v2 Free CFA-EBook

Index table
Sr. Title Page

No No.
1 Financial Statement Analysis : An Introduction 1

2 Financial Statement Analysis : Understanding the Income Statement 15
3 Financial Statement Analysis : Understanding the Balance Sheet 87
4 Quantitative Methods : Time Value of Money 121
5 Equity Investments: Overview of Equity Securities 164
6 Equity Investments: Equity Valuation Concepts and Basic Tools 190
7 Corporate Finance: Cost of Capital 229
8 Fixed Income : Fixed Income Securities Defining Elements 263
9 Fixed Income : Introduction to the Fixed-Income Valuation 283
10 Economics : Understanding Business Cycles 329
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1.Financial Statement
Analysis – An Introduction
Role of Financial Reporting and FSA
The role of Financial Reporting is to provide information about a

company’s financial position and performance which can be used by
external and internal parties related to the company.
The role of Financial Statement Analysis is to use these financial
statements to judge the past present and prospective financial position
from the purpose of making investments and other financial decisions.
Financial statement users
Short term creditors Long term creditors Are

Equity investors are are interested in always concerned in
interested in company’s company’s liquidity the company’s earning
long term growth because they always power and long term
want an early payback assets .
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Role of FRA
Performance
(Profitability, Cash Flow)
Forecast
Evaluate
Past & Future
Present
Financial Position
 Financial reports provide information about companies’ performance, financial

position, changes in financial position
 Purpose of analysis: making investment, credit, economic decisions

Role of Key Financial Statements
Key financial statements

Income statements
Balance sheet
Cash flow statement
Statement of changes in
owner’s equity
Supplementary information
Footnotes
Management discussion & analysis
External auditor’s report

Role of the Income Statement
Presents financial performance
Also called “statement of operations” and “profit and loss statement”
Basic Philospophy
Net Income = Revenues - Expenses

Role of the Balance Sheet
 Presents financial position of company
 Also called “statement of financial position”
 Basic Philosophy
Assets – Liabilities = Owner’s equity

Role of the Cash Flow Statement
Presents the sources and uses of cash
Three activities for Cash Transactions

 Operating: the day-to-day transactions that determine net income
 Investing: activities related to acquisition and disposal of long-term assets
 Financing: activities related to obtaining or repaying capital

Role of Changes in Owner’s Equity
 Presents the changes in equity

 Also called “statement of shareholder’s equity” and “statement of
retained earnings”
 It reports the amounts and sources of changes in equity from capital
transactions with owners.
 It reports ownership interests in order of preference upon liquidation
and dividends.

Financial Statement Notes and Supplementary Schedules
Financial Foot notes provide information about the accounting methods,

assumptions and estimates used by the management to develop the data
reported in the financial statements.
 Additional disclosure is provided in areas such as income taxes
inventory methods , fixed assets , debt , pensions.
Supplementary Schedules provide additional information about
company’s assets and liabilities as supplementary data outside the
financial statements.
 Examples of such disclosures include :
 Operating income or sales by region or business segment
 Oil and gas reserves reported by the oil and gas companies.
 Impact of changing prices , sales revenue.

Management ‘s Discussion and Analysis (MD&A)
Requires the management to assess the company’s current financial

condition , liquidity and planned capital expenditure for the next year.
 For publicly held companies in the United States the MD&A is
required to discuss results from operations, discussion of trends in
sales and expenses ,capital resources and liquidity and a general
business overview based on known trends.
 The MD&A section is not audited and it is for public companies only.

Objectives of Audits of Financial Statements and Auditor’s Reports
An Audit is an independent review of an entity’s financial statements

 The objectivity revolves around the fairness and reliability of the
financial statements.
The Auditor is responsible for seeing that the financial statements
issued comply with the Generally Accepted Accounting
Principles(GAAP).
 The Auditor examines the company’s accounting and internal
control systems.
 Auditors are supposed to be independent though they are hired by
the government.

Types of Audit Reports
Unqualified Opinion Report:

Qualified Opinion Report :
Company’s financial condition ,
It is issued when there are situations
position are fairly presented in the
which are exceptions to the accounting
financial statements. It is in accordance
principles like(GAAP).
with GAAP and free of misstatements.
Audit Reports
Adverse Opinion Report : Disclaimer of Opinion : It is issued

when an auditor tried to audit a
It is issued when statements are not company but could not complete due
presented fairly or when they do not to various reasons and does not issue
comply with the accounting standards. an opinion.

Other Sources Of Information Used by Analysts
• These reports are generally unaudited .

• Publicly held companies must file form 10-Q(Interim Report) on a quarterly
Interim basis.
Reports
• It contains information regarding compensation , management Qualifications

and stock options.
Proxy • These are issued to the shareholders and are filed with the SEC.
Statements
• These are the public relations or the sales material written by the
Corporate management.
Reports and
Press Releases

Financial Statement Analysis Framework
Objective and
• Define the purpose of the analysis , information presentation , time
context of the
availability and budget.
Analysis
• Gathering company’s financial data and also information on the
Gather Data economy and industry to understand the environment in which the
company operates.
• This involves calculation of ratios , preparing graphs ,performing

Process the data
statistical analyses and preparation of common size balance sheets.
Analyze and • Interpreting the output and using the data to answer the questions
interpret the data .
Report the
• Prepare the report and communicate the conclusion and
conclusions or
recommendation in the right format to the target audience.
recommendations
• Changing the conclusions or recommendations when necessary by

Update the Analysis
periodically repeating the above steps.

2.Understanding the Income
Statement
Inter Globe –Indigo Airlines
1. Inter Globe/Indio is a low cost airline

headquartered in Haryana
2. Market Share of 42.6% as of oct 2016
3. It has 41 destinations
4. Second largest Asian airline
5. Founded by Rahul Bhatia, a private company
6. The company went public in 2015
7. Issue price was 700-765
8. Issue size was: 1272 cr
9. Promoter holding :85%

Rahul Bhatia and New Shareholders Interest
•How should they

•How should they
find out how
understand the
much profit per
expense trend of
share was
the company?
generated?
•How should they

understand the
performance of
the company?

Why Do We Need Income Statement
Snapshot of Snapshot of
Sales Expenses
Snapshot of
Snapshot of
other
Profitability
activities

Format of Income Statement
Revenue • How many passengers were flown in years

- COGS • What was the cost of flying those passengers?
Gross Profit • After deducting those costs what's the Gross profit
- Operating Expenses • Other costs apart from direct costs related
EBITDA • What's the operating profit?
-Depreciation and Amortization • Costs of assets spread across years
EBIT • Profit before interest and tax is paid
-Non Operating Expenses • Cost of borrowed funds (this is interest not EMI)
EBT • Profit before Tax is Paid
- Tax • Tax paid at the corporate tax rate
PAT • Profit available for Rahul Bhatia and other shareholders

Brief Description of Line Items
Income Statement
Revenue
SG&A Net Income
Income earned through Principal Depreciation
activities Costs not directly related to the Final profit generated in the
Cost of assets allocated over time
production of goods business

Inter globe Income Statement 2015-16
Revenue From Operations [Gross] Total Expenses

Profit/Loss For The Period
35,000.00 2,500.00
30,000.00
2,000.00
25,000.00
1,500.00
20,000.00
15,000.00
1,000.00
10,000.00
500.00
5,000.00
0.00 0.00
2012.00 2013.00 2014.00 2015.00 2016.00

General Revenue Recognition Principles
Economic
Entity gives Revenue Cost can be
Risk Benefits
away Measured measured
Transferred Flow to the
control Reliably Reliably
entity
A customer Buys a product from flipkart, and Risk of ownership of the the product
the product is received by the customer transferred to the customer, flipkart
within 7 days doesn’t hold the risk anymore
A customer books a flat in Kolte Patil-wagholi Ownership not transferred, Kolte Patil still
project and pays 15 lacs as advance payment hasn’t transferred the risk of ownership
to the customer

Contra Examples for Revenue Recognition
IASB provides that revenue is Example when you cannot recognize revenue
to be recognized when:
Significant risks and rewards Goods are delivered to a retail store to be sold on
are transferred to buyer consignment or refund is possible
No managerial involvement is Real estate still in the course of construction and is
retained unavailable for use
Amount of revenue can be An company enters into a barter transaction for

measured reliably advertising services
Probable that the economic A sale happens in a foreign country but it is uncertain if
benefits will flow to the entity the foreign governmental authority will allow the
remittance of the money collected from that sale
Costs incurred or to be Cost of warranties for product defects cannot be
incurred can be measured measured reliably
reliably

General Revenue Recognition Standards
IFRS US GAAP
•Amount of revenue can be measured • Price is determined or determinable.
reliably. • Evidence of arrangement between buyer and
• It is probable that economic benefits seller.
associated with the transaction will flow to • Product has been delivered or service has
the entity. been rendered.
• Stage of completion of the transaction can • Recognize when “realized or realizable and
be measured reliably. earned”.
• Transaction costs can also be measured • Seller is reasonably sure of collecting
reliably. money.
• The entity no longer has any managerial
involvement or effective control over the
goods sold.

Revenue Recognition in Special Cases
Before Goods Are Fully At the Time Goods Are After Goods Are Delivered or
Delivered or Services Delivered or Services Services Rendered
Completely Rendered Rendered
For example, with long-term Recognize revenues using For example, with real estate
contracts where the outcome normal revenue recognition sales where there is doubt
can be reliably measured, the criteria. about the buyer’s ability to
percentage-of-completion complete payments, the
method is used. installment method and cost
recovery method are
appropriate.

Revenue In Different & Special Scenarios
Builder is selling pre Car showroom has a

ready flats on Pre customer buying a car
Booking Basis. in EMI basis but ability
to pay is doubtful
How Should We Recognise

Revenue and Cost?
Company Augusta
would like Company is
Electronic Shop sells
making roads in a three
electronics on EMI Basis
year project but can’t
measure costs reliably

Revenue Recognition In Special Cases
Special Cases Long Term Contracts
Revenue Recognition
Installment Sales

Long Term Contracts
A long-term contract is one that spans a number of accounting periods. In such cases, difficulty
arises in determining when revenue should be recognized.
Outcome Percentage of
Measured Reliably Completion
Long Term IFRS

Contracts
Extent of Contract
Outcome Not Costs
Measured Reliably US GAAP
Completed
Contract Method

Long Term Contracts Case
IRB Infrastructure Developers Ltd is an Indian

highway construction company, headquartered
in Mumbai. It is part of the IRB Group. IRB
Infrastructure, which executed the country's first
build-operate-transfer (BOT) road project, is one
of the largest operators of such ventures.
Currently it has about 3404.40 lane KM
operational and about 2330.4 lane KM under
development.[5] Among its notable projects are
the Mumbai Pune Expressway and the
Ahmedabad Vadodara Expressway[2][6]
In 2012, IRB acquired Tamil Nadu based BOT

Road builder MVR Infrastructure and Tollways
for ₹ 1.30 billion

IRB Revenue Recognition Policy(Ref AR-2015)
•IRB uses percentage of completion

method when outcome can be measured
reliably as shown in the red marked line.
•IRB uses extent of construct costs
method(IFRS) when outcome cannot be
measured reliably as shown in green
•

Revenue Recognition Problem – Long Term Contracts
Company ABC has a contract to build roads worth $ 12 million. It will take
three years to build these roads. The total costs to build the road are
estimated to be $ 10 million.
 If ABC recognizes the contract revenues on a percent of completion basis
and estimates percentage complete on the basis of expenses incurred then
what would be the revenues of ABC for the next 3 years are per the
percent of completion basis?
Year 1 Year 2 Year 3
Project Expenses 5 3 2
Total Project Expenses 5 8 10
 If ABC recognizes the revenues on a completed contract basis then what

would be the revenues of ABC for the next 3 years per the completed
contract basis revenue recognition technique?

Revenue Recognition Problem – Long Term Contracts
Revenue Recognition - Percent of Completion Revenue Recognition - Completed Contract

Method Method
All Numbers are in All Numbers are in $
$ Million Million
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

Total Project
Cost 10 Total Project Cost 10
Total Expected Total Expected
Revenue 12 Revenue 12
Expenses
Incurred 5 3 2 Expenses Incurred 5 3 2
% of Costs
Incurred in that % of Costs Incurred
Year 50 30 20 in that Year 50 30 20
% of Project % of Project
Complete 50 80 100 Complete 50 80 100
Expected
Revenue 6 4 2 Expected Revenue 0 0 12

Instalment Sales
Instalment sales are when sales proceeds are paid in instalments over multiple accounting
periods
Separate Sales and

Payments are Sure
Cost
Installment Sales
Instalment Method
Payments are not
Sure
Cost Recovery
Method

Revenue Recognition – Instalment Sales & Cost Recovery - Example
Assume the total sales price and cost of a property are $ 300,000 and
$150,000, respectively.
The profit on this transaction is $150,000.
The amount of cash received by the seller as a down payment is $100,000
with the remainder of the sales price to be recognized over a 5-year period.
It has been determined that there is significant doubt about the ability and
commitment of the buyer to complete all payments.
How much profit will be recognized attributable to the down payment if:
 The installment method is used?
 The cost recovery method is used?

Revenue Recognition – Installment Sales & Cost Recovery
 Installment Sales method

 Profit to Sales ratio = 150,000/300,000 = 0.50
 Cash Received in form of down payment = 100,000
 The profit attributable to the down payment amount = 50,000
 Cost Recovery Method
 Under cost recovery method profits will be attributed if costs are exceeded.
 In this case the costs are 150,000 and the down payment is 100,000.
 Thus no profit will be attributed to the down payment amount per the cost
recovery method. 0 1 2 3 4 5
Installment Sales Method
Cash Receipts 100,000 40,000 40,000 40,000 40,000 40,000
Costs 50,000 20,000 20,000 20,000 20,000 20,000
Profits 50,000 20,000 20,000 20,000 20,000 20,000
Cost Recovery Method

Cash Received 100,000 40,000 40,000 40,000 40,000 40,000
Costs Attributed 100,000 40,000 10,000 - - -
Costs Remaining 50,000 10,000 - - - -
Profits - - 30,000 40,000 40,000 40,000

Barter Transactions
InterGlobe Jet Airways

Hoarding hoarding
Board board
Interglobe will advertise in B
Jet Airways will advertise in A

Barter Transactions Standards
US GAAP: The barter

IFRS: Revenues can be reported transaction can be reported in the
in the income statement based on income statement at their fair
the fair value of revenues from a values if the company has a
similar non-barter transaction history of receiving cash
with unrelated parties payments for such good and
services

Gross v/s Net Revenues
Should it Show the Price of Should is show

products x Qty sold as commissions per Product X
revenue Number of Qty sold

Standards for Gross Vs Net Reporting
 Gross Revenue Reporting : Sales and cost of sales are reported separately
 Net Revenue Reporting : Only the difference between sales and costs of sales
is reported on the income statement
 US GAAP – Only under the following conditions can a company report
revenues based on the gross reporting
 Company is a primary obligor under the contract
 Company bears the inventory and credit risk
 Company can choose its suppliers
 Company has reasonable latitude to establish price

Gross vs. Net: Example
 Company pays only for tickets sold to customers

 Total revenue = $ 4,400,000
 Costs of tickets = $ 4,000,000
 Direct selling costs = $ 4,000
Gross Reporting Net Reporting
Revenues $ 4,400,000 $ 400,000
Cost of sales $ 4,004,000 $ 4,000
Gross profit $ 396,000 $ 396,000
 Which method should be used?

 Net reporting, because company pays only for tickets sold to customers,
so no inventory costs
 Company is not primary obligor under the contract
 US GAAP: Revenue reported are $ 400,000

Expense Recognition Case
• Force Motors, formerly Bajaj Tempo, is an Indian

manufacturer of three-wheelers, multi-utility and
cross country vehicles, light commercial vehicles,
tractors, buses and heavy commercial vehicles
• Force motors manufactures
1. Personal vehicles
2. LCV
3. SCV
4. MUV
5. Agricultural vehicles
• Force motors also started manufacturing plant
which produces test engines and transmission for
BMW and SU

Expense Recognition
Force Motors
How should Force

motors deal with
it?
Expense Recognition
issues
Force Motors sells

Force motors sells It also provides
previous year
vehicles to clients but warranty service to
manufactured
payment is doubtful clients for 2 years
vehicles

Expense Recognition – General Principles
Matching Principle
 Match expenses with associated revenues
 Example
 Some current period revenues are made from inventory purchased in the
previous period
 The matching principle requires that the company matches the COGS with the
revenues of the period
Period Costs
 Expenses that less directly matching the timing of revenues
 Example
 Administrative Expenses

Issues in Expense Recognition
Doubtful accounts
 When companies sell on credit, customers may default
 At the time of sale company estimates how much will be uncollectible based
on previous experience
 The estimated amount is written off as expense
Warranties
 Company estimates the amount of future expenses resulting from
warranties, to recognize an estimated warranty expense, and to update the
expense over the life of the warranty

Inventory Matching Method
Weighted Average
Methods
Cost
Last in First Out
First In First Out
Tata Motors
Method

Inventory Matching
Consider a company which started a year with an inventory of 100 units bought
at $10 each.
During the year company purchased an additional inventory of 800 units at an
average cost of $11 each.
Total sales made by the company were 750 units at $15 each.
It has been identified that the beginning inventory is completely sold this year.
 Estimate the gross profit of the company

 Estimate the inventory value left

Inventory Matching
Solution
Units Per Unit Value
Beginning Inventory 100 $ 10.00 1,000

Purchases 800 $ 11.00 8,800
Sales 750 $ 15.00 11,250
Closing Inventory 150 $ 11.00 1,650 Estimation of
Closing Inventory
can be done using
COGS 750 $ 10.87 8,150
FIFO
Part - 1 100 $ 10.00 1,000 LIFO
Part - 2 650 $ 11.00 7,150 AVCO
Sales 11,250
COGS 8,150
Gross Profit 3,100 Inventory Value 1,650

Depreciation
• Indigo Purchases 5 Air bus A350 for a

cost $115 Million each
• Should it recognise the entire costs in
one year itself?
• If it does then the income statement will
look very deflated
• What should indigo do?

Depreciation and Amortization
Tangible Depreciation
Costs that
Benefit> 1 Year
Intangible Amortization

Fixed Asset Cost-Deprecation
Costs
Recognition
Benefit Accrues
Benefits Accrues
more than a
only one year
year
Example: Example:
Salaries,
Advertisement Depreciation
Recognize on Spread Costs

year Across

Depreciation Methods
Long lived assets are assets expected to provide economic benefits over a future period
of time greater than one year Example – Property, Plant and Equipment
Depreciation is a process of systematically allocating costs of long lived assets over the
period during which the assets are expected to provide economic benefits
Methods of depreciation:
 Straight Line Method: Allocates evenly the cost of Long lived asset over the
useful life of the asset
 Accelerated Method: Allocates a greater proportion of costs to early years
of the useful life of the asset

Intangible Assets
An intangible asset is an asset that is

not physical in nature. Corporate
intellectual property, including items
such as patents, trademarks,
copyrights and business
methodologies, are intangible assets,
as are goodwill and brand
recognition.
•Trademarks
•Licensing agreements
•Patented technology
•Computer software
Micros
oft
Amortization
 Depreciation of Intangibles
 It spreads costs of intangibles (e.g. Patents, Copyrights, etc.) over life
 For intangible assets that must be amortized the process is same as for
depreciation
 Per IAS No. 38 , if the pattern cannot be determined over the useful life, then
straight line method should be used
 Goodwill generated during acquisition is not amortized
 Goodwill impairment happens on the bass of annual reviews

Other Line Items
Other Line Items
Unusual Or Infrequent
Shown Pre Tax
Items
Both unusual and

Extraordinary Items Shown net of tax
Infrequent
Operations management
Discontinued Operations Shown net of tax
decided to dispose of

Unusual or Infrequent Items
 Reported pre-tax before net income from continuing operations

 Included as part of operating income and explained in the footnotes
 The nature of these items should be highlighted to know if they will recur
 Items include:
 Gain (Loss) from disposal of a business segments or assets
 Gain (Loss) from sale of investment in subsidiary
 Provisions for environmental remediation
 Impairments, write-offs, restructuring, Integration expense for
recently acquired business

Extraordinary Items
 Items that are both unusual and infrequent

 Reported in a separate category below income from continuing (and
discontinued) operations
 Are shown net of tax
 Items include:
 Losses from expropriation of assets
 Uninsured losses from natural disaster
 Prohibited under IFRS, US GAAP allows for its qualification as stated above
 Should be excluded when forecasting future earnings of the company

Discontinued Operations (IFRS and GAAP)
 Operations that management has decided to dispose off one of the

operations but
 Has not done so, yet
 Did so in current year after it generated profit or loss
 Reported separately net of taxes after net income as “Discontinued
Operations”
 Assets, operations and financing activities must be physically and
operationally distinct from firm
 Placed in a separate category below income from continuing operations

Accounting Changes
Change in • e.g. LIFO to FIFO

Accounting • Retrospective application: IFRS and US GAAP require prior years’ data
shown in financial statements to be adjusted
Principle
Changes in • e.g. change in estimated life of a depreciable asset

Accounting • Does not require restatement of prior period earnings
Estimate • Disclosed in footnotes
• Correcting errors or changing from an incorrect accounting method to one

Prior Period that is acceptable typically requires restatement of prior period financial
Adjustments statements
• Must disclose the nature of the error and its effect on the net income

Non-Operating Items
 Financial Service Companies : Following are the major operating activities:

 Interest
 Dividends
 Gains / Losses on Disposal of assets
 Non Financial Service Companies : Non Operating activities will be investing
activities
 The above activities (interest, dividends, etc. ) qualify as non operating
activities
 If these are on a rise in a company then further investigation in the
footnotes becomes essential

Complex Capital Structure
Inter-globe
Convertible
Common Convertible Debt Preference Stock Options To
Preference
Shareholders Holders Shares Employees
Shares
Option to Buy
Convertible to Require Fixed
Inter globe
shares Dividend
shares

Earning Per Share
Total
Earnings
available to
Equity Share
Holders
Earning Per
Share
( EPS)
Number of
shares
outstanding

Simple versus Complex Capital Structure
 A simple Capital structure contains no potentially dilutive securities

 In this case firm will report only basic EPS
 A complex capital structure contains potentially dilutive securities
 Firm has to report both the basic and diluted EPS
 Dilutive Securities include
 Stock Options
 Warrants
 Convertible Debt
 Convertible Preferred Stock
 Dilutive Securities decrease EPS if exercised or converted to common stock
 Anti-dilutive securities increase EPS if exercised or converted to common stock

Basic EPS
 Basic EPS: Amount of income available to common shareholders divided by the

weighted average number of common shares outstanding over a period.
Net Income - Preferred Dividends

Basic EPS =
Weighted Average number of shares outstanding
 In case of stock splits:
 2 for 1 stock split increases the shares outstanding by 100%
 For EPS calculation purposes, a stock split is treated as if it occurred
at the beginning of the year
 In case of stock dividends:
 The weighted average outstanding shares increases with the dividend
 10% dividend results in a 10% increase in the shares outstanding

Computation of Weighted Average Shares & Basic EPS
Consider the following data on the companies number of outstanding shares.
Date Activity Number of Shares

01/01/2009 Shares Outstanding 100000
01/04/2009 Shares Issued 50000
01/07/2009 10% Sock Dividend
01/09/2009 Shares Repurchased 25000
If the company has a net income of $250,000 and no preferred stock
 What is the weighted average number of shares outstanding for the
company?
 What is the Basic EPS of the company?

Computation of Weighted Average Shares & Basic EPS
Shares adjusted for 10%

Date Activity No of shares Dividend No of months Months adjusted shares
Shares
01-01-2009 outstanding 100000 110000 12 110000
01-04-2009 Shares issued 50000 55000 9 41250

10% Stock
01-07-2009 dividend
Shares
01-09-2009 repurchased 25000 25000 4 -8333
Weighted
Shares 142917
Net Income - Preferred Dividends = 250000

Basic EPS = 142917
Weighted Average number of shares outstanding =1.74
250,000

Diluted EPS
If a company has dilutive securities then, diluted EPS will be lower than Basic EPS
There are 3 types of dilutive securities:
 Convertible Preferred Stock
 Convertible Outstanding Debt
 Stock Options, Warrants
If the security is dilutive i.e. it reduces the Diluted EPS < Basic EPS then it is converted. Else
conversion does not occur.
Included only if diluted security is present

(Net Income -
Convertible Preferred Convertible Debt
Preferred + +
Dividend Interest * (1-t)
Dividend)
Diluted EPS =
Shares From Conversion Shares from Shares issuable
Weighted
+ of Convertible + conversion of + for warrants and
Average Shares
Preferred Stock convertible debt options
Included only if diluted security is present

Diluted EPS – Dilution Check
 Convertible preferred:
 if (dividends/new shares) < basic EPS, then security is dilutive
 Convertible debt:
 if (interest (1 – t)/new shares) < basic EPS, then it’s dilutive
 Options and warrants:
 if (average market price of share ) > exercise price, then it’s dilutive

Diluted EPS – Convertible Preferred Stock
Example 31/21/2009
Net Income $500,000,000
Common Stock of $10 each 20000000 = Number of Shares
Tax Rate 40%
Preferred stock outstanding ($10 each) = $ 7,500,000

Preferred Dividend Rate = 6%
One preferred stock is converted into 1.25 common shares
Calculate fully diluted EPS for 2009

Diluted EPS – Convertible Preferred Stock
Net Income $500,000,000

Preferred Dividend 450000
Net Income - Preferred Dividends

Basic EPS =
Weighted Average number of shares outstanding
Basic EPS = 24.98
Number of common shares if preferred shares are coverted

Outstanding all year 20000000
On Conversion of
Preferred Stock 937500
Total Shares - Diluted 20937500
Diluted EPS = 500000000

20937500
= 23.88 EPS Basic > Diluted EPS, security is
dilutive in nature

Diluted EPS – Convertible Debt
Example 31/21/2009
Net Income $500,000,000
Common Stock of $10 each 20000000
Tax Rate 40% = Number of Shares
Convertible Debt outstanding ($1000 each) = $ 25,000,000

Bond Rate = 5%
One bond is converted into 125 common shares

Diluted EPS – Convertible Debt
Net Income 500000000

Add Interest
Saved 1250000
Tax -500000
Net Income Post

Conversion 500750000 Diluted EPS =
Basic EPS 25
500750000
23125000
No of shares if =21.65
debt is
converted
outstanding all
year 20000000
On debt
conversion 3125000
Total shares post

conversion 23125000

Diluted EPS – Stock Options
Example
31/21/2009
Net Income $500,000,000
Common Stock of $10 each 20,000,000 = Number of Shares
Average Price of stock $20.00
Exercise Price $15.00
Number of Options outstanding 1000000
Basic EPS $25.00

Diluted EPS – Stock Options
If all options are exercised -

Number of new shares issued 1000000
Cash Proceeds if all options $ 15,000,000

exercised
Number of shares that can be 15000000

purchsed at average price 20
= 750,000
Net increase in common stock

Total Shares needed 1000000
Shares purchased with 750,000
New Shares issued 250000
Diluted EPS = 500,000,000

20250000
= 24.69 EPS Basic > Diluted EPS, security is
dilutive in nature

Dilutive and Antidilutive Securities, & Implications of each in EPS
Calculation
Antidilutive securities result in an EPS higher than basic EPS
If the EPS after dilution is higher than the basic EPS, then the diluted EPS is the
same as the basic EPS
Example
 Net income = $2,500,000
 600,000 common stock outstanding
 20,000 shares of convertible preferred
 Preferred dividend per share of $10, each preferred share is
convertible into 2 shares of common stock

Dilutive and Antidilutive Securities, & Implications of each
in EPS Calculation
Basic EPS EPS Using If-
Converted Method
Net income $2,500,000 $2,500,000
Preferred dividend - 200,000 0
Numerator $2,300,000 $2,500,000
Weighted average number of 600,000 600,000
shares outstanding
If converted 0 40,000
Denominator 600,000 640,000
EPS $3.83 $3.91

Common Size Income Statement
 Expresses each income statement line item as a percentage of sales

 Used to analyze changes in cost structure and profitability
 Used for both cross sectional (across industry) and time series analysis

Common Size Income Statement
Apple Inc. - Income Statement

Year ended 26 September
2009 2008
Net sales 36,537 32,479

Cost of sales (23,397) (21,334)
Gross margin 13,140 11,145
Operating expenses:
Research and development (1,333) (1,109)
Selling, general & administrative (4,149) (3,761)
Total operating expenses 5,482 4,870
Operating income 7,658 6,275
Apple Inc. -Common Size Income Statement
Net sales 100% 100%

Cost of sales -64% -66%
Gross margin 36% 34%
Operating expenses:
Research and development -4% -3%
Selling, general & administrative -11% -12%
Total operating expenses -15% -15%
Operating income 21% 19%

Measures of Operating Performance
Operating Profitability ratios:
Gross Profit
Gross Profit Margin =
Net Sales
Net Profit
Net Profit Margin =
Net Sales
Both are obtained from the common size statement

Comprehensive Income
Comprehensive income is the change in equity of a business enterprise during

a period from transactions and other events and circumstances from non-owner
sources.
Total Comprehensive Income =
 Net Income +
 Foreign Currency Translation Adjustment +
 Unrealized gains or losses on derivatives contracts accounted for as
hedges +
 Unrealized gains and losses on available for sale securities +
 Pension Adjustment to funded status

Comprehensive Income
Opening stock holders equity was $300m. Closing stock holders equity was
$500m. On review of statement of stockholders’ equity we discover that
owners contributed $40m of equity during the year. Net Income for the year
was $100m and dividends paid were $15m .
Calculate the comprehensive income
Closing Equity 500

Opening Equity 300
Change in Equity 200
Owners Contribution 40 Other Comprehensive Income 75

Net Income 100
Dividend Paid -15 Net Income 100
125 Other Comprehensive Income 75
Comprehensive Income 175

Ratio Analysis Case- Asian Paints
Asian Paints Limited (BSE: 500820, NSE: ASIANPAINT)

is an Indian multinational paint company
headquartered in Mumbai, Maharashtra. The
Company is engaged in the business of manufacturing, Click Here
selling and distribution of paints, coatings, products
related to home decor, bath fittings and providing of
related services. Asian Paints is India's largest and
Asia's third largest paints corporation. As of 2015, it
has the largest market share with 54.1% in the Indian Financ ial A nalysis
Partic ulars
Re ve nue s
M ar ' 1 2
7 ,9 6 4 .2
M ar ' 1 3
8 ,9 7 2
M ar ' 1 4
1 0 ,4 1 9
M ar ' 1 5
1 1 ,6 4 9
paint industry. Asian Paints is the holding company of

Di re c t c os ts
Ma te ri a l c ons umpti on 4 ,8 6 6 .6 5 ,3 6 1 6 ,0 4 5 6 ,6 1 0
6 1 .1 % 5 9 .8 % 5 8 .0 % 5 6 .7 %
Powe r & fue l 7 7 .0 102 119 114

1 .0 % 1 .1 % 1 .1 % 1 .0 %
Stoc k a dj us te me nts (1 4 3 .8 ) (1 7 6 ) (7 5 ) (1 3 2 )
-1 .8 % -2 .0 % -0 .7 % -1 .1 %
Berger International.
Othe r mfg e xp - - - -
0 .0 % 0 .0 % 0 .0 % 0 .0 %
Total c osts 4 ,7 9 9 .8 5 ,2 8 7 6 ,0 8 8 6 ,5 9 1
6 0 .3 % 5 8 .9 % 5 8 .4 % 5 6 .6 %
Gross profit 3 ,1 6 4 .4 3 ,6 8 5 4 ,3 3 1 5 ,0 5 8
3 9 .7 % 4 1 .1 % 4 1 .6 % 4 3 .4 %
Indi re c t c os ts
Empl oye e c os ts 3 4 1 .6 405 482 607
4 .3 % 4 .5 % 4 .6 % 5 .2 %
SGA - - - -
0 .0 % 0 .0 % 0 .0 % 0 .0 %
Mi s c . e xp 1 ,4 7 1 .0 1 ,7 3 3 2 ,0 7 1 2 ,4 4 0
1 8 .5 % 1 9 .3 % 1 9 .9 % 2 0 .9 %
L e s s : pre -op e xp - - - -
0 .0 % 0 .0 % 0 .0 % 0 .0 %
Total indire c t 1 ,8 1 2 .6 2 ,1 3 8 2 ,5 5 3 3 ,0 4 7
2 2 .8 % 2 3 .8 % 2 4 .5 % 2 6 .2 %
Total c osts 6 ,6 1 2 .4 7 ,4 2 4 8 ,6 4 2 9 ,6 3 8
8 3 .0 % 8 2 .8 % 8 2 .9 % 8 2 .7 %
EBITDA 1 ,3 5 1 .8 1 ,5 4 7 1 ,7 7 7 2 ,0 1 1
1 7 .0 % 1 7 .2 % 1 7 .1 % 1 7 .3 %
De pre c i a ti on 9 9 .5 127 212 223
Let us analyse the company for three years on various

1 .2 % 1 .4 % 2 .0 % 1 .9 %
EBIT 1 ,2 5 2 .3 1 ,4 2 0 1 ,5 6 5 1 ,7 8 7
1 5 .7 % 1 5 .8 % 1 5 .0 % 1 5 .3 %
Inte re s t c os ts 3 0 .8 31 26 27
0 .4 % 0 .3 % 0 .3 % 0 .2 %
EBT (pre -othe r inc ome ) 1 ,2 2 1 .4 1 ,3 8 9 .7 1 ,5 3 8 .9 1 ,7 6 0 .3

1 5 .3 % 1 5 .5 % 1 4 .8 % 1 5 .1 %
parameters to judge the performance on various Othe r i nc ome (pos i ti ve )
EBT (post-othe r inc ome )
Ta xe s
1 4 1 .5
1 4 1 .5
1 .8 %
1 ,3 6 2 .9
1 7 .1 %
126
126
1 .4 %
1 ,5 1 5 .9
1 6 .9 %
164
164
1 .6 %
1 ,7 0 2 .6
1 6 .3 %
173
173
1 .5 %
1 ,9 3 3 .6
1 6 .6 %
- Inc ome ta x 4 0 4 .5 466 534 606
accounts
- FBT 0 .1 - - -
- De fe rre d Ta x - - - -
Tota l ta xe s 4 0 4 .6 466 534 606
e ffe c ti ve ta x ra te 2 9 .7 % 3 0 .7 % 3 1 .3 % 3 1 .3 %
PA T 9 5 8 .3 1 ,0 5 0 .0 1 ,1 6 9 .1 1 ,3 2 7 .4
1 2 .0 % 1 1 .7 % 1 1 .2 % 1 1 .4 %
Di vi de nd 5 3 9 .3 523 396 319

Pre fe re nc e Di vi de nd 0 0 0 0
Equi ty Di vi de nd % 400 460 530 610
EPS - Uni t Curr 9 9 .9 2 1 0 9 .4 7 1 2 .1 9 1 3 .8 4

Profitability Ratios
Profitability Ratios Numerator Denominator

Gross profit margin Gross profit Revenue
Return on sales
Operating profit margin Operating income Revenue
Pretax margin EBT (earnings before tax but Revenue
after interest)
Net profit margin Net income Revenue
Operating ROA Operating income Average total assets

Return on investment
ROA Net income Average total assets

Return on total capital EBIT Short- and long-term debt
and equity
ROE Net income Average total equity
Return on common equity Net income – Preferred Average common equity

dividends

Interpretation of Profitability Ratios
Gross Profit Margin

1. indicates % or revenue available to cover Operating Profit Margin
operating and other expenses 1. Gross margin minus operating costs
2.Higher margin means company has 2. Operating margin increasing faster than gross-
competitive advantage in product costs margin indicates that indirect expenses control is
3.Higher margin also indicates that company increasing
might be acquiring cheap inventory and selling
it profitably
4.A company with a high gross margin ratios Pretax Margin
mean that the company will have more money 1. Operating Profit minus interest
to pay operating expenses like salaries, utilities, 2. effects of leverage and non-operating income
and rent. on profitability
3.improving margins mean that lower interest
expenses and repayment of debt

Net Profit Margin

ROA (Return on Assets)
1.Manager tend to cut special budgets to
improve this ratio
2.Net Income includes both recurring and 1.Measures amount of net income generated
by the assets by using it efficiently
nonrecurring components 2.Higher ratio means more income on a given
3.This ratio also indirectly measures how level of assets
well a company manages its expenses 3.The return on assets ratio measures how
relative to its net sales. That is why effectively a company can earn a return on its
companies strive to achieve higher ratios. investment in assets. In other words, ROA
They can do this by either generating more shows how efficiently a company can convert
revenues why keeping expenses constant the money used to purchase assets into net
income or profits.
or keep revenues constant and lower
expenses.

Return on Total Capital

ROE (Return on Equity)
1.Measures profits on all capital (short-term
debt, long-term debt, and equity) 1.Measures return on all equity (minority equity, preferred
2.How efficiently the company uses it total equity, common equity
capital to generate Profits 2.Return on common equity measures return earned on
3.The return on capital employed ratio shows common equity only
how much profit each dollar of employed 3.Return on equity measures how efficiently a firm can
capital generates. Obviously, a higher ratio use the money from shareholders to generate profits and
would be more favourable because it means grow the company. Unlike other return on investment
that more dollars of profits are generated by ratios, ROE is a profitability ratio from the investor's point
each dollar of capital employed. of view—not the company. In other words, this ratio
calculates how much money is made based on the
investors' investment in the company, not the company's
investment in assets or something else.

3. Understanding the Balance Sheet
Why is Balance Sheet Important
Predicting future
Understanding The Understanding The
outflows and
Asset Position at a Debt Position at a
Inflows at a point in
point in time point in time
time
Liquidity and
solvency situation
over the years

Need of a Balance Sheet
Company Status Of the Company at a Point in

Where do
you record
Sells its Time
Goods
Liabilities
Value
we owe to
created for
others like
shareholders
Expense banks or
when
Accounting far
Principle suppliers
incurred
Assets
Revenue Created so
When
Earned far including
machinery
and cash

Format of Balance Sheet
• Assets, Liabilities and Equity in a single Column

Report Format
• Assets on Left
Account • Liabilities and Equity on the right of a central dividing line
Format
• Grouping of accounts into subcategory

• Current v/s Non Current
Balance Sheet
Classification • Liquidity based presentation

Accrual Process and Creation of Assets and Liabilities
Cash paid in
advance for
an expense
Revenue
Reported on Expense
Income Increase in Decrease in Reported
Statement but Assets( Prepaid assets( Cash) but cash
Cash Not Expense) not paid
Received
Accounts Cash Increase in Decrease In

Rec(Assets) Received in accounts Retained
Increase in advance for payable( Earnings(
Retained Earnings( a product Liability) Liability)
Liability)
Increase in
Deferred
Revenue
Increase in Cash

Characteristics of Assets and Liabilities
Assets are resources controlled by the • Probable future sacrifices of economic

enterprise as a result of past events and benefits arising from present obligations of
from which future economic benefits are an entity to transfer assets or provide
expected to flow to the enterprise. services to other entities in the future as a
(purchasing, financing, business result of past transactions or events.
activities)
• Liability is described as:
Asset is recognized if:  Amount received but not reported in
 Future benefits should flow to the income statement
the entity  Amounts reported as expenses in the
 Value of asset can be measured income statement but not paid
with reliability

Assets & Liabilities
Assets Liabilities
Accounts
Property Cash Debt
Payable
Investment Plant and Deferred Short term

s machinery Revenue borrowings
Prepaid Accounts Deferred Tax

Provisions
Expenses Receivable Liabilities

Equity
• It is the residual interest in assets of an entity after

deducting its liabilities
 Equity = Assets – Liabilities
• Characteristics of capital:
 It should be permanent
 Should not impose mandatory fixed charges against earnings
 Should allow for legal subordination to the rights of creditors

Maruti Suzuki
Maruti Suzuki is a listed

company in India
Its one of the best performing
stocks
Sound business practice with a
stable balance sheet
contributed to the business
growth
It has a market share of 47% in
the passenger segment
It is a subsidiary of Japanese
company Suzuki motor
corporation

Recent Balance Sheet of Maruti Suzuki
Assets Liabilities and Equity

Current Assets
 Assets expected to be liquidated (changed to cash) or used up within one year

or one operating cycle of the business, whichever is greater, are classified as
current assets
 Operating Cycle is the time it takes to produce inventory, sell the product and
collect the cash
 Current assets are presented in the order of liquidity
 Working Capital = Current Assets – Current Liability
 Non Current Assets are assets held for continuing use within the business not
for sale
 Assets not consumed in the current period of operation
 Provide the information of the investing activities of the firm

Current Assets of Maruti Suzuki
All in Millions(INR) 2016 2015
• If you look closely you could try to find if Maruti Suzuki’s inventory has increased faster than sales
• You could also try to understand why current investments has decreased so significantly

Inventories
• Inventories are physical products that will eventually be sold to the company’s customers, either in their
current form (finished goods) or as inputs into a process to manufacture a final product (raw materials
and work-in-process)
• The following techniques can be used to measure the cost of inventories if the resulting valuation
amount approximates cost:
I. Standard cost, which should take into account the normal levels of materials, labor, and actual capacity.
The standard cost should be reviewed regularly to ensure that it approximates actual costs.
II. The retail method in which the sales value is reduced by the gross margin to calculate cost. An average
gross margin percentage should be used for each homogeneous group of items. In addition, the impact
of marked-down prices should be taken into consideration.

Non Current Assets of Maruti Suzuki
All in Millions(INR) 2016 2015
• If you see the fixed assets section company has increased its fixed assets, you could try to read the note
12 on the same annual report to find out why and what

Current Liabilities
Current Liabilities
 Expected to be settled in the entities normal operating cycle
 Held primarily for the purpose of being traded
 Is due to be traded in less than 12 months from balance sheet date
 All other liabilities are non current in nature
All In Millions 2016 2015

Difference in Balance Sheet Format( IFRS & GAAP)
IFRS US GAAP
Current Assets
Non Current Assets
Non Current Assets

Current Assets
Current Liabilities
Non Current Liabilities
Non Current Liabilities

Current Liabilities
Minority Interest
Equity Component + Minority Interest
Equity Component

Valuation of Assets or Liabilities in a Company
Balance sheet looks

Should we value it at cost
understated
Property Value
Should we value it at Discretion in find the real

market value( Selling selling price
Price in the market)
Should we value it at cost Does not account the

of constructing it premium of the market
Should we value it using Discretion in discounting

probable future benefits rate

Measurement Principles
• Amount at which an asset can be exchanged

Fair Value • Liability can be settled
• Market Price = Fair Market Value Rate at which a property
is last sold in an area
• Cost or Fair Value at acquisition

Historical Cost • Includes other costs involved at acquisition Value at which a Car was
bought versus current
depreciated value
Current Cost • The cost to replace an asset Buying a property from

a builder vs. the actual
cost if constructed
Present Value • The NPV of future cash flows Cash flows generated in
the future by an asset
discounted to get the
value

Disclosures
• Recall that Balance sheet just

shows the number
• The number itself needs
analysis on its components
• For Example: Maruti’s non Maruti’s NON Current Liablities Annual Report)
current liabilities are
mentioned on the right side
taken from the annual report(
shows the various
components)
• Given on right is its number on
tangible assets
• As an analyst you would want
to know the disclosure on the
calculation

PRICOL LTD (2.10 Disclosure on Fixed Assets)

Measurement Disclosures ( IFRS)
 Accounting Policies, including the

cost formulas used
Other Disclosures
 Total carrying amount of inventory
and amount per category
 Specific accounting policies
 Amount of inventories carried at used
fair value less costs to sell  Terms of debt agreement
 Amount of any write-downs and  Lease information
reversals of any write-downs
 Off-balance sheet financing
 Circumstances or events that led to
the reversal of a write-down  Breakdowns of operations by
important segments
 Inventories pledged as security for
liabilities  Contingent assets and
liabilities
 Amount of inventories recognized
as expense  Detailed pension plan
disclosure

Investments Of Companies Case
• Pricol ltd has generated surplus cash in 2014-15

• It has an option to either invest in the business or Should
put some portion into buying investments we should
• Investments could include it at cost
1. Bonds
Current
2. Stocks of other companies
Market
3. Mutual funds investments Value
• How we do show the value of investment year on
year? Should we show
the profits in the
income statement?

Investments of Pricol
Non- Current Investments
Current Investments

Classification of Investments for Disclosure
Securities are classified based upon the company’s intent with

regard to eventual sale
• Securities (debt) that company intends to hold to maturity
Held to • Securities are carried at cost
maturity • IS Impact – Interest Income and realized gains on disposal
• BS Impact – Increase in Deposits (cash) account (asset) and Retained earning
securities (liability) due to increment in the interest income
• Securities (debt & equity) that may be sold to satisfy the company needs
Available • Securities carried at market value
for sale • IS Impact – Same as HTM
• BS Impact – Unrealized gains /Loss in Asset side and Other comprehensive income
securities in the equity (liabilities side)
• Acquired for the purpose of selling within 90 days

Held for • Securities carried at market value
Trading • IS impact – Periodic Income and Unrealized gains
• BS Impact – Unrealized gains in Assets and Retained earning in equity (liabilities)

Impact on Financial Statements- Question
Example
 ABC Intl purchased 10,000 shares on 1 Jan 2009 for $50 per share.
The market price of shares on 31st Dec 2009 was $75.
 Dividends of $2 were paid during the year
 Show the balance sheet and Income statement entries if these
share are classified as
 Held to maturity
 Available for sale
 Trading securities

Solution
Held to Maturity Available for sale Trading

Jan-09 Dec-09
Securities securities Securities
Share Price 50 75 Balance Sheet (31/12/2009)
Number of shares 10,000 10,000
Cost 500,000 500,000 Assets
Fair Value 500,000 750,000 Deposits (Cash) 20,000 20,000 20,000
Unrealized Gains (Losses) - 250,000 Cost of Securities (Investments) 500,000 500,000 500,000
Dividend Income ($2 per share) 20,000 Unrealized gains/(losses) on secur - 250,000 250,000
Total Impact 520,000 770,000 770,000
Liabilities
Equity
Paid in Capital 500,000 500,000 500,000
Retained earnings 20,000 20,000 270,000
Other Comprehensive Income - 250,000
Total Impact 520,000 770,000 770,000

Checksum - - -
Income Statement (31/12/2009)
Dividend Income (Other Income) 20,000 20,000 20,000

Unrealized gains/(losses) - - 250,000
Total Impact 20,000 20,000 270,000

Equity Components
Capital Contributed by
owners
Minority Interest( IFRS)
Equity
Retained Earnings
Treasury Stock
Accumulated other
comprehensive Income

Common Size Balance Sheet
Apple Inc. - Common Size Balance Sheet
Year ended 26 September Year ended 26 September

2009 2008 2009 2008
Assets Liabilities and Shareholders' Equity
Current assets: Current liabilities:
Cash and cash equivalents 10% 30% Accounts payable 10% 14%
Short Term Investments 34% 26% Income taxes payable 0% 0%
Common Size BS = Balance sheet Line Items / Total
Accounts receivable - net 6% 6% Accrued compensation 6% 9% Assets allows for:
Inventories
Deferred tax assets
1%
4%
1%
4%
Deferred revenue
Other accrued liabilities
19%
0%
12%
0%  Comparison of Time series data
Prepaid expenses and other current assets 13% 15% Short Term Debt 0% 0%  Comparison of cross sectional data
Total current assets 67% 82% Total current liabilities 36% 36%
Property and equipment, Net 5% 6% Long Term Debt 0% 0%
Goodwill 0% 1% Other long term liablities 4% 4%
Purchased intangible assets, Net 0% 1% Minority interest 0% 0%
Other Assets 7% 5% Deferred tax liabilities 0% 0%
Investments 20% 6% Product Deferred Revenue 8% 8%
Total Assets 100% 100% Shareholders' equity:
Common stock and additional paid-in capital 15% 18%
Retained earnings 36% 35%
Accumulated other comprehensive income 0% 0%
Less:Treasury Stock 0% 0%
Total shareholders' equity 52% 53%
Total Liabilities and Shareholders' Equity 100% 100%

Ratios Analysis of Balance Sheet
Its is very difficult to get a sense Liquidity Ratios Calculation Measurement

of the number unless we can
compare two companies Current Assets / Current
Current
Liabilities
Ratios help us understand the
(Cash + marketable Securities + Ability to meet
specific metric easily Quick (acid test)
Receivables) / Current Liabilities curret liabilities
Also it helps us break down the Cash
(Cash + Marketable Securities) /
size of a company and directly Current Liabilities
compare it with another
company Solvency Ratios Calculation Measurement
Long Term debt to Total long term debt / Total

equity equity
Financial risk and
Debt to Equity Total debt / total equity
financial leverage
Total Debt Total debt / total assets
Financial Leverage Total assets / total equity

Maruti Suzuki- Liquidity and Solvency Case
Liquidity Ratio Quick Ratio= Current Assets-Inventories

• Current Ratio = Current Assets/ Current Current Liabilities
Liabilities
Quick Ratio (2016)= 74043-31998 = 0.36
Current Ratio( 2016)= 74043 =0.64 114601
114601
Quick Ratio(2015)=86947-27453 = 0.66
89807
Current Ratio( 2015)= 86947 =0.96
89807
Current Ratio tries to measure the short term Quick ratio becomes more stricter to measure liquidity
liquidity of a company in this case the liquidity and removes inventory and then tries to measure short
has gone done from 2015 to 2015 term liquidity. In This case the liquidity has decrease to a
great extent

Maruti Suzuki
• Cash Ratio: Cash + Marketable securities/ Solvency Ratio

Current Liabilities Long Term Debt To Equity Ratio: (Lower the better)
Cash ratio(2016) 8748 =0.07 Long Term Debt
114601 Total Equity
Cash Ratio(2015): 16389 =0.18 Debt Ratio(2016)= 1471 =0.05
89807 27748
Cash ratio just considers those assets which on Debt Ratio(2015)=2783 =0.11
a practical basis are the most liquid assets like
investments and cash. In this case as well we 24314
see that the liquidity position has deteriorated

Maruti Suzuki
Debt to Assets Ratio: Total Debt

Total Assets
2015 =2783 Financial leverage Ratio: Total Assets/ Total Equity
344769 2015:344769
=0.008 243184
2016:= 1471 =1.41
402699 2016:402699
=0.003 277487
Higher ratio indicates higher percentage of assets =1.45
funded by debt Higher ratio indicates more assets being funded
by debt

Conclusion on Maruti Suzuki
1. Liquidity has deteriorated on all accounts

2. Solvency has increased on all accounts- mainly due to debt repayment by the company

Limitations of Balance Sheet
 There are various measurement bases for different items reported

 Items measured at current value reflect value that was current at
the end of the reporting period
 Omits many items that have financial value to the business, e.g.
human capital, brand value
 Balance sheet is a snapshot of a firm at a particular point in time,
i.e. the amounts on the balance sheet change on a daily basis

4.Time Value of Money
What is Time Value of Money?
TVM is the basic principle that money can earn interest, so something
Example
that is worth $1 today will be worth more in the future if invested.
Will you agree to a proposal
Definition:
by your company to receive
 The difference in the value of cash received (expended) now versus salaries on every 1st of the
its value if received sometime in the future. month instead of the last
Application in real life: day of that month?
 The value of an asset is determined by estimating the worth of the
stream of future cash flows.
Who would say ‘NO’
To Remember A dollar received NOW is

As investment analysts we evaluate several transactions with always more valuable than
present and future cash flows. a dollar received any time
LATER!

Compounding
Consider the following transaction:
Another way to understand this is to
Time 0 1 2 consider, two options
Entity (a) Receive Rs 10,000 today
10,000 11,000 12,100 (b) Receive Rs 11,000 a year later

Assuming that if you could invest Rs 10,000
today for 1 year at 10% than you will be
Present Value 10% Future Value indifferent between choice (a) and choice (b)
 You receive Rs.11,000 at the end of year 1 (10% over 10,000) – time value of money
 Your receive Rs 12,100 at the end of year 2 (10% over 11,000) – time value of money +
compounding effect
 A 10,000 invested for two years at 10% will fetch 12,000 – so the extra 100 is an
interest on interest (1000 earned during year 1 is also earning 10% for year 2)
 Compounding is earning interest on interest.

Discounting
In Discounting we compute the present values of all the future cash inflows at a
given rate of interest i.e. the value of money at time 0.
Time
0 1
(years)
Bank
Rs.11,000
Future Value
10%
You
Rs.10,000 One Year
Present Value
Example
 Compute the present value of $24,200 to be given at the end of 2 years for a rate
of interest of 10%.
 PV = 24200 / (1+ 10%)2 = 20,000.

Interest Rate – Various Interpretations
Interest Rate
Required rate of return/
Minimum expected rate Required rate of return is the rate which an investor expects to earn from investment
of return considering underlying risk of the asset.
Corporate Finance professionals need to continuously evaluate multiple projects to
identify the right project which will maximize their returns over their allocated capital.
Opportunity Cost Since, selecting one project over let say 2-3 other projects – the CFO is essentially forgoing
returns of those rejected projects. Hence, opportunity cost is the cost of forgoing other
opportunities to select a particular opportunity.
Discount rate is the rate used for discounting (i.e. bringing) future cash flows to present
Discount rate value.

Components of Interest Rate
Mathematically we compute the interest rate (r) as:
 r = Real risk free interest rate + inflation premium + default risk premium + liquidity
premium + maturity premium
Real risk free interest • It reflects the time preferences of individuals
for current versus future real consumption
Essentially, these are rate
the risk components
that an investor • Average inflation expected over the maturity To Remember
assumes while Inflation Premium of the debt
Nominal Risk Free Rate =
making an
investment decision. • Compensates the investor for default in Real Risk Free Rate +
Hence, investors Default Risk Premium payment by the borrower
Inflation
need to be
adequately • Compensates for the risk of conversion of the
compensated for Liquidity premium investment to cash
each risk factor by
the interest rate • Longer the investment maturity, higher is the
Maturity Premium maturity premium needed for compensating
investor needs

Future value of single cash flow
Formula
FV = PV * (1+r)N
Where,
 FV = future value of the investment N periods from today
 PV = present value o the investment
 r = rate of interest per period
0 1 2 3 … N-1 N
PV FV = PV * (1 + r) N
Salient Points:
 All cash flows should be brought in one time frame
 Future value increase with number of periods
 Future value increase with the interest rates

Future value of single cash flow
 Suppose, one wants to Your friend recommended you to check-out the Following are the NAVs of
invest lump sum money Franklin Templeton Prima Plus Mutual Fund. So, Franklin Templeton Prima
into a Mutual Fund for a after careful evaluation of its holdings, sector Plus on every last business
period of 5 years. exposure, fund manager credentials, etc You also day of Indian financial year:
wanted to find the past 5 year period return. To 31-03-2016 432
 Also, one decides to the right are the historical NAV details of this
refer past 5 year returns fund. 31-03-2015 442
of Mutual Funds, along 31-03-2014 288
with other risk factors NAV at time=0 is 224 & NAV at time=5 is 432
before finalizing the 28-03-2013 237
right Mutual Fund. So, the annualized return for this period is: 30-03-2012 219
432 = 224 (1 + R)5 31-03-2011 224
Solving for R gives you 14.04% 31-03-2010 201
Here, we have assumed annualized compounding 31-03-2009 109

of returns! 31-03-2008 158
30-03-2007 132

Future Value of lump sum
Example
 A bank offers interest rate of 9% per year compounded annually. How much will
you have at the end of 5 years, given the amount invested in the scheme is
Rs.50,000?

Solution:
 Given:
0 1 2 3 4 5
50,000 FV = PV * (1 + r) N
r = 9%
PV = 50,000
r = 9%
N=5
FV = 50000 * ( 1 + 9%)5
= 76,931.20

Future Value of lump sum (different annual time frame)
Example
 A bank offers interest rate of 9% per year compounded annually. If an amount of
Rs.50000 is invested, what would be the value of investment at the end of 5th
year?
 How much will be the amount, if we remain invested till 15 years, in the above
scheme?

Solution:
 Given:
At the end of 5th year 0 1 2 3 4 5 6 7 8 9 10
PV = 50,000 50000 FV = PV * (1 + r) N
r = 9%, N = 5
r = 9%
N=5
FV = 50000 * ( 1 + 9%)5
= 76931.20
 Given
At the end of 15th year
PV = 50,000
r = 9% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
50000 FV = PV * (1 + r) N
N = 15 r = 9%, N = 10
FV = 50000 * ( 1 + 9%)15
= 182124.12

Frequency of Compounding
Formula Tip to remember:

r mN
Where,
FV = PV ( 1 + s
m ) 1) Divide the annual interest rate by the number of
compounding period in a year – this will give you
 FV = future value of the investment N periods from today the Interest Rate
 PV = present value o the investment 2) Multiply the number of years with the number of
 rs = rate of interest per period compounding period in a year – this will give you
the Time Period
 m = number of compounding periods per year

Future Value of lump sum (different time frame)
Example
A bank offers interest rate of 9% per year. How much will you have at the end of 5 years, given
the amount invested in the scheme is Rs.50,000?
 If compounding is annual?
 If compounding is semi annual?
 If compounding is quarterly?
 If compounding is monthly?
 If compounding is daily?

Future Value of lump sum (different time frame)
Solution Formulae Used

PV = 50,000 N
FV = PV * ( 1 + r )
N = 5
r = 9%
FV = PV ( 1 + mr ) mN
s
Step Screen Remark For Semi Annual For Quarterly

1 ON Start
For Annual Compounding
Compounding Compounding
2 2ND -> CLR TVM Clear previous data r = 9% r = 9% r = 9%
3 50,000 then PV Enter Principal N = 5 N = 5 N = 5
4 9 then I/Y Enter rate m = 1 m = 2 m = 4
FV = 76,931.20 FV = 77,648.47 FV = 78,025.46
5 5 then N Enter total periods
6 CPT -> FV Compute Future Value
Now, to get different FV using different compounding frequencies For Monthly
For Daily Compounding
Step Screen Remark Compounding
1 4.5 then I/Y For semi-annual rate r = 9% r = 9%
2 10 then N For 10 periods
N = 5 N = 5
m = 12 m = 365
3 CPT -> FV Compute Future Value
FV = 78,284.05 FV = 78,411.26

Continuous Compounding
As we have learnt Formula FV = PV * e (rs N)

that Compounding is
a great thing when
you are earning it, a Where,
Continuous  FV = future value of the investment N periods from today
Compounding  PV = present value o the investment
assumes that you are
 rs = rate of interest per period
earning interest
constantly on your  e = 2.7182818 (constant)
principal and the
Example
interest on interest is
also continuously A bank offers interest rate of 9% per year. How much will you have at
getting the end of 5 years, given the amount invested in the scheme is
compounded! Rs.50,000?
 If compounding is continuous?

Continuous Compounding
Solution
For Continuous
Compounding
PV = 50,000 Formula
r = 9%
(rs N)
N = 5 FV = PV * e
(r N) = 1.57
e
FV = 78,415.61

Effective Rates
Formula
Effective Annual Rate = ( 1 + Periodic Interest Rate )m - 1

Since different
For continuous compounding, rs compounding
EAR = e - 1
frequencies can lead
to different rates, an
Where, Effective Rate
 FV = future value of the investment N periods from today computation shall
 PV = present value o the investment greatly help to
compare two
 rs = rate of interest per period different interest
 m = number of compounding periods per year rates with different
compounding
Example frequency.
 A bank offers interest rate of 9% per year compounded annually.
How much will you have at the end of 2.5 years, given the amount
invested in the scheme is Rs.50,000?
Effective Rates
Using Financial Calculator (TI BAII)
Press
Solution Steps
Buttons
Remarks
PV = 50,000 1 2ND Selects the second function of the calculator

r = 9% (Compounded Annually) 2 CLR WORK Clears memory
3 1.09 Number fed on the screen
N = 2.5 4 y
x
Selects the raise to (index) function
m = 2 5 0.5 Number fed on the screen
0.5
6 = Carries out the operation - 1.09 = 1.0403
Formula 7 - Subtraction sign pressed
8 1 Number fed on the screen
Effective Annual Rate = ( 1 + Periodic Interest Rate ) m - 1 9 * Multiplication sign pressed
9% = ( 1 + Eff.Semi Annual Rate) 2 - 1 11 = Output obtained is 4.403
Number appearing on the screen is assigneed to the I/Y
12 I/Y (Interest, remember this is a percent memory location)
Eff.Semi Annual Rate = (1 + 9%) (1/2) - 1
memory
Eff/ Semi Annual Rate = 4.403% Number appearing on the screen is assigneed to the N
14 N
(Number of years) memory
FV = PV * ( 1 + Eff. Semi Annual Rate) (m*N) Number appearing on the screen is assigneed to the PV
16 PV
memory
FV = 62,021 17 0 Number fed on the screen
Number appearing on the screen is assigneed to the
18 PMT
PMT (Payment or Annuity) memory
19 CPT Puts the calculator in computation mode
20 FV Computes FV for the given set of numbers

Future Value of a series of cash flow
Ever wondered how Equal Cash Flow – Ordinary Annuity Terms

does Govt builds road
on unpopular routes? Future value An Annuity is a finite series
Formula : annuity factor of equal cash flows
An Ordinary Annuity has a

By offering Fixed (1+r)N - 1
Annuity to private
FV = A [ r
] first cash flow that occurs
developers i.e. It one period from now, t =1.
assures a fixed series of Example
cash flow for a certain An Annuity Due has a first
period of time to the A bank offers interest rate of 9% per year compounded cash flow that occurs
developer. annually. An investor deposits Rs.5000 at equally
spaced interval of one year for the next 5 years. What immediately , t = 0
is the future value of this ordinary annuity after the A Perpetuity is an infinite
last deposit at t=5? series of equal cash flows
starting from t = 1.

Solution
Using Financial Calculator (TI BAII)
Press
Steps Remarks
Buttons
5000 5000 5000 5000 5000 Future Value
Number appearing on the screen is assigned
0 1 2 3 4 5 2 I/Y to the I/Y (Interest, remember this is a
N =0
5,000 percent memory location) memory
N = 1, r = 9% Number appearing on the screen is
5,450
4 N assigneed to the N (Number of years)
N = 2, r = 9% memory
5,941
N = 3, r = 9% Number appearing on the screen is
6,475 6 PV
assigneed to the PV memory
N = 4, r = 9% 7 5000 Number fed on the screen
7,058 Number appearing on the screen is
Total = 29,924 8 PMT assigneed to the PMT (Payment or Annuity)
memory
10 FV Computes FV for the given set of numbers

Unequal Cash Flow – Ordinary Annuity Tip to remember:

 At times cash flow streams are unequal
 In such cases the FVIFA formula cannot be used
Discount each cash
Example
flow separately and
 r = 9% then aggregate the
Future Value
Time Cash Flow total cash flows
at year 5
t=1 2,000 ?
t=2 4,000 ?
t=3 6,000 ?
t=4 8,000 ?
t=5 10,000 ?
Sum = ?
 What is the future value after 5 years for the given cash flow stream?

Solution
Given
r = 9%
Compounding Future Value

Cash Flow
Period at year 5
t=4 2000 2,823 Formula
t=3 4000 5,180 N
t=2 6000 7,129 FV = PV * ( 1 + r )
t=1 8000 8,720
t=0 10000 10,000
Sum = 33,852

Present value of single cash flow
Formula
FV = PV * (1+r)N
 PV = FV / (1+r)N
Where,
 FV = future value of the investment N periods from today
 PV = present value o the investment
 r = rate of interest per period
0 1 2 3 … N-1 N
FV
PV = FV / (1 + r) N

Present Value of lump sum
Example
 Abhijeet started working with Infosys and plans to pursue an international MBA
after completing 5 years of experience. The expected tuition fee for a good MBA
program overseas would be approximately USD 50,000. Infosys has provided a
signing bonus to Abhijeet and he wants to determine the right amount that he
should set aside today for his future studies. He visits HSBC and finds out that
they offer a fixed deposit for 5 years at an annual interest rate of 9% compounded
annually.
 How much should Abhijeet invest today to earn USD 50,000 at the end of 5 years?

Solution
Given: Using Financial Calculator (TI BAII)
Press
Steps Remarks
Buttons
0 1 2 3 4 5 1 2ND Selects the second function of the calculator
50,000 2 CLR WORK Clears memory
PV = FV / (1 + r) N Number appearing on the screen is assigneed to the FV
FV = 50,000 r = 9% 4 FV
memory
R = 9% Number appearing on the screen is assigneed to the I/Y
6 I/Y (Interest, remember this is a percent memory location)
N=5 memory
PV = 50000 / (1+9%)5 Number appearing on the screen is assigneed to the N
8 N
(Number of years) memory
= 32,496.57 9 0 Number fed on the screen
Number appearing on the screen is assigneed to the
10 PMT
PMT (Payment or Annuity) memory
12 PV Computes PV for the given set of numbers

Present value of single cash flow (different annual time frame)
Example
Bank fixed deposit will give Rs.5,00,000 after 10 years for the investment you make
today. How much will this investment grow to at the end of 4 years from now?
Interest rate offered by bank is 9% per year compounded annually.

Solution:
0 1 2 3 4 5 6 7 8 9 10
500000
r = 9%, N = 6
PV = FV / ( 1 + r )N
At the end of 4th year
FV = 5,00,000
r = 9%
N=6
PV = 500000 / ( 1 + 9%)6
= 2,98,133.66

Present value of single cash flow (different time frame)
Example Tip to remember:

A bank offers interest rate of 9% per year. How much will you invest today to earn
Rs.50,000 at the end of 5 years?
 If compounding is annual? Higher compounding
frequency shall provide
 If compounding is semi annual?
higher compounded
 If compounding is quarterly? benefits!
 If compounding is monthly?
 If compounding is daily?
 If compounding is continuous?

Present value of single cash flow (different time frame)
Solution Formulae Used

FV = 50,000 N (rs N)
N = 5
PV = FV / ( 1 + r ) PV = FV / e
r = 9%
PV = FV / ( 1 + mr ) mN
s
For Semi Annual For Quarterly

For Annual Compounding Step Screen Remark
Compounding Compounding
r = 9% r = 9% r = 9% 1 ON Start
N = 5 N = 5 N = 5 2 2ND -> CLR TVM Clear previous data
m = 1 m = 2 m = 4 3 50,000 then FV Enter Future Value
PV = 32,496.57 PV = 32,196.38 PV = 32,040.82
4 9 then I/Y Enter rate
5 5 then N Enter total periods
For Monthly For Continuous 6 CPT -> PV Compute Present Val
For Daily Compounding Compounding
Compounding
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
(r N)
m = 12 m = 365 e = 1.57
PV = 31,934.98 PV = 31,883.18 PV = 31,881.41

Present Value of a series of cash flows
Formula
A A A A A
PV = + + + + … +
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)N
OR
1 - 1/(1+r) N
Where,
PV = A [ r ]
 A = annuity amount
 r = interest rate per period
 N = number of annuity payments

Projected Present Value of ordinary Annuity
Example
A bank offers interest rate of 9% per year compounded annually. An investor
deposits Rs.5000 at equally spaced interval of one year for the 5 years, payment
happens at the end of year. What is the present value of this ordinary annuity?
Tip to remember:
In the TVM concept, mapping correct cash flows to correct time periods is the key!

Projected Present Value of ordinary Annuity
Solution
Present Value 5000 5000 5000 5000 5000
0 1 2 3 4 5
4,587
N = 1, r = 9%
4,208
N = 2, r = 9%
3,861
N = 3, r = 9%
3,542
N = 4, r = 9%
3,250
N = 5, r = 9%
Total = 19,448

Present Value of an Annuity Due
An ordinary Annuity has its payment or receipt at the end of the year.
Annuity Due has its payment or receipt at the beginning of the year.
To handle this:
 You can set your calculator at the BGN mode, we will see how in the next slides
 You can solve the problem assuming it is ordinary annuity and then multiply by
(1+I/Y) to convert it into annuity due
 You can ignore the first period amount, solve the rest of the amounts as
ordinary annuity for (N-1) periods and add the first amount. We recommend
this one!
 Lets see each one in action.

Example
deposits Rs.5000 at an annuity of 5 payments, payment happens at the start of year
with the first payment starting today. What is the present value of this annuity?

Set the Financial Calculator (TI BAII) into (or out of) beginning mode
Solution Part 1
Press
Steps Remarks
Buttons
1 2ND Selects the second function of the calculator
2 CLR WORK Clears memory

Present Value 5000 5000 5000 5000 5000
0 1 2 3 4 5
5,000
Selects the second funtion " BGN" Beginning
N = 0, r = 9% 4 PMT
mode of calculator
4,587
N = 1, r = 9%
4,208
N = 2, r = 9%
Sets the calculator into the beginning mode
3,861 6 ENTER
N = 3, r = 9% "SET"
3,542 7 2ND Selects the second function of the calculator
N = 4, r = 9%
Total = 21,199
Selects the second funtion " QUIT" to
8 CPT
complete the selection
After setting the calculator in the beginning mode

solve the question as per previously discussed steps.
PMT = 5000, N = 5, I/Y =9, FV = 0, CPT  PV

Solution Part II
 You could have also solved it using ordinary annuity. (Refer slide 32). Answer is
19448.
 PV of Annuity Due = 19448*(1.09) ≈21,199
Solution Part III
 Solve it as ordinary annuity of 4 payments of 5000 each.
 PMT = 5000, N = 4, I/Y =9, FV = 0, CPT  PV
 PV =16199
 Add the first payment of 5000
 PV of annuity Due = 21,199

Present Value of Perpetuity
Formula Perpetuity is an
∞ 1 Annuity with No End!
PV = A ∑ (1+r)t Hence, we use a
t= 1
terminal method to
For r >0, compute the present
PV = A / r value, which is dividing
the cash flow by
Example discount rate.
deposits Rs.5000 at equally spaced interval of one year till perpetuity. What is the
present value of this ordinary annuity?
Solution
PV = 5000 / 0.09 = 55,555.56

Present Value of Perpetuity…
Example
A bank offers interest rate of 9% per year compounded annually. An investor deposits Rs.5000 at
equally spaced interval of one year till perpetuity. First payment starting 5 years from now. What
is the present value of this ordinary annuity?
Solution A A ………… A A
0 1 2 3 4 5 6 …… ?
PV = A / r
r = 9%, N = 5
PV = FV / ( 1 + r )N
PV1 = 5,000 / 0.09

= 55,555.56
PV = PV1 / (1+ 0.09)5 First compute the PV till beginning of 5th year and then
discount to t=0
= 55,555.56 / 1.095
= 36,107.30

Present Value of a series of unequal cash flow
Example
r = 9%
Present
Time Cash Flow
Value
t=1 2,000 ?
t=2 4,000 ?
t=3 6,000 ?
t=4 8,000 ?
t=5 10,000 ?
Sum = ?
◦ What is the present value for the given cash flows?

Present Value of a series of unequal cash flow
Solution
r = 9%
Present
Time Cash Flow
Value
t=1 2,000 1,835 Formula Used
t=2 4,000 3,367
t=3 6,000 4,633 PV = FV / ( 1 + r )N
t=4 8,000 5,667
t=5 10,000 6,499
Sum = 22,001

Solving for interest rates
Formula
FV = PV * (1+r)N To Remember
In financial calculator
 r = (FV / PV)(1/N) – 1 add the PV and FV
values with opposite
signs (“+” & “ – ”)
Example
How much is the interest rate offered by a bank, if an investment of Rs.50,000
becomes equal to Rs.1,00,000 at the end of 5 years?
Solution
PV = 50000, FV = - 100000, N = 5, PMT = 0
Compute  I/Y = 14.87%

Solving for number of periods
Example
In how many years, an amount of Rs.50,000 will double, given the rate of interest
is 9%?
Solution
PV = 50000, FV = - 100000, I/Y = 9, PMT = 0
Compute  N = 8.04 years

5. Overview of Equity Securities
Equity Security in Global Financial Markets
 Equity markets are very large
 Historically equity markets have offered high returns relative to government bonds and T-bills,
but at higher risk

Types and Characteristics of Equity Securities
 Common shares represent an ownership interest in a company and give investors a claim on its operating
performance, the opportunity to participate in decision making through voting right, and a claim on the
company’s net assets in the case of liquidation
 Vote by proxy: A mechanism that allows a shareholder representative to vote on the shareholder’s behalf
 Statutory voting(A common method of voting where each share represents one vote) Vs Cumulative voting
(A voting process whereby each shareholder can accumulate and vote all his or her shares for a single
candidate in an election, as opposed to having to allocate their voting rights evenly among all candidates)
 For example, under cumulative voting, if four board directors are to be elected, a shareholder who owns 100
shares is entitled to 400 votes and can either cast all 400 votes in favor of a single candidate or spread them
across the candidates in any proportion

Types and Characteristics of Equity Securities
 Different classes: Company may issue two classes of common stock: Class A, which is the voting
stock, and Class B, which is the non-voting stock. There is no difference between the two classes
except for voting rights; they generally trade within a close price range of each other
 Callable Common shares that give the issuing company the option (or right), but not the
obligation, to buy back the shares from investors at a call price that is specified when the shares
are originally issued
 Putable common shares: Common shares that give investors the option (or right) to sell their
shares back to the issuing company at a price that is specified when the shares are originally
issued.

Preference Shares
 Preference shares are a form of equity in which payments made to preference shareholders
take precedence over payments to common shareholders
 Cumulative Preference shares for which any dividends that are not paid accrue and must be
paid in full before dividends on common shares can be paid Vs Non cumulative preference share
for which dividends that are not paid in the current or subsequent periods are forfeited
permanently (instead of being accrued and paid at a later date)

Preference Shares
 Participating Preference shares that entitle shareholders to receive the standard preferred
dividend plus the opportunity to receive an additional dividend if the company’s profits exceed a
pre-specified level vs Non participating preference share that do not entitle shareholders to
share in the profits of the company. Instead, shareholders are only entitled to receive a fixed
dividend payment and the par value of the shares in the event of liquidation.
 Convertible Preference shares A type of equity security that entitles shareholders to convert
their shares into a specified number of common shares

Private versus Public Equity Securities
Private Equity securities that are not listed on public exchanges and have no active secondary
market. They are issued primarily to institutional investors via non-public offerings, such as
private placements
Company’s management can focus on
 long term value creation
 Highly illiquid
 Potentially high returns

Venture capital
Venture Capital: Investments that provide “seed” or start-up capital, early-stage financing, or
mezzanine financing to companies that are in the early stages of development and require
additional capital for expansion

Leveraged buy out
Leverage buy out (LBO) A transaction whereby the target company management team converts the
target to a privately held company by using heavy borrowing to finance the purchase of the target
company’s outstanding shares

Management Buy out
Management Buy out (MBO) An event in which a group of investors consisting primarily of the
company’s existing management purchase all of its outstanding shares and take the company
private

Private Placement in public equity
 Private investment in public equity is generally sought by a public company that is in need of
additional capital quickly and is willing to sell a sizeable ownership position to a private investor
or investor group

INVESTING IN NON-DOMESTIC EQUITY SECURITIES
 Technological innovations have accelerated the integration and growth of global financial
markets
Increased integration makes it easier for
A. Companies to raise money and expand internationally
B. Investors to invest internationally
Many countries still impose foreign restrictions on companies from other countries.
There are three primary reasons for these restrictions.
A) Limit the amount of control that foreign investors can exert on domestic companies.
B) To give domestic investors the opportunity to own shares in the foreign companies that are
conducting business in their country.
C) Too reduce the volatility of capital flows into and out of domestic equity markets.

Direct Investing and Depository Receipt
 Direct investing: Buying and selling securities directly in foreign markets. This means that all
transactions including the purchase and sale of shares, dividend payments, and capital gains are
in the company’s domestic currency
 Investors must be familiar with the trading, clearing, and settlement regulations and
procedures of that market
 Depository Receipts: A security that trades like an ordinary share on a local exchange and
represents an economic interest in a foreign company
 A depository receipt is created when the equity shares of a foreign company are deposited in a
bank (i.e., the depository) in the country on whose exchange the shares will trade. The
depository then issues receipts that represent the shares that were deposited
 Depository bank issues receipts that represent deposited shares

Depository Receipt
 A DR can be sponsored or unsponsored

 A sponsored DR is when the foreign company whose shares are held by the depository has a
direct involvement in the issuance of the receipts. Investors in sponsored DRs have the same
rights as the direct owners of the common shares (e.g., the right to vote and the right to receive
dividends). In Unsponsored DR, the underlying foreign company has no involvement with the
issuance of the receipts, the depository bank retains the voting rights
 Basket of listed depository receipt: An exchange-traded fund (ETF) that represents a portfolio
of depository receipts.

Global Depository Receipts
 A depository receipt that is issued outside of the company’s home country and outside of the
United States mostly in US dollars
 A key advantage of GDRs is that they are not subject to the foreign ownership and capital flow
restrictions that may be imposed by the issuing company’s home country because they are sold
outside of that country

American Depository Receipts
 A US dollar-denominated security that trades like a common share on US exchanges
 They enable foreign companies to raise capital from US investors
 An ADR is one form of a GDR, however not all GDRs are ADRs

Types of ADR
 There are four primary types of ADRs, with each type having different levels of
corporate governance and filing requirements

Return Characteristics of Equity Securities
Two main sources of equity securities
1. Total return: price change (or capital gain) and dividend income
Total return, Rt = (Pt – Pt–1 + Dt)/Pt–1
2. Foreign exchange gains (or losses): Foreign exchange gains arise because of the change in the
exchange rate between the investor’s currency and the currency that the foreign shares are
denominated in. For example, US investors who purchase the ADRs of a Japanese company
will earn an additional return if the yen appreciates relative to the US dollar

Risk of Equity Securities
 A larger portion of shareholders’ total return is based on future price appreciation and future
dividends are unknown
 If the company is liquidated, common shareholders will receive whatever amount (if any) is
remaining after the company’s creditors and preference shareholders have been paid.

Comparing the risk/return characteristics
 Uncertainty surrounding the total return of preference shares is less than common shares,
preference shares have lower risk and lower expected return than common shares
 Putable common shares are less risky than non-callable shares because they give the investor
the option to sell the shares to the issuer at a pre-determined price. This pre-determined price
establishes a minimum price that investors will receive and reduces the uncertainty associated
with the security’s future cash flow
 Callable common shares are riskier than their non-callable counterparts because the issuer has
the option to redeem the shares at a pre-determined price
 Putable preference shares have lower risk than non-putable preference shares

EQUITY SECURITIES AND COMPANY VALUE
 Companies issue equity securities on primary markets to raise capital and increase liquidity.
Goal of raising capital are:
1. Finance the company’s revenue-generating activities in order to increase its net income and
maximize the wealth of its shareholders
2. Finance the purchase of long-lived assets, capital expansion projects, research and
development, the entry into new product or geographic regions, and the acquisition of other
companies
3. Capital is raised to fulfil regulatory requirements, improve capital adequacy ratios, or to
ensure that debt covenants are met

EQUITY SECURITIES AND COMPANY VALUE
Goal of management
 Increase the book value (shareholders’ equity on a company’s balance sheet) of the company
and maximize the market value of its equity
 Management actions can directly affect the book value of the company (by increasing net
income or by selling or purchasing its own shares), they can only indirectly affect the market
value of its equity

Accounting Return on Equity
Return on equity: A profitability ratio calculated as net income divided by average shareholders’
equity
ROE=NIt/Average BVEt
Blue chip: Widely held large market capitalization companies that are considered financially
sound and are leaders in their respective industry or local stock market
 ROE can increase if net income increases at a faster rate than shareholders’ equity

Reason for Increase in ROE
 One reason ROE can increase is if net income decreases at a slower rate than shareholders’
equity, which is not a positive sign
 ROE can increase if the company issues debt and then uses the proceeds to repurchase some
of its outstanding shares. This action will increase the company’s leverage and make its equity
riskier
 Therefore, it is important to examine the source of changes in the company’s net
income and shareholders’ equity over time
Note Further detail in DuPont formula(FRA)

The Cost of Equity and Investors’ Required Rates of Return
 When investors purchase the company’s equity securities, their minimum required rate of
return is based on the future cash flows they expect to receive. Because these future cash flows
are both uncertain and unknown, the investors’ minimum required rate of return must be
estimated
A. Cost of equity is the minimum expected rate of return that a company must offer its
investors to purchase its shares. Cost of equity may be different from investor’s required rate
of return
B. Because companies try to raise capital at the lowest possible cost, the cost of equity is often
used as a proxy for the investors’ minimum required rate of return
C. If this expected rate of return is not maintained in the secondary market, then the share
price will adjust so that it meets the minimum required rate of return demanded by investors

The Cost of Equity and Investors’ Required Rates of Return
Cost of equity can be estimated using

A) Dividend Discount Model (DDM)
B) Capital Asset Pricing Model (CAPM)

6.Equity Valuation: Concepts and Basic Tools
Estimated Value and Market Price
By comparing estimates of value and market price, an analyst can conclude whether security
is undervalued, overvalued, or fairly valued
If market value ≠ intrinsic value, consider:

A) Percentage difference
B) Confidence in your model
C) Model sensitivity to assumptions
D) Number of analysts
E) Will market price move towards intrinsic value
Estimated Value and Market Price
 An analyst’s final conclusion depends not only on the comparison of the estimated value and
the market price but also on the analyst’s confidence in the estimated value
 Confidence in the convergence of the market price to the intrinsic value over the investment
time horizon
 In seeking to identify mispricing and attractive investments, analysts are treating market prices
with skepticism

Major Categories of Equity Valuation Models
• Estimate Intrinsic value as present value of expected

Present value future economic benefit
Models(DCF)
• Estimate Intrinsic value based on multiple of some

Multiplier fundamental variable
Models
• Estimate Intrinsic value based on estimated value of

Asset Based asset and liabilities
Models

1. Present value models: In present value models, benefits are often defined in terms of cash
expected to be distributed to shareholders (dividend discount models) or in terms of cash flows
available to be distributed to shareholders after meeting capital expenditure and working capital
needs (free-cash-flow-to-equity models)
2. Multiplier models: The model estimates intrinsic value of a common share from a price
multiple for some fundamental variable, such as revenues, earnings, cash flows, or book value.
Examples of the multiples include price to earnings (P/E, share price divided by earnings per
share) and price to sales (P/S, share price divided by sales per share).

3. Enterprise value: A measure of a company’s total market value from which the value of cash
and short-term investments have been subtracted
4. Asset-based valuation models: These models estimate intrinsic value of a common share
from the estimated value of the assets of a corporation minus the estimated value of its
liabilities and preferred shares. The estimated market value of the assets is often determined
by making adjustments to the book value( carrying value) of assets and liabilities.

Dividends: Background for the Dividend Discount Model
 A dividend is a distribution paid to shareholders based on the number of shares owned, and a
cash distribution made to a company’s shareholders
 Cash dividends are typically paid out regularly at known intervals
 An extra dividend or special dividend is a dividend that supplements regular cash dividends
with an extra payment
 Companies in cyclical industries and companies undergoing corporate and/or financial
restructuring are among those observed to use extra dividends
 The payment of dividends is not a legal obligation: dividends must be declared (i.e., authorized)
by a company’s board of directors or they must also be approved by shareholders
 Dividend paid could be annually, Quarterly or semi-annually

 A stock dividend (also known as a bonus issue of shares) is a type of dividend in which a
company distributes additional shares of its common stock (typically, 2%–10% of the shares then
outstanding) to shareholders instead of cash. A stock dividend divides the “pie” (the market
value of shareholders’ equity) into smaller pieces without affecting the value of the pie or
proportional ownership
 A stock split involves an increase in the number of shares outstanding with a consequent
decrease in share price. An example a two-for-one stock split in which each shareholder is
issued an additional share
 A reverse stock split involves a reduction in the number of shares outstanding with a
corresponding increase in share price. In a one-for-two reverse stock split, each shareholder
would receive one new share for every two old shares held

 A share repurchase (or buyback) is a transaction in which a company uses cash to buy back its
own shares. Shares that have been repurchased are not considered for dividends, voting, or
computing earnings per share
key reasons for engaging in share repurchases
(1) Signaling shares are undervalued
(2) Flexibility in the amount and timing of distributing cash to shareholders
(3) Tax efficiency in markets where tax rates on dividends exceed tax rates on capital gains, and
(4) Ability to absorb increases in outstanding shares because of the exercise of employee stock
options

Declaration date: the day that the company issues a statement declaring a specific
dividend.
Ex-dividend date (or ex-date) The first date that a share trades without (i.e., “ex”) the
dividend. This is followed closely (one or two business days later) by the holder-of-record
date (also called the owner-of-record date), the date that a shareholder listed on the
company’s books will be deemed to have ownership of the shares for purposes of receiving
the upcoming dividend
Payment date (or payable date): the day that the company actually mails out (or
electronically transfers) a dividend payment to shareholders.

PRESENT VALUE MODELS: THE DIVIDEND DISCOUNT MODEL
If the issuing company is assumed to be a going concern, the intrinsic value of a share is the
present value of expected future dividends
If a constant required rate of return is also assumed, then the DDM expression for the intrinsic
value of a share is
V0 estimated as
Terminal stock value: The expected value of a share at the end of the investment horizon—in
effect, the expected selling price. Also called terminal value
Price = PV of Future Dividends + PV of Terminal Value

DDM(Single Holding Period)

DDM(Multiple Holding Period)

DDM(Multiple Holding Period)
V0=1.818+1.736+1.653+2.391+2.328+24.837
V0=$34.76
Using Financial Calculator
CF0=0 (press enter) [Press down Key]
CF1= 2 (press enter) [Press down Key twice]
CF2= 2.1 (press enter) [Press down Key twice]
CF3=2.2 (press enter) [Press down Key twice]
Press NPV
Interest =10
Press CPT and NPV
NPV=34.76

Present Value Model:FCFE Model
 For non-dividend-paying use of Dividend Discount model is typically difficult, so in such cases,
analysts often resort to FCFE models
 FCFE starts with the calculation of cash flow from operations (CFO). CFO is simply defined as
net income plus non-cash expenses minus investment in working capital. FCFE is a measure of
cash flow generated in a period that is available for distribution to common shareholders
FCFE = CFO – FCInv + Net borrowing
Value = PV of all future FCFE

Required rate of return Calculation
To estimate the required rate of return on a share, analysts frequently use the capital asset
pricing model (CAPM):
 Bond Yield Plus Risk Premium method: it is computed by using an appropriate risk-free rate
(usually a government bond) and adding a risk premium to the yield on the company’s bonds

Preferred Stock Valuation
For a non-callable, non-convertible perpetual preferred share paying a constant divided D and
assuming a required rate of return
V=D/r
For example, a $100 par value non-callable perpetual preferred stock offers an annual dividend of
$5.50. If its required rate of return is 6 percent, the value estimate would be $5.50/0.06 = $91.67

The Gordon Growth Model

Assumption of Gordon Growth Model
The assumptions of the Gordon model are as follows:

1. Dividends are the correct metric to use for valuation purposes.
2. The Dividend growth rate is perpetual
3. The required rate of return is also constant over time
4. The growth rate is less than the required rate of return

Example of Gordon growth Model
A company does not currently pay a dividend but is expected to begin to do so in five years (at t =
5). The first dividend is expected to be $4.00 and to be received five years from today. That
dividend is expected to grow at 6 percent into perpetuity. The required return is 10 percent.
What is the estimated current intrinsic value?
$0 $0 $0 $0 $4
The value is $65.818:

Two stage DDM
 The company is assumed to experience an initial, finite period of high growth, perhaps prior to
the entry of competitors, followed by an infinite period of sustainable growth
 The two-stage DDM thus makes use of two growth rates: a high growth rate for an initial, finite
period followed by a lower, sustainable growth rate into perpetuity
 The Gordon growth model is used to estimate a terminal value at time n that reflects the
present value at time n of the dividends received

Two Stage DDM
Stable Growth
High growth
Stable Growth Two-Stage growth

Two-Stage Dividend Discount Model
Example: A company forecasts that the current dividend of €0.40 will grow by 9
percent per year during the next 5 years. Thereafter, it believes that the growth
rate will decline to 5 percent and remain at that level indefinitely. Compute
Intrinsic value if required return is 7%
0.436 0.475 0.518 0.565 32.93


CF0=0 (press enter) Press down key

CF1=0.436 (press enter) Press down key twice
CF2= 0.475 (press enter) Press down key twice
CF3=0.518 (press enter) Press down key twice
Press NPV
Interest=7 (press enter) Press
Press CPT
NPV=25.15
Three stage DDM
Three-stage DDM: three-stage DDM would be most appropriate for a fairly
young companywhich makes use of three growth rates: a high growth rate
for an initial finite period, followed by a lower growth rate for a finite
second period, followed by a lower, sustainable growth rate into perpetuity
High Growth
Transition
Stable growth
Three stage growth

Three-Stage Dividend Discount Models
Example: IBM (as of early 2013) pays a dividend of $3.30 per year. An analyst makes the following
estimates:
the current required return on equity for IBM is 9 percent, and dividends will grow at 14 percent
for the next two years, 12 percent for the following three years, and 6.75 percent thereafter.
Based only on the information given, estimate the value of IBM using a three-stage DDM
approach.
3.762 4.29 4.80 5.38 291.89

D1=3.3×1.14=3.76
D2=3.76×1.14=4.29
D3=4.29×1.12=4.80
D4=4.80×1.12=5.38
D5=5.38×1.12=6.03
V5=6.03×1.065/(.09-.065)
V5=285.87

CF0=0 (press enter) Press Down key
CF1=3.76 (press enter) Press Down key twice
Press NPV
Interest =9 (press enter) Press Down key
Scroll down press CPT
Press CPT and NPV
NPV=204.28

MULTIPLIER MODELS(Based on Comparables)
Price Multiple: A ratio that compares the share price with some sort of monetary flow or value to
allow evaluation of the relative worth of a company’s stock
 If the ratio falls below a specified value, the shares are identified as candidates for purchase,
and if the ratio exceeds a specified value, the shares are identified as candidates for sale
 A common criticism of all of these multiples is that they do not consider the future. This
criticism is true if the multiple is calculated from trailing or current values of the divisor
 Counter this criticism by using forward (leading or prospective) price multiples
 Such ratios include those used to analyze business performance and financial condition based
on data reported in financial statements

MULTIPLIER MODELS(Based on Comparables)
Justified Price Multiple: A price multiple is often related to fundamentals through a discounted
cash flow model, however, such as the Gordon growth model.

PRESENT VALUE MODELS
Gordon Growth Model
Retention Ratio

PRESENT VALUE MODELS
Justified Trailing P/E=Justified Forward P/E × (1+growth)

MULTIPLIER MODELS
Justified trailing=justified leading × (1+g)
P/E is inversely related to the required rate of return
Positively related to the growth rate
Dividend displacement of earnings: Higher pay out ratio may imply a slower
growth rate as a result of the company retaining a lower proportion of earnings
for reinvestment

The Method of Comparables
This method essentially compares relative values estimated using multiples or the relative
values of multiples. The economic rationale underlying the method of comparables is the law of
one price
Using a price multiple to evaluate whether an asset is fairly valued, undervalued, or overvalued
in relation to a benchmark value of the multiple
Choices for the benchmark multiple include the multiple of a closely matched individual stock or
the average or median value of the multiple for the stock’s industry

Enterprise value multiple
EBITDA is calculated prior to payment to any of the company’s financial
stakeholders, using it to estimate enterprise value is logically appropriate
If market values are not available use Book value of debt
EBITDA is proxy for cash flow
Other denominators such as operating income can also be used

Enterprise value multiple
EBITDA is a proxy for operating cash flow because it excludes depreciation and amortization
P/E is problematic because of negative earnings, In EV/EBITDA multiple EBITDA is usually
positive
Alternative to using EBITDA in EV multiples is to use operating income
Substituting the book value of debt for the market value of debt provides only a rough estimate
of the debt’s market value

ASSET-BASED VALUATION
Asset-based valuations work well for companies that do not have a high proportion of intangible
or off the books assets and that do have a high proportion of current assets and current
liabilities
Commonly used for valuing private enterprises
Important facts that the practitioner should realize are as follows:
1.Companies with assets that do not have easily determinable market (fair) values such as
property, plant, and equipment are very difficult to analyze
2.Asset and liability fair values can be very different from the values at which they are carried on
the balance sheet of a company.
3.Some intangible assets may not be shown on the books, analyst can give a “floor” value for a
situation involving a significant amount of intangibles.
4.Asset values may be more difficult to estimate in a hyper-inflationary environment.
Equity Valuation Models
Multiplier Asset
Models Based
 Price to Valuation
Earning
Multiple Models
 Enterprise  Adjustment
value to Book
multiple Value

7.Cost of Capital
COST OF CAPITAL
COST OF CAPITAL: The rate of return that suppliers of capital require as compensation for their
contribution of capital
 A potential supplier of capital will not voluntarily invest in a company unless its return meets or
exceeds what the supplier could earn elsewhere
 A company typically has several alternatives for raising capital, including issuing equity, debt
and preference share
Weighted average cost of capital: A weighted average of the after tax required rates of return on
a company’s common stock, preferred stock, and long-term debt, where the weights are the
fraction of each source of financing in the company’s target capital structure.

COST OF CAPITAL
WACC = wdrd(1 – t) + wprp + were
Example: ABC Corporation has the following capital structure: 30 percent debt, 10 percent preferred stock, and 60 percent
equity. Its before-tax cost of debt is 8 percent, its cost of preferred stock is 10 percent, and its cost of equity is 15 percent. If
the company’s marginal tax rate is 40 percent, what is ABC’s weighted average cost of capital?
Solution Always take

marginal tax rate
The weighted average cost of capital is
not average tax
WACC = (0.3)(0.08)(1 – 0.40) + (0.1)(0.1) + (0.6)(0.15) rate
= 11.44 %

COST OF CAPITAL
Sales 100 100
Cost 40 40
G/P 60 60
Less S,G&A 20 20
Operating Profit 40 40
Less Interest 10 0
Profit before tax 30 40
Less Tax(30%) 9 12
Net Income 21 28
Tax shield Provided by Interest

WEIGHTS OF THE WEIGHTED AVERAGE
 If we assume that a company has a target capital structure and raises capital consistent with
this target, we should use this target capital structure
 The target capital structure is the capital structure that a company is striving to obtain
If Target Capital Structure is Unknown use the following approaches:
1. Assume the company’s current capital structure, at market value weights for the
components
2. Examine trends in the company’s capital structure or statements by management regarding
capital structure policy to infer the target capital structure
3. Use averages of comparable companies’ capital structures as the target capital structure
Never Take Book weights of Debts Equity and Preference shares

INVESTMENT OPPORTUNITY SCHEDULE
Investment opportunity schedule:A graphical depiction of a company’s investment opportunities

ordered from highest to lowest expected return. A company’s optimal capital budget is found
where the investment opportunity schedule intersects with the company’s marginal cost of
capital.

INVESTMENT OPPORTUNITY SCHEDULE
 The cost of capital reflect the riskiness of the future cash flows of the project, product, or
division
 For an average-risk project, the opportunity cost of capital is the company’s WACC. If the risk of
the project is above or below average relative to the company’s current portfolio of projects, an
upward or downward adjustment, respectively, is made to the company’s WACC

COST OF DEBT
1. Cost of Debt: The cost of debt financing to a company, such as when it issues a bond or takes
out a bank loans
There are two methods to estimate the cost of debt, rd:
a) the yield-to-maturity approach :
The yield to maturity (YTM) is the annual return that an investor earns on a bond if the investor
purchases the bond today and holds it until maturity.
It is the yield, rd, that equates the present value of the bond’s promised payments to its market
price

YIELD TO MATURITY
P = the current market price of the bond

C = the interest payment in period t
r = the yield to maturity
n = the number of periods remaining to maturity
F = the maturity value of the bond

DEBT-RATING APPROACH
B) Debt-Rating Approach: A method for estimating a company’s before-tax cost
of debt based upon the yield on comparably rated bonds for maturities that
closely match that of the company’s existing debt
Suppose a company’s capital structure includes debt with an average maturity
of 10 years and the company’s marginal tax rate is 35 percent. If the
company’s rating is AAA and the yield on debt with the same debt rating and
similar maturity is 4 percent, the company’s after-tax cost of debt is
rd(1 – t) = 4 percent(1 – 0.35) = 2.6 %

COSTS OF THE DIFFERENT SOURCES OF CAPITAL

The dividend on preferred stock is not tax-deductible by the company;
therefore, there is no adjustment to the cost for taxes
Example: Alcoa has one class of preferred stock outstanding, a $3.75

cumulative preferred stock, If the price of this stock is $72, what is the estimate
of Alcoa’s cost of preferred equity?
Solution:
Cost of Alcoa’s preferred stock = $3.75/$72.00 = 5.21%

3. Cost of Common Equity: is the rate of return required by a company’s
common shareholders.
 A company may increase common equity through the reinvestment of
earnings or through the issuance of new shares of stock
 The estimation of the cost of equity is challenging because of the uncertain
nature of the future cash flows in terms of the amount and timing

COST OF EQUITY
Cost of Equity
Bond Yield plus Risk

Capital Asset Pricing Dividend Discount Premium Approach
Model Approach Model Approach
E(Ri)=RF+βi[E(RM)−RF] re = rd + Risk premium

CAPITAL ASSET PRICING MODEL APPROACH
A. Capital Asset Pricing Model Approach: expected return on a stock, E(Ri), is the sum of the
risk-free rate of interest, RF, and a premium for bearing the stock’s market risk, βi(RM − RF)
E(Ri)=RF+βi[E(RM)−RF]
βi = the return sensitivity of stock i to changes in the market return
E(RM) = the expected return on the market
E(RM) − RF = the expected market risk premium

A risk-free asset is defined as an asset that has no default risk

A common proxy for the risk-free rate is the yield on a default-free government debt instrument
Example: Risk-free rate is 5 percent, equity risk premium is 7 percent, and Company’s equity beta
is 1.5. What is Company’s cost of equity using the CAPM approach?
Solution:
Cost of common stock = 5 percent + 1.5(7 percent) = 15.5 %

E(RM − RF), is the premium that investors demand for investing in a market portfolio relative to
the risk-free rate
Equity risk premium:The expected return on equities minus the risk-free rate; the premium that
investors demand for investing in equities
Multifactor model that incorporates factors that may be other sources of priced risk (risk for
which investors demand compensation for bearing), including macroeconomic factors and
company-specific factors
E(Ri)=RF+βi1(Factor risk premium)1+βi2(Factor risk premium)2+…+βij(Factor risk premium)j

WAYS TO ESTIMATE THE EQUITY RISK PREMIUM
i. Historical equity risk premium approach: An estimate of a country’s equity risk premium
that is based upon the historical averages of the risk-free rate and the rate of return on the
market portfolio
For example, an analyst might use the historical returns to the TOPIX Index to estimate the risk
premium for Japanese equities



DIVIDEND DISCOUNT MODEL APPROACH

DIVIDEND DISCOUNT MODEL APPROACH
There are two ways to estimate the growth rate:
i. To use a forecasted growth rate from a published source
ii. Use a relationship between the growth rate, the retention rate, and the
return on equity
Sustainable growth rate:The rate of dividend (and earnings) growth that can be
sustained over time for a given level of return on equity, keeping the capital
structure constant and without issuing additional common stock
G = (1 – Dividend Payout ratio)×ROE
Retention ratio

BOND YIELD PLUS RISK PREMIUM APPROACH
An estimate of the cost of common equity that is produced by summing the
before-tax cost of debt and a risk premium that captures the additional yield
on a company’s stock relative to its bonds
re = rd + Risk premium
This risk premium is forward looking, representing the additional risk
associated with the stock of the company as compared with the bonds of the
same company

THE REQUIRED RETURN ON EQUITY
Beta Estimation for a Public Company: The simplest estimate of beta results from an ordinary
least squares regression of the return on the stock on the return on the market. The actual values
of beta estimates are influenced by several choices:
a) The choice of the index used to represent the market portfolio
b) The length of data period(time) and the frequency of observations. The most common
choice is five years of monthly data, yielding 60 observations
Smoothing Technique/Mean reversion: Some analysts adjust historical betas to reflect the
tendency of betas to revert to 1.
Adjusted beta = (2/3)(Unadjusted beta) + (1/3)(1.0)
Adjusted beta = 0.667×(Unadjusted beta) + 0.333

BETA ESTIMATION FOR THINLY TRADED STOCKS
AND NON PUBLIC COMPANIES
Pure-play method: A method for estimating the beta for a company or project;
it requires using a comparable company’s beta and adjusting it for financial
leverage differences.
The analyst can estimate indirectly the beta of the nonpublic company (eg Jio)
on the basis of the public peer’s beta (eg Airtel).
The procedure must take into account the effect on beta of differences in
financial leverage between the nonpublic company and the benchmark
First, the benchmark beta is unlevered to estimate the beta of the
benchmark’s assets—reflecting just the systematic risk arising from the
economics of the industry
Then, the asset beta is re-levered to reflect the financial leverage of the
nonpublic company.

BETA ESTIMATION FOR THINLY TRADED STOCKS
AND NON PUBLIC COMPANIES
Beta asset Beta Equity
Beta Project

COUNTRY RISK
 Beta does not appear to adequately capture country risk for companies in
developing nations
 A common approach for dealing with this problem is to adjust the cost of
equity estimated using the CAPM by adding a country spread to the market
risk premium
 Calculate the country risk premium as the product of the sovereign yield
spread and the ratio of the volatility of the developing country equity market
to that of the sovereign bond market denominated in terms of the currency of
a developed country
Sovereign yield spread: is the difference between a government bond yield in
the country being analyzed(Example India), denominated in the currency of the
developed country, and the Treasury bond yield on a similar maturity bond in
the developed country(Example USA).

COUNTRY RISK

MARGINAL COST OF CAPITAL SCHEDULE
 The costs of the different sources of capital may change, resulting in a change in
the weighted average cost of capital for different levels of financing. The result is
the marginal cost of capital (MCC) schedule
 As the company experiences deviations from the target capital structure, the
marginal cost of capital may increase, reflecting these deviations

Amount of New After tax cost of Amount of New Equity Cost of Equity
Debt Debt
New Debt<2 million 2% New Equity<6 million 5%
2<New Debt<5 2.5% 6<New Equity<10 7%

million million
5 million < New 3% 10 million < New 9%

Debt Equity

For example, the first break point for debt financing is reached with €2
million/0.4 = €5 million of new capital raised. The first break point attributed to a
change in equity cost occurs at €6 million/0.6 = €10 million

FLOTATION COST
Flotation Cost: Fees charged to companies by investment bankers and other costs
associated with raising new capital

FLOTATION COST

FLOTATION COST
The weighted average cost of capital is 7.2 percent calculated as 0.40(3 percent) +
0.60(10 percent)
NPV = €69,591 – €61,800 = €7,791

8.Fixed Income Securities: Defining
Elements
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Introduction to Fixed Income Securities
Fixed Income Security is an instrument that allows governments, companies, and other types of
issuers to borrow money from investors
Bond: Contractual agreement between the issuer and the bondholders
The payment by issuer of security (most common among them is bond) may consist
 Interest/coupon payment
 Principal repayment
Cash flow of Plain Vanilla Bond

Indentures and Covenants
 Bond Indenture/Trust Deed: Legal contract that describes the form of a bond, the obligations
of the issuer, and the rights of the bondholders
 Trustee: trustee’s role is to monitor that the issuer complies with the obligations specified in
the indenture and to take action on behalf of the bondholders
 Bond covenants: are legally enforceable rules that borrowers and lenders agree on at the
time of a new bond issue
An Indenture will frequently include affirmative (or positive) and negative covenants

Covenant
Covenant
Affirmative Covenant Negative Covenant
 Restrictions on debt regulate the

 The issuer may also issue of additional debt
promise to comply with  Prevent the issuance of debt that
all laws and regulations would be senior existing debt
 Maintain its current lines  Restrictions on
of business investments constrain risky
 Insure and maintain its investments by blocking speculative
assets investments
 Pay taxes as they come  Restrictions on distributions to
due shareholders restrict dividends and
other payments to shareholders

Basic Features: Par Value, Maturity
 Par Value: It is the amount the issuer agrees to repay to the bondholder on the maturity date.
It is also termed as face value, maturity value, redemption value, or principal.
Bond prices are quoted as a percentage of their par value. For example, assume that a bond’s par
value is $1,000. A quote of 95 means that the bond price is $950 (95% × $1,000)
A bond may be issued above (premium) or below (discount) its par value.
 Maturity : The maturity date of a bond refers to the date when the issuer is obligated to
redeem the bond by paying the principal amount
Bond with original maturity of < = 1 year  Money market
Bond with original maturity of > 1 year  Capital market

Basic Features: Coupon Payments
 Coupon Rate: It is the interest rate that the issuer of the bond agrees to pay each year to the
bondholder.
 Coupon: The amount of interest payments made is called the coupon
 Calculation of coupon:
Coupon = Coupon Rate x Par Value
For example, a bond with a coupon rate of 6% and a par value of $1,000 will pay annual interest
of $60 (6% × $1,000)
 Zero Coupon Bond (ZCB): Bonds that do not pay interest during the bond’s life. It is issued at a
discount to par value and redeemed at par. Also called pure discount bonds
For example, if the par value is $1,000 and the purchase price is $950, the implied interest is $50
 Step up Note: Bond for which the coupon, increases by specified margins at specified dates

Basic Features: Coupon Payments
Deferred Coupon Bonds/Split Coupon Bonds
 Pays no coupons for its first few years but then pays a higher coupon than it otherwise
normally would for the remainder of its life
 Deferred coupon bonds common in project when the assets being developed do not
generate any income during the development phase
Floating-Rate Securities
 Floating-rate notes do not have a fixed coupon; instead, their coupon rate is linked to an
external reference rate, such as Libor
 The spread, also called margin, is typically constant and expressed in basis points (bps)
 There are 100 basis points in 1%
 E.g. Coupon Rate = 1-month LIBOR + 50 basis points. If 1-month LIBOR is 6%, then the
coupon rate is 6.5%.

Coupon rate - Floating-Rate Securities
CAP: Prevents the coupon from rising above a specified maximum rate
Eg. The coupon rate is calculated by formula:
Coupon rate =
10-year Treasury rate + 100 basis points,
Suppose the cap is 7.5%. If the 10-year Treasury rate is 7%, the coupon rate by the formula would
be 8%(7%+1%).Since the cap is 7.5%, the coupon paid will be 7.5%.
A ‘CAP’ benefits the issuer, because it sets a limit to the interest rate paid
on the debt during a time of rising interest rates

Coupon rate- Floating-Rate Securities
FLOOR: Prevents the coupon from falling below a specified minimum rate
Eg. The coupon rate is calculated by formula:
Coupon rate =
10-year Treasury rate + 100 basis points, and the floor is 7%. If the 10-year Treasury rate is 7%,
the coupon rate by the formula would be 6.5%. But as the floor is at 7%, the coupon rate paid will
be 7% instead of 6.5%.
A ‘FLOOR’ is benefits the bondholders, who are guaranteed that the

interest rate will not fall below the specified rate during a time of falling
interest rates.

Coupon Rate - Floating-Rate Securities
Inverse Floaters: is a bond whose coupon rate has an inverse relationship to the reference rate
 When interest rates fall, the coupon rate on an ordinary FRN decreases
 The coupon rate on a reverse FRN increases
 Inverse FRNs are typically favored by investors who expect interest rates to decline.
Credit-linked Coupon Bonds

 Bond for which the coupon changes when the bond’s credit rating changes
Example: Bond has a coupon rate of 9%, but the coupon will increase by 50 bps for every
credit rating downgrade below the bond’s credit rating at the time of issuance and will
decrease by 50 bps for every credit rating upgrade above the bond’s credit rating at the
time of issuance

Coupon Payment – floating rate securities
Payment-in-kind (PIK) bonds
 Allows the issuer to pay interest in the form of additional amounts of the bond issue rather
than as a cash payment
Index-linked bonds
 Bond for which coupon payments and/or principal repayment are linked to a specified
index
Inflation-linked bonds
 Example of index-linked bonds
 They offer investors protection against inflation by linking a bond’s coupon payments
and/or the principal repayment to an index of consumer prices such as the UK Retail Price
Index (RPI) or the US Consumer Price Index (CPI)
 US Treasury began introducing Treasury inflation-protected securities (TIPS)

Currency Bonds: Regulatory and Legal Considerations
 Dual-currency bond: Bonds that make coupon payments in one currency and pay the par
value at maturity in another currency
 Currency option bond: Bonds that give the bondholder the right to choose the currency in
which he or she wants to receive interest payments and principal repayments
 Domestic bond: Bonds issued in a particular country in local currency are domestic bonds
 Foreign bond: they are issued by entities incorporated in another country
 Euro Bond – Type of bond issued internationally, outside the jurisdiction of the country in
whose currency the bond is denominated
For example, Eurodollar and Euroyen bonds are denominated in US dollars and Japanese
yens, respectively

Collateral and credit enhancement: Regulatory and Legal
Considerations
 Secured : Bonds secured by assets or financial guarantees pledged to ensure debt repayment
in case of default
 Unsecured : have no collateral; bondholders have only a general claim on the issuer’s assets
and cash flows
 Covered bond: Debt obligation secured by a segregated pool of assets called the cover pool.
The issuer must maintain the value of the cover pool. In the event of default, bondholders
have recourse against both the issuer and the cover pool

Collateral and credit enhancement: Regulatory and Legal
Considerations
 Credit Enhancement ( reduce the credit risk of a bond issue)
Internal
i. Over-collateralization (posting more collateral than needed to obtain or secure financing)
ii. Reserve accounts (creating accounts and depositing in these accounts cash that can be used to absorb
losses)
iii. Subordination(cash flows generated by the assets are allocated with different priority to tranches of
different seniority)
External –
i. Surety bond: reimburse bondholders for any losses incurred if the issuer defaults
ii. Letter of credit: financial institution provides the issuer with a credit line to reimburse any cash
flow shortfalls from the assets backing the issue
iii. Cash collateral account: whereby the issuer immediately borrows the credit-enhancement
amount and then invests that amount, usually in highly rated short-term commercial paper

Credit enhancement
Credit
Enhancement
Internal Credit External Credit

Enhancement Enhancement
Over Reserve
Subordination collateralization accounts Letter of Cash Collateral a/c
Surety Bond
credit

Legal and Regulatory Considerations
Bearer bonds: Bonds for which ownership is not recorded; only the clearing system knows who
the bond owner is
Registered bonds: Bonds for which ownership is recorded by either name or serial number
 Interest income received by holders of local government bonds called municipal bonds in the
United States is often exempt from federal income tax
Tax Considerations:
 Income portion of a bond investment is taxed at the ordinary income tax rate, which is typically
the same tax rate that an individual would pay
 A capital gain or loss is usually treated differently from taxable income, the tax rate for long-
term capital gains is lower than the tax rate for short-term capital gains, and the tax rate for
short-term capital gains is equal to the ordinary income tax rate

Provisions for paying off bonds
Bullet Bonds: Large payment required at maturity to retire a bond’s outstanding principal amounts
Amortizing Securities: Payment schedule that calls for periodic payments of interest and repayments of
principal
 A bond that is fully amortized is characterized by a fixed periodic payment schedule that reduces the
bond’s outstanding principal amount to zero by the maturity date
Sinking fund provision: Provision that reduces the credit risk of a bond issue by requiring the issuer to retire
a portion of the bond’s principal outstanding each year, an issuer’s plans to set aside funds over time to
retire the bond

BONDS WITH CONTINGENCY PROVISIONS
Callable bond: A bond containing an embedded call option that gives the issuer the right to buy the bond
back from the investor at specified prices on pre-determined dates
American : The issuer has the right to call a bond at any time after first call date
European : The issuer has the right to call a bond at any time only once on the call date
Bermuda: Issuer has the right to call bonds on specified dates following the call protection period

Putable Bonds: Bonds that give the bondholder the right to sell the bond back to the issuer at a
predetermined price on specified dates
 The price of a putable bond will be higher than the price of an otherwise similar bond issued
without the put provision
 If interest rates rise after the issue date, thus depressing the bond’s price, the bondholders can
put the bond back to the issuer and get cash

Convertible Bonds: Bond that gives the bondholder the right to exchange the bond for a
specified number of common shares in the issuing company
 Because the conversion provision is valuable to bondholders, the price of a convertible bond is
higher than the price of an otherwise similar bond without the conversion provision
Conversion price: For a convertible bond, the price per share at which the bond can be converted
into shares
Conversion ratio: the number of common shares that each bond can be converted into
Conversion value: the current share price multiplied by the conversion ratio

9.Introduction to the Fixed-Income
Valuation
Valuation - General
 Valuation: Bond pricing is an application of discounted cash flow analysis.
 General Principals of Valuation
use a discount rate that correspond to the timing of the future cash flows.
 Steps of valuation of financial asset:
2
• Expected cash flow • Calculation of present
estimation value of expected cash
• In case of fixed income • Determination of an flows by discounting it
security – Coupon and appropriate discount with the discount rate.
principal repayment rate.
• Usually prevailing
market interest rate
1 3

BOND PRICES AND THE TIME VALUE OF MONEY
Bond Pricing with a Market Discount Rate

 For a fixed-rate bond, the promised future cash flows are a series of coupon interest payments
and repayment of the full principal at maturity
 The coupon payments are on regularly scheduled dates
 For example, an annual payment bond might pay interest on 15 June of each year for five
years. The final coupon typically is paid together with the full principal on the maturity date. The
price of the bond at issuance is the present value of the promised cash flow
Market discount rate: The rate of return required by investors given the risk of the investment in
a bond; also called the required yield or the required rate of return
Par value: The amount of principal on a bond

Valuation - Example
What would be the present value of a 5 year bond with coupon rate of 6% and par value of
Rs.20000. Assume the yield on the treasury bond of same maturity is 5.5%.
Solution:
Full (Dirty) price = Flat (clean price) + Accrued interest
T=0 T=1 T=2 T=3 T=4 T=5

Cash Flows (to be discounted to T=0) 6% Coupon 6% Coupon 6% Coupon 6% Coupon 6% Coupon+Principal

For example, suppose the coupon rate on a bond is 4% and the payment is made once a year. If
the time-to-maturity is five years and the market discount rate is 6%,
$40 $40 $40 $40 $1040
The price of the bond is 915.75 per 100 of par value


40  PMT
1000  FV
6  I/Y
5N
Press CPT + PV
PV=-915.75

For example, Suppose that another five-year bond has a coupon rate of 8% paid annually. If the
market discount rate is again 6%,
$80 $80 $80 $80 $1080
The price of the bond is 1084.25 per 100 of par value

This bond is trading at a premium because its price is above par value


80  PMT
1000  FV
6  I/Y
5N
Press CPT + PV
PV=-1084.25

For example, Suppose that another five-year bond has a coupon rate of 6% paid annually. If the
market discount rate is again 6%,
$60 $60 $60 $60 $1060
The price of the bond is 1000

This bond is trading at a par because its price is equal par value


60  PMT
100  FV
6  I/Y
5N
Press CPT + PV
PV=-1000

Coupon =Market rate Par

Coupon>Market rate Premium
Coupon<Market rate Discount

Present Value Properties
 Price Discount-Rate Relationship:

Par Value = Rs.1000; Coupon Rate = 5%, Maturity Period = 5 yrs.
The price of a bond and market interest rate (i.e. discounting rate) have inverse
relation

A $1000 face value 3 year bond pays coupon of 10%. Find the price of the bond at yields of 8%,
10% and 12%
At 8%
The bond price is
1,051.54 = 100 + 100 + 100+1000 inversely related to
(1+0.08)1 (1+0.08)2 (1+0.08)3 the market discount
rate. When the
At 10%
market discount rate
increases, the bond
1,000.00 = 100 + 100 + 100+1000
price decreases
(1+0.10)1 (1+0.10)2 (1+0.10)3
At 12%
951.96 = 100 + 100 + 100+1000

(1+0.12) 1 (1+0.12) 2 (1+0.12)3

 Bond prices change as time passes even if the market discount rate remains the same
 The bondholder comes closer to receiving the par value at maturity
Time to maturity Yield = 8% Yield = 10% Yield = 12%

3 years 1,051.54 1,000.00 951.96
2 years 1,035.67 1,000.00 966.20
1 year 1,018.52 1,000.00 982.14
0 year 1,000.00 1,000.00 1,000.00

Bond Price and Bond Characteristics
The bond price is inversely related to the market discount rate. When the market discount rate
increases, the bond price decreases
For the same coupon rate and time-to-maturity, the percentage price change is greater when the
market discount rate goes down than when it goes up
 For the same time-to-maturity, Lower (higher) the coupon rate  Higher (lower) the
percentage price change in Bond’s value
 Change in price of bond with 10% coupon will be lesser than change in price of bond with
8% coupon
 For the same coupon rate, Longer (Shorter) the maturity period  greater percentage price
change
Change in price of bond having 10 years maturity period will be higher than change in price of
bond having 3 years of maturity

Flat Price, Accrued Interest, and the Full Price
 When a bond is sold between coupon payment dates, its price has two parts: the flat price (PV
Flat) and the accrued interest (AI). The sum of the parts is the full price (PV Full), which also is
called the invoice or “dirty” price
 The flat price, which is the full price minus the accrued interest, is also called the quoted or
“clean” price
 The flat price usually is quoted by bond dealers. If a trade takes place, the accrued interest is
added to the flat price to obtain the full price paid by the buyer and received by the seller on the
settlement date. The settlement date is when the bond buyer makes cash payment and the
seller delivers the security

Accrued Interest convention

Matrix Pricing
Matrix pricing: If the market price for bond is not available, estimate the market discount rate and price based
on the quoted or flat prices of more frequently traded comparable bonds. These comparable bonds have
similar times-to-maturity, coupon rates, and credit quality
Example: Pricing an illiquid bond
An analyst needs to assign a value to an illiquid four-year, 4.5% annual coupon payment corporate bond. The
analyst identifies two corporate bonds that have similar credit quality:One is a three-year, 5.50% annual
coupon payment bond priced at 107.500 per 100 of par value, and the other is a five-year, 4.50% annual
coupon payment bond priced at 104.750 per 100 of par value. Using matrix pricing, the estimated price of the
illiquid bond
Answer
The first step is to determine the yields-to-maturity on the observed bonds. The required yield on the three-
year, 5.50% bond priced at 107.500 is 2.856%

Matrix Pricing
The required yield on the five-year, 4.50% bond priced at 104.750 is 3.449%
The estimated market discount rate for a four-year bond having the same credit quality is the
average of two required yields:
(2.856+3.449)/2 =3.1525%
Given an estimated yield-to-maturity of 3.1525%, the estimated price of the illiquid four-year,
4.50% annual coupon payment corporate bond is 1049.91

Yield Measures for Floating-Rate Notes
 The interest payments on a floating-rate note, which often is called a floater or an FRN, are not fixed.
 They Interest/Coupon payment vary from period to period depending on the current level of a reference
interest rate. The interest payments could go up or down
 A floater has a stable price even in a period of volatile interest rates.
 In a traditional fixed-income security, interest rate volatility affects the price because the future cash flows
are constant. With a floating-rate note, interest rate volatility affects future interest payments
 The reference rate on a floating-rate note usually is a short-term money market rate, such as three-month
Libor (the London Interbank Offered Rate)

Yield Measures for Floating-Rate Notes
Quoted margin:The specified yield spread over the reference rate, used to compensate an investor for the
difference in the credit risk of the issuer and that implied by the reference rate
Required margin(Discount margin):The yield spread over, or under, the reference rate such that an FRN is priced
at par value on a rate reset date
Credit Quality Quotes margin< Discounted Margin  Discount to par
Credit Quality Quotes margin> Discounted Margin  Premium to par

Floating Rate Notes (FRNs) Yields
Hero MotoCorp has issued a $ 100,000 semi-annual face value Floating Rate Bond with 3 year
maturity, where the reference rate is LIBOR and a quoted margin of 75 bps.
Today the LIBOR rate is 6.25% and the required yield on such bond is 90 bps. Compute the price
of the bond?
Solution:
Face Value: $ 100,000,
N = 6 periods (3 years semi-annual)
Coupon Rate: (6.25%+0.75%)/2 = 3.50%,
Coupon Amount (PMT): 100,000x3.5% = $3500 (every 6 months),

Floating Rate Notes (FRNs) Yields
Yield: (6.25%+0.90%)/2 = 3.70%

Price of the bond = $ 98,941 (N = 6, PMT = 3500, FV = $100,000 I/Y = 3.7%  CPT PV = -
98,941.26)
The bond value will change as the bond approaches the reset date (next semi-annum) of
reference rate
Day 0 – Rate is LIBOR (6.25%) + 90bps
Day 180 – Settlement of above coupon and Reset of rate for next period; First reset date – Rate
is LIBOR (at T-180 for 6 month) + 90 bps

Yield Measures for Money Market Instruments
• Annualized and compounded

Bond Market Yields • Calculated using standard time-value-of money
analysis
• Stated for a common periodicity for all times to-
maturity
Money Market • Annualized and stated on a simple interest basis

• Non-standard calculation; discount rates or add on
Yields rates
• Instruments with different times-to- maturity have
different periodicities for the annual rate

Yield Measures for Fixed-Rate Bonds
 An annualized and compounded yield on a fixed-rate bond depends on the assumed number of periods in the
year, which is called the periodicity of the annual rate
 A bond that pays semi-annual coupons has a stated annual yield-to-maturity for a periodicity of two
 A bond that pays quarterly coupons has a stated annual yield for a periodicity of four
 Most bonds in the United States make semi-annual coupon payments (periodicity of two), and yields (YTMs)
are quoted on a semi-annual bond basis, which is simply two times the semi-annual discount rate.
 It is necessary to adjust the quoted yield on a bond to make it comparable with the yield on a bond with a
different periodicity

Traditional Yield Measures
Types of Yield measures
 Current Yield
 Yield to Maturity
 Yield to call
 Yield to Put
 Yield to worst

Traditional Yield Measures
Current Yield: the sum of the coupon payments received over the year divided by the flat price
For example, a 10-year, 2% semiannual coupon payment bond is priced at 95 per 100 of par
value. Its current yield is 2.105%.

Yield-to-Maturity
Yield to maturity: Annual return that an investor earns on a bond if the investor purchases the bond today
and holds it until maturity. It is the discount rate that equates the present value of the bond’s expected cash
flows until maturity with the bond’s price. Also called yield-to-redemption or redemption yield
The yield-to-maturity has three critical assumptions:
I. The investor holds the bond to maturity
II. The issuer makes all of the coupon and principal payments in the full amount on the scheduled dates
III. The investor is able to reinvest coupon payments at that same yield

Yield-to-Maturity
Example
What would be YTM of 6% annual coupon Bond, with 5 year maturity having par value of $1,000
currently selling at Rs.979.2.
Solution:
60  PMT
1000  FV
-979.2  PV
5N
Press CPT + I/Y
I/Y=6.5

Yield to Maturity
Comparison of Semiannual-pay and Annual-pay bonds

 Given a YTM on an annual-pay bond, Different convention
Semi-annual bond basis (semi-annual effective rate) are followed in
different parts of the
= 2 [(1 + Yield on annual-pay bond)0.5 – 1] world for coupon
 Given a YTM on an annual-pay bond, payment. Some
follow annual
quarterly bond basis (quarterly effective rate)
payment and others
= 4 [(1 + Yield on annual-pay bond)0.25 )- 1] follow semi annual
payment.

Yield to Call
For a callable bond, an investor’s yield will depend on whether and when the bond is called.
The yield-to-call can be calculated for each possible call date and price
If a bond carries a callable option, then Yield to Call and Yield to Maturity are calculated. Yield to
Call is valuation upto the next Call date at Call Price.
 Yield to Worst:
 The lowest of yield-to-maturity and the various yields-to-call is termed the yield-to-worst
Assumptions:
• Investor will hold the bond to the
assumed call date.
• Issuer will call the bond on call date.

Example: Yield-to-call and yield-to-worst
Consider a 7-year, Annual-pay 8% bond trading at 1050 on January 1, 2014. The bond is callable according to the following
schedule: it is first callable at 1020 on the coupon payment date in four years, callable at 101 in five years
Calculate the bond’s YTM, yield-to-first call, yield-to-second call, and yield-to-worst.
Answer:
The yield-to-maturity on the bond is calculated as:
N = 7; PMT = 80; FV = 1,000; PV = –1,050; CPT → I/Y = 7.07%
7.07% = YTM
To calculate the yield-to-first call, we calculate the yield-to-maturity using the number of Annual periods until the first call
date (4) for N and the call price (1,020) for FV:
N = 4; PMT = 80; FV = 1,020; PV = –1,050; CPT → I/Y = 6.98%
6.98% = yield-to-first call

To calculate the yield-to-Second call, we calculate the yield-to-maturity using the number of
Annual periods until the Second call date (5) for N and the call price (1,010) for FV:
N = 5; PMT = 80; FV = 1,010; PV = –1,050; CPT → I/Y = 6.956%
6.956% = yield-to-Second call
The lowest yield, 6.956%, is realized if the bond is called at $1010, so the yield-to-worst is
6.956%.

Other Yields
 Street convention v/s True yield
Street convention - the internal rate of return on the cash flows assuming the payments are
made on the scheduled dates(neglect weekends and holidays )
True Yield – the internal rate of return on the cash flows using the actual calendar of weekends
and bank holidays
The true yield is never higher than the street convention yield because weekends and holidays
delay the time to payment
A government equivalent yield restates a yield-to-maturity based on 30/360 day-count to one
based on actual/actual.

Shape of yield curve
The graphical depiction of the relationship between the yield and maturity is known as yield
curve. The yield curve plots yields of bonds on the y-axis versus maturity on the x-axis
A yield curve is basically constructed on the basis of yields and maturities.
Types of yield curves: Upward sloping yield
curve:
Humped yield curve:
It indicates that
The longer maturity issues intermediate-term rates
have higher yields than are higher than both
the shorter maturity short-term and long-term
issues. This is a positively rates.
sloped or normal yield
curve. It is the most
common type of yield
curve.
Inverted: Flat yield curve:

Although it is less The yields across maturities
commonly observed, the may be so similar that the
yield curve can be yield curve is said to be flat
negatively sloped or
inverted, with
higher yields on the short
maturity Treasury
securities.

Spot Rate curve
 Spot rate curve: A sequence of yields-to-maturity on zero-coupon bonds

 Also zero or strip curve because coupon payments are “stripped” off of the bonds
 Spot rates are yields-to-maturity (or return earned) on zero coupon bonds maturing at the
date of each cash flow, if the bond is held to maturity
 Par curve: a sequence of yields-to-maturity such that each bond is priced at par value
 The bonds are assumed to have the same currency, credit risk, liquidity, tax status, and annual
yields stated for the same periodicity
 Forward rate: The interest rate on a bond or money market instrument traded in a forward
market
 Interpreted as an incremental, return for extending the time-to-maturity for an additional
time period

Arbitrage-free valuation approach
Facts
 Arbitrage-free approach: bond price (or value) determined using the spot rates is sometimes
referred to as the bond’s “no-arbitrage value.”
 The theoretical Treasury zero-coupon rates are called Treasury spot rates. These rates are
used to discount the cash flows to get the arbitrage-free value of a bond.
Steps of Arbitrage-free process

2
• Take each individual • Add up the value of each
cash flow of a coupon as zero to calculate the
a stand-alone zero- • Value each zero-coupon total value of the zero-
coupon bond. Each cash bond by discounting its coupon bond portfolio.
flow is the face value of cash flow at the
the corresponding zero. corresponding spot rate.
1 3

Arbitrage-free valuation approach
Example
Mr. Chandra is a dealer and he has invested in a 7% Treasury note with 1.5 years of maturity. Spot
rates are: 4%, 1 year = 5% and 2 year = 6%. If the note is selling for Rs.1020, compute the
arbitrage profit?
Solution:
Cash Flows = Rs.35, Rs.35 and Rs.1035
PV of cash flows using the spot rates
= (35/1.02) + (35/1.0252) + (1035/1.033)
= Rs.1014.8
Therefore, Arbitrage profit = 1020 – 1014.8 = Rs.5.20

Forward Rates
Facts
 It refers to the interest rate on a loan beginning some time in the future.
 Notion used for indicate forward rates include both the length of the lending/borrowing
period and the when the money will be lent/borrowed
 2y1y  1- year loan two-years from now
 3y2y 2-years loan three-years from now
 They are usually calculated based on the theoretical spot rate curve.
 (1+S2)2 = (1+S1) *(1+1y1y)
 (1+S3)3 = (1+S1) *(1+S2) *(1+1y1y) or (1+S1)*(1+1y2y)2

Forward Rates
Example
Based on the table below, calculate the annualized six-month forward rate 2.5 years from now.
Solution:
Spot rate for the 6th period = 0.0665
Spot rate for the 5th period = 0.0635
Annualized 6-month forward rate for 2.5 years from now
= [(1 + 0.0665/2)6/(1 + 0.0635/2)5] -1
= 4.08%.
Valuation using Forward Rates
PV of Rs.1 in X Periods = 1/(1 + zX)X
Where,
Z = one half the semi-annual basis yield of the theoretical 6-month spot rate
Forward Rates
The large institutional investors are willing to invest in 2-year Govt-bond at 4% and 4-year Govt
bond at 6%. What is the implied forward rate for 2-year two years from now?
S4 = 6%
T=2 T=4
S2 = 4% 2y2y
T=3
(1 + S4)4
= (1 + 2y2y)2
(1 + S2)2
√ (1.06)4
= 8.04%
(1.04)2

Valuing a Bond Using Forward Rates
 The yield spread over a specific benchmark is referred to as the benchmark spread and is
usually measured in basis points
 This benchmark is usually the most recently issued government bond and is called the on-the-
run security

Valuing a Bond Using Forward Rates
 Seasoned government bonds are off-the-run securities; they are not the most recently issued
or the most actively traded
 The yield spread in basis points over an actual or interpolated government bond is known as
the G-spread. The spread over a government bond is the return for bearing greater credit,
liquidity, and other risks relative to the sovereign bond
 The yield spread of a specific bond over the standard swap rate in that currency of the same
tenor is known as the I-spread or interpolated spread to the swap curve. This yield spread over
Libor allows comparison of bonds with differing credit and liquidity risks against an interbank
lending benchmark
 A disadvantage of G-spreads and I-spreads is that they are theoretically correct only if the spot
yield curve is flat so that yields are approximately the same across maturities. Normally,
however, the spot yield curve is upward-sloping (i.e., longer-term yields are higher than shorter-
term yields).

Types of Spread
A Z-spread (zero-volatility spread) is based on the entire benchmark spot curve. It is the constant
spread that is added to each spot rate such that the present value of the cash flows matches the
price of the bond.
Option-adjusted spread: The OAS, like the option-adjusted yield, is based on an option-pricing
model and an assumption about future interest rate volatility. Then, the value of the embedded
call option, which is stated in basis points per year, is subtracted from the yield spread. In
particular, it is subtracted from the Z-spread
OAS = Z-spread – Option value (in basis points per year)

Z-Spread
A $100 face value 2 year bond pays coupon of 10%. The 1 year and 2 year Treasury spot rates are
4% and 6%. The bond is trading at 103.74, calculate the Z-spread for the bond.
Price = Coupon + Coupon+Principal

Yield+Z-spread Yield+Z-spread
103.74 = 10 + 110
(1.04+Z)1 (1.06+Z)2
Z-spread is 2% or 200bps (calculated by Hit and trial method)
951.96 = 100 + 100 + 100+1000

Miscellaneous
Matrix pricing
 Used for estimating the required YTM for non-traded or infrequently traded bond, using
the YTM of comparable liquid/active bond (similar in maturity/coupon)
 Interpolation to be done in case of different maturity period of comparable bonds
 Alternatively required YTM of non-traded or infrequently traded bond = Treasury
security yield for similar maturity plus credit spread
 Credit spread can be estimated by using spread of comparable liquid/active bonds
Yield for money market instruments
 Add-on yield – Coupon/interest is paid in addition of principal amount and yield is
quoted on par
 Discount yield - Instrument bought at discount and repaid at par. However, the yield
quoted on par value
 Add on yield = Discount / (Par value – discount)

10.Understanding Business Cycles
Business cycle: Characteristics
• Typically prevalent in economies that rely on business enterprises
• Has a expected sequence of phases alternating between a recession and an expansion
• Phases occur simultaneously across all sectors at the same time
• Are recurrent i.e. occur again and again
• Not periodic i.e. do not occur with the same duration or intensity
• Normally last between 1 to 12 years

Phases of the Business Cycle
Expansion: Peak – Highest

economic activity point
is increasing
Contraction a.k.a.
Recession or
Trough – Lowest Depression
point (Extremely severe) –
economic activity is
Four phases declining
namely:

Phases of the Business Cycle
Early Expansion Late Expansion Peak Contraction (Recession)
(Recovery)
Economic Activity Start to expand Accelerating pace of Decelerating rate of Outright declines
growth growth
Employment Unemployment rate Rates fall to low levels Rate continues to fall Unemployment rate
remains high rises
Consumer & Business Most visible in housing, Becomes more broad Capital spending Cutbacks appear mostly
Spending durable consumer items based expands but rate of in industrial production,
growth starts to decline housing, consumer
durables
Inflation Moderate and continues Picks up modestly Further accelerates Decelerates with a lag
to fall

Inventory, Labour and Physical Capital Utilization
Early Expansion (Recovery) Late Expansion Peak Contraction

(Recession)
Inventory Low, production begins to Growing Start to accumulate, Liquidation of unsold
replenish inventory rise in inventory- inventory
sales ratio
Labor No immediate hiring Firms go all out hiring Idling workers - no Terminate all
more overtime consultants, workers
beyond the strict
minimum
Physical Start investing in equipment, Huge investment in Equipment is used at Low
capital plants, etc. physical capital less than full capacity
utilization

Example
https://www.youtube.com/watch?v=tZvjh1dxz08

Macroeconomic Schools of Thought - Neoclassical Macroeconomics
States that aggregate demand and supply are mainly

affected by technological changes.
Business cycles (troughs and peaks) are a result of deviations

from a long-term equilibrium. These deviations correct
themselves, hence the economy does not need any
intervention.
Policy prescription: Please do nothing!
Disadvantage: Could not explain the Great Depression

(1929 to 1933)

Macroeconomic Schools of Thought - Keynesian Macroeconomics
States that the shifts in the aggregate demand and supply are mainly due to expectations.
Level of optimism among businesses will lead them to either over-invest or under-invest. This
will cause the shift.
Highlights wages as the main problem. Wages are downward sticky, which means they are
difficult to decrease. Hence it is difficult to bring the economy back from recession
Policy prescription: increase aggregate demand through monetary and fiscal policy.
New Keynesian School: It adds that besides wages, other input prices (like materials) are also
downward sticky. Therefore, there will be additional barriers in restoring full employment
levels in an economy.

Macroeconomic Schools of Thought
MONETARIST MACRO-ECONOMICS
• Main belief is that the variations in aggregate demand are due to

variations in the monetary policy (most likely from wrong decisions
from policymakers)
• Therefore recessions are probably a result of inappropriate
decreases in the money supply or external shocks.
• Policy prescription: increase money supply in a predictable and
gradual measure.
AUSTRIAN SCHOOL
• Business cycles are caused by government interventions.

• Government reduces the interest rates to low levels, which leads
the corporations to over invest. When these investments turn bad,
profits become losses and employees are fired. Unemployment
levels jump, leading to recession.

New Classical School: Real Business Cycle Theory
Main argument is that the

policymakers should not try
The main focus here is on to counteract business
technology and external cycles because expansions
shocks in an economy. and contractions are
efficient market responses.

Example
https://www.youtube.com/watch?v=ZckAN1KYB5I

Unemployment
Population
Working age Young and

Population Institutionalized
Outside Labor
Labor force
force
Discouraged
Employed Unemployed
Worker
Long-term Frictionally Voluntarily

unemployment unemployed unemployed
Underemployed

Unemployment: Labour Market Indicators
Unemployment Rate
◦ Measures the percentage of people within the labor force who are unemployed
Unemployment rate = Number of unemployed people/ Labor force x 100
Activity or Participation Rate

◦ Measures the percentage of the working age population who are members of the
labor force
Labor force participation rate = Labor force/ Working age pop x100

Unemployment: Measures
Unemployment Rate
Lagging economic indicator of business cycles
Tends to point to a past economic condition – during a crisis, discouraged

workers cease job hunting, reducing number counted as unemployed making
market look stronger than it actually is
Businesses are reluctant to lay off people due to constraints written in labour
contracts or out of a desire to keep good workers – during a crisis,
unemployment rises more slowly than it actually would due to this reluctance

Unemployment: Measures
• Overall Payroll Employment and Productivity Indicators:
• Measuring size of payrolls helps to sidestep the issue of discouraged workers
• Another indicator used: managers cutting back on hours worked especially overtime is a clear sign of a
recession brewing
• Increasing employment of temporary workers is a clear indication of economic recovery/growth
• Productivity measures also help in identifying the cyclical stage of the economy i.e. if output falls and
workers are still on the payroll, measured productivity has fallen indicating rough times
• Productivity can also go up in response to technological breakthroughs or improved training techniques,

both of which could affect potential GDP

Example
https://www.youtube.com/watch?v=UMAELCrJxt0

Inflation
Inflation: sustained rise in the overall level of prices in the

economy
Inflation rate: percentage change in a price index
Higher the inflation, lesser the same amount of money can buy
Deflation: sustained decrease in aggregate price level similar to

a negative inflation rate i.e. a rate < 0%
Value of money increase i.e. can buy more with same amount of
money
In a debt contract, liability of borrower will increase revenues

fall and companies cut spending sharply to feed debt
worsening economic condition

Inflation
Hyperinflation: extremely fast increase in aggregate price level
similar to a very high inflation rate like 500% per year
Usually occurs when large-scale government spending is not

backed by real tax revenue and central banks accommodate the
government’s spending with unlimited money supply
Triggered by supply shortage during a war, economic regime

transition or prolonged economic distress due to political instability
Disinflation: decline in inflation rate e.g. from 15-20% to 4-5%.

Different from deflation because positive inflation rate persists
after initial decline

Construction of Price Indices
Value of
Example: To simplify, assume a basket of two goods– Price Consumption
wheat and rice. Reference base period is assumed to Good Quantity (Rz) Basket (Rs)
be 2xx3 and we have two periods 2xx3 and 2xx4.
Wheat 15 30 450
Step 1: Find value of basket in 2xx3
Rice 10 60 600
Step 2: Find value of basket in 2xx4 Value of
CPI= (Cost of CPI basket at current period prices/ Cost Consumptio
of CPI basket at base period prices) x100 n Basket (Rs) 1050
Step 3: Price index in base period is usually set to Value of

100. So assume price index in 2xx3 is 100, calculate Price Consumption
price index in 2xx4 Good Quantity (Rz) Basket (Rs)
Price index in 2xx4 = 1155 x 100/1050 = 110 Wheat 15 35 525

Rice 10 63 630
Step 4: Calculate Inflation:
Value of
Inflation rate = 110/100-1 = 10% Consumptio
n Basket (Rs) 1155

Measures of Inflation
Consumer Price Index (CPI)
• Different weights can be assigned to various categories of goods and services

• Scopes also vary i.e. in some countries like Japan, both urban and rural areas are
surveyed to collect data while in USA, only urban areas are surveyed
Producer Price Index (PPI)a.k.a. Wholesale Price Index (WPI)
• Reflects changes in prices experienced by domestic producers in the country
PPI can influence CPI
• Items included are fuels, farm products, metals, paper and pulp, machinery and
equipment, chemical products, etc.
• Differences in weights can be more dramatic as different sectors/industries are
dominant in different countries

Factors affecting Inflation
• Cost-Push Inflation
• Starts with an increase in costs typically wages or prices of inputs
• Unemployment rate is key – lower the unemployment rate, greater possibility that shortages will drive up
wages
• However economy will continue facing labour shortages long before unemployment reaches low figures
• Non- accelerating inflation rate of Unemployment (NAIRU) is the effective unemployment rate beyond
which markets gets pressured
• Productivity or output/hour is essential: greater each worker’s output/hour, lower prices businesses need to
charge to cover hourly labour costs

Demand-Pull Inflation
Starts with an increase in Aggregate demand caused by

interest rate cuts, increase in money supply, etc
Higher economy’s rate of capacity utilization actual GDP is
closer to potential GDP greater likely hood of economy
suffering bottlenecks, shortages, inability to meet demand
price increase
Accelerations or decelerations in money growth help detect
inflationary potential
If money growth outpaces growth of the nominal economy 

inflationary pressure

Inflationary Expectations
Inflation becomes embedded, making consumer and businesses to expect it and

build their actions around these expectations inflationary momentum
Such expectations have a self-sustaining character and may persist for decades
To gauge expectations practitioners rely on:
past inflation trends
surveys of inflation expectations
governments issuing bonds that adjust for inflation such as TIPS

Economic Indicators
• Have turning points that usually precede those of the overall

economy
Leading • Useful to predict economy’s future state, usually near-term
• Have turning points that are usually closer to those of the overall
economy
Coincident • Useful in identifying present state of economy
• Have turning points that take place later than those of the overall
economy
Lagging • Useful in identifying economy’s past state

Identifying Business Cycle Phase based on Economic Indicator
Type Description of Indicators Reason

Average weekly hours, manufacturing Businesses cut overtime before laying off
workers in a downturn
Average weekly initial claims for unemployment insurance Test of initial layoffs and rehiring
Leading New orders for consumer goods and materials Tend to lead at upturns and downturns
Vendor performance, slower deliveries diffusion index Offers a clear signal of unfolding
demands on business
New orders for non-defense capital goods Helps capture business expectation
Building permits for new private housing units Helps to predict new construction activity

S&P 500 Stock Index Provide early signal on economic
cycles
Money supply, real M2 Increase/decrease in money
indicate easy/tight monetary
Leading conditions
Interest rate spread between 10yr treasury yields and Wider/ narrower spreads indicate
federal funds rate economic upswing/ downturn
Index of Consumer Expectations, University of Provides insight into future
Michigan consumer spending
Coincident Employees on non-agricultural payrolls Are adjusted once recession or
recovery is clear


Aggregate real personal income Captures current economy state
Industrial Production Index Measures industrial output (most
volatile)
Coincident
Manufacturing and trade sales Measure of current business
activity
Average duration of unemployment Lags the cycle during up and down
turns
Inventory-sales ratio Inventories increase/decrease as
Lagging sales decline/pick up
Average bank prime lending rate Tends to lag other rates that move
either before cyclical turns or with
them


Change in unit labor costs Tend to rise into the early stages of
a recession and late in recovery
Commercial and industrial loans outstanding Support inventory building
Lagging Ratio of consumer installment debt to income Consumers borrow only when they
are confident indicating an upturn
Change in consumer price index for services Inflation usually adjusts to the
cycle late especially stable service
sector

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Index table

Sr. Title Page

1 Financial Statement Analysis : An Introduction 1

The role of Financial Reporting is to provide information about a

Financial statement users

Short term creditors Long term creditors Are

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 Financial reports provide information about companies’ performance, financial

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Key financial statements

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Presents financial performance

Also called “statement of operations” and “profit and loss statement”

Net Income = Revenues - Expenses

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 Presents financial position of company

 Also called “statement of financial position”

Assets – Liabilities = Owner’s equity

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Presents the sources and uses of cash

Three activities for Cash Transactions

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 Presents the changes in equity

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Financial Foot notes provide information about the accounting methods,

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Requires the management to assess the company’s current financial

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An Audit is an independent review of an entity’s financial statements

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Unqualified Opinion Report:

Adverse Opinion Report : Disclaimer of Opinion : It is issued

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• These reports are generally unaudited .

• It contains information regarding compensation , management Qualifications

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• This involves calculation of ratios , preparing graphs ,performing

• Changing the conclusions or recommendations when necessary by

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1. Inter Globe/Indio is a low cost airline

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•How should they

•How should they

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Revenue • How many passengers were flown in years

- Operating Expenses • Other costs apart from direct costs related

EBITDA • What's the operating profit?

-Depreciation and Amortization • Costs of assets spread across years

EBIT • Profit before interest and tax is paid

EBT • Profit before Tax is Paid

- Tax • Tax paid at the corporate tax rate

PAT • Profit available for Rahul Bhatia and other shareholders

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Revenue From Operations [Gross] Total Expenses

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Amount of revenue can be An company enters into a barter transaction for

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Builder is selling pre Car showroom has a