The Cost

of Capital

1
 Learning Goals
• Sources of capital
• Cost of each type of funding
• Calculation of the weighted average cost of capital
(WACC)
• Construction and use of the marginal cost of capital
schedule (MCC)

2
 Factors Affecting the Cost of Capital
• General Economic Conditions
– Affect interest rates
• Market Conditions
– Affect risk premiums
• Operating Decisions
– Affect business risk
• Financial Decisions
– Affect financial risk
• Amount of Financing
– Affect flotation costs and market price of security

3
 Weighted Cost of Capital Model
• Compute the cost of each source of capital
• Determine percentage of each source of
capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital
(WACC)

4
1. Compute Cost of Debt
• Required rate of return for creditors
• Yield to maturity on bonds (kd).
• Since interest payments are tax deductible, the
true cost of the debt is the after tax cost.
• If the company’s tax rate is 40%, the after tax
cost of debt is kd (1-t).

5
 2. Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.

Dividend (Dp)
Required rate kp =

Market Price (PP) - F

 Example: You can issue preferred stock for a net

price of $42 and the preferred stock pays a

$5 dividend.

6
• The cost of preferred stock:

$5.00
kp = = 11.90%
$42.00
 3. Compute Cost of Common
Equity
• Two Types of Common Equity Financing
– Retained Earnings (internal common equity)
– Issuing new shares of common stock (external
common equity)

8
3. Compute Cost of Common Equity
• Cost of Internal Common Equity
– Management should retain earnings only
if they earn as much as stockholder’s
next best investment opportunity of the
same risk.
– Cost of Internal Equity = opportunity
cost of common stockholders’ funds.
– Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
9
3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
kS = + g
P0

Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.

10
3. Compute Cost of Common Equity
• Solution

kS = 3(1+0.10) + .10 =.155 = 15.5%

60

11
3. Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Capital Asset Pricing Model

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

12
3. Compute Cost of Common Equity
• Solution

kS = 5% + 1.2(13% – 5%) = 14.6%

13
3. Compute Cost of Common Equity
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
14
3. Compute Cost of Common Equity
• Solution

kn = 3(1+0.10) + .10 = .1625 = 16.25%

52.80

15
Weighted Average Cost of Capital
XYZ Corporation estimates the following costs for
each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%

XYZ’s tax rate is 40% 16

Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

17
Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that XYZ’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.

18
Weighted Average Cost of Capital

 If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that XYZ’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09% 19
Weighted Average Cost of Capital

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

20
Weighted Average Cost of Capital

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%

21
 Marginal Cost of Capital
• Weighted average cost will change if one component
cost of capital changes.
• This may occur when a firm raises a particularly large
amount of capital such that investors think that the
firm is riskier.
• The WACC of the next dollar of capital raised is called
the marginal cost of capital (MCC).

22
 Contd…
• Assume now that XYZ Corporation has $100,000
in retained earnings with which to finance its
capital budget.
• We can calculate the point at which they will need
to issue new equity since we know that XYZ’s
desired capital structure calls for 50% common
equity.

23
 Contd…

Breakpoint = Available Retained Earnings

Desired capital structure

Breakpoint = ($100,000)/.5 = $200,000

24
 Balance Sheet
Assets Liabilities
Cash 5,000 LT Debt 3,000
Equipment 5,000 Pref. Stock 1,000
Stock 6,000
Tot. Assets 10,000 Tot. Debt & Eq. 10,000

Kd = 10%;
Kp = 8%
Ke = 12%
Tax rate = 40%
Calculate WACC?
Relationship bet. Equity and Asset Betas with
Constant D/V ratio
Relationship bet. Equity and Asset Betas with
Constant Debt
 Country risk premium
• The additional risk associated with investing in an
international company rather than the domestic market. 
• Macroeconomic factors such as political instability,
volatile exchange rates and economic turmoil causes
investors to be wary of overseas investment
opportunities and thus require a premium for investing.
• The country risk premium (CRP) is higher for developing
markets than for developed nations.
 How to estimate CRP?
• Using debt 1
• CAPM:
• Ri = Rf + Bi (Rm – Rf) + Crp
• Crp = {Avg. Bond Yield in Developing country -
Avg. Bond Yield in Developed country}
• Ri = Rf + Bi (Rm – Rf) + (ABYdev_c – ABYd_c)
 Contd...
• Using debt 2
• CAPM:
• Ri = Rf + Bi (Rm – Rf) + Crp
– Crp = {Avg. Bond Yield in Developing country - Avg. Bond
Yield in Developed country} * {Annualized standard
deviation of Equity index / Annualized standard deviation
of Bond index
• Ri = Rf + Bi (Rm – Rf) + (ABYdev_c –
ABYd_c)*(ASD_ei/ASD_bi)
Thank you
FINANCIAL STATEMENT ANALYSIS

32
 1. INTRODUCTION
Financial analysis is a process of selecting, evaluating, and interpreting
financial data, along with other pertinent information, in order to formulate an
assessment of a company’s present and future financial condition and
performance.

Financial
Market Data Disclosures

Economic
Data

Financial Analysis

33
EXAMPLES OF EXTERNAL USES OF
STATEMENT ANALYSIS
• Trade Creditors – Focus on the liquidity of the firm.

• Bondholders – Focus on the long-term cash flow of the firm.

• Shareholders – Focus on the profitability and long-term health of the firm.

34
EXAMPLES OF INTERNAL USES OF STATEMENT
ANALYSIS
• Plan – Focus on assessing the current financial position and evaluating
potential firm opportunities.

• Control – Focus on return on investment for various assets and asset

efficiency.

• Understand – Focus on understanding how suppliers of funds analyze the firm.

35
 2. COMMON-SIZE ANALYSIS
Common-size analysis is the restatement of financial statement information in
a standardized form.
- Horizontal common-size analysis uses the amounts in accounts in a
specified year as the base, and subsequent years’ amounts are stated as a
percentage of the base value.
- Useful when comparing growth of different accounts over time.
- Vertical common-size analysis uses the aggregate value in a financial
statement for a given year as the base, and each account’s amount is
restated as a percentage of the aggregate.
- Balance sheet: Aggregate amount is total assets.
- Income statement: Aggregate amount is revenues or sales.

36
 EXAMPLE: COMMON-SIZE ANALYSIS
Consider the CS Company, which reports the following financial information:
Year 2008 2009 2010 2011 2012 2013
Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

1. Create the vertical common-size analysis for the CS Company’s assets.

2. Create the horizontal common-size analysis for CS Company’s assets, using
2008 as the base year.

37
 EXAMPLE: COMMON-SIZE ANALYSIS
Vertical Common-Size Analysis:
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%

Graphically:
100%
Proportion
of Assets

50%

0%
2008 2009 2010 2011 2012 2013
Fiscal Year

Cash Inventory Accounts receivable

Net plant and equipment Intangibles
38
 EXAMPLE: COMMON-SIZE ANALYSIS
Horizontal Common-Size Analysis (base year is 2008):
Year 2008 2009 2010 2011 2012 2013
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

Graphically:
130%
120%
Percentage

110%
of Base

Amount

100%
Year

90%
2008 2009 2010 2011 2012 2013

Fiscal Year

Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets

39
 3. FINANCIAL RATIO ANALYSIS
• Financial ratio analysis is the use of relationships among financial statement
accounts to gauge the financial condition and performance of a company.
• We can classify ratios based on the type of information the ratio provides:

Liquidity Solvency Profitability

Activity Ratios
Ratios Ratios Ratios

Ability to
Effectiveness
Ability to meet manage
in putting its Ability to
short-term, expenses to
asset satisfy debt
immediate produce
investment to obligations.
obligations. profits from
use.
sales.

40
 ACTIVITY RATIOS
• Turnover ratios reflect the number of times assets flow into and out of the
company during the period.
• A turnover is a gauge of the efficiency of putting assets to work.
• Ratios:
Inventory turnover = How many times inventory is
created and sold during the
period.

How many times accounts

receivable are created and
collected during the period.

The extent to which total

assets create revenues during
the period.

The efficiency of putting

working capital to work

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 OPERATING CYCLE COMPONENTS
• The operating cycle is the length of time from when a company makes an
investment in goods and services to the time it collects cash from its accounts
receivable.
• The net operating cycle is the length of time from when a company makes an
investment in goods and services, considering the company makes some of its
purchases on credit, to the time it collects cash from its accounts receivable.
• The length of the operating cycle and net operating cycle provides information
on the company’s need for liquidity: The longer the operating cycle, the greater
the need for liquidity.
Number of Days of Inventory Number of Days of Receivables

| | | |

Buy Inventory on Pay Accounts Sell Inventory on Collect Accounts

Credit Payable Credit Receivable

Number of Days of Payables Net Operating Cycle

Operating Cycle

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OPERATING CYCLE FORMULAS

Average time it
takes to create
and sell
inventory.
Average time it
takes to collect
on accounts
receivable.

Average time it
takes to pay
suppliers.

43
OPERATING CYCLE FORMULAS

Time from investment in

inventory to collection
of accounts.

Time from investment in

inventory to collection
of accounts,
considering the use of
trade credit in
purchases.

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 LIQUIDITY
• Liquidity is the ability to satisfy the company’s short-term obligations using
assets that can be most readily converted into cash.
• Liquidity ratios:

Ability to satisfy current

liabilities using current assets.

Ability to satisfy current

liabilities using the most liquid
of current assets.

Ability to satisfy current

liabilities using only cash and
cash equivalents.

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 SOLVENCY ANALYSIS
• A company’s business risk is determined,
in large part, from the company’s line of
business. Risk
• Financial risk is the risk resulting from a
company’s choice of how to finance the
business using debt or equity. Business Financial
• We use solvency ratios to assess a Risk Risk
company’s financial risk.
• There are two types of solvency ratios:
component percentages and coverage Sales Risk
ratios.
- Component percentages involve
comparing the elements in the capital
structure. Operating
Risk
- Coverage ratios measure the ability to
meet interest and other fixed financing
costs.

46
 SOLVENCY RATIOS
Proportion of assets financed with debt.
Proportion of assets financed with long-
term debt.

Debt financing relative to equity

financing.
Reliance on debt financing.
Component-Percentage Solvency Ratios

47
 PROFITABILITY
• Margins and return ratios provide information on the profitability of a company
and the efficiency of the company.
• A margin is a portion of revenues that is a profit.
• A return is a comparison of a profit with the investment necessary to generate
the profit.

48
 PROFITABILITY RATIOS: MARGINS
•Each
  margin ratio compares a measure of income with total revenues:

49
 PROFITABILITY RATIOS: RETURNS
•  
Return ratios compare a measure of profit with the investment that
produces the profit:

50
THE DUPONT FORMULAS Return on Equity

• The DuPont formula uses the relationship

among financial statement accounts to
decompose a return into components. Net Profit Total Asset Financial
Margin Turnover Leverage
• Three-factor DuPont for the return on
equity:
- Total asset turnover
- Financial leverage Operating Profit
Margin
- Net profit margin
• Five-factor DuPont for the return on
equity:
Effect of Non-
- Total asset turnover operating
- Financial leverage Items
- Operating profit margin
- Effect of nonoperating items
Tax
- Tax effect
Effect

51
 FIVE-COMPONENT DUPONT MODEL
•  

52
 EXAMPLE: THE DUPONT FORMULA

Suppose that an analyst has noticed that the return on equity of the D
Company has declined from FY2012 to FY2013. Using the DuPont
formula, explain the source of this decline.

(millions) 2013 2012

Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90

Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000

53
 EXAMPLE: THE DUPONT FORMULA

2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11

Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42

Effect of nonoperating items 0.83 0.82

Tax effect 0.76 0.71

54
 OTHER RATIOS
•  Earnings per share is net income, restated on a per share basis:

• Basic earnings per share is net income after preferred dividends, divided by
the average number of common shares outstanding.
• Diluted earnings per share is net income minus preferred dividends, divided
by the number of shares outstanding considering all dilutive securities.
• Book value per share is book value of equity divided by number of shares.
• Price-to-earnings ratio (PE or P/E) is the ratio of the price per share of equity
to the earnings per share.
- If earnings are the last four quarters, it is the trailing P/E.

55
 OTHER RATIOS
•Measures
  of Dividend Payment:

Plowback ratio = 1 – Dividend payout ratio

- The proportion of earnings retained by the company.

56
 EXAMPLE: SHAREHOLDER RATIOS

Calculate the book value per share, P/E, dividends per share,
dividend payout, and plowback ratio based on the following
financial information:

Book value of equity $100 million

Market value of equity $500 million
Net income $30 million
Dividends $12 million
Number of shares 100 million

57
 EXAMPLE: SHAREHOLDER RATIOS

Book value per share $1.00 There is $1 of equity, per the books, for
every share of stock.
P/E 16.67 The market price of the stock is 16.67
times earnings per share.
Dividends per share $0.12 The dividends paid per share of stock.

Dividend payout ratio 40% The proportion of earnings paid out in the
form of dividends.
Plowback ratio 60% The proportion of earnings retained by the
company.

58
 EFFECTIVE USE OF RATIO ANALYSIS
• In addition to ratios, an analyst should describe the company (e.g., line of
business, major products, major suppliers), industry information, and major
factors or influences.
• Effective use of ratios requires looking at ratios
- Over time.
- Compared with other companies in the same line of business.
- In the context of major events in the company (for example, mergers or
divestitures), accounting changes, and changes in the company’s product
mix.

59
 4. PRO FORMA ANALYSIS

Estimate Construct
Estimate
typical Estimate future
sales-
relation fixed period
driven Estimate
between burdens, Forecast income
accounts fixed
revenues such as revenues. statement
based on burdens.
and sales- interest and and
forecasted
driven taxes. balance
revenues.
accounts. sheet.

60
 PRO FORMA INCOME STATEMENT
Imaginaire Company Income Statement (in millions)
    One Year  
Year 0 Ahead
Sales revenues €1,000.0 €1,050.0  Growth at 5%
Cost of goods sold 600.0 630.0  60% of revenues
Gross profit €400.0 €420.0  Revenues less COGS
SG&A 100.0 105.0  10% of revenues
Operating income €300.0 €315.0  Gross profit less operating exp.
Interest expense 32.0 33.6  8% of long-term debt
Earnings before taxes €268.0 €281.4  Operating income less interest exp.
Taxes 93.8 98.5  35% of earnings before taxes
Net income €174.2 €182.9  Earnings before taxes less taxes
Dividends €87.1 €91.5  Dividend payout ratio of 50%

61
 PRO FORMA BALANCE SHEET

Imaginaire Company Balance Sheet, End of Year (in millions)

    One Year  
Year 0 Ahead
Current assets €600.0 €630.0  60% of revenues
Net plant and equipment 1,000.0 1,050.0  100% of revenues
Total assets €1,600.0 €1,680.0  
       
Current liabilities €250.0 €262.5  25% of revenues
Long-term debt 400.0 420.0  Debt increased by €20 million
to maintain the same capital
structure
Common stock and paid-in 25.0 25.0  Assume no change
capital
Treasury stock   (44.0)  Repurchased shares
Retained earnings 925.0 1,016.5  Retained earnings in Year 0,
plus net income, less
dividends
Total liabilities and equity €1,600.0 €1,680.0  

62
 5. SUMMARY
• Financial ratio analysis and common-size analysis help gauge the financial
performance and condition of a company through an examination of
relationships among these many financial items.
• A thorough financial analysis of a company requires examining its efficiency in
putting its assets to work, its liquidity position, its solvency, and its profitability.
• We can use the tools of common-size analysis and financial ratio analysis,
including the DuPont model, to help understand where a company has been.
• We then use relationships among financial statement accounts in pro forma
analysis, forecasting the company’s income statements and balance sheets for
future periods, to see how the company’s performance is likely to evolve.

63
Relative Valuation

RT
 Relative valuation model
• Relative valuation model
– Asset valued based on market pricing of similar
assets
• Most widely adopted valuation model in
practice
– Easy to use, but also easy to misuse!
– Most investment thumb rules based on multiples
– Less time and resource intensive
– Reflects current market sentiments
 Contd...
• Relative valuation technique
– Find comparable assets that are priced by market
• Comparable in terms of risk, growth and cash flow potential
• Common proxies ~ firm size, life cycle, sector / industry
– Scale market prices to a common variable to generate
standardized prices that are comparable
• Equity values for equity multiples
• Firm values for value multiples
– Adjust for differences across assets
• Accounting differences; differences in fundamentals
Standardized Values and Multiples
• Earnings multiples
– Price-earnings (current P/E, trailing P/E, forward P/E)
• Book value or replacement value multiples
– Price-to-book ratio, Tobin’s Q
• Revenue multiples
– Price-to-Sales ratio
• Sector specific multiples
– Price-to-hits ratio, Price-to-subscriptions ratio
 Issues in Multiples Based Valuation

• Consistency in using multiples for valuation

– If numerator is equity value, denominator should
also be equity value
• Numerator ~ Share price or market value of equity
• Denominator ~ EPS, net income, book value of equity
– If numerator is firm value, denominator should
also be firm value
• Numerator ~ Enterprise value or firm value
• Denominator ~ EBIT, EBITDA, book value of capital
 Contd...
• Differences in accounting standards
– May affect earnings and book value numbers
differently even for similar firms
• Differences in depreciation, expense or revenue recognition
• Effect of outliers
– Positively skewed distributions ~ mean > median
• Biases in multiples estimation
– Negative P/E ratios not meaningful, hence ignored
– Upward bias in average P/E ratio due to elimination
 Scaling Variables for Equity Multiples

• Equity earnings variables

– Net Income, Earnings Per Share
• Equity cash flow measures
– Dividends, Free Cash Flow to Equity
• Equity book value measures
– Book value of equity
• Revenue measures
– Sales
 Common Equity Multiples
• Price-Earnings Ratio (P/E)
– P/E = Market value of equity / Net income
– P/E = Share price / Earnings per share
– Current P/E, trailing P/E, forward P/E
– Skewed distribution of P/E ratios
• Negative P/E ratios not meaningful, hence ignored
• PEG Ratio
– PEG Ratio = P/E ratio / Expected earnings growth rate
– Helps portfolio manager to identify undervalued stocks
 Contd...
• Price-to-Book Ratio
– P/B ratio = Market value of equity / BV of equity
– Affected by accounting conventions
• Price-to-Sales Ratio
– Price-to-Sales ratio = Market value of equity / revenues
– Widely used, although inconsistent
– Revenues almost always positive, easily available
• Price-to-Cash Flow Ratio
• Price/FCFE = Market value of equity / FCFE
 Example 1
• XYZ company’s current net income is $25m.
Comparable firms in the same industry are
trading at an average current P/E ratio of 15x.
The company currently has 2,50,000 shares
outstanding. Calculate value of equity.
 Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 15 = Equity value / 25000000
=> Equity value = 15 x 25000000 = 375000000
=> Equity value per share = 375000000 /250000
= $1500/share
 Example 2
• XYZ company’s current net income is $25m.
Comparable firms in the same industry are
trading at an average trailing P/E ratio of 12x.
The company currently has 2,50,000 shares
outstanding. Calculate value of equity.
 Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 12 = Equity value / 25000000
=> Equity value = 12 x 25000000 = 300000000
=> Equity value per share = 300000000/250000
= $1200/share
 Example 3
• XYZ company’s management has forecasted
the net income of the firm as $10m in the next
financial year. Comparable firms in the same
industry are trading at an average P/E ratio of
25x. The company currently has 2,50,000
shares outstanding. Calculate valuation of
equity.
 Answer
• Value of equity
P/E = Price / EPS
P/E = Equity value / Net Income
=> 25 = Equity value / 10
=> Equity value = 25 x 10000000 = 250000000
=> Equity value per share = 250000000/250000
= $1000/share
 Venture Capital Method of Valuation
• Venture Capital Method
– Commonly used in private equity industry
– Uses multiple at a future time, to arrive at exit value
– Exit (or terminal) value discounted back to present
value
• Hurdle rates ~ 40% – 75%, reflecting riskiness of
investment
– Discounted terminal value and size of proposed
– investment gives desired ownership interest in
company
 Contd...
• 1. Calculate Terminal Value
– Equity or Value multiples
• P/E ratio X Projected net income in exit year
– Discounted Cash Flow (DCF) method
• 2. Calculate Discounted Terminal Value
– Use hurdle rate for discounting
• Yield required by VC for compensation of risk and effort
– DTV = Terminal Value / (1 + hurdle rate)yrs
 Example 4
• Vijay is a partner in a venture capital firm. He is
planning to invest $5m in a tech start up firm.
The company management has forecasted the
net income of the firm as $20m in year 7. Few
profitable tech firms are trading at an average
P/E ratio of 15x. The company currently has
500,000 shares outstanding. Vijay believes that
hurdle rate of 50% is required for a venture of
this risk. Calculate value of equity.
 Answer
• Discounted Terminal Value (DTV)
Terminal value = P/E x Forecasted net earnings
= 15 x $20m = $300m
Current value = Terminal Value / (1 + Target)^yrs
= 300 / (1 + 50%)^7 = $17.5m
• Reqd. % Ownership = Investment / DTV
= 5 / 17.5 = 28.5%
 Common Value Multiples
• EV/EBITDA
– EV/EBITDA = Enterprise Value / EBITDA
• EV/EBIT
– EV/EBIT = Enterprise Value / EBIT
• EV/Book Value of Capital
– Enterprise Value / Book Value of Capital
• EV/Sales
– Enterprise Value / Sales
• EV = (Market Value of Equity + Market Value of
Debt) – Non-Operating Cash + Market value of
minority interests

• Approximation:-
• EV = (Market Value of Equity + Market Value of
Debt) – Non-Operating Cash
 Determinants of Equity multiples
• P/E ratio: Exp. Growth rate, payout, risk

• P/BV ratio: Exp. Growth rate, payout, risk, ROE

• P/S ratio: Exp. Growth rate, payout, risk, net

margin
 Estimating P/E of target company using
regression
Sl. Company P/E ratio Exp. Growth Risk (Beta) Payout ratio
No. rate (%) (%)

1 Accenture ltd 16.12 19.34 1.2 40

2 Adobe systems 13.68 25.62 1.5 30

.. ............. ... ... ... ...

.. ............. ... ... ... ...

50 BearingPoint 27.34 30.25 1.65 50

• P/E = 6.75 + 113.10*EGR – 0.919*Beta +
7.33*POR

• For instance, a firm with an EGR of 12%, a beta

of 1.2, and a payout ratio of 20% will have a
predicted P/E ratio:-
= 6.75 + 113.1*0.12 – 0.919*1.2 + 7.33*0.2
= 20.68
• If the net income is $100m
• Value of equity = P/E * NI
= 20.68 * $100m
= $2068m
If outstanding shares are 500000
Price/share = 2068000000 / 500000
= $4136
Say, current price = $3500
• Thank you
VALUATIONS

RT
Approaches to valuation
• Income oriented approach
• Income oriented approach is based on the principle of future
benefits, which states that the value of any business equals the net
present value of all future economic benefits attained as a result of
the ownership of the business.

• To arrive at the net present value we require a discount factor that

considers the risk-return assessment of the market to finally derive
the value of equity.

• The three commonly used valuation methods under this approach

are the cash flow method, dividend discount method, and residual
income method.
• Market oriented approach
• Market-oriented approach is based on the principle of quick
valuation of companies (see, Fernandez, 2002).

• It is a simple, economic and less time consuming approach to

compute value.

• It is used to measure the relative performance of the firms by

practitioners as a control mechanism to assess whether the
intrinsic value is in line with the market view of the comparable.

• The two commonly used valuation methods under this approach

Equity multiples and Value multiples.
• Cost oriented approach
• The Cost Oriented Approach, also known as the Asset-based
Approach, involves methods of determining a company’s value by
analysing the market value of a company’s assets.

• This valuation approach often serves as a valuation floor since most

companies have greater value as a going concern than they would if
liquidated, i.e., the present value of future cash flows generated by the
assets usually far exceed the liquidation value of those assets.

• This difference between the asset value and going concern value is
commonly referred to as “goodwill”. Therefore asset based approach
or cost oriented approach measures only a part of firm’s value.
• It does not assign any value for future growth.

• The cost oriented or asset based value approach assumes the

liquidation of the firm and therefore violates the principle of going-
concern.

• Nevertheless, the Cost oriented approach is only meaningful for

the valuation of individual financial investments and valuation of
assets in case of liquidation.
Income oriented approach
• Free cash flow model:-
• Residual income model:-
• Dividend discount model:-
Forecast horizon
• Forecast horizon means the length of forecast period.

• Five to ten years forecast period is very much in line with

the literature in this area.

• Forecast horizon is divided into three phases: growth

phase; transition phase and maturity phase.
Estimating growth rate
• One is to look at the growth in a firm’s past earnings – its
historical growth rate.

• The second is to estimate the growth from a firm’s

fundamentals. A firm’s growth ultimately is determined by
how much is reinvested into new assets.

• The third is to trust the equity research analysts that

follow the firm to come up with the right estimate of
growth for the firm, and to use that growth rate in
valuation.
 Free Cash Flow
Free Cash Flow to the Free Cash Flow to
Firm Equity

= Cash flow available = Cash flow available to

to

Common stockholders Common stockholders

Debtholders

Preferred stockholders
 FCFF vs. FCFE Approaches to
Firm & Equity Valuation

Equity Value

FCFE Discounted FCFF Discounted

at Required at WACC – Debt
Equity Return Value
Calculating FCFF & FCFE from Net Income
FCFF and FCFE from net income (NI):

FCFF = EBIT (1-Tax) + Dep. – CAPEX – WC

FCFE = NI + Dep. – CAPEX – WC + Net

borrowing
Example: Calculating FCFF & FCFE
EBITDA $1,000
Depreciation expense $400
Interest expense $150
Tax rate 30%
Purchases of fixed assets $500
Change in working capital $50
Net borrowing $80
FCFF vs. FCFE Approaches to
Equity Valuation
Single-Stage Free Cash Flow Models
Example: Single-Stage FCFF Model
Current FCFF $6,000,000
Target debt to capital 0.25
Market value to debt $30,000,000
Shares outstanding 2,900,000
Required return on equity 12%
Cost of debt 7%
Long-term growth in FCFF 5%
Tax rate 30%

Calculate Equity Value?

Example: Single-Stage FCFF Model
Example: Single-Stage FCFF Model
Firm
  value =

Firm
  value = = $120.5 million

Equity value = $120.5 million – $30 million = $90.5 million

Equity value per share = $90.5 million/2.9 million = $31.21

Simple Two-Stage FCF Models
Example: Two-Stage FCF Models
Current FCFF in millions $100 .00

Shares outstanding in millions 300 .00

Long-term debt value in millions $400.00
FCFF growth for Years 1 to 3 10%
FCFF growth for Year 4 and thereafter 5%
WACC 10%
Example: Three-Stage FCF Models
Current FCFF in millions $100 .00

Shares outstanding in millions 300 .00

Long-term debt value in millions $400.00
FCFF growth for Years 1 to 3 30%
FCFF growth for Year 4 24%
FCFF growth for Year 5 12%
FCFF growth for Year 6 and thereafter 5%
WACC 10%
Example: Three-Stage FCF Models
Year

1 2 3 4 5 6

FCFF growth rate 30% 30% 30% 24% 12% 5%

FCFF $130.0 $169.0 $219.7 $272.4 $305.1 $320.4

PV of FCFF $118.2 $139.7 $165.1 $186.1 $189.5

Example: Three-Stage FCF Models

Note : The above formula shows the present value of perpetual stream at t = 0
Example: Three-Stage FCF Models
 Summary
FCFF vs. FCFE

• FCFF = Cash flow available to all firm capital

providers
• FCFE = Cash flow available to common
equity holders
• FCFF is preferred when FCFE is negative

Equity Valuation with FCFF and FCFE

• Discount FCFF with WACC

• Discount FCFE with required return on equity
• Equity value = FCFF – Debt value
Thank you
Working Capital Management

RT
 Introduction
• The capital of a business which is used in its day-to-day trading operations.

• Working capital is a measure of both a company's efficiency and its short-

term financial health.

• If a company's current assets do not exceed its current liabilities, then it

may run into trouble paying back creditors in the short term. The worst-
case scenario is bankruptcy. A declining working capital ratio (Current
Assets/Current Liabilities) over a longer time period could also be a red
flag that warrants further analysis.

• Working capital management- the administration of the firm’s current

assets and the financing needed to support current assets.
Gross and Net Working Capital
• Gross Working Capital-
– Total of investments in all current assets
– Focus on optimization of investment in current assets and the means
of financing current assets

• Net Working Capital-

– Excess of total current assets over total current liabilities.
– Indicates the extent to which working capital needs may be financed
by permanent sources of funds.
– Can be positive or negative
Indian Manufacturing Current Assets and
Liabilities, March 31, 2013 (Rs. Million)
Break-up of Current Assets, India, 2013
Permanent And Variable Working Capital
• The magnitude of current assets keeps on changing from time
to time.

• Permanent or fixed working capital:

– A minimum level of current assets continuously required by a firm to
carry on its business operations

• Fluctuating or variable working capital:

– The extra working capital needed to support the changing production
and sales activities of the firm
Permanent and Variable Working Capital

Permanent Working Capital

Simple Cycle of Operations
Cash Conversion Cycle
 ACCOUNTS RECEIVABLE, PAYABLE &
INVENTORY PERIOD
• Debtors period / Receivable period
– (Average Debtors/Total Sales) x 360

• Creditors period / Payable period

– (Average Creditor/Total Purchase) x 360

• Inventory days outstanding

– (Average Inventory/Cost of Goods Sold) x 360
 Cash Conversion Cycle, Indian
Manufacturing, 2013 (Rs. Millions)
 Working Capital and the Cash Conversion
Cycle
• Cash Conversion Cycle
= operating cycle – accounts payable period
= (inventory period + receivables period) – accounts payable
period
• Cash Conversion Cycle

Cash Conversion
Cycle:
 HOW MUCH WORKING CAPITAL DO WE
NEED?
• To answer this question, you need to understand how money
will flow through your business – in other words, you need to
understand your “working capital cycle.”
– The cycle consists of:
• (i) how quickly accounts receivables & inventory are turned
into cash and
• (ii) how quickly that cash is used to pay accounts payable.

• When starting a business, you will have projections for key

items such as sales, cost of goods sold and other expenses. 
 Contd…
• You also need assumptions on the following: 
– How many days of inventory do you need to keep in
hand (“inventory turnover”)? 
– How many days will you give customers to pay you
(accounts receivable terms)?
– How many days will your vendors give you to pay
them (accounts payable terms)?  

• Armed with this information, you can calculate how much

working capital is needed to start your business.
WORKING CAPITAL REQUIREMENT
ANALYSIS: FRAMEWORK
 Cash Conversion Cycle,
Selected Companies, 2013
Working Capital Financing Policies

Financing Policies Sources

Long-term Equity, Debentures, Reserves and

Surplus, and Long term borrowings

Short-term Commercial Papers, working capital

funds from banks, factoring of
receivables

Spontaneous Trade (suppliers) credits and

outstanding expenses.
Working Capital Financing Policies
Approach Features

Matching Long term financing for fixed assets and permanent current
assets.
Short term financing for variable/temporary current assets.

Conservative Long term financing used for fixed assets, permanent current
assets and partially also for variable/temporary current assets.
Short term financing for remaining variable/temporary current
assets.

Aggressive Short term financing partially for permanent current assets as

well as for variable/temporary current assets.
Matching Approach
Conservative Approach
Aggressive Approach
 Inventory management
• Components of Inventory
– Raw materials
– Work in progress
– Finished goods
• Goal: Minimize amount of cash tied up in
inventory
– Tools used to minimize inventory
• Just-in-time
• EOQ
Inventory Conversion Period
• Inventory conversion period (ICP) = RMPC + WIPCP + FGCP
•  
• Raw Material Conversion Period (RMCP) =
 
• Work-In-Process Conversion Period (WIPCP) =

 
• Finished Goods Conversion Period (FGCP) =

• However, assuming 30 Days = 1 Month is normal

practice in some books. Thus 1 year = 360 Days.
Managing Inventories
Determining Optimal
Order Size
 Inventories
• Economic Order Quantity
– Order size that minimizes total inventory costs

• As Order Size Increases

– Number of orders decreases
– Order cost decreases
– Average amount in inventory increases
– Carrying cost of inventory increases
 Credit Management
• Terms of Sale
– Credit, discount, and payment terms offered on
sale

– Example: 5/10 net 30

• 5: Percent discount for early payment
• 10: Number of days discount is available
• Net 30: Number of days before payment due
 Credit Management
• Terms of Sale
– Firm that buys on credit borrows from supplier
• Save cash today, pay later (implicit loan)
• Cost of implicit loan:
 Credit Management
• Example
– Calculate implied interest rate on Rs.100 sale with
terms 5/10 net 60
 Credit Management
• Credit Analysis
– Procedure to determine likelihood that customer
will pay bills
• Credit agencies provide reports on credit
worthiness of potential customers
• Financial ratios can help determine a
customer’s ability to pay bills
• Set your credit policy to determine amount and
nature of credit extended to customers
Modelling credit risk: Credit Scoring Models

• Altman’s Z-Score Model

– This model uses a statistical technique, Multiple

Discriminant Analysis (logit or probit models can also
be used) to classify firms into those which are likely to
become bankrupt/non-bankrupt over a given future
horizon

– Past financial data on firm’s financial ratios and

bankruptcies were used to estimate the model
 Credit Management
• Collection Policy
– Procedure to collect and monitor receivables
(factoring services)

• Aging Schedule
– Classification of accounts receivable by time
outstanding
 Credit Management
• Sample Aging Schedule, Accounts Receivable
 Cash Management
• Cash Does Not Pay Interest
– Move money from cash accounts to short-
term securities
– Sweep programs
– Concentration banking
 Cash Management
• Electronic Funds Transfer (EFT)
– Allows instantaneous payment

• Automated Clearinghouse (ACH)

– Allows direct payment of recurring expenditures
Money-market Investments in India
Cash Budgeting
• A cash budget is a primary tool of short-run financial
planning.
• The idea is simple: Record the estimates of cash receipts
and disbursements.
• Cash Receipts
– Arise from sales, but we need to estimate when we actually
collect
• Cash Outflow
– Payments of Accounts Payable
– Wages, Taxes, and other Expenses
– Capital Expenditures
– Long-Term Financial Planning
 Example
• TKPL Inc. receives all income from sales
• Sales estimates (in millions)
– Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year
= 550
• Accounts receivable
– Beginning receivables = Rs.250
– Average collection period = 30 days
• Accounts payable
– Purchases = 50% of next quarter’s sales
– Beginning payables = 125
– Accounts payable period is 45 days
 Example

• Other expenses
– Wages, taxes and other expense are 30% of sales
– Interest and dividend payments are Rs.50
– A major capital expenditure of Rs.200 is expected
in the second quarter

• The initial cash balance is Rs.80 and the company maintains a

minimum balance of Rs.50
 Example (Accounts Receivables)
 ACP = 30 days, this implies that 2/3 of sales are collected in the
quarter made, and the remaining 1/3 are collected the following
quarter.
 Beginning receivables of Rs.250 will be collected in the first
quarter.

Q1 Q2 Q3 Q4
Beginning Receivables 250 167 200 217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267
 Example (Accounts Payables)
• Sales estimates (in millions)
– Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year =
550
• Accounts payable
– Purchases = 50% of next quarter’s sales
– Beginning payables = 125
– Accounts payable period is 45 days

Q1 Q2 Q3 Q4
Beginning Payables 125 150 162 200
Purchases 300 325 400 275
Cash paid 275 313 362 338
Ending Payables 150 162 200 137
 Example
• Payables period is 45 days, so half of the purchases will be
paid for each quarter, and the remaining will be paid the
following quarter.
• Beginning payables = Rs.125

Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 150 180 195 240
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628
 Example
Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
Total cash disbursements 475 743 607 628
Net cash inflow 108 -176 26 122
Beginning Cash Balance 80 188 12 38
Net cash inflow 108 -176 26 122
Ending cash balance 188 12 38 160
Minimum cash balance -50 -50 -50 -50
Cumulative surplus (deficit) 138 -39 -12 110
Cash Management Models
• Cash management models address the issue
of split between marketable securities and
cash holdings. Two such models are :

• Baumol model
• Miller and Orr model
 Baumol Model
• Baumol’s EOQ Model of Cash Management

• William J. Baumol (1952) suggested that cash should be

managed in the same way as any other inventory

• And that the inventory model could reasonably reflect the

cost- volume relationships as well as the cash flows.

• In this way, the economic order quantity (EOQ) model of

inventory management could be applied to cash management.
• The Baumol’s model assumes that the firm uses cash
at a constant rate per period.

• In the model, the carrying cost of holding cash-

namely the interest forgone on marketable securities
is balanced against the fixed cost of transferring
marketable securities to cash, or vice-versa.
•According
  to this model, the optimal conversion amount
of marketable securities into cash, C, is given by the
following formula:
C= 
– b is the cost of conversion into cash per transaction.
– T is the projected cash requirement during the
period.
– i is interest rate earned per planning period on
investments in marketable securities.
Question 1: Find out the optimum cash balance using Baumol's Model
          Annual cash needed                      Rs.48,00,000
        Transaction cost                          Rs.90 per conversion
         Interest rate                               9% 

Solution: As per Baumol's Model

C = Cash required each time to restore balance to minimum cash

F= Total cash required during the year = Rs.48,00,000
T= Cost of each transaction between cash and marketable securities
=Rs.90
r = Rate of interest on marketable securities = 9%
 Implication
• As per Baumol’s Model, the firm should start each
period with the cash balance equaling ‘C’ and spend
gradually until its balance comes to zero.

• At this time, the firm should replenish the equaling

‘C’ from the sale of marketable securities.
 Miller-Orr Model
• Baumol’s model is based on the basic assumption that the
size and timing of cash flows are known with certainty.

• This usually does not happen in practice.

• The cash flows of a firm are neither uniform nor certain.

• The Miller and Orr model overcomes the shortcomings of

Baumol model.
• Miller and Orr (A Model of the Demand for Money)
expanded on the Baumol model and developed
Stochastic Model for firms with uncertain cash
inflows and cash outflows.

• The Miller and Orr model provides two control limits-

the upper control limit and the lower control limit
along-with a return point as shown in the figure
below:
• When the cash balance touches the upper control limit (h),
marketable securities are purchased to the extent of hz to
return back to the normal cash balance of z.

• In the same manner when the cash balance touches lower

control limit (o), the firm will sell the marketable securities to
the extent of oz to again return to the normal cash balance.

• The spread between the upper and lower cash balance limits
(called z) can be computed using Miller-Orr model as below:
Miller-Orr Model

•   formula for determining the distance between the return

The
level and lower control limits (called Z) is as follows:
Z=
where:
is the variance of daily changes in cash balances
b is the cost of conversion into cash per transaction.
i is interest rate earned on investments in marketable
securities
Miller-Orr Model
The distance between lower limit and the upper limit should be
three times the distance between the lower limit and the return level.

Upper Limit = Lower Limit + 3 Z

Return Point ( Optimal Balance) = Lower Limit + Z

The net effect is that the firms hold the average the cash balance
equal to:

Average Cash Balance = Lower Limit + 4/3Z

Example
• Given the conversion cost = Rs. 150; Interest rate = 14% p.a.;
Minimum cash balance = 5,00,000; Standard deviation of daily
cash flow = 2,00,000.
• Based on the information find the upper limit, return point,
and the average cash balance?
Example
•  
Given conversion cost= Rs. 150, interest rate 14 percent per annum , minimum cash
balance of Rs.5,00,000and the standard deviation of daily net cash flows Rs. 2,00,000,
find the optimum cash balance and average cash balance using Miller-Orr Model.
• Z=
 
Z= = Rs. 2,27,227/=
 
Upper Limit = Lower Limit + 3 Z = Rs. 5,00,000 + 3 x 2,27,227 =
Rs.11,81,681 

Return Point = Lower Limit + Z = Rs. 5,00,000 + Rs. 2,27,227 =Rs.7,27,227

 Average cash balance = Lower Limit + 4 / 3 Z = Rs. 5,00,00 +( x 2,27,227)

= Rs. 8,02,969
• Suppose, a company pays suppliers of inventory
after 30 days, completes production and sells the
finished products to customers after 60 days of
procuring the inventory and receives cash from
the customers after 30 days from sale.

Day Activity
0 Procure inventory
30 Pay suppliers of inventory
60 Complete production and sell to customers
90 Collect cash from customers
• Answer
Operating Cycle = 90 days
Cash Cycle = 60 days
Thank you