FINANCIAL MANAGEMENT ASSIGNMENT

Q.3) What are the important reasons for mergers and acquisitions?

Ans.)

Merger : A merger is said to occur when two or more companies combine into one company.

Acquisition : Acquisition means acquiring the ownership in the company.

REASON FOR MERGER AND ACQUISITION

The following are important reasons for mergers and acquisition of firms.

Economies of scale : The combined firm can have larger volume of operations than the individual firms. Thus the combined firm can enjoy econimics of scale. The optimum utilization of plant capacity is possible to combined entity resulting in fall in the average cost of the output. The firm, which produces its output at the minimum average cost, is known as optimum firm. To cut the long story short we can say that, the mergers and acquisitions help the company to produce the goods more economically through the full utilization of plant capacities.

Synergy : Synergy is simply defined as 2+2=5 phenomenon. The value of the company formed through merger will be more than the sum of the value of the individual companies just merged.

Symbolically :

V(A)+V(B)

V(A)=value of A Ltd.

V(B)=value of B Ltd.

V(AB)=Value of merged company.

Diversification of risk : Company’s profits and cash flows fluctuate widely when it produces a single product. This increases the risk of a firm. So a company experiencing wide fluctuations in the earnings may merge with another company whose earnings are of different nature. The merger of companies whose earnings are negatively correlated will bring stability in the earnings of the combined firm. So diversification reduces the risk of the firm.

Growth : Growth is possible in 2 ways i.e. internal expansion of Greenfield ventures or external expansion through mergers and acquisitions. Internal expansion is slow and takes time and also involves a lot of risk. Mergers and acquisitions help the company to grow quickly without any gestation period.

Reduction in tax liability : In some cases tax shields may be the motivating factor for mergers. Under Income Tax Act, there is a provision for set off and carry forward of losses. A Sick company may not be in a position to earn sufficient profits in future to take advantage of the carry forward provision. So a sick company with accumulated losses may like some profitable company to merge with it to take advantage of tax benefits. Even the sick company with accumulated losses may be merged with a profitable company and take advantage of income tax benefits with the approval of government.

To increase market power and to kill competition : The merger can increase the market share of merged firm. This increases the market power and makes the demand for the product of the firm less elastic. Mergers also help the company to reduce competition in the marketplace. Many mergers have been intended to kill the competition and to increase the market power.

Financial Synergy : The following are the financial synergy available in the case of mergers.

a) Better Credit worthiness : This helps the company to purchase the goods on credit, obtain bank loan and raise capital in the market easily.

b) Reduces the cost of capital : The investors consider big firms as safe and hence they expect lower rate of return for the capital supplied by them. So the cost of capital reduces after the merger.

c) Increases the debt capacity : After the merger the earnings and cash flows become more stable than before. This increases the capacity of the company to borrow more funds.

d) Increases the P/E ratio and value per share : The liquidity and marketability of the security increases after the merger. The growth rate as well as earnings of the firm will also increase due to various economies after the merger. So the investors are willing to pay higher price for the shares of the merged company. All these factors help the company to enjoy higher P/E in the market.

e) Low floatation cost : Small companies have to spend higher percentage of the issued capital as floatation cost when compared to a big firm.

f) Raising of capital : After the merger due to increase in the size of the company and better credit worthiness and reputation, the company can easily raise the capital at any time.

Managerial motives : After the merger manager’s benefit in rank, status and perquisites. This is another motivation for mergers.

Q.4) What is an EBIT-EPS analysis ? Illustrate your answer.

Ans.)

EBIT-EPS analysis is a method to study the effect of financial leverage under variour levels of EBIT under alternative method of financing.

Using the following example we can explain the EBIT-EPS analysis.

A firm has a capital structure exclusively comprising of ordinary shares amounting to Rs. 1,00,000. The firm now wishes to raise additional

Rs. 1,00,000 for investment purposes. The company has 4 alternatives.

a) It can raise the entire amount in the form of equity shares.

b) It can raise 50% as equity and 50% as 5% debentures.

c) It can raise entire amount by 5% debentures.

d) It can raise 50% equity and 50% as 5% preference capital.

Further assume that existing EBIT is Rs. 12000/-, the tax rate is 50% outstanding number of equity shares are 1000.

The financial plan, which gives highest EPS, would be naturally better from the company’s point of view.

Calculation of EPS at an EBIT level of Rs. 12,000 ( ROI = 6% )

	A	B	C	D
EBIT ( Rs. )	12,000	12,000	12,000	12,000
Less : Interest ( Rs. )	-	2,500	5,000	-
EBIT ( Rs. )	12,000	9,500	7,000	12,000
Less : Tax@50%	6,000	4,750	3,500	6,000
EAT ( Rs. )	6,000	4,750	3,500	6,000

Less : Preference dividend (Rs.)	-	-	-	2,500
Earnings available to equity Shareholders ( EAESH ) ( Rs.)	6,000	4,750	3,500	3,500
No. of shares ( N )	2000	1500	1000	1500
EPS ( EAESH/N ) (Rs. )	3	3.16	3.5	2.33

Calculation fo EPS at an EBIT level of Rs. 8000 ( ROI = 4% )

Financing plans.

	A	B	C	D
EBIT ( Rs. )	8,000	8,000	8,000	8,000
Less : Interest ( Rs. )	-	2,500	5,000	-
EBIT ( Rs. )	8,000	5,500	3,000	8,000
Less : Tax @ 50% ( Rs. )	4,000	2,750	1,500	4,000
EAT ( Rs. )	4,000	2,750	1,500	4,000
Less : Preference Dividend (Rs)	-	-	-	2,500
Earnings available to equity Shareholder ( Rs. )	4,000	2,750	1,500	1,500
No. of shares	2000	1500	1000	1500
EPS ( Rs. )	2	1.83	1.5	1

Calculation of EPS at an EBIT level of Rs. 10,000 ( ROI = 5% )

Financial Plans

	A	B	C	D
EBIT ( Rs. )	10,000	10,000	10,000	10,000
Less : Interest ( Rs. )	-	2,500	5,000
EBIT ( Rs. )	10,000	7,500	5,000	10,000
Less : Tax @ 50% ( Rs. )	5,000	3,750	2,500	5,000
EAT ( Rs. )	5,000	3,750	2,500	5,000
Less : Preference Dividend ( Rs.)	–	-	-	2,500
Earnings available to equity Shareholders ( Rs. )	5,000	3,750	2,500	2,500
No. of shareholders	2000	1500	1000	1500
EPS ( Rs. )	2.5	2.5	2.5	1.66

Calculation of EPS at an EBIT level of Rs. 20,000 ( ROI = 10% )

	A	B	C	D
EBIT ( Rs. )	20,000	20,000	20,000	20,000
Less : Interest ( Rs. )	-	2,500	5,000	-
EBT ( Rs. )	20,000	17,500	15,000	20,000
Less : Tax @ 50% ( Rs. )	10,000	8,750	7,500	10,000
EAT ( Rs. )	10,000	8,750	7,500	10,000
Less : Preference dividend (Rs)	-	-	-	2,500
Earnings available ESH ( Rs. )	10,000	8,750	7,500	7,500
No of shares	2000	1500	1000	1500
EPS (Rs. )	5	5.83	7.5	5

Calculation of EPS at an EBIT level of Rs. 30,000 ( ROI = 15% )

	A	B	C	D
EBIT ( Rs. )	30,000	30,000	30,000	30,000
Less : Interest ( Rs. )	-	2,500	5,000	-
EBT ( Rs. )	30,000	27,500	25,000	30,000
Less : Tax @ 50% ( Rs. )	15,000	13,750	12,500	15,000
EAT ( Rs. )	15,000	13,750	12,500	15,000
Less : Preference Dividend (Rs.)	-	-	-	2,500
Earnings available to ESH ( Rs. )	15,000	13,750	12,500	12,500
No. of shares	2000	1500	1000	1500
EPS ( Rs. )	7.5	9.16	12.5	8.33

Analysis of results :

1) EPS increases along with the increases in EBIT under all financial plans.

2) When the financial leverage in absent ( When only equity share are issued), EPS increases proportionately along with the increase in EBIT. That is 1% change in EBIT will be followed by only 1% change in EPS as in the case of financial plan A.

3) If the ROI is less than the cost of debt ( e.g.:EBIT of Rs. 8,000 ROI=4%), there is unfavourable financial leverage. So EPS falls as and when more and more debt is issued.

4) If ROI is more than the cost of debt ( e.g.: EBIT of Rs. 30,000 ROI=15%) there is favourable financial leverage. So issue of more and more of low cost debt increases the EPS. So EPS will be maximum when the debt is maximum.

5) If ROI is just equal to the cost of debt, issue if debt neither makes any sense nor objectionable. So there is neither favourable nor unfavourable financial leverage. So EPS remains same at an EBIT level of Rs. 10,000 ( ROI=5% ) under plans A,B and C.

6) If the company considers the issue of 5% preference shares, the Roi must be atleast 10%. If the ROI is less than 10% issue of 5% preference shares does not make sense. If the ROI is more than 10% issue of 5% preference shares will increase the EPS.

7) Whenever the leverage is present the change in EPS for a given change in EBIT is more than proportionate. For example under the financial plan C, EPS is Rs. 2.5. When EBIT is Rs. 10,000 and it increases to Rs. 7.5 on EBIT level of Rs. 20,000.

8) The level of EBIT at which EPS is same under two or ,more alternatives is called indifference level of EBIT. For example : For alternatives A and B, indifference level of EBIT is Rs. 10,000. For alternatives A and D indifference level of EBIT is Rs. 20,000. If the EBIT is below the indifference level, equity financing will give higher EPS and of the EBIT is above the indifference level debt or preference capital will give higher EPS.

Q. 5) What do you understand by ‘ Exchange Ratio ‘? What are the significance?

Ans.)

Exchange Ratio is the number of the acquirer’s shares to be offered to the shareholders of the Target company for each share held by them in the target company. Both the Acquire and the target company conduct valuation of the target company and then the Acquire determines the maximum price it is willing to pay to the target and the target determines the minimum price it is willing to accept. Within these limits the actual agreement price will be fixed based on the relative bargaining power and investment opportunities.

The determination of the exchange ratio is based on the value of shares of the companies involved in the merger. As the basic objective of financial management is to maximize the shareholders wealth, even the Merger decision is to be taken in the light of wealth maximisation. Hence, a successful merger would be one that maximizes the EPS and market price of the shares of the acquiring company.

FINANCIAL MANAGEMENT ASSIGNMENT

MBA IT SEM II Assignment
FINANCIAL MANAGEMENT

Q. 1) What are the factors to be considered while designing a dividend policy of a firm?

Ans : So far as we have discussed only the theoretical aspects of dividend policy. Yet when the company establishes a dividend policy, it looks a number of other factors. The following are the important factors, which influence the dividend decision of a firm.

Internal Factors : The following are the internal factors, which affect the dividend policy of the firm.

(a)Desires of shareholders: Even if the directors have considerable liberty regarding the disposal of firm’s earnings, the shareholders are technically the owners of the company and therefore their desire cannot be overlooked by the directors while taking the dividend decision. Incase of a closely held company, the desires of shareholders are usually known and hence there is no problem. But in the case of a widely held company, it is very difficult to ascertain the preferences of shareholders. The interests of various shareholders are usually in conflict. Here the management can try to satisfy majority of shareholders by its dividend policy. Further the dividend policy once established should be continued as long as possible to create a ‘clientele effect ‘. ( to attract those investors who are happy with the firm’s dividend policy.)

(b) Financial needs of the company : Financial needs of the company may be in direct conflict with the desire of the shareholders to receive large dividends. However a prudent management should give proper weightage to the financial needs of the company. So growth firms are likely to follow low payout ratio and declining companies are likely to follow high payout ratio.

(c) Nature of earnings : The companies with stable earnings need to follow high payout ratio and vice versa. Public utilities are the classic examples of firms with stable earnings and they follow high payout ratio.

(d) Desire for control : If a growth company requires additional funds, it has to issue additional equity shares. If the existing shareholders are unable to buy the additional shares their voting power will be diluted. So the management may not pay more dividends in the fear of losing control over the company.

(e) Liquidity position : Liquidity is the continuous ability of a company to meet the maturing obligations as and when they become due. Payment of dividends means outflow of cash. So a firm may have adequate earnings but it may not be in a position to pay dividend due to liquidity problems.

(f) Return on investment : The firm should not retain the earnings if return on investment is less than the cost of capital.

External Factors : The following are the external factors, which affects the dividend policy of a firm.

(a) General state of the economy : The general state of the economy affects to a great extend the management’s decision to retain or to distribute earnings of the firm. In case of uncertain economic and business conditions, the management may like to retain whole or part of the firm’s earnings to build up reserves to absorb shock in the future. Similar policy may be followed by the management during depression to improve the liquidity position of the firm. During boom, the management may not declare liberal dividends though the earnings are high because of availability of profitable investment opportunities.

(b) State of the capital market : A company, which is not sufficiently liquid, can pay dividends if it is able to raise debt or equity in the capital market. Generally sound and big companies will not find it difficult to raise funds in the capital market. But a small company which does not have a sound cash position and also unable to raise capital in the market, will not be able to pay more dividends. Thus favorable conditions in the capital market will enable the company to pay liberal dividends even if it is not liquid.

(c) Contractual restrictions : Lenders generally put restrictions on dividend payments to protect their own interest. For example loan argument may prohibit the payment of dividend as long as current ratio is less than 2:1.

(d) Tax Policy :

1. Corporate Tax : Heavy taxes reduce the residual profits available for distribution.

2. Dividend Tax : Dividend tax discourage the company from paying liberabl dividends. Dividend tax has to be paid when dividends are paid.

(e) Legal restrictions : The companies Act of 1956 has put several restrictions regarding payment and declaration of dividends. Some of them are :

1. Dividends can be paid out of current profits. Payment of dividend out of capital is illegal.

2. A company is not entitled tp pay dividend unless it has provided for present as well as arrears of depreciations.

3. Certain percentage of net profits of that year as specified by the Act not exceeding 10% must be transferred to the reserves of the company.

4. Past profits can be used for declaration of dividends only as per rules framed by the Central Govt. Similarly Indian Income Tax Act also lays down certain restrictions on payment of dividends. The management has to consider all these restrictions while determining the dividend policy.

Q2) Explain Walter’s and Gordon’s theory of dividend?

Ans)

Walter’s Model ( Relevant Theory )

Prof James E Walter argues that the choice of dividend payout ratio almost always affects the value of the firm. Prof. J.E.Walter has very scholarly studied the significance of the relationship between internal rate of return ( R ) and cost of capital ( K ) in determining optimum dividend policy which maximizes the wealth of shareholders.

Walter’s model is based on the following assumptions :

1) The firm finances its entire investments by means of retained earnings only.

2) Internal rate of return ( R ) and cost of capital ( K ) of the firm remains constant.

3) The firm’s earnings are either distributed as dividend or reinvested internally.

4) Bigining earnings and dividends of the firm will never change.

5) The firm has a very long or infinite life.

Walter’s formula to determine the price per share is as follows :

D+r/k (E-D)

P= K

P = Market Price per share.

D = Dividend per share.

E = Earnings per share.

R = Internal rate of return

K = Cost of capital.

According to the theory, the optimum dividend policy depends on the relationship between the firm’s internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings. Whereas it should distribute the earnings to the shareholders in case the RK is that the firm is able to produce more return than the shareholders from the retained earnings.

Walter’s view on optimum dividend payout ratio can be summarized as below :

a) Growth Firms ( R>K ) :- The firms having R>K may be referred to as growth firms. The growth firms are assumed to have ample profitable investment opportunities. These firms naturally can earn a return which is more than what shareholders could earn on their own. So optimum payout ratio for growth firm is 0%.

b) Normal Firms ( R = K ) :- If R is equal to K, the firm is known as normal firm. These firms earn a rate of return which is equal to that of shareholders. In this case dividend policy will not have any influence on the price per share. So there is nothing like optimim payout ratio for a normal firm. All the payout ratios are optimum.

c) Declining Firm ( R

So according to Walter, the optimum payout ratio is either 0%

( when R>K ) or 100% ( when R

Criticisms :

Walter’s model is based on certain assumptions which are true for Walter but not true in the real world. The following are the limitations of the Walter’s model.

1) Walter assumes that there is no external financing. When R>K, the firm must issue additional security and finance its profitable investments. If the company uses, only retained earnings, all the profitable investments cannot be undertaken. So the investment decision of the firm will be sub-optimum.

2) Constant R - Internal rate of return cannot remain same. It actually diminishes as and when we make more and more investments.

3) Constant K – Cost of capital of a company cannot remain same. Risk of the company definitely changes with additional investment of retained earnings

GORDEN’S MODEL

Another theory, which contends that dividends are relevant, is the Gordon’s model. This model which opines that dividend policy of a firm affects its value is based on the following assumptions :

a) The firm is an all quity firm ( no debt )

b) There is not outside financing and all investments are financed exclusively by retained earnings.

c) Internal rate of return ( R ) of the firm remains constant.

d) Cost of capital ( K ) of the firm also remains same regardless of the change in the risk complexion of the firm.

e) The firm derives its earnings in perpetuity.

f) The retention ratio ( b ) once decided upon is constant. Thus the growth rate ( g ) is also constant ( g=br )

g) K>g.

h) A Corporate tax does not exist.

Gordon used the following formula to find out price per share.

P= E1 ( 1 – b )

K-br

P = price per share.

K = cost of capital.

E1 = earnings per share.

B = retention ratio.

( 1-b ) = payout ratio.

G = br growth rate. ( r = internal rate of return )

According to Gordon, when R>K the price per share increases as the dividend payout ratio decreases.

When R

Thus Gordon’s view on the optimum dividend payout ratio can be summarized as below :

1) The optimum payout ratio for a growth firm ( R>K ) is zero.

2) There no optimum ratio for a normal firm ( R=K )

3) Optimum payout ratio for a declining firm R

Thus the Gordon’s Model’s is conclusions about dividend policy are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models.