Finance Compendium Club Chanakya

Finance Compendium
Prepared by Ninad Solanky (PRM 39, Vivritti Capital)
Finance Revision Sheet
Basic Accounting Concepts

Accounting Principles
These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are
1. Going Concern Concept: This principle assumes that a business will go on, that is, it will continue in the
foreseeable future – it has no finite life. We use this principle to project cash flows in the future.
2. Legal Entity: The business is an entity separate from owners; even if it’s a small, one-person business running
out of home. Therefore, the business accounts are taken separate from the owners.
3. Conservatism: Be cautious and conservative while accounting. Recognize income only when it’s definite.
4. Accrual Concept: Income and expense are recognized/recorded when a transaction occurs- not when cash
changes hands. Income and expense are recorded irrespective of cash.
5. Matching Concept: The business must match the expenses incurred for a period, to the income earned during
that period.
6. Cost Concept: All assets are recorded on the books at purchase price, not market price, with some exceptions.
Basic overview of financial statements
There are four basic financial statements that provide the information you need to evaluate a company:
• Balance Sheet
• Income Statement
• Statements of Cash Flows
• Statements of Retained Earnings
These four statements are provided in the annual reports (also referred to as "lOKs") published by public companies.
In addition, a company's annual report is almost always accompanied by notes to the financial statements.
These notes provide additional information about each line item of numbers provided in the four basic financial
statements.
The Balance Sheet
The Balance Sheet presents the financial position of a company at a given point in time. It is comprised of three
parts: Assets, Liabilities, and Shareholder's Equity. Assets are the economic resources of a company. They are the
resources that the company uses to operate its business and include Cash, Inventory, and Equipment. (Both financial
statements and accounts in financial statements are capitalized.) A company normally obtains the resources it uses
to operate its business by incurring debt, obtaining new investors, or through operating earnings. The Liabilities
section of the Balance Sheet presents the debts of the company. Liabilities are the claims that creditors have on the
company's resources. The Equity section of the Balance Sheet presents the net worth of a company, which equals
the assets that the company owns less the debts it owes to creditors. In other words, equity is comprised of the
claims that investors have on the company's resources after debt is paid off.
The most important equation to remember is that:
Assets (A) = Liabilities (L) + Shareholder's Equity (SE)

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The structure of the Balance Sheet is based on that equation. This example uses the basic format of a Balance Sheet:
Assets Liabilities
Particulars Amount Particulars Amount
Cash 1000 Payable 500
Receivables 3000 Equity
Building 50000 Shares 10000
Retained Earnings 43500
54000 54000
With respect to the right side of the balance sheet, because companies can obtain resources from both investors and
creditors, they must distinguish between the two. Companies incur debt to obtain the economic resources necessary
to operate their businesses and promise to pay the debt back over a specified period of time. This promise to pay is
based on a fixed payment schedule and is not based upon the operating performance of the company. Companies
also seek new investors to obtain economic resources. However, they don't promise to pay investors back a
specified amount over a specified period of time. Instead, companies forecast for a return on their investment that
is often contingent upon assumptions the company or investor makes about the level of operating performance.
Since an equity holder's investment is not guaranteed, it is riskier in nature than a loan made by a creditor. If a
company performs well, the upside to investors is higher. The promise-to-pay element makes loans made by
creditors a Liability and, as an accountant would say, more "senior" than equity holdings, as it is paid back before
distributions to equity-holders are made.
To summarize, the Balance Sheet represents the economic resources of a business. One side includes assets, the
other includes liabilities (debt) and shareholder's equity, and Assets = L+E. On the liability side, debts owed to
creditors are more senior than the investments of equity holders and are classified as Liabilities, while equity
investments are accounted for in the Equity section of the Balance Sheet.
The Income Statement
We have discussed two of the three ways in which a company normally obtains the economic resources necessary
to operate its business: incurring debt and seeking new investors. A third way in which a company can obtain
resources is through its own operations. The Income Statement presents the results of operations of a business over
a specified period of time (e.g., one year, one quarter, one month) and is composed of Revenues, Expenses and Net
Income.
Revenue: Revenue is a source of income that normally arises from the sale of goods or services and is recorded
when it is earned. For example, when a retailer of roller blades makes a sale, the sale would be considered revenue.
Expenses: Expenses are the costs incurred by a business over a specified period of time to generate the revenues
earned during that same period of time. For example, in order for a manufacturing company to sell a product, it
must buy the materials it needs to make the product. In addition, that same company must pay people to both make
and sell the product. The company must also pay salaries to the individuals who operate the business. These are all
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types of expenses that a company can incur during the normal operations of the business. When a company incurs
an expense outside of its normal operations, it is considered a loss. Losses are expenses incurred as a result of one-
time or incidental transactions. The destruction of office equipment in a fire, for example, would be a loss. Incurring
expenses and acquiring assets both involve the use of economic resources (i.e., cash or debt). So, when is a purchase
considered an asset and when is it considered an expense?
Assets vs. expenses: A purchase is considered an asset if it provides future economic benefit to the company, while
expenses only relate to the current period. For example, monthly salaries paid to employees for services they already
provided to the company would be considered expenses. On the other hand, the purchase of a piece of
manufacturing equipment would be classified as an asset, as it will probably be used to manufacture a product for
more than one accounting period.
Net income: The Revenue a company earns, less its Expenses over a specified period of time, equals its Net Income.
A positive Net Income number indicates a profit, while a negative Net Income number indicates that a company
suffered a loss (called a "net loss"). Here is an example of an Income Statement:
Revenues
Sales 10000
Other
Incomes 500
Expenses
Salaries 2500
Rent 2000
Utilities 500
Net Income 5500

To summarize, the Income Statement measures the success of a company's operations; it provides investors and
creditors with information needed to determine the enterprise's profitability and creditworthiness. A company has
earned net income when its total revenues exceed its total expenses. A company has a net loss when total expenses
exceed total revenues.
Statement of Retained Earnings
Retained earnings is the amount of profit a company invests in itself (i.e., profit that is not used to pay back debt
or distributed to shareholders as a dividend). The Statement of Retained Earnings is a reconciliation of the Retained
Earnings account from the beginning to the end of the year. When a company announces income or declares
dividends, this information is reflected in the Statement of Retained Earnings. Net income increases the Retained
Earnings account. Net losses and dividend payments decrease Retained Earnings.
Here is an example of a basic Statement of Retained Earnings:
Retained Earnings Amount
Retained Earnings From Previous Years 20000
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Add: Net Income 5000
Less: Dividends Declared 2000
Retained Earnings at the end of the

Year 23000
Statement of Cash Flows
Remember that the Income Statement provides information about the economic resources involved in the operation
of a company. However, the Income Statement does not provide information about the actual source and use of
cash generated during its operations. That's because obtaining and using economic resources doesn't always involve
cash. For example, let's say you went shopping and bought a new mountain bike on your credit card in July -but
didn't pay the bill until August.
Although the store did not receive cash in July, the sale would still be considered July revenue. The Statement of
Cash Flows presents a detailed summary of all of the cash inflows and outflows during the period and is divided
into three sections based on three types of activity:
• Cash flows from operating activities: Includes the cash effects of transactions involved in calculating net
income.
• Cash flows from investing activities: Basically, cash from non-operating activities or activities outside the
normal scope of business. This involves items classified as assets in the Balance Sheet and includes the purchase
and sale of equipment and investments.
• Cash flows from financing activities: Involves items classified as liabilities and equity in the Balance Sheet; it
includes the payment of dividends as well as issuing payment of debt or equity.
This example shows the basic format of the Statement of Cash Flows:
Cash Flow Statement

Cash Flow from Operating Activities
Net Income 20000
Depreciation 2000
Less: Increase In Receivables 1000
Add: Increase In Payables 500
Net Cash Flow from Operating
Activities 21500
Cash Flow from Investing Activities
Purchase of Building -7000
Sale of Long Term Investment 2500
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Net Cash Flow from Investing

Activities -4500
Cash Flow from Financing Activities
Dividend Payout -2000
Share Issue 3000
Net Cash Flow from Financing
Activities 1000
Net Increase in Cash 18000
Cash At Beginning of the Year 15000
Cash At End of the Year 33000
As you can tell be looking at the above example, the Statement of Cash Flows gets its information from all three
of the other financial statements.
Financial Ratios
A few basic things:
• One ratio cannot be used for the analysis of the whole company and several of them have to be looked at
simultaneously to form the whole picture
• The ratios vary vastly across different industries. Also, for the purpose of financial analysis, ratios cannot
be looked at in isolation, therefore they must be compared to the ratios of their peer companies (cross
sectional analysis) as well as against its ratios in the previous years (time series analysis) to get a fair idea
about the company’s performance
There are majorly five different types of ratios. They are as follows:
• Liquidity ratios: These ratios provide information about the ability of the company to meet its short-term
obligations.
• Solvency ratios: Solvency ratios provide information about a company’s ability to meet its long-term
obligations. They also provide an information about the leverage of the company. Therefore, these ratios
are also referred to as the debt ratios (Leverage refers to the use of borrowed money by a company to fund
its operations)
• Activity ratios: These ratios give indication of how efficiently is a company using it assets like inventory
and fixed assets. These ratios are also referred to as turnover ratios.
• Profitability ratios: These ratios provide information on how well a company generates profits from its
sales, assets, capital etc.
• Valuation ratios: Valuation ratios are generally used to estimate the attractiveness of a potential or an
existing investment and get an idea of the company’s valuation in comparison to its peer companies.
PROFITABILITY RATIOS
Profit Margins
Margins are the profit metric used as a percentage of the total sales. Thus
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Margin = Profit Metric / Total Sales

The Profit metric used could be Gross Profit, EBITDA, EBIT, PBT or PAT, and the margin is called the metric
followed by the word “Margin”, for example:
Gross profit Margin = Gross profit / Total sales
Net profit Margin = Net Profit / Total sales
Comparing the margins for competitors could give an idea of the relative performance of companies and the
differences in margins for a company are used to analyse how much money is spent at what stage of the business.
Return on Assets
ROA = EBIT*(1-tax) / Average Total Assets
Return on assets is an indicator of how profitable a company relative to its total assets. Therefore, a higher ROA is
generally considered good for a company. Sometimes, just EBIT is used in the numerator. It is useful especially
when the income tax rate changes over time, when the funding structure changes or when comparing entities with
different financing structure. EBIT*(1-t) in the numerator is useful when comparing enterprises with different share
of liabilities in the financial structure. Thus, ROA is a measure of how efficiently the company manages its assets.
Generally, a high Return on assets ratio is considered to be good for a company.
Return on Capital Employed
ROCE = EBIT*(1-tax)/ Average Capital employed
Where Capital Employed = Total Assets – Current Liabilities
Capital Employed may also be seen Equity + Non-Current Liability or as the total money the company has raised
through financing.
Similar to ROA, a high ratio for ROCE also, is generally considered better. Although both ROA and ROCE convey
similar information, ROCE is from the liability perspective as to how much return a company gives per the amount
of capital raised, whereas ROA is from the asset perspective as to how well the company is using its assets.
Return on Invested Capital
ROIC = EBIT*(1-tax)/ Invested Capital
where Invested Capital is Capital Employed – Cash and Cash equivalents.
This is a further refinement of ROCE since the cash although is needed to buy assets needed to generate profits,
but in itself, sitting with the company as reserves, it isn’t generating any revenue or profit for the company, thus
makes sense to be removed from the Employed Capital.
NOTE: NOPAT (Net operating profit after tax) is usually used for ROA, ROCE and ROIC calculations to account
for tax payable directly on the operating profit. But even here, interest expense is not reduced because the
denominator contains assets financed from both debt and equity and thus portion of the income contributed towards
debt holders (ie interest) should not be removed.
NOPAT = EBIT*(1-tax) OR Net Income + Interest*(1-tax)
Return on Equity
ROE = Net Income/ Average shareholders’ Equity
ROE is a metric of how profitable it is to invest in the equity of a company.
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Net income, instead of EBIT is used in the numerator for ROE, because Net Income is the value that is given back
to the shareholders through dividends paid or the increase in shareholder’s equity through retained earnings. The
interest and tax paid is removed from EBIT to arrive at Net income for the ROE calculation. This is done as the
interest payment and the taxes belongs to the lender and the government respectively.
It is to be noted that two companies with the exactly same assets and performance may have very different ROE if
they have different capital structures. This can be better understood from a DuPont analysis. (The DuPont analysis
uses a number of different ratios that will be covered ahead; therefore, you can come back to DuPont analysis after
having read the other ratios)
A DuPont analysis tells you what exactly are the drivers of your ROE. The above-mentioned formula of ROE can
be broken down into the following three components:
ROE = (Net income / Sales) * (Sales / Average total assets) * (Average total assets / Average equity)
Mathematically, if you multiply these three components, you will get Net income / Average equity i.e. ROE as a
result.
Looking at these components individually,
The first component i.e. (Net income / Sales) is actually the formula for net profit margin
The second component i.e. (Sales / Average total assets) is actually the formula for asset turnover
The third component i.e. (average total assets/ average equity) is the leverage ratio
Thus, it can be deduced that a company’s ROE can be driven by either high profit margins or the efficient use of
its assets (asset turnover) or it can simply be the effect of high amount of debts and low equity of a company
(leverage ratio). Based on an understanding of where the ROE is coming from, an analyst must make his judgements
accordingly.
TURNOVER RATIOS
These usually imply how effectively you transform something that the business has to something that the business
generates from it (for example: sales from assets), or a balance sheet item to a corresponding P&L item that the
balance sheet item is ultimately used for. Usually the Balance sheet items are the average of the opening and closing
values for the period for which the PnL is being considered.
Asset Turnover Ratio
In general, the purpose of all the assets is to generate sales for the business. Thus
ATR = Net Sales/ Average Total Assets
A high ATR ratio is usually preferred for a company. It means that the company is more efficiently generating sales
from thee assets that it owns.
NOTE: This ratio has further application in the DuPont Analysis.
Cash Conversion Cycle and Operational Turnover Ratios:
Inventory turnover ratios
A business usually has inventories so that they can be consumed to be sold off as the final product. The formula
for Inventory turnover ratios is as follows:
Inventory Turnover Ratio = COGS / Average Inventory
Sometimes, when COGS is not given, Net Sales can also be taken in place of it.
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This can be interpreted as the number of times the average inventory has to be restocked for all the production in
the year. Hence
Days Inventory Outstanding = 365 / (Inventory Turnover Ratio)
This can be interpreted as the number of days it takes from buying the raw material to selling the produced goods.
Thus, a lower DIO indicates inventory efficiency of the company and is desirable.
Receivables turnover ratio
Receivables are usually owed by the customers to the business, and are a part of the sales by the company.
Receivables turnover ratio = Net Credit Sales/ Average Accounts Receivables
This ratio can be interpreted as how efficiently does a company collects receivables from the credit that it has
extended to its customers. This is mostly used in the form of DSO
Days Sales Outstanding (DSO) = 365/ (Receivables turnover ratio)
This is the number of days a company takes to collect revenue after a sale has been made. Due to the high
importance of cash in running a business, it’s best for the company to collect outstanding receivables as quickly as
possible and reinvest in the business, and thus a low DSO is desirable and a high DSO could lead to cash flow
problems for the company. However, it is to be noted that that a very low DSO is also not considered very good,
as it might indicate that the company has a very strict credit policy and thus it might lose out on potential sales
opportunities.
Trade Payables turnover ratio and DPO
Payables are usually to the suppliers of the business to purchase the raw material and other things.
Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables
This is mostly used in the form of DPO
Days Payables Outstanding (DPO) = 365 / (Trade Payables turnover ratio)
This is the number of days the company on an average take to pay its suppliers. A high DPO could imply that the
suppliers have trust in the company are willing to give it supplies on credit. Another way to look at it could be that
the company is having trouble paying its suppliers and is taking very long.
Cash Conversion Cycle
Usually a company acquires inventory on credit, which results in accounts payable. A company can also sell
products on credit, which results in accounts receivable. Cash, therefore, is not involved until the company pays
the accounts payable and collects the accounts receivable. So the cash conversion cycle measures the time between
the outlay of cash and the cash recovery and measures the number of days each net input dollar is tied up in the
production and sales process before it is converted into cash.
Its formula is given by
CCC = DIO + DSO – DPO
CCC is not looked usually at a standalone basis and it is seen as a pattern over the years or with respect to its
competitors, along with other ratios. But typically, a lower CCC is considered healthier for a company and a higher
CCC could indicate cash flow problems.
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A negative cash flow basically means that the company has higher powers to dictate terms. This could be due to
the large size of the company in the market or the company could be the only monopoly player. Taking a large
fmcg as eg, (ITC) can have a -ve cash flow since it can demand a higher credit period from its suppliers and in turn
give lower credit to the customers. Also, some industries like the e-commerce
This is also known as the Operating Cycle.
MARKET AND VALUATION RATIOS

EPS
EPS refers to the amount of net income that each shareholder is entitled to
EPS = Net Income / Average No. of Shares outstanding
NOTE: Unlike several of the Market Ratios, EPS is independent of the market price of the share and not to be
confused with the dividends paid.
Dividend Payout Ratio and Retention Ratio:
The net income generated by a company can be utilized for 2 purposes. To pay cash rewards to the shareholders or
to invest back and grow the business. The portions of the Net Income given to these 2 purposes are the Dividend
Payout Ratio and Retention Ratio respectively. Thus
Dividend Payout Ratio = Total Dividends Paid/Net Income Retention Ratio = (Net Income – Total Dividends
Paid)/Net Income
Note: Total Dividends Paid = Dividend given per share * #Shares, but given the financials of the company, you
can calculate the Total Dividends Paid by checking what part of the net income has not been added to the retained
earnings, ie Net Income – (Increase in the Retained Earnings from opening to closing)
Price to Earnings Ratio
Often called the PE ratio, its formula is as its name suggests
PE Ratio = Price per share/EPS
The EPS taken is usually for the past year or TTM (Trailing Twelve Months)
This ratio is the price you pay in order to earn a dollar of earnings from the total earnings of the company. A high
PE ratio means that you have to pay more to earn every dollar of the company’s earnings and thus it might indicate
that the company is overvalued and similarly a low PE ratio
might indicate that a company is undervalued. So, normally you’d prefer a lower PE. Different industries have very
different ranges of PE ratios and even within an industry, the capital structure adversely changes the PE ratio.
PEG Ratio
Price/Earnings-to-growth ratio considers the estimated growth of the company of the company. The earnings in PE
ratio are historical, but for PEG ratio, we consider the future estimates of earnings for the coming year, thus the
denominator is estimated EPS or TTM EPS * growth estimate.
PEG Ratio = Share Price / (EPS * Projected Earnings Growth)
This could give a better picture to compare 2 shares for investing purposes.
When the PEG exceeds one, this tells you that the market expects more growth than estimates predict, or that
increased demand for a stock has caused it to be overvalued.
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A ratio result of less than one says that either analysts have set their consensus estimates too low, or that market
has underestimated the stock’s growth prospects and value.
Price/Book Value Ratio
The Book Value of the equity is its value that is mentioned on the liabilities side in the Balance Sheet, which can
also be calculated as the difference of the total assets and the liabilities. The Price part denotes what the market
values this equity as. It can be calculated using the following formula:
P/B ratio = (Market Capitalization/Book Value of Equity)
OR
(Share Price/Book Value per share) where Market Capitalization = Share Price * Shares outstanding
P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued
at market prices. A higher P/B ratio implies that investors expect management to create more value from a given
set of assets, all else equal.
EV/EBITDA
One major drawback of the PE ratio is its dependence on the capital structure of the firm, for which EV/EBITDA
is a better measure. Here, note that EBITDA is used in the denominator instead of EBIT as the depreciation method
adopted by different companies could be different. Although, EBIT is a better proxy for operating profits but we
are not interested in operating profits rather, we are more interested in a proxy for cash flows. Being a market
valuation ratio, the asset value corresponding to the operating profit has to be based on what the market evaluates
the company’s operating assets value to be. Thus Enterprise Value is defined as the market value of operating assets
Enterprise Value = Market Value of Equity + Market Value of Liabilities – Cash Reserves = Market
Capitalization + Total Liabilities – Cash
OR
Enterprise Value = Market Capitalization + Preferred Stock + Outstanding Debt + Minority Interest – Cash
and Cash Equivalents
Cash is excluded from the enterprise value as cash is received back by the acquirer. So, it reduces the net payment
made for the acquisition.
Thus, the ratio is given by
EV/EBITDA = Enterprise Value/ EBITDA
The main advantage of this ratio over PE ratio is its inherent incorporation of the capital structure.
Other Industry Specific Ratios:
Various other ratios are used for specific industries for example Price/Sales for retail industry or EV/tonne for the
cement industry.
Dividend Yield
A financial ratio that indicates how much a company pays out in dividends each year relative to its share price. It
is somewhat a measure of bang for your buck.
Dividend Yield = Annual Dividend per Share/Share Price
Finance Compendium
Yields for a current year are often estimated using the previous year’s dividend yield or by taking the latest quarterly
yield, multiplying by 4 (adjusting for seasonality) and dividing by the current share price.
LIQUIDITY RATIOS
Liquidity has to do with a firm's assets and liabilities. In particular, liquidity looks at whether or not a firm can pay
its current liabilities with its current assets.
Following are the list of liquidity ratios -
Current Ratio
The current ratio shows how many times over the firm can pay its current debt obligations from its current assets.
In general, current assets refers to those assets which will be utilized and hence generate cash in 1 year and current
liabilities refers to those liabilities that need to be paid within 1 year that is cash will be utilized. So, this ratio means
how much current assets a firm has to meet its current liabilities.
Current Ratio = Current Assets/Current Liabilities
Remarks - A current ratio of less than 1 indicates that the company may have problems meeting its short-term
obligations so a current ratio of more than 1 around 1.5-2.5 is safe. However, too high current ratio is also not
desirable because that would mean company is not using its current assets efficiently – For instance, current ratio
for Apple was recently around 10 or 12 because they amassed a hoard of cash. But investors get impatient, saying,
“We didn’t buy your stock to let you tie up our money. Give it back to us.” And then they are in a position of paying
dividends.
Quick Ratio or acid ratio
The quick ratio is a more stringent test of liquidity than is the current ratio. It looks at how well the company can
meet its short-term debt obligations without having to sell any of its inventory to do so.
Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a
buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-
term debt obligations without having to rely on selling inventory. Also, prepaid expenses are something which are
already been paid and hence, are not included.
Quick Ratio = Current Assets – Inventory – Prepaid Expenses/ Current Liabilities
Cash Ratio
The cash ratio is a further more stringent measure of the liquidity as compared to the current ratio and the quick
ratio. It measures the amount of cash, cash equivalents or invested funds there are in current assets to cover current
liabilities. It only looks at the most liquid short-term assets of the company, which are those that can be most easily
be used to pay off current obligations. It ignores inventory, prepaid expenses and receivables as there are no
assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities. Between
quick ratio and cash ratio, the difference is that account receivables is not present in cash ratio unlike quick ratio.
Cash Ratio = (Cash + Cash Equivalents) / (Current Liabilities)
Remarks - A cash ratio of 1.00 and above means that the business will be able to pay all its current liabilities in
immediate short term. Therefore, creditors usually prefer high cash ratio. But businesses usually do not plan to
keep their cash and cash equivalent at level with their current liabilities because they can use a portion of idle cash
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to generate profits. This means that a normal value of cash ratio is somewhere below 1.00. Also, it is not realistic
for a company to purposefully maintain high levels of cash assets to cover current liabilities. The reason being that
it's often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this
money could be returned to shareholders or used elsewhere to generate higher returns.
DEBT RATIOS / SOLVENCY RATIOS

These ratios aim to highlight the amount of debt taken by a firm. In most cases, a high amount of debt is not
generally preferable, as higher debt means higher obligations to pay interest payments, thus a higher financial risk.
However, a higher debt is not always bad as long as the company is using that debt to expand or optimize its
business operations or make long term investment which will generate revenue or reduce cost – for instance
purchase/replace equipment or buy land or buy plant. In general, debt means long term borrowings and other non-
current liabilities (not including provisions)
There are primarily 3 types of debt ratios:
Debt to Assets ratios: This is the simplest ratio to measure the amount of debt. It means what percentage of assets
are being funded by debt
Debt Ratio = Total Debt / Total Assets
Generally, large well-established companies can push the liability component of their balance sheet structure to
higher percentages without getting into trouble.
Debt to Equity Ratio: It is another way of representing the capital structure of the firm. This is a measurement of
how much lenders, creditors and obligors have committed to the company versus what the shareholders have
committed.
Debt/Equity = Total Debt/Shareholder’s Equity
In general, if your debt-to-equity ratio is too high, it’s a signal that your company may be in financial distress and
unable to pay your debtors. But if it’s too low, it’s a sign that your company is over-relying on equity to finance
your business, which can be costly and inefficient.
Remarks - The debt to equity ratio can be misleading at times. An example is when the equity of a business contains
a large proportion of preferred stock. In this case a dividend may be mandated in the terms of the stock agreement.
This in turn impacts the amount of available cash flow to pay debt. Then the preferred stock has the characteristics
of debt, rather than equity.
Financial Leverage: This is another way of type of debt ratio. It means how much assets is funded by equity.
Lower the leverage, the more is equity-funded asset.
Financial Leverage: Total Assets / Total Equity
This is also known as Equity Multiplier
So, if the ratio is high it means less equity has been used to fund total assets. Business companies with high leverage
are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts, it might lead to difficulties
in getting new lenders in future.
Finance Compendium
Interest Coverage Ratio:

More the debt, higher will be the interest expense. That means the company has to have higher EBIT to cover it.
ICR = EBIT(1-tax rate) / Interest Expense
This ratio shows how the ability of the company to meet its interest payments from its operating income. The higher
the ratio, the better position a company is in, to meet its interest obligations.
Using tax Rate in the numerator is optional as taking tax into account is a more conservative approach – since tax
will anyways be deducted from the total income, so we remove the tax component before calculating ICR.
However, it is not necessary to remove tax but we have to consistent with the formula. In most cases, the above
formula is preferred. The formula for ICR without taking the Tax rate into consideration is as follows:
ICR = EBIT / Interest Expense
Remarks: As a general rule of thumb, investors should not own a stock or bond that has an interest coverage ratio
under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash
necessary to pay its interest obligations.
For a company, in a situation where its sales decline and the there is a subsequent decrease in its net income, a high
interest obligation can be a cause of concern. An excessive decrease in the net income would result in a sudden,
and equally excessive, decline in the interest coverage ratio, which should send up red flags for any conservative
investor.
Financial Management Basics
1. Planning for funds – This involves deciding on the Capital structure of the firm
2. Raising funds – The quantum and type of funds (debt/equity, etc.) is decided. This fund is raised at a certain
cost known as Weighted Average Cost of Capital (WACC)
3. Management of funds – This involves Capital Budgeting (long-term planning) and
4. Distribution of funds – This involves planning for dividends. It is important for a firm to decide whether to
reinvest the reserves & surplus or pay dividends.
Role of Corporate Finance

The objective of Corporate Finance is to create shareholder value. It has 4 primary functions:
Working capital management (Short-term planning)
Capital Budgeting
Introduction
The Capital Budgeting Process is the process of identifying and evaluating capital projects, i.e., projects where the
cash flow to the firm will be received over a period longer than a year. Capital budgeting usually involves the
calculation of each project’s future accounting profit by period, the cash flow by period, the present value of the
cash flows after considering the time value of money, the number of years it takes for a project’s cash flow to pay
back the initial cash investment, an assessment of risk, and other factors.
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Key Principles of Capital Budgeting:

1) Decisions are based on cash flows, not accounting income (Incremental cash flows are to be considered, not
sunk costs)
2) Cash flows are based on opportunity costs
3) The timing of cash flows is important
4) Cash flows are analyzed on an after-tax basis
5) Financing costs are reflected in the project’s required rate of return
Decision Criterion
Net Present Value (NPV)
The NPV is the sum of present values of all expected incremental cash flows if a project is undertaken. The discount
rate used is the firm’s cost of capital, it is calculated based on the next best alternative use of the money. For a
normal project with an initial cash outflow, flowed by a series of cash inflows (after tax), the NPV is given by:
For independent projects, the NPV decision rule is to accept projects with positive NPVs and to reject projects with
negative NPVs.
Simple Example
Year Project A (INR) Project B (INR)
0 -2000 -2000
1 1000 200
2 800 600
3 600 800
4 200 1200
The Table shows the expected net after-tax cash flows of two projects, A and B. Discount Rate (Required rate of
Return) = 10%
NPV of A
-2000 + 1000/ (1.1) ^1 + 800/ (1.1) ^2 + 600/ (1.1) ^3 + 200/ (1.1) ^4 = INR 157.64
NPV of B
-2000 + 200/ (1.1) ^1 + 600/ (1.1) ^2 + 800/ (1.1) ^3 + 1200/ (1.1) ^4 = INR 98.36
Both projects A and B have positive NPVs, so both can be accepted. But, if only one project is to be chosen and if
other factors are kept constant, then Project A should be chosen because it has a positive NPV.
Advantage of the NPV Method: It is a direct measure of the expected increase in the value of the firm/project
Disadvantage of the NPV Method: The project size is not measured. For example, an NPV of INR 100 for a
project costing INR 10,000 is good, but the same NPV of INR 100 is not so good for a project costing INR
10,000,000.
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Terminal Year Calculation

The terminal year represents the year (usually 10 years in the future) when the growth of the company is considered
stabilized.
In other words,
The cash flows of the first 10 years are determined by company management or a financial analyst, based on
predictions and forecasts of what will happen. Then, a terminal year value needs to be calculated assuming that
after year 10 the cash flows of the company keep growing at a constant "g." Values of "g" are typically not as high
as the first 10 years of growth, which are considered un-stabilized growth periods.
Instead, "g" represents the amount the company can feasibly grow forever once it has stabilized (after 10 years).
The value of the terminal year cash flows (that is, the value in year 10) is given by:
Adding it up
Adding the discounted value of the first 10-year FCFs, and the terminal year FCFs (CFs after year 10 into
perpetuity) gives us the value of the company under the DCF analysis.
Internal Rate of Return (IRR)
The IRR is the discount rate which makes the present values of a project’s estimated cash inflows equal to the
present value of the project’s estimated cash outflow. It is the discount rate at which the NPV of a project is equal
to 0.
If IRR > the required rate of return, accept the project If IRR < the required rate of return, reject the project
Continuing with the above example used for NPV:-
Project A:
0 = -2000 + 1000/ (1 + IRRA) ^1 + 800/ (1 + IRRA) ^2 + 600/ (1 + IRRA) ^3 + 200/ (1 + IRRA) ^4
Project B:
0 = -2000 + 200/ (1 + IRRB) ^1 + 600/ (1 + IRRB) ^2 + 800/ (1 + IRRB) ^3 + 1200/ (1 + IRRB) ^4
Using trial-and-error methods, financial calculators or Excel, the IRR for Project A = 14.49%
and the IRR for Project B = 11.79%. Both can be accepted as the IRRs for both projects > 10%.
Advantage of the IRR Method: It measures profitability as a percentage, showing the return in each Rupee
invested. One can comment on how much below the IRR the actual project return could fall (in percentage terms)
before the project becomes economically unfeasible
Disadvantages of the IRR Method: The possibility of producing rankings of projects which may differ from the
NPV rankings (either due to cash flow timing differences or due to differences in project size) and the possibility
of Multiple IRRs for the same project or no IRR.
Payback Period
The Payback Period is the number of years it takes to recover the initial cost of an investment. Continuing with the
same example:
Finance Compendium
Project A (INR) Project B (INR)

Year
NCF Cumulative NCF NCF Cumulative NCF

0 -2000 -2000 -2000 -2000
1 1000 -1000 200 -1800
2 800 -200 600 -1200
3 600 400 800 -400
4 200 600 1200 800
Payback Period= Full Years Until Recovery + (Unrecovered Cost at the beginning of the year/Cashflow
during Last Year)
Payback Period (Project A) = 2 + (200/600) = 2.33 years
Payback Period (Project B) = 3 + (400/1200) = 3.33 years
Since the Payback Method does not take into account the time value of money and cash flow Beyond the payback
period, project decisions cannot be based solely on this method. However, this method is a good measure of project
liquidity.
Discounted Payback Method
This method uses the present values of the projects’ estimated cash flows. It must be
greater than the Payback Period without discounting. Continuing with the same example:
Year Project A (INR) Project B (INR)
Discounted Discounted
NCF NCF
NCF Cumulative NCF NCF Cumulative NCF
0 -2000 -2000.00 -2000.00 -2000 -2000 -2000
1 1000 909.09 -1090.91 200 181.818182 -1818.181818
2 800 661.16 -429.75 600 495.867769 -1322.31405
3 600 450.79 21.04 800 601.051841 -721.2622089
4 200 136.60 157.64 1200 819.616146 98.35393757
Discounted Payback Period (Project A) = 2 + (429/451) = 2.95 years

Discounted Payback Period (Project B) = 3 + (721/820) = 3.88 years
This method addresses the concern of discounting cash flows at the project’s required rate of
return, but it still does not consider cash flows beyond the discounted payback period.
Profitability Index (PI)
This is the Present Value of a project’s future cash flows divided by the initial cash outlay. It
is closely related to the NPV.
PI= (PV of future Cashflows/ Initial Investment) = 1+ (NPV/ Initial Investment)
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If PI > 1.0, accept the project, else, if PI < 1.0, reject the project.
Cost of Capital
Introduction
A firm must decide on how to raise capital for its various projects, to funds its business and for growth, dividing it
among common equity, debt and preferred stock. The optimum mix which produces the minimum overall cost of
capital will maximize the value of the firm. Debt, preferred stock and common equity are referred to as the capital
components of the firm. The cost of each of these components is called the component cost if capital.
kd: Cost of Debt – The rate at which the firm can issue new debt. It can also be considered as the yield to maturity
on existing debt (pre-tax component)
kd(1 – t): After-tax cost of Debt. “t” is the firm’s marginal tax-rate
kp: Cost of preferred Stock
ke: Cost of Equity – The required rate of return on common stock. The Cost of Equity is always higher than the
Cost of Debt
WACC: Weighted Average Cost of Capital – It is the cost of financing the firm’s assets. WACC is the average
of the costs of the above sources of financing, each of which is weighted by its respective use in the given situation.
WACC= Wd*Kd(1-T) + We*Ke + Wp*Kp
Where,
wd = percentage of debt in the capital structure, wp = percentage of preferred stock in the capital structure, we =
percentage of equity in the capital structure
Simple Example
Suppose Company A’s target capital structure is as follows: wd = 0.45, wp = 0.05, we = 0.50. Before-tax cost of
debt = 8%, cost of equity = 12%, cost of preferred stock = 8.4%, marginal tax rate = 40%
WACC = (wd) [kd (1 – t)] + (wp) (kp) + (we) (ke)
WACC = (0.45) (0.08) (1 – 0.40) + (0.05) (0.084) + (0.50) (0.12) = 0.0858 = 8.58%
The weights in the calculation of WACC should be based on the firm’s target capital structure
(The proportions the firm aims to achieve over time). The assumption here is that the firm would stick to the same
capital structure throughout the life of the project.
The Optimal Capital Budget
In the figure below, the intersection of the investment opportunity schedule with the marginal cost of capital curve
identifies the amount of the optimal capital budget. The firm should undertake projects, whose IRRs are greater
than the cost of funds as this will maximize the value created.
Finance Compendium
It is useful to view graphically how WACC alters as leverage changes. The classic figure below shows how WACC
is high at low levels of leverage (debt), it reaches an ‘optimum’ at the idealized WACC before rising quickly into
the territory where financial distress (risk of bankruptcy) becomes a major factor.
Cost of Debt
The after-tax cost of debt is the interest rate at which firms can issue new debt net of the tax savings from the tax
deductibility of interest.
After-Tax cost of Debt= Interest Rate – Tax Saving=Kd-Kd*T= Kd(1-T)
Cost of Preferred Stock
If a company has preferred stock in its capital structure, the cost of preferred stock (kp) is:
Kp= Preferred Dividends (Dps)/Market Price of Preferred Stock (P)
Cost of Equity
The cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for
the risk they undertake by investing their capital. Two methods have been discussed below to calculate the Cost of
Equity: the Capital Asset Pricing Model (CAPM) and the Dividend Discount Model.
Capital Asset Pricing Model (CAPM)
The most commonly accepted method for calculating cost of equity comes from the Capital Asset Pricing Model
(CAPM): The cost of equity is expressed formulaically below:
Ke= rf + (rm- rf) * β
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Where, ke = the cost of equity or the required rate of return on equity, rf = the risk free rate, rm= expected return on
the market portfolio, (rm– rf) = the equity market risk premium, β= beta coefficient = systematic risk of the firm
Risk Free Rate (rf): The amount obtained from investing in securities considered free from credit risk, such as
government bonds from developed countries
Beta (β): This measures how much a company's share price reacts against the market as a whole. A beta of 1
indicates that the company moves in line with the market. If the beta is in excess of 1, the share is exaggerating the
market's movements; less than 1 means the share is more stable. Occasionally, a company may have a negative
beta, which means the share price moves in the opposite direction to the broader market.
Equity Market Risk Premium (rm – rf): It represents the returns investors expect to compensate them for taking
extra risk by investing in the stock market over and above the risk-free rate.
Dividend Discount Model Approach
If dividends are expected to grow at a constant rate, g, then the current value of the
company’s stock is given by this model.
P0=D1/(Ke-g)
Where: P0 = the current value of the company’s stock, D1 = next year’s dividend, ke = required rate of return on
equity or cost of equity, g = the firm’s expected constant growth rate (g = (Retention
Rate)(Return on Equity ROE)). Re-arrange the terms to solve for ke
WACC Example
Question: Monetrix Inc. (a listed firm) is considering a project in the Financial Education business. It has a D/E
ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of 14%. The equity beta is 0.966. The risk-
free rate is 5% and the expected return on the market portfolio is 12%. Calculate the appropriate WACC to evaluate
the project.
Solution
Project Cost of Equity = 5% + 0.966(12% - 5%) = 11.762%
Cost of Debt = 14%, Cost of Preferred Stock = 0%, Weight of preferred stock = 0 As D/E = 2, wd = 2/3, we = 1/3
Therefore, WACC = 1/3(11.762%) + 2/3(14%) (1 – 0.40) = 9.52%
Measures of Leverage
Introduction
Leverage, in general, refers to the amount of fixed costs a firm has. These fixed costs may be fixed operating
expenses (such as building or equipment leases) or fixed financing costs (such as interest payments on debt. Greater
leverage leads to greater variability of the firm’s after- tax operating earnings and income. Leverage increases the
risk and potential return of a firm’s earnings and cash flows.
Business Risk:
Refers to the risk associated with the firm’s operating income and is the result of uncertainty about a firm’s revenues
and the expenditures necessary to produce those revenues. It is the combination of the firm’s sales risk and
operating risk (the additional uncertainty about operating earnings caused by fixed operating costs).
Financial Risk: Refers to the additional risk that a firm’s common stockholders must bear when a firm uses fixed
cost (debt) financing. The fixed expenses, in this case, are in the form of interest payments. The use of financial
Finance Compendium
leverage increases the level of ROE and it also increases the rate of change of ROE. The use of financial leverage
increases the risk of default, but it also increases the potential return for equity shareholders.
Degree of Operating Leverage (DOL)
It is defined as the percentage change in operating income (EBIT) that results from a given percentage change in
sales.
To calculate a firm’s DOL for a particular unit level of sales, Q:
Where: Q = quantity of units sold, P = price per unit, V = variable cost per unit, F = fixed costs
The DOL is highest at low levels of sales and declines at higher levels of sales.
Degree of Financial Leverage (DFL)
It is interpreted as the ratio of the percentage change in Net Income (or EPS) to the percentage change in EBIT.
For a particular level of operating earnings, DFL is calculated as
DFL = EBIT/ (EBIT – Interest)
Degree of Total Leverage (DTL)
It combines the Degree of Operating Leverage and Financial Leverage. DTL measures the sensitivity of EPS to the
change in sales.
Breakeven Quantity of Sales

The level of sales that a firm must generate to cover all its fixed and variable costs is called the breakeven quantity.
At this quantity, revenues = total costs, implying that net income is 0.
The Contribution Margin, which is the difference between the price and the variable cost per unit, is used to cover
the fixed cost.
Dividends
A dividend is a pro rata distribution to shareholders that is declared by the company’s board of
Finance Compendium
directors and may or may not require approval by shareholders.

Dividend Policy
The decision to pay out earnings versus retaining and reinvesting them. Dividend policy issues include:
a. High or low dividend payout?
b. Stable or irregular dividends?
c. How frequently to pay dividends?
d. Announce the dividend policy?

The 3 theories of dividend policy:
1. Dividend irrelevance: Investors don’t care about dividend payout.
2. Bird-in-the-hand: Investors prefer a high payout.
3. Tax preference: Investors prefer a low payout.
Signaling Hypothesis
Investors view dividend increases as signals of management’s view of the future.
Since managers hate to cut dividends, they won’t raise dividends unless they think the raise is
sustainable.
However, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not
a desire for dividends.
Clientele Effect
1. Different groups of investors, or clienteles, prefer different dividend policies
2. Firm’s past dividend policy determines its current clientele of investors
3. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch
companies.
Residual Dividend Model
1. Find the retained earnings needed for the capital budget.
2. Pay out any leftover earnings (the residual) as dividends
only if more earnings are available than are needed to
support the optimal capital budget.
3. This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
Dividends = Net Income – (Target equity ratio * Total capital budget)
Simple Example:
Capital budget = $800,000
Target capital structure = 40% debt, 60% equity
Forecasted net income = $600,000
How much of the forecasted net income should be paid out as dividends?
• Calculate portion of capital budget to be funded by equity
Finance Compendium
Of the $800,000 capital budget, 60% ie. $480,000 will be equity financed
• Calculate the excess or need for equity capital?
There will be $600,000 - $480,000 = $120,000 left over to be paid as dividends.
• Calculate the dividend payout ratio (DIV/PAT)?
$120,000 / $600,000 = 0.2 or 20%
Stock Repurchases
A repurchase of stock is a distribution in the form of the company buying back its stock from shareholders.
Reasons for Repurchases:
1. As an alternative to distributing cash as dividends.
2. To dispose of one-time cash from an asset sale.
3. To make a large capital structure change.
Advantages of Share Repurchases
1. Stockholders can tender (sell) or not.
2. Helps avoid setting a high dividend that cannot be maintained.
3. Income received is capital gains rather than higher-taxed dividends (sometimes).
4. Stockholders may take as a positive signal--management thinks stock is undervalued.
Disadvantages of Share Repurchases
1. May be viewed as a negative signal (firm has poor investment opportunities).
2. IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.
3. Selling stockholders may not be well informed, hence be treated unfairly.
4. Firm may have to bid up price to complete purchase, thus paying too much for its own stock.
Stock Dividends vs. Stock Splits
Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If stock dividend is 10%, shareholders
get 10 shares for each 100 shares owned.
Stock split: Firm increases the number of shares outstanding, say 2:1. Shareholders get extra shares in the ratio of
stock split.
Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller
pieces.”
Unless the stock dividend or split conveys information, or is accompanied by another event
like higher dividend the stock price falls so as to keep each investor’s wealth unchanged.
Reasons for Stock Dividends or Stock Splits
There’s a widespread belief that the optimal price range for stocks is $20 to $80.
Stock splits can be used to keep the price in this optimal range.
Stock splits generally occur when management is confident, so are interpreted as positive signals. On average,
stocks tend to outperform the market in the year following a split.
Conclusion
1. Share repurchases have a positive effect on share prices.
2. Dividend initiations have a positive effect on share prices.
3. Dividend increases have a positive effect on share prices.
Finance Compendium
Pecking Order Theory:

1. Firms prefer internal financing.
2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden
changes in dividends.
3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that
internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the
firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or
sells its marketable securities, rather than reduce dividends.
4. If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly
hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for
internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated
with issuing equity, positive signaling associated with debt.
Pecking Order theory states that for their financing needs, firms prefer Internal financing to External financing (by
using the current R&E), as external financing comes with a cost (which can be substantial at times). Thereafter, in
external financing they prefer different external sources of financing in the following order:
Internal Financing >Secured Debt > Unsecured Debt > Preference Shares > Equity
The pecking order theory explains the inverse relationship between profitability and debt ratios.
Investment Banking Basics

Introduction
This investment banking / corporate finance module looks at some of the basic concepts associated with the
financial strategy-related issues of companies and institutions.
Broadly, from a bank’s perspective, the IBD division liaises with the CFO and Corporate Finance divisions of
companies which are seeking capital for various projects as well as advice on various mergers, acquisitions and
similar corporate restructuring mandates. It is the private side of the firm and provides advisory services on strategy
as well as execution capabilities related to raising financing.
The three well-documented aspects which this primer module will cover are:
1) Investment- related decision making – Capital budgeting, working capital allocation as well as mergers and
acquisitions etc.
2) Payout-related decision making – Dividend policy, debt repayment scheduling, stock buybacks etc.
3) Financing decisions – Debt financing vs. equity financing, structuring of financing etc.
Capital Budgeting
Capital budgeting entails making decisions to invest present funds in long-term projects in order to earn future
returns.
Importance of Capital Budgeting
▪The capital resources available to a firm are limited, and the success of a firm largely depends on how well it uses
the limited resources available to it. Capital Budgeting helps a manager to select the most profitable avenues for
the investment of the scarce resources of the company.
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▪Capital budgeting is usually used in evaluating Capital projects, which are Long-term investment projects
requiring relatively large sums to acquire, develop, improve, and/or maintain a capital asset (such as land, buildings,
dykes, roads). The outlays on these projects can be so big that the future of corporations may be decided by capital
budgeting decisions. Reversal of capital budgeting decisions cannot be done at a low cost; hence mistakes in the
selection of capital projects can be very costly.
▪The other corporate decisions also have scope for the application of capital budgeting principles, as adopted for
the specific case. Examples of such areas of application are investments in working capital, mergers and
acquisitions, leasing and bond refunding.
▪The valuation principles in capital budgeting are quite similar to those used in portfolio management and security
analysis. Thus, the diverse use of capital budgeting methods extends to these areas also.
▪The focus of capital budgeting is on ultimately maximizing shareholder value. Thus, correct capital budgeting
decisions have payoffs for a number of stakeholders in the company.
The Capital Budgeting Process
We will try to understand this process while using an example. Suppose a firm XYZ & Co. has enough funds and
now has decided to invest in Capital projects. The process it will follow is:
▪Step One: Generating Ideas- Generation of investment ideas can be from anywhere. All levels of the
organization- from the top to the bottom, from departments to functional areas- can contribute by generating fresh
investment ideas. Ideas can also be generated from outside the company. In our example, the firm can increase its
existing production capacity, expand its product line by setting up an additional factory, invest in some other
business, etc.
▪Step Two: Analyzing Individual Proposals- In the next step XYZ & Co. would gather adequate, reliable
information in order to first forecast future cash flows from each proposed project and then evaluate their
profitability. In this stage, the non-profitable proposals are screened away and the remaining are moved on to next
stage
▪Step Three: Planning the Capital Budget- Next, the profitable proposals are organized after taking into account
two key considerations:
• The match between the proposal and the company’s overall strategic objectives,
• The duration and timing of the project.
Since companies have various financial and other resource constraints, the proposals usually have to be scheduled
on a priority-basis.
Suppose XYZ & Co. identifies two potential profitable investments as investing in a different business and
expanding its existing production facility. The option of investing in a different business is forecasted to generate
a better profitability, but the money would be locked in for a long period and one of the company’s goals is to
Finance Compendium
become a market leader in its existing market. In such a situation, the option of expanding its existing production
facility would be ranked highest and undertaken first.
▪Step Four: Monitoring and Post-auditing- Post-auditing capital projects are as important as selecting and
implementing them. Firstly, it serves to monitor the analysis and forecasts that the capital budgeting process is
based on. Overly optimistic forecasts can be detected and such systematic errors rectified. Secondly, the negative
deviation between actual performance and expectations can be corrected by taking adequate measures, wherever
possible, which in turn improves business operations. Lastly, sound ideas for future investments may be evolved
during post-auditing current investments.
A few concepts to keep in mind
Sunk Cost
A sunk cost is one that has already been incurred. It is a past and irreversible outflow. Because sunk costs are
bygones and cannot be changed, they cannot be affected by the future decisions, and so they should be ignored in
decision-making.
EXAMPLE: Lockheed had already spent $1 billion on the development of the TriStar airplane. In order to continue
its development, the company sought a federal guarantee to back a new bank loan for it. On the one hand, those in
favor of the project argued that it would be extremely imprudent on the part of the company to abandon a project
on which such huge capital expenditures had already been made. On the other hand, some of Lockheed’s critics
countered that it would be equally foolish to continue with such a project that did not offer a satisfactory return on
that $1 billion. Both groups were guilty of the sunk-cost fallacy; the $1 billion was irrecoverable and, therefore,
irrelevant. (Brealey). The decision should be solely based upon the future cash flows.
PRINCIPLE: Today’s decisions should be based on current and future cash flows and should not be affected by
prior or sunk costs.
Opportunity Cost
It is the cost of any activity measured in terms of the best alternative forgone. It is the sacrifice related to the second-
best choice available to someone who has picked among several mutually exclusive choices. In capital budgeting,
the opportunity cost of capital or the discount rate is the expected rate of return that is foregone by investing in the
project chosen rather than investing in the next-best alternative.
EXAMPLES:
Suppose that a company already owns a building that could be used for a new project instead of buying a new
building. If the company’s managers decide to use this building, the company would not incur the cash outlay of
$12 million that would be required to buy a new building. Would this mean that the $12 million expenditure should
be excluded from the analysis, which would obviously raise the expected NPV? The answer is that we should
exclude the cash flows related to the new building, but we should include the opportunity cost associated with the
new building as a cash cost. For instance, if the building had a market value of $14 million, then the company
would be giving up $14 million if it uses the building for the project. Therefore, the $14 million that would be
foregone as an opportunity cost should be charged to the project.
• If an old machine is replaced with a new one, what is the opportunity cost? The opportunity cost here is the
cash flows that the old machine would generate.
Finance Compendium
• If $20 million is invested, what is the opportunity cost? The $20 million itself is the opportunity cost here
since it could have been invested elsewhere.
Discount Rate/ Time Value of Money
Discount rate is the interest rate used to calculate the present value of future cash flows. It essentially flows from
the concept of ‘time value of money’, which says that, other things being equal, due to its potential earning power,
a given sum of money has higher worth now than it would be in future.
The discount rate takes into account the time value of money and the risk or uncertainty associated with future cash
flows.
The discount rate applicable to a capital project depends on many factors such as the riskiness of the project, the
weighted average cost of capital of a firm, etc.
EXAMPLE: For e.g., An instrument which returns Rs. 100 each at end of next two years would have a present
value of 173.55 when the discount rate is 10%
Cannibalization
Cannibalization takes place when an investment results in one part of a company taking away customers and sales
from another part. An externality is defined as the effect that an investment has on other things besides the
investment itself and cannibalization is one such externality. The lost cash flows due to cannibalization should be
charged to the new project.
However, it often turns out that if the company would not have produced the new product, some other company
would have and hence, the old cash flows would have been lost anyway. In this case, no charge should be assessed
against the new project.
All this makes determining the cannibalization effect difficult, because it requires estimates of changes in sales and
costs, and also of the timing when those changes will occur.
EXAMPLE: Apple’s introduction of the iPod Nano caused some people who were planning to purchase a regular
iPod to switch to a Nano. The Nano project generates positive cash flows, but it also reduces some of the company’s
current cash flows. This is a manifestation of the cannibalization effect because the new business eats into the
company’s existing business.
PRINCIPLE: Cannibalization can be important, so its potential effects should be considered and any significant
lost cash flows due to it should be charged to the new project.
Project Valuation method

These concepts are very relevant and have been discussed earlier in the compendium.
Why Mergers & Acquisitions take place?
There are several reasons why companies enter into M&A activity. The prominent ones include:
1. Growth
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Companies wanting to grow into bigger companies or enter into new avenues are most likely to enter into M&A.
It is typically faster for companies to acquire companies to grow themselves, rather than invest money and resources
in developing from within (organic growth). It’s always less risky to acquire an established player rather than enter
an unfamiliar market on one’s own. Example: Indian Generic Pharma companies have become the target of many
inbound M&A deals as the foreign players look to protect their bottom line in wake of their drugs going off patent.
They increasingly see India as a potential market where they could leverage their sales and distribution skills to
expand their market share.
2. Synergies
Synergies occur when the combined company is worth more than the sum of the parts. Synergy is a theoretical term
and usually denotes enhanced revenues by means of cross selling or reduced costs via economies of scale.
Companies often end up paying huge amounts for targets if they feel it can provide benefits in the long run. For
example, Sanofi when it first made a bid for Genzyme back in July 2010, its offer price was $69 - a 38% premium
over Genzyme’s share price of $50.
3. Increase Market Power
M&A that is done from the sole point of increasing market power is called Horizontal Mergers. In it companies
acquire firms in the same market. It is most likely to attract the ire of the regulator as such mergers are looked as
stifling competition.
When an acquirer feels that the target company is underperforming for the moment, and it feels it has the capability
to unlock its potential. Companies engage M&A from this perspective if they feel they can acquire the company
for less than the Break Up value or the value obtained from dividing the company and selling its assets.
Companies enter into fields that are not at all related to their current field of activity to diversify and shore up
revenues in bad times. Diversification is sometimes viewed negatively by investors because it doesn’t add to
shareholder value as they are free to diversify their stock holdings themselves. Example: BHP Biliton, a world
leader in mining made a bid for Canadian Potash manufacturer, Potash. The deal could not be consummated because
of concerns from the Canadian government.
When companies feel they can no longer internally create cost effective capabilities needed to grow, they engage
in M&A, to acquire the desired capability. Companies believe they can get resources for less than Replacement
Value. Example: Low cost drug manufacturing and technical expertise of most Indian Pharma companies have
generated substantial foreign interest.
1. Unlock Hidden Values
When an acquirer feels that the target company is underperforming for the moment, and it feels it has the capability
to unlock its potential. Companies engage M&A from this perspective if they feel they can acquire the company
for less than the Break Up value or the value obtained from dividing the company and selling its assets.
2. Diversification
Companies enter into fields that are not at all related to their current field of activity to diversify and shore up
revenues in bad times. Diversification is sometimes viewed negatively by investors because it doesn’t add to
shareholder value as they are free to diversify their stock holdings themselves. Example: BHP Biliton, a world
Finance Compendium
leader in mining made a bid for Canadian Potash manufacturer, Potash. The deal could not be consummated because
of concerns from the Canadian government.
3. Acquiring unique capabilities and resources
When companies feel they can no longer internally create cost effective capabilities needed to grow, they engage
in M&A, to acquire the desired capability. Companies believe they can get resources for less than Replacement
Value. Example: Low cost drug manufacturing and technical expertise of most Indian Pharma companies have
generated substantial foreign interest.
M&A Definitions
Mergers: When one (smaller) company is absorbed by another (bigger) company and the smaller company ceases
to exist.
Acquisitions: When one defined segment of a company, assets of or the entire company is acquired by another it
is termed an acquisition. Example: Abbott India acquiring the domestic formulations business of Piramal
Healthcare solutions.
Reverse Mergers: Similar to a merger but the bigger company ceases to exist as it acquires the smaller company’s
name. Usually done when the smaller company has a more well-known brand name. Example: ICICI Bank reverse
merger back in 2001.
Consolidations: A consolidation is similar to a merger except that both companies lose their previous legal
existence and form a new legal entity. Example: The Indian telecom tower sector has seen a wave of consolidations
this past year as smaller players look to exit the market owing to lack of scale and efficiency.
Methods of Valuation
A very important part of any M&A is valuation of a firm. When you go to buy a second hand car, you try to estimate
its value using factors like age, miles driven, price of similar second-hand cars etc. and then based on this estimate
you negotiate a price with the dealer. Similarly when you set out to acquire a firm, you need to figure out its value
and it is based on that estimate that you quote a price at which you’ll purchase that firm. There are several methods
for valuation and depending on the industry different methods are the gold- standard when it comes to valuing
companies. In this section we will look at some of the most common methods, discuss what is right and wrong
about them and in which sector they are used the most.
Replacement Cost
This method is used to value the firm by totaling the cost incurred in replacing the assets of the firm today with
similar assets. This method reflects current price conditions and is quite effective in valuing firms during periods
of high inflation. The replacement cost value is usually higher than the book value because depreciation is not taken
into account. Total Replacement cost minus Liabilities equals the value of the business. Depreciated Replacement
cost method of valuation, however, takes into account the depreciation of the asset to be replaced.
But this method is not without its share of disadvantages – replacement cost is the cost of replacing assets today,
but usually managers don’t expect the old designs/assets to continue in the future. Besides being subjective, it is
also problematic to value intangible assets.
Finance Compendium
Market Priced Based

The market price of the firm is simply the sum of market values of firm’s debt and equity. Market value of equity
can be obtained by multiplying share price with the number of shares whilst the market value of debt can be
calculated by using present value of estimated debt cash flows. In some cases book value of debt (from balance
sheet) is used as a proxy for market value of debt.
As the market prices reflect what is known, this method is a logical place to start valuation if the shares are actively
traded in the market and the market is efficient i.e. the prices reflect all public information available about the firm.
It is therefore a useful metric for merger negotiations.
Book Value Based
Book value of a firm is derived from the books of accounting. It is a simple method for valuing firms with audited
financial reports. An advantage is that it reflects the principle of conservatism as accounting relies on the same
principle. The failings of this method include inability to value intangible assets (such as brand value, employee
skills etc.), based on past market information. Also, Book value is a backward-looking figure, whereas valuation
needs to be forward looking.
Cash Flow Based
There are different cash flows that can be used to calculate the value of the firm. Free Cash Flow for the firm
(FCFF) and Free Cash Flow to Equity (FCFE) are two most common methods.
Cash flow based methods are excellent for valuation because they can be used for valuing a firm from a control
perspective which Discounted Cash Flows (DCF) doesn’t allow.
DCF
We know that NPV of any project is the present value of cash flows. Thus, NPV of a firm can be calculated as the
present value of Free Cash Flow to the Firm with the hurdle rate being the cost of capital for the firm (WACC).
This model of valuing a firm is called the Discounted Cash Flow Model. The value of a business is usually
computed as discounted value of Free Cash Flows till valuation horizon, plus present value of the forecasted value
of business at the time horizon. Thus, the present value of a firm is given by
Where FCFi represents Free cash flow to firm (see definition below) in period i, and H is the horizon. PVH is the
expected value of firm after period H, the horizon chosen for valuation.
Valuation horizons are used because it would be impractical and error prone to try and calculate cash flows till
infinity. PVH is effectively an estimate of discounted cash flows from year H+1 onwards.
It can be calculated in many ways, some of which are constant growth method, based on P/E ratio etc.
FCFF, FCFE, Dividend, Residual Income
Cash flow, as the name suggests, concerns the inflows and outflows of cash (liquidity) in a business. While cash
flows do not always convey much information about the profitability of the firm, they are of prime importance as
they indicate the ability of firm to finance its operating capital and investment needs, and its requirements of debt.
For a growing firm, cash flows are usually negative because of high investment demands but they become positive
as the business matures.
Finance Compendium
Free cash Flow is the surplus cash available to the firm after making all its expenditures including investments both
in assets as well as in working capital.
Free Cash Flow = EBIT*(1-t) + Depreciation/Amortization – Changes in Working Capital – Investment in fixed
assets
(t= tax rate)
This cash flow is also called the Free Cash Flow for the Firm (FCFF) and is available to all the security holders
of the organization including equity and debt holders alike (hence interest not subtracted from FCFF).
Since debt holders also have a claim on the cash flow described above, we can further find out cash flow available
to equity holders called Free Cash Flow to Equity (FCFE). FCFE additionally takes into consideration repayment
of debt as well as new debt capital raised by the firm.
It is given by:
FCFE = FCFF + New debt – Debt Repayment – Preferred Dividends- Interest*(1-t)
Example: Following are the details for a firm: Net Income = $2,176 Million, Capital Expenditures = $494 Million,
Depreciation = $ 480 Million, Change in Non-Cash Working Capital = $ 35 Million.
FCFE = 2176 + 480 – 494 – 35
FCFE = $2127 million
FCFF – It is a measure of company’s profitability (net cash generated) after taking into consideration its expenses,
taxes and investments.
A positive value of FCFF suggests that company generated sufficient cash to cover its expenses and investment
activities, while a negative value of FCFF indicates otherwise. If FCFF is negative, the investors should investigate
the actual reasons for the same to unearth any bigger problem in the company.
FCFE – It measures the amount of cash that can be paid to equity shareholders after accounting for expenses, tax,
investments and debt repayments.
FCFE has become increasingly popular of late owing to doubts over the effectiveness of the Dividend Discount
Model.
Now, that we know what is the surplus cash available to the equity holders, the question arises as to what does firm
do with this cash? There are two options for the firm, either to invest further in the business or to pay out the cash
to equity holders in the form of dividends. Dividend is basically the portion of earnings of the firm paid out to
equity holders.
In this context we define payout ratio as the ratio of earnings of the firm distributed to equity holders.
Payout ratio = Dividend per share / Earnings per share
Example: Consider a firm that has EPS of $2.5 and pays out $0.5 as dividend Then payout ratio = 0.5/2.5 = 0.2
The dividends are of particular interests to shareholders since that is the only way they get paid back for the equity
capital invested in the firm (except liquidation). Thus, dividends are instrumental in finding the value of equity
shares of a firm as we will see later.
Finance Compendium
So far, we have discussed about the cash flows available to firm and the equity holders. If, however, we want get a
better idea of the kind of returns shareholders are getting, we use another measure called residual value or
Economic Value Added (EVA)
EVA = income earned – opportunity cost of capital * capital employed
The advantage of using EVA is that it does not just look at the earnings of the firm but also takes into consideration
the returns on capital required or the opportunity cost of the capital. If a firm/division has a positive income but
negative EVA, it means that the profits earned are not enough to cover the cost of capital and thus the capital can
be better employed elsewhere.
Example: Consider a firm which made an income of $130 million and employed capital of $1000 million.
Furthermore, the cost of capital is 10%.
Then EVA = 130 -.1*1000 = $30 million (Source: BMA)
Value of a Firm
We take a look at how the financing policy of a firm (how much should be debt or equity?) affects the valuation of
a firm.
RETURN ON ASSETS
The source of a firm’s value is the cash-flows which its assets can generate. These assets are financed by a mixture
of debt and equity. The value of a firm depends on its cash-flow generating real assets (like machines, patents etc.)
The value of a firm’s debt and equity is equal to the value of the firm. So a question which arises is: can we produce
any changes in the value of a firm by merely changing its debt to equity mixture? How does the expected return on
equity of the firm change if we, say, increase the debt and reduce the equity? Modigliani & Miller have tried to
answer these questions (under certain assumptions) below:
MODIGLIANI MILLER THEOREMS
Modigliani and Miller said that under the assumptions of perfect and frictionless markets (described below), no
transaction costs, no default risk, no taxation, both firms and investors can borrow at the same rd interest rate; the
value of a firm is same regardless of its financing decision i.e. firm value is independent of D/E ratio. In simple
terms, the value of a firm depends on its current and future earning potential and risk of its underlying assets, and
is independent of the way company decides to finance itself. This is the first proposition of Modigliani Miller
Theorem.
• Proposition 2: The expected rate of return on equities of a levered firm increases linearly with the
debt/equity ratio, given the return on capital employed is higher than the interest paid to debt holders.
• Proposition 3: The firm’s dividend policy does not affect its value; it only changes the mix of debt and
equity.
• Proposition 4: For new investment to be feasible, the marginal cost of new capital should equal the average
one.
The MM theorem further states that:
Finance Compendium
Perfect market – The market where stock prices reflect all available, relevant information, and the matching of
buyers and sellers occurs immediately. It is assumed that all the investors have the same information available to
make decisions.
Frictionless market – The market where all the costs and restrains related to the transactions are absent. In practical
markets, however, transactions costs like commissions, and restraints like tax implications are present.
Example: Consider a firm A, that is unlevered and firm B which has a Debt-equity ratio of 1. Let V denote the
value of firm, D denote debt, E the equity, P denote profit, and rD be the interest on debt. Suppose there are 100
shares of A each of price 1Re and firm B has 50 shares at price 1Re and the other 50 comes from debt. Now if one
buys 10% of shares for company
A then his return on investment would be .1*P. Compared to this if one purchases the same fraction of debt AND
equity from firm B his returns would be: 0.1*(P-interest) + 0.1*interest = 0.1*P, which is the same as in previous
case.
Thus, in a perfect market both firms would be valued equally as long as investors can lend (or borrow) money on
same terms as the firm.
What implication does Modigliani Miller theorem have for the Expected return on assets ra?
Since a firm’s borrowing decision does not affect its total market value, it does not affect the expected return on
firm’s assets, ra. The expected return thus, is simply a weighted average of expected returns on individual holdings.
Where, D is the market value of the Debt, E is the market value of the Equity, and rD and rE are the cost of debt
and equity respectively.
WEIGHTED AVERAGE COST OF CAPITAL
In the absence of taxes, ra is also the Weighted Average Cost of Capital (WACC). With the presence of tax,
however, the interest paid by the firm on its debt is tax deductible and thus the after tax cost of debt becomes rD*(1-
T) and thus for the firm, the weighted average cost of capital comes out to be.
Where, D is the market value of the Debt, E is the market value of the Equity, T is the Tax rate and rD and rE are
the cost of debt and equity respectively.
Example: Consider a firm for which cost of debt = 8%, cost of equity = 15%, tax rate = 35% & D/E = 9. According
the formula, WACC = 0.08*(1-0.35)(0.9)+0.15*0.1 = 0.62 = 6.2%
In order to gain a better understanding of WACC, let us explore each of the terms further.
COST OF DEBT
Cost of debt (rD) is the rate of interest that has to be paid on the debt capital issued by the firm. Usually, it depends
on the leverage ratio (D/E) of the firm and the default risk. If the D/E ratio increases, then the probability that
creditors will not get fully reimbursed if the firm is dissolved increases which leads to a rise in cost of debt. Thus,
Finance Compendium
the cost of debt can be modeled as a risk free rate plus a risk premium which incorporates the risk of default. Since
cost of debt is composed of interest paid, it is fairly easy to calculate.
COST OF EQUITY
Cost of Equity (rE) is the rate of return demanded by the investors. It is effectively the opportunity cost of investing
in the firm for equity holders. Since, creditors have the first claim on the assets of the company; cost of equity is
greater than the cost of debt. Estimation of cost of equity presents considerably more challenge compared to the
cost of debt. For estimating rE we can use the Capital Asset Pricing Model (CAPM). According to CAPM,
Expected return on stock = rf + β(rm – rf)
Where rf is the risk free rate of return, rm is the expected rate of return on market portfolio and beta is the measure
of market risk on the stock i.e how sensitive it is to movements in market.
Since, cost of equity is greater than cost of debt, one may wonder if it is possible to reduce overall WACC by taking
more and more debt. The answer ofcourse is that it cannot be done and the reason comes from Modigliani Miller
theorem.
With increase in leverage, the cost of equity rises (since with rising debt, the risk for equity holders increases).
Exactly how much does the cost of equity increase can be calculated as follows:
The firm’s asset Beta can be written as
β a = βD *(D/D+E) + βE*(E/D+E)
Now, when D/E ratio changes, since ra does not depend on financing decision of the firm (MM), βa remains
unchanged. Thus, for the original D/E ratio and using original βE, calculate the βa.
This is called unlevering the β.
Equity for new leverage ratio can then be calculated as
This process is called relevering the β. Once we have the new equity β, we can calculate the new cost of equity
(using CAPM) and then calculate the new WACC.
INTEREST TAX SHIELD
If the return on debt is rD and the market value of debt is D then:
Interest Payment I = rD*D
This interest is tax deductible, which leads to following implications. If interest were not tax deductible, we would
have had to pay entire I from EBIT *(1-T) and thus out net income would have been, net income = EBIT (1-T) – I
Now, due to the tax laws, we can play interest from EBIT and they pay taxes, therefore
Net income = (EBIT – I)*(1-T) = EBIT (1-T) – I + I*T
The difference between of I*T is called the interest tax shield. It arises because interest paid on debt is tax
deductible. Furthermore,
PV (tax shield) = T*I/rD = T*D
Thus, the effective payment becomes rD*D – T*D = (rD-T)*D and hence, we see that effective cost of debt become
rD*(1-T) as was mentioned earlier.
Finance Compendium
Now, that we have a deeper understanding of each of the components of WACC, let us see what exactly does
WACC signify. WACC essentially is the hurdle rate or the discount rate for the firm. It is the rate of return the firm
must be able to achieve to justify investment of capital. WACC can also be used as a discount rate for any new
projects that the form might take, but only if the D/E ratio for the new project is same as firm D/E and project is as
risky as firm’s other assets are on an average.
MULTIPLES BASED
Multiple – It measures a specific aspect of the company’s financial health. It is calculated by dividing one financial
metric by another. Numerator is generally greater than the denominator. For Example: P/E, the price per share to
earnings per share (EPS) ratio, is a multiple that measures how much the investors value the company’s stock
relative to its earnings. If P/E =15, then investors are ready to pay a multiple of 15 times the current EPS of the
company.
Multiples approach - A valuation method which states that when firms are comparable, then the value of one firm
can be used to find the value of another similar firm.
Trading VS Transactional Multiples
• Both are examples of Relative Valuation; whose aim is to calculate the value of a given asset in line with
the current market values of similar assets.
• Analysis of trading multiples factors both a company’s current trading price and the current trading prices
of its competitors to arrive at a valuation that is in line with valuation multiples of comparable public traded
companies. Common Multiples used for trading analysis are P/E, EV/EBITDA.
• Transactional Multiples relies on transactions of similar firms in the market to obtain the valuation of the
desired firm. It requires data – actual prices and multiples, for acquisition of “similar” firms in the market.
Data can often be hard to get as most acquisitions are done in private. Secondly, it is hard to describe
“similar” firms. Thirdly, data should not be very old, as they would reflect different market conditions.
Advantages
• It can be undertaken quicker and is more efficient than DCF valuation.
• The intuitive nature of relative valuation is attractive to prospective investors than the technical nature of
DCF.
Disadvantages
• For some companies, it is difficult to find true value because of low trading pattern and small market
capitalization.
• Also, volatile market sentiments may lead to stock prices that are not true reflection of a company’s intrinsic
value.
Price Multiples: It is the ratio that measures share price of a company with a per share factor. Few common Price
Multiples are Price to Earnings Ratio (P/E), Price to Book ratio (P/BV), and Price to sales Ratio (P/S).
Finance Compendium
P/E Price-to-earnings ratio is the most common financial multiple and measures what price an investor pays for 1$
of earnings.
• The numerator is the price of the firm scrip, and the denominator is the Earnings per share (EPS).
• P/E can be trailing, based on the preceding 12 months (or 4 quarters), or forward looking, based on the
estimated 12 month or 4 quarter forward earnings.
Advantages
Ideally one would like to compare like-for-like. The Price in the numerator is the market price and Earnings are
what are used to pay out dividends to shareholders.
Disadvantages
• EPS can be negative or zero, and in such cases P/E doesn’t make sense
• EPS can be distorted by managers which affects the comparability among peer companies.
P/BV
• Ratio of price per share to book value per share.
• It reflects investment made by common shareholders in the company
Advantages
• Book Value is positive unlike EPS which can be negative or zero.
• Book Value is more stable than earnings
• Book Value is primarily beneficial for companies that are no longer expected to be a going concern, in
other words are expected to be liquidated.
Disadvantages
• P/B may be misleading when the level of assets employed are different.
• Intangible assets are not included. Many-a-time acquisitions are done to acquire the “human capital” which
BV omits.
• Book Value reflects the historical cost of asset acquisitions. Hence P/B doesn’t reflect the present scenario
very well.
Enterprise Multiples (also, EBITDA multiple): It measures the Enterprise value of a firm, as given below, with
other financial metrics such as EBITDA, sales etc. Since it takes debt into account, hence it is a better representative
of a firm’s value than P/E as any potential acquirer would have to assume the debt as well.
EV/EBITDA
This is the most common enterprise multiple.
• Enterprise Value (EV) is calculated as sum of market values of common equity, debt and preferred stock
minus cash and short-term investments. Short term investments are subtracted as the acquirer must buyout
Finance Compendium
both equity and debt and then receives cash. It reflects the value that acquirer has to pay for acquisition of
the firm.
• EBITDA is a measure of pre-interest, pre-tax operating cash flow to both debt and equity holders; hence it
makes sense to use Enterprise Value and not Price in the numerator. EBITDA is frequently positive.
Advantages
• EV/EBITDA is better than P/E when the levels of financial leverage differ.
• EBITDA excludes depreciation and amortization while EPS is post both. Hence, for capital intensive
business (subject to depreciation) EV/EBITDA is much better.
EV/S
Enterprise Value-to-Sales is a better alternative to Price-to-Sales ratio because not all sales are attributed to the
equity investors. Also, in a debt financed company, P/S is not meaningful because share price does not take into
account debt situation of the firm.
Non-Financial
Besides the set of financial ratios discussed above there are certain industry-specific ratios that are non-financial in
nature and are useful places to start valuation. Ideally one would want to use non- financial ratios to triangulate the
valuation rather than using it as a primary measure.
Retail Companies
• Same stores sales
• Sales per square meter
Service Sectors
• Revenues per employee
• Net income per employee
Hotel/ Hospitals
• Average daily rate
• Occupancy rate
Financial Firms
• Current Account Savings Account.
• Net Interest Margins
• Monetary reserves
Finance Compendium
IPO
• When a company offers its shares for subscription to the public for the first time, the offering is called an
Initial Public Offering. An IPO could be dilutive or non-dilutive or a mix of the two. In a dilutive offering,
fresh shares are issued to new subscribers which dilute the EPS and shareholding for the existing
shareholders. In non-dilutive offering existing shareholders sell some or all of their shares as part of the
offering thereby keeping total number of shares & EPS constant.
• An IPO involves taking a private company public. Reasons for undertaking an IPO include lower cost of
capital, greater liquidity for shareholders, opening up newer sources of funding, greater prestige related to
being a public company, raising funds without reducing control (loss of Board seats).
• An IPO is undertaken through underwriters who form a syndicate to sell the issue to the public. The
underwriters also buy the non-subscribed portion of shares in case actual subscription is below expectations.
The pricing of an IPO is a contentious issue for both the company and investors.
• An underpriced issue could lead to oversubscription but will also imply that the company has left too much
money on the table. An overpriced issue would lead to under subscription and could lead to losses on listing
to investors which is also not desirable.
• Some of the recent oversubscribed IPOs include Bandhan Bank, HDFC AMC.
FPO- FOLLOW-ON PUBLIC OFFER

Any public issue of shares by a company subsequent to an IPO is called a follow-on public offer (FPO). NTPC and
NMDC came out with FPOs recently.
Finance Compendium
SEO-SEASONED EQUITY OFFERING

A Seasoned Equity Offering is a FPO by an established company whose shares have substantial liquidity and
trading volume in the secondary markets
A seasoned equity offering could be either dilutive or non-dilutive.
RIGHTS ISSUE
A rights issue is an invitation to the existing shareholders to buy more shares of the company. The number of shares
offered in a rights issue is in a fixed proportion to their current holdings.
The rights are similar to a call option as they vest in the rights owner the right to buy a specified number of shares
at a pre-specified price on a stated maturity date. The rights holder can exercise the rights, allow them to lapse or
sell them to other investors. The intrinsic value of the rights helps to compensate the shareholder for the subsequent
dilution. However, if the rights are ‘Non-renounceable’ they will not be tradable.
Rights issues are usually preferred by companies with weak balance sheets when they are unable to borrow money.
The rights issue was also preferred as a source of funding during the credit crisis when external funding sources
dried up.
However, rights issues are also made by companies with strong balance sheets to meet capital expenditure plans
and to fund acquisitions.
• QIP- QUALIFIED INSTITUTIONAL PLACEMENT
A QIP is a means of raising capital in which a listed company issues securities directly to Qualified Institutional
Buyers (QIB). QIBs are sophisticated investors who due to their expertise and financial strength need less
protection from issuers as compared to retail investors. The securities issued under a QIP can be equity shares or
any other securities convertible to equity shares except warrants.
QIPs involve few procedural & regulatory requirements and hence are a quicker mode of raising capital as
compared to other options. Indian companies were found to prefer foreign markets for fund raising due to their less
complicated requirements. To prevent excessive dependence on foreign capital, QIPs were introduced in India.
During the credit crisis, cash strapped Indian companies issued a number of QIPs to repair their debt laden balance
sheets.
Banking Business
Bank
The term ‘bank’ is used generally to refer to any financial institution that is licensed to accept deposits that are
repayable on demand, and lend money.
Services offered by a bank to a corporate:
• Loans: Banks provide short and long-term funds to businesses.
• Cash Deposits: Corporates deposit surplus funds in a bank.
• Foreign exchange transactions: Banks act as authorized dealers to facilitate foreign exchange transactions.
• Advisory Services: Banks provide financial advisory services such as valuations, issue management, mergers
& acquisitions, etc. to corporates.
Finance Compendium
• Trade Services: Banks play the role of the trusted intermediary between parties involved in trade and facilitate
trade and commerce.
Categories of banks in India
• Scheduled banks: Banks which have deposits > INR 200 crore are ‘Scheduled Banks’.
• Non-scheduled banks: Banks which have deposits <= INR 200 crore are ‘Non-scheduled Banks’.
Banking Structure in India:
Public sector banks: PSBs are those where the government holds a majority (>50%) ownership.
Private Banks: Private banks, are banks owned by private (i.e. non-government) Indian entities such as corporates
and individuals.
Foreign Banks: Foreign Banks are those owned by multinational/non-Indian entities.
Regional Rural Banks: RRBs are also banks with a Government ownership. The idea was to create banks which
will focus on the rural areas and serve the under banked sector. A scheduled commercial bank acts as a sponsor of
an RRB.
Urban co-operative banks: Co-operative banks are formed by a group of members. Traditionally the thrust of
UCBs has been, to mobilize savings from the middle- and low-income urban groups and ensure credit to their
members - many of which belong to the weaker section.
State Co-operative banks: SCBs are set up with state government partnership to help agricultural and rural
development.
The Central Bank
The Central Bank’ (CB) of any country is the banker’s bank. It acts as a regulator for other banks, while providing
various facilities to facilitate their functioning. It also acts as the government’s bank.
Responsibilities of a Central bank:
• Conducting the Monetary Policy of the country: i.e. directing interest rates in the economy
• Ensuring sufficient pool of funds: increase or decrease money supply to manage inflation.
• Maintaining the stability of financial system: by regulating banks
Finance Compendium
• Monitoring the foreign currency assets & liabilities: managing the money which India has invested in other
countries
• Providing financial services to the government
National Housing Bank: National Housing Bank, a wholly owned subsidiary of RBI, governs the functioning of
all housing finance companies.
Reserve requirements
Reserve requirements are a certain percentage of deposits taken which are to be maintained with the RBI. Reserve
requirements in India are of two types:
Cash Reserve Ratio: A certain percentage of all deposits must be placed with the RBI in the form of cash. CRR
defines this percentage.
Statutory Liquid Ratio: A certain percentage of all deposits must be used to purchase Government securities
defines this percentage.
Key Concepts for Banks & NBFCs
Net Owned Funds: Essentially NOF is Owners’ Equity – i.e., money belonging to the owners (Owner’s equity –
losses)
Capital adequacy ratio: A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted
credit exposures. This ratio is used to protect depositors and promote the stability and efficiency of financial
systems around the world. Two types of capital are measured: tier one capital, which can absorb losses without a
bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and
so provides a lesser degree of protection to depositors.
CAR = (Tier one Capital + Tier Two Capital)/ Risk Weighted Assets
Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."
Bank Rate: Bank rate is the rate of interest which is levied on Long-Term loans and Advances taken by
commercial banks from RBI. Changes in the bank rate are often used by central banks to control the money supply.
Repo Rate: Repo rate is the rate of interest which is levied on Short-Term loans taken by commercial banks from
RBI. Whenever the banks have any shortage of funds, they can borrow it from RBI. A reduction in the Repo rate
will help banks to get money at a cheaper rate. When the repo rate increases, borrowing from RBI becomes more
expensive.
Reverse Repo Rate: This is exact opposite of Repo rate. Reverse repo rate is the rate which RBI pays to the
commercial banks on their surplus funds with RBI. An increase in Reverse repo rate can cause the banks to transfer
more funds to RBI due to these attractive interest rates. In India, Reverse Repo = Repo - 1%
Cash Reserve Ratio: Cash reserve Ratio (CRR) is the amount of cash funds that the banks have to maintain with
RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI doesn’t
pay any interest on CRR deposits.
Statutory Liquidity Ratio: SLR (Statutory Liquidity Ratio) is the amount a commercial bank needs to maintain
in the form of cash, or gold or government approved securities (Bonds) before providing credit to its customers.
Finance Compendium
SLR is determined and maintained by the RBI in order to control the expansion of bank credit. SLR is determined
as the percentage of total demand and time liabilities.
Understanding CRR and SLR
For the sake of simplicity, let’s assume there are only four entities in India:
1) Household Savers
2) Businessmen
3) Commercial banks (like SBI)
4) Central Bank (RBI)
Common men save their money in bank. Bank gives them say 7% interest rate on savings.
Then Bank gives that money as loan to businessmen and charges 12% interest rate. So 12-7=5% is the profit of
Bank. (Although that’s technically incorrect, because we’ve not counted bank’s input cost like staff salary,
telephone-internet-electricity bill, office rent etc. So actual profit will be less than 5%.)
SBI has only one branch in a small town. It was opened on Monday.
On the very same day, Total 100 Household Savers deposited 1 lakh each in their savings accounts here (total
deposit is 1 crore) and SBI offered them 7% interest rate per year on their savings.
On Tuesday, SBI Branch manager gives away entire 1 crore to a businessman as loan for 12% interest rate for 5
years. From SBI’s point of view, sounds very good right? 12-7=5% profit!
But we’ve not considered the fact that on Wednesday, some of those Household Savers (account holders) will need
to take out some money from their banks savings account- to pay for gas, electricity, mobile bills, college fees,
writing cheques and demand drafts etc. But SBI’s office doesn’t have a single paisa left!
Base Rate:The Base Rate is the minimum interest rate of a Bank below which it cannot lend. The base rate was
designed to replace the flawed benchmark prime lending rate (BPLR), which was introduced in 2003 to price bank
loans on the actual cost of funds. The bulk of wholesale credit was contracted at sub-BPL rates and it comprised
nearly 70% of all bank credit. Under this system, banks were subsidising corporate loans by charging high interest
rates from retail and small and medium enterprise customers. This system defeated the purpose of having a prime
lending rate, or the rate that banks charge from its best customers. It also resulted in another problem: bank interest
rates ceased to respond to monetary policy changes that the RBI introduced periodically.
Open Market Operations: An open market operation is an instrument of monetary policy which involves buying or
selling of government securities from or to the public and banks.
NPA Account: If interest and instalments and other bank dues are not paid in any loan account within a specified
time limit, it is being treated as non-performing assets of a bank.
Capital Adequacy Ratio:-Capital adequacy ratio measures the amount of a bank’s_ _capital expressed as a
percentage of its credit exposure. Applying minimum capital adequacy ratios serves to protect depositors and
promote the stability and efficiency of the financial system by reducing the likelihood of banks be coming insolvent.
Impacts of Increase in following rates on Money Supply:-
Finance Compendium
Methods of securing a loan with security/ collateral:

• Pledge: Pledge is used when the lender (pledgee) takes actual possession of assets (i.e. certificates, goods). Such
securities or goods are movable securities. In this case the pledgee retains the possession of the goods until the
pledger (i.e. borrower) repays the entire debt amount. In case there is default by the borrower, the pledgee has a
right to sell the goods in his possession and adjust its proceeds towards the amount due (i.e. principal and interest
amount). Some examples of pledge are gold /jewelry loans, Advance against goods/stock, Advances against
National Saving Certificates etc.
• Hypothecation: Hypothecation is used for creating charge against the security of movable assets, but here the
possession of the security remains with the borrower itself. Thus, in case of default by the borrower, the lender (i.e.
to whom the goods / security has been hypothecated) will have to first take possession of the security and then sell
the same. The best example of this type of arrangement are Car Loans. In this case Car / Vehicle remains with the
borrower but the same is hypothecated to the bank /financer. In case the borrower, defaults, banks take possession
of the vehicle after giving notice and then sell the same and credit the proceeds to the loan account. Other examples
of these hypothecation are loans against stock and debtors.
• Mortgage: Mortgage is used for creating charge against immovable property which includes land, buildings or
anything that is attached to the earth or permanently fastened to anything attached to the earth (However, it does
not include growing crops or grass as they can be easily detached from the earth). The best example when mortgage
is created is when someone takes a Housing Loan / Home Loan. In this case house is mortgaged in favor of the
bank /financer but remains in possession of the borrower, which he uses for himself or even may give on rent.
• Lien: A lien means the claim of the lender on any asset used to secure the loan. The legal right of a creditor to
sell the collateral property of a debtor who fails to meet the obligations of a loan contract. A lien exists, for example,
when an individual takes out an automobile loan. The lien holder is the bank that grants the loan, and the lien is
released when the loan is paid in full.
• NPA: An NPA is a ‘Non Performing Asset’. Lenders must ‘provision’ for NPAs, which means they must keep
aside a certain portion of their income to provide for the losses against these NPAs. For a bank, a loan becomes an
NPA after 90 days ‘past due’ overdue; for an NBFC, 180 days after repayment is due and hasn’t been made. A non
performing asset (NPA) is a loan or an advance where:
o interest and/ or instalment of principal remains overdue for a period of more than 90 days in respect of a term
loan
o the account remains ‘out of order’ , in respect of an Overdraft/Cash Credit (OD/CC)
o the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted,
o the instalment of principal or interest thereon remains overdue for two crop seasons for short duration crops,
Finance Compendium
o the instalment of principal or interest thereon remains overdue for one crop season for long duration crops
The two ways in which NPA’s can be removed are by Income recognition and Write off.
Banks are required to classify nonperforming assets further into the following three categories based on the period
for which the asset has remained nonperforming and the realisability of the dues:
• Substandard Assets
• Doubtful Assets
• Loss Assets
A substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. In such
cases, the current net worth of the borrower/ guarantor or the current market value of the security charged is not
enough to ensure recovery of the dues to the banks in full. In other words, such an asset will have well defined
credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the
banks will sustain some loss, if deficiencies are not corrected.
An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the
added characteristic that the weaknesses make collection or liquidation in full, – on the basis of currently known
facts, conditions and values – highly questionable and improbable.
A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection
but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of
such little value that its continuance as a bankable asset is not warranted although there may be some salvage or
recovery value.
Basel Norms
A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out
the minimum capital requirements of financial institutions with the goal of minimizing credit risk.
Tier I capital is core capital, this includes equity capital and disclosed reserves. Equity capital includes instruments
that can't be redeemed at the option of the holder.
Tier 2 capital is supplementary bank capital that includes items such as revaluation reserves, undisclosed reserves,
hybrid instruments and subordinated term debt. Components of Tier 2 Capital can be split into two levels: upper
and lower. Upper Tier 2 maintains characteristics of being perpetual, senior to preferred capital and equity; having
deferrable and cumulative coupons; and its interest and principal can be written down. Lower Tier 2 is relatively
cheap for banks to issue; has coupons not deferrable without triggering default; and has subordinated debt with a
maturity of a minimum of 10 years.
BASEL I
The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset
classification system. This classification system grouped a bank's assets into five risk categories:
0% - cash, central bank and government debt and any OECD government debt
0%, 10%, 20% or 50% - public sector debt
Finance Compendium
20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one
year maturity) and non-OECD public sector debt, cash in collection
50% - residential mortgages
100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital
instruments issued at other banks
The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if
a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million.
BASEL II
Basel II is the second of the Basel Committee on Bank Supervision's recommendations, and unlike the first accord,
Basel I, where focus was mainly on credit risk, the purpose of Basel II was to create standards and regulations on
how much capital financial institutions must have put aside. Banks need to put aside capital to reduce the risks
associated with its investing and lending practices.
The guidelines were based on three parameters, which the committee calls it as pillars. - Capital Adequacy
Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets -
Supervisory Review: According to this, banks were needed to develop and use better risk management techniques
in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks -
Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR,
risk exposure, etc.
BASEL III
Post crisis, with a view to improving the quality and quantity of regulatory capital, it has been decided that the
predominant form of Tier 1 capital must be Common Equity; since it is critical that bank’ risk exposures are backed.
by high quality capital base. Non-equity Tier 1 and Tier 2 capital would continue to form part of regulatory capital
subject to eligibility criteria as laid down in Basel III. Accordingly, under revised guidelines (Basel III), total
regulatory capital will consist of the sum of the following categories:
1. Tier 1 Capital (going-concern capital) a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital (gone-concern capital)
Limits and Minima
1. As a matter of prudence, it has been decided that scheduled commercial banks operating in India shall maintain
a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs) as against a MTC of 8% of RWAs as
prescribed in Basel III.
2. Common Equity Tier 1(CET1) capital must be at least 5.5% of risk weighted assets (RWAs) i.e. for credit risk+
market risk + operational risk on an ongoing basis. Globally it is4.5% as per Basel III but RBI asks for an additional
1%.
3. Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the minimum Tier 1 capital,
Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs.
Finance Compendium
4. Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an ongoing basis. Thus, within
the minimum CRAR of 9%, Tier 2 capital can be admitted maximum up to 2%.
5. If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios, then the excess
Additional Tier 1 capital can be admitted for compliance with the minimum CRAR of 9% of RWAs.
6. In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are also required to maintain
a capital conservation buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. Thus, with
full implementation of capital ratios and CCB the capital requirements are summarised as follows:
For the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 (AT1) capital and Tier 2 (T2)
capital will be recognised in the same proportion as that applicable towards minimum capital requirements. This
would mean that to admit any excess AT1 and T2 capital, the bank should have excess CET1 over and above 8%
(5.5%+2.5%).
8. In cases where the bank does not have minimum Common Equity Tier 1 + capital conservation buffer of 2.5%
of RWAs as required but, has excess Additional Tier 1 and / or Tier 2 capital, no such excess capital can be reckoned
towards computation and reporting of Tier 1 capital and Total Capital.
9. For the purpose of all prudential exposure limits linked to capital funds, the ‘capital funds will exclude the
applicable capital conservation buffer and countercyclical capital buffer as and when activated, but include
Additional Tier 1 capital and Tier 2 capital which are supported by proportionate amount of Common Equity Tier
1 capital. Accordingly, capital funds will be defined as [(Common Equity Tier 1 capital) + (Additional Tier 1 capital
and Tier 2 capital eligible for computing and reporting CRAR of the bank)]. It may be noted that the term ‘Common
Equity Tier 1 capital’ _does not include capital conservation buffer and countercyclical capital buffer.
Common Equity Tier 1 Capital
Elements of Common Equity Tier 1 Capital
Elements of Common Equity Tier 1 capital will remain the same under Basel III. Accordingly, the Common Equity
component of Tier 1 capital will comprise the following:
(i) Common shares (paid-up equity capital) issued by the bank which meet the criteria for classification as common
shares for regulatory purposes;
(ii) Stock surplus (share premium) resulting from the issue of common shares; (iii) Statutory reserves;
(iv) Capital reserves representing surplus arising out of sale proceeds of assets; (v) Other disclosed free reserves,
if any;
Finance Compendium
(vi) Balance in Profit & Loss Account at the end of the previous financial year.
Elements of Additional Tier 1 Capital
Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital consists of the sum of the
following
elements:
1.Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory requirements.
2. Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital;
3. Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with the regulatory
requirements;
4. Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in
Additional Tier 1 capital;
5. While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments issued by
consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Additional
Tier 1 capital; and
6. Less: Regulatory adjustments / deductions applied in the calculation of Additional Tier 1 capital.
Finance Compendium
Elements of Tier 2 Capital
(i) General Provisions and Loss Reserves
Provisions or loan-loss reserves held against future, presently unidentified losses, which are freely
available to meet losses which subsequently materialize, will qualify for inclusion within Tier 2
capital. Accordingly, General Provisions on Standard Assets, Floating Provisions, Provisions held
for Country Exposures, Investment Reserve Account, excess provisions which arise on account of
sale of NPAs and countercyclical provisioning buffer will qualify for inclusion in Tier 2 capital.
However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25% of the
total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based
(IRB) approach, where the total expected loss amount is less than total eligible provisions, banks
may recognise the difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted
assets calculated under the IRB approach.
b. Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether
individual or grouped should be excluded. Accordingly, for instance, specific provisions on NPAs,
both at individual account or at portfolio level, provisions in lieu of diminution in the fair value of
assets in the case of restructured advances, provisions against depreciation in the value of
investments will be excluded.
(ii) Debt Capital Instruments issued by the banks;
(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) /
Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference
Shares (RCPS)] issued by the banks;
(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2
capital;
(v) While calculating capital adequacy at the consolidated level, Tier 2 capital instruments issued
by consolidated subsidiaries of the bank and held by third parties which meet the criteria for
inclusion in Tier 2 capital;
(vi) Revaluation reserves at a discount of 55%;
Understanding Risk
Risk is the probability that financial loss will occur. Risk management is a three-stage process:
Risk management is a three-stage process:
1. Identify the Risk
Finance Compendium
A financial institution such as a bank, faces the following typical types of risks:
• Credit risk - This is the risk of default by a borrower.
• Regulatory risk - This refers to the risk of loss if a Financial Institution (FI) does not comply
with the regulations needed by a country’s regulator.
• Liquidity risk - This is the risk of not having cash when it is needed. This risk is critical for a
bank, as it needs to always have sufficient money on hand to repay withdrawals by depositors.
Operational risk - This is the risk of loss occurring from inefficiency in a bank’s people, process
and systems. This includes risk of theft, fraud, process inefficiency and so on.
• Legal risk - This is the risk of loss resulting from not being adequately protected by legal
contract.
• Market risk - Any entity when trading in a market is exposed to the risk of loss, and a bank is
no different, if it trades in financial markets. Depending on the specific market, the market risk can
be further categorized into:
• Equity risk (risk of loss in the stock markets),
• Interest rate risk (risk of loss in bond markets), etc.
Credit risk, operational risk and market risk are regulated by a global standard called the Basel
Norms. By ‘global’, we mean that, the norms are broadly similar across the world for all banks.
Managing Risk
Once the risk is identified and measured, steps can be taken to lessen its impact.
• Diversification- Diversification refers to spreading risk across different actions or options.
• Hedging- This refers to protecting oneself against risk, using specific financial instruments.
• Insurance-Another way to manage risk is to transfer it to an insuring party, paying a fee (called
the premium).
• Setting risk limits- A business can set risk limits to the amount of risk it is willing to face, and
thus manage
risk.
The Risk-return Principle
The higher the expected return, the higher is the attached risk and the lower the risk; the lower is
the potential reward. That means, if you expect higher returns from any investment, there will be
a higher risk associated with it, and vice versa.
Revenue Streams
Finance Compendium
The primary function of a bank is to collect funds (deposits) at a lower interest rate and lend them
out at a higher interest rate.
A bank makes money via ‘Net Interest Income’
Net Interest Income (NII) = Interest Earned on Loans – _Interest Paid on Deposits However, a
sizeable portion of income comes from fee charged on various services such as
• Demand drafts
• Advisory services to corporate,
• Trading income,
• Commission via selling other (non-bank) financial products like insurance and mutual funds.
Corporate Banking
Products and Services
1. Fund Based Facilities
2. Non-Fund Based Facilities
Fund based facilities
These are products in which a bank is 'out of funds' by lending money to its customers - hence they
are loan products. The earning of the bank for such facilities in mainly interest income.
Non – Fund Based Facilities:
Here, the bank primarily stands guarantee for its customer. Examples of non-fund based facilities
are ‘letters of credit’ and ‘guarantees’. They are called non-fund facilities as they do not involve
actual lending of funds.
Further, both fund-based and non fund-based facilities can be classified on the basis of:
1. Purpose
2. Maturity
3. Revolving and one-off
4. Security
To understand the various facilities, we will use the funded and non funded classification.
Funded facilities:
1. Working Capital Loans
• Overdraft Facility
• Cash Credit Facility
• Working Capital Demand Loans (WCDL)
Finance Compendium
2. Long-term Loans
3. Trade Finance
• Pre-shipment Loans
• Post-shipment Loans
Non Funded facilities:
1. Trade Finance
• Intermediaries
• Letter of Credit (LC)
2. Cash Management Services (CMS)
Working Capital Loans: Banks provide various forms of loans to meet the daily requirements of
businesses. These are generally for a short term (up to 1 year).
Overdraft Facility: An overdraft facility or OD is a revolving credit facility that allows a borrower
to overdraw funds beyond the available balance, up to an agreed limit, from her account.
Cash Credit Facility: As in an OD, the business can withdraw up to the sanctioned limit when
needed, paying interest only on the amount withdrawn and for the period withdrawn. This is a
facility against collateral of receivables and inventory of the business. The limit is typically 60-
70% of the value of the collateral. The buffer (30-40%) which the bank keeps on the value of the
asset is called the ‘margin’.
Working Capital Demand Loans (WCDL):Working Capital Demand Loan (WCDL) is, in
essence, a short term revolving loan facility given for the working capital requirement of the
company.
Long Term Loans: Banks provide secured or unsecured long term loans to corporations – _these
could be to finance expansions, buy real estate or machinery etc.
Trade Finance: Corporate banking provides services to facilitate international trade. These
include loans to the seller, to bridge his funding requirements till he/she gets payment from the
buyer. These can be both preshipment and post-shipment loans.
Banks also act as intermediaries for documents and funds flow in an international trade transaction.
This is because transfer through banking channels is far more secure, than if the buyer were to
send money directly to the seller, or the seller trying to send documents directly to the buyer.
Finance Compendium
Letter of Credit: The Letter of Credit (LC) allows the buyer and seller to contract a trusted
intermediary (a bank), that will guarantee full payment to the seller provided he has shipped the
goods and complied with the terms of the agreement.
Cash Management Services (CMS): CMS involves no credit risk for the bank. It provides a pure
administrative service for the corporate, and hence credit evaluation (that is, evaluating whether
or not to grant a credit limit for the company) is not relevant here.
Credit Evaluation: Before granting a facility/loan, the bank must follow a stringent credit
evaluation process, to determine whether or not to give the loan to the company. This function
analyses the ‘credibility’ of an organization. The credit process involves a qualitative and
quantitative appraisal of the client.
Qualitative analysis includes analysis of:
1. Promoter’s reputation
2. Industry outlook
3. Past track record
4. Extent of competition etc.
Quantitative analysis includes comparing the financials over a period of time to evaluate
performance.
Merchant Banking: When a bank provides to a customer various types of financial services like
accepting bills arising out of trade, arranging and providing underwriting, new issues, providing
advice, information or assistance on starting new business, acquisitions, mergers and foreign
exchange.
NBFC
Introduction
Non Banking Finance Companies (NBFCs) are financial institutions that provide services, similar
to banks, but they do not hold a banking license. The main difference is that NBFCs cannot accept
deposits repayable on demand.
Classification if NBFCs
NBFCs have been classified into three types:
1. Asset Finance Company (AFC): An AFC is an NBFC, whose principal business is the
financing of physical assets. This includes financing of automobiles, tractors, lathe machines,
Finance Compendium
generator sets, earth moving and material handling equipments and general purpose industrial
machines.
An AFC may be either
a. Giving loans to businesses for purchasing the physical assets – _tractors, machinery etc. b.
Leasing these assets to businesses.
Examples of AFCs are Infrastructure Finance Limited, Diganta Finance etc.
Investment Company (IC): This is an NBFC whose primary business is purchase and sale of
securities (financial instruments, such as stocks and bonds). A mutual fund would come under this
category. Examples of an Investment Company (IC) are Motilal Oswal, UTI Mutual Fund etc.
3. Loan Company (LC): Loan Company (LC) means any NBFC whose principal business is that
of providing finance, by giving loans or advances. It does not include leasing or hire purchase.
Example of a Loan Company (LC) is Tata Capital Limited.
NBFCs can be further classified into those taking deposits or those not taking deposits. Only those
NBFCs can take deposits, that
a) Hold a valid certificate of registration with authorization to accept public deposits. b) Have
minimum stipulated Net Owned Funds (NOF – i.e. owners’ funds)
c) Comply with RBI directions such as investing part of the funds in liquid assets, maintain
reserves, rating etc. issued by the bank.
The three key differences between a bank and NBFC are:
1. An NBFC cannot accept deposits which are repayable on demand. Some can accept fixed-term
deposits. 2. Any deposits accepted by NBFCs (these will be of fixed maturity as explained above)
are not insured
3. Only banks can participate in the payment system; hence NBFCs cannot issue cheque books to
their customers.
Banking Laws
Some of the main laws in banking are:
SARFAESI Act: SARFAESI stands for Securitization And Reconstruction of Financial Assets
and Enforcement of Security Interest Act. This Act covers the rights a lender has over the
collateral, when a secured loan defaults. ‘Reconstruction’ of an asset, is banker-speak for
reworking the terms of a loan to ensure that the money is repaid.
The SARFAESI Act in case of default, covers features such as:
Finance Compendium
1. Securitization: Issuing securities – _financial instruments – _against the recovered assets. It can
be done only by specific registered entities called an asset reconstruction company or securitization
company.
2. Guidelines for Asset Reconstruction: It covers how a defaulting business should be managed or
controlled to ensure repayment. Payments can be rescheduled, and secured collateral repossessed.
3. No court intervention needed: One of the main features of this Act is, the lender can take over
the collateral without court intervention, which was not possible earlier.
Access RBI circulars to know more about Banks
Bonds and Interest

A Remedial Lesson
A bond is a borrowing arrangement through which the borrower (or seller of a bond) issues or sells
an IOU document (the bond) to the investor (or buyer of the bond). The arrangement obligates the
borrower to make specified payments to the bondholder on agreed-upon dates. For example, if you
purchase a five-year U.S. Treasury note, the U.S. government is borrowing money from you for a
period of five years. For this service, the government will pay you interest at the T-bill rate (the
interest) and return the amount it borrowed (the principal) at the end of five years. Meanwhile, if
you choose not to keep the bond until it matures, you can sell the bond in the market for the current
value of the future interest payments and the end principal. Different types of organizations can
issue bonds: companies like Ford Motor or Procter & Gamble, and municipal organizations, like
countries and states.
Bond Terminology
Before going any further in our discussion of bonds, we will introduce several terms you should
be familiar with.
• Par value or face value of a bond: This is the total amount the bond issuer will commit to pay
back at the end of the bond maturity period (when the bond expires).
• Coupon payments: The payments of interest that the bond issuer makes to the bondholder. These
are often specified in terms of coupon rates. The coupon rate is the bond coupon payment divided
by the bond's par value.
• Bond price: The price the bondholder (i.e. the lender) pays the bond issuer (i.e. the borrower) to
hold the bond (to have a claim on the cash flows documented on the bond).
Finance Compendium
• Default risk: The risk that the company issuing the bond may go bankrupt, and default on its
loans.
• Default premium: The difference between the promised yields on a corporate bond and the yield
on another wise identical government bond. In theory, the difference compensates the bondholder
for the corporation's default risk.
• Credit ratings: Bonds are rated by credit agencies (Moody's, Standard & Poor's), which examine
a company's financial situation, outstanding debt, and other factors to determine the risk of default.
Companies guard their credit ratings closely, because the higher the rating, the easier they can raise
money and the lower the interest rate.
• Investment grade bonds: These bonds have high credit ratings, and pay a relatively low rate of
interest.
• Junk bonds: Also known as high yield bonds, these bonds have poor credit ratings, and pay a
relatively high rate of interest.
• U.S. Treasury bills, notes, and bonds: Bills mature in one year or less, notes in two to 10 years,
and bonds in 30 years. (The 30-year U.S. Treasury bond is also called The Long Bond.)
To illustrate how a bond works, let'slookatan8%coupon,30-year maturity bond with a
parvalueof$1,000, paying 60 coupon payments of $40 each.
Let's illustrate this bond with the following schematic:
Coupon rate = 8% Par value= $1,000

Therefore, the coupon = 8% x $1,000 = $80 per year
Because this bond is a semi-annual coupon, the payments are for $40 every six months. We can
also say that the semi-annual coupon rate is 4 percent.
Since the bond's time to maturity is 30 years, there are total of 30 x 2 = 60 semi-annual payments.
At the end of Year 30, the bondholder receives the last semi-annual payment of $40 dollars plus
the principal of $1,000.
Pricing Bonds
The question now is, how much is a bond worth?
Finance Compendium
The price of a bond is the net present value of all future cash flows expected from that bond.
(Recall net present value from our discussion on valuation.)
Here:
r = Discount rate
t= Interval (for example, 6 months) T = Total payments
First, we must ask what discount rate should be used. Remember from our discussion of valuation
techniques that discount rate for a cash flow for a given period should be able to account for the
risk associated with the cash flow for that period. In practice, there will be different discount rates
for cash flows occurring in different periods. However, for the sake of simplicity, we will assume
that the discount rate is the same as the interest rate on the bond.
So, what is the price of the bond described earlier? From the equation above we get:
Calculating the answer for this equation is complex. Luckily, this can be solved using a financial
calculator. It might be worth noting that the first term of this equation is the present value of an
annuity with fixed payments, $40 every 6 months for 30 years in this example.
Also, there are Present Value tables available that simplify the calculations. In this case, the interest
rate is 4 percent and T is 60. Using the Present Value tables we get
= $904.94 + $95.06 = $1000
Also, if we look at the bond price equation closely, we see that the bond price depends on the
interest rate. If the interest rate is higher, the bond price is lower and vice versa. This is a
fundamental rule that should be understood and remembered.
The Yield to Maturity (YTM) is the measure of the average rate of return that will be earned on
a bond if it is bought now and held until maturity. To calculate this, we need the information on
bond price, coupon rate and par value of the bond.
Finance Compendium
Example: Suppose an 8% coupon; 30-year bond is selling at $1,276.76. What average rate of return
would be earned if you purchase the bond at this price?
To answer this question, we must find the interest rate at which the present value of the bond
payments equals the bond price. This is the rate that is consistent with the observed price of the
bond. Therefore, we solve for r in the following equation.
This equation can be solved using a financial calculator; in completing the calculation we see that
the bond's yield to maturity is annually.
Callable Bonds
For the sake of simplification in our earlier discussions, we assumed that the discount rate was
equal to the interest rate, and that the interest rate was constant at the coupon rate. However, in the
real world, this is not always the case.
If the interest rate falls, bond prices can rise substantially, due to the concept of opportunity cost
of investments.
We'll illustrate mathematically why this happens with an example. Let's say a company has a bond
outstanding. It took $810.71 and promised to make the coupon payments as described above, at
$40 every six months. Let's say the market interest rates dropped after a while (below 8 percent).
According to the bond document, the company is still expected to pay the coupon at a rate of 8
percent.
If the interest rates were to drop in this manner, the company would be paying a coupon rate much
higher than the market interest rate today. In such a situation, the company may want to buy the
bond back so that it is not committed to paying large coupon payments in the future. This is referred
to as calling the bond. However, an issuer can only call a bond if the bond was originally issued
as a callable bond. The risk that a bond will be called is reflected in the bond's price. The yield
calculated up to the period when the bond is called back is referred to as the yield to call.
Zero coupon bonds
This type of bond offers no coupon or interest payments to the bondholder. The only payment the
zero coupon bondholder receives is the payment of the bond face value upon maturity. The returns
Finance Compendium
on their coupon bonds must be obtained by paying a lower initial price than their face value for
them. These bonds are priced at a considerable discount to par value.
Forward rates
These are agreed-upon interest rates for a bond to be issued in the future. For example, the one
year forward rate for a five-year U.S. Treasury note represents the interest forward rate on a five-
year T-note that will be issued one year from now (and that will mature six years from now). This
"forward" rate changes daily just like the rates of already-issued bonds. It is essentially based on
the market's expectation of what the interest rate a year from now will be, and can be calculated
using the rates of current bonds.
The RBI and Interest Rates
The RBI has broad responsibility for the health of the U.S. financial system. In this role, the RBI
sets the margin requirements on stocks and options, and regulates bank lending to securities market
participants.
The RBI also has the responsibility of formulating the nation's monetary policy. In determining
the monetary policy of the nation, the RBI manipulates the money supply to affect the macro
economy. When the RBI increases the money supply going into the economy, the monetary policy
set by the RBI is said to be expansionary. This encourages investment and subsequently increases
consumption demand. In the long run, however, an expansionary policy can lead to higher prices
and inflation. Therefore, it is the RBI's responsibility to maintain a proper balance and prevent the
economy from both hyperinflation and recession.
The RBI uses several tools to regulate the money supply. The RBI can
1. use its check writing capabilities, using open market operations 2. raise or lower the interest
rates, or
3. manipulate the reserve requirements for various banks to control the money flow and thereby
the interest rate.
Let's look at these tools one by one:
1. Open market operations
The RBI can "write a check" to buy securities and thereby increase the money supply to do such
things as buy back government bonds in the market. Unlike the rest of us, the RBI doesn't have to
pay the money for a check it has written. As we will see, an increase in the country's money supply
Finance Compendium
stimulates the economy. Likewise, if the RBI sells securities, the money paid for them leaves the
money supply and slows the economy.
2. Changing interest rates
The RBI can raise or lower interest rates by changing: (a) the discount rate (the interest rate the
RBI charges banks on short-term loans), and/or (b) the repo rate, the rate banks charge each other
on short- term loans. When the RBI raises or lowers interest rates, banks usually quickly follow
by raising or lowering their prime rate (the rate banks charge on loans to its most creditworthy
customers). A reduction of the interest rate signals an expansionary monetary policy. Why?
Because by reducing the interest of its loans to banks, the RBI allows banks to lend out money at
lower rates. More businesses and individuals are willing to take out loans, thus pouring more
money into the economy.
3. Reserve requirements
All banks that are governed by the RBI are required to maintain a minimum balance in a reserve
account with the RBI. The amount of this minimum balance depends on the total deposits of the
bank's customers. These minimum deposits are referred to as "reserve requirements." Lowering
the reserve requirements for various banks has the same expansionary effect. This move allows
banks to make more loans with the deposits it has and thereby stimulates the economy by
increasing the money supply.
But why does an increase in money supply stimulate the economy? An increase in the money
supply usually results in investors having too much money in their portfolios, which leads them to
buy more stocks and bonds and gives them more discretionary income. In part, this action increases
the demand for bonds, dives up bond prices, and thereby reduces interest rates. More money
available also increases demand for stocks and real estate. This availability leads to higher
investments and greater demand for goods.
The RBI and Inflation
Inflation is the rise of prices over time - it is why over the long-term, we are guaranteed to hear
and (sorry, it's true) speak phrases like: "When I was your age, a can of Coke was only INR 10."
Prices rise over time because of increases in population and resultant demands for products.
Inflation directly affects interest rates. Consider this: Iflending money is healthyfor the economy
because itpromotes growth, interest rates must be higher than inflation. (If I lent out money at a 5
Finance Compendium
percent annual interest rate, but inflation was at 10 percent, I would never lend money.) Thus, the
Federal Reserve watches inflation closely as part of its role of setting interest rates.
Lenders issuing long-term loans such as mortgages can also issue what are called floating rate (or
adjustable) loans, whose yield depends on an interest rate (like the prime rate) which adjusts to
account for changes in inflation. Using floating rates, lenders can be protected from inflation.
At the same time, some amount of inflation (usually around 1 to 2 percent) is a sign of a healthy
economy. If the economy is healthy and the stock market is growing, consumer spending increases.
This means that peopleare buying more goods, and by consequence, more goods are in demand.
No inflation means that you do not have a robust economy - that there is no competitive demand
for goods.
Either way, inflation must be watched closely. From basic microeconomics we know that if the
demand rises because of higher personal income, the new equilibrium price is higher. Once prices
rise, supply rises more (sellers of goods enter the market to take advantage of the opportunity (i.e.,
growth in macroeconomic terms). Hence, prices reach a new equilibrium above the previous
equilibrium. Trends can theoretically spiral upward, as increased supply indicating a healthy
economy further boosts the demand and supply.
Effect of Inflation on Bond Prices
The effect of inflation on bond prices is very simple: when inflation goes up, interest rates rise.
And when interest rates rise, bond prices fall. Therefore, when inflation goes up, bond prices fall.
The ways in which economic events, inflation, interest rates, and bond prices interact are basic to
an understanding of finance - these relationships are sure to be tested in finance interviews. In
general, a positive economic event (such as a decrease in unemployment, greater consumer
confidence, higher personal income, etc.) drives up inflation over the long term (because there are
more people working, there is more money to be spent), which drives up interest rates, which
causes a decrease in bond prices.
The following table summarizes this relationship with a variety of economic events.
Finance Compendium
Leading Economic Indicators

The following table is a look at leading economic indicators, and whether their rise or fall signal
positive economic events or negative economic events. For finance interviews, know this chart
cold.

Finance Compendium Club Chanakya

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Finance Compendium

Prepared by Ninad Solanky (PRM 39, Vivritti Capital)

Finance Revision Sheet

Basic Accounting Concepts

Assets (A) = Liabilities (L) + Shareholder's Equity (SE)

Net Income 5500

Add: Net Income 5000

Less: Dividends Declared 2000

Retained Earnings at the end of the

Cash Flow Statement

Net Cash Flow from Investing

Margin = Profit Metric / Total Sales

MARKET AND VALUATION RATIOS

DEBT RATIOS / SOLVENCY RATIOS

Interest Coverage Ratio:

3. Management of funds – This involves Capital Budgeting (long-term planning) and

Role of Corporate Finance

Key Principles of Capital Budgeting:

Terminal Year Calculation

Project A (INR) Project B (INR)

NCF Cumulative NCF NCF Cumulative NCF

Year Project A (INR) Project B (INR)

Discounted Payback Period (Project A) = 2 + (429/451) = 2.95 years

To calculate a firm’s DOL for a particular unit level of sales, Q:

Breakeven Quantity of Sales

directors and may or may not require approval by shareholders.

b. Stable or irregular dividends?

c. How frequently to pay dividends?

d. Announce the dividend policy?

Pecking Order Theory:

Investment Banking Basics

Project Valuation method

Market Priced Based

FPO- FOLLOW-ON PUBLIC OFFER

SEO-SEASONED EQUITY OFFERING

Methods of securing a loan with security/ collateral:

Bonds and Interest

Coupon rate = 8% Par value= $1,000

Leading Economic Indicators

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