks during the financial crisis of 2007–2009 led to calls to re-impose leverage limits, by which most people meant accounting leverage limits, if they understood the distinction at all. However, in view of the 181 CU IDOL SELF LEARNING MATERIAL (SLM)

problems with Basel I, it seems likely that some hybrid of accounting and notional leverage will be used, and the leverage limits will be imposed in addition to, not instead of, Basel II economic leverage limits. Figure 11.3: Leverages 11.2.1 Financial With the aim to increase the level of security of supply and to improve the sustainability of energy sector the Latvian Cabinet of Ministers adopted Regulations No. 571 on the Guidelines for Energy Sector Development 2007–2016 (Cabinet of Ministers, 2006). The Regulations set the target for the country's energy sector to increase the share of electricity from renewable energy sources (RES-E) in the final consumption of electricity up to 49.3% in 2010. Seeking to achieve this target the country self-committed to promote the construction of cogeneration units and production of RES-E. After the National Renewable Energy Action Plan (2009) was published in 2009, the RES-E target for the Latvian energy sector was updated and increased up to 59.8% in 2020. Although hydro resources will play a crucial role in fulfilling the RES-E target, it is expected that the contribution of wind electricity will be meaningful too. It is planned that the share of electricity produced from wind resources will contribute by structural share of 10.5% to the RES-E target implementation in 2020. There will be installed totally 416 MW of wind power plants in 2020, which will produce up to 910 GWh of electricity. In order to achieve the RES-E targets in wind sector additional investments are required. Considering the peculiarities of wind electricity sector (namely, requirements for high initial investment, sufficient growth of the installed wind capacities and electricity generation volume) diversified financial sources are needed for the acquisition of assets and formation of an optimal capital structure in the companies by ensuring profitability, wealth to the shareholders and increasing value of the company. This means that exclusively internal financing sources are not sufficient; huge and 182 CU IDOL SELF LEARNING MATERIAL (SLM)

increasing external financing in the form of debt, showing an increasing financial leverage, is needed. Thus far, little is known about the financial leverage and its determinants in the companies engaged in wind electricity sector in Latvia. For the author of this paper this information was necessary when making the economic assessment of wind electricity sector in Latvia. Namely, the information was needed when computing the cost of the investment in wind electricity sector in Latvia and calculating the wind electricity production cost. Thus, this paper covers the following question: what are the values of the financial leverage ratios in the company’s producing electricity from wind resources in Latvia and what are the determinants of the financial leverage? The paper aims to analyse the financial leverage, its tendencies and the determinants in the company’s producing electricity from wind resources in Latvia during 2005–2012. To implement the aim the following tasks were set:  to prepare a set of indicators used to describe the development of the financial leverage in Latvia after reviewing the scientific literature on the issue of the financial leverage and its determinants;  to present methodology applied for determining the relationship between the financial leverage and selected variablesto discuss the developments of the financial leverage in the companies producing electricity from wind resources;  to assess the relationships between the financial leverage and its determinants. The literature review, financial statement and the method of regression analysis are used to implement the aim and tasks of the paper. The value of the DOL indicator shows how strongly the given percentage change in sales influences the change of the EBIT. The financial leverage is associated with the financing activities. If the fixed cost funds (debt or preferred capital), which require fixed interest rate or fixed preferred dividend payments, are included into the capital structure of the company, it is said that the company uses the financial leverage. Since the use of debt is more common in practice than the use of preferred capital, the financial leverage usually refers to the use of debt in capital structure. A company having debt on its balance sheet is called leveraged and a company that finances its activity only through equity is said to be unleveraged. The financial leverage is used to augment the results of a company by using fixed cost financing. Namely, J. Graham & S. Smartshowed that the common practice of a company to deduct interest payments from the taxable income gives a good incentive for that company to substitute the debt for equity. The degree of the financial leverage (DFL) is computed byChange % in EBIT Change % in EPS DFL  (2) where EPS is the earnings per share. Value of the DFL indicator shows how strongly a certain percentage change in EBIT will influence the change of profit after taxes or earnings per share. B. Static Trade-off and Pecking Order Theories The financial leverage has been well documented in the scientific literature. The interest in the topic arose after the paper by F. Modigliani & M. H. Millerwas published. In their paper the authors presented the leverage \"irrelevance\" theory. It states that \"in the absence of the transaction cost, no tax subsidies on the payment of interest, and the same rate of interest of borrowing by individuals and corporations, firm value is independent of its leverage\". In later years new theories, such as models based on agency costasymmetric information signalling frameworkstatic trade-off and pecking order theorieswere developed, 183 CU IDOL SELF LEARNING MATERIAL (SLM)

which analysed the determinants of the financial leverage in the company. Considering the number and content of recently published papers, which mainly refer to the static trade-off (STO) and pecking order (PO) theories, it is worth to present the main propositions of these frameworks, which are the bases of further investigations. The STO theory is substantiated by the proposition that the capital structure of a company is formed by making a trade-off between the benefits received from the use of debt and the costs related to the usage of debt. Namely, bankruptcy costs and tax benefits are considered when deciding about the capital structure and the usage of the leverage in the company. As R. Kumarobserved \"the higher the cost of bankruptcy, the lower the debt and vice versa\" and \"the higher the maximum marginal rate of tax, the higher the debt and vice versa\" PO theory states that the company's capital structure is a function of the dividend and investment policiesThe theory is based on the statement that \"the companies prefer to use internal equity to pay dividends and finance new investment\". Actually, they have a hierarchy of the financing sources. To avoid flotation costs resulting from the external financing, the companies initially prefer internal financing sources to pay dividends and realize growth expectations. If the internal financing sources (retained earnings, surplus or reserves) are used intensively and there are only several perspective investment opportunities then the debt level in that company is low and the companies are low leveraged. In the case of the financial deficiency, the companies use the external financing sources to realize investment opportunities. Since the flotation costs of debt are lower compared to the external equity, their debt stands the first in the rank when choosing the external financing source. Again, the companies prefer bank loan and the public debt is used only later if external financing is required. Equities are issued when market overvalues them. Hybrid securities are used as a last resort. The results of the empirical research prove that the financial leverage decreases with the age of the company. This means that matured and experienced companies are able to accumulate necessary funds themselves. Since they need less both short- and long-term borrowed funds, they are less leveraged. The proponents of the PO theory state that the \"companies with high growth rates should have a higher debt ratio since the need for external funds would be higher\"Gillempirically proved the statement. Opposed to the STO theory, the PO theory states that there exists a negative relationship between the profitability of the company and the financial leverage. The main argument is that profits are used to cover the debt and related interest payments. When the company earns profit, debts are paid and the financial leverage decreases. The leverage is different in domestic and multinational companies. Multinational companies use various sources of earnings. As a result they have better opportunities to earn profits and use them to finance investments. Thus, multinational companies have less debt and are less leveraged. Determinants of the Financial Leverage Thus far, a lot of papers investigating the determinants of the financial leverage in companies have been published. The increasing interest in the topic arose because of the impact of the financial leverage on profitability, wealth to shareholders and value of the company. Besides, when an inappropriate capital structure is chosen the risk of bankruptcy increases as it was 184 CU IDOL SELF LEARNING MATERIAL (SLM)

observed by F. J. Sanchez-Vidalthe investigation of the determinants of the financial leverage is crucial for economic policy making. One could notice that papers dealing with the determinants of the financial leverage are unified by several generic features. Firstly, the authors of the studies mainly empirically test the selected financial leverage theories. Secondly, the papers focus on the establishment of links between the financial leverage and its determinants by estimating the determinant elasticity of the financial leverage. Thirdly, the method of the regression analysis is one of the most often employed methods for the assessment of positive/negative impact of determinants on the financial leverage. However, as it will be disclosed below, the findings of the researchers are different and they depend on the industry, country, time, phase of the business cycle and the financial leverage ratios analysed. A relevant review of the determinants that influence the company's financial leverage was done by R. Kumar. After the review of more than one hundred papers published in the academic journals during a decade till 2005, the author segregated and discussed eight frameworks/theories helping to understand the level of the financial leverage in a company and summarized the determinants of the financial leverage found in the scientific literature. The results of the analysis revealed that among various determinants the size of the company, profitability and tangibility (collateral value) of assets are the most important determinants of the financial leverage. H. S. Songanalysed the determinants of the financial leverage in about 6000 Swedish companies utilizing the panel data regression analysis method. The impact of eight financial leverage determinants on three financial leverage ratios (total debt, short-term debt and long-term debt ratio) was analysed. The results of the research showed that the uniqueness and expected growth of total assets were not correlated to and, thus, were not statistically significant determinants of the selected financial leverage ratios. The author assumed that the reasons for this could beincorrectly selected indicators describing the determinants of the financial leverage. They could not give relevant information about the companies' growth possibilities in future, because \"the effects of the two different theories neutralize each other\". 11.2.2 Operating Most business people who borrow money are familiar with the term financial leverage. Financial leverage, expressed as the ratio of debt to equity (L = D/E), refers to the magnitude that a business is financed by debt versus equity. The more debt the greater the financial leverage Operating leverage is a lesser known term or concept. Even if you do not borrow money you do not necessarily avoid the risk of operating leverage. Operating leverage measures a firm's fixed versus variable costs. The greater proportion of fixed costs, the greater the operating leverage. Like financial leverage, operating leverage magnifies results, making gains look better and losses look worse. Both operating and financial leverage increase risks because they make returns less predictable over time. A cow-calf enterprise on native range might be an example of a high degree of operating leverage. Substantial amounts of capital are tied up in land, breeding and working (horses) 185 CU IDOL SELF LEARNING MATERIAL (SLM)

livestock, housing and pickups for employees, and fences. These are all fixed costs. Their depreciation, interest or opportunity cost, and upkeep - when averaged over output (pounds of calf sold) -are high. Variable costs, however, such as feed and fertilizer, are low - both in total and on a per unit of production basis. An intensive stocker enterprise on introduced grass offers an example of a low degree of operating leverage. Capital expenditures associated with land, fences and operating equipment are minimal. There is no capital investment in breeding livestock. Variable costs, however, for fertilizer, feed and stocker cattle are high for this type of operation. In a base case scenario the two operations' cost and return structure might look like chart 1. What happens if both operations have an opportunity to expand revenue? Assume additional pasture is available for rent and that both operations can handle the expansion with existing assets. The new 'pasture' will add $25,000 of revenue to either operation. If the cow-calf operation expands, variable costs will run 35% of revenue and fixed costs remain flat at $35,000. (We must assume the operator saved additional replacement heifers, anticipating an opportunity.) Variable costs for the stocker operation will be 55% of revenue and fixed costs are capped at $15,000. Figure 11.4: Operating The cow-calf operation's income expanded more than the stocker operation. The net income margin increased from 30% to 37% of revenue. Of the additional revenue, 65% fell through to the bottom line. The stocker operation also benefited from the expansion, but only 45% of the additional revenue showed up in net income. Because of operating leverage the cow-calf operation, with a large fixed cost base, benefited the most from expanding revenues. What happens if revenues fall? Just as with financial leverage, the operation with the highest operating leverage is hurt the most. 186 CU IDOL SELF LEARNING MATERIAL (SLM)

When revenues contract, the cow-calf operation with high fixed costs, and thus high operating leverage, moves into a loss situationHowever, the stocker operation, with its low fixed costs, remains marginally profitable Figure 11.5: Operating leverage vs Financial leverage Is one situation or cost structure better than the other? Not necessarily, because leverage is neither good nor bad. Operating leverage, just like financial leverage, is a higher risk strategy. Each individual must assess the amount of risk he or she is willing to take while striving to achieve their business and personal objectives. Business growth and survival can be dramatically affected by factors as seemingly simple as cost structure. Knowing your farm or ranches' cost structure and learning to manage accordingly can have profound effects on long term business success. If you desire assistance in analysing the cost structure of your agricultural operation, contact one of the agricultural economists at the Noble Research Institute. 11.2.3 Combined Leverage Combined leverage is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. Competitive firms choose high level of degree of combined leverage whereas conservative firms choose lower level of degree of combined leverage. Degree of combined leverage indicates benefits and risks involved in this particular leverage. Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to percentage change in sales. The financial leverage shows the financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Both operating and financial leverages are closely concerned with ascertaining the firm’s ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result is total leverage and the risk associated with combined leverage is known as total risk. It measures the effect of a percentage change in sales on percentage change in EPS. The combined leverage may be 187 CU IDOL SELF LEARNING MATERIAL (SLM)

favourable or unfavourable. It will be favourable if sales increase and unfavourable when sales decrease. This is because changes in sales will result in more than proportional returns in the form of EPS. As a general rule, a firm having a high degree of operating leverage should have low financial leverage by preferring equity financing, and vice versa by preferring debt financing. If a firm has both the leverages at a high level, it will be very risky proposition. Therefore, if a firm has a high degree of operating leverage the financial leverage should be kept low as proper balancing between the two leverages is essential in order to keep the risk profile within a reasonable limit and maximum return to shareholders. 11.3 MEASUREMENT Measurement is the quantification of attributes of an object or event, which can be used to compare with other objects or events. The scope and application of measurement are dependent on the context and discipline. In natural sciences and engineering, measurements do not apply to nominal properties of objects or events, which is consistent with the guidelines of the International vocabulary of metrology published by the International Bureau of Weights and Measures. However, in other fields such as statistics as well as the social and behavioural sciences, measurements can have multiple levels, which would include nominal, ordinal, interval and ratio scales. Measurement is a cornerstone of trade, science, technology and quantitative research in many disciplines. Historically, many measurement systems existed for the varied fields of human existence to facilitate comparisons in these fields. Often these were achieved by local agreements between trading partners or collaborators. Since the 18th century, developments 188 CU IDOL SELF LEARNING MATERIAL (SLM)

progressed towards unifying, widely accepted standards that resulted in the modern International System of Units (SI). This system reduces all physical measurements to a mathematical combination of seven base units. The science of measurement is pursued in the field of metrology. Measurements most commonly use the International System of Units (SI) as a comparison framework. Six of these units are defined without reference to a particular physical object which serves as a standard (artifact-free), while the kilogram is still embodied in an artifact which rests at the headquarters of the International Bureau of Weights and Measures in Sevres near Paris. Artifact-free definitions fix measurements at an exact value related to a physical constant or other invariable phenomena in nature, in contrast to standard artifacts which are subject to deterioration or destruction. Instead, the measurement unit can only ever change through increased accuracy in determining the value of the constant it is tied to. Measurement refers to the quantification of results obtained by using measurement tools. As such, inspection refers to comparing the values obtained through measurement with available references to determine whether a product is acceptable or not. When measuring a length using a ruler, it is possible to make some sort of decision based on the value, such as “The measurement is a little too long/short.” This determination is another way of saying, “Based on the value obtained using a ruler (measurement), it has been determined that this value is slightly longer (or shorter) than the length of interest.” Although there is often no need to use these definitions separately, it is a good idea to at least recognise the difference between the two.The first proposal to tie an SI base unit to an experimental standard independent of fiat was by Charles Sanders Peircewho proposed to define the metre in terms of the wavelength of a spectral line. This directly influenced the Michelson–Morley experiment; Michelson and Morley cite Peirce, and improve on his method. 11.4 EFFECT ON PROFIT The establishment of a company must have a clear purpose. There are several things that suggest about the purpose of establishing a company. The first objective of the company is to achieve maximum profit or maximum profit. The second objective of the company is to prosper the company owner or shareholders. While the third objective of the company is to maximize the firm value reflected in the price of its shares. The three objectives of the company are actually not much different. It's just that the emphasis that each company wants to achieve is different from one to the other. The higher the firm value describes the more prosperous the owner of the company. The firm value is very importantthis is because if the firm value is high it will be followed by the high prosperity of shareholders. The higher the stock price the higher the firm value. The value of a company will be reflected in its stock price, with investment opportunities, it can provide a positive signal about the company's growth in the future so that it will increase stock prices. Investors will be more interested in 189 CU IDOL SELF LEARNING MATERIAL (SLM)

buying securities in companies that have maximum corporate value. With more investments made by investors towards the company, it will have the potential to obtain maximum profits. In 2017 there are 4 issuers in hotel, restaurant and tourism services which experienced the most drastic decline in shares. The first ICON experienced the most significant decrease of 72.20%. Followed by JGLE which also decreased by 66.41%In additionPSKT also decreased by 61.74%Last HOME, which decreased by 59.58%Information in financial statements must be relevant and representations in order to influence the purpose of decision making. Information provided by management to shareholders must be able to represent the good and bad condition of the economic condition of a company. According to Scott states that if several parties involved in business transactions have more information than other parties, then the condition is said to be information asymmetry. The condition of the asymmetry is utilized by the management to maximize his personal interests by hiding information that is not known by shareholders. Everything is inseparable from what is referred to as efforts to obtain personal benefits or benefits (obtaining private gains). Management can influence accounting numbers in financial reporting by making profit management. Profit management is defined as the efforts of company managers to intervene or influence the information in financial statements with the aim of tricking stakeholders who want to know the performance and conditions of the company. Profit management does not have to be associated with attempts to manipulate accounting data or information, but it can also be associated with the selection of accounting methods to regulate the benefits that can be made because it is permissible according to accounting regulation. Therefore, the income statement is one of the objects that become a means of manipulation activities carried out by management with the aim of obtaining unilateral profits but on the other hand will be able to harm other parties such as investors and other creditors. Profit management practices are considered detrimental because they can reduce the value of financial statements and provide information that is not relevant to investors. According to Herawatyagency theory provides the view that profitmanagement problems can be minimized by self-supervision through good corporate governance. The purpose of good corporate governance is to create added value for all interested parties. Good corporate governance which contains four important elements namely fairness, transparency, accountability and accountability is expected to be a way to reduce agency conflict and profit management practices. With good corporate governance, it is expected that the firm value will be valued better by investors. Capital investment is one of the main aspects of investment decisions besides determining the composition of assets. Investment decisions are provisions made by the company is spending its funds in the form of certain assets in the hope of obtaining profits in the future. If investing in a company is able to generate profits by using company resources efficiently, the company will gain the trust of prospective investors to buy their shares. Thus the higher the company's profits, the higher the firm value, which means the greater prosperity that will be received by the company owner. Making investment activities is the most difficult decision for company management because it will affect the firm value. The purpose of investment decisions is to obtain a high 190 CU IDOL SELF LEARNING MATERIAL (SLM)

level of profit with a certain level of risk. High profits accompanied by manageable risks are expected to increase firm value, which means increasing shareholder prosperity. In signalling theory, investment expenditure shows a positive signal about the growth of company assets in the future, thus increasing stock prices as an indicator of firm value. 11.5 SUMMARY  The Independent Board of Commissioners variable has a significant probability value of 0.045, far less than 0.05. So it can be concluded that the Independent Board of Commissioners has an influence on Company Values and it can be seen the results of the hypothesis are H2 accepted. Thus it can be concluded that the independent board of commissioners in this study has a significant negative effect on firm value. This means that companies that have a large number of independent commissioners actually make the firm value decline.  This is because there are still many independent boards of commissioners who have a term of more than two periods. The term of office that exceeds two periods is feared to make them no longer independent. Because independent commissioners who have served too long can influence their independence in the results of this study are consistent with the research conducted by HerawatyLestari and Pamudjiwhich states that independent commissioners influence the firm value because the presence of independent commissioners in the company can minimize fraudulent actions carried out by managers and will affect the firm value. Institutional Ownership Variables have a significant probability value of 0.022 far smaller than 0.05.  So that it can be concluded that Institutional Ownership has an influence on Company Values and it can be seen that the hypothesis is that H3 is accepted. Thus it can be concluded that institutional ownership in this study has a significant positive effect on firm value. This means that companies that have large amounts of institutional ownership make the firm value increase. Institutional ownership in companies can monitor management policies that have an impact on increasing company value.  The greater the institutional ownership, the more efficient the utilization of company assets and is expected to also be able to act as a deterrent to the waste and manipulation of profits made by management so that it will increase the firm value. The results of this study are consistent with the research conducted by Herawaty which states that institutional ownership is related to company values relating to institutional ownership in the company can help fund reduction actions carried out by managers and will be related to firm value.  The Investment Decision variable has a significant probability value of 0.592 far greater than 0.05. Rejected can be approved by the Investment Decision not approved against the Company Value and it can be estimated that the result of the hypothesis is 191 CU IDOL SELF LEARNING MATERIAL (SLM)

H4 is rejected. Thus it can be concluded from the investment decisions in this study that it is not approved of the firm value. Companies that make investment decisions are not proven to increase company value. This is due to the lack of proper investment decisions made by managers.  In addition, the growth of assets resulting from investment only compares the assets of the current year with the assets of the previous year. However, assets for the current year will be calculated that will not be guaranteed the following year assets will also be returned or cancelled. Do this not too much attention for investors if they invest. If investors consider the company to have good prospects, investors will continue to invest.  T. Ashraf & S. Rasoolexplored the determinants of the financial leverage in automobile industry in Pakistan during 2005–2010. Seven determinants were analysed by applying the multiple regression method. The results of the research showed that the financial leverage depended only on the size of a company (log of total assets was taken as a proxy), tangibility of non-current assets (gross non-current assets to total assets ratio was employed) and growth of total assets. It was found that both the growing and larger in size companies were less leveraged.  The authors assumed that this could be related to the preferences of the owners of companies to use the internal financing source for acquisition of assets instead of debt financing. However, the companies, which had more tangible assets, were more leveraged because tangible assets could have a collateral value, which was considered when receiving the long-term loan. Since correlations between the financial leverage and profitability, taxes, risk and nondebt tax shield were found statistically insignificant, thus, it could be stated that these determinants were of low importance when deciding about the capital structure in the companies. A. Gill & N. Mathurinvestigated the determinants of the financial leverage in a small sample of the Canadian manufacturing and service companies during 2008–2010.  The ordinary least square regression method was used. Three regression models were prepared: 1) using entire sample; 2) using the data of the manufacturing industry; 3) using the data of service industry. The research results showed that the financial leverage in the entire sample of the companies could increase when the size of a company and the number of subsidiaries increased, but it could decrease when profitability, value of collateralized assets and the effective tax rate of the company increased as well as in the case when the company had good growth opportunities. 192 CU IDOL SELF LEARNING MATERIAL (SLM)

11.6 KEYWORDS  Fiscal Plan: Estimates of revenues, based on recommended tax policy and moderate economic assumptions, and projections of currently known or recommended commitments for future uses of resources.  Fiscal Projections: Estimates of revenues and projections of possible expenditures for the functions of government, including analysis of the impact of tax and expenditure patterns on public programs and the economy of the county.  Fiscal Year (FY): A twelve-month period designated as the operating year for accounting and budgeting purposes in a county. A fiscal year can start on different dates depending upon the county, including January 1st and July 1st.  Fixed Assets: Assets of a long-term character that are intended to continue to be held or used. Examples of fixed assets include items such as land, buildings, machinery, furniture, and other equipment.  Flat Tax: A tax for which the marginal tax rate is constant throughout the entire range of Incomes. 11.7 LEARNING ACTIVITY 1. Create a session on operating leverage. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on financial leverage. ___________________________________________________________________________ ___________________________________________________________________________ 11.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define the term financial? 2. Define the term operating? 3. How to determine profit in operating leverage? 4. How to determine profit in financial leverage? 5. What is meaning of profit? 193 CU IDOL SELF LEARNING MATERIAL (SLM)

Long Questions 1. Explain the advantages of operating leverage. 2. Elaborate the disadvantages of operating leverage. 3. Discuss on the scope of financial leverage. 4. Examine the scope of combined leverage. 5. Illustrate the effect on profit. B. Multiple Choice Questions 1. Which form of market efficiency states that current security prices fully reflect all information, both public and private? a. Weak b. Semi-strong c. Strong d. Highly strong 2. Which form of market efficiency states that current prices fully reflect the historical sequence of prices? a. Weak b. Semi-strong c. Strong d. Highly strong 3. Which is one that maximizes value of business, minimizes overall cost of capital, that is flexible, simple and futuristic, that ensures adequate control on affairs of business by the owners and so on? a. Minimal capital structure b. Moderate capital structure c. Optimal capital structure d. Deficit capital structure 4. What refers to make-up of a firm's capitalization. a. Capital structure b. Capital budgeting c. Equity shares d. Dividend policy 194 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Which of different sources of capital influences capital structure? a. Restrictive covenants b. Tax advantage c. Cost of capital d. Trading on equity Answers 1-b, 2-c, 3-a, 4-c, 5-a 11.9 REFERENCES References  Edison, H. & Warnock, F, (2003). A simple measure of the intensity of capital controls. Journal of Empirical Finance.  Edison, H, J. Levine, R. Ricci, L. & Sløk, T. (2002). International financial integration and economic growth, Journal of International Money and Finance.  Eichengreen, B. (2001). Capital account liberalisation: What do cross-country studies tell us? The World Bank Economic Review. Textbooks  Eichengreen, B. & Leblang, D. (2003). Capital account liberalisation and growth: was Mr. Mahathir right? International Journal of Finance and Economics.  Eicher, T. & Hull, L. (2004). Financial liberalisation, openness and convergence. Journal of International Trade and Economic Development.  Eicher, T, S. Turnovsky, S. & Walz, U. (2000). Optimal policy for financial market liberalisations: decentralization and capital flow reversals. Germany Economic Review. Website  http://www.nou.ac.in/Online%20Resourses/13-7/bba1.pdf  https://www.keyence.co.in/ss/products/measure/measurement_library/basic/measurem  https://www.researchgate.net/publication 195 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-12 DIVIDEND POLICY STRUCTURE 12.0 Learning Objective 12.1 Introduction 12.2 Forms of Dividend 12.3 Determinants of Dividends Policy 12.4 Theories of Dividend 12.4.1 Walter’s Model 12.4.2 Gordon’s Model 12.4.3 MM Hypothesis 12.5 Summary 12.6 Keywords 12.7 Learning Activity 12.8 Unit End Questions 12.9 References 12.0 LEARNING OBJECTIVE After studying this unit, you will be able to  Explain the concept of dividends policy.  Illustrate the theories of dividend.  Examine the forms of dividend. 12.1 INTRODUCTION A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business (called retained earnings). The current year profit as well as the retained earnings of previous years is available for distribution; a corporation is usually prohibited from paying a dividend out of its capital. Distribution to shareholders may be in cash (usually a deposit into a bank account) or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or by share repurchase. In some cases, the distribution may be of assets. 196 CU IDOL SELF LEARNING MATERIAL (SLM)

The dividend received by a shareholder is income of the shareholder and may be subject to income tax (see dividend tax). The tax treatment of this income varies considerably between jurisdictions. The corporation does not receive a tax deduction for the dividends it pays.A dividend is allocated as a fixed amount per share, with shareholders receiving a dividend in proportion to their shareholding. Dividends can provide stable income and raise morale among shareholders. For the joint-stock company, paying dividends is not an expense; rather, it is the division of after-tax profits among shareholders. Retained earnings (profits that have not been distributed as dividends) are shown in the shareholders' equity section on the company's balance sheet – the same as its issued share capital. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from the fixed schedule dividends. Cooperatives, on the other hand, allocate dividends according to members' activity, so their dividends are often considered to be a pre-tax expense. Cash dividends are the most common form of payment and are paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income of the shareholder, usually treated as earned in the year they are paid (and not necessarily in the year a dividend was declared). For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is 50 cents per share, the holder of the stock will be paid $50. Dividends paid are not classified as an expense, but rather a deduction of retained earnings. Dividends paid does not appear on an income statement, but does appear on the balance sheet. Different classes of stocks have different priorities when it comes to dividend payments. Preferred stocks have priority claims on a company's income. A company must pay dividends on its preferred shares before distributing income to common share shareholders. Stock or scrip dividends are those paid out in the form of additional shares of the issuing corporation, or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned. Nothing tangible will be gained if the stock is split because the total number of shares increases, lowering the price of each share, without changing the market capitalization, or total value, of the shares held. Stock dividend distributions do not affect the market capitalization of a company. Stock dividends are not includable in the gross income of the shareholder for US income tax purposes. Because the shares are issued for proceeds equal to the pre-existing market price of the shares; there is no negative dilution in the amount recoverable. Property dividends or dividends in specie are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer, however, they can take other forms, such as products and services. 197 CU IDOL SELF LEARNING MATERIAL (SLM)

Interim dividends are dividend payments made before a company's Annual General Meeting (AGM) and final financial statements. This declared dividend usually accompanies the company's interim financial statements. Other dividends can be used in structured finance. Financial assets with known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for \"spinning off\" a company from its parent is to distribute shares in the new company to the old company's shareholders. The new shares can then be traded independently. Some believe that company profits are best re-invested in the company: research and development, capital investment, expansion, etc. Proponents of this view (and thus critics of dividends per se) suggest that an eagerness to return profits to shareholders may indicate the management having run out of good ideas for the future of the company. Some studies, however, have demonstrated that companies that pay dividends have higher earnings growth, suggesting that dividend payments may be evidence of confidence in earnings growth and sufficient profitability to fund future expansion. Taxation of dividends is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding. 12.2 FORMS OF DIVIDEND The important aspect of dividend policy is to determine the amount of earnings to be distributed to shareholders and the amount to be retained in the firm. Retained earnings are the most significant internal sources of financing the growth of the firm. On the other hand, dividends may be considered desirable from the shareholders’ point of view as they tend to increase their current return. Dividends, however, constitute the use of the firm’s funds. Dividend policy involves the balancing of the shareholders’ desire for current dividends and the firms’ needs for funds for growth. Cash Dividends The most common type of dividend is a cash dividend. Commonly, public companies pay regular cash dividends four times a year. As the name suggests, these are cash payments made directly to shareholders, and they are made in the regular course of business. In other words, management sees nothing unusual about the dividend and no reason why it won’t be continued. Sometimes firms will pay a regular cash dividend and an extra cash dividend. By calling part of the payment “extra” management is indicating that the “extra” part may or may not be repeated in the future. A special dividend is similar, but the name usually indicates that this dividend is viewed as a truly unusual or one-time event and won’t be repeated. 198 CU IDOL SELF LEARNING MATERIAL (SLM)

Finally, the payment of a liquidating dividend usually means that some or all of the business has been liquidated, that is, sold off. However it is labelled, a cash dividend payment reduces corporate cash and retained earnings, except in the case of a liquidating dividend. Bonus Shares (Stock Dividend) An issue of bonus shares is the distribution of shares free of cost to existing shareholders. Bonus shares are issued in addition to the cash dividend and not in lieu of cash dividends. Hence, companies may supplement cash dividend by bonus issues. Issuing bonus shares increase the number of outstanding shares of the company. The bonus shares are distributed proportionately to the existing shareholder. Hence there is no dilution of ownership. For example, if a shareholder owns 100 shares at the time when a 10 per centbonus issue made, he will receive 10 additional shares. The declaration of the bonus shares will increase the paid-up share capital and reduce the reserve and surplus earnings of the company. The total net worth is not affected by the bonus issue. Stock Split A stock split is essentially the same thing as a stock dividend, except that a split is expressed as a ratio instead of a percentage. When a split is declared, each share is split up to create additional shares. For example, in a three-for-one stock split, each old share is split into three new shares. Standard Method of Cash Dividend Payment The decision to pay a dividend rests in the hands of the board of directors of the corporation. When a dividend has been declared, it becomes a debt of the firm and cannot be rescinded easily. Sometime after it has been declared, a dividend is distributed to all shareholders as of some specific date. Commonly, the amount of the cash dividend is expressed in terms of dollars per share (dividends per share). As we have seen in other chapters, it is also expressed as a percentage of the market price (the dividend yield) or as a percentage of net income or earnings per share (the dividend pay-out). 12.3 DETERMINANTS OF DIVIDENDS POLICY The determinants of dividend policy have been investigated for decades, yet there is no consensus on which factors affect the propensity to pay dividends and dividend pay-out. Researchers rely on variables such as dividend yield, dividend pay-out ratio (DPR) or propensity to pay dividends when investigating the determinants of dividend policy, but results are often inconsistent. For instance, Botoc and Pirteaidentify profitability and liquidity as positive determinants of DPR in 16 emerging markets, whereas Kuzucu argues that profitability is a negative determinant and liquidity is a non-significant predictor of DPR in Turkish listed firms. Moreover, since the 1950s past dividends have been investigated as a key determinant of dividend policywith similarly inconsistent results. For instance, Yusof and 199 CU IDOL SELF LEARNING MATERIAL (SLM)

Ismailidentify past dividends as a non-significant predictor of DPR in Malaysia, whereas Al- Kayedhighlights past dividends as a key factor influencing corporate dividend policy in the Saudi Arabian context. Al-Kayedreveals a negative impact on dividend yield from profitability, liquidity, leverage, growth and past dividends among conventional banks, in contrast to Botoc and Pirteawho single out profitability and liquidityand to Yusof and Ismailwho name past dividends exclusively. Rather than dividend payout, Fama and French De Angeloand Denis and Osobovinvestigate the determinants of propensity to pay dividends. This study argues that determinants of dividend policy cannot be investigated by looking at a single dimension, and hence both the propensity to pay dividends and its payout should be included in analyses. The present study extends the literature of determinants of a dividend policy by investigating determinants of both propensity to pay dividends and its payout in a single study allowing to evaluate whether they contain the same set of determinants. Sri Lanka is an emerging and developing marketwith 296 listed companies across 20 sectors totalling $20bn in market capitalization (Colombo Stock Exchange, 2017). A lack of prior studies on dividend determinants in Sri Lanka, alongside the inconsistency of recent findings on determinants of dividend policy in other emerging and developing markets (Saudi Arabia, Morocco, Malaysia and Turkey) are the main justifications for our study. Past dividends Lintneridentifies past dividends as the main factor in corporate dividend policy. Past dividends have been identified as a key determinant of dividend policy in the US contextand in the banking industry. Theis and Duttaidentify previous year dividends as an appositive determinant of dividend policy. As stated by Al-Ajmi and Hussainand Al- Kayedwe predict a positive impact of lagged dividends on current dividend policy in our sampled Sri Lankan firms, and formulate the following hypotheses: In his seminal article, Lintnerrecommends lowering dividend payout for higher tax liability. Miller and Modiglianiidentify taxes as one of the factors creating imperfections, attracting a clientele favouring a precise dividend policy. Elton and Gruberemphasize the impact of taxes on corporate dividend policy. Amidu and Aborpropose that taxes have a positive impact on dividend policy in Ghana, contrary to Arkowho disclose a negative relationship between taxes and corporate dividend policy in the same context. Al-Malkawiidentifies no significant effect of taxes on corporate dividend policy. Since the previous findings are contradictory regarding the impact of taxes on dividend policy, we propose the following hypotheses. Corporate governance Donaldsonintroduces the stewardship theory that postulates an inverse relationship between corporate governance and agency costs. Setiawan and PhuaBoţoc and Pirteaand Benjamin and Zainidentify dividends as a substitute for corporate governance, while Yarram and DolleryBadar and Changjunand Shamsabadisupport the outcome model of corporate governance. Since corporate governance has also been considered a determinant of dividend policy, we hypothesize. Ownership structure According to Shleifer and VishnuLa PortaClaessensand Facciomost organizations exhibit concentrated ownership and are governed by families, states, or single 200 CU IDOL SELF LEARNING MATERIAL (SLM)