Corporate Finance - 1

12th August, 2010

Structure of an Investment
Bank
Clients Seeking Capital Intermediary Directing / Facilitating the Flow of Capital Investors With Capital

INVESTMENT MANAGEMENT
(Private Wealth / Asset Management)
PUBLIC INSTITUTIONAL
COMPANIES INVESTORS
E.g. – Reliance
INVESTMENT BANKING MERCHANT MARKETS E.g. ICICI Mutual Fund.
BANKING
Advisory Financing Traditional Private Sales
Group Equity Fund
Groups Trading
Country Debt Product Real Estate Private Strategy
Teams Groups Equity Fund Structuring
PRIVATE RETAIL
COMPANIES Industry Equity Infrastructure INVESTORS
E.g. Unlisted Teams Product Fund E.g. You and Me
Companies Groups
Derivatives

GLOBAL INVESTMENT RESEARCH

GOVERNMENT & Operations, Technology Human Capital Legal/Management GOVERNMENTS

AGENCIES & Finance Management Compliance Controls & AGENCIES
E.g. Delhi Metro *Including Services E.g. LIC

Chinese Wall
What is Corporate Finance ?

• Working Capital Management

Investment • Mergers and Acquisitions
• Capital Expenditure

• Dividend Policy
Payout • Share buyback
• Stock Split and Bonus Shares

• IPO/QIP/FPO
Financing • Debt/Equity/Mezannine Debt/Warrants
• Foreign Market vs domestic Market

• Operating Risk
Risk • Financing Risk
Management
Topics

• Financing : Options for Financing, Financing Decisions

• Investment : Capital Budgeting
• Payout : Dividend Policy; Bonus Shares vs Stock Split
• Analysis :
 Leverage : Concept, Classification of their Ratios,
implications
 Financial Ratios : Classification, formulae definitions,
implications on decision making
 Profitability – Metrics at different levels
Financing - Equity

• Equity : Ownership in the assets of the company by virtue of ownership of

shares of the company
– Payout options : Share Buyback, Capital Gains, Dividend payout
• Preference Shares : share owners have the first right to dividends
– Dividend payout might be fixed for the term
– Can have the option of being convertible to common share
• Financing Options
– Initial Public Offering (IPO)-First listing of the company in a stock market
• French Auction, Traditional Auction, Green Shoe Option
– Follow-on Public Offering (FPO) –Money raising by an already listed firm
– Qualified Institutional Placement (QIP) – Restricted to Institutional Inv.
– Rights Issues – Raising capital from existing shareholders
Financing - Equity

• Commonly used Terms

– Underwriter : Firm (Investment Bank) that buys the shares from the company
and sells it to the investors. If the shares are not sold, the bank guarantees buying
the shares.
– Prospectus : Summary of the company provided to the regulator and the
investors detailing the company’s financial position and business plan
– Initial Public Offering (IPO)
– French Auction – Helps in price discovery if no historic price is available as there
is no upper limit on bidding. Allotment on price-priority basis. [Read News
about NTPC FPO]
– Traditional Auction – Bidding within a band of price. Allotment at a single price.
– Green Shoe Option – A percentage of shares allotted to the Investment Bank to
stabilize the share prices immediately after listing.
 Financing - Other Options

• Debt / Bonds/ Debentures

– Capital issued against the assets of the company at an interest
– Assets can be liquidated if debt is not repaid
– Limited Liability – Share holders are not liable to pay the debt
• Mezzanine Debt
– Convertible Bonds
• Equity : Option of converting to equity after a certain period of time
• Debt : Interest payment on the outstanding balance converted to principal (PIK Bonds)
– Preferred Equity
• Equity : Ownership of the company
• Debt : Fixed dividend payment annually
• Warrants – Entitles holders to buy shares at a pre-determined price. Issued warrants can be
exercised if the share price is more than the fixed price. Otherwise they
expire unexercised.

What is the difference between an option and a warrant ?

Pecking Order of financing
Due to asymmetric information, managers prefer to raise
capital in a certain order:
 Internal Funds (financial slack)
 Signal : Cash rich company
 Signal : Comfortable financial position
 Debt
 Signal : Company has maintained a healthy leverage
 Signal : Company will have a good financial
performance
 Equity
 Signal : Inability to raise debt due to high leverage
Investment - Capital Budgeting
Measures

• Accounting Rate of Return / Book Return

• Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index
Book Rate of Return

 Book Rate of Return - Average income divided by

average book value over project life. Also called
Accounting rate of return

 ARR = Book Income / Book Assets

 Managers rarely use this measurement to make

decisions. The components reflect tax and
accounting figures, not market values or cash
flows.
Payback Period
• The payback period of a project is the number of years
it takes before the cumulative forecasted cash flow
equals the initial outlay

• Decision rule :
– Accept If : Project Payback Period< Desired time
frame
– For Alternative projects: Choose one with lowest
Payback

• This method is flawed, primarily because it ignores later

year cash flows and the present value of future cash
flows
NPV

• Takes care of Time Value of Money

• Estimate Cash Flows on an Incremental basis
• Include all incidental effects & Working Capital needs
• Include opportunity cost
• Don’t include Sunk Costs
• Treat inflation consistently
• Decision rule :
– Accept If : NPV > 0
– Reject If : NPV < 0
– For Alternative projects: Choose one with highest NPV
IRR

• The implicit rate of return on a project, which equals the

cost outlay of the project to the cash inflows from the
project over its lifetime
• Decision rule :
– Accept If : Project IRR > hurdle rate
– Reject If : Project IRR < hurdle rate
– For Alternative projects: Choose one with highest IRR
• Normally same decision as NPV method, especially for
Accept-Reject decisions, though some exceptional
situations exist
Profitability Index

 When resources are limited, the profitability index (PI)

provides a tool for selecting among various project
combinations and alternatives

 PI = PV of inflows/ PV of outflows

 A set of limited resources and projects can yield

various combinations

 The highest weighted average PI can indicate which

projects to select
Payout - Dividend Policy

• Cash Dividend - Payment of cash by the firm to its

shareholders
• Stock Dividend - Distribution of additional shares to
a firm’s stockholders (also called Bonus shares)
• Stock Splits - Issue of additional shares to firm’s
stockholders
• Stock Repurchase - Firm buys back stock from its
shareholders
The Dividend Decision

• Firms have longer term target dividend payout ratios

• Managers focus more on dividend changes than on
absolute levels
• Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in
earnings
• Managers are reluctant to make dividend changes that
might have to be reversed
• Firms repurchase stock when they have accumulated a
large amount of unwanted cash or wish to change their
capital structure by replacing equity with debt
Dividend Policy

 Dividend Irrelevance – Since investors do not need dividends

to convert shares to cash they will not pay higher prices for
firms with higher dividend payouts. In other words, dividend
policy will have no impact on the value of the firm

 Signaling – Dividend increases send good news about cash

flows and earnings. Dividend cuts send bad news

 Taxation Implication – Companies can convert dividends into

capital gains by shifting their dividend policies. If dividends are
taxed more heavily than capital gains, taxpaying investors
should welcome such a move and value the firm more favorably
Payout vs. Investment decision

 If some of the firm’s shareholders prefer payouts to

support current consumption, while others want
investment to support future, higher, consumption

 No discrepancy between the two. A project favorable to

the first category will be favorable to the second category,
and vice versa (loosely, because the stock prices will
adjust to incorporate the positive NPV of this project, and
the shareholder can borrow against this or sell the stock)
Stock Split

“HDFC : The board has approved the subdivision of the

company's shares in the ratio of 1:5, that is one share of
Rs 10 will be split into 5 shares of Rs 2 each”
Share Price of HDFC (on 3rd May) : Rs. 2,827
BEFORE SPLIT AFTER SPLIT
Share Capital : 1,000 Share Capital : 1,000
(100 shares @Rs. 10) (500 shares @Rs. 2)

Reserves and Surplus : 2,500 Reserves and Surplus : 2,500

Share Price : 2,827 Share Price : 565.4

Bonus Issue

“ITC Ltd’s shareholders will get one share for every

existing share by way of a bonus issue.”
Share Price of ITC (on 20th June) : Rs. 150

BEFORE Bonus Issue AFTER Bonus Issue

Share Capital : 1,000 Share Capital : 2,000
(100 shares @Rs. 10) (200 shares @Rs. 10)

Reserves and Surplus : 2,500 Reserves and Surplus : 1,500

Share Price : 150 Share Price : 75

What is the difference between the two as far dividend payout is
concerned ?
Leverage

Revenue 1000
(Variable Costs) 400
Contribution 600
Operating Leverage 1.50
(Fixed Operating Costs) 200
EBIT 400 Financial Leverage 1.33
(Interest) 100
PBT 300 Combined Leverage 2
(Taxes) 120
PAT 180
Leverage

 Operating Leverage(OL) = Contribution/EBIT

 It shows how much the profit will change for a given change in net
sales

 Financial Leverage (FL) = EBIT/PBT

 It shows the impact of the extent of debt servicing by a firm

 Combined Leverage (CL) = OL * FL

 Perceived riskiness of firm based on above ratios

Financial Leverage - Effect

Equity 800000 1000000 400000 400000 400000 500000 500000 500000

Debt 200000 0 600000 600000 600000 500000 500000 500000
No. of Shares 10000 12500 5000 5000 5000 6250 6250 6250

EBIT 200000 200000 100000 200000 300000 100000 200000 300000

Interest 20000 0 60000 60000 60000 50000 50000 50000
PAT 108000 120000 24000 84000 144000 30000 90000 150000
EPS 10.8 9.6 4.8 16.8 28.8 4.8 14.4 24

Interest 10%
Price per share 80
Tax 40%

Leverage amplifies the returns to shareholders.

Ratio Analysis

 A financial ratio is a mathematical relationship between two or more

amounts reported in the financial statements. It helps in –
 Summarizing large quantities of data
 Comparison of performance – over time, with competitors
 Cues to problem areas – an indicative tool

 Classification of financial ratios –

 Profitability
 Turnover or Utilization
 Liquidity
 Solvency
CATEGORIES OF RATIOS THAT HELP IN
ASSESSING THE FINANCIAL PERFORMANCE

Profitability Asset Turnover

• How much return the company is able to
generate for its stakeholders?
• How well the company is able to manage
costs?
Illustrative ratios:
• Returns - ROE, ROA, ROCE
• Margins - Gross Profit/Operating/Net
Profit Margin
• Efficiency of assets being utilized?
• Efficiency of managing working capital?
– What is average number of days to
convert receivables into cash?
– How long is the credit period?
Illustrative ratios: Total Asset Turnover,
Fixed Assest Turnover, Working Capital
Turnover, Inventory Turnover

Solvency Liquidity
• What is the level of financial risk borne by • How are short term financing
the shareholders from long term view ? requirements being met?
• How well is the company placed to meet • Are there sufficient liquid assets to meet
its interest obligations? its short term obligations?

Illustrative ratios: Debt to Equity, Debt to

Total Capital, Interest Coverage Ratio, Total Illustrative ratios: Current Ratio, Quick
Coverage Ratio Ratio, Cash Ratio, Interval Measure
PROFITABILITY RATIOS - MEASURE THE
RETURNS EARNED ON CAPITAL INVESTED

Metric Formulae Measures

Net Income
Return on Return on owners' capital
equity (ROE) Average Shareholders’ Equity1

Efficiency with which assets are

Return on EBIT(1-t) utilized to generate returns for
assets (ROA) stakeholders
Average Total Assets

Return on Capital Returns available to all

Net Income + Interest Expense
Employed2 stakeholders, both
Average Capital Employed3 shareholders and debt-holders
(ROCE)

* Average of the year

1 Shareholders Equity = Common Equity (Share Capital + Reserves & Surplus) + Preferred Equity + Minority Interest
2 Here tax is deducted while measuring the return as this is not available for the distribution to the stakeholders
3 Capital Employed is defined as long term debt + pension provision + shareholders equity
MARGINS MEASURE COST EFFICIENCY
OF BUSINESS ACTIVITIES

Metric Formulae Measures

Gross Profit Ability of a company to

Gross Margin control ‘direct’1 costs
Sales

Operating Profit Overall operating efficiency;

Operating
accounts for all operating
Margin Sales
expenses

Net Profit Proportion of sales available for

Net Profit
distribution to shareholders
Margin Sales

1 Costs that can be directly attributed to the goods & services produced
TURNOVER RATIOS - MEASURE THE
EFFICIENCY OF ASSET UTILIZATION

Metric Formulae Measures

Asset Turnover Sales Efficiency of overall asset

Average Total Assets utilization

Fixed Asset Sales Efficiency of utilization

Turnover of fixed assets
Average Fixed Asset

Inventory COGS* Number of times a company turns

Turnover over its inventory in year
Average Inventory

Average Collection Average Receivables Average no of days to convert

Period receivables to cash
Average Daily Sales

Average Credit Accounts Payable Average no of days it takes to pay

Period the suppliers
Average Daily Purchases*

*Sales could be used as proxy in case COGS/Purchases are not available

Cash Cycle

• Cash-to-Cash Cycle = Average days of Inventory + Average days of

receivables pending- Average days of payables pending
• Average days of Inventory = 365 / Inventory Turnover
• Average collection period = Average Receivables /Sales per Day
– Average Receivables = (Receivables t-1 + Receivablest )/2
• Average Credit period = Average Accounts Payable/COGS per day

• Number of days for which working capital is required or

• Number of days after which operating capital is recovered
LIQUIDITY RATIOS – MEASURE AVAILABILITY
OF SHORT-TERM ASSETS TO MEET CURRENT OBLIGATIONS

Metric Formulae Measures

Availability of current asset to meet short

Current Ratio Total Current Assets
term obligations
Total Current Liabilities

Current Assets – Inventory – Prepaid Availability of liquid assets to meet

Quick Ratio
expenses current obligations
(‘acid test”)
Current Liabilities

Availability of most liquid assets to

Cash Ratio Cash + Marketable Securities meet current obligations
Current Liabilities

Cash + Short-Term Securities + No. of days worth operating expenses

Interval Measure Receivables that can be easily funded by availability
Average Daily Expenditure from of liquid current assets
Operations
SOLVENCY RATIOS -
MEASURE FINANCIAL RISK
FROM SHAREHOLDER’S PERSPECTIVE
AND DEFAULT RISK FROM CREDITOR’S PERSPECTIVE

Metric Formulae Measures

Total Debt* Financial risk borne by the

Debt-to-Equity shareholders from the long
Shareholders Equity**
term perspective

Total Debt* Extent to which assets are being

Debt-to-
financed from external source -
Capital Debt + Shareholders Equity**
creditors

Likelihood of a company
Interest EBITDA
defaulting on its interest
Coverage Interest Charges obligations

Principle repayment along with

Coverage EBITDA
interest obligations while
Total Fixed Charges estimating the coverage
* Total Debt = Short term borrowing + Long term borrowings + Pension Provisions (unfunded portion)
** Total Shareholders Equity = Book Value of Common Equity + Book Value of Preferred Equity + Minority Interest.
DECOMPOSING A RATIO, ANALYZING
HISTORICAL TRENDS OR BENCHMARKING,
LEADS TO MEANINGFUL FINANCIAL ANALYSIS

What are key drivers?

Decomposing ratios into
How do different drivers interplay
key financial driver to affect a ratio?

How has the ratio evolved over time?

Analyzing historical trends Which driver has caused the
maximum change?

How has the firm performed

Comparing results with against peers and / or industry
benchmarks benchmark?
DECOMPOSING ROE TO UNDERSTAND
THE IMPACT OF LEVERAGE
Return on Equity (ROE):
Net Income/Equity

Net Income Margin: Asset Turnover: Leverage:

X X

Net Income / Sales Sales / Assets Assets/Equity

Return on Equity is a function of Return on Asset and leverage. Clearly as long as yield
on debt is less than total return on asset, the shareholders would be better off in terms
of returns with increase in leverage – this happens on account of tax shield on interest
payment and trading on thin equity. Having said that, one should also keep in mind
that financial risk component for equity holders also increases with leverage and
hence the minimum expected return. 33
Interest Tax Shield

Company 1 Company 2  Since interest is a tax-

Revenues 1000 1000 deductible expense, a
(Operating Costs) 600 600 levered company
EBITDA 400 400 return s more to its
(Depreciation) 100 100 capital providers
EBIT 300 300  The difference in
(Interest) 0 100 returns is due to the
PBT 300 200 tax saved, called the
Taxes @ 40% 120 80 “Interest Tax Shield”
PAT 180 120
 The value of this
shield = Interest
Return to Stakeholders 180 220
expense * tax rate =
100*0.4 = 40
Depreciation Tax Shield

Company 1 Company 2  Since depreciation is a

Revenues 1000 1000 tax-deductible
(Operating Costs) 600 600 expense, faster
EBITDA 400 400 depreciation of assets
(Depreciation) 100 0 generates more cash
PBT 300 400  The difference in
Taxes @ 40% 120 160 returns is due to the
PAT 180 240 tax saved, called the
“Depreciation Tax
Cash Generated 280 240 Shield”
 The value of this
shield = Depreciation *
tax rate = 100*0.4 = 40

What is the significance of the Tax Shields?

Thank You