Session 1.

Introduction to Corporate Finance

PGP, IIM INDORE
Evaluation
•Class participation – 10%
•Quizzes – 30%
• Two quizzes

•Mid-term Examination – 25%

•End-term Examination – 35%
•Text for reference:
• Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata McGraw-
Hill Education. Referred to as BM
• Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: Theory & practice. Cengage Learning.
Referred to as BE
Core Functions Of Corporate Finance
Investment Decisions

Financing Decisions

Earnings Distribution Decisions

Other Aspects of Corporate Finance
•Risk Management Function
• Risk management decisions that add to firm value

•How to value companies

• Interaction of Investment and Financing decisions
Growth Opportunities
•Tata Motors (TM) will invest USD 2 billion to launch 10 new electric vehicles
• Investment over 4 years
• TPG Rise Climate and others invest USD 1 billion into TM’s passenger electric vehicles division

•Hertz Global Holdings Inc. (Oct 2021) placed an order for 100,000 EVs with Tesla
• The cars will be delivered over the next 14 months, and Tesla’s Model 3 sedans would be available to
rent at Hertz locations in major U.S. markets and parts of Europe
• The single-largest purchase ever for electric vehicles (Evs), and represents about $4.2 billion of revenue
for Tesla

•Etisalat completed the acquisition of German Cybersecurity giant Help AG, Feb 2020
• UAE based multinational telecommunication company
• Enable creation of a strong cyber security unit in the region, and strengthen Etisalat’s cloud, IOT, AI, Big
data and analytics lines of business
Growth Opportunities
•Wipro Ltd. undertook its biggest acquisition by acquiring Capco (The Capital Markets Co NV) for
USD 1.45 billion (March 2021)
• IT consulting firm based in the UK
• The target services the financial services industry across the American sub-continent, Europe and Asia-
Pacific regions (Srinath Srinivasan 2021).

•Byju’s acquired Aakash Educational Services for USD 950 million

• The acquirer had bought White Hat Junior in 2020 for USD 300 million

•KKR acquired majority stake in JB Chemicals & Pharmaceuticals for approx. $ 500 million, Jul
2020
• Carlyle to acquire 20% stake in Piramal Pharma Ltd. for approx. $490 million, Jul 2020
Growth Opportunities
•Ultratech Cement to invest $ 740 million in capacity expansion, Dec 2020
• Increase its capacity by 12.8 million tonne per annum

•Facebook announces investment of $5.7 bn in Reliance Jio in April 2020

•HCL Tech
• Jul 2019: Completed acquisition of IBM’s software assets worth $1.8 bn

•Tata Starbucks, a 50:50 joint venture between coffee store chain Starbucks and Tata Global
Beverages
• Aug 2019: Planned to open 30 stores across cities in India. Investment required is INR 15 to 20 million
Core Functions: Investment decisions
§Investment decision
§ Capital Budgeting Decision
§ Which Real Assets the firm should acquire?
§ Real Assets: Assets used to produce goods and services.
• Decision to invest in tangible (eg. PPE) or intangible assets (eg. R&D, patents, trademarks)
…also called Capital Expenditures or (CAPEX) decisions
• Includes decisions not to invest as well

•Principle: Invest in assets that earn a return greater than the minimum acceptable rate of
return
• Opportunity cost of capital (Hurdle rate)
• The hurdle rate based on - Time value of money + Riskiness of the investment
Examples
•Online food delivery platform Zomato raised approx. USD 1.26 billion in IPO in July 2021
• 38 times oversubscription
•Clean Science rasied approx. INR 1546 crores IPO in July 2021
• Clean Science IPO has been subscribed 93.41 times
•Raymond plans to raise INR 100 crores by Issuing Non-Convertible Debentures (Dec 2021)
•Barbeque nation raised INR 453.6 crores in IPO in Mar 2021
• Burger King raised Rs. 810 crores Dec 2020: IPO received a stellar debut in terms of oversubscription
and stock market prices on getting listed
•Tata Capital Financial Services raised Non-convertible Debentures in Aug 2019
• Issue size approx. INR. 2157 crores, CRISIL and CARE rated it AAA, listed on BSE & NSE
• Tata Capital Housing Finance (subsidiary of Tata Capital) to raise INR 2000 crores (issue closed on 17th
Jan’20)
Examples
•IRCTC raised INR 645 crores for 12.6% stake
• IPO in Oct 2019, shares were issued at INR 320

•Bandhan Bank
• Mar, 2018: Completed an IPO of upto Rs. 4500 crores

•Aston Martin
• Went for an IPO in September 2018 on LSE
Core Functions: Investment, financing and Earnings
Distribution decisions
§Financing decision = Sale of financial assets
§ Financial Assets: Financial Claims ( or Securities): To pay for real assets, the corporation sells claims on
the assets and on the cash flow that they will generate
§ How to raise money to pay for investments in real assets?
§ Also includes, meeting obligations to banks, bondholders, stockholders that contribute financing

§Also called -Capital Structure Decision: Firm’s mix of long-term financing

§Principle often followed: Choose the financing mix that maximizes the value of the firm, and
ideally matches the tenor of the assets being funded.
§ Consistent with its debt policy
Examples
•TCS announced a dividend of Rs. 7 per share for the third quarter of 2021-22
• It was Rs. 6 per share for the same quarter in 2020-21
•GAIL (India) Limited announced that the board had approved the payment of interim dividend of
Rs. 4 per share for the FY2021-22 (Dec 2021)
•Microsoft approved share repurchase programme of $60 billion in Sept 2021
• Microsoft approved share repurchase programme of $40 billion in Sept 2019
• It had bought back shares worth $ 35 bn from 2017 to 2019
•Infosys closed a share buy back worth INR 8260 crores in Aug 2019, bought back 11.05 crore
shares
• Infosys completed a share buy back of worth Rs. 13000 crores in Dec, 2017.
• TCS completed a mega share buy back of worth Rs. 16000 crores in May 2017
• Wipro, Cognizant, HCL Technologies and Mindtree have all done share buy backs in past few years
Core Functions: Investment, financing and Earnings
Distribution decisions
§Earnings Distribution decision:
§ Reinvest in the firm (Equivalent to raising equity)
§ Hold as cash reserves for future investments
§ Pay-out to the shareholders: Pay dividends (Dividend Decision) and/or Repurchase shares

§Principle: If you cannot find investments that make your minimum acceptable rate, consider
returning the cash to investors
§ How much cash you can return depends upon current & potential investment opportunities
A thought exercise
What Fundamental trade-off a Financial Manager faces?
Fundamental trade-off for corporate
investment decisions
Cash

Investment
Investment
Financial Opportunity
Opportunity Shareholders
Manager (Financial
(Real Asset)
Assets)

Alternative: Pay Shareholders

Invest
dividend to invest for
shareholders themselves
• Keep and reinvest cash, Or return it to investors

Ref. Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Chapter 5. Principles of corporate finance. Tata McGraw-Hill Education. Referred to as BM
hereafter.
Value: A Leitmotif
•A Key Goal
• Maximize shareholder value by identifying investments and financing arrangements that
favourably impact shareholder wealth

•By creating more cash than it uses (in present value terms) – a firm creates Value
•Hence, the Value of an Investment /Asset / Project
"#! "#" "## "#$
𝐶𝐹! + + + + …… +
(%&'! )! (%&'" )" (%&'# )# (%&'$ )$

•Value of an Investment is determined by its Free Cash Flows

• Discounted at a relevant rate: opportunity cost of capital/ hurdle rate
• To consider the time value of the cash flows, as well as the risk of the cash flows
Free Cash Flows
•Free Cash flows are
• Cash flow available for (free) for distribution to all investors (Equity + Debt)
• After paying current expenses, taxes, and making the investments necessary for growth
• FCF = EBIT - Taxes + Depreciation – Capex – Change in NWC

•Uses that FCF can be put to:

• Pay interest on debt, repay debt, pay dividends, buyback shares, buy marketable securities
Importance of Cash flow
•Net income or accounting income is not cash flow
•Cash Flow – Cash received minus cash paid out
•Earnings vs. Cash-flows
• Net Income and Cash Flow can be extremely different values
• Non-cash expenses (e.g., depreciation, amortization), revenue recognition, Investments (capex &
working capital)

Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Chapter 6. Principles of corporate finance. Tata McGraw-Hill Education.
•Leading international mining group, second largest metals and mining company
•Listed on London Stock Exchange and Australian Securities Exchange
•Major products are aluminium, copper, diamonds, coal, uranium, gold, industrial minerals
(borax, titanium dioxide, salt, talc), and iron ore.
•Major presence in Australia and North America with significant businesses in South America,
Asia, Europe and Africa.
Rio Tinto
Numerical example
Thank you
Session 2, 3 and 4. Investment Decision
Rules – Part I
PGP, IIM INDORE
CFO Decision Tools

Results from Graham and Harvey Survey (2001)

The Net Present Value (NPV) Rule
•Net Present Value (NPV) = Total PV of future CF’s - Initial Investment
•Minimum Acceptance Criteria: Accept if NPV > 0
•Ranking Criteria: Choose the highest NPV
Net Present Value

What is the net present value if the minimum required return is 10%?
Net Present Value

What is the net present value if the minimum required return is 10%?
Why Use Net Present Value?
•Accepting positive NPV projects benefits shareholders.
• You select projects that are value creating
•NPV uses cash flows
•NPV uses all the cash flows of the project
•NPV considers the time value of money
Payback Period Method
•How long does it take the project to “pay back” its initial investment?
•Number of years before cumulative cash flow equals initial outlay
•Payback Period = number of years taken to recover initial costs
Payback Period Method: An Example

Assumptions: all cash flows happen at the end of the year

Payback Period Method
Payback Period Method: An Example

Payback period in precise no. of years =

Unrecovered cost at start of the year
Number of years prior to full recovery +
Cash :low during full recovery year
Payback Period Method

Payback period A (precise years) = 2.2 years

Payback period B (precise years) = 1.83 years
Payback period C (precise years) = 1.4 years
How to apply the Payback period method?
Payback period method
Payback Rule
◦ Requires you to specify a cut-off pay back period
◦ Only accept projects that pay back within desired time frame
Example: The mandated cut-off period for the current example is 2 year
◦ Accept those projects which payback within 2 years
Payback Period and NPV
Compare the choices made as per Payback period and NPV

Payback period A (precise years) = 2.2 years

Payback period B (precise years) = 1.83 years
Payback period C (precise years) = 1.4 years

What are the disadvantages of using the Payback Period approach?

The Payback Period Method
Disadvantages:
• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires an arbitrary acceptance criteria
• A project accepted based on the payback criteria may not have a positive
NPV
Advantages:
• Easy to understand
• Biased towards liquidity
The Discounted Payback Period
•How long does it take the project to “pay back” its initial investment,
taking the time value of money into account?
•Decision rule: Accept the project if it pays back on a discounted basis
within the specified time.
Numerical Example: Discounted Payback
Year Project S Project L

0 -1000 -1000

1 500 100

2 400 300

3 300 400

4 100 600

Note: The discount rate is 10%

Solution
Year Project S PV Year count
0 -1000
1 500 454.55
2 400 330.58
3 300 225.39
4 100 68.30
Note: The discount rate is 10%
Solution
Year Project S PV Precise No. of years
0 -1000
1 500 454.55 1
2 400 330.58 1
3 300 225.39 0.95
4 100 68.30

Discount rate 10%

Payback period 2.95
Solution
Precise no. of Precise no. of
Year Project S PV years Project L PV years
0 -1000 -1000
1 500 454.55 1 100 90.91 1
2 400 330.58 1 300 247.93 1
3 300 225.39 0.95 400 300.53 1
4 100 68.30 600 409.81 0.88

Discount rate 10%

Payback period 2.95 3.88

Downside - if the cut off is 3 years (for example), then the subsequent year’s cash flows are ignored
 The Internal Rate of Return
•IRR is defined as the discount rate that makes NPV equal to zero.
• It is a rate of return that is internal to the project
•Illustration
Internal Rate of Return: Illustration
◦ Tool A costs 4,000. Investment will generate Rs. 2,000 and Rs. 4,000
in cash flows for two years. What is the IRR?
◦ Hint – IRR is between 25 and 30%

2,000 4,000
NPV = -4,000 + 1
+ 2
=0
(1 + IRR ) (1 + IRR )

IRR = 28.08%
Internal Rate of Return - Plotting the NPV Profile
The graphical method can be
used to calculate the IRR, but
it is time consuming.
 The Internal Rate of Return: Application
•The discount rate that makes NPV equal to zero.
•General application - Minimum Acceptance Criteria: Accept if the IRR
exceeds the minimum required rate of return
•Ranking Criteria: Select alternative with the highest IRR
• To exercise caution while ranking (ref. discussions on mutually exclusive
projects)
Internal Rate of Return: Pitfall 1
Which project would you choose as per NPV approach? As per IRR approach?
Internal Rate of Return
Pitfall 1: Lending or Borrowing?
◦ NPV of project increases as discount rate increases for some cash
flows
◦ Decision criteria – Borrowing – Accept the project if the IRR is less
than the opportunity cost of capital
Internal Rate of Return
◦ Examples of costs occurring later – abandonment expenditure, asset
retirement obligation, decommission costs, scheduled maintenance.
◦ What is the IRR for the following project?
Internal Rate of Return
Pitfall 2: Multiple Rates of Return
◦ Certain cash flows generate NPV = 0 at different discount rates
◦ IRR% of 3.5% and 19.54%
◦ Examples of costs occurring later – abandonment expenditure, asset
retirement obligation, decommission costs.
◦ What is the IRR for the following project?
Multiple Rates of Return

The project has positive NPV for discount rates between 3.5% and 19.54%
References
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch. 5 and 6
Session 2, 3 and 4. Investment Decision
Rules – Part II
PGP, IIM INDORE
Recap of Session 2
•Net present value
•Payback period approach
• Discounted payback period approach
• Limitations and advantages

•Internal rate of return (IRR)

• To exercise caution: Borrowing type
• Non-conventional cash flows (where cash flow signs change more than once)
• Multiple IRRs
Internal Rate of Return
Pitfall 2: Multiple Rates of Return
◦ Certain cash flows generate NPV = 0 at different discount rates
◦ IRR% of 3.5% and 19.54%
◦ Examples of costs occurring later – abandonment expenditure, asset
retirement obligation, decommission costs.
◦ What is the IRR for the following project?
Multiple Rates of Return

The project has positive NPV for discount rates between 3.5% and 19.54%
Modified Internal rate of return
Discount the later cash flows – till the point – there is only one sign change
Ref. Excel
Internal Rate of Return
•Pitfall: No IRR
•Project can have 0 IRR and a positive NPV
IRR: To Exercise Caution
Does not distinguish between investing and borrowing
◦ Care to be taken in appraising such projects

Multiple IRRs or Zero IRR

◦ IRR(s) not a meaningful figure

The above two problems are common to Independent and Mutually Exclusive Projects
Problems specifically with Mutually Exclusive Projects
◦ Scale Problem
◦ Timing Problem
Mutually Exclusive vs. Independent
•Mutually Exclusive Projects: only ONE of several potential projects can be
chosen, e.g., acquiring an accounting system.
• Such projects serve the same purpose, hence the acceptance of one would make
others redundant.
• RANK all alternatives and select the best one.
•Independent Projects: accepting or rejecting one project does not affect the
decision of the other projects.
• Must exceed a MINIMUM acceptance criteria
Internal Rate of Return
•Pitfall 3: Mutually Exclusive Projects

•Which project will you select as per NPV criteria if the cost of capital is 10%?
•Which project would you select as per IRR criteria if the cost of capital is 10%?
Internal Rate of Return: Mutually Exclusive Projects
◦ IRR sometimes ignores magnitude of project – Scale problem

◦ NPV and IRR do not agree on the choice of the project

Internal Rate of Return
•Application of IRR for Mutually Exclusive
Projects
Project E-D (Incremental CFs if project
Time E is selected over D)
0 -10000
1 15000

Incremental IRR 50%

Recommendation: Select Project E over D

References
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch. 5 and 6
Session 2, 3 and 4. Investment Decision
Rules
PGP, IIM INDORE
Recap of Session 3
•Modified Internal Rate of Return
• Multiple IRRs
• No IRR

•Mutually Exclusive Projects vs. Independent Project

• Projects with difference in Scale
Internal Rate of Return
•Pitfall 3: Mutually Exclusive Projects

•Which project will you select as per NPV criteria if the cost of capital is 10%?
•Which project would you select as per IRR criteria if the cost of capital is 10%?
Internal Rate of Return: Mutually Exclusive Projects
◦ IRR sometimes ignores magnitude of project – Scale problem

◦ NPV and IRR do not agree on the choice of the project

Internal Rate of Return
•Application of IRR for Mutually Exclusive
Projects
Project E-D (Incremental CFs if project
Time E is selected over D)
0 -10000
1 15000

Incremental IRR 50%

Recommendation: Select Project E over D

Internal Rate of Return
•Application of IRR for Mutually Exclusive
Projects
Project D-E (Incremental CFs if
Time project D is selected over E)
0 10000
1 -15000

Incremental IRR 50%

Recommendation: Do not select Project D over E

Mutually Exclusive Projects: Timing of Cash Flows
Rs.10,000 Rs.1,000 Rs.1,000
Project A
0 1 2 3
-Rs.10,000

Rs.1,000 Rs.1,000 Rs.12,000

Project B
0 1 2 3
-Rs.10,000
What are the IRRs of the two projects?
The Timing Problem
Year Project A Project B

0 -10000 -10000

1 10000 1000
2 1000 1000

3 1000 12000

IRR 16.04% 12.94%

a. Generally, the project with large cash flows later has lower IRR. What about the payback period?
b. The preferred project in this case depends on the discount rate, not the IRR.
c. Consider NPV for selecting the projects
 5000.00

4000.00

3000.00

2000.00 Crossover rate = 10.55%

1000.00
NPV

IRR_Project A = 16.04%
0.00
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28%
-1000.00
IRR_Project B = 12.94% Discount rate
-2000.00

-3000.00

-4000.00 NPV Project A NPV Project B

a. Cross over rate is the IRR of incremental cash flows (i.e., CFs of B-A, or A-B).
b. Conflict area – when r < Cross-over rate
NPV versus IRR
•NPV and IRR will generally give the same decision.
•Exceptions:
•Non-conventional cash flows – cash flow signs change more than once
•Mutually exclusive projects.
• Initial investments are substantially different.
• Timing of cash flows is substantially different
Additional Concepts
Choosing Capital Investments When Resources are Limited
•When resources are limited, work out all the possible combinations of projects
within the capital constraint
•Select the combination that maximizes the Net Present Value within the constraint
!"# $%"&"'# ()*+"
•𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
,'("&#-"'#
•Also, expressed as Present value / Investment
Choosing Capital Investments When Resources are Limited
◦ Select best projects for Rs. 300,000
Project NPV Investment PI

A 230,000 200,000 1.15

B 141,250 125,000 1.13

C 194,250 175,000 1.11

D 162,000 150,000 1.08

Profitability Index
•Select the combination with the highest weighted average PI
Project NPV Investment PI Weight (Investment / Budget)

A 2,30,000 2,00,000 1.15 0.67

B 1,41,250 1,25,000 1.13 0.42
C 1,94,250 1,75,000 1.11 0.58
D 1,62,000 1,50,000 1.08 0.50

!"#$$$ ∗ !.!' (!#$$$$ ∗ !.$)) ("#$$$ ∗ $)

•𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝐼 𝐵𝐷 = '$$$$$
+ '$$$$$
+ '$$$$$
Profitability Index
•The combination with highest Weighted average PI is project B and C
Combinations Weighted PI Combined NPV
A only 0.77 2,30,000
B only 0.47 1,41,250
C only 0.65 1,94,250
D only 0.54 1,62,000
B&C 1.12 3,35,500
B&D 1.01 3,03,250
References
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch. 5 and 6
Session 6, 7 and 8. The Cost of Capital – Part I
PGP, IIM INDORE
Discount rate
•Opportunity cost of capital: The return investors could earn on alternative investments of
equal risk
•An appropriate rate that reflects the time value of money and riskiness of cash flows
• The denominator in the NPV
• Risk: Likelihood that we will receive returns that are different from the returns we expect

•The terms discount rate, minimum required return, and cost of capital – used interchangeably
Company and Project Costs of Capital
Weighted Average Cost of Capital
◦Traditional measure of capital structure, risk and return
! #
◦𝑊𝐴𝐶𝐶 = ∗ 𝑘𝑑 ∗ 1 − 𝑡 + 𝑘𝑒
" "
◦V = D+E
◦Because interest expense is tax-deductible, we multiply the
cost of debt by (1 – TC).
Weights in WACC
Note on WACC
Weights in WACC
◦ Market value weights
◦ Target Capital Structure -Weights should represent the long-term target capital structure (if the same is
known)
◦ Consistent rates to be used in deriving cost of equity and WACC
Cost of Debt
Jet Airways’ Interest cost
ICRA downgraded Jet Airways rating from BB to B in Oct 2018. BB is moderate level of default
risk. B is high risk of default
ICRA downgraded the rating again in Dec to C. C is very high risk of default
ICRA downgraded the rating again in Jan 2019 to D. Instruments with this rating are in default or
are expected to be in default soon.
Cost of Borrowings was around 12 to 13% for year ending March 2018.
Cost of Debt
•Expected return on a long-term debt obligation of a credit quality that corresponds to the
capital structure ratios built into the WACC Formula
The interest rate likely to be charged on new debt.
Find the yield on the company’s debt, if it has any.
Find the bond rating for the company and use the yield on other bonds with a similar rating.
• Default spread (also called credit spread or bond spread)
• Rd = Rf + Default spread
• Example - Company debt outstanding (non-traded) – $100 mn, and it has debt rating of A+. The
prevailing default spread on A+ rated securities is 1.52% and the risk-free rate is 4.75%. Then the cost of
debt for this company is 6.27%
Example – Corporate bond Default
Spreads as per credit rating
•Spread over risk free rate
Bond rating Corporate Bond Default spread
AAA 0.75% •Default risk premium
AA 1.02% •If risk free rate is 4.75%, then yield on a AAA
A+ 1.52% rated bond would be 5.5%
A 1.60%
A- 1.75%
BBB+ 2.79%
BBB 2.87%
BBB- 3.89%
BB+ 6.67%
BB 6.74%
BB- 6.95%
B+ 8.53%
B 9.95%
B- 10.71%
Example – Corporate bond yields as per
credit rating
Bond rating Corporate Bond Yields

AAA 5.50%
AA 5.77%
A+ 6.27%
A 6.35%
A- 6.50%
BBB+ 7.54%
BBB 7.62%
BBB- 8.64%
BB+ 11.42%
BB 11.49%
BB- 11.70%
B+ 13.28%
B 14.70%
B- 15.46%
Cost of equity
The Cost of Equity Capital
•From the firm’s perspective, the expected return is the Cost of Equity Capital:
•𝑘𝑒 = 𝑅! + 𝛽 𝑅" − 𝑅!
•To estimate a firm’s cost of equity capital, we need to know three things:
• Rf - Risk-free rate,
• 𝑅! − 𝑅" : Market risk premium
• 𝛽 - Company beta
Cost of equity: CAPM
•Marginal investor: An investor that is most likely to trade next, generally well-
diversified.
• The only risk that she perceives in an investment is risk that cannot be diversified away (i.e,
market or non-diversifiable risk)
• The only risk for which she earns a risk premium: systematic risk
Example
•Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations,
has a beta of 1.5. The firm is 100% equity financed.
•Assume a risk-free rate of 3% and a market risk premium of 7%.
•What is the appropriate discount rate for an expansion of this firm?
•𝑘𝑒 = 𝑅$ + 𝛽 𝑅% − 𝑅$
•𝑘𝑒 = 3% + 1.5 7%
•𝑘𝑒 = 13.5%
Risk free rate
•Risk free: actual return = expected return
• No default risk
• No reinvestment risk

•Returns on Government Security

• Yield to Maturity on a long term Treasury bond

•Long-term for a going concern, else the maturity should meet the projected cash flow period
• Match the duration of the analysis to the duration of the risk free rate
• Alternate argument: CAPM is a period model, hence use T-bill rate

•Debate between using T-bill rate or Treasury bond rate

Market risk premium
•Risk Premium:
• Measures “extra returns” for making an average risk investment rather than risk-free investment.
• Function of risk aversion of an investor
•Estimating Risk premium:
• Common Approach: Estimate historical premium
• Time period used: Estimation as back as 1926, 50 yrs, 20 yrs, 10 yrs

•Mistake to avoid: Historical data for market returns, and current long-term bond
yield
Estimation of Beta
•Market Portfolio - Portfolio of all assets in the economy. In practice, a
broad stock market index, such as the S&P 500, is used to represent
the market.
•Beta - Sensitivity of a stock’s return to the return on the market
portfolio.
Reference
•Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education.
Session 6, 7 and 8. The Cost of Capital Part II
PGP, IIM INDORE
Recap
•Cost of Debt
• kd = Rf + Default spread
• Credit ratings and the corresponding default spread

•Cost of Equity
• Risk free rate
• Market risk premium
• Beta
Example
•Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations,
has a beta of 1.5. The firm is 100% equity financed.
•Assume a risk-free rate of 3% and a market risk premium of 7%.
•What is the appropriate discount rate for an expansion of this firm?
•𝑘𝑒 = 𝑅! + 𝛽 𝑅" − 𝑅!
•𝑘𝑒 = 3% + 1.5 7%
•𝑘𝑒 = 13.5%
Estimation of Beta
•Market Portfolio - Portfolio of all assets in the economy. In practice, a
broad stock market index, such as the S&P 500, is used to represent
the market.
•Beta - Sensitivity of a stock’s return to the return on the market
portfolio.
Beta
•Determinants of Beta:
• Type of business – cyclical / non-cyclical, operating leverage, financial leverage
•Highly cyclical stocks have higher betas.
◦ Empirical evidence suggests that automotive firms, luxury products, fluctuate with economic cycle.
◦ Food / Staples, beverages, tobacco, FMCG, household and personal products, Power generation, other
utilities, etc. - are less dependent on the business cycle.

•Operating Leverage
— Firms with greater proportion of fixed costs that largely remain unchanged under different production
volumes
— Versus, firms with comparatively more variable costs that are directly tied to the production
— Other things being equal, higher ratio of fixed costs to project value will have higher beta
Financial Leverage and Beta
•Financial leverage is the sensitivity to a firm’s fixed costs of financing.
•The relationship between the betas of the firm’s debt, equity, and assets
is given by:
%#&$ ()-*$+
𝛽!""#$ = %#&$'()*$+
∗ 𝛽,#&$ + 𝛽
%#&$'()-*$+ #)-*$+
•Financial leverage increases the equity beta relative to the asset beta.
Example
•Consider Grand Sport, Inc., which is currently all-equity financed and has a beta of
0.90.
•The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity.
•Since the firm will remain in the same industry, its asset beta should remain 0.90.
•Assuming a zero beta for its debt, calculate its equity beta.
%
•𝛽!""#$ = 0.90 = ∗ 𝛽#'()$*
%&%
•𝛽#'()$* = 2 ∗ 0.90 = 1.80
Beta and leverage
•If beta of debt is assumed to be zero:
)
•𝛽!"#$%& = 𝛽'((!% ∗
*
•There is alternate formula derived by Robert Hamada:
+
•𝛽!"#$%& = 𝛽'((!% ∗ [1 + { 1 − 𝑡 ∗ }]
*
A numerical Example: WACC
Example: International Paper
— The beta is 0.82, the risk free rate is 3%, and the market risk premium
is 8.4%.
— Thus, the cost of equity capital is:

ke = Rf + b × ( Rm – Rf)

= 3% + 0.82×8.4%

= 9.89%
Example: International Paper
•The yield on the company’s debt is 8%, and the firm has a 37% marginal tax rate.
•The debt to value ratio is 32%
E D
WACC = × ke + × kd ×(1 – T)
E+D E+D

WACC = 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37) = 8.34%

•8.34% is International Paper’s cost of capital.

•It should be used to discount any project where one believes that the project’s risk is equal to the
risk of the firm as a whole
Company and Project Cost of Capital
•Suppose the Conglomerate Company is an all-equity firm. The risk-free rate is 4%, the market
risk premium is 10%, and the firm’s beta is 1.3.
•Cost of capital as per CAPM:
• 17% = 4% + 1.3 × 10%
•This is a breakdown of the company’s investment projects:
• 1/3 Automotive Retail b = 2.0

• 1/3 Computer Hard Drive Manufacture b = 1.3

• 1/3 Electric Utility b = 0.6
• Average b of assets = 1.3

• When evaluating a new electrical generation investment, which cost of capital should be used?
Capital Budgeting & Project Risk

SML

Project return 24% Investments in hard drives or

auto retailing should have
17% higher discount rates.

10%

Project’s risk (beta)

0.6 1.3 2.0

ke = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of
the project.
Capital Budgeting & Project Risk

Project IRR
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle
R F + β FIRM ( R M - R F )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
Assume this is an all equity firm, and the firm’s cost of capital is the cost of
equity
Should the company use the same WACC (i.e., company WACC) as the
hurdle rate for each of its divisions/projects?
•NO! The company WACC reflects the risk of an average project undertaken by the firm.
• Company WACC is appropriate for discounting the cash flows of division/project with average risk as
the business
•Different divisions/projects may have different risks.
• The division’s WACC should be adjusted to reflect the division’s risk
Methods for Estimating Beta for a Division or a Project
•Pure play: Find a set of publicly traded companies exclusively in project’s/division’s business.
• Use average of their betas as proxy for project’s beta.
•Detailed steps (USING PURE PLAY firms)
• Pure play approach - Identify the business lines, i.e., industry (for the division or the project)
• Estimate unlevered (asset) beta for comparable public firms in the corresponding industry
• Estimate simple or weighted average of unlevered betas
• Estimate levered beta by current market value of debt and equity
Data on Industry peers (pure plays)
Company Equity Beta Debt proportion in total capital

ABCL Corp. 1.45 20%

National Media Corp. 1.75

33.33%

Tax rate 30%

Data on Industry peers (pure plays)
DEBT
EQUITY UNLEVERED BETA
COMPANY PROPORTION IN D/E
BETA (HAMADA)
TOTAL CAPITAL

ABCL Corp. 1.45 20% 0.25 1.23

National Media
1.75
Corp. 33.33% 0.50 1.296

Average 1.27

The average asset beta from industry peers (pure plays) can be considered as asset beta for a business
segment (with operations in the same industry).
Reference
•Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education.
Session 11. Financing Choices and Claims
PGP, IIM INDORE
Preferred Stock
•Preference Shares – hybrid security, with features of debt and equity
•Preferred dividend – fixed charge like debt
• Not tax deductible
• Dividends can be deferred without putting the firm in default
• However, company cannot pay ordinary share dividends unless it has paid dividend
on preference shares
• Usually cumulative, unpaid dividends are carried forward
Preferred Stock
•No voting right
• Thus, avoids dilution of control
• But non-payment of dividends (for two or more cumulative years) can entitle
preference shareholders to nominate a member on the board of the company
•Other features of preference stocks
•Perpetual, redeemable, convertible, callable
Preferred stock
•For the issuer: Preferred stock is less risky than bond
•Non-payment of dividend does not force a company into bankruptcy
•For the investor: It is riskier than bond
•Preferred stockholders’ claims are subordinated to debt in the event of liquidation
•Bond holders are likely to continue receiving income during hard times than are preferred
stockholders
•Investors require a higher after-tax return on a given firm’s preferred stock than on its
bonds
•Differential tax treatment of dividend income as compared to interest income in some
countries
Advantages and Disadvantages of Preferred
stock financing
Advantages
◦ For the issuer: Preferred stock is less risky than bond, because non-payment of dividend does not force
company into bankruptcy
◦ Avoids dilution of common stock (control), no voting right
◦ Avoids large repayment of principal if it is perpetual

Disadvantages
◦ Preferred dividends not tax deductible, so typically costs more than debt
◦ Increases financial leverage (due to fixed payments), and hence the firm’s cost of common equity
Warrants
Warrants
—Warrants - give the holder the right (but not the obligation) to buy shares of
common stock directly from a company at a fixed price for a given period of
time.
— The fixed price of shares (called exercise price) is generally higher than the current
market price
Example
—In 2007, Infomatics corporation would have had to pay 10% coupon if they issued a
straight bond
—They issued 8% Bonds (in 2007) with face value of US $1000 maturing in 2027, with 20
warrants.
—Each warrant entitled the holder to buy one share of equity at an exercise price of $22 (strike
price).
— Current stock price was $20, and the warrants would expire in 2017
— Shareholders can buy the firms stock at $22 regardless of how high the market price climbs
anytime before 2017.
—A bond which would have otherwise required a higher yield
— Lower yield + warrant makes the package an attractive one for investors.
Warrants in India
•In August 2020, HDFC issued 17,057,400 warrants at an issue price of Rs. 180 per warrant
• The warrant holders can exchange each warrant for one equity share at a price of Rs. 2165 per share
• Anytime before the expiry period of 36 months or until Aug 10, 2023
• HDFC was trading at Rs. 1827.60 per share

•In 2015, HDFC issued 3.65 cr warrants, giving warrant holders the right to exchange one warrant
for one equity share in the next three years at a prefixed price of Rs 1,475.
• Stock price in 2015: Rs. 1240
• Time to maturity: 3 years
Warrants
—Generally issued with bonds (as an “equity kicker”)
— Could be issued with new issues of preferred stock
— Used as sweeteners by small and rapidly growing firms

—A long-term call option to buy stocks at exercise price

— Warrants tend to have longer maturity periods than exchange traded options.
— Exercise of warrants requires the company to issue shares, whereas exercise of exchange traded option
does not require a company to do so.
Warrants
•Coupon rate for a bond with warrants package is lower than a straight bond.
• The example: Infomatics corporations would have paid 10% coupon on a straight bond

•Detachable and tradable

•Warrants bring in additional capital when exercised
•Requires fresh issue of stock when exercised
• Dilution of claims of existing shareholders - control and EPS
• Wealth transfer from equity holders to warrant holders (Exercise price is < Market price)
• But bondholders previously transferred wealth to existing stockholders, in the form of a low coupon
rate, when the bond was issued.

•Not entitled to dividends paid on the underlying stock

Convertibles
Convertible Bonds
•A convertible bond: A security with an option* to convert to an equity security at a later date
•The security pays fixed coupon and specifies the ratio or the price at which it can be converted
to equity shares.
•It is quite similar to a bond with warrants, yet distinct in some regard.

*Exception: Compulsorily convertible debentures (CCDs)

Conversion Price and Conversion Ratio
•In June 2010, Microsoft raised US $1.15bn by issuing zero coupon convertible debentures due in
2013.
•The F.V. of bond was US$ 1000
•Each bond was convertible into 29.9434 shares of equity anytime before maturity.
•Conversion ratio (an exchange ratio):
• No. of shares for each bond: 29.9434
•Conversion Price
• FV Bond / Conversion ratio = 1000 / 29.9434 = 33.40
•If the stock price of Microsoft is $25.11 per share, then the Conversion premium
• Conversion Price – Current Stock Price
• If the current stock price is $25.11 per share, then conversion premium is 33%
Illustration: Conversion Price and Conversion Premium
•In 2014, Twitter raised $1.8 billion in convertible bond offering.
•The 7-year bond has a $1,000 face value with 1% coupon rate, and a conversion rate of 12.8793
shares.
•This means that an investor can effectively purchase 12.8793 shares for $1,000/12.8793 =
$77.64 per share.
How can issuing companies ensure
conversion?
•Convertibles often contain a call provisions
• Call protection period: period after which company can call the bonds
•Example: As per the terms of issue - Conversion price is $ 50, conversion ratio is 20.
•As of today, the market price of stock (risen to) $ 60, and the call price on this bond is $ 1000
•If the company calls the bond:
• The investor has two options – either to tender the bonds against the call price or to convert
• Conversion value = market price of stock * Conversion ratio
• Conversion value = 1200 USD
• Versus price at which the bond is being called $ 1000
•Thus, investors are forced to convert
•Call provisions give the issuing firm a way to force conversion
• Provided the market price of the stock is greater than the conversion price (i.e., conversion value is greater
than the call price).
Warrants versus Convertibles
Comparison of Convertibles and Warrants
•Warrants bring in new capital, while convertibles do not.
•Most convertibles are callable, while warrants are not.
•Warrants typically have shorter maturities than convertibles and expire before the
accompanying debt.
•Not entitled to dividends on the underlying stock
•Protected against stock splits, stock dividends, etc.
Warrants: Additional concepts
Implied Value of a warrant
Example
Ref. the Infomatics example discussed earlier
•In 2007, Infomatics corporation issued 8% Bonds with face value of US $1000 maturing in 2027,
with 20 warrants (issued at par).
•If they had not issued warrants along with the bonds, the coupon required would have been
10% (issued at par).
•Value of straight bond + value of warrants package = Issue price
• Issue price in this case is the Par value (since bonds are issued at par)

•What is the value of straight bond?

Value of the straight bond
•N = 20 years, Coupon payments = 80, r = 10%, FV = US $1000
•Present value of this bond = US $829.73
•Recall, Value of straight bond + value of warrants package = Par value
• since bonds are issued at par

•Therefore, US $829.73 + Value of Warrants Package = US $1000

•The value of Warrants package = US $170.27
•The warrants package = 20 warrants
•Value of each warrant = 170.27/20 = US $8.5135
Summary: Why are warrants and
convertible issued?
Why Are Warrants and Convertibles Issued?
•To lower initial interest costs: Young, risky, growing firm might issue warrants due
to lower initial interest costs
• When it is successful – i.e. equity value increases, warrants will be converted
• Same for convertibles
•Some company wanting to sell equity might not do so due to current
undervaluation of market prices
• If prices are temporarily depressed – issue warrants or convertibles: Gives company a
chance to offer equity at a higher prices (later)
• Backdoor listing of equity
Warrants and convertibles help reduce agency costs
•Agency costs due to conflicts between shareholders and bondholders
◦ Bait and switch: Firm with history of less risky projects issues low-cost straight debt, then invests in risky
projects
◦ Bondholders suspect this, so they charge high interest rates
◦ Convertible debt allows bondholders to share in upside potential, so it has low rate.
◦ Therefore, convertible bonds reduce agency costs by aligning the incentives of stockholders and
bondholders.
Agency issues addressed by warrants and convertibles
•Agency Costs Between Current Shareholders and New Shareholders
• Information asymmetry: company knows its future prospects better than outside
investors
• Outside investors think company will issue new stock only if future prospects are not as good as market
anticipates
• Issuing new stock sends negative signal to market, causing stock price to fall

•Company with good future prospects can issue stock “through the back door” by issuing
convertible bonds
• Since prospects are good, bonds will likely be converted into equity, which is what the company wants
to issue
• Issue of warrants / convertibles help avoid this negative signaling.
References
Brigham and Ehrhardt, Financial Management, Chapter 21, Edition 11.
◦ It is Chapter 19 in Edition 13.
Session 12. Capital Structure Decisions Part I
PGP, IIM INDORE
Capital Structure
•Does Debt Policy Matter?

•What is the ratio of debt-to-equity (if any) that maximizes shareholder

value?
Financial Leverage and ROE
•Consider an all-equity firm that is contemplating raising debt (may be some existing
shareholders want to cash out)
•Assume – 0 taxes
Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50
The firm plans to borrow Rs.8,000 and buys back 160 shares at Rs.50
per share.
If EBIT is Rs. 2000, what is the current and new EPS and ROE?
EPS and ROE
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Net income Rs.2,000 Rs.1,360
EPS Rs.5.00 Rs.5.67
ROE 10% 11.30%

Current Shares Proposed Shares

Outstanding = 400 Outstanding = 240
shares shares

• Does that mean increase in financial leverage will ALWAYS increase

EPS and ROE?
Different scenarios
Current Proposed
Recession Expected Expansion Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000 Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0 640 640 640
Net income Rs.1,000 Rs.2,000 Rs.3,000 Rs.360 Rs.1,360 Rs.2,360
EPS Rs.2.50 Rs.5.00 Rs.7.50 Rs.1.50 Rs.5.67 Rs.9.83
ROE 5% 10% 15% 3.00% 11.30% 19.70%

Current Shares Outstanding = Proposed Shares Outstanding =

400 shares 240 shares

To sum up - Effect of leverage depends on company’s income

(similar example – Kavita Spot removers – Brealey and Myers, Ch. 17)
Borrowing and EPS
•Borrowing increases EPS above a certain level of income (Effect of leverage depends on
company’s income), but does it increase share price or firm value?
• Modigliani Miller theorems
• Trade-off Theory
Effect of Financial Leverage on
Competitive Tax-free Economy
•Modigliani & Miller: Capital structure is irrelevant in determining firm value
• Value is independent of the debt ratio

•Assumptions
• No taxes*, No bankruptcy costs*, Companies and investors can borrow/lend at the same rate, no
information asymmetry, EBIT not affected by the use of debt, Frictionless markets – no transaction
costs, and others

•When firm pays no taxes and capital markets function well, no difference if firm borrows or
individual shareholders borrow
• Investor can create a levered or unlevered position by adjusting the trading in their own account –
Homemade leverage
*Capital structure, therefore, does not affect cash flows.
Recall the earlier example
An all-equity firm, with no debt:

Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50

The company is proposing a new capital structure such Debt is 40% in total capital and equity is
60%.
An investor can create the same leverage, substitute personal leverage for company’s leverage
The investor can buy 10% of company (unlevered) – can buy 40 shares of a Rs.50 stock
Of the total funds required, Rs. 2000, he borrows 40%, that is – he take Rs.800 loan
 Homemade Leverage
Expected
EPS of Unlevered Firm Rs.5.00
Earnings for 40 shares Rs.200
Less interest on Rs.800 (8%) Rs.64
Net Profits Rs.136
ROE (Net Profits / Rs.1,200) 11.30%

Investor can buy 40 shares of a Rs.50 stock, using Rs.800 in

loan.
She gets the same ROE as if she bought into a levered firm.
Investor’s personal debt-equity ratio is: 800/1200 = 2/3
MM Propositions I & II (Without Taxes)

Proposition I (without Corporate Taxes)

◦ Value of a levered firm is equal to the value of an unlevered firm
VL = VU
Proposition II (without Corporate Taxes)
◦ Ka (WACC) is constant, cost of equity (Ke ) increases with the increase in financial leverage.
Capital Structure Decisions

Static Trade-off
Benefit from Tax
Theory: Bankruptcy Pecking Order
Deductibility of
Costs and Costs of Hypothesis
Interest
Financial Distress
MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)

◦ Firm value increases with leverage
VL = VU + Present value of tax shields

• To note: if debt level (dollar value) is constant then, VL = VU + D*t

Tax Effects
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + D*t

Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)

Optimal amount of debt

The Effect of Financial Leverage
Cost of capital: R
(%)

WACC = Kd × (D/V) ×(1-TC) + Ke × (E/V)

Kd

Debt-to-equity
ratio (B/S)
Implications of Benefits associated with Taxes
•WACC reduces as more debt is used
•As WACC reduces, firm value increases (if all other factors are
held constant) G

B
•Does this mean the optimal capital structure is 99.99% debt?
Capital Structure Decisions

Static Trade-off
MM
Benefit from Tax Theory:
Propositions: Pecking Order
Deductibility of Bankruptcy Costs
Capital Structure Hypothesis
Interest and Costs of
Irrelevance
Financial Distress
Costs of Financial Distress
Financial Distress Costs

Financial distress includes failure to pay interest or principal or both

◦ Occurs when promises to creditors are broken or honored with difficulty.

Direct Costs of Bankruptcy - Legal and administrative costs

Cost of Financial Distress
◦ Costs arising from bankruptcy or distorted business decisions before bankruptcy

Indirect Costs - Impaired ability to conduct business

◦ Example: lost sales, inability to negotiate long-term supply contracts, loss of credibility
Tax Effects and Financial Distress
•Trade-off Theory of Capital Structure
• There is a trade-off between the tax advantage of debt and the costs of financial distress.
Value of the Firm when Costs of Financial
Distress are considered
•Value of firm = value if all-equity financed + PV(tax shield) - PV(costs of financial
distress)
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 17 & 18
Session 13. Capital Structure Decisions Part
II
PGP, IIM INDORE
Recap
•Financial Leverage and ROE
•Does financial leverage affect firm value?
• Modigliani Miller Theorems
• World without taxes and other assumptions: Value of levered firm = Value of an unlevered
firm
• In the presence of corporate taxes: Value of a levered firm is higher by present value of
tax shields
• Does that mean that the optimal level of debt would be 99.99% debt?
• Costs of Financial Distress and Bankruptcy
• Value of Levered firm = value if all-equity financed + PV(tax shield) - PV(costs of financial distress)
• Trade-off theory
• Capital Structure decisions in the presence of information asymmetry
Capital Structure Decisions

Static Trade-off
Benefit from Tax
Theory: Bankruptcy Pecking Order
Deductibility of
Costs and Costs of Hypothesis
Interest
Financial Distress
Equity and Debt Issues with Information Asymmetries
•Information asymmetries
•Managers know more about their firm’s prospects, risks and values, than outside investors
• That is, there are information asymmetries between managers and outside investors

•Managers are less likely to issue equity when it is undervalued.

•In fact, managers are more likely to issue equity when it is overvalued
— Investors anticipate this, and they watch corporate action to interpret the value of equity
— Equity issuance often signals overvaluation
— Therefore, as a step 1: Use internal financing first
— Step 2: Issue debt next. If you have exhausted your debt capacity – issue new equity as the last
resort
The Pecking-Order Hypothesis
—The pecking-order theory implies:
—Firms prefer internal finance
—If external finance is required, firms issue debt first, then hybrid security
(possibly), then equity as a last resort.
—There is no target D/E ratio (contrary to Trade-off theory)
— There are two kinds of equity: one (internal) at the top of the pecking order
and one (external) at the bottom
—The theory also implies
—Profitable firms use less debt
— They may not need external funding
—Companies prefer to have financial slack
The Pecking-Order Hypothesis
—Financial Slack (cash, near cash, easily saleable real assets, spare debt
capacity)
—Positives of having financial slack: It is valuable.
—If positive NPV opportunities arise, you use internal funding or easily
access debt markets
—Negatives of financial slack: Lead to agency problems – misuse of cash
Is there a Theory of Optimal
Capital Structure?
Is there a theory of optimal capital
structure?
•There is no ONE theory that captures everything about the Debt-equity
choice
•Profitable firms:
• Have lower debt ratio, because they can rely on internally generated profits for
funding investments (pecking order hypothesis)
• This is contrary to the prediction of Trade-off theory that more profitable firms
could use tax shields, and thus should lever up.
•Tangible assets: Firms with higher fixed assets (as % of Total assets)
• They tend to borrow more
• Assets can serve as collateral and reduce financial distress
Is there a theory of optimal capital
structure?
•Smaller growth company:
• Less need for interest tax shields
• Preserving debt capacity / financial slack is more important
• Costs of financial distress are high
• They are most likely to use equity financing (confirms to Trade-off theory)
•Mature public corporation:
• Often follow pecking order
• Information asymmetries deter large equity issues
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 17 & 18
Session 15 and 16. Earnings Distribution
Decision
PGP, IIM INDORE
Core Functions: Investment, financing and Earnings
Distribution decisions
§Earnings Distribution decision:
§ Reinvest in the firm (Equivalent to raising equity)
§ Hold as cash reserves for future investments
§ Pay-out to the shareholders: Pay dividends (Dividend Decision) and/or Repurchase shares

§Principle: If you cannot find investments that make your minimum acceptable rate, return the
cash to investors
§ How much cash you can return depends upon current & potential investment opportunities
§ Assuming Debt is at prudent levels or the levels are as per the Debt policy
Earnings Distribution Decision
•Does Pay-out Policy affect firm value?
•Relevance of the investment policy and the debt policy in setting the earnings distribution policy
The Dividend Puzzle
“The harder we look at the dividend picture, the more it seems like a
puzzle with pieces that just don’t fit together” -Fisher Black
Types of Dividends / Distributions
Cash Distribution
◦ Cash Dividend (Regular or special)
◦ Stock Buyback

Sanofi announced a dividend of Rs. 181 (Feb 2022)

◦ And a special dividend of Rs. 309 per share
◦ The Board of Sanofi India had approved a dividend of Rs. 125 per share (1250%) for the year ended
December 2020 and a special dividend of Rs. 240 per share for the same period.
Procedure for Cash Dividend
25 Oct. 3 Nov. 4 Nov. 5 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Buyer of stock does not receive the dividend. Seller of the stock
retains the dividend. Generally, one business day before the record date.
Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 5 November. Person who appears as a shareholder on this date in
company records, receives dividend.
Price Behavior
— In a perfect world, the stock price will fall by the amount of the
dividend on the ex-dividend date.
-t … -2 -1 0 +1 +2 …

Rs.P

Rs.P - div
The price drops Ex-dividend
by the amount of Date
the cash Taxes complicate things a bit. Empirically, the
dividend. price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
Dividends: Price Behavior
Dividends: Price Behavior
Stock Repurchase
Repurchase of Stock
•Firms can payout excess cash through buying shares of their own stock.
•Infosys bought back shares worth Rs 9,200 crore 2021
•Infosys closed a share buy back worth INR 8260 crores in August 2019
• a special dividend of Rs. 4 per share (Jan 2019)
• Infosys completed a share buy back of worth Rs. 13000 crores in Dec, 2017.
•TCS announced a buyback worth INR 18000 crores – 2022
• To buy 4 crores of its shares, i.e., 1.1% of equity, at Rs. 4500 per share (share price around Rs.
3794.8 on 21st, the last day for tender offer
• TCS announced the buyback worth INR 16000 crores (2020)
• Initiated on 18th December 2020 and closed on 1st January 2021.
• Number of shares – 5.33 crores, price Rs. 3000.
Repurchase of Stock
•TCS had announced the biggest buyback (till then ) worth INR 16000 crores in Feb, 2017
• Number of shares – 5.61 crores
• 2.85% of the total paid equity capital
• Price – INR 2850
• TCS’ investors clearly liked the buyback plan as the company’s stock soared over 4 per
cent to close at ₹2,506.50 on Monday on the BSE
Repurchases
•Reasons for repurchases:
• As an alternative to distributing excess cash as special dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.
•Approaches:
◦ Tender Offer to Shareholders
• Example: TCS buyback worth INR 16000 crores in Feb, 2017
• Number of shares – 5.61 crores, Price – INR 2850
◦ Buy Shares on Market, i.e., open offer purchase
◦ Negotiated Deals, i.e., targeted buyback (not allowed in India)
 Open offer purchase
•Infosys bought back shares worth Rs 9,200 crore 2021
• Buyback period was for six months (starting in the end of June 2021), but completed early (Sep
2021)
• Infosys was willing to pay a maximum of Rs 1,750 per share.
• The company's stock was trading at Rs 1,502.85 apiece before the buyback commenced
•Reliance Industries announced a buyback offer worth INR 10440 crores, in
Jan, 2012.
• The buyback of 12 crore equity shares
• Maximum price of INR 870 Per share
• The period of buyback – 1st Feb, 2012 to 19th January, 2013.
•When a company undertakes open offer purchase, the investors do not know that they might be
selling the shares back to the company
• http://economictimes.indiatimes.com/markets/stocks/news/reliance-industries-rs-10440-cr-share-buyback-to-start-from-february-
1/articleshow/11612446.cms
Share Repurchase
•In some cases, it might keep stock price higher: Companies might be able to give a
positive signal that the stock is undervalued
•Tax benefits: If Capital gains are taxed lower than dividends
•Helps avoid setting a high dividend that cannot be maintained
Dividend Policy Theories
Do investors prefer high or low payouts?
Dividends are irrelevant: Investors don’t care about payout
◦ Dividends do not affect value
Bird-in-the-hand: Investors prefer a high payout
◦ Dividends increase value
Tax preference: Investors prefer a low payout, hence expect capital
appreciation
Irrelevance of Dividend Policy
The Irrelevance of Dividend Policy
•Dividend policy is irrelevant.
• Modigliani-Miller support irrelevance.
•Investors are indifferent between dividends and retention-generated capital gains.
•If they want cash, they can sell stock.
• If they don’t want cash, they can use dividends to buy stock.
• Thus, they will not pay higher prices for firms with higher dividends.
•Assumptions: No taxes, No transactions costs and No information asymmetry
•Implication: Dividend policy will have no impact on the value of the firm because
investors can create whatever income stream they prefer by using homemade
dividends.
Dividends and Investment Policy
•One of the assumptions underlying the dividend-irrelevance argument is: “The
investment policy of the firm is set ahead of time and is not altered by changes in
dividend policy.”
•Thus, firms should never forgo positive NPV projects to increase a dividend (or to
pay a dividend for the first time).
Dividend versus repurchases: MM
Irrelevance of pay-out policy
Stock Repurchase or Dividend
•A firm is evaluating a special dividend versus share repurchase
•In either case, INR 4000 would be spent (out of excess cash)
•Current stock price is INR 46 (also the repurchase price)
•Shares outstanding are 800
•Ignore taxes and other imperfections (like transaction costs)
•Evaluate the two alternatives in terms of –
• The effect on the price per share of the stock. Assume that share buyback does not give any information
about firm’s prospects.
• Shareholder wealth
• Cash flow received and stock holding
Solution
Cash Dividend:
DPS $ 5.00
Price per share (ex-dividend date) $ 41.00
The wealth of a shareholder who is holding one share is
Value of share + Dividend received $ 46.00
Repurchase:
Shares repurchased 86.96
Shareholder wealth, if you tender $ 46.00
Shareholder wealth, if you don’t tender $ 46.00

Shareholder wealth is the same under cash dividend and repurchase in absence of taxes and
other imperfections
‘Dividends are good’ School of Thought
Bird-in-the-Hand Theory
•The theory claims that investors think dividends are less risky than
potential future capital gains, hence they like dividends.
• Investors are less certain of receiving capital gains that are supposed to result
from retained earnings
• Dividend yield component is less risky than the expected capital gain
‘Dividends are good’ School of Thought
•Some investors might be restricted from holding stocks not paying dividends
•A natural clientele like elderly, retirees, etc. rely on dividends as source of income
•Self-discipline associated with dividends usage: Behavioral psychology
•Support for the theory: Paying out funds to shareholders prevents managers from misusing or
wasting funds.
•If so, investors would value high payout firms more highly, i.e., a high payout would result in a
high P0.
Tax Preference Theory
Tax Preference Theory
•Low payouts mean higher capital gains.
• Capital gains taxed at lower rates than dividends
• So companies should pay lowest dividend possible.

• Even when they are taxed at the same rate

• Capital gains can be deferred (time value effects): Thus the tax rate on dividends is greater than the
effective rate on capital gains.

•This could cause investors to prefer firms with low payouts, i.e., a high
payout results in a low P0.
Implications of the 3 Theories for
Managers

Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout

Empirical examination has not been able to determine which theory, if any,
is correct.
Information content (signalling)
hypothesis
Information Content of Dividend
•Dividend decisions may contain information
◦ Asymmetric information may be conveyed
◦ Dividend increases could mean increased future profits
◦ Signal varies based on prior information about company
Dividend Policy Survey 2004
Payout Facts: Information Content of
Dividend
•Managers are reluctant to make dividend changes that may be reversed
• Managers do not increase dividends unless confident that the increased dividend can be maintained
• Dividends are rarely cut back – Generally managers do not prefer to cut / reduce dividends. They may
raise new funds to maintain payout
• Eliminating or reducing dividends is often seen as a negative signal.

•Summary: Dividend changes follow shifts in long-run sustainable earnings

• Transitory earnings changes unlikely to affect dividend payouts

•To avoid risk of reduction in payout, managers “smooth” dividends

•Managers focus on dividend changes over absolute levels
◦ Paying a dividend of Rs.2.00 per share is an important decision if last year's dividend was Rs.1.50
◦ Paying a dividend of Rs.2.00 is not as important a decision if last year's dividend was Rs.2.00
Clientele Effect
What’s the “clientele effect”?
•Different groups of investors, or clienteles, prefer different dividend
policies.
• Retired individual, pension funds vs. younger investors (tax brackets)
• Some institutional investor are precluded from selling stock and then spending
capital
•Firm’s past dividend policy determines its current clientele of investors.
• Investors who want current income should own shares in high dividend payout
firms
•Clientele effects impede changing dividend policy (frequently).
•Taxes & brokerage costs hurt investors who have to switch companies due to a
change in payout policy.
Clientele Effect (contd.)
•The clienteles who prefer high payout may be willing to pay more for
firms with high payout
• Only if the supply of such firms < Demand for such firms, the prices
would be bid up
• Once the demand is met, firms will not be able to increase their share
price by changing their dividend payout
• Because high-dividend clientele would have several high-dividend stocks to choose
from
Additional concepts
Non-cash distribution
◦ Stock Dividend
◦ Distribution of additional shares to firm’s stockholders on a pro-rata basis.
◦ In India – Bonus issue of shares
◦ BSE announced 2:1 bonus issued (Feb 2022)
◦ Stock Split
◦ Shree Ganesh Biotech (in Dec 2021) announced that it would go for 10:1 stock split
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 16
Session 11. Financing Choices and Claims
PGP, IIM INDORE
Preferred Stock
•Preference Shares – hybrid security, with features of debt and equity
•Preferred dividend – fixed charge like debt
• Not tax deductible
• Dividends can be deferred without putting the firm in default
• However, company cannot pay ordinary share dividends unless it has paid dividend
on preference shares
• Usually cumulative, unpaid dividends are carried forward
Preferred Stock
•No voting right
• Thus, avoids dilution of control
• But non-payment of dividends (for two or more cumulative years) can entitle
preference shareholders to nominate a member on the board of the company
•Other features of preference stocks
•Perpetual, redeemable, convertible, callable
Preferred stock
•For the issuer: Preferred stock is less risky than bond
•Non-payment of dividend does not force a company into bankruptcy
•For the investor: It is riskier than bond
•Preferred stockholders’ claims are subordinated to debt in the event of liquidation
•Bond holders are likely to continue receiving income during hard times than are preferred
stockholders
•Investors require a higher after-tax return on a given firm’s preferred stock than on its
bonds
•Differential tax treatment of dividend income as compared to interest income in some
countries
Advantages and Disadvantages of Preferred
stock financing
Advantages
◦ For the issuer: Preferred stock is less risky than bond, because non-payment of dividend does not force
company into bankruptcy
◦ Avoids dilution of common stock (control), no voting right
◦ Avoids large repayment of principal if it is perpetual

Disadvantages
◦ Preferred dividends not tax deductible, so typically costs more than debt
◦ Increases financial leverage (due to fixed payments), and hence the firm’s cost of common equity
Warrants
Warrants
—Warrants - give the holder the right (but not the obligation) to buy shares of
common stock directly from a company at a fixed price for a given period of
time.
— The fixed price of shares (called exercise price) is generally higher than the current
market price
Example
—In 2007, Infomatics corporation would have had to pay 10% coupon if they issued a
straight bond
—They issued 8% Bonds (in 2007) with face value of US $1000 maturing in 2027, with 20
warrants.
—Each warrant entitled the holder to buy one share of equity at an exercise price of $22 (strike
price).
— Current stock price was $20, and the warrants would expire in 2017
— Shareholders can buy the firms stock at $22 regardless of how high the market price climbs
anytime before 2017.
—A bond which would have otherwise required a higher yield
— Lower yield + warrant makes the package an attractive one for investors.
Warrants in India
•In August 2020, HDFC issued 17,057,400 warrants at an issue price of Rs. 180 per warrant
• The warrant holders can exchange each warrant for one equity share at a price of Rs. 2165 per share
• Anytime before the expiry period of 36 months or until Aug 10, 2023
• HDFC was trading at Rs. 1827.60 per share

•In 2015, HDFC issued 3.65 cr warrants, giving warrant holders the right to exchange one warrant
for one equity share in the next three years at a prefixed price of Rs 1,475.
• Stock price in 2015: Rs. 1240
• Time to maturity: 3 years
Warrants
—Generally issued with bonds (as an “equity kicker”)
— Could be issued with new issues of preferred stock
— Used as sweeteners by small and rapidly growing firms

—A long-term call option to buy stocks at exercise price

— Warrants tend to have longer maturity periods than exchange traded options.
— Exercise of warrants requires the company to issue shares, whereas exercise of exchange traded option
does not require a company to do so.
Warrants
•Coupon rate for a bond with warrants package is lower than a straight bond.
• The example: Infomatics corporations would have paid 10% coupon on a straight bond

•Detachable and tradable

•Warrants bring in additional capital when exercised
•Requires fresh issue of stock when exercised
• Dilution of claims of existing shareholders - control and EPS
• Wealth transfer from equity holders to warrant holders (Exercise price is < Market price)
• But bondholders previously transferred wealth to existing stockholders, in the form of a low coupon
rate, when the bond was issued.

•Not entitled to dividends paid on the underlying stock

Convertibles
Convertible Bonds
•A convertible bond: A security with an option* to convert to an equity security at a later date
•The security pays fixed coupon and specifies the ratio or the price at which it can be converted
to equity shares.
•It is quite similar to a bond with warrants, yet distinct in some regard.

*Exception: Compulsorily convertible debentures (CCDs)

Conversion Price and Conversion Ratio
•In June 2010, Microsoft raised US $1.15bn by issuing zero coupon convertible debentures due in
2013.
•The F.V. of bond was US$ 1000
•Each bond was convertible into 29.9434 shares of equity anytime before maturity.
•Conversion ratio (an exchange ratio):
• No. of shares for each bond: 29.9434
•Conversion Price
• FV Bond / Conversion ratio = 1000 / 29.9434 = 33.40
•If the stock price of Microsoft is $25.11 per share, then the Conversion premium
• Conversion Price – Current Stock Price
• If the current stock price is $25.11 per share, then conversion premium is 33%
Illustration: Conversion Price and Conversion Premium
•In 2014, Twitter raised $1.8 billion in convertible bond offering.
•The 7-year bond has a $1,000 face value with 1% coupon rate, and a conversion rate of 12.8793
shares.
•This means that an investor can effectively purchase 12.8793 shares for $1,000/12.8793 =
$77.64 per share.
How can issuing companies ensure
conversion?
•Convertibles often contain a call provisions
• Call protection period: period after which company can call the bonds
•Example: As per the terms of issue - Conversion price is $ 50, conversion ratio is 20.
•As of today, the market price of stock (risen to) $ 60, and the call price on this bond is $ 1000
•If the company calls the bond:
• The investor has two options – either to tender the bonds against the call price or to convert
• Conversion value = market price of stock * Conversion ratio
• Conversion value = 1200 USD
• Versus price at which the bond is being called $ 1000
•Thus, investors are forced to convert
•Call provisions give the issuing firm a way to force conversion
• Provided the market price of the stock is greater than the conversion price (i.e., conversion value is greater
than the call price).
Warrants versus Convertibles
Comparison of Convertibles and Warrants
•Warrants bring in new capital, while convertibles do not.
•Most convertibles are callable, while warrants are not.
•Warrants typically have shorter maturities than convertibles and expire before the
accompanying debt.
•Not entitled to dividends on the underlying stock
•Protected against stock splits, stock dividends, etc.
Warrants: Additional concepts
Implied Value of a warrant
Example
Ref. the Infomatics example discussed earlier
•In 2007, Infomatics corporation issued 8% Bonds with face value of US $1000 maturing in 2027,
with 20 warrants (issued at par).
•If they had not issued warrants along with the bonds, the coupon required would have been
10% (issued at par).
•Value of straight bond + value of warrants package = Issue price
• Issue price in this case is the Par value (since bonds are issued at par)

•What is the value of straight bond?

Value of the straight bond
•N = 20 years, Coupon payments = 80, r = 10%, FV = US $1000
•Present value of this bond = US $829.73
•Recall, Value of straight bond + value of warrants package = Par value
• since bonds are issued at par

•Therefore, US $829.73 + Value of Warrants Package = US $1000

•The value of Warrants package = US $170.27
•The warrants package = 20 warrants
•Value of each warrant = 170.27/20 = US $8.5135
Summary: Why are warrants and
convertible issued?
Why Are Warrants and Convertibles Issued?
•To lower initial interest costs: Young, risky, growing firm might issue warrants due
to lower initial interest costs
• When it is successful – i.e. equity value increases, warrants will be converted
• Same for convertibles
•Some company wanting to sell equity might not do so due to current
undervaluation of market prices
• If prices are temporarily depressed – issue warrants or convertibles: Gives company a
chance to offer equity at a higher prices (later)
• Backdoor listing of equity
Warrants and convertibles help reduce agency costs
•Agency costs due to conflicts between shareholders and bondholders
◦ Bait and switch: Firm with history of less risky projects issues low-cost straight debt, then invests in risky
projects
◦ Bondholders suspect this, so they charge high interest rates
◦ Convertible debt allows bondholders to share in upside potential, so it has low rate.
◦ Therefore, convertible bonds reduce agency costs by aligning the incentives of stockholders and
bondholders.
Agency issues addressed by warrants and convertibles
•Agency Costs Between Current Shareholders and New Shareholders
• Information asymmetry: company knows its future prospects better than outside
investors
• Outside investors think company will issue new stock only if future prospects are not as good as market
anticipates
• Issuing new stock sends negative signal to market, causing stock price to fall

•Company with good future prospects can issue stock “through the back door” by issuing
convertible bonds
• Since prospects are good, bonds will likely be converted into equity, which is what the company wants
to issue
• Issue of warrants / convertibles help avoid this negative signaling.
References
Brigham and Ehrhardt, Financial Management, Chapter 21, Edition 11.
◦ It is Chapter 19 in Edition 13.
Session 12. Capital Structure Decisions Part I
PGP, IIM INDORE
Capital Structure
•Does Debt Policy Matter?

•What is the ratio of debt-to-equity (if any) that maximizes shareholder

value?
Financial Leverage and ROE
•Consider an all-equity firm that is contemplating raising debt (may be some existing
shareholders want to cash out)
•Assume – 0 taxes
Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50
The firm plans to borrow Rs.8,000 and buys back 160 shares at Rs.50
per share.
If EBIT is Rs. 2000, what is the current and new EPS and ROE?
EPS and ROE
Current Proposed
Expected Expected
EBIT Rs.2,000 Rs.2,000
Interest 0 640
Net income Rs.2,000 Rs.1,360
EPS Rs.5.00 Rs.5.67
ROE 10% 11.30%

Current Shares Proposed Shares

Outstanding = 400 Outstanding = 240
shares shares

• Does that mean increase in financial leverage will ALWAYS increase

EPS and ROE?
Different scenarios
Current Proposed
Recession Expected Expansion Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000 Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0 640 640 640
Net income Rs.1,000 Rs.2,000 Rs.3,000 Rs.360 Rs.1,360 Rs.2,360
EPS Rs.2.50 Rs.5.00 Rs.7.50 Rs.1.50 Rs.5.67 Rs.9.83
ROE 5% 10% 15% 3.00% 11.30% 19.70%

Current Shares Outstanding = Proposed Shares Outstanding =

400 shares 240 shares

To sum up - Effect of leverage depends on company’s income

(similar example – Kavita Spot removers – Brealey and Myers, Ch. 17)
Borrowing and EPS
•Borrowing increases EPS above a certain level of income (Effect of leverage depends on
company’s income), but does it increase share price or firm value?
• Modigliani Miller theorems
• Trade-off Theory
Effect of Financial Leverage on
Competitive Tax-free Economy
•Modigliani & Miller: Capital structure is irrelevant in determining firm value
• Value is independent of the debt ratio

•Assumptions
• No taxes*, No bankruptcy costs*, Companies and investors can borrow/lend at the same rate, no
information asymmetry, EBIT not affected by the use of debt, Frictionless markets – no transaction
costs, and others

•When firm pays no taxes and capital markets function well, no difference if firm borrows or
individual shareholders borrow
• Investor can create a levered or unlevered position by adjusting the trading in their own account –
Homemade leverage
*Capital structure, therefore, does not affect cash flows.
Recall the earlier example
An all-equity firm, with no debt:

Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50

The company is proposing a new capital structure such Debt is 40% in total capital and equity is
60%.
An investor can create the same leverage, substitute personal leverage for company’s leverage
The investor can buy 10% of company (unlevered) – can buy 40 shares of a Rs.50 stock
Of the total funds required, Rs. 2000, he borrows 40%, that is – he take Rs.800 loan
 Homemade Leverage
Expected
EPS of Unlevered Firm Rs.5.00
Earnings for 40 shares Rs.200
Less interest on Rs.800 (8%) Rs.64
Net Profits Rs.136
ROE (Net Profits / Rs.1,200) 11.30%

Investor can buy 40 shares of a Rs.50 stock, using Rs.800 in

loan.
She gets the same ROE as if she bought into a levered firm.
Investor’s personal debt-equity ratio is: 800/1200 = 2/3
MM Propositions I & II (Without Taxes)

Proposition I (without Corporate Taxes)

◦ Value of a levered firm is equal to the value of an unlevered firm
VL = VU
Proposition II (without Corporate Taxes)
◦ Ka (WACC) is constant, cost of equity (Ke ) increases with the increase in financial leverage.
Capital Structure Decisions

Static Trade-off
Benefit from Tax
Theory: Bankruptcy Pecking Order
Deductibility of
Costs and Costs of Hypothesis
Interest
Financial Distress
MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)

◦ Firm value increases with leverage
VL = VU + Present value of tax shields

• To note: if debt level (dollar value) is constant then, VL = VU + D*t

Tax Effects
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + D*t

Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)

Optimal amount of debt

The Effect of Financial Leverage
Cost of capital: R
(%)

WACC = Kd × (D/V) ×(1-TC) + Ke × (E/V)

Kd

Debt-to-equity
ratio (B/S)
Implications of Benefits associated with Taxes
•WACC reduces as more debt is used
•As WACC reduces, firm value increases (if all other factors are
held constant) G

B
•Does this mean the optimal capital structure is 99.99% debt?
Capital Structure Decisions

Static Trade-off
MM
Benefit from Tax Theory:
Propositions: Pecking Order
Deductibility of Bankruptcy Costs
Capital Structure Hypothesis
Interest and Costs of
Irrelevance
Financial Distress
Costs of Financial Distress
Financial Distress Costs

Financial distress includes failure to pay interest or principal or both

◦ Occurs when promises to creditors are broken or honored with difficulty.

Direct Costs of Bankruptcy - Legal and administrative costs

Cost of Financial Distress
◦ Costs arising from bankruptcy or distorted business decisions before bankruptcy

Indirect Costs - Impaired ability to conduct business

◦ Example: lost sales, inability to negotiate long-term supply contracts, loss of credibility
Tax Effects and Financial Distress
•Trade-off Theory of Capital Structure
• There is a trade-off between the tax advantage of debt and the costs of financial distress.
Value of the Firm when Costs of Financial
Distress are considered
•Value of firm = value if all-equity financed + PV(tax shield) - PV(costs of financial
distress)
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 17 & 18
Session 13. Capital Structure Decisions Part
II
PGP, IIM INDORE
Recap
•Financial Leverage and ROE
•Does financial leverage affect firm value?
• Modigliani Miller Theorems
• World without taxes and other assumptions: Value of levered firm = Value of an unlevered
firm
• In the presence of corporate taxes: Value of a levered firm is higher by present value of
tax shields
• Does that mean that the optimal level of debt would be 99.99% debt?
• Costs of Financial Distress and Bankruptcy
• Value of Levered firm = value if all-equity financed + PV(tax shield) - PV(costs of financial distress)
• Trade-off theory
• Capital Structure decisions in the presence of information asymmetry
Capital Structure Decisions

Static Trade-off
Benefit from Tax
Theory: Bankruptcy Pecking Order
Deductibility of
Costs and Costs of Hypothesis
Interest
Financial Distress
Equity and Debt Issues with Information Asymmetries
•Information asymmetries
•Managers know more about their firm’s prospects, risks and values, than outside investors
• That is, there are information asymmetries between managers and outside investors

•Managers are less likely to issue equity when it is undervalued.

•In fact, managers are more likely to issue equity when it is overvalued
— Investors anticipate this, and they watch corporate action to interpret the value of equity
— Equity issuance often signals overvaluation
— Therefore, as a step 1: Use internal financing first
— Step 2: Issue debt next. If you have exhausted your debt capacity – issue new equity as the last
resort
The Pecking-Order Hypothesis
—The pecking-order theory implies:
—Firms prefer internal finance
—If external finance is required, firms issue debt first, then hybrid security
(possibly), then equity as a last resort.
—There is no target D/E ratio (contrary to Trade-off theory)
— There are two kinds of equity: one (internal) at the top of the pecking order
and one (external) at the bottom
—The theory also implies
—Profitable firms use less debt
— They may not need external funding
—Companies prefer to have financial slack
The Pecking-Order Hypothesis
—Financial Slack (cash, near cash, easily saleable real assets, spare debt
capacity)
—Positives of having financial slack: It is valuable.
—If positive NPV opportunities arise, you use internal funding or easily
access debt markets
—Negatives of financial slack: Lead to agency problems – misuse of cash
Is there a Theory of Optimal
Capital Structure?
Is there a theory of optimal capital
structure?
•There is no ONE theory that captures everything about the Debt-equity
choice
•Profitable firms:
• Have lower debt ratio, because they can rely on internally generated profits for
funding investments (pecking order hypothesis)
• This is contrary to the prediction of Trade-off theory that more profitable firms
could use tax shields, and thus should lever up.
•Tangible assets: Firms with higher fixed assets (as % of Total assets)
• They tend to borrow more
• Assets can serve as collateral and reduce financial distress
Is there a theory of optimal capital
structure?
•Smaller growth company:
• Less need for interest tax shields
• Preserving debt capacity / financial slack is more important
• Costs of financial distress are high
• They are most likely to use equity financing (confirms to Trade-off theory)
•Mature public corporation:
• Often follow pecking order
• Information asymmetries deter large equity issues
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 17 & 18
Session 15 and 16. Earnings Distribution
Decision
PGP, IIM INDORE
Core Functions: Investment, financing and Earnings
Distribution decisions
§Earnings Distribution decision:
§ Reinvest in the firm (Equivalent to raising equity)
§ Hold as cash reserves for future investments
§ Pay-out to the shareholders: Pay dividends (Dividend Decision) and/or Repurchase shares

§Principle: If you cannot find investments that make your minimum acceptable rate, return the
cash to investors
§ How much cash you can return depends upon current & potential investment opportunities
§ Assuming Debt is at prudent levels or the levels are as per the Debt policy
Earnings Distribution Decision
•Does Pay-out Policy affect firm value?
•Relevance of the investment policy and the debt policy in setting the earnings distribution policy
The Dividend Puzzle
“The harder we look at the dividend picture, the more it seems like a
puzzle with pieces that just don’t fit together” -Fisher Black
Types of Dividends / Distributions
Cash Distribution
◦ Cash Dividend (Regular or special)
◦ Stock Buyback

Sanofi announced a dividend of Rs. 181 (Feb 2022)

◦ And a special dividend of Rs. 309 per share
◦ The Board of Sanofi India had approved a dividend of Rs. 125 per share (1250%) for the year ended
December 2020 and a special dividend of Rs. 240 per share for the same period.
Procedure for Cash Dividend
25 Oct. 3 Nov. 4 Nov. 5 Nov. 7 Dec.
…

Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Buyer of stock does not receive the dividend. Seller of the stock
retains the dividend. Generally, one business day before the record date.
Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 5 November. Person who appears as a shareholder on this date in
company records, receives dividend.
Price Behavior
— In a perfect world, the stock price will fall by the amount of the
dividend on the ex-dividend date.
-t … -2 -1 0 +1 +2 …

Rs.P

Rs.P - div
The price drops Ex-dividend
by the amount of Date
the cash Taxes complicate things a bit. Empirically, the
dividend. price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
Dividends: Price Behavior
Dividends: Price Behavior
Stock Repurchase
Repurchase of Stock
•Firms can payout excess cash through buying shares of their own stock.
•Infosys bought back shares worth Rs 9,200 crore 2021
•Infosys closed a share buy back worth INR 8260 crores in August 2019
• a special dividend of Rs. 4 per share (Jan 2019)
• Infosys completed a share buy back of worth Rs. 13000 crores in Dec, 2017.
•TCS announced a buyback worth INR 18000 crores – 2022
• To buy 4 crores of its shares, i.e., 1.1% of equity, at Rs. 4500 per share (share price around Rs.
3794.8 on 21st, the last day for tender offer
• TCS announced the buyback worth INR 16000 crores (2020)
• Initiated on 18th December 2020 and closed on 1st January 2021.
• Number of shares – 5.33 crores, price Rs. 3000.
Repurchase of Stock
•TCS had announced the biggest buyback (till then ) worth INR 16000 crores in Feb, 2017
• Number of shares – 5.61 crores
• 2.85% of the total paid equity capital
• Price – INR 2850
• TCS’ investors clearly liked the buyback plan as the company’s stock soared over 4 per
cent to close at ₹2,506.50 on Monday on the BSE
Repurchases
•Reasons for repurchases:
• As an alternative to distributing excess cash as special dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.
•Approaches:
◦ Tender Offer to Shareholders
• Example: TCS buyback worth INR 16000 crores in Feb, 2017
• Number of shares – 5.61 crores, Price – INR 2850
◦ Buy Shares on Market, i.e., open offer purchase
◦ Negotiated Deals, i.e., targeted buyback (not allowed in India)
 Open offer purchase
•Infosys bought back shares worth Rs 9,200 crore 2021
• Buyback period was for six months (starting in the end of June 2021), but completed early (Sep
2021)
• Infosys was willing to pay a maximum of Rs 1,750 per share.
• The company's stock was trading at Rs 1,502.85 apiece before the buyback commenced
•Reliance Industries announced a buyback offer worth INR 10440 crores, in
Jan, 2012.
• The buyback of 12 crore equity shares
• Maximum price of INR 870 Per share
• The period of buyback – 1st Feb, 2012 to 19th January, 2013.
•When a company undertakes open offer purchase, the investors do not know that they might be
selling the shares back to the company
• http://economictimes.indiatimes.com/markets/stocks/news/reliance-industries-rs-10440-cr-share-buyback-to-start-from-february-
1/articleshow/11612446.cms
Share Repurchase
•In some cases, it might keep stock price higher: Companies might be able to give a
positive signal that the stock is undervalued
•Tax benefits: If Capital gains are taxed lower than dividends
•Helps avoid setting a high dividend that cannot be maintained
Dividend Policy Theories
Do investors prefer high or low payouts?
Dividends are irrelevant: Investors don’t care about payout
◦ Dividends do not affect value
Bird-in-the-hand: Investors prefer a high payout
◦ Dividends increase value
Tax preference: Investors prefer a low payout, hence expect capital
appreciation
Irrelevance of Dividend Policy
The Irrelevance of Dividend Policy
•Dividend policy is irrelevant.
• Modigliani-Miller support irrelevance.
•Investors are indifferent between dividends and retention-generated capital gains.
•If they want cash, they can sell stock.
• If they don’t want cash, they can use dividends to buy stock.
• Thus, they will not pay higher prices for firms with higher dividends.
•Assumptions: No taxes, No transactions costs and No information asymmetry
•Implication: Dividend policy will have no impact on the value of the firm because
investors can create whatever income stream they prefer by using homemade
dividends.
Dividends and Investment Policy
•One of the assumptions underlying the dividend-irrelevance argument is: “The
investment policy of the firm is set ahead of time and is not altered by changes in
dividend policy.”
•Thus, firms should never forgo positive NPV projects to increase a dividend (or to
pay a dividend for the first time).
Dividend versus repurchases: MM
Irrelevance of pay-out policy
Stock Repurchase or Dividend
•A firm is evaluating a special dividend versus share repurchase
•In either case, INR 4000 would be spent (out of excess cash)
•Current stock price is INR 46 (also the repurchase price)
•Shares outstanding are 800
•Ignore taxes and other imperfections (like transaction costs)
•Evaluate the two alternatives in terms of –
• The effect on the price per share of the stock. Assume that share buyback does not give any information
about firm’s prospects.
• Shareholder wealth
• Cash flow received and stock holding
Solution
Cash Dividend:
DPS $ 5.00
Price per share (ex-dividend date) $ 41.00
The wealth of a shareholder who is holding one share is
Value of share + Dividend received $ 46.00
Repurchase:
Shares repurchased 86.96
Shareholder wealth, if you tender $ 46.00
Shareholder wealth, if you don’t tender $ 46.00

Shareholder wealth is the same under cash dividend and repurchase in absence of taxes and
other imperfections
‘Dividends are good’ School of Thought
Bird-in-the-Hand Theory
•The theory claims that investors think dividends are less risky than
potential future capital gains, hence they like dividends.
• Investors are less certain of receiving capital gains that are supposed to result
from retained earnings
• Dividend yield component is less risky than the expected capital gain
‘Dividends are good’ School of Thought
•Some investors might be restricted from holding stocks not paying dividends
•A natural clientele like elderly, retirees, etc. rely on dividends as source of income
•Self-discipline associated with dividends usage: Behavioral psychology
•Support for the theory: Paying out funds to shareholders prevents managers from misusing or
wasting funds.
•If so, investors would value high payout firms more highly, i.e., a high payout would result in a
high P0.
Tax Preference Theory
Tax Preference Theory
•Low payouts mean higher capital gains.
• Capital gains taxed at lower rates than dividends
• So companies should pay lowest dividend possible.

• Even when they are taxed at the same rate

• Capital gains can be deferred (time value effects): Thus the tax rate on dividends is greater than the
effective rate on capital gains.

•This could cause investors to prefer firms with low payouts, i.e., a high
payout results in a low P0.
Implications of the 3 Theories for
Managers

Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout

Empirical examination has not been able to determine which theory, if any,
is correct.
Information content (signalling)
hypothesis
Information Content of Dividend
•Dividend decisions may contain information
◦ Asymmetric information may be conveyed
◦ Dividend increases could mean increased future profits
◦ Signal varies based on prior information about company
Dividend Policy Survey 2004
Payout Facts: Information Content of
Dividend
•Managers are reluctant to make dividend changes that may be reversed
• Managers do not increase dividends unless confident that the increased dividend can be maintained
• Dividends are rarely cut back – Generally managers do not prefer to cut / reduce dividends. They may
raise new funds to maintain payout
• Eliminating or reducing dividends is often seen as a negative signal.

•Summary: Dividend changes follow shifts in long-run sustainable earnings

• Transitory earnings changes unlikely to affect dividend payouts

•To avoid risk of reduction in payout, managers “smooth” dividends

•Managers focus on dividend changes over absolute levels
◦ Paying a dividend of Rs.2.00 per share is an important decision if last year's dividend was Rs.1.50
◦ Paying a dividend of Rs.2.00 is not as important a decision if last year's dividend was Rs.2.00
Clientele Effect
What’s the “clientele effect”?
•Different groups of investors, or clienteles, prefer different dividend
policies.
• Retired individual, pension funds vs. younger investors (tax brackets)
• Some institutional investor are precluded from selling stock and then spending
capital
•Firm’s past dividend policy determines its current clientele of investors.
• Investors who want current income should own shares in high dividend payout
firms
•Clientele effects impede changing dividend policy (frequently).
•Taxes & brokerage costs hurt investors who have to switch companies due to a
change in payout policy.
Clientele Effect (contd.)
•The clienteles who prefer high payout may be willing to pay more for
firms with high payout
• Only if the supply of such firms < Demand for such firms, the prices
would be bid up
• Once the demand is met, firms will not be able to increase their share
price by changing their dividend payout
• Because high-dividend clientele would have several high-dividend stocks to choose
from
Additional concepts
Non-cash distribution
◦ Stock Dividend
◦ Distribution of additional shares to firm’s stockholders on a pro-rata basis.
◦ In India – Bonus issue of shares
◦ BSE announced 2:1 bonus issued (Feb 2022)
◦ Stock Split
◦ Shree Ganesh Biotech (in Dec 2021) announced that it would go for 10:1 stock split
Reference
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 16
Session 17 and 18. Principles of Corporate
Valuation
PGP, IIM INDORE
Firm Valuation
The value of the firm is the present value of expected future
(distributable) cash flow discounted at the WACC
Firm Valuation Models
Free Cash Flows to Firm
◦ Also called the WACC approach
◦ 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝐹𝑖𝑟𝑚 / Asset
!"!! !"!" !"!# !"!$
+ + + …… +
($%&)! ($%&)" ($%&)# ($%&)$
◦ EBIT(1-t) + Depreciation – Capital expenditure – Change in Net working Capital
◦ Discount at WACC
◦ D/E ratio is assumed constant
Estimating Terminal Values
•A publicly traded firm potentially has an infinite life. The value is therefore the
present value of cash flows forever.
• Most projects have finite lives
•Since we cannot estimate cash flows forever, we estimate cash flows for a “growth
period” and then estimate a terminal value, to capture the value at the end of the
period
Approaches to Estimating Terminal Value
1. Terminal Value as a Growing Perpetuity
2. Terminal Value as a Stable Perpetuity
3. Terminal Value as a multiple
◦ Price-to-earnings, EV/EBITDA, and other multiples
 Revenue, Earnings and Investment Forecasts (in $ Valuation
Example
Current '000s)

Year: 0 1 2 3

1 Sales 40,123 46,351 50,155 52,345

Corporate tax rate is 35%. WACC is 12%
2 Cost of goods sold 22,879 24,678 27,560 29,459
and the sustainable long-term growth
3 Other costs 8,025 8,426 8,848 9,290 rate is 4%. Estimate the value of the
firm’s operations
4 EBITDA (1 - 2 - 3) 9,219 13,247 13,747 13,596

5 Depreciation 5,678 5,690 5,770 5,770

6 Profit before tax (EBIT) (4 - 5) 3,541 7,557 7,977 7,826

a Change in working capital 45 54 105 120

b Investment (chg. in gross fixed assets) 6547 7345 7450 7870

Free cash flows

Free cash flow calculation Year 1 Year 2 Year 3

NOPAT (EBIT*(1-tc)) 4911.888 5185.334 5086.939

Plus. Depreciation 5,690 5,770 5,770

Less. Change in NWC 54 105 120

Less. Capex 7345 7450 7870

FCF 3,203 3,400 2,867

Value of Operations
Free cash flow calculation Year 0 Year 1 Year 2 Year 3

FCF 3,203 3,400 2,867

PV FCF (Year 1 to Year 3) 2859.721 2710.726 2040.63

i. Sum PVs FCFs (Year 1 to Year 3) 7611.07699

ii. Terminal Value (Horizon Value) 37270.2

iii. PV of Terminal Value 26528.1934

Value of Operations (i + ii) 34139.2704

Adjusted Present Value
Adjusted Present Value Approach
APV approach: 𝑉! = 𝑉" + 𝑉#$%
The value of an unlevered firm (all-equity firm) plus the present value
of the financing side effects (V_FSE).
Side effects of financing:
◦ Interest tax shields
◦ The Costs of Financial Distress
◦ Subsidies, etc.
Adjusted Present Value (APV)
APV analyses financial manoeuvres separately and then adds their value to that of the business
Value of the firm with no Leverage
◦ Evaluate the business as if it were financed entirely with equity
◦ Free Cash flows to firm discounted at the unlevered cost of equity, i.e., 𝐾% (Cost of equity of an all-
equity firm)

Add Financing side effects (FSE)

◦ Present Value of Interest tax-shields generated by raising a given amount of debt
◦ Discounted at 𝐾&

Value of the firm (APV approach): 𝑉! = 𝑉" + 𝑃𝑉 𝐼𝑇𝑆

Summary: APV, and WACC
— Guidelines:
— Use FCF (WACC) approach if the firm’s target debt-to-value ratio is
constant or known.
— Use APV if the level of debt is known and D/V is not constant
— In the real world, the FCF (WACC approach) is, by far, the most widely
used.
Firm Value
•Intrinsic valuation (using FCFF, APV approaches) gives Value of Operations (also called Core
Enterprise Value)
◦ Value (Firm) = Value of Operations + Value of Non-operating Assets

Non-operating assets
◦ Excess cash (non-operating cash), marketable securities, equity stake in affiliates (minority stake
investments)

Equity Value
◦ Firm Value – Debt (at time 0) = Equity Value
◦ Equity Value / Outstanding Shares = Equity Value per share
Additional concepts: The Valuation of
AirThread Connections
Growth rate
Stable growth rate: Generally cannot exceed the long term growth rate
in the economy
Fundamentals
◦ How much the firm is investing in new projects
◦ What returns these projects are making for the firm
Expected Growth rate from
Fundamentals
When looking at growth in earnings, the inputs can be cast as follows:
Reinvestment Rate * ROIC = g
◦ Where Reinvestment Rate is: (Capex + Change in WC – Dep) / Nopat
◦ Where ROIC is = NOPAT/Invested Capital

Assumption: The ROIC above is sustainable in the long-term

The long term growth in the economy serves as the cap
References
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education. Referred to as BM hereafter.
◦ BM: Ch 19
Session 20. Derivatives and Risk Management
PGP, IIM INDORE
Calls and Puts
•Call Option
◦ The holder has the right to buy an asset at specified price on or before exercise
date
•Put Option
◦ Holder has the right to sell asset at specified price on or before exercise date
Calls and Puts
•Option Obligations
•Buyer of an option: Long position in the option
•Seller (Writer) of an option: Short position in the
option
Long Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
Options on Hindustan Unilever Stock, October
2013
•HUL was trading at Rs. 600
•Common features to be discussed
HUL Position Diagram: Payoffs to owners
of HUL Call option
•Option Value: Value at
expiration is a function
of stock price and
exercise price
Payoff to Seller of HUL Call
HUL Position Diagram: Payoff to owners
of HUL Put option
Payoff to Seller of HUL Put
Selling Options
•The seller (or writer) of an option has an obligation.
•The seller receives the option premium in exchange.
Profit Diagram for the Owners of HUL
Call option
Profit Diagram for the seller of HUL Put
option
Calls, Puts, and Shares
Derivatives
◦ Financial instrument created from another instrument

Option Premium
◦ Price paid for buying an option

Exercise Price (Strike Price)

◦ Price at which security is to be bought or sold
American option
◦ Can be exercised any time up to expiration date
European option
◦ Can only be exercised on expiration date
Options
In-the-Money
◦ Exercising the option would result in a positive payoff (cash flow).
◦ Call option – exercise price is lower than the market (spot) price
◦ Put option – exercise price is above the market (spot) price

At-the-Money
◦ Exercising the option would result in a zero payoff (i.e., exercise price equal to spot price).

Out-of-the-Money
◦ Exercising the option would result in a negative payoff.
Forwards and Futures Contracts
Forward Contracts
•A forward contract specifies that a certain commodity / asset will be
exchanged at a specified time in the future at a price specified today.
• Its not an option: both parties are expected to hold up their end of the deal.
• There is a counterparty default risk – one of the parties may refuse to honor
the contract
Forward Contract example
• Example: A Jeweler, requires 100 kg of gold to deliver gold jewelry before Christmas to the a
trader
• The Jeweler worries about the high gold prices in future and wants to lock in the cost of
buying gold
• A miner, extracts gold, and plans to sell gold before December. He worries about the adverse
change in gold prices, and wants to lock in the price
• In August, the Jeweler agrees to buy 100 kg gold from the Miner at Rs. 55000 per 10 grams,
to be paid on delivery in November
• Therefore, two counterparties with offsetting risks can eliminate risk by hedging through
forward contracts
Futures Contracts
•A futures contract is like a forward contract:
• It specifies that a certain commodity will be exchanged at a specified
time in the future at a price specified today.

•A futures contract is different from a forward:

• Futures are standardized contracts trading on organized exchanges,
settled through a clearinghouse.
• Since traded on an exchange: more liquid market in futures
• There is counterparty risk in Forward contracts. Futures contracts are
marked to market (daily resettlement of gain or loss)
Types
Equity derivatives : Options and futures in stock and indices
◦ NSE and BSE Equity derivatives segment
◦ In stock options, the buyer has a right not an obligation
◦ In stock futures, both the buyer and the seller are obliged to buy/sell the underlying stock

Other financial assets: Currency Futures, Interest rate futures (Bond futures)
Commodities: Options and futures trading in Non-ferrous metals, agricultural products, oil, gold
◦ MCX (Multi-commodity exchange), NCDEX (National Commodity and Derivatives Exchange), etc.
Why manage risk?
Why Manage Risk?
•Risk management: Managing the exposure of a firm’s earnings, cashflows, or market value to
external factors such as interest rates, exchange rates, commodity prices, and other factors
•Does risk management create value?
Does risk management create value?
Contd.
•Certain market imperfections may make risk management relevant
•Asymmetric Information: Company has greater information on the potential risks
•Financial Distress: Reduce financial distress through risk management, and improve financial
flexibility
•Investment policy: Firms involve in cash flow hedging and therefore ensure steady stream of
internally generated funds required to make necessary investments
References
BM: Ch 20 (Section 20.1) and BE: Ch 23
◦ BM: Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. 11th ed.
Tata McGraw-Hill Education.
◦ BE: Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: Theory & practice. 14th ed. Cengage
Learning.

Tufano, P. & Headley, J. S. (1994). Why Manage Risk? HBS No. 9-294-107. Boston, MA: Harvard
Business School Publishing