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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 13
OPERATING LEVERAGE & CAPITAL RATIONING
The following topics will be discussed in this lecture.
Economic Break Even
Degree of Operating Leverage
Capital Rationing
Hard Rationing
Soft Rationing
Single Period Rationing
Multi period ­ linear programming with only two variables
Limitation of Linear Programming / Criticism
ECONOMIC BREAK EVEN:
The difference between the accounting and economic break even is a cost factor known as opportunity cost
of capital. In accounting break even we calculate the accounting earnings first and then deduct all the costs
from earnings to reach at break even except the opportunity cost of capital that is invested in the project.
According to Economic Value Added (EVA) concept, a firm creates value by earning returns of invested
capital greater than its cost of capital. Basically, EVA is the economic profit a firm earns after all capital
costs are deducted. More precisely stated, it is firm's net operating profit after tax less the cost of capital
charge for the capital employed.
A firm can create value for its investors either by investing in new assets or it can return cash to investors
who will invest this money for themselves by trading in the stock market. A firm that earns more than the
cost of capital is better off since it is providing investors with better returns than they can earn for
themselves on stand alone basis.
Economic break even suggests that when you deduct other cost from accounting earnings you should also
deduct the cost of capital employed. A project having a positive EVA adds value to firm and a negative
EVA reduces the firm's value.
DEGREE OF OPERATING LEVERAGE
A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs.
1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly
leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to
be less leveraged. As the volume of sales in a business increases, each new sale contributes less to
fixed costs and more to profitability.
2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said
to have used more operating leverage. Those businesses with lower fixed costs and higher variable
costs are said to employ less operating leverage.
The higher the degree of operating leverage the greater the potential danger from forecasting risk. That is, if
a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow
projections. The opposite is true for businesses that are less leveraged. A business that sells millions of
products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each
individual sale.
For example, convenience stores are significantly less leveraged than high-end car dealerships.
Capital Rationing
Many companies specify an overall limit on the total budget for capital spending. There is no conceptual
justification for such budget ceiling, because all projects that enhance long run profitability should be
accepted.
The factors for putting limit:
·  Net present values or IRR may strongly influence the overall budget amount
·  Top management's philosophy toward capital spending.
·  Same managers are highly growth minded whereas others are not.
·  The outlook for future investment opportunities that may not be feasible if extensive current
commitments are undertake.
·  The funds provided by the current operations less dividends.
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Corporate Finance ­FIN 622
VU
·
The feasibility of acquiring additional capital through borrowing or sale of additional stock. Lead-
time and costs of financial market transactions can influence spending.
·  Period of impending change in management personnel, when the status quo is maintained.
·  Management attitudes toward not.
Capital Rationing occurs when a company has more amounts of capital budgeting projects with positive net
present values than it has money to invest in them. Therefore, some projects that should be accepted are
excluded because financial capital is limited.
This is known as artificial constraint because the management may dictate the amount to be invested for
project purposes.
It is also the artificial constraints because the amount is not based on the product marginal analysis in which
the return for each proposal is related to the cost of capital and projects with net present values are
accepted.
A company may adopt a posture of capital rationing because it is fearful of too much growth or hesitant to
use external sources of financing.
Reasons for Capital Rationing:
There are basically two types of reasons of capital rationing.
·  External Reasons
These arise when a firm is unable to borrow from the outside. For example if the firm is under
financial distress, tight credit conditions, firm has a new unproven product.
Borrowing limits are imposed by banks particularly in relation to smaller firms and individuals.
·  Internal Reasons
Private owned company: Owners might decide that expansion is a trouble not worth taking. For
example there may that management fear to lose their control in the company.
o  Divisional Constraints: Upper management allocates a fixed amount for each division as
part of the overall corporate strategy. This arises from a point of view of a department,
cost centre or wholly owned subsidiary, the budgetary constraints determined by senior
management or head office.
o  Human Resource Limitations: Company does not have enough middle management to
manage the new expansions
o  Dilution: For example, there may be a reluctance to issue further equity by management
fearful of losing control of the company.
o  Debt Constraints: Earlier debt issues might prohibit the increase in the firm's debt beyond
a certain level, as stipulated in previous debt contracts. For example bondholders requiring
in the bond contract, that they would accept a maximum Debt-to-Asset ratio = 40%.
Capital Rationing could be said to signal a managerial failure to convince suppliers of funds of the value of
the available projects. Although there may be something in this argument, in practice it is not a well-
informed judgment. Furthermore, even if there were no limits on the total amounts of available finance, in
reality the price may vary with the size as well as the term of the loan.
HARD CAPITAL RATIONING:
This arises when constraints are externally determined. This will not occur under perfect market.
If share prices are depressed or market is bearish, raising capital is very difficult.
Restriction on lending by Banks.
High interest rate
High cost associated with issuance of share / debt instrument.
SOFT CAPITAL RATIONING:
This arises with internal, management-imposed limits on investment expenditure. The factors leading to
soft rationing are as under:
Management is reluctant to issue new share because of the fear of outsider taking control of
company.
Dilution of EPS
Increased interest payments in case of debt financing.
Company's will to maintain limited investment level that can be financed thru retained
earnings.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk