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Introduction

Prior to

advent of

MONEY

Consume all the

goods you have

Exchange your

goods for other

goods and then

consume them

Could not

put away goods

for later use

With the

advent of

MONEY

Everything could be

denominated in

units of

the currency

The currency served

as the medium

of exchange

Money gave you

the freedom

to

SAVE

Barter Non-Barter

What role money plays?

Money has two roles to play

As a Measure

Estimating cash flow

Valuing the assets and liabilities

Financial & Cost Accounting

As a Resources

Planning of Spending

Planning of Investment

Allocation of Money (capital) as resources

Money as a Measure͙

Cash flows happens over a period of time

Value of same amount of cash flow will be different at different time

± Rs. 1000 now is not same as Rs. 1000 one year from now because

Same money can be invested and positive return can be generated

Present is certain and future in uncertainty

Inflation reduces purchasing power of money

One need to estimate the value of all the cash flows

± Need to express all the cash flows into one time dimension

Present Value

Future value

Study of Time Value of Money Helps in Consistent Measurement« Study of Time Value of Money Helps in Consistent Measurement«

Learning from Economic Theory Money As a Resource͙

What is price of Capital?

Interest Rate

Dividend Yield

Expected Capital Appreciation

Bond/Debenture Yield

Who Provides Capital?

Individual

Financial Institutions

Input Output Process

Product

Services

Labor

Capital

Raw

Material

Financial Market Provides Capital for a Price and Firms Create

Assets with the Help of Capital to Generate Wealth«

Financial Market Provides Capital for a Price and Firms Create

Assets with the Help of Capital to Generate Wealth«

Understanding the Financial Market

Surplus Business

Unit (SBU)

(Households,

Corporate)

Deficit Business

Unit (DBU)

(Government,

Corporate)

funds

claim

Create Assets for DBU

Creates Liabilities for DBU

Claims of SBU can be debt claims or equity claims

Assets Liabilities

CLAIMS

or

DEBT or borrowed capital

or

EQUITY or owners capital

FUNDS

Total Assets = Total Liabilities

Understanding the Firm

What is a firm?

A firm is an organization that combines inputs and

follows some process to produce some forms of

output

What are the goals of a firm?

Should a firm maximize the welfare of employees, or customers, or supplier

Should it maximize shareholders wealth, profits, EPS, return on investment?

A Firm Need to Use its Scare Resources (Capital) Optimally to

Achieve the Goal«

A Firm Need to Use its Scare Resources (Capital) Optimally to

Achieve the Goal«

Goods

Financial

Assets

Physical

Assets

Services

MARKETS

Firms Operates in Markets

What goods and services to produce?

What are the target market?

Finance Manager Plays an Important Role to Make Sure the Firm Meets the

Goal it has Aimed for«

Finance Manager Plays an Important Role to Make Sure the Firm Meets the

Goal it has Aimed for«

What are the questions Financial Mangers deal with?

How big the firm should be?

How fast it should grow?

Where should it invest?

What should be the composition of its assets?

How should the assets be financed?

How should the returns to be distributed?

How to get the best return from the investment?

How to minimize the expenditure without affecting the growth of the firm?

Finance Strategy is Driven by Objective of the Firm, Business

Opportunity, Cost of Capital for the Firm«

Finance Strategy is Driven by Objective of the Firm, Business

Opportunity, Cost of Capital for the Firm«

Organization Structure

CEO

CFO

Treasurer

Controller

Manages the cash

Planning and capital

budgeting

Raising the money

Managing the external

relationship

Managing the credit

and fraud issues

Prepare the accounts

Manage the expenditure

Internal audit

Reporting and preparing

balance sheet and P&L

Financial Management Objective is to Maximize Value of the Firm by

Balancing Between Risk and Reward..

Financial Management Objective is to Maximize Value of the Firm by

Balancing Between Risk and Reward..

Complexity of role of finance manager is a function of

type of firm

Types of firm:

Sole proprietorship

Partnership

Cooperative society

Private company

Public limited company

How does external environment affect financial management?

External factors that affects most of the financial decision

can be broadly divided into:

Regulatory Framework

Taxes

Financial system

Financial decisions of a firm depends on legal forms of the

organization which is an internal matter with in the frame

work of the external environment

Financial Management maximizes value with the external

regulatory environment«

Financial Management maximizes value with the external

regulatory environment«

How regulatory framework affects financial decisions?

Principal elements of regulatory framework are:

Industrial policy

Companies act

Securities and Exchange Board of India Guidelines

How does taxes affects financial decisions?

Corporate income tax

Depreciation

Interest expenses vis-à-vis dividend payment

Exemptions and deductions

Dividend distribution tax

Capital gain tax

Sales tax

Customs duty

Financial Institution

Commercial Banks

Insurance Companies

Mutual Funds

Provident Funds

Non Banking

Financial Companies

Supplier Of Funds

Individual

Business

Government

Funds

Deposits/Shares

Private

Placement

Purchaser of Funds

Individual

Business

Government

Financial Markets

Money Market

Capital Market

Funds

Funds

Funds

How financial framework affects financial decisions?

Interest Rate

&

Time Value of Money

Interest Rate

Introduction

Most of us would have either paid and/or received

interest if͙

± We have taken loans and have paid interest to the lender.

Student loan

Auto loan

Personal loan

Mortgage loan

± We have invested have received interest from the borrower.

Saving account deposits

Fixed deposits

Infrastructure bonds

Bonds Debentures of companies

Introduction (Cont͙)

What is interest?

± Compensation paid by the borrower of capital to the

lender

Rent paid by the borrower of capital to the lender. The rent is for

permitting the borrower to use funds of lender

How is interest rate determined?

± Depends on the market for capital

In a free market it is determined by demand and supply of capital

In a controlled market, regulator can specify the interest rate

In a regulated market, market can determine the interest rate but

regulator can intervene if it fills that market is not functioning

optimally

Real vis-à-vis Nominal Interest Rate͙

What is real interest rate?

± Compensation paid by the borrower of capital to the

lender when lender has zero risk and inflation rate is zero

Loans to government when there is no inflation

What are the implication of no inflation?

± If one lends Rs. 100 at 10% for a year

Assuming that the Rs. 100 can buy 100 mangoes

Next year the Rs. 110 can buy 110 mangoes

If there is positive inflation then next year Rs. 110 will able to buy

less that 110 mangoes

This implies that in case of inflation the real interest rate would be

less than 10%

Real vis-à-vis Nominal Interest Rate͙

Most people who invest do so by acquiring financial assets such as

± Shares of stock

± Shares of a mutual fund

± Or bonds/debentures

± deposits with commercial bank

Financial assets give returns in terms of money without any assurance about the

investor͛s ability to acquire goods and services at the time of repayment

Financial assets therefore give a NOMINAL or MONEY rate of return.

± In the example, the GOI gave a 10% return on an investment of Rs 100.

± Let us say inflation rate is 5%

± The # of mangoes that can be bought is 110/1.05 = 104.74

± The real rate of return is 4.76% which is different from 10% nominal return

± The relationship between the nominal and real rates of return is expressed in

the FISHER hypothesis;

͞Nominal Return͟ = ͞Real Return͟ + Inflation Rate (Approximate)

Interest Rate and Uncertainty͙

In FISHER equation it is assumed that the rate of inflation is known with

certainty.

± In real life inflation is uncertain and is random

± In the case of random variables exact outcome is not known in

advance

± Agents would have expected value of inflation

Which is a probability weighted average of the values that the

variable can take.

Therefore in real life a default free security will not give an assured real

rate.

± It will give an assured nominal rate

± The real rate will depend on the actual rate of inflation

There is Uncertainty (Risk) over the Real Rate of Return even if the Nominal

Return is Certain due to Uncertainty over Inflation«

There is Uncertainty (Risk) over the Real Rate of Return even if the Nominal

Return is Certain due to Uncertainty over Inflation«

Uncertainty and Risk Aversion͙

Majority of investors are characterized by Risk Aversion.

± What is risk aversion?

It does not mean that investor would not take risk

It means that investor would expect higher return to take higher risk.

Given a choice between two investments with the same expected rate of

return the investor will choose the less risky option

In the case of existence of positive inflation

± The investor will not accept the expected inflation as compensation

± To tolerate the inflation risk the investor will demand a POSITIVE risk premium

± Compensation over and above the expected rate of inflation

Why?

± The actual inflation could be higher than anticipated resulting in actual

real rate lower than anticipated.

± The Fisher equation need to be modified to take into risk aversion nature of the

investor

The Fisher equation may be restated as

± Nominal Return = Real Return + Expected Inflation + Risk Premium

What Drives Interest Rate͙

From the discussion so far with zero default the interest rate would depends on

± The real rate

± The expected inflation

± The risk premium of the investor

When we relax the assumption of zero default risk the interest rate would depends

Credit risk involved with the borrower, which would vary from individual to individual

± The risk of non-payment of interest rate

± The risk of non-payment of principal

± Higher the risk of default higher would be expected interest rate

Tenure of the investment

± Higher the tenure higher could be credit risk

± The lender would prefer to lend for short-term and borrower would prefer to borrow for

long-term for a given rate of interest rate

± Lender would demand higher interest rate to lend for long tenure

Nuances of Calculating Interest

Income͙

Simple interest rate vis-à-vis compound interest rate

± When interest is calculated on interest income generated during the

previous period

± They will differ when the interest conversion period is different from

the measurement period

± What is interest conversion period?

The unit of time over which interest is paid once and is reinvested to earn

additional interest is called interest conversion period

± What is measurement period?

The unit on which the time is measured is called measurement period

The interest conversion period is typically less than or equal to the

measurement period.

Nominal interest rate vis-à-vis effective interest rate

± The quoted interest rate per measurement period is called the

nominal interest rate

± The interest that a unit of currency invested at the beginning of a

measurement period would have earned by the end of the period is

called the effective rate

Using the Right Rate for

Measurement͙

Effective rate is what one gets and nominal rate is what one sees

Compounding yields greater benefits than simple interest

± The larger the value of N the greater is the impact of compounding. Thus, the

earlier one starts investing the greater are the returns.

If the length of the interest conversion period is equal to the measurement period

± The effective rate will be equal to the nominal rate

If the interest conversion period is shorter than the measurement period

± The effective rate will be greater than the nominal rate

If the interest conversion period is longer than the measurement period

± The effective rate will be lower than the nominal rate

If we are comparing two alternative investment opportunity, first thing we need to do

is convert the rate of return into effective rate of return

Effective Rate is Appropriate Rate to Measure« Effective Rate is Appropriate Rate to Measure«

Future & Present Value

Future Value of Money

Q1. Rs. 10,000 is invested and the investor gets 10% return every year for three years.

What would be the future value of the money invested?

Ans: Present Value (PV) = Rs. 10,000

Rate of Return (r) = 10% = 10/100 = 0.10

Number of Years (N) = 3

Future Value (FV) at the end of first year = Rs. 10,000 + 0.10*Rs. 10,000

FV at the end of second year = Rs. 10,000 + 0.10*Rs. 10,000

+ 0.10*Rs. 10,000

FV at the end of third year = Rs. 10,000 + 0.10*Rs. 10,000

+ 0.10*Rs. 10,000 + 0.10*Rs. 10,000

= Rs. 10,000 (1 + 0.10 + 0.10 + 0.10)

= Rs. 10,000 (1 + 3 * 0.10)

If we generalize: FV = PV ( 1 + Nr) when return is simple return

Future Value of Money

Q2. Rs. 10,000 is invested and the investor gets 10% return every year for three years.

What would be the future value of the money invested if the compounding of

return happens at the end of every year?

Ans: Present Value (PV) = Rs. 10,000

Rate of Return (r) = 10% = 10/100 = 0.10 ; Number of Years (N) = 3

Future Value (FV) at the end of first year

= Rs. 10,000 + 0.10*Rs. 10,000

FV at the end of second year

= (Rs. 10,000 + 0.10*Rs. 10,000) + 0.10* (Rs. 10,000 + 0.10*Rs. 10,000)

= Rs. 10, 000 (1+0.10) + 0.10 * Rs. 10, 000 ( 1 + 0.10)

= Rs. 10,000 (1+0.10) ( 1 + 0.10) = Rs. 10, 000 ( 1 + 0.10)²

FV at the end of third year

= Rs. 10, 000 ( 1 + 0.10)² + Rs. 10, 000 ( 1 + 0.10)² * 0.10

= Rs. 10, 000 ( 1 + 0.10)² ( 1 + 0.10)

= Rs. 10, 000 ( 1 + 0.10)³

If we generalize the formula: FV = PV ( 1 + r)

N

Calculative Simple and Compound Interest͙

Simple interest can be calculated by using the formula;

pP(1+rN)

Compound interest can be calculated by using the formula;

pP(1+r)

N

Where;

P | principal invested at the outset

N | # of measurement periods for which the investment is being made

r | nominal rate of interest per measurement period

Future Value of Money

Q3. Rs. 10,000 is invested and the investor gets 10% return every year for three years.

What would be the future value of the money invested if the compounding of

return happens at the end of every six month?

Ans: Present Value (PV) = Rs. 10,000

Rate of Return (R) = 10% = 10/100 = 0.10

Number of Years (N) = 3

Number of compounding per year (k) = 2

Future Value (FV) at the end of first year

= Rs. 10,000 + (0.10/2)*Rs. 10,000

+ (Rs. 10,000 + (0.10/2)*Rs. 10,000) * (0.10/2)

= Rs. 10,000 ((1 + (0.10/2)) + Rs. 10,000 ((1 + (0.10/2)) * (0.10/2)

= Rs. 10,000 ((1 + (0.10/2)) ( (1 + (0.10/2))

= Rs. 10,000 ((1 + (0.10/2))

1*2

Contd«

Future Value of Money

Future Value (FV) at the end of second year

= [Rs. 10,000 ((1 + (0.10/2))

1*2

+ Rs. 10,000 ((1 + (0.10/2))

1*2

* (0.10/2)]

+ [Rs. 10,000 ((1 + (0.10/2))

1*2

+ Rs. 10,000 ((1 + (0.10/2))

1*2

* (0.10/2)] * (0.10/2)

= Rs. 10,000 ((1 + (0.10/2))

1*2

* ((1+(0.10/2))

+ Rs. 10,000 ((1 + (0.10/2))

1*2

* ((1+(0.10/2)) * (0.10/2)

= Rs. 10,000 ((1 + (0.10/2))

1*2

* ((1+(0.10/2)) ((1 + (0.10/2))

= Rs. 10,000 ((1 + (0.10/2))

2*2

Future Value (FV) at the end of third year

= [Rs. 10,000 ((1 + (0.10/2))

2*2

+ Rs. 10,000 ((1 + (0.10/2))

2*2

* (0.10/2)]

+ [Rs. 10,000 ((1 + (0.10/2))

2*2

+ Rs. 10,000 ((1 + (0.10/2))

2*2

* (0.10/2)] * (0.10/2)

= Rs. 10,000 ((1 + (0.10/2))

2*2

(( 1 + (0.10/2))

+ Rs. 10,000 ((1 + (0.10/2))

2*2

(( 1 + (0.10/2)) * (0.10/2)

= Rs. 10,000 ((1 + (0.10/2))

2*2

(( 1 + (0.10/2)) * ((1 + (0.10/2))

= Rs. 10,000 ((1 + (0.10/2))

3*2

If we generalize the formula; FV = PV ( 1 + r/m)

Nm

Calculative Effective Interest Rate͙

The effective rate i can be calculated by using the formula when the

Nominal rate is r and m # of interest conversion periods per

measurement period.

Conversely the nominal rate r can be calculated if we know i and m

And N=1

Two Nominal Rates Compounded at Different Intervals are Equivalent if they

Yield the Same Effective Rate «

Two Nominal Rates Compounded at Different Intervals are Equivalent if they

Yield the Same Effective Rate «

Continuous Compounding

Consider Rs P is invested for N periods at r per cent per period and the

interest is compounded m times per period, the terminal value will be

If # of compounding very large and approaches infinite; as mpg

the terminal value will be

Effective Rate is Nothing But Compounding Rate When Interest Rate Conversion

Period is Different From Measurement Period«

Effective Rate is Nothing But Compounding Rate When Interest Rate Conversion

Period is Different From Measurement Period«

Future Value of Money

When an amount is deposited for a time period at a given rate of

interest

± The amount that is accrued at the end is called the future value of the

original investment

± So if Rs P is invested for N periods at r% per period

( 1 + r/m)

Nm

is the amount to which an investment of Rs 1 will grow at

the end of N periods.

It is called FVIF ± Future Value Interest Factor.

It is a function of r and N.

It is given in the form of tables for integer values of r and N

If the FVIF is known, the future value of any principal can be found by

multiplying the principal by the factor.

FV = PV ( 1 + r/m)

Nm

Present Value of Money

When an amount is expected to come in a future date it would be

important to know what would the amount be worth at present

± The worth of the a certain cash flow at present is called the present value of

the future cash flow

± So if Rs FV is expected cash flow at the end of period N the PV is

Where r is interest rate and m is the # of times interest is accessed per

measurement period.

1 / [( 1 + r/m)

Nm

] is the amount that need to be invested to get Rs 1 at

the end of N periods.

It is called PVIF ± Present Value Interest Factor.

It is a function of r and N.

It is given in the form of tables for integer values of r and N

If the PVIF is known, the present value of any amount can be found by

multiplying the future value by the factor.

PV = FV / [( 1 + r/m)

Nm

]

Future & Present Value

Illustrations

Illustration - 1

Pritam has deposited Rs 20,000 with SBI for 4 years

The bank pays simple interest at the rate of 15% per annum

What is amount Pritam is going to receive at the end of 4

th

year

FV = P(1+rN)

FV = 20000 (1+0.15*4) = 20000 (1+.6) = Rs. 32,000

What is amount Pritam is going to receive at the end of 4.5

years (every thing else remain the same)?

FV = 20000 (1+0.15*4.5) = 20000 (1+.675) = Rs. 33,500

Illustration - 2

Pritam has deposited Rs 20,000 with SBI for 4 years

The bank pays 15% per annum interest rate compounded annually

What is amount Pritam is going to receive at the end of 4

th

year

FV = P(1+r)

N

FV = 20000 (1+0.15)

4

= 20000 * 1.749 = Rs. 34,980

What is amount Pritam is going to receive at the end of 4.5 years (every

thing else remain the same)?

FV = 20000 (1+0.15)

4.5

= 20000 (1+.975) = Rs. 37,512

What amount Pritam is going to receive at the end of 4.5 years if he gets

compounding rate till the 4

th

year and simple rate for the next 6 months

(every thing else remain the same)?

FV = 34980 + 34980 * (0.15/2) = 34980 + 2623.5 = Rs. 37,603

Illustration - 3

ICICI Bank is quoting 9% per annum compounded

annually and HDFC Bank is quoting 8.75% per annum

compounded quarterly.

Where would you invest?

In the case of ICICI

± The nominal rate is 9% per annum

± The effective rate is also 9% per annum

In the case of HDFC

± The nominal rate is 8.75% per annum

± The effective rate is (1+0.0875/4)

4

= 9.0413% per annum

Illustration - 4

Suppose HDC Bank wants to offer an effective annual rate of

10% with quarterly compounding

± What should be the quoted nominal rate

ICICI Bank is offering 9% per annum with semi-annual

compounding.

What should be the equivalent rate offered by HDFC

Bank if it intends to compound quarterly.

Illustration - 5

Pritam has deposited Rs 10,000 with SBI for 5 years at 10%

per annum compounded continuously.

What is the amount Pritam is going to get after 5 years

FV = 10000 * e

(r*N)

= 10000 * (2.7206)

0.1*5

= 10000 *

1.649 = Rs. 16,490

Illustration - 6

Pritam has deposited Rs 10,000 for 5 years at 10% compounded annually.

What is the Future Value?

Thus F.V. = 10,000 x 1.6105 = Rs 16,105

Pritam has deposited Rs 10,000 for 4 years at 10% per annum

compounded semi-annually.

What is the Future Value?

10% for 4 years is equivalent to 5% for 8 half-years

Thus F.V. = 10,000 x 1.4775 = Rs 14,775

Illustration - 7

LIC has collected a one time premium of Rs 10,000 from Pritam

and has promised to pay her Rs 30,000 after 10 years.

The company is in a position to invest the premium at 10%

compounded annually.

Can LIC meet its obligation?

The future value of Rs 10,000 after 10 years is

FV = 10,000 x FVIF (10,10) = 10000 * (1.1)10 = 10000 * 2.5937 =

Rs 25,937

The FV is lesser than the liability of Rs 30,000

Therefore LIC can not meet its commitment, and to meet its

commitment it has to either increase the premium or increase

the effective rate of return

Illustration -8

Syndicate Bank is offering the following scheme

± An investor has to deposit Rs 10,000 for 10 years

± Interest for the first 5 years is 10% compounded annually

± Interest for the next 5 years is 12% compounded annually

± What is the Future Value?

The first step is to calculate the future value after 5

years:

The next step is to treat this as the principal and

compute its terminal value after another 5 years

Illustration - 9

Pritam would like to have Rs. 12000 after 4 years

What amount Pritam need to invest if he gets a 10%

simple rate of return

PV = FV / (1+rN) = 12000 / [1+0.1*4] = Rs. 8571

What amount Pritam need to invest if he gets a 10%

return compounded quarterly

PV = FV / (1+r)

N

= 12000 / (1+0.1/4)

16

= Rs. 8084

SBI is offering an instrument that will pay Rs

10,000 after 5 years.

The price that is quoted is Rs 5,000.

If the investor wants a 10% rate of return,

should he invest.

The problem can be approached in three

ways.

Illustration ± 10: Evaluating an Investment

The Future Value Approach

Assume that the instrument is bought for

5,000.

If the rate of return is 10% the future value is

5,000 x FVIF (10,5) = 5000 * 1.6105 = Rs

8,052.50

Since the instrument promises a terminal

value of Rs 10,000 which is greater than the

required future value, the investment is

attractive.

Illustration ± 10: Evaluating an Investment

The Present Value Approach

The present value of Rs 10,000 using a discount rate

of 10% is;

10,000 * PVIF(10,5) = 10000 * 0.6209 = Rs 6,209

Therefore to get a 10% return over 5 years the

investor would have to pay Rs 6,209

In this case the investment is Rs 5,000 which is less

than Rs 6,209

The investment is attractive

Illustration ± 10: Evaluating an Investment

The Rate of Return Approach

The investor invest Rs 5,000 and receive Rs 10,000 after 5

years.

What is the rate of return?

The rate of return can be calculated by:

Illustration ± 10: Evaluating an Investment

The rate of return that would equal LHS with RHS is

14.87%

In this case the actual rate of return is 14.87% and the

required rate for the investor is 10%

Therefore the investment is attractive.

Illustration - 11: The Internal Rate of

Return

Let us assume that an investment of Rs 18,000 will

entitle us to the following cash flows for the next 5

years.

± What is the rate of return of this investment?

Illustration - 11: The Internal Rate of

Return

The rate of return is the solution to the following

equation:

The solution to this equation is called the

Internal Rate of Return (IRR)

It can be obtained using the IRR function in

EXCEL.

In this case, the solution is 14.5189%

Annuities

Understanding Annuities

What is an annuity?

± Annuity is a series of equal payments made/received at equally spaced

time intervals

± Annuity are of two types

Ordinary annuity: When payment made/received at the end of first period

Annuity Due: When payment made/received at the beginning of the first

period

± Examples of annuity

House rent and monthly salary till it is revised ʹ Ordinary Annuity

Insurance premium: Annuity Due

EMIs on housing/automobile loans: Ordinary Annuity

The interval between successive payments/receipt is called the

payment/receipt period

We will assume that the payment/receipt period is the same as the

interest conversion period for valuation purpose

The assumption implies that is, if the annuity paid/received

annually/semi-annually, we will assume annual/semi-annual

compounding

Future Vale of Annuity

´ ) ´ ) ´ )

´ ) ´ ) ´ ) ´ ) ´ )

´ ) ´ ) ´ ) ´ )

´ ) ´ ) ´ ) ´ ) ´ )

´ ) ´ )

´ ) ´ ) . J

´ ) . J

´ ) . J 1 1

1 1

1 1 1

1 1

1 1 1 1 1

1 1 1 1

1 1 1 1 1

1 1 1

2

2

3 2

1 2

!

!

!

!

!

!

!

!

N

N

N

N

N

N

N

N

r

r

A

FV

r A FVr

r A FV r FV

A r A FV r FV

A r A r a r A r A A r FV

A A r A r A r A r FV

r A r A r A r A r FV

r A r A r A A FV

Where

A = Regular Annuity

r = interest rate

Present Vale of Annuity

´ ) ´ ) ´ )

´ )

´ ) ´ ) ´ )

´ )

´ ) ´ ) ´ ) ´ ) ´ )

´ )

´ )

´ )

´ )

´ )

´ )

¦

¦

¦

+

=

¦

¦

¦

+

+ =

+

= +

+

+ = +

+

+

+

+

+ +

+

+

+

+ = +

+

+ +

+

+

+

+ = +

+

+ +

+

+

+

+

+

=

N

N

N

N

N N N

N

N

r r

P

r

P r

r

P r P

r

P r P

r r r r r

r P

r r r

r P

r r r r

P

1

1

1

1

1

1

1

1

1 1 1 1 1

1

1 1 1

1

1 1 1 1

1 2

1 2

3 2

Where

A = Regular Annuity

r = interest rate

Understanding Annuities

PVIFA is the present value of an annuity that pays Rs 1 per period for N period.

± We can calculate the present value by multiplying the annuity with the PVIFA

FVIFA is the future value of an annuity that pays Rs 1 per period for N period.

± We can calculate the future value by multiplying the annuity with the FVIFA

Present Value Interest Factor of Annuity

(PVIFA)

Future Value Interest Factor of Annuity

(FVIFA)

Relationship Between PVIFA and FVIFA

Present Value of Annuity Due

The present value of an annuity due is greater than that

of an ordinary annuity that makes N payments

Why?

Each cash flow has to be discounted for one period less.

Future Value of Annuity Due

The future value of an annuity due is greater than that of

an ordinary annuity that makes N payments

Why?

Each cash flow will get one period more to yield return.

Perpetuities

An annuity that pays forever is called a perpetuity.

The future value of a perpetuity has a finite present

value.

Illustration - 12

LIC is offering an instrument that will pay Rs 10,000 per year for next 20

years, beginning one year from now.

If the rate of interest is 10%, what is the present value?

± PV = 10,000xPVIFA(10,20) = 10,000 x 8.5136 = Rs 85,136

If the rate of interest is 10%, and payment is for 25 years what is the

present value?

± PV = 10,000xPVIFA(10,20) = 10,000 x 9.0770 = Rs 90,770

If the rate of interest is 8%, what is the present value?

± PV = 10,000xPVIFA(10,20) = 10,000 x 9.8181 = Rs 98,181

If the rate of interest is 8%, and payment is for 25 years what is the

present value?

± PV = 10,000xPVIFA(10,20) = 10,000 x 10.6748 = Rs 106,748

The Present Value of Annuity would Decrease if the Interest Rate

Goes Up and Increases with the # of Years of Payment

The Present Value of Annuity would Decrease if the Interest Rate

Goes Up and Increases with the # of Years of Payment

Illustration - 13

Pritam is expecting to receive Rs 10,000 per year for next 20 years,

beginning one year from now.

If the cash flow can be invested at 10%, what is the future value?

± FV = 10,000xFVIFA(10,20) = 10,000 x 57.275 = Rs 572,750

If the rate of interest is 10%, and Pritam is going to receive the payment for

25 years, what is the present value?

± FV = 10,000xFVIFA(10,25) = 10,000 x 98.3471 = Rs 983,471

If the rate of interest is 8%, what is the present value?

± FV = 10,000xFVIFA(8,20) = 10,000 x 45.7620 = Rs 457,620

If the rate of interest is 8%, and Pritam is going to receive the payment for

25 years, what is the present value?

PV = 10,000xPVIFA(10,20) = 10,000 x 73.1059 = Rs 731,059

The Future Value of Annuity would Increase if the Interest Rate

Goes Up and Increases with the # of Years of Payment

The Future Value of Annuity would Increase if the Interest Rate

Goes Up and Increases with the # of Years of Payment

Illustration - 14

Pritam bought a insurance policy, which requires him to pay Rs. 10,000 per

year as insurance premium for next 20 years.

If the rate of interest is 10%, what is the present value?

± PV = 10,000xPVIFA

AD

(10,20) = 10,000 x 9.3649 = Rs 93,649

± Which is equal to Rs. 85,136 * (1+r) = Rs. 93,649

Pritam bought a insurance policy, which requires him to pay Rs. 10,000 per

year as insurance premium for next 20 years.

If Pritam would have invested the amount he would have got 10% per

annum, what is the future value of the cash he invested in the insurance

policy?

± FV = 10,000xFVIFA

AD

(10,20) = 10,000 x 63.0025 = Rs 630,025

± Which is equal to Rs. 572,750 * (1+r) = Rs. 630,025

Illustration - 15

A financial instrument promises to pay Rs 10,000 per year forever.

If the investor requires a 10% rate of return, how much should he be willing

to pay for it?

The value of the perpetuity is: 10,000 / 0.1 = 100,000

If the investor requires a 20% rate of return, how much should he be willing

to pay for it?

The value of the perpetuity is: 10,000 / 0.2 = 50,000

If the payment from the instrument increases to Rs.12,000 and investor

requires a 10% rate of return, how much should he be willing to pay for it?

The value of the perpetuity is: 12,000 / 0.1 = 120,000

The Value of the Perpetuity would Decrease if the Required Rate of

Return Increases and Value would Increase if the Payment Increases

The Value of the Perpetuity would Decrease if the Required Rate of

Return Increases and Value would Increase if the Payment Increases

Amortization

Understanding Amortization

The amortization is a process of repaying an installment loan by

means of equal installments at periodic intervals.

Each of the installments paid can be seen in form of an annuity.

± Logically speaking the present value of the annuity discounted at the

loan interest rate would be equal to the loan amount

Each equal installment would consists of two component

± A Portion of the principal amount

± Interest on the outstanding loan amount

An amortization schedule would show the payment that goes

into principal component and payment that goes into interest

component, together with the outstanding loan balance after

the payment is made.

Estimating the Amortization Schedule

Consider a loan which is repaid in N installments of Rs A each.

The original loan amount is Rs L, and the periodic interest rate is r.

Estimating the Amortization Schedule

Illustration - 16

Pritam has borrowed Rs 10,000 from SBI and has to

pay it back in five equal annual installments.

The interest rate is 10% per annum on the

outstanding balance.

What is the installment amount?

Illustration ʹ 16: Amortization Schedule

At time 0, the outstanding principal is 10,000

After one period an installment of Rs 2,637.97 is made.

The interest due for the first period is 10% of 10,000 or Rs 1,000

So the excess payment of Rs 1,637.97 is a partial repayment of principal.

After the payment the outstanding principal is Rs 8,362.03

After another period a second installment is paid.

The interest for this period is 10% of 8,362.03 which is Rs 836.20.

The balance of Rs 1,801.77 constitutes a partial repayment of principal.

The value of the outstanding balance at the end should be zero.

After each payment the outstanding principal keeps declining.

Since the installment is constant

The interest component steadily declines

While the principal component steadily increases

Amortization with a Balloon Payment

Pritam has taken a loan of Rs 100,000 from SBI.

She has to pay in 5 equal annual installments along with a terminal

payment of Rs 25,000

The terminal payment which has to be made over and above the

scheduled installment in year 5

± Is called a BALLOON payment.

If the interest rate is 10% per annum, the annual installment

may be calculated as

Amortization Schedule

Types of Interest Computation

Financial institutions employ a variety of different techniques to calculate the interest on the loans made by

them. The interest that is effectively paid on the loan may be very different from the rate that is quoted. Thus

what you see is not what you get.

The Simple Interest Method

In this technique, interest is charged for only the period of time that a borrower has actually used the funds.

± Each time principal is partly repaid, the interest due will decrease.

The Add-on Rate Approach

In this case interest is first calculated on the full principal.

The sum of interest plus principal is then divided by the total number of payments in order to determine the

amount of each payment.

In Alfred͛s case if he repays in one annual installment, there will be no difference with this approach as

compared to the simple interest approach.

The Discount Method Approach

In this approach the total interest is first computed on the entire loan amount.

This is then deducted from the loan amount.

The balance is lent to the borrower.

The Compensating Balance Approach

Many banks require that borrowers keep a certain percentage of the loan amount with them as a deposit.

This is called a Compensating Balance.

It raises the effective interest rate

± Since the borrower cannot use the entire amount that is sanctioned

Illustration ʹ 17: Simple Interest

Method

Pritam has borrowed 5,000 from the bank for a year.

The bank charges simple interest at the rate of 8% per annum.

If the loan is repaid at the end of one year:

± Interest payable = 5000x0.08 = 400

± Total amount repayable = 5,400

Assume the loan is repaid in two equal semi-annual installments.

± After six months principal of 2,500 is repaid.

± Interest will however be charged on 5,000.

± Amount repayable = 2500 + 5000x0.08x.5 = 2700

For the next six months interest will be charged only on 2,500.

± The amount payable at the end of the second six-monthly period

= 2500 + 2500x0.08x.5 = 2,600

± Total outflow on account of principal plus interest = 2700 + 2600 = 5300

± Obviously the more frequently the principal is repaid the lower is the interest.

Illustration ʹ 18: Add-on Rate

Approach

What if he repays in two installments?

± Interest for the entire year = 400

± This will be added to the principal and divided by 2.

± Thus each installment = (5000 + 400) / 2 = 2700

The quoted rate is 8% per annum.

But the actual rate will be higher.

The actual rate is given by

The solution is i = 10.5758%

This is of course the nominal annual rate.

The effective annual rate is 10.8554%

Illustration ʹ 19: The Discount Method

Approach

Prtam borrows 5000 at 8% for a year.

The interest for the year is 400.

So Pritam will be given 4600 and will have to repay

5000 at the end.

The effective rate of interest

= [(5000 ʹ 4600) / 4600 ] * 100 = 8.6957%

Illustration ʹ 20: The Compensating

Balance Approach

Pritam is sanctioned 5,000 at the rate of 8%.

But he has to keep 10% of the loan amount with the bank for

the duration of the loan.

So while he pays an interest of 400, the usable amount is only

5000x0.9 = 4500

The effective interest cost is [400 / 4500] * 100 =

8.8889%

Quite obviously

± The higher the compensating balance, the greater will be

the effective interest rate.

Annual Percentage Rate (APR)

The effective rate of interest that is paid by a borrower is a

function of the type of loan that is offered to him.

Since different lenders used different loan structures,

comparisons between competing loan offers can be difficult.

To ensure uniformity the U.S. Congress passed the

± Consumer Credit Protection Act

± This is commonly known as

The Truth-in-Lending Act

The law requires institutions extending credit to use a

prescribed method for computing the quoted rate.

Every lending institution is required to compute the APR and

report it before the loan agreement is signed.

The most accurate way to compute the APR is by equating the

present value of the repayments made by the borrower to the

loan amount.

Valuation of Assets

(Debt & Equity)

Valuation of Debt

Understanding the Debt Instrument

What is debt and who issues it?

± It is a financial claim issued by borrower of funds for whom it is a liability.

Who holds it?

± The lender of funds for whom it is an asset

What is the difference between debt and equity?

± Equity confer ownership rights where as debt does not.

± Debt promises to pay interest at periodic intervals and to repay the principal

itself at a pre-specified maturity date, where as equity gives right to the surplus

generated by the organization without any promise

± Debt usually has a finite life span where as equity has infinite life

± The interest payments are contractual obligations borrowers are required to

make payments irrespective of their financial performance

In the event of liquidation

± The claims of debt holders must be settled first, Only then can equity holders

be paid.

Terminology Associate with Debt

Instrument

Face Value

It is the principal value and the amount payable by the borrower to the

lender at maturity.

Periodic interest payments are calculated on this amount

Term to Maturity

It is the time remaining for the bond to mature and time remaining for

which interest has to be paid as promised.

The Coupon Rate and the Coupon Value

Periodic interest rate (coupon rate) need to paid by the borrower.

The value of the coupon can be calculated by multiplying the face value

with the coupon rate.

Yield to Maturity (YTM)

YTM is the rate of return an investor will get if held to maturity and all

coupon received before maturity must be reinvested at the YTM

Terminology Associate with Debt

Instrument

Discount Bonds

If the price of the bond is less than the face value at the time of issue then it is a

discount bond

If the bond is trading at lower than face value then also is called discount bond

± This will happen when the YTM is higher than the coupon rate.

Par Bonds

If the price of the bond is equal to the face value at the time of issue then it is a par

bond

If the bond is trading at face value then also is called par bond

± This will happen when the YTM is equal to coupon rate.

Premium Bonds

If the price of the bond is more than the face value at the time of issue then it is a

premium bond

If the bond is trading at higher than face value then also is called discount bond

± This will happen when the YTM is lower than the coupon rate.

A Zero Coupon Bonds

In a zero coupon bond coupon rate is zero

It is issued at a discount and repays the principal at maturity. The difference

between the offer price and the face value is the return received by the investor.

Valuing Debt: Discounted Cash-flow

Method

Value of a bond is derived from the stream of cash flows that the bond holders have

the right to receive at periodic interval.

How would we derive the value when the cash-flows are received at different time

intervals?

± All future cash flows including the payment of principal at maturity needs to be

discounted to the present to derive the value of the cash flows

Value of bond is a function YTM which is determined by;

± The face value or the maturity amount

± The coupon rate

± The term to maturity

± The market price of the bond

The valuation can be arrived by treating periodic cash flows as annuity and the

terminal face value is a lump sum payment.

± If the coupon is paid more often than once per year then the coupon amount needs to

calculated accordingly

Nuances of Valuing bonds

± If the investor know the yield that is required by him, then he can calculate the price that

would give him the expected yield.

± Conversely, if the investor buys the bond at a certain price, he could calculate the yield he

would receive from the investment.

± Therefore the yield and price is dependent on each other and need to be determined

simultaneously

Valuing Debt: Example

Let us take following example;

± Tata Motors were to issue a bond with 10 years to maturity.

± The maturity amount at the end of 10 year is Rs.1000

± The coupon rate is 8%, and coupon amount is Rs. 80.

± The coupon is paid at the end of the year

The company is going to pay 10 coupons which can be treated as annuity and the

present value of the annuity would be

± (R80 / 0.08) * [1 - 1 / (1+0.8)

10

] = 1000 * [1 ʹ 1 / 2.1589]

= 1000 * 0.53681 = Rs.536.81

The company is going to pay Rs.1000 at the end of 10

th

year. The present value of

the maturity amount would be

± 1000 / (1+0.08)

10

= 1000 / 2.1589 = Rs.463.19

The two parts can be added to get the value of the bond

± Rs.536.81 + Rs.463.19 = Rs.1000

The bond is selling at its face value. Given the coupon rate is 8% and coupon

amount is Rs.80, the bond will be valued at Rs.1000

Valuing Debt: Example of Change in Interest rate

Let us a year has gone by and the interest rate has changed to 10%;

± Tata Motors bond has 9 years to maturity.

± The maturity amount at the end of 9 year is Rs.1000

± The coupon rate is 8%, and coupon amount is Rs. 80.

± The coupon is paid at the end of the year

The company is going to pay 9 coupons which can be treated as annuity and the present value

of the annuity would be

± (R80 / 0.1) * [1 - 1 / (1+0.1)

9

] = 800 * [1 ʹ 1 / 2.3579] = 800 * 0.57590 = Rs.460.72

The company is going to pay Rs.1000 at the end of 9

th

year. The present value of the maturity

amount would be

± 1000 / (1+0.1)

9

= 1000 / 2.3579 = Rs.424.10

The two parts can be added to get the value of the bond

± Rs.460.72 + Rs.424.10 = Rs.884.82

The bond would sell at Rs.885 after one year when the interest rate is 10%

± Given the going interest rate is 10%, the YTM has to be 10%. The investor would only get

YTM of 10% on 8% coupon rate bond only if the investor get the bond at discount

± Loss in interest rate of 2% will compensated by the difference in value at maturity and

market price

± Rs.1000 ʹ Rs. 884.82 = Rs.115.18 is nothing but the present value of difference in coupon

value at 8% and 10% coupon rate which is value of annuity of Rs.20 for 9 years discounted

at 10%.

± (R20 / 0.1) * [1 - 1 / (1+0.1)

9

] = 200 * [1 ʹ 1 / 2.3579] = 200 * 0.57590 = Rs.115.18

Valuing Debt: Example of Change in Interest rate

Let us a year has gone by and the interest rate has changed to 6%;

± Tata Motors bond has 9 years to maturity.

± The maturity amount at the end of 9 year is Rs.1000

± The coupon rate is 8%, and coupon amount is Rs. 80.

± The coupon is paid at the end of the year

The company is going to pay 9 coupons which can be treated as annuity and the present value of

the annuity would be

± (R80 / 0.06) * [1 - 1 / (1+0.06)

9

] = 1333.333 * [1 ʹ 1 / 1.6895] = 1333.333 * 0.40810 =

Rs.544.14

The company is going to pay Rs.1000 at the end of 9

th

year. The present value of the maturity

amount would be

± 1000 / (1+0.06)

9

= 1000 / 1.6895 = Rs.591.89

The two parts can be added to get the value of the bond

± Rs.544.14 + Rs.591.89 = Rs.1,136.03

The bond would sell at Rs.1,136 after one year when the interest rate is 6%

± Given the going interest rate is 6%, the YTM has to be 6%. The investor would only get YTM

of 6% on 8% coupon rate bond only if the investor get the bond at premium

± Gain in interest rate of 2% will compensated by the difference in value at maturity and

market price

± Rs.1136.03 ʹ Rs. 1000 = Rs.136.03 is nothing but the present value of difference in coupon

value at 8% and 6% coupon rate which is value of annuity of Rs.20 for 9 years discounted at

10%.

± (R20 / 0.06) * [1 - 1 / (1+0.06)

9

] = 333.33 * [1 ʹ 1 / 1.6895] = 333.33 * 0.40810 = Rs.136.03

Valuing Debt: Generalizing

Based on the learning from the examples we can generalize the formula for valuing

the bond

V = [C/r] * [1 ʹ 1/(1+r)

t

] + [F/(1+r)

t

, where

± V is the price of the bond

± C is the coupon amount

± r is the yield required from the bond

± F is the face value or the amount received at the maturity

± t is the time term left to maturity

In case the coupon is paid more than once in a year, we need to change the r

and t accordingly, for example;

± If the coupon is paid twice in a year then the appropriate yield would be r/2

± The time left to maturity would be 2t

Valuing Debt: Risk Associated with Bonds

All bonds are exposed to one or more sources of risk.

± Credit risk: This risk refers to the possibility of default on payment of principal or the

periodic interest payments.

± Interest rate risk: This risk refer to change in value of bonds due to change in interest rate

and risk of re-investment return due to change in Change in interest rate.

± Liquidity risk: This risk refers to not able to sell the bond

± Inflation risk: This refers to risk associated with inflation

± Foreign exchange risk: This risk involved only if bond is issued in foreign currency

The potential investor need to evaluate the risk associated with the bond

± At the time of issue, it is the issuer͛s responsibility to provide accurate information about his

financial soundness and creditworthiness, which is provided in the offer document or the

prospectus.

± Given the complexity of offer document, a general investor may not able to evaluate the

bond issuer͛s credibility

± This work is generally done by credit rating agencies

± This agencies take all available information and provide ratings in simple terms so that the

investor can understand the risk associated with the bond

Higher the risk associate with the bonds higher would be the yield

± If the risk change before the maturity period then it can be reflected on the price of the

bond

± Credit rating agencies provide rating updates to help the investors to make appropriate

decisions

Understanding Complex Bonds

Floaters

Floaters is a types of bond where the coupon rate can that can change over

time instead of a fixed coupon in case of plain vanilla bond

± Floaters can be linked to a benchmark rate like LIBOR or government

treasury bonds.

± The coupon rate would be Benchmark Rate +/- x%

± The difference between the benchmark and coupon rate is call the spread

± The spread can be positive as well as negative

Inverse Floater

In the case of an inverse floater the coupon varies inversely with the

benchmark.

± For instance the rate on an inverse floater may be specified as 10% - LIBOR.

± In this case as LIBOR rises, the coupon will decrease, whereas as LIBOR falls, the

coupon will increase.

In case of inverse floater a a floor has to be specified for the coupon because

if the in the absence of a floor the coupon can become negative

Callable Bonds

In the case of callable bonds the issuer has the right to call back the bond

before the maturity of the bond by paying the face value.

± When the yield is falling the issuer would be better of calling back the bond if

he has the option

± On the other hand the buyer would like to hold on to the bond because he is

getting higher yield, and he has a re-investment risk

± The call option always works in favor of the issuer

Buyers of callable bonds would like to expect a higher yield because he

faces uncertainty over the cash flow

± To compensate for the risk the buyer would demand higher coupon rate or

lower price of the bond.

Freely callable bonds can be called at any time and hence offer the lender

no protection. On the other hand deferred callable bonds can be called

after some pre-specified time

In some cases some premium is paid (one years coupon) at the time of

calling the bond, which is called the call premium

Putt-able Bonds

In the case of putt-able bonds the subscriber has the right to return the

bond before the maturity and collect the face value.

± When the yield is rising the subscriber would be better of surrendering the bond

if he has the option

± On the other hand the issuer would like the lender to hold on to the bond

because the issuer would have to pay higher yield, and he has a re-issuance risk

± The put option always works in favor of the lender

Seller of putt-able bonds would like to provide a lower yield because the

issuer faces uncertainty over the withdrawal of bond

± To compensate for the risk the issuer would demand a premium resulting in

lower coupon rate or higher price of the bond.

Freely putt-able bonds can be returned at any time and hence offer the

issuer no protection. On the other hand deferred putt-able bonds can be

returned after some pre-specified time

In some cases some premium is paid (one years coupon) at the time of

returning the bond, which is called the put premium

Convertible and Exchangeable Bonds

A convertible bond is right for the bond holder to convert the bond into

common stocks of the issuing corporation.

± The conversion ratio (# of common stock per bond) is predetermined.

± The conversion can be made after the a pre-specified time or over a pre-

specified period.

± The stated conversion ratio may also decline over time depending on the

provision

± The conversion ratio generally adjusted proportionately for stock splits

and stock dividends.

Exchangeable bonds are a category of convertible bond, that grants the

holder a privilege to gets the shares of a different company.

± Exchangeable bonds may be issued by firms which own blocks of shares

of another company and intend to sell them eventually by doing in a

exchangeable bond way is to defer the selling decision because

The expectation that the price of the exchangeable stock will rise

Tax benefit involved

Valuation of Equity

Introduction

Valuation of an equity would depend on the required return the investor

would demand to invest in the equity.

What are the factors that determine the required rate of return on an

investment?

± Risk associated with the investment. The greater the risk, greater will be

the required return.

± The size of the cash flows received from it. Greater the cash flow

greater would be the valuation

± The timing of the cash flows.

How do we define and measure risk of an investment and what do we

mean when we say that investment in asset A is riskier than the investment

in asset B?

± What is the relationship between an asset͛s risk and its required

return?

Risk associated with an asset can be of two types

± Systematic risk: The risk contributed by the factors that affect all the

assets. For example decline in growth rate of the economy.

± Unsystematic risk: The risk contributed by the factors that affect only

the asset under consideration. For example decline in growth rate of

the company where the investment has been made.

Valuation of Equity: Cash Flow Method

What are the cash flows from an equity investment?

± Dividend for each holding period

± Inflow from sale of the stock at the end of investment horizon.

Consider the case of an investor who plans to hold the stock for one

period

± Price of the equity can be expressed by

Generalization of the Cash Flow

Equation

If we assume that the person who buys the stock after one period also has

a one period investment horizon, then:

Extending the same logic for t period would give us

Therefore value of any equity share is the present value expected

stream dividends expected to be paid over infinite period

Equity Valuation: The Constant Growth

Model

It is extremely difficult to forecast an infinite stream of dividends, which is

required to derive the valuation of equity.

To make it simple we can assume that the dividends are going to grow at a

constant rate over the infinite period

± Let us assume dividends is going to grow at g% per year and the declared

declared dividend now is d

0

± The value of the equity is

Equity Valuation: Solving for r

The cash flow method would require us to use the most appropriate value

for r (the discount rate)

The discount rate would depend on risk associated with the equity in

question

To derive the value of r we need know the risk associated with the equity,

and the relationship between risk and expected return

The relationship between risk and return can be derived if we know the risk

premium market would pay to take an extra unit of risk

This relationship is described in Capital Asset Pricing Model (CAPM)

The CAPM would help us determine the expected return from a asset.

The CAPM only provides incremental return for taking systematic risk

because the unsystematic risk can be eliminated through diversification

Equity Valuation: Role of Diversification

When an investor makes an investment he takes two kind of risk

± One that is specific to the equity

± Other that is related to the macro economic factor, which would affect all

equities

If two equities are co-related with each other by combining these two

equities one can reduce the risk associated with individual equities.

If we take a very large number of equities and the investors will allocate

the invest able fund across all these equities then the portfolios will not

have any equity specific risk (unsystematic risk)

The portfolio would only have systematic risk, and market would only

provide incremental return for taking the systematic risk.

This has an important implication

± To a diversified investor only systematic risk matters

± The investment decision would depend on individual assets contribution to

the systematic risk

Understanding Systematic Risk

There is a reward on an average for bearing incremental risk and the

reward depends only on the systematic risk of the investment

Why?

± Unsystematic risk can be eliminated by diversification, hence no

reward for taking the risk. Market will not reward for taking

unnecessary risk.

Only systematic risk is relevant for determining the expected return and

the risk premium of an asset

Systematic risk is measured by the BETA of an asset - F (Beta)

Beta measures the systematic risk of an asset relative to market portfolio.

By definition market portfolio has a beta of 1.0

± So an asset with a beta of 0.50 has half as much systematic risk as the

market portfolio

± An asset with a beta of 2.0 has twice as much systematic risk as the

market portfolio

The larger the beta, the higher the systematic risk and the greater will be

the expected return

Security A may have higher unsystematic risk than security B, if security B

has more systematic risk then the expected return on security B would be

higher than security A

Understanding the Portfolio Return and

Risk

Portfolio return can be calculated by taking a weighted average of expected

return of all assets that constitute the portfolio.

Risk of an asset can be measured by calculating the standard deviations of

returns of the asset.

Calculation of portfolio risk is more complex because of interaction among

assets

The portfolio risk is measured by summing of all the co-variances

A well diversified portfolio has only systematic risk. Therefore we can calculate

the contribution of an individual asset to the portfolio risk by measuring the

co-variances between the asset and well diversified portfolio (market

portfolio)

The Beta which measure the systematic risk of an asset is nothing but the co-

variance between the asset and a market portfolio (well diversified portfolio)

A security would enter a portfolio only when its contribution towards portfolio

return is higher in comparison to its contribution towards portfolio risk

Risk Premium & CAPM

A risk averse investor demands risk premium if he is taking incremental

risk

If R

i

is the return from an asset i and risk-free rate is R

f

then the risk

premium of the asset I is R

i

ʹ R

f

± Is the risk premium (R

i

ʹ R

f

) adequate for the asset i

± How would we know adequacy of risk premium of an asset?

First we need to calculate the risk premium market demand for a market portfolio,

which is (R

m

ʹ R

f

) where R

m

is the expected return from the market

Multiply (R

i

ʹ R

f

) with the quantity of risk associate with the asset I, which is

measure by Beta

Once we know the risk premium of the asset i we can easily calculate the

expected return from the asset I

The expected return from asset i is described in the form CAPM

Deriving the CAPM

Let us take an asst i

± Asset i͛s contribution to risk premium is R

i

ʹ R

f

± Asset i͛s contribution to risk is Cov(Ri, Rm)

± Risk premium per unit of risk is = (R

i

ʹ R

f

)/ Cov(R

i

, R

m

)

Let us take the market portfolio m

± The risk premium in the market is R

m

ʹ R

f

± The risk of the market portfolio is Cov(R

m

, R

m

) = ʍ

m

2

± Risk premium per unit of risk is = (R

m

ʹ R

f

)/ ʍ

m

2

In the equilibrium the risk premium per unit of risk for the asset I will be

equal to the risk premium per unit of risk for the market portfolio

Therefore (R

i

ʹ R

f

)/ Cov(R

i

, R

m

) = (R

m

ʹ R

f

)/ ʍ

m

2

± (R

i

ʹ R

f

) = (R

m

ʹ R

f

) * [Cov(R

i

, R

m

)/ ʍ

m

2

]

± R

i

= R

f

+ Cov(R

i

, R

m

)/ ʍ

m

2

] * (R

m

ʹ R

f

)

± R

i

= R

f

+ ɴ

i

* (R

m

ʹ R

f

) where ɴ = Cov(R

i

, R

m

)/ ʍ

m

2

]

Now we have equation which would help us in calculating the expected

return for an asset

Using CAPM

The CAPM can be used for many purpose

± Pricing of risky assets

If the expected return is higher then the asset is over priced

If the expected return is lower then the asset is under priced

As a investor one is always looking for under priced asset

± Calculating the cost of equity

The CAPM equation would help us in calculating the cost of equity

by giving the return that an investor is looking from the specific

equity investment

± Calculating the risk premium

CAPM gives us the frame work to calculate the market price for risk

It would help us to calculate the incremental return that is required

to take an unit of incremental risk

Establishes the relationship between risk and return

Cost of Capital

Understanding Cost of Capital

Firms need capital for creating assets that would generate return for the

owners of firm

The capital is provided by organizations that have surplus capital

± Capital can have two types of claim

Debt

Equity

The SBU demand a return to provide capital

± The expected return demanded by the SBU is the cost of capital for the firm,

the DBU

± The expected return would be a function of types of capital

The firm͛s overall cost of capital will reflect the required return on the

firms composition of types of capital

± Overall cost of capital will be a mixture of the returns required by the creditors

(debt capital provider) and the returns required by the shareholders (equity

capital provider)

± The cost of capital is related to the expected return required by the provider of

both of capital

± A firm͛s cost of capital is nothing but the weighted average cost of debt and

equity

± COST OF CAPITAL= REQUIRED RETURN ON THE INVESTMENT

Required Return vis-à-vis Cost of Capital

What is required rate of return?

± Required rate of return is the rate of return above which the investor would be

better of

± For example

If the required rate of return on a investment is 10%, the investor would be better of

if the return is more than 10%

On the other hand the investor would not invest if the rate of return is below 10%

In this specific example the cost of capital for the investment would be 10%

The required return would be a function of the risk associated with the

project

± Let us evaluate a risk-free project

How would we determine the required rate of return for the risk-free project?

Required return for a risk free project is nothing but the return an investor gets when

the investor invest in risk free instrument, which is nothing but return available on

government bonds

± Let us evaluate a risky project

Required return would be higher for a risky project and will depend on the risk-free

rate and the risk premium demanded by the investor

The cost of capital associated with an investment depends on the risk of the

investment

Cost of capital primarily depends on the use of funds

Understanding Cost of Equity

Cost of equity of firm is the expected return form the firm͛s

equity

How would we know the firm͛s cost of equity?

± This is a difficult question

Why?

± There is no way of directly measuring the expected return of the investor in

the firm͛s equity.

± Therefore the cost of equity of firm need to be estimated.

We will discuss four approaches for estimating the cost of

equity

± The dividend growth model approach

± The security market line (SML) approach

± Bond yield plus risk premium approach

± Earning-Price ratio approach

The Dividend Growth Model Approach

Let us assume that;

± A firm is currently paying D

0

dividend

± The dividend is expected to grow at a constant rate g

± The required return on equity is R

E

From our valuation of equity classed we know that:

± P

0

= D

0

x(1+g) / R

E

ʹ g = D

1

/ R

E

ʹ g

± By rearranging we will get R

E

= [D

1

/ P

0

] + g

± Given that R

E

is the required rate of return on firm͛s equity, it would be the cost

of equity capital for the firm

To estimate the R

E

we need to know P

0

, D

1

, and g

It would be easy to get P

0

and D

1

for listed firm, but estimating the g would

a challenge

Pros & Cons of the Dividend Growth Model Approach

It is a simple model

There are some practical difficulties we would face when we

are calculating the cost of equity for firms

± Who does not pay any dividends

± Even if companies pay dividends there is no guaranty that it would grow

at a constant rate

± Importantly the estimated cost of equity is very sensitive to the

estimated growth rate ͞g͟

Conceptually this approach excludes risk associated with the

firms business

± Investors expected return would increase if the risky-ness of investment

increases

However, there is no direct adjustment for the risky-ness of an investment

in this model

There is no allowance for the degree of uncertainty associate with the

estimated growth rate of the dividend payout

The SML Approach

From our valuation of equity classed we know that

± R

i

= R

f

+ ɴ

i

* (R

m

ʹ R

f

)

± Where;

R

i

is the expected return from the firm i (which is nothing but the cost of

equity for firm i)

R

f

is the risk free rate of return

ɴ

i

is

m

the risk associate with the firm I

R

m

is the market return from equity investment

To use the SML approach for estimating the cost of equity we would require

± The available risk-free rate, which can be easily found by considering 1

year return from investment in government security

± Estimate for the market return, which can be calculated by considering

the return from the investment in the equity index fund (in case of India

it can be return from NIFFTY or SENSEX)

± Estimate of the risk associated with the company, which can be

estimated from the historical data of the firms equity

Pros & Cons of the SML Approach

What are the advantages?

± The SML approach has two distinctive advantages

It explicitly quantifies risk associate with the investment

It can be estimated for the firms that do not pay any dividends

What are the disadvantages?

± The SML approach has two distinctive disadvantages

It is quite difficult to estimate the risk associate with the firm and the

market return

Estimates dependent

We would be using few estimates to estimate cost of equity. Therefore if

our estimates are poor then the cost of equity will be inaccurate

The dividend growth as well as the SML approach uses the past

data to predict the future

± Economic conditions can change quickly and the past may not be the

best guide to the future

± The cost of equity can be sensitive to change is economic conditions

Bond Yield Plus Risk Premium & Earning-Price Ratio Approach

Bond Yield Plus Risk Premium Approach

In case of this approach

± The cost of equity = Yield on long term yield bonds + Risk-premium

The logic of this approach is simple

± The firm which is risky will have higher cost of equity

± The cost of equity is linked to cost of debt

However, this approach is silence on how one should calculate the risk

premium, the calculation is subjective approach by analysts

Earning-Price Ration Approach

In case of this approach

± The cost of equity = E1 / P0, where

E1 = E0 (1+growth of earning for equity share)

P0 is the current price of the equity

This approach is quite useful when the firm is not listed

This approach would provide appropriate cost of equity, when;

± The EPS is expected to be constant and the dividend pay-out is 100%

± Retained earnings are expected to generate rate of return equal to cost of equity

Both the conditions are rare occurring all the time, making it a weak approach

Understanding Cost of Debt

The cost is debt of firm is the return that the firm͛s lenders demand

The cost of debt unlike the cost of equity can be observed either directly

or indirectly

± The cost of debt is the interest rate that the firm must pay on new borrowings

± Interest rates can be observed from the financial market

Let us take the case of a firm that has already issued bonds

± The YTM of the outstanding bonds is the required rate of return on the firm͛s

debt

± Cost of debt in case of such firms is equal to the YTM of existing bonds

± The coupon rate of the existing bonds is irrelevant to cost of debt for new debt

Let us say the firm is going to issue new bonds

± The bond needs to be rated by the credit rating agencies

± The rating of bonds would provide the benchmark rate for the bond

± In case of first time bond offerings the cost of debt would be equal to the

YTM of the bonds corresponding to the same risk category

Understanding Cost of Preferred Stock

Some times firms raise capital by using hybrid form of capital

± This hybrid form of capital having some characteristics of debt and

equity

The debt characteristic

± It pays fixed amount

± It has higher rights than equity in case of insolvency

The equity capital

± It is for perpetuity

± It has lower rights than the debt in case of insolvency

± This type of hybrid capital is called preferred stock

The cost of preferred stock is given by:

R

p

= D/P

0

where

± R

p

expected return from the preferred stock

± D is the fixed annual dividend

± P

0

is the current price per share

Thus the cost of preferred stock is equal to the dividend yield

on the equity

Weighted Average Cost of Capital

We have discussed the three types of capital employed by a firm.

How would we calculate the cost of capital for the firm?

± First estimate the share of each type of capital

± Calculate cost of each types of capital

± Calculate the weighted average costs of capital where the weights are the shares of each

type of capital

Let us take a hypothetical example where E is the market value of a firm͛s equity, D is

the market value of a firm͛s debt, and P is the market value of firms preferred stock

± Total value of the firm is (V); V = E + P + D

± Therefore E/V is the share of equity, P/V is the share of preferred stock and D/V is the

share of debt.

± E/V + P/V + D/V = 100%

We need to calculate the value of equity, preferred stock, and debt

± The market value of equity = market price per share * the number of shares outstanding.

± The market value of debt = market value of a bond * the number of bonds outstanding.

If there are multiple bond issues repeat the calculation of D for each bond issue and add up the

values.

What is some of the debt is not publicly traded?

± We must estimate the yield from similar debt that is publicly traded and this yield should be used to price

the privately held debt.

± The market value of preferred stock is=(D/r)*no of preferred stock; D=fixed annual

dividend

We have discussed the three types of capital employed by a firm.

How would we calculate the cost of capital for the firm?

± First estimate the share of each type of capital

± Calculate cost of each types of capital

± Calculate the weighted average costs of capital where the weights are the shares of each

type of capital

Let us take a hypothetical example where E is the market value of a firm͛s equity, D is

the market value of a firm͛s debt, and P is the market value of firms preferred stock

± Total value of the firm is (V); V = E + P + D

± Therefore E/V is the share of equity, P/V is the share of preferred stock and D/V is the

share of debt.

± E/V + P/V + D/V = 100%

We need to calculate the value of equity, preferred stock, and debt

± The market value of equity = market price per share * the number of shares outstanding.

± The market value of debt = market value of a bond * the number of bonds outstanding.

If there are multiple bond issues repeat the calculation of D for each bond issue and add up the

values.

What is some of the debt is not publicly traded?

± We must estimate the yield from similar debt that is publicly traded and this yield should be used to price

the privately held debt.

± The market value of preferred stock is=(D/r)*no of preferred stock; D=fixed annual

dividend

Weighted Average Cost of Capital ʹ Tax Implications

The firm is always concerned with after-tax cash flows

Therefore the cost of capital should incorporate the

effect of tax

± This has implications for cost of debt because debt gives the

firm a tax shield

If T is the tax rate the effective cost of debt is R

D

*(1-T)

Therefore;

± WACC = R

E

x E/V + P/V x R

P

+ D/V x R

D

(1-T)

Divisional and Project Costs of Capital

What would be cost of capital for a new project, will it be same as before

the new project?

± A manufacturer company is thinking of expanding production by setting up a

new plant

± A manufacturing company is thinking of expanding to retail business

± There will be situations where the cash flows from the new project could have

different risk from the risk with the current cash flows of the overall firm.

Let us assume that the riskless rate is 8%, and the market risk premium is

10%. If the firm is an all-equity firm with a beta of 1.2

± The cost of equity = WACC = 21.6%=(Rf+Risk premium)*beta

± If the firm has to evaluate new projects using this cost of capital, it would

accept project that would provide return in excess of 21.6%.

If the risk of the new project is lower then the risk premium required for

the same project would be lower than 10%, hence the cost of capital

would be less than 21.6%.

± Use of same cost of capital could reject project that are relatively safe

± Therefore, if the new project risk is different from the risk of the existing

business then using the same cost of capital to would result in sub-optimal

investment decision

Divisional and Project Costs of Capital

The same type of error can arise if a company has multiple lines of business.

± Assume a corporation has two business divisions

A grocery retail business

An electronics manufacturing operation

± The first has relatively low risk

± The second has relatively high risk

The corporation͛s cost of capital is a mixture of the costs of capitals of two distinct business

± It is natural to say that both of these divisions would be competing for capital

The retail business wants to expand to new cities

Manufacturing unit wants to set up a new plant

± What happen if we use WACC as a tool to allocate capital?

The manufacturing division would get more capital

± The cost of capital is same for both the division

± It would provide more return in comparison to retail business because the

business has more risk

± The less risky retail division may have great profit potential, but it would not get capital

for expansion

Therefore WACC may not be suitable criterion for evaluating project with different levels of

risk.

Ideally the cost of capital needs to estimated for not only for new projects but also for the

different divisions with in an existing business conglomerate

± This can be done by following the same method we have discussed before with minor

modifications

Illustration - 21

A company has 2MM shares outstanding

The stock price is Rs.40͙͙..rs 20

The debt is quoted at 90% of face value and the face value of debt is 10

MM, it might be single debt therefore value of debt= market value of bond

x no of bonds= 90% of 10 * 1=9

The YTM for the debt is 10%= cost of debt RD

The risk-free rate is 5%

The market risk premium is 10% and the beta is .75

The tax rate is 30%

R

E

= 5 + .75 x 10 = 12.5% and R

D

= 10%

The value of equity is 2 x 40 = 40MM

Value of debt is 0.90 x 10 = 9MM

Total value V = 49MM

WACC = 40/49 x 12.5 + 9/49 * 10 x (1-0.3) = 11.49%

Capital Budgeting

3 layers of efficient capital market

Total or realized return= expected return +

error(systematic and unsystematic risk)

3 layers depends on how we define available

First weak form efficient- available means

historically available

Second semi strong form efficient- publically

available(includes historically available)

Third strong form efficient- privately (including

publically available.)

Introduction

Capital budgeting addresses the following questions;

± What new projects the firm should invest?

Should it expand to new market?

Should it launch new products?

Should it increase the production by setting up new plants?

And many more questions that would require the firm to invest in physical (new

technology, new factory) or intangible assets (increase the marketing expenses to

increase the brand value)

Capital budgeting decision would affect the firms growth, profitability, and

competitiveness in the long-run

± Why?

Fixed assets created through investment will have long life

The long-tern investment is generally not easily reversible

The firm will have many alternative where investment can be made, and

capital budgeting process helps the financial managers to make the

appropriate choice.

There are a number of techniques for capital budgeting like;

± Net Present Value (NPV) method

± Internal Rate of Return (IRR) method

Modified Internal Rate of Return (MIRR) method

± Pay-back period method

± Benefit-cost ratio method

Net Present Value (NPV)

When should one make an investment?

± If the investment creates value after taking care of the cost

± The value is net of cost and therefore called Net Present Value (NPV)

How do we create value? Let us take an example;

± An individual has a house valued at Rs. 25 Lakhs

± If he renovates it can be sold at Rs. 30 Lakhs

± The cost of renovation is Rs. 3 Lakhs

± The owner of house can create value of Rs. 2 Lakhs by investing Rs. 3 Lakhs

± Therefore the renovation project would yield a NPV of Rs. 2 Lakhs

The challenge any investor faces is is to identify in advance that an

investment would generate positive NPV, which is the subject matter of

capital budgeting

The capital budgeting process is nothing but a search for project that would

generate positive NPV project for investment

In the case of the house that we considered there is a ready market from

where an estimate of the sales proceeds can be obtained, which simplifies

the investment decision making process

Capital budgeting becomes more difficult when we cannot observe the

market value of at least comparable investments, which is more realistic

Net Present Value (NPV)

Let us assume that we are planning to set up an dairy firm.

± We can estimate what would it cost to set up the dairy firm

± However, would not know the revenue stream from this project

± We have to make an estimate of the revenues that would be generated from the diary

project?

Once we have an estimate of the cash flow from the estimate we would have to

calculate the present value of the cash flows

Difference between the investment and the present value of the future cash-flow of

the project will give us the NPV of the project. The cost of setting up the project is

Rs. 30,000

Assume that the cash flows from investment will be Rs. 20,000 per year with a

operating expenses of Rs. 14,000 per year.

The net cash inflow from the project is 20,000 ʹ 14,000 = 6,000 per annum. The

business will be wound up in 8 years.

The salvage value of plant and machinery will be Rs. 2,000 after 8 years.

We will use a 15% discount rate on new projects.

Thus we have an 8 year annuity of Rs. 6,000 per annum plus one lump sum inflow of

Rs. 2,000 after 8 years.

The PV of the cash flows = Rs. 27,578 and the NPV = -30,000+27,578= -Rs. 2422

Since the NPV is negative, this project is not worth undertaking. If the NPV is positive

accept the project and If the NPV is negative reject the project

Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of cash out-flows

with the cash in-flows of a project.

± Present value of cash out-flow will be equal to cash in-flow when the NPV of the

project is equal to zero

The IRR can be calculated if we set the NPV equation equal to zero

± Consider a simple project; Invest 500 today Get back 550 next year.

± The NPV of the project = -100 + 110/(1+r)

± Equating the NPV to zero would imply 110/(1+r) - 100 = 0 r = 10%

± Therefore the IRR is 10%

IRR of a project is the required return from an investment that would make

the NPV of the investment equal to zero

Let us take an example

± A project costs 4000 and the required return from the project is 15%

± The cash inflows are 1000, 2000, and 3000 in the first, second, and third year

respectively

± The IRR can calculated by making the NPV = 0, in this case it is 19%.

± Given that IRR is greater than the required rate of return the project should be

accepted

Therefore investment in a project is acceptable when IRR exceeds the

required rate from the project

NPV vis-à-vis IRR

Calculation of NPV and IRR seems similar!

± Does it mean that use of NPV and IRR would lead to the same decisions about

the investment proposal?

The answer is yes as long as two conditions are met

± The project͛s cash flows must be conventional

The first cash flow is negative and all the rest are positive

± The project must be independent

That is the decision taken with respect to this project does not affect

the decision to accept or reject another

± If two investments are mutually exclusive then

Accepting one would mean rejecting another

If we have two or more mutually exclusive projects which is the

best

± The answer is, the one with the largest NPV

± Is it necessarily the one with the highest IRR

± The answer is NO

± Let us take an example to show this

NPV vis-à-vis IRR - Illustrations

Let us look at two projects; project A and project B, whose cash flows are

given below

Year Project A Project B

0 -1000 -1000

1 550 350

2 655 465

3 405 750

4 355 600

The project A has an IRR of 38% and Project B has an IRR of 35%. if use IRR

as the tool project A is better

Let use NPV as a tool to evaluate the projects

If our required rate is 15%, the NPV method would identify the project B to be

better

If our required rate is 25%, the NPV method would identify the project A to be

better

NPV vis-à-vis IRR ʹ Learning from

Illustrations

The NPV method is sensitive to the required rate of return

± What should be the appropriate required return?

It should be at least the cost of capital

NPV and IRR method may result in different choices

It can be misleading to evaluated two projects and rank them on the basis of

IRR to determine which is the best project

Thus if we have mutually exclusive projects we should not rank then based

on their returns

Therefore to compare two projects we should look at the NPV because it

provides an estimate of contribution of the project towards the value of the

firm

However IRR is very popular in practice in comparison to NPV method

It is simple to understand in terms returns than value creation from a project

IRR is a simple way of communicating about the contribution of a project

The IRR may have a practical advantage because to estimate NPV we need to

know the cost of capital but IRR can be estimated without knowing the cost

of capital

Modified Internal Rate of Return (MIRR)

To address the shortcomings of IRR, MIRR is use

± The MIRR can be calculated by;

Calculate the present value of the costs (PVC)

Calculate the terminal value of the cash inflows expected from the

project (TV)

Conceptually PVC = TV / (1+MIRR)

n-1

We can easily solve for the MIRR from the equation

Cost of capital is used as the discount rate.

Let us take an example

± The project cash flows are -120, -80, 20, 60, 80, 100, 120 and cost of

capital is 15%

± The PVC = 120 + 80 / 1.15 = 189.6

± The TV = 20(1.15)4 + 60(1.15)3 + 80(1.15)2 + 100(1.15) +120= 467

± 189.6 = 467 / (1+MIRR)6

± The MIRR = 0.162 = 16.2%

± The IRR of the same project is 16.81%

In this case the differences is small but this need not always be the case

Payback Period Method

Payback is the length of time taken to recover the investment amount

Let us understand the payback method through this example.

Time Cash Flow of a

Project

Cumulative Cash

Flow the Project

0 (155,000) (155,000)

1 55,000 (100,000)

2 75,000 (25,000)

3 25,000 0

4 25,000 25,000

The project recovers the initial investment amount by 3

rd

year

Therefore for this project the payback period is 3 years.

The payback period rule would be

If required payback is higher than the actual payback period then accept

the project else reject it

Payback Period Method

The payback period method has some shortcomings.

± Firstly to compute the payback period we simply add up the cash flows

± Secondly there is no discounting

± Time Value of Money is totally ignored.

Payback period method does not factor in risk differences

± In practice a more risky project would be evaluated using a higher

discount rate

± Since the payback criterion ignores discounting it analyzes projects with

different risk profiles without factoring in the risk differences.

A major issue is how do we choose a cutoff period

± What is the basis for stating that we will accept projects with a payback

of say 3 years or less

± In practice the cutoff has to be arbitrarily decided

The criterion totally ignores cash flows arising after the initial

investment is recovered.

Benefit Cost Ratio Method (BCR)

The benefit cost ratio is defined as the ration of

the present value of all the benefits (PVB) that

is going to occur (positive cash inflows) and the

initial investment (I)

Let us take an example

± A projects initial investment is Rs. 200

± The present value of future cash flows is 250

± The BCR = PVB / I = 250 / 200 = 1.25

± What does BCR of 1.25 means

It means per Rs. 1 invested we get Rs. 1.25

The BCR rule would be;

± If the project has a BCR of greater than 1 then

accept the project

Capital Budgeting in Practice

NPV is the most appropriate methods for capital budgeting

decisions?

± When the NPV can be computed, why look at other methods?

Investment decision making process needs to take care of uncertainties

regarding the future

Real NPV is unknown and the NPV calculated is an estimate.

± Let us assume a project has a positive NPV; short payback and a high IRR

The information about the project suggests one should proceed with the

project

± On the other hand if the NPV is positive; payback is long and IRR is low

The information suggests one should be careful

Verify the estimates

Do further analysis

Therefore though NPV is technically is the best method it can be

used in conjunction with other method to make a better

decision

Project Cash Flow Analysis

Understanding the Cash Flows

Why should firm go for new projects?

± To increase the future cash flow, which would increase the value of the

firm in future

± To invest the surplus generated productively to increase the value of the

firm in future.

To evaluate an investment, we need to consider:

± The changes in the firm͛s cash flows due to the investment

± The change in cash flow need to increase the value of the firm

± The relevant cash flow for a investment would be the incremental cash

flow because of the direct consequence of the decision to take up the

new project.

± Therefore the existing cash flow of the firm has now relevant on the

investment decision.

What are incremental cash flows?

± The incremental cash flows for a project is any changes in the firm͛s

future cash flows that can be exclusively attributed to the investment in

new project.

Understanding the Cash Flows

The incremental cash flow is based on the stand alone principle

The stand alone principle treats the investment as;

± The project is like a small firm

± The projects has its own futures revenues and costs associated with it

like any other firm

± The project can generate its own assets

± The project can have its own liabilities

± The assets will generate cash flows from the assets it creates and pay

back the liabilities

± At the end the project should have the surplus that would increase the

value of the firm

The investment amount on the new project is like acquiring the

cash flows from the small firm.

± It is easy to make errors while deciding what cash flows are incremental.

± We will discuss some of the potential pitfalls and how to avoid them

Understanding the Cash Flows

A project could have externalities: positive as well as

negatives

± A negative externalities would negatively affect the existing

cash flow, which is called value erosion

± A positive externalities would positively affect the existing

cash flow, which is called value addition

In accounting for erosion ʹ it is important to recognize

that sales that would have been lost because of future

competition should not be attributed to the project

± Erosion is relevant only when the sales would not otherwise

be lost

Understanding the Cash Flows

Evaluation of an investment proposal should not include the cost of capital

Why?

± The goal in project evaluation is to compare the cash flows from a project to the

cost of acquisition ʹ the NPV

The mix of debt-equity used is a managerial variable that determines how

cash flows will be divided between owners and creditors

The cash flow of the new investment should take into account the effect of

tax

The capital budgeting process would involve in preparing one pro-forma or

projected financial statements

To prepare a pro-forma statement we need estimates of quantities like:

± # of unit of sales

± Selling price per unit

± Variable cost per unit

± Fixed costs

± Total investment required Including investment in NWC

±

Understanding the Cash Flows ʹ The

Sunk Cost

What is a sunk cost of a project?

± The sunk cost is the cost that has already being incurred

± It is the cost that the firm has to make whether it takes up the project or

not

The sunk cost can not be changed the decision of accepting or rejecting the

project

It is not relevant for the decision making process

Therefore the sunk cost principle is not to include it on the cost

side of the project cash flow

For example;

± A diary firm evaluating whether to lunch butter as a product in market

± To evaluate the proposal it hires a consultant

± The consulting fee should not be considered as a cost in incremental cash

flow method

The firm any way has to be paid whether or not the product is launched

Understanding the Cash Flows ʹ Opportunity Costs

What is opportunity cost of a project?

± An opportunity cost of a project is the benefit it has to sacrifice to take

up the project

A firm is thinking of using an ideal piece of land for building

multiplex

± To build a multiplex the firm has to buy the land

± In this case there is no cash out flow for the purchase of the land

because the firm already own it

± For the multiplex project what should be the cost of land

Is it a free given that there is no cash out flow?

± The principle of opportunity cost would say it is not because it is a valuable

resource that can be used by other competing project s or at the least it can be

sold and money can be used for other purpose as well

Therefore when we are estimating the cash flows for a project

we need to take into account all the possible opportunity costs

of the assets that are going to be used in the project, which is

currently owned by the firm

Understanding the Cash Flows: Effect on

Working Capital

A new project would require incremental working capital

± New project would need cash on hand to pay expenses

± Cash needed to finance the inventories of inputs, and outputs

± Some of the cash requirement can be financed through account

payables

± The balance has to be generated

± The balance cash required in termed as Net Working Capital

As the project is wound up

± Inventories will be sold

± Receivables will be collected

± Bills will be paid

± Cash balances will be utilized

± These activities will free up the NWC that was initially invested

While estimating the cash flows of a project we need to

account for net working capital expenses

Risk Analysis in Capital Budgeting

Sources of Risk for Capital Budgeting

Most of the capital budgeting decision involves risk

± Risk of increase in expenses to execute the project

± Risk of non-realization of expected revenue from the project

Sources of risk for a project

± Project specific risk

± Competitive risk

± Industry specific risk

± Market risk

± International risk

Techniques of Risk Analysis

Risk analysis for capital budgeting is complex

The techniques of risk analysis can be broadly divided into two

types

± Analysis of standalone risk

± Analysis of contextual risk

The analysis of standalone risk can be done in many different ways

± Breakeven analysis

± Scenario analysis

± Sensitivity analysis

± Hiller model

± Simulation analysis

± Decision tree analysis

The analysis of contextual risk can be done in many different ways

± Corporate risk analysis

± Market risk analysis

Break-even analysis

In sensitivity and scenario analysis we attempt to estimate the

effect of changes in certain factors on the project viability

In case of break-even analysis we attempt to estimate the

minimum amount of sales that would make sure that the project

does not loose money

± The process of estimating the break-even point is called break-even

analysis

The break-even analysis is of two types

± Accounting break-even analysis: In this case the analysis would involve to

identifying the sales amount that would result in zero cash profit

± Financial break-even analysis: In this case the analysis would involve to

identifying the sales amount that would result in zero NPV

Accounting break-even point = (Fixed cost + depreciation) / Gross

Margin or contribution margin ratio

Financial break-even point = contribution/1-variable cost %

Scenario Analysis

In scenario analysis, several factors are changed simultaneously

to understand the risk involved in a given project

Typically three case are considered

± Normal

± Pessimistic

± Optimistic

Scenario analysis is an improvement over sensitivity analysis

with respect to variability of factors happening simultaneously

However, in case of scenario analysis there is no well defined

scenarios, the project manager has to create hypothetical cases

by using his/her experiences

The project managers estimate of different scenario would affect

the assessment of risk involved in a project

Sensitivity Analysis

Identify the factors that can change the cash flow of the project

in question

Change one factor at a time by fixing all other factors

± This would help us in identifying the most sensitive factor

± Once the most sensitive factor is identified we can take necessary

measures to reduce the risk involved in that factor

± This would also help in monitoring the performance of the project

The sensitivity analysis is very subjective and requires good

understanding of the project

Two individuals may decide differently depending on the

prospective

Sensitivity analysis only changes one factor at a time where as in

real world variables tend to change simultaneously

An Example͙

Data on Investment

Low-cost Housing Project requires an investment of 530,000 in fixed-assets (machinery) and

60,000 (at t=0) in NWC (net working capital)

The machine can be sold off for 30,000 at the end of its five-year life

So, DPY (Depreciation per Year) = (530,000 ʹ 30,000)/5 = 100,000

Data on Income and expenses

Base Figures and Maximum Expected Variations:

± Apartments per Year= 25 units give & take 4%

± Price per Apartment = 70,000 give & take 5%

± ͞Variable cost to Price͟ Ratio = 80% give and take 8%

± Fixed Cost = 150,000 give and take 12%

± We can compute that DTS (Depreciation Tax Shield) = $100,000 x 34% (tax rate) = 34,000

WACC is given to be 15%

Lower Bound Base Case Upper Bound

Number of Apartments Sold 24 25 26

Price per Apartment 66,500 70,000 73,500

Variable Cost as % of Revenue 88% 80% 72%

Fixed Costs 168,000 150,000 132,000

An Example͙

Revenue (70,000 x 25) 1,750,000

- Variable Costs (80% of Revenue) 1,400,000

= Contribution 350,000

- Fixed Cost (excluding Non-Cash Charges) 150,000

- Non-Cash Charges (like Depreciation) 100,000

= EBIT 100,000

- Interest 0

= Taxable Income 100,000

- Taxes @34% 34,000

= NI (Net Income) 66,000

+ Non-Cash Charges (like Depreciation) 100,000

= OCF 166,000

OCF= NI+ DEP + INT= TR- FC-VC-TAX- INT., exclude non cash

charges.

An Example͙

At what price (per apartment) Operating CF is zero?

Net Income = OCF ʹ Non-Cash Charge = 0 - 100,000 = -100,000

EBIT = Taxable Income = -100,000 /(1-34%) = -151,515

Contribution = -151,515 + Non-Cash Charge + Fixed Cost = 98,485

Breakeven Revenue = Contribution / (1-80%) = 492,424

Breakeven Price (per apartment) = 492,424 / 25 = 19,697

(assuming that 25 apartments are sold annually)

AND Breakeven Number of Apartments = 492,424 / 70,000 у 7

(assuming that each apartment is sold for 70,000)

Caveat: Breakeven is often measured by the number of units to be sold

This is referred as Cash Breakeven Point

An Example͙

At what price (per apartment) Revenue just covers actual costs (excludes non-cash

charges)? Therefore, contribution= dep + FC + EBIT, here EBIT=0 AND dep is

excluded.

Requires that Contribution = Fixed Cost = 150,000

=> Breakeven Revenue = Contribution / (1-80%) = 750,000

Breakeven Price (per apartment) = 750,000 / 25 = 30,000

AND Breakeven Number of Apartments = 750,000 / 70,000 у 11

This is also referred as Cash Breakeven Point

If there were no taxes, Breakeven Points 1 and 2 would be the same. Because then

contribution= EBIT + FC + dep = -100000 + 150000 + 100000= 150000= FC , it is the tax

rate which is making difference between the ocf=o and just covered cost method cash

break even point.

An Example͙

At what price (per apartment) Net Income is zero?

Taxable Income = 0 => EBIT = 0

Contribution = 0 + Non-Cash Charge + Fixed Cost = 250,000

Breakeven Revenue = Contribution / (1-80%) = 1,250,000

Breakeven Price (per apartment) = 1,250,000 / 25 = 50,000

AND Breakeven Number of Apartments = 1,250,000 / 70,000 у 18

This is the Accounting Breakeven Point

At this point, Operating Cash Flow equals Depreciation

Depreciation is taken here as the Recovery of Investment in Fixed Assets

(clearly ignores time value of money)

Estimating the Cash Flows ʹ Base Case

Net Sales OR Revenue 1,750,000

- Variable Costs and Fixed Costs 1,550,000

(Exclude Non-Cash Charges)

- Actual Taxes 34,000

(This has to be known or given)

= Operating CF 166,000

NI (Net Income) 66,000

+ Non-Cash Charges 100,000

+ Interest 0

= Operating CF 166,000

The top-down approach

The bottom-up approach

Estimating the Cash Flows ʹ Base Case

The tax-shield approach

Revenue ($70,000 x 25) 1,750,000

- Variable Costs (80% of Revenue) 1,400,000

= Contribution 350,000

- Fixed Cost (excluding Non-Cash Charges) 150,000

= Taxable Income without Non-Cash Charges & Interest 200,000

- Taxes @34% 68,000

= EAT 132,000

+ DTS (Depreciation Tax Shield) 34,000

= OCF (Un-levered) 166,000

Scenario Analysis: Base-Case NPV

Project-LcH Special CF CFs at Special CF

at t =0 t=1 t=2 Ʀ t=5 at t= 5

-530,000 +30,000

-60,000 +60,000

OCF OCF Ʀ OCF

TOTAL -590,000 OCF OCF Ʀ OCF 90,000

NPV

LcH

= -590,000 + OCF x PVIFA

15%,5

+

= -545,254 + 166,000 x PVIFA

15%,5

= -545,254 + 556,458

= 11,204

5

%) 15 1 (

000 , 90

**Scenario Analysis: Worst-Case NPV
**

Project-LcH Special CF CFs at Special CF

at t =0 t=1 t=2 Ʀ t=5 at t= 5

-530,000 +30,000

-60,000 +60,000

OCF OCF Ʀ OCF

TOTAL -590,000 OCF OCF Ʀ OCF 90,000

NPV

LcH

= -590,000 + OCF x PVIFA

15%,5

+

= -545,254 + 49,523

*

x PVIFA

15%,5

= -379,245

*Derive this under most unfavorable figures for units sold, price, variable cost, and fixed cost

5

%) 15 1 (

000 , 90

**Scenario Analysis: Best-Case NPV
**

Project-LcH Special CF CFs at Special CF

at t =0 t=1 t=2 Ʀ t=5 at t= 5

-530,000 +30,000

-60,000 +60,000

OCF OCF Ʀ OCF

TOTAL -590,000 OCF OCF Ʀ OCF 90,000

NPV

LcH

= -590,000 + OCF x PVIFA

15%,5

+

= -545,254 + 300,033

*

x PVIFA

15%,5

= 460,502

*Derive this under most favorable figures for units sold, price, variable cost, and fixed cost

5

%) 15 1 (

000 , 90

Thank You

MM Hypothesis

Capital structure does not matters investors

can lend and invest their own.

Thus whatever the capital structure the stock

prices will remain the same

When taxes =0 then,

WACC= E/V*Re + D/V *Rd

Re= WACC+ (WACC-Rd)* D/E

M &M

The cost of equity depends on

Wacc

Rd

D/E ratio

The cost of equity given by a straight line with

a slope of WACC- Rd

According to MM hypothesis cost of equity

does not depend on the D/E ratio

The fact that debt is cheaper than equity will

be offset by the rise in cost of equity

The net result is what WACC remain the same

MM hypothesis and implication of tax

and bankrutptcy

Debt has two features

Interst on debt is tax deductible

Bankruptcy: one limiting factor affecting the

amount of debt a firm can raise is bankruptcy

cost.

bankruptcy

When this happen the ownership of firm get

transferred to the debt holders

When the value of assets becomes equal to

the value of debt the firm is called bankrupt

Then value of equity becomes 0.

And the debt holders holds the asset equals to

the value of debt provided there is no

transactional cost involved.

In the real world it is expensive to be get

bankrupt

The cost associated with bankruptcy may

offset the tax benefit due to leveraging

Direct cost of bankruptcy

Legal and administration cost

A fraction of asset get

disappeared(bankruptcy tax)

This cost is incentive for debt financing

Indirect cost of bankruptcy

Time

Strain

Financial distress

Profitable projects may be get terminated

Conclusion of bankruptcy

The tax benefit from leveraging is important to firms that are in tax

paying condition

Firm with high dep tax shield will get less benefit from leveraging

Firm with substantial accumulated loss will get little value form tax

shield

Greater the volatility less a firm should borrow

Borrowing depends on asset quantity

Financial distress is more costly for some firm

The cost of bankruptcy depends on asset and easiness of transfer of

the asset

The firm will greater risk of facing financial distress will borrow less

Dividend policy

The connecting link between owner and

management is dividend policy which a manager

decides

Residual dividen policy: growth and capital

appreciation driven

Managed dividend policy: under managed

dividend policy manager attempts to reduce the

variablity of pay out of dividend

It is constant, increasing or predictable cash

outflow

Mutual funds: dividend & growth

agency problem &Dividend policy

Dividend stripping

cash flow is shared by debt and equity holders

Debtors get assured when company has liquidable

assets

Shareholders enjoy upside potential

Debtholders enjoy downside risk with equity holders

How I can get my money back quicky in case of equity

holdr- by getting more and large dividend paid

To reduce the conflict between debt and stock holders

there is need of managed dividend policy

Leveraging and dividend policy

Higher the leverage more the divident paid is

incentive for the equity holders

In case of levereged firm payment of divident

increase the default

In low levereged firm dividend payment will

have very low impact on value of debt

Dividend payment makes debt more risky

Low the debt low is the chances of default

Pricing mechanism and repurchase vis-

vis cash dividend

Assymetry of info arises when two individual have

different set of info.

Manager tries to reduce it through the divident policy

The signal will be credible and believable only when it

can͛t be mimiced

Pricing mechanism must separate the firm with

favourable information with the firm with less

fabourable information based on the dividend signal

When prices of the share is low what managers

perceived what it should be, then mangers go for buy

back, the manger will be benefit more than paying

dividend provided company has money to buy back.

Working capital management

Deals with short term mangement of assets and

liability

Gross wc

Net wc

Wcminvolve

Cash and liquidity mangement

Account receivable and payable management

Formulate credit policy and negotiate favourable credit

terms

Estimates working capital need

Monitoring the inventories

Factor influencing working cap

requirement

Nature of business

Cycle of business

Seasonality of business

Market condition

Supplier condition

Level of WC & CA requirement

Less CA ʹ shortage cost

More CA ʹ carrying cost

In order to balance these two cost we need

optimum working capital

Level of working capital depends on

Operating cycle

- inventory period( inventory supplied ʹ goods

finished and sold)

- account receivable period(sale- cash

received)

Cash cycle

- operating cycle

- account payable period( bill received to paid)

OC= INVENTORY PERIOD + ARP

CC= OC- APP

LEVEL OF CA AND WC REQUIREMENT

Inventory period= avg inventory/ (cogs/365)

ARP = avg account receivable/ (sale/365)

APP = avg account payable period / (cogs/365)

Cash and liquidity management

Why do firm need cash

Transaction motive

Precautionary motive

Speculative motive

Collection float, disbursement float and net float

The firm objective is to

Maximize the float to increase the cash balance

Speeding the collection

Delaying the payment

Concentration banking

Investing the surplus fund

Criteria for evaluating the investment

requirement

Safety

Liquidity

Maturity period and

yield

Understanding the need to decide on

the portfolio investment

Ready cash segment: cash needed to meet un

anticipated operational requrirement. Safety

& liquidity

Controable cash segment: cash requied for

planned investments. Safety, size and maturity

period of instrument

Free cash segment: amount or cash which

must be invested. Safety & yield.

Investing options

Bill discounting

Inter corporation deposit

Mutual fund schemes

Equity, debt and balanced.

Treasurey bills

CD, CP and FD with banks

Credit management

Credit payment: credit period, billing &

payment conditions, cash discount

Credit policy variables: cash discount,

collection efforts, credit period and credit

standard

Credit evaluation

Credit granting decision

Credit monitoring

Introduction

Barter

Prior to advent of MONEY

Non-Barter

With the advent of MONEY

Consume all the goods you have

Exchange your goods for other goods and then consume them

Could not put away goods for later use

Everything could be denominated in units of the currency

The currency served as the medium of exchange

Money gave you the freedom to SAVE

What role money plays?

**Money has two roles to play As a Measure
**

Estimating cash flow Valuing the assets and liabilities Financial & Cost Accounting Planning of Spending Planning of Investment Allocation of Money (capital) as resources

As a Resources

Money as a Measure

Cash flows happens over a period of time Value of same amount of cash flow will be different at different time ± Rs. 1000 now is not same as Rs. 1000 one year from now because ± Same money can be invested and positive return can be generated Present is certain and future in uncertainty Inflation reduces purchasing power of money

One need to estimate the value of all the cash flows Need to express all the cash flows into one time dimension Present Value Future value

Study of Time Value of Money Helps in Consistent Measurement«

**Learning from Economic Theory Money As a Resource
**

Input

Process

Output

**Labor Capital Raw Material What is price of Capital?
**

Product Services

Interest Rate Dividend Yield Expected Capital Appreciation Bond/Debenture Yield Individual Financial Institutions

**Who Provides Capital?
**

Financial Market Provides Capital for a Price and Firms Create Assets with the Help of Capital to Generate Wealth«

Understanding the Financial Market

Surplus Business Unit (SBU) (Households, Corporate)

funds claim

Deficit Business Unit (DBU) (Government, Corporate)

Create Assets for DBU

Creates Liabilities for DBU Claims of SBU can be debt claims or equity claims

Assets

FUNDS

Liabilities

CLAIMS or DEBT or borrowed capital or EQUITY or owners capital

Total Assets = Total Liabilities

or customers. EPS.Understanding the Firm What is a firm? A firm is an organization that combines inputs and follows some process to produce some forms of output What are the goals of a firm? Should a firm maximize the welfare of employees. return on investment? A Firm Need to Use its Scare Resources (Capital) Optimally to Achieve the Goal« . profits. or supplier Should it maximize shareholders wealth.

Firms Operates in Markets Services Goods MARKETS Physical Assets Financial Assets What goods and services to produce? What are the target market? Finance Manager Plays an Important Role to Make Sure the Firm Meets the Goal it has Aimed for« .

Cost of Capital for the Firm« .What are the questions Financial Mangers deal with? How big the firm should be? How fast it should grow? Where should it invest? What should be the composition of its assets? How should the assets be financed? How should the returns to be distributed? How to get the best return from the investment? How to minimize the expenditure without affecting the growth of the firm? Finance Strategy is Driven by Objective of the Firm. Business Opportunity.

.Organization Structure CEO CFO Treasurer Manages the cash Planning and capital budgeting Raising the money Managing the external relationship Managing the credit and fraud issues Controller Prepare the accounts Manage the expenditure Internal audit Reporting and preparing balance sheet and P&L Financial Management Objective is to Maximize Value of the Firm by Balancing Between Risk and Reward. .

Complexity of role of finance manager is a function of type of firm Types of firm: Sole proprietorship Partnership Cooperative society Private company Public limited company .

How does external environment affect financial management? External factors that affects most of the financial decision can be broadly divided into: Regulatory Framework Taxes Financial system Financial decisions of a firm depends on legal forms of the organization which is an internal matter with in the frame work of the external environment Financial Management maximizes value with the external regulatory environment« .

How regulatory framework affects financial decisions? Principal elements of regulatory framework are: Industrial policy Companies act Securities and Exchange Board of India Guidelines .

How does taxes affects financial decisions? Corporate income tax Depreciation Interest expenses vis-à-vis dividend payment Exemptions and deductions Dividend distribution tax Capital gain tax Sales tax Customs duty .

How financial framework affects financial decisions? Funds Deposits/Shares Funds Financial Institution Commercial Banks Insurance Companies Mutual Funds Provident Funds Non Banking Financial Companies Supplier Of Funds Individual Business Government Funds Private Placement Purchaser of Funds Individual Business Government Funds Financial Markets Money Market Capital Market .

Interest Rate & Time Value of Money .

Interest Rate .

Student loan Auto loan Personal loan Mortgage loan Saving account deposits Fixed deposits Infrastructure bonds Bonds Debentures of companies ± We have invested have received interest from the borrower.Introduction Most of us would have either paid and/or received interest if ± We have taken loans and have paid interest to the lender. .

Introduction (Cont ) What is interest? ± Compensation paid by the borrower of capital to the lender Rent paid by the borrower of capital to the lender. market can determine the interest rate but regulator can intervene if it fills that market is not functioning optimally . regulator can specify the interest rate In a regulated market. The rent is for permitting the borrower to use funds of lender How is interest rate determined? ± Depends on the market for capital In a free market it is determined by demand and supply of capital In a controlled market.

110 will able to buy less that 110 mangoes This implies that in case of inflation the real interest rate would be less than 10% . 110 can buy 110 mangoes If there is positive inflation then next year Rs.Real vis-à-vis Nominal Interest Rate What is real interest rate? ± Compensation paid by the borrower of capital to the lender when lender has zero risk and inflation rate is zero Loans to government when there is no inflation What are the implication of no inflation? ± If one lends Rs. 100 at 10% for a year Assuming that the Rs. 100 can buy 100 mangoes Next year the Rs.

Real vis-à-vis Nominal Interest Rate Most people who invest do so by acquiring financial assets such as ± Shares of stock ± Shares of a mutual fund ± Or bonds/debentures ± deposits with commercial bank Financial assets give returns in terms of money without any assurance about the investor s ability to acquire goods and services at the time of repayment Financial assets therefore give a NOMINAL or MONEY rate of return. ± In the example.05 = 104. the GOI gave a 10% return on an investment of Rs 100. Nominal Return = Real Return + Inflation Rate (Approximate) .76% which is different from 10% nominal return ± The relationship between the nominal and real rates of return is expressed in the FISHER hypothesis.74 ± The real rate of return is 4. ± Let us say inflation rate is 5% ± The # of mangoes that can be bought is 110/1.

± It will give an assured nominal rate ± The real rate will depend on the actual rate of inflation There is Uncertainty (Risk) over the Real Rate of Return even if the Nominal Return is Certain due to Uncertainty over Inflation« . Therefore in real life a default free security will not give an assured real rate. ± In real life inflation is uncertain and is random ± In the case of random variables exact outcome is not known in advance ± Agents would have expected value of inflation Which is a probability weighted average of the values that the variable can take.Interest Rate and Uncertainty In FISHER equation it is assumed that the rate of inflation is known with certainty.

± What is risk aversion? It does not mean that investor would not take risk It means that investor would expect higher return to take higher risk. Given a choice between two investments with the same expected rate of return the investor will choose the less risky option In the case of existence of positive inflation ± The investor will not accept the expected inflation as compensation ± To tolerate the inflation risk the investor will demand a POSITIVE risk premium ± Compensation over and above the expected rate of inflation Why? ± The actual inflation could be higher than anticipated resulting in actual real rate lower than anticipated. ± The Fisher equation need to be modified to take into risk aversion nature of the investor The Fisher equation may be restated as ± Nominal Return = Real Return + Expected Inflation + Risk Premium .Uncertainty and Risk Aversion Majority of investors are characterized by Risk Aversion.

What Drives Interest Rate From the discussion so far with zero default the interest rate would depends on ± ± ± The real rate The expected inflation The risk premium of the investor When we relax the assumption of zero default risk the interest rate would depends Credit risk involved with the borrower. which would vary from individual to individual ± The risk of non-payment of interest rate ± The risk of non-payment of principal ± Higher the risk of default higher would be expected interest rate Tenure of the investment ± Higher the tenure higher could be credit risk ± The lender would prefer to lend for short-term and borrower would prefer to borrow for long-term for a given rate of interest rate ± Lender would demand higher interest rate to lend for long tenure .

Nuances of Calculating Interest Income Simple interest rate vis-à-vis compound interest rate ± When interest is calculated on interest income generated during the previous period ± They will differ when the interest conversion period is different from the measurement period ± What is interest conversion period? The unit of time over which interest is paid once and is reinvested to earn additional interest is called interest conversion period ± What is measurement period? The unit on which the time is measured is called measurement period The interest conversion period is typically less than or equal to the measurement period. Nominal interest rate vis-à-vis effective interest rate ± The quoted interest rate per measurement period is called the nominal interest rate ± The interest that a unit of currency invested at the beginning of a measurement period would have earned by the end of the period is called the effective rate .

first thing we need to do is convert the rate of return into effective rate of return Effective Rate is Appropriate Rate to Measure« . Thus. Using the Right Rate for Measurement Effective rate is what one gets and nominal rate is what one sees Compounding yields greater benefits than simple interest ± The larger the value of N the greater is the impact of compounding. the earlier one starts investing the greater are the returns. If the length of the interest conversion period is equal to the measurement period ± The effective rate will be equal to the nominal rate If the interest conversion period is shorter than the measurement period ± The effective rate will be greater than the nominal rate If the interest conversion period is longer than the measurement period ± The effective rate will be lower than the nominal rate If we are comparing two alternative investment opportunity.

Future & Present Value .

10.000 + 0.10 + 0.10 Number of Years (N) = 3 Future Value (FV) at the end of first year = Rs. 10. 10. 10. What would be the future value of the money invested? Ans: Present Value (PV) = Rs.000 (1 + 0. 10. 10.000 = Rs. Rs.10*Rs. 10.10*Rs.000 Rate of Return (r) = 10% = 10/100 = 0.10*Rs.000 + 0.10) = Rs. 10. 10. 10. 10.000 + 0.Future Value of Money Q1.000 = Rs.000 is invested and the investor gets 10% return every year for three years.10 + 0.000 FV at the end of second year FV at the end of third year = Rs.000 + 0.000 + 0.10*Rs.10*Rs.10*Rs. 10.000 (1 + 3 * 0. 10.10) If we generalize: FV = PV ( 1 + Nr) when return is simple return .000 + 0.

Future Value of Money Q2. 10.10 * Rs.10*Rs.10) = Rs.10)² * 0.10) + 0.10* (Rs.000 + 0.10*Rs.10 = Rs. 10. 10. 10.10)² ( 1 + 0. 10.10) ( 1 + 0. 000 ( 1 + 0. 10.000) + 0. 000 ( 1 + 0. 10.10*Rs.10) = Rs.000 Rate of Return (r) = 10% = 10/100 = 0. 10. 000 ( 1 + 0.10)³ If we generalize the formula: FV = PV ( 1 + r)N .000 + 0.000) = Rs. 000 ( 1 + 0.000 + 0. What would be the future value of the money invested if the compounding of return happens at the end of every year? Ans: Present Value (PV) = Rs. 000 ( 1 + 0. 000 (1+0.000 (1+0. Number of Years (N) = 3 Future Value (FV) at the end of first year = Rs. 10.10)² + Rs. 10. 10.000 is invested and the investor gets 10% return every year for three years. 10.10)² FV at the end of third year = Rs. 10.10 . 000 ( 1 + 0. Rs. 10. 10.10) = Rs.000 FV at the end of second year = (Rs. 10.

pP(1+rN) Compound interest can be calculated by using the formula.Calculative Simple and Compound Interest Simple interest can be calculated by using the formula. pP(1+r)N Where. P | principal invested at the outset N | # of measurement periods for which the investment is being made r | nominal rate of interest per measurement period .

000 + (Rs.10/2)) * (0.Future Value of Money Q3. 10. What would be the future value of the money invested if the compounding of return happens at the end of every six month? Ans: Present Value (PV) = Rs.000 Rate of Return (R) = 10% = 10/100 = 0. 10.000 + (0.000 ((1 + (0.000 ((1 + (0. 10. Rs.10/2)) = Rs. 10. 10.000 + (0. 10.10 Number of Years (N) = 3 Number of compounding per year (k) = 2 Future Value (FV) at the end of first year = Rs.000) * (0.000 ((1 + (0.10/2)) + Rs.10/2))1*2 Contd« .10/2)*Rs.10/2) = Rs.10/2) = Rs.000 ((1 + (0.10/2)) ( (1 + (0. 10. 10. 10.10/2)*Rs. 10.000 is invested and the investor gets 10% return every year for three years.

000 ((1 + (0.000 ((1 + (0. 10.10/2))1*2 * (0.10/2))2*2 * (0. 10. 10.000 ((1 + (0.10/2))2*2 + Rs.10/2) = Rs.000 ((1 + (0.10/2) = Rs.10/2))1*2 * ((1+(0.10/2)] + [Rs. 10.10/2)) * (0. 10.10/2) = Rs. 10.10/2)) * (0.10/2)) ((1 + (0.10/2))2*2 (( 1 + (0.000 ((1 + (0. 10.000 ((1 + (0.000 ((1 + (0.10/2)) + Rs.000 ((1 + (0.10/2))2*2 Future Value (FV) at the end of third year = [Rs.10/2)] * (0.10/2) = Rs. 10.10/2))1*2 + Rs.000 ((1 + (0. 10. 10.10/2)) * ((1 + (0. 10. 10.000 ((1 + (0.10/2))3*2 If we generalize the formula.10/2))1*2 * ((1+(0.10/2))1*2 + Rs.000 ((1 + (0.10/2))2*2 + Rs. 10.10/2))2*2 * (0.000 ((1 + (0.000 ((1 + (0.10/2))2*2 (( 1 + (0.000 ((1 + (0. 10.000 ((1 + (0.000 ((1 + (0. FV = PV ( 1 + r/m)Nm .10/2))1*2 * ((1+(0.10/2)) = Rs.10/2)] + [Rs.Future Value of Money Future Value (FV) at the end of second year = [Rs.10/2)] * (0.10/2))1*2 * (0. 10.10/2)) = Rs. 10.10/2)) + Rs.10/2))2*2 (( 1 + (0.

Conversely the nominal rate r can be calculated if we know i and m And N=1 Two Nominal Rates Compounded at Different Intervals are Equivalent if they Yield the Same Effective Rate « .Calculative Effective Interest Rate The effective rate i can be calculated by using the formula when the Nominal rate is r and m # of interest conversion periods per measurement period.

the terminal value will be If # of compounding very large and approaches infinite. as mpg the terminal value will be Effective Rate is Nothing But Compounding Rate When Interest Rate Conversion Period is Different From Measurement Period« .Continuous Compounding Consider Rs P is invested for N periods at r per cent per period and the interest is compounded m times per period.

. It is called FVIF ± Future Value Interest Factor. It is a function of r and N.Future Value of Money When an amount is deposited for a time period at a given rate of interest ± The amount that is accrued at the end is called the future value of the original investment ± So if Rs P is invested for N periods at r% per period FV = PV ( 1 + r/m)Nm ( 1 + r/m)Nm is the amount to which an investment of Rs 1 will grow at the end of N periods. the future value of any principal can be found by multiplying the principal by the factor. It is given in the form of tables for integer values of r and N If the FVIF is known.

1 / [( 1 + r/m)Nm] is the amount that need to be invested to get Rs 1 at the end of N periods. It is a function of r and N. .Present Value of Money When an amount is expected to come in a future date it would be important to know what would the amount be worth at present ± The worth of the a certain cash flow at present is called the present value of the future cash flow ± So if Rs FV is expected cash flow at the end of period N the PV is PV = FV / [( 1 + r/m)Nm] Where r is interest rate and m is the # of times interest is accessed per measurement period. It is given in the form of tables for integer values of r and N If the PVIF is known. It is called PVIF ± Present Value Interest Factor. the present value of any amount can be found by multiplying the future value by the factor.

Future & Present Value Illustrations .

5 years (every thing else remain the same)? FV = 20000 (1+0.000 What is amount Pritam is going to receive at the end of 4.500 .000 with SBI for 4 years The bank pays simple interest at the rate of 15% per annum What is amount Pritam is going to receive at the end of 4th year FV = P(1+rN) FV = 20000 (1+0.15*4) = 20000 (1+.15*4. 33.675) = Rs.5) = 20000 (1+.1 Pritam has deposited Rs 20.Illustration . 32.6) = Rs.

980 What is amount Pritam is going to receive at the end of 4.15)4.5 years (every thing else remain the same)? FV = 20000 (1+0. 34.512 What amount Pritam is going to receive at the end of 4. 37.15/2) = 34980 + 2623.5 years if he gets compounding rate till the 4th year and simple rate for the next 6 months (every thing else remain the same)? FV = 34980 + 34980 * (0.975) = Rs.15)4 = 20000 * 1.000 with SBI for 4 years The bank pays 15% per annum interest rate compounded annually What is amount Pritam is going to receive at the end of 4th year FV = P(1+r)N FV = 20000 (1+0.603 . 37.Illustration .2 Pritam has deposited Rs 20.749 = Rs.5 = Rs.5 = 20000 (1+.

75% per annum compounded quarterly.0413% per annum .0875/4)4 = 9. Where would you invest? In the case of ICICI ± The nominal rate is 9% per annum ± The effective rate is also 9% per annum In the case of HDFC ± The nominal rate is 8.Illustration .75% per annum ± The effective rate is (1+0.3 ICICI Bank is quoting 9% per annum compounded annually and HDFC Bank is quoting 8.

Illustration .4 Suppose HDC Bank wants to offer an effective annual rate of 10% with quarterly compounding ± What should be the quoted nominal rate ICICI Bank is offering 9% per annum with semi-annual compounding. What should be the equivalent rate offered by HDFC Bank if it intends to compound quarterly. .

What is the amount Pritam is going to get after 5 years FV = 10000 * e (r*N) = 10000 * (2.7206)0.5 Pritam has deposited Rs 10.1*5 = 10000 * 1.490 . 16.649 = Rs.000 with SBI for 5 years at 10% per annum compounded continuously.Illustration .

V.105 Pritam has deposited Rs 10.6105 = Rs 16.775 .Illustration . = 10.6 Pritam has deposited Rs 10.000 x 1.000 for 5 years at 10% compounded annually.000 for 4 years at 10% per annum compounded semi-annually.000 x 1.V.4775 = Rs 14. What is the Future Value? Thus F. = 10. What is the Future Value? 10% for 4 years is equivalent to 5% for 8 half-years Thus F.

The company is in a position to invest the premium at 10% compounded annually.000 Therefore LIC can not meet its commitment.7 LIC has collected a one time premium of Rs 10.000 from Pritam and has promised to pay her Rs 30.1)10 = 10000 * 2.10) = 10000 * (1. and to meet its commitment it has to either increase the premium or increase the effective rate of return .000 after 10 years is FV = 10.5937 = Rs 25.000 x FVIF (10. Can LIC meet its obligation? The future value of Rs 10.Illustration .937 The FV is lesser than the liability of Rs 30.000 after 10 years.

Illustration -8 Syndicate Bank is offering the following scheme ± ± ± ± An investor has to deposit Rs 10.000 for 10 years Interest for the first 5 years is 10% compounded annually Interest for the next 5 years is 12% compounded annually What is the Future Value? The first step is to calculate the future value after 5 years: The next step is to treat this as the principal and compute its terminal value after another 5 years .

8084 .9 Pritam would like to have Rs.1/4)16 = Rs.Illustration . 12000 after 4 years What amount Pritam need to invest if he gets a 10% simple rate of return PV = FV / (1+rN) = 12000 / [1+0. 8571 What amount Pritam need to invest if he gets a 10% return compounded quarterly PV = FV / (1+r)N = 12000 / (1+0.1*4] = Rs.

Illustration ± 10: Evaluating an Investment SBI is offering an instrument that will pay Rs 10. should he invest. The price that is quoted is Rs 5. . The problem can be approached in three ways. If the investor wants a 10% rate of return.000 after 5 years.000.

Illustration ± 10: Evaluating an Investment The Future Value Approach Assume that the instrument is bought for 5.5) = 5000 * 1.000 which is greater than the required future value. the investment is attractive. If the rate of return is 10% the future value is 5.6105 = Rs 8. .000.052.000 x FVIF (10.50 Since the instrument promises a terminal value of Rs 10.

000 which is less than Rs 6. 10.6209 = Rs 6.5) = 10000 * 0.209 The investment is attractive .209 In this case the investment is Rs 5.000 * PVIF(10.000 Approach The presentPresent Value using a discount rate of 10% is.Illustration ± 10: Evaluating an Investment The value of Rs 10.209 Therefore to get a 10% return over 5 years the investor would have to pay Rs 6.

000 and receive Rs 10.87% and the required rate for the investor is 10% Therefore the investment is attractive.000 after 5 years.87% In this case the actual rate of return is 14. What is the rate of return? The rate of return can be calculated by: The rate of return that would equal LHS with RHS is 14. .Illustration ± 10: Evaluating an Investment The Rate of Return Approach The investor invest Rs 5.

± What is the rate of return of this investment? .11: The Internal Rate of Return of Rs 18.000 will Let us assume that an investment entitle us to the following cash flows for the next 5 years. Illustration .

5189% .11: The Internal Rate of Return The rate of return is the solution to the following equation: The solution to this equation is called the Internal Rate of Return (IRR) It can be obtained using the IRR function in EXCEL.Illustration . In this case. the solution is 14.

Annuities .

we will assume annual/semi-annual compounding . if the annuity paid/received annually/semi-annually.Understanding Annuities What is an annuity? ± Annuity is a series of equal payments made/received at equally spaced time intervals ± Annuity are of two types Ordinary annuity: When payment made/received at the end of first period Annuity Due: When payment made/received at the beginning of the first period ± Examples of annuity House rent and monthly salary till it is revised Ordinary Annuity Insurance premium: Annuity Due EMIs on housing/automobile loans: Ordinary Annuity The interval between successive payments/receipt is called the payment/receipt period We will assume that the payment/receipt period is the same as the interest conversion period for valuation purpose The assumption implies that is.

Future Vale of Annuity FV ! A A.

r A.

r A.

r 1 1 1 2 2 2 3 N 1 N FV .

r ! A.

r A.

r A.

r A.

r 1 1 1 1 1 N 2 FV .

r ! A.

r A.

r A.

r A A 1 1 1 1 FV .

r ! A A.

r A

r a

r A

r A 1 1 1 1 1 N FV .

r ! FV A.

r A 1 1 N FV .

r FV ! A .

r 1 1 1 N FVr ! A .

r 1 ? A FV ! ?1 r .

r N N ? 1A 1A A Where A = Regular Annuity r = interest rate .

Present Vale of Annuity P P P P P ! 1 r .

1 r 2 .

1 r 3 .

1 r N .

1 r N 1 .

1 r N 1 .

1 r ! .

1 r ! .

1 r ! .

1 r P .

1 r .

1 r .

1 r .

1 r 2 2 .

1 r N .

1 r N P ! .

1 r N .

1 r N P r ! P » « ¬1 .

1 r N ¼ ½ » « 1 ! ¬ r .

1 r N ¼ ½

Where A = Regular Annuity r = interest rate

Understanding Annuities

Present Value Interest Factor of Annuity (PVIFA)

Future Value Interest Factor of Annuity (FVIFA)

** PVIFA is the present value of an annuity that pays Rs 1 per period for N period.
**

± We can calculate the present value by multiplying the annuity with the PVIFA

** FVIFA is the future value of an annuity that pays Rs 1 per period for N period.
**

± We can calculate the future value by multiplying the annuity with the FVIFA

Relationship Between PVIFA and FVIFA

.Present Value of Annuity Due The present value of an annuity due is greater than that of an ordinary annuity that makes N payments Why? Each cash flow has to be discounted for one period less.

Future Value of Annuity Due The future value of an annuity due is greater than that of an ordinary annuity that makes N payments Why? Each cash flow will get one period more to yield return. .

The future value of a perpetuity has a finite present value. .Perpetuities An annuity that pays forever is called a perpetuity.

what is the present value? ± PV = 10.5136 = Rs 85. and payment is for 25 years what is the present value? ± PV = 10. and payment is for 25 years what is the present value? ± PV = 10.000xPVIFA(10.Illustration .000 x 8.000xPVIFA(10.6748 = Rs 106.8181 = Rs 98.000xPVIFA(10.000 x 10.000 x 9.20) = 10.000 per year for next 20 years. beginning one year from now. If the rate of interest is 10%.12 LIC is offering an instrument that will pay Rs 10.181 If the rate of interest is 8%.20) = 10.000xPVIFA(10. what is the present value? ± PV = 10.770 If the rate of interest is 8%.20) = 10.000 x 9.0770 = Rs 90.136 If the rate of interest is 10%.20) = 10.748 The Present Value of Annuity would Decrease if the Interest Rate Goes Up and Increases with the # of Years of Payment .

000 x 73.13 Pritam is expecting to receive Rs 10.20) = 10.000 per year for next 20 years.20) = 10.3471 = Rs 983.000xFVIFA(8.1059 = Rs 731. what is the present value? ± FV = 10.7620 = Rs 457. what is the present value? PV = 10.059 The Future Value of Annuity would Increase if the Interest Rate Goes Up and Increases with the # of Years of Payment . and Pritam is going to receive the payment for 25 years.471 If the rate of interest is 8%. what is the present value? ± FV = 10.275 = Rs 572. beginning one year from now.000xPVIFA(10. what is the future value? ± FV = 10.25) = 10.000xFVIFA(10.20) = 10.750 If the rate of interest is 10%.000 x 57.000 x 45.000xFVIFA(10.Illustration . If the cash flow can be invested at 10%. and Pritam is going to receive the payment for 25 years.000 x 98.620 If the rate of interest is 8%.

If Pritam would have invested the amount he would have got 10% per annum. 85.0025 = Rs 630.649 Pritam bought a insurance policy. what is the future value of the cash he invested in the insurance policy? ± FV = 10.000xPVIFAAD(10. 10.750 * (1+r) = Rs.000xFVIFAAD(10.Illustration . 93.025 .000 per year as insurance premium for next 20 years.000 x 63. 10. If the rate of interest is 10%. 630.000 per year as insurance premium for next 20 years. 572. which requires him to pay Rs.20) = 10.649 ± Which is equal to Rs.14 Pritam bought a insurance policy.000 x 9.20) = 10.025 ± Which is equal to Rs. which requires him to pay Rs.136 * (1+r) = Rs. what is the present value? ± PV = 10.3649 = Rs 93.

1 = 100.000 If the payment from the instrument increases to Rs.1 = 120.15 A financial instrument promises to pay Rs 10. how much should he be willing to pay for it? The value of the perpetuity is: 12.000 per year forever.000 and investor requires a 10% rate of return.Illustration .000 The Value of the Perpetuity would Decrease if the Required Rate of Return Increases and Value would Increase if the Payment Increases .000 / 0. how much should he be willing to pay for it? The value of the perpetuity is: 10.12.000 / 0.000 If the investor requires a 20% rate of return.2 = 50. how much should he be willing to pay for it? The value of the perpetuity is: 10. If the investor requires a 10% rate of return.000 / 0.

Amortization .

Each of the installments paid can be seen in form of an annuity. . ± Logically speaking the present value of the annuity discounted at the loan interest rate would be equal to the loan amount Each equal installment would consists of two component ± A Portion of the principal amount ± Interest on the outstanding loan amount An amortization schedule would show the payment that goes into principal component and payment that goes into interest component. together with the outstanding loan balance after the payment is made.Understanding Amortization The amortization is a process of repaying an installment loan by means of equal installments at periodic intervals.

. The original loan amount is Rs L. and the periodic interest rate is r.Estimating the Amortization Schedule Consider a loan which is repaid in N installments of Rs A each.

Estimating the Amortization Schedule .

000 from SBI and has to pay it back in five equal annual installments.16 Pritam has borrowed Rs 10. What is the installment amount? .Illustration . The interest rate is 10% per annum on the outstanding balance.

20.801.362.000 After one period an installment of Rs 2.97 is made. The interest for this period is 10% of 8.97 is a partial repayment of principal.362. The balance of Rs 1. After the payment the outstanding principal is Rs 8. Since the installment is constant The interest component steadily declines While the principal component steadily increases .Illustration 16: Amortization Schedule At time 0.77 constitutes a partial repayment of principal. The interest due for the first period is 10% of 10.03 After another period a second installment is paid. the outstanding principal is 10. The value of the outstanding balance at the end should be zero.637.637.000 So the excess payment of Rs 1.000 or Rs 1.03 which is Rs 836. After each payment the outstanding principal keeps declining.

If the interest rate is 10% per annum. the annual installment may be calculated as .000 from SBI. She has to pay in 5 equal annual installments along with a terminal payment of Rs 25.000 The terminal payment which has to be made over and above the scheduled installment in year 5 ± Is called a BALLOON payment.Amortization with a Balloon Payment Pritam has taken a loan of Rs 100.

Amortization Schedule .

It raises the effective interest rate ± Since the borrower cannot use the entire amount that is sanctioned . The Simple Interest Method In this technique. there will be no difference with this approach as compared to the simple interest approach. This is called a Compensating Balance. The balance is lent to the borrower. the interest due will decrease. The Add-on Rate Approach In this case interest is first calculated on the full principal. The interest that is effectively paid on the loan may be very different from the rate that is quoted.Types of Interest Computation Financial institutions employ a variety of different techniques to calculate the interest on the loans made by them. The Discount Method Approach In this approach the total interest is first computed on the entire loan amount. ± Each time principal is partly repaid. The sum of interest plus principal is then divided by the total number of payments in order to determine the amount of each payment. interest is charged for only the period of time that a borrower has actually used the funds. In Alfred s case if he repays in one annual installment. The Compensating Balance Approach Many banks require that borrowers keep a certain percentage of the loan amount with them as a deposit. Thus what you see is not what you get. This is then deducted from the loan amount.

± After six months principal of 2.400 Assume the loan is repaid in two equal semi-annual installments.5 = 2700 For the next six months interest will be charged only on 2. ± Interest will however be charged on 5.000. ± The amount payable at the end of the second six-monthly period = 2500 + 2500x0. If the loan is repaid at the end of one year: ± Interest payable = 5000x0.08x.5 = 2.000 from the bank for a year. ± Amount repayable = 2500 + 5000x0.600 ± Total outflow on account of principal plus interest = 2700 + 2600 = 5300 ± Obviously the more frequently the principal is repaid the lower is the interest.08 = 400 ± Total amount repayable = 5.500. .500 is repaid.08x. Illustration 17: Simple Interest Method Pritam has borrowed 5. The bank charges simple interest at the rate of 8% per annum.

But the actual rate will be higher. Illustration 18: Add-on Rate Approach What if he repays in two installments? ± Interest for the entire year = 400 ± This will be added to the principal and divided by 2. The actual rate is given by The solution is i = 10.5758% This is of course the nominal annual rate.8554% . ± Thus each installment = (5000 + 400) / 2 = 2700 The quoted rate is 8% per annum. The effective annual rate is 10.

The interest for the year is 400.Illustration 19: The Discount Method Approach Prtam borrows 5000 at 8% for a year. The effective rate of interest = [(5000 4600) / 4600 ] * 100 = 8.6957% . So Pritam will be given 4600 and will have to repay 5000 at the end.

Illustration 20: The Compensating Balance Approach Pritam is sanctioned 5. So while he pays an interest of 400.000 at the rate of 8%.9 = 4500 The effective interest cost is [400 / 4500] * 100 = 8. . the usable amount is only 5000x0. But he has to keep 10% of the loan amount with the bank for the duration of the loan.8889% Quite obviously ± The higher the compensating balance. the greater will be the effective interest rate.

The most accurate way to compute the APR is by equating the present value of the repayments made by the borrower to the loan amount. Since different lenders used different loan structures. comparisons between competing loan offers can be difficult.S. Every lending institution is required to compute the APR and report it before the loan agreement is signed. Congress passed the ± Consumer Credit Protection Act ± This is commonly known as The Truth-in-Lending Act The law requires institutions extending credit to use a prescribed method for computing the quoted rate. To ensure uniformity the U.Annual Percentage Rate (APR) The effective rate of interest that is paid by a borrower is a function of the type of loan that is offered to him. .

Valuation of Assets (Debt & Equity) .

Valuation of Debt .

Only then can equity holders be paid. . where as equity gives right to the surplus generated by the organization without any promise ± Debt usually has a finite life span where as equity has infinite life ± The interest payments are contractual obligations borrowers are required to make payments irrespective of their financial performance In the event of liquidation ± The claims of debt holders must be settled first. ± Debt promises to pay interest at periodic intervals and to repay the principal itself at a pre-specified maturity date. Who holds it? ± The lender of funds for whom it is an asset What is the difference between debt and equity? ± Equity confer ownership rights where as debt does not.Understanding the Debt Instrument What is debt and who issues it? ± It is a financial claim issued by borrower of funds for whom it is a liability.

**Terminology Associate with Debt Instrument Face Value
**

It is the principal value and the amount payable by the borrower to the lender at maturity. Periodic interest payments are calculated on this amount

Term to Maturity It is the time remaining for the bond to mature and time remaining for which interest has to be paid as promised. The Coupon Rate and the Coupon Value Periodic interest rate (coupon rate) need to paid by the borrower. The value of the coupon can be calculated by multiplying the face value with the coupon rate. Yield to Maturity (YTM) YTM is the rate of return an investor will get if held to maturity and all coupon received before maturity must be reinvested at the YTM

**Terminology Associate with Debt Instrument Discount Bonds
**

If the price of the bond is less than the face value at the time of issue then it is a discount bond If the bond is trading at lower than face value then also is called discount bond ± This will happen when the YTM is higher than the coupon rate. Par Bonds If the price of the bond is equal to the face value at the time of issue then it is a par bond If the bond is trading at face value then also is called par bond ± This will happen when the YTM is equal to coupon rate. Premium Bonds If the price of the bond is more than the face value at the time of issue then it is a premium bond If the bond is trading at higher than face value then also is called discount bond ± This will happen when the YTM is lower than the coupon rate. A Zero Coupon Bonds In a zero coupon bond coupon rate is zero It is issued at a discount and repays the principal at maturity. The difference between the offer price and the face value is the return received by the investor.

Valuing Debt: Discounted Cash-flow Method Value of a bond is derived from the stream of cash flows that the bond holders have

the right to receive at periodic interval. How would we derive the value when the cash-flows are received at different time intervals?

± All future cash flows including the payment of principal at maturity needs to be discounted to the present to derive the value of the cash flows

**Value of bond is a function YTM which is determined by;
**

± ± ± ±

The face value or the maturity amount The coupon rate The term to maturity The market price of the bond

The valuation can be arrived by treating periodic cash flows as annuity and the terminal face value is a lump sum payment.

± If the coupon is paid more often than once per year then the coupon amount needs to calculated accordingly

**Nuances of Valuing bonds
**

± If the investor know the yield that is required by him, then he can calculate the price that would give him the expected yield. ± Conversely, if the investor buys the bond at a certain price, he could calculate the yield he would receive from the investment. ± Therefore the yield and price is dependent on each other and need to be determined simultaneously

the bond will be valued at Rs.463.81 + Rs.1000 The coupon rate is 8%.53681 = Rs.1000 The bond is selling at its face value.536. The maturity amount at the end of 10 year is Rs. The coupon is paid at the end of the year The company is going to pay 10 coupons which can be treated as annuity and the present value of the annuity would be ± (R80 / 0.19 The two parts can be added to get the value of the bond ± Rs. ± ± ± ± Tata Motors were to issue a bond with 10 years to maturity.8)10] = 1000 * [1 1 / 2.463.1589] = 1000 * 0. 80.19 = Rs.1000 .1589 = Rs.1 / (1+0.536.08)10 = 1000 / 2. Given the coupon rate is 8% and coupon amount is Rs.81 The company is going to pay Rs.80.08) * [1 .1000 at the end of 10th year. The present value of the maturity amount would be ± 1000 / (1+0. and coupon amount is Rs.Valuing Debt: Example Let us take following example.

± The coupon is paid at the end of the year The company is going to pay 9 coupons which can be treated as annuity and the present value of the annuity would be ± (R80 / 0.1) * [1 .424. and coupon amount is Rs.1000 ± The coupon rate is 8%.18 is nothing but the present value of difference in coupon value at 8% and 10% coupon rate which is value of annuity of Rs.1000 at the end of 9th year.1 / (1+0.20 for 9 years discounted at 10%.1)9 = 1000 / 2.1)9] = 800 * [1 1 / 2.424.18 .72 + Rs.1) * [1 .1 / (1+0. The investor would only get YTM of 10% on 8% coupon rate bond only if the investor get the bond at discount ± Loss in interest rate of 2% will compensated by the difference in value at maturity and market price ± Rs.10 = Rs. 884.82 The bond would sell at Rs.10 The two parts can be added to get the value of the bond ± Rs.57590 = Rs. 80. the YTM has to be 10%. The present value of the maturity amount would be ± 1000 / (1+0.460.3579] = 200 * 0.3579 = Rs.57590 = Rs.Valuing Debt: Example of Change in Interest rate Let us a year has gone by and the interest rate has changed to 10%.1000 Rs.885 after one year when the interest rate is 10% ± Given the going interest rate is 10%.460.72 The company is going to pay Rs.115. ± Tata Motors bond has 9 years to maturity.82 = Rs.884. ± The maturity amount at the end of 9 year is Rs.115.3579] = 800 * 0. ± (R20 / 0.1)9] = 200 * [1 1 / 2.

136 after one year when the interest rate is 6% ± Given the going interest rate is 6%.03 is nothing but the present value of difference in coupon value at 8% and 6% coupon rate which is value of annuity of Rs.33 * 0.33 * [1 1 / 1. ± The maturity amount at the end of 9 year is Rs.1000 ± The coupon rate is 8%.1 / (1+0.03 The bond would sell at Rs.1 / (1+0.1.333 * [1 1 / 1.03 Rs. ± The coupon is paid at the end of the year The company is going to pay 9 coupons which can be treated as annuity and the present value of the annuity would be ± (R80 / 0.06)9 = 1000 / 1.136.6895] = 333. 80.14 + Rs.40810 = Rs.03 .40810 = Rs. ± (R20 / 0.06) * [1 .06) * [1 .14 The company is going to pay Rs.1000 at the end of 9th year. The present value of the maturity amount would be ± 1000 / (1+0. the YTM has to be 6%.Valuing Debt: Example of Change in Interest rate Let us a year has gone by and the interest rate has changed to 6%.89 = Rs.6895 = Rs.136.544.1136.6895] = 1333. ± Tata Motors bond has 9 years to maturity. 1000 = Rs.06)9] = 333.136.89 The two parts can be added to get the value of the bond ± Rs.1.544.333 * 0.591.06)9] = 1333. The investor would only get YTM of 6% on 8% coupon rate bond only if the investor get the bond at premium ± Gain in interest rate of 2% will compensated by the difference in value at maturity and market price ± Rs.591. and coupon amount is Rs.20 for 9 years discounted at 10%.

for example. we need to change the r and t accordingly.Valuing Debt: Generalizing Based on the learning from the examples we can generalize the formula for valuing the bond V = [C/r] * [1 1/(1+r)t] + [F/(1+r)t. where ± V is the price of the bond ± C is the coupon amount ± r is the yield required from the bond ± F is the face value or the amount received at the maturity ± t is the time term left to maturity In case the coupon is paid more than once in a year. ± If the coupon is paid twice in a year then the appropriate yield would be r/2 ± The time left to maturity would be 2t .

a general investor may not able to evaluate the bond issuer s credibility ± This work is generally done by credit rating agencies ± This agencies take all available information and provide ratings in simple terms so that the investor can understand the risk associated with the bond Higher the risk associate with the bonds higher would be the yield ± If the risk change before the maturity period then it can be reflected on the price of the bond ± Credit rating agencies provide rating updates to help the investors to make appropriate decisions . ± Interest rate risk: This risk refer to change in value of bonds due to change in interest rate and risk of re-investment return due to change in Change in interest rate. it is the issuer s responsibility to provide accurate information about his financial soundness and creditworthiness. which is provided in the offer document or the prospectus.Valuing Debt: Risk Associated with Bonds All bonds are exposed to one or more sources of risk. ± Credit risk: This risk refers to the possibility of default on payment of principal or the periodic interest payments. ± Given the complexity of offer document. ± Liquidity risk: This risk refers to not able to sell the bond ± Inflation risk: This refers to risk associated with inflation ± Foreign exchange risk: This risk involved only if bond is issued in foreign currency The potential investor need to evaluate the risk associated with the bond ± At the time of issue.

the coupon will increase. In case of inverse floater a a floor has to be specified for the coupon because if the in the absence of a floor the coupon can become negative . the coupon will decrease. whereas as LIBOR falls. ± The coupon rate would be Benchmark Rate +/.Understanding Complex Bonds Floaters Floaters is a types of bond where the coupon rate can that can change over time instead of a fixed coupon in case of plain vanilla bond ± Floaters can be linked to a benchmark rate like LIBOR or government treasury bonds. ± In this case as LIBOR rises.LIBOR. ± For instance the rate on an inverse floater may be specified as 10% .x% ± The difference between the benchmark and coupon rate is call the spread ± The spread can be positive as well as negative Inverse Floater In the case of an inverse floater the coupon varies inversely with the benchmark.

Callable Bonds In the case of callable bonds the issuer has the right to call back the bond before the maturity of the bond by paying the face value. ± When the yield is falling the issuer would be better of calling back the bond if he has the option ± On the other hand the buyer would like to hold on to the bond because he is getting higher yield. On the other hand deferred callable bonds can be called after some pre-specified time In some cases some premium is paid (one years coupon) at the time of calling the bond. and he has a re-investment risk ± The call option always works in favor of the issuer Buyers of callable bonds would like to expect a higher yield because he faces uncertainty over the cash flow ± To compensate for the risk the buyer would demand higher coupon rate or lower price of the bond. which is called the call premium . Freely callable bonds can be called at any time and hence offer the lender no protection.

Freely putt-able bonds can be returned at any time and hence offer the issuer no protection. ± When the yield is rising the subscriber would be better of surrendering the bond if he has the option ± On the other hand the issuer would like the lender to hold on to the bond because the issuer would have to pay higher yield. and he has a re-issuance risk ± The put option always works in favor of the lender Seller of putt-able bonds would like to provide a lower yield because the issuer faces uncertainty over the withdrawal of bond ± To compensate for the risk the issuer would demand a premium resulting in lower coupon rate or higher price of the bond.Putt-able Bonds In the case of putt-able bonds the subscriber has the right to return the bond before the maturity and collect the face value. On the other hand deferred putt-able bonds can be returned after some pre-specified time In some cases some premium is paid (one years coupon) at the time of returning the bond. which is called the put premium .

± The conversion ratio (# of common stock per bond) is predetermined. ± The stated conversion ratio may also decline over time depending on the provision ± The conversion ratio generally adjusted proportionately for stock splits and stock dividends. ± The conversion can be made after the a pre-specified time or over a prespecified period. that grants the holder a privilege to gets the shares of a different company. Exchangeable bonds are a category of convertible bond.Convertible and Exchangeable Bonds A convertible bond is right for the bond holder to convert the bond into common stocks of the issuing corporation. ± Exchangeable bonds may be issued by firms which own blocks of shares of another company and intend to sell them eventually by doing in a exchangeable bond way is to defer the selling decision because The expectation that the price of the exchangeable stock will rise Tax benefit involved .

Valuation of Equity .

For example decline in growth rate of the economy. How do we define and measure risk of an investment and what do we mean when we say that investment in asset A is riskier than the investment in asset B? ± What is the relationship between an asset s risk and its required return? Risk associated with an asset can be of two types ± Systematic risk: The risk contributed by the factors that affect all the assets. For example decline in growth rate of the company where the investment has been made. greater will be the required return. ± Unsystematic risk: The risk contributed by the factors that affect only the asset under consideration.Introduction Valuation of an equity would depend on the required return the investor would demand to invest in the equity. The greater the risk. What are the factors that determine the required rate of return on an investment? ± Risk associated with the investment. . Greater the cash flow greater would be the valuation ± The timing of the cash flows. ± The size of the cash flows received from it.

Consider the case of an investor who plans to hold the stock for one period ± Price of the equity can be expressed by .Valuation of Equity: Cash Flow Method What are the cash flows from an equity investment? ± Dividend for each holding period ± Inflow from sale of the stock at the end of investment horizon.

then: Generalization of the Cash Flow Equation Extending the same logic for t period would give us Therefore value of any equity share is the present value expected stream dividends expected to be paid over infinite period . If we assume that the person who buys the stock after one period also has a one period investment horizon.

which is It is extremely difficult to forecast an infinite required to derive the valuation of equity.Equity Valuation: The Constant Growth Model stream of dividends. To make it simple we can assume that the dividends are going to grow at a constant rate over the infinite period ± Let us assume dividends is going to grow at g% per year and the declared declared dividend now is d0 ± The value of the equity is .

The CAPM only provides incremental return for taking systematic risk because the unsystematic risk can be eliminated through diversification . and the relationship between risk and expected return The relationship between risk and return can be derived if we know the risk premium market would pay to take an extra unit of risk This relationship is described in Capital Asset Pricing Model (CAPM) The CAPM would help us determine the expected return from a asset.Equity Valuation: Solving for r The cash flow method would require us to use the most appropriate value for r (the discount rate) The discount rate would depend on risk associated with the equity in question To derive the value of r we need know the risk associated with the equity.

Equity Valuation: Role of Diversification When an investor makes an investment he takes two kind of risk ± One that is specific to the equity ± Other that is related to the macro economic factor. and market would only provide incremental return for taking the systematic risk. If we take a very large number of equities and the investors will allocate the invest able fund across all these equities then the portfolios will not have any equity specific risk (unsystematic risk) The portfolio would only have systematic risk. which would affect all equities If two equities are co-related with each other by combining these two equities one can reduce the risk associated with individual equities. This has an important implication ± To a diversified investor only systematic risk matters ± The investment decision would depend on individual assets contribution to the systematic risk .

Market will not reward for taking unnecessary risk. the higher the systematic risk and the greater will be the expected return Security A may have higher unsystematic risk than security B.0 ± So an asset with a beta of 0.0 has twice as much systematic risk as the market portfolio The larger the beta. Only systematic risk is relevant for determining the expected return and the risk premium of an asset Systematic risk is measured by the BETA of an asset .Understanding Systematic Risk There is a reward on an average for bearing incremental risk and the reward depends only on the systematic risk of the investment Why? ± Unsystematic risk can be eliminated by diversification. By definition market portfolio has a beta of 1. if security B has more systematic risk then the expected return on security B would be higher than security A .F (Beta) Beta measures the systematic risk of an asset relative to market portfolio.50 has half as much systematic risk as the market portfolio ± An asset with a beta of 2. hence no reward for taking the risk.

Calculation of portfolio risk is more complex because of interaction among assets The portfolio risk is measured by summing of all the co-variances A well diversified portfolio has only systematic risk. Risk of an asset can be measured by calculating the standard deviations of returns of the asset.Understanding the Portfolio Return and Risk Portfolio return can be calculated by taking a weighted average of expected return of all assets that constitute the portfolio. Therefore we can calculate the contribution of an individual asset to the portfolio risk by measuring the co-variances between the asset and well diversified portfolio (market portfolio) The Beta which measure the systematic risk of an asset is nothing but the covariance between the asset and a market portfolio (well diversified portfolio) A security would enter a portfolio only when its contribution towards portfolio return is higher in comparison to its contribution towards portfolio risk .

which is (Rm Rf) where Rm is the expected return from the market Multiply (Ri Rf) with the quantity of risk associate with the asset I. which is measure by Beta Once we know the risk premium of the asset i we can easily calculate the expected return from the asset I The expected return from asset i is described in the form CAPM .Risk Premium & CAPM A risk averse investor demands risk premium if he is taking incremental risk If Ri is the return from an asset i and risk-free rate is Rf then the risk premium of the asset I is Ri Rf ± Is the risk premium (Ri Rf) adequate for the asset i ± How would we know adequacy of risk premium of an asset? First we need to calculate the risk premium market demand for a market portfolio.

Rm) = m2 ± Risk premium per unit of risk is = (Rm Rf)/ m2 In the equilibrium the risk premium per unit of risk for the asset I will be equal to the risk premium per unit of risk for the market portfolio Therefore (Ri Rf)/ Cov(Ri. Rm) ± Risk premium per unit of risk is = (Ri Rf)/ Cov(Ri. Rm)/ m2] Now we have equation which would help us in calculating the expected return for an asset . Rm)/ m2] ± Ri = Rf + Cov(Ri. Rm) = (Rm Rf)/ m2 ± (Ri Rf) = (Rm Rf) * [Cov(Ri. Rm) Let us take the market portfolio m ± The risk premium in the market is Rm Rf ± The risk of the market portfolio is Cov(Rm. Rm)/ m2] * (Rm Rf) ± Ri = Rf + i * (Rm Rf) where = Cov(Ri.Deriving the CAPM Let us take an asst i ± Asset i s contribution to risk premium is Ri Rf ± Asset i s contribution to risk is Cov(Ri.

Using CAPM The CAPM can be used for many purpose ± Pricing of risky assets If the expected return is higher then the asset is over priced If the expected return is lower then the asset is under priced As a investor one is always looking for under priced asset ± Calculating the cost of equity The CAPM equation would help us in calculating the cost of equity by giving the return that an investor is looking from the specific equity investment ± Calculating the risk premium CAPM gives us the frame work to calculate the market price for risk It would help us to calculate the incremental return that is required to take an unit of incremental risk Establishes the relationship between risk and return .

Cost of Capital .

Understanding Cost of Capital Firms need capital for creating assets that would generate return for the owners of firm The capital is provided by organizations that have surplus capital ± Capital can have two types of claim Debt Equity The SBU demand a return to provide capital The firm s overall cost of capital will reflect the required return on the firms composition of types of capital ± The expected return demanded by the SBU is the cost of capital for the firm. the DBU ± The expected return would be a function of types of capital ± Overall cost of capital will be a mixture of the returns required by the creditors (debt capital provider) and the returns required by the shareholders (equity capital provider) ± The cost of capital is related to the expected return required by the provider of both of capital ± A firm s cost of capital is nothing but the weighted average cost of debt and equity ± COST OF CAPITAL= REQUIRED RETURN ON THE INVESTMENT .

which is nothing but return available on government bonds ± Let us evaluate a risky project Required return would be higher for a risky project and will depend on the risk-free rate and the risk premium demanded by the investor The cost of capital associated with an investment depends on the risk of the investment Cost of capital primarily depends on the use of funds .Required Return vis-à-vis Cost of Capital What is required rate of return? ± Required rate of return is the rate of return above which the investor would be better of ± For example If the required rate of return on a investment is 10%. the investor would be better of if the return is more than 10% On the other hand the investor would not invest if the rate of return is below 10% In this specific example the cost of capital for the investment would be 10% The required return would be a function of the risk associated with the project ± Let us evaluate a risk-free project How would we determine the required rate of return for the risk-free project? Required return for a risk free project is nothing but the return an investor gets when the investor invest in risk free instrument.

Understanding Cost of Equity Cost of equity of firm is the expected return form the firm s equity How would we know the firm s cost of equity? ± This is a difficult question Why? ± There is no way of directly measuring the expected return of the investor in the firm s equity. We will discuss four approaches for estimating the cost of equity ± ± ± ± The dividend growth model approach The security market line (SML) approach Bond yield plus risk premium approach Earning-Price ratio approach . ± Therefore the cost of equity of firm need to be estimated.

D1. and g It would be easy to get P0 and D1 for listed firm. it would be the cost of equity capital for the firm To estimate the RE we need to know P0. ± A firm is currently paying D0 dividend ± The dividend is expected to grow at a constant rate g ± The required return on equity is RE From our valuation of equity classed we know that: ± P0 = D0x(1+g) / RE g = D1 / RE g ± By rearranging we will get RE = [D1 / P0] + g ± Given that RE is the required rate of return on firm s equity.The Dividend Growth Model Approach Let us assume that. but estimating the g would a challenge .

Pros & Cons of the Dividend Growth Model Approach It is a simple model There are some practical difficulties we would face when we are calculating the cost of equity for firms ± Who does not pay any dividends ± Even if companies pay dividends there is no guaranty that it would grow at a constant rate ± Importantly the estimated cost of equity is very sensitive to the estimated growth rate g Conceptually this approach excludes risk associated with the firms business ± Investors expected return would increase if the risky-ness of investment increases However. there is no direct adjustment for the risky-ness of an investment in this model There is no allowance for the degree of uncertainty associate with the estimated growth rate of the dividend payout .

Ri is the expected return from the firm i (which is nothing but the cost of equity for firm i) Rf is the risk free rate of return i is mthe risk associate with the firm I Rm is the market return from equity investment To use the SML approach for estimating the cost of equity we would require ± The available risk-free rate. which can be estimated from the historical data of the firms equity . which can be calculated by considering the return from the investment in the equity index fund (in case of India it can be return from NIFFTY or SENSEX) ± Estimate of the risk associated with the company. which can be easily found by considering 1 year return from investment in government security ± Estimate for the market return.The SML Approach From our valuation of equity classed we know that ± Ri = Rf + i * (Rm Rf) ± Where.

Pros & Cons of the SML Approach What are the advantages? ± The SML approach has two distinctive advantages It explicitly quantifies risk associate with the investment It can be estimated for the firms that do not pay any dividends What are the disadvantages? ± The SML approach has two distinctive disadvantages It is quite difficult to estimate the risk associate with the firm and the market return Estimates dependent We would be using few estimates to estimate cost of equity. Therefore if our estimates are poor then the cost of equity will be inaccurate The dividend growth as well as the SML approach uses the past data to predict the future ± Economic conditions can change quickly and the past may not be the best guide to the future ± The cost of equity can be sensitive to change is economic conditions .

± The EPS is expected to be constant and the dividend pay-out is 100% ± Retained earnings are expected to generate rate of return equal to cost of equity Both the conditions are rare occurring all the time. the calculation is subjective approach by analysts Earning-Price Ration Approach In case of this approach ± The cost of equity = E1 / P0. where E1 = E0 (1+growth of earning for equity share) P0 is the current price of the equity This approach is quite useful when the firm is not listed This approach would provide appropriate cost of equity. when. this approach is silence on how one should calculate the risk premium. making it a weak approach .Bond Yield Plus Risk Premium & Earning-Price Ratio Approach Bond Yield Plus Risk Premium Approach In case of this approach ± The cost of equity = Yield on long term yield bonds + Risk-premium The logic of this approach is simple ± The firm which is risky will have higher cost of equity ± The cost of equity is linked to cost of debt However.

Understanding Cost of Debt The cost is debt of firm is the return that the firm s lenders demand The cost of debt unlike the cost of equity can be observed either directly or indirectly ± The cost of debt is the interest rate that the firm must pay on new borrowings ± Interest rates can be observed from the financial market Let us take the case of a firm that has already issued bonds ± The YTM of the outstanding bonds is the required rate of return on the firm s debt ± Cost of debt in case of such firms is equal to the YTM of existing bonds ± The coupon rate of the existing bonds is irrelevant to cost of debt for new debt Let us say the firm is going to issue new bonds ± The bond needs to be rated by the credit rating agencies ± The rating of bonds would provide the benchmark rate for the bond ± In case of first time bond offerings the cost of debt would be equal to the YTM of the bonds corresponding to the same risk category .

Understanding Cost of Preferred Stock Some times firms raise capital by using hybrid form of capital ± This hybrid form of capital having some characteristics of debt and equity The debt characteristic ± It pays fixed amount ± It has higher rights than equity in case of insolvency The equity capital ± It is for perpetuity ± It has lower rights than the debt in case of insolvency ± This type of hybrid capital is called preferred stock The cost of preferred stock is given by: Rp = D/P0 where ± Rp expected return from the preferred stock ± D is the fixed annual dividend ± P0 is the current price per share Thus the cost of preferred stock is equal to the dividend yield on the equity .

Weighted Average Cost of Capital We have discussed the three types of capital employed by a firm. preferred stock. What is some of the debt is not publicly traded? ± We must estimate the yield from similar debt that is publicly traded and this yield should be used to price the privately held debt. and P is the market value of firms preferred stock ± Total value of the firm is (V). P/V is the share of preferred stock and D/V is the share of debt. If there are multiple bond issues repeat the calculation of D for each bond issue and add up the values. How would we calculate the cost of capital for the firm? ± First estimate the share of each type of capital ± Calculate cost of each types of capital ± Calculate the weighted average costs of capital where the weights are the shares of each type of capital Let us take a hypothetical example where E is the market value of a firm s equity. D=fixed annual dividend . V = E + P + D ± Therefore E/V is the share of equity. ± E/V + P/V + D/V = 100% We need to calculate the value of equity. ± The market value of preferred stock is=(D/r)*no of preferred stock. ± The market value of debt = market value of a bond * the number of bonds outstanding. and debt ± The market value of equity = market price per share * the number of shares outstanding. D is the market value of a firm s debt.

± WACC = RE x E/V + P/V x RP + D/V x RD(1-T) .Weighted Average Cost of Capital Tax Implications The firm is always concerned with after-tax cash flows Therefore the cost of capital should incorporate the effect of tax ± This has implications for cost of debt because debt gives the firm a tax shield If T is the tax rate the effective cost of debt is RD*(1-T) Therefore.

2 ± The cost of equity = WACC = 21. if the new project risk is different from the risk of the existing business then using the same cost of capital to would result in sub-optimal investment decision .6%. If the firm is an all-equity firm with a beta of 1.6%. it would accept project that would provide return in excess of 21.Divisional and Project Costs of Capital What would be cost of capital for a new project.6%=(Rf+Risk premium)*beta ± If the firm has to evaluate new projects using this cost of capital. Let us assume that the riskless rate is 8%. hence the cost of capital would be less than 21. ± Use of same cost of capital could reject project that are relatively safe ± Therefore. will it be same as before the new project? ± A manufacturer company is thinking of expanding production by setting up a new plant ± A manufacturing company is thinking of expanding to retail business ± There will be situations where the cash flows from the new project could have different risk from the risk with the current cash flows of the overall firm. and the market risk premium is 10%. If the risk of the new project is lower then the risk premium required for the same project would be lower than 10%.

but it would not get capital for expansion Therefore WACC may not be suitable criterion for evaluating project with different levels of risk. Ideally the cost of capital needs to estimated for not only for new projects but also for the different divisions with in an existing business conglomerate ± This can be done by following the same method we have discussed before with minor modifications . ± Assume a corporation has two business divisions A grocery retail business An electronics manufacturing operation ± The first has relatively low risk ± The second has relatively high risk The corporation s cost of capital is a mixture of the costs of capitals of two distinct business ± It is natural to say that both of these divisions would be competing for capital The retail business wants to expand to new cities Manufacturing unit wants to set up a new plant ± What happen if we use WACC as a tool to allocate capital? The manufacturing division would get more capital ± The cost of capital is same for both the division ± It would provide more return in comparison to retail business because the business has more risk ± The less risky retail division may have great profit potential.Divisional and Project Costs of Capital The same type of error can arise if a company has multiple lines of business.

rs 20 The debt is quoted at 90% of face value and the face value of debt is 10 MM..Illustration .90 x 10 = 9MM Total value V = 49MM WACC = 40/49 x 12.49% .5 + 9/49 * 10 x (1-0.5% and RD = 10% The value of equity is 2 x 40 = 40MM Value of debt is 0.3) = 11.75 x 10 = 12. it might be single debt therefore value of debt= market value of bond x no of bonds= 90% of 10 * 1=9 The YTM for the debt is 10%= cost of debt RD The risk-free rate is 5% The market risk premium is 10% and the beta is .40 .21 A company has 2MM shares outstanding The stock price is Rs.75 The tax rate is 30% RE = 5 + .

Capital Budgeting .

publically available(includes historically available) Third strong form efficient.available means historically available Second semi strong form efficient.privately (including publically available.3 layers of efficient capital market Total or realized return= expected return + error(systematic and unsystematic risk) 3 layers depends on how we define available First weak form efficient.) .

± Net Present Value (NPV) method ± Internal Rate of Return (IRR) method ± Pay-back period method ± Benefit-cost ratio method Modified Internal Rate of Return (MIRR) method . new factory) or intangible assets (increase the marketing expenses to increase the brand value) Capital budgeting decision would affect the firms growth. and capital budgeting process helps the financial managers to make the appropriate choice. ± What new projects the firm should invest? Should it expand to new market? Should it launch new products? Should it increase the production by setting up new plants? And many more questions that would require the firm to invest in physical (new technology.Introduction Capital budgeting addresses the following questions. and competitiveness in the long-run ± Why? Fixed assets created through investment will have long life The long-tern investment is generally not easily reversible The firm will have many alternative where investment can be made. There are a number of techniques for capital budgeting like. profitability.

which is more realistic . 2 Lakhs The challenge any investor faces is is to identify in advance that an investment would generate positive NPV. 25 Lakhs If he renovates it can be sold at Rs. 3 Lakhs The owner of house can create value of Rs. 2 Lakhs by investing Rs. which is the subject matter of capital budgeting The capital budgeting process is nothing but a search for project that would generate positive NPV project for investment In the case of the house that we considered there is a ready market from where an estimate of the sales proceeds can be obtained. 3 Lakhs Therefore the renovation project would yield a NPV of Rs. ± ± ± ± ± An individual has a house valued at Rs.Net Present Value (NPV) When should one make an investment? ± If the investment creates value after taking care of the cost ± The value is net of cost and therefore called Net Present Value (NPV) How do we create value? Let us take an example. 30 Lakhs The cost of renovation is Rs. which simplifies the investment decision making process Capital budgeting becomes more difficult when we cannot observe the market value of at least comparable investments.

000 14. We will use a 15% discount rate on new projects.Net Present Value (NPV) Let us assume that we are planning to set up an dairy firm. Thus we have an 8 year annuity of Rs.000 per annum.000 after 8 years. 20. 2. If the NPV is positive accept the project and If the NPV is negative reject the project .578= -Rs. 6. 2. The cost of setting up the project is Rs. The salvage value of plant and machinery will be Rs. ± We can estimate what would it cost to set up the dairy firm ± However.000 per year. The net cash inflow from the project is 20. 27.000 per year with a operating expenses of Rs.000 = 6.578 and the NPV = -30. this project is not worth undertaking.000 Assume that the cash flows from investment will be Rs.000 per annum plus one lump sum inflow of Rs.000+27. 14. The business will be wound up in 8 years. 2422 Since the NPV is negative. would not know the revenue stream from this project ± We have to make an estimate of the revenues that would be generated from the diary project? Once we have an estimate of the cash flow from the estimate we would have to calculate the present value of the cash flows Difference between the investment and the present value of the future cash-flow of the project will give us the NPV of the project. The PV of the cash flows = Rs. 30.000 after 8 years.

Invest 500 today Get back 550 next year.Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of cash out-flows with the cash in-flows of a project. The NPV of the project = -100 + 110/(1+r) Equating the NPV to zero would imply 110/(1+r) . 2000. and 3000 in the first. second.100 = 0 r = 10% Therefore the IRR is 10% IRR of a project is the required return from an investment that would make the NPV of the investment equal to zero Let us take an example ± A project costs 4000 and the required return from the project is 15% ± The cash inflows are 1000. ± Present value of cash out-flow will be equal to cash in-flow when the NPV of the project is equal to zero The IRR can be calculated if we set the NPV equation equal to zero ± ± ± ± Consider a simple project. ± Given that IRR is greater than the required rate of return the project should be accepted Therefore investment in a project is acceptable when IRR exceeds the required rate from the project . and third year respectively ± The IRR can calculated by making the NPV = 0. in this case it is 19%.

the one with the largest NPV Is it necessarily the one with the highest IRR The answer is NO Let us take an example to show this .NPV vis-à-vis IRR Calculation of NPV and IRR seems similar! ± Does it mean that use of NPV and IRR would lead to the same decisions about the investment proposal? The answer is yes as long as two conditions are met ± The project s cash flows must be conventional The first cash flow is negative and all the rest are positive ± The project must be independent That is the decision taken with respect to this project does not affect the decision to accept or reject another ± If two investments are mutually exclusive then Accepting one would mean rejecting another If we have two or more mutually exclusive projects which is the best ± ± ± ± The answer is.

the NPV method would identify the project A to be better . project A and project B. the NPV method would identify the project B to be better If our required rate is 25%.Illustrations Let us look at two projects.NPV vis-à-vis IRR . if use IRR as the tool project A is better Let use NPV as a tool to evaluate the projects If our required rate is 15%. whose cash flows are given below Year 0 1 2 3 4 Project A -1000 550 655 405 355 Project B -1000 350 465 750 600 The project A has an IRR of 38% and Project B has an IRR of 35%.

NPV vis-à-vis IRR Learning from Illustrations The NPV method is sensitive to the required rate of return ± What should be the appropriate required return? It should be at least the cost of capital NPV and IRR method may result in different choices It can be misleading to evaluated two projects and rank them on the basis of IRR to determine which is the best project Thus if we have mutually exclusive projects we should not rank then based on their returns Therefore to compare two projects we should look at the NPV because it provides an estimate of contribution of the project towards the value of the firm However IRR is very popular in practice in comparison to NPV method It is simple to understand in terms returns than value creation from a project IRR is a simple way of communicating about the contribution of a project The IRR may have a practical advantage because to estimate NPV we need to know the cost of capital but IRR can be estimated without knowing the cost of capital .

-80.15)2 + 100(1. 100.Modified Internal Rate of Return (MIRR) To address the shortcomings of IRR. MIRR is use ± The MIRR can be calculated by.15)3 + 80(1. 80.6 = 467 / (1+MIRR)6 ± The MIRR = 0.2% ± The IRR of the same project is 16. 20.15) +120= 467 ± 189. Calculate the present value of the costs (PVC) Calculate the terminal value of the cash inflows expected from the project (TV) Conceptually PVC = TV / (1+MIRR)n-1 We can easily solve for the MIRR from the equation Cost of capital is used as the discount rate.162 = 16.6 ± The TV = 20(1.15 = 189.81% In this case the differences is small but this need not always be the case . 60.15)4 + 60(1. 120 and cost of capital is 15% ± The PVC = 120 + 80 / 1. Let us take an example ± The project cash flows are -120.

000 The project recovers the initial investment amount by 3rd year Therefore for this project the payback period is 3 years.000) (25. The payback period rule would be If required payback is higher than the actual payback period then accept the project else reject it . Time 0 1 2 3 4 Cash Flow of a Project (155.000) (100.000) 0 25.Payback Period Method Payback is the length of time taken to recover the investment amount Let us understand the payback method through this example.000 25.000) 55.000 25.000 75.000 Cumulative Cash Flow the Project (155.

Payback Period Method The payback period method has some shortcomings. ± Firstly to compute the payback period we simply add up the cash flows ± Secondly there is no discounting ± Time Value of Money is totally ignored. Payback period method does not factor in risk differences ± In practice a more risky project would be evaluated using a higher discount rate ± Since the payback criterion ignores discounting it analyzes projects with different risk profiles without factoring in the risk differences. A major issue is how do we choose a cutoff period ± What is the basis for stating that we will accept projects with a payback of say 3 years or less ± In practice the cutoff has to be arbitrarily decided The criterion totally ignores cash flows arising after the initial investment is recovered. .

Benefit Cost Ratio Method (BCR) The benefit cost ratio is defined as the ration of the present value of all the benefits (PVB) that is going to occur (positive cash inflows) and the initial investment (I) Let us take an example ± A projects initial investment is Rs. 1 invested we get Rs. 1.25 means It means per Rs.25 ± What does BCR of 1. ± If the project has a BCR of greater than 1 then accept the project . 200 ± The present value of future cash flows is 250 ± The BCR = PVB / I = 250 / 200 = 1.25 The BCR rule would be.

Capital Budgeting in Practice NPV is the most appropriate methods for capital budgeting decisions? ± When the NPV can be computed. payback is long and IRR is low The information suggests one should be careful Verify the estimates Do further analysis Therefore though NPV is technically is the best method it can be used in conjunction with other method to make a better decision . short payback and a high IRR The information about the project suggests one should proceed with the project ± On the other hand if the NPV is positive. ± Let us assume a project has a positive NPV. why look at other methods? Investment decision making process needs to take care of uncertainties regarding the future Real NPV is unknown and the NPV calculated is an estimate.

Project Cash Flow Analysis .

To evaluate an investment.Understanding the Cash Flows Why should firm go for new projects? ± To increase the future cash flow. we need to consider: ± The changes in the firm s cash flows due to the investment ± The change in cash flow need to increase the value of the firm ± The relevant cash flow for a investment would be the incremental cash flow because of the direct consequence of the decision to take up the new project. which would increase the value of the firm in future ± To invest the surplus generated productively to increase the value of the firm in future. . What are incremental cash flows? ± The incremental cash flows for a project is any changes in the firm s future cash flows that can be exclusively attributed to the investment in new project. ± Therefore the existing cash flow of the firm has now relevant on the investment decision.

± The project is like a small firm ± The projects has its own futures revenues and costs associated with it like any other firm ± The project can generate its own assets ± The project can have its own liabilities ± The assets will generate cash flows from the assets it creates and pay back the liabilities ± At the end the project should have the surplus that would increase the value of the firm The investment amount on the new project is like acquiring the cash flows from the small firm.Understanding the Cash Flows The incremental cash flow is based on the stand alone principle The stand alone principle treats the investment as. ± It is easy to make errors while deciding what cash flows are incremental. ± We will discuss some of the potential pitfalls and how to avoid them .

which is called value erosion ± A positive externalities would positively affect the existing cash flow. which is called value addition In accounting for erosion it is important to recognize that sales that would have been lost because of future competition should not be attributed to the project ± Erosion is relevant only when the sales would not otherwise be lost .Understanding the Cash Flows A project could have externalities: positive as well as negatives ± A negative externalities would negatively affect the existing cash flow.

Understanding the Cash Flows Evaluation of an investment proposal should not include the cost of capital Why? ± The goal in project evaluation is to compare the cash flows from a project to the cost of acquisition the NPV The mix of debt-equity used is a managerial variable that determines how cash flows will be divided between owners and creditors The cash flow of the new investment should take into account the effect of tax The capital budgeting process would involve in preparing one pro-forma or projected financial statements To prepare a pro-forma statement we need estimates of quantities like: ± ± ± ± ± ± # of unit of sales Selling price per unit Variable cost per unit Fixed costs Total investment required Including investment in NWC .

± A diary firm evaluating whether to lunch butter as a product in market ± To evaluate the proposal it hires a consultant ± The consulting fee should not be considered as a cost in incremental cash flow method The firm any way has to be paid whether or not the product is launched . What is a sunk cost of a project? Understanding the Cash Flows The Sunk Cost The sunk cost can not be changed the decision of accepting or rejecting the project It is not relevant for the decision making process ± The sunk cost is the cost that has already being incurred ± It is the cost that the firm has to make whether it takes up the project or not Therefore the sunk cost principle is not to include it on the cost side of the project cash flow For example.

Understanding the Cash Flows Opportunity Costs What is opportunity cost of a project? ± An opportunity cost of a project is the benefit it has to sacrifice to take up the project A firm is thinking of using an ideal piece of land for building multiplex ± To build a multiplex the firm has to buy the land ± In this case there is no cash out flow for the purchase of the land because the firm already own it ± For the multiplex project what should be the cost of land Is it a free given that there is no cash out flow? ± The principle of opportunity cost would say it is not because it is a valuable resource that can be used by other competing project s or at the least it can be sold and money can be used for other purpose as well Therefore when we are estimating the cash flows for a project we need to take into account all the possible opportunity costs of the assets that are going to be used in the project. which is currently owned by the firm .

A new project would require incremental working capital ± New project would need cash on hand to pay expenses ± Cash needed to finance the inventories of inputs. and outputs ± Some of the cash requirement can be financed through account payables ± The balance has to be generated ± The balance cash required in termed as Net Working Capital Understanding the Cash Flows: Effect on Working Capital As the project is wound up ± ± ± ± ± Inventories will be sold Receivables will be collected Bills will be paid Cash balances will be utilized These activities will free up the NWC that was initially invested While estimating the cash flows of a project we need to account for net working capital expenses .

Risk Analysis in Capital Budgeting .

Sources of Risk for Capital Budgeting Most of the capital budgeting decision involves risk ± Risk of increase in expenses to execute the project ± Risk of non-realization of expected revenue from the project Sources of risk for a project ± ± ± ± ± Project specific risk Competitive risk Industry specific risk Market risk International risk .

Risk analysis for capital budgeting is complex The techniques of risk analysis can be broadly divided into two types ± Analysis of standalone risk ± Analysis of contextual risk Techniques of Risk Analysis The analysis of standalone risk can be done in many different ways ± ± ± ± ± ± Breakeven analysis Scenario analysis Sensitivity analysis Hiller model Simulation analysis Decision tree analysis The analysis of contextual risk can be done in many different ways ± Corporate risk analysis ± Market risk analysis .

Break-even analysis In sensitivity and scenario analysis we attempt to estimate the effect of changes in certain factors on the project viability In case of break-even analysis we attempt to estimate the minimum amount of sales that would make sure that the project does not loose money ± The process of estimating the break-even point is called break-even analysis The break-even analysis is of two types ± Accounting break-even analysis: In this case the analysis would involve to identifying the sales amount that would result in zero cash profit ± Financial break-even analysis: In this case the analysis would involve to identifying the sales amount that would result in zero NPV Accounting break-even point = (Fixed cost + depreciation) / Gross Margin or contribution margin ratio Financial break-even point = contribution/1-variable cost % .

the project manager has to create hypothetical cases by using his/her experiences The project managers estimate of different scenario would affect the assessment of risk involved in a project .Scenario Analysis In scenario analysis. in case of scenario analysis there is no well defined scenarios. several factors are changed simultaneously to understand the risk involved in a given project Typically three case are considered ± Normal ± Pessimistic ± Optimistic Scenario analysis is an improvement over sensitivity analysis with respect to variability of factors happening simultaneously However.

Sensitivity Analysis Identify the factors that can change the cash flow of the project in question Change one factor at a time by fixing all other factors ± This would help us in identifying the most sensitive factor ± Once the most sensitive factor is identified we can take necessary measures to reduce the risk involved in that factor ± This would also help in monitoring the performance of the project The sensitivity analysis is very subjective and requires good understanding of the project Two individuals may decide differently depending on the prospective Sensitivity analysis only changes one factor at a time where as in real world variables tend to change simultaneously .

000 give & take 5% Variable cost to Price Ratio = 80% give and take 8% Fixed Cost = 150.000 Base Case 25 70.000)/5 = 100.000 Upper Bound 26 73.000 .500 72% 132.000 (at t=0) in NWC (net working capital) The machine can be sold off for 30.000 WACC is given to be 15% Lower Bound Number of Apartments Sold Price per Apartment Variable Cost as % of Revenue Fixed Costs 24 66.000 give and take 12% We can compute that DTS (Depreciation Tax Shield) = $100.000 x 34% (tax rate) = 34.An Example Data on Investment Low-cost Housing Project requires an investment of 530.000 Data on Income and expenses Base Figures and Maximum Expected Variations: ± ± ± ± ± Apartments per Year= 25 units give & take 4% Price per Apartment = 70.000 in fixed-assets (machinery) and 60.000 at the end of its five-year life So.500 88% 168. DPY (Depreciation per Year) = (530.000 30.000 80% 150.

000 34.Non-Cash Charges (like Depreciation) = EBIT .000 = Contribution .750.000 1.Fixed Cost (excluding Non-Cash Charges) .000 x 25) Variable Costs (80% of Revenue) 1.000 66..000 100.000 OCF= NI+ DEP + INT= TR.000 350.000 0 100.Taxes @34% = NI (Net Income) + Non-Cash Charges (like Depreciation) = OCF 166.INT.An Example - Revenue (70. exclude non cash charges.000 100.400. .Interest = Taxable Income .000 100.000 150.FC-VC-TAX.

000 EBIT = Taxable Income = -100.485 Breakeven Revenue = Contribution / (1-80%) = 492.515 Contribution = -151.424 Breakeven Price (per apartment) = 492.100.515 + Non-Cash Charge + Fixed Cost = 98.000) Caveat: Breakeven is often measured by the number of units to be sold This is referred as Cash Breakeven Point .000 7 (assuming that each apartment is sold for 70.An Example At what price (per apartment) Operating CF is zero? Net Income = OCF Non-Cash Charge = 0 .697 (assuming that 25 apartments are sold annually) AND Breakeven Number of Apartments = 492.424 / 70.424 / 25 = 19.000 = -100.000 /(1-34%) = -151.

contribution= dep + FC + EBIT. .000 11 This is also referred as Cash Breakeven Point If there were no taxes. it is the tax rate which is making difference between the ocf=o and just covered cost method cash break even point.000 Breakeven Price (per apartment) = 750. Because then contribution= EBIT + FC + dep = -100000 + 150000 + 100000= 150000= FC .An Example At what price (per apartment) Revenue just covers actual costs (excludes non-cash charges)? Therefore.000 / 70. Breakeven Points 1 and 2 would be the same.000 => Breakeven Revenue = Contribution / (1-80%) = 750. Requires that Contribution = Fixed Cost = 150.000 AND Breakeven Number of Apartments = 750.000 / 25 = 30. here EBIT=0 AND dep is excluded.

000 / 25 = 50.250. Operating Cash Flow equals Depreciation Depreciation is taken here as the Recovery of Investment in Fixed Assets (clearly ignores time value of money) .000 Breakeven Revenue = Contribution / (1-80%) = 1.000 / 70.000 Breakeven Price (per apartment) = 1.000 AND Breakeven Number of Apartments = 1.250.250.An Example At what price (per apartment) Net Income is zero? Taxable Income = 0 => EBIT = 0 Contribution = 0 + Non-Cash Charge + Fixed Cost = 250.000 18 This is the Accounting Breakeven Point At this point.

Estimating the Cash Flows Base Case The top-down approach Net Sales OR Revenue Variable Costs and Fixed Costs (Exclude Non-Cash Charges) 1.000 0 166.000 34.000 Actual Taxes (This has to be known or given) = Operating CF The bottom-up approach NI (Net Income) + Non-Cash Charges + Interest = Operating CF 66.000 100.000 1.550.000 166.000 .750.

750.000 = Taxable Income without Non-Cash Charges & Interest 200.000 = Contribution 350.000 + DTS (Depreciation Tax Shield) 34.000 .Estimating the Cash Flows Base Case The tax-shield approach Revenue ($70.000 = OCF (Un-levered) 166.000 x 25) 1.000 .Fixed Cost (excluding Non-Cash Charges) 150.000 .000 .Taxes @34% 68.Variable Costs (80% of Revenue) 1.000 = EAT 132.400.

5 + 166.Scenario Analysis: Base-Case NPV Project-LcH Special CF CFs at Special CF at t =0 -530.000 = -590.254 + = 11.000 90 .458 .000 OCF OCF TOTAL NPVLcH -590.000 +60.000 + = -545.254 + = -545.5 556.204 OCF OCF OCF OCF 90.000 t=1 t=2 t=5 at t= 5 +30.000 -60.000 (1 15%)5 OCF x PVIFA15%.000 x PVIFA15%.

245 OCF OCF OCF OCF 90. price.000 t=1 t=2 t=5 at t= 5 +30.000 (1 15%)5 OCF x PVIFA15%.000 + = -545.000 = -590.5 + 49.Scenario Analysis: Worst-Case NPV Project-LcH Special CF CFs at Special CF at t =0 -530. variable cost. and fixed cost .5 *Derive this under most unfavorable figures for units sold.254 + = -379.000 -60.523* x PVIFA15%.000 OCF OCF TOTAL NPVLcH -590.000 90 .000 +60.

variable cost. and fixed cost .502 OCF OCF OCF OCF 90.000 (1 15%)5 OCF x PVIFA15%.254 + = 460.5 *Derive this under most favorable figures for units sold.000 -60.Scenario Analysis: Best-Case NPV Project-LcH Special CF CFs at Special CF at t =0 -530.000 +60.033* x PVIFA15%.000 90 .000 OCF OCF TOTAL NPVLcH -590. price.000 t=1 t=2 t=5 at t= 5 +30.5 + 300.000 + = -545.000 = -590.

Thank You .

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MM Hypothesis Capital structure does not matters investors can lend and invest their own. Thus whatever the capital structure the stock prices will remain the same When taxes =0 then. WACC= E/V*Re + D/V *Rd Re= WACC+ (WACC-Rd)* D/E .

M &M The cost of equity depends on Wacc Rd D/E ratio The cost of equity given by a straight line with a slope of WACC.Rd According to MM hypothesis cost of equity does not depend on the D/E ratio .

The fact that debt is cheaper than equity will be offset by the rise in cost of equity The net result is what WACC remain the same .

.MM hypothesis and implication of tax and bankrutptcy Debt has two features Interst on debt is tax deductible Bankruptcy: one limiting factor affecting the amount of debt a firm can raise is bankruptcy cost.

. And the debt holders holds the asset equals to the value of debt provided there is no transactional cost involved.bankruptcy When this happen the ownership of firm get transferred to the debt holders When the value of assets becomes equal to the value of debt the firm is called bankrupt Then value of equity becomes 0.

In the real world it is expensive to be get bankrupt The cost associated with bankruptcy may offset the tax benefit due to leveraging .

Direct cost of bankruptcy Legal and administration cost A fraction of asset get disappeared(bankruptcy tax) This cost is incentive for debt financing .

Indirect cost of bankruptcy Time Strain Financial distress Profitable projects may be get terminated .

Conclusion of bankruptcy The tax benefit from leveraging is important to firms that are in tax paying condition Firm with high dep tax shield will get less benefit from leveraging Firm with substantial accumulated loss will get little value form tax shield Greater the volatility less a firm should borrow Borrowing depends on asset quantity Financial distress is more costly for some firm The cost of bankruptcy depends on asset and easiness of transfer of the asset The firm will greater risk of facing financial distress will borrow less .

increasing or predictable cash outflow Mutual funds: dividend & growth .Dividend policy The connecting link between owner and management is dividend policy which a manager decides Residual dividen policy: growth and capital appreciation driven Managed dividend policy: under managed dividend policy manager attempts to reduce the variablity of pay out of dividend It is constant.

by getting more and large dividend paid To reduce the conflict between debt and stock holders there is need of managed dividend policy .agency problem &Dividend policy Dividend stripping cash flow is shared by debt and equity holders Debtors get assured when company has liquidable assets Shareholders enjoy upside potential Debtholders enjoy downside risk with equity holders How I can get my money back quicky in case of equity holdr.

Leveraging and dividend policy Higher the leverage more the divident paid is incentive for the equity holders In case of levereged firm payment of divident increase the default In low levereged firm dividend payment will have very low impact on value of debt Dividend payment makes debt more risky Low the debt low is the chances of default .

Manager tries to reduce it through the divident policy The signal will be credible and believable only when it can t be mimiced Pricing mechanism must separate the firm with favourable information with the firm with less fabourable information based on the dividend signal When prices of the share is low what managers perceived what it should be.Pricing mechanism and repurchase visvis cash dividend Assymetry of info arises when two individual have different set of info. . then mangers go for buy back. the manger will be benefit more than paying dividend provided company has money to buy back.

Working capital management Deals with short term mangement of assets and liability Gross wc Net wc Wcm involve Cash and liquidity mangement Account receivable and payable management Formulate credit policy and negotiate favourable credit terms Estimates working capital need Monitoring the inventories .

Factor influencing working cap requirement Nature of business Cycle of business Seasonality of business Market condition Supplier condition .

Level of WC & CA requirement Less CA shortage cost More CA carrying cost In order to balance these two cost we need optimum working capital .

Level of working capital depends on Operating cycle .account receivable period(sale.cash received) Cash cycle .operating cycle .account payable period( bill received to paid) .inventory period( inventory supplied goods finished and sold) .

OC= INVENTORY PERIOD + ARP CC= OC.APP LEVEL OF CA AND WC REQUIREMENT Inventory period= avg inventory/ (cogs/365) ARP = avg account receivable/ (sale/365) APP = avg account payable period / (cogs/365) .

disbursement float and net float The firm objective is to Maximize the float to increase the cash balance Speeding the collection Delaying the payment Concentration banking .Cash and liquidity management Why do firm need cash Transaction motive Precautionary motive Speculative motive Collection float.

Investing the surplus fund Criteria for evaluating the investment requirement Safety Liquidity Maturity period and yield .

size and maturity period of instrument Free cash segment: amount or cash which must be invested. Safety & yield. . Safety & liquidity Controable cash segment: cash requied for planned investments. Safety.Understanding the need to decide on the portfolio investment Ready cash segment: cash needed to meet un anticipated operational requrirement.

Investing options Bill discounting Inter corporation deposit Mutual fund schemes Equity. CP and FD with banks . debt and balanced. Treasurey bills CD.

cash discount Credit policy variables: cash discount. credit period and credit standard Credit evaluation Credit granting decision Credit monitoring . billing & payment conditions. collection efforts.Credit management Credit payment: credit period.

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