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CORPORATE FINANCE

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Chapter 1
INTRODUCTION
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COPORATE FINANCE
Corporate finance is an area of finance dealing with financial decisions business
enterprises 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 longterm and shortterm decisions and techni!ues.
"apital investment decisions are longterm choices about which pro#ects receive investment,
whether to finance that investment with e!uity or debt, and when or whether to pay dividends to
shareholders. $n the other hand, the short term decisions can be grouped under the heading
%&orking capital management. This sub#ect deals with the shortterm balance of current assets and
current liabilities' the focus here is on managing cash, inventories, and shortterm borrowing and
lending.
The Corporate Firm
The firm is a way of organizing the econiomic activity of many individuals, and there are
many reasons why so much economic activity is carried out by firms and not by individuals. A
basic problem of the firm is how to raise cash. The corporate form of business, that is organizing
the firm as a corporation, is the standard method for solving problems encountered in raising large
amounts of cash. (owever, businesses can take other forms.
The Corporation
$f the many forms of business enterprises, the corporation is by far the most important. )t
is a legal distinctentity. A corporation can have a name and en#oy many of the legal powers of
natural persons. *or example, corporations can ac!uire and exchange property. "orporations can
enter in to contracts and may sue and be sued.
+tarting a corporation is more complicated then starting a proprietorship or partnership. The
incorporators must prepare articles of incorporation and a set of bylaws. The articles of
incorporation must include the following,
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1. .ame of the corporation.
2. )ntended life of the corporation.
3. /usiness purpose.
4. .umber of shares of stock that the corporation is authorised to issue, with a statement
of limitations and rights of different classes of shares.
5. .ature of the rights granted to shareholders.
. .umber of members of the initial board of directors.
The bylaws are the rules to be used by the corporation to regulate its own existence, and they
concern its shareholders, directors, and officers. /ylaws range from the briefest posssible statement
of rules for the corporation's management to hundreds of pages of text.
)n its simplest form, the corporation comprises three sets of distinct interests, the
shareholders, the directors, who inturn selects the top management. 0embers of hte top
management serve as corporate officers and manage the operation of the corporation in the best
interest of the shareholders. )n closely held corporations with few shareholders, there may be a
large overlap manong the shareholders, the directors, and the top management. (owever, in larger
corporationsx the shareholders, directors, and the top management are likely to be distinct groups.
The potential seperation of ownership from management gives the corporation several
advantages over proprietorships and partnerships,
/ecause ownership in a corporation is represented by share of stock, ownership can be
redily transfered to new owners. /ecause the corporation exists independently of those who
own its shares, there is no limit to the transferability of shares as there is in partnerships.
The corporation has unlimited life. /ecause the corporation is a seperate from its owners,
the death or withdrawal of an owner does not affect its legal existence. The corporations
can continue on after the orginal owners have withdrawn.
The shareholders' liability is limited to the amount invested in the ownership shares. *or
example, if a shareholder purchased 1s.1222 in shares of a corporation, the potential loss
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would be 1s.1222. )n a partnership, a general partner with a 1s.1222 contribution could
lose the 1s.1222 plus any other indebtedness of the partnership.
4imited liability, ease of ownership transfer, and perpetual succession are the ma#or advantages of
the corporation form of business organisation. These give the corporation an enhanced ability to
raise cash.
There is however, one great disadvantage to incorporation. The federal government taxes
corporate income. This tax in addition to the personal income tax that shareholders pay on dividend
income they receive. This is double taxation for shareholders when compared to taxation on
proprietorships and partnerships.
!oa"# of the Corporate Firm
The 0anagers in a corporation make decisions for the stockholders because the stockholders
own and control the corporation. +o, the goals for the corporations is to
Add value for the stockholders
To maximize corporate value
0anage the firm5s financial risks
$a"ance %heet &o'e" of the Firm
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The assets of the firm are on the lefthand side of the balance sheet. These assets thought of
as current and fixed. *ixed assets are those that will last a long time, such as buildings. +ome fixed
assets are tangible, such as machinery and e!uipment. $ther fixed assets are intangibles such as
patents, trademarks, and the !uality of management. The other category of assets, current assets,
comprises those that have short lives, such as inventory. 7nless we have overproduced, they will
leave the firm shortly.
/efore an company can invest in an asset, it must obtain financing, which means that it
must raise the money to pay for the investment. The forms of financing are represented on the
1ighthand side of the balance sheet. A firm will issue pieces of paper called debt or e!uity shares.
8ust as assets are classified as longlived or shortlived, so too are liabilities. A shortterm debt is
called as current liability. +hortterm debt represents loans and other obligations that must be
repaid within one year.4ong term debt that does not have to be repaid within one year.
+hareholders' e!uity represents the difference between the value of the assets and the debt of the
firm. )n this sense it is a residual claim on the firm's assets.
*rom the balance sheet model of the firm, it is easy to understand how finance is collected and
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utilized by the firm.
o "apital budgeting and capital expenditures are used to describe the process of making and
managing expenditures on long term assets.
o To raise cash re!uired for capital expenditure, c!apital structure represents the proportion
of the firm's financing fron current and longterm debt and e!uity.
o +hort term operating cash flows : there is often mismatch between the timing of cash
inflows and cash outflows during operating activities. The amount and timing of operating
cash flows are not known with certainity. The financial managers must attempt to manage
the gaps in cash flow from a balancesheet perspective, shortterm management of cash
flow is associated with a firm's net working capital. .et working capital is defined as
current assets minus current liabilities.
C(APTER 2
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)ON! TER& * %(ORT TER& %OURCE% OF
FINANCE
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/usiness enterprises need funds to meet their different types of re!uirements. All the
financial needs of a business may be grouped into the following three categories,
)on+ Term Financin+ Nee' #,
The longterm decisions of a firm involve setting of the firm, expansion, diversification,
modernization and other similar capital expenditure decisions. All these decisions involve huge
investment, the benefits of which will be seen only in the long term and these decisions are also
irreversible in nature. /y the nature of these pro#ects, long term sources of funds become the best
suited means of financing. *unds re!uired to finance permanent or hard core working capital
should be procured from long term sources.
&e'i,m Term Financin+ Nee'#,
+uch 1e!uirements refer to those funds which are re!uired for a prior exceeding one year
but not exceeding 9 years. *or example, if a company resorts to extensive publicity and
advertisement campaign then such type of expenses may be written off over a period of 3 to 9
years. These are called deferred revenue expenses and funds re!uired for them are classified in the
category of medium term financial needs. +ometimes long term re!uirements, for which long term
funds cannot be arranged immediately may be met from medium term sources and thus the demand
of medium term financial needs, are generated. As and when the desired long term funds are made
available, medium term loans taken earlier may be paid off.
%hort Term Financia" Nee'#,
+uch type of financial needs arise to finance in current assets such as stock, debtors, cash
etc. investment in these assets is known as meeting of working capital re!uirements of the concern.
The re!uirement of working capital depends upon a number of factors which may differ from
industry to industry and from company to company in the same industry. The main characteristic of
short term financial needs is that they arise for a short period of time not exceeding the accounting
period i.e. one year.
)on+ Term %o,rce# of Finance
The main sources of longterm finance can broadly divided into,
1= )nternal +ource and
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-= ?xternal +ource
Interna" %o,rce# inc",'e
a= +hare "apital @?!uity and preference shares=.
b= 1eserves and +urplus @1etained ?arnings=.
c= Aersonal loans of owners.
E-,it. %hare Capita"
?!uity shareholders are the owners of the business. They en#oy the residual profits of the
company after having paid the preference shareholders and other creditors of the company and
their liability is restricted to the amount of share capital they contributed to the company. The
advantage of e!uity capital to the issuing firm is that without any fixed obligation for the payment
of dividends, it offers permanent capital with limited liability for repayment. (owever, the cost of
e!uity capital is higher than other capital. *irstly, since the e!uity dividends are not tax deductible
expenses and secondly, the high costs of issue. )n addition to this since the e!uity shareholders
en#oy voting rights, excess of e!uity in the firms capital structure will lead to dilution of effective
control.
&erit# of E-,it. %hare#/
1. .o fixed burden on company
-. )t is a life time source
3. )t does not have any charge against assets of the company
6. .o risk of magnified losses during bad times
9. "an be easily marketed
Demerit# of E-,it. %hare#
1. ?xpectations of shareholders are high and hence more costly.
-. "hances of losing control of the company.
3. .ew share holders have e!ual voting rights.
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6. "ost of issuing is generally high.
9. Cividend not deductable for tax purpose.
Preference %hare Capita"
Areference shares have some attributes similar to e!uity shares and some to debentures.
4ike in the case of e!uity shareholders, there are no obligatory payments to the preference
shareholders and the preference dividends are not tax deductable. (owever similar to the debenture
holders the preference holders earn a fixed rate of return for their investment. )n addition to this the
preference share holders have a preference over e!uity shareholders to the post tax earnings in the
form of dividends and assets in the event of li!uidation.
$ther features of the preference capital include the call feature wherein the issuing company
has the option to redeem the shares, prior to the maturity date, at a certain price. Arior to the
"ompany5s Act, 1B9; companies could issue preference shares with voting rights. (owever, with
the commencement of "ompany5s Act, 1B9; the issue of preference rights with voting rights have
been restricted only to the following places,
1. There are arrears in dividends for two or more years incase of cumulative preference
shares.
-. Areference dividends is due for a period of two or more consecutive preceding years, or
3. )n the preceding six years including the immediately preceding financial year, if the
company has not paid the preference dividend for a period of three or more years.
Areference capital represents a hybrid form of financing it takes some characteristics of e!uity
and some attributes of debentures.
It re#em0"e# e-,it. in the fo""o1in+ 1a.#
1. Areference dividend is payable only out of distributed profits
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-. Areference dividend is not an obligatory payment

Preference capita" i# #imi"ar to 'e0ent,re# in #e2era" 1a.#
1. The dividend rate of preference capital is usually fixed
-. The claim of preference shareholders is prior to the claim of e!uity shareholders
3. Areference shareholders do not normally en#oy the right to vote.
A'2anta+e# of preference capita"
1. There is no legal obligation to pay preference dividend. A company does not face
bankruptcy or legal action if it skips preference dividend.
-. There is no redemption liability in the case of perpetual preference shares. ?ven in the case
of redeemable preference shares, financial distress may not be much because.
Aeriodic sinking fund payments are not re!uired.
1edemption can be delayed without significance penalties.
3. Areference capital is generally regarded as part of .et worth. (ence it enhances the credit
worthiness of the firm.
6. Areference shares do not, under normal circumstances, carry voting right. (ence there is no
dilution of control.
Preference Capita" ho1e2er #,ffer# from #erio,# #hortcomin+#
1. "ompared to debt capital, it is an expensive source of financing because the dividend paid
to preference shareholders is not, unlike debt interest, or tax deductable expense.
-. Though there is no legal obligation to pay preference dividends, skipping them can
adversely affect the image of the firm in the capital market.
3. "ompared to e!uity shareholders, preference shareholders have a prior claim on the assets
and earnings of the firm.
Retaine' Earnin+#
1etained earnings represent the internal sources of finance available to the company. )t is
not a method of financing but it refers to accumulation of profits by the company to finance its
developmental activities or repay loans. Also called as D)nternal *inancing5 it is an important
source of long term financing for corporate enterprises.
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E3terna" %o,rce Inc",'e
1. Term loan from financial institution and international bodies like )nternational
0onetary *unds, &orld /ank, Asian Cevelopment /ank.
-. Cebentures.
3. 4ease *inancing.
6. (ire Aurchase.
9. (ypothecation.
Term )oan#
Term loans are directly from the banks and financial institutions in )ndia. Term loans are
generally obtained for financing large expansions, modernizations and diversification pro#ects.
Therefore, this method of financing is also called as pro#ect financing. Term loans have a maturity
of more than one year. *inancial institutions provide term loans for the period of six to ten years
and in some cases a grace period of one or two years is also granted. "ommercial banks advance
term loans for a period of three to five years.
De0ent,re#
Another way of raising the loan is to issue a financial instrument called EdebenturesF. A
debenture is a loan raised by the company from the capital market against which the assets of the
company are mortgaged with the trustees. Cebentures carry a fixed rate of interest. Cebenture
holders are the creditors of the company. There exists obligation on the part of the company
contractual interest as well as to repay the principal amount. Cebenture finance is also cheaper than
share capital. )t also commands a tax benefit as a debenture interest is allowed as deductible
business expenses.
T.pe# of De0ent,re#/4
$earer De0ent,re#
They are registered and are payable to its bearers. They are negotiable instruments and are
transferable by delivery.
Re+i#tere' De0ent,re#
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They are payable to the registered holder whose name appears both on debentures and in
register of debenture holders maintained by the company. 1egistered debentures can be transferred
but have to be registered again. 1egistered debentures are not negotiable instruments.
%ec,re' De0ent,re#
Cebenture, which create a charge on the assets of the company which may be fixed or
floating are known as secured debentures.
Un#ec,re' or Na5e' De0ent,re#
Cebentures, which are issued without any charge on assets, are unsecured or naked
debentures, the holders are like unsecured creditors and may sue the company for recovery of debt.
Re'eema0"e De0ent,re#
.ormally debentures are issued on the condition that they shall be redeemed after a certain
period. They can however be reissued after redemption.
Perpet,a" De0ent,re#
&hen debentures are redeemable they are called perpetual.
Con2erti0"e De0ent,re#
)f an option is given to convert debentures in to e!uity shares at stated rate of exchange
after a specified period the are called convertible debentures. )n our country convertible debentures
are very popular. $n conversion, the holders cease to be lenders and become owners.
Cebentures are usually issued in series with a pari passu@at the same rate= clause which
entitles them to discharge rate ably though issued at different times. .ew series of debentures
cannot rank pari passu wit hold series unless the old series provides so. .ew debt instruments
issued by public limited companies are participating debentures, convertible debentures with
options, third party convertible debentures, and convertible debentures redeemable at premium,
debt e!uity swaps and zero coupon convertible notes.
Participatin+ De0ent,re#
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&hen debentures are unsecured, corporate debt securities which participate in the profits of
the company. They might find investors id issued by existing dividend paying companies.
Con2erti0"e De0ent,re# 1ith option#
They are a derivative of convertible debentures with embedded options, providing
flexibility to the issuer as well as the investor to exit from the terms of the issue. The coupon rate is
specified at the time of issue.
Thir' part. con2erti0"e De0ent,re#
They are debt with a warrant allowing the investor to subscribe to the e!uity of a third firm
at a preferential visGvis the market price interest rate on third party convertible debentures is
lower than pure debt on account of the conversion option.
Con2erti0"e De0ent,re# re'eema0"e at a premi,m
"onvertible debentures are issued at a face value with an option entitling investors to later
sell the bond to the issuer at a premium. They are basically similar to convertible debentures but
embody less risk.
&erit# of De0ent,re#
1. The debentures are for specific periods and hence financial planning is easy.
-. .o dilution of control.
3. "ompany can trade on e!uity.
6. )nterest is deductible for tax purpose.
Demerit# of De0ent,re#
1. )nterest has to be paid irrespective of performance : in case of failure to pay interest,
debenture holder can file winding up petition.
-. (as to be repaid on maturity.
)ea#e Financin+
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A lease is a form of financing employed to ac!uire the economies use of assets for a stated
period without owing them. ?very lease involves two parties, the lease and the leasor. 4easing is
the contractual arrangement between the lease and the leasor , where in companies can enter into a
lease in with the manufacturer of the instruments or through some intermediary. This deal will give
the company the right to use the assets till the maturity of the lease deal and can later retain the
assets or buy from the manufacturers. Curing the lease period the company will have to pay lease
rentals, which generally is at a negotiable rates and payable every month.
(ire P,rcha#e
*inance companies usually offer the facility of leasing as well as hire purchase to the clients.
The features of hire purchase are given as follows
1. The hirer purchases the assets and gives it on hire to hiree.
-. The hiree pays regularly the hire purchase installments covering interest as well as
repayment of the principal amount. &hen the hiree pays the last installment, the title of the
asset is transferred to hiree.
3. The hirer charges interest on a flat basis.
6. The total interest collected by the hirer is allotted over various years.
(.pothecation
7nder this arrangement, the possession of goods is not given to the banker. The
commodities remain at the disposal and in the godown of the borrower. The banker is given access
to goods whenever he so desires. The borrowing business unit has to furnish periodical returns of
stock to the banker. The banker advances the money only to the borrower in whose integrity it has
full confidence.
%OURCE% OF FINANCE FRO& A$ROAD
American Depo#itor. Receipt# 6ADR7
AC1 is an instrument similar to HC1. )t is issued in the capital markets of 7+A alone.
Henerally far more stringent rules and regulations prevail for bringing out and AC1 issue.
AC1 is defined as a receipt or a certificate issued by the bank representing title to the
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specified number of share of a non 7+ company. The 7+ bank is the depository in this case. AC1
is the evidence of ownership of underlying shares. AC1 is freely traded in the 7+ without actual
delivery of underlying non 7+ shares.
)n this case the issuing company actively promotes the company5s AC1 in 7+A. A single
depository bank is normally chosen and an AC1 is routed through this bank.
The organisation with AC1s with securities exchange commission @+?"= is not
compulsory. Technically AC15s are different from HC1s. The size of AC1s can be expanded or
reduced. Henerally it depends upon demand as depositories bank can issue or withdraw
corresponding shares in the local market.
!"o0a" Depo#itor. Receipt 6!DR7
HC1 is a new financial instrument. 0ade its appearance in 1BB1 and became an instant
success. )t also started when company5s in countries like +outh Iorea and 0alaysia began
attracting investors from ?urope and 7+A. )nspite of the investor interest companies face
difficulties. A novel way was found and it works in this way.
A bank in ?urope ac!uires the shares of such a company and then issues its own receipts or
certificates to the investors. This bank is also called depository and such certificates are called
HC1. These HC1s can be traded on the ?uropean exchange or in private placement in 7+A. A
HC1 is a dollar denominated instrument tradable on the stock exchange in ?urope or private
placement in 7+A. HC1 represents one or more shares of the issuing company.
1eliance was the first company to issue HC1 in 0ay 1BB-, to raise 7+ J122 million. The
bookings were about 9 times the size of the issue and 1eliance retained 7+ J192 million.
Forei+n C,rrenc. Con2erti0"e $on'# 6FCC$#7
*""/s mean bonds which can be issued and subscribed by nonresidents of )ndia in
foreign currency and convertible into ordinary shares of the issuing company in any manner, i.e. in
whole, or in part.
A foreign currency convertible bond is a foreign currency dominated bond issued by a
company generally in a ?uropean or 7+ markets. A convertible bond can be exchanged for e!uity
shares at some later date after the issue of bond. "onvertible bond generally have smaller coupon
rate than nonconvertible. The advantages of *""/ are that there is no immediate dilution of
earning.
These bonds are issued and subscribed under the E)ssue of *oreign "urrency "onvertible
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bonds and $rdinary +hares +chemeF initiated by "entral government of )ndia in 1BB3.
%o,rce# of %hort4term Finance
+hort term finance is concerned with decisions relating to current assets and current
liabilities and is also called as working capital finance. +hort term financial decisions typically
involve cash flows within a year or within the operating cycle of the firm. .ormally short term
finance is for a period upto 3 years.
The main #o,rce# of %hort term finance are/
1. "ash credit
-. /ills discounting
3. 4etter of credit
6. )nter corporate deposits
9. "ommercial papers
;. *actoring
<. Aublic deposits
>. /ridge finance
Ca#h Cre'it
"ash "redit is the arrangement under which a customer is allowed and advanced upto
certain limit against credit granted by the bank. 7nder this arrangement, a customer need not
borrow entire amount of advance at one go, he can only draw to the extent of his re!uirement and
deposit his surplus funds in his account. )nterest is charged not on the full amount of advance but
on the amount actually availed by him. Henerally cash credit limits are sanctioned against the
security of goods by way of pledge or hypothecation.
O2er'raft
$verdraft arrangement is similar to the cash credit arrangement. 7nder this arrangement,
the customer is permitted to overdraw upto a prefixed limit. )nterest is charged on the amount
overdrawn sub#ect to some charge as in the case of cash credit arrangements. $verdraft accounts
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operate against security in the form of pledging of share security, assignment of the 4)" policies
and sometimes even mortgage of fixed assets.

)etter of Cre'it
+uppliers, particularly the foreign supplier insists that the buyer should ensure that his bank
would make payment if he fails to honor its obligation. This is ensured through letter of credit @4"=
arrangement. A bank opens a 4" in favour of a customer to facilitate his purchase of goods. )f the
customer doesn5t pay to the supplier within the credit period, the bank makes the payment under
the 4" arrangements. This arrangement passes the risk of supplier to the bank. /ank charges the
amount for opening 4". )t will extend such facilities to the financially sound customers.
Inter corporate Depo#it#
A deposit made by one company with another, normally for a period upto six months, is
referred to as inter corporate deposit. +uch deposits are usually are 3 types,
1. Ca"" Depo#it#/ A call deposit is withdrawable by the lender on giving a days notice. )n
practice, however the lender has to wait for at least three days. The interest on such deposit
may be around 1;K.
-. T1o month# 'epo#it#/ These are more popular in practice. These deposits are taken from
borrowers to tie over short term cash inade!uacy that may be caused by one or more of the
following factors, disruption in production, excessive imports of raw materials, tax
payment, and delay in collection, dividend payment and unplanned capital expenditure. The
interest on such deposits is around 1>K per annum.
3. %i3 month# 'epo#it#/ .ormally, lending companies do not extend deposits beyond this
time frame. +uch deposits usually made with first class borrowers. These deposits carry on
interest rate of around -2K pa.
Commercia" Paper
"ommercial paper represents short term unsecured promissory notes issued by firms, which
en#oy fairly high credit rating. Henerally, large firms with considerable financial strength are able
to issue commercial paper. The important features of commercial papers are as follows,
1. The maturity period of commercial paper ranges from B2 to 1>2 days.
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-. "ommercial paper is sold at a discount from its face value and redeemed at its face value.
(ence, the implicit interest rate is a function of the size of the discount and the period of
maturity.
3. "ommercial paper is either directly placed with investor or sold through dealers.
6. )nvestors who intend holding it till its maturity usually by commercial paper. (ence, there
is no well developed secondary market for commercial paper.
Factorin+
)n factoring accounts receivable are generally sold to a financial institution @factor= that charges
commission and bears the credit risks associated with the accounts receivable purchased by it. The
company can enter into agreement with a factor working out a factoring arrangement according to
its re!uirement. The factor then takes responsibility of monitoring, follow up, collection and risk
taking and provision of advance. *actoring offers the following advantages which makes it !uite
attractive to many firms,
1. The firm can convert accounts receivables into cash without bothering about repayment.
-. *actoring ensures a definite pattern of cash inflows.
3. "ontinuous factoring virtually eliminates the need for credit department.
6. 7nlike a unsecured loan, compensating balance is not re!uired to be kept with the financial
institution in this case.
9. *actoring relives the borrowing firm of substantial credit and collection costs and to a
degree a considerable part of cash management.
P,0"ic Depo#it#
Aublic deposits are very important source of short term and medium term finances
particularly due to credit s!ueeze by the 1eserve /ank of )ndia. These deposits may be accepted
for a period of six months to three years. Aublic deposits are unsecured loans taken from public'
they should not be used for ac!uiring fixed assets since they are to be repaid within a period of 3
years. These are mainly used to finance working capital re!uirements.
$ri'+e Finance
/ridge finance refers to loans taken by a company normally from commercial banks for a
short period, pending disbursement of loans sanctioned by financial institutions.
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Chapter 3
DECI%ION% UNDER CORPORATE FINANCE
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The decisions can be divided into longterm and shortterm decisions and techni!ues.
)on+ Term Deci#ion#
"apital investment decisions are longterm choices about which pro#ects receive
investment, whether to finance that investment with e!uity or debt, and when or whether to pay
dividends to shareholders.The capital structure of a company refers to the proportion of Cebt and
?!uity or the mixing of long term finances used by the firm.
The capital structure includes *unds received from the owners of the business i.e the
+hareholders and therefore called as shareholders funds.
The capital structure also includes /orrowed *unds, which are further divided into,
+ecured 4oans @/ank 4oans, debentures=
7nsecured )oans
The combination of the above constitutes the capital structure or the total "apital
?mployed. )t is the financial planning of the company.
%hort term 'eci#ion#
$n the other hand, the short term decisions deals with the shortterm balance of current
assets and current liabilities' the focus here is on managing cash, inventories, and shortterm
borrowing and lending @such as the terms on credit extended to customers=.
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Chapter 4
FUNCTION% OF FINANCIA) &ANA!ER
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There are three main functions of a financial manager. They are investment decision,
financing decision and dividend decision.
Capita" In2e#tment 'eci#ion#/
"apital investment decisions are longterm corporate finance decisions relating to fixed assets and
capital structure. Cecisions are based on several interrelated criteria.
o "orporate management seeks to maximize the value of the firm by investing in pro#ects
which yield a positive net present value when valued using an appropriate discount rate.
o These pro#ects must also be financed appropriately.
o )f no such opportunities exist, maximizing shareholder value dictates that management
must return excess cash to shareholders @i.e., distribution via dividends=. "apital investment
decisions thus comprise an investment decision, a financing decision, and a dividend
decision.
1. In2e#tment 'eci#ion# relates to the selection of assets in which funds will be invested
by a firm. The assets, which can be ac!uired, fall into two broad groups,
4ong term assets which yield a return over a period of time in future@"apital /udgeting=.
+hort term or current assets, defined as those assets which in normal course of business are
convertible into cash without diminution in value, usually within a year@working capital
management=.

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Chapter45
CAPITA) $UD!ETIN!
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The first and the most important decision that any firm has to make is to define the business
that it wants to be in. This decision has a significant bearing on how capital is allocated in the firm.
A plan has to be deployed to invest in buildings, machineries, e!uipment, research and
development, brands and other longlived assets. This is capital budgeting process. "onsiderable
managerial time, attention, and energy are devoted to identify, evaluate and implement investment
pro#ects. *rom a financial point of view the magnitude, timing and the risk of cash flows associated
with the pro#ect have to be studied. "apital budgeting decisions involves evaluating each
investment with respect to the related benefits and returns and also the risks and uncertainties
associated with it.
Capita" 0,'+etin+ @or investment appraisal= is the planning process used to determine whether
a firm's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development pro#ects are worth pursuing. )t is budget for ma#or capital, or
investment, expenditures.
0any formal methods are used in capital budgeting, including the techni!ues such as
Accounting rate of return
.et present value
Arofitability index
)nternal rate of return
0odified internal rate of return
?!uivalent annuity
These methods use the incremental cash flows from each potential investment, or pro#ect
Techni!ues based on accounting earnings and accounting rules are sometimes used though
economists consider this to be improper such as the accounting rate of return, and %return on
investment.%
Net present value
?ach potential pro#ect's value should be estimated using a discounted cash flow @C"*=
valuation, to find its net present value @.AL=. This valuation re!uires estimating the size and
timing of all the incremental cash flows from the pro#ect. These future cash flows are then
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discounted to determine their present value. These present values are then summed, to get the .AL.
+ee also Time value of money. The .AL decision rule is to accept all positive .AL pro#ects in an
unconstrained environment, or if pro#ects are mutually exclusive, accept the one with the highest
.AL @H?=.
The .AL is greatly affected by the discount rate, so selecting the proper rate sometimes
called the hurdle rate is critical to making the right decision. The hurdle rate is the minimum
acceptable return on an investment. )t should reflect the riskiness of the investment, typically
measured by the volatility of cash flows, and must take into account the financing mix. 0anagers
may use models such as the "AA0 or the AAT to estimate a discount rate appropriate for each
particular pro#ect, and use the weighted average cost of capital @&A""= to reflect the financing
mix selected. A common practice in choosing a discount rate for a pro#ect is to apply a &A"" that
applies to the entire firm, but a higher discount rate may be more appropriate when a pro#ect's risk
is higher than the risk of the firm as a whole.
Internal rate of return
The interna" rate of ret,rn @)11= is defined as the discount rate that gives a net present
value @.AL= of zero. )t is a commonly used measure of investment efficiency.
The )11 method will result in the same decision as the .AL method for @nonmutually
exclusive= pro#ects in an unconstrained environment, in the usual cases where a negative cash flow
occurs at the start of the pro#ect, followed by all positive cash flows. )n most realistic cases, all
independent pro#ects that have an )11 higher than the hurdle rate should be accepted.
.evertheless, for mutually exclusive pro#ects, the decision rule of taking the pro#ect with the
highest )11 which is often used may select a pro#ect with a lower .AL.
Equivalent annuity method
The e!uivalent annuity method expresses the .AL as an annualized cash flow by dividing
it by the present value of the annuity factor. )t is often used when assessing only the costs of
specific pro#ects that have the same cash inflows. )n this form it is known as the e!uivalent annual
cost @?A"= method and is the cost per year of owning and operating an asset over its entire
lifespan.
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)t is often used when comparing investment pro#ects of une!ual lifespan. *or example if
pro#ect A has an expected lifetime of < years, and pro#ect / has an expected lifetime of 11 years it
would be improper to simply compare the net present values @.ALs= of the two pro#ects, unless the
pro#ects could not be repeated.
Real options
1eal options analysis has become important since the 1B<2s as option pricing models have
gotten more sophisticated. The discounted cash flow methods essentially value pro#ects as if they
were risky bonds, with the promised cash flows known. /ut managers will have many choices of
how to increase future cash inflows, or to decrease future cash outflows. )n other words, managers
get to manage the pro#ects not simply accept or re#ect them. 1eal options analysis tries to value
the choices the option value that the managers will have in the future and adds these values to
the .AL.
Ranked Projects
The real value of capital budgeting is to rank pro#ects. 0ost organizations have many
pro#ects that could potentially be financially rewarding. $nce it has been determined that a
particular pro#ect has exceeded its hurdle, then it should be ranked against peer pro#ects @e.g.
highest Arofitability index to lowest Arofitability index=. The highest ranking pro#ects should be
implemented until the budgeted capital has been expended.
Funding Sources
&hen a corporation determines its capital budget, it must ac!uire said funds. Three
methods are generally available to publicly traded corporations, corporate bonds, preferred stock,
and common stock. The ideal mix of those funding sources is determined by the financial
managers of the firm and is related to the amount of financial risk that corporation is willing to
undertake. "orporate bonds entail the highest financial risk and therefore generally have the lowest
interest rate. Areferred stock have no financial risk but dividends, including all in arrears, must be
paid to the preferred stockholders before any cash disbursements can be made to common
stockholders' they generally have interest rates higher than those of corporate bonds. *inally,
common stocks entail no financial risk but are the most expensive way to finance capital pro8ect#.
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Pro8ect 2a",ation
?ach pro#ect's value will be estimated using a discounted cash flow @C"*= valuation, and
the opportunity with the highest value, as measured by the resultant net present value @.AL= will
be selected .This re!uires estimating the size and timing of all of the incremental cash flows
resulting from the pro#ect. +uch future cash flows are then discounted to determine their present
value. These present values are then summed, and this sum net of the initial investment outlay is
the .AL.
Three t.pe# of 9a",ation/
1. /usiness valuation
-. +tock valuation, and
3. *undamental analysis
$,#ine## 2a",ation
$,#ine## 2a",ation is a process and a set of procedures used to estimate the economic
value of an owner5s interest in a business. Laluation is used by financial market participants to
determine the price they are willing to pay or receive to consummate a sale of a business. )n
addition to estimating the selling price of a business, the same valuation tools are often used by
business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate
business purchase price among business assets, establish a formula for estimating the value of
partners' ownership interest for buysell agreements, and many other business and legal purposes.
Standard and premise of value
/efore the value of a business can be measured, the valuation assignment must specify the
reason for and circumstances surrounding the business valuation. These are formally known as the
business value standard and premise of value. The standard of value is the hypothetical conditions
under which the business will be valued. The premise of value relates to the assumptions, such as
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assuming that the business will continue forever in its current form @going concern=, or that the
value of the business lies in the proceeds from the sale of all of its assets minus the related debt
@sum of the parts or assemblage of business assets=.
/usiness valuation results can vary considerably depending upon the choice of both the
standard and premise of value. )n an actual business sale, it would be expected that the buyer and
seller, each with an incentive to achieve an optimal outcome, would determine the fair market
value of a business asset that would compete in the market for such an ac!uisition. )f the synergies
are specific to the company being valued, they may not be considered. *air value also does not
incorporate discounts for lack of control or marketability.
.ote, however, that it is possible to achieve the fair market value for a business asset that is
being li!uidated in its secondary market. This underscores the difference between the standard and
premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the
market in which the sub#ect business might be sold. (owever, these conditions are assumed
because they yield a uniform standard of value, after applying generallyaccepted valuation
techni!ues, which allows meaningful comparison between businesses which are similarly situated.
Elements of business valuation
Economic con'ition#
A business valuation report generally begins with a description of national, regional and
local economic conditions existing as of the valuation date, as well as the conditions of the industry
in which the sub#ect business operates.
Financia" Ana".#i#
The financial statement analysis generally involves common size analysis, ratio analysis
@li!uidity, turnover, profitability, etc.=, trend analysis and industry comparative analysis. This
permits the valuation analyst to compare the sub#ect company to other businesses in the same or
similar industry, and to discover trends affecting the company andMor the industry over time. /y
comparing a company5s financial statements in different time periods, the valuation expert can
view growth or decline in revenues or expenses, changes in capital structure, or other financial
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trends. (ow the sub#ect company compares to the industry will help with the risk assessment and
ultimately help determine the discount rate and the selection of market multiples.
Norma"i:ation of financia" #tatement#
The most common normalization ad#ustments fall into the following four categories,
"omparability Ad#ustments. The valuer may ad#ust the sub#ect company5s financial
statements to facilitate a comparison between the sub#ect company and other businesses in
the same industry or geographic location. These ad#ustments are intended to eliminate
differences between the way that published industry data is presented and the way that the
sub#ect company5s data is presented in its financial statements.
.onoperating Ad#ustments. )t is reasonable to assume that if a business were sold in a
hypothetical sales transaction @which is the underlying premise of the fair market value
standard=, the seller would retain any assets which were not related to the production of
earnings or price those nonoperating assets separately. *or this reason, nonoperating
assets @such as excess cash= are usually eliminated from the balance sheet.
.onrecurring Ad#ustments. The sub#ect company5s financial statements may be affected by
events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an
unusually large revenue or expense. These nonrecurring items are ad#usted so that the
financial statements will better reflect the management5s expectations of future
performance.
Ciscretionary Ad#ustments. The owners of private companies may be paid at variance from
the market level of compensation that similar executives in the industry might command. )n
order to determine fair market value, the owner5s compensation, benefits, per!uisites and
distributions must be ad#usted to industry standards. +imilarly, the rent paid by the sub#ect
business for the use of property owned by the company5s owners individually may be
scrutinized.
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Income; A##et an' &ar5et Approache#
Three different approaches are commonly used in business valuation, the income approach,
the assetbased approach, and the market approach. &ithin each of these approaches, there are
various techni!ues for determining the value of a business using the definition of value appropriate
for the appraisal assignment. Henerally, the income approaches determine value by calculating the
net present value of the benefit stream generated by the business @discounted cash flow=' the asset
based approaches determine value by adding the sum of the parts of the business @net asset value='
and the market approaches determine value by comparing the sub#ect company to other companies
in the same industry, of the same size, andMor within the same region.
A number of business valuation models can be constructed that utilize various methods
under the three business valuation approaches.
)n determining which of these approaches to use, the valuation professional must exercise
discretion. ?ach techni!ue has advantages and drawbacks, which must be considered when
applying those techni!ues to a particular sub#ect company. 0ost treatises and court decisions
encourage the valuator to consider more than one techni!ue, which must be reconciled with each
other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics
is helpful.
Income approaches
The income approaches determine fair market value by multiplying the benefit stream
generated by the sub#ect or Target "ompany times a discount or capitalization rate. The discount or
capitalization rate converts the stream of benefits into present value. There are several different
income approaches, including capitalization of earnings or cash flows, discounted future cash
flows @EC"*F=, and the excess earnings method @which is a hybrid of asset and income
approaches=. 0ost of the income approaches look to the company5s ad#usted historical financial
data for a single period' only C"* re!uires data for multiple future periods. The discount or
capitalization rate must be matched to the type of benefit stream to which it is applied. The result
of a value calculation under the income approach is generally the fair market value of a controlling,
marketable interest in the sub#ect company, since the entire benefit stream of the sub#ect company
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is most often valued, and the capitalization and discount rates are derived from statistics
concerning public companies.
Di#co,nt or capita"i:ation rate#
A discount rate or capitalization rate is used to determine the present value of the expected
returns of a business. The discount rate and capitalization rate are closely related to each other, but
distinguishable. Henerally speaking, the discount rate or capitalization rate may be defined as the
yield necessary to attract investors to a particular investment, given the risks associated with that
investment.
)n C"* valuations, the discount rate, often an estimate of the cost of capital for the business
is used to calculate the net present value of a series of pro#ected cash flows.
$n the other hand, a capitalization rate is applied in methods of business valuation that are
based on business data for a single period of time. *or example, in real estate valuations for
properties that generate cash flows, a capitalization rate may be applied to the net operating
income @.$)= @i.e., income before depreciation and interest expenses= of the property for
the trailing twelve months.
There are several different methods of determining the appropriate discount rates. The discount
rate is composed of two elements,
@1= The riskfree rate, which is the return that an investor would expect from a secure,
practically riskfree investment, such as a high !uality government bond' plus
@-= A risk premium that compensates an investor for the relative level of risk associated
with a particular investment in excess of the riskfree rate. 0ost importantly, the selected
discount or capitalization rate must be consistent with stream of benefits to which it is to be
applied.
Capita" A##et Pricin+ &o'e" 6CAP&7
The "apital Asset Aricing 0odel @"AA0= is one method of determining the appropriate
discount rate in business valuations. The "AA0 method originated from the .obel Arize winning
studies of (arry 0arkowitz, 8ames Tobin and &illiam +harpe. The "AA0 method derives the
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discount rate by adding a risk premium to the riskfree rate. )n this instance, however, the risk
premium is derived by multiplying the e!uity risk premium times Ebeta,F which is a measure of
stock price volatility. /eta is published by various sources for particular industries and companies.
/eta is associated with the systematic risks of an investment.
$ne of the criticisms of the "AA0 method is that beta is derived from the volatility of
prices of publiclytraded companies, which are likely to differ from private companies in their
capital structures, diversification of products and markets, access to credit markets, size,
management depth, and many other respects. &here private companies can be shown to be
sufficiently similar to public companies, however, the "AA0 method may be appropriate.
<ei+hte' A2era+e Co#t of Capita" 6<ACC7
The weighted average cost of capital is an approach to determining a discount rate. The
&A"" method determines the sub#ect company5s actual cost of capital by calculating the weighted
average of the company5s cost of debt and cost of e!uity. The &A"" must be applied to the
sub#ect company5s net cash flow to total invested capital.
$,i"'4Up &etho'
The /uild7p 0ethod is a widelyrecognized method of determining the aftertax net cash
flow discount rate, which in turn yields the capitalization rate. The figures used in the /uild7p
0ethod are derived from various sources. This method is called a EbuildupF method because it is
the sum of risks associated with various classes of assets. )t is based on the principle that investors
would re!uire a greater return on classes of assets that are more risky. The first element of a /uild
7p capitalization rate is the riskfree rate, which is the rate of return for longterm government
bonds. )nvestors who buy largecap e!uity stocks, which are inherently more risky than longterm
government bonds, re!uire a greater return, so the next element of the /uild7p method is the
e!uity risk premium. )n determining a company5s value, the longhorizon e!uity risk premium is
used because the "ompany5s life is assumed to be infinite. The sum of the riskfree rate and the
e!uity risk premium yields the longterm average market rate of return on large public company
stocks.
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sset!based approaches
The value of assetbased analysis of a business is e!ual to the sum of its parts. That is the
theory underlying the assetbased approaches to business valuation. The asset approach to business
valuation is based on the principle of substitution, no rational investor will pay more for the
business assets than the cost of procuring assets of similar economic utility. )n contrast to the
incomebased approaches, which re!uire the valuation professional to make sub#ective #udgments
about capitalization or discount rates, the ad#usted net book value method is relatively ob#ective.
Aursuant to accounting convention, most assets are reported on the books of the sub#ect company
at their ac!uisition value, net of depreciation where applicable. These values must be ad#usted to
fair market value wherever possible. The value of a company5s intangible assets, such as goodwill,
is generally impossible to determine apart from the company5s overall enterprise value. *or this
reason, the assetbased approach is not the most probative method of determining the value of
going business concerns. )n these cases, the assetbased approach yields a result that is probably
lesser than the fair market value of the business. )n considering an assetbased approach, the
valuation professional must consider whether the shareholder whose interest is being valued would
have any authority to access the value of the assets directly. +hareholders own shares in a
corporation, but not its assets, which are owned by the corporation. A controlling shareholder may
have the authority to direct the corporation to sell all or part of the assets it owns and to distribute
the proceeds to the shareholders. The noncontrolling shareholder, however, lacks this authority
and cannot access the value of the assets. As a result, the value of a corporation's assets is rarely the
most relevant indicator of value to a shareholder who cannot avail himself of that value. Ad#usted
net book value may be the most relevant standard of value where li!uidation is imminent or
ongoing' where a company earnings or cash flow are nominal, negative or worth less than its
assets' or where net book value is standard in the industry in which the company operates. .one of
these situations applies to the "ompany which is the sub#ect of this valuation report. (owever, the
ad#usted net book value may be used as a Esanity checkF when compared to other methods of
valuation, such as the income and market approaches.
"arket approaches
The market approach to business valuation is rooted in the economic principle of
competition, that in a free market the supply and demand forces will drive the price of business
assets to certain e!uilibrium. /uyers would not pay more for the business, and the sellers will not
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accept less, than the price of a comparable business enterprise. )t is similar in many respects to the
Ecomparable salesF method that is commonly used in real estate appraisal. The market price of the
stocks of publicly traded companies engaged in the same or a similar line of business, whose
shares are actively traded in a free and open market, can be a valid indicator of value when the
transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.
The difficulty lies in identifying public companies that are sufficiently comparable to the
sub#ect company for this purpose. Also, as for a private company, the e!uity is less li!uid @in other
words its stocks are less easy to buy or sell= than for a public company, its value is considered to be
slightly lower than such a marketbased valuation would give.
%toc5 2a",ation
)n financial markets, #toc5 2a",ation is the method of calculating theoretical values of
companies and their stocks. The main use of these methods is to predict future market prices, or
more generally potential market prices, and thus to profit from price movement : stocks that are
#udged undervalued @with respect to their theoretical value= are bought, while stocks that are
#udged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in
value, while overvalued stocks will, on the whole, fall.
)n the view of fundamental analysis, stock valuation based on fundamentals aims to give an
estimate of their intrinsic value of the stock, based on predictions of the future cash flows and
profitability of the business.
%toc5 9a",ation &etho'#
+tocks have two types of valuations. $ne is a value created using some type of cash flow,
sales or fundamental earnings analysis. The other value is dictated by how much an investor is
willing to pay for a particular share of stock and by how much other investors are willing to sell a
stock for @in other words, by supply and demand=. /oth of these values change over time as
investors change the way they analyze stocks and as they become more or less confident in the
future of stocks. 4et me discuss both types of valuations.
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*irst, the fundamental valuation. This is the valuation that people use to #ustify stock prices.
The most common example of this type of valuation methodology is AM? ratio, which stands for
Arice to ?arnings 1atio. This form of valuation is based on historic ratios and statistics and aims to
assign value to a stock based on measurable attributes. This form of valuation is typically what
drives longterm stock prices.
The other way stocks are valued is based on supply and demand. The more people that
want to buy the stock, the higher its price will be. And conversely, the more people that want to sell
the stock, the lower the price will be. This form of valuation is very hard to understand or predict,
and it often drives the shortterm stock market trends.
)n short, there are many different ways to value stocks. ) will list several of them here. The
key is to take each approach into account while formulating an overall opinion of the stock. 4ook
at each valuation techni!ue and ask yourself why the stock is valued this way. )f it is lower or
higher than other similar stocks, then try to determine why. And remember, a great company is not
always a great investment. (ere are the basic valuation techni!ues,
Earnin+# Per %hare 6EP%7 4 Nou've heard the term many times, but do you really know what it
means. ?A+ is the total net income of the company divided by the number of shares outstanding. )t
sounds simple but unfortunately it gets !uite a bit more complicated. "ompanies usually report
many ?A+ numbers.
Price to Earnin+# 6P=E 7 4 AM?s are probably the single most important valuation method because
they reflect the future growth of the company into the figure. And all stocks are priced based on
their future earnings, not on their past earnings. (owever, past earnings are sometimes a good
indicator for future earnings. AM?s are computed by taking the current stock price divided by the
sum of the ?A+ estimates for the next four !uarters, or for the ?A+ estimate for next calendar of
fiscal year or two.
!ro1th Rate Laluations rely very heavily on the expected growth rate of a company. *or
starters, you can look at the historical growth rate of both sales and income to get a feeling for
what type of future growth that you can expect. (owever, companies are constantly changing, as
well as the economy, so don't rely on historical growth rates to predict the future, but instead use
them as a guideline for what future growth could look like if similar circumstances are encountered
by the company.
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PE! Ratio4 This valuation techni!ue has really become popular over the past decade or so. )t is
better than #ust looking at a AM? because it takes three factors into account' the price, earnings, and
earnings growth rates. To compute the A?H ratio @a.k.a. Arice ?arnings to Hrowth ratio= divide the
*orward AM? by the expected earnings growth rate @you can also use historical AM? and historical
growth rate to see where it's traded in the past=. This will yield a ratio that is usually expressed as a
percentage. The theory goes that as the percentage rises over 122K the stock becomes more and
more overvalued, and as the A?H ratio falls below 122K the stock becomes more and more
undervalued. The theory is based on a belief that AM? ratios should approximate the longterm
growth rate of a company's earnings. &hether or not this is true will never be proven and the
theory is therefore #ust a rule of thumb to use in the overall valuation process.
Ret,rn on In2e#te' Capita" 6ROIC7 : This valuation techni!ue measures how much money the
company makes each year per dollar of invested capital. )nvested "apital is the amount of money
invested in the company by both stockholders and debtors. The ratio is expressed as a percent and
you should look for a percent that approximates the level of growth that you expect. )n its simplest
definition, this ratio measures the investment return that management is able to get for its capital.
The higher the number, the better the return.
Ret,rn on A##et# 6ROA7 +imilar to 1$)", 1$A, expressed as a percent, measures the
company's ability to make money from its assets. To measure the 1$A, take the pro forma net
income divided by the total assets. (owever, because of very common irregularities in balance
sheets @due to things like Hoodwill, writeoffs, discontinuations, etc.= this ratio is not always a
good indicator of the company's potential. )f the ratio is higher or lower than you expected, be sure
to look closely at the assets to see what could be over or understating the figure.
Price to %a"e# 6P=%74 This figure is useful because it compares the current stock price to the annual
sales. )n other words, it tells you how much the stock costs per dollar of sales earned. To compute
it, take the current stock price divided by the annual sales per share. The annual sales per share
should be calculated by taking the net sales for the last four !uarters divided by the fully diluted
shares outstanding. The price to sales ratio is useful, but it does not take into account any debt the
company has. *or example, if a company is heavily financed by debt instead of e!uity, then the
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sales per share will seem high @the AM+ will be lower=. All things e!ual, a lower AM+ ratio is better.
(owever, this ratio is best looked at when comparing more than one company.
&ar5et Cap4 0arket "ap, which is short for 0arket "apitalization, is the value of all of the
company's stock. To measure it, multiply the current stock price by the fully diluted shares
outstanding. 1emember, the market cap is only the value of the stock. To get a more complete
picture, you'll want to look at the ?nterprise Lalue.
Enterpri#e 9a",e 6E97 : ?nterprise Lalue is e!ual to the total value of the company, as it is
trading for on the stock market. To compute it, add the market cap @see above= and the total net
debt of the company. The total net debt is e!ual to total long and short term debt plus accounts
payable, minus accounts receivable, minus cash. The ?nterprise Lalue is the best approximation of
what a company is worth at any point in time because it takes into account the actual stock price
instead of balance sheet prices. &hen analysts say that a company is a %billion dollar% company,
they are often referring to its total enterprise value. ?nterprise Lalue fluctuates rapidly based on
stock price changes.
E9 to %a"e#4 This ratio measures the total company value as compared to its annual sales. A high
ratio means that the company's value is much more than its sales. To compute it, divide the ?L by
the net sales for the last four !uarters. This ratio is especially useful when valuing companies that
do not have earnings, or that are going through unusually rough times. *or example, if a company
is facing restructuring and it is currently losing money, then the AM? ratio would be irrelevant.
(owever, by applying a ?L to +ales ratio, you could compute what that company could trade for
when its restructuring is over and its earnings are back to normal.
E$ITDA4?/)TCA stands for earnings before interest, taxes, depreciation and amortization. )t is
one of the best measures of a company's cash flow and is used for valuing both public and private
companies. To compute ?/)TCA, use a companies income statement, take the net income and then
add back interest, taxes, depreciation, amortization and any other noncash or onetime charges.
This leaves you with a number that approximates how much cash the company is producing.
?/)TCA is a very popular figure because it can easily be compared across companies, even if all
of the companies are not profitable.
E9 to E$ITDA4 This is perhaps one of the best measurements of whether or not a company is
cheap or expensive. To compute, divide the ?L by ?/)TCA. The higher the number, the more
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expensive the company is. (owever, remember that more expensive companies are often valued
higher because they are growing faster or because they are a higher !uality company. &ith that
said, the best way to use ?LM?/)TCA is to compare it to that of other similar companies.
F,n'amenta" A na".#i#
F,n'amenta" ana".#i# of a business involves analyzing its financial statements and health,
its management and competitive advantages, and its competitors and markets. &hen applied to
futures and forex, it focuses on the overall state of the economy, interest rates, production,
earnings, and management. &hen analyzing a stock, futures contract, or currency using
fundamental analysis there are two basic approaches one can use' bottom up analysis and top down
analysis. The term is used to distinguish such analysis from other types of investment analysis,
such as !uantitative analysis and technical analysis.
*undamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible ob#ectives,
to conduct a company stock valuation and predict its probable price evolution,
to make a pro#ection on its business performance,
to evaluate its management and make internal business decisions,
to calculate its credit risk.
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Chapter4
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<OR>IN! CAPITA) &ANA!E&ENT
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&orking "apital 0anagement refers to investment in working capital @current assets
current liabilities=.The finance manager has to properly manage current assets such as cash,
inventory and account receivables. (e has to ensure trade off between li!uidity and profitability.
Ade!uate level of current assets is necessary to maintain the re!uired level of li!uiditu of funds.
$n the other hand, if the funds are idle the profitability may be low. "urrent assets are to be fully
and efficiently utilized to attain these twin ob#ectives i.e. 4i!uidity and profitability.
<or5in+ capita" @abbreviated <C= is a financial metric which represents operating li!uidity
available to a business, organization, or other entity. Along with fixed assets such as plant and
e!uipment, working capital is considered a part of operating capital. )t is calculated as current
assets minus current liabilities. )f current assets are less than current liabilities, an entity has a
1or5in+ capita" 'eficienc., also called a 1or5in+ capita" 'eficit. .et working capital is working
capital minus cash @which is a current asset= and minus interest bearing liabilities @i.e. short term
debt=. )t is a derivation of working capital, which is commonly used in valuation techni!ues such
as C"*s @Ciscounted cash flows=.
&orking "apital O "urrent Assets P "urrent 4iabilities
A company can be endowed with assets and profitability but short of li!uidity if its assets
cannot readily be converted into cash. Aositive working capital is re!uired to ensure that a firm is
able to continue its operations and that it has sufficient funds to satisfy both maturing shortterm
debt and upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable and cash.
Cecisions relating to working capital and short term financing are referred to as working
capital management. These involve managing the relationship between a firm's shortterm assets
and its shortterm liabilities.
As above, the goal of "orporate *inance is the maximization of firm value. )n the context of
long term, capital investment decisions, firm value is enhanced through appropriately selecting and
funding .AL positive investments. These investments, in turn, have implications in terms of cash
flow and cost of capital.
The goal of &orking capital management is therefore to ensure that the firm is able to operate,
and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short
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term debt and upcoming operational expenses. )n so doing, firm value is enhanced when, and if,
the return on capital exceeds the cost of capital
Deci#ion criteria
&orking capital is the amount of capital which is readily available to an organization. That
is, working capital is the difference between resources in cash or readily convertible into cash
@"urrent Assets=, and cash re!uirements @"urrent 4iabilities=. As a result, the decisions relating to
working capital are always current, i.e. short term, decisions.
)n addition to time horizon, working capital decisions differ from capital investment
decisions in terms of discounting and profitability considerations' they are also reversible to some
extent.
&orking capital management decisions are therefore not taken on the same basis as long
term decisions, and working capital management applies different criteria in decision making, the
main considerations are @1= cash flow M li!uidity and @-= profitability M return on capital @of which
cash flow is probably the more important=.
The most widely used measure of cash flow is the net operating cycle, or cash conversion
cycle. This represents the time difference between cash payment for raw materials and cash
collection for sales. The cash conversion cycle indicates the firm's ability to convert its
resources into cash. /ecause this number effectively corresponds to the time that the firm's
cash is tied up in operations and unavailable for other activities, management generally
aims at a low net count. Another measure is gross operating cycle which is the same as net
operating cycle except that it does not take into account the creditors deferral period.
The most useful measure of profitability is 1eturn on capital @1$"=. The result is shown as
a percentage, determined by dividing relevant income for the 1- months by capital
employed' 1eturn on e!uity @1$?= shows this result for the firm's shareholders. As above,
firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. 1$"
measures are therefore useful as a management tool, in that they link shortterm policy with
longterm decision making.
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&ana+ement of 1or5in+ capita"
Huided by the above criteria, management will use a combination of policies and
techni!ues for the management of working capital. These policies aim at managing the current
assets @generally cash and cash e!uivalents, inventories and debtors= and the short term financing,
such that cash flows and returns are acceptable.
Ca#h mana+ement. )dentify the cash balance which allows for the business to meet day to
day expenses, but reduces cash holding costs.
In2entor. mana+ement. )dentify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials and minimizes reordering costs
and hence increases cash flow
De0tor# mana+ement. )dentify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will be
offset by increased revenue and hence 1eturn on "apital @or vice versa=' see Ciscounts and
allowances.
%hort term financin+. )dentify the appropriate source of financing, given the cash
conversion cycle the inventory is ideally financed by credit granted by the supplier'
however, it may be necessary to utilize a bank loan @or overdraft=, or to convert debtors to
cash through factoring.
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Chapter4?
FINANCIN! DECI%ION
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The decision to finance the operations of the business enterprise, has to be made by the
finance manager. This decision is referred to as financingmix or capital structure or leverage.
"apital structure refers to the proportion of debt@fixed interest sources of financing= and e!uity
capital @variable dividend securitites=. The financing decision of a firm relates to the choice of
proportion of these sources to finance the investment re!uirements.
Achieving the goals of corporate finance re!uires that any corporate investment be financed
appropriately. As above, since both hurdle rate and cash flows will be affected, the financing mix
can impact the valuation. 0anagement must therefore identify the optimal mix of financingQthe
capital structures that result in maximum value.
The sources of financing will, generically, comprise some combination of debt and e!uity
financing. *inancing a pro#ect through debt results in a liability or obligation that must be serviced
thus entailing cash flow implications independent of the pro#ect's degree of success. ?!uity
financing is less risky with respect to cash flow commitments, but results in a dilution of
ownership, control and earnings. The cost of e!uity is also typically higher than the cost of debt
and so e!uity financing may result in an increased hurdle rate which may offset any reduction in
cash flow risk.
0anagement must also attempt to match the financing mix to the asset being financed as
closely as possible, in terms of both timing and cash flows.
$ne of the main theories of how firms make their financing decisions suggests that firms
avoid external financing while they have internal financing available and avoid new e!uity
financing while they can engage in new debt financing at reasonably low interest rates. Another
ma#or theory is the Trade$ff Theory in which firms are assumed to tradeoff the tax benefits of
debt with the bankruptcy costs of debt when making their decisions. An emerging area in finance
theory is rightfinancing whereby investment banks and corporations can enhance investment
return and company value over time by determining the right investment ob#ectives, policy
framework, institutional structure, source of financing @debt or e!uity= and expenditure framework
within a given economy and under given market conditions. $ne last theory about this decision is
the 0arket timing hypothesis which states that firms look for the cheaper type of financing
regardless of their current levels of internal resources, debt and e!uity.
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Chapter4@
DI9IDEND PO)ICA DECI%ION
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The third ma#or decision of financial management is the decision relating to the dividend
policy. Two alternatives are available in dealing with the profits of the firm they can be distributed
to the shareholders in the form of dividends or they can be retained in the business itself. The
decision as to whic hsystem should be followed forms the basis for dividend decision. *urther the
preference of the shareholders and the investment opportunities available to the firm influence the
dividend policy of the firm.
The Di2i'en' Deci#ion, in "orporate finance, is a decision made by the directors of a company. )t
relates to the amount and timing of any cash payments made to the company's stockholders. The
decision is an important one for the firm as it may influence its capital structure and stock price. )n
addition, the decision may determine the amount of taxation that stockholders pay.
There are three main factors that may influence a firm's dividend decision,
*reecash flow
Cividend clienteles
&hether to issue dividends, and what amount, is calculated mainly on the basis of the
company's inappropriate profit and its earning prospects for the coming year. )f there are no .AL
positive opportunities, i.e. pro#ects where returns exceed the hurdle rate, then management must
return excess cash to investors. These free cash flows comprise cash remaining after all business
expenses have been met.
This is the general case, however there are exceptions. *or example, investors in a Hrowth
stock, expect that the company will, almost by definition, retain earnings so as to fund growth
internally. )n other cases, even though an opportunity is currently .AL negative, management may
consider investment flexibility M potential payoffs and decide to retain cash flows.
0anagement must also decide on the form of the dividend distribution, generally as cash
dividends or via a share buyback. Larious factors may be taken into consideration, where
shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock
buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies
will pay %dividends% from stock rather than in cash.
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Chapter 4 B
%U$%IDIARA FUNCTION
6B
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Apart from the above primary functions, a finance manager also undertakes the following
subsidiary function,
1. Ca#h mana+ement , The finance manager has to ensure that all sections i.e branches,
factories, departments and units of the organisation are supplied with ade!uate funds.
+ections whic hhave excess of funds have to contribute to the central pool for the use in
other sections ehich need funds. An ade!uate supply of cash at all points of time is
absolutely essential for the smooth flow of business operations.
-. E2a",atin+ financia" performance, 0anagement control systems are often based upon
financial analysis. $ne prominent example is the 1$) @return on investment= system of
divisional control . A finance manager has to constantly review the financial performance
of the various units of the organisation.
3. Financia" ne+otiation#, A ma#or portion of the time of the finance manager is utilized in
carrying out negotiations with the financial institutions, banks and public depositors. (e
has to furnish a lot of information to these institutions and persons and has to ensure that
raising of funds is within the statues like companies Act, etc. .egotiations for outside
fnancing re!uire specialised skills.
6. Ieeping touch with stock exchange !uotations and behaviour of share prices. This involves
analyzing ma#or trends in the stock market and #udging their impact on the prices of the
shares of the company.
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Chapter 4 1C
FINANCIA) RI%> &ANA!E&ENT
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Financia" ri#5 mana+ement
1isk management is the process of measuring risk and then developing and implementing
strategies to manage that risk. *inancial risk management focuses on risks that can be managed or
hedged using traded financial instruments typically changes in commodity prices, interest rates,
foreign exchange rates and stock prices. *inancial risk management will also play an important
role in cash management.
This area is related to corporate finance in two ways. *irstly, firm exposure to business risk
is a direct result of previous )nvestment and *inancing decisions. +econdly, both disciplines share
the goal of enhancing, or preserving, firm value. All

large corporations have risk management
teams, and small firms practice informal, if not formal, risk management. There is a fundamental
debate on the value of 1isk 0anagement and shareholder value that !uestions a shareholder's
desire to optimize risk versus taking exposure to pure risk. The debate links value of risk
management in a market to the cost of bankruptcy in that market.
Cerivatives are the instruments most

commonly used in financial risk management.
/ecause uni!ue derivative contracts tend to be costly to create and monitor, the most costeffective
financial risk management methods usually involve derivatives that trade on wellestablished
financial markets or exchanges. These standard derivative instruments include options, futures
contracts, forward contracts, and swaps. 0ore customized and second generation derivatives
known as exotics trade over the counter aka $T".
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Chapter 4 11
RE)ATION%(IP <IT( OT(ER AREA% IN
FINANCE
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Re"ation#hip 1ith other area# in finance
In2e#tment 0an5in+
The terms corporate finance and corporate financier tend to be associated with investment
banking : i.e. with transactions in which capital is raised for the corporation. These may include
1aising seed, startup, development or expansion capital.
0ergers, demergers, ac!uisitions or the sale of private companies.
0ergers, demergers and takeovers of public companies, including publictoprivate deals.
0anagement buyout, buyin or similar of companies, divisions or subsidiaries : typically
backed by private e!uity.
?!uity issues by companies, including the flotation of companies on a recognised stock
exchange in order to raise capital for development andMor to restructure ownership.
1aising capital via the issue of other forms of e!uity, debt and related securities for the
refinancing and restructuring of businesses.
*inancing #oint ventures, pro#ect finance, infrastructure finance, publicprivate partnerships
and privatisations.
+econdary e!uity issues, whether by means of private placing or further issues on a stock
market, especially where linked to one of the transactions listed above.
1aising debt and restructuring debt, especially when linked to the types of transactions
listed above.
Per#ona" an' p,0"ic finance
"orporate finance utilizes tools from almost all areas of finance. +ome of the tools
developed by and for corporations have broad application to entities other than corporations, for
example, to partnerships, sole proprietorships, notforprofit organizations, governments, mutual
funds, and personal wealth management. /ut in other cases their application is very limited outside
of the corporate finance arena. /ecause corporations deal in !uantities of money much greater than
96
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individuals, the analysis has developed into a discipline of its own. )t can be differentiated from
personal finance and public finance
)i#t of $an5# in In'ia 1hich +i2e# financia" a##i#tance to corporate #ector 4
A/. A01$ /ank
Andhra /ank
Axis /ank
/ank of /aroda
/ank $f )ndia
/arclays /ank
"anara /ank
"entral /ank of )ndia
"itibank
"orporation /ank
Cena /ank
Ceutsche /ank
H? *inancial
(C*" (+/"
)")")
)C/)
)ndiabulls *inancial +ervices
)ndian /ank )ndian $verseas /ank
).H Lysya
Iotak 0ahindra /ank
4)" (ousing *inance "orporation
.ational (ousing /ank
$riental /ank of "ommerce
A./ Aun#ab R +ind /ank
1eliance 0oney
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+/) +tandard "hartered
+yndicate /ank
7nion /ank of )ndia


Data Ana".#i#
*rom the above research conducted ) have analysed that companies raise their funds mainly
through two sources namely internal and external source. "ompanies can raise funds through this
source in order to meet their short term and long term re!uirements. These funds help the company
to meet their goals and achieve their ob#ectives. )t also helps them to expand their business and
enter into new markets and grow their business.
/anks grant term loans to business organizations. Term loans are also sources of finance. /ank
before granting loans undertakes pro#ect appraisal in order to check the feasibility of the pro#ects.

"orporate +tructure of every firm is mainly a mixture of Cebt and e!uity. The debt e!uity ratio
is decided by the firms based on the risks which they are above to undertake and the amount of
funds available with them.
?very company measures its performance with the help of various ratios such as &e usually
calculate "urrent 1atio, Aroprietors5 1atio, Cebt?!uity 1atio, Cebtors Turnover 1atio, 1eturn on
"apital ?mployed which helps the company to #udge the existing performance. These ratios
calculated help the company to take various decisions for the current and future pro#ects.
"ompanies also calculate the ?conomic value Added i.e. the remaining surplus with the firm
after paying off all the dues. "ompanies also compare their share prices prevailing in the market
with that of the face value of the shares. )t helps them to analyse their performance and formulate
new strategies to beat competition and be a leader in the market.
9;
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Recommen'ation#
Fo""o1in+ are a fe1 recommen'ation# for the compan. in or'er to ha2e a #o,n' corporate
#tr,ct,re4
The company can raise additional funds by Cebt as the ratio of debt is very lower as
compared to that of e!uity. ?!uity capital is costlier than debt as the returns vary as per the
profits earned.
The company can issue debentures as the rate of interest is fixed, the company can earn
huge profits which it can return it to the shareholders and also retain a part of it for future
expansion.
The company in order to attract new clients can extend its credit period from existing
32days to 69days so that debtors get enough time to make payments.
The company can also take the advice of experts so that they have sound financial pattern
as the existing pattern in not a perfect structure for the firm. &hen the company takes the
help of experts, it can further take correct decisions regarding the risks it can undertaken
with a change in the debte!uity ratio.
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Conc",#ion

*rom the above research conducted ) conclude that the financial structure of the firm is mainly
a combination if various sources of funds. "orporate firms by effectively utilizing the funds to a
productive purpose make huge profits for the risks undertaken and then distribute the same as per
the predetermined ratio. *or success of every company, it has to depend on various hands which
help the company to achieve its target and keep expanding in the business world.
?very firm has different pattern of raising funds. They have various options available with
them in order to expand their business. +o the corporate structure of one firm is not at all similar to
another as the risk undertaken by the firm differs from one another.
&hen the company makes proper analysis of every pro#ect and accordingly selects the right
pro#ect. The selected pro#ect should fulfill the criteria of lesser payback period and higher .et
Aresent Lalue. The company should also discount its future inflows so that the exact earnings in the
future can be calculated. Thus it actually helps the company to have a sound inflow pattern for the
business.

The decision regarding the investment of funds is very crucial as one wrong decision will
strongly affect the financial structure of the company.
) also conclude that the various sources of funds have its own advantages and disadvantages.
Cepending upon the needs of the company and the risk it is ready to undertake, corporate firms opt
a particular source of fund. The decision regarding from where to collect funds is also very
important for every business as they re!uire a proper amount of funds to carry out their business
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activities.
9ario,# Ratio#4 An O2er2ie1
1atios help the +takeholders to #udge the performance of the "ompany
Ratio Form,"a In',#tr.
%tan'ar'
"urrent 1atio "urrent Assets
"urrent 4iabilities
-,1
Suick 1atio Suick Assets
Suick 4iabilities
1,1
Aroprietors5 1atio +hareholders5 ?!uity
Total Assets
;2<9K
proprietors
fund
"apital Hearing 1atio Areference "apitalTlong term loans
UUUUUUUUUUUUUUUUUUUUUUUUUUUUU
?!uity "apital plus 1eserves R +urplus
less Arofit R 4oss AMc less
0iscellaneous ?xpenditure
(ighly geared
ratio is
preferable
Cebt?!uity 1atio Cebt
?!uity
-,1
+tock to &orking "apital
1atio
"losing +tock
&orking "apital
1,1
1eturn on "apital ?mployed .et Arofit before )nterest R Tax
9B
*100
*100
*10
0
CORPORATE FINANCE
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Total *unds ?mployed
1eturn on Aroprietors *und .et Arofit after Tax
Aroprietor5s *unds

1eturn on ?!uity "apital .et Arofit after Tax less


preference Cividend
Aaid up ?!uity "apital

?arnings Aer +hare .et Arofit after Tax less preference


Cividend
.umber of ?!uity +hares

CividendAayout 1atio Cividend per ?!uity +hare


?arnings per ?!uity +hare

Arice?arning 1atio 0arket Arice of a +hare


?arnings per ?!uity +hare

Cebt+ervice "overage 1atio Arofit T Cepreciation Taxes


)nterest T 4oan 1epayment )nstallment

)nterest "overage 1atio


?/)T
)nterest ?xpenses

Cebtors Turnover 1atio .et credit +ales


Average Cebtors or /ills 1eceivables

"reditors Turnover 1atio .et "redit Aurchase


Average "reditors or /ills Aayable

?conomic Lalue Added Arofit After Tax @&A""V"apital


?mployed=

0arket Lalue Added 0arket Lalue of the *irm : ?conomic


"apital

;2
*10
0
*100
*100
*100
CORPORATE FINANCE
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$I$)IO!RAP(A
%econ'ar. Data/ collected through referring various books, newspaper and internet.
*ollowing are the books referred for colleting the data
Tata 0cHraw(ill Aublishing "o. +tephen A 1oss, 1andolph & &esterfeild and 8effery 8affe
Arinciples of "orporate *inance @0cgraw (ill +eries in *inance= 1ichard A. /realey and
+tewart ". 0yers
+pecial +tudies )n *inanceLipul Aublications Arvind Chond
*inancial 0anagement Lipul Aublications Arvind Chond
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<E$)IO!RAP(A
http,MMen.wikipedia.orgMwikiM"orporateUfinance
http,MMwww.economywatch.comMfinanceMcorporatefinance
http,MMwww.!uickmba.comMfinanceMcf
http,MMweb.mit.eduMcareerMwwwMguideMfinance.pdf
;-