CORPORATE FINANCE

FUNDAMENTAL VALUATION
CONCEPTS
COURSE OUTLINE
 Overview of Financial Management
 Fundamental Valuation Concepts
 Capital Budgeting
 Cost of Capital
 Working Capital Management
 Capital Structure
 Dividend Policy
THE STORY SO FAR
 Every business decision has financial implications, thus
everything that a business does fits under the rubric of
corporate finance.

 The job of the financial manager in India has become more

complex due to Liberalisation and Market Volatility

 Key Financial Intermediaries are commercial banks, financial

institutions, insurance companies, mutual funds, NBFCs and
financial services companies

 Indian financial system is widening, deepening, maturing and

growing in sophistication
 KEY PRINCIPLES
Objective – Maximise the Value of the Firm
 Maximisation of shareholder wealth
Share price is easily observable, constantly updated, reflects wisdom of corporate
decisions instantly and can be used for theories for resource allocation, financing of
investments and paying out of dividends.

 Maximisation of Profit
Profit in absolute terms is not relevant, leaves considerations of timing and duration undefined and
glosses over the factor of risk

 Maximisation of EPS or ROE

Leaves considerations of timing and duration undefined and glosses over the factor of risk

 Investment Principle

 Financing Principle

 Dividend Principle
KEY PRINCIPLES
 Invest in projects that yield a return greater than the
minimum acceptable hurdle rate.
 The hurdle rate should be higher for riskier projects and reflect
the financing mix used – owners’ funds (equity) or borrowed
money (debt)

 Returns on projects should be measured based on cash flows and

the timing of these cash flows; they should also consider both
positive and negative side effects of these projects.
 Choose a financing mix that minimises the hurdle rate and matches the assets
being financed.
 If these are not enough investments that earn the hurdle rate, return the cash
to shareholders.
 The forms of returns – dividends and share buybacks – will depend upon
the shareholders’ characteristics.
FUNDAMENTAL PRINCIPLE
 A business proposal-regardless of whether it is a new investment or
acquisition of another company or a restructuring initiative –raises the
value of the firm only if the present value of the future stream of net
cash benefits expected from the proposal is greater than the initial
cash outlay required to implement the proposal.

CASH ALONE MATTERS

Investors
Investors provide the initial cash required
The business
to finance the business proposal proposal
•Shareholders
•Lenders

The proposal generates cash returns

to investors
INVESTMENT DECISION
 Q : Which investment decision will raise the value of
the firm ?

 A : When NPV > 0

NPV = PV (future cash benefits) – Initial Outlay

So what is “Present Value”, “Future Value” and “Time

Value of Money” ?
TIME VALUE OF MONEY
 What would you rather have :
 Rs 10,000 today ?
OR
 Rs 10,000 in 5 years ?

 Why ?

 The value of money depends on when money is to

be received. A rupee today is worth more than
today’s promise of a rupee tomorrow.

This is true, even in the absence

of uncertainty and with no
possibility of inflation.
WHY TIME ?
 TIME allows one the opportunity to postpone consumption
and earn interest.
 Preference for current consumption over future consumption

 Productivity of capital
 Capital will generate positive returns when invested

 Inflation
 Rs 100 today has greater purchasing power than Rs 100 one
year later

 NOT having the opportunity to earn interest on money is

called OPPORTUNITY COST.
 FUTURE VALUE OF A SINGLE AMOUNT
Rs 100 at r% interest for 3 years with compounding of interest
T=1 T=2 T=3
T=0

Rs 100
Rs 100 + (100 * r)
= Rs 100 * (1+r)
[Rs 100 *(1+ r)] + [Rs 100 *(1+ r) * r]
= Rs 100 * (1+r)2

Rs 100 *(1+r)3

FORMULA
FUTURE VALUEn = PRESENT VALUE (1+r)n
DOUBLING PERIOD
Common question – how many years to double the amount ?

Thumb Rule : Rule of 72

Doubling period = 72 .
Interest rate
Interest rate : 15 percent

Doubling period = 72 . = 4.8 years

15

A more accurate thumb rule : Rule of 69

Doubling period = 0.35 + 69 .
Interest rate
Interest rate : 15 percent

Doubling period = 0.35 + 69 . = 4.95 years

15
EXAMPLE : FV OF SINGLE AMOUNT
 Sales of ABC Ltd. are growing at 15% every year. In how many
years would the sales double ?
 4.8 or 4.95

 Number of employees of Alpha Ltd. are growing at 10% every

year, how many employees would the organisation have in 3
years if the current number is 500 ?
 666

 Zeta Corp had revenues of Rs 100 cr in 2000 and is projected to

have revenues of Rs 1000 cr in 2010. What is the CAGR that
has been assumed ?
 100 (1+g)10 = 1000
g = 0.26 = 26%
FUTURE VALUE OF AN ANNUITY
 Annuity is a stream of constant cash flows (payment
or receipt)
 Occuring at regular intervals of time
 Payment at end of the period (ordinary annuity)*

 Examples
 Insurance payments
 Recurring FD / PPF deposit
 Annual saving to accumulate a desired amount
 Deposit in sinking fund account for bond redemption

* Annuity due = payment at beginning of period

EXAMPLE 1 : FV OF AN ANNUITY
You save Rs 1000 annually for 5 years in a bank deposit @ 10 %
1 2 3 4 5
1,000 1,000 1,000 1,000 1,000
+
1,100 = 1000 (1.10)

+
1,210 = 1000 (1.10)2
+
1,331 = 1000 (1.10)3
+
1,464 = 1000 (1.10)4

Rs.6,105

 Future value of an annuity = A [(1+r)n-1]

r

(FVAn )
FV formula
FVAn = A(1+r)n-1 + A(1+r)n-2 ……. + A

Multiply both sides by (1+r) and subtract (1) from (2)

Future value
FVAn = A (1+r) – 1
n
interest factor
FVIFA 10%, 5years
r
 FVIFA tables

VALUE OF FVIFA r,n FOR VARIOUS

COMBINATIONS OF r AND n

n/r 6% 8% 10 % 12 %
14 %
2 2.060 2.080 2.100 2.120
2.140
4 4.675 4.507 4.641 4.779
4.921
6 6.975 7.336 7.716 8.115
8.536
8 9.897 10.636 11.436 12.299
13.232
10 13.181 14.487 15.937 17.548
19.337
 NOTATION

PV : Present value
FVn : Future value n years hence

Ct : Cash flow occurring at the end of year t

A : A stream of constant periodic cash flow over a

given time
r : Interest rate or discount rate
g : Expected growth rate in cash flows
n : Number of periods over which the cash flows occur.
 EXAMPLE 2 : FV OF AN ANNUITY
WHAT LIES IN STORE FOR YOU
Suppose you have decided to deposit Rs.30,000 per year in your Public
Provident Fund Account for 30 years. What will be the accumulated
amount in your Public Provident Fund Account at the end of 30 years if
the interest rate is 11 percent ?
The accumulated sum will be :
Rs.30,000 (FVIFA 11%,30yrs)

= Rs.30,000 (1.11)30 - 1
0.11

= Rs.30,000 [ 199.02]
= Rs.5,970,600
 EXAMPLE 3 : FV OF AN ANNUITY
HOW MUCH SHOULD YOU SAVE ANNUALLY
You want to buy a house after 5 years when it is expected to cost Rs.20 million. How
much should you save annually if your savings earn a compound return of 12
percent ?

The future value interest factor for a 5 year annuity, given an interest rate
of 12 percent, is :
(1+0.12)5 - 1
FVIFA n=5, r =12% = = 6.353
0.12

The annual savings should be :

Rs.20,000,000 = Rs.3,148,119
6.353
 EXAMPLE 4 : FV OF AN ANNUITY
ANNUAL DEPOSIT IN A SINKING FUND
Futura Limited has an obligation to redeem Rs.500 million bonds 6 years
hence. How much should the company deposit annually in a sinking fund
account wherein it earns 14 percent interest to cumulate Rs.500 million in 6
years time ?
The future value interest factor for a 5 year annuity, given an interest
rate of 14 percent is :
FVIFAn=6, r=14% = (1+0.14)6 – 1 = 8.536

0.14
The annual sinking fund deposit should be :
Rs.500 million = Rs.58.575 million
8.536
 EXAMPLE 5 : FV OF AN ANNUITY
FINDING THE INTEREST RATE
A finance company advertises that it will pay a lump sum of Rs.8,000 at the
end of 6 years to investors who deposit annually Rs.1,000 for 6 years. What
interest rate is implicit in this offer?
The interest rate may be calculated in two steps :
1. Find the FVIFA r,6 for this contract as follows :

Rs.8,000 = Rs.1,000 x FVIFA r,6

FVIFAr,6 = Rs.8,000 = 8.000

Rs.1,000
2. Look at the FVIFA r,n table and read the row corresponding to 6 years

until you find a value close to 8.000. Doing so, we find that
FVIFA12%,6 is 8.115 . So, we conclude that the interest rate is slightly below
12 percent.
 EXAMPLE 6 : FV OF AN ANNUITY
HOW LONG SHOULD YOU WAIT
You want to take up a trip abroad which costs Rs.1,000,000 the cost is
expected to remain unchanged in nominal terms. You can save annually Rs.50,000
for the trip. How long will you have to wait if your savings earn an interest of 12
percent ?
The future value of an annuity of Rs.50,000 that earns 12 percent is equated to
Rs.1,000,000.
Assignment – 1/2
 You plan to go abroad for higher studies after working for the next five
years and understand that an amount of Rs.2,000,000 will be needed
for this purpose at that time. You have decided to accumulate this
amount by investing a fixed amount at the end of each year in a safe
scheme offering a rate of interest at 10 percent. What amount should
you invest every year to achieve the target amount?

 Someone offers to give Rs.80,000 to you after 18 years in return for

Rs.10,000 deposited today. Using the rule of 69, figure out the
approximate interest rate offered.

 You can save Rs.5,000 a year for 3 years, and Rs.7,000 a year for 7
years thereafter. What will these savings cumulate to at the end of 10
years, if the rate of interest is 8 percent?
Assignment – 2/2
 How much should Vijay save each year, if he wishes to
purchase a flat expected to cost Rs.80 lacs after 8 years, if the
investment option available to him offers a rate of interest at 9
percent? Assume that the investment is to be made in equal
amounts at the end of each year.

 A finance company advertises that it will pay a lump sum of

Rs.100,000 at the end of 5 years to investors who deposit
annually Rs.12,000. What interest rate is implicit in this offer?