FINANCE

COMPENDIUM

Prepared By:

XFIN
The Finance
Association of
XIMB
 Table of Contents
INTRODUCTION .......................................................................................................................... 1
The Financial Industry ............................................................................................................ 1
Investment banking .......................................................................................................... 1
Commercial banking.......................................................................................................... 1
Investment management .................................................................................................. 1
Venture capital .................................................................................................................. 1
Private Equity .................................................................................................................... 2
Industry .............................................................................................................................. 2
Sample Interview Questions ............................................................................................. 2
VALUATION TECHNIQUES........................................................................................................... 4
How Much is it Worth? .......................................................................................................... 4
Basic Accounting Concepts: ................................................................................................... 5
Accounting Principles ........................................................................................................ 5
The Balance Sheet ............................................................................................................. 5
The Income Statement ...................................................................................................... 6
The Statement of Retained Earnings ................................................................................ 6
The Statement of Cash Flows ........................................................................................... 6
Business Valuation ................................................................................................................. 7
Asset-based/Cost-based approaches ............................................................................... 7
Earning value approaches ................................................................................................. 8
Market value approaches ................................................................................................. 8
Discounted Cash Flow (DCF) ............................................................................................. 9
Comparable Transactions ............................................................................................... 14
Precedent Transaction Analysis ...................................................................................... 15
Questions ......................................................................................................................... 16
EQUITY ANALYSIS AND PORTFOLIO MANAGEMENT ................................................................ 21
Investment Management and Portfolio Theory ................................................................... 21
Risk ................................................................................................................................... 21
Portfolio risk vs. a single security’s risk .......................................................................... 21

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 Correlation ....................................................................................................................... 21
Diversification.................................................................................................................. 22
Stock Analysis and Stock Picking .......................................................................................... 22
Technical analysis vs. fundamental analysis .................................................................. 22
Stock valuation techniques ............................................................................................. 22
Financial ratios ................................................................................................................ 23
Questions ......................................................................................................................... 25
STOCKS ..................................................................................................................................... 27
Equity vs. Debt (Stocks vs. Bonds) ........................................................................................ 27
Stock Terminology ................................................................................................................ 28
Dividends ......................................................................................................................... 28
Types of Stocks ................................................................................................................ 29
Stock splits ....................................................................................................................... 30
Stock buybacks ................................................................................................................ 31
New stock issues ............................................................................................................. 31
Other Terms ..................................................................................................................... 32
Questions ......................................................................................................................... 32
BONDS AND INTEREST RATES ................................................................................................... 36
Bond Terminology ................................................................................................................ 36
Pricing Bonds ........................................................................................................................ 37
Holding Period Return (HPR) .......................................................................................... 39
Callable bonds ................................................................................................................. 39
Zero coupon bonds.......................................................................................................... 39
Forward rates .................................................................................................................. 40
Effect of Inflation on Bond Prices ......................................................................................... 40
Leading Economic Indicators ................................................................................................ 41
Gross Domestic Product (GDP) ....................................................................................... 41
Unemployment Rate ....................................................................................................... 41
Inflation Rate ................................................................................................................... 41
Interest Rates .................................................................................................................. 42
Questions ......................................................................................................................... 42
DERIVATIVES ............................................................................................................................. 45

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 Options ................................................................................................................................. 45
Futures and Forwards .......................................................................................................... 48
Swaps ................................................................................................................................... 49
Credit Derivatives ................................................................................................................. 50
Questions ......................................................................................................................... 50
MERGERS AND ACQUISITIONS ................................................................................................. 52
Stock Swaps vs. Cash Offers ............................................................................................ 52
Tender Offers................................................................................................................... 53
Mergers vs. Acquisitions ................................................................................................. 53
Accretive vs. Dilutive Mergers ........................................................................................ 54
Questions ......................................................................................................................... 54
FINANCE GLOSSARY .................................................................................................................. 57
QUESTION BANK....................................................................................................................... 63
General Banking .............................................................................................................. 65
Corporate Finance/ General Finance .............................................................................. 65
Equity Research ............................................................................................................... 66
Investment Banking ........................................................................................................ 66

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 INTRODUCTION
The Financial Industry
Investment banking
An investment bank is a financial services firm that functions as an intermediary in large and
complex financial transactions. When a start-up company prepares for the launch of an initial
public offering (IPO) and when a company merges with a competitor, an investment bank is
normally involved. It also has a position as a broker or financial advisor for large institutional
clients, such as pension funds. Investment banks are best known as intermediaries between a
corporation and the financial markets. That is, in an IPO or an additional stock offering, they
help companies issue shares of stock. By finding large-scale buyers for corporate bonds, they
also arrange debt funding for companies.

Commercial banking
The term commercial bank refers to a financial institution that accepts deposits, provides
checking account services, makes various loans, and provides individuals and small businesses
with basic financial products such as certificates of deposit (CDs) and savings accounts. A
commercial bank is where most individuals do their banking. Commercial banks make money
through offering and earning interest from these loans such as mortgages, auto loans, business
loans, and personal loans. Customer deposits provide banks with funds to make these loans.

Investment management
Investment management applies to the management of financial assets and other
investments—not just purchasing and selling them. Management involves devising a short- or
long-term plan for purchasing and disposing of portfolio holdings. Banking, budgeting, and tax
services and duties can also be included. The concept most commonly applies to the
management and trading of holdings within an investment portfolio to achieve a particular
investment objective. Investment management is also known as money management,
portfolio management, or wealth management.

The “customers,” or “buy-side” of an institutional sale of financial instruments, are asset

managers. The traders and salespeople, who supply liquidity to the asset managers, are on the’
sell-side.’ A customer or client gives money to an asset manager or fund manager, who then
spends it to accomplish the client’s goals. The sell-side individuals provide the buy-side with
information (research, ideas, meetings with officials) and try to get the asset managers to trade
with them (the sell-side makes a commission on any trade that it facilitates).

Venture capital
Venture capital is a form of private equity and a type of funding given by investors to start-ups
and small companies that are believed to have the potential for long-term growth. In general,

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venture capital comes from well-off investors, investment banks and other financial
institutions. It does not always take a monetary form; it can be knowledge in technical or
managerial matters. Usually, venture capital is allocated to small businesses with extraordinary
growth potential or to businesses that have expanded rapidly and are likely to continue to
develop.

Private Equity
Equity capital is not quoted on the public exchange. Private equity consists of investors and
funds that invest directly in private companies or buy-outs of public companies, resulting in
public equity being de-listed. Private equity capital is raised by retail and institutional investors
and can be used to finance new technology to increase working capital within a private equity
firm, to make acquisitions or to strengthen the balance sheet.
Majority of private equity consists of institutional investors and accredited investors who can
commit large sums of money for long periods of time. Private equity investments require long
holding periods for a turnaround of a distressed company or a liquidity event such as an IPO or
sale to a public company.

Industry
Corporate finance officials may perform a broad variety of functions, ranging from managing
the stock buyback policy of a company to its internal auditing, cost, pricing, or profitability.
These functions may be similar to the functions performed by the investment banking
professionals in some situations. Many large corporations, for instance, maintain small internal
M&A arms that seek out opportunities for acquisition and help structure such transactions. In
order to help them hedge their foreign exchange risk, businesses with broad international
operations often hire financial professionals.

The entry-level role in the corporate finance feature is generally referred to as “financial
analyst." The chief financial officer (CFO) position is the peak. Employees work closely with
other functions (most commonly marketing and operations) during a finance career in the
industry, partly to disclose and clarify financial statements, and partly to work out both short-
term and long-term strategies.

Sample Interview Questions

1. Why do you want to do investment banking/investment management/ whatever career you
plan to pursue?
2. What exactly do investment bankers (or investment managers, etc.) do?
3. Here’s a whiteboard. Stand in front of it and present a chapter from your favourite finance
textbook. You have five minutes.
4. Walk me through your resume.

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5. Why should we hire you?
6. Why did you decide to do an MBA?
7. If you were the CEO of our bank, what three things would change?
8. Give me an example of a time you worked as part of a team.
9. What is a hedge fund?

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 VALUATION TECHNIQUES
How Much is it Worth?
Visualize yourself as the CEO of a publicly-traded corporation that produces widgets. So far you
have had a highly profitable company and want to sell the business to someone interested in
purchasing it. How do you know how much it should be sold for? Similarly, consider the
acquisition of FleetBoston Financial by Bank of America. How did Bank of America determine
how much it should pay to acquire FleetBoston Financial?

To begin with, the value of a company is equal to the value of its assets, and that

Value of Assets = Debt + Equity or Assets = D + E

If a person buys a company, he buys its stock (equity). Buying the equity of a company means
that he actually gains the company's ownership i.e. if he buys 50 percent of the equity of a
company, he owns 50 percent of the company. Being the owner also means that he promises
to pay the lenders (debt) of the company the amount owed by the previous owner.

The value of the debt is easy to calculate: the debt's market value is equal to the debt's book
value. However, this knowledge is difficult to come by, so the book value is more secured to
be used. It is trickier to find out the market value of equity, and that is where valuation methods
come into play.
Primarily there are three approaches that can be taken to determine the worth of a company

Market-based approach Asset-based approach Income based approach

What a comparable company is
worth
May or may not require forecast
Identify a comparable firm (same
industry, similar business and
markets)
Identify the suitable multiple to be
used. It can be P/E ratio, EV/EBITDA,
Price to sales ratio
What is the worth of the assets of your
company
Does not require forecast
The Net Asset Value (NAV) is the
easiest to understand. It is calculated
simply as fair value of the assets of the
business less the external liabilities
owed. The key here is determining fair
value
What is the worth of future
cashflows of your company
Requires forecasting
This primarily involves
calculating the value of the
company using Discounted Cash
Flow (DCF). In short and very
simply, this means calculating
the present value of the future
cash flows of the company.

Choose the correct variable and

multiply
Generally, before understanding valuation, it’s important to understand accounting, the
language upon which valuation is based. Let us have a look at them

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Basic Accounting Concepts:
Accounting Principles
These are called Generally Accepted Accounting Principles (GAAP). The key principles include:

Going Concern Concept: This idea means that a corporation will continue in the future-it does
not have a finite existence. This theory is used to predict cash flows in the future. It is assumed
that the entity has neither the intention, nor the need, to liquidate its operations.

Legal Entity: The corporation is a distinct entity from the owners; even if it is a one- person
company operating from home. The business accounts are also taken separately from the
owners.

Conservatism: While accounting, its important to be careful and conservative. Revenue should
be recognized only when it's definite.

Accrual Concept: When a transaction happens, income and expenses are recognized/recorded
at that time itself even before the cash changes hands. Income and expenses, regardless of
cash, are registered at that moment itself.

Matching Concept: Expenses should be matched to the revenues recognized in the same
accounting period and be recorded in the period the expense was incurred.

Cost Concept: All properties, with certain exceptions, are reported on the books at the
purchase price and not at the market price. It’s important to record the acquisition price of
anything you spend money on and properly record depreciation for those assets.

Basic overview of financial statements

There are four basic financial statements that provide the information you need to evaluate a
company:
Balance Sheets
Income Statements
Statements of Cash Flows
Statements of Retained Earnings

The Balance Sheet

The Balance Sheet presents a company's financial position at a given point in time. It consists
of three parts: assets, liabilities, and the equity of the shareholder. The economic resources of
a company are assets. The company uses assets to generate revenue. Assets include current
assets and fixed assets. Current assets can be readily converted into cash or its equivalent
resources within a year and are known as liquid assets. Example: Cash, inventory, and

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marketable securities. Fixed assets cannot be converted to cash or its equivalent in a year’s
time. Examples include land, machinery, equipment, building, trademarks, etc. By incurring
debt, obtaining new investors, or by operating profits, a company obtains the money it uses to
run its business. The segment on liabilities of the balance sheet presents the company's debts.
Liabilities are the claims on the capital of the company that creditors have. The Equity portion
of the balance sheet presents a company's net worth.

The Income Statement

The effects of a company's activities for a defined period of time (e.g., one year, one quarter,
one month) are presented in the Income Statement and are composed of revenues, expenses
and net income.

Revenue: Revenue is a source of income that normally arises from the sale of goods or services
and is recorded when it is earned.

Expenses: Expenses are incurred during a given period by a corporation to produce the profits
received over the same period. For a manufacturing company to sell a product, for example, it
must obtain the materials that it needs to produce the product, pay wages to its employees.
These are some kinds of costs that can be incurred by a corporation during the company's
regular activities.

To summarise, the Income Statement evaluates the performance of the activities of a company
over a period of time; it offers details required to assess the viability and creditworthiness of
the business to investors and creditors. A corporation has gained net profits when its total sales
outweigh its total expenditures. If total costs surpass total sales, a business has a net loss.

The Statement of Retained Earnings

Retained earnings are the profits left over after paying out dividends to shareholders that a
corporation invests in itself. From the beginning to the end of the year the declaration of
retained earnings is expressed in the Statement of Retained Earnings when a corporation
reports profits or declares dividends.

The Statement of Cash Flows

The information on the economic resources involved in the management of a business is given
in the Income Statement. However, information on the actual source and use of cash
generated during its activities is not given in the Income Statement. That is because it does not
always require cash to acquire and use economic tools. For instance, in July, let's say you went
shopping and bought a new mountain bike on your credit card, but until August you didn't pay
the bill. The sale will still be called July sales, although the store did not collect cash in July. A
detailed description of all cash inflows and outflows during the period is given in the Statement
of Cash Flows and is divided into three parts based on three categories of activity:

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• Cash flows from operating activities: Cash flows from operating activities explains the sources
and uses of cash from ongoing regular business activities in a given period. This includes net
income from the income statement, adjustments to net income, and changes in working
capital.

• Cash flows from investing activities: Basically, cash from non-operating activities or activities
outside the normal scope of business. This involves items classified as assets in the Balance
Sheet and includes the purchase and sale of physical assets and securities.

• Cash flows from financing activities: This shows the net flow of funds used to run the
company including debt, equity, and dividends. Involves items classified as liabilities and equity
in the Balance Sheet; it includes the payment of dividends as well as issuing payment of debt
or equity.

Business Valuation
A business valuation is a general process of determining the economic value of a whole
business or company unit. Performing business valuation means you are trying to determine
the worth of that company.
The main objective of the valuation process is to identify the critical value-generating areas of
the business. Business valuation can be used to determine the fair value of a business for a
variety of reasons, including sale value, establishing partner ownership, taxation, and even
divorce proceedings.
The valuation of a business is used by many parties including investors, creditors, sellers, and
buyers interested in a company. Owners will often turn to professional business evaluators for
an objective estimate of the value of the business.
It is easy to calculate the worth of a publicly-traded company. All you need to do is find the
stock price (the price of a single share of the company), multiply it by the number of
outstanding shares, and you have the company's equity market value. (This is known as market
capitalization or "market cap" as well).
When determining the value of a company, there are many methods you'll come across.
Analysts use a wide range of models to value assets in practice, ranging from the simple to the
sophisticated. However, there are three approaches that are most commonly used to evaluate
worth:
Asset-based/Cost-based approaches
This uses the current value of a company’s tangible net assets as the key determinant of fair
market value. This approach is typically used where a business is not a going concern, or where
a business is a going concern but its value is tied directly to the liquidation value of its
underlying tangible assets and investments. The cost approach method is useful in valuing real
estate, such as commercial property, new construction, or special use properties. The asset-

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based approach also provides a useful reasonableness check when reviewing the value
conclusions derived under the income or market approaches. Methods being Net Asset Value
Method, Adjusted Net Book Value Method
Earning value approaches
An earning value approach is based on the idea that a business's value lies in its ability to
produce wealth in the future. The estimated future benefits that accrue to the owner are
discounted or capitalized at a rate appropriate for the risks associated with those future
benefits. Approaches being Capitalisation of Excess Income Method, Discounted Cash Flow
Method.
Market value approaches
This determines fair market value by reviewing actual transactions of comparable companies
and assets. The fundamental basis of this approach is predicated on the theory that the fair
market value of a closely-held company can be estimated based on the price’s investors are
paying for the stocks of similar, publicly traded (or private) companies. Methods being
Comparable Company Analysis, Precedent Transaction Analysis.
All these methods of valuation typically fall into two main categories: absolute valuation and
relative valuation. Therefore, we can categorise the above discussed approaches under two
broad methods of valuation as well:
1. Absolute valuation models attempt to find the intrinsic or "true" value of an investment
based only on fundamentals. Valuation models that fall into this category include the
Earning based model and asset-based model.

2. Relative valuation models in contrast, operate by comparing the company in question

to other similar companies. Market Value approaches falls under this category of
valuation
The type of valuation method used for analysis will then depend on factors such as the industry
sector where the company operates, the size of the company, expected cash flow and the type
of product or service it offers. The purpose of the business valuation determines the
appropriate approach and methodology to be applied.
No single valuation model fits every situation, but by knowing the characteristics of the
company, you can select a valuation model that best suits the situation. Additionally, investors
are not limited to just using one model. Often, investors will perform several valuations to
create a range of possible values or average all of the valuations into one.
When valuing a company as a going concern, there are three main valuation methods used by
industry practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent
transactions. These are the most common methods of valuation used in investment banking,
equity research, private equity, corporate development, mergers & acquisitions (M&A),
leveraged buyouts (LBO), and most areas of finance.

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 Discounted Cash Flow (DCF)

● Analysis of discounted cash flow (DCF) is a means of valuing the intrinsic value of a corporation
(or asset). In simple terms, discounted cash flow, based on estimates of all the cash that it will
make available to investors in the future, attempts to figure out the benefit today. Because of
the concept of "discounted" (i.e. cash in the future is worth less than cash today), it is defined
as "time value of money" cash flow.

● The benefit of DCF analysis is that it provides the closest thing to an intrinsic stock value - if an
entire industry or market is overvalued, relative valuation measures such as price-earnings
(P/E) or EV/EBITDA ratios are not very useful. Furthermore, the DCF approach is forward-
looking and relies more on future assumptions than historical findings. Free cash flow (FCF),
which is less susceptible to distortion than any other estimates and ratios calculated from the
statement of income or the balance sheet, is also the basis of the process.

So how does it work?

1. Estimate Cashflows
2. Estimate Growth Profile (1 stage, 2 stage, 3 stage etc) & Growth Rates
3. Calculate Discount Rate
4. Calculate the Terminal Value
5. Calculate fair value of company and its equity
6. Estimating Cashflows

A. Estimating Cash flows

One of the most important methods of valuating a company is based on cash which is
generated from operation. It is also significant to estimate the free cash flows which does not
take in account the expenditure on capital assets. Free cash flow shows how efficient a
company is at generating cash. Investors use free cash flow to measure whether a company
might have enough cash, after funding operations and capital expenditures, to pay investors
through dividends and share buybacks.

Cash Flow from Operation (CFO) = Net Income +/- Non-Cash Expenses/Income +/- Non-
Operating Expenses/Income
Free Cash Flow (FCF)= Cash Flow from Operation (CFO) – Net Capital Expenditure- – Changes
in Operating Assets & Liabilities

There are two types of Free Cash Flows: Free Cash Flow to Firm (FCFF) (also referred to as
Unlevered Free Cash Flow) and Free Cash Flow to Equity (FCFE), commonly referred to as
Levered Free Cash Flow.

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1. Free cash flow to equity investors (FCFE) is the cash flow remaining for returning cash through
dividends or share repurchases to current common equity investors or for reinvesting in the
firm after the firm satisfies all obligations.
FCFE = Free Cash Flow – Interest – Net Debt Issued

2. Free cash flow to the firm (FCFF) represents the cash available for the company after all
expenses and investment has taken place to repay creditors or pay dividends and interest to
investors

FCFF = Free Cash Flow – Interest Tax Shield

B. Forecasting Cash Flows growth profile

The next step is to predict how rapidly the company's free cash flow can increase. This is a vital
component of any evaluation and is usually where the most significant mistakes creep in.
People appear to overestimate how rapidly a business can develop.

1.Extrapolate from historic growth - One option is to use historic growth rates
2.Trust the Analysts - The second approach is to trust the equity research analysts that follow
the firm to come up with the right estimate of growth for the firm, and to use that growth rate
in valuation.
3.Fundamental Determinants - Growth is an exogenous variable with both historical and
analyst forecasts that affects value but is divorced from the company's operational data. The
alternative way to turn growth into a value is to make it endogenous, i.e., to make it a feature
of how much a business reinvests for future growth and the efficiency of its reinvestment. If a
company has a stable return on capital, the projected growth in operating income (and thus
cash flow) is a product of the reinvestment rate, i.e., the proportion of the post-tax operating
income invested in net capital and non-cash working capital expenses, and the quality of the
reinvestment calculated as the return on the capital invested.\

Option 3 is probably the best option. A simpler approach would be to look at historical growth,
take an average, and then reduce it in stages over the past few years. A three-stage model
could take the growth rate of the last 3 years, extend it to the next five years, cut it in half for
the
next five years, and then reduce it to 3% (long-term inflation rate, e.g. no "real growth) from
then on.

C. Calculate discount rate and present value

We need an appropriate discount rate that we can use to measure the net present value (NPV)
of the cash flows after estimating the free cash flow of the business for the next ten years. This

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is a vital ingredient in valuing discounted cashflow. Errors in the calculation of the discount rate
or incompatibility of cash flows and discount rates can lead to serious valuation errors. It is
critical that the discount rate must be in line with the discounted cash flow. If the cash flows
being discounted are cash flows to equity, the equity cost is the appropriate discount rate. The
acceptable discount rate is the cost of capital (or WACC - the weighted average cost of capital)
if the cash flows are cash flows to the company.

Cost of Equity
Equity shareholders expect a certain return on their equity investment in a business to be
acquired. From the perspective of the company, the appropriate rate of return of the equity
holders is an expense. However, unlike debt costs, which can be calculated from the
observation of interest rates in the stock markets, the current equity cost of a business is not
measurable and must be calculated.
There are several ways to measure discount rates. We will now look at the most common
approaches tested in finance interviews for discounted cash flow (DCF) analysis: the WACC
(Weighted Average Cost of Capital). For WACC, using the capital asset pricing model (CAPM),
we determine the discount rate for leveraged equity (reL).
WACC
For WACC, the discount rate is calculated with the following formula:

Here:

D = Market value of debt

E = Market value of equity

rd = Discount rate for debt = Average interest rate on long-term debt

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is used to calculate the required rate of return for any
risky asset.
According to the CAPM, risk and return are related in a linear manner as follows:
re = rf + ß(rm - rf)

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 Here:
re = Discount rate for an all-equity firm
rf = Risk-free rate
rm = Market return
rm - rf = Excess market return (Equity Risk Premium)
ß = Beta of the security
Beta represents the relative volatility of the investment in relation to the market. For instance,
if an investment's beta is 1, it means that the return on the investment (stock/bond/portfolio)
varies with the return on the market or the price activity of the stock is strongly correlated with
the market. A Beta of less than 1 means that the investment is less risky than the market, such
as 0.5. A Beta greater than 1, such as 1.5, indicates that the investment is more volatile than
the market. It would be expected that a company in a volatile industry would have a beta
greater than 1.

Present Value
Present value (PV) is the current value of a future sum of money or stream of cash flows given
a specified rate of return.
Suppose, one is expecting $20 one year from now, however for some reason, they would like
to have the money today. Then, how much money should be accepted, today? Should it be
more than 20 dollars, exactly 20 dollars, or lesser than 20 dollars?
Present value is the concept that states an amount of money today is worth more than that
same amount in the future. In other words, money received in the future is not worth as much
as an equal amount received today.
In general, for two basic reasons, a dollar today is worth more than a dollar tomorrow.
a) First, a dollar can be deposited in a bank today and presumably earn a rate of return.
b) Second, the purchasing power of future money is reduced by inflation.
For calculating the present value, the future cash flows are discounted at the discount rate. A
discount rate is said to be the expected return from a project that matches the risk profile of
the project in which one would invest $20. It is different from the opportunity cost of the
money. Opportunity cost is a measure of the opportunity lost. Discount rate is a measure of
the risk. These are two separate concepts.
To express the relationship between the present value and future value, we use the following
formula:

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Here, "rd" is the discount rate, and "n" is the number of years in the future.
We can see that the higher the discount rate, the lower the present value of the future cash
flows.

Terminal Year Calculation

The terminal year represents the year (usually 10 years in the future) when the growth of the
company is considered stabilized.
In other words, the cash flows of the first 10 years are determined by company management
or a financial analyst, based on predictions and forecasts of what will happen. Then, a terminal
year value is calculated assuming that after 10th year the cash flows of the company will keep
growing at a constant "g."
Values of "g" are typically not as high as the first 10 years of growth, which are considered un-
stabilized growth periods. Instead, "g" represents the amount the company can feasibly grow
forever once it has stabilized (after 10 years). The value of the terminal year cash flows (that
is, the value in 10th year) is given by:

The present value of the terminal year cash flows is given by:

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Summing the discounted value of FCFs in the first ten years and FCFs of the terminal year (CFs
after year ten till perpetuity), the value of the company under the DCF analysis can be derived.

Economic Value Added (EVA)

A measure of a company's financial performance based on the residual wealth calculated by
deducting the cost of capital from its operating profit (adjusted for taxes on a cash basis) is
known as Economic Value Added. (Also referred to as "economic profit".)
The formula for calculating EVA is as follows:

EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

Comparable Transactions
Comparable company analysis (also called “trading multiples” or “peer group analysis” or
“equity comps” or “public market multiples”) is a relative valuation method in which you
compare the current value of a business to other similar businesses by looking at trading
multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common
valuation method.
"Comparable" transactions that have taken place in the industry and accompanying related
measures such as "multiples" or ratios (e.g., price paid: EBITDA) should be considered for
applying the "comparable transactions" technique of valuing a business.
Using comparable transaction form, key valuation parameters used have to be determined.
That is, were the companies priced as a multiple of EBIT, EBITDA, income, or some other
parameter in those transactions? This will further help in analysing how the comparable
businesses were valued at what multiples of those parameters. A similar strategy can then be
used to find the value of the business being considered.

For example, there is an Internet start-up of healthcare called echicago.com that plans to go
public. The question that will be posed by the financial management of the company, its
investment bankers and the fund managers who intend to purchase stock in the company is:
"How much is the company worth?" Recent comparable transactions need to be analysed to
obtain value for the business. For instance, eharvard.com and estanford.com are other
Internet health care businesses that have recently gone public successfully.

In practice, most buyers choose the simplified valuation method based on EBITDA multiples.
Valuating by multiples is a valid method only if the following criteria are reached:
• If you have a wide range of similar companies
• If the scope of companies or transactions is homogeneous
• If the data is relevant and timely
These are just some of the main criteria investors should look at when choosing which ratio or
multiples to use. If the P/E multiple cannot be used, choose a different ratio, such as the price-
to-sales or price-to-cash flow multiples

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The “comps” valuation method provides an observable value for the business, based on what
other comparable companies are currently worth. Comps are the most widely used approach,
as they 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 $2.50 per share, company Y’s stock must
be worth $25.00 per share (assuming the companies have similar attributes.

Precedent Transaction Analysis

Precedent transactions analysis is another form of relative valuation where you compare the
company in question to other businesses that have recently been sold or acquired in the same
industry. These transaction values include the take-over premium included in the price for
which they were acquired.

The values represent the en bloc value of a business. They are useful for M&A transactions but
can easily become stale-dated and no longer reflective of the current market as time passes.
They are less commonly used than Comps or market trading multiples.

Steps to Perform Precedent Transaction Analysis:

A. Search for relevant transactions
The process begins by looking for other transactions that have happened in (ideally) recent
history and are in the same industry.

The screening process requires setting criteria such as:

• Industry classification
• Type of company (public, private, etc.)
• Financial metrics (revenue, EBITDA, net income)
• Geography (headquarters, revenue mix, customer mix, employees)
• Company size (revenue, employees, locations)

B. Analyze and refine the available transactions

Once the initial screen has been performed and the data is transferred into Excel, then it’s time
to start filtering out the transactions that don’t fit the current situation.

In order to sort and filter the transactions, an analyst has to “scrub” the transactions by
carefully reading the business descriptions of the companies on the list and removing any that
aren’t a close enough fit.

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C. Determine a range of valuation multiples
When a shortlist is prepared (following steps 1 and 2), the average, or selected range, of
valuation multiples can be calculated. The most common multiples for precedent transaction
analysis are EV/EBITDA and EV/Revenue.

D. Apply the valuation multiples to the company in question

After a range of valuation multiples from past transactions has been determined, those ratios
can be applied to the financial metrics of the company in question.

E. Graph the results (with other methods) in a football field

Once a valuation range has been determined for the business that’s being valued, it’s
important to graph the results so they can be easily understood and compared to other
methods.
The Football field chart is the best way to illustrate the various methods on one page in a simple
way. Investment bankers will often put together a football field chart to summarize the range
of values for a business based on the different valuation methods used.

Questions
1.What is the difference between the Income Statement and the Statement of Cash Flows?
The Income Statement is a report of revenues and expenses, while the Cash Flows Statement
records the real cash that has either entered the corporation or left it. The Cash Flow
Statement has the following categories: Operating Cash Flow, Investing Cash Flow, and
Financing Cash Flow. Interestingly, as seen in the Income Statement, a corporation may be
profitable, but can still go bankrupt if it doesn't have the cash flow to cover interest payments.

2. What is the link between the Balance Sheet and the Income Statement?
The key connection between the two statements is that the gains generated in the Income
Statement are added as retained earnings to the shareholder's equity on the balance sheet. In
the Income Statement, debt on the balance sheet is sometimes used to measure interest
expense.

3.What is the link between the Balance Sheet and the Statement of Cash Flows?
The Cash Flow Statement begins with the starting cash balance, which comes from the balance
sheet. Cash from operations is also extracted using the adjustments (such as Accounts Payable,
Accounts Receivable, etc.) in balance sheet accounts. The net gain in cash flow for the previous
year goes back to the balance sheet for the following year.

4. What is EBITDA?
A short form for cash flow, EBITDA is Earnings Before Interest, Taxes, Depreciation, and
Amortization.

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5. Suppose, the Net Income of a company is given. How would you evaluate the “free cash
flow” of that company?
Beginning with the Net Income of the company, add back the charges for depreciation and
amortization. Then, deduct the Capital expenses incurred by the company (CAPEX- spending
on equipment and plant). Finally, make an adjustment to account for the changes in the
working capital (Working Capital= Current Assets-Current Liabilities) to arrive at the value of
the Free Cash Flow of the company.

6. What happens to each of the three primary financial statements when you change a) Gross
Margin b) Capital Expenditures c) any other change?
Firstly, reflect on the meaning of these changing variables. For instance, Gross margin is gross
profit/sales, which represents the percentage of revenue that the company has been able to
convert to gross profit after accounting for the cost of goods sold. Therefore, if the
a) Gross Margin falls, then, relative to revenue, gross profit also declines. Hence, you would
potentially pay fewer taxes, but in case nothing else changes, you would probably have a lower
net income. So, everything else constant, the amount of cash will decline. Now, in the balance
sheet, a decrease in shareholder equity will balance the effect of the decrease in Cash.
b) If the capital expenditure is decreased, then the value of capital expenses which is reflected
in the Statement of Cash Flows would also decline. This will lead to an increase in the value of
cash in the balance sheet and an equal decrease in the value of the property, plant, equipment
which will balance the effect. In the succeeding years, the depreciation expense would be
lesser and the net income earned would be higher, which will result in an increase in the values
of capital and shareholder equity.
c) We must ensure that we understand and grasp the effects of transactions on each of the
three financial statements and remember that modifying one of the statements impacts the
other statement.

7. How do you value a company?

Use a "risk-adjusted discount rate" to discount the expected cash flows of the company. Firstly,
you would forecast a company's cash flows for 10 years. After 10 years, you need to pick a
steady growth rate. Finally, you have to pick a suitable discount rate and add a "terminal value"
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after predicting the first five or 10 years of results, which reflects the present value of all
potential cash flows for another 10 years. The Terminal Value can be measured in one of two
ways:
(1) You take the earnings of the last year you predicted, say year 10, and multiply that by
several markets, such as 20 times the earnings, or use that as your terminal value.
(2) You take the last year, say year 10, and presume some constant growth rate like 10 percent.
The present value after year 10 of this rising stream of payments is the Terminal Value. Finally,
the "Capital Asset Pricing Model" (or "CAPM") can be used to find out at what "discount rate"
the cash flows of the business will be discounted. (In a nutshell, CAPM states that the correct
discount rate that should be used is the risk-free interest rate modified upwards to represent
the market risk or "Beta" of this particular company.)
Examine the methods of APV and WACC for a more advanced response. Other ways of valuing
a corporation should also be mentioned, like looking at "Comparable" (how recently other
similar businesses were priced as a multiple of their revenue, net income, or some other
measure).

8. What are the different multiples that can be used to value a company?
The multiple which is most often used to value a company is price-to-earnings, or "P/E ratio."
Other multiples used include sales, EBITDA, EBIT, and Book Value. The related number depends
on the field. Internet businesses, for instance, are often priced with revenue multiples; this
explains why low-profit businesses may have such high market caps. EBITDA is used as a
measure to value companies in the metals and mining industry.
Not only should you be aware of the financial metric being used as stated in the section on
valuation, but you should also know the period which the metric used represents: for instance,
in a P/E ratio, the earnings can be for the previous or projected fiscal year, or for the previous
or projected 12 months.

9. How do you get the discount rate for an all-equity firm?

The Capital Asset Pricing Model, or CAPM is used to arrive at the discount rate for an all-equity
firm.

10. How much would you pay for a company with $50 million in revenue and $5 million in
profit?
If this is all the data that has been specified, then the comparable transaction or multiple
method (rather than the DCF method) should be used to value this business. The common
stock data of similar companies in the same sector should be analyzed to obtain average
industry multiples of price-to-earnings to use the multiple approach. Then, the value of the
given business can be determined by the application of that approach.

18
11. What is the difference between the APV and WACC?
WACC incorporates the effect of tax shields into the discount rate used to measure the present
value of cash flows. WACC is usually measured for firms or sectors using actual data and
numbers from balance sheets.
The present value of the funding effects (most commonly the debt tax shield) is added by APV
to the net present value, assuming an all-equity value, and the adjusted present value is
determined. In particular, the APV strategy is useful in situations where subsidised funding
costs are more complicated, such as in the case of a leveraged buyout.

12. How would you value a company with no revenue?

One can first make reasonable assumptions about the company’s projected revenues (and
projected cash flows) for future years. Then we can calculate the Net Present Value of these
cash flows.

13. How do you unlever a company’s Beta?

Unlevering a company’s Beta means calculating the Beta under the assumption that it is an all-
equity firm. The formula is as follows:

14. Name three companies that are undervalued and tell me why you think they are
undervalued.
For equity research and fund management jobs, this is a very common problem.
Using different approaches, study the stocks you want and value them: DCF, multiples,
equivalent transactions, etc. Then choose many undervalued (and overvalued) stocks and be
prepared, using financial and strategy details, to back up your evaluation assessment.

15. Which industries are you interested in? What are the multiples that you use for those
industries?
Different industries use different multiples. To answer the first part of the question, select an
industry and understand any significant events that are occurring. Next, if you are interested
in a certain field, you better know how businesses are generally valued in the industry.
(Without understanding the answer to the second, do not answer the first question!)

16. Is 10 a high P/E ratio?

The response to this or any question like this is it depends. P/E ratios are relative measures,
and we need to know the general P/E ratios of comparable businesses in order to know if a P/E

19
ratio is high or low. Higher growth companies will usually have higher P/E ratios because their
profits will be low compared to their price, with the idea that the earnings will ultimately rise
faster than the price of the stock.

17. Describe a typical company's capital structure.

The capital structure of a company is the capital structure that makes up the firm, or its debts
and equity. The capital structure contains the company's long-term, permanent funding,
including long-term debt, preferred stock and common stock, and retained earnings.
The statement of the capital structure of a corporation illustrates the order in which the
creditors to the capital structure are compensated or paid back and the order in which they
have claims on the assets of the company if it is liquidated. The first priority is debt, then
preferred holders of stock, then common holders of stock. The left overs are put in the retained
earnings account.

18. Is There a Rule of Thumb for Valuing a Business?

As discussed earlier, there is no ultimate formula or perfect valuation method for each
situation. Still, by knowing the characteristics of the company and its corresponding
environment, the best fit method can be chosen from a variety. It is an essential process to be
able to maximize the price of the company backed by logical reasoning and numerical
argument. Often, investors will perform several valuations to create a range of possible values
or average all of the valuations into one.

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 EQUITY ANALYSIS AND PORTFOLIO MANAGEMENT
Investment Management and Portfolio Theory
Modern portfolio theory (MPT) refers to a theory that illustrates how risk-averse investors can
construct portfolios to maximize expected return given a certain level of market risk. The basic
concepts of portfolio theory are expected to be clearly understood by Asset managers and
portfolio managers (as well as potential job candidates). Regardless of the sort of portfolio one
manages, the aim of every portfolio manager is the same: maximize return while minimizing
risk - generate alpha for your investors. The type of risk you can take as a portfolio manager
varies depending on the assets/funds you manage, but your goal is to keep risk as low as
possible while still delivering the projected returns. The approach that should be used in
selecting the most desirable portfolio entails the use of indifference curves, representing the
investor’s preferences for risk and return.

Risk
Riskiness of a portfolio is defined as the standard deviation of the portfolio's expected returns.
Standard deviation is a measure of volatility (can be upside or downside). So, the more
predictable a portfolio’s returns are perceived to be, the less risky it is and vice-versa. For
instance, a portfolio of stocks with relatively low revenue and high growth prospects, where
the prices can be volatile, is a relatively "risky" portfolio.
As a portfolio manager in order to receive an increased return from the investment portfolio,
you need to accept an increased amount of risk. Keep in mind, keeping the assets in your
portfolio in cash reduces the portfolio's risk, but it also reduces the potential return.

Portfolio risk vs. a single security’s risk

When risks of various stocks are not directly related, then the risk in a portfolio of diverse
individual stocks will always be less than the risk inherent in holding any one of the individual
stocks. Rather than looking at risk at the individual security level, portfolio managers must
constantly measure the risk of an entire portfolio. When an interviewer asks you whether you
recommend adding a particular security to a portfolio, don't simply base your decision on the
risk of the given security, instead, consider how that security contributes to the overall risk of
the portfolio using techniques like correlation.

Correlation
The tendency for two investments in a portfolio to move together in price under the same
circumstances is called "correlation." If two investments have a strong positive correlation,
they tend to move together. Note that the correlation can be measured by a number called a
correlation coefficient. The correlation coefficient ranges from -1 (i.e., a perfect negative
correlation) to +1(i.e., a perfect positive correlation). A correlation coefficient of zero implies
that the two assets have no correlation with one another. Combining two assets with zero

21
correlation with each other reduces the risk of the portfolio. While a zero correlation between
two assets returns is preferable when compared to positive correlation, it does not provide the
risk reduction results like that in case of a negative correlation coefficient.

Diversification
Diversification basically refers to building a portfolio comprising securities from different asset
classes, like stocks and bonds. Modern portfolio theory can be used as a means to diversify
portfolios and by integrating a diverse set of assets, a portfolio can reduce its variance as well
as its volatility. However, realize that this is the case precisely because bonds often tend to do
well when stocks don't (i.e., they have a low correlation). Another way to diversify a portfolio
is to buy securities in the same asset class that are not affected by the same variables and
hence have a low correlation (E.g., oil and airlines). Conversely, a portfolio of securities with a
strong positive correlation will be relatively undiversified and therefore riskier, but may gain
higher returns.

Type of Correlation Correlation Coefficient Risk Level Example

Securities have a strong Close to 1 High Microsoft and Intel
positive correlation
Securities have a weak Close to zero Medium Microsoft and H&R Block
or zero correlation
Securities have a strong Close to -1 Low Exxon and Federal Express
negative correlation

Stock Analysis and Stock Picking

Technical analysis vs. fundamental analysis
Technical analysis involves looking at charts and patterns associated with a stock’s historical
price movements to try to profit from predictable patterns, regardless of fundamentals such
as revenue growth or expense trends.

In contrast, fundamental analysis of a stock (or other security) involves using financial analysis
to analyze the company’s underlying business, such as sales growth, its balance sheet, etc., (its
“fundamentals”) to decide whether and when to buy and sell.

Stock valuation techniques

The most common forms of fundamental analysis involve the traditional valuation techniques
(DCF, multiples analysis) as well as the various accounting and financial statement analyses
that are covered in the Valuation Techniques chapter. For investment management interviews,
you should have a strong command over these techniques for valuing individual stocks.

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Financial ratios
Another important form of stock analysis is Ratio Analysis, which involves looking at a
company’s various financial ratios and how they have changed over time to spot trends or
trouble spots in the company’s operations. A financial ratio by itself doesn’t necessarily tell you
very much. More important is comparing how a company’s financial ratios are changing from
one quarter to the next, and how they compare a company’s financial ratios with other
companies in its industry.
Below are the most common ratios used in finance to analyse companies. Particularly if you
are interviewing for investment management, equity research or similar finance positions, you
may be asked questions about how to calculate common financial ratios and what they signify.

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 Return on Assets Net Profit After Taxes / Total Assets Shows profits relative to a
company’s assets

Return on Equity (also called

Net Profit After Taxes Shows profits relative to equity
Return on Net Worth)
Net Worth

These ratios can be used to ascertain the health of a company. For example, a higher current
ratio is better; a company’s position improves when the collection period declines.

Here’s a quick chart that explains whether a higher or lower ratio is better.
Ratio Good Trend Bad Trend
Quick Ratio Rising Falling
Current Ratio Rising Falling
Cash Ratio Rising Falling
Debt to Equity Falling Rising
Current Liabilities to Inventory Falling Rising
Total Liabilities to Net Worth Falling Rising
Collection Period Falling Rising
Inventory Turnover Rising Falling

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 Ratio Good Trend Bad Trend
Sales to Assets Rising Falling
Sales to Net Working Capital Rising Falling
Gross Profit Margin Rising Falling
Return on Assets Rising Falling
Return on Equity Rising Falling

Questions
1. If you add a risky stock into a portfolio that is already risky, how is the overall portfolio risk
affected?

In modern portfolio theory, if you add a risky stock into a portfolio that is already risky, the
resulting portfolio may be more or less risky than before.

A portfolio's overall risk is determined not just by the riskiness of its individual positions but
also by how those positions are correlated with each other. For example, a portfolio with two
high-tech stocks might, at first glance, be considered risky. However, if those two stocks tend
to move in opposite directions, the portfolio's riskiness could be significantly lower. So, the risk
effect of adding new stock to an existing portfolio depends on how that stock correlates with
the other stocks in the portfolio.

2. Put the following portfolios consisting of 2 stocks in order from the least risky to the most
risky and explain why
A. A portfolio of a cable television company stock and an oil company stock
B. A portfolio of an airline company stock and a cruise ship company stock
C. A portfolio of an airline company stock and an oil company stock.

Answer: Least risky: C. Then A. B is the most risky.

The least risky portfolio is the one where the two securities have a strong negative correlation.
Stocks with a strong negative correlation tend to move in the opposite direction under the
same circumstances. Therefore, the portfolio's value will remain relatively stable over time,
making the portfolio less risky. In this question, since high fuel prices might be good for oil
companies but bad for airlines who need to buy the fuel, you would expect companies' stocks
in these two industries to move in opposite directions. These two industries have a strong
negative correlation, and portfolio C is the least risky.

Portfolio B is the most risky because the stocks of airline companies and cruise ship companies
have a strong positive correlation: they tend to move in the same direction under the same
circumstances. For example, after the September 11 terrorist attacks, all travel-related
businesses suffered from sharply lower demand. A portfolio of two securities with a strong

25
positive correlation will be the most risky.

Portfolio A is in the middle because cable TV stocks and oil stocks have a weak correlation. A
weak correlation (correlation coefficient of around 0) means that the two securities generally
do not move in the same direction under the same circumstances.

3. How do you calculate a company’s Days Sales Outstanding?

The average number of days a company takes to collect payment after a sale has been made
is known as Days Sales Outstanding (DSO).

(Average Accounts Receivable during a period/ Total credit sales during the same period) x No.
of days in the period.

For example, DSO on an annual basis is measured as - Average Accounts Receivable/ Sales x
365 days.

4. How do you calculate a company’s Current Ratio?

Current assets (cash, accounts receivable, etc.) / Current liabilities (accounts payable and other
short-term liabilities)

A high current ratio indicates that a company has enough cash (and assets they can quickly
turn into cash, like accounts receivable) to cover its immediate payment requirements on
liabilities.

5. Gotham Energy just released second-quarter financial results. Looking at its balance sheet,
you calculate that its Current Ratio went from 1.5 to 1.2. Does this make you more or less likely
to buy the stock?
Less likely. This means that the company’s ability to cover its immediate liabilities with cash on
hand and other current assets is lower than the last quarter.

6. Xeron Software Corporation’s days sales outstanding have gone from 58 days to 42 days.
Does this make you more or less likely to issue a Buy rating on the stock?
More likely. When the company’s days sales outstanding (DSO) decreases, it means the
company is able to collect money from its customers faster. In other words, Xeron’s customers
went from taking an average of 58 days to pay their bills to 42 days. All things being equal,
having faster-paying customers is almost always a good thing.

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 STOCKS
Equity vs. Debt (Stocks vs. Bonds)
Companies are traditionally financed through a combination of debt and equity to raise capital
for needs of the business. Debt financing entails borrowing money, whereas equity financing
entails selling a portion of the company's equity. The fundamental advantage of equity
financing is no obligation to repay the funds acquired whereas for debt financing, it does not
require a firm owner to relinquish control, as it would with equity financing.

Equity, or an ownership stake, is more volatile as its value fluctuates with the firm's value. The
Cost of Equity is often higher than the Cost of Debt because equity investors assume more risk
when acquiring a company's stock rather than a company's bond. As a result, an equity investor
will expect higher returns (Equity Risk Premium) than equivalent bond investor.

The equity of a company is represented by securities called stocks/ shares/ common stock/
stock without a guaranteed return. Equity has a book value. This value that can be calculated
from the company's Balance Sheet. It also has a market value which can be calculated as:

Stock Price x No. of Shares Outstanding = Market Value of Equity/Market Capitalization

The market value of a private company can be estimated using valuation techniques. However,
any method used to measure either the book value or market value of a company depends on
highly volatile factors such as the company's performance, the industry, and the market as a
whole – and is thus highly volatile itself. Investors can make lots of money based on their equity
investment decisions and the subsequent changing value of those stocks after they are bought.

The other component of the financing of a company is debt, which is represented by securities
called bonds. (In its simplest form, debt is issued when investors loan money to a company at
a given interest rate.)

In the middle of the continuum is preferred stock. One type of preferred stock is referred to as
convertible preferred. If the preferred stock is convertible, it can be converted into common
stock as prescribed in the initial issuance of the preferred stock. Like bondholders, holders of
preferred stock are assured an interest-like return – also referred to as the preferred stock’s
dividend. (A dividend is a payment made to stockholders, usually quarterly, that is intended to
distribute some of the company’s profits to shareholders.)

In what is referred to as the seniority of creditors, the debt holders have first claim on the
assets of the firm if the company goes bankrupt or becomes insolvent. Preferred shareholders
are next in line, while the common stock shareholders bring up the rear. This isn’t just a matter
of having to wait in line longer if you are a common stock shareholder. If the bondholders and
owners of preferred stock have claims that exceed the value of the assets of a bankrupt
company, the common stock shareholders won’t see a dime.

27
There is a tax advantage for corporations who invest in preferred stock rather than in bonds
for other companies. Corporate investors are taxed for only 30 percent of the dividends they
receive on preferred stock. On the other hand, 100 percent of the interest payments on bonds
paid to corporate investors are taxed. This tax rule comes in handy when structuring mergers.

Factors that need to be taken into consideration when making a financing (debt vs equity)
decision:

Factors High Low

Flotation Costs Issue Debt Issue Equity

Interest Rates Issue Equity Issue Debt

Tax Rate Issue Equity Issue Debt

Earnings Volatility Issue Equity Issue Debt

Business Growth Issue Equity Issue Debt

% Debt in Capital Structure Issue Equity Issue Debt

% Equity in Capital Structure Issue Debt Issue Equity

Stock Terminology
A company's commitment to its stock does not end after the issuance of shares. Companies
communicate with shareholders regarding the firm's past revenues, expenses and profits and
the future of the business. There are also ways a company can manage their shares once the
stock is on the open market to maximize shareholder value, the company's reputation and the
company's future ability to raise funds. Here are several concepts and terms you'll need to be
familiar with when you study stocks and how public companies manage their shares.

Dividends
Dividends are paid to shareholders of common stock and preferred stock. However, the
directors cannot pay any dividends to the common stock shareholders until they have paid all
outstanding dividends to the preferred stockholders. The incentive for company directors to
issue dividends is that companies in industries that are particularly dividend sensitive have
better market valuations if they regularly issue dividends. Issuing regular dividends is a signal
to the market that the company is doing well.

Unlike bonds, however, the company directors decide when to pay the dividend on preferred
stock. In contrast, if a company fails to meet bond payments as scheduled, the bondholders
can force the company into bankruptcy.

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Types of Stocks
1. Common Stock
A security that represents a stake in the capital of a joint-stock company. It grants the investor
many rights, the most important of which are: the right to attend general assembly meetings,
receiving dividends when distributed, the right to vote and the priority to subscribe in the
company’s new stocks issuance.

2. Preferred Stock
A class of shares that gives its holder a set of rights which the holder of common stock does
not have. These include the priority of preferred shareholders to get a predetermined
percentage of company profits, and the priority over holders of common stock in obtaining
their rights in the event of a company’s liquidation.

3. Defensive Stock
A stock, the return of which is not expected to decrease during recessions but may achieve
returns higher than the market average. Usually, it represents corporate stocks whose activity
is not normally affected by the state of the overall economy or by the resulting business cycle
fluctuations. They are therefore perceived as low risk stocks.

4. Treasury Stocks
Stocks that the issuing company repurchase through the market under certain controls. The
company can hold these stocks, re-issue or cancel them. These shares are not part of the
company capital, and they do not pay dividends.

5. Cash-paid Stocks
Stocks that are paid for in cash. An example of such stocks would be stocks of companies and
commercial banks in some countries where the laws require buyers to pay for them in cash
instead of other tangibles.

6. Non-cash paid stocks

Stocks whose value is collected in form of tangibles other than cash, like machinery, buildings,
and lands. Usually, the nature of these contributions, and how to evaluate and determine
stocks in exchange for them, are determined according to the law of the joint-stock companies.

7. Bearer stocks (payable to the holder)

Stocks that do not carry the owner’s name in their ownership certificate, as is the case with
banknotes issued by the Saudi Arabian Monetary Agency. Therefore, a shareholder must keep
the certificate of ownership in a safe place since it is 11 the only proof of ownership.

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8. Income stock
Ordinary stock of companies that tend to pay most of their net profits as cash dividends to
their shareholders, such as service companies.

9. Speculative stock
Stocks of companies with high-risk relative to any potential positive returns or capital gains.

10. Cyclical stock

Stocks of companies that mirror the overall economic performance. Their revenues and
earnings, and therefore their share prices, rise when economic growth is strong, and decreases
when growth is slowing down.

11. Listed stock

Stocks of companies that meet the requirements for listing in the capital market. These
requirements must be compiled with by all companies as a prerequisite for their listing in the
capital market.

12. Unlisted stocks

Stocks that the issuing company did not apply for its listing in the financial market, or else they
did not meet the listing requirements of the capital market

Stock splits
A corporate action in which a company’s existing shares are divided into multiple shares. This
does not entail an increase in the shareholder equity, because the par value and market value
of the share are decreased in proportion to the approved split ratio. If the share’s par value
was 50 SR, its market value was 500 SR, and the number of issued shares was 1,000,000 shares,
and if the split was at a rate of 5 to 1, then the values after the split would be as follows: the
share’s nominal value would be 10 SR, its market value would be 100 SR, and the number of
shares outstanding would be 5,000,000 shares
As a company grows in value, it sometimes splits its stock so that the price does not become
absurdly high. This enables the company to maintain the liquidity of the stock. If The Coca-Cola
Company had never split its stock, the price of one share bought when the company’s stock
was first offered would be worth millions of dollars. If that were the case, buying and selling
one share would be a very crucial decision. This would adversely affect a stock’s liquidity (that
is, its ability to be freely traded on the market). In theory, splitting the stock neither creates
nor destroys value. However, splitting the stock is generally received as a positive signal to the
market; therefore, the share price typically rises when a stock split is announced.

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Stock buybacks
Often you will hear that a company has announced that it will buy back its own stock. Such an
announcement is usually followed by an increase in the stock price.

The reason behind the price increase is fairly complex, and involves three major reasons. The
first has to do with the influence of earnings per share on market valuation. Many investors
believe that if a company buys back shares, and the number of outstanding shares decreases,
the company’s earnings per share goes up. If the P/E (price to earnings-per-share ratio) stays
stable, the price should go up. Thus, investors drive the stock price up in anticipation of
increased earnings per share.

The second reason has to do with the signalling effect. This reason is simple to understand, and
largely explains why a company buys back stock. No one understands the health of the
company better than its senior managers. No one is in a better position to judge what will
happen to the future performance of the company. So, if a company decides to buy back stock
(i.e., decides to invest in its own stock), these managers must believe that the stock price is
undervalued and will rise (or so most observers would believe). This is the signal company
management sends to the market, and the market pushes the stock up in anticipation.

The third reason the stock price goes up after a buyback can be understood in terms of the
debt tax shield (a concept used in valuation methods). When a company buys back stock, its
net debt goes up (net debt = debt - cash). Thus, the debt tax shield associated with the
company goes up and the valuation rises (see APV valuation).

New stock issues

The reverse of a stock buyback is when a company issues new stock, which usually is followed
by a drop in the company’s stock price. There are 3 main reasons for stock buyback. First,
investors believe that the issuance of new shares dilutes their earnings. That is, issuing new
stock increases the number of outstanding shares, which decreases earnings per share, which,
given a stable P/E ratio, decreases the share price. (Of course, the issuing of new stock will
presumably be used in a way that will increase earnings, and thus the earnings per share figure
won’t necessarily decrease, but because investors believe in earnings dilution, they often drive
stock prices down).

Secondly, it's due to the Signalling effect, which means investors may question the company's
senior managers decision to issue equity rather than debt to meet their financing
requirements. Also, the investors may believe that management knows that the valuation of
their stock is high (possibly inflated) and that by issuing stock, they can take advantage of this
high price

Finally, if the company believes that the project for which they need money will definitely be
successful, it would have issued debt, thus keeping all of the upside of the investment within
the firm rather than distributing it away in the form of additional equity. The stock price also
drops because of debt tax shield reasons. Because cash is infused into the firm through the
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 sale of equity, the net debt decreases. As net debt decreases, so do the associated debt tax
shield.

Other Terms
● Stock Dividends (bonus shares): Dividends paid to stockholders in a form of stocks, often in
place of a dividend paid in cash. Also known as bonus shares.
● Market value of the security: The price at which securities are traded in the stock market at a
certain time.
● Book value of a common stock: The value of the total equity (shareholder equity) that excludes
preferred stock, divided by the number of issued common shares outstanding
● Capital gains (losses): Profits (losses) resulting from the difference between the securities buy
price and sell price.
● Cash dividend: Money paid to stockholders. The distribution can be done annually, semi-
annually, or quarterly.
● IPO prospectus: A document that provides details about an investment offering for sale to the
public, to be used by investors in the evaluation of the security to be issued, the issuer, and
the method of subscription.
● Efficient portfolio: Portfolio that has a maximum expected return for a certain level of risk, or
a minimum level of risk for any expected return.
● Privilege for an additional issue: Privilege giving current stockholders the right to buy in a new
offering all the shares that have not been sold in the original IPO. The amount of shares that
can be bought are in proportion to the share of each shareholder in the company.
● Rights issue: With the issued rights, existing shareholders have the privilege to buy a new
common stock from the firm in proportion to their current equity of the existing shares.
● Ticker symbol: An abbreviated name of the listed company that is approved by the regulator
of trading.

Questions
1. What kind of stocks would you issue for a startup?
A startup typically has more risk than a well-established firm. The kind of stocks that one would
issue for a startup would be those that protect the downside of equity holders while giving
them upside. Hence the stock issued may be a combination of common stock, preferred stock
and debt notes with warrants (options to buy stock).

2. When should a company buy back stock?

When a company believes the stock is undervalued, has extra cash, and believes it can make
money by investing in itself, it can go for buying back of stocks.

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3. Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax
deductible for the company?
The dividend paid on common stock is taxable on two levels in the U.S. First, it is taxed at the
firm level, as a dividend comes out from the net income after taxes (i.e., the money has been
taxed once already). The shareholders are then taxed for the dividend as ordinary income (O.I.)
on their personal income tax. Dividend for preferred stock is treated as an interest expense
and is tax-free at the corporate level.

4.When should a company issue stock rather than debt to fund its operations?
There are several reasons for a company to issue stock rather than debt. If the company
believes its stock price is inflated, it can raise money (on very good terms) by issuing stock.
Second, if the projects for which the money is being raised may not generate predictable cash
flows in the immediate future, it may issue stock. A simple example of this is a startup company.
The owners of startups generally will issue stock rather than take on debt because their
ventures will probably not generate predictable cash flows, which is needed to make regular
debt payments, and also so that the risk of the venture is diffused among the company’s
shareholders. The third reason for a company to raise money by selling equity is if it wants to
change its debt-to-equity ratio. This ratio, in part determines a company’s bond rating. If a
company’s bond rating is poor because it is struggling with large debts, the company may
decide to issue equity to pay down the debt.

5. Why would an investor buy preferred stock?

1) An investor that wants the upside potential of equity but wants to minimize risk would buy
preferred stock. The investor would receive steady interest-like payments (dividends) from the
preferred stock that are more assured than the dividends from the common stock.
2) The preferred stock owner gets a superior right on the company’s assets, if the company go
bankrupt.
3) A corporation would invest in preferred stock because the dividends on preferred stock are
taxed at a lower rate than the interest rates on bonds.

6. Why would a company distribute its earnings through dividends to common stockholders?
Regular dividend payments are signals that a company is healthy and profitable. Also, issuing
dividends can attract investors (shareholders). Finally, a company may distribute earnings to
shareholders if it lacks profitable investment opportunities.

7. What did the S&P 500 close at yesterday?

Another question designed to make sure that a candidate is sincerely interested in finance.
This question (and others like it – “What’s the Dow at now?” “What’s the yield on the Long
Bond?”) can be expected especially of those looking for sales and trading positions

33
8. Can you tell me about a recent IPO that you have followed?
Read The Wall Street Journal and stay current with recent offerings.

9. What is your investing strategy?

Different investors have different strategies. Some look for undervalued stocks, others for
stocks with growth potential and yet others for stocks with steady performance. A strategy
could also be focused on the long-term or short-term, and be more risky or less risky. Whatever
your investment strategy is, you should be able to articulate these attributes.

10. How has your portfolio performed in the last five years?
If you are applying for an investment management firm as an MBA, your answer to this
question is very crucial. If you don’t have a portfolio, start a mock one using Yahoo! Finance or
other tools. Also, if you are going to say it has outperformed the S&P each year, better be well
prepared to explain why you think this happened.

11. If you read that a given mutual fund has achieved 50 percent returns last year, would you
invest in it?
You should look for more information, as past performance is not necessarily an indicator of
future results. How has the overall market done? How did it do in the years before? Why did it
give 50 percent returns last year? Can that strategy be expected to work continuously over the
next five to 10 years? You need to look for answers to these questions before making a
decision.

12. You are on the board of directors of a company and own a significant chunk of the
company. The CEO, in his annual presentation, states that the company’s stock is doing well,
as it has gone up 20 percent in the last 12 months. Is the company’s stock in fact doing well?
Another trick stock question that one should not answer too quickly. First, ask what the Beta
of the company is. (Remember, the Beta represents the volatility of the stock with respect to
the market.) If the Beta is 1 and the market (i.e. the Dow Jones Industrial Average) has gone
up 35 percent, the company actually has not done too well compared to the broader market.

13. Which do you think has higher growth potential, a stock that is currently trading at $2 or
a stock that is trading at $60?
This question tests your fundamental understanding of a stock’s value. The short answer to the
question is, “It depends”. While at first glance it may appear that the stock with the lower price
has more room for growth, price does not tell the entire picture. Suppose the $2 stock has 1
billion shares outstanding. That means it has $2 billion market cap, hardly a small cap stock.
On the flip side, if the $60 stock has 20,000 shares gives it a market cap of $1,200,000, and

34
hence it is extremely small and is probably seen as having higher growth potential. Generally,
high growth potential has little to do with a stock's price, and has more to do with its operations
and revenue prospects.

14. Why do some stocks rise so much on the first day of trading after their IPO and others
don’t? How is that money left on the table?
By “money left on the table”, bankers mean that the company could have successfully
completed the offering at a higher price and that the difference in valuation thus goes to initial
investors rather than the company. Why this happens is not easy to predict from responses
received from investors during roadshows. Moreover, if the stock rises a lot the first day it is
good publicity for the firm. But in many ways, it is money left on the table because the company
could have sold the same stock in its initial public offering at a higher price. However, bankers
must honestly value a company and its stock over the long-term, rather than simply trying to
guess what the market will do. Even if a stock trades up significantly initially, a banker looking
at the long-term would expect the stock to come down, as long as the market eventually
correctly values it.

15. What is insider trading and why is it illegal?

Insider trading describes the illegal activity of buying or selling stock based on information that
is not public information. The law against insider trading exists to prevent those with privileged
information (company execs, I-bankers, and lawyers) from using this information to make a
tremendous amount of money unfairly.

16. Who is a more senior creditor, a bondholder, or a stockholder?

The bondholder is always more senior. Stockholders (including those who own preferred stock)
must wait until bondholders are paid during a bankruptcy before claiming company assets.

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 BONDS AND INTEREST RATES
Bond Terminology
Before going any further in our discussion of bonds, we will introduce several terms you should
be familiar with.

● Par value or face value of a bond: The total amount the bond issuer will commit to pay back at
the end of the bond maturity period (when the bond expires).
● Coupon payments: The payments of interest that the bond issuer makes to the bondholder.
These are often specified in terms of coupon rates. The coupon rate is the bond coupon
payment divided by the bond’s par value.
● Bond price: The price the bondholder (i.e., the lender) pays the bond issuer (i.e., the borrower)
to hold the bond (to have a claim on the cash flows documented on the bond).
● Default risk: The risk that the company issuing the bond may go bankrupt, and default on its
loans.
● Default premium: The difference between the promised yields on a corporate bond and the
yield on an otherwise identical government bond. In theory, the difference compensates the
bondholder for the corporation’s default risk.
● Credit ratings: Bonds are rated by credit agencies (Moody’s, Standard & Poor’s), which examine
a company’s financial situation, outstanding debt, and other factors to determine the risk of
default. Companies guard their credit ratings closely, because the higher the rating, the easier
they can raise money and the lower the interest rate.
● Investment grade bonds: These bonds have high credit ratings and pay a relatively low rate of
interest.
● Convertible bond: A certificate of debt which grants the holder the option to exchange it with
several common stocks in the same issuing company based on a predetermined ratio.
● Perpetual bond: A bond with no maturity date that pays coupons forever. This type of bond
usually comes in the form of preferred stock.
● Conversion ratio: The number of shares of common stock that will be received in exchange for
each convertible bond or preferred share when the conversion takes place.
● Callable bond: A bond that can be redeemed in part or in full by the bond issuer prior to its
maturity.
● Call price: The price payable to bond holder when redeeming the security prior to the maturity
date. This price is usually equal to the face value plus a call premium.
● Face value of the security: The nominal value of a security stated by the issuer. The security
could be a bond or common or preferred stock. It does not mean the value paid by subscribers
when the security is offered for an IPO. The security may be issued at an additional price (issue
premium) or discounted prices in some cases (less than the par value).
● Junk bonds: Also known as high yield bonds, these bonds have poor credit ratings, and pay a
relatively high rate of interest.

To illustrate how a bond works, let’s look at an 8% coupon, 30-year maturity bond with a par

36
value of $1,000, paying 60 coupon payments of $40 each.
Let’s illustrate this bond with the following schematic:

Coupon rate = 8%

Par value = $1,000

Therefore, the coupon = 8% * $1,000 = $80 per year

Because this bond is a semi-annual coupon, the payments are for $40 every six months. We
can also say that the semi-annual coupon rate is 4 percent.

Since the bond’s time to maturity is 30 years, there are a total of 30 x 2 = 60 semi-annual
payments.

At the end of Year 30, the bondholder receives the last semi-annual payment of $40 plus the
principal of $1,000.

Pricing Bonds
The price of a bond is the net present value of all future cash flows expected from that bond.
(Recall net present value from our discussion on valuation.)

Here:
r = Interest rate,
t= Interval (for example, 6months),
T= Total Payments

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First, we must ask what discount rate should be used? The discount rate for a cash flow for a
given period should be able to account for the risk associated with the cash flow for that period.
In practice, there will be different discount rates for cash flows occurring in different periods.
However, for the sake of simplicity, we will assume that the discount rate is the same as the
interest rate on the bond.

So, what is the price of the bond described earlier? From the equation above we get:

Calculating the answer for this equation is complex. It might be worth noting that the first term
of this equation is the present value of an annuity with fixed payments,
$40 every 6 months for 30 years in this example. Also, there are Present Value tables available
that simplify the calculations. In this case, the interest rate is 4 percent and T is 60. Using the
Present Value tables, we get

= $904.94 + $95.06

= $1000

Also, looking at the bond price equation closely, it can be seen that the bond price depends on
the interest rate. If the interest rate is higher, the bond price is lower and vice versa. This is a
fundamental rule that should be understood and remembered.

The Yield to Maturity (YTM) is the measure of the average rate of return that will be earned on
a bond if it is bought now and held until maturity. To calculate this, information is required on
bond price, coupon rate and par value of the bond.

Example: Suppose an 8% coupon, 30-year bond is selling at $1,276.76. What average rate of
return would be earned if you purchase the bond at this price?
To answer this question, we must find the interest rate at which the present value of the bond
payments equals the bond price. This is the rate that is consistent with the observed price of
the bond. Therefore, solving for r in the following equation.

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Holding Period Return (HPR)
The income earned over a period as a percentage of the bond price at the start of the period,
assuming that the bond is sold at the end of the period.

Example: Let’s take a 30-year bond, with an $80 coupon, purchased for
$1000 with a Yield to Maturity (YTM) of 8 percent. Say at the end of the year, the bond price
increases to $1,050. Then the YTM will go below 8 percent, but the HPR will be higher than 8
percent and is given by:

($80) + ($1,050 - $1,000)

HPR = = 13%
$ 1,000

Callable bonds
For the sake of simplification in our earlier discussions, we assumed that the discount rate was
equal to the interest rate, and that the interest rate was constant at the coupon rate. However,
in the real world, this is not always the case.

If the interest rate falls, bond prices can rise substantially, due to the concept of opportunity
cost of investments.

To illustrate mathematically, let’s say a company has a bond outstanding. It took $810.71 and
promised to make the coupon payments as described above, at $40 every six months. Let’s say
the market interest rates dropped after a while (below 8 percent). According to the bond
document, the company is still expected to pay the coupon at a rate of 8 percent.

If the interest rates were to drop in this manner, the company would be paying a coupon rate
much higher than the market interest rate today. In such a situation, the company may want
to buy back the bond so that it is not committed to paying large coupon payments in the future.
This is referred to as calling the bond. However, an issuer can only call a bond if the bond was
initially issued as a callable bond. The risk that a bond will be called is reflected in the bond’s
price. The yield calculated up to the period when the bond is called back is referred to as the
yield to call.

Zero coupon bonds

This type of bond offers no coupon or interest payments to the bondholder. The only payment
the zero-coupon bondholder receives is the payment of the bond face value upon maturity.
The returns on their coupon bonds must be obtained by paying a lower initial price than their
face value. These bonds are priced at a considerable discount to par value.

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Forward rates
These are agreed-upon interest rates for a bond to be issued in the future. For example, the
one-year forward rate for a five-year U.S. Treasury note represents the interest forward rate
on a five-year T-note that will be issued one year from now (and that will mature six years from
now). This “forward” rate changes daily just like the rates of already-issued bonds. It is
essentially based on the market’s expectation of what the interest rate a year from now will
be and can be calculated using the rates of current bonds.

Effect of Inflation on Bond Prices

Inflation is the decline of purchasing power of a given currency over time. As a currency loses
value, prices rise and it buys fewer goods and services. This loss of purchasing power impacts
the general cost of living for the common public which ultimately leads to a deceleration in
economic growth.

To combat this, a country's appropriate monetary authority, like the central bank, then takes
the necessary measures to manage the supply of money and credit to keep inflation within
permissible limits and keep the economy running smoothly. For this, normally the Central Bank
increases the interest rates so as to bring down the purchasing power of people.

In case of bonds, the interest rates are inversely proportional to the prices of bonds. So, when
the interest rates are increased to reduce the liquidity in the market, the bond prices fall.

In general, a positive economic event (such as a decrease in unemployment, greater consumer

confidence, higher personal income, etc.) drives up inflation over the long term (because there
are more people working, there is more money to be spent which increases liquidity) and
ultimately it drives up interest rates, which causes a decrease in bond prices.

The following table summarizes this relationship with a variety of economic events.

Inflation Interest Rates Bond Prices

Higher Employability RISE RISE FALL

Lower Consumer Confidence FALL FALL RISE

Deficit financing RISE RISE FALL

Printing more money RISE RISE FALL

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 Rising import prices RISE RISE FALL

Low wages FALL FALL RISE

Leading Economic Indicators

What are economic indicators ?
Economic Indicators refer to any metric which is used to monitor, measure, and evaluate the
macroeconomy's overall health.

Why is it important to understand economic indicators ?

Economic indicators have the potential to cause sudden movement in the market and
thereby can lead to a lot of money being lost or made in an instant. Financial Analysts keep a
track of the economic indicators because they understand that any changes in the economy
can be a source of risk for their companies.
Hence, in finance, it is important to know about the economic indicators.
Now that we understand the meaning and importance of economic indicators, let us have a
look at some of the leading economic indicators

Gross Domestic Product (GDP)

Gross domestic product (GDP) is one of the most important metrics used to assess a
country's economic health. It represents the value of all goods and services produced over a
specific time period within a country.

GDP helps determine whether an economy is growing or experiencing a recession.

Positive GDP figures indicate expansion of the economy (Positive indicator) while declining
figures signify that the economy is shrinking. (Negative indicator)
If investors feel the GDP is growing, they are more inclined to pay a higher price for any
specific stock whereas if GDP is declining, they will only be ready to buy a certain stock for
less, causing the stock market to fall.

Unemployment Rate
The employment level of any country indicates the health of that country’s economy.
Unemployment metric is used to determine how many citizens out of the total population in
the country are unemployed. Lower the unemployment rate, more efficient is the economy
and better it is for the businesses to flourish thus a positive indicator.

Whereas a high unemployment rate is unfavourable and reflects that the economy is not able
to use its resources efficiently and thus is a negative indicator.

Inflation Rate
Inflation is an important indicator for financial markets because it indicates how much of an
investment's actual value is being lost and the rate of return required to compensate for that
loss. The Consumer Prices Index (CPI) is the main measure of inflation. Because of
41
 its considerable impact on company and asset performance, inflation is an important
indicator for financial analysts. Low inflation reduces a company's costs and boosts
profitability. So, low inflation is preferable than high inflation for the market and thus a
positive indicator.

Interest Rates
The interest rate is typically defined as the cost of borrowing or the gains on lending. A rise in
GDP (i.e., economic growth) will, in general, result in an increase in an economy's average
interest rates thereby encouraging people to save more but reducing the investment within
the economy. In contrast, a reduction in GDP (a recession) will, on average, result in a
decrease in an economy's interest rates.

Questions
1. What is the relationship between a bond's price and its yield?
They are inversely related. That is, if a bond's price rises, it's yield falls, and vice versa. Simply
put, current yield = interest paid annually / market price * 100%.

2. How are bonds priced?

Bonds are priced based on the net present value of all future cash flows expected from the
bond.

3. How would you value a perpetual bond that pays you $1,000 a year in coupon?
Divide the coupon by the current interest rate. For example, a corporate bond with an interest
rate of 10 percent that pays $1,000 a year in coupons forever would be worth $10,000.

4. When should a company issue debt instead of issuing equity?

First, a company needs a steady cash flow before it can consider issuing debt (otherwise, it can
quickly fall behind interest payments and eventually see its assets seized). Once a company can
issue debt, it should almost always prefer issuing debt to issuing equity.
Generally, if the expected return on equity is higher than the expected return on debt, a
company will issue debt
Also, interest payments on bonds are tax deductible. A company may also wish to issue debt if
it has taxable income and can benefit from tax shields.
Finally, issuing debt sends a quieter message to the market regarding a company’s cash
situation.
5. What major factors affect the yield on a corporate bond?
The short answer:
1) Interest rates on comparable U.S. Treasury bonds, and
2) The company’s credit risk.
Long answer:
Corporate bond yields trade at a premium, or spread, over the interest rate on comparable
U.S. Treasury bonds. (For example, a five-year corporate bond that trades at a premium of 0.5

42
percent, or 50 basis points, over the five-year Treasury note is priced at 50 over.) The size of
this spread depends on the company’s credit risk: the riskier the company, the higher the
interest rate the company must pay to convince investors to lend it money and, therefore, the
wider the spread over U.S.Treasuries.

6. If you believe interest rates will fall, which one should you buy: a 10-year coupon bond or a
10-year zero-coupon bond?
A 10-year zero-coupon bond. A zero-coupon bond is more sensitive to changes
in interest rates than an equivalent coupon bond, so its price will increase more if interest rates
fall.

7. Which is riskier: a 30-year coupon bond or a 30-year zero-coupon bond?

A 30-year zero-coupon bond is riskier because a coupon bond pays interest semi-annually and
pays the principal when the bond matures (after 30 years, in this case). A zero-coupon bond
pays no interest but pays one lump sum upon maturity (after 30 years, in this case). The coupon
bond is less risky because you receive some of your money back before overtime, whereas with
a zero-coupon bond, you must wait 30 years to receive any money back. (Another answer: The
zero-coupon bond is riskier because its price is more sensitive to changes in interest rates.)

8. What is the Long Bond trading at?

The Long Bond is the U.S. Treasury’s 30-year bond. This question is particularly relevant for
sales and trading positions and corporate finance positions. Interviewers want to see that you
are interested in the financial markets and follow them daily.

9. If you believe interest rates will fall, should you buy bonds or sell bonds?
Since bond prices rise when interest rates fall, you should buy bonds.

10. How many basis points equal .5 percent?

Bond yields are measured in basis points, which are 1/100 of 1 percent. 1 percent = 100 basis
points. Therefore, .5 percent = 50 basis points.

11. Why can inflation hurt creditors?

If a creditor lends out money at a fixed rate, inflation cuts into the percentage that he is actually
making. For example - If he lends out money at 7 percent a year, and inflation is 5 percent,
then he is really clearing 2 percent.

12. What does the government do when there is a fear of hyperinflation?

The government has fiscal and monetary policies that it can use in order to control
hyperinflation. The monetary policies include the Central Bank’s use of interest rates, reserve
requirements, etc. Fiscal policies include the use of taxation and government spending to
regulate the aggregate level of economic activity. Increasing taxes and decreasing government
spending slows down growth in the economy and fights inflation.

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13. How would you value a perpetual zero-coupon bond?
The value of a perpetual zero-coupon bond will be zero. A zero-coupon bond does not pay any
coupons, and if that continues perpetually, we will never get paid.

14. Let’s say a report released today showed that inflation last month was very low. However,
bond prices closed lower. Why might this happen?
Bond prices are based on expectations of future inflation. In this case, you can assume that
traders expect future inflation to be higher (regardless of the report on last month’s inflation
figures), and therefore, they bid bond prices down today. (A report which showed that inflation
last month was benign would benefit bond prices only to the extent that traders believed it
was an indication of low future inflation as well.)

15. If the stock market falls, what would you expect to happen to bond prices and interest
rates?
You would expect that bond prices would increase and interest rates would fall.

16. If unemployment is low, what happens to inflation, interest rates, and bond prices?
Inflation goes up, interest rates also increase, and bond prices decrease.

17. What is a bond's “Yield to Maturity"?

A bond's yield to maturity is the yield that would be realized through coupon and principal
payments if the bond were to be held to the maturity date. If the yield is greater than the
current yield (the coupon/price), it is said to be selling at a discount. If the yield is less than the
current yield, it is said to be selling at a premium.

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 DERIVATIVES

A derivative is a security that derives its value from the value or return of another asset or
security. A physical exchange exists for many options contracts and futures contracts.
Exchange traded derivatives are standardized and backed by a clearinghouse.

Forwards and swaps are custom instruments and are traded/created by dealers in a market
with no central location. A dealer market with no central location is referred to as an over the-
counter market. They are largely unregulated markets and each contract is with a
counterparty, which may expose the owner of a derivative to default risk (when the
counterparty does not honour their commitment). Some options trade in the over-the-counter
market, notably bond options.

Options
Options, as the word suggests, give the bearers the “option” to buy or sell a security – without
the obligation to do so. Two of the simplest forms of options are call options and put options.

Options are of two types:

a- European- Can be exercised only at expiry

b- American- Can be exercised any time on or before expiry

In India, only European options are traded on Indian Exchange (NSE). It is rumoured that BSE
will soon start with derivatives trading, but no derivatives are traded on BSE as of now.
Only 137 companies out of 2000 listed on NSE have Futures and Options contract that are
traded on NSE.

All the stock options expire on only and only “ Last Thursday” of the month, while the Index
options (for Nifty and Bank nifty) have both a weekly and a monthly expiry taking place only
on “Thursday”.

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a) Call options (https://www.youtube.com/watch?v=_7pGmY58iBw)
A call option gives the holder the right to purchase an asset for a specified price on or before
a specified expiration date. (Technically, this definition refers to an “American option.”
Standard European call options can only be converted i.e. exercised only on the expiration
date.)

Ex- A 31st December call option on Reliance stock with exercise price of Rs.2000 is trading at a
premium of Rs.60. The owner of this option is entitled to purchase Reliance stock at Rs.2000
even if the stock price jumps to Rs. 2200 by exercising the option on expiration (31 st
December). So, the holder can buy the stock at Rs.2000 and the sell it in the market for Rs.
2200 and earn a profit of 200 (minus the price of the option. Net profit of 200-60=Rs.140). Or
the holder can hold onto the number of shares purchased through the option.

Note: When a call option’s exercise price is exactly equal to the current stock price, the option
is called an “at the money” call. When a call option has an exercise price that is less than the
current stock price, it is called an “in the money” call. When a call option’s exercise price is
greater than the current stock price, it is called an “out of the money” call.

b) Put Options (https://www.thestreet.com/video/what-is-a-put-option-15130863)

The other common form of option is a put option. A put option gives it’s holder the right to sell
an asset for a specified exercise price on or before a specified expiration date. For example, a
December 31 put option on Reliance with a strike price of Rs.2000 with a premium of Rs.60,
entitles its owner to sell Reliance stock at Rs.2000 at the time of expiration, even if market
price is lower than Rs.2000. So, if the price drops to Rs.1800, the holder of the put option would
buy the stock at Rs.1800, sell it for Rs2000 by exercising her option, and make a neat profit of
Rs 200 (minus the price of the option, i.e. a Net profit of 200-60=Rs.140). On the other hand,
if the price goes over Rs.2000, the holder of the put option will not exercise the option and will
lose the amount he paid to buy the option.

Writing (Selling) Options

How are these options created? And who buys and sells the stock that the options give holders
the right to buy and sell?

There is a whole market that makes these trades of options, called the options market. There
has to be an option seller for an option buyer. This seller is often referred to as the option
writer. So, writing a put is called selling a put option. Anyone who owns the underlying asset,
such as an individual or a mutual fund – can write options, although not necessary. Retail
investors/traders like us can do the same but it’s too risky.

Let’s go back to our previous example. If you buy the December 31st call option on Reliance
stock with an exercise price of Rs.2000 trading at a premium of Rs.60, you are betting that the
price of Reliance will go above Rs.2000 before December 31st. You can make this bet only if
there is someone who believes that the price of Reliance will not go above Rs.2000 before
December 31st. That person is the seller, or “writer,” of the call option.

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He or she first gets a non-refundable fee for selling the option, which you pay. If the price goes
to Rs.2200 on December 31st at expiry and you exercise your option, the person who sold the
call option has to buy the stock from the market at Rs.2200 (assuming he does not already own
it) and sell it to you at Rs.2000, thus incurring a loss of Rs.200 (minus the option premium
received ie -200+60 = Loss of Rs140).

But remember that you had to buy the option originally. The seller of the option, who has just
incurred a loss of Rs. 200, already received the price of the option when you bought the option.
On the other hand, say the price had stayed below Rs.2000 and closed at Rs 1990 on December
31. The seller would have made the amount he sold the option for, but would not make the
difference between the strike price. Why not?

Because as the buyer of the call option, you have the right to buy at Rs.2000 but is not obligated
to. If the stock price of Reliance stays below Rs.2000, you as the option buyer will not exercise
the option.

Options Pricing (https://www.youtube.com/watch?v=MiybniIIvx0)

There are at least six factors that affect the value of an option: the stock price, exercise price,
the volatility of the stock price, the time to expiration, the interest rate and the dividend rate
of the stock. To understand how these factors affect option values, we will look at their effect
on call options (the option to buy a security).

• Price of underlying security: The value of the call option increases when an option is acquired
at a fixed exercise price and the price of the underlying stock increases. Clearly, if you have the
option to buy ITC stock at Rs100, the value of your option will increase with any increase in
stock price: from Rs95 to Rs100, from Rs100 to Rs105, from Rs.105 to Rs.106, etc. (The value
of a put option in this scenario decreases.)

• Exercise (“strike”) price: Options can be bought at various exercise prices. For example, you
can buy an option to buy stock in ITC at Rs.100 strike, or you can buy an option to buy stock in
ITC at Rs.110 strike. The higher the exercise price, the lower the value of the call option, as the
stock price has to go up higher for you to be ‘in the money’. (Here, the value of the put option
increases, as the stock price does not need to fall as low.)

• Volatility of underlying security: The option value increases if the volatility of the underlying
stock increases.

• Time to expiration: The more time the holder has to exercise the option, the option becomes
more valuable. The further away the date of the exercise, the more time it takes for

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unpredictable things to happen and the wider the range of probable stock price increase. Time
to expiration, like volatility, increases the value of both options for put and call.

• Interest rates: If interest rates are higher, the exercise price has a lower present
value. This also increases the value of the call option.

• Dividends: A higher dividend rate policy of the company means that out of the total expected
return on the stock, some is being delivered in the form of dividends. This implies that the
stock's expected capital gain will be lower, and the potential stock price increase will be lower.
Thus, the call value is lowered by larger dividend pay-outs.

The following table summarizes the relationships between these factors and the
value of options:

If this variable increases The value of a call option

Stock price Increases

Exercise price Decreases
Volatility Increases

Time to expiration Increases

Interest rate Increases
Dividend payouts Decreases

Futures and Forwards

A futures contract is a type of forward that requires an asset or its cash value to be delivered
at a specified date of delivery or maturity for an agreed price. This price is called the price of
the future, and when the contract expires, it must be paid. It is said that the trader who
commits to buying the commodity on the delivery date is in the long position. When the
contract matures, the trader who takes the short position commits to delivering the
commodity.
Futures are liquid, standardised, exchange tradable contracts, and their prices are settled at
the end of each trading day (i.e. futures traders collect/pay the gains and losses of their day
at the end of each day).
Forwards, on the other hand are non-standardised, non-exchange traded and less liquid.
Futures are actively traded and are liquid securities.

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Swaps
The simple exchange of future cash flows is another derivative, a swap. Foreign exchange
swaps and interest rate swaps include some popular forms of swaps. Let’s review foreign
exchange swaps first.
Say Sun Microsystems regularly outsources to India its software development. In such a
situation, it would make payments in rupees to companies in India and thus find itself exposed
to the risks of fluctuating foreign exchange rates. Sun would like to enter into a
foreign exchange swap, a predetermined exchange of currency, with another party to hedge
these exchange risks. For instance, for each of the next five years, Sun might want to swap $1.0
million for Rs 40 million. For example, with the Birla Group in India, which has many expenses
in U.S. dollars and is therefore also subject to the same exchange rate fluctuation risk, it could
enter into a swap. Both firms protect their business from exchange rate risks by agreeing to a
foreign exchange swap.

Interest rate swaps function similarly. Consider Firm ABC, which at a fixed
interest rate of 8% has issued bonds with a total par value of $10 million. By issuing the bonds,
the company is obligated at the end of each year to pay a fixed interest rate
of $800,000.

In such a situation, it may enter into an interest rate swap with another company called XYZ,
where Firm ABC pays the LIBOR rate to Firm XYZ and Firm XYZ agrees to pay the fixed rate to
Firm ABC. In such a situation, every year, Firm ABC would receive $800,000 that it could use to
make its loan payment. For its part, Firm ABC would be required to pay Firm XYZ $10 million x
LIBOR each year. Firm ABC has therefore switched its fixed interest rate debt to floating rate
debt. (The Firm swaps rates with Firm XYZ, referred to as the counterparty. The counterparty
wins because it probably wants to swap its floating rate debt for fixed-rate debt, locking it into
a fixed rate.) This swap is illustrated in the chart below.

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Credit Derivatives
A credit derivative is a contract that provides a bondholder (lender) with protection against a
downgrade or a default by the borrower. The most common type of credit derivative is a
credit default swap (CDS), which is essentially an insurance contract against default. A
bondholder pays a series of cash flows to a credit protection seller and receives a payment if
the bond issuer defaults.
Another type of credit derivative is a credit spread option, typically a call option that is
based on a bond’s yield spread relative to a benchmark. If the bond’s credit quality decreases,
its yield spread will increase and the bondholder will collect a payoff on the option.

Arbitrage is an important concept in valuing (pricing) derivative securities. In its purest

sense, arbitrage is riskless. If a return greater than the risk-free rate can be earned by holding
a portfolio of assets that produces a certain (riskless) return, then an arbitrage opportunity
exists. Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will
continue until they affect supply and demand enough to bring asset prices to efficient (no-
arbitrage) levels.

Questions
1. When would you write a call option?
When you expect the price of the stock to fall (or stay somewhat the same i.e. sideways).
Because a call option on a stock may be a bet that the worth of the stock will increase, or you'd
be willing to write down (sell) a call choice to an investor if you believed the stock would not
rise.

Max Profit = Option premium you received when you sold the option

Max Loss = Unlimited

2. Say I hold a put option on ICICI Bank stock with an exercise price of Rs600, the expiration
date is today, and it is trading at Rs590. About what proportion is my put worth, and why?
Your put is worth about Rs.10, because today, you can sell a share of stock for Rs600, and buy
it for Rs590. (If the expiration date were within the future, the choice would be more valuable,
because the stock could conceivably drop more.)

3. When would a trader seeking profit from a long-term possession of a future be in a long
position?
This position would be held by the trader if she believes the price of the commodity will
increase. On the delivery date, she could either commit to buying a commodity or earn
speculative profits from the price increase.

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4. All else being equal, which would be more valuable: a December call option for Maruti or a
January call option for Maruti?
The January option: The later an option’s expiration date, the more valuable the choice.

5. Why do interest rates matter when figuring the price of options?

Because of the ever-important concept of net present value, all else being equal, higher
interest rates lower the worth of call options.

6. If the strike price (say Rs.500) is below the current price (say Rs.550), is the option holder at
the money, in the money, or out of the money?
For Call options- It is In the money
For Put Options- It is Out of the money

7. What is the main distinction between contracts for futures and forward contracts?
The principle distinction between futures and forward contracts is that futures contracts are
traded on exchanges and forwards are over-the-counter traded. You can only trade specific
futures contracts that are traded on the exchange due to this distinction. Forward contracts
are more flexible because they are negotiated privately, and if both parties agree, they can
represent any assets and can alter settlement dates.

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 MERGERS AND ACQUISITIONS
Why Merge?
Main reason- Synergies that theoretically result from a merger. Examples of these synergies
include: reductions in redundant workforce, and utilizing the technology, market share of the
other party to the deal, and combinations of service offerings. Let’s take a look at the major
reasons for M&A activity.
A company might merge with another company to gain a foothold into a new market, which
can come in the form of a product/service or a geographic region, and sometimes both.
In other cases, companies merge to consolidate operations, thus lowering costs and boosting
profits (think economies of scale) and sometimes the companies merge to survive in a
consolidating market Eg. Merger between Vodafone and Idea to survive in the telecom market.

Why not merge?

While mergers are fun and exciting to talk about, the logistics of post-merger are not always
as anticipated. The synergies initially targeted are not achieved by more than one out of every
five mergers. This is not just due to poor implementation following the merger. Many deals are
simply ill-advised or involve a clash of organisational cultures.
One reason for the merger's failure is that many mergers are also the result of the egos of
management and the excitement produced in a market of merger mania. The huge I-banking
fees that the deals produce are another powerful force pushing mergers. Investment bankers
will argue to their clients that the mergers are in their best interest because, in fact, they are
in their best interest (the bankers ').

Types of buyers
There are two main categories of business buyers: strategic buyers and financial buyers.
Strategic buyers are corporations that for strategic business reasons, want to acquire another
business. Financial buyers are buyers who wish purely as a financial investment to acquire
another company. LBO (Leveraged Buyout) Funds or other private equity funds are typically
financial buyers.
Who's going to pay more: strategic buyers or financial buyers for a business? Nine times out of
ten, a financial buyer will pay more than a strategic buyer.
Rationale? - The strategic buyer will assume that the post-acquisition cash flows of the
company will be higher than is currently anticipated. They will get a higher valuation when they
discount these higher cash flows.

Stock Swaps vs. Cash Offers

When there is a strong stock market, stock swaps occur more often because companies with
a high market capitalization can acquire businesses with their high value stock. According to
Fortune magazine, in 1998, when the equity markets peaked. 67 percent of the merger activity

52
in 1998 was accomplished through stock versus 33 percent through cash. The ratio was just 7
percent stock to 93 percent cash in 1988.

Type of Merger 1988 1998

Stock 7% 67%
Cash 93% 33%

Tax Impact of cash and stock swap deal

In a cash deal, when they receive the cash, owners must pay taxes. The tax rate for their
earnings is the marginal tax rate for ordinary income (your tax rate increases as the income
bracket you are in goes higher), which for big players is 39.6 percent. In a stock swap, by
contrast, no taxes are paid at the time of the swap. But the shareholder must pay capital gains
tax at a marginal tax rate of 20% if the exchanged stock is sold on the market.
All these tax rates are indicative and are from the US markets, although situation is similar in
India.

Tender Offers
Hostile takeovers are synonymous with tender offers. In a tender offer, in an effort to gather a
controlling stake, the aggressive acquirer makes a tender offer for public stock at a price higher
than the current market. Of course, by employing an IB firm to make a counter bid at higher
prices, the target company can protect itself from the takeover.

Mergers vs. Acquisitions

The terms merger and acquisition are often used loosely and interchangeably. For example,
once Deutsche Bank officials became irked at the continuous reference of Bankers Trust execs
to the agreement as a merger when it was actually an acquisition, a bit of friction emerged in
the Bankers Trust/Deutsche Bank contract. It is referred to as a 'Merger' when two businesses
of relatively equal size decide to combine forces.
There are real legal and accounting differences between the two, despite this sometimes loose
definition of how we usually categorise mergers and acquisitions, which basically rely on the
method used for the transaction (stock swap, etc as discussed above).

Will That Be Cash or Stock?

The decision of whether to make a cash offer or a stock swap is primarily based on the tax
considerations as discussed above. However, it may also, rely on other factors. For example, if
the acquired company's shareholders respect their acquirer's stock and assume that the
combined company would be a long-term leader in the industry (and is thus a company whose
stock they would like to receive), they would press for a stock exchange.

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It is also important to consider the uncertainty in the stock market; if the market acts like a
roller coaster, and the company's board of directors and shareholders can determine that a
stock swap cannot be operated efficiently, and opt for a cash offer. Another aspect that can
come into play is how easily an acquired business gets cash in a cash transaction and how
urgently it needs the cash.
Accretive vs. Dilutive Mergers
A merger is accretive when the acquiring company’s earnings per share will increase after the
merger.
A merger is dilutive when the acquiring company’s earnings will fall after a merger.
Let’s take a look at an example. Say OLA, wants to acquire a fast-growing competitor, Uber.
Also, suppose that OLA’s earnings are $10 mn and have 1 million outstanding shares (and thus
has earnings of $10 per share) and Uber’s earnings are $2 mn.
Whether the acquisition will be accretive or dilutive depends on the amount OLA will pay for
Uber. Say that OLA agrees to a stock swap in which it would issue 500,000 shares which it will
trade for all of Uber’s shares. The combined company will have 1.5 mn shares and $12 mn in
earnings. The new earnings per share are $8 per share. This deal is dilutive to OLA’s earnings.
But say that the terms of the acquisition are different, and OLA agrees to issue 100,000 new
shares instead of 500,000 shares. The combined company will have $12 mn in earnings and
1.1 million shares or earnings of $10.91 per share. This deal is accretive to OLA’s earnings.
Another way of looking at it is: When a company with a higher price to earnings ratio (we will
call the company “Company 1”, and label its P/E ratio “P/E1”) acquires a firm, “Company 2” of
a lower P/E ratio (which we will label as “P/E2”), it is an accretive merger.
If Company 1 acquires Company 2
Earnings Relationship Merger Type

P/E1 > P/E2 Accretive

P/E1 < P/E2 Dilutive

Questions
1. Describe a recent M&A transaction about which you have heard.

This question is a must-prepare question. Read the articles or search the Internet to have at
least one transaction thoroughly prepared. Different elements of the transactions should be
covered by you. You should know what the structure of the deal was and who are the parties
in the deal.

Recently, for a valuation of ₹182.12 crores, Reliance Retail Ventures (RRVL), a subsidiary of RIL,
acquired equity shares of Urban Ladder Home Decor Solutions (Urban Ladder), RIL said in a
statement. This investment reflects a 96 percent stake in Urban Ladder's equity share capital.

54
RRVL has the option of purchasing the remaining stake. A further investment of up to ₹75
crores, expected to be completed by December 2023, has been proposed.

2. Your customer is a human resources software firm that is privately owned. You have
to advise the company on the future sale of the firm. Which business will you expect to pay
more: Oracle Software (a competitor) or Kohlberg Kravis Roberts (an LBO fund)?
Oracle. Usually, a strategic purchaser like Oracle will pay more than a financial buyer like KKR.
Oracle would be able to reap additional benefits from the purchase and therefore have higher
cash flows than KKR. Oracle, for example, will be able to minimize support and administrative
personnel, merge the R&D budget of the business with Oracle's, get lower procurement and
development costs in larger volumes, etc.

3. Company A is considering acquiring Company B. Company A’s P/E ratio is 55 times earnings,
whereas Company B’s P/E ratio is 30 times earnings. After Company A acquires Company B,
will Company A’s earnings per share rise, fall, or stay the same?
Company A’s earnings per share will rise, because of the following rule: When a higher P/E
company buys a lower P/E company, the acquirer’s earnings-per-share will rise. The deal is said
to be accretive, as opposed to dilutive, to the acquirer’s earnings.
Company A’s earnings per share will rise, because of the following rule: When a higher P/E
company buys a lower P/E company, the acquirer’s earnings-per-share will rise. The deal is said
to be accretive, as opposed to dilutive, to the acquirer’s earnings.

4. Can you think of two companies that you think should merge?
Identifying synergies between two firms is just part of addressing this question correctly. You
must also ensure that the merger doesn’t pose any competitive concerns. You could suggest
that Apple and Microsoft should merge, for instance, but the merged company would have an
unfair monopoly on the market for operating systems, and the merger will not be approved.
(In addition, if the individuals who operate the two businesses do not like each other then
they will not want to merge.)

5. How do you explain a hostile tender offer?

Company A may issue a tender offer if Company A wants to acquire Company B, but Company
B refuses. Company A will take ads in essential newspapers/websites in this bid to purchase
stock in company B at a price far higher than the market price. If Company A is capable of
having more than 50 percent of the stock that way it can officially run Company B and make all
big decisions, including firing the top management. This is something of a simplistic view; there
are scores of rules and regulations from the regulatory bodies such as SEBI/SEC governing such
activity.

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6. What is a leveraged buyout? How is it different than a merger?
A leveraged buyout happens when a group is able to increase the company's valuation by
refinancing a business with debt. Typically, LBOs are carried out by either financial groups such
as KKR or company management, while M&A deals are led by businesses in the sector.

7. If Company A buys Company B, what will the Balance Sheet of the combined company look
like?
In this accounting, simply add each line item on the Balance Sheet.

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 FINANCE GLOSSARY

Accretive merger: A merger in which the earnings per share of the acquiring company rises.

Allotment notice/letter: A letter sent to the investor by the issuing company, indicating the
number of shares allocated to him.

Balance Sheet: The balance sheet describes a company's financial status at a given point in
time, including assets, liabilities and equity, and is one of the four essential financial
statements.

Beta: A value which reflects the relative volatility of the investment in relation to the market.

Bond price: The price charged by the bondholder (the lender) to the issuer of the bond (the
borrower) to keep the bond (i.e. to have a cash flow claim written on the bond).

Bond spreads: The gap between a corporate bond's yield and a U.S. Treasury security having
similar maturity period

Buy-side: Investment bank customers (mutual funds, hedge funds and other groups sometimes
referred to as 'institutional investors') who purchase shares, bonds and securities offered by
investment banks. (The "sell-side" is referred to as the investment banks that sell these goods
to investors.)

Callable bond: A bond that the issuer may buy back so that in the future it is not bound to
making high coupon payments.

Call option: The option which gives the holder the right, on or before a specified expiry date,
to buy an asset for a specified amount.

Capital Asset Pricing Model (CAPM): A model which is used to compute the discount rate of
the cash flows of a business.

Commercial bank: A financial institution which accepts deposits and provides loans. For eg, if
a corporation needs $30 million to start a new manufacturing centre, a commercial bank such
as Bank of America or Citibank may be approached for a loan. (Increasingly, commercial banks
provide consumers with investment banking services as well.)

Commercial paper: Corporate short-term debt instrument, which usually matures in nine
months or less.

Commodities: Objects that are typically compatible with one another (usually agricultural
goods or metals) and thus have a similar price. For instance, on commodity markets worldwide,
maize, wheat, and rubber usually trade at one price.

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Common stock: Common stock, also referred to as common equity, reflects a stake in a
company's ownership (as opposed to preferred stock, described below). Since common stock
requires investors to vote on business issues, the vast majority of stocks exchanged on the
markets today are common. A person with 51 percent or more of shares owned owns a
corporation and can delegate the board of directors or the management team to anyone
he/she likes.

Comparable transactions (comps): A way of valuing a corporation for a merger

or takeover that requires the analysis of related transactions.

Convertible preferred stock: Convertible preferred stock, a form of securities issued by a

corporation, is often given when either straight common stock or straight debt cannot be
effectively sold. Like how a mortgage pays interest fees, the preferred stock also pays a
dividend, then eventually transfers to common stock after some time. It is merely a
combination of debt and equity; it is commonly used as a way for a risky business to raise
money.

Capital market equilibrium: The theory that equilibrium should prevail in global interest rate
markets

Convertible bonds: Bonds which have the provision to convert to a specified number of stock
shares

Cost of Goods Sold: The associated costs of manufacturing goods. For example, this entails the
cost of labor, machinery, and supplies to manufacture the final product

Coupon payments: The interest contributions that the issuer of the bond gives to the holder of
the bond

Credit ratings: The rating that credit rating agencies assign to bonds. These ratings reflect the
probability of default.

Currency appreciation: When compared with other currencies, the worth of a currency rises.

Currency depreciation: When the value of a currency declines compared to other currencies

Currency devaluation: A devaluation occurs when a country makes a conscious decision to

lower its exchange rate in a fixed or semi-fixed exchange rate.

Currency revaluation: Under fixed exchange rates, when a currency strengthens

Default premium: The contrast between a corporate bond's promised yields and the yield on
the otherwise similar government bond.

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Default risk: The risk that the bond issuing firm would go broke and "default" on its debt
obligations

Derivatives: An instrument whose value is derived from another asset's worth. Call options, put
options, futures, and interest-rate derivatives are examples of derivatives.

Dilutive merger: A type of merger in which the earnings per share of the acquiring business
falls

Discount rate: A rate that calculates an investment's risk. It can also be defined as the expected
return from a project associated with a specified amount of risk.

Discounted Cash Flow analysis (DCF): A valuation approach that considers the net present value
of a company's free cash flows.

Dividend: A payment by a firm to the owners of its shares, usually as a means of transferring
to shareholders, some or all of the profits.

Ex-date: The date on or after which a security is traded without a previously declared dividend
or distribution. After the ex-date, a stock is said to trade ex-dividend.

High-yield bonds (a.k.a. junk bonds): Bonds with low credit scores that pay a reasonably high-
interest rate or can be bought for a face value of cents per dollar.

Holding Period Return: The income earned during the period as a percentage of the bond price at
the end of the term.

Income Statement: The Income Statement, one of the four basic financial statements, shows the
performance of a company's activities for a given period, and is composed of revenues, expenses,
and net income.

Initial Public Offering (IPO): An IPO is the first time that a business issues stock to the market, the
dream of any entrepreneur. 'Going public' means more than raising capital for a company; by
deciding to take on public shareholders, a company enters a whole world of mandatory SEC
disclosures and quarterly revenue and earnings reports, not to mention future shareholder
litigation.

Investment-grade bonds: High credit rating bonds that pay a relatively low-interest rate but are
very low-risk.

Leveraged Buyout (LBO): The purchasing of a business with borrowed capital, frequently using the
own properties of the company as collateral. In the early 1980s, LBOs became the order of the day
when prominent LBO firms such as Kohlberg Kravis Roberts developed a trend of purchasing,
restructuring, and reselling companies or making them public at a substantial profit. .

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Liquidity: The volume of a given stock or bond available for market trading. They are said to be
highly liquid instruments for commonly traded securities, such as large-cap stocks and U.S.
government bonds. Small-cap stocks and smaller fixed income concerns are also referred to as
illiquid (as they are not actively traded) and are subject to a liquidity discount, i.e. trading at lower
valuations as compared to similar, but more liquid securities.

The Long Bond: The U.S. 30-year treasury bond. Treasury bonds are used as the starting point for
pricing many other bonds. Treasury bonds are used because they are considered to have zero
credit risk, taking factors such as inflation into account. For Example, A corporation issues a bond
that trades "40 over Treasuries." The 40 refers to 40 basis points (100 basis points = 1 percentage
point).

Market capitalization: The overall value (total shares outstanding x price per share)
of a company on the stock market.

Money market securities: This concept is commonly used to describe the market securities
maturing within one year. These include short-term CDs, repurchase deals, commercial paper (low-
risk corporate problems). These are low-risk, short-term securities that have treasuries-like
returns.

Mortgage-backed bonds: Bonds that are collateralized by a mortgage pool. Interest and principal
payments are based on the mortgage payments being received by the individual homeowners. The
more diverse the mortgage pool that backs the bond, the less volatile they are.

Multiples method: A method of valuing a company that includes a multiple of an indicator such
as price-to-earnings, EBITDA, or revenues.

Municipal bonds: Bonds issued by local and state governments, or municipalities. These are
designed for the lender as tax-free, ensuring borrowers receive interest payments in
municipalities without paying federal taxes. Investors are excluded from paying any state and
local taxes, too. As a result, municipalities pay lower interest rates on municipal bonds than
other similar-risk bonds.

Net present value (NPV): The present value, minus initial investment, of a series of cash flows
produced by an investment. Because of the significant notion that money today is worth more
than the same money tomorrow, NPV is assessed.

Non-convertible preferred stock: A stock that does not give the issuer the right to call in or
redeem the preferred stock at a pre-set price after a predetermined date. Therefore, it stays
outstanding and trades like stocks in perpetuity. The most popular issuers of non-convertible
preferred stock are utilities.

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Par value: The amount of money that the bond issuer promises to pay back at the maturity
date of the bond.

P/E ratio: The price to earnings ratio or the P/E ratio is the ratio of the stock price of a company
to its earnings-per-share. The higher the P/E ratio, the quicker the investors think that the
business can expand.

Price correction: A term that describes a short-term steady decline in the financial market. This
usually comes after a period of substantial rise in stock prices in the market.

Prime rate: The average rate U.S. banks charge to companies for loans.

Put option: An option that gives the holder, on or before a specified expiry date, the right to
sell an asset for a specified price.

Securities and Exchange Commission (SEC): An independent federal agency that was created
as a result of the 1929 stock market collapse and the subsequent downturn like the Glass-
Steagall Act. The SEC regulates the disclosure to stockholders, financial
reports and offers safeguards against fraud.

Securitize: It implies turning an asset into a security that can be sold to buyers afterwards. It is
possible to transform almost every income-generating asset into security. For instance, it is
possible to bundle a 20-year mortgage on a home with other mortgages and shares of this
mortgage pool would then be sold to buyers.

Selling, General & Administrative Expense (SG&A): It includes all the costs that are not primarily
involved in revenue generation. It is the sum of all direct and indirect selling expenses and all
general and administrative expenses (G&A) of a company.

Spot exchange rate: The currency costs prevailing in the market for earliest exchange and
delivery.

Statement of Cash Flows: A full description of all cash inflows and outflows over a given time.
It is one of the four standard financial statements

Statement of Retained Earnings: The Retained Earnings Statement is a

reconciliation of the Retained Earnings Report, one of the four basic financial statements. The
declaration contains facts such as dividends or announced revenue. The Declaration of
Retained Earnings contains details on what the management of a company is doing with the
earnings of the company.

Stock: It is the ownership inside a company in proportion to shares purchased. These can be
preferred or common stock.

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Stock swap: A type of M&A activity in which one company’s stock is exchanged for the stock of
another company

Strong currency: A currency whose value, relative to other currencies, is rising. It all depends
upon the market forces by the levels of supply and demand on the international market.

Swap: A swap is a type of derivative instrument, which is the exchange of future cash flows
between two counter-parties. Common swaps include interest rate swaps and foreign
exchange swaps.

10-K: A periodic annual report submitted with the Securities and Exchange Commission (SEC)
by a public corporation. It includes a comprehensive summary of a company’s financial
performance including financial data, business data, risk factors, etc.

Tender offers: A process by which an aggressive acquirer makes a bid to a company’s owners
to collect a majority stake in the company. The prospective acquirer would typically offer to
purchase shares from shareholders at a far greater value than the current value.

Treasury securities: These are U.S. government-issued bonds. It can be split into Treasury bills
(up to 2 years of maturity), Treasury notes (2 years to 10 years of maturity) and Treasury bonds
(10 years to 30 years of maturity). Because they are insured by the government, treasuries are
also called risk-free securities. In principle, while
the U.S. Treasuries do not have default risk, they have an interest rate risk; which implies that
if rates rise, UST values will decline.

Underwrite: The process by which an institution takes on financial risk for a fee. Investment
banks usually help businesses in issuing shares to their customers through this process.
Technically, the investment bank buys the company's shares initially and later immediately
resells the securities at a slightly higher value to buyers, thereby earning profit in the difference

Weak currency: A currency with a falling value relative to other currencies.

Yield to call: The return that one would earn if they held a bond until its call date before its
date of maturity. This is applicable only for callable bonds.

Yield: The earnings generated and realized on an investment over a particular period of time.

Yield to maturity: It is the measure of the annual rate of return that will be paid on a bond if
the bond is kept until maturity.

Zero-coupon bonds: A bond that gives the bondholder no coupon or interest payments.

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 QUESTION BANK
1. What kind of firms are expected to take the IRR as a tool to evaluate projects? Which firms
would look at NPV?
2. Explain the difference in reinvestment assumptions while calculating NPV and IRR. What
implication does it have on the project profile?
3. Explain broad differences in NPV and IRR
4. Given the WACC equation, a company should have 100% debt, because that is the point where
the cost of capital will be minimized. Is this correct?
5. Explain the difference between Dividend Pay-out, Dividend Rate and Dividend Yield
6. As a manager, what would your endeavour be while looking at a firm’s working capital?
7. When can we call an asset Risk Free? Why is the government bond considered risk free, even
though we hear the news of governments defaulting?
8. What kind of firms will you expect to have higher betas? Which ones will have lower betas?
9. While calculating the Weighted Average Cost of Capital, what weights should we use? Market
Values or Book Values?
10. What drives the Price to Earnings Ratio of a company?
11. In what sectors do we use EV/EBITDA as a metric?
12. What do we mean by Enterprise Value? How do we calculate it?
13. Explain what do we mean by Goodwill?
14. Give an example of Short-Term Provisions on the Balance Sheet
15. Give an example of Long-Term Provisions on the Balance Sheet
16. Explain what do you mean by minority interest?
17. A company reports a profit of Rs 2000 crore. Its depreciation is 350 crores. Receivables last
year were Rs 510 crore, this year are 620 crores. Payables were 340 crore last year and 420
crore this year. The company has planned a capital expenditure of Rs 1220 crore. Interest cost
is 100 crores. Calculate the CFO, CFI and CFF for the company, assuming the company raises
800 crores in debt, and pays 400 crores as dividend.
18. How do we calculate the beta for an unlisted firm?
19. How can we calculate cost of debt for a firm?
20. How can a firm book revenue early? Give an example from any sector to explain this concept
21. Explain with example the concept of Capitalization of any expense
22. Explain how seasonality affects the working capital of a firm?
23. Discuss the implications of working capital management, with reference to firms like Flipkart
and Future Retail (or Amazon and Walmart). What do you think is different in the two firms’
working capital scenario? What are the elements that you think the two firms should manage
well?
24. Explain what is interest coverage ratio. Following are the interest coverage ratios for 4 firms.
What would your analysis be on these firms? DLF: 1.3, JP Associates: 0.8, Hindalco: 2.2, TVS
Motors: 5.3
25. Explain the difference between a bonus and a stock split – with examples. Which one of these
is considered as a sign of the company performing well?
26. Explain the benefits of over-diversification with an example
27. Explain how an airline company can hedge the price of oil for their usage, by using derivative
contracts. Assume that the price today is USD 50 per barrel of oil.

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28. Can a company do well even if its Return on Equity is going down?
29. The current ratio of a company goes from 1 to 1.5, but cash balances have not increased.
Would this be positive for the stock market?
30. What is the boundary condition for a company to grow in terminal stage in a DCF Valuation?
31. Walk us through different valuation models.
32. Explain DCF model in detail
33. Explain Comparable method with an example.
34. Pitch any stock of your choice.
35. Tell us about a company you admire and what makes it attractive.
36. If you had $X to invest, where would you invest and why?
37. What do you understand by Enterprise value/Equity value?
38. What do you understand by FCFF/FCFE?
39. What do you understand by ROCE/ROIC?
40. What do you understand by Terminal value?
41. What do you understand by CAPM?
42. What do you understand by Beta and adjusted beta?
43. What do you understand by WACC?
44. What do you understand by Deferred tax assets and liabilities?
45. What do you understand by Basic and Diluted EPS?
46. Company changed depreciation method, and depreciation has now increased. What is the
impact on P&L and Cash Flow?
47. When RoE > RoCE, what does it imply?
48. When Beta is negative then how to calculate Cost of Equity?
49. Company wants to decrease its current ratio from 1 to 2. How to do that?
50. What are your current views on Market?
51. If EBITDA is growing faster than operating income then what could it mean?
52. When do we use P/E, P/B, P/S, EV/EBITDA, EV/EBIT multiples?
53. What is the significance of and impact of buyback on share prices?
54. How are 3 financial statements related to each other?
55. Financial modeling test on portfolio companies- to invest or not
56. What industry trends you will look at when looking for potential investment.
57. Market position and competitive advantage. Explain.
58. Stable & recurring cash flows. Explain.
59. Multiple drivers to trigger growth. Explain.
60. Explain strong management.
61. If you would look into only one financial investment, what would it be and why?
62. How to improve IRR? And issues with IRR?
63. Explain LBO and Leveraged cashflows.
64. Why this firm? - Research about the firm, fund size, market presence and value, investment
stages and procedure, nature of the investment, past investments etc.
65. Which of our investment you like the most and why?
66. What do you like about the company?

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General Banking
1. What is BASEL II and how it different than BASEL 1, and 2?
2. How to assess management quality?
3. What is the difference between Gross NPA and Net NPA?
4. What do you mean by divergence in NPA and how to assess the same?
5. A Client has ₹ 1 Cr. - what will be your suggestion with respect to asset
management/investment and what asset classes and why?
6. How will you assess WC Requirement for Infrastructure companies?
7. If a restaurant company come with loan requirement then what kind of loan will you approve
and how will you assess the need?
8. How will you assess liquidity and leverage?
9. Why ROA is better indicator for Banks compared to any other return ratios?
10. Explain different types of Amortization.
11. Explain NPA crisis and why some banks were not recognizing bad loans.
12. What is happening with Debt Mutual Funds and why some of the debt fund schemes closed?
13. Why CASA ratio for some banks is around 50-% and some banks around 40-57 How it is
determined broadly?
14. How banks earn money?
15. Fundamental difference between Banks in India and Banks in USA?
16. Explain PCR and why is not enforced by RBI?
17. When is PCA enforced and why?
18. Major reasons why Banks lend to NBFCS
Corporate Finance/ General Finance
1. Working capital should be positive or negative and why?
2. How to assess profitability and which is the best measure?
3. Why return ratios are calculated?
4. Difference between RoE, ROCE, RoIC and RoA?
5. How to calculate Cost of Debt?
6. Why a company goes for stock and bonus?
7. Impact of operating lease and financial lease of financial statements and ratios.
8. What is constant current revenue mean?
9. How will you asses growth prospects of Cinema Business vs FMCG Business?
10. Why companies go for price war? Is there any metric which says that price war will happen in
a particular industry?
11. Why some companies (like Apple) have lot of debt despite having lot of cash and equivalents
on the Balance Sheet?
12. What kind of inferences you can have from Cash Flow statements which is tricky through other
two financial statements?
13. According to you, what Industries will perform better after COVID and why?
14. What kind of companies use NPV and what kind of companies use IRR?
15. Is declining RoE a good/bad indicator? Why?
16. How will you assess that do we need new manufacturing facility/warehouse facility?

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Equity Research
1. When to use DCF and when to use Relative Valuation?
2. What is the Effect of Stock Split and Dividend on EPS?
3. When to use P/E and when to use EV/EBIDTA?
4. Why do we take market value weights in WACC?
5. What is Price/Sales metric and is it a good metric to do a valuation?
6. Difference between FCFE and FCFF?
7. How to project Capex and explain with example.
8. What is Enterprise Value and what does it signify?
9. What effect Debt will have on Enterprise Value?
10. What value of Risk-free rate and Terminal growth rate to take?
11. What critical parameters to consider while evaluating a business with heavy fixed cost?
12. Explain growth projection methods for different industries (retail/telecom/paints etc).
13. Is high P/E justifiable?
14. How do you determine forward PE?
15. What is circular referencing issue. How do you solve that?
16. How to treat cash while performing valuation exercise?
17. Tell us. investment thesis about one of your selection of stocks
18. How do you decide when to exit from stock? Any example
19. Tell us about one sector which you are tracking now.
Investment Banking
1. Concept of Levered Beta and Unlevered Beta.
2. What is more important: FCF or Profits?
3. How to value a company is Cash Flow is negative?
4. How is LBO modelling different than DCF modelling?
5. Any idea how companies decide to go for stocks swap or all cash deal.
6. How do you value a synergy? Give example of operational synergy and financial synergy.
7. How do you decide which comparable to use with example?
8. How do you determine what value of comparable to use with example?
9. Is negative/positive working capital good/bad?
10. Can you explain the term tag along and drag along?
11. How do you find cost of equity for an unlisted entity?
12. How to determine beta in case of no stock price information is available?
13. Have you analyzed any IPO? What are your views on that?
14. What are the exit options available from unlisted entity?
15. Explain anti-dilution.
16. What do you mean by liquidation preference?
17. How will you go about analyzing food tech/ed tech company?
18. What are your views on online retail and why it is difficult/easy?
19. What set of financial ratios will you evaluate for a startup and why?

Disclaimer: Published by the Finance Committee, X -FIN, XIM,Bhubaneswar.

No part of the publication maybe transmitted in any form without prior written permission of the
publisher. Information contained in this journal has been obtained from sources believed to be
reliable. However, X-FIN does not guarantee the accuracy of or completeness of any information
published here and shall not be held responsible for any errors and omissions.

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