Under Walter's model, a firm whose return on investment exceeds its cost of capital should have an optimum dividend payout ratio of:

Any ratio, since payout does not affect value

Under the net operating income approach to capital structure, as the proportion of debt rises the overall cost of capital:

Remains constant, so the value of the firm is unaffected

Falls continuously, so value is maximised at all-debt

Falls, reaches a minimum and then rises

Rises continuously, so debt should be avoided

In computing the operating cycle, the creditors payment period is:

Subtracted, because supplier credit finances part of the cycle

Added, because it lengthens the time before cash returns

Ignored, because it is a current liability and not an asset

Multiplied by the debtors collection period

Modigliani and Miller's capital structure proposition WITHOUT corporate taxes rests on:

An arbitrage argument, since an investor can replicate leverage personally

The tax deductibility of interest

The bird-in-hand preference of investors

The existence of bankruptcy costs

Financial leverage arises from the presence of:

Fixed financial charges such as interest in the capital structure

Fixed operating costs in the cost structure

A high proportion of equity in the capital structure

Variable cost that changes with output

The cost of retained earnings is generally taken to be:

Zero, because no payment is made to anyone

Equal to the after-tax cost of debt

Equal to the rate of corporate tax

Business Finance I: Cost of Capital, Capital Structure and Investment Decisions

Unit 4 is the finance function set out as four decisions: where the money comes from, what it costs, which projects it is put into, and what is given back to the shareholder. The syllabus lists them in that order and the paper follows it. Nearly every question here is a short calculation or a named theory, and the two are not separable — Modigliani and Miller is a theory that reduces to an arithmetic claim, and the internal rate of return is an arithmetic that carries an assumption most candidates never state. This chapter covers the domestic half; the international half is the next one.

1. Scope and sources of finance, and lease financing

Business finance is the acquisition and use of funds. Its scope is usually set out as three decisions — the investment or capital budgeting decision, the financing decision, and the dividend decision — with working capital management as a fourth that recurs daily rather than periodically. The objective assumed throughout is the maximisation of shareholder wealth rather than of profit, and the difference matters: profit maximisation ignores the timing of returns and the risk attached to them, while wealth maximisation prices both.

Sources of finance by term
Term	Typical sources	What is usually financed
Long term	Equity shares, preference shares, debentures, term loans, retained earnings	Fixed assets and the permanent part of working capital
Medium term	Term loans, lease finance, hire purchase, public deposits	Equipment and modernisation
Short term	Trade credit, bank overdraft and cash credit, commercial paper, factoring	The fluctuating part of working capital

Lease financing is the use of an asset without owning it. A finance lease transfers substantially all the risks and rewards of ownership to the lessee, is non-cancellable, runs for most of the asset's life and is capitalised in the lessee's books; an operating lease does none of that and its rentals are simply an expense. The examinable point is the transfer of risk and reward, not the length of the lease, although the two usually travel together.

ℹ️ Sale and leaseback

A firm sells an asset it owns and immediately leases it back, keeping the use of it while converting it into cash. It is a financing transaction dressed as a sale, and it is named in questions because it shows what leasing is really for: access to the asset's service, separated from ownership of the asset.

2. Time value of money and the cost of capital

A rupee today is worth more than a rupee a year from now, because it can be invested. Compounding carries a present sum forward, discounting brings a future sum back, and every valuation in this unit is one of the two. The present value of a perpetuity is the cash flow divided by the rate; of a growing perpetuity, the cash flow divided by the rate less the growth rate — which is the Gordon formula that reappears in both share valuation and dividend policy.

The cost of capital is the return the firm must earn to leave the value of its securities unchanged. Each source has its own cost, and the weighted average cost of capital is the discount rate used in capital budgeting.

Cost of debt is the interest rate adjusted for tax, since interest is deductible: Kd = i(1 − t). This tax shield is the single most examinable fact in the whole unit, because it is why debt is cheaper than equity and why capital structure matters at all.
Cost of preference capital is the preference dividend over the net proceeds. It is NOT tax adjusted, because preference dividend is an appropriation of profit rather than a charge against it.
Cost of equity may be found by the dividend growth model, Ke = D₁/P₀ + g, or by the capital asset pricing model, Ke = Rf + β(Rm − Rf).
Cost of retained earnings equals the cost of equity, because the shareholder forgoes exactly what they would have earned had the money been paid out and reinvested.

⚠️ Only debt gets the tax adjustment

Interest is charged before tax and reduces the tax bill; preference dividend and equity dividend are paid out of post-tax profit and do not. Applying (1 − t) to preference capital is the standard error in a weighted average cost of capital question, and it makes the answer too low in exactly the direction that looks plausible.

3. Capital structure: four theories and one leverage

The capital structure question is whether the mix of debt and equity changes the value of the firm. Four positions are named, and they are best held apart by what each says happens to the cost of capital as debt rises.

The four capital structure theories
Theory	As debt rises, the overall cost of capital	Value of the firm
Net income (Durand)	Falls continuously	Rises; maximum at all-debt
Net operating income (Durand)	Stays constant	Unchanged; structure is irrelevant
Traditional	Falls, reaches a minimum, then rises	Maximum at one optimal mix
Modigliani and Miller	Constant without taxes; falls with taxes	Irrelevant without taxes; rises with debt once tax is allowed

🎯 Why MM's two propositions look contradictory and are not

Without taxes, MM argue that value depends on the earning power of the assets and not on how they are financed, and they prove it by arbitrage: if two identical firms were priced differently, an investor could borrow personally, buy the cheaper one and be better off, which the market would close. Introduce corporate tax and one thing changes — interest is deductible, so a levered firm pays less tax and the value rises by the present value of the tax shield. The two results are the same model with one fact added, not two opinions.

Leverage measures the sensitivity that a fixed cost creates. Operating leverage is contribution divided by earnings before interest and tax, and arises from fixed operating cost; financial leverage is EBIT divided by earnings before tax, and arises from fixed interest; combined leverage is their product, contribution over earnings before tax. A firm with high operating leverage and high financial leverage magnifies a small change in sales into a large change in earnings per share, in both directions.

4. Capital budgeting: conventional and scientific techniques

The syllabus's own words divide the techniques into conventional ones, which ignore the time value of money, and scientific or discounted ones, which do not. That division is the whole of what most questions test.

The techniques and what each decides
Technique	Rule	Chief weakness
Payback period	Accept if the initial outlay is recovered within a set time	Ignores the time value of money and everything after payback
Accounting rate of return	Accept if average profit over average investment exceeds a cut-off	Uses accounting profit, not cash flow, and ignores timing
Net present value	Accept if the discounted inflows exceed the outlay	Needs the cost of capital as an input, and is an absolute figure
Internal rate of return	Accept if the rate that makes NPV zero exceeds the cost of capital	Assumes reinvestment at the IRR, and can give multiple rates
Profitability index	Accept if the present value of inflows over the outlay exceeds one	A ratio, so it ranks well under rationing but not by value added

⚠️ When NPV and IRR disagree, follow NPV

For mutually exclusive projects differing in size or in the timing of their cash flows, the two methods can rank differently. NPV wins, because its reinvestment assumption is the cost of capital — a rate the firm can actually earn — while IRR assumes intermediate flows are reinvested at the IRR itself, which for a very good project is a rate available nowhere. NPV also measures the rupees of value added, which is what shareholder wealth is.

5. Working capital management

Working capital is current assets less current liabilities, and managing it is a permanent trade-off between liquidity and profitability: idle cash is safe and earns nothing, while a thin buffer earns more and risks default on an ordinary bill. The operating cycle is the machinery for measuring the need — the time from paying for raw material to collecting from the customer.

Operating cycle = raw material holding period + work in progress period + finished goods period + debtors collection period − creditors payment period. The last term is subtracted because a supplier's credit finances part of the cycle for you.
Permanent working capital is the minimum level always required and is financed long term; temporary working capital fluctuates with the season and is financed short term. Financing permanent needs from short-term sources is the aggressive policy, and the risk it carries is renewal rather than cost.
Cash management models are named: Baumol's, which treats cash like inventory with a fixed conversion cost, and Miller-Orr, which sets an upper and a lower control limit and acts only when the balance breaches one.

6. The dividend decision: theories and policies

The dividend question is whether paying out rather than retaining changes the value of the share. The theories split into those that say it does — relevance — and those that say it does not.

Walter's model — relevance. Value depends on the relation between the firm's return on investment r and its cost of capital Ke. If r exceeds Ke the firm should retain everything, so the optimum payout for a growth firm is nil; if r is below Ke it should pay out everything; if they are equal the payout makes no difference.
Gordon's model — relevance, through the bird-in-hand argument: investors discount distant and uncertain future dividends more heavily, so a higher payout raises the price. P = D₁/(Ke − g).
Modigliani and Miller — irrelevance. Under perfect markets a shareholder wanting cash can sell a share and one not wanting it can reinvest the dividend, so the policy only changes the form of the return and not its amount. The argument is the same arbitrage that carries their capital structure result.

🧠 Walter in one comparison

Compare r with Ke and the answer follows without the formula. A firm that earns more inside than shareholders can earn outside should keep the money; a firm that earns less should hand it back. Questions state r and Ke precisely so that this comparison decides the payout, and the arithmetic is only there to confirm it.

Key takeaways

Only debt carries a tax shield: Kd = i(1 − t), while preference dividend is an appropriation of profit and takes no tax adjustment at all.
The four capital structure theories are told apart by what happens to the overall cost of capital as debt rises — falling, constant, U-shaped, or constant until tax is allowed in.
When NPV and IRR rank mutually exclusive projects differently, NPV wins: its reinvestment rate is one the firm can actually earn, and it measures value added in rupees.
The operating cycle subtracts the creditors period because a supplier's credit finances part of the cycle for you — the only negative term in the formula.
Walter compares r with Ke: a firm earning more inside than shareholders can earn outside should retain everything, and one earning less should pay everything out.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

A company issues 10% debentures and its tax rate is 30%. The after-tax cost of debt is:
1. 7%
2. 10%
3. 13%
4. 3%
Show answer
Answer: A — 7%
Interest is deductible before tax, so each rupee of interest reduces the tax bill by the tax rate and the effective cost is i(1 − t) = 10% × 0.70 = 7%. The figure 10% ignores the shield entirely and is the before-tax rate. 13% comes from multiplying by (1 + t) instead of (1 − t), which would make debt dearer for being deductible. 3% is the tax saving alone rather than the cost that remains. This shield is the reason debt is cheaper than equity and the reason capital structure has any effect on value at all.
Under Walter's model, a firm whose return on investment exceeds its cost of capital should have an optimum dividend payout ratio of:
1. Zero
2. One hundred per cent
3. Fifty per cent
4. Any ratio, since payout does not affect value
Show answer
Answer: A — Zero
Walter's model makes the payout depend entirely on the comparison of r with Ke. A firm that earns more on money kept inside than shareholders could earn on the same money outside creates value by retaining, so its optimum payout is nil — the growth-firm case. A declining firm, where r is below Ke, should pay everything out. Where r equals Ke the payout is a matter of indifference. A fixed fifty per cent is not a result of any model, and the irrelevance answer belongs to Modigliani and Miller rather than to Walter.
Which capital budgeting technique assumes that intermediate cash flows are reinvested at the project's own rate of return?
1. Internal rate of return
2. Net present value
3. Payback period
4. Accounting rate of return
Show answer
Answer: A — Internal rate of return
The internal rate of return is the discount rate that makes net present value zero, and the mathematics that produces it implicitly reinvests every intermediate inflow at that same rate. For an unusually good project that rate may be available nowhere in the market, which is the assumption's weakness. Net present value discounts at the cost of capital, a rate the firm can actually earn, which is why NPV is preferred when the two rank mutually exclusive projects differently. Payback and the accounting rate of return do not discount at all and so make no reinvestment assumption.
Under the net operating income approach to capital structure, as the proportion of debt rises the overall cost of capital:
1. Remains constant, so the value of the firm is unaffected
2. Falls continuously, so value is maximised at all-debt
3. Falls, reaches a minimum and then rises
4. Rises continuously, so debt should be avoided
Show answer
Answer: A — Remains constant, so the value of the firm is unaffected
The net operating income approach holds that the overall capitalisation rate is constant whatever the mix, because the cheapness of debt is exactly offset by the higher return equity holders then demand for the extra financial risk. Value therefore depends on operating income and business risk alone and capital structure is irrelevant. A continuously falling cost with maximum value at all-debt is the net income approach, and a cost that falls to a minimum and then rises is the traditional view with its single optimal mix. The fourth option matches no named theory in this unit.
In computing the operating cycle, the creditors payment period is:
1. Subtracted, because supplier credit finances part of the cycle
2. Added, because it lengthens the time before cash returns
3. Ignored, because it is a current liability and not an asset
4. Multiplied by the debtors collection period
Show answer
Answer: A — Subtracted, because supplier credit finances part of the cycle
The operating cycle measures how long the firm's own money is tied up, from paying for raw material to collecting from the customer. Credit taken from suppliers means the firm has not yet paid for part of that period, so somebody else is financing it and the days concerned come out of the firm's requirement. That makes the creditors period the only negative term in the formula, and omitting the subtraction overstates the working capital a firm actually needs. The other three options describe operations that no version of the formula performs.
A lease that transfers substantially all the risks and rewards of ownership to the lessee is:
1. A finance lease
2. An operating lease
3. A sale and leaseback
4. A hire purchase agreement
Show answer
Answer: A — A finance lease
The transfer of substantially all risks and rewards is the defining test of a finance lease, and it is why the asset is capitalised in the lessee's books even though legal title stays with the lessor. An operating lease transfers neither, runs for a short part of the asset's life and is cancellable, so its rentals are simply an expense. Sale and leaseback describes how a lease came about rather than what kind it is, and the resulting lease may be either type. Hire purchase differs in that ownership passes to the hirer on payment of the final instalment, which no lease does.
Modigliani and Miller's capital structure proposition WITHOUT corporate taxes rests on:
1. An arbitrage argument, since an investor can replicate leverage personally
2. The tax deductibility of interest
3. The bird-in-hand preference of investors
4. The existence of bankruptcy costs
Show answer
Answer: A — An arbitrage argument, since an investor can replicate leverage personally
Without taxes, MM argue that the value of a firm depends on the earning power of its assets and not on how those assets are financed, and the proof is arbitrage: if a levered and an unlevered firm with identical operating income were priced differently, an investor could borrow on personal account, buy the cheaper firm's shares and earn the same income for less, and that trade would close the gap. Tax deductibility is what they add in the second proposition, which reverses the conclusion. The bird-in-hand argument belongs to Gordon on dividends, and bankruptcy costs are one of the frictions later theories introduce to restore an optimum.
Financial leverage arises from the presence of:
1. Fixed financial charges such as interest in the capital structure
2. Fixed operating costs in the cost structure
3. A high proportion of equity in the capital structure
4. Variable cost that changes with output
Show answer
Answer: A — Fixed financial charges such as interest in the capital structure
Financial leverage is EBIT divided by earnings before tax, and the gap between those two figures is fixed interest. Because interest does not change with earnings, a given percentage change in EBIT produces a larger percentage change in earnings per share, in both directions. Fixed operating cost produces operating leverage instead, measured as contribution over EBIT, and the product of the two is combined leverage. Equity carries no fixed charge, so a structure heavy in equity has low financial leverage, and variable cost creates no leverage at all because it moves with output.
The cost of retained earnings is generally taken to be:
1. Equal to the cost of equity
2. Zero, because no payment is made to anyone
3. Equal to the after-tax cost of debt
4. Equal to the rate of corporate tax
Show answer
Answer: A — Equal to the cost of equity
Retained earnings belong to the equity shareholders, and money kept inside the firm is money they could have received and invested elsewhere at the return they require. That forgone return is a genuine opportunity cost even though no cash leaves the company, which is why treating retained earnings as free capital is wrong and why the cost is the cost of equity. In practice it is sometimes taken slightly below the cost of a fresh equity issue, because retention avoids flotation costs, but the benchmark remains the shareholders' required return rather than anything to do with debt or tax rates.