FINANCIAL CONCEPTS

Weighted average cost of capital (WACC) –

A company raises its capital majorly through two sources: Debt and Equity. To raise this capital, the
company has to bear some costs. Weighted Average Cost of Capital (WACC) is a method to calculate
the cost of capital to the company. WACC represents the minimum rate of return at which a
company produces value for its investors.

WACC formula:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity
Rd = cost of debt
T = tax rate

Cost of Equity (Re): A firm’s cost of equity represents the compensation demanded in owning the
asset and bearing the risk of ownership. The cost of equity is calculated using a method called
Capital Asset Pricing Model (CAPM).

CAPM: It is used throughout finance for the pricing of risky securities(equity) and generating
expected returns for these assets, given their risk.

CAPM formula:

Ra = Rrf + [Ba * (Rm – Rrf)]

Where:

Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

Rm – Rrf= Market Risk Premium

The risk-free rate (Rrf) in the formula accounts for the time value of money.

The Beta of security (Ba) is a measure of how much risk the investment in the stock will add to the
portfolio. If a stock is riskier than the market, it will have a Beta > 1. If a stock has a Beta < 1, it
reduces the risk of the portfolio. Beta is assessed in two ways:
 1. Levered Beta: Both debt and equity are factored in while assessing a company’s risk profile
in the market. As levered beta includes the equity component, it is also called Equity beta.

2. Unlevered Beta: In this, the debt component is not considered. It segregates the risk due
solely to the assets of the company. Due to this, the unlevered beta is also referred to as
Asset beta.

With the increase in company’s debt, the uncertainty of future earnings also increases. However, it is
not a result of market or industry risk. Also, each company’s capital structure is different, an analyst
will often want to look at how “risky” the assets of a company are, regardless of what percentage of
debt or equity funding it has. Therefore, equity beta is unlevered to calculate the asset beta-

Formula for unlevering of beta-

Asset Beta= Equity beta/ [1+(1-tax rate) (Debt/Equity)]

To re-lever the beta again, we use the above formula in the following manner-

Equity Beta= Asset Beta* [1+(1-tax rate) (Debt/Equity)]

Note: Interest paid on debt reduces the net profit and helps in saving of taxes. This is why while
unlevering or re-levering of beta (1-tax rate) is taken into account.

Cost of Debt (Rd): It refers to the effective rate a company pays on its current debt. To calculate
the cost of debt the company must determine the total amount of interest it is paying on each of its
debts for the year and divide it by all of its debts

G-Sec- A government security (G-Sec) is a debt raised by the government to fund their expenditure.
These instruments are tradable and are issued either by the central or the state government. These
are both short term and long term.

Various types of G-secs are- Treasury bills, dated govt securities, cash management bills etc.

Treasury bills, generally shortened as T-bills, are issued for a short period of time (91 days, 182 days,
364 days). Treasury bills don’t pay any interest. However, they are issued at a discount and
redeemed on the face value after maturity.

Rates of treasury bills (Dated: 12th July)-

91-Day T-Bill- 5.98%

182- Day T-Bill-6.12%

364- Day T-Bill-6.13%

5-Year G-sec – 6.425%

10- year G-sec – 6.76%

Discounted Cash Flow (DCF): It is a valuation method used to estimate the value of an investment
based on its future cash flows. DCF Analysis attempts to figure out the value of a company today
based on how much money it will generate in the future. It uses a discount rate to find out the
present value of the investment. DCF is based on the concept of time value of money.
Techniques of DCF:
1) Net Present Value (NPV): It is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time.

A positive Net Present value indicates that the projected earnings generated by the
investment exceeds the anticipated costs, and hence is profitable. A negative Net Present
Value means the investment will result in a net loss.

2) Internal Rate of Return (IRR): It is used to estimate the profitability of potential

investments. It is a discount rate that makes the Net present value (NPV) of all cash flows
from a particular project equal to zero.

This discount rate is the Internal Rate of Return (IRR).

Discounted Cash Flow Valuation Methods: Free cash flow (FCF) is the amount of cash flow a firm
generates (net of taxes) after taking into account non-cash expenses, change in operating assets and
liabilities, and capital expenditures. FCF varies from metrics like operating EBITDA, EBIT or net
income since the former leaves out non-cash expenses and subtracts the capital expenditure
required for sustenance.

a) Free Cash flow to Equity model (FCFE): It calculates how much ‘cash’ a firm can return to
its common equity shareholders. This cash flow includes the impact of leverage, that is, it
subtracts the interest payments and principal repayments to debt holders to arrive at the
cash flow, and hence, is also called a levered cash flow.
 Free Cash flow to Equity (FCFE) = Operating EBIT- Interest- Taxes+
Depreciation/Amortization (non-cash cost)– fixed capital expenditure-Increase in
networking capital-net debt repayment

Where, net debt repayment= principal debt repayment –new debt issue
FCFE= Cash flow from operations – fixed capital expenditure – Net debt repayments

b) Free cash flow to the firm (FCFF): It represents the amount of cash flow from operations
available for distribution after depreciation expenses, taxes, working capital, and
investments are accounted for and paid to all investors of a firm. FCFF is essentially a
measurement of a company's profitability after all expenses and reinvestments. It
excludes the impact of leverage and is also called unlevered cash flow.

Free Cash flow to the firm (FCFF) = NI + D&A +INT (1 – TAX RATE) – CAPEX – Δ Net WC
Where:
NI = Net Income
D&A = Depreciation and Amortisation
Int = Interest Expense
CAPEX = Capital Expenditures
Δ Net WC = Net Change in Working capital

FCFF = CFO + INT (1-Tax Rate) – CAPEX

Where:
CFO = Cash Flow from Operations
INT = Interest Expense
CAPEX = Capital Expenditures

EBIT*(1 – Tax Rate) + D&A – Δ Net WC – CAPEX

Where:
EBIT = Earnings before Interest and Tax
D&A = Depreciation and Amortisation
CAPEX = Capital Expenditures
Δ Net WC = Net Change in Working capital

c) Residual Income Method- Residual income is calculated as net income minus a

deduction for the cost of equity capital. The deduction is called the equity charge. Equity
charge is simply a firm's total equity capital multiplied by the required rate of return of
that equity, and can be estimated using the capital asset pricing model. The formula
below shows the equity charge equation:

Equity Charge = Equity Capital x Cost of Equity

Once we have calculated the equity charge, we only have to subtract it from the firm's net
income to come up with its residual income.

Book Value: An asset's book value is equal to its carrying value on the balance sheet, and
companies calculate it by deducting the accumulated depreciation from the assets.

Relative Valuation: It is a valuation method that compares a company’s value to that of its
competitors or industry peers to assess the firm’s financial worth.
 Absolute Valuation is a method where we determine a company’s intrinsic worth based on
its estimated future free cash flows discounted to their present value, without any reference
to another company or industry average.

Multiples used in relative valuation:

1) Earnings per share: It is the firms’ net income divided by the average number of shares
outstanding during the year.
2) Dividend per share: It measures the percentage of income that a company pays out to
the shareholders in the form of dividends.
3) Price-earnings ratio: It is the ratio of market price per share to the annual earnings per
share.

A higher PE ratio implies that the investors are paying more for each unit of net income,
which means investors are optimistic about the growth of the company. Stocks with
higher PE ratio are called growth firms and stocks with lower PE ratio are called as
income firms.
PE ratio is prevalent in specifically insurance and software sectors

4) Enterprise Value to EBITDA Ratio: It is used as a method of valuation tool to compare

the value of a company, debt included, to the company’s cash earnings less non-cash
expenses. EV (Enterprise value) is calculated as-

EV = market capitalization + preferred shares + minority interest + debt - total cash

EV/EBITDA is used in many industrial, consumer industries, retail industries and

emerging markets.

5) Price-Book Ratio: The price-book ratio is widely used as a conservative measure of

relative valuation of an asset, where the assets of the firm are valued at book. Investors
also widely use the ratio to judge whether the stock is undervalued or overvalued. The
formula to calculate the ratio is:

Price-book ratio = Market price of the share / Book Value per share.

P/B Ratio is very popular among Banking and NBFC organizations.

6) Return on Equity
Return on equity measures profitability from the equity shareholders point of view. It is
the return to the equity shareholders and is measured by the following formula:

Some Ratios used by lenders to evaluate the financial wealth of the company are as
follows-
1. Current Ratio: It is a basic measure of solvency. Ideally it’s supposed to be 2:1. It is
calculated by dividing current assets and current liabilities.
 2. Quick ratio: It's the current ratio with inventory removed. The quick ratio tells you if
you have enough readily available funds to cover short-term obligations. It should be
at least 1:1.
3. Return on assets: This ratio lets you know if you're using your assets efficiently. It is
calculated by dividing net profit before taxes with total assets.
4. Account receivables turnover ratio: This ratio tells you how quickly your company is
collecting on receivables. It is calculated by dividing average receivables with annual
sales.
5. Operating Cash-Flow Ratio: It tells you the volume of cash you are generating
compared with the amount you will have to lay out. It is calculated by dividing cash
flow from operations with current liabilities.
6. Inventory Turnover: It talks about how effective the company is at managing its
inventory. It is calculated by dividing the cost of goods sold for a period by the
average inventory for that period.

Monetary Policies of RBI

The Reserve Bank of India, uses certain monetary policies to control the liquidity of money in the
markets. Following are some of the policies used by the RBI-

1. Cash Reserve Ratio- Percentage of banks total deposit to be kept with RBI in cash is
known as Cash Reserve Ratio (CRR). At present the CRR is 4%.
2. Statutory Liquidity Ratio- Percentage of banks total deposits to be invested in Govt
securities is known as the Statutory Liquidity Ratio (SLR). The current SLR is 19%
3. Repo Rate- The rate at which RBI lends money to the commercial bank is called the repo
rate. The current repo rate is 5.75%
4. Reverse Repo Rate- The rate at which RBI borrows money from the commercial banks is
called the reverse repo rate. The current Reverse repo rate is 5.5%