UNIT 1

Government intervention and regulation

As well as the general measures to impact business operations discussed above,

governments can also take more specific measures to regulate business.

These measures will cover aspects such as:

• Competition policy
• Provision of government assistance Green policies
• Corporate governance guidelines

Government responses

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Fair competition: public provision and regulation

The response to the problems associated with monopoly power can take a variety of
forms. The first of these is public provision. This is where an economic activity is
nationalised.

The advantages of this are as follows:

• unfair pricing practices and/or excessive prices can be eliminated

• cost advantages of economies of scale can be reaped.

Traditionally, public utilities have presented the most convincing case for nationalization
because they are natural monopolies. However, nationalized industries may have
disadvantages, notably a greater potential for cost-inefficiency. The alternative response to
the dangers of monopoly is regulation.

Self-regulation is common in many professions where the profession itself establishes

codes of conduct and rules of behavior (e.g. the Law Society, the British Medical
Association).

The alternative is some form of public or legal regulation. An example in the UK is the
establishment of regulatory bodies for privatized utilities such as OFTEL and OFGAS.
These were established in recognition of the monopoly power of the privatized utilities and
have a degree of power over both prices and services in these industries. Another UK
regulatory body is the Financial Services Authority (FSA) that has responsibility for
regulating the financial services, banking and insurance markets. The FSA does not have to
control monopolies, but it is concerned with ensuring fair competition and protecting the
public against unfair treatment by financial organisations.

Fair competition: the control of monopoly Formal competition policy has typically centred
upon two broad issues.

• monopolies and mergers

• restrictive practices.

• The concern for monopolies is with firms which have a degree of monopoly power
(defined as having more than 25% of the market) or with mergers which may
produce a new company with more than 25% of market share. The underlying
presumption is that monopolies are likely to be inefficient and may act against the
interests of customers. The concern over restrictive practices is with trading
practices of firms that may be deemed to be uncompetitive and act against the
interests of consumers.

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 WORKING CAPITAL

What is working capital?

• What is 'Working Capital'. Working capital, also known as net working capital, is
the difference between a company’s current assets, like cash, accounts receivable
(customers’ unpaid bills) and inventories of raw materials and finished goods, and
its current liabilities, like accounts payable.

• Working Capital = Current Assets - Current Liabilities.

Objectives

The primary objectives of working capital management include the following

• Smooth operating cycle

• Optimum working capital

• Minimize the rate of interest or cost of capital

• Optimal return on current asset investment

The key objective of working capital management is to ensure a smooth working CPITl
cycle (i.e., the cycle starting from the acquisition of raw material to its conversion to cash).
Managing the working capital cycle is not an easy task; it is as good as juggling several
balls. It could be best achieved if the business is able to manage all the components of its
working capital in the best possible manner. In the following points, let’s learn how to
manage these components.

• Raw material should be available when required, and it should not hinder
production.

• All other requirements of production should be in place before time.

• The finished goods should be sold as early as possible once they are produced and
inventoried.

• The accounts receivable should be collected on time.

• Pay accounts payable as and when they become due without any delay.

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• Cash should be available whenever required, along with some cushion.

It means the working capital cycle should never stop for the lack of liquidity, whether for
buying raw materials, salaries, tax payments, etc.

Working Capital Cycle may vary from industry to industry. Take any industry, but the
objective would always be to keep this as smooth as possible. The bottleneck in any of the
activities would break the business supply chain and increase the cycle.

Importance of Working Capital Management

Althrough the importance of working capital is unquestionable in any business, working
capital management is a day-to-day activity, unlike capital budgeting decisions. Most
importantly, inefficiencies at any level of management impact the working capital and its
management. The following are the main points that signify Ensures Higher Return on
Capital
• Improvement in Credit Profile & Solvency
• Increased Profitability
• Better Liquidity
• Business Value Appreciation
• Most Suitable Financing Terms
• Interruption Free Production
• Readiness for Shocks and Peak Demand
• Advantage over Competitors

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 UNIT 2

Payback method of appraisal

Payback period = initial investment / annual cash flow.

A project is expected to have the following cash flows:
Year Cash flow $000
0 (1900)
1 300
2 500
3 600
4 800
5 500
What is the expected payback period?
Year Cashflo Cumulative Cashflow
w
0 (1900) (1900)
1 300 (1600)
2 500 (1100)
3 600 (500)
4 800 300
5 500 800

In the table above a column is added for cumulative cash flows for the project to date.
Figures in brackets are negative cash flows.

Each year’s cumulative figure is simply the cumulative figure at the start of the year plus the
figure for the current year. The cumulative figure each year is therefore the expected
position as at the end of that year.

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Payback is between the end of Year 3 and the end of Year 4 – that is during Year 4. This is
the point at which the cumulative cash flow changes from being negative to positive. If we
assume a constant rate of cash flow throughout the year, we could estimate that payback will
be three

years plus ($500/800) of Year 4. This is because the cumulative cash flow is minus $500 at
the start of the year and the Year 4 cash flow would be $800. $500/800 = 0.625

Therefore, payback is after 3.625 years.

Payback in years and months is calculated by multiplying the decimal fraction of a year by
12 months. In this example, 0.625 years = 7.5 months (0.625 × 12 months), which is
rounded to 8 months. So therefore, payback occurs after 3 years 8 months.

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 NET PRESENT VALUE METHOD
Year Cash Flow $
0 (150000)
1 40000
2 60000
3 35000
4 20000
5 10000
The company’s cost of capital is 9%.
Calculate the NPV of the project to assess whether it should be undertaken

Year Cashflow Discount factor @ 10% Present Value

0 (150000) 1.0 (150000)
1 40000 0.909 36360
2 60000 0.826 49560
3 35000 0.751 26285
4 20000 0.683 13660
5 10000 0.621 6210
Net Present Value 17925

.The project can be undertaken because of excess surplus of net present value of 17925

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 UNIT 3

Profitability Index Method:

This method is also called Excess Present Value Index or Present Value Index Method.
Under this method, a present value index is found out by comparing the total value of
future inflow and total present value of future outflow. This can be calculated by

Profitability Index = Present value of future cash inflow/Present value of future cash
outflow

TCS Limited is completing the purchase of a machine. The Machine X and Y are
available each costing 1,25,000. The company use discount rate of 8% for comparing
profitability of projects.

Earnings after tax and before depreciation are expected to be as follows

Decide which machine would be more profitable apply profitability index method?
Solution:
Year PV @8% Machine X P.V. Machine Y P.V.
1 0.926 30,000 27,780 20,000 18,250
2 0.857 40,000 34,280 50,000 42,850
3 0.794 40,000 31,760 40,000 31,760
4 0.735 30,000 22,050 40,000 29,400
5 0.681 20,000 13,620 10,000 6810
Total 1,29,490 1,29,340

Profitability Index of Machine X = 1,29,490/1,25,000

= 1.036
Profitability Index of Machine Y = 1,29,340/1,25,000

= 1.035
Accept or Reject Criteria:
Profitability Index < 1 Accepted
Profitability Index > 1 Rejected

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Since the profitability index of machine X is greater than machine Y, the management
should need to choose machine X.

Internal Rate of Return:

The IRR is an annual rate of growth that an investment is expected to generate. It’s
calculation rely on the same formula as NPV does keep in mind that IRR is not the
actual return that makes NPV equal to zero.

Generally the higher an IRR, the more desirable an investment is to

undertake. A company has to select one of the following two projects
Particulars Project A Project B
Cost 11,000 10,000
Cash flow year
1 6,000 1,000

2 2,000 1,000
3 4,000 2,000
4 5,000 10,000

Using IRR method suggest which project is preferable.

Solution:

F - factor to be located

I – initial investment
C – average annual cash flow

Factor to be located = initial investment/average annual cash flow

Average annual cash flow = (6000 + 2000 + 1000 + 5000)/4

= 14,000/4

= 3,500

Project A = 11,000/3,500 = 3.14

Project B = 10,000/3,500 = 2.85

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 Factor in case of project A would be 3.14 and discount would be somewhere between
10% and 12%

Calculation of IRR

Year Cash PVfactor@10% PV PVfactor@12% PV

inflow

1 6,000 0.909 5,454 0.893 5,358

2 2,000 0.826 1,652 0.797 1,594
3 1,000 0.731 751 0.712 712
4 5,000 0.638 3,415 0.636 3,180
Total 11,272 10,844

IRR = Base rate + (Difference in calculated PV and the required net cash outlay/Difference
in calculated PV)* Difference in ratio
IRR of project A = 10% + [(11,272 – 11,000)/(11,272 – 10,844)] * 2
= 11.27%
Factor in case of project B would be 2.857 and discount percentage would be somewhere
in 10% and 15%

Calculation of IRR

Year Cash PVfactor@10% PV PVfactor@15% PV

inflow

1 1,000 0.909 909 0.869 869

2 1,000 0.826 826 0.756 756
3 2,000 0.751 1,502 0.657 1,314
4 10,000 0.683 6,830 0.571 5,710
Total 10,067 8,649

IRR for project B = 10%+[(10,067-10,000)/(10,067-8,649)]*5

= 10.236%

Therefore Project A is better than project B, because of its higher internal rate of
return.

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 UNIT 4

Cost of debt and the impact of tax relief

A distinction must be made between the required return of debt holders / lenders (Kd) and
the company’s cost of debt (Kd(1-T)). Although in the context of equity the company’s cost
is equal to the investor’s required return, the same is not true of debt. This is because of the
impact of tax relief.
Irredeemable debt
The company does not intend to repay the principal but to pay interest forever.
Assumptions:
Market price (MV) = Future expected income stream from the debt discounted at the
investor’s required return.
 expected income stream will be the interest paid in perpetuity.
The formula for valuing a loan note is therefore:
MV = I/Kd
where:
I = annual interest in $ starting in one year's time
MV = market price in $ of the loan note now (year 0)
Kd = debt holders’ required return (pre-tax cost of debt), expressed as a decimal.
The required return (pre-tax cost of debt) can be found by rearranging the
formula:
Kd = I/MV
The post-tax cost of debt to the company is found by adjusting the formula to take account
of the tax relief on the interest:
'Kd (1 – T)' = I (1 – T)/MV
where T = rate of corporation tax, expressed as a decimal

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Redeemable debt
The company will pay interest for a number of years and then repay the principal
(sometimes at a premium or a discount to the original loan amount).
Assumptions:
 Market price = Future expected income stream from the loan notes discounted at the
investor’s required return (pre-tax cost of debt).
 expected income stream will be:
– interest paid to redemption
– the repayment of the principal

Convertible debt
A form of loan note that allows the investor to choose between taking the redemption
proceeds or converting the loan note into a pre-set number of shares.
To calculate the cost of convertible debt you should:
(1) Calculate the value of the conversion option using available data
(2) Compare the conversion option with the cash option. Assume all investors will choose
the option with the higher value.
(3) Calculate the IRR of the flows as for redeemable debt

Non-tradeable debt
Bank and other non-tradeable fixed interest loans simply need to be adjusted for tax relief:
Cost to company = Interest rate × (1 – T).
Alternatively, the cost of any 'normal' traded company debt could be used instead (for
example, when the examiner does not give you the interest rate).

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 BUSINESS VALUATION BASED ON COMPANY’S FUNDAMENTALS

Fundamental approach to valuation of business asserts importance of company’s

fundamentals for its valuation. These methods ascertain the company’s value on the basis of
financial information that is relevant to company and its future. This type of valuation is also
called as ‘stand-alone valuation’. The multiple factors that are used in valuation of business
are:

- Revenue or Sales Multiple

- Operating Profit Multiple

- Operating Free Cash Flow Multiple

- Operating Multiple

- Price/Earnings Multiple

- Price/Book Value Multiple

Revenue or Sales multiple

> Revenue or sales multiple reflects value of enterprise in relation to its revenues.

> Revenue multiples are used to calculate both enterprise value and equity value.

> Revenue multiples are generally used for valuation of companies which are not currently
profitable.

Operating Profit Multiple

> EBIDT (Earnings before interest, depreciation and tax) multiple express enterprise value
in relation to cash flow as ascertained from Income statement.

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> EBIDT can be easily taken from audited financial statements and it is more stable over
time.

> Use of cash flow in ascertainment of enterprise value is more appropriate, since cash flow
generation capacity will determine enterprise value (EV).

Operating Multiple

> Operational multiples express value of company in relation to a specific operational

activity.

> This method considers revenue generating unit specific to particular industry is
considered.

Price/earnings multiple

> Price/earnings (P/E) multiple expresses value of equity in relation to its earnings after tax.

> Stock prices of quoted companies are regularly described in terms of their P/E ratio.

> P/E is inverse of earnings yield, dividing price by earnings.

Price/book value multiple

>Book value multiple reflects market value of equity in relation to company’s book value.

>Book value is adjusted book value of total assets less adjusted book value of liabilities.

>Ratio is called price/book value or P/BV ratio.

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 UNIT 5

Earnings Yield

What Is Earnings Yield?

Earnings Yield helps the investor understand how much they will be earning for each dollar
invested in the company and is therefore calculated as Earnings per share divided by the
stock price per share. This ratio helps an investor to make the comparison between two or
more companies or between investments in shares versus the investment in risk-free
securities.

Earnings Yield Formula

Earning yield =Earnings per share X 100
Stock price per share

In some scenarios, an earnings yield calculation is used as a dividend pay-out ratio. It is

important to understand that the dividend that is distributed among shareholders is the
earnings of the company. Any yield above 10 basis points over the government bond yield
for 10 years is considered a significantly good deal for the investor.

Earnings Yield Explained

Earnings yield is the earnings of an investor per share for the last one year divided by the
current market price. It gives the investors an idea of the gains they have made for every
dollar invested.

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It helps the stakeholders to understand about the return for each dollar invested and also to
make sure that the additional risk of investing in stock over risk-free security (like treasury
bill, gold, fixed deposit) is worth taking or not.

The earnings yield method is the exact opposite of P/E ratio. While the former provides
insights into the earning per share, the latter determines how long it would take for the
company’s share to reach the current market value per share.

Nevertheless, a higher earning yield would indicate that the stock is undervalued and might
be a good opportunity to buy the stock as it is expected to give a significant run-up in the
market.

Formulas

Let us understand the formulas to aid earnings yield calculation:

Earnings Yield Formula = Earnings Per Share / Stock Price Per Share*100

Here we take the 12 months earnings per share of the company is divided by the market
price per share of the stock and represent in a percent manner to make the comparison.

Earnings Yield Formula=1/Price Earning * 100

As we know that it is the inverse of P/E, we can calculate it by using the above formula and
represent it in a percent manner to make the comparison.

How is Earnings Yield used by Investors?

Consider an investment in stock as against an investment in a Treasury bill or a fixed

deposit, which are virtually risk-free investments. So, if the earnings yield of an investment
in the stock is higher than the treasury bill / Fixed deposit, only then will it make sense to
invest in stock as we take risks while investing in stocks.

The Earnings yield calculation of 10 years treasury bill is 4.5%, i.e., we earn 4.5% for each
dollar invested, and the yield for the stock of Company A INC is 8.28 %, i.e., we earn 8.28%
for each dollar invested. This clearly shows that the additional risk which we are taking by
investing in stock instead of the treasury bill is providing additional returns. If the yield of
the risk-free security is equal to or more than the stock, we can say that the stock is
overvalued stocks. As we can clearly see in such a case, there are no additional benefits
received by making a riskier investment.

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 INTEREST RATE RISK

Interest rate risk is the probability of a decline in the value of an asset resulting from
unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-
income assets (e.g., bonds) rather than with equity investments. The interest rate is one of
the primary drivers of a bond’s price. The current interest rate and the price of a bond
demonstrates an inverse relationship. In other words, when the interest rate increases, the
price of a bond decreases.

FACTORS IMPACTING INTERESTS RATES RISKS OF A FIRM

There are many factors, which directly impact the interest rate risk associated with a
company. These factors are discussed below in detail.

Credit risk associated with a company: A company's debt to equity ratio is one of the
primary determinants of credit risk. A rise in interest rates leads to more expense for a

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company since they have to pay more interest to its investors. As a result, the credit risk of
an institution increases.

Length of loan terms: Length of loan terms, both as a borrower as well as a lender, are
major determinants of the interest rate risks of an institution. Companies and ventures
charging a fixed interest on their receivable accounts might have baselines dropping down if
they need to refinance themselves. This, in turn, increases the risk involved with the shift in
interest rates.

Market fluctuation: Market fluctuation and inflation can immensely impact the risk related
to interest rates since refinancing, or other such necessities can become more difficult during
such times. Such circumstances often lead to a situation where outgoing cash flow crosses
the incoming cash flow, making it more difficult for the institution to function.

Foreign exchange rates: Any company which has foreign debt is also affected by a change
in foreign exchange rates. The associated interest rate risks increase with a fall in the price
of the prevalent currency, while the inverse happens in case there is a rise in the price
of the currency.

MANAGING INTEREST RATE RISKS

It is important to learn how to manage interest rate risk since it can potentially make an
institution dysfunctional and ultimately bankrupt. The few methods which can be employed
to manage the interest rate and in turn associated risks are discussed below.

Diversification: Among the different options that can be employed by an institution to

manage the interest rate risk associated with them, one of the most effective options is to
diversify their financial investments. For investors who invest in both equity and fixed
investment options, this is the best method to manage the risks associated with interest rates.

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Safer investments: The safest option for investors who are trying to reduce the risks
associated with interest rates is to invest in bonds and certificates, which have short maturity
tenure. Securities with short maturity tenure are less susceptible to fluctuations in interest
rates. This method for interest rate management reduces the chance of being subjected to
interest rate fluctuations since they have low maturity tenure.

Hedging: Hedging is an option, which can be used successfully to reduce the risks related to
interest rates. Generally referring to the purchase of various types of derivatives that are
available, there are many ways of hedging.

Selling long-term bonds: A common method that is often used is that of selling long-term
bonds. This effectively clears up the investment funds for re-investment in bonds with
higher returns, thus allowing investors to manage the interest rate risk better. It is advisable
to re-invest in securities that have shorter maturity tenure since these carry lesser risks
related to interest rates.

Purchasing floating-rate bonds: Floating rate bonds, as suggested by their name, have a
rate of interest, which is directly related to market fluctuations. It is advisable to invest in
these securities since being related to the market fluctuations, the return on these
investments go up and down too. It is helpful in reducing the interest rate risk involved.

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