BFD Summary Sheets

SUMMARY SHEETS
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Following format of net cash flows is critical for computation of net present value, internal rate of return, payback period, modified internal rate of return.
Net Cash Flows of project 0 1 2 3 4 5
Annual Sales Revenue or Annual income x x x x x
Less: Annual variable costs:
Material purchase cost - regular use or not in stock (x) (x) (x) (x) (x)
Material opportunity cost - non regular use (x) (x)
Labour cost when spare capacity 0 0 0 0 0
Labour cost at remining rate (x) (x) (x) (x) (x)
Labour cost at lower of overtime/hiring /diversion (x) (x) (x) (x) (x)
Variable overheads cost (x) (x) (x) (x) (x)
Variable selling and marketing cost (x) (x) (x) (x) (x)
Variable comission or % of sales (x) (x) (x) (x) (x)
Royalty payment (% of sales) (x) (x) (x) (x) (x)
Advertisment cost (per unit or % of sales) (x) (x) (x) (x) (x)
INVESTMENT APPRIASAL – DECISION MAKING TECHNIQUES
Less: Annual incremental fixed costs (other than dep)

1) CAPITAL INVESTMENT APPRAISAL
Annual fixed overheads (x) (x) (x) (x) (x)

Annual adminstration costs (x) (x) (x) (x) (x)
Annual salaries cost (x) (x) (x) (x) (x)
Annual maintenance cost (x) (x) (x) (x) (x)
Annual advertisment cost in total (x) (x) (x) (x) (x)
Annual fixed selling costs (x) (x) (x) (x) (x)
Annual rental cost at the end of each year (x) (x) (x) (x) (x)
Annual insurance cost at the end of each year (x) (x) (x) (x) (x)
Less: Annual opportunity cost

Annual rental income forgone (x) (x) (x) (x) (x)
Annual contribution forgone (W1) (x) (x) (x) (x) (x)
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Less: Annual tax depreciation (W2) (x) (x) (x) (x) (x)
Tax gain/(loss) on disposal of asset under WDV method (W2) x/(x)
Annual taxable profit/ (loss) (x) x x x x

Tax payment or Tax saving @ 30% x (x) (x) (x) (x)
Add: Annual tax depreciation x x x x x

Tax (gain)/loss on disposal of asset under WDV method - - - - (x)/x
Annual cash flows paid at start of each year:

Less: Rent expense at start of each year (x) (x) (x) (x) (x)
Add: Tax saving on rent expense @ 30% x x x x x
Less: Annual insurance at the start of each year (x) (x) (x) (x) (x)
Add: Tax saving on annual insurance @ 30% x x x x x
Annual operating cash flows after tax (x) x x x x x

Initial investment and scrap value of new assets:
1) Net Cash Flows of Project
Land (x) x
Building (x) x
Plant and machinery (x) x
Furniture and Fittings (x) x
Mobile sets (x) x
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Cars and vehicles (x) x
Existing assets are used for project (x) x

Working capital changes (W3) (x) (x) (x) (x) (x) x
= Net Cash Flows of project (x) x x x x x
2) PAYBACK PERIOD 4) NET PRESENT VALUE
A) Same Annual Cash Flows NPV = PV of Cash inflows – PV of initial investment
Payback Period = Initial Investment = Ans ( in Years )
0 1 2 3 4 5
Annual Cash Flows Net Cash Flows (x) x x x x x
B) Different Annual Cash Flows x: Discount at WACC x x x x x x
By using the assumed data: = Present value (x) x x x x x
Years Net Cash Flows Cumulative Net Cash Flows Notes:
0 (2,000) (2,000) • For expansion projects, NPV is computed at current WACC.
1 400 (1,600) • For diversification projects, NPV is computed by using risk adjusted WACC.
2 600 (1,000)
3 700 (300) COMPLEX NPV
4 500 200 A) Relevant costing in NPV
5 800 1,000
All future cash flows that will be incurred and paid due to new investment project will be
relevant costs. Major examples of relevant costs are listed in previous table of net cash flows
▪ In case of cash occur at the end of each year, payback will be 4 years. (OR)
but irrelevant costs will be as follows:
▪ In case of evenly cash flows throughout the year, payback period will more
than 3 years but less than 4 years so it will be as follows: ▪ Interest payment,
▪ Dividend Payment,
Payback period = 3 years + (Recoverable amount ÷ Recovered amount) ▪ Depreciation expenses,
Payback period = 3 years + (300 ÷ 500) = 3.6 years. ▪ Allocated Fixed FOH, absorbed Fixed FOH and apportioned Fixed FOH,
▪ Historical Research and Development cost
Note: Conversion of Accounting profit into Cash Flows
▪ Market Research cost already undertaken
Cash Flow = Accounting profit + Depreciation expenses
▪ Lease rental of existing assets
In case of silent question, straight line depreciation will be assumed ▪ Current annual salary of managerial staff
Straight Line Annual Depreciation = (Cost of asset – Scrap)/Life
B) Inflation in NPV
Decision rule
Single project How to inflate cash flows?
Project’s payback period ≤ Target payback period → Accept the project For NPV purpose, all cash flows will be taken in nominal terms or money terms or inflated
Project’s payback period > Target payback period → Reject the project figures. Cash Flows will be inflated as follows:
Multiple projects If inflation rate of each year is same
Project with short payback period will be better. Nominal Cash Flows = Real Cash Flow x (1 + inflation rate) n (OR)
Where n = number of inflationary jumps
3) DISCOUNTED PAYBACK PERIOD
If inflation rate of each year is different
Discounted payback period is the time period to recover initial investment through present
Nominal Cash Flows = Previous Year Cash Flow x (1 + Current inflation rate)
value of cash inflows.
Table of Cumulative Cash Flows (Rs. ’000) Timing of inflation
Years 0 1 2 3 4 5 Situation Inflated cash flow from
PV of Cash Flows at (10,000) 2,000 4,000 3,000 2,000 1,500 If sale price or costs are given at current prices Year 1 and onwards
WACC If sale price or costs are given at year 1 terms Year 2 and onwards
PV of Cumulative C. Flows (10,000) (8,000) (4,000) (1,000) 1,000 2,500 If silent Year 2 and onwards
Discounted Payback period = 3.5 years (1,000 ÷ 2,000) How to inflate cost of capital rate?
Decision rule Cost of capital is normally given in normal terms but when real cost of capital is given then
fisher equation can be used to inflate the rate:
Single project
Project’s payback period ≤ Target payback period → Accept the project
(1 + nominal rate) = (1 + real rate) x (1 + General inflation rate)
Project’s payback period > Target payback period → Reject the project
Multiple projects: Project with short payback period will be better.
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NET PRESENT VALUE (CONTD.) Determination of Working capital changes
C) Taxation in NPV There are four possible situations in working capital:
Tax allowable depreciation and tax gain/loss on disposal i) – Amount of working capital is given and no change
ii) – Amount of working capital is given with annual increase
Tax allowable depreciation can be asked under iii) – Amount of working capital is dependent upon sales and no inflation
a) Straight line method iv) – Amount of working capital is dependent upon sales and inflation exists
b) reducing balance method
These four situations are explained with the help of examples
Straight line method
▪ Annual depreciation = (Cost of assets – Scrap value) ÷ Useful life
Situation 1
▪ No gain or loss on disposal will arise.
For example, project life is 3 years and additional investment in working capital
Reducing balance method will required at start of project amounting Rs. 200,000.
Years Rs. There is no increase mentioned in above statement so working capital changes will
1 Initial allowance (Cost of asset x initial allowance %) N1 x be as follows:
Normal depreciation (Cost – Initial allowance) x Dep % x 0 1 2 3
x Working capital required 200,000 200,000 200,000 0
2 Normal depreciation (Previous dep x (1 – Dep %) x Working capital changes (200,000) - - 200,000
3 Normal depreciation (Previous dep x (1 – Dep %) x
4 Normal depreciation (Previous dep x (1 – Dep %) x Situation 2
5 Normal depreciation (Previous dep x (1 – Dep %) x For example, project life is 3 years and additional investment in working capital
= Accumulated tax depreciation x will required at start of project amounting Rs. 200,000 and will increase by 10%
Y5: Tax gain or loss on disposal of asset p.a.
Tax gain or loss = Scrap value – Carrying value of asset 0 1 2 3
N1) Initial allowance will be taken when given in question clearly. Working capital required @ 10% 200,000 220,000 242,000 0
Working capital changes (200,000) (20,000) (22,000) 242,000
Tax payment or Tax saving
i. Tax payment on taxable profits can be made in the:
Situation 3
▪ Same year or
For example, project life is 3 years and additional investment in working capital
▪ Following year (known as tax payment one year in arrear)
will required at start of each year equal to 5% of sales of that year. Annual sales
ii. If taxable loss occurs at the end of first year, then there are two possible
will be Rs. 4,000,000
treatments:
0 1 2 3
If business has already engaged in other business activities: Annual Sales 4m 4m 4m
Tax saving on the loss of Year 1 will be computed and adjusted. Working capital required @ 5% 200,000 200,000 200,000 0
If business has no other business activities: Working capital changes (200,000) -- -- 200,000
Taxable Loss of year 1 will be carried forward to adjust against taxable profit of
future years so tax payment of year 1, 2 onwards will be: Situation 4
▪ Tax payment of Year 1 = Nil For example, project life is 3 years and additional investment in working capital
▪ Tax payment of Year 2 = (Taxable profit – B/F loss of Year 1) x Tax rate will required at start of each year equal to 5% of sales of that year. Annual sales
D) Working Capital Changes will be Rs. 4,000,000 in year 1 and will inflate by 10% from year 2 onwards:
Working capital changes 0 1 2 3
▪ Start of project = Investment in working capital is cash outflow Annual Sales after 10% inflation 4m 4.4m 4.84m
▪ During life of project = Increase is cash outflows and vice versa Working capital required @ 5% 200,000 220,000 242,000 0
▪ End of project = Recovery of working capital is cash inflow Working capital changes (200,000) (20,000) (22,000) 242,000
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5) INTERNAL RATE OF RETURN (IRR) 7) ACCOUNTING RATE OF RETURN (ARR)
Calculation of IRR Accounting rate of return
(i) Calculate first NPV of project at given discount rate/cost of capital rate Accounting rate of return is annual accounting profit expected from capital investment
(ii) Select second discount rate and calculate second NPV project. It is also known as return on capital employed (ROCE).
▪ If first NPV is +ve then select higher second discount rate Calculation of Accounting rate of return (ARR)
▪ If first NPV is –ve then select lower second discount rate
Rs.
(iii) Use interpolation formula (provided below) to estimate IRR
Total Sales revenue over the life of project x
Interpolation Formula: Where
L = Lower discount rate Less Total operating cost (other than depreciation) over life of project (x)
NPVL H = Higher discount rate Total operating cash Flows over the life of project Rs. x
IRR = L + x (H-L) NPVL = NPV at lower discount rate
NPVL- NPVH Les Total accounting Depreciation (Cost of asset – Scrap Value) (Rs. x)
NPVH = NPV at higher discount rate
Total Accounting Profit Rs. x
Decision Rule of IRR ÷ Project life x years
= Estimated Average Annual Accounting profit Rs. x
Single project
÷ Initial Investment Rs. x
Project’s IRR > Cost of Capital → Accept the project (OR)
Project’s IRR < Cost of Capital → Reject the project Average Investment
(Initial investment + Closing value of investment at the end of
Multiple projects project life) ÷ 2
Project with highest IRR will be better. Accounting Rate of Return (ARR) x%
6) MODIFIED INTERNAL RATE OF RETURN (MIRR) Note:

i. Closing value of investment will be considered equal to scrap of asset.
(A) TERMINAL VALUE METHOD ii. In case of silent question, using initial investment for calculation of ARR would be
i. Calculate future Value (Terminal Value) for Cash inflows of each year at simple.
reinvestment rate Decision Rule
Terminal value = Cash inflow x (1 + reinvestment rate)n Single project
ii. Calculate present value of initial investment at given cost of capital (WACC) Project’s ROCE > Target ROCE → Accept the project
iii. Calculate modified internal rate of return (MIRR) using following Formula: Project’s ROCE < Target ROCE → Reject the project
MIRR = (Terminal value ÷ PV of investment)1/n – 1 Multiple projects
Project with highest ROCE will be better
(B) FORMULA METHOD
Where
PVR = Present value of return phase (Cash
inflows)
PVI = Present Value of investment phase
r e = Cost of Capital = Reinvestment rate
Decision Rule of MIRR

Single project
Project’s MIRR > Cost of Capital → Accept the project
Project’s MIRR < Cost of Capital → Reject the project
Multiple projects
Project with highest MIRR will be better.
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RISK & UNCERTAINTY IN CAPITAL INVESTMENT APPRAISAL
1) SENSITIVITY ANALYSIS 2) EXPECTED VALUES & PROBABILITIES
There are three main situations in sensitivity analysis Definition of expected value
(A) SENSITIVITY PERCENTAGE Expected value is the weighted average of all possible uncertain items by using probabilities
or chances of occurrence.
▪ In this form of sensitivity, company determines how much percentage change in any
project variable will change present NPV of the project to zero or negative. Calculation of expected value
▪ Sensitivity percentage can be computed as follows: Expected value = (Uncertain item1 x probability1) + (Uncertain item2 x probability2)
Initial Investment = NPV x 100 Decision making methods by using expected values
Present value of initial investment (after tax)
Scrap Value = NPV x 100 There are three methods for decision making by using expected values:
Present value of Scrap value (after tax) a) Simple Expected value
Sales Price = NPV x 100 b) Expected value by using Joint probability table
Present value of Annual Sales Revenue (after tax) c) Decision making by using Decision Tree
Variable Cost = NPV x 100 (A) SIMPLE EXPECTED VALUE IN A SINGLE UNCERTAIN ITEM
Present value of Annual Variable Cost (after tax)
Fixed Cost = NPV x 100 There are two methods to compute NPV with single uncertain project variable:
Present value of Annual Fixed Cost (after tax) Method 1
Sales Volume = NPV x 100
(i) Calculate expected value of uncertain project variable by using probability
Present value of Annual Contribution (after tax)
(ii) Calculate expected NPV by using expected value of uncertain variable and other
Tax rate = NPV x 100
information.
Present value of Annual tax expense
Life of project = Current life of project – Revised life by discounted payback x 100 Method 2
Current life of the project (i) Calculate NPV of the project multiple times by using all given figures of uncertain
Cost of Capital = Revised Cost of capital (Using IRR) – Current Cost of Capital x 100 project variable
Current Cost of Capital (ii) Calculate expected value of NPV by using probabilities.
Note:
Present value of initial investment (after tax) Note: Normally method 1 is used to compute NPV.
= Present value of initial investment – Present value of tax saving on tax depreciation (B) EXPECTED VALUE BY USING JOINT PROBABILITY TABLE
Present value of scrap value (after tax) Joint Probability
= Scrap value – Tax payment on gain on disposal
Joint probability is the product of probabilities of different uncertain items. It can be
Interpretation of Sensitivity percentage
calculated as:
▪ High sensitivity percentage = Least critical variable
▪ Low sensitivity percentage = Most critical variable/ most sensitive variable Joint probability = Probability1 x Probability2
(B) CHANGE IN NPV BY % CHANGE IN PROJECT VARIABLE Joint probability table
Joint probability table approach is used when two different uncertain variables are given
▪ In this form of sensitivity, company can determine the change in NPV of the project
with their probabilities.
by % change in any variable of the project.
▪ Under this situation, present value of changed cash flow is computed. Uncertain Probability Uncertain Probability Profit Joint Expected
item # 1 #1 item # 2 #2 & loss Probability value of
(C) SENSITIVITY BETWEEN 2 OPTIONS (Rs.) P&L
x x x x x x x
▪ In this form of sensitivity, company wants to determine percentage change in any x x x x x x x
project variable to change decision from selection of option 1 to option 2 or vice versa. x x x x x x x
▪ Sensitivity percentage between two options can be computed as follows: x x x x x x x
Sensitivity (%) = Difference in NPV of two options Expected value of profit and loss x
Difference in PV of relevant cashflow (after tax) Decision: Select the option where expected value of profit & loss is higher.
RISK & UNCERTAINTY IN CAPITAL INVESTMENT APPRAISAL (CONTINUED)
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(C) DECISION MAKING BY USING DECISION TREE 3) SIMULATION
Definition Definition
Decision tree is a diagrammatic technique to present complex decision with multiple Simulation is the imitation of the operation of a real-world process of system over time.
uncertain variables in pictorial form. It is normally used when more than two uncertain
factors are given. Process of simulation
Symbols (i) Random numbers are assigned to uncertain variables based on their probabilities
(ii) Generate the random numbers via excel
Sr. Name of Symbol Symbol Purpose (iii)Pick data of all uncertain variables on the basis of generated random numbers
No. (iv) Calculate NPV and Joint probability from picked data.
i) Decision Node It will show the decision choices. Every (v) Repeat the steps (ii), (iii) and (iv) again and again multiple times to find multiple
decision tree will start from decision node. NPVs.
➢ Choose higher benefit; or (vi) Calculate expected NPV and standard deviation to find risk and return of the project.
➢ Choose lower cost
ii) Probability Node In order to show all possible outcomes with
probability, this circle will be used.
iii) Connecting Line Decision node and probability node will be

connected with the help of this line to show
branches of decision tree.
Steps for Decision Tree
(i) Construct decision tree from left to right to show all possible outcomes with their
probabilities.
(ii) Perform roll back calculations from right to left by using following rules:
➢ At every circle: Compute expected value of cost or revenue or profit & loss
➢ At every square: Select from two options as for income select higher one but for
cost select lower cost.
(iii) Take decision – Select the option where:
➢ Expected value of profit is highest or
➢ Expected value of total cost is minimum
Value of perfect and imperfect information
▪ Value of perfect information is the possible extra benefit that can be obtained if any
consultant or expert provides certain information about doubtful estimates.
▪ Value of perfect information can be computed as follows:
Rs.
Expected value with perfect information x
Less: Expected value without perfect information (x)
= Value of perfect information (Extra benefit from perfect information) x
Decision making regarding perfect information

Company can decide whether to obtain certain information from expert after paying price
or not. So, decision can be taken as follows:
▪ Value of perfect information > Cost of perfect information → Accept
▪ Value of perfect information < Cost of perfect information → Reject
ASSETS REPLACEMENT DECISION
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(A) SELECTION FROM MULTIPLE ASSETS’ OPTIONS (C) OVERHAUL THE ASSET (OR) REPLACE IT WITH NEW ONE
▪ It is a buying decision to select one machine from different types of machines. ▪ Company can overhaul the existing asset to extend its life or purchase the new one by
▪ There are two sub-situations in it. selling existing asset.
(I) SAME LIFE FOR EVERY ASSET Decision making Approach
When every asset in each proposal has same life then simple NPV approach can be used. ▪ When life of overhauled asset is similar to the life of new asset then NPV is used to
take decision.
▪ Step 1 – Compute NPV of each asset (i.e., machine) ▪ When life of overhauled asset is different from the life of new asset then equivalent
▪ Step 2 – Select the asset where highest positive NPV or lowest negative NPV annual cost (EAC) method is used.
(II) DIFFERENT LIFE FOR EVERY ASSET
When every asset (i.e., machine) given in each proposal has different life then equivalent
annual cost (EAC) or equivalent annual benefit (EAB) approach is used. It has following
steps:
Step 1 – Calculate NPV of each asset (i.e., NPV of each machine)
Step 2 – Calculate equivalent annual NPV of each asset/each machine:
Equivalent annual benefit (EAB) = Positive NPV ÷ Annuity Factor
(OR)
Equivalent annual cost (EAC) = Negative NPV ÷ Annuity Factor
Step 3 – Select the asset/machine with:
➢ Highest EAB; or
➢ Lowest EAC.
(B) OPTIMAL REPLACEMENT CYCLE

▪ It is a selling decision in which company wants to decide when to sell the existing asset
(i.e., existing machine).
▪ There are also two sub-situations in it:
(I) SINGLE INFLATION RATE (OR) NO INFLATION RATE IS GIVEN
When inflation rate is not given or single inflation rate is given then we can use equivalent
annual cost (EAC) approach in real terms and has following steps:
Step 1 – Calculate NPV of each replacement cycle
Step 2 – Calculate EAC of each replacement cycle
EAC = Negative NPV ÷ Annuity factor
Step 3 – Select the replacement cycle with lowest EAC.
(III) MULTIPLE INFLATION RATES ARE GIVEN
When multiple inflation rates are given then we can use lowest common multiple (LCM)
method in nominal terms and has following steps:
Step 1 – Calculate lowest common multiple time period for each replacement cycle
Step 2 – Calculate NPV of each replacement cycle for the lowest common multiple period.
Step 3 – Select the replacement cycle with lowest NPV.
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INVESTMENT APPRAISAL UNDER CAPITAL RATIONING
1) BASICS OF CAPITAL RATIONING 2) SINGLE PERIOD CAPITAL RATIONING – PROFIABILITY INDEX
Definition of capital rationing Step 1 – Calculate NPV of each project.
Capital rationing means the shortage of funds or company has to decide which project Step 2 – Calculate profitability index of each project
should be undertaken within the limited funds. Profitability index = NPV of the project ÷ Initial investment of the project
Reasons of capital rationing (OR)
Profitability index = PV of cash inflows ÷ Initial investment of the project
(a) Soft Capital Rationing - Internal Reasons
(i) Funds are small in relation to cost of finance Step 3 – Rank projects on the basis of profitability index (PI) from highest to lowest
(ii) To avoid dilution of Control or EPS by issue of new shares Step 4 – Prepare optimal investment plan and total NPV.
(iii) To avoid fixed interest cost burden due to expected economic crisis Situation Treatment
Divisible projects Prepare single investment plan on the basis of
(b) Hard Capital Rationing - External Reasons ranking and compute total NPV for all projects
(i) Investor may feel that company is too risky due to low credit rating undertaken by the company.
(ii) General unwillingness of investor to provide funds for capital investments Divisible but mutually Prepare different investment plans on the basis of
(iii) Short supply due to crowding-out effect as a result of high government borrowings exclusive projects ranking and select the investment plan where total
(iv) Lack of appropriate asset to serve as collateral NPV is maximum.
(v) Poor dividend history Non-divisible projects Prepare different investment plans on the basis of
(vi) Lack of past track record or poor track record ranking and select the investment plan where total
(vii) Government restrictions on specific industry NPV is maximum. Surplus funds are reinvested in
market.
Terminology of capital rationing
3) MULTI PERIOD CAPITAL RATIONING – LINEAR
Single period vs multiperiod capital rationing PROGRAMMING
▪ When funds are short immediately then it is known as single period capital rationing
▪ When funds are short for more than one period then it is known as multiperiod Linear programming approach is used when company is facing shortage in multiple
capital rationing. periods. Detailed steps are as follows:
Divisible vs indivisible projects Step 1 - Define variables
▪ Divisible project refers to any project that can be scaled up or scaled down means X = Proportion of project 1 to be undertaken
can be undertaken above 100% or below 100%. Y = Proportion of project 2 to be undertaken
▪ Indivisible project refers to any project which can’t scaled up or scaled up. It is Step 2 – Formula objective function
performed 100% when funds are available or nothing when funds are not available. Company wants to maximise total NPV so:
Independent vs interdependent vs mutually exclusive projects 5,000X + 3,000Y = Z
▪ Independent project refers to separate projects and no need to perform together. Step 3 – Formula constraints in form inequalities
▪ Interdependent projects must be performed together. Constraints will be formulated through present value of investment and inflows for each
▪ Any two or more projects that can’t be performed simultaneously. Only one project year when funds have shortage:
can be undertaken. T0: 25,000X + 20,000Y ≤ 25,000
T1: 13,656X + 27,270Y ≤ 27,270
Surplus funds in indivisible projects 0 ≤ X ≤ 1,
In case of non-divisible projects, there might be some unused funds that can be reinvested in 0≤Y≤1
market or into same investment project. Step 4 – Plot constraints on graph and identify corner points of feasible area
➢ NPV of surplus funds would be positive when rate of return is more than cost of Step 5 – By point inspection method, find total NPV at each corner point of feasible region
capital rate; or and select the optimal point (as optimal investment plan) where total NPV is maximum.
➢ NPV of surplus funds would be zero when rate of return is equal to cost of capital; or
➢ NPV of surplus funds would be negative when rate of return is less than cost of capital Note: Linear programming technique is used for divisible project (not for indivisible ones).
rate.
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WEIGHTED AVERAGE COST OF CAPITAL (WACC)
1) BASICS OF WACC 2) ORDINARY SHARES
1.1) Definition of WACC 2.1) Current cost of equity (KE)
▪ Weighted average cost of capital is the minimum required rate of return for all Current cost of equity for ordinary shares can be computed by using:
financers of the company according to the risk they face or feel in the company. ▪ Dividend models
▪ It is also known as: ▪ Capital asset pricing model (CAPM)
➢ Overall cost of capital of the company ▪ Arbitrage pricing theory model (APT)
➢ Hurdle rate of the company ▪ Modigliani and Miller Proposition II
(A) Dividend Models
1.2) Need of WACC Methods Market value per share Current cost of equity (KE)
Weighted average cost of capital may be needed for: Dividend MVex-div = D ÷ KE KE = D ÷ MVex-div
▪ Evaluation of capital investment projects model Where
(without Where D = Dividend per share
▪ Valuation of companies for mergers and acquisition D = Dividend per share
▪ Evaluation of demerger growth) MVex-div = Market value per shares
KE = Cost of equity (excluding dividend)
▪ Evaluating the impact of additional equity and/or debt financing
▪ Identification of optimal capital structure Dividend MVex-div = D1 ÷ KE KE = [D1 ÷ MVex-div] + g
model
Where Where
(with
1.3) Types of WACC g = Constant growth rate of dividend g = Constant growth rate of dividend
constant
D1 = Dividend of next year D1 = Dividend of next year
▪ Current WACC – It is used for investment appraisal projects which involve growth)
= D0 (1+g) = D0 (1+g)
expansion of existing business operations. D0 = Dividend of recent year D0 = Dividend of recent year
▪ Risk adjusted WACC – It is used for investment appraisal of the projects which KE = Cost of equity MVex-div = Market value per shares
involve diversification into a new industry. (excluding dividend)
▪ Revised WACC – It is used when any investment project is implemented or Dividend Step 1 – Computation of future N/A
when there is change in debt or equity ratio of the company. model dividends
▪ Combined WACC – It is used when two entities are merged and market value of (with Step 2 – Market value is equal to
combined entity is needed. variable present value of future dividends
1.4) Computation of WACC growth) discounted at KE.
Note: Constant growth rate of dividend
Sources of Total Specific Overall cost ▪ Growth rate by using dividend history: g = (Latest dividend ÷ Oldest dividend)1/n – 1
Finance MV cost (%) ▪ Growth rate by Gordon’s growth model: g = b x re
(Rs.) (%) b = retention rate (or) b = (1 – (DPS/EPS)) (or) b = 1 – dividend pay-out ratio
Equity re = return on equity (or) re = (Profit after tax – preference dividend)/Book value of Equity
Ordinary shares MV per share x No. of shares Ve Ke Ke x Ve/MV
Methods Cost of equity (KE)
Preference shares MV per share x No. of shares Vp Kp Kp x Vp/MV
CAPM Current KE = RF + βe (RM – RF)
Long term debt βe = Current equity beta of the company (used for expansion project)
Bank loan Market value = Book value Vd Kd1 - T Kd x Vd/MV Arbitrage Current KE = RF + β1(R1 – RF) + β2(R2 – RF) + β3(R3 – RF) + …
Irredeemable debt MV per debt x No. of debts Vd Kd1 – T Kd x Vd/MV pricing β1 = Beta or systematic risk of first macroeconomic factor
Redeemable debt MV per debt x No. of debts Vd Kd1 – T Kd x Vd/MV theory
β2 = Beta or systematic risk of second macroeconomic factor
Convertible debt MV per debt x No. of debts Vd Kd1 – T Kd x Vd/MV β3 = Beta or systematic risk of third macroeconomic factor
MV WACC = x (R1,2,3 – RF) = the risk premium associated to each macroeconomic factor
➢ Ve = Total market value of ordinary shares/equity ratio, Ke =s Cost of equity MM Current KE = Current KEU + (KEU – KD) VD/VE (1 – T)
➢ Vp = Total market value of preference shares/preference shares ratio, Proposition VD/VE = Debt equity ratio of investing company (in terms of MV)
➢ Kp = Cost of preference shares II KEU = Ungeared cost of equity of investing company
➢ Vd = Total market value of debt/debt ratio, Kd1 – T = Cost of debt after tax
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2) ORDINARY SHARES (CONTD.) 2) ORDINARY SHARES (CONTD.)
2.2) Risk adjusted cost of equity (KE) (I) Revised KE of after implementation of expansion project with change in D/E
ratio
Risk adjusted cost of equity for ordinary shares is used when company is planning to − Step 1: Compute current βa of company by ungearing at current D/E ratio
diversify into new industry and can be computed by using either: − Step 2: Re-gear current βa at post investment revised D/E ratio of the company.
▪ Capital asset pricing model; or − Step 3: Compute revised KE by using CAPM
▪ Modigliani & Miller Proposition II
(II) Revised KE after implementation of diversification project
(I) Risk adjusted KE by using CAPM
Without change in D/E ratio
Steps Description Formula
(i) Un-gear βe of βa = βe of proxy Co. x [VE ÷ (VE + VD (1 – T))] − Step 1: Compute βa of existing (old) operations of the company and new industry
proxy at their D/E at their respective D/E ratios.
where − Step 2: Compute overall asset beta of the company by taking weighted average of
ratio VD, VE & T = D/E ratio and tax of proxy company current asset beta and asset beta of new industry by using market value of equity as
βe = Equity beta of proxy company weights.
βa = Asset beta of proxy company=? Total Market Asset Overall asset beta
(ii) Re-gear βa of βa = Adjusted βe x [VE ÷ (VE + VD (1 – T))] value of Beta
proxy company at where equity
D/E ratio of VD, & VE = D/E ratio of investing company Old industry 1st Ve Old βa Current βa x 1st Ve/Total Ve = x
investing Co. T = Tax rate of investing company New industry 2nd Ve New βa New βa x 2nd Ve/Total Ve = x
Adjusted βe = Risk adjusted equity beta for new project=? Total Ve Overall βa = x
(iii) Put adjusted βe Risk adjusted KE = RF + Risk adjusted βe (RM – RF) − Step 4: Re-gear overall βa of the company at D/E ratio of the company.
into CAPM − Step 3: Compute revised KE by using CAPM
(II) Risk adjusted KE by using MM Proposition II Change in D/E ratio
Steps Description Formula − Step 1: Compute βa of existing (old) operations of the company and new industry
(i) Un-gear KE of KE = Proxy KEU + (KEU – KD) VD/VE (1 – T) at current D/E ratios.
proxy at their Where − Step 2: Compute overall asset beta of the company by taking weighted average of
D/E ratio to VD & VE = D/E ratio of proxy company current asset beta and asset beta of new industry by using market value of equity as
find KEU KD = Pre-tax cost of debt (OR) Risk free rate weights.
T = Tax rate of proxy company Total Market Asset Overall asset beta
KEU = Ungeared cost of equity of proxy Co.=? value of Beta
(ii) Re-gear KEU of Adjusted KE = Proxy KEU + (KEU – KD) VD/VE (1 – T) equity
proxy company Old industry 1st Ve Old βa Current βa x 1st Ve/Total Ve = x
Where nd
at D/E ratio of New industry 2 Ve New βa New βa x 2nd Ve/Total Ve = x
VD & VE = D/E ratio of investing company
investing Co. Total Ve Overall βa = x
KD = Pre-tax cost of debt (OR) Risk free rate
T = Tax rate of investing company − Step 4: Re-gear overall βa of the company at revised D/E ratio of the company.
− Step 3: Compute revised KE by using CAPM
KEU = Ungeared cost of equity of proxy Co.
Adjusted KE = Risk adjusted cost of equity=? (III) Revised KE after change in D/E ratio without new investment
− Step 1: Compute βa of the company by ungearing at present D/E ratio.
2.3) Revised cost of equity (KE)
− Step 2: Re-gear βa of the company at revised D/E ratio.
Revised cost of equity for ordinary shares is used when company has: − Step 3: Computed revised KE by using CAPM
▪ Implemented an expansion project with change in D/E ratio; or
▪ Implemented a diversification project without and with change in D/E ratio; or
▪ Just change in D/E ratio without any new investment project
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2) ORDINARY SHARES (CONTD.) 4. COST OF DEBT (AFTER TAX)
Cost of debt after tax can be computed by using the:
2.4) Combined cost of equity (KE) of merged entity ▪ Type of debts
Combined cost of equity for combined entity can be computed under the following ▪ Capital asset pricing model
situations: ▪ Credit spread
▪ Merger with a company in same industry but change in D/E ratio of merged 4.1) Post-tax Cost of debt (KD) by using Types of debts
entity ▪ Debts can be classified into short term and long-term debts.
▪ Merger with a company in different industry ▪ Long term debts may include debentures and bank loans.
➢ Without change in D/E ratio ▪ Debentures may include:
➢ With change in D/E ratio
➢ Irredeemable debentures
(I) Combined KE for merger in same industry but change in D/E ratio ➢ Redeemable debentures
− Step 1: Use current asset beta of acquiring company ➢ Convertible debentures
− Step 2: Re-gear current asset beta at post acquisition D/E ratio of combined Non-traded debts or floating rate debts
entity
− Step 3: Compute cost of equity for merged entity by using CAPM Type Market value per share Cost of bank loan (after tax)
Bank Loan N/A KD (1 – T) = Interest rate (1 – T)
(II) Combined KE for merger in different industry
Where
Without change in D/E ratio T = Tax rate
− Step 1: Un-gear equity beta of acquiring and target company at their pre- Traded debts or Debentures (Bonds) or fixed rate debts
acquisition D/E ratio
− Step 2: Compute overall βa of combined entity by using weighted average of Type Market value per share Cost of bank loan (after tax)
individual assets betas and market value of equity. Perpetual MVex-int = I ÷ KD KD (1 – T) = I (1 – T) ÷ MVex-int
− Step 2: Re-gear overall asset beta of merged entity at D/E ratio of acquiring firm bonds Where T = Tax rate
(Irredeemable I = Amount of interest I = Amount of interest = Rs. 100 x coupon
− Step 3: Compute cost of equity for merged entity by using CAPM
bonds) KD = Debt investors’ rate
With change in D/E ratio
required rate of return MVex-int = Market value per bond
− Step 1: Un-gear equity beta of acquiring and target company at their pre- (excluding interest)
acquisition D/E ratios. Redeemable MV of debenture KD (1 – T) = IRR of cash flows (after tax)
− Step 2: Compute overall βa of combined entity by using weighted average of bonds = PV of interest at pre- Year Description CF PV PV
individual assets betas and market value of equity. tax KD + PV of 0 (MV of bond) (x) (x) (x)
− Step 2: Re-gear overall asset beta of merged entity at post-acquisition D/E ratio redemption value at pre- 1–n Interest (1 – T) x x x
of merged entity. tax KD n Redemption x x x
− Step 3: Compute cost of equity for merged entity by using CAPM value
3. PREFERENCE SHARES +v -ve
IRR = L + NPVL x (H – L)
Cost of preference shares can be computed by using dividend valuation model NPVL – NPVH
(without growth). Convertible MV of debenture KD (1 – T) = IRR of cash flows (after tax)
bonds = PV of interest at pre- Year Description CF PV PV
Methods Market value per share Current cost of equity (KE) tax KD + PV of 0 (MV of bond) (x) (x) (x)
Dividend MVex-div = D ÷ KP KP = D ÷ MVex-div redemption value or 1–n Interest (1 – T) x x x
model Where conversion value n Redemption/ x x x
(without Where D = Preference dividend per share
D = Preference dividend per share = (whichever is higher) Conversion
growth) MVex-div = Market value per shares discounted at pre-tax KD +v -ve
Par value x Dividend rate (%) (excluding dividend) = MV cum-div – IRR = L + NPVL x (H – L)
KP = Cost of preference shares recent dividend per share NPVL – NPVH
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5. MODIGILANI & MILLER CAPITAL STRUCTURE THEORIES
4.2) Post-tax Cost of debt (KD) by using CAPM
5.1) MM Theory (without corporate tax)
▪ Pre-tax cost of debt or gross yield can be computed by using debt beta and
CAPM equation. MM Theory without corporate tax has following propositions:
KD = RF + βd (RM – RF) Formula Description
▪ Post-tax cost of debt by using CAPM can be computed as: Market value of geared company will be equal to
KD (1 – T) = [RF + βd (RM – RF)] (1 – T) MVG = MVUG market value of ungeared company
βd = Debt beta indicates the risk of debt investors. WACC of geared company will be similar to
WACCG = WACCUG WACC of ungeared company
Cost of equity for geared company will be higher
4.3) Post-tax Cost of debt (KD) by using Credit Spread KE = KEU + (KEU – KD) VD than cost of equity of ungeared company due to
Definition of credit risk VE higher financial risk faced by shareholders.
▪ Credit risk is the risk borne by a debt investor for default of company on interest
payments and/or repayments of principal at the due date. 5.2) MM Theory (with corporate tax)
▪ Credit agencies (e.g. Standard and Poor’s) can help in assessing such a risk. Such
agencies produce scales showing risks of default. MM Theory with corporate tax has following propositions:
Formula
▪ Debt investor will require premium over and above the risk-free rate of interest to Market value of geared company will be
compensate credit risk (known as the credit spread or Default risk premium). MVG = MVUG +VD x T higher than the market value of similar
Computation of cost of debt by using credit risk ungeared company.
▪ Yield on corporate bond = Yield on T-Bills + Credit spread WACC of geared company will be lower
WACCG = WACCUG x 1 – VD x T
▪ Cost of debt on bonds = [Yield on T-bills + Credit Spread] (1 – T) VE + VD than the WACC of similar ungeared
company.
Note: Credit spread is determined on the basis of loan duration and credit rating of the KE = KEU + (KEU – KD) VD (1 – T) Cost of geared company will be higher than
company. VE the cost of equity for similar ungeared
company.
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ADJUSTED PRESENT VALUE (APV)
EXAM STANDARD LAYOUT
Base Case Net Present Value of Project Years
0 (Rs. ) 1 (Rs. ) 2 (Rs. ) 3 (Rs. ) 4 (Rs. ) 5 (Rs. )
Inflated Sales Revenue x x x x
Less: Inflated variable Cost (x) (x) (x) (x)
Less: Inflated incremental Fixed Cost (x) (x) (x) (x)
Less: Tax allowable Depreciation & tax loss or tax gain on disposal (w-i) (x) (x) (x) (x)
Add/Less: Tax gain or loss on disposal of non-current assets x/(x)
= Profit before tax x x x x
Less: Taxation payment (x) (x) (x) (x)
Add back: Tax allowable Depreciation x x x x
Less/Add: Reversal of tax loss or gain (x)/x
Initial Investment in non-current asset (x)
Scrap Value/Residual value x
Working Capital Changes (w-ii) (x) (x) (x) (x) x
= Net Cash Flows (also known as Free Cash Flows of project) (x) x x x x (x)
Present value factor at KeU (w-iii) x x x x x x
Present Value (x) x x x x (x)
Rs.
Base case NPV x/(x)
Adjustment of financing effects
i. P.V of issue costs (after tax saving) (w – iv) (x)
ii. P.V. of tax saving on interest payment of every debt (w - v)
Normal Debt x
Cheap Debt x
Spare Debt x x
iii. P.V of interest saved (after tax saving lost) due to cheap debt (w - vi) x
Adjusted Present Value (APV) x/(x)
Decision
▪ In case of +ve APV ⟾ Accept the project
▪ In case of –ve APV ⟾ Reject the project
Exam Note: First 2 workings will be similar to the topic of NPV.
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(W- III) Ungeared cost of Equity (assuming 100% Equity financed) (W- V) P.V of Tax Saving on interest Payment of every Debt
Base case NPV will be calculated at ungeared Ke which can be calculated using:
Situation 1: If no repayment of Loan during project Life
CAPM (When information of beta is given in question)
KeU = RF + βA (RM – RF) Debts PV of tax saving on interest payment Rs.
Where RF = Risk free rate (Treasury Bill rate) RM = Average market rate of Normal Gross amount of loan x normal interest rate p.a. x Tax rate x Annuity Factor x
return debt x 1 Year discount factor (if tax in arrear)
ΒA = Asset beta of target industry (If diversification project) (OR) Current asset beta of Cheap Gross amount of loan x Subsidized interest rate p.a. x Tax rate x Annuity x
company (If expansion project) debt Factor x 1 Year discount factor (if tax in arrear)
Spare Spare Debt amount x normal interest rate p.a. x Tax rate x Annuity Factor x x
MM Proposition II (When beta is not given but geared cost of equity is given) debt 1 Year discount factor (if tax in arrear)
KeG = KeU + (1 – T ) (KeU –Kd)Vd
Ve Note: Annuity Factor and P.V Factor can be taken at RF or Normal borrowing rate (interest rate).
where Situation 2: If repayment of Loan during project Life
KeG = Geared cost of equity T = Tax rate i. Calculate amount of equal annual installment for repayment (inclusive of interest)
Kd = Debt is risk free so here risk free rate will be used as pre-tax cost of debt. Equal annual installment = Gross amount of loan
Vd = Market value of debt (OR) Debt Ratio Annuity Factor at interest rate & project life
Ve = Market Value of equity (OR) Equity Ratio ii. Prepare loan amortization schedule to calculate annual amount of interest
(W- IV) P.V of Issue Cost of Equity and Debt (after tax saving) Year Opening Annual Breakup of Installment Closing
Balance Installment Interest Principal Balance
Sources Net Amount Issue cost Issue Cost Gross
(Rs.) Rate (Rs.) Amount (Rs.) 1
Equity x 5/95 or 5/100 x x 2
Normal Debt x 2/98 or 2/100 x x 3
Cheap Debt x 3/97 or 3/100 x x 4
x x x iii. Calculate P.V of tax saving on interest payment
Less: PV of tax saving on issue cost 1 2 3 4 5
(Issue cost x Tax Rate x Discount Factor RF) (x) Amount of Interest x x x X
= Present value of issue cost (after tax saving) x x : Tax Rate (arrear tax) -- x x X x
Notes: = Annual tax savings on interest x x X X
(i) If issue cost is given as: x : P.V Factor at RF or Interest rate x x X x
• % of gross amount then issue cost rate would be 5/95 , 2/98 and 3/97 P.V of Tax saving x x X x
• % of net amount then issue cost rate would be 5/100, 2/100 and 3/100
(ii) Tax saving on issue cost is taken when specific in question as “issue cost is tax (W- VI) P.V of Annual interest Saving (after tax saving lost) due to Cheap Debt
allowable expense”. Rs.
(iii) Present value of tax saving on issue cost is taken as follows:
PV of annual interest Saving
Date at Tax payment Present value (Gross amount of cheap debt x Annual Interest Rate Saving. x Annuity Factor) x
T0 Less: PV of Tax Saving lost due to interest saving
Same year PV of tax saving is discounted at RF or normal (PV of annual interest saving x Tax Rate x 1 Year Discount Factor – If tax in arrear) (x)
First Day
borrowing rate for year 1.
of tax = PV of annual interest saving (after tax saving forgone) X
1 year in arrears PV of tax saving is discounted at RF or normal
year
borrowing rate for year 2.
Last Day Same year PV of tax saving is not discounted.
of tax 1 year in arrears PV of tax saving is discounted at RF or normal
year borrowing rate for year 1.
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INVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT
1. RISK & RETURN OF SINGLE INVESTMENT 2. RISK & RETURN OF 2 ASSETS PORTFOLIO
1.1) Investments & Sources of Return 2.1) Portfolio Theory Basics
Any investor can make investment in the following opportunities to return from 2 sources:  Portfolio is the collection or 2 or more different investments.
Sr. Type of investment Sources of Return  Portfolio is preferable over single investment because it reduces (diversify) risk
of investors.
No.
 Risk of Portfolio is measured through variance and standard deviation.
(i) Investment in shares Regular dividend income Increase in MV of shares
 Portfolio risk depends upon:
(ii) Investment in bonds Regular interest income Increase in MV of bonds
(i) Portfolio weight
(iii) Investment in property Regular rental income Increase in MV of
(ii) Covariance or Correlation between two individual assets in a portfolio
property
(iii) Risk of individual investment in a Portfolio
(iv) Investment in units Regular dividend income Increase in NAV of units
offered by mutual 2.2) Portfolio Weight
funds Portfolio weight indicates the ratio of individual investment in total market value of
(v) Investment in banks Regular interest income N/A investment portfolio. For example, An investor plans to make total investment of
(vi) Investment in T-Bills N/A Increase in MV of T-Bill Rs. 500,000 in a portfolio which consists of Rs. 300,000 in shares of A Co. and Rs.
200,000 in shares of B Co. So weight of investment in Shares of A Co. would be
0.60 or 60% [Rs. 300,000 ÷ Rs. 500,000]. So its formula is:
1.2) Measurement of Investment’s Rate of Return (%)
Weight of individual investment = Market value of individual investment
Rate of Return (%) = [Regular income +/- Capital gain or loss] ÷ Market value at the start of period
Total Market value of portfolio
1.3) Measurement of Expected Rate of Return (Average rate) for individual investment 2.3) Expected Rate of Return (Average rate) of 2 Assets Portfolio
It is the weighted average for rate of returns under different economic conditions. It is the weighted average for individual investments’ expected rate of returns. For
Economic Probability Rate of Return (%) Expected Rate of Return (%) example, investment in Share of A Co. & B Co. has expected rate of return of 10%
Condition (2) (3) (Col. 4 = 2 x 3) and 8% respectively with weight of investment in company A is 0.60. So overall
(1) expected rate of return for portfolio would be 9.2%.
Good 0.30 20 0.30 x 20 = 6 Expected portfolio rate of return = Weight A x Expected Return A + Weight B x Expected Return B
OK 0.50 10 0.50 x 10 = 5 Expected portfolio rate of return = (0.60 x 9) + (0.40 x 8) = 9.2%
Poor 0.20 (10) 0.20 x (10) =(2)
2.4) Covariance in 2 assets of a portfolio
Expected Return = 9%
Covariance is the crude form of relationship between returns of two assets in an
1.4) Definition of Risk investment portfolio. It indicates the positive or negative relationship between
 Risk refers to the fluctuations in regular income of investment. returns of 2 assets but strength of that relationship can’t be determined.
 For example dividend income of shareholders fluctuates due to variation in annual Covariance = Sum of [(Return A - Expected Return A )(Return B - Expected Return B) x Probability]
profits of company.
Econ. Prob. Rate of Return Covariance (%)
1.5) Measurement of Risk for individual investment (Single asset) Sum of [(Return A - Expected Return A ) (Return B -
(1) (2) (%)
Risk (fluctuations in regular income) of individual investment is measured through variance A Co. B Co. Expected Return B) x Probability]
& standard deviation of expected returns. Good 0.30 20 25 = (20 – 9)(25 – 11) x 0.30 = 46.20
Economic Probability Rate of Return Variance OK 0.50 10 13 = (10 – 9)(13 – 11 ) x 0.50 = 1.00
Condition (2) (%) (3) = Sum of [Return – Expected Return]2 x Prob. Poor 0.20 (10) (15) = (– 10 – 9)( – 15 – 11) x 0.20 = 98.80
(1) Expected Return 9% 11% Covariance (Cov. A & B) = 146
Good 0.30 20 = [20 – 9]2 x 0.30 = 36.30 2.5) Correlation between 2 investments of a portfolio
OK 0.50 10 = [10 – 9]2 x 0.50 = 0.50 Correlation is a standardised form to indicate relationship between returns of 2
Poor 0.20 (10) = [(10) – 9]2 x 0.20 = 72.2 assets in a portfolio. It also indicates strength of relationship in addition to direction
Average = 9% Variance (σ2 ) = 109 of relation. Its answer can range from +1 to -1. For example investment A and B
Risk = Standard deviation (σ) = 109 = can be written as:
10.44% Correlation ( ρ) = Covariance between 2 investments in a Portfolio
Note: Standard deviation can’t be computed directly so first we have to calculate variance and then take Standard deviation of A x Standard deviation of B
square root of variance to convert into standard deviation.
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2.6) Risk of 2 Assets’ Portfolio
Risk of portfolio depends upon weights; standard deviation of each investment and
4. DECISION MAKING BY USING PORTFOLIO THEORY
Under portfolio theory, investment decisions can be undertaken by using:
covariance (or Correlation) between 2 assets in portfolio. It is weighted average of variance
and standard deviation of individual investments with respect to their covariance and (i) Comparison Risk and Return characteristics
(ii) Coefficient of variation (CV)
correlation.
(iii) Sharpe Ratio
Risk of Portfolio
4.1) Comparison of Risk & Return Characteristics
If Covariance is given or calculated: Risk and return characteristics of a portfolio can be compared for decision making
Standard Deviation (Risk) = W2Aσ2A + W2σ2B + 2WAWB CovarianceA&B but it is not possible to take decision in all situations.
(OR) For example, an investor has current investment in shares of A company and wants
If Correlation is given: to evaluate which of the following investment portfolios are feasible?
Standard Deviation (Risk) = W2Aσ2A + W2Bσ2B + 2WAWB ρA&B x σA x σ B
Investment Portfolio Portfolio Possible Decision
Where
Portfolio Return Risk
WA = Weight of investment A
(Shares) (%) (%)
WB = Weight of investment B
Current A Co. 15% 5%
σ2A = Variance of investment A
A&B 20% 5% Acceptable because portfolio return increases
σ2B = Variance of investment B
due to new investment at same level of risk
σA = Standard deviation (Risk) of individual investment A
A & C Co. 15% 3.5% Acceptable because portfolio risk reduces due
σB = Standard deviation (Risk) of individual investment B
to new investment at same level of return.
ρA&B = Correlation between investment A and B
A & D Co. 18% 4% Acceptable because portfolio return increases
3. RISK & RETURN OF 3 ASSETS PORTFOLIO due to new investment and risk diminishes.
A & E Co. 15% 7% Rejected because portfolio risk increases due
3.1) Expected Rate of Return (Average rate) of 3 Assets Portfolio
to new investment at same level of return.
It is the weighted average for 3 individual investments’ expected rate of returns.
A & F Co. 13% 5% Rejected because portfolio return decreases
Expected portfolio rate of return of 3 investment’s portfolio due to new investment at same level of risk.
= Weight A x Expected Return A + Weight B x Expected Return B + Weight C x Expected Return C A & G Co. 12% 8% Rejected because portfolio risk increases due
to new investment with decrease in return.
3.2) Risk of 3 Assets Portfolio
A & H Co. 18% 9% Unable to decide because risk and return
If Covariance is given or calculated: both are increased due to new investment.
A & I Co. 13% 3.5% Unable to decide because risk and return
SD (Risk) = W2Aσ2A +W2Bσ2B +W2Cσ2C +2WAWBCov.A&B +2WAWBCov.A&B both are reduced due to new investment.
+2WAWBCov.A&B
4.2) Coefficient of Variation (CV)
If Correlation is given:  Coefficient of variation is the ratio of risk taken against earning one unit of expected
Risk of Portfolio % return. It can be known as risk/return ratio. It is normally used when risk and return
W2Aσ2A x of portfolio increases or decreases simultaneously due to new investment and we are
+W2Bσ2B x unable to decide.
 Lower Coefficient of variation (CV) is acceptable for investment portfolio.
+W2Cσ2C x
x Coefficient of variation (CV) = Risk of Portfolio
+2WAWB ρA&B x σA x σ B
Expected Return of Portfolio
+2WAWC ρA&C x σA x σ C x
 By using the above table
+2WB WC ρB& C x σB x σ C x  Current investment portfolio of A Co. has CV of 0.33 (5% ÷ 15%).
= Variance (σ 2) x  A Co. & H Co. portfolio has CV of 0.50 (9% ÷ 18%) which is not acceptable
because risk level is increased as compared to return.
Risk (Standard Deviation) Variance  A Co. and I Co. portfolio has CV of 0.27 (3.5% ÷ 13%) which is acceptable
because risk level is reduced as compared to return.
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4.3) Sharpe Ratio 5.2) Concept of Beta
 Sharpe ratio measures the excess return available from investment portfolio as compared to  Beta measures the systematic risk of investment in relation to systematic risk of
one unit of risk taken. It is also known as reward to variability ratio. market portfolio as a whole.
 Excess return means expected return of investment portfolio over and above risk free rate of Beta of market portfolio is 1.0.
return  Beta of investment can be interpreted as follows:
 Higher Sharpe Ratio is better for investment portfolio. Beta Direction Interpretation
Sharpe Ratio = Expected Return of Portfolio – Risk free Rate 2.0 Investment is twice as responsive as the
Standard deviation (Risk) of Portfolio market.
Move in same
 For example, assuming risk free rate of 2% then Sharpe ratio of investment portfolios would 1.0 Investment is same as responsive as the
direction as market
be: market.
Investment Portfolio Portfolio Sharpe Ratio 0.5 Investment is one half as responsive as the
Portfolio Return Risk market
(Shares) (%) (%) 0 Investment is unaffected by market
Current A Co. 15% 5% =(15% - 2%) ÷ 5% = 2.6 movements.
A & H Co. 18% 9% =(18% - 2%) ÷ 9% = 1.78 -0.5 Investment is one half as responsive as the
A . & I Co. 13% 3.5% =(13% - 2%) ÷ 3.5% = 3.14 market.
Note: In portfolio theory, coefficient of variation is normally used for decision making. Sharpe ratio is used -1.0 Move in opposite Investment is same as responsive as the
for decision making when examiner clearly requires. direction as market market
-2.0 Investment is twice as responsive as the
5. RISK UNDER CAPM market.
5.1) Systematic and Unsystematic Risk 5.3) Beta of individual investment
According to portfolio theory, risk can be reduced (diversified) by making investment in Beta of individual investment can be measured with the help of
portfolio but according to CAPM some risk can’t be eliminated by well diversified portfolio  Covariance of investment with market and variance of market or
so total risk is divided into two types of risks:  Correlation of investment with market and standard deviations.
Types Description Examples If Covariance is given or already calculated:
Unsystematic Risk associated with individual  Risk due to damage of cotton Beta = Covariance of individual investment with market
Risk company or industry and can be crop. Variance of market
eliminated by portfolio. It is also  Risk due to imposition of (OR)
known as: extra tax on banking industry. If Correlation is given:
 Diversifiable Risk  Strike of workers in one
 Unique Risk factory. Beta = Correlation of particular investment with market x Standard deviation of particular
 Specific Risk investment
Risk associated with economic and  Risk due to fluctuations of foreign Standard deviation of market
Systematic
Risk financial system, faced by market as exchange rate. 5.4) Portfolio Beta
a whole and can’t be eliminated by  Risk due to rapid increase in Beta of portfolio is determined on the basis of beta of individual investments and
portfolio. inflation rate. their weight on the basis of market values. For example, one portfolio has three
 Risk due to increase in overall investments. Investment in A company amounting Rs. 300,000 has beta of 1.2,
It is also known as: investment of Rs. 200,000 in B Company has beta of 2.5 and investment of Rs.
 Non-diversifiable Risk taxation rate of all persons.
500,000 in C Company has beta of 0.75.
 Market Risk So beta of portfolio would be:
 In a well-diversified portfolio, the unsystematic risk is therefore zero. Investors should
therefore not require any additional return to compensate them for unsystematic risk. Beta of investment portfolio
 The only risk for which investors should want a higher return is systematic risk. This is the = Weight A x Beta A + Weight B x Beta B + Weight C x Beta C
risk that the market as a whole will perform worse or better than expected. = (300÷ 1000) x 1.2 + (200÷ 1000) x 2.5+ (500÷ 1000) x 0.75 = 1.235
 Systematic risk of investment is measured through beta coefficient.
33
6. DECISION MAKING BY USING CAPM
Under CAPM theory, investment decisions can be undertaken by using:
(i) Alpha value (Abnormal return) – Most important 6.3) Under-valued or over-valued Shares
(ii) Tryenor’s Ratio  Under-valued shares actually trade in stock market at less than equilibrium price
(iii) Under-valued or over-valued shares (CAPM price) and over-valued shares actually trade in stock market at more than
equilibrium price (CAPM price).
6.1) Abnormal Returns (α value)
 Equilibrium price (CAPM price) of shares can be determined by taking:
 When any investment portfolio has expected rate of return (from regular income and  PV of future dividend discounted at Ke (Dividend valuation model)
increase in market values) more than investors required rate of return then excess return in  PV of future free cash flows to equity discounted at Ke (FCFE model)
known as abnormal return and also known as alpha (α) value.  Shareholders’ required rate of return (Ke) is determined by using CAPM.
 Required rate of return is determined on the basis of CAPM equation  Decision Making Table
 Alpha value can be positive or negative. So all investments with positive alpha values are Situation Value Recommendation
acceptable and known as outperformance of portfolio. If two investment portfolios have
I have Actual market price < CAPM Under Hold the shares
positive alpha values then higher will be better.
shares price
Actual market price > CAPM Over Sell the shares
6.2) Treynor’s Ratio
price
 Treynor’s ratio also measures the excess return available from investment portfolio as
compared to one unit of risk taken. It is also known as reward to variability ratio. I want to Actual market price < CAPM Under Buy the shares
 It is similar to sharpe ratio but risk is measured through beta (not standard deviation). buy price
 Higher ratio would be better for investment portfolio. shares Actual market price > CAPM Over Don’t buy the shares
price
Treynor’s Ratio = Expected Return of Portfolio – Risk free Rate
Beta (Systematic Risk) of Portfolio
Note: It is used in question when examiner clearly requires otherwise alpha value is normally used for
decision making under CAPM.
34
BUSINESS VALUATION (SUMMARY SHEET)
1. VALUATION OF DEBT
Sr. No. Type of Debt Formula

1. Irredeemable Debt Market value of irredeemable debentures
= Amount of interest
Pre- tax Kd
Where
Amount of interest = Nominal value x Annual Coupon Rate
2. Preference Shares Amount of Preference Dividend

Preference Shareholders’ Required rate of return (Kp)
Where
Amount of Preference Dividend = Nominal value x Rate of Preference dividend
3. Redeemable Debt Market Value of Redeemable Debt = Present value of future cash Flows at debt investors’ required rate of return
Years Description Cash Flows DF at Pre-tax Kd Present Value
1–n Annual Interest X X X
(Nominal Value x Coupon Rate)
n Redemption Value X X X
Market Value X
4. Convertible Debt Market Value of Redeemable Debt = Present value of future cash Flows at investors’ required rate of return
Years Description Cash Flows DF at Pre-tax Present Value
Kd
1–n Annual Interest X X X
(Nominal Value x Coupon Rate)
n Higher of Redemption or Conversion Value X X X
Market Value X
Conversion Value = [Current Share price x (1+ share price growth rate)n ] x No. of Shares received against each debenture
Exam Notes:
▪ Pre- tax Kd is also known as Gross Redemption Yield (GRY) or Yield to Maturity (YTM).
▪ If pre-tax Kd of any debenture is not given then pre – tax Kd of similar risk class bond will be used or can be calculated from data if similar risk class bond.
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2 - VALUATION OF EQUITY - MARKET BASED /INCOME BASED MODELS
SR. METHOD FORMULA
NO.
1. Market Capitalisation Total Market Value of ordinary Shares
Method = No. of shares x Current market price per share from stock exchange
2. P/E Ratio Method Total Market Value of ordinary Shares

= Earnings (Profit after tax) of Target Co x Suitable P/E ratio
(OR)
Market Value per share
= EPS x Suitable P/E ratio
where
▪ Suitable P/E ratio means P/E ratio of similar quoted company or average P/E ratio of industry.
▪ It is generally used for valuation of equity of non-listed company.
▪ P/E ratio can be scaled down by specific percentage (say 10%) due to non-listed company status, risk level, level of managerial skills.
▪ Current Profit after tax or Expected profit after tax after 1 year can be used for valuation.
3. Earning Yield Method Total Market Value of ordinary Shares
= Earnings (Profit after tax) of Target Co
Suitable Earning Yield ratio
(OR)
Market Value per share
= EPS
Suitable Earning Yield rate
where
▪ Suitable Earning Yield rate means Earning Yield of similar quoted company or industry average Earning Yield rate.
▪ It is a reverse method of P/E ratio method so it is not so popular method but it is also used for valuation of equity of non-listed company.
4. Earning growth Model Total Market Value of ordinary Shares
= E0 (1 + g)
WACC - g
Where
E0 = Recent yearend earnings or profit after tax.
5. Dividend yield Total Market value of ordinary Shares
Method = Total Dividend of Target Co
Suitable Dividend Yield ratio
where
▪ Suitable Dividend Yield ratio means dividend yield of similar quoted company or industry average dividend yield rate.
▪ This method is used to value small shareholdings where shareholders are only interested to receive income stream.
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3- VALUATION OF EQUITY - DIVIDEND VALUATION MODELS
1. Dividend Valuation Model Without growth 3. Dividend Valuation Model With variable growth (Multi – stage dividend model)
Value of Equity = Present value of future dividends and terminal value of dividends discounted
Market Value of ordinary shares = D ÷ Ke
at shareholders’ required rate of return (i.e. cost of equity – Ke)
Where
D= Amount of dividend Market value of Ordinary Shares 1 2 3
Ke= Required rate of return for equity holders of Target Co. by using CAPM Future dividends (Previous dividend x (1 + g)] x x x
Add: Terminal value = [D3 (1 + g) ÷ (Ke – g)] -- -- x
2. Dividend Valuation Model With Constant growth = Total dividends x x x
x: DF @ Ke x x x
Market Value of ordinary Shares = Present value x x x
= D0 (1 +g)
Ke - g Total Present value = Market value of ordinary Shares
(OR) 4. VALUATION OF EQUITY - ASSETS BASED VALUATION MODEL

Market Value of ordinary Shares Rs.
= D1 Value of assets
Ke - g Non-current assets x
Where Intangible assets (If reliable estimate is given) x
D1= D0(1+g) = Amount of dividend expected in 1 years’ time Current assets x
Ke= Required rate of return of equity holders of Target Co. by using CAPM Total assets x
g = Constant growth rate by using historical growth or Gordon’s growth Less: Liabilities
Current Liabilities (x)
HISTORICAL GROWTH GORDON’S GROWTH
Non-current Liabilities (x)
g = b x re Value of equity x
1÷n
g= Latest Dividend where:
re = ROE/ROCE Exam Notes:
Earliest Divide d -1 ▪ Non-current assets and current assets can be taken at replacement cost or NRV or book
value by using the following rules:
where: ▪ ROE = PAT /Equity
n = number of times dividend is ▪ ROCE = PBIT/Capital Employed Value of Circumstances to use
changing assets
b = Retained Earnings Ratio (Retention Replacement Replacement cost is used when business is valued on “Going
ratio) cost Concern Basis”.
(OR) Net Net realizable value is used when business is valued on
b = 1 – Dividend payout ratio Realizable “Liquidation Basis”.
(OR) value
b = 1 – (DPS ÷ EPS) Book value Book value is used when replacement cost and net realizable
where values are difficult to estimate and are not given in question. A
DPS = Dividend per share book value method estimates the minimum value of business.
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3 - VALUATION OF EQUITY – FREE CASH FLOWS METHODS / DISCOUNTED CASH FLOWS MODELS
1. Free Cash Flows to Equity (FCFE) 2. Free Cash Flows to Firm (FCFF)
Market value of shares = Present value of future free cash flows to equity discounted at Market value of shares = Present value of future free cash flows to firm discounted at
shareholders’ required rate of return (i.e., cost of equity – Ke). WACC minus market value of debts.
Market value of Ordinary Shares 1 2 3 1 2 3

Sales Revenue x x X Sales Revenue x x X
Profit before interest and tax (% of sales) x x X Profit before interest and tax (% of sales) x x X
Less: Interest expense payment (x) (x) (x) Less: Tax payment on PBIT (x) (x) (x)
= Profit before tax x x X Add: Tax depreciation x x X
Less: Tax payment (x) (x) (x) = Net operating cash flows x x X
Add: Tax depreciation x x X Less: Annual CAPEX for replacement of (x) (x) (x)
= Net operating cash flows x x X assets
Less: Annual CAPEX for replacement of (x) (x) (x) Less: Annual CAPEX for addition in assets (x) (x) (x)
assets +/- : Working capital changes
Less: Annual CAPEX for addition in assets (x) (x) (x) Increase in working capital (x) (x) (x)
+/- : Working capital changes Decrease in working capital x x X
Increase in working capital (x) (x) (x) = Free cash flows to firm for each year x x X
Decrease in working capital x x X Add: Terminal value = [FCFF3 (1 + g) ÷ -- -- x
Less: Annual repayment of loans (x) (x) (x) (WACC – g)]
+/- : Any financing cash flows (excluding x/(x) x/(x) x/(x) = Total free cash flows to firm x x x
dividend) x: Discount @ WACC x x x
= Free cash flows to equity for each year x x x = Present value of free cash flows to firm x x x
Add: Terminal value = [FCFE3 (1 + g) ÷ (Ke – -- -- x
g)] Total Present value of FCFF = Total Market value of entire Company
= Total free cash flows to equity x x x
x: Discount @ Ke x x x Total Market Value of ordinary Shares
= Present value of free cash flows to equity x x x = Total Market value of entire Company – Total Market Value of debt
Total Present value of FCFE = Market value of ordinary Shares

Exam Notes:
▪ If WACC is given then Free Cash Flows to firm method will be used.
▪ If Ke is given then Fee Cash Flows to equity method will be used.
▪ If examiner is silent then free cash flows to firm method will be used.
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4 – Value of synergy benefits and maximum price payabke to target Co. 6 – Market value of shares for Combined entity
Market value of shares for combined entity can be determined by using two ways:
Rs. a) Use free cash flows to equity or free cash flows to firm method
Market value of combined company after acquisition b) Conversion of pre-merger market value into market value of combined entity
(Using Free Cash Flows or P/E ratio or other methods) X
Less: Current Market value of Acquiring Co. (x) We are discussing second method to compute market value of combined entity.
= Maximum price payable for Target Company X
Less: Current Market Value of Target Company (x) Market value of combined entity
Synergy benefits/Premium payable to Target Co. X Pre-merger MV of shares for acquiring Company x
Add: Pre-merger MV of shares for target company x
5 - Pre-merger Market value of each company Add: MV of any synergy benefits x
a) PV of annual cost savings
Methods When to use
(OR)
Net asset value
a) method Balance sheet is given with assets and liabilities c) Annual costs saving x PE ratio
PE ratio When industry PE ratio or PE ratio of any company is Add: One-off cash inflow (sale of surplus building or part of entity) x
b) method given Less: One-off cash outflows (Redundancy payments) (x)
Free Cash Growth rate of revenue, costs and annual CAPEX
c) Flows to Firm with cost of capital Add: Tax saving of B/F losses x
Free Cash Growth rate of revenue, costs and annual CAPEX = Market value of shares for merger entity x
d) Flows to equity with cost of equity
Dividend 7 - Evaluation of merger and acquisition for shareholders
valuation Dividend amount and distribution policy of the Step 1: Calculate pre-merger market value of shares for both companies
e) model company Step 2: Calculate post-merger market value of combined entity and market value per share
Step 3: Allocate post-merger market value of combined company into individual companies
Step 4 Calculate percentage gain to the shareholders and accept the M& A if there is positive
gain.
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39
EXCHANGE RATE RISK MANAGEMENT
Exchange rate risk:
Future payment or Future receipt in Foreign currency
Exchange rate risk management techniques

Purpose: To lock the exchange rate
Answer will be expressed in LCY
Minor techniques
1 Invoice in home currency
2 Leading and lagging
3 Matching of receipts and payments
Adjust all transactions of same FCY and same duration
4 Multilateral netting
Step 1: Convert all FCY transactions into one common currency by using mid spot rate
Step 2: Prepare netting table Receiving
Paying Co A Co. B Co C Co. Total payments
A - x x x
B x - x x
C x x - x
Total Receipts x x x
Step 3: Total receipts x x x

Less: Total payment (x) (x) (x)
x x (x)
5 Do nothing - no protective
Buy or Sell FCY from open market at due date of payment or receipt.
Direct Quote (2nd currency to 1st Currency)

LCY per 1 unit of FCY LCY is first currency and FCY is second currency
Indirect Quote (1st currnecy to 2nd currency)
FCY per 1 units of LCY FCY is first currency and LCY is second currency
40
Major Techniques
1) Forward contract - Direct Quote system

2 to 1 Payment in LCY = FCY payment x High forward rate
2 to 1 Receipt in LCY = FCY receipt x Low forward rate
Note: Estimation of forward rate

Forward rate = Current spot rate + Premium
Forward rate = Current spot rate - Discount
Estimation of forward rate by using interest rate parity ( Up to one year)

Forward rate = Spot rate x (1 + interest rate of 1st currency) ÷ (1 + interest rate of 2nd currency)
Note Interest rate should be time apportioned when less than one year is required.
Forward contract - Indirect Quote system

Payment in LCY = FCY payment ÷ Low forward rate
1st to 2nd
Receipt in LCY = FCY Receipts ÷ High Forward rate
1st to 2nd
Note Estimation of forward rate

Forward rate = Current spot rate - Premium
Forward rate = Current spot rate + Discount
Estimation of forward rate by using interest rate parity ( Up to one year)

Forward rate = Spot rate x (1 + interest rate of 1st currency) ÷ (1 + interest rate of 2nd currency)
Interest rate should be time apportioned when less than one year is required.
Note Estimation of forward rate through interpolation under direct and indirect quote system
3 months forward rate (PKR per USD) 174
9 months' forward rate (PKR per USD) 190
Estimation of 5 months forward rate = ?
41
Months Forward rate
3 174
9 190
Change 6 16
Change per month 2.666667 per month
3 months Forward rate 174.00
Add: Extra 2 months
(2 month x 2.6667) 5.33
179.3333
MONEY MARKET HEDGE

FCY payment
Step 1: PV of FCY payment at FCY deposit rate
PV = FCY payment ÷ (1 + (FCY deposit rate x t/12))
Step 2 Conversion of PV of FCY into LCY at spot rate

Direct LCY amount = PV of FCY x High spot rate
(OR)
Indirect LCY amount = PV of FCY ÷ low spot rate
Step 3: Future value in LCY

FV = LCY amount x (1 + ( LCY borrowing rate x t/12))
FCY RECEIPTS
Step 1: PV of FCY receipts at FCY borrowing rate
PV = FCY receipt ÷ (1 + (FCY borrowing rate x t/12))
Step 2 Conversion of PV of FCY into LCY at spot rate

Direct LCY amount = PV of FCY x Low spot rate
(OR)
Indirect LCY amount = PV of FCY ÷ High spot rate
Step 3: Future value in LCY

FV = LCY amount x (1 + ( LCY deposit rate x t/12))
42
FCY CURRENCY OPTIONS
FCY payment
Hedge construction - Today
Step 1
Company will enter into FCY call option contract for march/june/sep/dec expiry at a best exercise price of Rs. PER USD
NOTES Expiry date: Immediately next date to the date of FCY payment
Best exercise price under FCY call option = Lowest total cost (Exercise price + Premium rate)
No of contracts = FCY payment ÷ FCY Contract Size
Premium cost = Premium rate x number of contracts x FCY contract Size (or) FCY payment x premium rate
Step 2: Comparison on date of payment

a) Buy FCY from open market at spot rate of due date LCY
b) Buy FCY under option contract at exercise price LCY
Lower of (a) or (b)
Step 3 Net Outcome: LCY

Buy FCY as per Step 2 cost
Premium cost cost
Finance cost on premium cost
Total cost of payment in LCY cost
FCY receipt
Step 1 Hedge construction - Today
Company will enter into FCY put option contract for march/june/sep/dec expiry at a best exercise price of Rs. PER USD
NOTES Expiry date: Immediately next date to the date of FCY receipt
Best exercise price under FCY put option = Highest total receipt (Exercise price - Premium rate)
No of contracts = FCY receipt ÷ FCY Contract Size
Premium cost = Premium rate x number of contracts x FCY contract Size (or) FCY receipt x premium rate
Step 2: Comparison on date of receipt

a) Sell FCY from open market at spot rate of due date LCY
b) Sell FCY under option contract at exercise price LCY
Higher of (a) or (b)
43
Sell FCY as per Step 2 receipt
Premium cost cost
Net receipt in LCY receipt
LCY CURRENCY OPTIONS

FCY payment
Company will enter into LCY put option contract for march/june/sep/dec expiry at a best exercise price of Rs. PER USD
Best exercise price under LCY put option = Highest of (Exercise price - Premium rate)
No of contracts = (FCY payment ÷ exercise price) ÷ LCY Contract Size
Premium cost in LCY = Premium rate x No of contract x LCY contract size = Premium in FCY ÷ Low spot rate
Step 2: Comparison on date of payment

a) Buy FCY from open market at spot rate of due date LCY
b) Buy FCY under option contract at exercise price LCY
Lower of (a) or (b)

Buy FCY as per Step 2 cost
Premium cost cost
44
FCY receipt
Company will enter into LCY Call option contract for march/june/sep/dec expiry at a best exercise price of Rs. PER USD
Best exercise price under LCY Call option = Lowest total cost (Exercise price + Premium rate)
(No of contracts = FCY receipt ÷ exercise price) ÷ LCY Contract Size
Premium cost = Premium rate x no of contract x LCY contract size = Premium in FCY ÷ Low spot rate
Step 2: Comparison on date of receipt

a) Sell FCY from open market at spot rate of due date LCY
b) Sell FCY under option contract at exercise price LCY
Higher of (a) or (b)

Sell FCY as per Step 2 receipt
Premium cost cost
FCY FUTURES
FCY payment
Company will open the position in future market by BUYING FCY future contracts for march/june/sep/dec expiry at a future price of
Rs. PER USD
No of contracts = FCY payment ÷ FCY Contract Size
Step 2: Close the position

Company will close the position in future market by selling FCY future contracts for march/june/sep/dec expiry at a closing future
price of Rs. PER USD
Company will earn gain or loss from future market.
45
(W1) Closing Future price Now Payment date Expiry date
Futures price x x
Spot rate as per direct or indirect quote (x) (x)
Basis x O/S x 0
O/S basis = Total basis ÷ Total period till expiry x Remaining period from payment date to expiry date
Gain or loss in future market

Selling future price x
Less Buy future price (x)
Gain or loss per contract x
Total gain/ loss = Gain or loss per contract x number of contracts x FCY contract size

Buy FCY from open market at spot rate of due date cost
Gain or loss from future market loss or (gain)
FCY receipt
Step 1
Company will open position in future market by SELLING FCY FUTURE contract for march/june/sep/dec expiry at a future price of
Rs. PER USD
No of contracts = FCY receipt ÷ FCY Contract Size

Company will close the position in future market by BUYING FCY future contracts for march/june/sep/dec expiry at a closing future
price of Rs. PER USD. Company will earn gain or loss from future market.
Futures price x x
Basis x O/S x 0
46
Total gain/ loss = Gain or loss per contract x number of contracts x FCY contract size

Sell FCY in open market at spot rate of due date receipt
Gain or loss from future market gain or (loss)
LCY FUTURES
FCY payment
Step 1
Company will open the position in future market by SELLING LCY future contracts for march/june/sep/dec expiry at a future price
of Rs. PER USD
No of contracts = FCY payment ÷ Future price) ÷ LCY Contract Size

Company will close the position in future market by BUYING LCY future contracts for march/june/sep/dec expiry at a closing future
price of Rs. PER USD. Company will earn gain or loss from futures market.
Futures price x x
Basis x O/S x 0

Total gain in LCY = Gain per contract x number of contracts x LCY contract size = Gain in FCY ÷ High spot rate
Total loss in LCY = Loss per contract x number of contract x LCY contract size = Loss in FCY ÷ Low spot rate
47
Buy FCY from open market at spot rate of due date cost
Gain or loss from future market loss or (gain)
FCY receipt
Company will open position in future market by BUYING LCY FUTURE contract for march/june/sep/dec expiry at a future price of
Rs. PER USD
No of contracts = (FCY receipt ÷ Future price) ÷ LCY Contract Size
Company will close the position in future market by SELLING LCY future contracts for march/june/sep/dec expiry at a closing future
price of Rs. PER USD. Company will earn gain or loss from futures market.
Futures price x x
Basis x O/S x 0

Total gain in LCY = Gain per contract x number of contracts x LCY contract size = Gain in FCY ÷ High spot rate
Total loss in LCY = Loss per contract x number of contract x LCY contract size = Loss in FCY ÷ Low spot rate

Sell FCY in open market at spot rate of due date receipt
Gain or loss from future market gain or (loss)
Step 4 Hedge efficiency

= Gain in spot market ÷ Loss in future market (OR) Gain in future market ÷ Loss in spot market
48
INTEREST RATE RISK MANAGEMENT
INTEREST RATE FRA OF LOAN INTEREST RATE FRA OF INVESTMENT

Interest Rate FRA Interest Rate FRA
2 v 5 FRA at 4% - 6% 2 v 5 FRA at 4% - 6%
Market KIBOR 8% 4% Market KIBOR 3% 5%
Locked KIBOR 6% 6% Locked KIBOR 4% 4%
Compensation receivable (Market KIBOR is more than Compensation receivable (Market KIBOR less than Locked
locked KIBOR) 2% KIBOR) 1%
Compensation payable (Market KIBOR is lower than locked KIBOR) 2% Compensation payable (Market KIBOR more than locked 1%
Net outcome on the date of loan Rs. Rs. Net outcome on the date of investment Rs. Rs.
Actual interest payment at market rate Actual interest income at market rate
(Market KIBOR + Credit Spread = Actual interest rate (Market KIBOR - Credit Spread = Actual interest income rate
p.a. x amount of loan x loan duration/12 x x cost p.a. x amoun of investment x inventsment duration/12 x x income
Compensation (receivable)/compensation payable Compensation receivable/compensation (payable)
(Compensation rate x amount of loan x loan (Compensation rate x amount of investment x investment
duration/12) (x) x duration/12) x (x)
Total interest cost x x Cost Total interest income x x income

Effective interest rate Effective interest rate
(Interest cost after hedging/loan x 100 x 12/loan (Interest income after hedging/Investment x 100 x 12/investment
duration) x% p.a. x% p.a. duration) x% p.a. x% p.a.
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INTEREST RATE GUARANTEE OF LOAN INTEREST RATE GUARANTEE OF INVESTMENT
Interest Rate Guarantee /OTC interest rate option Interest Rate Guarantee /OTC interest rate option
Non-binding agreement to lock interest rate of loan. Premium cost is paid and compensation Non-binding agreement to lock interest rate of investment.
is receivable not payable. Premium cost is paid and compensation is
receivable but not payable.
Market KIBOR 8% 4%
Locked KIBOR 6% 6%
Market KIBOR 3% 5%
Compensation receivable (Market KIBOR is more than
locked KIBOR) 2%
Locked KIBOR 4% 4%
Compensation payable (not applicable) 0%
Compensation receivable (Market KIBOR less than Locked 1%
Net outcome on the date of loan Rs. Rs. Compensation payable (Not applicable) 0%
Actual interest payment at market rate Net outcome on the date of investment Rs. Rs.
(Market KIBOR + Credit Spread = Actual interest rate Actual interest income at market rate
p.a. x amoun of loan x loan duration/12 x x cost (Market KIBOR - Credit Spread = Actual interest income rate
Compensation (receivable) p.a. x amoun of investment x inventsment duration/12 x x income
(Compensation rate x amount of loan x loan Compensation receivable/compensation (payable)
duration/12) (x) -- income (Compensation rate x amount of investment x investment
Premium cost duration/12) x 0
(Premium rate % x amount of loan x loan
duration/12) (x) (x) cost
= Total interest cost x x Cost Total interest
Effective income
interest rate x x income
Effective interest rate (Interest income after hedging/Investment x 100 x 12/investment x% p.a. x% p.a.
(Interest cost after hedging/loan x 100 x 12/loan
duration) x% p.a. x% p.a.
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INTEREST RATE FUTURE OF LOAN INTEREST RATE FUTURE OF INVESTMENT
iii) Short term Interest rate Futures iii) Short term Interest rate Futures
Standardised interest rate forward contract. Standardised interest rate forward contract.
Forward vs futures : Non-standardised but future is standardise contract Forward vs futures : Non-standardised but future is
Step 1) Hedge construction (1st March) Now Step 1) Hedge construction (1st March) Now
Company will open position in future market by SELLING 20 future contract for Company will open position in future market by BUYING 20 future contract for
March/June/Sep/Dec expiry date ( immediately following to the date of loan) at a future price March/June/Sep/Dec expiry date ( immediately following to the date of loan) at a future price of
of 95.00 (according to expiry date). Company will deposit initial margin of Rs. xxxxx. 95.00 (according to expiry date). Company will deposit initial margin of Rs. xxxxx.
Note: No of future contracts = (Amount of loan ÷ Contract Size) x Loan duration ÷ Contract duration)
Note: Expiry date: Immediately next to the date of borrowing
Note: Future price : select as per expiry date
Step 2) Close
Company the position
will close position ininfuture
future market
market by(Date of future
BUY 20 loan) 1st July for
contract Step 2) Close the position in future market (Date of loan)
March/June/Sep./Dec. expiry date at a future price of 93.43. Company will earn gain in future Company will close position in future market by BUY 20 future contract for March/June/Sep./Dec.
market of Rs. Xxxx expiry date at a future price of 93.43. Company will earn gain in future market of Rs. Xxxx
(W1) Closing future price 1-Mar 1st (W1) Closing future price 1-Mar 1st July
Date Date of
Now of loan Now loan
Future price 95 93.43 Future price 95 93.43
Spot rate (100%- Current KIBOR 6%) 94 (100% - 7%) 93 Spot rate (100%- Current KIBOR 6%) 94 (100% - 93
Basis (%) 1 0.43 Basis (%) 1 0.43
Outstanding Basis = (1/7 month x 3 months) = 0.43 Outstanding Basis = (1/7 month x 3 months) = 0.43
Note Silent or basis will move to zero on evenly basis in each month. Note Silent or basis will move to zero on evenly basis in each
(W2) Gain/loss of future (W2) Gain/loss of future

Sell future price 95.00 Sell future price 93.43
Less Buy future price (93.43) Less Buy future price -95
Gain per contract 1.57 % Loss per
(%) contract
x number of contracts x contract size x future contract (1.57) %
Gain (%) x number of contracts x contract size x future contract duration/12 duration/12
Step 3) Net Outcome on date of loan Rs. Rs. Step 3: Net outcome on the date of investment Rs. Rs.
Actual interest payment at market rate Actual interest income at market rate
(Market KIBOR + Credit Spread = Actual interest rate (Market KIBOR - Credit Spread = Actual interest income rate
p.a. x amoun of loan x loan duration/12 x x cost p.a. x amoun of investment x inventsment duration/12 x x income
Gain/loss in future market from step ii x (x) cost/(in Compensation receivable/compensation (payable)
Finance cost of margin (amount x interest rate x loan (Compensation rate x amount of investment x investment
duration/12) - if any x x cost duration/12) x 0
Interest cost x x Total interest income x x income

Effective interest rate
Effective interest rate (Interest cost after hedging/loan (Interest income after hedging/Investment x 100 x 12/investment
x 100 x 12/loan duration) x% p.a. x% p.a. duration) x% p.a. x% p.a.
ABDUL AZEEM
51
OPTIONS ON INTEREST RATE FUTURE OF LOAN OPTIONS ON INTEREST RATE FUTURE ON INVESTMENT
iv) Options on interest rate futures iv) Options on interest rate futures
Step 1) Hedge construction (Today) Step 1) Hedge construction (Today)

Company will enter into 20 put option (sell futues) contracts for Mar./ June /Sep./Dec expiry Company will enter into 20 Call option (Buy futues) contracts for Mar./ June /Sep./Dec expiry
at a best exercise of 95.00. Company will pay premium cost of Rs.xxxxx. at a best exercise of 95.00. Company will pay premium cost of Rs.xxxxx.
Note Best exercise price of put option for June expiry June Note Best exercise price of Call option for June expiry Implied June
premium Implied interest interest premium Total
Exercise price rate cost rate Total cost Exercise price income rate income
94.5 0.271 5.5 5.771 94.5 5.5 0.271 5.229
95 0.52 5 5.52 95 5 0.52 4.48
Note Premium cost Note Premium cost
Premium rate % x number of option contract x contract size x option contract duration/12 Premium rate % x number of option contract x contract size x option contract duration/12
0.52% x 20 contract x Rs. 200,000 x 3 month/12 0.271% x 20 contract x Rs. 200,000 x 3 month/12
Step 2) Close the position in future market (Date of loan) 1st July Step 2) Close the position in future market (Date of loan) 1st July
Company will close position in future market by buying 20 future contract for Company will close position in future market by Selling 20 future contract for
March/June/ Sep. /Dec. expiry date at a future price of 93.43. Company will earn gain in March/June/ Sep. /Dec. expiry date at a future price of 93.43. Company will earn gain in future
future market. market.
Sell future price 95.00 Sell future price 94.50
Less: Buy future price (93.43) Less: Buy future price (93.43)
Gain per contact 1.57 % Gain per contact 1.07 %
Gain (%) per contract x no of contract x contract size x contract duration/12 Gain (%) per contract x no of contract x contract size x contract duration/12
Note: Loss on option then ignore this options and don't close it. Note: Loss on option then ignore this options and don't close it.
Step 3) Net Outcome on date of loan Rs. Rs.

Actual interest payment at market rate Step 3: Net outcome on the date of investment Rs. Rs.
(Market KIBOR + Credit Spread = Actual interest rate
p.a. x amoun of loan x loan duration/12 x x cost Actual interest income at market rate
(Market KIBOR - Credit Spread = Actual interest income rate
Gain from option market from step ii x -- p.a. x amoun of investment x inventsment duration/12 x x income
Finance cost of margin
(amount x interest rate x loan duration/12) - if any x x cost Gain from options on interest rate future
x 0
= Interest cost after hedging x x
Effective interest rate (Interest cost after hedging/loan
x 100 x 12/loan duration) x% p.a. x% p.a. Total interest income x x income
Effective interest rate
(Interest income after hedging/Investment x 100 x 12/investment
duration) x% p.a. x% p.a.
ABDUL AZEEM
52

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Less: Annual incremental fixed costs (other than dep)

Annual fixed overheads (x) (x) (x) (x) (x)

Less: Annual opportunity cost

Annual taxable profit/ (loss) (x) x x x x

Add: Annual tax depreciation x x x x x

Annual cash flows paid at start of each year:

Annual operating cash flows after tax (x) x x x x x

Cars and vehicles (x) x

Existing assets are used for project (x) x

6) MODIFIED INTERNAL RATE OF RETURN (MIRR) Note:

Decision Rule of MIRR

iii) Connecting Line Decision node and probability node will be

Decision making regarding perfect information

ASSETS REPLACEMENT DECISION

(B) OPTIMAL REPLACEMENT CYCLE

Exam Note: First 2 workings will be similar to the topic of NPV.

ABDUL AZEEM – SKANS CA FINAL COMPENDIUM Page 1

ABDUL AZEEM – SKANS CA FINAL COMPENDIUM Page 3

ABDUL AZEEM – SKANS CA FINAL COMPENDIUM Page 4

Sr. No. Type of Debt Formula

2. Preference Shares Amount of Preference Dividend

2. P/E Ratio Method Total Market Value of ordinary Shares

(OR) 4. VALUATION OF EQUITY - ASSETS BASED VALUATION MODEL

Market value of Ordinary Shares 1 2 3 1 2 3

Total Present value of FCFE = Market value of ordinary Shares

Exchange rate risk management techniques

Step 3: Total receipts x x x

Direct Quote (2nd currency to 1st Currency)

1) Forward contract - Direct Quote system

Note: Estimation of forward rate

Estimation of forward rate by using interest rate parity ( Up to one year)

Forward contract - Indirect Quote system

Note Estimation of forward rate

Estimation of forward rate by using interest rate parity ( Up to one year)

Estimation of 5 months forward rate = ?

MONEY MARKET HEDGE

Step 2 Conversion of PV of FCY into LCY at spot rate

Step 3: Future value in LCY

Step 2 Conversion of PV of FCY into LCY at spot rate

Step 3: Future value in LCY

Step 2: Comparison on date of payment

Step 3 Net Outcome: LCY

Step 2: Comparison on date of receipt

LCY CURRENCY OPTIONS

Step 2: Comparison on date of payment

Lower of (a) or (b)

Step 3 Net Outcome: LCY

Step 2: Comparison on date of receipt

Higher of (a) or (b)

Step 3 Net Outcome: LCY

Step 2: Close the position

Gain or loss in future market

Step 3 Net Outcome: LCY

Step 2: Close the position

Step 3 Net Outcome: LCY

Step 2: Close the position

Gain or loss in future market

Gain or loss in future market

Step 3 Net Outcome: LCY

Step 4 Hedge efficiency

INTEREST RATE FRA OF LOAN INTEREST RATE FRA OF INVESTMENT

Total interest cost x x Cost Total interest income x x income