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Table of Contents
Organizational Forms, Corporate Issuer Features, and Ownership .................................................. 4
Investors and Other Stakeholders ............................................................................................... 10
Corporate governance: conflicts, mechanisms, risks, and benefits ............................................... 19
Working Capital ......................................................................................................................... 29
Capital Investments and Allocation ............................................................................................ 35
Capital Structure ........................................................................................................................ 52
Weighted Average Cost of Capital .................................................................................................... 52
Business Models ........................................................................................................................ 68
Formula ..................................................................................................................................... 75
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We will discuss many features regarding these business structures. Make sure you emphasize more
on the following points-
Sole Proprietorship
• It has only one owner. He owns the business as well as manages the business. He/she is called
the sole trader/proprietor.
• The business has no separate legal identity.
• The owner retains full control over the business i.e., what products to sell, at what price, how
to operate the business.
• The owner retains all the return and assumes all the risk.
• The business is financed informally as funding is not available easily. This limits the growth
potential.
• The owner has unlimited liability. This means that he/she can be held financially held
• Responsible for all the debt the business owes.
• The profits from business are taxed as personal income.
General Partnership
• It has two or more owners called partners whose rules and responsibilities in the business are
• Outlined in a partnership agreement.
• The business has no separate legal identity.
• All profits, losses and risks of the business are collectively assumed and shared by the
• Partners. If one partner is unable to pay their share of the business’ debts, the remaining
• Partners are fully liable.
• The profits are taxed as personal income.
• The potential for growth is limited as funding options are less.
Organizational Forms, Corporate Issuer Features, and Ownership 5
Limited Partnership
• It is a special type of partnership which must have at least one general partner and other
limited partners.
• GP has unlimited liability and is responsible for managing the business.
• LPs have limited liability, i.e., they can lose only up to the amount of their investment in
the partnership. With limited liability, personal assets are considered separate to, and
thus protected from, the liabilities of the business.
• The business has no separate legal identity.
• All partners are entitled to a share in profits, with general partners typically getting a
larger portion given their management responsibility for the business.
• The profits are taxed as personal income.
• Thus, GP operates the business having unlimited liability. LPs have limited liability but lack
control over business operations.
Corporation
➢ The business has a separate legal identity. This means that in the eyes of the law, owner and
his business are two separate entities. Since the business has a separate legal entity, it can
enter contracts, hire employees, sue and be sued, borrow and lend money, make investments,
and pay taxes.
➢ In case of a corporation, there is a separation between those who own the business and those
who operate it. (Hereafter, referring them as owner & manager respectively)
➢ The owner’s own shares of the company which is why they are also called shareholders. Each
share represents ownership interest. The more shares an investor owns, the greater their
ownership stake in the company.
➢ The managers are involved in the day-to-day operations of the company. Board of directors
and senior officers are what we refer as managers. They are elected by the owners. The
appointed BODs are obligated to act in the best interest of shareholders. If they do not, then
the shareholders have the ability to change operational control through use of voting rights.
➢ The shareholders/owners of the company have limited liability. The maximum amount that
the owners can lose is what they have invested in the company. The owners have a residual
claim to the company’s net assets after its liabilities have been paid. No contractual obligation
exists for the company to repay ownership capital.
➢ The taxation for corporations can differ greatly from country to country. In most countries,
corporations are taxed directly on their profits. In many countries, shareholders pay an
additional tax on distributions (dividends) that are passed on to them. This is called double
taxation of corporate profits. In some countries, shareholders do not pay a personal tax on
dividends if the corporation has paid tax previously on them. While shareholders may be
taxed on distributions, owners in other business structures are taxed on profits, regardless of
distributions.
➢ A corporation has ample funding availabilities and has unlimited business growth potential.
Organizational Forms, Corporate Issuer Features, and Ownership 6
To raise substantial capital, a corporation issues shares to its proprietors, who are known as
shareholders. These shares enable the corporation to raise substantial funds. Shareholders are vested
with the privilege of voting, which empowers them to elect the board of directors. If shares are listed
on an exchange, they can be easily bought or sold. Consequently, the board of directors may opt to
allocate a portion of the corporation's profits to shareholders as dividends.
While the concept of double taxation on corporate income is a drawback, its impact is less pronounced
for investors in corporations that allocate a smaller proportion of their earnings as dividends and
reinvest the remaining funds. The subsequent example serves to illustrate this concept.
Illustration:
XYZ Ltd. Has a pretax income of $20 million and corporate tax rate of 25%. Shareholders are taxed at
20% of their dividend income. Calculate the effective tax rate if:
Solution:
1. Non-profits
➢ The purpose of creation of such companies is to promote public benefit, religious benefit,
or charitable mission. They are called non-profit corporations or non-profit organizations.
➢ They do not have shareholders.
➢ They do not distribute dividends.
➢ They are exempt from paying taxes. (generally)
➢ If they are run well, they can generate profits. However, the profits must be re- invested
in promoting the mission of the organization. E.g.: Harvard University, Asian Development
Bank, etc
Organizational Forms, Corporate Issuer Features, and Ownership 7
2. For-Profits
➢ Majority companies fall in this category. These companies are incorporated with the
motive of earning profit.
➢ These companies can be either private or public. The distinction between whether a
company is a private company or a public company, is not the same in all countries.
➢ In Australia/UK, if the number of members are more than a certain limit, then it is called
a public company or else it is a private company. In US, a company which is listed on the
stock exchange is a public company. All others are private companies.
➢ Even the short forms are different across countries.
There are few similarities and differences between a private and a public company. It is imperative
to understand these points thoroughly.
➢ Shares of public companies are often listed on a stock exchange and thereafter traded on
the exchange in the open market. This is called secondary market. Before this, they
undergo a “go public” event which is called IPO- initial public offering. This is called
primary market. IPO is a process in which shares of the company are offered to the public
for the first time. An exchange listing allows ownership to be transferred very easily. In
contrast, private company shares do not trade on an exchange. Thus, no price
transparency or visible valuation exists for the company. Shares are not easily bought or
sold. If an owner of a private company wants to sell shares, he must find a willing buyer
and the two parties must agree on a price.
➢ To raise more capital after listing, public companies may issue additional shares in the
capital markets, which is called FPO- follow-on public offer. Investors in private companies
are typically invited to purchase shares in the company through a private placement
whose terms are outlined in a legal document called a PPM- Private Placement
Memorandum. Only accredited investors, those who are sophisticated enough to take
greater risks generally invest in private companies.
➢ Public companies are required to register with a regulator authority. They are subject to
greater compliance and reporting requirements. They must disclose all kinds of
information to not just members of company but to public at large. In contrast, private
companies are generally not subject to the same level of regulatory oversight. They have
no obligation to disclose certain information to the public.
B. Direct Listing-
A private company can go public through this process too. This method is very similar to IPO with
just 2 major differences.
➢ DL does not involve any underwriter.
➢ DL raises no new capital. E.g.- Spotify
Acquisition-
It refers to acquisition of private company by a public company.
i. SPAC- special purpose acquisition company.: A SPAC is a shell company (blank cheque)
company because it exists solely for the purpose of acquiring an unspecified private company
sometime in the future. SPACs raise capital through an IPO. Proceeds are placed in a trust
account and can only be disbursed to complete the acquisition or for return back to investors.
SPACs are publicly listed and may specialize in a particular industry. They have finite time, such
as 18 months, to complete the deal or otherwise return proceeds to investors. Once SPAC
completes the purchase of a private company, then that company becomes public. E.g.- Virgin
Galactic
ii. Reverse Merger: This is a case where smaller private company acquires a larger listed
company. This leads to backdoor listing. E.g.- ICICI Bank.
A. Limited
B. Unlimited
C. The same as a LP
A. MBO
B. SPAC
C. Reverse Merger
Organizational Forms, Corporate Issuer Features, and Ownership 9
A. Debt
B. Equity
C. None
4. Identify the route that the company should select. The company wants to go public but is
not requirement of funds right now.
A. SPAC
B. Direct Listing
C. IPO
Answers:
1. B is correct. GP has unlimited liability whereas LP has limited liability in case of a limited
partnership.
4. B is correct. Direct Listing takes a private company public when such company doesn’t want
to raise any funds.
Investors and Other Stakeholders 10
Financing Difficulty Very High Very High to High Moderate to low Increasing
M-Cap vs EV:
➢ Often people get confused between the two terms- Market capitalization and Enterprise
Value. Market Capitalization represents the market value of the company’s shares in
aggregate. M-Cap = Current stock price * total shares outstanding.
➢ Enterprise Value represents the total market value of the corporation, net of cash held.
EV = Market value of shares + Market value of debt – Cash
A. Positive
B. Negative
C. Zero
A. 8,340
B. 15,320
C. 17,320
Investors and Other Stakeholders 12
Answers:
1. B is correct. Initially, a start-up has to burn cash to acquire market share. Thus, the cashflow
generally remains negative.
1. Shareholders
If you own shares of a company, you can say that you own equity in that company. This gives you a
right to the company’s net assets, or equity based on the value of shares that you hold.
You also have voting rights. For example, you can vote during elections for the Board of Directors, and
you have the right to voice your opinions at the company’s annual meetings (Annual General Meetings
or AGMs).
Preference shareholders, however, usually do not have voting rights. Instead, they have a claim to
dividends before dividends are paid to ordinary shareholders.
2. Board of Directors
The Board’s primary role is to serve the interests of the shareholders. They have the responsibility to
create a senior management team (CEO, CFO, COO, etc.) that is most effective in delivering
profitability. They also monitor the financial and non-financial activities of a firm to keep management
in check. They essentially represent the shareholders.
The Board can have executive and non-executive members. For example, the Chief Executive Officer
(CEO) of a company can be the chairperson of the Board of Directors, and other executive members
can also serve on the board
The term “Executive Director” typically means the CEO or the managing director (MD) of a company. The same
term in the U.K. can mean that an executive director is a board member who also has a senior management title.
So, it is possible to have different executive directors for different departments. Executive directors are involved
in the day-to-day management of a company.
The non-executive members usually perform an advisory role to oversee the organisation. Non-
executive members are usually there to provide independence and objectivity and keep the executive
directors in check. They are also called independent directors.
Major Indian companies follow the one-tier structure, which includes executive and independent
directors. There is also a two-tier structure which will be seen later in this reading.
Investors and Other Stakeholders 13
Senior Managers
This group must be analysed carefully because of conflicts of interest with shareholders. Senior
managers are most likely incentivised by maximizing their salary and bonus, whereas shareholders
want to increase profitability.
As an analyst, you must note any increase in senior managers’ compensation versus an increase in
profitability to understand if managers are aligned with the interests of the shareholders. We will
explore this in more detail later.
1. Employees
As an employee, you have a direct interest in the company's success because this is your source of
income. If a company declares bankruptcy, you will lose your job by force. You will also be interested
in the wage rate, post-employment benefit schemes, how much you will learn at the company, career
progression, work conditions, etc.
2. Creditors
If you are a bank or any other credit provider, you will be directly interested in a company's financial
health. You are interested in the company’s ability to make fixed payments to repay a loan. Although
you will not have voting rights, you can lay down certain covenants and obligations that the company
must follow.
3. Suppliers
If you are supplying raw material or such goods to a company, you will be interested in maintaining
relations with that company as they are your source of sales. You will be interested in the certainty
Investors and Other Stakeholders 15
that this company will continue to operate and keep you as a supplier and not change suppliers. This
emphasises relationship management.
You will also be selling certain goods on credit. So, you will also be interested in a company's financial
health and if they can pay you back in time.
4. Customers
As a customer, you are most interested in quality products and value for money. For example, you
would not want a company to compromise on cheap quality material despite improving its margins.
Customer feedback may be an essential component for smaller companies as it encourages innovation
and growth.
After-sales service is also an essential aspect of customer relationships.
A. They monitor the activities of managers and represent the interests of shareholders
B. They represent the interests of shareholders and run the daily operations of the
company
C. They represent the management team and run the daily operations of the company
3. What is the most likely reason to analyse the interests and incentives of each stakeholder
group?
4. If SEBI charges a fine to a financial company for insider trading, which stakeholder group is
addressed?
A. Government
B. Legal
C. Regulatory
A. Some shareholders are stakeholders, but not all stakeholders are shareholders
B. All shareholders are stakeholders, but not all stakeholders are shareholders
C. All stakeholders are shareholders, but not all shareholders are stakeholders
Answers:
1. A is correct. The Board’s primary role is to serve the interests of the shareholders. They do not
run the daily operations; instead, they are there to make the management team make such
decisions.
2. C is correct. The chairperson of the Board can be an executive member like the CEO.
3. B is correct. Stakeholder theory is not just about the financial costs but also about assessing
the potential conflicts of each group.
4. C is correct. SEBI is the financial markets regulator of India, the SEC is in the U.S., and the
Financial Conduct Authority is in the U.K.
5. B is correct. All shareholders are stakeholders since they are directly interested in the
company, no matter how big or small. All stakeholders are not shareholders. For example, a
customer of a company does not necessarily have to hold shares of the company.
Investors and Other Stakeholders 17
1. Government Priorities: Regulatory changes are increasingly emphasizing climate change and social
policies, making government stakeholders prioritize these issues.
2. Impact on Results: ESG factors can significantly impact a company's performance, leading to
potential financial losses due to fines, legal judgments, or the loss of customer goodwill. Weak
corporate governance can also result in exploitation of shareholders by senior managers.
3. Investor Preferences: Younger investors, in particular, are incorporating ESG considerations into
their investment decisions, reflecting a growing awareness of sustainability and ethical concerns.
The concept of negative externalities arises when a company or its investors do not bear the
complete cost of their actions, such as environmental harm. Heightened government regulations
and increased stakeholder awareness are compelling companies to acknowledge and address these
costs explicitly in their financial statements or implicitly in their operations.
Environmental Factors:
Social Factors:
Social factors pertain to safeguarding customer privacy, ensuring information security, enhancing
customer satisfaction, fostering employee engagement, promoting diversity and inclusion, managing
labour relations, and maintaining positive community ties. Addressing social risks can lead to
tangible benefits, including improved employee productivity, reduced turnover, stronger customer
loyalty, and lowered litigation risks.
Governance:
Corporate governance involves aspects like board composition, executive compensation, anti-
corruption measures, political contributions, and lobbying practices. Effective governance ensures
ethical conduct, legal compliance, and alignment with shareholder interests.
Analysts need to identify and evaluate ESG-related risks that could impact a company's future cash
flows. Equity investors carry a higher risk burden from adverse outcomes, while debt investors are
less exposed unless losses lead to default. The level of exposure varies among debt investors, with
longer-term debt holders potentially facing more significant ESG risks due to delayed effects.
Overall, incorporating ESG considerations into investment analysis provides a comprehensive view of
a company's risk profile and its potential for sustainable long-term performance.
Investors and Other Stakeholders 18
1. For a company that is financially sound, increasing the company's rate of growth
A. equity holders.
B. debtholders.
C. neither debtholders nor equity holders.
shareholder?
of:
A. governance factors.
B. social factors.
C. stranded assets.
Answers:
2. B is correct as minority shareholders prefer independent directors, as they would act in the
best interests of the shareholders as opposed to acting in the interests of the
management. Full board election would allow the shareholders to vote out the
board if it was ineffective. Staggered elections delay changes to the board
membership.
3. C is correct as stranded assets arise from obsolescence of existing assets that do not conform
to new environmental standards.
Corporate governance: conflicts, mechanisms, risks, and benefits 19
If you are in the management team of a company, you immediately have more information about the
company than a shareholder who is simply holding your shares and working at another job.
This is called information asymmetry because one party has more information than the other.
Suppose - A car salesman, has all the information on any defects the car has. This may include issues
with steering, mileage, tyres, etc. However, the customer may be unaware of these problems due to
the difficulty involved in obtaining this information which, in turn, affects their valuation. This creates
a gap in the valuation of the car by the salesman v/s the actual valuation. As a result, the customer
pays way more than they should the for a faulty car, whilst the salesman makes a handsome amount
by acting in his best interests.
You immediately have all the power because of asymmetric information and can choose to cover it
up as you see fit.
Similarly, when the interests of shareholders and managers do not meet, it becomes impractical to
monitor what the senior managers are doing daily. This information gap can be from daily operations
to long-term strategic decisions.
It is important to note that management discloses this information in annual reports, company
presentations, and analyst conference calls. But these disclosures are infrequent and can be biased to
show a better picture than there is.
This conflict is managed by performing “arm’s length” transactions according to the Companies Act,
2013. Based on certain criteria, the transaction will take place as if the two parties are unrelated so that
there is no conflict.
As an equity owner, you can actively vote for issuing new debt in the future. As a company takes on
more unsustainable debt, it increases the risk of filing for bankruptcy. This makes it less attractive to
lend money to that company and will also increase the cost of debt capital for the company.
3. Between Shareholders and Other Stakeholders
The company has other stakeholder interests like customers, regulators, and government agencies.
Any action to reduce the quality of products, get around regulations, or avoid paying taxes creates a
direct conflict with these groups.
A. Shareholders are principals because they have voting rights and are the decision-makers
of the company
B. The management team are principals because they operate the organisation
C. The management team are agents because they operate the organisation of the
company
3. Which is most likely the problem of information asymmetry in the context of a publicly listed
company?
A. Principals have more information than the agents since they know that they can replace
the agents if they do not perform well
B. Agents have more information than the principals since they know the daily operations
and inner workings of the company
C. Agents have more information than the principals since they know the incentives of the
principals and can exploit them
A. ESOPs because they tie the performance of the company to the management’s
compensation
B. Contracts that tie management to the company when the company acquires another
company
C. Contracts that tie management to the company even if they are acquired
5. Which of the following is least likely an essential conflict between two shareholder groups?
Answers
1. A is correct. The principal-agent problem is the conflict between those who own the company
and those who manage the company.
2. C is correct. This statement is least likely to be false because the management team is
considered an agent. They are meant to act on behalf of the shareholders. A is incorrect
because although shareholders have voting rights, they are not the decision-makers of the
company.
3. B is correct. While C is also true to some extent, B is more likely in the context of a publicly
listed company. Agents can manipulate or hide data from shareholders until they believe it is
an apt time to disclose the information.
5. C is correct. Both A and B are good conflicts. If promoters act in their self-interest, they can
make transactions that benefit their position in other companies. If promoters hold majority
shareholding, then they can dictate the pace and direction of the company. Conflicts between
two minority shareholder groups are likely to happen but are not the most important out of
the other two options.
6. B is correct. C is incorrect because the return to creditors is always at a fixed rate, depending
on the terms negotiated by the company and creditors. It is simply the amount of debt that
can change. B is correct because increasing substantially more debt will decrease the
company's credit rating, thereby making it more difficult to raise more debt financing. These
funds can be used to finance new projects to increase profitability.
Corporate governance: conflicts, mechanisms, risks, and benefits 24
Minority shareholders may have certain rights when a company is acquired. Companies in the E.U.
must take on “sell-out rights.” Suppose the buyer of a company (the bidder) purchases more than 90%
of the voting rights of a company. The sell-out right will force the bidder to pay a fair price for these
shares when the deal is approved.
➢ Cumulative Voting
As a shareholder, you can choose not to vote for two out of three seats, but you can use
those extra votes on the third seat. So, the candidate who you choose to vote for on the
third seat now has a value of three votes rather than one. This way, minority shareholders
are better represented because they can all choose to pool their vote for the candidate,
they see fit. Minority shareholders are also protected by legal rights when another company
acquires the company.
Shareholders elect the Board of Directors to appoint top management and oversee the performance
of the company. The Board is the bridge between shareholders and management. They perform
several functions covered in LOS 27.f, and so it is essential to assess the effectiveness of their systems
and policies.
Audit Effectiveness
The effectiveness of internal and external auditors is a vital function of the health and quality of the
company’s financials. The objectivity and independence of the external auditor’s opinion must be
considered. These factors are crucial to mitigate the risk of fraud or material misstatement of
accounts.
The quality and methods for internal controls must be assessed to see which risks a company can
mitigate.
Reporting and Transparency
There is an information asymmetry between company management and shareholders, which will be
explored later.
Corporate governance: conflicts, mechanisms, risks, and benefits 26
A. Legal infrastructure
B. Contractual infrastructure
C. Organisational infrastructure
2. Which of the following is most likely violated SEBI fines a company for violation of disclosure
of takeover information?
A. Legal infrastructure
B. Contractual infrastructure
C. Governmental infrastructure
Corporate governance: conflicts, mechanisms, risks, and benefits 27
A. The shareholder attends the annual general meeting and votes for one board member
only
B. The shareholder allows another person to vote on their behalf, and the proxy may also
vote as per their judgement for specific issues
C. The shareholder is allowed more than one vote per share
4. Which of the following is least likely an ordinary resolution on which shareholders may vote?
A. Takeover propositions
B. Appointing of auditors
C. Voting for the Board of Directors
5. Which of the following are most likely an advantage for minority shareholders?
A. Minority voting
B. Majority voting
C. Cumulative voting
Answers
1. C is correct. Legal infrastructure deals with external stakeholders and addresses the rules to
follow if stakeholder rights are violated and if they act against the company. Contractual
infrastructure deals with internal conflicts and is built on corporate governance codes and
the Code of Ethics.
3. B is correct. A proxy is sent to vote on the shareholder’s behalf when the shareholder cannot
attend the annual general meeting (AGM). C is incorrect because one ordinary share usually
equals one vote.
5. C is correct. Minority shareholders can choose to pool all their votes for one board seat
instead of using one vote for each seat.
Corporate governance: conflicts, mechanisms, risks, and benefits 28
LOS 28c: Identify potential risks of poor corporate governance and stakeholder
management and identify benefits from effective corporate governance and
stakeholder management.
Why is there a direct link between corporate governance and company value?
We have seen the different roles and responsibilities of the board of directors. Failure to fulfil these
roles leads to poor audit quality and oversight, leading to poor corporate governance. This has
negative impacts because it increases the chance of accounting fraud and poor stakeholder
management.
When senior management is not monitored correctly, the company may take on projects that are not
the best suited for the company’s risk profile. Either they are too risky or not risky enough, and
shareholders lose value because funds are not being used optimally.
Management may also act in their self-interest regarding compensation, and this will worsen the
principal-agent problem.
There is also a risk of not complying with regulations. If the governance committee is not strict enough
to enforce new regulations, the company may face lawsuits. This damages the reputation of the
company, and this may also have severe financial consequences.
Working Capital
LOS 29a: Explain the cash conversion cycle and compare issuers' cash conversion
cycles.
The cash conversion cycle (CCC) is a crucial metric that assesses a company's efficiency in managing
its cash flow. It quantifies the time it takes for a company to transform its investments in inventory
and other operating resources into cash inflows from sales. Essentially, the CCC provides insights into
the speed with which a company can convert its invested capital into cash, which can then be
reinvested in new opportunities or used to meet financial obligations.
1. Days Inventory Outstanding (DIO): DIO measures the average number of days it takes for a
company to sell its inventory. It reflects how efficiently a company manages its inventory levels. A
lower DIO indicates faster inventory turnover.
2. Days Sales Outstanding (DSO): DSO represents the average number of days it takes for a company
to collect payment from its customers after making a sale. A lower DSO indicates quicker collection of
accounts receivable and more efficient credit management.
3. Days Payables Outstanding (DPO): DPO measures the average number of days it takes for a
company to pay its suppliers for goods and services. A higher DPO indicates that a company is taking
longer to settle its payables, effectively delaying cash outflows.
The formula for calculating the cash conversion cycle (CCC) is as follows:
A shorter CCC is generally more favourable, as it indicates that a company is able to quickly convert its
invested resources into cash and reinvest that cash in new opportunities. This efficiency can provide
a competitive advantage by freeing up capital for growth, reducing the need for external financing,
and enhancing overall liquidity.
Conversely, a longer CCC suggests that a company takes more time to convert its investments into
cash, which can tie up valuable capital and potentially hinder the company's ability to respond to new
business opportunities or financial obligations.
Monitoring and managing the CCC is essential for optimizing cash flow management. By analysing the
components of the CCC and identifying areas for improvement in inventory management, sales
collection, and payables management, companies can enhance their operational efficiency and
financial health.
A company can enhance its Cash Conversion Cycle (CCC) by optimizing its inventory levels and
managing receivables, or by extending its payable period. However, each of these approaches comes
with potential drawbacks:
Reducing raw material inventories might lead to production bottlenecks due to disruptions in the
supply chain. Decreasing finished goods inventory could result in the inability to meet sudden surges
in customer demand.
Working Capital 30
Implementing stricter credit policies towards customers might lead to missed sales opportunities.
Accounts payable can be thought of as an implicit form of credit from suppliers, distinct from explicit
credit sources like bank loans. Suppliers offer payment terms in the format a/b net c, indicating a
percentage discount of a if the invoice is settled within b days; otherwise, the full payment is expected
within c days. Opting out of the discount for prompt payment essentially amounts to borrowing funds
from the supplier for (c – b) days, at an effective annual rate.
where:
a = percent discount
b = days until discount expires
c = days until full payment is due
Cash conversion cycles exhibit variation across different industries. For instance, pharmaceutical
companies tend to experience prolonged CCCs due to the maintenance of inventories of high-margin
medications, allowing them to address unexpected spikes in demand. Conversely, airlines typically
boast shorter CCCs due to the prevalence of prepaid sales and minimal inventory retention. It is
advisable for analysts to leverage the CCC for inter-industry company comparisons or to monitor a
company's performance longitudinally.
In tandem with the CCC, the overall magnitude of working capital provides insights into a company's
liquidity management efficiency. To facilitate cross-size comparisons, analysts compute working
capital as a percentage of sales. Given the industry-dependent nature of this ratio, caution is
warranted when assessing firms operating in analogous sectors. Total working capital is delineated as
the difference between current assets and current liabilities. Notably, analysts often favour the
evaluation of net working capital, focusing solely on operational current assets and liabilities, due to
its strong correlation with the CCC.
Liquidity, when pertaining to an asset, denotes its proximity to cash, while for a liability, it signifies
its proximity to settlement. Assets with the ability for swift conversion into cash (such as marketable
securities) are categorized as highly liquid.
Comparatively, inventory possesses lower liquidity than accounts receivable. Inventory often
necessitates processing before a sale, and upon sale, it might transform into accounts receivable,
requiring collection for eventual conversion into cash.
In the context of a corporate issuer, liquidity encompasses the availability of cash and other liquid
assets to fulfil short-term obligations. Principal sources of liquidity encompass existing cash,
marketable securities, bank borrowings, and cash generated from operational activities. The
company's long-term financial stability hinges on its capacity to generate ample cash flow from its
operations to service its liabilities. Evaluation of a company's liquidity management is chiefly
conducted through an analysis of its statement of cash flows.
Working Capital 31
Typically, companies rely on primary liquidity sources. However, if necessary, secondary liquidity
sources may be employed, including:
It is important to note that resorting to secondary liquidity sources can transmit unfavourable signals
to the market and generally carries greater costs compared to primary liquidity sources.
A company's cash conversion cycle can fluctuate based on seasonal variations and shifting business
conditions. Cash and marketable securities function as a cushion to meet company obligations
during deviations from the customary cash conversion cycle. This surplus cash, however, comes with
an associated cost as it represents capital not actively invested in the business. Nonetheless,
inadequate liquidity can compel reliance on higher-cost secondary sources.
Liquidity Ratios
Current Ratio
The current ratio is the bread and butter of liquidity ratios.
It answers the question: if I sold all my current assets today and received cash immediately, would I
be able to repay all my current liabilities immediately?
Current Ratio = Current Assets ÷ Current Liabilities
A ratio of greater than 1 means that the company’s current assets can indeed be used to pay off all
the current liabilities. The ideal ratio is 2.00.
We can see the trend of the current ratio in the following table:
It seems that both companies have had a decreasing current ratio, and that implies that current
liabilities have been increasing faster than current assets for both companies. A current ratio that is
below 2.00 is not considered healthy, and so Britannia Industries is worse off than Tata Consumer
from this perspective.
Quick Ratio
The quick/acid-test/liquid ratio compares only the most liquid current assets to the current liabilities.
Inventories and other current assets take time to sell. Hence, they are less liquid than assets like short-
term marketable securities (investments), cash, and receivables.
It answers the question: if I sold only my most liquid assets today, would the cash received be able to
pay for my current liabilities?
Quick Ratio = (Short-Term Marketable Securities (Investments) + Cash and Cash Equivalents +
Trade Receivables) ÷ Current Liabilities
A ratio of greater than 1 means that the company’s most liquid current assets can indeed be used to
pay off all the current liabilities. The ideal ratio is 1.00.
The ratios for the two companies are as follows:
The trend of the current ratio and the quick ratio usually follows a similar pattern. We can see again
that the two companies have had a decreasing trend in this ratio which is not a good sign. A quick ratio
of less than 1.00 (in the case of Britannia) suggests that they are not efficient at managing their most
liquid current assets compared to current liabilities.
LOS 29c: Describe issuers' objectives and compare methods for managing working
capital and liquidity.
Working capital management pursues the dual objective of enhancing firm profits while ensuring the
availability of ample liquidity to sustain operational activities and fulfil obligations. Firms may opt to
retain higher levels of short-term assets, even though they yield lower returns, to guarantee
sufficient cash for meeting commitments. Another avenue is the financing of working capital
through short-term loans, which tend to be more cost-effective compared to long-term debt and
equity sources. Nevertheless, careful consideration of the potential cost and feasibility of renewing
short-term debt is imperative.
A prudent working capital strategy involves holding elevated quantities of short-term assets relative
to long-term assets, with financing stemming from more durable sources such as long-term debt and
equity. This conservative tactic offers merits such as a reduced reliance on short-term debt rollovers,
heightened adaptability during market disruptions, and a heightened likelihood of meeting
immediate obligations. However, the conservative path comes at the expense of increased costs and
diminished profitability. Furthermore, long-term lenders might impose operational limitations, such
as a minimum interest coverage ratio.
A balanced or moderate strategy seeks a middle ground, channelling long-term capital to sustain
permanent current assets and employing short-term resources to finance variable seasonal current
assets.
Turning to short-term liquidity sources, firms are advised to diversify their options and evaluate
associated costs well in advance, pre-emptively securing sources to address surges in liquidity
requirements. Factors influencing a firm's approach to short-term funding include company size,
creditworthiness impacting interest rates and operational constraints, the legal framework affecting
funding alternatives, regulatory considerations for specific industries, and the underlying assets
serving as loan collateral.
1. Compared to its industry peers, a company with a shorter cash conversion cycle
most likely:
A. has more inventory.
B. has less accounts receivable.
C. pays its suppliers more promptly.
2. A company receives an invoice of $150,000 for machine tools with terms of ″1.5/15
net 40.″ The cost to the company of delaying payment of this receivable is most
appropriately described as $2,250 for the use of:
A. $150,000 for 40 days.
B. $150,000 for 25 days.
C. $147,750 for 25 days.
3. Which of the following actions is most likely to increase liquidity for a corporation?
A. Selling inventory at a discount of 5%.
B. Availing of a discount of 10% by paying accounts payable early.
C. Extending customers' credit terms from 90 days to 120 days.
4. Which of the following is least likely a primary source of liquidity?
A. Borrowings from banks.
B. Cash flow from operations.
C. Delaying capital expenditures.
Working Capital 34
Answers:
1. B CCC = DOH + DSO - DPO. A company with a shorter CCC would have lower
DOH (lower amount of cash tied in inventory), lower DSO (lower amount of
cash tied in accounts receivables), or higher DSO (increased use of supplier
credit).
2. C The terms indicate that the company can pay $150,000(1 - 0.015) = $147,750
on day 15 (after the invoice date) or pay $150,000 on day 40—effectively
gaining the use of $147,750 for 25 days at a cost of $2,250. (LOS 25.a)
3. A Liquidity can be increased by reducing inventory. Extending repayment times
would increase DSO, reducing liquidity. Paying suppliers earlier decreases DPO,
thus, reducing liquidity.
The key pillars of corporate finance are capital budgeting, capital structuring, and working capital
management.
The capital budgeting decision is all about how capital is allocated towards different capital projects.
Capital projects are infrequent and long-term investments, and they have large capital requirements.
They generate cash flows over a long period, and these cash flows must be discounted at an
appropriate discount rate.
Make sure that you are familiar with the concept of the time value of money and the effects of
discounting.
There are several reasons that a company needs to have a budget and capital allocation system for
capital projects. These are some of the key categories of capital projects
Replacement Projects
➢ Companies often need to replace assets like machinery and equipment simply to maintain
the current operations.
➢ This is due to factors like the wear and tear of machines. There is not much detail that goes
into these projects.
Replacement Projects for Cost Reduction
➢ The company needs to know if the current equipment is obsolete. It may be usable, but that
does not mean it is most efficient.
➢ This requires more analysis because the company must understand if there is better
equipment available if it can be purchased and if it will add more value to the company by
cutting costs.
Expansion Projects
➢ These are more complex decisions since the company needs to assess how it can grow its
business.
➢ The company must forecast future demand, expected cash flows, the riskiness of the
project, etc.
New Products or Market Development
➢ This also requires complex analysis.
➢ There is a lot of uncertainty involved when companies launch a new product.
➢ It requires detailed market research.
➢ Like an expansion project, it will require a detailed analysis of the demand and cash flows.
Capital Investments and Allocation 36
Mandatory Projects
➢ These are projects that are required by government agencies or insurance companies.
➢ They are generally related to safety or environmental concerns.
➢ They generate very little revenue but will assist future projects that will generate revenue.
Other Projects
➢ These include research and development (R&D).
➢ R&D projects are difficult to analyse if typical capital allocation processes are used.
➢ Their cash flows can be irregular and uncertain.
➢ Other projects could also include management’s “pet projects” that they want to carry out
for themselves.
LOS 30b: Describe the capital allocation process and basic principles of capital
allocation.
Every company must make long-term investments into all sorts of projects. Either they will grow their
current business, or they will expand into a new line of business. They may even consider replacing
large assets like machinery or equipment. All these things require capital expenditures or capex.
The capital allocation process (or capital budgeting process) is the analysis of all such investments,
expenses, and incomes. It shows us which projects will be profitable, the return on these projects,
how much cash flow these projects will generate over a period, and the net present value of these
cash flows. It shows us if the project will make a difference to the value of the company or not.
The capital allocation process also lays the foundation for understanding how much working capital
the company needs or if the company can make strategic mergers and acquisitions. The end goal is to
increase the value of the company and therefore increase shareholder value.
There are four key steps to this process:
1. Idea Generation: the company needs to have a list of potential ideas. These ideas can come from
various sources like company management, employees, divisions within the company, or outside
sources
2. Analysing the Proposals: once the list is prepared, the company must do a financial analysis. This
is a detailed analysis of the cash flows that each project will generate and if they will be profitable.
This is the entire point of this reading
3. Firm-Wide Budgeting: once each project has been ranked according to its cash flows and
profitability, the company must see which ones are possible, given the company’s resources and
strategic plan. Just because a project is profitable, that does not mean it fits into the company’s
long-term vision
4. Monitoring and Post Audit: the company must evaluate the success of each project once it has
been completed. Expectations must be matched to reality, and if the project has not been as
profitable as expected, then the management must be questioned.
Capital Investments and Allocation 37
LOS 30b: Calculate net present value (NPV), internal rate of return (IRR), and return
on invested capital (ROIC), and contrast their use in capital allocation.
Net Present Value (NPV)
Now that we have set the foundations for capital budgeting principles, we can move forward with
applying these principles to the mathematical concept.
As a reminder, here is a checklist of the key principles regarding cash flows:
➢ They are incremental cash flows.
➢ They do not include sunk costs.
➢ They include the effect of positive and negative externalities.
➢ They include opportunity costs.
➢ They are on an after-tax basis.
➢ Timing of cash flows is important.
Let us now use an example to derive the formula that you will require for the NPV calculation. Note
that this entire reading requires you to be familiar with the financial calculator and how to use the
cash flow worksheet. But before that, we will see how to do an NPV analysis using some information.
The company you are analysing has announced in their analyst conference call that they plan to
expand their asset base. They will buy new equipment to make a product which keeps up with the
new technology. Let us call this Project 1.
You ask management certain questions about the project and gather the following information:
➢ It will cost Rs. 100,000,000 to buy the equipment and Rs. 5,000,000 to install it.
➢ The company had previously spent Rs. 6,000,000,000 to rent a factory for one year, but it is
now vacant. They will use this factory to manufacture the new product.
➢ The equipment will be used to make a new product that will bring in cash flows over the next
6 years.
➢ The discount rate for this project is 9.50%.
You make the following table of the additional cash flows that this new project will bring to the
company:
1 25,000,000.00
2 30,000,000.00
3 35,000,000.00
4 45,000,000.00
5 25,000,000.00
Capital Investments and Allocation 38
6 35,000,000.00
Using this information, you would like to do an NPV analysis to confirm if the company’s management
is right that this project will add value to the company.
Let us go through each piece of information that you have gathered as an analyst.
The company must make sure that the equipment is not only purchased but also available to use. So,
installation costs are included in the initial outlay. You can calculate the initial outlay as Rs.
100,000,000 plus Rs. 5,000,000 to give a total initial outlay of Rs. 105,000,000
The rent of the vacant factory is a sunk cost. The company has already spent this money and will not
recover any cash flows from it.
We can now make a full table of all the cash flows that we expect from this project.
0 -105,000,000.00
1 25,000,000.00
2 30,000,000.00
3 35,000,000.00
4 45,000,000.00
5 25,000,000.00
6 35,000,000.00
Year 0 means today, and we will assume that the money is spent immediately to buy the new
equipment. We use the negative sign to denote a cash outflow and the positive sign to denote cash
inflow. Note that these are the cash flows received at the end of the year.
The next step is to see the timing of the cash flows. This is extremely important for a discounted cash
flow analysis and can be easily represented by drawing a timeline. It is highly recommended to draw
a timeline when you are first trying to understand the NPV calculations.
Now we need the present value of each of these cash flows. We have assumed that the discount rate
will not change and is 9.5% for each year. This will give us a present value for all these cash flows.
Capital Investments and Allocation 39
The sum of the entire present value column is the net present value of the project. The NPV for this
project is Rs. 36,994,879.51, which adds that much value to the company.
There are two key points that this example has shown you:
➢ Although the total cash flow of the project is positive, once we use the discounted cash flows,
it does not look like a good project
➢ The timing of cash flows is extremely important. The project will bring in a cash flow of Rs. 25
million in Year 5, which is the same as the cash flow of Year 1. But when we use the time value
of money concept, we see that the same amount does not have the same value
We have now solved the following formula:
We can also draw an NPV profile of a project. This plots the potential NPV on the y-axis, given a
required rate of return on the x-axis.
Capital Investments and Allocation 40
We can observe the following relationships between NPV and the discounting rate:
➢ The NPV increases as the discounting rate decreases (i.e., cash flows are discounted at a lower
rate, so the present value of these cash flows increases as the discounting rate decreases).
➢ The NPV decreases as the discounting rate increases (i.e., cash flows are discounted at a
higher rate, so the present value of these cash flows decreases as the discounting rate
increases).
➢ The internal rate of return (IRR) is when the NPV curve touches the x-axis is the internal rate
of return (IRR). We will explore this in the next section of this LOS.
Positive NPV projects increase the wealth of a company, while negative NPV projects decrease the
wealth of a company. We can make the following decision rule for NPV:
If NPV > 0, then accept the project
If NPV < 0, then reject the project
Advantages of NPV
➢ NPV shows the direct amount of value-added to the company by taking a project.
➢ Considers the time value of incremental after-tax cash flows.
Disadvantage of NPV
➢ Does not consider the size of the project.
Suppose there are two projects with the same required rate of return, but one project has cash flows
that are twice the size of the other. The NPV rule will favour the LARGER PROJECT because it will add
more incremental value to the company. But larger projects also require larger outlays so the NPV rule
may be overridden if the company cannot afford the outlay due to budget constraints.
Capital Investments and Allocation 41
Or
𝐶𝐹
𝑁𝑃𝑉 = ∑𝑛𝑡=0 (1+𝑟)
𝑡
𝑡
Then we can solve for the discount rate, r. You do not need to know how to solve this formula; you
just need to know what the IRR means. Simply input this information into the financial calculator.
Another interpretation is from the opportunity cost perspective. It means that if we can find an
investment that will constantly give us more than 20.1423% every year, then we are better off
investing in that opportunity.
We can compare projects with low IRRs to the risk-free rate. For example, assume the annual risk-free
rate is 3.00%, and the IRR for another project is 1.50%. Then it makes more sense to buy a risk-free
asset and earn an annual interest of 3.00% rather than investing in a risky project and earn 1.50% on
average every year.
Advantages of IRR
➢ Shows a percentage return on projects. Taking a percentage will always make two projects or
cash flows comparable because it shows the return of each rupee invested.
Disadvantages of IRR
➢ The IRR could be for a small investment size or only for a specific period.
➢ Multiple IRR problem: A project can have no IRR or many IRRs. This is a mathematical
property – the NPV is a parabolic function of the discount rate. It can intersect the x-axis at
two points or at no points.
➢ Abnormal cash flows: The multiple IRR problem is possible when a project has abnormal cash
flows. In this case, it is better to use the NPV method.
The image below shows the multiple IRR problem. The NPV profile cuts the x-axis at more than one
point, so we cannot know which point is the true IRR of the project.
The IRR and NPV analysis can give conflicting conclusions. Suppose there are two projects that are
being compared. It is possible that one project’s IRR is higher, but its NPV is lower. It is then up to
management to decide whether they want to add more value or if they want a better rupee return on
their investment. The NPV criterion is preferred when the two methods give conflicting conclusions.
Also, note that the NPV method assumes reinvestment of cash flows at the required rate of return
while the IRR method assumes reinvestment of cash flows at the IRR. This is also a mathematical
property – if the cash flows are discount from the future at a certain rate, then it is assumed that the
cash flows have been reinvested at that rate in the present.
Capital Investments and Allocation 43
Use the following information for questions 1 to 3. A company faces a discount rate of 11% and has
the following after-tax cash flows for a project.
Year $ (Million)
0 -5,670.00
1 1,567.00
2 2,852.00
3 2,931.00
4 2,573.00
5 1,900.00
A. 29.74%
B. 29.34%
C. 39.34%
3. The required rate of return for this project is 35%. Should this project be accepted based on
the IRR?
4. Which of the following most likely highlights the conflict between NPV and IRR?
A. One independent project can have a higher NPV but lower IRR than another
independent project, and so management must choose which project they prefer.
B. One mutually exclusive project can have a higher NPV and higher IRR than another
mutually exclusive project, and so management must choose which project they prefer.
C. One mutually exclusive project can have a higher NPV but a lower IRR than another
mutually exclusive project, and so management must choose which project they prefer.
Capital Investments and Allocation 44
5. What is most likely the nature of the multiple IRR problem regarding normal and abnormal
cash flows?
A. A project with abnormal cash flows can have multiple discount rates at which the NPV is
positive
B. A project with abnormal cash flows can have multiple discount rates at which the NPV is
0
C. A project with normal cash flows can have multiple discount rates at which the NPV is 0
A. The projects can have similar results for the investment decision by using NPV and IRR
B. The projects can have conflicting results for the investment decision by using NPV and
IRR
C. The projects can have different IRRs for different discounted rates
7. A company wants to increase shareholder value and has two mutually exclusive projects to
decide. Project 1 has an NPV of Rs. 100 crore and an IRR of 5%. Project 2 has an NPV of Rs.
15 crores and an IRR of 13%. Which of the two is the company most likely to take, given their
objective?
A. Project 1
B. Project 2
C. Both projects
Answers
1. A is correct. C is incorrect because this does not take the discounted cash flows. The correct
method is to input all the data into the cash flow worksheet of the financial calculator.
2. A is correct. Once the cash flows have been input into the worksheet, select CPT à IRR
3. B is correct. The IRR is 29.34%, while the required rate is 35%. The IRR of a project must at
least recover its required rate of return. The project may be rejected if the IRR is not above
the required rate of return.
5. B is correct. A project with abnormal cash flows can have more than one point at which the
NPV profile cuts the x-axis. This means that there are at least two points at which the project
becomes profitable. It is not possible to know which appropriate IRR is to use in this case. A is
incorrect because this is true for projects with normal cash flows too. C is incorrect because it
is unlikely for a project with normal cash flows to have multiple IRRs.
Capital Investments and Allocation 45
6. B is correct. This is the most likely outcome with projects that have very different sizes of cash
flows and investment outlays. It is possible that the larger project brings in more value in terms
of NPV but has a lower IRR. It is up to the company to decide what their priority is. C is incorrect
because it is given in the question that the projects have normal cash flows. A can be a correct
answer, but not enough information is given, and so B is more likely than A.
7. A is correct. Theoretically speaking, the NPV of a project should increase shareholder value in
the proportion of that NPV. Since the objective is to increase shareholder value, NPV should
be the criteria in this case because of the huge difference in the NPV of both projects. IRR
shows the rupee rate of return. B is incorrect because Project 2 may be more beneficial from
comparing the return of investment, not from absolute gains. C is incorrect because the
projects are mutually exclusive.
LOS 30c: describe principles of capital allocation and common capital allocation
pitfalls
➢ Negative externality: Suppose Apple launches a new iPhone. The sales of previous models
will reduce because they are not in demand anymore. This means that the previous models
become cannibalised.
➢ The reduction in cash flow of the previous models because of launching a new model must
be considered in the cash flow analysis.
➢ Positive externality: If the newer models support only AirPods, then sales of AirPods will
increase.
➢ The increase in cash flow from the AirPods segment must be considered in the cash flow
analysis.
➢ All externalities must be considered.
Cash Flow Pattern
➢ Conventional cash flows: A big expenditure (denoted by a negative sign) followed by steady
positive cash flows (denoted by a positive sign).
➢ Unconventional cash flows: Series of sign changes (i.e., the cash flows may be positive from
Years 1 to 3 and then negative for Year 4 and back to positive until the end of the project).
Capital Investments and Allocation 46
Opportunity Costs
➢ Funds that are spent on a project are spent at the cost of not taking on other projects.
➢ The opportunity cost is the cost of not taking the next best use of funds.
➢ Opportunity costs must be included in the cash-flow analysis.
Timing of Cash Flows
➢ Capital budgeting is all about the time value of money.
➢ Cash flows that are earned earlier in the project’s life are more valuable than those earned
later. Cash flows earned later are discounted at a higher rate and have a lower value.
The logical argument is that one would prefer Rs. 100 immediately rather than Rs. 100 in 10 years.
This is because we can invest this Rs. 100 over a ten-year period and earn interest on it. The Rs. 100
might grow to Rs. 150 in 10 years due to compounding effects.
After-Tax Basis
➢ The company is valued on the cash flows that it gets to keep or retain.
➢ Taxes are paid out to the government.
➢ The cash flows of a project must therefore be analysed on an after-tax or post-tax basis.
Financing Costs
➢ These are reflected in the discount rate of the project.
➢ They do not affect incremental cash flows and do not need to be considered in the cash flow
aspect of the project.
Project Interactions
Independent vs. Mutually Exclusive Projects
➢ Independent projects: These are unrelated projects. Two or more projects can be taken on
at the same time.
➢ Mutually exclusive projects: Only one project (out of a choice of two or more projects) can
be accepted.
Suppose there are three profitable projects that are on the table. But accepting one project will mean
that the company cannot take on the other two projects. This is a mutually exclusive project. If all
three can be accepted within the capital budget, then they are independent projects. In this case, all
are likely to be accepted because they are all profitable.
Project Sequencing
➢ A company may not have enough funds to take on multiple independent projects at once.
They may choose to take on one project at a time based on a timeline.
➢ It is also possible that if a project is not profitable, the company may choose not to take on
the next project.
Capital Investments and Allocation 47
Companies typically use standardised capital allocation templates (excel sheets, for example) to assess
hundreds of capital projects. Each project will have its nuances and special considerations. This poses
a risk to the output of a model if inappropriate templates or information is used.
Pet Projects
These projects are management’s preferred or favourite projects over other projects that a company
would consider important. These projects may not undergo the same capital allocation analysis, or
they might be given optimistic projections.
Accounting Measures
Analysts and investors typically focus on accounting measures like EPS (earnings per share), net
income, or ROE (return on equity). These are all accounting measures, and they include non-cash
items.
Management knows that the market is closely monitoring these figures, and they might act so that
these metrics are boosted in the short term. This threatens the long-term strategy of the company
and the economic interests of shareholders.
Using IRR Over NPV
NPV is overall a better economic approach to value an investment decision. The IRR is also good for
independent projects but must not be used for mutually exclusive projects or projects with
unconventional cash flows.
Incorrect Cash Flows
Some cash flows may be either omitted or double-counted, or taxes may not be accounted for
appropriately.
Capital Investments and Allocation 48
Overhead Costs
Costs like management time, I.T. support cost, financial system management, and other support costs
are difficult to estimate. The misestimation of these costs may give misleading estimates of the
profitability of projects.
Discount Rates
The required rate of return is dependent on the risk of a project. The discount rate should be the
overall required return of that specific project rather than the individual cost of debt or cost of equity
associated with that project.
It is also possible that a company takes on a riskier project than the typical projects of the company.
The required rate of return must be adjusted upwards to reflect the additional risk.
Capital Allocation Restraints
Suppose Rs. 10 crores have been sanctioned for a project. The company requires only 8 out of these
ten crores, but it uses the entire budget instead. This is an example of overspending the capital
budget. There was no real need to spend the extra Rs. 2 crores, and this money could have been used
elsewhere.
If the total amount has not been used (i.e., the company has underspent the budget), then
management should consider other profitable avenues for the excess funds.
Alternative Investment Routes
This should be considered in the idea generation step of the capital allocation process. Many
alternative options are not even considered before taking on a capital project. These avenues may
have been more profitable.
Breakeven analysis, scenario analysis, and simulation analysis may help consider different economic
states or uses of capital. This will assist the investment decision process.
Sunk Costs and Opportunity Costs
Sunk costs may be substantial, and it may be appropriate to include them in the investment analysis.
Opportunity costs may be overlooked, and this may result in a sub-optimal capital allocation decision.
1. Which of the following statements regarding accounting measures for capital projects is
most likely correct?
Statement 1: Accounting measures are preferred over cash flow methods to find the NPV of
a project.
Statement 2: Accounting measures are not theoretically sound but are likely to be used
because the market pays attention to these measures.
A. Statement 1 is correct
B. Statement 2 is correct
C. Both statements are correct
Capital Investments and Allocation 49
2. Which of the following is the most likely risk of underspending the capital allocation on a
successful and profitable project?
Answers
1. B is correct. Capital projects must be assessed on after-tax cash flows. Accounting measures
are not theoretically sound because the NPV and IRR methods consider incremental after-tax
cash flows rather than accounting profit.
2. C is correct. If a company has excess cash after a project is complete, then it must find different
investment avenues so that this cash earns interest. A is incorrect because sunk costs are costs
that cannot be recovered and have already been spent. B is incorrect because this is a risk
from overspending the budget rather than underspending the budget.
Fundamental Options
We saw earlier that a company might wait until they have more information about a project before
investing more capital. These decisions add value to the project. However, it can become complex to
use real options, so management may prefer to use more basic approaches towards capital allocation.
➢ DCF (discounted cash flow) analysis without options: If the NPV of a project is already positive
without the added value of an embedded option, then it is unnecessary to evaluate options.
➢ Net value addition: Recall that options have value when they increase the cash flows of a
project on a net basis.
➢ Decision trees: These are not conceptually sound for option-pricing models, but they can help
a company to understand the sequential decision-making process.
➢ Use option pricing models.
Capital Investments and Allocation 51
1. The cost of an option exceeds the benefits of the option. Is the company most likely to
engage in a real option in this case?
A. Fundamental option
B. Timing option
C. Sizing option
3. Which of the following options is most likely beneficial if a company wants to sequence its
projects?
A. Flexibility option
B. Timing option
C. Sizing option
Answers
1. B is correct. Project NPV = NPV without Options – Cost of Options + Value of Options. If the
cost is greater than the value, then the net benefit is negative, and the company will most
likely go ahead with the project without the real option.
3. B is correct. Timing options allow a company to delay investments in the same project or to
take on one project after another. A is incorrect because flexibility options are used to change
production levels or price of a product once there is more information on market demand. C
is incorrect because sizing options refer to the abandonment or growth decision.
Capital Structure 52
Capital Structure
We have seen that a discount rate is required to calculate the NPV of a project. This entire reading will
help you to understand how to calculate that discount rate. It is a significant input in several
applications in finance like NPV analysis and discounted cash flow modelling.
Ensure that you are familiar with the different ways to calculate the different component costs of
capital, the difference between asset beta and equity beta, and how to treat floatation costs.
LOS 31a: Calculate and interpret the weighted average cost of capital (WACC) of a
company.
You may think of the cost of capital and the minimum required rate of return as two sides of the
same coin: any project’s return must at least recover the cost of the capital employed in the project.
So, we can assume that the cost of capital is equal to the required rate of return in NPV calculations.
The cost of capital is, therefore, the compensation to providers of capital (i.e., debt providers and
equity providers), given the risk of a company’s operations.
Next, we require the market value of each source of financing to determine the weight of each
source in the total capital structure.
Note that the firm’s total market value is the sum of all sources of capital. We can now obtain the
weight of each source of capital in the firm’s capital structure.
An analyst may also notice a trend in the capital structure. For example, a company may be paying
down a lot of debt over the last few years. Then it is safe to assume that this trend will continue, and
the weight of debt may be adjusted downwards in subsequent years. An analyst may also use the
industry’s average capital structure.
Capital Structure 54
We will use the example of Eveready Industries India Ltd. (Eveready) throughout this reading to
explain how the WACC is calculated.
India’s secondary corporate debt market is not as developed as other developed nations’ corporate
bond markets. Indian companies usually take short-term and long-term loans from banks to support
their debt financing. You will find all this information in the company’s annual report.
Eveready’s capital structure (as per the FY 19-20 annual report) is as follows:
The proportions of different sources of financing can be expressed literally as a pie chart. We will use
this information to calculate the WACC in subsequent learning outcomes.
2. Can the WACC be adjusted, and how can a company change its WACC?
A. No, because the cost of capital remains constant throughout the company’s life
B. Yes, because the company can change the shape of the capital structure to match a
certain target
C. Yes, because the company can reduce the cost of equity capital by negotiating better
terms with shareholders
A. Cost of equity
B. Cost of preferred shares
C. Cost of debt
Capital Structure 55
4. Which of the following is the correct treatment for tax in the WACC calculation?
5. Which of the following is most likely used for the cost of debt?
Statement 1: The WACC and required return on a company are the same because its
management should at least recover the cost of the capital that it has employed.
Statement 2: The WACC is an appropriate proxy for the required rate of return because
investors of a company should be compensated for the risk that the company bears.
Answers
1. C is correct. The WACC combines the amount and cost of each source of capital to give a
weighted average cost of capital.
2. B is correct. The shape of the “pie” of the capital structure can be changed. Each component's
cost of capital might remain the same, but the weightage of the most expensive cost of capital
can be reduced by buying back shares or by repaying debt.
3. C is correct.
4. B is correct. “Cost of Debt × Tax” is the interest tax shield, and this must be reduced from the
cost of debt. The expression kd × t must be reduced from the cost of debt, i.e., kd. Therefore,
the after-tax cost of debt is kd(1 - t). A is incorrect because the cost of equity is unaffected by
tax.
5. B is correct.
6. C is correct.
Capital Structure 56
7. B is correct. The WACC is useful for management because it can be used in NPV analysis to
understand the minimum level of return that a project should earn. The WACC is also useful
for investors because it is a proxy for the risk of the company’s operations.
LOS 31b: Explain factors affecting capital structure and the weighted-average cost of
capital
Capital structures can vary significantly among companies, and they aim to minimize the weighted
average cost of capital (WACC) while considering the nature of their assets and other factors. These
factors that influence capital structures can be internal or external and are crucial in determining a
company's ability to service debt.
Internal Factors:
1. Characteristics of the Business or Industry: Factors such as growth prospects, stability of revenue,
and business risk play a role in determining the proportion of debt a company can have in its capital
structure. Companies in noncyclical industries and those with stable and predictable revenues can
support higher levels of debt.
2. Company's Life Cycle Stage: Start-up companies with low or negative cash flows and high business
risk are typically financed with equity. As companies mature and generate more stable cash flows,
they may incorporate more debt into their capital structures.
3. Existing Debt Level: High levels of existing debt can limit a company's ability to take on additional
debt, affecting its capital structure choices.
4. Corporate Tax Rate: Higher corporate tax rates can make debt financing more attractive due to
interest expense tax deductions.
External Factors:
1. Market and Business Cycle Conditions: Economic conditions and market sentiment influence the
cost and availability of debt financing. Downturns may lead to higher borrowing costs due to increased
default risk.
2. Regulation: Regulatory changes can affect the attractiveness and availability of debt financing for
companies.
3. Industry Norms: Industry practices and norms can influence a company's capital structure decisions.
The growth and stability of revenue, predictability of cash flow, amount of business risk, liquidity of
assets, and cost and availability of debt financing all impact a company's debt capacity. More stable
and recurring revenues and cash flows allow for a higher proportion of debt.
Capital Structure 57
The types of assets a company uses also affect its ability to issue and service debt. Tangible assets are
often preferred as collateral, and owning productive assets outright enhances access to debt
financing. Existing debt levels, earnings volatility, leverage, and coverage ratios are used to analyse
debt capacity.
1. Start-up Stage: High business risk, low cash flows, and limited collateral result in equity financing.
2. Growth Stage: Rising cash flows and reduced business risk allow for some debt financing, often
secured by assets or receivables.
3. Mature Stage: Stable cash flows and lower business risk support unsecured debt financing at lower
costs.
Top-down macroeconomic factors, including inflation, real GDP growth rate, monetary policy, and
exchange rates, influence benchmark interest rates and credit spreads. Economic downturns lead to
higher yield spreads for corporate debt, while specific industries may experience shifts in spreads
based on their economic environment.
Equity
40%
Debt
60%
Now assume that another analyst within the company proposes the following structure:
Debt
40%
Equity
60%
The MM Propositions basically say that the size of the pie (i.e., the firm value) does not change
regardless of how the pie is cut.
Capital Structure 59
Equity
40%
Debt
60%
Equity
40%
Debt
60%
It is like cutting one pizza either into four pieces or eight pieces – the size of the individual pieces will
be different, but the pizza won’t become bigger or smaller.
We will now explore both propositions, with and without taxes.
Capital Structure 60
The cost of debt remains constant, but as the leverage increases, the cost of equity increases too.
However, this does not change firm value.
Capital Structure 61
Let us take a hypothetical example to prove that the firm value does not change when the debt-to-
equity ratio changes.
Let us assume that the firm value is determined solely by cash flows to equity holders (CFe) and that
these expected cash flows are perpetual. The discounting rate is the WACC. (Note that the WACC and
the cost of equity are the same for an unlevered company).
We can denote this information in the following formula:
CFe
V=
rWACC
If the expected cash flow is Rs. 12,000, the company has no debt, and the WACC is 6.00%, then the
value is 12,000 ÷ 6.00% = Rs. 200,000.
Now suppose it changes the capital structure to 40% debt and 60% equity by buying back its equity
and issuing debt. The cost of debt is 3.00%. The value of debt is Rs. 80,000, and the value of equity is
Rs. 120,000. Let us see how the cost of equity changes.
D
re = r0 + (r - r )
E 0 d
80,000
re = 6.00% + × (6.00% - 3.00%) = 8.00%
120,000
Now let us consider the return to debt holders and equity holders. Debt holders receive Rs. 80,000 ×
3.00% = Rs. 2,400. This reduces the cash flow to equity holders from Rs. 12,000 to Rs. 9,600. Now let
us use the same formula that we used for the company’s value by using the cash flows to both
providers of capital and their respective component costs of capital.
V=D+E
2,400 9,600
V= + = 200,000
0.03 0.08
The value remains unchanged.
WACC = (0.6 × 8.00%) + (0.4 × 3.00%) = 6.00%
The WACC does not change either.
Even the systematic risk (beta) of a company can be proven in a similar way.
D E
βa = βd + βe
V V
This proves that the asset beta βa is a function of the debt beta βd and the equity beta βe. MM
proposes that the company’s cost of capital does not depend on capital structure, but it does
depend on the business risk. The risk is borne by equity holders as debt levels increase.
So, we can prove with the equation above that:
D
βe = βa + (β - β )
E a d
We will now relax the assumption of taxes and see how the conclusions of the two propositions
change.
Capital Structure 62
The additional value from tax savings due to interest raise the question of whether companies should
be fully financed by debt. Modigliani and Miller countered this argument with the theory of personal
taxes. If interest income is taxed at a higher rate than a dividend distribution, then companies would
prefer to issue equity. Debt investors would demand a higher interest rate if the tax on interest was
higher than the tax on dividends, and this would increase the cost of debt.
Direct costs of financial distress include legal fees and other expenses related to bankruptcy
proceedings. Indirect costs are also called agency costs, and they include reputational risk, loss of
business activity, and costs that arise from the conflicts between debt holders and management.
Capital-heavy companies typically have less financial distress costs since their assets can be readily
sold, and some amount of the default can be recovered. However, companies with a high level of
intangible assets may have higher financial distress costs.
A. The value of an unlevered company is greater than the value of a levered company
B. The value of a levered company is equal to the value of an unlevered company
C. The value of a levered company is greater than the value of an unlevered company
A. The value of an unlevered company is greater than the value of a levered company due
to the costs of taking on additional debt
B. The value of a levered company is equal to the value of an unlevered company because
the finance costs from debt offset the value from the interest tax shield
C. The value of a levered company is greater than the value of an unlevered company by
the interest tax shield
3. The cost of equity of an unlevered company is 8.60%. It would like to raise debt capital so
that the total market value of debt is Rs. 100 million, and the total market value of equity is
Rs. 200 million. The cost of debt is 4.75%, and the tax rate is 25.00%. What is the cost of
equity of the levered company according to MM Proposition II with taxes?
A. 9.56%
B. 10.04%
C. 11.83%
4. According to MM Proposition II, without taxes, what is the most likely effect on the WACC if
an unlevered company takes on additional debt?
A. WACC decreases
B. WACC increases
C. WACC remains unchanged
5. Which of the following most accurately describes the concept of homemade leverage?
A. The company can issue debt to increase its leverage, thereby increasing the leverage of its
shareholders
B. Investors can adjust the leverage in their personal accounts to match their own risk profile
C. Shareholders can vote for the company to take on more leverage
Capital Structure 64
Answers
1. B is correct. MM Proposition I without taxes suggests that it does not matter how a company
is financed (i.e., it does not matter in what proportions they raise debt and equity). This
indicates that the value of an unlevered company (fully financed by equity) will be the same
as the value of a similar, levered company (financed by equity and debt).
2. C is correct. VL = VU + tD, where “tD” is the interest tax shield. Assuming that interest is tax-
deductible, a company will benefit from the tax savings on making interest payments.
However, a company must not take on too much debt; otherwise, it may suffer financial
distress costs.
3. B is correct.
D 100
re = r0 + E (r0 - rd )re = 8.60% + 200 x (1 – 25.00%) x (8.60% - 4.75%) = 10.04%
A is incorrect because it takes the proportion of debt in the total capital structure rather
than the debt-to-equity ratio.
C is incorrect because it does not subtract rd from r0 in the bracket.
4. C is correct. The benefit of taking on more debt is offset by the increase in the cost of equity.
LOS 31d: Describe the use of target capital structure in estimating WACC and
calculate and interpret target capital structure weights.
We saw earlier in MM Proposition I with taxes that a company can enhance its value by taking on
more debt. But what level of debt is optimal before the company suffers financial distress costs?
There is no rule for an optimal capital structure, but we can make the following argument: the
theoretical point of the debt-to-equity ratio at which the company’s value is maximised can be called
the optimal capital structure.
Suppose a company has taken on some debt and wants to assess the optimal debt-to-equity ratio at
which the firm value is maximised. They may plot the market value of the firm against the debt-to-
equity ratio. But if the debt-to-equity ratio is too high, then they may suffer financial distress costs in
the future. The market value of the company must therefore account for the present value of financial
distress costs.
This is simply a theoretical point, and it is difficult to find this point in practice. If a company does
approximate the optimal structure, then they can use this as the target capital structure. This is the
long-run proportion of debt and equity in the capital mix and can be used in the WACC calculation.
In reality, all relevant information is not readily available and is not complete. Analysts may need to
make estimates of the appropriate capital structure and especially for the appropriate cost of common
equity.
The company’s management may disclose their target capital structure via annual reports or via
analyst conference calls if they have a target to provide. The target structure is the target proportion
of each capital component in the pie that the company expects to reach over a period of time.
India’s secondary corporate debt market is not as developed as other developed nations’ corporate
bond markets. Indian companies usually take short-term and long-term loans from banks to support
their debt financing. You will find all this information in the company’s annual report.
You may also use the peer group average capital structure (plus or minus relevant adjustments for
firm-specific risk). This will take the average of the capital structure of all comparable companies as a
proxy for the firm’s capital structure. Note that there is no pre-defined optimal structure within
industries and that there may be large differences in how each company decides to cut its pie.
1. Which of the following is the most accurate description of the target capital structure?
A. The target capital structure is the capital structure that shows the target weights of all
sources of capital
B. The target capital structure is the capital structure that shows the target cost of capital
of all sources of capital
C. The target capital structure is the capital structure that shows the target cost of equity
to all shareholders
2. Which method for capital structure, from most accurate to least accurate, is used in the
WACC calculation?
3. Which of the following is the correct treatment of target weights in the cost of capital?
A. The target weights are averaged, and this average is multiplied by the average cost of
capital. The result is the WACC
B. The target weight of each component of capital is multiplied by each component's cost
of capital. The result is the WACC
C. The target weight of each component of capital is added, and this is multiplied by the
average cost of capital from each source of capital. The result is the WACC.
Answers
1. A is correct. The target weights are the weightage of each source of capital based on their
market values. These weights can be adjusted to achieve a target (or optimal) WACC.
Capital Structure 67
2. A is correct. This is the most likely order in which an analyst can determine the target capital
structure. Management disclosure of targets is most likely to give an accurate forecast. The
current capital structure can be used but must be adjusted for trends and changes in capital
structure. Firms in the same industry can have extremely different capital structures based
on the company’s investment policies.
3. B is correct. WACC = wdkd(1 - t) + wpskps + wcekce. Each target weight is multiplied by its
respective cost of capital.
Business Models 68
Business Models
LOS 32a: Describe key features of business models
Revenue
from 24,71.4 Crores 2,894.9 Crores
operations
• Channels (Where)
A firm’s channel strategy refers to “where” the firm is selling its offering; that is how it reaches
its consumers. Manufacturers may employ a direct sales strategy, selling directly to the end
consumer. Direct Sales to the end customer bypass the intermediaries like the distributor or
retailer. With e-commerce, however, direct selling has become a cost-effective strategy across
many business and consumer markets.
In the e-commerce realm, the drop-shipping model enables an online marketer to have goods
delivered directly from manufacturer to end consumer without taking the goods in inventory. For
example, when we buy a book from Amazon, it doesn’t buy the book from manufacturer.
Often, channels are used in combination. The strategy where both, physical & digital channels are
used in combination to complete a sale. For example, a customer might order an item online and pick
it up in a store (“click and collect”) or select an item in a store and have it delivered. The use of a digital
channel strategy introduces potential cybersecurity and access risks, while having a physical location
Business Models 71
might introduce substantially greater financial risk. The channels used by a business can influence a
firm’s revenues, cost structure, profitability and sensitivity to Internal and external risk factors.
• Pricing (How Much)
Companies with little differentiation are “commodity” producers that must accept market
prices dictated to them (“price taker”), whereas companies with high differentiation can
command premium pricing (“price setter”).
Pricing and Revenue Models
Pricing approaches are typically value or cost based. Value based pricing attempts to set
pricing based on the value received by the customer. Cost based pricing attempts to set pricing
based on costs incurred.
Price Discrimination
The term “Price Discrimination” means when firms charge different prices to different customers. The
objective of price discrimination is to maximize revenues in a situation where different customers have
different willingness to pay. Some common strategies include:
a. Tiered pricing charges different prices to different buyers, most commonly based on volume
purchased. Note that volume discounts achieve a similar result.
b. Dynamic pricing charges different prices at different times. Specific examples include off-peak
pricing, surge pricing and congestion pricing.
c. Action/reverse auction models establish prices through bidding
Alternatives to Ownership
Business Models 72
Value Chain
Value Chain refers to the systems and processes within a firm that create value for its customers.
Business Models 73
It involves:
1. Identifying the specific activities carried out by the firm,
2. Estimating the value added and costs associated with each activity, and
3. Identifying opportunities for competitive advantage.
Michael Porter’s 1985 book Competitive Advantage defined five primary activities:
• inbound logistics,
• operations,
• outbound logistics,
• marketing, and
• sales and service.
In addition, a firms four primary “support” activities are procurement, human resources, technology
development, and firm infrastructure. This is a useful starting point for an analyst evaluating the value
chain of a company, although dramatic advances in digital technology have radically changed the way
that some of these functions are carried out in many businesses.
Business Models 74
Formula
Capital Investments
CF CF CF CF
• 1
NPV = CF0 + (1+k) 2 n
1 + (1+k)2 … … … . + (1+k)n =
∑nt=0 t
(1+k)t
CF CF CF CF
• 1
IRR: 0 = CF0 + (1+IRR) 2 n
1 + (1+IRR)2 … … … . + (1+IRR)n =
∑nt=0 t
(1+IRR)t
Working Capital
current asset
• Current Ratio = current liabilities
credit sales
• Receivables turnover = average receivables
purchases
• Payables turnover ratio = average trade payables
Dps
• Cost of preferred stock = k ps = P
o k ce = Rf + β[E(R m ) − R f ]
1
• Unlevered asset beta: βASSET { (1−t)
1+[ ]
D/E
(1−t)
• Target beta: βASSET {1 + [ ]}
D/E