Finance Pre-Read 2023

PRE READ | 2023
FINANCE
TABLE OF CONTENTS
SR. TOPICS PAGE NO.
1. BASICS OF MACROECONOMICS 2
2. FINANCIAL ACCOUNTING 6
3. FINANCIAL RATIOS 11
4. INTRODUCTION TO CORPORATE FINANCE 14
5. TIME VALUE OF MONEY 15
6. CAPITAL BUDGETING 16
7. COST OF CAPITAL 17
8. VALUATION 19
9. RELATIVE VALUATION 24
10. FINANCIAL MARKETS AND DERIVATIVES 26
© Preparation Committee’23 1 Pre Read-Finance

BASICS OF MACROECONOMICS
1. Gross Domestic Product (GDP)
GDP is the total value of all final products and services produced in a country over a period. It is an important concept in
macroeconomics. GDP may also be referred to as total output. Economists may express it on a per person or per capita basis;
GDP per capita is equal to GDP divided by the population. This measure allows comparisons of GDP between countries or
within a country over time because it is adjusted to reflect different population levels among countries or changes in
population levels within a country.
Measuring GDP
Expenditure approach: GDP is estimated with the following equation: GDP = C + I + G + (X – M)
The equation shows that GDP is the sum of the following components:
• Consumer (or household) spending (C)
• Business spending (or gross investment) (I)
• Government spending (G)
• Exports (or foreign spending on domestic products and services) (X)
• Imports (or domestic spending on foreign products and services) (M)
• The term (X – M) represents net exports.
Changes in GDP
GDP changes as the amount spent changes. Changes in the amount spent could be the result of changes in either the
quantity purchased, or the prices of products and services purchased. If a change in GDP is solely the result of changes in
prices with no accompanying increase in quantity of products and services purchased, then the economic production of
the country has not changed.
Nominal GDP reflects the current market value of products and services, unadjusted for price changes, may over- or
understate actual economic growth.
Real GDP is nominal GDP adjusted for changes in price levels.

Changes in real GDP, which reflect changes in actual physical output, are a better measure of economic growth than
changes in nominal GDP.
2. Economic Indicators
Economic indicators are measures that offer insight regarding economic activity and are reported with greater frequency
than GDP. Economic indicators are estimated and reported by governments and private institutions. Economic indicators
can be used to guide forecasts of future economic activity as well as forecasts of activity and performance in the financial
markets and exchange rates.
Economic indicators are often categorized as lagging, coincident, or leading, based on whether they signal or indicate that
changes in economic activity have already happened, are currently underway, or are likely to happen in the future.
● Lagging indicators signal a change in economic activity after output has already changed. An example of a
lagging indicator is the employment rate, which tends to fall after economic activity has already declined.
● Coincident indicators reveal current economic conditions, but do not have predictive value. Examples of
coincident indicators include industrial production and personal income statistics.
● Leading indicators usually signal changes in the economy in the future and are considered useful for economic
prediction and policy formulation. Examples of leading indicators include money supply (the amount of money
in circulation) and broad stock market indices, such as the S&P 500 Index, the FTSE Index, and the Hang Seng
Index.

Inflation
Inflation is the decline in purchasing power of a given currency over time. Consequently, a general rise in prices for
products and services. Food that cost on average ₹100 a week last year, may cost on average ₹110 a week this year.
Measuring Inflation
A price index is used to measure inflation. It tracks the price of a product or service, or a basket of products and services
over time. The basic measure of inflation is the percentage change in an index from one period to another.
• CPI - A consumer price index (CPI) is used to measure the change in price of a basket of goods typically
purchased by a consumer or household over time. Weight is assigned to each product and service in a typical
household’s spending in base year (2012). Frequency is monthly. January 2022 CPI stood at 165.7.Refer to this:
https://www.numberbasket.com/india/economy/cpi/consumer-price-index-weights-table
• Wholesale Price Index - WPI is an index that measures and tracks the changes in the price of goods in the
stages before the retail level. The index basket of the WPI covers commodities falling under the three Major
Groups namely Primary Articles, Fuel and Power and Manufactured products. Frequency is monthly and base
year is 2011-12. January 2022 WPI stood at 150.6.
Deflation - A continuous decrease in prices across most products and services in an economy is called deflation due to
contraction in the supply of money and credit or increased productivity and technological improvements.
Stagflation - When high inflation occurs with no economic growth, it is known as stagflation (stagnant economy +
inflation). It is a period of stagnant economy, high unemployment levels, and high inflation.
Hyperinflation - Hyperinflation involves price increases so large and rapid that consumers find it hard to afford many
products and services. Hyperinflation is rapidly rising inflation, typically measuring more than 50% per month.
3. Monetary and Fiscal Policies
Monetary Policy
Monetary policy refers to central bank activities (RBI) to influence the money supply (the amount of money in circulation)
and credit (the amount of money available for borrowing and at what cost or interest rate) in an economy.
The goal is to influence key macroeconomic targets:
● Output or GDP
● Employment
● Price stability - maintaining level inflation, as it affects unemployment and output.
Tools used for monetary policy:

● Open market operations - Purchase and sale of government notes and bonds to commercial banks.
Government increases the money supply by purchasing bonds from the bank. It puts more money incirculation
and reduces the interest rates. Central bank decreases money supply by selling the bonds to banks.It leads to a
contraction of money supply in the economy and a rise in interest rates.
● Central Bank lending rates - The interest rate that the RBI charges when commercial banks borrow money
from it is the repo rate. The interest rate that the RBI pays commercial banks when they park their excess
cash with the central bank is called the reverse repo rate. Central bank influences money supply usingthese
rates. When it wants to increase money supply, it reduces repo rate, which decreases the cost of borrowing
for commercial banks. This is further transferred by banks to customers in forms of lower interest rate.
● Reserve requirements - Central banks can affect the amount of money available for borrowing in an economy
by changing bank reserve requirements. The reserve requirement is the proportion of deposits that must be
held by a bank rather than be lent to borrowers. By increasing the reserve requirement, central banks reduce
access to credit in the economy because bank lending is reduced and vice versa.

Fiscal Policy
Governments use fiscal policy to affect economic activity. Fiscal policy involves the use of government spending and tax
policies. Fiscal policy may be aimed at stimulating a weak economy through increased spending or decreased taxes and
slowing an overheating economy through decreased spending or increased taxes.
An expansionary policy, which aims to stimulate a weak economy can,

• Reduce taxes on consumers or businesses with the objective of increasing consumer and business spending and
aggregate demand.
• Increase public spending on social goods and infrastructure, such as hospitals and schools, which increases
spending and aggregate demand directly as it can increase the personal income of workers and increase the
revenues of companies hired for those public projects. Those individuals and companies may then increase
spending and aggregate demand.
4. International Trade
International trade is the exchange of products, services, and capital between
countries.
● Imports and Exports: Imports refer to products/ services that are

produced outside a country’s borders and then brought into the country.
For example, many countries in the European Union import natural gas
from Russia. Exports refer to products/services that are produced within a country’s borders and then transported
to another country. For example, Japan exports consumer electronics to the rest of the world.
● Balance of Payments (BoP): The balance of payments tracks transactions between a country and the rest of the
world over a period, usually a year. The balance of payments shows the flow of money in and out of the country
because of exports and imports of products and services. The BoP includes two accounts:
o Current account: It is primarily driven by the trade of products and services with the rest of the world—
that is, exports and imports,
o Capital and financial account: It reflects investments by domestic entities in foreign entities and
investments by foreign entities in domestic entities including acquisitions of production facilities or
purchases and sales of financial securities, such as debt and equity securities.
In theory, the sum of the current account and the capital and financial account is equal to zero.
5. Foreign Exchange Rate Systems

The rate at which one currency can be exchanged for another is called the foreign
exchange rate or exchange rate, and it is expressed as the number of units of one
currency it takes to convert into the other currency.
These rates change continuously depending on supply and demand. If a lot of people want
to buy a particular currency, such as the euro, demand for the euro will increase and the
price of the euro will rise. It will take more of the other currency to buy a euro. In this case, the euro is said to appreciate
(get stronger) relative to other currencies. Alternatively, if a lot of people want to sell the euro, demand for the euro will
decrease and the price of the euro will fall. It will take less of the other currency to buy a euro. In this case, the euro is said
to depreciate (get weaker) relative to other currencies.
Types of exchange rate systems:

● Fixed rate System:
o At the Bretton Woods conference in 1944, the major nations of the Western world agreed to an exchange
rate system in which the value of the US dollar was defined as $35 per ounce of gold. So, a dollar was
equivalent to one thirty-fifth of an ounce of gold. All other currencies were defined or “pegged” in terms

of the US dollar. Such a system of exchange rates, which does not allow for fluctuations of currencies, is
known as a fixed exchange rate system,
● Pure Floating rate:

o To overcome the disadvantages of a fixed exchange rate system, the Bretton Woods system was
abandoned in 1973 and currency values were left to market forces. In a pure floating exchange rate
system, a country’s central bank does not intervene and lets the market determine the value of its
currency. That is, the exchange rate is only driven by supply and demand for each currency.
● Managed floating rate:

o Under this, a central bank intervenes to stabilize its country’s currency. To do so, it buys its domestic
currency using foreign currency reserves to strengthen the domestic currency or it buys foreign currency
using domestic currency to weaken the domestic currency.
Currency Values
The major factors that influence the value of a currency include the country’s Balance of
payments, level of Inflation, interest rates, level of Government debt and its political and
economic environment.

FINANCIAL ACCOUNTING
Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial
transactions pertaining to a business over a period.
Accounting principles are the rules and guidelines that companies must follow when reporting financial data. The common
set of U.S. accounting principles is the Generally Accepted Accounting Principles (GAAP).
The need for GAAP arises to be:
• logical & consistent
• Conform to established practices and procedures
The 10 principles of GAAP are:

• Accounting Period: Income is measured for a specified interval of time called accounting period. Ex: 12 months
• Going Concern: Business will continue to exist and carry on its operations for an indefinite period and would not
liquidate in the foreseeable future.
• Cost Concept: It states that the long-term assets are shown in the financial statements at their historical cost (the
cost at which the assets are acquired) irrespective of the current realizable or liquidation value.
• Separate Entity: Business is a separate accounting entity for which accounts are kept, i.e., business and the
businessman are separate entities.
• Money Measurement: Only those transactions that can be expressed in terms of money should be recorded in
the books of accounts.
• Accrual: Income and expense are recorded when they are “accrued” not when they are “realized” i.e., cash paid or
received.
• Matching: Expenses should be matched against the revenue generated to ascertain profit.
• Conservatism: Anticipate no profit but anticipate all losses i.e., recognize gains only when they are reasonably
certain and recognize losses even if they are reasonably probable.
• Materiality: Insignificant details should be avoided but all-important information must be disclosed.
• Consistency: Accounting methods once chosen must be applied consistently period after period unless there are
strong reasons to change and if there is a change the same must be disclosed separately.
STEP #1: JOURNAL ENTRY

The initial step is to identify the business transaction of financial nature, after which these transactions are listed in an
accounting journal that shows a company's debit and credit balances. The journal entry can consist of several recordings,
each of which is either a debit or a credit.
Type of Account Debit Credit
Asset a/c Increase Decrease
Liability a/c Decrease Increase
Capital a/c Decrease Increase
Revenue a/c Decrease Increase
Expense a/c Increase Decrease
Drawings a/c Increase Decrease
STEP #2: Ledger Entry
A ledger is a book or collection of accounts where account transactions are recorded. Each account has an opening or carry-
forward balance and records each transaction as either a debit or credit in separate columns, and the ending or closing balance.
STEP #3: Summarization

Trial Balance: A trial balance is a report that lists the balances of all general ledger accounts of a company at a certain
point in time.
Rule of thumb: Total of debit side = Total of credit side

STEP #4: Preparation of Financial Statements
1. Profit and Loss Account / Income Statement
The income statement is used to show the profitability of a company over a period. It captures revenues and expenses
from both operating & non-operating activities.
Statement of Profit & Loss (Income Statement)
Particulars Amount
Revenue XXX
Less: Cost of Goods Sold (XXX)
Gross Profit XXX
Less: Selling General & Administrative Expenses (SG&A) (XXX)
Earnings before Interest, Tax and Depreciation and Amortization (EBITDA) XXX
Less: Depreciation & Amortization (XXX)
Earnings before Interest and Tax (EBIT) XXX
Less: Interest (XXX)
Earnings or Profit before Tax (EBT or PBT) XXX
Less: Tax Expense (XXX)
Profit after Tax (PAT) or Net Profit XXX
Operating activities: All the activities that contribute to generating revenue from the business’s core operations.
Manufacturing, marketing, and selling of goods is clubbed under this head.
Non-operating activities: All activities that are not a part of the business’s core operations are called non-operating
activities. Example: Interest income, dividend income, foreign exchange gains etc.
Revenue
This is income generated by a company from its main business activities (sales of goods or services) and is also called
turnover or top line. The Income statement has another head called ‘Other Revenue', this is income generated from its
non-operating activities.
Cost of Goods Sold (COGS)

Cost of goods sold (COGS) is the direct cost of making a company’s products. It includes costs such as raw materials and
labor that vary depending on the amount of product you produce.
Selling General & Administrative Expenses (SG&A)

SG&A expenses comprise all day-to-day operating costs of running a business that aren’t related to producing a good or
service. This includes rent, advertising and marketing, and salaries of management and administrative staff.
Depreciation
The value of the assets gets depleted due to constant use for business purposes. Companies depreciate to account for this
value throughout the useful life of that asset. It is a fixed cost for the companies. Forexample, if a company buys a piece
of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every
accounting year, the company will expense $100,000 (assuming straight-line depreciation method is followed)
Amortization
The only difference between depreciation and amortization is that the latter is applied on intangible asset.
Tax Expenses
A tax expense is a liability owing to federal, state/provincial, and municipal governments.
• Current Tax – tax expected to be paid on current years income
• Deferred Tax – net effect of recognizing deferred tax liability / assets
✓ Deferred Tax Assets – higher taxes paid in the current year will result in lower taxes in future years

✓ Deferred Tax Liabilities – tax saved in the current year will reverse and result in higher taxes in future.
✓
2. Balance Sheet
A Balance Sheet is a financial statement that summarizes a company's assets, liabilities, and shareholders' equity at a
specific point in time.
Balance Sheet
As on 31st As on 31st
Particulars
March, 2021 March, 2022
Current Assets
Cash 1,67,971 1,81,210
Accounts Receivable 5,100 5,904
Prepaid expenses 4,806 5,513
Inventory 7,805 9,601
Total current assets 1,85,682 2,02,228
Non Current Assets
Property & Equipment 45,500 42,350
Goodwill 3,580 3,460
Total non-current assets 49,080 45,810
Total Assets 2,34,762 2,48,038
Liabilities
Current Liabilities
Accounts Payable 3,902 4,800
Accrued expenses 1,320 1,541
Unearned 1,540 1,560
Total current liabilities 6,762 7,901
Non Current Liabilities
Long-term debt 50,000 50,000
Other long-term liabilities 5,526 5,872
Total non-current liabilities 55,526 55,872
Total Liabilities 62,288 63,773
Shareholders Equity
Equity Capital 1,70,000 1,70,000
Retained Earnings 2,474 14,265
Shareholder's Equity 1,72,474 1,84,265
Total Liabilities & Shareholders Equity 2,34,762 2,48,038
Assets
An asset is anything of value that can be converted into cash. Assets are owned by individuals, businesses, and
governments.
Assets can be broadly divided into 2 categories:
• Current Assets: All assets that are reasonably expected to be converted into cash within one year or in the operating
cycleof business. Example: Cash, accounts receivable, inventory, prepaid expenses etc.
• Non-Current Assets: Assets that are expected to be converted into cash in a time frame greater than a year or anything
that isn’t a current asset. Example: Property, Plant and Equipment (PPE), Intellectual Property, Goodwill
Liabilities
Liabilities are the money that a company owes to outside parties, from bills it must pay to suppliers to interest on bonds it
has issued to creditors to rent,utilities and salaries.
Liabilities can be broadly divided into 2 categories:
• Current Liabilities are debts payable within one year or in the operating cycle, ex-interest payable, rent, tax, utilities,
wages payable, customer prepayments.
• Long-term liabilities are debts payable over a longer period like long term debt and pension fund liability.

Owner’s Equity
Owner’s equity is the amount that belongs to the business owners as shown on the capital side of the balance sheet, and
the examples include common stock, preferred stock, and retained earnings. Accumulated profits, general reserves, other
reserves, etc.
3. Cash Flow Statement

The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a
specified period, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long
term, based on how much cash is flowing into and out of the business.
There are two ways to prepare a cash flow statement:

1. Direct method – Operating cash flows are presented as a list of ingoing and outgoing cash flows. Essentially, the
direct method subtracts the money you spend from the money you receive.
2. Indirect method – The indirect method presents operating cash flows as a reconciliation from profit to cash flow.
This means that depreciation is factored into your calculations.
Direct Method Indirect Method: Operating Activities

Operating Activities Operating Activities
Cash received from customers 800 Net Income 400
Cash paid to suppliers (150) Depreciation & Amortization 150
Employee compensation (200) (lncrease)/ Decrease in Accounts Receivables (200)
Other operating expenses paid (150) (lncrease)/ Decrease in Inventory (150)
Net cash from operating activities 300 lncrease/ (Decrease) in Accounts Payable 100
Investing Activities Net cash from operating activities 300
Sele of land 200 Investing Activities
Purchase of equipment (300) Sale of land 200
Net cash from investing activities (100) Purchase of equipment (300)
Financing Activities Net cash from investing activities (100)
Common share dividends (200) Financing Activities
Payment of long term debt (300) Common share dividends (200)
Net cash from financing aciivities (500) Payment of long-term debt (300)
Net cash from financing activities (500)
Net change in cash (300)
Beginning Cash Balance 1,000 Net change in cash (300)
Ending Cash Balance 700 Beginning Cash Balance 1,000
Ending Cash Balance 700
Segregation of Cash Flows:

The statement of cash flows is segregated into three sections:
1. Cash Flow from Operating Activities (CFO): CFO is cash flow that arises from normal operations such as revenues
and cash operating expenses net of taxes.
2. Cash Flow from Investing Activities (CFI): CFI is cash flow that arises from investment activities such as the
acquisition or disposition of current and fixed assets.
3. Cash flow from financing activities (CFF): CFF is cash flow that arises from raising (or decreasing) cash through
the issuance (or retraction) of additional shares,short-term or long-term debt for the company's operations.
Note: Reporting Non-cash Investing and Financing Transactions:

Some investing and financing activities do not flow through the statement of cash flow because they do not require the
use of cash. Though these items are typically not included in the statement of cash flow, they can be found as footnotes
to the financial statements.
• Conversion of debt to equity

• Conversion of preferred equity to common equity
• Acquisition of assets through capital leases
• Acquisition of long-term assets by issuing notes payable
Linkage of three financial statements

The 3 financial statements are all linked and dependent on each other and various items have multiple effects on the three
accounts. For example:
1. Net income from the income statement flows to the balance sheet and cash flow statement.
2. Depreciation is added back, and Capex is deducted in the cash flow statement, which determines PP&E on the balance
sheet.
3. Financing activities mainly affect the balance sheet and cash from finalizing, except for interest, which is shown on
the income statement.
4. The closing cash balance on the balance sheet is the sum of the last period’s closing cash balance plus this period's
cash from operations, investing, and financing.
What is the impact of a $10 increase in depreciation on the three financial statements?
• Income Statement - Increase expense by $10 to represent the increase in depreciation.
Pre-tax income is down by $10. After-tax (assuming a 40% tax rate) net income will be down by $6.
• Statement of Cash Flows - Net Income flows onto the statement of cash flows reduces by $6.
Depreciation is added back since it is a non-cash expense. Net effect is an increase in CFO by $4 (-$6 + $10).
• Balance Sheet - Cash is up by $4 on the assets side but PPE is down by $10 as depreciation is making that asset less
valuable. Total assets are down by $6. On the Liabilities side, net income flows into retained earnings, reduced by $6.
In summary, the simplest approach to understanding the linkage between the three financial statements is to follow net
income. Net income is found on the bottom of the income statement (after deducting all expenses from revenues), which is
then adjusted for non-cash charges and changes in net working capital on the cash flow statement (to help solve for "cash
and equivalents" found on the balance sheet). Net income is also utilized to calculate retained earnings on the balance sheet.

FINANCIAL RATIOS
Financial Ratios are important metrics which are used for analyzing a company’s financial performance. They are
calculated by extracting values from a company’s 3 financial statements. Ratio analysis provides useful insights for
various stakeholders of a company. They are useful for both internal users, viz. the management, employees etc.
and the external users which consists of financial analysts, retail investors, creditors, competitors, tax authorities,
regulatory authorities etc.
Ratios can be classified into 5 categories based on the kind of information that they provide.
Financial
Ratios
Liquidity Profitability Leverage Efficiency Valuation

Ratios Ratios Ratios Ratios Ratios
Liquidity Ratios: Liquidity ratios measure a company’s ability to meet its debt using its current assets. When a company
is experiencing financial difficulties and is unable to pay its debts, itcan convert its assets into cash and use the money.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
1.𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Gauges how able a business is to pay current liabilities by using current assets. A rule of thumb for the current ratio is 2:1.
However, an industry average may be a better standard. The quality and management of assets must also be considered.
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔−𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
2. 𝑸𝒖𝒊𝒄𝒌 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Focuses on immediate liquidity (i.e., cash, accounts receivable, etc.) but specifically ignores inventory. Also called the acid
test ratio, it indicates the extent to which you could pay current liabilities without relying on the sale of inventory. Quick
assets are highly liquid--those immediately convertible to cash. A rule of thumb states that, generally, your ratio should be 1.
Profitability Ratios: Profitability ratios measure a business’ ability to earn profits, relative to their expenses. Recording
a higher profitability ratio than in the previous financial reporting period shows that the business is improving financially. A
profitability ratio can also be compared to a similar firm’s ratio to determine how relatively profitable the business is.
𝑮𝒓𝒐𝒔𝒔 𝐏𝐫 𝒐𝒇𝒊𝒕
1.𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕 𝑹𝒂𝒕𝒊𝒐 = 𝑺𝒂𝒍𝒆𝒔
Indicates how well the company can generate a return at the gross profit level. It addresses three areas: inventory control,
pricing, and production efficiency.
𝑵𝒆𝒕 𝐏𝐫 𝒐𝒇𝒊𝒕
2.𝑵𝒆𝒕 𝐏𝐫 𝒐 𝒇𝒊𝒕 𝑹𝒂𝒕𝒊𝒐 = 𝑺𝒂𝒍𝒆𝒔
Shows how much net profit is derived from every dollar of sales. It indicates how well the business has managed its operating
expenses and whether the business is generating enough sales to cover minimum fixed costs and still leave an profit.
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
3.𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑨𝒔𝒔𝒆𝒕𝒔 =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Evaluates how effectively the company employs its assets to generate a return. It measures efficiency.

𝑵𝒆𝒕 𝐏𝐫 𝒐𝒇𝒊𝒕
4. 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 = l
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅
It measures the return that is generated on the entre capital of a business. If the ROCE is greater than the WACC, it means
that the company is creating value for its shareholders.
Leverage Ratio: It measure a business’ ability to service its debts and other obligations. Leverage ratios across several
reporting periods are used to draw a trend that predicts the company’s financial position in the future. A higher leverage
ratio means that a business can service its debts and obligations with greater ease.
𝑬𝑩𝑰𝑻
1.𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 = 𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆
This is majorly used in order gauge the debt paying capacity of a company. The higher this ratio, the better it is as the
company is in a better position to pay back its debt.
𝑬𝑩𝑰𝑻
2.𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 = 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑫𝒖𝒆
This ratio gives the times the company can generate its income compared to the interest due. It helps in understanding
that whether the company will be able to pay back interest, and how comfortable will it be in doing that.
𝑫𝒆𝒃𝒕
3.𝑫𝒆𝒃𝒕 𝑬𝒒𝒖𝒊𝒕𝒚 𝑹𝒂𝒕𝒊𝒐 = 𝑬𝒒𝒖𝒊𝒕𝒚 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
This ratio helps to understand the distribution between debt and equity capital of a company. A significantly high debt
equity ratio indicates a greater amount of financial risk for a company.
Efficiency/Activity ratios: These measure how well the business is using its assets and liabilities to generate sales
and earn profits. They calculate the use of inventory, machinery utilization, turnover of liabilities, as well as the usage of
equity. These ratios are important because, when there is an improvement in the efficiency ratios, the business stands to
generate more revenues and profits.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑺𝒐𝒍𝒅

1.𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
𝟑𝟔𝟓
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑫𝒂𝒚𝒔 =
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
Helps us in understanding the number of times a company can rotate its inventory each year. Higher this ratio, more
efficiently does an enterprise use its inventory to carry on business. Inventory days resemble the average number of days
that are required to complete one cycle of inventory. The lower this period, resembles higher efficiency of rotating inventory.
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
2.𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆
𝟑𝟔𝟓
𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑫𝒂𝒚𝒔 =
𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
It indicates the average period that the receivables of the company take to pay back their short-term commitments.
Higher the receivables turnover, the better it is, as it means that the receivables are paying on time. The receivables day
should be as low as possible to resemble greater efficiency.

𝑵𝒆𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔
3.𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔
𝟑𝟔𝟓
𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 𝑫𝒂𝒚𝒔 = 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐
Indicates the number of times that a company can rotate its payables. In other words, the ratio indicates the number
of times the payables are cleared off on an average. Payable days resembles the average period that a company takes
to pay off the creditors. A very high ratio might lead that creditors are not willing to give goods on credit to the
company owing to irregular or late payments. However, this is subjective on the basis of the scale and position of a
company to negotiate. For example, FMCG companies generally have high payable days as they can squeeze in a
higher credit period from payables owing to greater bargaining power.
Cash Conversion Cycle: It indicates the days within which a company is able to covert its inventories and receivables
into cash. It attempts to measure how long each net input dollar is tied up in the production and sales process before it
gets converted into cash received.
𝐶𝐶𝐶 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠
The lower this cycle is, the better it might be for a company, as it will be able to faster liquidate its current assets into cash.
A negative CCC might be a good sign for a company as it is able to get money from its receivables, while it has the power to
delay paying its payables.
EPS and its types

Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its common stock. The
resulting number serves as an indicator of a company's profitability.
The higher a company's EPS, the more profitable it is.
Dilutive securities include financial instruments like ESOPs, warrants convertible debt, convertible preferred stock which
increases the number of common shares if exercised, which then reduces, or dilutes, the EPS.
Antidilutive securities are stock financial instruments that would increase EPS if exercised or converted to common stock.
Diluted EPS is a calculation used to gauge the quality of a company's earnings per share if all convertible securities were
exercised.
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆−𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔

Basic EPS =
𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆−𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔

Diluted EPS =
𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈+𝑫𝒊𝒍𝒖𝒕𝒊𝒗𝒆 𝑺𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔
Example on Basic & Diluted EPS

XYZ ltd. has 2 lakh common shares and XYZ grants employee stock options that could be converted to 1 lakh additional
common shares and convertible preferred shares that could be converted to 50 thousand common shares. Compute the
basic & diluted EPS if net profit earned after tax is Rs. 40 lakhs.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒−𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 Diluted EPS =

Basic EPS = 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝐻𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒−𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠+𝐷𝑖𝑙𝑢𝑡𝑖𝑣𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
40 𝐿𝑎𝑘ℎ𝑠
=
2 𝐿𝑎𝑘ℎ 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠
40 𝐿𝑎𝑘ℎ𝑠
= Rs. 20 per share = (2+1+0.5)𝐿𝑎𝑘ℎ 𝑆ℎ𝑎𝑟𝑒𝑠
= Rs. 11.43 per share

INTRODUCTION TO CORPORATE FINANCE
What is Finance?
Finance is a branch of economics that studies the management of funds (money and similar assets). Through financial
analysis, decisions and corrective actions can be taken regarding the collection and usage of those funds to optimize their
use toward the objectives of an organization (states, companies, and businesses) or individual. Finance also encompasses the
oversight, creation, and study of money, banking, credit, investments, assets, and liabilities that make up financial systems.
What is Corporate Finance?

Corporate finance deals with the capital structure of a corporation, including its funding and the actions that management
takes to increase the value of the company. Corporate finance also includes the tools and analysis utilized to prioritize and
distribute financial resources. The ultimate purpose of corporate finance is to maximize the value of a business through
planning and implementation of resources while balancing risk and profitability.
The activities that govern corporate finance can be divided into three decisions that a company needs to take:
1. Investment Decisions: Which assets must company invest in to create value for the firm
2. Financing Decisions: How to raise money required to fund those assets
3. Dividend Decisions: How much should company pay back to its equity investors and in what form

TIME VALUE OF MONEY
As per Time Value of Money (TVM), money in the present is worth more than the same sum of money to be received in the
future. The time value of money is sometimes referred to as the Net Present Value (NPV) of money. Time value of money
also relates to the concepts of inflation and purchasing power because inflation constantly erodes the value, and therefore
the purchasing power, of money.
A simple example to illustrate the same: Rs 100 would get a person 7 units of an object today. The same Rs 100 would have
gotten him 8 units of the same object 5 years earlier and 5 years down the line, the same Rs 100 would yield just 6 units.
Present Value (PV), also called "discounted value," is the current worth of a future sum of money or stream of cash flows at
a specified rate of return.
Future value (FV) is the value of a current asset at a future date based on an assumed rate of growth.
A discount rate, usually equal to the cost of capital, is used to compute the future value from the present value or vice versa.
The process of computing the PV from the FV is called discounting and the process of computing the FV from the PV is called
compounding.
FV = PV x [1+i] n
FV: Future value
PV: Present value
i: Interest per compounding period
n: Number of periods
Example: Let’s assume you have Rs. 5,000 and expect to earn 5% interest on that sum each year for the next two years.
Assuming the interest is only compounded annually, the future value of your Rs. 5,000 today can be calculated as follows:
FV = 5,000 x (1 + 5%)2 = 5,512.50
If interest was compounded semi-annually, the future value would have been:
FV = Rs 5000 x (1 + 2.5%)4 = 5519.06
The same formula can also be used to calculate the present value of money to be received in the future.
PV = FV / [1+ i] n
In the previous example, suppose we want to know the present value of Rs 5,512.5 that we will get after 2 years. Present
value will be calculated as:
PV = 5,512.5 / (1 + 5%)2 = 5,000
When we talk about money, it is not just the amount of money but also when you receive the money which is important.
TVM says that the same amount of money is always more valuable today than in the future. Unlike accounts, finance always
considers the difference in the value of money at different points of time.
The following links can be viewed to understand more on this topic:

https://www.investopedia.com/terms/t/timevalueofmoney.asp
https://corporatefinanceinstitute.com/resources/knowledge/valuation/time-value-of-money/

CAPITAL BUDGETING
Corporations may have multiple options of projects to undertake and look to select those projects that will increase
profitability and thus enhance shareholders' wealth. Capital budgeting involves analyzing these alternatives and selecting
projects that add value to the company.
Most common methods of capital budgeting:
1. PAYBACK PERIOD (PBP)

The payback period calculates the length of time required to recoup the original investment. For example,
Investment Cash Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
-1,00,000 20,000 30,000 40,000 20,000 30,000
Payback period in these case = 3.5 years
2. NET PRESENT VALUE (NPV)

In the NPV method, the after-tax cash flows are discounted by the weighted average cost of capital allowing managers to
determine whether a project will be profitable or not. Unlike the IRR method explained below, NPVs reveal exactly how
profitable a project will be in comparison to alternatives.
The NPV rule is as follows:

NPV is positive → Accept Project
NPV is negative → Reject Project
Multiple projects with positive NPVs → Accept the project with the highest NPV
3. INTERNAL RATE OF RETURN (IRR)

Internal rate of return (or expected return on a project) is the discount rate that would result in a net present value of zero.
The IRR rule is as follows:

IRR > Cost of Capital → Accept Project
IRR < Cost of Capital → Reject Project
NPV v/s IRR

• NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.
• IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a
discount rate.
• Most project managers prefer to use NPV because it is considered the best when ranking mutually exclusive projects
but there is no exact answer since different situations ask for the use of different methods.
4. PROFITABILITY INDEX (PI)

The profitability index is calculated as the ratio between the present value of future expected cash flows and the initial
amount invested in the project. A higher PI means that a project will be considered more attractive.
5. ACCOUNTING RATE OF RETURN (ARR)

This formula divides an asset's average revenue by the company's initial investment to derive the ratio or return that one
may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows and thus, it
is not used often.

Capital Budgeting: What It Is and Methods of Analysis (investopedia.com)

COST OF CAPITAL
The cost of capital is the cost of a company's funds, or, from an investor's point of view – the required rate of return on a
portfolio's basket of existing securities.
The cost of various capital sources varies from company to company, and depends on factors such as its operating history,
profitability, credit worthiness, etc. A firm can raise capital either using debt or equity and accordingly, the cost of capital is
calculated.
A firm may raise money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or
institutional investors. Creditors have priority over shareholders in receiving interest and repayment of capital.
COST OF EQUITY
A stock or any other security representing an ownership interest is equity. In finance, in general, you can think of equity as
ownership in any asset after all debts associated with that asset are paid off.
Cost of equity can be approximated using the:

1. Capital Asset Pricing Model (CAPM): CAPM considers the riskiness of an investment relative to the market, where:
Cost of Equity = Risk-free rate + (Company’s Beta x Risk Premium)
• Risk-free return is the return obtained from investing in securities considered free from credit risk, such as
government bonds from developed countries.
• Risk premium = Market return - Risk free return
• Market return is the return on the market portfolio measured using indexes.
• Beta measures the volatility or systematic risk (non-Diversifiable) of a security compared to the market as a whole.
There are 2 types of beta:
▪ Levered Beta is the beta of a firm inclusive of the effects of the capital structure. Other things remaining
constant, higher debt in the capital structure will mean higher interest expense which leads to higher beta.
β (Unlevered) = β (Levered) / (1+(1-t) D/E)
▪ Unlevered Beta doesn't include the debt part in the capital structure. It shows the pure business risk.
The general idea behind CAPM is that investors need to be compensated in two ways: Time Value of Money and Risk. The
risk-free rate in the formula compensates the investors for placing money in any investment over a period of time. The other
half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional
risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of
time and to the market premium.
2. Dividend Capitalization Model: The Dividend Capitalization Model only applies to companies that pay dividends, and it
also assumes that the dividends will grow at a constant rate. The model does not account for investment risk to the extent
that CAPM does (since CAPM requires beta).
Cost of Equity = (Dividend per share next year / Current Share Price) + Dividend growth rate
COST OF PREFERENCE SHARES

Preferred stock is a form of equity that may be used to fund expansion projects or developments that firms seek to engage
in. Like other equity capital, selling preferred stock enables companies to raise funds. Preferred stock has the benefit of not
diluting the ownership stake of common shareholders, as preferred shares do not hold the same voting rights that common
shares do.
Cost of Preference = Preference Dividend per share / Current Share Price

COST OF DEBT
Debt securities include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, collateralized securities,
and zero-coupon securities. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility.
However, it is rarely the optimal structure since a company's risk generally increases as debt increases.
The cost of debt is merely the interest rate paid by the company on such debt. However, since interest expense is tax-
deductible, the after-tax cost of debt is calculated as:
Pre-Tax Cost of Debt = Interest Expense / Total Debt

After-Tax Cost of Debt = Pre-Tax Cost of Debt * (1 – Tax Rate)
WEIGHTED AVERAGE COST OF CAPITAL
The firm’s overall cost of capital is based on the weighted average of cost of debt and cost of equity.
WACC = E/(D+E+P) * Re + D/(D+E+P) * Rd + P/(D+E+P) * Rp
Re = cost of equity
Rp = cost of preference
Rd = cost of debt
E = market value of the firm's equity
D = book value of the firm's debt
For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10%
and after-tax cost of debt is 7%.
Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company
directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate
to use for cash flows with risk that is similar to that of the overall firm.
Example: a company has reported return for its last fiscal year as 10.85%. The company has outstanding debt of $50,000,000
and common equity valued at $70,000,000. The tax rate is 34%. The company pays interest at the rate of 8% on its debt. The
risk-free rate of return is 4%, while the return on the Dow Jones Industrials is 11% (Market rate of return) and ABC Limited’s
beta is 1.3.
Solution:
Weight of debt = 50 million / 120 million = 0.42
Weight of equity = 70 million / 120 million = 0.58
Cost of debt = 8% * (1 - 34%) = 5.28%
Cost of equity= 4% + 1.3 * (11% – 4%) = 13.1%
Therefore, WACC= 0.42 (5.28%) + 0.58(13.1%) = 2.22 + 7.60 = 9.82%

https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-capital/

VALUATION
What does the valuation of a company mean?
Valuation (Corporate or business valuation) is comprised of the methods to find the value or estimate what a company is
worth. Arriving at this value helps current and potential investors to form their investment decisions (Such as when to
invest in a company). There are many methods to value a business. There are several variables to consider such as the
dividend policy, time horizon of the investment, and the industry of the company.
INTRINSIC VALUATION
Dividend Discount Model
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 its future dividend payments when discounted back to
their present value.
When is it suitable?
•Company is dividend paying or is expected to pay dividends in the coming years
•Established dividend policy that bears an understandable and consistent relationship to the company’s profitability
•The investor while valuing takes a non-control perspective as it cannot govern the dividend policy of the firm
Let’s start with an example with a single period model, if a company pays $0.58 dividend in the next year and its expected
share price is $27 next year, what should be its current market price?
Gordon Growth Model
In the Gordon Growth Model, instead of explicitly forecasting dividends for future years, we assume that dividends grow
indefinitely at a constant rate and that growth rate is less than required return on equity.
Free Cash Flow Method
The formal definition of FCFF is the cash available to all the firm’s investors, including stockholders and bondholders,
after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short-and long-
term investments.

What does the firm do with its FCFF? First, it takes care of its bondholders because common shareholders are last in line
at the money store. So, it makes interest payments to bondholders and borrows more money from them or pays some of
it back. However, making interest payments to bondholders has one advantage for common shareholders: it reduces the
tax bill.
The amount that’s left after the firm has met all its obligations to its other investors is called free cash flow to equity
(FCFE). However, the board of directors still has discretion over what to do with that money. It could pay it all out in
dividends to its common shareholders, but it might decide to only pay out some of it and put the rest in the bank to save
for next year. That way, if FCFE is low the next year, it won’t have to cut the dividend payment. So FCFE is the cash available
to common shareholders after funding capital requirements, working capital needs, and debt financing requirements.
Calculating FCFF & FCFE:
FCFF = [EBIT*(1 – tax rate)] + NCC – FCInv – WCInv, where EBIT = Earnings before Interest & Taxes
NCC = Non-Cash Charges, Int = Interest Expense, FCInv = Fixed Capital Investment, WCInv = Working CapitalInvestments
If we start with EBIT, we add back depreciation because it was subtracted out to get to EBIT. However, because EBIT is
“before interest and taxes” we don’t have to take out interest (remember that it’s a financing cash flow). We must adjust
for taxes by computing after-tax EBIT, which is EBIT times one minus the tax rate.
Noncash charges are added back to net income to arrive at FCFF because they represent expenses that reduced reported
net income but didn’t result in an outflow of cash. The most significant noncash charge is usually depreciation.
Investments in fixed capital are subtracted because they represent cash leaving the firm. Fixed capital investment is a net
amount: it is the difference between capital expenditures (investments in long-term fixed assets) and the proceeds from
the sale of long-term assets. Both capital expenditures and proceeds from long-term asset sales (if any) are likely to be
reported on the firm’s statement of cash flows. If no long-term assets were sold during the year, then capital expenditures
will also equal the change in the gross PP&E account from the balance sheet.
FCInv = capital expenditures = ending gross PP&E – beginning gross PP&E
Calculating FCFE from FCFF: FCFE = FCFF – Int*(1 – tax rate) + net borrowing
If we start with FCFF, we must adjust for the two cash flows to calculate FCFE: the after-tax interest expense and any new
long- or short-term borrowings. We only subtract the after-tax interest expense because paying interest reduces the firm’s
tax bill and reduces the cash available to the shareholders by the interest paid minus the taxes saved.
Explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE:
The short answer is that dividends, share repurchases, and share issues have no effect on FCFF and FCFE; changes in
leverage have only a minor effect on FCFE and no effect on FCFF.
The reason is that and FCFE represent cash flows available to investors and shareholders, respectively, before any financing
decisions. Dividends, share repurchases, and share issues, on the other hand, representuses of those cash flows; as such,
these financing decisions don’t affect the level of cash flow available. Changes in leverage will have a small effect on FCFE.
For example, a decrease in leverage through a repayment of debt will decrease FCFE in the current year and increase
forecasted FCFE in future years as interest expense is reduced.
It is assumed that payments to stockholders are not tax-deductible, and payments to debtholders are tax-deductible.
Thus, the after-tax cost of debt is the before-tax rate of return on debt times one minus the firm’s marginal tax rate. WACC
will change over time as the firm’s capital structure changes. Therefore, analysts usually use target capital structure
weights rather than actual weights.

Discounted Cash Flow Method (Multiple stage FCFF)
The DCF method is also a commonly used method in venture capital financings because it focuses on what the investor is
buying, a piece of the future operations of the company. Its focus on future cash flows also coincides with a critical concern
of all venture investors, the company's ability to sustain its future operations through internally generated cash flow.
The premise of the discounted free cash flow method is that company value can be estimated by forecasting the future
performance of the business and measuring the surplus cash flow generated by the company. The surplus cash flows and
cash flow shortfalls are discounted back to a present value and added together to arrive at a valuation. The discount factor
used is adjusted for the financial risk of investing in the company. The mechanics of the method focus investors on the internal
operations of the company and its future.
The Free Cash Flows for the Firm (FCFF) are discounted using a discount factor to arrive at the present value of the firm.
The discounted cash flow method can be applied in six distinct steps. Since the method is based on forecasts, a good
understanding of the business, its market, and its past operations is a must. The steps in the discounted cash flow method
are as follows:
1. Develop debt-free projections of the company's future operations. The more closely the projections reflect a good
understanding of the business and its realistic prospects, the more confident investors will be with the valuation its
supports.
2. Quantify positive and negative cash flow in each year of the projections. The cash flow being measured is the surplus
cash generated by the business each year. In years when the company does not generate surplus cash, the cash
shortfall is measured. So that borrowings will not distort the valuation, cash flow is calculated as if the company had
no debt. In other words, interest charges are backed out of the projections before cash flows are measured. It is
basically predicting the future cash flows of the firm by taking logical assumptions supported by relevant data.
3. Estimate a terminal value for the last year of the projections. Since it is impractical to project company operations
out beyond three to five years in most cases, some assumptions must be made to estimate how much value will be
contributed to the company by the cash flows generated after the last year in the projections. Without making such
assumptions, the value generated by the discounted cash flow method would approximate the value of the company
as if it ceased operations at the end of the projection period. One common and conservative assumption is the
perpetuity assumption. This assumption assumes that the cash flow of the last projected year will continue forever
and then discounts that cash flow back to the last year of the projections.
4. Determine the discount factor to be applied to the cash flows. The larger the factor is, the lower the valuation it will
generate. This discount factor should reflect the business and investment risk involved. The less likely the company
is to meet its projections, the higher the factor should be. Discount factors used most often are a compromise
between the cost of borrowing and the cost of equity investment. If the cost of borrowed money is 10% and equity

investors want 30% for their funds, the discount factor would be somewhere in between -- in fact, the weighted-
average cost of capital (WACC).
5. Apply the discount factor to the cash flow surplus and shortfall of each year and to the terminal value. The amount
generated by each of these calculations will estimate the present value contribution of each year's future cash flow.
Adding these values together estimates the company's present value assuming it is debt free.
6. Subtract present long term and short-term borrowings from the present value of future cash flows to estimate the
company's present value.
The following table illustrates the computations made in the discounted cash flow method. The chart assumes a discount
factor of 13% (IBM's estimated weighted-average cost of capital) and uses the growing perpetuity assumption to generate a
residual value for the cash flows after the fifth year.
To know more about the methods of Valuation, you can refer to these videos-
DCF Video Link - https://youtu.be/gLULdxrS-CU
Comparable Methods Valuation - https://youtu.be/CPtBJN3SAvs
Enterprise Value
Enterprise value (EV) measures a company's total value and is often used as a more comprehensive alternative
to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term
and long-term debt and any cash or cash equivalents on the company's balance sheet. EV can be thought of as the
effective cost of buying a company or the theoretical price of a target company.
Enterprise value is used as the basis for many financial ratios that measure a company's performance.
The simple formula for enterprise value is:
EV = Market Capitalization + Market Value of Debt – Cash and Equivalents

The extended formula is:
EV = Common Shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents
Enterprise value is a financing calculation — the amount you would need to pay to those who have a financial interest in the
firm. That means everyone who owns equity (shareholders) and everyone who has loaned it money (lenders).
So, if you’re buying the company, you must pony up for the stock and then pay off the debt, but you get the company’s cash
reserves upon acquisition. Because you receive that cash, it means you paid that much less to buy the company. That’s why
you add the debt but subtract the cash when you calculate an acquisition target’s enterprise value.
What is Minority Interest?
Minority interest, or noncontrolling interest (NCI), represents an ownership stake of a company which is less than 50% in
another company (hence the term minority, or noncontrolling). For accounting purposes, noncontrolling interest is classified
as equity and shows up on the balance sheet of the company that owns the majority interest in the subsidiary.
Why is minority interest added to EV?

Minority interest is the portion of a subsidiary not owned by the parent company (who owns a greater than 50% but less
than 100% position in the subsidiary). The financial statements of this subsidiary are consolidated in the financial results of
the parent company.
We add this minority interest to the calculation of EV because the parent company has consolidated financial statements
with that minority interest; meaning the parent includes 100% of the revenues, expenses, and cash flow in its numbers even
though it doesn’t own 100% of the business. By including the minority interest, the total value of the subsidiary is reflected
in EV as well.

RELATIVE VALUATION
Relative valuation is a method of determining the value of an asset by comparing it to similar assets in the same market. The
aim of relative valuation is to establish a price relationship between an asset and other comparable assets, such as publicly
traded companies in the same industry or a group of similar bonds. This process assumes that assets with similar
characteristics will trade at similar multiples, such as price-to-earnings or price-to-book. The relative valuation approach is
commonly used in financial analysis, especially in the stock market, to evaluate the relative worth of a company compared
to its peers and make investment decisions.
RV Multiples
Earnings multiples:
Price to Earnings ratio (P/E) - The PE Ratio is used for RV when evaluating publicly traded companies in the same industry.
For example, if Company A has a P/E ratio of 20 and Company B has a P/E ratio of 15, an investor might conclude that Company
B is relatively undervalued compared to Company A and therefore a better investment opportunity.
EV/EBITDA - The Enterprise Value (EV) of a firm is given by market capitalization + total debt - cash and cash equivalents. The
ratio EV/EBITDA is commonly used in RV when evaluating the financial performance and value of companies in capital-
intensive industries, such as utilities, telecommunications, and natural resource companies. These industries typically have
high levels of depreciation and amortization expenses, which can make traditional valuation metrics less meaningful.
For example, if Company A has an EV/EBITDA ratio of 8 and Company B has an EV/EBITDA ratio of 10, an investor might
conclude that Company A is relatively undervalued compared to Company B.
EV/EBIT - Though less commonly used than EV/EBITDA, EV/EBIT is an important ratio when it comes to valuation. The major
difference between the two ratios is EV/EBIT inclusion of depreciation and amortization. It is useful for capital-intensive
businesses where depreciation is a true economic cost.
Book Value Multiples:

Price/Book Value - The price-to-book ratio is important because it can help investors understand whether a company's
market price seems reasonable compared to its balance sheet. For example, if a company shows a high price-to-book ratio,
investors might check to see whether that valuation is justified given other measures. It is often read with ROE. A stock with
lower P/B ratio and higher ROE is valued higher. A P/B Ratio is a more popular measure of the valuation of a bank and/or
financial services company compared to a P/E Ratio.
Revenue Multiples:
EV/Sales - EV/Sales is calculated by dividing a company's Enterprise Value by its annual sales. This is commonly used in
industries where earnings or earnings potential may be difficult to determine, such as technology/growth/early-stage
companies.
Price/Sales - The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market capitalization and divide
it by the company's total sales or revenue over the past 12 months. This ratio too is used to value growth/early stages
companies.
Relative Valuation example

RV of company A
We can see that the P/E ratio and P/B ratio of Company A is lesser than the industry median. This means that Company A’s
stock may be undervalued compared to the industry. This represents an investment opportunity.
It is important to note that any ratio should not be used in isolation and should be considered in conjunction with other
financial metrics and industry trends.
P/E Ratio vs EV/EBITDA Ratio
The price-to-earnings ratio (P/E) is one of the most widely used tools by which investors and analysts determine a stock's
relative valuation. The P/E ratio helps one determine whether a stock is overvalued or undervalued. It is used as an indicator
of a company's future growth potential. However, it does not reveal the full picture, and it is most useful when comparing
only companies within the same industry or comparing companies against the general market.
P/E ratio is a gauge of what the market is willing to pay for the stock for every rupee earned by it. As mentioned earlier, the
P/E is the input and determines the price of the stock. EV/EBITDA, on the other hand, measures the payback period. It is the
number of years that it takes for your investment in the company to be recovered in the form of EBITDA generated by the
company.
P/E is a good measure for the equity value of the company. Since it considers the residual profit (EPS) as the denominator, it
gives a better picture of equity valuation. EV/EBITDA is a better gauge of company valuation, especially when one is looking
at mergers and acquisitions. EV/EBITDA takes a more holistic picture of the company and covers the equity and the debt
components of the capital structure.
Generally, you can use the EV to EBITDA valuation method to value capital intensive sectors like the following –
• Oil & Gas Sector
• Automobile Sector
• Cement Sector
• Steel Sector
• Energy Companies
Links for references

1. https://corporatefinanceinstitute.com/resources/knowledge/valuation/relative-valuation-models/
2. https://www.investopedia.com/terms/r/relative-valuation-model.asp

FINANCIAL MARKETS
Stock Market
The stock market is a component of a free-market economy. It enables businesses to raise funds by selling stock shares and
corporate bonds, giving investors a chance to profit from the business's financial success through capital gains and dividend
payments. The stock market serves as a platform for directing individual investors' savings and investments into profitable
business ventures, which helps the nation's capital formation and economic expansion.
The market participant can be classified into various categories –
• Domestic Retail Participants – These are people like us transacting in markets.
• NRI’s and OCI – These are people of Indian origin but based outside India.
• Domestic Institutions – These are corporate entities in India.
• Domestic Asset Management Companies (AMC) – Mutual fund companies like SBI Mutual Fund, HDFC AMC,
Edelweiss, ICICI Pru, etc.
Foreign Institutional Investors – Non-Indian corporate entities. These could be foreign asset management companies, hedge
funds, and other investors. In India, the stock market regulator is called The Securities and Exchange Board of India, often
referred to as SEBI. SEBI aims to promote the development of stock exchanges, protect the interest of retail investors, and
regulate market participants' and financial intermediaries’ activities. In general, SEBI ensures:
• The stock exchange conducts its business fairly.
• Stockbrokers conduct their business fairly.
• Participants don’t get involved in unfair practices.
• Corporates don’t use the markets to benefit themselves (Satyam Computers) unduly.
• Small investors’ interests are protected.
• Large investors with mega cash piles should not manipulate the markets.
• Overall development of markets
Most of the trading in the Indian stock market takes place on its two stock exchanges: The S&P BSE Sensex represents the
Bombay stock exchange, and the Nifty 50 represents the National Stock exchange. The Indian stock exchange follows a free-
float market capitalization method. The weights are assigned based on the company’s free-float market capitalization. The
index reflects the overall sentiment and trend in the market.
Recent developments in the stock market

India will be the first market to achieve a complete T+1 trading settlement. It will not only reduce the risk of non-payment or
non-delivery of shares by the broker, but also will provide liquidity to the investors as they get their funds one day earlier. In
this way, the market turnover may increase on the possibility of increased transactions, hence benefiting the brokers also.
https://zerodha.com/varsity/chapter/the-stock-markets/
https://www.livemint.com/market/stock-market-news/indian-stock-market-to-shift-to-a-shorter-trading-cycle-t-1-
settlement-on-jan-27-11673878481583.html
https://www.investopedia.com/articles/stocks/09/indian-stock-market.asp#toc-the-bse-and-nse
Bonds Market
A bond is a debt security that represents a loan made by an investor to a borrower (typically corporations or governments).
The borrower agrees to pay periodic interest payments to the bondholder and to repay the principal (the amount borrowed)
when the bond matures. Bonds are generally considered to be less risky than stocks but also offer lower returns. They are
often used as a way for investors to receive a predictable and steady stream of income.
• Face value (par value) is the amount of money the bond will be worth at maturity; it is also the reference amount the
bond issuer uses when calculating interest payments. For example, an investor purchases a bond at a premium of

₹1,090, and another investor buys the same bond later when trading at a discount for ₹980. Both investors will
receive the ₹1,000 face value when the bond matures.
• The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a
percentage. For example, a 5% coupon rate means that bondholders will receive 5% x ₹1,000 face value = ₹50 every
year.
• Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made at any
interval, but the standard is semiannual.
• The maturity date is the date on which the bond will mature, and the bond issuer will pay the bondholder the face
value of the bond.
• The issue price is the price at which the bond issuer initially sells the bonds. In many cases, bonds are issued at par.
Types of bonds
Government Bonds
In general, fixed-income securities are classified according to the length of time before maturity. These are the three main
categories:
• Bills - debt securities maturing in less than one year.
• Notes - debt securities maturing in one to ten years.
• Bonds - debt securities maturing in more than ten years
Municipal Bonds
The term “municipal bond” refers to a type of debt security issued by local, county, and state governments. They are
commonly offered to pay for capital expenditures, including the construction of highways, bridges, or schools.
Corporate Bonds
A corporate bond is a type of debt security that is issued by a firm and sold to investors. The company gets the capital it needs
and in return the investor is paid a pre-established number of interest payments at either a fixed or variable interest rate.
When the bond expires, or "reaches maturity," the payments cease, and the original investment is returned.
Derivatives
Derivates are financial assets that derive their value from an underlying asset. For example, wheat derivatives will
derive their values from the prices of wheat. If the price of wheat goes up, the value of derivative will go up and vice
versa. Underlying assets can be financial assets, commodities like wheat, gold, silver etc. A derivative contract can be
used either to hedge against current investments or to make speculative gains.
Futures and Forwards
Forwards are derivative instruments which give the holder of the contract an obligation to buy or sell a certain asset. It is
over the counter (OTC) transaction wherein the parties involved in the contract negotiate and privately conclude the
contract.
Some features of forwards are:
• At a specified price (forward price}

• At a specified time (contract maturity or expiration date)
• Typically, not traded on exchange
Futures on the other hand are similar to forwards except that they are freely traded on exchanges like the MCX and NCDEX.

Some features of futures are:
• They are standardized contracts unlike forwards. For example, if there is a futures contract of 100kgs of wheat, it
can be bought only in multiples of this standard contract. • Futures are traded on the basis of margin. For example,
if there is a margin of 10%, and a future contract is worth Rs. 1000, one will need to pay only Rs. 100 to enter the
contract.
• Future contracts are settled daily on the exchange, at marked to market (MTM) prices, which are essentially the
closing price of the futures contract.
Options
Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at
an agreed-upon price and date. Call options and put options form the basis for a
wide range of option strategies designed for hedging, income, or speculation. There are mainly two types of options,
call and put.
What does an Option do?
A "call option" gives the holder the right to purchase an asset for a specified price on or before a specified expiration
date. (This specified price is called the "exercise price" or "strike price."} The opposite would have been true for
buying a put option, the buyer would have profited only if the price of the option goes below the strike price of that
option.
A call option gives the buyer profit when the underlying goes up in price and put gives a profit when it goes down and
for the seller, the opposite, loss when underlying goes up in calls and loss when underlying goes down in selling puts.
Underlying Stock price goes up Underlying stock price goes down
Call Buyer
Call Seller
Put Buyer
Put Seller

Important Keywords and Concepts-Finance
Macro vs Micro Economics IRR VS NPV
GDP, WPI, CPI Cost of Capital
Deflation Cost of Equity
Stagflation CAPM Model
Monetary and Fiscal Policy Risk free return and Risk premium
Balance of Payment Beta- Levered and Unlevered
GAAP Principles Dividend Capitalization Model
Journal and Ledger Entry Preference Shares
Types of financial statement Pre and After Tax Cost of Debt
COGS, SG&A, EBIT, EBT, PAT Weighted Average Cost of Capital
Depreciation and Amortization Valuation
Current and Non Current Assets Dividend Discount Model
Liabilities and Equity Gordon Growth Model
Cash flow from Operating, Investing and FCFF
Financial Activity Stockholders
Liquidity Ratios FCFE
Profitability Ratios Discounted Cash Flow Method
Leverage Ratios Enterprise Value
Efficiency Ratios Market Capitalization
Valuation Ratios Minority Shares
Corporate Finance Cash and Equivalents
Investment Decision Relative Valuation
Financing Decisions Book Value
Dividend Decisions EV/EBITDA
Hurdle Rate Asset Management
Rate of return FII
Time Value of Money Bondholders
Present Value Face Value and Coupon Rate
Future Value Maturity Rate and Issue Price
Discounting and Compounding Forward and Futures
Capital Budgeting OTC transactions
Payback Period Options
Net Present Value Call Buyer and Seller
Internal Return Rate Put Buyer and Seller
© Preparation Committee’23 29 Pre -Read Finance

Finance Pre-Read 2023

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Finance Pre-Read 2023

Uploaded by

Copyright:

Available Formats

PRE READ | 2023

SR. TOPICS PAGE NO.

4. INTRODUCTION TO CORPORATE FINANCE 14

5. TIME VALUE OF MONEY 15

10. FINANCIAL MARKETS AND DERIVATIVES 26

© Preparation Committee’23 1 Pre Read-Finance

Real GDP is nominal GDP adjusted for changes in price levels.

© Preparation Committee’23 2 Pre Read-Finance

3. Monetary and Fiscal Policies

Tools used for monetary policy:

© Preparation Committee’23 3 Pre Read-Finance

An expansionary policy, which aims to stimulate a weak economy can,

● Imports and Exports: Imports refer to products/ services that are

5. Foreign Exchange Rate Systems

Types of exchange rate systems:

© Preparation Committee’23 4 Pre Read-Finance

● Pure Floating rate:

● Managed floating rate:

© Preparation Committee’23 5 Pre Read-Finance

The 10 principles of GAAP are:

STEP #1: JOURNAL ENTRY

STEP #3: Summarization

© Preparation Committee’23 6 Pre Read-Finance

1. Profit and Loss Account / Income Statement

Cost of Goods Sold (COGS)

Selling General & Administrative Expenses (SG&A)

© Preparation Committee’23 7 Pre Read-Finance

© Preparation Committee’23 8 Pre Read-Finance

3. Cash Flow Statement

There are two ways to prepare a cash flow statement:

Direct Method Indirect Method: Operating Activities

Segregation of Cash Flows:

Note: Reporting Non-cash Investing and Financing Transactions:

© Preparation Committee’23 9 Pre Read-Finance

Linkage of three financial statements

© Preparation Committee’23 10 Pre Read-Finance

Liquidity Profitability Leverage Efficiency Valuation

© Preparation Committee’23 11 Pre Read-Finance

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑺𝒐𝒍𝒅

© Preparation Committee’23 12 Pre Read-Finance

EPS and its types

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆−𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆−𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔

Example on Basic & Diluted EPS

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒−𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 Diluted EPS =

© Preparation Committee’23 13 Pre Read-Finance

What is Corporate Finance?

© Preparation Committee’23 14 Pre Read-Finance

FV = 5,000 x (1 + 5%)2 = 5,512.50

The following links can be viewed to understand more on this topic:

© Preparation Committee’23 15 Pre Read-Finance

Most common methods of capital budgeting:

1. PAYBACK PERIOD (PBP)

Payback period in these case = 3.5 years

2. NET PRESENT VALUE (NPV)

The NPV rule is as follows:

3. INTERNAL RATE OF RETURN (IRR)

The IRR rule is as follows:

NPV v/s IRR

4. PROFITABILITY INDEX (PI)

5. ACCOUNTING RATE OF RETURN (ARR)

The following links can be viewed to understand more on this topic:

© Preparation Committee’23 16 Pre Read-Finance

Cost of equity can be approximated using the: