Wealth maximisation is preferred to profit maximisation as the goal of financial management because it:

Accounts for the time value of money and risk through discounted cash flows

Is easier to measure from the profit and loss account

Ignores the interests of creditors

Focuses on short-term accounting profit

According to the Net Operating Income approach to capital structure:

The overall cost of capital and the value of the firm are independent of the degree of leverage

The value of the firm rises continuously as debt replaces equity

The overall cost of capital is U-shaped with an optimum range

Firms prefer retained earnings, then debt, then equity

Modigliani and Miller's 1963 correction for corporate taxes concludes that the value of a levered firm equals the value of an unlevered firm plus:

The present value of the interest tax shield

The present value of bankruptcy costs

Nothing — leverage remains irrelevant

In computing the weighted average cost of capital, the cost of debt is taken after tax because:

Interest on debt is a tax-deductible expense, so the government bears part of it

Debt holders pay tax on the interest they receive

Preference dividend is also tax-deductible

Zero-base budgeting, in which every activity must be justified afresh each period through ranked decision packages, was developed by:

Peter Pyhrr at Texas Instruments (1970)

Donaldson Brown at Du Pont (1920s)

The degree of financial leverage is measured as:

EBIT ÷ EBT (percentage change in EPS ÷ percentage change in EBIT)

At the EBIT-EPS indifference point between an all-equity plan and a debt-equity plan:

Both plans yield the same EPS; above it the debt plan yields higher EPS

The weighted average cost of capital is minimised

The debt plan always yields lower EPS

Financial Management: Functions, Capital Structure Theories, Cost of Capital, Sources of Finance, Budgeting and Leverages

The second half of Unit 4 is corporate finance from the financing side: what financial management is for, the four theories of capital structure and what each says the debt-equity mix does to firm value, how the cost of each source and the weighted average are computed, the sources themselves, budgeting and budgetary control including zero-base budgeting, and the three leverages with EBIT-EPS analysis, the financial break-even point and the indifference point. Every topic here has a formula, and the paper sets small numbers on them; the tables give the formula and one figure each.

1. Financial management: concept, goals and functions

Financial management is the planning, raising, controlling and administering of the funds a business uses — Solomon's 'efficient use of an important economic resource, namely capital funds', Weston and Brigham's decision-making about the acquisition and financing of assets. It evolved from the traditional approach (raising funds — instruments, institutions, episodic events) to the modern approach (the three decisions and their effect on value). Its goal is the maximisation of shareholders' wealth — the market value of equity, or the net present value of decisions — rather than profit maximisation, which is vague about which profit, ignores timing (the time value of money), ignores risk, and can be manipulated by accounting choices; wealth maximisation counts cash flows, discounts them for time and adjusts for risk. Agency theory (Jensen and Meckling, 1976) notes that managers may pursue their own goals — size, perquisites, security — and that agency costs (monitoring, bonding, residual loss) are borne to align them, through stock options, boards, debt covenants and the takeover market. Stakeholder wealth and sustainable value are the widened contemporary versions.

The decisions (functions) of financial management
Decision	Question it answers	Tools
Investment (capital budgeting) decision	In which long-term assets should funds be placed? Also working-capital (current-asset) investment	NPV, IRR, payback; risk analysis; the trade-off between liquidity and profitability
Financing (capital structure) decision	From which sources, in what proportion of debt and equity, at what cost?	Cost of capital, leverage, EBIT-EPS, capital structure theories
Dividend decision	How much of earnings to distribute and how much to retain?	Payout ratio, dividend theories, bonus shares, buy-back
Liquidity (working capital) decision	How to keep the firm able to pay as obligations fall due?	Cash, receivables, inventory and payables management; often folded into the investment decision
Executive and routine functions	Forecasting, planning, raising, allocating, controlling; record-keeping, custody of securities, cash management, reporting	The treasurer handles funds and the controller handles accounting and control, both under the chief financial officer

2. Capital structure: theories, cost of capital and sources of finance

Capital structure theories: does the debt-equity mix change firm value?
Theory	Assumption about Kd and Ke	Conclusion
Net income approach (Durand)	Kd and Ke both constant as leverage rises; debt is cheaper	More debt lowers the overall cost Ko and raises value; optimum at 100% debt — relevance
Net operating income approach (Durand)	Ko constant; Ke rises exactly enough to offset cheaper debt	Value independent of leverage; every structure is optimum — irrelevance
Traditional approach (Solomon)	Ke rises slowly at first then sharply; Kd rises after a point	Ko falls, reaches a minimum, then rises — an optimum range of moderate leverage; U-shaped Ko
Modigliani-Miller without taxes (1958)	Perfect markets, no taxes, homogeneous risk classes, personal and corporate borrowing at the same rate — arbitrage	Proposition I: value is independent of capital structure (the NOI result proved by arbitrage); Proposition II: Ke = Ko + (Ko − Kd) × D/E
Modigliani-Miller with corporate taxes (1963)	Interest is tax-deductible	Value of levered firm = value of unlevered firm + present value of the tax shield (t × D); optimum at 100% debt
Trade-off theory	Tax shield against bankruptcy and agency costs of debt	An interior optimum where marginal shield equals marginal distress cost — the modern statement of the traditional view
Pecking order (Myers and Majluf, 1984)	Asymmetric information; issuing equity signals over-valuation	Firms prefer internal funds, then debt, then equity last; no target ratio
Signalling, agency and market-timing views	Ross's signalling; Jensen's free-cash-flow discipline of debt; Baker and Wurgler's timing	Debt signals confidence and curbs managerial waste; structure is the residue of past issue windows

Cost of capital is the minimum rate of return a firm must earn on its investments to keep the market value of its shares unchanged — the investors' required return, the hurdle rate for capital budgeting. Its components: cost of debt after tax Kd = I(1 − t) ÷ net proceeds, or for redeemable debt the yield that equates proceeds with the after-tax interest and redemption value, approximated by [I(1 − t) + (RV − NP)/n] ÷ [(RV + NP)/2]; cost of preference Kp = preference dividend ÷ net proceeds, not tax-deductible, with the same redemption adjustment; cost of equity by the dividend growth (Gordon) model Ke = D1/P0 + g, by the capital asset pricing model Ke = Rf + β(Rm − Rf), by the earnings-price approach Ke = EPS/P0, or by bond yield plus risk premium; cost of retained earnings Kr = Ke, or Ke adjusted for personal tax and brokerage since retention spares the shareholder those; the weighted average cost of capital Ko = Σ(weight × component cost), weighted at book values or, preferably, market values, and the marginal cost of capital that rises in steps as cheaper sources are exhausted (the break points). Explicit cost is the discount rate that equates funds received with outflows; implicit cost is the opportunity cost of the funds — the return on the best alternative forgone.

🧠 A WACC in one line

Debt 40% at 10% before a 25% tax gives 7.5% after tax; preference 10% at 9%; equity 50% at 14%. Ko = 0.4 × 7.5 + 0.1 × 9 + 0.5 × 14 = 3 + 0.9 + 7 = 10.9%. The paper's traps: forgetting the (1 − t) on debt, applying it to preference dividend, and weighting by book value when market values are given. Under MM Proposition II a rise in leverage raises Ke by (Ko − Kd) × D/E — cheaper debt does not lower the average because equity becomes dearer.

Sources of finance
By term	Sources	Points the paper tests
Long-term ownership funds	Equity shares (IPO, FPO, rights issue, bonus issue, private placement, qualified institutional placement, sweat equity, ESOPs), preference shares (cumulative, participating, convertible, redeemable — must be redeemed within 20 years under the Companies Act), retained earnings (ploughing back), venture capital and private equity, angel funds	Equity carries residual claim and voting; preference has fixed dividend and priority; retained earnings are the cheapest external-cost-free source but not cost-free (Kr = Ke); rights issue under s. 62 is offered to existing holders in proportion
Long-term borrowed funds	Debentures and bonds (secured or unsecured, convertible or non-convertible, redeemable, zero-coupon, deep-discount, floating-rate; debenture redemption reserve), term loans from banks and development finance institutions, external commercial borrowings, foreign currency convertible bonds, masala bonds, lease finance, public deposits (up to three years), securitisation	Interest is deductible, so debt is cheaper than equity but adds financial risk; a debenture holder is a creditor, not an owner; convertible debentures bridge the two
Medium-term	Term loans of one to five years, hire purchase, leasing, medium-term notes	Lease rentals are deductible and the lessor keeps ownership; hire purchase transfers ownership on the last instalment
Short-term	Trade credit, bank overdraft and cash credit, bills discounting, working-capital demand loans, commercial paper (7 days to one year, rated, from companies with net worth of 4 crore or more), factoring, inter-corporate deposits, accrued expenses and provisions, advances from customers	Trade credit is 'spontaneous' finance; its implicit cost when a cash discount is forgone is discount ÷ (1 − discount) × 365 ÷ extra days
Internal versus external	Internal: retained earnings, depreciation provision, sale of assets. External: everything raised from outside	Pecking order predicts internal first; depreciation is a source of funds in the funds-flow sense though not a cash inflow

3. Budgeting and budgetary control: types, process and zero-base budgeting

A budget is a financial and quantitative statement prepared and approved before a defined period of the policy to be pursued during that period for attaining a given objective (the CIMA definition); budgetary control is the establishment of budgets relating managers' responsibilities to the requirements of a policy, and the continuous comparison of actual with budgeted results to secure the objective or provide a basis for its revision. The process runs: set the budget period and the key (principal budget) factor — the constraint, usually sales, that all other budgets must fit — form a budget committee under a budget officer, issue the budget manual, prepare the functional budgets (sales first, then production, materials, purchases, labour, overheads, capital expenditure, cash, research), consolidate them in the master budget (budgeted profit and loss account and balance sheet), obtain approval, and then report variances by responsibility centre — cost, revenue, profit and investment centres. Its advantages are coordination, communication, delegation, motivation through participation and control by exception; its dangers are rigidity, padding and budgetary slack, gaming to meet targets, spend-it-or-lose-it behaviour, and treating the budget as a ceiling rather than a plan. Beyond Budgeting (Hope and Fraser) and rolling forecasts are the modern critique.

Types of budget
Basis	Types	Point tested
Time	Long-term (capital), short-term (annual, quarterly), current, rolling or continuous (always twelve months ahead)	A rolling budget adds a period as one expires
Function	Sales, production, materials, purchases, labour, overhead, cash, capital expenditure, R&D, master budget	Sales budget is prepared first because sales is usually the key factor; the cash budget is the most important for liquidity
Flexibility	Fixed (static) budget — one activity level; flexible budget — recast for the actual level using cost behaviour	Only a flexible budget gives meaningful variances when output differs from plan
Approach	Incremental (last year plus a percentage); zero-base; performance (programme) budgeting — outputs and outcomes; activity-based budgeting; participative (bottom-up) versus imposed (top-down)	Incremental budgeting perpetuates past inefficiency, which is the case for ZBB

ℹ️ Zero-base budgeting

Zero-base budgeting, developed by Peter Pyhrr at Texas Instruments in 1970 and applied to the State of Georgia's budget by Governor Jimmy Carter in 1973, requires every activity to be justified from a zero base each period, as if it were new, rather than as an increment on last year. The process: identify decision units (the lowest level at which budget decisions are made), prepare decision packages for each — describing the activity, its purpose, costs, benefits, alternative ways of doing it and the consequences of not doing it, at several funding levels — rank the packages by cost-benefit across the organisation, and allocate funds down the ranking until the money runs out. Its merits are the elimination of obsolete activities, a link between spending and results, participation of lower managers and an answer to budgetary slack; its costs are the time and paperwork of justifying everything annually, resistance from managers whose programmes are questioned, and the difficulty of ranking dissimilar packages — which is why it is often applied to discretionary and support costs rather than to direct production costs, and on a rotating rather than an annual basis. India experimented with it in the Union Budget from 1986-87 and several States have used it for departmental budgets.

4. Leverages, EBIT-EPS analysis, financial break-even and the indifference point

The three leverages, with a worked firm: sales 10,00,000, variable cost 6,00,000, fixed cost 2,00,000, interest 1,00,000, tax 25%
Leverage	Formula	Meaning	Worked value
Operating leverage	DOL = contribution ÷ EBIT = % change in EBIT ÷ % change in sales	Sensitivity of operating profit to sales, caused by fixed operating costs; business risk	Contribution 4,00,000, EBIT 2,00,000: DOL = 2
Financial leverage	DFL = EBIT ÷ EBT = EBIT ÷ (EBIT − interest − preference dividend/(1 − t)) = % change in EPS ÷ % change in EBIT	Sensitivity of EPS to operating profit, caused by fixed financial charges; financial risk; 'trading on equity'	EBT 1,00,000: DFL = 2
Combined (total) leverage	DCL = DOL × DFL = contribution ÷ EBT = % change in EPS ÷ % change in sales	Total risk to the shareholder; a firm with high DOL should keep DFL low	DCL = 4: a 10% fall in sales cuts EPS 40%

Favourable financial leverage — trading on equity — exists when the firm earns more on borrowed funds than they cost, so that EPS and return on equity rise with debt; it is unfavourable when the return on assets falls below the interest rate. EBIT-EPS analysis compares financing plans by computing EPS at various levels of EBIT: EPS = (EBIT − I)(1 − t) − Dp, divided by the number of equity shares, N. The plan with more debt has a steeper EPS line, so it wins at high EBIT and loses at low EBIT. The financial break-even point is the EBIT at which EPS is zero — the EBIT that just covers interest and the pre-tax equivalent of preference dividend: EBIT = I + Dp/(1 − t); below it the shareholder loses. The indifference point (EBIT-EPS break-even between two plans) is the EBIT at which both plans give the same EPS, found by equating (EBIT − I1)(1 − t)/N1 with (EBIT − I2)(1 − t)/N2 (adding the preference adjustment where relevant); above it the higher-debt plan gives higher EPS, below it the equity plan does. Because EPS ignores risk, the choice also weighs the variability of EPS, the coverage ratios, cash-flow ability to service debt, control (equity dilutes the promoters' vote) and flexibility to borrow later.

🧠 An indifference point in numbers

A firm needs 10,00,000. Plan A: all equity, 1,00,000 shares of 10. Plan B: 5,00,000 equity (50,000 shares) and 5,00,000 debt at 10%, so interest 50,000. Tax 40%. Equate (EBIT − 0)(0.6)/1,00,000 = (EBIT − 50,000)(0.6)/50,000. Cancel 0.6: EBIT/1,00,000 = (EBIT − 50,000)/50,000, so 50,000 EBIT = 1,00,000 EBIT − 5,000,000,000, giving EBIT = 1,00,000. At that EBIT both plans give EPS of 0.60; above it Plan B wins. Plan B's financial break-even is EBIT = 50,000 (EPS zero); Plan A's is zero.

Key takeaways

Wealth maximisation beats profit maximisation because it counts timing, risk and cash flows; the three decisions are investment, financing and dividend, with liquidity as the fourth; agency costs align managers with owners.
NI says debt lowers Ko; NOI and MM (no tax) say structure is irrelevant; the traditional view has a U-shaped Ko with an optimum range; MM with tax adds the tax shield t × D; pecking order goes internal, debt, equity.
Kd is after tax, Kp is not; Ke = D1/P0 + g or Rf + β(Rm − Rf); Kr = Ke; WACC weights by market value where possible; MM II: Ke = Ko + (Ko − Kd)D/E.
Sales is usually the key factor and its budget comes first; a flexible budget recasts costs for actual output; ZBB (Pyhrr, 1970) justifies every decision package from zero and ranks them; responsibility centres are cost, revenue, profit and investment.
DOL = contribution ÷ EBIT, DFL = EBIT ÷ EBT, DCL = DOL × DFL; financial break-even EBIT = I + Dp/(1 − t); the indifference point equates EPS under two plans, and above it the debt plan wins.

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.

Wealth maximisation is preferred to profit maximisation as the goal of financial management because it:
1. Accounts for the time value of money and risk through discounted cash flows
2. Is easier to measure from the profit and loss account
3. Ignores the interests of creditors
4. Focuses on short-term accounting profit
Show answer
Answer: A — Accounts for the time value of money and risk through discounted cash flows
Profit maximisation is vague about which profit, ignores timing and risk, and is open to accounting manipulation; wealth maximisation uses the present value of expected cash flows adjusted for risk, which is what the share price reflects.
According to the Net Operating Income approach to capital structure:
1. The overall cost of capital and the value of the firm are independent of the degree of leverage
2. The value of the firm rises continuously as debt replaces equity
3. The overall cost of capital is U-shaped with an optimum range
4. Firms prefer retained earnings, then debt, then equity
Show answer
Answer: A — The overall cost of capital and the value of the firm are independent of the degree of leverage
Under NOI the cost of equity rises exactly enough to offset the cheaper debt, so Ko is constant — the irrelevance result MM later proved by arbitrage. Continuous rise is the NI approach, the U-shape the traditional approach, and the ordering the pecking order theory.
Modigliani and Miller's 1963 correction for corporate taxes concludes that the value of a levered firm equals the value of an unlevered firm plus:
1. The present value of the interest tax shield
2. The present value of bankruptcy costs
3. The agency cost of equity
4. Nothing — leverage remains irrelevant
Show answer
Answer: A — The present value of the interest tax shield
Because interest is deductible, each rupee of perpetual debt adds t × D of value, implying an all-debt optimum; the trade-off theory then subtracts expected bankruptcy and agency costs to find an interior optimum. The 1958 no-tax paper is the irrelevance result.
A company's equity share sells at 200 rupees, the expected dividend next year is 10 rupees and dividends are expected to grow at 6% a year. Using the dividend growth model, the cost of equity is:
1. 11%
2. 5%
3. 6%
4. 16%
Show answer
Answer: A — 11%
Ke = D1/P0 + g = 10/200 + 0.06 = 0.05 + 0.06 = 11%. Forgetting the growth term gives 5%; adding 10% instead of the yield gives 16%.
In computing the weighted average cost of capital, the cost of debt is taken after tax because:
1. Interest on debt is a tax-deductible expense, so the government bears part of it
2. Debt holders pay tax on the interest they receive
3. Preference dividend is also tax-deductible
4. Debt is riskier than equity
Show answer
Answer: A — Interest on debt is a tax-deductible expense, so the government bears part of it
Kd = I(1 − t) ÷ net proceeds. Preference dividend and equity dividend are paid out of after-tax profit and get no such adjustment, which is one reason debt is the cheaper source to the firm.
Zero-base budgeting, in which every activity must be justified afresh each period through ranked decision packages, was developed by:
1. Peter Pyhrr at Texas Instruments (1970)
2. Peter Drucker (1954)
3. Robert Kaplan (1992)
4. Donaldson Brown at Du Pont (1920s)
Show answer
Answer: A — Peter Pyhrr at Texas Instruments (1970)
Pyhrr's ZBB was adopted by Jimmy Carter for Georgia in 1973 and later the US federal budget. Drucker gave MBO, Kaplan the balanced scorecard, and Brown the DuPont ratio decomposition.
The degree of financial leverage is measured as:
1. EBIT ÷ EBT (percentage change in EPS ÷ percentage change in EBIT)
2. Contribution ÷ EBIT
3. Contribution ÷ EBT
4. Sales ÷ fixed cost
Show answer
Answer: A — EBIT ÷ EBT (percentage change in EPS ÷ percentage change in EBIT)
DFL = EBIT ÷ EBT captures the effect of fixed financial charges. Contribution ÷ EBIT is operating leverage (fixed operating costs) and contribution ÷ EBT is combined leverage, the product of the two.
A firm has interest of 2,00,000 rupees, preference dividend of 1,50,000 rupees and a tax rate of 25%. Its financial break-even point (EBIT at which EPS is zero) is:
1. 4,00,000 rupees
2. 3,50,000 rupees
3. 2,00,000 rupees
4. 3,12,500 rupees
Show answer
Answer: A — 4,00,000 rupees
EBIT = I + Dp/(1 − t) = 2,00,000 + 1,50,000/0.75 = 2,00,000 + 2,00,000 = 4,00,000. Preference dividend is paid from after-tax profit, so it must be grossed up; adding it without grossing up gives the 3,50,000 distractor.
At the EBIT-EPS indifference point between an all-equity plan and a debt-equity plan:
1. Both plans yield the same EPS; above it the debt plan yields higher EPS
2. EPS is zero under both plans
3. The weighted average cost of capital is minimised
4. The debt plan always yields lower EPS
Show answer
Answer: A — Both plans yield the same EPS; above it the debt plan yields higher EPS
The indifference point equates (EBIT − I1)(1 − t)/N1 with (EBIT − I2)(1 − t)/N2. The debt plan's EPS line is steeper, so it overtakes the equity plan above the crossing. Zero EPS defines the financial break-even point, a different concept; WACC minimisation belongs to capital structure theory.