Advance

Corporate
Finance
Unit – I
Introduction –
Valuation
Introduction – Valuation

Introduction of Course: Course overview

Approaches to Valuation

Valuation of Bond
Advance
Corporate
Finance
ACF: Need of Hour
• In today's global economy, identifying and responding to fast-
moving financial developments requires an objective framework
to analyze and evaluate the opportunities and risks.
• To remain competitively relevant, Senior-level finance executives
need a firm grounding in issues like
• capital structure,
• risk management,
• financial technologies, and
• mergers and acquisitions,
ACF: Major Learning
Goals
• Consider how financial institution or firm can effectively manage
risk in today's uncertain economy
• Determine whether it is more efficient to take on debt, offer
equity, or do a combination of both when making capital structure
decisions
• Examine how valuation models change when making financial
decisions
• Understand the complexities of mergers and acquisitions
• Understanding implications of Financial Derivatives
Valuation -
Introduction
Business Valuation

Business Valuation is the process of determining the financial value of a

business.

Business valuation is performed because it is helpful information during

litigation; it helps develop your business' exit strategy for buying and selling a
business, acquiring funding, and strategic planning.

Valuation methods refer to the different approaches and methods set in place to
determine the value of your business or asset for financial reporting.
Valuation

Valuation refers to the process of determining the present value of

a company, investment or an asset.

Analysts who want to place a value on an asset normally look at the

prospective future earning potential of that company or asset.
 Valuation - Basics
By trading a security on an exchange, sellers and buyers will dictate the market
value of that bond or stock.

However, intrinsic value is a concept that refers to a security’s perceived value on

the basis of future earnings or other attributes that are not related to a security’s
market value.

Therefore, the work of analysts when performing a valuation is to know if an

investment or a company is undervalued or overvalued by the market.
 Valuation is the process of determining the
theoretically correct value of a company,
investment or asset, as opposed to its cost
or current market value.

Valuation - Common reasons for performing a valuation

are for M&A, strategic planning, capital
Basics financing and investing in securities.

The three most common investment

valuation techniques are: DCF analysis,
comparable company analysis and
precedent transactions.
 Buying or selling a business

Reasons for Strategic planning

Performing a
Valuation Capital financing

Securities investing
Popular
Methods of
Valuations
 DCF Analysis
Popular
Methods Comparable Company
Analysis (“comps”)
of
Valuation Precedent Transactions
Method 1: DCF
analysis
• Discounted cash flow
(DCF) analysis is an intrinsic
value approach where an
analyst forecasts a
business’s unlevered free
cash flow into the future
and discounts it back to
today at the firm’s
weighted average cost of
capital (WACC).
DCF Analysis

A DCF analysis is performed by building a financial model in Excel and requires an

extensive amount of detail and analysis.

It is the most detailed of the three approaches and requires the most estimates and
assumptions.

The effort required to preparing a DCF model may also often result in the least
accurate valuation due to the sheer number of inputs.
 However, a DCF model allows the analyst
to forecast value based on different
scenarios and even perform a sensitivity
analysis.

DCF Analysis
For larger businesses, the DCF value is
commonly a sum-of-the-parts analysis,
where different business units are
modeled individually and added together.
 Method 2: • Comparable company
Comparable analysis (also called
“trading comps”) is
Company a relative valuation
method in which you
Analysis compare the current
value of a business to
(“comps”) other similar businesses
by looking at trading
multiples like
P/E, EV/EBITDA, or other
multiples.
Comparable Company Analysis (“comps”)
The “comps” valuation method provides an observable value for the business,
based on what other comparable companies are currently worth.

Comps is the most widely used approach, as the multiples are easy to calculate
and always current.

The logic follows that if company X trades at a 10-times P/E ratio, and company Y
has earnings of 250 per share, company Y’s stock must be worth 2500 per share
(assuming the companies have similar risk and return characteristics).
 Precedent transactions
analysis is another form
of relative valuation These transaction values
where you compare the include the take-over
company in question to premium included in the
other businesses that price for which they were

Method 3: have recently been sold

or acquired in the same
industry.
acquired.

Precedent
They are useful for M&A

Transactions The values represent the

entire value of a business
and not just a small stake.
transactions but can
easily become dated and
no longer reflective of
current market conditions
as time passes.
 The Asset Approach

• calculates the fair market value of individual assets, often

including the cost to build or cost to replace.
• is useful in valuing real estate, such as commercial property,
new construction, or special-use properties.

The income Approach

Valuation • with the discounted cash flow (DCF) being the most common
Approaches • A DCF is the most detailed and thorough approach to
valuation modeling.

The Market Approach

• A form of relative valuation and is frequently used in the

finance industry.
• It includes comparable company analysis and precedent
transactions analysis.
Valuation of
Bond
Corporate Bonds

Corporate bonds generally

Corporate bonds are bonds
offer higher yields than Additionally, there are
issued by corporations to
government bonds because different types of corporate
finance various activities,
they usually come with a bonds that range in levels of
including operations,
higher probability of default, risk and yield.
expansion, or M&A.
making them riskier.
What is Corporate Bond Valuation?
Corporate bond valuation is the
process of determining a
corporate bond’s fair value
based on the present value of
the bond’s coupon payments
and the repayment of the
principal.
The valuation of corporate
However, the probability
bonds is similar to that of any
of default for the bond and the
risky asset; it is dependent on
payout ratio if the bond defaults
the present value of future
(ratio of face value received if
expected cash
bond defaults) must be factored
flows, discounted at a risk-
into the valuation.
adjusted rate (similar to a DCF).
 Types of Bonds

 Government Bonds
 Corporate Bonds
 Straight Bonds
 Zero Coupon Bonds
 Floating Rate Bonds
 Bonds with Embedded Options
❑ Convertible Bonds
❑ Callable Bonds
❑ Puttable Bonds
 Commodity Linked Bonds
 Bond Valuation

 P = ∑ [C / (1 + r)t ] + M / (1 + r)n
 P = C x PVIFA r, n + M x PVIF r, n

❑ P = Value (In Rupee)

❑ n = Number of Years
❑ C = Annual Coupon Payment (In Rupee)
❑ r = Periodic Required Return
❑ M = Maturity Value
❑ t = Time Period when the payment is received.
 Example:

Example 1:
 5 – Year, 12% Coupon Bond with a Par Value of Rs. 1,000
 Maturity Price @ 10% Premium
 Required Rate of Return = 13%
Answer: 1019/-

Example 2:
 6 – Year, 13% Coupon Bond with a Par Value of Rs. 500
 Maturity Price @ 20% Premium
 Required Rate of Return = 9%
Answer: ????
How to Value a Corporate
Bond (Probability Tree
Method)
A common way
to visualize the
valuation of
corporate bonds
is through a
probability tree.
Example
• Consider the following example of a corporate bond:
• 3-year maturity
• 1,000 face value
• 5% coupon rate (50 coupon payments paid annually)
• 60% Default Payout ratio (600 default payout)
• 10% probability of default
• 5% risk-adjusted discount rate
EV Calculation
Bond Yields
 1. Current Yield

 CURRENT YIELD = ANNUAL INTEREST / PRICE

 It reflects only the coupon Interest Rate.

 It doesn’t consider Capital Gain or Loss.

 It also ignores Time Value of Money.

 An Incomplete and Simplistic Measure of Yield

 2. Yield to Maturity (YTM)

 Rate of Return offered by the BOND over it’s Life

 YTM refers to the “Discounting Rate” which makes the present value of the cash flows receivable
from owning the bond to the price of the bond.

Formula:
𝑀 −𝑃
𝐶+
𝑛
 Approximation: 𝑌𝑇𝑀 =
0.4 𝑀+0.6 𝑃
𝑃𝑉 𝑎𝑡 𝑅1 – 𝑃
 Trial and Error: YTM = 𝑅1 + [𝑅2 – 𝑅1]
𝑃𝑉 𝑎𝑡 𝑅1 – 𝑃𝑉 𝑎𝑡 𝑅1
 3. Yield to Call (YTC)

 Applicable to Callable Bonds

 Similar to YTM except the Duration

 M= Call Price

 n = Number of Years until the assured call date

 4. Realized Yield to Maturity (RYTM)

 It considers the re-investment factor in computation of Yield to Maturity.

 YTM refers to the “Discounting Rate” which makes the present value of the cash flows receivable
from owning the bond to the price of the bond.
Example - Computation of ACF
Rs. 1000 15% 5 Year – Bond,
Reinvestment Rate = 16%, Current Price = Rs. 850
Re- INV Compound
Year INV INT FV ACF
Period Factor

0 (850) - - - - -

1 - 150 4 1.81 271.5 0

2 - 150 3 1.56 234.0 0

3 - 150 2 1.35 202.5 0

4 - 150 1 1.16 174.0 0

5 - 150 0 1.00 150.0 1032 + MATURITY PRICE

 Valuation of Equity Using
Dividend Discount Model

Valuation of Valuation of Firm Using FCFF &

Equity FCFE Model.

Valuation of Equity and Firm

Using Earning Multiples.
1. Valuation of
Equity Using
Dividend
Discount Model
Dividend Discount Model (DDM)
The dividend discount model (DDM) is a quantitative method used for predicting the price
of a company's stock based on the theory that its present-day price is worth the sum of all
of its future dividend payments when discounted back to their present value.

It attempts to calculate the fair value of a stock irrespective of the prevailing market
conditions and takes into consideration the dividend pay-out factors and the market
expected returns.

If the value obtained from the DDM is higher than the current trading price of
shares, then the stock is undervalued and qualifies for a buy, and vice versa.
1.1 Single Duration Valuation Model
 1.2 Multiple Duration Valuation Model

Infinite Duration

Finite Duration
1.3 Constant Growth Model
2. Valuation of
Firm Using
FCFE &
FCFF Model
3. Valuation of Equity and
Firm Using Earning Multiples
Valuation relative to
Industry Averages

• Dividend Yield Method

• Earnings Yield Method
• Return on Capital Employed Method
• Price / Earning Method
Formula

Dividend Yield Method Earning Yield Method ROCE Method

Value of Share = Value of Share = Value of Share =

𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 (%) 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑌𝑖𝑒𝑙𝑑 (%) 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑂𝐶𝐸 (%)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 (%) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑌𝑖𝑒𝑙𝑑 (%) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑅𝑂𝐶𝐸 (%)
𝑥 𝑃𝑎𝑖𝑑 𝑢𝑝 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒 𝑥 𝑃𝑎𝑖𝑑 𝑢𝑝 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒 𝑥 𝑃𝑎𝑖𝑑 𝑢𝑝 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒

Value of Share = Value of Share =

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝑅𝑠.) 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝑅𝑠.)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 (%) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑌𝑖𝑒𝑙𝑑 (%)
3.1 Dividend
Yield
Method
Dividend Yield Method
Illustration 1
• Ashoka Builders Ltd has an issued and paid up capital of
5,00,000 shares of Rs. 10 each.
• The company declared a dividend of Rs. 12.50 lac during last
five year and expects to maintain the same level of dividends
in future.
• The control and ownership of the company is lying in the few
hands of directors and their family members.
• The average dividend yield for listed companies in the same
line of business is 18%.
• Calculate the value of 3000 shares in the company.
Dividend Yield Method
Illustration 2

• ABC Ltd has declared dividend during the past five years are as follows:
• Year >1 2 3 4 5
• Rate of Dividend > 12 14 18 21 24
• The average rate of return prevailing in the same industry is 15%
• Calculate the value per share of Rs. 10 of ABC Ltd. Based on the dividend yield
method.
 • The profits of X Ltd. For the year ended March 31,
2022 were Rs. 60 Lac.
• After setting apart amounts for interest on
borrowings, taxation and other provisions, the net
surplus available to shareholders is estimated at
Rs. 15 Lac.
• The Company's capital consisted of:
• 1,00,000 Equity Shares of Rs. 100 each, Rs.
Dividend Yield Method 50 per share paid up
• 25,000 12% Cumulative Redeemable
Illustration 3 Preference Shares of Rs 100 each fully paid
up
• Enquiries in the stock market reveal that shares of
companies engaged in similar business are
declaring dividend of 15% on equity shares are
quoted at a premium of 10%.
• What do you expect the market value of the
company's shares to be basing your working on
the yield method?
3.2 Earning
Yield Method
Earning Yield Method

• Prediction of Future Maintainable

Profits for the company to be valued
• Identification of Required Earning Yield
by reference to the companies of similar
Industry Peers
• Capitalize the value of share by dividing
earning Yield of company by industry
earning yield
Earning Yield Method
Illustration 1
• Kaveri Industries Ltd is expected
to Generate future profits of 54
Lac.
• Determine the value of business if
investment of similar nature earns
a yield of 15%.
Earning Yield Method
Illustration 2
XYZ Ltd. Agrees to acquire business of PQR Ltd based on
capitalisation of Last Three Years Profits of PQR Ltd at an
Earning Yield of 21%

Earnings of Last Three years are 75, 89 & 82 Lac respectively.

Determine the value of business.

 Earning Yield Method - Illustration 3
Liability Amount Asset Amount Additional Information:
Share Capital # On Year End, Goodwill of company was valued at
40000 shares of 4,00,000 Goodwill 40,000 50,000, while other fixed assets were valued at
RS.10 Each 3,50,000.
# The net profit for company earned in last three
Other Fixed years has been 51,600; 52,000; and 51,650
General Reserve 90,000 5,00,000
Assets respectively.
Current # 20% of profit is transferred to General Reserve
Profit & Loss A/c 20,000 2,00,000
Assets (as per Industry Norms).
10% Debentures 1,00,000 # A return of 10% on the investment is considered
as fair in the industry.
Current Liabilities 1,30,000
7,40,000 7,40,000 Compute the value of company's share by the
Earning Yield Method (Simple Average Method).
3.3 Return on Capital
Employed Method
Illustration 1

From the following data available from books of

accounts of the firm, determine value of share
based on return on capital employed:
Year Capital Employed Profit
2018 20 3
2019 26 5
2020 33 6
2021 35 8
2022 41 11
The market expectation being 16%.
3.4 Price /
Earning
Method
Illustration
Valuation of
Equity Using
Dividend
Discount Model
and FCFE Model.
 Measurement of Risk in Capital Budgeting
Decisions.

Risk analysis in capital budgeting- Sensitivity

analysis, Scenario Analysis, Simulation Analysis.

Risk Risk Analysis in Capital Budgeting- Risk Adjusted

Analysis in Discount Rate and Certainty Equivalent Approach.

Capital
Investment decisions with capital rationing.
Budgeting
Techniques of Risk Analysis in Capital
Budgeting
Risk Adjusted
Discount Rate
(RADR)
Risk Adjusted Discount Rate (RADR)
Illustration - RADR
Solution
Solution
Certainty
Equivalent
Certainty Equivalent
Illustration
Scenario
Analysis
Scenario
Analysis
Illustration
Solution
Sensitivity
Analysis
Sensitivity
Analysis
Solution
Sensitivity
Analysis
 Overview of Financial Derivatives

Managing Risk through Futures

Financial
Derivatives
Managing Risk through Options

Managing Interest Rate Risk through

Interest Rate Swap.
4.1 Overview
of Financial
Derivatives
DERIVATIVES

The term “derivatives” is used to refer to financial instruments which

derive their value from some underlying assets.

The underlying assets could be equities (shares), debt (bonds, T-bills, and
notes), currencies, and even indices of these various assets, such as the
Nifty 50 Index.

Derivatives derive their names from their respective underlying asset.

Participants in Derivative Market
Hedgers

These investors have a position (i.e., have bought stocks) in the underlying
market but are worried about a potential loss arising out of a change in
the asset price in the future.

Hedgers participate in the derivatives market to lock the prices at which

they will be able to transact in the future (Thus, they try to avoid price
risk).

A hedger normally takes an opposite position in the derivatives market to

what he has in the underlying market.
Speculators

A Speculator is one who bets on the derivatives market based on his views on the potential movement of the
underlying stock price.

Speculators take large, calculated risks as they trade based on anticipated future price movements.

They hope to make quick, large gains; but may not always be successful.

They normally have shorter holding time for their positions as compared to hedgers. If the price of the underlying
moves as per their expectation they can make large profits. However, if the price moves in the opposite direction of
their assessment, the losses can also be enormous.
Arbitrageurs

Arbitrageurs attempt to profit from An arbitrageur may also seek to

pricing inefficiencies in the market make profit in case there is price
by making simultaneous trades that discrepancy between the stock
offset each other and capture a price in the cash and the
risk-free profit. derivatives markets.
Economic Function
of Derivative Market
– Risk Management,
Market Efficiency,
Price Discovery
 • The most important purpose of the derivatives market is risk
management. Risk management for an investor comprises of
the following three processes:

• Identifying the desired level of risk that the investor is

Risk willing to take on his investments;
management • Identifying and measuring the actual level of risk that the
investor is carrying; and

• Making arrangements which may include trading

(buying/selling) of derivatives contracts that allow him to
match the actual and desired levels of risk.
Market efficiency

Efficient markets are fair and competitive and do not allow an

investor to make risk free profits.

Derivatives assist in improving the efficiency of the markets, by

providing a self-correcting mechanism.

Actions of Arbitrageurs quickly narrow the prices and thereby

reducing the inefficiencies.
 • One of the primary functions of derivatives markets is price
discovery.

• They provide valuable information about the prices and expected

price fluctuations of the underlying assets in two ways:

• First, many of these assets are traded in markets in different

geographical locations. Because of this, assets may be traded
Price discovery at different prices in different markets. In derivatives markets,
the price of the contract often serves as a proxy for the price of
the underlying asset.

• Second, the prices of the futures contracts serve as prices that

can be used to get a sense of the market expectation of future
prices.
4.2 Managing
Risk through
Futures
FORWARD CONTRACTS

A contract between two parties to

buy or sell an asset at a certain future It may be noted that Forwards are
date (i.e. Expiry Date) for a certain private contracts and their terms are
price (pre-decided on the date of the determined by the parties involved.
contract, i.e. Forward Price)

A drawback of forward contracts is Default risk is also referred to as

that they are subject to default risk. counter party risk or credit risk.
Futures
Like a forward contract, a futures contract is an agreement between two
parties in which the buyer agrees to buy an underlying asset from the
seller, at a future date at a price that is agreed upon today.

However, unlike a forward contract, a futures contract is not a private

transaction but gets traded on a recognized stock exchange.

In addition, a futures contract is standardized by the exchange.

Functioning of Futures
Sells Futures Payment

Futures Clearing Futures

Seller Corporation Buyer

Payment Buys
Futures
 FORWARDS​ FUTURES​
Difference Privately negotiated
Traded on an exchange​
between contracts​
Not standardized​ Standardized contracts​
Forwards and Settlement dates can be set Fixed settlement dates as
Futures: by the parties​ declared by the exchange​

Almost no counter party

High counter party risk​
risk​
Long Position on an Asset (Long Equity / Futures)

Profit

Price

Buying Price

Loss
Short Position on an Asset (Short Equity / Futures)

Profit

Price

Selling Price

Loss
Margins
Margins

One of the tools through which NSCCL protects itself from default by
either party, is margin payments.

These are collected from both parties to the futures contract.

NSCCL collects the requisite margins from Clearing Members, who will
collect it from Trading Members who in turn will collect from the client.
Margins….

• The margin payments are based on

Standard Portfolio Analysis of Risk (SPAN)®,
a registered trademark of the Chicago
Mercantile Exchange.
• It is a highly sophisticated, value-at-risk
methodology that calculates performance
bond/ margin requirements by analyzing
the “what-if’s” of virtually any market
scenario.
• The margins are monitored on-line on intra-
day basis.
Daily Mark-to-
Market and
Final
Settlement
4.3 Managing
Risk through
Options
Option

An option is a derivative contract between a buyer and a seller, where one party (say First
Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or
sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price.

In return for granting the option, the party granting the option collects a payment from the
other party.

This payment collected is called the “premium” or price of the option.

 Option Option
Buyer / Holder Seller / Writer

Premium PAY RECEIVE

Increase in Stay / Decline in
Expectation Market Price Market Price
MP > EP MP < EP
Reward (Unlimited) (Premium)
MP < EP MP > EP
Risk (Premium) (Unlimited)

• Call option provides a right to buy an asset at a fixed price during

Call Option certain period.

 Option Option
Buyer / Holder Seller / Writer

Premium PAY RECEIVE

Stay / Decline in Increase in
Expectation Market Price Market Price
MP < EP MP > EP
Reward (Unlimited) (Premium)
MP > EP MP < EP
Risk (Premium) (Unlimited)

• Put option provides a right to sell an asset at a fixed price during

Put Option certain period.

Difference between Futures and Options

FUTURES OPTIONS

The buyer of the option has the right and not an obligation
Both the buyer and the seller are under an obligation to
whereas the seller is under obligation to fulfill the contract
fulfill the contract.
if and when the buyer exercises his right.

The buyer and the seller are subject to unlimited risk of The seller is subjected to unlimited risk of losing whereas the
loss. buyer has limited potential to lose (which is the option premium).

The buyer has potential to make unlimited gain while the

The buyer and the seller have potential to make seller has a potential to make unlimited gain. On the other
unlimited gain or loss. hand the buyer has a limited loss potential and the seller
has an unlimited loss potential.
Options Payoffs,
Application of Payoffs
Pay-off of Option
• Pay-off of Call Option:

P(c) = Max [ (MP – EP), 0]

(i) MP > EP

(ii) MP ≤ EP

• Pay-off of Put Option:

P(c) = Max [ (EP – MP), 0]

(i) MP ≥ EP

(ii) MP < EP
Trade off of Long Call

Profit

Strike Price +
Premium
Price

Premium

Strike Price

Loss
Trade off of Short Call

Profit

Strike Price +
Premium
Premium Price

Strike Price

Loss
Trade off of Long Put

Profit

Strike Price
- Premium
Price

Premium

Strike Price

Loss
Trade off of Short Put

Profit

Premium Price

Strike Price

Strike Price
- Premium

Loss
Option Payoff Example
Underlying Asset > NIFTY k / Premium
Lot Size > 50 Call 18000 / 460
Expiry > Next Month Put 18000 / 210
Buy (Nifty) Sell (Nifty)
Call (18000 / 460) Put (18000 / 210)
Expected Market Long Short Long Short
Price (at
Expiry) Long Call Short Call Long Put Short Put
Exercise Payoff Payoff Exercise Payoff Payoff
16500 No -460 460 Yes 1290 -1290
17000 No -460 460 Yes 790 -790
17500 No -460 460 Yes 290 -290
18000 Yes / No -460 460 Yes / No -210 210
18500 Yes 40 -40 No -210 210
19000 Yes 540 -540 No -210 210
19500 Yes 1040 -1040 No -210 210
 Long Call Long Put
1200 1400
1000 1200
800 1000
600 800
400 600
200 400
0 200
16000 16500 17000 17500 18000 18500 19000 19500 20000
-200 0
-400 16000 16500 17000 17500 18000 18500 19000 19500 20000
-200
-600 -400

Short Call Short Put

600 400

400 200

200 0
16000 16500 17000 17500 18000 18500 19000 19500 20000
0 -200
16000 16500 17000 17500 18000 18500 19000 19500 20000
-200 -400

-400 -600

-600 -800

-800 -1000

-1000 -1200

-1200 -1400
4.4 Managing
Interest Rate
Risk through
Interest Rate
Swap
How does Interest Swap Work?
Credit Interest Rate Credit Interest Rate
Rating: to Rise Rating: to Fall
AA 8% 8.5% B

MIBOR MIBOR

Aim: Fixed Aim: Floating

0.50%
7% MIBOR + 1%
MIBOR – 1% 9.5%
+1.00% +0.50%

Fixed Rate : 7% Fixed Rate : 10%

Floating Rate : MIBOR Floating Rate : MIBOR + 1%
 CASE - 1
<<< <<<
A B
MB (0.5)
(1) (0.5)
>>> >>>

7 MIBOR + 1

Fixed - 7% Fixed - 10%

Floating - MIBOR% Floating - MIBOR+1%

CASE - 1
<<< 8 8.5 <<<
A B
ME (0.5)
(1.0) (0.5)
>>> MIBOR MIBOR >>>

7 MIBOR + 1

Fixed - 7% Fixed - 10%

Floating - MIBOR% Floating - MIBOR+1%

Logic A: FxRD = 3% - FLRD = 1% >>> Margin = 2%

Logic B: New Aggregate Rate (Mibor + 10) - Old Aggregate Rate (7 + Mibor + 1)>>> Margin = +2%
 Case - 2
<<< <<<
A B
ME (0.5)
(0.25) (0.25)
>>> >>>

MIBOR + 5 8

Fixed - 12% Fixed - 8%

Floating - MIBOR + 5% Floating - MIBOR + 2%

Case - 2
<<< MIBOR MIBOR <<<
A B
ME (0.5)
(0.25) (0.25)
>>> 6.75 6.25 >>>

MIBOR + 5 8

Fixed - 12% Fixed - 8%

Floating - MIBOR + 5% Floating - MIBOR + 2%

Logic A: FxRD = 4% - FLRD = 3% >>> Margin = 1%

Logic B: New Aggregate Rate (12+ Mibor + 2) - Old Aggregate Rate (Mibor + 5 + 8)>>> Margin = +1%
 Case - 3
<<< <<<
A B
MB (0.5)
(0.25) (0.25)
>>> >>>

Fixed >> Floating Floating >> Fixed

12 MIBOR

Fixed - 12% Fixed - 8%

Floating - MIBOR + 3% Floating - MIBOR%

Case - 3
<<< XXX XXX <<<
A B
ME (0.5)
(0.25) (0.25)
>>> XXX XXX >>>

12 MIBOR

Fixed - 12% Fixed - 8%

Floating - MIBOR + 3% Floating - MIBOR%

Logic A : FxRD = 4% - FLRD = 3% >>> Margin = 1%

Logic B : New Aggregate Rate (Mibor + 3 + 8) - Old Aggregate Rate (12+ Mibor)>>> Margin = -1%
 Mergers and Acquisitions-Overview

Merger Analysis
Mergers &
Acquisitions Demerger Analysis - Spin off, split up and
divestiture

Management Takeover – Value of

Corporate Control
Mergers and
Acquisitions-
Overview
Business
Alliances

135
136
 (i) Horizontal Merger
Horizontal Merger is a merger
between companies selling similar
products in the same market and
in direct competition and share
the same product lines and
markets. It decreases competition
in the market.
The main objectives of horizontal
merger are to benefit from
Example - Facebook’s acquisition
economies of scale, reduce
of Instagram
competition, achieving monopoly
status and control of the market.
137
(ii) Vertical Merger

Vertical Merger is a merger between companies in the same industry, but at diff stages of production
process.

In another words, it occurs between companies where one buys or sells something from or to the other.

To illustrate, suppose XYZ Ltd. produces shoes and ABC Ltd. produces leather. ABC has been XYZ’s leather
supplier for many years, and they realize that by entering into a merger together, they could cut costs and
increase profits. They merge vertically because the leather produced by ABC is used in XYZ’s shoes.

138
(iii) Conglomerate Merger

Conglomerate merger is a merger between two companies that have no common business
areas.

It refers to the combination of two firms operating in industries unrelated to each other.

The business of the target company is entirely different from the acquiring company.

The main objective of a conglomerate merger is to achieve big size e.g., a watch manufacturer
acquiring a cement manufacturer, a steel manufacturer acquiring a software company, etc.

139
 (iv) Congeneric Merger
Congeneric merger is a merger between
two or more businesses which are
related to each other in terms of
customer groups, functions or
technology e.g., combination of a
computer system manufacturer with a
UPS manufacturer.
An example of a congeneric merger is
when banking giant Citicorp merged
with financial services company
Travelers Group in 1998. In a deal
valued at $70 billion, the two
companies joined forces to create
Citigroup Inc. While both companies
were in the financial services industry,
they had different product lines.
140
 A reverse merger is a merger in which a
private company becomes a public
company by acquiring it.

(v) Reverse It saves a private company from the

complicated process and expensive
Merger compliance of becoming a public
company.

Instead, it acquires a public company as

an investment and converts itself into a
public company.

141
Merger Process

142
143
144
Merger
Analysis

145
146
147
148
149
150
Demerger
Analysis - Spin
off, Split up and
divestiture

151
Demerger
IT IS A BUSINESS STRATEGY IN
WHICH A SINGLE BUSINESS IS
BROKEN INTO COMPONENTS,
EITHER TO OPERATE ON THEIR
OWN, TO BE SOLD OR TO BE
DISSOLVED.
A DEMERGER ALLOWS A LARGE
COMPANY, SUCH AS A
CONGLOMERATE, TO SPLIT OFF ITS
VARIOUS BRANDS TO INVITE OR
PREVENT AN ACQUISITION, TO
RAISE CAPITAL BY SELLING OFF
COMPONENTS THAT ARE NO
LONGER PART OF THE BUSINESS’S
CORE PRODUCT LINE, OR TO
CREATE SEPARATE LEGAL ENTITIES
TO HANDLE DIFFERENT
OPERATIONS.
DEMERGER IS AN ARRANGEMENT
WHEREBY SOME PART /
UNDERTAKING OF ONE COMPANY
IS TRANSFERRED TO
ANOTHER COMPANY WHICH
OPERATES COMPLETELY SEPARATE
FROM THE ORIGINAL COMPANY.
SHAREHOLDERS OF THE ORIGINAL
COMPANY ARE USUALLY GIVEN AN
EQUIVALENT STAKE OF OWNERSHIP
IN THE NEW COMPANY.
152
Examples
• Reliance Industries demerged to
Reliance Industries and Reliance
Communications Ventures
Ltd, Reliance Energy Ventures Ltd,
Reliance Capital Ventures Ltd, Reliance
Natural Resources Ltd.
• In April 2018, Whitbread plc.
announced to de-merge Costa Coffee
from their stable of businesses.
• Pfizer sold their infant nutrition
business to Nestle.

153
Divestiture
• Divestiture means selling or
disposal of assets of the company
or any of its business
undertakings/divisions, usually
for cash (or for a combination of
cash and debt).

154
Spin-offs
• The shares of the new entity are distributed to the shareholders of the
parent company on a pro-rata basis.
• The parent company also retains ownership in the spun-off entity.
• Approaches
• In the first approach, the company distributes all the shares of the
new entity to its existing shareholders on a pro rata basis. This leads
to the creation of two different companies holding the same
proportions of equity as compared to the single company existing
previously.
• The second approach is the floatation of a new entity with its equity
being held by the parent company. The parent company later
sells the assets of the spun off company to another company.

155
Splits / Divisions
• Splits involve dividing the company into two or more parts with an aim to
maximize profitability by removing stagnant units from the mainstream business.
Splits can be of two types, Split-ups and Split-offs.
• Split-ups:
• It is a process of reorganizing a corporate structure whereby all the capital
stock and assets are exchanged for those of two or more newly established
companies resulting in the liquidation of the parent corporation.
• Split-offs:
• It is a process of reorganizing a corporate structure whereby the capital
stock of a division or subsidiary of corporation or of a newly affiliated
company is transferred to the stakeholders of the parent corporation in
exchange for part of the stock of the latter.
• Some of the shareholders in the parent company are given shares in a
division of the parent company which is split off in exchange for their
shares in the parent company.

156
Management Takeover –
Value of Corporate Control
The Market for Corporate Control

THE TERM CORPORATE THIS RANGES FROM LEGAL “WHEN A BIDDING FIRM WHILE CORPORATE THE BASIC PROPOSITION THE MARKET FOR
CONTROL IN A BROADER AND REGULATORY ACQUIRES A TARGET BOARDS ALWAYS RETAIN ADVANCED BY THE CORPORATE CONTROL
SENSE IS USED TO SYSTEMS, COMPETITION FIRM, THE CONTROL THE TOP-LEVEL CONTROL MARKET FOR CORPORATE ASSUMES A “HIGH
DESCRIBE THE VARIOUS IN PRODUCT AND FACTOR RIGHTS TO THE TARGET RIGHTS, THEY NORMALLY CONTROL IS THAT “THE POSITIVE CORRELATION
FORCES THAT INFLUENCE MARKETS TO THE FIRM ARE TRANSFERRED DELEGATE THE RIGHTS TO CONTROL OF BETWEEN CORPORATE
THE BEHAVIOR OF A CONTROL OF A MAJORITY TO THE BOARD OF MANAGE CORPORATE CORPORATIONS MAY MANAGERIAL EFFICIENCY
CORPORATION. OF SEATS ON A DIRECTORS OF THE RESOURCES TO INTERNAL CONSTITUTE A VALUABLE AND THE MARKET PRICE
CORPORATION’S BOARD ACQUIRING FIRM. MANAGERS. IN THIS WAY ASSET”. OF SHARES OF THAT
OF DIRECTORS. THE TOP MANAGEMENT COMPANY”.
OF THE ACQUIRING FIRM
ACQUIRES THE RIGHTS TO
MANAGE THE RESOURCES
OF THE TARGET FIRM.”
 Unit VI
Foreign Exchange Market
 Foreign Exchange Market –
Exchange Rate Determination

Foreign
Managing Foreign Exchange
Exchange Risk
Market
Multinational Capital Budgeting
Decisions.
Foreign Exchange Market – Exchange Rate Determination
Purchasing Power Parity

Purchasing power of a currency is

This theory was enunciated by
determined by the amount of goods
Swedish Economist Gustav Cassel in
and services that can be purchased
1918.
with one unit of that currency.

If there is more than one currency, it

is fair and equitable that the
This is referred to as purchasing
exchange rate between these
power parity.
currencies provides the same
purchasing power for each currency.
Interest Rate Parity

There is a relationship between the foreign exchange market and the money
market.

This relationship affects the rate of exchange as well as the difference between
spot rate and forward rate.

The IRP says that the spread between the forward rate and the spot rate should
be equal but opposite in sign to the difference in interest rates between two
countries.
International Fisher Effect

All interest rates in a country are nominal The real interest rate, and
interest rates consisting of two elements: The expected rate of inflation

So, the Fisher Effect analyses the relationship between the interest rates and the
expected inflation.

The countries with higher rate of inflation will have higher nominal interest rates.
Managing Foreign
Exchange Risk
 Foreign Exchange Risk Exposure

Translation Exposure Transaction Exposure Economic Exposure

Accounting-based changes in
consolidated financial statements
caused by a change in Exchange
Rates
Impact of setting outstanding
obligations entered into before the
change in exchange rates but to be
settled after change in exchange
rates
Change in expected cash flows
arising because of an unexpected
change in exchange rates
Techniques for Risk Management

Internal Techniques External Techniques

Price Consideration Forward Contracts
Settlement Parallel Loans
Netting Currency Swaps
Leading and Lagging Currency Futures
Lease instead of Purchase / Sells Currency Options
Adjustment of Foreign Debt Patterns Matching
Matching
Netting
Netting
Exercise
Solution
Paying Subsidiary

Subsidiary Subsidiary Subsidiary Subsidiary

Receiving Subsidiary
A B C D

Subsidiary A - 520 350 980 1850 920

Subsidiary B 180 - 350 790 1320 -330

Subsidiary C 280 620 - 450 1350 0

Subsidiary D 470 510 650 - 1630 -590

930 1650 1350 2220

Multinational
Capital
Budgeting
Decisions
International Capital Budgeting
Firms calculate the net present value of a project by estimating the cash flows
the project will generate in each time period, and discounting them back to
present.

When evaluating international projects, firms must also consider risk

adjustment, currency selection, and choice of perspective for the calculations.

Only consider those cash flows that can be “repatriated” (returned) to the
home-country parent.

173
Capital
Budgeting
Approach
I. NPV Approach
Estimate expected cash flows in the foreign currency.

Compute their domestic currency equivalents at the expected exchange

rate.

Determine the NPV of the project using the domestic required

rate of return, with the rate adjusted upward or downward for any risk
premium effect associated with the foreign investment.
 1. Initial investment
2. Consumer demand
Input for 3.
over time
Product price over time
Multinational 4.
5.
Variable cost over time
Fixed cost over time
Capital 6. Project lifetime
7. Salvage (liquidation)
Budgeting value
8. Restrictions on fund
transfers
9. Tax payments and
credits
10. Exchange rates
11. Required rate of return

176
Multinational Capital Budgeting
• NPV = – initial outlay
n
+ S cash flow in period t
t =1 (1 + k )t

+ salvage value
(1 + k )n

k = the required rate of return on the project

n = project lifetime in terms of periods

• If NPV > 0, the project can be accepted.

177
178
179
II. IRR Approach
A project can also be evaluated using the internal rate of return.

This method requires that managers first estimate the cash flows generated by each project
under consideration in each time period, then the interest rate, or the internal rate of return
is calculated that makes the net present value of the project just equal to zero.

The project’s internal rate of return is then compared to the hurdle rate, the minimum rate of
return the firm finds acceptable for its capital investments.
III. Pay Back Approach

A firm can also calculate a project’s payback period, the number of

years it will take to recover, or pay back, from the project’s earnings
the original cash investment, when evaluating projects.

This method is a simple one, however, it ignores the profits generated

by the investment in the longer run.
Major Issues in Multinational
Capital Budgeting
(a) Risk Adjustment
 Firms may adjust the discount rate upward, or the
expected cash flows downward,
 to account for a higher level of risk that may be
associated with a project in a particular country.

183
(b) Choice of Currency
 The choice of which currency the project should be
evaluated in depends on the nature of the project.
 A project that is integral to a subsidiary’s strategy
may be evaluated in the foreign currency
 While a project that is central to the firm’s overall
strategy might be evaluated in the home country’s
currency.

184
(c) Whose Perspective:
Parent’s or Project’s?

• A firm must decide whether to evaluate a project’s

potential in terms of the cash flows of the
individual project, in terms of its impact on the
parent company, or in terms of both.
• In addition, any governmental restrictions on
currency movements that might affect the firm’s
ability to repatriate profits must be considered.

185
(d) Subsidiary versus Parent
Perspective

A PARENT’S PERSPECTIVE IS HOWEVER, ONE EXCEPTION TO THIS RULE

APPROPRIATE WHEN EVALUATING A OCCURS WHEN THE FOREIGN SUBSIDIARY
PROJECT, SINCE ANY PROJECT THAT CAN IS NOT WHOLLY OWNED BY THE PARENT.
CREATE A POSITIVE NET PRESENT VALUE
FOR THE PARENT SHOULD ENHANCE THE
FIRM’S VALUE.

186
Remitting Subsidiary Earnings to the Parent

Cash Flows Generated by Subsidiary Corporate Taxes

Paid to
Host Government
After-Tax Cash Flows to Subsidiary
Retained Earnings
by Subsidiary
Cash Flows Remitted by Subsidiary
Withholding Tax
Paid to
After-Tax Cash Flows Remitted by Subsidiary Host Government

Conversion of Funds
to Parent’s Currency

Cash Flows to Parent

Parent
187
 Exchange rate fluctuations

Inflation

Factors to Financing arrangement

Consider in
Multinational
Capital Blocked funds

Budgeting Uncertain salvage value

Impact of project on prevailing cash flows

Adjusting Project
Assessment for Risk
Adjusting Project Assessment
for Risk
• When an MNC is unsure of the estimated cash flows of a
proposed project, it needs to incorporate an adjustment for this
risk.
• One method is to use a risk-adjusted discount rate. The greater
the uncertainty, the larger the discount rate that should be
applied to the cash flows.
• An MNC may also perform sensitivity analysis or simulation using
computer software packages to adjust its evaluation.
• Sensitivity analysis involves considering alternative estimates for
the input variables, while simulation involves repeating the
analysis many times using input values randomly drawn from
their respective probability distributions.

190
 Complexities

Profits remitted to the

All cash flows from the
Patent cash flows are parent are subject to two
foreign projects must be
different from project cash taxing jurisdictions – the
converted into the currency
flows. parent country and the host
of the parent firm.
country.

Anticipate the differences in

the rates of national
The possibility of foreign
inflation as they can result
exchange risk and its effect
in changes in competitive
on the parent’s cash flows.
position and thus in cash
flows over a period of time.
 Complexities

If the host country provides some

concessionary financing
arrangements and / or other
benefits, the profitability of the
foreign project may go up.
The host country may impose
Initial investment in the host
various restrictions on the
country may benefit from a partial
distribution of cash flows
or total release of blocked funds
generated from foreign projects.

It is more difficult to estimate the

terminal value in multinational
Political risk must be evaluated
capital budgeting because
thoroughly as changes in political
potential buyers in the host or
events can drastically reduce the
parent company may have widely
availability of expected cash flows.
different views on the value to
them of acquiring the project.