Corporate Finance Books

1. Corporate Finance, Ross 8th Edition

2. Barleay
3. Fundamentals of Financial Management by Van C. Horne
4. Financial Management and Policy by Van Horne

What is finance all about?

1. Investment Decisions
2. Financing Decisions
3. Asset management Decisions

Topics

1. Valuation of Securities
2. Capital Budgeting (Cash flows)
3. Capital Structure
4. Dividend Policy
5. Mergers
6. Leasing
7. Working Capital

Balance Sheet

Assets Amount Liab + Equity Amount

Current Assets Current Liabilities 20
Cash 10
A/R 10
Inventory 20 Long Term debt 10

Debt/Bonds 30

Fixed Assets OE 40
Plant and Machinery 60

100 100
 - Levered firm
- Unlevered firm

Firm A

Debt : Equity (Capital Structure)

60 : 40

Firm B

Debt : Equity (Capital Structure)

40 : 60

Debt Equity
Risky Less Risky
Cheap Costly
Concentration of ownership Dilution of ownership
Tax Shield Benefit -

IRR = 18 %

Debt = 12 %

IRR = 18 %

Equity = 12 %

Income Statement
Revenue XXXXX
-costs XXXXX
-interest expense XXXXX
------------------
Profit before tax xxxxxx
-TAX XXXX
-----------------
Profit after tax XXXX

-dividend XXXX
--------------
Retained Earnings XXXX
Asset Management Decisions

Working Capital = Total value/amount of current assets

Net Working Capital = current assets – current liabilities

Increase in inventory

Costs Benefits
Insurance Ordering cost
Storage Unexpected Sales demand/reputation
Spoilage/Theft Cost Price fluctuations
Opportunity cost of funds

Suppose
Costs = 110,000
Benefits = 125,000

22-10-2020
Market
Mechanisms and means/procedures through which trading can take place.

Capital Market
Market where long term securities are traded

Primary Market
Where new securities are bought and sold

Secondary Market
Where already issued securities are traded.

Long Term Securities

a) Preferred Stock
b) Common Stock
c) Bonds

Preferred Stock

Hybrid Security: Debt and equity features

Priority in dividend payment/ claims
Generally dividend is fixed/predetermined/ no voting right

1. Cumulative Preferred Stock or Non-cumulative preferred stock

2. With Call Option or Without Call Option
3. Convertible or non convertible
4. Participating or non-participating

Common Stock

IPO (Initial Public Offering): first issue of a new company

Seasoned Equity/offering: subsequent issuance of shares

Supported a new firm “A” is incorporated and issued 5,000 shares (IPO)

After some time 2,000 more shares were issued (seasoned equity)

After some time 1,000 more shares were issued (seasoned equity)

Full Subscription

Firm “A” wants to offer 5000 shares and applications/subscription for 5000 shares is received

Over Subscription

Firm “A” wants to offer 5000 shares and applications/subscription for 7000 shares is received

a) First come first served

b) Balloting
c) Green Shoe Option
d) Pro-rata basis

Under subscription

Firm “A” wants to offer 5000 shares and applications/subscription for 4000 shares is received

Unsold shares will be sold to underwriter (commercial bank, investment bank or any other
financial institution) against some premium

Underwriter Syndicate: Group of underwriters

 Sale shares to underwriter on wholesale basis and underwriter will sale these share to
the market in retail
 - Risk Transfer
- Expertise, skills

 Company will sale shares and responsibility of unsold shares will lie on underwriter
- Risk Transfer

 Best Efforts Selling: Underwriter will put his best efforts to sale shares, however, will
not assume the responsibility of unsold shares
- Expertise

 None or all which means if all shares are sold, whole issue will be
considered as cancelled

Appointment of Underwriter

1. Competitive Bid

Appointment of underwriter through bids

Suppose,

Firm A bids for Rs. 8 per share

Firm B bids for Rs. 9 per share
Firm C bids for Rs. 7 per share

2. Negotiated Offering

Appointment of underwriter though negotiation

 Agency Relationship: Principal agent relationship, shareholders management
relationship
Agency Conflict: conflict of interest between shareholders and management

Principal-Principal Conflict: Conflict of interest among shareholders such as conflict

of interest between institutional shareholders and individual shareholders

Principal-creditor conflict: Conflict of interest between shareholders and creditors

Board of Directors: To protect the interests of all stakeholders’ particularly individual

shareholders

Owners/ Principal Shareholders

Board of Directors

CEO

Management/Agent CFO

Management Team/Staff

Board of Directors

1. Executive Directors

An employee/Executive of the company working also as board member such as

CEO/CFO

2. Non-Executive Directors

Not an employee of the company and working only as board member

i. Representative Non Executive Directors

 Representative of any stakeholders such as creditors, government or
institutional investors etc

ii. Non-Representative Non-Executive Directors/Independent NED

Hired on the basis of their knowledge, experience, qualification and skills

Sources of Finance
Debt
Equity
Retained Earnings/By forgoing Dividends

Substitution Hypothesis: Dividends substitutes governance

mechanisms/monitoring

Outcome Hypothesis: Dividend payout is the outcome of governance

mechanism

Borrowing Sources

- Bank/Financial Institution (Either short term or long term)

- Financing by payables (Short term)
- Public Borrowing by issuing securities (Either Short term or long term)
- Retained Earnings/ By forgoing dividends

 Commercial Paper (Short Term)

Maturity less than one year, normally 270 days , issued by corporation

Marketability of these securities depends upon the credit rating of

issuing corporation

Different credit rating agencies such as PACRA in Pakistan, Moodies

and S &P internationally rates different companies on the basis of their
cash flows/credit standings

 Treasury Bills (Short Term)

Issued by government, auction sale, discount, risk free, 7 weeks, 14
weeks, 26 weeks etc

Bonds
 Long Term borrowing by issuing debt securities

Different credit rating agencies such as PACRA in Pakistan, Moodies

and S &P internationally rates different companies on the basis of their
cash flows/credit standings

 Corporate Bonds
 Treasury Bonds (Directly issued by treasury department)
 Federal Govt. Bonds (Issued by any federal government backed
institution)
 Municipal Bonds

Trustee: legal representative of bondholders

Indenture: Terms conditions, legal contract between bondholders and issuing firm

Debenture: Unsecured bond

Asset Backed Securities: securities sold against some collateral

Junk Bonds: High risk high return bonds, low credit rating

`Serial Bonds: mature in series, for example every year company will pay principal amount
along with interest.

Valuation of Long Term Securities

Going Concern Value

The amount a firm could be sold for as a continuing operating business.

Liquidation Value

The amount of money that could be realized if an asset or a group of assets (e.g., a firm) is
sold separately from its operating organization

Book Value

The accounting value; asset cost minus accumulated depreciation

Market Value

The value at which asset trades

Intrinsic Value

The price a security “ought to have” based on all factors bearing on valuation

If market value is greater than intrinsic value = Overvalued (sale)

If market value is lesser than intrinsic value = undervalued (Buy)

If market value is equal to the intrinsic value = fairly valued

Real Assets: Tangible, physical, value of these assets is inherited in asset itself

Financial Assets: Pieces of paper evidencing a claim on some issuer.

Intrinsic Value of financial assets = present value of all future cash inflows

Preferred Stock

1. With Call Option

IV = Dp /(1+Kp)n + Call Price /(1+ Kp)n

2. Without Call Option

IV = Dp / Kp

Bonds

1. Perpetual Bonds

IV = I / Kd

2. Coupon Bonds

IV = I /(1+Kd)n + Maturity Value /(1+ Kd)n

3. Zero Coupon Bonds

 IV = Maturity Value /(1+ Kd)n

Question NO. 1

7 percent preference shares valued 500 $ per share issued for 3 years. These shares will
be called back at 520$ per share. Calculate intrinsic value if required rate of return is 12
percent.

IV = Dp /(1+Kp)n + Call Price /(1+ Kp)n

IV = 35 /(1+.12)1+ 35 /(1+.12)2+ 35 /(1+.12)3 + 520 /(1+ .12)3

= 30.97 + 27.90 + 24.90 + 360.38

= 444.15 $

Question NO. 2

9 percent preference shares valued 1000 $ per share issued for 2 years. These shares will be
called back at 1010$ per share. Calculate intrinsic value if required rate of return is 14
percent

Question NO. 3

9 percent preference shares valued 1000 $ per share issued. Calculate intrinsic value if
required rate of return is 14 percent

IV = Dp / Kp

IV = 90/ .14

IV = 642.85

Question NO. 4

7 percent bonds valued 1000 $ per bond issued. Calculate intrinsic value if required rate of
return is 13 percent

IV = I/kd = 70/.13 = 538.46 $

Question NO. 5
7 percent bonds valued 1000 $ per share issued for 2 years. Calculate intrinsic value if
required rate of return is 13 percent

IV = I /(1+Kd)n + Maturity Value /(1+ Kd)n

IV = I /(1+Kd)n + I /(1+Kd)n + Maturity Value /(1+ Kd)n
IV = 70 /(1+.13) + 70 /(1+.13) + 1000 /(1+ .13)2
1 2

IV = 899.92 $

Question NO. 6

Bonds valued 1000 $ per share issued for 2 years. Calculate intrinsic value if required rate of
return is 13 percent

IV = Maturity Value /(1+ Kd)n

IV = 1000 /(1+ .13)2
IV = 783.15 $

Common Stock

1. No Growth

For example company is paying 2 $ every year in terms of dividend

payments

IV = De/ Ke

Suppose a company pays 2 $ dividend every year on its common stock.

Calculate intrinsic value if required rate of returns is 13 percent.

IV = De/ Ke

IV = 2/.13 = 15.38 $

2. Constant Growth

For example company increases dividend by 10 percent every year

IV = D0 (1+ g) / Ke - g

or
 IV = D1 / Ke - g

Suppose a company pays 2 $ dividend on its common stock which grows by

8 percent every year. Calculate intrinsic value if required rate of returns is 13
percent.

IV = 2 (1+ .08) / .13 - .08

IV = 43.2 $

Suppose a company expects to pay 2 $ dividend on its common stock this

year. The growth rate on the dividends is 8 percent every year. Calculate
intrinsic value if required rate of returns is 13 percent.

IV = 2 / .13 - .08

IV = 40 $

3. Phases Growth

For example company will increase dividend by 10 percent for 3 years

after which dividends will grow at the rate of 8 percent forever.
A company pays dividend of 2$ which is expected to grow at the rate of 10
percent for the next 3 year after which growth rate will be 8 percent forever. If
required rate of return is 14 percent, calculate intrinsic value?

D0 (1+ g ) = D1

1) 2 (1 + .10 ) = 2.2 / (1.14)1 = 1.92

2.) 2.2 (1 + .10) = 2.42/ (1.14)2 = 1.86

3.) 2.42 (1 + .10) = 2.66/ (1.14)3 = 1.79

------------------

= 5.57

4. D0 (1+ g )/ke – g

= 2.66 ( 1 + .08) / .14 - .08

= 47.88 / (1 + .14)3 = 32.31

-----------------

= 37.88
 Phases Growth Example 2

A company pays dividend of 1.8$ which is expected to grow at the rate of 9

percent for the next 2 year followed by a growth rate of 7 percent for the next 2
years. After which growth rate will be 5 percent forever. If required rate of
return is 13 percent, calculate intrinsic value?

D0 (1+ g ) = D1

1) 1.8 (1 + .09 ) = 1.96/ (1.13)1 = 1.73

2.) 1.96 (1 + .09) = 2.14 / (1.13)2 = 1.67

3.) 2.14 (1 + .07) = 2.29 / (1.13)3 = 1.58

4.) 2.29 (1 + .07) = 2.45 / (1.13)4 = 1.50

------------------

= 6.48

5. D0 (1+ g )/ke – g

= 2.45 ( 1 + .05) / .13 - .05

= 32.15 / (1 + .13)4 = 19.72

-------------------

Intrinsic Value = 26.19 $

Market Value = 30 $-------------------------- Overvalued

And if,

Market Value = 25 $--------------------------Undervalued

A company pays dividend of 2$ which is expected to remain constant for 4
years after which growth rate will be 8 percent forever. If required rate of return
is 14 percent, calculate intrinsic value?

D0 = D1

1) 2 (1 + .00 ) = 2 / (1.14)1 = 1.75

2.) 2 (1 + .00) = 2 / (1.14)2 = 1.53

3.) 2 (1 + .00) = 2 / (1.14)3 = 1.34

4.) 2 (1 + .00) = 2/ (1.14)4 = 1.18

------------------

= 5.8

5. D0 (1+ g )/ke – g

= 2 ( 1 + .08) / .14 - .08

= 36 / (1 + .14)4 = 21.3

-------------------

Intrinsic Value = 27.11 $

KSE 100 index
Suppose total 540 companies are listed at Pakistan stock exchange

Total 36 sector including open ended mutual funds

Three Types of Indices

1. Price Weighted Index (DJIA 30, Nikkie 225)

2. Value Weighted Index (KSE 100 index, S & P 500)
3. Equally Weighted Index (a few of regional indices/ academic research)

Sector Base Representation

One company from each sector (excluding Open-End Mutual Fund Sector) on the
basis of the largest Free-Float Capitalisation

It means a total of 35 firms would be selected

Market Capitalization = Market price per share * Number of shares

Free-Float means proportion of total shares issued by a company that are readily
available for trading at the Stock Exchange. It generally excludes the shares held by
controlling directors I sponsors I promoters, government and other locked-in shares
not available for trading in the normal course.

Free Float Market Capitalization = Market price per share * Num. Free Float shares

Capitalization Base Representation

And, the remaining 65 companies are selected on the basis of largest Free-Float
Capitalisation in descending order

It will make a total of 100 firms (35 based on sector representation and 65 based on
capitalization)

Day 1
 (Overall Free Float Market Capitalization/Base) * 1000

(1000,000/1000,000) * 1000

= 1000

Day 2

(Overall Free Float Market Capitalization/Base) * 1000

(1200,000/1000,000) * 1000

= 1200

Day 3

(Overall Free Float Market Capitalization/Base) * 1000

(900,000/1000,000) * 1000

= 900

Re-composition of Index

Re-composition period = 6 months

1. Time-based rule:

A company (not in the index) which becomes the largest in its sector (by any amount
of value) will enter the index after maintaining its position as largest in the sector for
two consecutive re-composition periods.

Suppose Company A was selected from cement sector based on highest free float
market capitalization

 After 6 months, during re-composition of index, company B gain the highest position

(B gain top position for 1 re-composition period)

 After another 6 months, during re-composition of index, company A gain the highest
position
 After another 6 months, during re-composition of index, company B gain the highest
position

(B gain top position for 2 re-composition periods but not for consecutive periods)

 After another 6 months, during re-composition of index, company B again gain the
highest position

(B gain top position for 2 consecutive re-composition periods)

2. Value Based Rule

A company (not in the index) which becomes the largest in its sector by a minimum
of 10% greater in capitalisation value than the present largest in the sector (in the
index) will enter the index after one re-composition period.

Suppose Company A was selected from cement sector based on highest free float
market capitalization

 After 6 months, during re-composition of index, company B gain the highest position

Company A market capitalization = 100,000

Company B market Capitalization = 120,000

Percentage Difference = more than 10 percent

For sector based 35 Firms (Time Based and Value Based Rule)

And

For Value Based 65 Firms (Only Time Based Rule is applicable)

Rules for new issues

Newly listed company or a privatized company shall qualify to be included in the

existing index (after one re-composition period) if the Free-Float Capitalisation of the
new or privatized company is at least 2% of the total Free-Float Capitalisation.
 Risk

Chances of deviation of actual outcome from expected outcome

Chances of deviation of actual outcome from average

Deviation from average

Deviation from standard

Standard deviation

Capital Budgeting

The process of identifying analyzing and selecting investment projects whose returns
extend beyond one year

 Depreciation
 Cash Flows
 Capital Budgeting Techniques

Depreciation

Gradual decrease in the value of asset

100/5 = 20

Allocation of cost over useful life of an asset

MACRS (Modified Accelerated Cost Recovery System)

Asset Price = 100,000

Suppose Assets falls into five years property class, calculate depreciation.

1. 100,000 @ 20 % = 20,000
2. 100,000 @ 32 % = 32,000
3. 100,000 @ 19.2 % = 19,200
4. 100,000 @ 11.52 % = 11,520
5. 100,000 @ 11.52% = 11,520
6. 100,000 @ 5.76 % = 5760
 Half year convention
 Double Declining Balance Method

5 Years

=100/5 = 20 % * 2 = 40 %

Years MACRS Straight Line MACRS

RATES
1 = 100 *40/100= 40/2 = 20 % = 100/5 = 20 /2 = 10 % 20 %
2 = 80 * 40/100 = 32 % = 80/4.5= 17.78 % 32 %
3 =48 *40/100 = 19.2% = 48/3.5 = 13.71 % 19.2 %
4 =28.8 *40/100 = 11.52% = 28.8/2.5 = 11.52 11.52%
5 11.52%
6 5.76%

7 Years

=100/7 = 14.29 % * 2 = 28.57 %

Years MACRS Straight Line MACRS

RATES
1 =100*28.57/100 = 28.57/2 = 14.29 =100/7=14.29/2 = 7.14 14.29
2 =85.71 * 28.57/100 = 24.49 = 85.71/6.5 = 13.186 24.49
3 =61.22* 28.57/100 =17.49 = 61.22/5.5 = 11.13 17.49
4 =43.73* 28.57/100 = 12.49 = 43.73/4.5 = 9.71 12.49
5 =31.24* 28.57/100 = 8.93 =31.24/3.5= 8.93 8.93
6 8.93
7 8.93
8 4.46
Cash Flows

 Cash based transactions

 Incremental cash flows

Incremental cash flows

1. New Plant/project

Cash Outflow
0----------------------------------------------------1,000,000

Cash Inflows
0----------------------------------------------------100,000 monthly

2. Replacement of existing project

Cash Outflow
1,000,000 ---------------------------------------------------- 1,800,000

Cash Inflows
100000 ----------------------------------------------------160,000 monthly

Question 1
 Old Machine

Current market price = 70,000, 3 years old, original Price = 300,000

Book value = 86400, useful life remaining = 8 years, 5 Years property class

New Machine

Original Price = 480,000, incremental cash inflow = 100,000

Salvage value = 40000, useful life remaining = 8 years, 5 Years property class
Tax rate = 40 percent

5 Years MACRS = 20 %, 32%, 19.2%, 11.52 %, 11.52 %, 5.76%

Initial Cash Outflow

New machine price = 480,000

Old machine sale = 70,000
-------------
= 410,000
Tax shield
16400 * 40/100 = 6560
-----------------

Net cash outflow = 403440

0 1 2 3 4 5 6 7 8
(403440) 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000

Dep
(old) 34560 34560 17280

Dep
(new) 96000 153600 92160 55296 55296 27648

Incr dep 61440 119040 74880 55296 55296 27648

(403440) 38560 (19040) 25120 44704 44704 72352 100,000 100,000

Tax (15424) 7616 (10048) (17882) (17882) (28941) (40,000) (40,000)

Add dep 61440 119040 74880 55296 55296 27648

(inc)

Salvage 24000

Net (403440) 84576 107616 89952 82118 82118 71059 60000 84000
cash
flows
Question 2

Old Machine
Current market price = 140000, 2 years old, original Price = 320,000
Book value = 130000, useful life remaining = 8 years, 5 Years property class,
maintenance cost annually = 4000
New Machine

Original Price = 520,000, incremental cash inflow = 140,000

Salvage value = 50000, useful life remaining = 8 years, 5 Years property class,
maintenance cost annually = 10,000, repair of engine in year 5 = 25000
Tax rate = 40 percent

5 Years MACRS = 20 %, 32%, 19.2%, 11.52 %, 11.52 %, 5.76%

Initial Cash Outflow
New machine price = 520,000
Old machine sale = 140,000
-------------
= 380,000
Tax shield
10,000* 40/100 = 4000
-----------------
Net cash outflow = 384000
0 1 2 3 4 5 6 7 8
(384000) 140,000 140,000 140,000 140,000 140,000 140,000 140,000 140,000

Maint. (6000) (6000) (6000) (6000) (6000) (6000) (6000) (6000)

repair (25000)
Dep (61440) (36864) (36864) (18432)
(old)

Dep (104000) (166400) (99840) (59904) (59904) (29952)

(new)

Incr dep (42560) (129536) (62976) (41472) (59904) (29952)

(384000) 91440 4464 71024 92528 49096 104048 134000 134000

Tax (36576) (1786) (28410) (37011) (19638) (41619) (53600) (53600)

Add dep 42560 129536 62976 41472 59904 29952

(inc)

Salvage 30000
(384000) 97424 132214 105590 96989 89362 92381 80400 110400
Net
cash
flows
Question 3

3 Years MACRS = 33.33%, 44.45%, 14.81%, 7.41%

Initial Cash Outflows

New equipment cost = 500,000

0 1 2 3 4
(500,000) 150,000 150,000 150,000 150,000

Maint. (6000) (6000) (6000) (6000)

Depreciation (166500) (222250) (74050) (37050)

(500,000) (22500) (78250) 69950 106950

Tax 40% 9000 31300 (27980) (42780)

Add dep (inc) 166500 222250 74050 37050

Salvage 30000

(500,000) 153000 175300 116020 131220

Net cash flows
 Question 4

Old Machine
Current market price = 90000, 3 years old, original Price = 420,000
Book value = 95000, useful life remaining = 8 years, 5 Years property class,
maintenance cost annually = 10,000
New Machine

Original Price = 600,000, incremental cash inflow = 180,000

Salvage value = 60000, useful life remaining = 8 years, 5 Years property class,
maintenance cost annually = 6,000 which will increase by 1000 annually, repair of
engine in year 5 = 25000, new machine may save electricity cost by 2000 in the first
year which may increase by 500 annually.
Tax rate = 40 percent

5 Years MACRS = 20 %, 32%, 19.2%, 11.52 %, 11.52 %, 5.76%

New machine cost = 600,000
Old machine sale = 90,000
------------------------
510,000
5000*40/100 2000
-----------------------
Net Cash Outflow = 508000

0 1 2 3 4 5 6 7 8
(508000) 180,000 180,000 180,000 180,000 180,000 180,000 180,000 180,000

Maint.cost old 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

Maint.cost new 6000 7000 8000 9000 10000 11000 12000 13000

Inc. main cost 4000 3000 2000 1000 0 (1000) (2000) (3000)

Repair engine (25000)

Electricity saving 2000 2500 3000 3500 4000 4500 5000 5500

Dep (old) 48384 48384 24192

Dep (new) 120000 192000 115200 69120 69120 34560

Incr dep (71616) (143616) (91008) (69120) (69120) (34560)

(508000) 114384 41884 93992 115380 89880 148940 183000 182500

Tax 40 % (45754) (16754) (37597) (46152) (35952) (59576) (73200) (73000)

Add dep (inc) 71616 143616 91008 69120 69120 34560

36000
Salvage
(508000) 140246 168746 147403 138348 123048 123924 109800 145500
Net cash flows
Question 5

Old Machine
Current market price = 100000, 2 years old, original Price = 280,000,
Book value = 95000, useful life remaining = 5 years, 3 Years property class,
maintenance cost annually = 6,000
New Machine

Original Price = 500,000 with installation cost of 20,000, incremental cash inflow =
100,000 and 6 percent inflation in savings is expected from the second year. Salvage
value = 40000, useful life remaining = 5 years, 3 Years property class, maintenance
cost annually = zero maintenance for 1st year, 5000 for 2nd year and 10 percent
increase in 3rd and 4th year, machine overhauling in year 3 = 12000, new machine may
save electricity cost by 8000 in the first year which may decrease by 500 annually.
Tax rate = 40 percent
MACRS 3 Years Rates = 33.33%, 44.45%, 14.81%, 7.41%

Initial Cash Outflows

Price new machine = 500,000
Installation cost = 20,000
--------------------
New machine total cost = 520,000
Old machine sale price = 100,000

---------------------
= 420,000
Tax on profit
5000* 40/100 = 2000

-------------------

Initial cash Outflow = 422000

 0 1 2 3 4 5
(422000) 100,000 106,000 112360 119102 126248

Maint.cost old (6000) (6000) (6000) (6000) (6000)

Maint.cost new (00000) (5000) (5500) (6050) (6655)

Inc. main cost 6000 1000 500 (50) (655)

Machine overhauling (12000)

Electricity saving 8000 7500 7000 6500 6000

Dep (old) (41468) (20748)

Dep (new) (173316) (231140) (77012) (38506)

Incr dep (131848) (210392) (77012) (38506)

(422000) (17848) (95892) 30848 87096 131593`

Tax 40 % 7139 38357 (12339) (34838) (52637)

Add dep (inc) 131848 210392 77012 38506

24000
Salvage
(422000) 121139 152897 95521 90764 102956
Net cash flows

Capital Budgeting Techniques

1. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return (IRR)

Payback Period

The period of time required for the cumulative expected cash flows from an investment
project to equal the initial cash outflow

0 1 2 3 4 5
(500000) 100000 100000 100000 100000 100000

Acceptance Criterion: If the payback period calculated is less than some maximum accepted
payback period, the proposal is accepted; if not, it is rejected

Net Present Value

The present value of an investment project’s net cash flows minus the project’s initial cash
outflow
NPV = PV of cash inflows – PV of Cash outflows

Acceptance Criterion: If an investment project’s net present value is zero or more, the project
is accepted; if not, it is rejected.

Project A:

PV of cash inflows = 60000

PV of cash outflows = 50000
NPV of Project A = 10000

Project B:

PV of cash inflows = 110000

PV of cash outflows = 100000
NPV of Project B = 10000

Profitability Index

The ratio of the present value of a project’s future cash flows to the project’s initial cash
outflow

PI = PV of cash inflows /PV of cash outflows

PI of Project A = 60000/50000 = 1.2

PI of Project B = 110000/100000 = 1.1

Acceptance Criterion: As long as the profitability index is 1 or greater, the investment

proposal is acceptable.

Internal Rate of Return (IRR)

The discount rate that equates the present value of the future net cash flows from an
investment project with the project’s initial cash outflow

100,000 = 110,000
0 1
100000 110,000

10,000

Or

10 %
 0 1 2 3 4
(100,000) 30000 30000 40000 30000

2 (1+.5) = 3

3 / (1+.5) = 2

NPV = 2 – 2 = 0

Acceptance Criterion: IRR>cost of capital=accept

The acceptance criterion generally employed with the internal rate of return method is to
compare the internal rate of return to a required rate of return, known as the cut-off or hurdle
rate.

Hurdle Rate: The minimum required rate of return on an investment in a discounted cash
flow analysis; the rate at which the project is acceptable

Question 1

0 1 2 3 4
(100,000) 34432 39530 39359 32219

Required rate of return = 12 %

a) Payback Period

PBP = 100,000 – 34432 = 65568

= 65568 - 39530 = 26038

= 26038 /39359 = .66

Payback Period = 2.66 Years

b) Net Present Value

 NPV = PV of Cash Inflows – PV of Cash Outflows

= 110746 - 100,000

= 10746

0 1 2 3 4
(100,000) 34432 39530 39359 32219

34432/(1+.12)1 39530/(1+.12)2 39359/(1+.12)3 32219/(1+.12)4

30743 31513 28014 20476

c) Profitability Index

PI = PV of Cash Inflows/ PV of Cash Outflows

= 110746/ 100,000

= 1.11

d) Internal Rate of Return (IRR)

12 %

NPV = PV of Cash Inflows – PV of Cash Outflows

= 110746 - 100,000

= 10746

0 1 2 3 4
(100,000) 34432 39530 39359 32219

34432/(1+.12)1 39530/(1+.12)2 39359/(1+.12)3 32219/(1+.12)4

30743 31513 28014 20476

 20 %

0 1 2 3 4
(100,000) 34432 39530 39359 32219

34432/(1+.20)1 39530/(1+.20)2 39359/(1+.20)3 32219/(1+.20)4

28693 27451 22777 15538

NPV = PV of Cash Inflows – PV of Cash Outflows

= 94459 - 100,000

= (5541)

= iL + (iH - iL)(NPVL – NPVIRR)/ (NPVL – NPVH)

= .12 + (.20 -.12) (10746 - 0)/ (10746 + 5541)

= .12 + (.08)(10746)/ 16287

= .12 + 859.68/16287

= .12 + .053

= .173

Q#2

0 1 2 3 4 5 6 7 8
(404424 86890 106474 91612 84801 84801 75400 66000 92400
)

Required rate of return is 14 percent.

a) Payback Period

1-4 years ). 404424 – 86890 – 106474 – 91612 - 84801 = 34647

5th year = 34647 / 84801 = .408

Payback Period = 4+.408 = 4.408 Years

 b) NPV

0 1 2 3 4 5 6 7 8
(404424) 86890 106474 91612 84801 84801 75400 66000 92400
PV of 86890/(1.14)1 106474/(1.14)2 91612/(1.14)3 84801/(1.14)4 84801/(1.14)5 75400/(1.14)6 66000/(1.14)7 92400/1.1
Cinflow 4)8

76219 81928 61836 50209 44043 34351 26376 32392

NPV = PV of cash inflows – PV of cash outflows

= 407354- 404424

= 2930

c) Profitability Index

PI = PV of cash inflows /PV of cash outflows

= 407354/ 404424

= 1.007

d) IRR

14 %

0 1 2 3 4 5 6 7 8
(404424) 86890 106474 91612 84801 84801 75400 66000 92400
PV of 86890/(1.14)1 106474/(1.14)2 91612/(1.14)3 84801/(1.14)4 84801/(1.14)5 75400/(1.14)6 66000/(1.14)7 92400/1.1
Cinflow 4)8

76219 81928 61836 50209 44043 34351 26376 32392

NPV = PV of cash inflows – PV of cash outflows

= 407354- 404424
 = 2930

18 %

0 1 2 3 4 5 6 7 8
(404424) 86890 106474 91612 84801 84801 75400 66000 92400
PV of 86890/(1.18)1 106474/(1.18)2 91612/(1.18)3 84801/(1.18)4 84801/(1.18)5 75400/(1.18)6 66000/(1.18)7 92400/1.1
Cinflow 8)8

73636 76468 55758 43739 37067 27931 20719 24582

NPV = PV of cash inflows – PV of cash outflows

= 359900 - 404424

= (44524)

= iL + (iH - iL)(NPVL – NPVIRR)/ (NPVL – NPVH)

= .14 + (.18 - .14)(2930 – 0)/ (2930 + 44524)

= .14 + (.04)(2930 )/ (47454)

= .14 + 117.2/47454

= .14 + .002470

= .1425

Cost of Capital (WACC)

The required rate of return on the various types of financing. The overall cost of capital is a
weighted average of the individual required rates of return (costs)

Cost of Debt (Kd)

The required rate of return on investment of the lenders of a company

Cost of Common Equity (Ke)

The required rate of return on investment of the common shareholders of the company
Cost of Preferred Stock (Kp)
The required rate of return on investment of the preferred shareholders of the company

Suppose amount required = 100,000

IRR/ Project Rate = 17.3 %

Company decided to issue debt securities of 40,000 at 12 percent and 30000 will be raised by
issuing preference shares at 13 percent. Remaining amount will be raised by issuing common
stock. The required rate of return by common stock holders is 16 percent. Tax rate = .40

Debt = 40,000 Wd = .40, Kd = .12

Pref Stock = 30000 Wp = .30, Kp = .13
C. Stock = 30000 We = .30, Kd = .16

WACC = (Wd)(Kd)(1-t) + (We)(Ke) + (Wp)(Kp)

WACC = (.40)(.12)(1-.40) + (.30)(.16) + (.30)(.13)

WACC = .136 or 13.6 %

A company has the following capital structure

Debt = 1000000 Wd = 1000000/6000000 = .1667

Common Stock = 3000000 We = 3000000/6000000 = .50
Pref. Stock = 2000000 Wp = 2000000/6000000 = .333

Cost of debt = 14 percent, cost of preferred stock = 15 percent, cost of

common stock = 18 percent, tax rate = 40 percent.

WACC = (Wd)(Kd)(1-t) + (We)(Ke) + (Wp)(Kp)

WACC = (.1667)(14)(1-.40) + (.50)(.18) + (.333)(.15)
WACC = .154 or 15.4 %
A company has the following capital structure

Debt = 2000000 , Wd = 2000000/5000000 = .40

Common Stock = 2000000 , Wc = 2000000/5000000 = .40
Pref. Stock = 1000000 , Wp = 1000000/5000000 = .20

Cost of debt = 12 percent, cost of preferred stock = 14 percent, cost of

common stock = ?, percent, tax rate = 40 percent.
Risk Free Rate = 12 %, market return = 18 percent, beta = 1.2

Ke = Rf + b (Rm – Rf)

Ke = .12 + 1.2 (.18 – .12)

Ke = .192

WACC = (Wd)(Kd)(1-t) + (We)(Ke) + (Wp)(Kp)

WACC = (.40)(.12)(1-.40) + (.40)(.192) + (.20)(.14)
WACC = .1336 or 13.36 percent

A company has the following capital structure

Debt = 3000000 Wd = .30

Common Stock = 5000000 We = .50
Pref. Stock = 2000000 Wp = .20

Cost of debt = 10 percent, cost of preferred stock = 13 percent, cost of

common stock = ?, percent, tax rate = 40 percent.

Current dividend on common stock = 1 $, growth = .12 and current market

value of common share = 20 $ per share

V = Do (1+g) / Ke -g

20 = 1 (1+.12) / Ke - .12

20Ke - 2.4 = 1.12

20Ke = 1.12+ 2.4

20Ke = 3.52
Ke = 3.52/20
 Ke = .176 or 17.6 percent

WACC = (Wd)(Kd)(1-t) + (We)(Ke) + (Wp)(Kp)

WACC = (.30)(.10)(1-.40) + (.50)(.176) + (.20)(.13)

WACC = (.30)(.10)(.60) + (.50)(.176) + (.20)(.13)
WACC = .018 +.088 + .026
WACC = .132 or 13.2 percent

Takeover

Transfer of control of a firm from one group of shareholders to another

1. Acquisition
I. Merger or Consolidation

Acquiring Firm ……………. Bidder

Acquired Firm ……………… Target Firm

Merger means complete absorption of one company by another wherein the

acquiring firm retains its identity and the target firm ceases to exist as a
separate entity

Co A acquired Co B wherein company B ceases to exist and Co A retains it

identity

Consolidation: A merger in which an entirely new firm is created and both the
acquired and acquiring firm cease to exist

Co A acquiring company and Co B target company ceases their existence and

a new firm “Firm AB” is created

II. Acquisition of Stock

A way to acquire another firm by simply purchasing the firm’s voting stock
with an exchange of cash, shares of stock, or other securities. Normally bidder
firm makes tender offer in the market. Tender offer means a public offer by
one firm to directly buy the share of another firm

III. Acquisition of Assets

A firm can effectively acquire another firm by buying most or all of its assets.
 Acquisition Classifications

 Horizontal Acquisition

This is an acquisition of a firm in the same industry as the bidder

 Vertical Acquisition

A vertical acquisition involves firms at different step of the production

process.

 Conglomerate Acquisition

When the bidder and the target firms are in unrelated lines of business,
the merger is called a conglomerate acquisition

2. Proxy Contest

When a group attempts to gain controlling seats on the board of directors by voting in
new directors. A proxy is the right to cast someone else’s votes. In a proxy contest,
proxies are collected by an unhappy group of shareholders from the rest of the
shareholders.

3. Going Private

In going private transaction, all of the equity shares of a public firm are purchased by
a small group of investors. Usually, the group includes members of existing
management.

i- Leveraged Buyouts (LBOs): Buyout using borrowed money

ii- Management Buyouts (MBOs): Management is heavily involved in going
private transaction

Joint Venture

Typically an agreement between firms to create a separate co-owned entity established to

pursue a goal

Strategic Alliance

Agreement between firms to cooperate in pursuit of a joint goal

Antitakeover Defensive Strategies/Tactics
1. Repurchase and Standstill Agreements / Greenmail
Standstill agreements are contracts wherein the bidding firm agrees to limit its holding
in the target firm. It will normally be followed by a targeted repurchase of target
company stock at premium.

2. Supermajority Amendment
Supermajority is required in case of takeover instead of simple majority

3. Counter Tender Offer (Pac-man defence)

Target Company will make a counter tender offer to the bidding company
shareholders

Co A wants to takeover company B and made a tender offer to Company B

shareholders. In response company B make a counter offer to Co A shareholders

4. Fair Price Provision

A fair price provision means that all selling shareholders will receive the same price
from the bidder.

Tender Offer: Offer by bidding firm to the shareholders of target firm to buy shares at
a certain price

Two Tier Tender Offer

First 20000 shares at 25
Remaining shares at 20

5. Bear Hug
A bear hug is an unfriendly takeover designed to be so attractive that the target firm’s
management has little choice but to accept it.

6. Golden Parachute
Some target firms provide compensation to top-level management if a takeover
occurs. Depending on your perspective and the amounts involved, golden parachute
can be viewed as payment to management to make it less concerned for its own
welfare and more interested in stockholders when considering a takeover bid.

7. Dual Class Capitalization

A company issue dual class of shares where voting right may vary for each class of
shares. For example, a company issued Class A shares (with one vote each share) and
 Class B shares (with two votes each share) has typically concentrated power in class
B shares.

8. Proxy War

To counter the proxy contest, company management is also involved in proxy contest

9. White Knight
A firm facing unfriendly merger offer might arrange to be acquired by a different,
friendly firm. The firm thereby rescued by a white knight. Usually, the friendly firm
retains the existing management.

10. Lady Macbeth Strategy

White Knight betrays the target firm and supports the bidder

11. Staggered Board

A system in which a company only open up a portion of their director position at

election time. For example, a company with nine board members divided into three
classes, will choose 3 directors at every election. This will increase the time required
to take over the company and may help existing management to avoid it.

12. Poison Pill

Poison pill is a defensive tactic utilized by existing management to make the company
unattractive for the hostile bidder

 Selling the crown jewel: selling the most profitable segment of the
business
 Issue of debt securities repayable in case of takeover
 Issue of shares to at discount diluting the ownership concentration
which may increase the percentage of shares required for any takeover

Divestitures and Restructurings

Divestitures

The sale of assets, operations, divisions, and/ or segments of a business to a third party

Reasons of divestitures unrelated to Merger and Acquisition

  An unprofitable segment is sold
 Profitable segment sold to realize the gains
 Sometimes firm in liquidity problem may sale their assets/segments

Equity Carve-out

The sale of stock in a wholly owned subsidiary via an IPO

Instead of selling a complete segment/unit, a company may create a subsidiary company of

that segment (because the segment is large to be sold). Next, the parent company arranges an
IPO in which a fraction, perhaps 20 percent of the shares is sold.

Spin-Off

The distribution of shares in a subsidiary to existing parent company shareholders on pro-rate

basis. Very commonly, a company will first do an equity carve-out to create an active market
for the shares and then subsequently do a spinoff of the remaining shares at a later date.

Split-Up

The splitting up of a new company into two or more companies