1
University of BAMENDA
Faculty of Economics and Management Sciences
(FEMS)
Course title: Advanced Corporate Finance
FINM6133/6125
Lectures: Dr Dadem/Dr kenmegni
Banking and Finance, Accounting and Management
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PART ONE: CONCEPTS OF CORPORATE FINANCE, MARKOWITZ PORTFOLIO
THEORY AND SHARPE THEORY
CHAPTER I: GENERAL INTRODUCTION
Finance is defined as the management of money and includes activities such as
investing, borrowing, lending, budgeting, saving, and forecasting. There are three main types
of finance: (1) personal, (2) corporate, and (3) public/government. This guide will unpack the
question: what is finance?
1. Meaning and Definition of corporate finance
The definition of corporate finance varies considerably across the world. In the United
States, for example, it is used in a broader way than in the UK to describe activities, decisions
and techniques that deal with many aspects of capital allocation – including funding of new
activities, investment in and divestment of assets, and the generation and management of
cash.
Corporate finance can be delineated as a monetary or financial activity dealing with a
company and its money. As per Investopedia, this can consist of anything from IPOs to
acquisitions. A corporate finance specialist assists a firm in evaluation of operating data and
industry indicators in addition to providing advice about management on budget adjustment
and decisions regarding general investment. Corporate finance is also sometimes referred as
‘corporate financier.’
Generally speaking, corporate finance is an area of finance which deals with monetary
decisions made by business enterprises as well as the tools and analysis used for making these
decisions. The regulation can be categorized into short term and long term decisions and
techniques. Long term choices (about which projects receive investment) include capital
investment, whether to finance that investment with debt or equity, and also whether and
when to pay dividends to shareholders.
Conversely, short term decisions involve dealing with short term balance of the
current assets along with current liabilities. The main focus herein is on managing inventories,
cash, and short term borrowing and lending activities (like the terms and conditions on credit
extended to customers).
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2. Types of corporate finance activity

Mergers and acquisitions (M&A), and demergers involving private companies.

Mergers, demergers and takeovers of public companies, including public-to-private
deals.

Management buy-outs, buy-ins or similar of companies, divisions or subsidiaries
typically backed by private equity.

Equity issuance by companies, including the listing of companies on a recognized stock
exchange by way of an initial public offering (IPO) and the use of online investment and
share-trading platforms; the purpose may be to raise capital for development or to restructure
ownership.

Financing and structuring joint ventures or project finance.

Raising infrastructure finance and advising on public-private partnerships and
privatizations.

Raising capital via the issuance of other forms of equity, debt, hybrids of the two, and
related securities for the refinancing and restructuring of businesses.

Raising seed, start-up, development or expansion capital.

Raising capital for specialist corporate investment funds, such as private equity,
venture capital, debt, real estate and infrastructure funds.

Secondary equity issuance, whether by means of private placing or further issues on a
stock market, especially where linked to one of the transactions listed above.

Raising and restructuring private corporate debt or debt funds.
3. Principal roles
The principals in corporate finance transactions may include:

Companies acting through their directors and other staff, including specialists in
strategy, corporate development and M&A;

Institutional or private investors, including private equity firms and venture capitalists;

Banks and independent lenders who provide debt;

Governments and other public authorities and agencies.
4. Corporate finance advisory roles
In professional services firms, such as accountancy practices, law firms and
independent corporate finance advisers, the service lines and professionals who work in
corporate finance are described variously as advisory, financial advisory, deal advisory,
transaction advisory services, transactions, deals or corporate finance.
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Brokers, or corporate brokers, focus on capital markets transactions, including raising
new finance for IPOs, secondary equity issuance and acquisitions. Transaction services
specialists, including those who work in accountancy firms, are appointed by a business, or by
an investor in, lender to or acquirer of a business, asset or project in order to carry out
financial and other forms of due diligence and transaction-related services. The scope of such
work can be driven by the requirements of the investor/buyer, or by regulation, and the reports
issued can be private or public, depending on the purpose.
In the case of transactions on capital markets, reporting accountants are appointed by
issuers to provide due diligence and opinions about the information to be published in a
prospectus or shareholder circular. Such opinions may be private to the parties involved or
published in an investment circular. In law firms, solicitors who provide advice in relation to
corporate finance, including carrying out legal due diligence, work in divisions that are in
general known as corporate or corporate finance.
5. Other advisory roles
There are many other types of specialist advisers who may be involved in corporate
finance activities, including individual transactions. There is no definitive list and advisory
roles may be quite fluid, but, for example, in 2019 report, Corporate Finance Faculty listed the
following as specialist types of advisory in professional services firms:

Corporate finance/lead advisory

Transaction services/support

Private equity/management buyouts

Debt advisory

Public company

Capital markets

Capital projects and infrastructure

Reorganisation/restructuring

Real estate

Growth finance

Operational due diligence

Completion mechanisms

Sale and purchase agreements

Post-merger integration

Financial modelling

Commercial due diligence
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
Cyber security

Valuations

Specialist tax services

Forensics [forensic accounting

Pensions consultancy

Value creation services

Environmental, social and governance advice.
6. Goal of Corporate Finance
The main goal of corporate finance is maximizing the shareholder value while
managing the financial risk of the firm. Even though it is different in principle from
managerial finance which studies all firms’ financial decisions, instead of the corporations
alone, the core concepts included in the study of corporate finance are applicable to the
financial problems of all types of firms.
The term corporate finance is also considered to be associated with investment
banking. The specific role of an investment bank is evaluating the financial requirements of a
company and thus raising the correct type of capital which fits those requirements in the best
possible way. Therefore, the term ‘corporate financier’ or ‘corporate finance’ can be linked
with transactions which involve raising capital so as to create, develop, grow, or acquire
businesses.
Besides being demanding, corporate finance jobs can be equally rewarding for a
person involved in corporate finance ensures that controls around financial reporting
mechanisms operate in an adequate and effective manner thus avoiding errors in financial
statements.
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CHAPTER II: OBJECTIVES, TYPES AND SCOPE OF CORPORATE
FINANCE
1- Scope of Corporate Finance
Every decision that a business makes has financial implications, and any decision
made which in turn affects the finances of a business is a corporate finance decision. In broad
terms, everything that a business does fits under the rubric of corporate finance. Each and
every business, whether it is small or large, public or private, must make investment and key
financing decisions (Damodaran, 1996).
The objective of all businesses in corporate finance is to maximize value within the
business. In this paper, aspects of corporate financial planning including the objectives of
corporate financial planning, the benefits that arise from its introduction to a business will be
outlined in order to give the best strategy to advise this moderately sized but rapidly growing
business. Any problems that arise from any practical method of Corporate Financial planning
which are introduced will be analysed and solutions to overcome these problems will be
discussed. Shareholders’ wealth maximisation is the primary objective of a company and
certain strategies are implemented to achieve this objective and they will be analysed.
Financial planning or Budgeting is also key to the success of any business and this will also
be looked at in terms of understanding how to consult and improve this privately owned
company.
2- Types of Corporate Finance
Corporate financing includes raising funds via either:

Equity funds

Debt funds
The types of corporate finance also emphasise the difference between ownership and
management, the basis for the development of strategies and procedures under this concept.
i.
Owner’s funds: Equity or ownership finance is strictly limited to raising capital for
the owners of a company.
ii.
Debt funds: Also known as external finance, debt funds come in multiple options like
debentures, corporate loans, private financing, etc. While debentures can be issued to the
general public for refinancing, institutional lenders are the primary source of private finance.
3. Scope of Corporate Finance
Capital investment decisions are an important part of corporate finance. These
decisions include
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
Deciding whether the dividends should be offered to shareholders or not

Sanctioning or rejecting proposed investment. If the investment is approved, it is also
to be decided whether the company should pay with debt of equity or both.

Managing of short term assets and liabilities, investments, inventory control and other
short term financial issues by the financial manager.
Corporate finance understands the financial problems of a company and prevents
them beforehand. It also deals with the financial aspects, promotion and administration of new
enterprises.
4. Nature or Principles of Corporate Finance
Corporate finance is based on the following three principles:

The Investment Principle: According to this principle, the funds of an organization
should be invested in such a way to derive maximum return on investment. This investment
should be made at acceptable and minimum hurdle rate which depends on the project’s debt
and equity. The riskier the project is; the higher will be the hurdle rate.

The Financing Principle: According to this principle, one should choose the ratio of
debts and equity in such a way so as to attain maximum return on investment and to match the
assets’ financial nature. The corporate finance manager has to analyze how to attain the
optimum financial mix of debt and equity for the organization.

The Dividend Principle: According to this principle, when a business reaches a
saturation point where cash flow surpasses the required fund, the corporate finance manager
needs to search for alternative sources like dividends, stocks and assets to maintain a balance
between the cash flow and required funds.
5. Objectives of corporate finance
Corporate finance is the field of finance dealing with financial decisions that business
enterprise make and the tools and analysis used to make these decisions. The primary goal of
corporate finance is to maximize corporate value while managing the firm’s financial risks.
Although it is in principle different from managerial finance which studies the financial
decisions of all firms, rather than corporations alone, the main concepts in the study of
corporate finance are applicable to the financial problems of all kinds of firms. The discipline
can be divided into long-term and short-term decisions and techniques. Capital investment
decisions are long-term choices about which projects receive investment, whether to finance
that investment with equity or debt, and when or whether to pay dividends to shareholders. On
the other hand, short term decisions deal with the short-term balance of .current assets and
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current liabilities; the focus here is on managing cash, inventories, and short-term borrowing
and lending.
Corporate finance covers every decision a firm makes that may affect its finances
which can be grouped into five areas for the conceptual understanding.
 The first is the objective function, where we define what exactly the objective in decision
making should be;
 The second is the investment decision, where we look at how a business should allocate of
resources across competing uses;
 The third is the financing decision, where we examine the sources of financing and
whether there is an optimal mix of financing;
 The fourth is the dividend decision, which relates to how much a business should reinvest
back into operations and how much should be returned to the owners;
 Finally, there is valuation, where all of the decisions made by a firm are traced through to
a final value
6- Functions of Corporate Finance

Acquisition of Resources: Acquisition of resource indicates fund generation at the
lowest possible cost. Resource generation is possible through:
(a)
Equity: This includes proceeds received from retained earnings, stock selling, and
investment returns.
(b)
Liability: This includes warranties of products, bank loans, and payable account.

Allocation of Resources: Allocation of resources is nothing but investment of funds
for profit maximization. Investment can be categorized into 2 groups:
(a)
Fixed Assets Buildings, Land, Machinery etc.
(b)
Current Assets cash, receivable accounts, inventory, etc.
Broad Functions of Corporate Finance are:
 Raising of Capital or Financing;

Budgeting of Capital;
 Corporate Governance;
 Financial management;
 Risk Management
7- Objective of Decision making in corporate Finance
a.
Long term decisions: This includes capital investment decisions like viability
assessment of projects, financing it through equity and/or debt, pay dividend or reinvest the
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profit. Long term corporate finance decisions that are normally related to fixed assets and
capital structure are known as Capital Investment Decisions. Senior management always
targets to maximize the value of the firm by investing in projects having positive Net Present
Value. If such opportunities are not arising then reinvestment of profits should be stalled and
excess cash should be returned to shareholders in form of dividends. Thus, Capital Investment
Decisions constitute 3 decisions:

Decision on Investment

Decision on Financing

b.
Decision on Dividend
Short term decisions: These are also called working capital management decisions
which try to strike a balance between current assets such as cash, inventories, etc and current
liabilities i.e. a company’s debts/obligations impending for less than a year.
Principles of Corporate Finance:
The broad principles of corporate finance are:
 Investment Decision
 Financing Decision
 Dividend Decision
 Liquidity Decision
1.
Investment Decision: The firm has limited resources that must be allocated among
challenging uses. On the one hand the funds may be used to generate added capacity which in
turn generates additional revenue and profits and on the other hand some investments results
in lesser costs. In financial management the returns, from a proposed investment are
compared to a minimum acceptable hurdle rate in order to accept or reject a project. The
hurdle rate is the minimum rate of return below which no investment proposal would be
accepted.
2.
Financing Decision: Another important area where financial management plays an
important role is in deciding when, where, from and how to acquire funds to meet the firm’s
investment needs. These aspects of financial management have acquired greater importance in
recent times due to the multiple avenues from which funds can be raised. The core issue in
financing decision is to maintain the optimum capital structure of the firm that is in other
words, to have a right mix of debt and equity in the firm’s capital structure. In case of pure
equity firm the shareholders returns should be equal to the firm’s returns. The use of debt
affects the risk and return of shareholders. In case, cost of debt is used the firm’s rate of return
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the shareholder’s return is going to increase and vice versa. The change in shareholders return
caused by change in profit due to use of debt is called the financial leverage.
3.
Dividend Decision: Dividend decisions is the third major financial decision the share
price of a firm is a function of the cash flows associated with the share. The share price at a
given point of time is the present value of future cash flows associated with the holding of
share. These cash flows are dividends. The finance manager has to decide what proportion of
profits has to be distributed to the shareholders. The proportion of profits distributed as
dividends is called the dividend payout ratio and the retained proportion of profits is known as
retention ratio.
4.
Liquidity Decision: A firm must be able to fulfill its financial commitments at all
points of time. In order to ensure this the firm should maintain sufficient amount of liquid
assets. Liquidity decisions are concerned with satisfying both long and short-term financial
commitments. The finance manager should try to synchronize the cash inflows with cash
outflows. An investment in current assets affects the firm’s profitability and liquidity. A
conflict exists between profitability and liquidity while managing current assets. In case, the
firm has insufficient current assets it may default on its financial obligations. On the other
hand excess funds result in foregoing of alternative investment opportunities.
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CHAPTER III: PRINCIPLES OF CORPORATE FINANCE: DEFINING
AND PLANNING THE PRINCIPLES OF CORPORATE FINANCE
I- Objectives
 Defline planning and control ;
 Know the primary goals of corporate financial planning and control;
 Define and know the benefits, breakeven, and drawbacks of profit maximization;
 How profit, value, risk and return affect a firm's overall performance;
 Introduction to capital budgeting methods used to select proposed projects.
II. Principles of Corporate Planning and Control
II.1. Defining Planning and Control

PLANNING
Planning involves the development of future objectives and the preparation of a
number of budgets to achieve those objectives. It requires investment and activity decisions to
be determined, based on the firm's financial situation and structure.
Short-term planning includes investment decisions that are less risky or uncertain.
Short-term market trends are more predictable, and it is easier to use short range solutions to
adjust to changing market trends and fulfill immediate operation’s needs. Short-term plans
typically conclude within months, or within the calendar year. Time-sensitive items are
prioritized, and goals are realized more quickly.
Long-term planning is strategic. Planned new products, services, goals, and objectives
are anticipated, scheduled, and funded, over a longer period (typically four to five years).
Revenue milestones are also projected. Action plans are proposed for each year of the longterm plan, so progress may be monitored and funds allocated as necessary.

CONTROL
Control involves the steps taken by management to ensure that objectives established
in the planning stage are attained. Control also ensures all parts of the organization function
consistently with established organizational policies. Good planning, without effective
control, is time wasted. Moreover, unless plans are established in advance, there will be no
objectives to control.
II.2. Measuring Performance, Profit, Value, Risk

PERFORMANCE
Performance is a subjective measure of a firm's general financial condition over a
given period, in comparison to similar firms within the same industry or aggregate sector. It is
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an indicator of the efficient use of assets generated from the primary business operation and
revenues. Financial analysis compares solvency, profitability, growth, and other ratios to gain
a clear picture of the firm's past and present performance, and to forecast, more accurately, the
future performance of the company.

Past Performance historically tracks the firm over a period (typically three to five
years).

Future Performance uses historical figures, calculations, and statistics, including
present and future values. (Caution: Extrapolation can result in errors, since past statistics
can be poor predictors of future prospects.)

Comparative Performance gauges the firm's performance, compared to similar
firms within the industry.
Financial statements can indicate declining debt or margin growth rate. The following
financial statement line items may be used to determine performance.

Operations revenue

Operating income, or cash-flow

Total unit sales

PROFIT AND PROFIT MAXIMIZATION
A company's bottom line is its net income, or profit. Maximized profit is the surplus
base profit after all production costs, including management's wages, have been paid. This
applies to firms that are under competition, as well as to monopolies. To maximize profit,
firms under competition may have to lower their product price to increase sales, while
monopolies are better able to keep their product price consistent. Profit maximization may be
expressed as:
Maximized Profit = Total Revenues – Total Costs
P = TR – TC
Where, P = Profit.
TR = Total Revenue.
TC = Total Costs.
THE PROFIT MAXIMIZATION RULE (MAXIMIZING PROFIT)
Product supply and demand must be understood to maximize profit. The firm's
demand curve indicates the point (of demand) where the product is purchased at a certain
price. Competition influences the product price. The quality of the product also influences
product price. High value or high quality products can be sold at higher prices. Higher prices
translate into bigger profits. As a result, larger quantities of these high value types of products
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are produced with the intent to maximize profit. Therefore, when demand is high, the supply
decreases, due to product sales. Conversely, when demand is low, supply is high, and the firm
lowers the price to move the product.
When product supply decreases and the demand remains the same, the firm will raise
the product price with the intent of maximizing their profit. The targeted goal is when
maximum profits are achieved, while costs have been kept to a minimum. Volume economics
make this possible. It enables the firm to produce more products, with less capital investment.
The profit maximization rule states that the firm must choose the level of output where,
The Marginal Cost (MC) = the Marginal Revenue (MR)
And
The Marginal Cost (MC) Curve is:
If MR > MC, profit is increasing and marginal profit is positive.
If MR < MC, profit is decreasing and marginal profit is negative.

VALUE
Rather than focusing singularly on earnings, performance is more accurately measured
according to how the earnings are valued by the investor. Investors calculate the risk to their
investment. Shareholder stock increases in value when profit is maximized. When investors
analyze the corporation, they typically consider the following:

How risky are the company's operations

Patterned earnings increases or decreases over time

The value and reliability of reported earnings
Capital expenditures related to financial investment policies can significantly increase
the value of the firm. This usually occurs when the production capacity is expanded, facilities
are upgraded, or there are other changes in the firm's capital budgeting. There is a relationship
between capital expenditure and stock price announcements. An announcement of a planned
increase or decrease in capital expenditure tends to have a positive or negative impact,
respectively, on stock returns. This is not to imply that managers deliberately act in the best
interests of the shareholders to maximize the market value of the firm through capital
expenditure decisions.
III. RISK AND RETURN

REAL RATE OF RETURN
The real rate of return is the rate of return that the investor requires in exchange for
relinquishing their current use of the funds on a non-inflation adjusted basis. Essentially:
Real Rate of Return = Rate of Return - Inflation Rate
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RISK-FREE RATE OF RETURN
The risk-free rate of return is compensation to the investor for the current use of the
investor's funds, plus loss in purchasing power due to inflation. It does not compensate for
associated risk.

RISK
Firms continually monitor and re-evaluate decisions in an effort to mitigate risks.
There are basic kinds of risk that the company watches.

Business risk.

Financial risk.

Risk premium.
Business risk involves the firm's ability or inability to maintain its competitive position
and advantage, and to retain its stability and earnings growth. Financial risk involves the
firm's ability or inability to meet its debt obligations as they come due. The risk premium is a
special kind of risk associated with an investment. The risk premium will be greater or less,
depending on the type of investment (That is common stock, bonds, and so forth.).
III. Capital Costs and Operations
Capital costs are total, fixed, one-time costs incurred on the firm's purchase for
production or services necessary to move a project to a commercially operational stage.
Capital costs can range from initial new factory construction, office building, and equipment,
to copyrights, trademarks, and intellectual property development.
1. ESTIMATING NEW PROJECT CAPITAL COST
The capital cost of operations is the funds committed because of an investment
decision. Prior to financing a new project, the firm must assess the overall degree of risk the
new project carries, relative to current business operations. Future profits for a new operation
are generally calculated using one or all of the following methods.

The Net Present Value (NPV) method

The Time Adjusted or, Internal Rate of Return method

The Payback Period
The NPV is the most commonly used decision-making tool. Using the Payback Period
method is more beneficial when liquidity is unclear.
2. NET PRESENT VALUE (NPV)
The net present value (NPV) is the difference between the present value of the cash
inflows and cash outflows associated with the investment project. The NPV is the simplest
method to use, and the easiest to adjust for risk. In the NPV formula, the cost of capital
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becomes the actual discount rate, which is used to compute the net present value of the
proposed project. The discount rate in the NPV formula recognizes that the money earned
today will be less valuable in the future. Projects that generate negative net present values are
rejected.
The net present value (NPV) of a project is equal to the present value of all the anticipated
cash flows of the project from which the initial investment is subtracted.
=(
)
+(
b- Decision rule
)
+(
)
+……………. +(
)
-I
- If the projects are independent, we accept those that the net present value is greater than zero
(NPV> 0);
- If the projects are mutually exclusive, then we accept the one with the highest positive net
present value (NPV).
3. INTERNAL RATE OF RETURN (IRR)
The internal rate of return (IRR) may also be referred to as the economic rate of return
(ERR), or time adjusted rate of return. Definitively, the IRR is the interest yield an investment
project promises over its useful lifespan, or essentially, it is the proposed project's expected
growth rate.
The IRR is the discount rate used in capital budgeting that makes the net present value
of all project cash flows equal zero. The higher a project's IRR, the more feasible the project
becomes. When several prospective projects are under consideration, the IRR may be used to
rank their acceptability, if all factors among the projects are equal.
It may be deduced that the higher the IRR is, the stronger the potential growth of the project.
The actual rate of return (ROR) generated by the proposed project will differ from its
estimated IRR rate. It may be deduced that the higher the IRR is, the stronger the potential
growth of the project. The IRR may be compared against the cost of capital that the firm
needs for the investment project. When the IRR is equal to, or greater than, the cost of capital,
the project should be acceptable for investment. When the IRR is less than the cost of capital,
the project should be rejected, since it is anticipated that the project will not return at least the
cost of the funds invested in it.
The IRR method advantageously considers certain assumptions:

The time value of money, discounting future returns and costs back to the present

All cash flows over the entire economic life of a capital good

Comparing investments with unequal first costs and unequal lives
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Drawbacks of using the IRR method include the following:

Its compound complex interest calculations

Its assumption capital goods generate revenue, which is generally not true for
individual capital assets, and

It is a difficult method to understand
The internal rate of return (IRR) is the discount rate for which the net present value (NPV) is
zero (0). It is deduced from the following formula:
(
)
+(
)
+(
)
+………. +(
The internal rate of return (IRR) =?
)
–I=0
The unknown in this formula is the internal rate of return (IRR), it can hardly be calculated
when n is greater than 2 (n > 2). When n is greater than two, we will proceed by linear
mathematical interpolation or by the use of financial calculators or tables capable of
performing this kind of calculation.
The decision rule
- If the projects are independent, then we accept those that the internal rate of return (IRR) is
higher than the required rate r;
- If, on the contrary, the projects are mutually exclusive, then we accept the one with the
highest internal rate of return (IRR) provided that it is higher than the required rate of return r.
4. PAYBACK METHOD and PAYBACK PERIOD
The payback method focuses on the payback period, defined as the length of time it
takes for an investment to recoup its initial cost from its generated cash receipts.
Theoretically, the sooner the cost of the investment can be recovered, the more desirable the
initial investment appears to be. The payback period is the investment required, or initial cost
of the project, divided by the net annual cash inflow. The payback method does not account
for the time value of money or profitability. For these reasons, the net present value (NPV) or
internal rate of return (IRR) capital budgeting methods are preferred.
a- decision rule
• If the projects are independent then, we accept those that the payback period occurs within a
critical time set by the managers of the company;
• If the projects are mutually exclusive, then we choose the one with the shortest recovery
time provided it is less than the critical time set by the managers of the company.
b- Formulation
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It differs depending on whether the cash flows generated by the projects are constant or
unequal.
• The case where the cash flows are constant
If the cash flows are constant from one year to the next then, the capital recovery time is
determined by the following expression: RT 
I
where I am the initial investment and MF
MF
is the annual cash flow of the project.
RISK
The discounted net present value (NPV) should exceed the expected cost of financing
to approve of investing in the particular project. High risk projects have a discount rate that is
larger than the firm's apparent historic weighted average cost of capital (WACC). The firm's
WACC includes stocks, bonds, other debt, and capital sources. The firm must add sufficient
value to compensate for risk.
Profit forecasts must be accurately determined to account for potential risk. Expected
profits must surpass the expected costs of financing. An unrealistic high NVP may occur if
the firm erroneously underestimates its capital costs. On the other hand, overestimating
capital costs may indicate a potential loss and the firm may reject a potentially good prospect.
Low-risk firms typically borrow capital at lower rates, or through investors that require lower
returns.
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CHAPTER IV: THE MARKOWITZ PORTFOLIO THEORY
I-
Modern Portfolio Theory
Harry Markowitz developed a theory, also known as Modern Portfolio Theory (MPT)
according to which we can balance our investment by combining different securities,
illustrating how well selected shares portfolio can result in maximum profit with minimum
risk. He proved that investors who take a higher risk can also achieve higher profit. The
central measure of success or failure is the relative portfolio gain, i.e. gain compared to the
selected benchmark.
Modern portfolio theory is based on three assumptions about the behavior of investors who:

wish to maximize their utility function and who are risk averse,

choose their portfolio based on the mean value and return variance,

Have a single-period time horizon.
Markowitz portfolio theory is based on several very important assumptions. Under
these assumptions a portfolio is considered to be efficient if no other portfolio offers a higher
expected return with the same or lower risk.

Investors view the mean of the distribution of potential outcomes as the expected
return of an investment.

Investors view the variability of potential outcomes about the mean as the risk of an
investment. Variability is measured by variance or standard deviation.

Investors all have the same holding period. This eliminates time horizon risk.

Investors base all their decisions on expected return and risk. By connecting all the
points of equal utility, a series of curves called the investor’s indifference or utility
map is created.

For a given risk level, investors prefer higher returns to lower returns, or for a given
return level, investors prefer less risk to more risk.
By using risk (standard deviation – σ) and the expected return (Rp) in a two-
dimensional space, following figure presents portfolio combinations available to the investor.
Thus, each point within the space enclosed by points XYZ, represents a certain portfolio.
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By analyzing the figure the conclusion can be drawn that in a new combination of
securities the portfolio can be moved:

Upwards: which would imply higher returns with the same level of risk or

To the left: this implies higher returns with less risk.
It can be noticed that the portfolios below the XY curve, unlike the portfolios on the curve,
offer the investor the same return with a higher level of risk or a higher risk with less return,
which is not acceptable to the investor. Investors tend to select the combination of shares that
would position their portfolio on the XY curve, called the efficient frontier. If the portfolio
does not belong to the frontier, the investor can improve the situation by changing the
structure of the portfolio, i.e. by changing its content.
Investors will opt for the portfolio that best corresponds to their risk attitude. Those
who are more risk inclined will select the portfolio on the efficient frontier, closer to point X,
whereas the more risk averse will select the portfolio closer to point Y. It can be said that the
Markowitz portfolio theory helps investors in the selection of the set of shares that will ensure
a higher portfolio return with the desired level of risk (the tendency is to minimize risk and
maximize return on investment).
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1- The Efficient Frontier
Markowitz constructed what is called the efficient frontier. First, he combined all the stocks
in the universe together into “two stock” portfolios. He observed that the risk-return line of
each of the two stock combinations bent backwards toward the return (Y) axis. He then built
“two portfolio” portfolios out of all the “two stock” portfolios. The risk-return line of these
combination portfolios bent even further back toward the return (Y) axis. He kept combining
stocks and portfolios composed of different weightings until he discovered at some point you
get no more benefits from diversification. He called this final or “optimal” bent line the
efficient frontier. The efficient frontier represents the set of portfolios that will give you the
highest return at each level of risk.
The efficient frontier has a curvilinear shape because if the set of possible portfolios of assets
is not perfectly correlated the set of relations will not be a straight line, but is curved
depending on the correlation. The lower the correlation the more curved.
2- Investor’s Utility Curves or Indifference Curves
The utility curves for an individual specify the trade-offs he/she is willing to make between
expected return and risk.
These utility curves are used in conjunction with the efficient
frontier to determine which particular efficient portfolio is the best for a particular
investor. Two investors will not choose the same portfolio from the efficient set unless their
utility curves are identical. In the following picture, l1 and l2 denotes investor’s utility curves.
Investor’s utility curves are important because they indicate the desired tradeoff by
investors between risk and return. Given the efficient frontier, they indicate which portfolio
is preferable for the given investor. Notably, because utility curves differ one should expect
different investors to select different portfolios on the efficient frontier.
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3- Efficient frontier and Capital Market Line (CML)
An efficient portfolio is one that produces the highest expected return for any given level of
risk.
Markowitz showed how to find the frontier of risk and returns for stocks. Only
portfolios on the frontier are efficient. Sharpe added the riskless asset return and noted that
returns on a line connecting rrf and the tangency point on the efficient frontier was also
“feasible” in the sense that portfolios consisting of some of the riskless asset and some of the
market portfolio could be developed.
The introduction of a risk-free asset in the portfolio changes the Markowitz efficient frontier
into a straight line. He called that straight efficient frontier line the Capital Market Line
(CML), and he used indifference curves to show how investors with different degrees of risk
aversion would choose portfolios with different mixes of stocks and the riskless
asset. Investors who are not at all averse to risk could borrow and buy stocks on margin, and
thus move out the CML beyond the tangency point. Since the line is straight, the math
implies that any two assets falling on this line will be perfectly positively correlated with each
other.
The optimal portfolio for an investor is the point where the new CML is tangent to the old
efficient frontier when only risky securities were graphed. This optimal portfolio is normally
known as the market portfolio.
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Two rational investors could hold portfolios at different points on the CML.
An
extremely risk averse investor could hold only riskless assets, while someone who is not at all
sensitive to risk but who wants to maximize expected returns could move on out the CML by
buying stock on margin.
History
Harry Markowitz came up with MPT and won the Nobel Prize for Economic Sciences in 1990
for it.
Definition
It is an investment theory based on the idea that risk-averse investors can construct
portfolios to optimize or maximize expected return based on a given level of market risk,
emphasizing that risk is an inherent part of higher reward. It is one of the most important and
influential economic theories dealing with finance and investment.
How it works?
Markowitz Portfolio Theory (MPT) assumes that investors are risk averse, meaning
that given two portfolios that offer the same expected return, investors will prefer the less
risky one. Thus, an investor will take on increased risk only if compensated by higher
expected returns. Conversely, an investor who wants higher expected returns must accept
more risk. The exact trade-off will be the same for all investors, but different investors will
evaluate the trade-off differently based on individual risk aversion characteristics.
Diversification
An investor can reduce portfolio risk simply by holding combinations of instruments
that are not perfectly positively correlated. If all the asset pairs have correlations of 0 they are
perfectly uncorrelated the portfolio's return variance is the sum over all assets of the square of
the fraction held in the asset times the asset's return variance (and the portfolio standard
deviation is the square root of this sum).
Efficient Frontier
This graph shows expected return (vertical) versus standard deviation. This is called
the 'risk-expected return space.' Every possible combination of risky assets, can be plotted in
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this risk-expected return space, and the collection of all such possible portfolios defines a
region in this space.
Two Mutual Fund Theorem
One key result of the above analysis is the two mutual fund theorem. This theorem
states that a portfolio on the efficient frontier can be generated by holding a combination of
any two given portfolios on the frontier; the latter two given portfolios are the "mutual funds"
in the theorem's name. So in the absence of a risk-free asset, an investor can achieve any
desired efficient portfolio even if all that is accessible is a pair of efficient mutual funds. If the
location of the desired portfolio on the frontier is between the locations of the two mutual
funds, both mutual funds will be held in positive quantities. If the desired portfolio is outside
the range spanned by the two mutual funds, then one of the mutual funds must be sold short
(held in negative quantity) while the size of the investment in the other mutual fund must be
greater than the amount available for investment (the excess being funded by the borrowing
from the other fund).
Criticisms
Despite its theoretical importance, critics of MPT question whether it is an ideal
investment tool, because its model of financial markets does not match the real world in many
ways. The risk, return, and correlation measures used by MPT are based on expected values,
which means that they are mathematical statements about the future (the expected value of
returns is explicit in the above equations, and implicit in the definitions of variance and
covariance). In practice, investors must substitute predictions based on historical
measurements of asset return and volatility for these values in the equations. Very often such
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expected values fail to take account of new circumstances that did not exist when the
historical data were generated.
II- Markowitz model
In the March 1952 issue of Journal of Finance, Harry M. Markowitz published an article
titled Portfolio Selection. In the article, he demonstrates how to reduce the risk of asset
portfolios by selecting assets whose values aren't highly correlated. At the same time, he laid
down some basic principles for establishing an advantageous relationship between risk and
return. This has come to be known as diversification of assets. In other words, don’t put all
your eggs in one basket.
A key to understanding the Markowitz model is to be comfortable with the statistic known as
the variance of a portfolio. Mathematically, the variance of a portfolio is:
∑i∑j Xi Xj σi,j
where,
Xi
is the fraction of the portfolio invested in asset i,
σi,j
for i≠j: is the covariance of asset i with asset j, and for i=j: is the variance of asset i.
Variance is a measure of the expected fluctuation in return the higher the variance, the riskier
the investment. The covariance is a measure of the correlation of return fluctuations of one
stock with the fluctuations of another. High covariance indicates an increase in one stock’s
return is likely to correspond to an increase in the other. A covariance close to zero means the
return rates are relatively independent. A negative covariance means an increase in one
stock’s return is likely to correspond to a decrease in the other.
The Markowitz model seeks to minimize a portfolio's variance, while meeting a desired
level of overall expected return.
The Markowitz model is a model whose objective is to find the optimal investment
portfolio for each investor in terms of profitability and risk. This, making a suitable choice
of the assets that make up said portfolio.
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We can affirm without fear of being wrong that the Markowitz model represented a
before and after in the history of investment. Before 1952, all investors based their
calculations and strategies on the idea of maximizing the return on their investments. That
is, when choosing whether to make an investment or not, they answered the question:
Which investment generates the most profitability for me?
Portfolio formation theory
The theory of portfolio formation is made up of three stages:

Determination of the set of efficient portfolios.

Determination of the investor’s attitude towards risk.

Determine the optimal portfolio.
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CHAPTER
V:
SHARPE
THEORY
OF
PORTFOLIO
MANAGEMENT
Markowitz Model had serious practical limitations due to the rigours involved in
compiling the expected returns, standard deviation, variance, covariance of each security to
every other security in the portfolio. Sharpe Model has simplified this process by relating
the return in a security to a single Market index. Firstly, this will theoretically reflect all
well traded securities in the market. Secondly, it will reduce and simplify the work
involved in compiling elaborate matrices of variances as between individual securities.
If thus the market index is used as a surrogate for other individual securities in the
portfolio, the relation of any individual security with the Market index can be represented
in a Regression line or characteristic line. This is drawn below, with the excess return on
the security on the y-axis and excess return on the Market Portfolio on the x-axis.
The equation of the characteristic line is Ri – Rf = a + βim (Rm – Rf) + ei
Where:
Ri is the holding period return on security i
Rf is the riskless rate of interest
Alpha is the vertical intercept on y-axis representing the return on the security when only
unsystematic risk is considered and systematic risk is measured by Beta. c i is the residual
component, not captured by the above variables.
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The sharpe equation is as follows:
Rj = αj + βj + ej
Where αj is some constant, say risk free return
βj is the Beta which is a risk measure of the market called systematic risk
I is the value or return on the stock index.
ej is the residual factor which cannot be specified.
Optimal Portfolio of Sharpe Model:
This optimal portfolio of Sharpe is called the Single Index Model. The optimal portfolio is
directly related to the Beta. If Ri is expected return on stock i and Rf is Risk free Rate, then
the excess return = Ri – Rf This has to be adjusted to Bi, namely,
Ri – Rf/βi which is the equation for ranking Stocks in the order of their return adjusted for
risk.
The method involves selecting a cut-off rate for inclusion of securities in a portfolio. For this
purpose, excess return to Beta ratio given above has to be calculated for each stock and rank
them from highest to lowest. Then only those securities which have Ri – Rf/βi, greater than
cut-off point, fixed in advance can be selected.
The basis for finding the cut-off Rate Ci is as follows:
Basis for Cut-off Rate:
For a portfolio of i stocks, Ci is given by cut-off rate-
σm2 = variance in the market Index
σei2 = variance in the Stock movement in unsystematic Risk.
Ri, Rf, Bi have the same meanings as referred to above.
Take an example. Rf = 10, Beta = 1
Expected Return Ri = 15, σei2 = unsystematic risk is given by 50, then,
We have-
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Exemple:
We have to see that for the optimum Ci that is C*, to be selected, the securities should have
excess return to Betas above Ci. Excess return to Beta ratio should be above Ci to be included
in the portfolio, to be precise. This Ci is that point which shows the cut-off point among those
excess returns to Beta ratios.
The calculation of C requires data, which are shown below:
Rf = Risk free Return = 5%
Based on the above data, we have to calculate the ‘C’ values for each security for inclusion in
the optimum portfolio.
The following table gives the example:
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All securities with excess return to Beta ratio above the cut-off rate C*, say 3.0 in the
above table will be chosen in the portfolio. The calculation of cut-off point is also explained.
In arriving at the optimal portfolio, the emphasis of Sharpe Model is on Beta and on the
Market Index. Sharpe’s optimal portfolio would thus consist of those securities only which
have excess return to Beta ratio above a cut-off point.
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By this method, selection of the portfolio has become easier due to the ranking of the
securities in the order of their excess return and applying the yardstick of a required cut-off
point for selection of securities. That cut-off point is related to the excess return to Beta ratio
on the one hand and variance of the market index σm2 and variance of the stock’s movement
which is related to the unsystematic risk, namely, σei2.
It is thus seen that Sharpe’s Portfolio takes into account both the systematic market related
risk and unsystematic risk and residual risk.
Distribution of Investments:
Once the choice of securities is made then one has to decide the proportion of his funds to be
invested in each security.
The percentage to be invested in each security is:
The second expression in the bracket will determine the proportion of funds to be invested in
each security. The first expression simply scales the weight on each security, so that the total
is summing upto 1.
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PART TWO: CAPITAL STRUCTURE, COST OF CAPITAL AND FIRM VALUE
CHAPTER ONE: CAPITAL STRUCTURE
The capital structure is made up of debt and equity securities and refers to permanent
financing of a firm. It is composed of long-term debt, preference share capital and
shareholder’s funds.
According to Gestenberg: “Capital structure of a company refers to the composition or make
up of its capitalization and it includes all long-term capital resources viz: loans, reserves,
shares and bonds”
Forms of capital structure
a) Equity shares only
b) Equity and preference Shares
c) Equity Shares and Debentures
d) Equity, preference and Debentures.
Factors Determining the Capital Structure
1. Financial Leverage:
2. Growth and Stability of Sales:
3. Cost of Capital:
4. Cash flow Ability to Service the Debt:.
5. Nature and Size of Firm:
6. Control:
7. Flexibility.
8. Requirement of Investors:
9. Capital Market Conditions.
10. Assets structure.
11. Period of Financial.
12. Purpose of financing.
13. Costs of floatation.
14. Personal Consideration:
15. Corporate Tax Rule:
Theories of Capital Structure
Different kinds of theories have been propounded by different authors to explain the
relationship between Capital structure and cost of capital and value of the firm. The
important theories are:
1. Net income approach
2. Net Operating Income approach
3. The Traditional approach
4. Modigliani and Miller approach
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Assumptions: In discussing the theories of capital structure, the following assumptions have
been used:
1. There are only two sources of finance i.e. equity and debt
2. There would be no change in the investment decision.
3. That the firm has a policy of distributing the entire profits among the shareholders
implying that there are no retained earnings.
4. The operating profits of the firm are given and nor expected to grow.
5. The business risk complexion of the firm is given and is not affected by the financing
mix.
6. There is no corporate and personal tax.
In discussing the theories of capital structure, the following definitions and notations have
been used:
E = Total market value of the Equity
D = Total market value of the Debt
V = Total market value of the firm i.e., D + E
I = Total Interest Payment
NOP = Net operating profit i.e. EBIT
NP = Net Profit or profit after Tax
Do = Dividend paid by the company at Time o
D1 = Expected Dividend at the end of the year 1
Po = Current market price of the Share
P1 = Expected Market Price of the share after 1 year.
Kd = After Tax Cost of Debt i.e. I/D
Ke = Cost of Equity i.e. D/Po
Ko = Overall Cost of Capital i.e. WACC
D
E
NOP EBIT



D+E D  E
V
V
1. Net Income Approach:
According to Durand, this theory states that there is a relationship between Capital structure
and the value of the Firm and therefore the firm Can affects its value by increasing or
decreasing the Debt proportion in the overall financing mix. This approach is based on the
following assumptions:
 The total Capital requirement of the firm is given and remains constant.
 The cost of debt is less than cost of Equity.
 Both Kd and Ke remain constant and increase in financial leverage i.e. use of more and
debt financing in the capital structure does not affect the risk perception of the
investors.
The line of argument in favor of Net Income approach is that as the proportion of Debt
financing in capital structure increases, the proportion of an expensive source of fund
increases. This results in the decrease in overall cost of capital leading to an increase in the
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value of the firm. The reason for assuming Kd less than Ke are that interest rates are usually
lower than the dividend rates due to the element of risk and the benefit of tax as the interest is
a deductible expense. The total market value of the firm on the basis of Net Income approach
can be ascertained as below:
V ED
Where
V = Total market value of the firm
E = Total market value of the Equity
= Earnings available to equity shareholder (NP)
Equity Capitalization rate (Ke)
D = Total market value of the Debt.
Overall cost of Capital can be calculated as below:
Ko 
EBIT
V
Illustration 1: The expected EBIT of a firm is 80,000 F. It has 200,000 F 8% debentures. The
equity capitalization rate of the company is 10%. Calculate the value of the firm and over all
Capitalization rate according to Net Income Approach.
Calculation of the Value of Firm if Debentures is raised to 300,000 F.
Important conclusion: Thus, it is evident that with the increase in debt financing, the value
of the firm has increased and the overall cost of capital has decreased.
2. Net Operating Income Approach:
The NOI approach is opposite to the NI approach. According to NOI approach, the market
value of the firm depends upon the net operating profit or EBIT and the overall cost of
Capital. The financing mix or the capital structure is irrelevant and does not affect the value of
the firm. The NOI approach makes the following assumptions:
1) The Kd is taken as constant.
2) The Ko of the firm is also taken as constant.
3) The firm capitalizes the total earnings of the firm to find the value of the firm as a
whole.
4) The use of more and more debt in capital structure increase the risk of the shareholders
and thus results in the increase in cost of equity capital i.e. K e. The increase in Ke is
such as to completely offset the benefits of employing cheaper debts.
The value of a firm on the basis of NOI approach can be determined as below:
V
EBIT
Ko
Where,
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V = Value of the firm
EBIT = Earning Before Interest and Tax
Ko = Overall cost of Capital
The market value of equity is residual value, calculated as
E V  D
And the Cost of Equity is,
Ke 
EBIT  Interest
V D
Thus, financing Mix is irrelevant and does not affects the value of the firm. The value of the
firm remains for all types of debt – equity mix. Since there will be change in the risk of the
shareholders as a result of change in Debt-Equity mix, therefore the Ke will be changing
linearly with change in debt proportion.
Illustration 2. A firm has an EBIT of 200,000 F and belongs to a risk class of 10%. What is
the value of equity capital if it employees 6% debt to the extent of 30%, 40%, 50% of the total
capital fund of 1,000,000 F.
3. Traditional Approach:
The traditional approach also known as intermediate approach is a compromise between the
two extremes of Net income approach and Net operating income approach. According to this
theory, the value of the firm can be increased initially or the cost of capital can be
decreased by using more debt as the debt is the cheaper source if finance then equity. Thus,
the optimum capital structure can be reached by a proper Debt Equity mix. Beyond a
particular point, the cost of equity increases because increased debt increases the financial risk
of the equity shareholders. The advantage of cheaper debt at this point of capital structure is
offset by increased cost of equity. After this there comes a stage, when the increased cost of
equity cannot be offset by the advantage of low-cost debt. Thus, the overall cost of debt
decreases up to a certain point, remains more or less unchanged for moderate increase in debt
thereafter and increases or rises beyond a certain point.
Thus, as per the traditional approach, a firm can be benefited from a moderate level of
leverage when then advantages of using debt outweighed the disadvantages of increasing K e.
The overall cost of capital is a function of financial leverage. The value of the firm can be
affected, by the judicious use of debt and equity in capital structure.
Illustration 3. Compute the market value of the firm, value of shares and average cost of
capital from the following information:
Net operating income
Total Investment
Equity Capitalization rate
 If firm uses no Debt
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200,000
1,000,000
10%
35


If firm uses 4,00,000 F Debentures
If firm uses 6,00,000 F Debentures
11%
13%
Assume that 4, 00,000 F debentures can be raised at 5% rate of interest whereas 6, 00,000 F
Debentures can be raised at 6% rate of interest.
4. Modigliani and Miller Approach:
M&M Model, which was presented in 1958 on the relationship between the leverage, cost of
capital and the value of the firm. The model emphasis that under a given set of assumptions
the capital structure and its composition have no effect on the value of the firm. There is
nothing which may be called the optimal capital structure, the model is based on the following
assumptions:
1. The capital markets are perfect and the complete information is available to all the
investors free of cost.
2. The securities are infinitely divisible.
3. Investors are rational and well informed about the risk return of all the securities.
4. The personal leverage and the corporate leverage are perfect substitute.
On the basis of the above assumptions, the M&M Model derived that:
1. The total value of the firm is equal to the capitalized value of the operating earnings of
the firm.
2. The total value of the firm is independent of the financial mix.
3. The cut off rate of the investment decision of the firm depends upon the risk class to
which the firm belongs, and thus is not affected by the financing pattern of this
investment.
The M&M model argues that if two firms are alike in all respects except that they differ in
respect of their financing patter and their market value, then the investors will develop a
tendency to sell the shares of the overvalued firm and to buy the shares of the undervalued
firm. This, buying and selling pressure will continue till the two firms have same market
value.
Illustration 4. Suppose there are two firms, LEV & Co. and ULE & Co.. These are alike and
identical in all respect except that the LEV & Co. is a leveraged firm and has 10% debt of
3,000,000 F in its capital structure. On the other hand, the ULE & Co. is an unleveled firm
and has raised funds only by the issue of the equity share capital. Both these firms have an
EBIT of 1,000,000 F and the equity capitalization rate, Ke of 20%.
Ascertain the total value and WACC of both firms. And conclude
The Arbitrage Process: The arbitrage process refers to undertaking by a person of two related
actions or steps simultaneously in order to derive some benefits. E.g. buying by a speculator
in one market and selling the same at the same time in some other market. The benefit from
the arbitrage process may be in any form: increased income from the same level of investment
or same income from lesser investment.
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CHAPTER TWO: COST OF CAPITAL
The cost of capital of a firm is the minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by the firm. According to Solomin
Ezra: “Cost of capital is the minimum required rate of earning or the cutoff rate of capital
expenditure.”
Features of Cost of capital
1. Cost of capital is not a cost as such. In fact, it is the rate of return that a firm requires
earning from its projects.
2. It is the minimum rate of return. Cost of Capital of a firm is that minimum rate of
return, which will at least maintain the market value of the firm.
3. It comprises of three elements.
K=r+b+f+o
Where,
K= cost of capital
r = The expected normal rate of return at zero risk level
b= premium for business risk
f = premium for finance risk
o =other risk
1. Significance of Cost of Capital
As Acceptance Criteria in Capital Budgeting: According to the present value method of
capital budgeting, if the present value of expected returns from investment is greater than or
equal to the cost of investment, the project may be accepted, otherwise it may be rejected.
As a Determinant of Capital Mix in Capital Structure Decisions: Financing the firm asset is
the very crucial problem in every business and as a general rule there should be a proper mix
of debt and equity capital in financing the firm’s assets.
As a Basis for Evaluating the Financial Performance: The concept of cost of capital can be
used to evaluate the financial performance of the top management. The actual profitability of
the project is compared the projected overall cost of capital and the actual cost of capital of
funds rise to finance the project if the actual profitability of the project is more than the
projected.
As the Basis for taking other Financial decisions: The cost of capital is also used in making
other financial decisions such as dividend policy, capitalization of profits, making the right
issue and working capital.
2 Computation of Cost of Capital
Computation of overall cost of capital of a firm involves:
Computation of cost of Specific source of finance
a) Cost of Debt
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b)
c)
d)
e)
Cost of Preference Capital
Cost of Equity Capital
Cost of Retained earnings
Weighted average cost of capital
Computation of cost of Specific source of finance
Cost of Debt: The cost of debt is the rate of interest payable on debt.
Cost of perpetual / Irredeemable Debt
Before tax cost of debt
I
K db 
P
Where,
Kdb = before tax cost of debt; I = Interest; P = Principal
In case if debt is raised at premium or discount, P would be considered as the amount of net
proceeds received from the issue and not the face value of the securities. The formula may
change to:
K db 
I
NP
Where NP = Net proceeds
After Tax Cost of Debt
K da = K db (1-t)
Where,
Kda = after tax cost of debt
t
= Rate of tax
Cost of Redeemable Debt: Usually the debt is issued to be redeemed after a certain period
during the lifetime of the firm. Such a debt issue is known as Redeemable Debt. The cost of
Redeemable debt may be computed as:
Before Tax Cost of Debt
K db 
I
1
( RV  NP )
N
1
( RV  NP )
2
Where,
I = Interest
N = Number of years in which debt is to be redeemed
RV = Redeemable value of debt
NP = Net Proceeds
After Tax cost of debt, Kda = Kdb (1-t)
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K da 
I
1
( RV  NP )
N
(1  t )
1
( RV  NP )
2
Where, t = Tax rate
Illustration 5. Koko Ltd. issues 50,000 F 8% debenture. The tax rate applicable is 50%.
Compute the cost of debt capital, if debentures are issued:
(i)
at par,
(ii)
at Premium of 10%,
(iii) at discount of 10%.
Illustration 6. A company issues 1,000,000 F; 10% debentures at a discount of 5%. The cost
of floatation amounts to 30,000 F. The debentures are redeemable after 5 years. Calculate
before tax and after-tax cost of debt assuming a tax rate of 50%.
Illustration 7. A 5-year 100 F debenture of a firm can be sold for a net price of 96.50 F. The
coupon rate of interest is 14% per annum, and the debenture will be redeemed at 5% premium
on maturity. The firm’s tax rate is 40%. Compute the after-tax cost of debenture.
Cost of Preference Capital: A fixed rate of dividend is payable on preference shares.
Though dividend is payable at the discretion of the Board of Directors and there is no legal
binding to pay dividends yet it does not mean that preference capital is cost free. The cost of
preference capital is the function of the dividend expected by its investors.
Formula
Kp 
D
P or NP
Where,
Kp = Cost of preference Capital
D = Dividend
P = Preference Share Capital
NP = Net Proceedings
Cost of Redeemable Preference Capital: Sometimes redeemable preference Capital Shares
is issued which can be redeemed or cancelled on maturity date. The cost of such capital can
be computed as follows;
1
D  ( MV  NP )
N
K pr 
1
( MV  NP )
2
Where,
Kpr = Cost of redeemable Preference Capital
D = Annual Preference Dividend
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MV = Maturity value of preference shares
NP = Net proceeds Preference shares
Illustration 8. A company issues 1,000 7% preference shares of 100 F each at a premium of
10% redeemable after 5 years at par. Compute the cost of preference Capital.
Cost of Equity Share Capital
The cost of the equity is the “maximum rate of return that the company must earn on equity
financed portion of its investments in order to leave unchanged the market price of its stock.”
The cost of equity capital is a function of the expected return by its investors. The cost of
equity can be computed in the following ways:
Dividend Yield method or Dividend / Price Ratio method:
According to this method the cost of equity capital is the discount rate that equates the present
value of expected future dividend per share with the net proceeds of a share.
Ke 
D
NP
OR
Ke 
D
MP
Where,
Ke = Cost of Equity Capital
D = Expected Dividend per share
NP = Net Proceeds per share
MP = Market Price per share
Dividend Yield plus growth in dividend method:
When the dividends of the firm are expected to grow at constant rate and the dividend payout
ratio is constant this method may be used to compute the cost of equity capital.
Ke 
D (1  g )
D1
G  o
G
NP
NP
Where:
Ke = Cost of Equity Capital
D1 = Expected Dividend Per Share at the end of the year
NP = Net Proceeds per share
G = Rate of Growth in dividends
Do = Previous year’s dividend
Earning Yield Method:
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According to this method, the cost of equity capital is the discount rate that equates the
present values of expected future earnings per share with the net proceeds of share.
Ke 
EPS
NP or MP
Illustration 9. The shares of a company are selling at 40 F per share and it had paid a
dividend of 4 F per share last year. The investor’s market expects a growth rate of 5% per
year.
a) Compute the company’s equity cost of capital;
b) If the anticipated growth rate is 7% per annum, calculate the indicated market price
per share.
Cost of Retained Earnings:
The cost of retained earnings may be considered as the rate of return which the existing
shareholders can obtain by investing the after-tax dividends in alternatives opportunity of
equal qualities. It is thus the opportunity cost of dividends foregone by the shareholders
 D

Kr  
 G  (1  t )(1  b)
 NP

Where,
Kr = Ke(1-t)(1-b)
D = Expected Dividends
G = Growth Rate
NP = Net Proceeds of equity issue
t = Tax rate
b = Cost of purchasing new securities
Ke = Rate of return available to shareholders.
Computation of Weighted Average Cost of Capital:
Weighted average cost of capital is the average cost of various sources of financing. It is also
known as Composite Cost of Capital, Overall Cost of capital, average cost of capital. Once
the cost of specific source of capital is determined, weighted average cost of capital can be
computed by putting weights to the specific costs of capital in proportion of the various
sources of funds to the total. The CIMA defines the weighted average cost of capital “as the
average cost of company’s finance (equity, debentures, bank loans) weighted according to the
proportion each element bears to the total pool of capital, weighting is usually based on
market valuation current yields and costs after tax.” Weights can be given in the following
way:
Historical or existing weights (Book value weights & Market value weights)
Marginal weights.
Historical or existing weights: Historical or existing weights are the weights based on the
actual or existing proportions of different sources in the overall capital structure. Such
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weighing system is based on the actual proportions at the time when the WACC is being
calculated. In other words, the weighing system is the proportions in which the funds have
already been raised by the firm.
The use of historical weights is based on two important assumptions namely:
a) That the firm would raise the additional resources required for financing the
investment proposals, in the same proportions in which they are appearing at present
in the capital structure,
b) That the present capital structure is optimal and therefore the firm wants to continue
with the same pattern in future also. However, there may be some problems in
applying the historical weights. The firm may not be able to raise additional finance in
the same proportion as existing one because of prevailing economic and capital market
conditions, legal constraints or other factors.
Book Value Weights: The weights are said to be book value weights if the proportions of
different sources are ascertained on the basis of the face values i.e., the accounting values.
The book value weights can be easily calculated by taking the relevant information from the
capital structure as given in the balance sheet of the firm.
The book value weights are considered as a sound weighing system as it is operational in
nature and a firm may design its capital structure in terms of as it appears in the balance sheet.
However, the book value weights system does not truly reflect the economic values. In fact,
the weighing system should be market determined. The book value weights system is not
consistent with the definition of the overall cost of capital, which is defined as the minimum
rate of return needed to maintain the firm’s market value. The book value weights ignore the
market values.
Market Value Weights: The weights may also be calculated on the basis of the market value
of different sources i.e., the proportion of each source at its market value. In order to calculate
the market value weights, the firm has to find out the current market price of the securities in
each category. However, a problem may arise if there is no market value available for a
particular type of security.
The advantages of using the market value weights may be:
1) The market value weights are consistent with the concept of maintaining market value
in the definition of the overall cost of capital. The market value weights provide
current estimate of the investor’s required rate of return.
2) The market Value weights yield good estimate of the cost of capital that would be
incurred should the firm require additional funds from the market.
However, the market values weights suffer from some limitations, as follows:
a) Not only that the market values of all types of securities issue have to be obtained but
also that the market value of equity share is to be segregated into capital and retained
earnings.
b) The market values are subject to change from time to time and so the concept of
optimal capital structure in terms of market values does not remain relevant any
longer. External factors, which affect the market value, will affect the cost of capital
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also and therefore, the investment decision process will be influenced by the external
factors.
The WACC based on market value will generally be greater than the WACC based on book
values. The reason being that the equity capital having higher specific cost of capital usually
has market value above the book value. However, this is not the rule.
Marginal Weights: The other system of assigning weights is the marginal weights system.
The marginal weights refer to the proportions in which the firm wants or intends to raise
funds from different sources. In other words, the proportions in which additional funds
required to finance the investment proposals will be raised are known as marginal weights.
So, in case of marginal weights, the firm in fact, calculates the actual WACC of the
incremental funds. Theoretically, the system of marginal weights seems to be good enough as
the return from investment will be compared with the actual cost of funds. Moreover, if a
particular source which has been used in the past but is not being used now to raise additional
funds, or cannot be used now for one or the other reason then why should it be allowed to
enter the decision process even through the weighing system.
However, there are some shortcomings of the marginal weights system. In particular, the
capital budgeting decision process requires the long-term perspective whereas the marginal
weights ignore this. In the short run, the firm may be tempted to raise funds only from cheaper
sources and thereby accepting more & more proposals. However, later on when other sources
will have to be resorted to, some projects, which should have been accepted otherwise, will be
rejected because of higher cost of capital.
Formula
Kw 
 XW
W
Where,
Kw = Weighted average cost of capital
X = Cost of specific source of finance
W = Weight, proportion of specific source of finance
Illustration 10.
A firm has the following capital structure and after-tax cost for the different sources of funds
used:
Source of funds
Debt
Preference capital
Equity Capital
Retained Earnings
Total
Amount(F)
Proportion (%)
1,500,000
1,200,000
1,800,000
1,500,000
6,000,000
You are required to compute the weighted average cost of capital.
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20
30
25
100
After tax cost (%)
5
10
12
11
43
Illustration 11. A company has the following capital structure and after-tax costs of different
sources of Capital used:
Type of Capital
Debt
Preference
Equity
Book Value
Proportion (%) After-tax cost (%)
450,000
30
7
375,000
25
10
675,000
45
15
1,500,000
100
a) Determine the weighted average cost of capital using book Value weights.
b) The firm wishes to raise further 600,000 F for the expansion of the project as below:
Debt
Preference Capital
Equity Capital
300,000
150,000
150,000
Assuming that specific costs do not change, compute the weighted marginal cost of capital.
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CHAPTER THREE: DIVIDEND POLICY
The term dividend refers to that part of profits of a company which is distributed by the
company among its shareholders. It is the reward of the shareholders for investments made by
them in the shares of the company. The investors are interested in earning the maximum
return on their investments and to maximize their wealth. A company, on the other hand,
needs to provide funds to finance its long-term growth. If a company pays out as dividend
most of what it earns, then for business requirements and further expansion it will have to
depend upon outside resources such as issue of debt or new shares. Dividend policy of a firm,
thus affects both the long-term financing and the wealth of shareholders.
I.
Dividend Decision and Value of Firms
The value of the firm can be maximized if the shareholders' wealth is maximized. There are
conflicting views regarding the impact of dividend decision on the valuation of the firm.
According to one school of thought, dividend decision does not affect the share-holders'
wealth and hence the valuation of the firm. On the other hand, according to the other school of
thought, dividend decision materially affects the shareholders' wealth and also the valuation
of the firm. We will discuss below the views of the two schools of thought under two groups:
1. The Irrelevance Concept of Dividend or the Theory of Irrelevance,
2. The Relevance Concept of Dividend or the Theory of Relevance.
1. The Irrelevance Concept of Dividend or the Theory of Irrelevance
1.1. Residual Approach
According to this theory, dividend decision has no effect on the wealth of the shareholders or
the prices of the shares, and hence it is irrelevant so far as the valuation of the firm is
concerned. This theory regards dividend decision merely as a part of financing decision
because the earnings available may be retained in the business for re-investment. But, if the
funds are not required in the business they may be distributed as dividends. This theory
assumes that investors do not differentiate between dividends and retentions by the firm.
Their basic desire is to earn higher return on their investment. In case the firm has profitable
investment opportunities giving a higher rate of return than the cost of retained earnings, the
investors would be content with the firm retaining the earnings to finance the same. However,
if the firm is not in a position to find profitable investment opportunities, the investors would
prefer to receive the earnings in the form of dividends. Thus, a firm should retain the
earnings if it has profitable investment opportunities otherwise it should pay them as
dividends.
1.2. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive manner in support of the
theory of irrelevance. They maintain that dividend policy has no effect on the market price of
the shares and the value of the firm is determined by the earning capacity of the firm or its
investment policy. The splitting of earnings between retentions and dividends, may be in any
manner the firm likes, does not affect the value of the firm. As observed by M.M. "Under
conditions of perfect capital markets, rational investors, absence of tax discrimination
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between dividend income and capital appreciation, given the firm's investment policy, its
dividend policy may have no influence on the market price of the shares.'"
1.2.1. Assumptions of MM Hypothesis
a) There are perfect capital markets.
b) Investors behave rationally.
c) Information about the company is available to all without any cost.
d) There are no floatation and transaction costs.
e) No investor is large enough to affect the market price of shares.
f) There are no taxes or there are no differences in the tax rates applicable to dividends
and capital gains.
g) The firm has a rigid investment policy.
1.2.2. The Argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in the
value of the firm results from the payment of dividend, will be exactly off set by the decline in
the market price of shares because of external financing and there will be no change in the
total wealth of the shareholders. For example, if a company, having investment opportunities,
distributes all its earnings among the shareholders, it will have to raise additional funds from
external sources. This will result in the increase in number of shares or payment of interest
charges, resulting in fall in the earnings per share in the future. Thus whatever a shareholder
gains on account of dividend payment is neutralized completely by the fall in the market price
of shares due to decline in expected future earnings per share. To be more specific, the market
price of a share in the beginning of a period is equal to the present value of dividends paid at
the end of the period plus the market price of the shares at the end of the period. This can be
put in the form of the following formula:
Po 
D1  P1
1  Ke
Where,
P0 = Market price per share at the beginning of the period, or prevailing market price of a
share.
D1 = Dividend to be received at the end of the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity capital or rate of capitalization.
The value of P1 can be derived by the above equation as under:
P1  Po (1  K e )  D1
The MM hypothesis can be explained in another form also presuming that investment
required by the firm, on account of payment of dividends is financed out of the new issue of
equity shares.
In such a case, the number of shares to be issued can be computed with the help of the
following equation:
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m
I ( E  nD1 )
P1
Further, the value of the firm can be ascertained with the help of the following formula:
nPo 
(n  m) P1  ( I  E )
1  Ke
Where,
m = number of shares to be issued.
I = Investment required.
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity capital.
N = number of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.
nP0= Value of the firm
Illustration 1. Titi Ltd. belongs to a risk class for which the appropriate capitalization rate is
10%. It currently has outstanding 5,000 shares selling at 100 F each. The firm is
contemplating the declaration of dividend of 6 F per share at the end of the current financial
year. The company expects to have a net income of 50, 000 F and has a proposal for making
new investments of 100,000 F. Show that under the MM hypothesis, the payment of dividend
does not affect the value of the firm.
1.2.3. Criticism of MM Approach
1. Prefect capital market does not exist in reality
2. Information about the company is not available to. all the persons.
3. The firms have to incur flotation costs while issuing 'securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital
gains.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees, etc. while doing any transaction.
7. Shareholders may prefer current income as compared to further gains.
2. The Relevance Concept of Dividend or the Theory of Relevance
The other school of thought on dividend decision holds that the dividend decisions
considerably affect the value of the firm. The advocates of this school of thought include
Myron Gordon, James Walter and Richardson. According to them dividends communicate
information to the investors about the firms' profitability and hence dividend decision
becomes relevant Those firms which pay higher dividends, will have greater value as
compared to those which do not pay dividends or have a lower dividend payout ratio. We
have examined below two theories representing this notion: Walter's Approach and Gordon's
Approach.
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2.1. Walter's Approach
Walter's approach supports the doctrine that dividend decisions are relevant and affect the
value of the firm. Walter's model is based on the relationship between the firms’s
(i)
return on investment (r),
(ii)
the cost of capital or the required rate of return (k).
According to Walter, If r > k i.e., if the firm earns a higher rate of return on its investment
than the required rate of return, the firm should retain the earnings. Such 'firms are termed as
growth firm and the optimum pay-out would be zero in their case. In case of declining firms
which do not have profitable investments, i.e., where r < k, the shareholders would stand to
gain if the firm distributes its earnings. For such firms, the optimum pay-out would be 100%
and the firms should distribute the entire earnings as dividends. In case of normal firms
where r = k, the dividend policy will not affect the market value of shares as the
shareholders will get the same return from the firm as expected by them. For such firms,
there is no optimum dividend payout and the value of the firm would not change with the
change in dividend rate.
2.1.1. Assumption of Walter's Model
a) The investments of the firm are financed through retained earnings only and the firm
does not use external sources of funds.
b) The internal rate of return (r) and the cost of capital (k) of the firm are constant.
c) Earnings and dividends do not change while determining the value.
d) The firm has a very long life.
Walter’s formula for determining the value of a share:
D
P
r ( E  D)
Ke
Ke
OR
P
D r ( E  D) / K e

Ke
Ke
Where,
P = Price of Equity Share
D = Initial dividend per share
Ke = Cost of Equity capital
r = Internal rate of return
E = Earning per share
Illustration 2. The following information is available in respect of a firm:
Capitalization Rate = 10%; Earning per share = 50 F.
Assumed rate of return on investment: i) 12%; ii) 8% and iii) 10%.
Show the effect of dividend policy on market price of shares applying walter’s model when
dividend payout ratio is: i) 0%; ii) 40% and iii) 100%.
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2.1.2. Criticism of Walter's Model
The basic assumption that investments are financed through retained earnings only is seldom
true in real world. Firms do raise funds by external financing. The internal rate of return, i.e. r,
also does not, remain constant. As a matter of fact, with increased investment the rate of
return also changes. The assumption that cost of capital (k) will remain constant also does not
hold good. As a firm's risk pattern does not remain constant, it is not proper to assume that k
will always remain constant.
2.2. Gordon's Approach
Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that
dividends are relevant and the dividend decision of the firm affects its value. His basic
valuation model is based on the following assumptions:
a) The firm is an all equity firm.
b) No external financing is available or used. Retained earnings are the only. Source of
finance.
c) The rate of return on the firm's investment r, is constant.
d) The retention ratio, b, is constant. Thus, the growth rate of the firm g = br, is also
constant.
e) The cost of capital for the firm remains constant and it is greater than the growth rate,
i.e. k > br.
f) The firm has perpetual life.
g) Corporate taxes do not exist.
According to Gordon, the market value of a share is equal to the present value of future
stream of dividends. Thus,
P
D1
D2

 ............
(1  K ) (1  K ) 2
Gordon's basic valuation formula can be simplified as under:
P
E (1  b)
K e  br
Or
Po 
D (1  g )
D1
 o
Ke  g
Ke  g
Where,
P = Price of shares
E = Earnings per share
b = Retention ratio
Ke = Cost of equity capital
br = g = Growth rate in r,i.e. rate of return on investment
D0 = Dividend per share
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D1 = Expected dividend at the end of year 1.
The implications of Gordon's basic valuation model may be summarized as below:
1. When r > k, the price per share increases as the dividend payout ratio decreases. Thus,
growth firm should distribute smaller dividends and should retain maximum earnings.
2. When r = k, the price per share remains unchanged and is not affected by dividend
policy. Thus, for a normal firm there is no optimum dividend payout.
3. When r < k, the price per share increases as the dividend payout ratio increases. Thus, the
shareholders of declining firm stand to gain if the firm distributes its earnings. For such
firms, the optimum payout would be 100%.
Illustration 3. The following information is available in respect of the rate of return on
investment (r), the cost of capital (k) and earning per share (E) of Ashley Ltd.
Rate of return on investment (r) = (i) 15% (ii) 12% and (iii) 10%
Cost of capital (K) = 12%
Earning per share (E). = 10 F
Determine the value of its shares using Gordon's Model assuming the following:
(a)
(b)
(c)
D/P ratio (1- b)
100
80
40
Retention ratio (b)
0
20
60
Gordon's Revised Model
The basic assumption in Gordon's Basic Valuation Model that cost of capital (k) remains
constant for a firm is not true in practice. Thus, Gordon revised his basic model to consider
risk and uncertainty. In the revised model, he suggested that even when r = k, dividend policy
affects the value of shares on account of uncertainty of future, shareholders discount future
dividends at a higher rate than they discount near dividends. That is there is a twofold
assumption, namely (i) investors are risk averse, and (ii) they put a premium on a certain,
return and discount/penalize uncertain returns. Because the investors are rational and they
want to avoid risk, they prefer near dividends than future dividends. Stockholders often act on
the principle that a bird in hand is worth than two in the bushes and for this reason are willing
to pay a premium for the stock with the higher dividend rate, just as they discount the one
with the lower rate. Thus, if dividend policy is considered in the context of uncertainty, the
cost of capital cannot be assumed to be constant and so firm should set a high dividend payout
ratio and offer a high dividend yield in order to minimize its cost of capital.
II.
Determinants of Dividend Policy
The payment of dividend involves some legal as well as financial considerations. The
following are the important factors which determine the dividend policy of a firm:
1) Legal Restrictions: Legal provisions relating to dividends lay down a framework within
which dividend policy is formulated.
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2) Magnitude and Trend of Earnings: As dividends can be paid only out of present or past
year's profits, earnings of a company fix the upper limits on dividends.
3) Desire and Type of Shareholders: Desires of shareholders for dividends depend upon their
economic status.
4) Nature of Industry: Certain industries have a comparatively steady and stable demand
irrespective of the prevailing economic conditions.
5) Age of the Company: The age of the company also influences the dividend decision of a
company.
6) Future Financial Requirements.
7) Economic Policy.
8) Taxation Policy:
9) Inflation.
10)
Control Objectives.
11)
Requirements of Institutional Investors.
12)
Stability of Dividends.
13)
Liquid Resources. Etc…
III.
Types of Dividend Policy
The various types of dividend policies are discussed as follows:
 Regular Dividend Policy,
 Stable Dividend Policy,
 Irregular Dividend Policy,
 No Dividend Policy.
1. Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The investors such as
retired persons, widows and other economically weaker persons prefer to get regular
dividends.
Advantages of regular dividend policy:
(i)
It establishes a profitable record of the company.
(ii)
It creates confidence amongst the shareholders.
(iii) It aids in long-term financing and renders financing easier.
(iv)
It stabilizes the market value of shares.
(v)
The ordinary shareholders view dividends as a source of funds to meet their dayto-day living expenses.
(vi)
If profits are not distributed regularly and are retained, the shareholders may have
to pay a higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by
companies of long standing and stable earnings.
2. Stable Dividend Policy:
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The term “stability of dividends” means consistency in the stream of dividend payments. In
more precise terms, it means payment of certain minimum amount of dividend regularly. A
stable dividend policy may be established in any of the following three forms:
(i)
Constant dividend per share. Policy of paying fixed dividend per share
irrespective of the level of earnings year after year. Such firms, usually, create a
'Reserve for Dividend Equalization' to enable them pay the fixed dividend even in
the year when the earnings are not sufficient.
(ii)
Constant payout ratio. Constant pay-out ratio means payment of a fixed
percentage of net earnings as dividends every year. The amount of dividend in
such a policy fluctuates in direct proportion to the earnings of the company.
(iii) Stable dividend plus extra dividend. Some companies follow a policy of paying
constant low dividend per share plus an extra dividend in the years of high profits.
Such a policy is most suitable to the firm having fluctuating earnings from year to
year.
Advantages of Stable Dividend Policy
(i)
It is sign of continued normal operations of the company.
(ii)
It stabilizes the market value of shares;
(iii) It creates confidence among the investors, improves credit standing and makes
financing easier;
(iv)
It provides a source of livelihood to those investors who view dividends as a
source of fund to meet day-to-day expenses;
(v)
It meets the requirements of institutional investors who prefer companies with
stable dividend.
3. Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the following:
(i)
Uncertainty of earnings,
(ii)
Unsuccessful business operations,
(iii) Lack of liquid resources.
4. No Dividend Policy
A company can follow a policy of paying no dividends presently because of its unfavorable
working capital position or on account of requirements of funds for future expansion and
growth.
IV.
Forms of Dividend
Dividends can be classified in various forms. Dividend paid in the ordinary course of business
is known as Profit dividends, while dividends paid out of capital are known as Liquidation
dividends. A dividend which is declared between two annual general meetings is called
interim dividend, while the dividend recommended to the shareholders at the annual general
meeting is known as final dividend.
Classification on the basis of medium in which they are paid:
Advanced corporate finance, 2023-2024/ Dr DADEM- Dr KENMEGNI
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1) Cash Dividend: A cash dividend is a usual method of paying dividends. Payment of
cash results in outflow of funds and reduces the company's net worth, though the
shareholders get an opportunity to invest the cash in any manner they desire. This is
why the ordinary shareholders prefer to dividends in cash.
2) Scrip or Bond Dividend: A scrip dividend promises to pay the shareholders at a future
specific date. In case a company does not have sufficient funds to pay dividends in
cash, it may issue notes or bonds for amount due to the shareholders.
3) Property Dividend: Property dividends are paid in the form of some assets other than
cash are distributed under exceptional circumstances.
4) Stock Dividend: Stock dividend means the issue of bonus shares to the existing
shareholders. If a company does not have liquid resources it is better to declare stock
dividend. Stock dividend can be related to "Bonus Issue".
V.
Bonus Issue
A company can pay bonus to its shareholders either in cash or in the form of shares. Many
times, a company is not in a position to pay bonus in cash in spite of sufficient profits because
of unsatisfactory cash position or because of its adverse effects on the working capital of the
company. In such cases, if the articles of association of the company provide, it can pay bonus
to its shareholder in the form of shares by making partly paid shares as fully paid or by the
issue of fully paid bonus shares. Issue of bonus shares in lieu of dividend is not permitted by
laws and regulations in some countries; no dividend can be paid except in cash. It cannot be
termed as a gift because it only represents the past sacrifice of the shareholders.
Advanced corporate finance, 2023-2024/ Dr DADEM- Dr KENMEGNI