FM Merged

Financial
Management 1
S S S Kumar
Resources
In addition to the recommended text book

Also refer to
1.  Principles of Corporate Finance by Brealey and Myers
2.  Corporate Finance by Ross, Westerfield and Jaffe
3.  Corporate Finance by Aswath Damodaran
4.  Financial Management by I M Pandey
5.  Financial Management by Prasannachandra

Resources contd…
q  A regular finance daily viz, ET, BS, FE or BL

A professional journal like
–  Journal of Applied Corporate Finance,
–  McKinsey Quarterly (online edition available)

Request: Always come to the class with your calculators
Flow of topics and evaluation
q  Check the course outline for complete details
Microsoft Word Document

Financial markets
The Financial System
Financial
System
Financial Financial
intermediaries market
6
Indian Financial Markets
Indian Financial
Markets
Derivatives
Money market Capital market Forex market
market
7
Capital Market
Capital
market
Debt Equity
market market
Primary Secondary Primary Secondary

mkt mkt mkt mkt
8
Primary market contd…
q  Initial Public Offer (IPO)

q  Follow on Public Offer (FPO)
q  Rights Issue
Primary market contd…
q  When equity issue is offered to select entities then it is
termed as Private Placement.
q  On the other hand if any one can subscribe to the issue it is
termed as Public Offer.
Secondary market
q  A secondary market is a market for previously issued

securities.
q  The issuing firm is not directly affected by transactions in
the secondary markets.
Secondary market contd..
q  A security can trade an unlimited number of times in
secondary markets.
q  The sale/purchase of these securities are carried out at the
specific Stock Exchange(s), where the companies get their
public issues listed for trading.
q  The volume of trade in secondary markets is much higher
than in primary markets
What should be the goal…..
q  Survive
q  Avoid financial distress and bankruptcy
q  Beat the competition
q  Maximize sales or market share
q  Minimize costs
q  Maximize profits
q  Balance the needs of all stakeholders
q  Maximize shareholders wealth
Goal of the Organization
Maximize shareholder value
Most financial economists recommend this!

Time Value of Money
S S S Kumar

Financial Management 1
15
Time value concepts
q  What is time value of money?
q  Why time value of money?
q  How is it incorporated in Finance decisions?
16
Why money has time value?
q  Current consumption
q  Inflation
q  Risk
q  Returns
17
q  You cannot add or subtract cash flows that occur at different
times without first compounding or discounting them to the
same point in time.
–  Once at the same point in time, we can add or subtract the resulting
equivalency cash flows.
–  This is known as the cash flow additivity principle: If two or more cash
flows occur at the same point in time, we can add or subtract them
together.
•  One implication of this is that we can add cash flow patterns
together once we account for the differences in timing.
18
Simple Interest
In its most basic form, interest is calculated by multiplying
principal by rate multiplied by time. This is called simple
interest.

19
Simple Interest
Usually simple interest is used in financial institutions for
interest periods of less than one year.
20
Compound Interest
However, if interest is left in the account to accumulate for a longer period
common practice requires that after interest is earned and credited for a given
period, the new sum of principal + interest must now earn interest for the next
period, etc. This is compound interest.
21
Compounding
0 1 2 3
10%
100 FV = ?
Given a present value (PV), we can compound to return a

future value (FV).
22
Discounting
Given a future value (FV), we can discount it to return a

present value (PV).
0 1 2 3
10%
PV = ? 100
23
example
Suppose you invest Rs. 1500 in a bank today and if the bank
pays 9% annually, how much will you have in two years?
FV = 1500 x (1.09) x (1.09) = 1782.16
We have simple formulae for computing FV,PV etc.,
24
The Time Line
End of Start of
second year third year
Today
t=0 t =1 t=2 t=3 t=4
Note:
The end of one year is the start of the next year.
25
Future Value Formula
Let PV = Present Value

FVn = Future Value at time n
r = interest rate (or discount rate) per period.
FVn = PV (1 + r ) n = PV × FVFr ,n
26
Future Value
•  ICICI Top 100 fund provided a return 25.70% per

annum over the last 10 years. If the fund
continues to earn this rate of return, a Rs 10,000
investment will grow to how much in 20 years?
27
Present Value Formula
Let PV = Present Value

FVn = Future Value at time n
r = interest rate (or discount rate) per period.
⎡ 1 ⎤
PV = FVn ⎢ n ⎥
= FVn × PVFr ,n
⎣ (1 + r ) ⎦
28
Present Value
Today you withdrew Rs. 10 mn – a birthday gift given by your

Grandfather 15 years back. If he deposited at a rate of 9%
per year, how much did your Grandfather deposited?
29
Series of cashflows
Assume to day is Jan 1 2005 and Mr. Rao deposits Rs

15,000 on Dec 31 every year for 4 years I.e., till
2008. How much balance will the account show at
the end of 4th year?(i = 10%)
Dec 31 Dec 31 07 Dec 31 08

Jan 1 05 Dec 31 06
05
15000 15000 15000 15000
30
Series of cashflows contd…
Dec 31 Dec 31 07 Dec 31 08
Jan 1 05 Dec 31 06
05
15000 15000 15000 15000
15000
15000 (1.1)
15000 (1.1)2
15000 (1.1)3
∑
Rs. 69,615
31
Series of cashflows contd…
q  If Mr. Rao deposits for 25 years? How much will the balance
be???
Ø  The computations are slightly involved and such cumbersome

calculations can be handled considering the series of cashflows
as “annuities”
32
Annuities
q  An annuity is a stream of constant cashflow occurring at

regular intervals of time.
q  For example: Insurance premiums, EMIs of loans etc.,
q  When cashflows occur at the end of each period its termed
as regular or ordinary annuity or deferred annuity.
33
Cashflow map of a typical annuity
0 1 2 3
i%
100 100 100

Time line for an ordinary annuity of Rs. 100 for 3 years.
34
FV of an annuity
q  In general FV of an annuity is given as
F = A (1+i) n-1 + A(1+i)n-2 + …………+A
⎡ (1 + i )n − 1⎤
FVseries/annuity = A × ⎢ ⎥
⎣ i ⎦
Where A = regular installment/payment
Annuity factor or
i = interest rate
FVIFA
n = number of periods
35
Saving to clear your edu loan
Your child will be migrating to the US for higher education and
you are planning to finance the first semester’s college fee.
The fee payable 5 years from now is Rs 45 lakhs. If the rate is
9% how much money would you need to set aside at the end
of each year to be able to pay college fee? Ignore inflation
and other effects.
36
PV of an annuity
q  A single premium plan promises to make a payment of Rs
1,50,000 pa for five years. How much will you pay to buy
this plan? Assume 10% interest rate.
⎡ (1 + i )n − 1⎤
PVseries/annuity = A × ⎢ n ⎥
⎣ i(1 + i ) ⎦
PV int annuity
factor
37
The worth of an Executive MBA
q  Several salary surveys indicate that graduates who hold an
Executive MBA will earn on an average Rs250,000 more than
their non certified counterparts. If you still have ten more
years of service how much will you pay as fee for an Executive
MBA programme today? Assume interest rate of 7%.
38
TV and Excel
You can work out the TV problems using Excel spreadsheet.
Please explore the following financial functions.
q  FV(RATE, NPER, PMT, PV, Type)
q  PV(RATE, NPER, PMT, FV, Type)
q  PMT(RATE, NPER, PV, FV, Type)
q  RATE(NPER, PMT, PV, FV, Type)
q  NPER(RATE, PMT, PV, FV, Type)
39
Summary
TVM
FV_SS FV_Ann PV_SS PV_Ann

PV (1 + r ) n ⎡ 1 ⎤
FVn ⎢ n ⎥
⎣ (1 + r ) ⎦
⎡ (1 + i )n − 1⎤ ⎡ (1 + i )n − 1⎤
A× ⎢ ⎥ A× ⎢ n ⎥
⎣ i ⎦ ⎣ i(1 + i ) ⎦
40
Summary contd..
Type Example Relevant Table Referred to as
FV of single sum ICICI Top 100 Mutual fund Table A1 FVIF (r, n)
FV of annuity Rao’s deposits Table A2 FVIFA (i, n)
PV of single sum Birthday gift from Grandfather Table A3 PVIF (r, n)
PV of annuity Value of Executive MBA Table A4 PVIFA (i, n)
41
TV and Excel
You can work out the TV problems using Excel spreadsheet.
Please explore the following financial functions.
q  FV(RATE, NPER, PMT, PV, Type)
q  PV(RATE, NPER, PMT, FV, Type)
q  PMT(RATE, NPER, PV, FV, Type)
q  RATE(NPER, PMT, PV, FV, Type)
q  NPER(RATE, PMT, PV, FV, Type)
42
Present value of Perpetuity
𝑃𝑉𝑃=𝐴/(1+𝑖)↑1  +𝐴/(1+𝑖)↑2  + 𝐴/(1+𝑖)↑3  +⋯⋯⋯∞
⎡ (1 + i )n − 1⎤ A ⎡ (1 + i )n − 1⎤
PV annuity = A × ⎢ n ⎥
= ×⎢ n ⎥
⎣ i(1 + i ) ⎦ i ⎣ (1 + i ) ⎦
𝑃𝑉𝑃= 𝐴/𝑖 
43
Perpetuity Example
Perpetual bonds, known as additional tier-I papers in market

parlance, do not have any fixed maturity. The bonds have
offered 8.85% interest rate.

For the first time, the bank has sold such bonds that are
compliant with Basel III, an international standard for bank
capital.

Read more at:
https://economictimes.indiatimes.com/markets/bonds/hdfc-bank-raises-rs-8000-crore-via-perpetual-bond-sale/articleshow/
58616932.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst
44
Perpetuity - Example
SBI Life’s pension plan:
q  You pay today Rs. 20,00,000
q  Annual payout of Rs 175,710 pa for the rest of your life
Assuming you are 60 years old and if your rate of interest is 7% is
it a worthy plan?
45
Annuity Due
46
Annuity Due
q  Annuity Due ≡ Beginning of the period
q  Annuity Ordinary a.k.a Regular ≡ End of the period
q  We can continue to use the same formulae and Tables with
adjustment for difference in timing of the cashflows
FVIFADue = FVIFAOrd × (1+i)
PVIFADue = PVIFAOrd × (1+i)
q  While working in Excel….
–  Type = 0 [for Ordinary annuity]
–  Type = 1 [for annuity Due]
47
Annuity due Example
q  Soso Bank promises to pay interest on all their deposits at the
time of making the deposit. You deposit a sum of Rs. 1,00,000
for a 3-year term. If the rate of interest is 10% PA what will be
the maturity value?
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
Classifications of Interest Rates
q  Nominal rate (APR) – also called the quoted or stated rate.
An annual rate that ignores compounding effects.
q  Periodic rate – amount of interest charged each period, e.g.
monthly or quarterly.
q  Effective (or equivalent) annual rate (EAR/EIR) – the annual
rate of interest actually being earned, accounting for
compounding.
–  Should be indifferent between receiving 10.25% annual interest and receiving 10%
interest, compounded semiannually.
66
Why is it important to consider effective rates of return?
q  Investments with different compounding intervals provide
different effective returns.
q  To compare investments with different compounding
intervals, you must look at their effective returns
67
Why is it important to consider effective rates of return?
q  See how the effective return varies between investments
with the same nominal rate, but different compounding
intervals.
EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
68
When is each rate used?
q  Nominal Rate: Written into contracts, quoted by banks
and brokers. Not used in calculations or shown on time
lines.
q  Periodic: Used in calculations and shown on time lines.
q  EAR: Used to compare returns on investments with different
payments per year. Used in calculations when annuity
payments don’t match compounding periods.
69
EIR
In practice we will make use of the following relationship
m
⎡ i⎤
EIR = ⎢1 + ⎥ − 1
⎣ m⎦
Where m is the frequency of compounding
70
To become a Big Bazaar PROFIT CLUB member, you need to pay
an amount of Rs. 10,000 which will be topped up on the card
immediately. FVRL will add an amount of Rs. 2,000 at the time of
card issuance. Members can only spend upto a maximum of Rs.
1,000 every calendar month for a period of 12 months. Amount
unused in a particular month will be carried forward to the next
month with a maximum carry forward upto 18 months from
enrolment into the Big Bazaar PROFIT CLUB program. Is it
financially worth taking up this offer??
71
Loan Tenor 12 months 24 months 36 months 48 months
Indicative
Monthly Rs. 9,216 Rs. 5,041 Rs. 3,666 Rs. 2,990
Instalment
Source:https://www.online.citibank.co.in/portal/citi_home_center.jsp?
frameset=centerFrameset&frameval2=ELoansWID&frameval1=ELoansNID&framevar2=workID&framevar1=navID&eOfferCode=
Compute the interest rate meant in this deal

(48 months case) ?
Disclaimer: This is not to meant to show usury etc., in Indian financial markets but only to give practice
to students in computing interest rates
Increase in EMI
q  You are contemplating to take a 50-month personal loan of Rs
5,00,000 at 1% per month. Compute your EMI’s assuming:
(i)  EMIs payable at the end of the month
(ii)  EMIs payable at the beginning of the month
73
And Mr. Ambani wins IPL Franchisee
q  The news papers claim that IPL is cash rich cricketing league in
the World. For instance the Mumbai Indians franchisee Mr.
Mukesh Ambani won it at a stupendous bid of $112 mn. But
Mr. Modi says that it is not true in a present value sense and
that IPL will really be making $11.2 mn per year as Franchisee
fee. Assuming BCCI can earn 7% on their investments, what is
the present value of the contract?
74
Practice problem
As winner of a breakfast cereal competition, you can chose one of the

following:
– 100,000 now
– 180,000 at the ned of five years
– 19,000 for each year of 10 years
If the interets rate is 12% which alternative will you choose?
75
Practice problem
q  You have decided to start your own firm. Being prudent, you
want to have enough money saved to use for living expenses
for two years before you quit. You can currently put away
$45,000 a year. You know that you will have living expenses
of $75,000 a year for each of the two years (paid at the end of
the year, simplifying assumption). You would like to quit in
three years. If you put $45,000 into an account bearing 5% PA
interest each of the next two years, how much must you put
into the account at the end of Year 3 so that you can quit?
76
Practice problem
q  You are saving for a new car and have calculated that you will
be able to make five payments before you need to buy the
car. Your stock market account is expected to earn 8% each
year, and you will need $45,000 to buy the car you want. How
much must you save each year to buy the car at the end of
five years?
77
Practice problem
q  Along with your new car in five years, you have decided to
buy a new house now. Current mortgage rates are 4% PA and
you have decided to finance the house for 30 years. The
house you want is $860,000, and you are able to finance 80%
of that. How much will your monthly payment be?
78
Capital Budgeting Rules
1
Prelims
q  What is a capital investment?

q  Also termed as projects.
2
Features of investment decisions
q  Large cashflows
q  Affect LT profitability
q  Irreversible decisions
q  Top management’s attention

Capital budgeting decisions can be the most complex decisions
facing management.
3
How are Projects classified?
q  Independent
–  Acceptance or rejection has no affect on other projects.
q  Mutually Exclusive
–  Acceptance of one automatically rejects the others.
q  Contingent
–  Acceptance of one project is dependent upon the selection of
another.
4
Investment evaluation techniques
q  Non-discounted cashflow techniques
–  Pay back
q  Discounted Cashflow Techniques
–  NPV
–  IRR
–  PI
So what is a good evaluation technique?
5
Good evaluation technique
Good evaluation technique should:

q  Takes in to consideration TVM
q  Includes risk adjustment
q  Consistent with the SWM
6
Payback
q  This is a simple approach to capital budgeting that is designed
to tell you how many years it will take to recover the initial
investment.
q  It is often used by financial managers as one of a set of
investment screens, because it gives the manager an intuitive
sense of the project’s risk.
How is it computed?
Decision Rule
Accept if the payback period is less than some preset limit
7
Payback
Initial cost = $100,000

AT cash flow benefits = $60,000
Useful life(years) = 5
Cost of Capital = N/A
Cumulative
Year Cashflow After-tax incremental CF PV Factor Cash Flows
0 Initial cost -$100,000 -$100,000
1 ATCF operating benefit 60,000 -$40,000
2 ATCF operating benefit 60,000 $20,000
3 ATCF operating benefit 60,000
Payback period = 1.7 years
8
Payback calculation
Year A B C
0 -100 -200 -200
1 30 40 40
2 40 20 20
3 50 10 10
4 60 130
Payback 2.6 years Never 4 years
9
Pros and Cons of payback
1. Provides an 1. Ignores the TVM

indication of a project’s risk (time value of money).
and liquidity. 2. Ignores CFs
2. Easy to calculate and occurring after the payback
understand. period.
May lead to decisions that do not maximize

shareholder wealth.
10
Discounted payback
q  Calculates the time it takes to recover the initial investment in
current or discounted dollars.
q  Incorporates time value of money by adding up the
discounted cash inflows at time 0, using the appropriate
hurdle or discount rate, and then measuring the payback
period.
q  It is still flawed in that cash flows after the payback are
ignored.
11
Discounted Payback
Initial cost = $1,00,000

Cost of Capital = 12%
Cumulative
Year Cashflow After-tax incremental CF PV Factor Cash Flows
0 Initial cost -$1,00,000 1 -$1,00,000
1 ATCF operating benefit 60,000 0.892857 $53,571
2 ATCF operating benefit 60,000 0.797194 $47,832
Payback period = 1.97 years
12
Net Present Value
q  The difference between the market value of a project and its
cost
q  How much value is created from undertaking an investment?
13
Net Present Value contd…
• This rule is always consistent with maximizing the value of the

firm
• Economically, take all projects for which benefits > costs (in
PV rupees)
• Mathematically, sum the present values of all the cash flows
NPV = ∑
CF
n
− CF
j
j 0
(1+ k )
j =1
14
Net Present Value contd…
Decision rule
If the NPV is positive, accept the project
Example:

Cost of Capital = 12.0%
Year Cashflow After-tax incremental CF PV Factor Present Value

0 Initial cost -$100,000 1 -$100,000
1 ATCF operating benefit $60,000 0.892857 $53,571
NPV = $146,684
15
NPV with Excel
Discount Rate
Future Cash flows
Assumption that cash

flows occur at the end
of the period
16
NPV and Shareholder Wealth
q  A project’s NPV is the net effect that undertaking a project is
expected to have on the firm’s value
q  A project with an NPV > (<) 0 should increase (decrease) firm
value
q  Since the firm desires to maximize shareholder wealth, it
should select the project with the highest NPV
q  Why +ive NPV projects lead to SWM?
17
NPV Example

After-tax
incremen PV Present
Year Cashflow tal CF Factor Value
0 Initial cost -$100,000 1.000 -$100,000
NPV = $260,000
Discount Rate = 0.0%

NPV = $260,000
NPV Example

After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = $161,316
Discount Rate = 0.0% 10.0%

NPV = $260,000 $161,316
NPV Example

After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = $99,531
Discount Rate = 0.0% 10.0% 20.0%

NPV = $260,000 $161,316 $99,531
NPV Example

After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = $58,565
Discount Rate = 0.0% 10.0% 20.0% 30.0%

NPV = $260,000 $161,316 $99,531 $58,565
NPV Example

After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = $30,078
Discount Rate = 0.0% 10.0% 20.0% 30.0% 40.0%

NPV = $260,000 $161,316 $99,531 $58,565 $30,078
NPV Example

After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = $9,465
Discount Rate = 0.0% 10.0% 20.0% 30.0% 40.0% 50.0%

NPV = $260,000 $161,316 $99,531 $58,565 $30,078 $9,465
NPV Example

After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = -$5,960
Discount Rate = 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%

NPV = $260,000 $161,316 $99,531 $58,565 $30,078 $9,465 -$5,960
NPV Example

Useful life(years) = 6 IRR = 55.8058%
After-tax
incremen PV Present
0 Initial cost -$100,000 1.000 -$100,000
NPV = $0
Discount Rate = 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 55.8%

NPV = $260,000 $161,316 $99,531 $58,565 $30,078 $9,465 $0
25
NPV to IRR Rule
NPV
$
IRR
0
Discount Rate
26
IRR Rule
q  This is the most important alternative to NPV.
q  The most prominent measure with the practitioners is the
internal rate of return rule.
q  It is often used in practice and is intuitively appealing
q  It is based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
Definition
q  IRR is the return that makes the NPV = 0
Decision Rule
Accept the project if the IRR is greater than the required return
27
Finding IRR
q  There is no general algebraic closed-form formula that solves
the IRR for many cash flows.
q  In Excel, this function is called IRR()
28
More about IRR
q  Intuitively, a project with a higher IRR is more profitable.
q  Multiplying each and every cash flow by the same factor,
positive or negative, will not change the IRR.
29
More about IRR
q  The IRR rule leads often (but not always) to the same answer
as the NPV rule, and thus to the correct answer. This is also
the reason why IRR has survived as a common method for
capital budgeting.
q  If you use IRR correctly and in the right circumstances, it can
not only give you the right answer, it can also often give you
nice extra intuition about your project itself, separate from
the capital markets.
30
Profitability Index
q  Measures the benefit per unit cost, based on the time value
of money
q  A profitability index of 1.1 implies that for every Re. 1 of
investment, we create an additional Re. 0.10 in value
q  Used occasionally. Not as common as IRR.
Acceptance Rule
q  Invest if PI > 1. Reject if PI < 1.
q  Often gives the same recommendation as NPV.
PV of cash inflows
PI =
PV of cash outflows
31
NPV and IRR - dilemmas
q  NPV and IRR give consistent results when the projects are not
mutually exclusive and when IRR > k (cost of capital)
Which one would you select?
Project A Project B
year cash flow year cash flow
0 (135,000) 0 (30,000)
1 60,000 1 15,000
2 60,000 2 15,000
3 60,000 3 15,000
required return = 12% required return = 12%
IRR = 15.89%% IRR = 23.38%
NPV = 9,110= 1.07 NPV = 6,027
Pattern of cashflows
The prevailing cost of capital is 10%. Now consider two exclusive
projects which one should you take?
Time 0 1 2 3 4 IRR NPV

M -500 75 175 225 300 16% ₹ 86.76
N -500 290 200 150 50 19% ₹ 75.77
Fisher’s intersection/crossover
200
150
100
NPVM = 56.24 = NPVN
IRRN = 19%
50
0
0.03 0.05 0.07 0.09 0.11 0.13 0.15 0.17 0.19 0.21 0.23 0.25
-50
12% IRRM = 16%

-100
-150
M N
35
…. dilemmas
q  NPV profiles of projects can cross when project size
differences exist (the cost of one project is larger than that of
the other) or
q  When timing differences exist (most of the cash flows from
one project come in the early years, while most of the cash
flows from the other project come in the later years)
….dilemmas
q  If the cost of capital is greater than this crossover rate, the
two methods give same answer
q  If the cost of capital less than crossover rate, two methods
give separate answers
What is the IRR?
0 1 2
-800,000 5,000,000 -5,000,000

Which one would you prefer?
Project A 1000 -1500 IRR = 50%
Project B -1000 1500 IRR = 50%

Indifferent.
MIRR
q  The interest rate where the FV of a project’s inflows (TV) are
discounted to equal the PV of a project’s outflows.
q  Assumes cash inflows are reinvested at the project’s cost of
capital (k).
q  This slight difference, makes the MIRR more accurate than
the IRR.
Steps to find MIRR
q  Find terminal value of inflows by finding FV of each annual
inflow to the end of the project’s life at the cost of capital.
q  Find PV of outflows at the cost of capital today.
q  Then find interest rate over the n years of the project that
equates the TV (=FV) to the PV of the outflows(=PV).
q  Decision rule same as IRR: Compare MIRR to cost of capital.
Indian Practice Scene
Source: S. Singh, P.K. Jain, S.S. Yadav (2012) “Capital budgeting decisions: Evidence from India” Journal of
Advances in Management Research, 9 (1), pp. 96-112
42
What do the practitioners use?
PI 16.90%
IRR 68.90%
NPV 67.60%
ARR 18.20%
Payback 68.90%
0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%
Source: Batra and Verma (2017)

What IRRs Corporates are looking for?
44
Extracts from the Transport plan for NCR 2032
45
Extracts from the Transport plan for NCR 2032
46
Cashflow Estimation
S S S Kumar

Financial Management 1
Capital budgeting process
q  All evaluation approaches (NPV, IRR, Discounted Payback, and PI) require
the same data:
–  Estimate of initial cost (ICF)
–  Operating cash flows (OCF)
–  Cost of Capital (k)
–  Estimate of useful life (n)
–  Ending Cash flows (TCFn)
–  Corporate tax rate (T)
Cashflows and capital budgeting
q  Decisions are only as good as the information used to make
them.
q  Cashflow estimation is a multi disciplinary approach
Cash flows: general guidelines
q  Cash flows should be:
–  Incremental or marginal
–  After-tax
–  Do not include interest or dividends
q  Determine the appropriate time horizon for the project
q  Consider the effect of all project interdependencies on cash
flow estimates.
q  Treat inflation consistently
Relevant and Irrelevant cash flows.
IIM is debating whether it should start a new academic program.
The cashflows generated by the new program (such as tuition
fee) are relevant cash inflows and the salary of the Librarian is
considered as irrelevant cash flow.
Incremental cash flows
q  Incremental cash flows are cash flows that will occur if a
project is accepted, but that will not occur if the investment is
rejected.
q  “What is different if project is accepted?”
The cash flows of the firm with the project minus the cash flows
of the firm without the project
Project CFt = Firm' s CFt with project − Firm' s CFt without project
Basic Cash Flow Pattern
Initial After-Tax
If CF 0 < PV of Cash Flow (CF0)
CFt , then
benefits exceeds
costs, the NPV is
positive.
t=1 2 3 n-1 n
ACCEPT the
Project
CF1 CF2 CF3 CFN-1 CFN

Expected Annual After-Tax Operating Cash Flows (CF tt)
Terminal Cash
n
CFt Flow (ECFn)
PV of CFt = ∑
t =1 (1 + k ) t
Deconstructing the Basic Cash Flow Pattern
q  The basic cash flow pattern can be deconstructed into:
q  Initial investment (ICF )
q  Annual stream of after-tax cash flows throughout the project
life (OCF )
q  Terminal or Ending cash flows (TCF )

Initial cashflow
q  The initial cashflow is basically the amount of money the firm
has to spend to get the new project started.
q  Cash outflow at beginning of project (time period zero)
q  Includes cost of acquiring fixed assets (purchase price plus
other costs incurred in getting asset to your company and up
and running, such as shipping, installation, etc.)
q  Also includes changes in net working capital caused by
proposed project
Net working capital
q  Increase in NWC = outflow (additional cost of project)
q  Decrease in NWC = inflow (savings created by project)
Operating cash flows
q  These are the cash flows resulted from the project directly.
Terminal Cashflows
q  Include after tax salvage value and reduction in net working

capital
1)  After-tax proceeds from sale of fixed asset(s)

2)  Generally, the sale of a “capital asset” generates a capital
gain (asset sells for more than book value) or capital loss
(asset sells for less than book value).

Terminal Cashflows
q  Include after tax salvage value and reduction in net working capital
1)  After-tax proceeds from sale of fixed asset(s)
2)  Return of NWC to its original (before-project) level

a.  If the project caused an increase in NWC in the beginning, that increased
investment is no longer needed when the project is completed. Those
funds are freed up to be used elsewhere. Amount of NWC is counted as
cash inflow in DCF.
b.  If the project caused a decrease in NWC in the beginning, that benefit no
longer exists at end of project. Amount of NWC is counted as cash
outflow in DCF.

Initial cashflow = Purchase price + incidental expenses ± net
working capital
Operating cashflow = EBIT (1-T) +Dep
Terminal Cashflow = ATSV ± net working capital

Don’t include financing effects like interest payments, principal
repayments and dividends as outflows

Why?
q  The cost of capital already incorporates interest and dividend
affects in the analysis by way of discounting process.
q  If we include them as cash flows, we would be double
counting capital costs.
Cashflows: points to remember
q  Sunk costs
q  Opportunity costs
q  Inflation treatment
q  Overhead allocations
q  Include all externalities
Example: Suppose a building was built in 2000 for Rs. 500,000. In

2019, the firm needs to decide if the building should be
remodeled for project A (which will generate an income of Rs.
50,000) at a cost of Rs.25,000 or for project B (which will
generate an income of Rs.72,000) at a cost of Rs.50,000.
Identify the relevant and irrelevant cash flows.
17
Example: After graduation, you decided to go and pursue a one-year PG

course. The annual tuition fees for the course is approximately Rs.
250,000. What is the total cost of your PG course if you also have a job
offer that gives you a monthly income of Rs 25,000?
18
Practice Question
A four-year project has cash flows before taxes and depreciation
of $12,000 per year. The project requires the purchase of a
$50,000 asset that will be depreciated over five years, straight
line. At the end of the fourth year the asset will be sold for
$18,000. The firm's marginal tax rate is 35%. Calculate the
cash flows associated with the project. (For convenience
assume the gain on the sale of the asset is taxed at 35%.)
19
Bond and Stock Valuation
S S S Kumar

Financial Management
Bond definition
1.  A bond is similar to a promissory note.
2.  A bond is a fixed income instrument that represents a loan made by

an investor to a borrower typically corporate or government.
3.  Owners of bonds are debtholders, or creditors, of the issuer.
4.  Amount borrowed through the bond should be returned on the

maturity date and periodically the borrower has to pay interest,
which is a statutory obligation.
5.  Bonds can be traded on the exchanges.
6.  Bonds are otherwise known as debentures. (?)
2
The bond terminology
1.  Par value: Face amount; paid at maturity. It is also the reference
amount the bond issuer uses when calculating interest payments.
2.  Coupon interest rate: Stated interest rate. Multiply by par value to
get interest in rupee terms. Generally fixed.
3.  Maturity: time to return the principal; as time elapses this declines.
4.  Issue date: Date when bond was issued.
3
Categories of bonds
q  Based on convertibility
•  Non convertible
•  Partly convertible
•  Fully convertible
•  Optionally convertible
q  Based on Security
–  Secured
–  Unsecured
4
Basic Valuation premise
The (market) value of any investment asset is simply the

present value of expected cash flows
In a coupon paying bond..
Therefore value of a bond
= PV of all expected interest and principal payments.
5
Bond valuation contd….
Assume a bond of Rs. 100 face value

q  Annual coupon rate = 10%
q  Maturity = 5 years
q  Required return by investors = 10%

What will be the market price of this bond?
6
Bond valuation example
FV, Coup - Fixed
As time passes
‘n’ reduces
Company Investors
‘k’ changes
unpredictably
Microsoft Excel Sheet
7
Bond prices when required return (k) changes
k = 10% k = 12% k = 8%
1 10 10 10
2 10 10 10
3 10 10 10
4 10 10 10
5 110 110 110
Bond price 100 92.79 107.99
8
Bond Valuation contd….
1.  For a Fixed interest rate bond – Once a bond is issued by the company,
the coupon rate and the face value will remain unchanged.
2.  When you hear about interest rate increase/decrease it refers to the
changes in REQURIED RETURN/DISCOUNTING RATE (k)
3.  Accordingly the cashflows (numerator) remains unchanged but the
discounting rate (denominator) only changes, accordingly the market price
of the bond changes and the gains or losses be borne by investors, but not
the company that issued those bonds.
9
Basic components of the discount rate
The discount rate (k) is the opportunity cost of funds, i.e., the rate
that could be earned on alternative investments of equal risk.
In general made up of some or all of the following components:
k = RR + IP + MRP + DRP
10
The YTM story
We have seen how to value a bond can we reverse the dynamics??

i.e., lets find out return implied on a bond given its price (P0)
𝑃↓0 =𝐶𝐹↓1 /(1+𝑦)↑1  +𝐶𝐹↓2 /(1+𝑦)↑2  +⋯⋯+𝐶𝐹↓𝑛 /(1+𝑦)↑𝑛  
This is the same equation we saw earlier when we solved for price. In
this case, we know the market price but are solving for return ‘y’ used
by the market top arrive at a traded price P0.

11
q  The yield to maturity measures the compound annual return to an
investor and considers all bond cash flows. It is similar to the IRR in
capital budgeting context (we will see what IRR means in due course of
time).
q  In other words it is the single rate that when used to discount a bond’s
Cashflows produces the bond’s market price
12
YTM application
q  LAST YEAR your company issued a bond with 6 years to
maturity @ a coupon of 12% and a face value of Rs 100.
q  Now this bond is trading in the market at Rs 99.06.
q  Suppose, this company now wants to raise new capital in the
form of bonds of 5 years maturity.
q  What should be the coupon rate on the new bonds so that
investors will buy them at face value?
13
Stock Valuation
S S S Kumar
Indian Institute of Management Kozhikode
1
What is Equity capital?
Equity capital represents the ownership capital also

termed as the risk capital since equity holders
bear all the associated risks and returns.
What is Equity capital?
Characteristics of Equity shares
1.  Residual claim The equity shares bestow the

holders with only the residual claim on income
and assets of the firm.
Residual claim
Suppliers
Sales Employees
Raw mat expenses Services
Wages and salaries
Other expenses Capital
Profit before depreciation, interest charge
and tax (PBDIT)
Depreciation
Lenders
Profit before interest and tax (PBIT)
Interest
Profit before tax (PBT) Govt
Tax
Profit after tax (PAT) Equity
holders
Equity capital contd..
2.  Ownership equity share holders as owners of the firm

enjoys the right to control the firm.
3.  Pre-emptive right This enables the equity shareholders

to maintain their proportional ownership of the firm in
case of a capital expansion.
Preference shares
Preference shares are a hybrid form of instruments.

They resemble equity share as well as debentures
Resemblances to equity share
q  Dividend payable from distributable profits
q  No obligation on the firm to preference dividend
Resemblances to a debenture
q  Rate of dividend fixed
q  Preference shareholders enjoy priority/preference

over equity holders
Features of Preference shares
q  Accumulation of dividends
q  Callability
q  Convertibility
q  Redeemability
q  Participation in excess profits

Stock valuation
q  Value Vs Price
8
Benefits to Stockholders
q  If you buy a share of stock, you can receive cash in two ways
–  The company pays dividends
–  You sell your shares, either to another investor in the market or back
to the company
q  As with bonds, the price of the stock is the present value of

these expected cash flows
Estimating Dividends: Various Cases
q  Constant dividend
–  The firm will pay a constant dividend forever
–  This is like perpetual preferred stock
–  The price is computed using the perpetuity formula
q  Constant dividend growth
–  The firm will increase the dividend by a constant percent every period
q  Supernormal growth
–  Dividend growth is not consistent initially, but settles down to constant
growth eventually
Zero Growth
q  If dividends are expected at regular intervals forever, then

this is like perpetual preferred stock and is valued as a
perpetuity
V0 = D / k
• Suppose stock is expected to pay a Rs 2.50 dividend every

year and the required return is 10%. What is the value of the
stock?
Dividend Growth Model
q  Dividends are expected to grow at a constant percent per
period.
–  V0 = D1 /(1+k) + D2 /(1+k)2 + D3 /(1+k)3 + …
–  V0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/

(1+k)3 + …
q  With a little algebra, this reduces to:
D0 (1+ g) D1
V0 = =
k-g k-g
DDM: constant growth rate
•  Example 1: stock ABC, next year

dividend = 3, required return k = D1 3
V0 = = = 42.86
15%, constant growth rate = 8%. k − g .15 − .08
What is the value of the stock
•  Example 2: stock ABC, just paid Do (1 + g ) 0.5(1 + .02)

V0 = = = 3.92
dividend = 0.50, required return k k−g .15 − .02
= 15%, constant growth rate =
2%. What is the value of the stock
Implications of constant growth DDM
D1
V0 =
k −g
§  If expected dividend D1 increases, then V0 increases.
§  If k decreases, then V0 increases.
§  If g increases, then V0 increases.
§  Price grows at the same rate as dividend, assuming k and g remains
unchanged
D1 = D0 (1 + g )
P1 = P0 (1 + g )
Key drivers of equity valuation
q  Key equation
g = ROE × b
Where:

ROE = Return on Equity
b = Plowback Ratio
(or Earning Retention Ratio)
Growth rate - g
Microsoft Excel 97 - 2004

Worksheet
16
‘g’
q  Stable growth rate – This is a growth rate that a firm can
sustain forever in earnings, dividends and cashflows.
q  This is a function of the economy’s growth rate
Microsoft Excel 97 - 2004

Worksheet
Infy Growth Story
Sales growth rate

140
120
100
80
60
40
20
0
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Infosys – Sales growth rate
30.00%
25.00% 24.24%
22.66%
20.00% 19.62%
17.11% 17.23%
15.00%
10.00% 9.68% 9.82%
6.36%
5.00%
2.98%
0.00%
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
19
Microsoft over 1992-2019
140 50.0%
46.1% 125.84
120 110.36 40.0%

36.0%
34.4%
100 31.0% 93.58 30.0%
29.4% 89.95
27.7% 86.83 85.32
23.9% 77.85 22.7%
80 73.72 20.0%
18.2% 69.94
16.3% 15.4%
14.4% 62.484
60.42 58.437 14.0%
12.1% 13.5% 11.3% 11.9% 11.5%
60 10.2% 10.0%
8.0% 51.122 6.9% 7.8%
44.282 5.4% 5.6% 5.4%
39.788
36.835
40 32.187 0.0%
28.365 -3.3%
22.956 25.296
19.747
20 15.262 -8.8% -10.0%
11.358
8.671
5.937
2.759 3.753 4.649
0 -20.0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Revenue Growth rate

What happens if g > k?
D1
V0 =
k−g
q  If k < g, get negative stock price, which is nonsense.
q  We can’t use DDM unless:
–  g < k, and
–  g is expected to be constant forever.
q  Because g must be a long-term growth rate, it cannot be > k.

Implications of constant growth DDM
•  We can backout the required return k:

D1
V0 =
k−g
•  In equilibrium, the intrinsic value = market price i.e. Vo = Po, therefore,
D1
P0 =
k−g
D
k = 1 +g
P0
Capital
Dividend
Gains Yield
Yield
2 stage model
D1 D2 D3 Dn Dn + 1 D∞
+ + +……….. + +……….+
(1 + k )1 (1 + k )2 (1 + k )3 (1 + k )n (1 + k )n+1 (1 + k )∞
PV of divs during normal growth period

PV of divs during SG period T = n+1,……….∝
T = 1………..n
D1 D2 D3 Dn Pn
1
+ 2
+ 3
+……….. n
+
(1 + k ) (1 + k ) (1 + k ) (1 + k ) (1 + k )n
Dn + 1
divs during
PV of horizon value Pn = (k − g )
PV of divs during SG period T = n+1,……….∝
T = 1………..n (1 + k )n
2s model
1.  Find the PV of the dividends during the period of super normal
growth rate
2.  Find the price of the stock at the end of super normal growth
period, at which point it has become a constant growth stock,
discount this price back to the present
3.  Add these two components to find the intrinsic value of the stock
If we have supernormal growth of
30% for 3 years, then a long-run constant g = 6%, what is P0? k is
still 13%. Just paid a dividend of Rs 2.00
q  Can no longer use constant growth model.

q  However, growth becomes constant after 3 years.
2s model example
0 1 2 3 4
K =13%
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
4.6576
46.1135 Pˆ3 = = 66.5371
0.13 − 0.06
54.1067 = P0
q  Waters Corporation has a stock price of $20 a share. The
stock’s year-end dividend is expected to be $2 a share (D1 =
$2.00). The stock’s required rate of return is 15 percent and
the stock’s dividend is expected to grow at the same constant
rate forever. What is the expected price of the stock seven
years from now?
q  The last dividend paid by Klein Company was $1.00. Klein's
growth rate is expected to be a constant 5 percent for 2
years, after which dividends are expected to grow at a rate of
10 percent forever. Klein's required rate of return on equity
(rs) is 12 percent. What is the current price of Klein's common
stock?

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Financial

In addition to the recommended text book

1. Principles of Corporate Finance by Brealey and Myers

2. Corporate Finance by Ross, Westerfield and Jaffe

3. Corporate Finance by Aswath Damodaran

4. Financial Management by I M Pandey

5. Financial Management by Prasannachandra

q A regular finance daily viz, ET, BS, FE or BL

q Check the course outline for complete details

Microsoft Word Document

Primary Secondary Primary Secondary

q Initial Public Offer (IPO)

q A secondary market is a market for previously issued

Maximize shareholder value

Most financial economists recommend this!

In its most basic form, interest is calculated by multiplying

principal by rate multiplied by time. This is called simple

Usually simple interest is used in financial institutions for

interest periods of less than one year.

However, if interest is left in the account to accumulate for a longer period

period, etc. This is compound interest.

Given a present value (PV), we can compound to return a

Given a future value (FV), we can discount it to return a

FV = 1500 x (1.09) x (1.09) = 1782.16

We have simple formulae for computing FV,PV etc.,

t=0 t =1 t=2 t=3 t=4

Let PV = Present Value

• ICICI Top 100 fund provided a return 25.70% per

Let PV = Present Value

Today you withdrew Rs. 10 mn – a birthday gift given by your

Assume to day is Jan 1 2005 and Mr. Rao deposits Rs

Dec 31 Dec 31 07 Dec 31 08

15000 15000 15000 15000

15000 15000 15000 15000

Ø The computations are slightly involved and such cumbersome

q An annuity is a stream of constant cashflow occurring at

100 100 100

q In general FV of an annuity is given as

F = A (1+i) n-1 + A(1+i)n-2 + …………+A

FV_SS FV_Ann PV_SS PV_Ann

Type Example Relevant Table Referred to as

FV of annuity Rao’s deposits Table A2 FVIFA (i, n)

PV of single sum Birthday gift from Grandfather Table A3 PVIF (r, n)

PV of annuity Value of Executive MBA Table A4 PVIFA (i, n)

Perpetual bonds, known as additional tier-I papers in market

In practice we will make use of the following relationship

Where m is the frequency of compounding

Compute the interest rate meant in this deal

As winner of a breakfast cereal competition, you can chose one of the

If the interets rate is 12% which alternative will you choose?

q What is a capital investment?

Good evaluation technique should:

Accept if the payback period is less than some preset limit

Initial cost = $100,000

1. Provides an 1. Ignores the TVM

May lead to decisions that do not maximize

Initial cost = $1,00,000

• This rule is always consistent with maximizing the value of the

• Mathematically, sum the present values of all the cash flows

Initial cost = $100,000

Year Cashflow After-tax incremental CF PV Factor Present Value

Future Cash flows

Assumption that cash

1.  Principles of Corporate Finance by Brealey and Myers

2.  Corporate Finance by Ross, Westerfield and Jaffe

3.  Corporate Finance by Aswath Damodaran

4.  Financial Management by I M Pandey

5.  Financial Management by Prasannachandra

q  A regular finance daily viz, ET, BS, FE or BL

q  Check the course outline for complete details

q  Initial Public Offer (IPO)

q  A secondary market is a market for previously issued

•  ICICI Top 100 fund provided a return 25.70% per

Ø  The computations are slightly involved and such cumbersome

q  An annuity is a stream of constant cashflow occurring at

q  In general FV of an annuity is given as

q  What is a capital investment?

• This rule is always consistent with maximizing the value of the

• Mathematically, sum the present values of all the cash flows

q  Include after tax salvage value and reduction in net working

1)  After-tax proceeds from sale of fixed asset(s)

1)  After-tax proceeds from sale of fixed asset(s)

2)  Return of NWC to its original (before-project) level

1.  A bond is similar to a promissory note.

2.  A bond is a fixed income instrument that represents a loan made by

3.  Owners of bonds are debtholders, or creditors, of the issuer.

4.  Amount borrowed through the bond should be returned on the

5.  Bonds can be traded on the exchanges.

6.  Bonds are otherwise known as debentures. (?)

4.  Issue date: Date when bond was issued.

1.  Residual claim The equity shares bestow the

2.  Ownership equity share holders as owners of the firm

3.  Pre-emptive right This enables the equity shareholders

q  No obligation on the firm to preference dividend

q  Preference shareholders enjoy priority/preference

q  Participation in excess profits

q  As with bonds, the price of the stock is the present value of

q  If dividends are expected at regular intervals forever, then

• Suppose stock is expected to pay a Rs 2.50 dividend every

–  V0 = D1 /(1+k) + D2 /(1+k)2 + D3 /(1+k)3 + …

–  V0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/

•  Example 1: stock ABC, next year

•  Example 2: stock ABC, just paid Do (1 + g ) 0.5(1 + .02)

q  Stable growth rate – This is a growth rate that a firm can

q  This is a function of the economy’s growth rate

q  If k < g, get negative stock price, which is nonsense.

q  We can’t use DDM unless:

–  g is expected to be constant forever.

q  Because g must be a long-term growth rate, it cannot be > k.

•  We can backout the required return k: