Finance

1.

What is finance? A branch of economics concerned with resource allocation as well as resource management, acquisition and investment. It is the commercial activity of providing funds and capital.

2.

What is capital budgeting?
Capital budgeting (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 projects are worth pursuing.

3.

Which method is btr?
Below-Target-Risk (BTR) - The expected value of unfavorable deviations of a random variable from a specified target level.

4.

How do u arrive at the free cash flows?
To arrive at free cash flow, take net cash flow from operating activities and subtract dividends and purchases of plant assets and add in sales of plant and equipment assets.

5.

What is accrued cash flows?
An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition.

6.

Why is depreciation added back?
Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.

7.

What if there is a mismatch between npv & irr? How do u select?

Conflicts between NPV and IRR can arise in numerous circumstances: different lives, different sizes, different risk factors, or different timing of cash flows. The underlying cause of the conflict resides in the assumption of cash flow reinvestment. The process of discounting and time value of money is predicated on interest compounding and discounting (defined in Chapter 2) is predicated on what discount rate is chosen. In IRR calculation, the implied interest rate of reinvestment of cash flows is IRR itself. In NPV calculation, it is the discount rate. Which of the two methods is correct depends on the choice of what is a more realistic rate of reinvestment of cash flows: IRR or discount rate. Most often the reinvestment opportunities that a company has are those that can earn its weighted average cost of capital, because it is what its projects earn on average. Relying on an assumption of weight average cost of capital as the reinvestment opportunity is also more conservative. Thus, NPV is most often the safest basis for decision. But that may not be always the case. For instance, choosing projects that have positive NPV implies that they earn a higher return than risk adjusted cost of capital. This implies that we expect opportunities for reinvestment of cash flows at higher rates. Higher rates of return can also be required when future inflation is anticipated. To investigate the impact of cash flow reinvestment opportunity, advanced textbooks in financial management recommend calculating an adjusted NPV and an adjusted IRR. These are obtained by first calculating a terminal value which is the future value of cash flows compounded at the opportunity rate of reinvestment. Then the terminal value is discounted to the present using the weighted average cost of capital. Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include: • NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; • Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;

• The IRR Method cannot be used to evaluate projects where there are changing cash Flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); • However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,

Can npv be negative? If the NPV of a prospective project is positive. Simplistically stated. accounting. If NPV is less than 0.• While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project. 12. rather than short-term . The IRR method always gives the same recommendation. • Applying NPV using different discount rates will result in different recommendations. Debt capital usually refers to long-term capital. negative. Thus. it should be accepted. which is to say. What is capital? Assets available for use in the production of further assets. 9. 11. Why assets are equal to liabilities? One of the most important things to understand about the balance sheet is that it must always balance. Is debt a part of capital? Debt capital is funds supplied by lenders that are part of a firm's capital structure. the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. is preferable to a larger project that will generate more cash. the project should probably be rejected because cash flows will also be negative. 8. However. specifically bonds. assets are Anything tangible economic or resources that owned by business usually intangible one possesses. assets are things of value that can be readily converted into cash (although cash itself is also considered an asset). the project should not be immediately rejected. considered as applicable to the payment of one's debts is considered an asset. Total assets will always equal total liabilities plus total equity. Sometimes companies have to execute an NPVnegative project if not executing it creates even more value destruction. if NPV is negative. What are assets? In financial or company. you know for sure that the company's liabilities and equity increased by the same amount. 10. if a company's assets increase from one period to the next.

Put another way. however. Equity = Proprietor's funds] ii) Capital Gearing Ratio Fixed cost funds Funds not carrying fixed cost -do-do- 1:1 60% to 75% -do- 2:1 -do- 2:1 . 13.although bankruptcy is probably near.Debit balances of P & L A/c and Miscellaneous Expenses] Capitalisation i) Debt Equity Ratio Debt Equity [Debt = Long/Short-term loans. ACCOUNTING RATIOS To test Liquidity and Solvency Name of Ratio i) Current Ratio Formula Current Assets Current Liabilities Parties interested Short-term creditors. If the short-term debt is continually rolled over. What is net worth of a firm? Net worth is total assets minus its total liabilities.Bank Overdraft . and it will have trouble paying its bills in hard times. it can be considered relatively permanent and thus debt capital. 14. investors. which represents creditors' interest.Stock Prepaid Expenses Current Liabilities . money lenders & like parties -do- Industry norm 2:1 ii) Liquid/Quick/ Acid Test Ratio Current assets . bills.loans to be paid off within one year. But a high net worth company with few liabilities may be squandering opportunities by refusing to take out loans.). as opposed to liabilities.Prereceived Income 1:1 iii) Absolute Liquid Cash + Marketable securities Ratio iv) Proprietary Ratio Quick Liabilities Proprietor's Fund Total Assets [Proprietor's funds = Equity Capital + Preference Capital + Reserves and Surplus + Accumulated funds . net worth represents the owners' interest in company assets. etc. its assets are mostly financed by debt. If a firm has little net worth. debentures. (A company can have negative net worth -.liabilities exceed assets -. What are the different ratios? Explain each.

Investors � -do� -do� Net profit x 100 Capital employed [Capital employed = Fixed Assets + Current Assets Current Liabilities]. of Equity Shares Total Dividend paid to ordinary shareholders Number of ordinary shares Cost of goods sold Average Stock Debtors + Bills receivable x 365 Net Credit sales Credit sales Avg. Debentures.) . Longterm Creditors. expenses]. Profit after tax Proprietor's funds -do� -do� i) Gross Profit Ratio Gross Profit x 100 Net sales Shareholders. iii) Return on Capital Employed (ROCE) iv) Return on Proprietors fund v) Return on Capital vi) Earnings per share [EPS] vii) Dividend per share [DPS] Management efficiency ii) Debtors Turnover Ratio iii) Debtor's Turnover Rate iv) Creditor's Turnover Ratio v) Creditor's i) Stock Turnover Profit after tax less pref. Government -do5% to 10% 20% to 30% . Bal. financial institutions.P & L A/c (Dr. Profit before tax or Profit after tax]. Profitability and management efficiency ii) Net Profit Ratio Net Profit x 100 Net sales [Net profit may be either Operating Net profit. Loans from banks. Debtors + Bills receivable Creditors + Bills payable x 365 Credit purchases Credit purchases -doManagement 60 to 90 days Management Management 5 to 6 times 45 to 60 days Shareholders. other unsecured loans]. [Funds not carrying fixed cost = Equity share capital + undistributed profit . Dividend x 100 Equity Share Capital Profit after tax less pref.Misc.[Fixed cost funds = Preference share capital. Dividend Total No.

2) Returned to owners eg a ‘dividend’. speculators Earnings per share (EPS) 15. The ratios investors look at most often. Dividend) Equity Dividend Net profit (before Interest & Tax) (PBIT) Fixed interests & charges Debentureholders. creditors. called the income statement in the US.Turnover Rate vi) Operating Ratio Average Creditors Operating Costs x 100 Net sales [Operating Cost = Cost of goods sold + Operating expenses (viz. investors. Administrative. . Explain the P&L Account? The diff stages of a P&L a/c and what do u obtain? The profit and loss account (P & L). lenders Management shareholders Management between net profit ratio Fixed expenses to total cost ratio Material consumption to sales ratio Wages to sales ratio Fixed expenses Total cost Material consumption Sales Wages Sales Management The future market Price earning ratio price of a share Market price of a share (MPS) Investors. selling & finance expenses)] Number of times preference by net profit Number of times equity dividends covered by net profit Number of times fixed interest covered by net profit Relationship and total fixed charges The idle capacity in the Organisation Material consumption to sales Wages to sales Preference shareholders' Net profit (after Interest & Tax Preference but before equity dividend) Preference Dividend Net profit (after interest. such as the PE andyield. shows the profit or loss a company has made over a period of time. tax & Equity shareholders Pref. 1) Retained for future investment and growth. Loan creditors shareholders dividends covered coverage ratio Equity shareholder's coverage ratio Interest coverage ratio Total coverage Net profit (before Interest & Tax) (PBIT) Total fixed charges Shareholders. Profits are ‘spent’ in three ways. are calculated using numbers from the P & L. 3) Paid as tax.

2) The Profit and Loss Account proper This starts with the Gross Profit and adds to it any further costs and revenues. It is a popular benchmark used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company. the easier it is to obtain a loan.Parts of the Profit and Loss Account: The Profit & Loss Account aims to monitor profit. What is cost of capital? The cost of capital is the cost of a company's funds (both debt and equity). it might be buying goods wholesale and selling them retail. An example is income received from investments. 1) The Trading Account. including overheads. DSCR = Annual Net Income + Amortization/Depreciation + other non-cash and discretionary items (such as non-contractual management bonuses) / Principal Repayment + Interest payments + Lease payments 17. 16. This records the money in (revenue) and out (costs) of the business as a result of the business’ ‘trading’ ie buying and selling. from an investor's point of view "the expected return on a portfolio of all the company's existing securities”. These further costs and revenues are from any other activities not directly related to trading. or. This shows how the profit is ‘appropriated’ or divided between the three uses mentioned above. thus setting a benchmark that a new project has to meet. It has three parts. principal and lease payments. This might be buying raw materials and selling finished goods. 3) The Appropriation Account. is the ratio of cash available for debt servicing to interest. The figure at the end of this section is theGross Profit. . Wat is debt service coverage ratio? The debt service coverage ratio (DSCR).

18. while being aware of the priceto-sales ratio of other companies in the industry. The time value of money is represented by the risk-free (Rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. . What is the different M&A valuation techniques? There are many legitimate ways to value companies. acquire property and get the right equipment. Here are just a few of them: 1. an acquiring company makes an offer that is a multiple of the earnings of the target company. DCF is tricky to get right. it takes a long time to assemble good management.capital expenditures change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly. 19. What is CAPM? Explain the different elements.people and ideas . This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-Rf). the acquiring company makes an offer as a multiple of the revenues.  Enterprise-Value-to-Sales Ratio (EV/Sales) . Replacement Cost . Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. suppose the value of a company is simply the sum of all its equipment and staffing costs. For simplicity's sake. A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The most common method is to look at comparable companies in an industry.are hard to value and develop. The acquiring company can literally order the target to sell at that price. 2.A key valuation tool in M&A.The following are two examples of the many comparative metrics on which acquiring companies may base their offers:  Price-Earnings Ratio (P/E Ratio) . 3. or it will create a competitor for the same cost. Naturally.With this ratio.In a few cases.With the use of this ratio. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets . but deal makers employ a variety of other methods and tools when assessing a target company. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. but few tools can rival this valuation method. Discounted Cash Flow (DCF) . Comparative Ratios . again. acquisitions are based on the cost of replacing the target company. discounted cash flow analysis determines a company's current value according to its estimated future cash flows. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. Forecasted free cash flows (net income + depreciation/amortization .

often prevent the expected benefits from being fully achieved. companies have a bad habit of biting off more than they can chew in mergers. investors should start by looking for some of these simple criteria:  A reasonable purchase price . acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. For sellers. marketing. For buyers. the synergy promised by deal makers might just fall short. They . 20. requires synergy of stellar proportions for the deal to make sense. Alas.  Cash transactions . resource. 10% above the market price seems within the bounds of level-headedness. say. discipline can go by the wayside. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. What to Look For It's hard for investors to know when a deal is worthwhile. Synergy is hard to create from companies in disparate business areas. It also involves issues related to business concerns such as competition. Let's face it. on the other hand. the success of a merger is measured by whether the value of the buyer is enhanced by the action. it would be highly unlikely for rational owners to sell if they would benefit more by not selling. that premium represents their company's future prospects. A premium of 50%. regardless of what pre-merger valuation tells them. However.  Sensible appetite – An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. That means buyers will need to pay a premium if they hope to acquire the company. Why do firms go for M&A apart from synergy? The reasons to merge or acquire are varied. product.A premium of. To find mergers that have a chance of success. Sadly. which we discuss in part five. a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy. The burden of proof should fall on the acquiring company. The equation solves for the minimum required synergy: In other words. the practical constraints of mergers. When stock is used as the currency for acquisition.Synergy: The Premium for Potential Success For the most part. The justification for doing so nearly always boils down to the notion of synergy.Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. efficiency. and tax issues. the premium represents part of the post-merger synergy they expect can be achieved. These range from acquiring market share and restructuring corporate structure to meeting global competition. Stay away from companies that participate in such contests.

It reduces competition. that larger firms exhibit economies of scale when compared to smaller firms). acquisition. and thereby maximize shareholder wealth. Acquisitions or takeovers occur between the bidding and the target company. takeover? Merger is a financial tool that is used for enhancing long-term profitability by expanding their operations. Mergers occur when the merging companies have their mutual consent. Reverse takeover occurs when the target firm is larger than the bidding firm. If the target company is publicly traded. This is often the stated motive for mergers in the financial services industry. . Eliminate Competition One important reason that companies combine is to eliminate competition. a merger is a combination of two companies to form a new company. while an acquisition is the purchase of one company by another in which no new company is formed. Takeover: A corporate action where an acquiring company makes a bid for an acquiree.can also occur because of some very personal reasons such as retirement and family concerns. Acquiring a competitor is an excellent way to improve a firm's position in the marketplace. one way to grow is to combine with other small firms until the firm is optimally sized. 21. There may be either hostile or friendly takeovers. the acquiring company will make an offer for the outstanding shares. firms may benefit on a cost basis from being a certain size.. Whats the difference btwn merger. and allows the acquiring firm to use the target's resources and expertise. In the course of acquisitions the bidder may purchase the share or the assets of the target company. In simple words. the assumption is that larger firms are more cost-effective than are smaller firms (i. As far as economic theory is concerned. Generally. Clearly. major reasons are explained below: Cost Efficiency and the Long-Range Average Cost Curve Due to technology and market conditions. Corporate Greed Some people say that mergers and acquisitions occur because the greedy corporations want to acquire everything. the primary objective of a firm is to maximize profits. However.e.

although they applied fair value accounting.22. What are the accounting requirements for M&A? New standards effective at the beginning of 2009 will impact the accounting for mergers and acquisitions. appraisers and other advisors. Instead. these costs were capitalized as part of the overall purchase price for an acquisition.that is. IN-PROCESS R&D In-process research and development will continue to be measured at fair value on the acquisition date. earnings in the period prior to the acquisition will be negatively impacted. earn-outs and other contingent consideration are to be recorded at fair value at the date of the acquisition. rather than the announcement date. However. Therefore. the acquirer's restructuring plan must be in place at the date of the acquisition. TRANSACTION COSTS M&A transaction costs typically include payments to investment bankers. focused more on an accumulation of costs related to the acquisition (called the purchase method). attorneys. costs to restructure the operations of an acquired company can be recognized as part of the acquisition accounting only if certain conditions are met . it would not be adjusted for changes in fair value in subsequent periods. EARN-OUTS Previously. ACQUISITION DATES The acquisition date is the closing date of the transaction. FAIR VALUE ACCOUNTING The focus of the new standards is on the use of fair value accounting. these costs will be expensed as incurred. In other words. By contrast. If equity securities are issued as all or a part of the purchase price. these assets will no longer be written off as a one-time expense immediately after the acquisition. accountants. because they are considered incremental costs to the transaction and not a component of the fair value of the business acquired. The cost of these restructurings will be charged to earnings in the post-acquisition period. Under the new standards. regardless of the likelihood of payment. these costs were recorded as a liability at the time of the acquisition. Subsequent changes in the fair value of most contingent consideration will be recorded in earnings. RESTRUCTURING COSTS Under the new standards. subject to impairment until completion. Under the new standards. earn-outs were considered part of the acquisition cost. these will be measured on the closing date. Previously. However. if the contingent condition is classified as equity. IPR&D will be capitalized and recorded as an indefinite-lived intangible asset. . the former standards. resulting in higher goodwill. all assets acquired and liabilities assumed in an acquisition are to be measured at their fair values on the date of acquisition (called the acquisition method). Abandoned projects will be written off as an expense. Previously.

. thus reducing the likelihood of having to revise prior-period statements. Although options can be traded on a variety of swaps. i. FRAs are over-the counter derivatives. and netted. are indeed significant. The resulting changes. FAIR GAME In summary. swaps. bonds. and receives a floating interest rate equal to a reference rate (the underlying rate). index. 23. FRA’s. The contracts are traded on a futures exchange. The reference rate is fixed one or two days before the effective date. but not the obligation. options. rights or warrants. changes in the value of the acquirer's stock after the announcement date and before closing will have an impact on the amount of the purchase price for accounting purposes. ADJUSTMENTS As was the case before. A forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate.Therefore.e. A futures contract is a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future and at a market-determined price (the futures price). value or condition (known as the underlying asset). A swap is a combination of FRAs. although they may not at first blush appear to be dramatic. only the differential is paid. A swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. However. futures. A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. to engage in a future transaction on some underlying security. the new standards require that prior-period statements be revised to record any material adjustments of the estimated provisional amounts recorded at the acquisition date. A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Option is an instrument that conveys the right. dependent on the market convention for the particular currency. forwards. They are still securities. What are derivatives. the term "swaption" typically refers to options on interest rate swaps. The payments are calculated over a notional amount over a certain period. event. however. though they are a type of derivative contract. This will likely increase the due diligence efforts to provide more accurate estimates. companies will have a one-year period of time to recognize adjustments to the provisional values that are recorded. or in a futures contract. It is paid on the effective date. fair value accounting is pervasive throughout the new standard. swaptions? A derivative is a financial instrument that is derived from some other asset. Futures contracts are not "direct" securities like stocks.

. This strategy will lose money if the underlier appreciates by an amount greater than the option premium. The payoff diagram for a short call is illustrated below: Payoff of a Short Call Position The payoff of a short call equals the option premium received for the option less any intrinsic value of the option at expiration. the position will be profitable. Long call Pay-off diagram below represents the effective pay-off of a long call position of an option at the time of the expiry date. A long put strategy breaks even if the underlier falls by an amount equal to the option premium. If the underlier falls further than that. Draw long call. long put. short call & short put? Payoff of a Long Put Position The payoff of a long put equals any intrinsic value of the option at expiration less the premium paid for the option. It looks at the option from the point of view of buyer.24.

The break even point is $4. .50 at this time. It looks at the option from the point of view of seller. there will be a linear relationship between the share price and the profit. less the option premium.50.50 (the different between the exercise price. If at expiry date. The break even point for this trade is $5. Assume he bought a call option (strike price is $5 and premium is 50 cent). If the share price has moved up to $6 by the option expiry date.50. the underlying share is trading at a point between $5 and $5. However if the share price drops. the seller will receive full premium if the share price is at or above $5 strike price.50) Short put Pay-off diagram below shows the effective pay-off of a short put position of an option at the time of the expiry date. he will be able to recover portion of the premium by exercising the option. and the current share price. If the share is above $5. there is a linear relationship between the index and the loss made on this position. where the profit is equal to the loss incurred. which is $5.50.If a trader believes the share of a company is on the rise. the profit on the option will be $0. In this example. he can purchase a call option without buying the share. which is $0.

1. These were evidently standardised contracts. What are the different option strategies? There is a wide variety of different option strategies. Buying Leaps. 3. Buying short term options. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka. As long as the stock does not go past the strike price of the option the option would expire worthless and you would walk away with the premium. However. 5. This strategy tries to capture an income from the market by Selling out of the money options and collecting the premium. the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. The first one is that you are limited to selling call. Selling short term options. The only difference is that you buy the leap or the right to buy a stock at a given price and sell short term calls. There are only two major differences. Below is a list of the different things you can do with options. Selling covered calls. Who discovered derivatives? The history of derivatives is surprisingly longer than what most people think.25. Japan around 1650. This strategy is not for the long term but seeks to take advantage of sudden swings. If you get called out you can buy the stock with the leap and sell it. the largest derivative exchange in the world. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. The Chicago Board of Trade (CBOT). futures contracts have remained more or less in the same form. as we know them today. . 4. 26. Because a leap is normally one to two years out you would have a long term perspective with the power of leverage on your side as well. This is similar to selling short term options. This is similar to the covered call strategy. was established in 1848 where forward contracts on various commodities were standardised around 1865. or overproduction. Unlike short term options the leap is said to take advantage if the longer term prospective on a stock. each with their own advantages and disadvantages. The second is you buy the stock first so that if the stock goes above your strike price and you have to sell you do not have to buy the stock at a higher price and sell it at a lower price. You already have the stock so you will just sell the stock you already own. Forming a diagonal spread. which made them much like today's futures. 2. From then on. This can be beneficial if you believe that a stock is going to make a big move anytime soon.

however. the return to equity that investors have contributed to the firm) into three distinct elements. 28. Using this formula. Du Pont analysis relies upon the accounting identity. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). Basic formula ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)    Operating efficiency (measured by profit margin) Asset use efficiency (measured by asset turnover) Financial leverage (measured by equity multiplier) ROE analysis The Du Pont identity breaks down Return on Equity (that is. Variations may be used in certain industries.27. as long as they also respect the underlying structure of the Du Pont identity.t is the time to maturity  S is the spot price of the underlying asset  K is the strike price . that is. DuPont Model or the DuPont method) is an expression which breaks ROE (Return on Equity) into three parts. that do not use certain concepts or for which the concepts are less meaningful. such as investment banking. the value of a call option in terms of the Black–Scholes parameters is: The price of a put option is: For both. It is obtained by solving the Black–Scholes PDE . is less useful for some industries. What is the black schole’s formula? The Black Scholes formula is used for obtaining the price of European put and call options. The Du Pont identity. as above:  N(•) is the cumulative distribution function of the standard normal distribution  T . a statement (formula) that is by definition true.see derivation below. What is the DU PONT formula? DuPont analysis (also known as the DuPont identity.

Stock or company specific risk Credit or Default Risk . respectively. the opportunity may be a good one. bankruptcy costs. which is used to evaluate the potential for investment.Politcal stability of a country Execution risk . r is the risk free rate (annual rate. and neither of these is the true probability of expiring in-the-money under the real probability measure. What is the M&M theory? The Modigliani-Miller theorem (of Franco Modigliani. What are the different types of risks? Systematic Risk or market risk Unsystematic Risk .the time between when you see your price and when the trade actually goes to the market. 31.will your money depreciate when you buy an asset in another country? Interest Rate Risk . in the absence of taxes. The equivalent martingale probability measure is also called the risk-neutral probability measure. the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. What is the DCF method? A valuation method used to estimate the attractiveness of an investment opportunity.will the central bank raise interest rates Political Risk . Therefore. Merton Miller) forms the basis for modern thinking on capital structure. expressed in terms of continuous compounding)  σ is the volatility in the log-returns of the underlying Interpretation N(d1) and N(d2) are the probabilities of the option expiring in-the-money under the equivalent exponential martingale probability measure (numéraire = stock) and the equivalent martingale probability measure (numéraire = risk free asset). If the value arrived at through DCF analysis is higher than the current cost of the investment. and asymmetric information. the value of a firm is unaffected by how that firm is financed. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value. Note that both of these are probabilities in a measure theoretic sense. It does not matter what the firm's dividend policy is.can they pay the interest on the load or the dividend on that stock Country Risk . 30. under a certain market price process (the classical random walk).Measure of politcial and economic stability Foreign Exchange Risk . and in an efficient market. 29. It does not matter if the firm's capital is raised by issuing stock or selling debt. . The basic theorem states that.

According to the model. i. 33. Bird in the hand: Investors prefer a high payout. Dividend Irrelevance Theory  Investors are indifferent between dividends and retention-generated capital gains. Need empirical test.. If they don’t want cash.. it is only the firms' investment policy that will have an impact on the share value of the firm and hence should be given more importance. Bird-in-the-Hand Theory   Investors think dividends are less risky than potential future capital gains. a high payout results in a low P0. This model which was based on a few assumptions sidelined the importance of the dividend policy and its effects thereof on the share price of the firm. investors would value high payout firms more highly. hence may not be true. Tax Preference Theory   Retained earnings lead to long-term capital gains.e. a high payout would result in a high P0. hence they like dividends. Miller and Modigliani Model Miller and Modigliani have propounded the MM hypothesis to explain the irrelevance of a firm's dividend policy.   Modigliani-Miller support irrelevance.32. they can use dividends to buy stock. Critical Assumptions This model is based on the following assumptions . What is the traditional theory of capital structure? The theory that an optimal capital structure exists. What are the different dividend policy theory? There are three theories:    Dividends are irrelevant: Investors don’t care about payout. Theory is based on unrealistic assumptions (no taxes or brokerage costs). If so. they can sell stock.e. Capital gains taxes are also deferred. If they want cash. Tax preference: Investors prefer a low payout. i. hence growth. which are taxed at lower rates than dividends. This could cause investors to prefer firms with low payouts. where the WACC is minimized and market value is maximized.

This model assumes that the basis of the valuation of stock is:    The Current Dividend Growth of the Dividend Required Rate of Return The formula for the Dividend Growth Model is: Value = (Current Dividend * (1 + Dividend Growth)) / (Required Return . it was also assumed that the investors are able to forecast the future earnings. The optimal ratio needs to be carefully determined for each individual situation. The working capital ratio is calculated as: Positive working capital means that the company is able to pay off its short-term liabilities. 4. Negative working capital means that a company currently is unable to meet its shortterm liabilities with its current assets (cash. In perfect market condition there is easy access to information and the flotation and the transaction costs do not exist. The securities are infinitely divisible and hence no single investor is big enough to influence the share price. 'A stock valuation model that deals with dividends and their growth. discounted to today'. If the long-term prospects are so poor that a company can never make sufficient profits to benefit from leverage then the opportunity is probably not worth pursuing. It is unlikely that this ratio will consist of 100% equity. it is assumed that there are no taxes. or the "working capital ratio". 3. Also known as "net working capital".Dividend Growth) 34. 35. Finally. 2. What is working capital? A measure of both a company's efficiency and its short-term financial health. The first assumption is the existence of a perfect market in which all investors are rational. the dividends and the share value of the firm with certainty. which will not change the risk complexion not the rate of return even in cases where the investments are funded by the retained earnings. How do decide what is the risk taking capacity of the company to decide what is the optimal combination of debt & equity? Investments into companies usually require both debt and equity. implying that there are no differential tax rates for the dividend income and the capital gains. Conversely. . Dividend Growth Model is.1. The third assumption is a constant investment policy of the firm. Secondly. accounts receivable and inventory).

The result is that the cost of capital declines with debt and reaches a minimum point before rising again.  Modigliani-Miler Approach: The Modigliani-Miller theorem forms the basis for modern thinking on capital structure.  Net Operating Income Approach: The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt. in the absence of taxes. Depending on individual circumstances and opportunities the trick for each investment is to find the best mix of both. pushing the cost of capital back upward. and the weighting toward lower-cost debt pushes the cost of capital down.  Traditional Approach: The traditional approach assumes that both creditors and investors increase their required rates of return as a company takes on debt. Further. Equity needs to be rewarded with long-term profits. Therefore. the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. they are very different in nature and complement each other. and asymmetric information. Debt and equity financing should not be seen as substitutes for each other. The result is that the cost of capital remains constant regardless of the financing mix. the rate at which creditors and investors increase their required rates of return accelerates and dominates the weighting toward debt. the . Eventually. The basic theorem states that. This approach concludes that the optimal financing mix is all debt. The cost of capital declines as higher-cost equity is replaced with lower-cost debt. This approach concludes that there is no optimal financing mix any mix is as good as any other. It does not matter what the firm's dividend policy is. 36. bankruptcy costs. What are the different capital structure theories?  Net Income Approach: The net income approach makes the simplest assumptions.relying on 100% debt financing often places a heavy cash drain on companies and leads to sub-optimal growth. but investors do. and in an efficient market. Debt needs to be repaid in cash. This approach concludes that there is a optimal financing mix consisting of some debt and some equity. that neither creditors nor investors increase their required rates of return as a company takes on debt. It does not matter if the firm's capital is raised by issuing stock or selling debt. At first this increase is small. the value of a firm is unaffected by how that firm is financed. under a certain market price process. Instead.

What is infrastructure financing? Infrastructure is the physical underpinning of a country that support activities and transportation. In contemporary jargon. financing.Modigliani-Miller theorem is also often called the capital structure irrelevance principle. operation and maintenance. in which the latter assumes substantial financial. the basic abilities and structure of a company. technical and operational risks in the design. building and operation of an infrastructure project. Other Financing Options   Debt Equity Financing Options o o o o BOT B & LB PPP Bonds Benefits of other Financing Options   The projects generate direct and indirect employment opportunities Government don’t have to wait for availability of funds to embark of developmental projects . What is PPP? (public pvt partnership) We can define a PP partnership as a contract between a public sector ‘Institution’ and a private party. 37. implement and operate an infrastructure project. involving a medium to long term relationship between the public and private sector in which private sector capital and management is mobilised to plan. Financing Options   Government sole financing – implementation. This is faced with the following issues: o o o o o o Cost efficiency Equity consideration Allocational efficiency Fiscal prudence Future residence enjoy the facilities at no cost Inefficiency on management/poor maintenance Hence other financing options are being adopted worldwide. railways. It is thus an alternative method of procurement for the public sector. It involves sharing and transferring of risks and rewards between the public sector and the private partner. such as roads. electrical systems. and so on. 38.

   . White elephant projects are eliminated – projects are backed by economic jurisdiction Cases of abandoned projects eliminated Government can initiate expensive projects quickly and share the burden with future users Infrastructure can be used to drive economic growth instead of vice versa.

Sign up to vote on this title
UsefulNot useful