BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

TABLE OF CONTENTS
INTRODUCTION ............................................................................................................................................................ 3
CAPITAL BUDGETING ............................................................................................................................................... 3
IMPORTANCE OF CAPITAL BUDGETING ............................................................................................................... 3
THE CAPITAL BUDGETING PROCESS ..................................................................................................................... 3
BASIC PRINCIPLES OF CAPITAL BUDGETING ........................................................................................................ 4
A FEW BASIC CONCEPTS IN CAPITAL BUDGETING ................................................................................................... 5
SUNK COST ........................................................................................................................................................... 5
OPPORTUNITY COST............................................................................................................................................. 5
DISCOUNT RATE/TIME VALUE OF MONEY ........................................................................................................... 6
CANNIBALIZATION ............................................................................................................................................... 6
INCREMENTAL CASH FLOWS ................................................................................................................................ 7
PROJECT VALUATION METHODS: ............................................................................................................................ 7
PAYBACK PERIOD ................................................................................................................................................. 7
PROFITABILITY INDEX ........................................................................................................................................... 8
AVERAGE ACCOUNTING RATE OF RETURN (AAR) ................................................................................................ 9
NET PRESENT VALUE (NPV) .................................................................................................................................. 9
INTERNAL RATE OF RETURN (IRR) ...................................................................................................................... 10
COMPARISON BETWEEN NPV AND IRR.............................................................................................................. 11
WHY MERGERS & ACQUISITIONS? ......................................................................................................................... 13
M&A DEFINITIONS ................................................................................................................................................. 14
METHODS OF VALUATION ..................................................................................................................................... 14
REPLACEMENT COST .......................................................................................................................................... 15
MARKET PRICE BASED ........................................................................................................................................ 15
BOOK VALUE BASED ........................................................................................................................................... 15
CASH FLOW BASED............................................................................................................................................. 15
VALUE OF A FIRM ................................................................................................................................................... 17
RETURN ON ASSETS ........................................................................................................................................... 17
MODIGLIANI MILLER THEOREMS ....................................................................................................................... 17
WEIGHTED AVERAGE COST OF CAPITAL ............................................................................................................ 18
COST OF DEBT .................................................................................................................................................... 19
COST OF EQUITY................................................................................................................................................. 19

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INTEREST TAX SHIELD......................................................................................................................................... 19
VALUATION METHODS CONTINUED ...................................................................................................................... 20
DCF ..................................................................................................................................................................... 20
DDM ................................................................................................................................................................... 20
MULTIPLES BASED .............................................................................................................................................. 21
FINANCING ............................................................................................................................................................. 23
THE PECKING ORDER THEORY OF FINANCE ....................................................................................................... 23
DEBT: TRANCHES AND SENIORITY ..................................................................................................................... 24
EQUITY: TRANCHES AND SENIORITY .................................................................................................................. 24
IPO INITIAL PUBLIC OFFERING ......................................................................................................................... 25
FPO- FOLLOW-ON PUBLIC OFFER....................................................................................................................... 26
SEO-SEASONED EQUITY OFFERING .................................................................................................................... 26
RIGHTS ISSUE ..................................................................................................................................................... 26
QIP- QUALIFIED INSTITUTIONAL PLACEMENT ................................................................................................... 27
AUCTIONS .......................................................................................................................................................... 27
PAYOUT .................................................................................................................................................................. 27
STOCK SPLITS...................................................................................................................................................... 27
BONUS SHARE .................................................................................................................................................... 28
STOCK REPURCHASES......................................................................................................................................... 28
DIVIDEND (PAYOUT POLICY) .............................................................................................................................. 28

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

INTRODUCTION
This investment banking / corporate finance module of the Basics Module of Beta Primer looks at some of the
basic concepts associated with the financial strategy-related issues of companies and institutions.
Broadly, from a banks perspective, the IBD division liaises with the CFO and Corporate Finance divisions of
companies which are seeking capital for various projects as well as advice on various mergers, acquisitions and
similar corporate restructuring mandates. It is the private side of the firm and provides advisory services on
strategy as well as execution capabilities related to raising financing.
The three well-documented aspects which this primer module will cover are:
1) Investment- related decision making Capital budgeting, working capital allocation as well as mergers
and acquisitions etc.
2) Payout-related decision making Dividend policy, debt repayment scheduling, stock buybacks etc.
3) Financing decisions Debt financing vs. equity financing, structuring of financing etc.

CAPITAL BUDGETING
Capital budgeting entails making decisions to invest present funds in long-term projects in order to earn
future returns.
IMPORTANCE OF CAPITAL BUDGETING
Firstly, the capital resources available to a firm are limited, and the success of a firm largely depends
on how well it uses the limited resources available to it. Capital Budgeting helps a manager to select
the most profitable avenues for the investment of the scarce resources of the company.
Secondly, Capital budgeting is usually used in evaluating Capital projects, which are Long-term
investment projects requiring relatively large sums to acquire, develop, improve, and/or maintain a
capital asset (such as land, buildings, dykes, roads). The outlays on these projects can be so big that
the future of corporations may be decided by capital budgeting decisions. Reversal of capital
budgetingdecisions cannot be done at a low cost; hence mistakes in the selection of capital projects
can be very costly.
Thirdly, many other corporate decisions also have scope for the application of capital budgeting
principles, as adopted for the specific case. Examples of such areas of application are investments in
working capital, mergers and acquisitions, leasing and bond refunding.
Fourthly, the valuation principles in capital budgeting are quite similar to those used in portfolio
management and security analysis. Thus, the diverse use of capital budgeting methods extends to
these areas also.
Fourthly, the focus of capital budgeting is on ultimately maximizing shareholder value. Thus, correct
capital budgeting decisions have payoffs for a number of stakeholders in the company.
THE CAPITAL BUDGETING PROCESS
We will try to understand this process while using an example. Suppose a firm XYZ & Co. has enough funds and
now has decided to invest in Capital projects. The process it will follow is:
Step One: Generating Ideas- Generation of investment ideas can be from anywhere. All levels of the
organization- from the top to the bottom, from departments to functional areas- can contribute by
generating fresh investment ideas. Ideas can also be generated from outside the company. In our
example, the firm can increase its existing production capacity, expand its product line by setting up
an additional factory, invest in some other business, etc.

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Step Two: Analyzing Individual Proposals- In the next step XYZ & Co. would gather adequate,
reliable information in order to first forecast future cash flows from each proposed project and then
evaluate their profitability. In this stage, the non-profitable proposals are screened away and the
remaining are moved on to next stage
Step Three: Planning the Capital Budget- Next, the profitable proposals are organized after taking
into account two key considerations:
o The match between the proposal and the companys overall strategic objectives,
o The duration and timing of the project.
Since companies have various financial and other resource constraints, the proposals usually have to
be scheduled on a priority-basis.
Suppose XYZ & Co. identifies two potential profitable investments as investing in a different business
and expanding its existing production facility. The option of investing in a different business is
forecasted to generate a better profitability, but the money would be locked in for a long period and
one of the companys goals is to become a market leader in its existing market. In such a situation,
the option of expanding its existing production facility would be ranked highest and undertaken first.
Step Four: Monitoring and Post-auditing- Post-auditing capital projects are as important as selecting
and implementing them. Firstly, it serves to monitor the analysis and forecasts that the capital
budgeting process is based on. Overly optimistic forecasts can be detected and such systematic
errors rectified. Secondly, the negative deviation between actual performance and expectations can
be corrected by taking adequate measures, wherever possible, which in turn improves business
operations. Lastly, sound ideas for future investments may be evolved during post-auditing current
investments.
BASIC PRINCIPLES OF CAPITAL BUDGETING
1. Cash flows are the basis for decisions. Accounting concepts, such as net income, are not the basis
for decisions.
2. Timing of cash flows is crucial due to the fact that provided money can earn interest, any amount of
money is worth more the sooner it is received.
3. Cash flows are based on opportunity costs. Here we consider what the increase in cash flows is due
to the investment, with respect to the cash flows without the investment.
4. Cash flows are adjusted for tax payments, i.e. after-tax cash flows are taken.
5. Financing costs are not accounted for: A company can finance its Capital projects from various
sources. The major sources are Debt and Equity. Each of these different sources has a cost of raising
and using the funds associated with them. However, while evaluating capital projects, we do not take
them into account. Instead, the operating cash flows are focused on and the costs of debt (and other
capital) are reflected in the discount rate (explained below)
6. Cash flows are recorded only when they actually occur and not when work is undertaken or a
liability is incurred.

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A FEW BASIC CONCEPTS IN CAPITAL BUDGETING

SUNK COST
A sunk cost is one that has already been incurred. It is a past and irreversible outflow. Because sunk costs are
bygones and cannot be changed, they cannot be affected by the future decisions, and so they should be
ignored in decision-making.
EXAMPLE: Lockheed had already spent $1 billion on the development of the TriStar airplane. In order to
continue its development, the company sought a federal guarantee to back a new bank loan for it. On the
one hand, those in favor of the project argued that it would be extremely imprudent on the part of the
company to abandon a project on which such huge capital expenditures had already been made. On the
other hand, some of Lockheeds critics countered that it would be equally foolish to continue with such a
project that did not offer a satisfactory return on that $1 billion. Both groups were guilty of the sunk-cost
fallacy; the $1 billion was irrecoverable and, therefore, irrelevant. (Brealey). The decision should be solely
based upon the future cash flows.

PRINCIPLE: Todays decisions should be based on current and future cash flows and should not
be affected by prior or sunk costs.
OPPORTUNITY COST
Opportunity cost is the cost of any activity measured in terms of the best alternative forgone. It is the
sacrifice related to the second best choice available to someone who has picked among several mutually
exclusive choices. In capital budgeting, the opportunity cost of capital or the discount rate is the expected
rate of return that is foregone by investing in the project chosen rather than investing in the next-best
alternative.
EXAMPLES:
Suppose that a company already owns a building that could be used for a new project instead of
buying a new building. If the companys managers decide to use this building, the company would
not incur the cash outlay of $12 million that would be required to buy a new building. Would this
mean that the $12 million expenditure should be excluded from the analysis, which would obviously
raise the expected NPV? The answer is that we should exclude the cash flows related to the new
building, but we should include the opportunity cost associated with the new building as a cash cost.
For instance, if the building had a market value of $14 million, then the company would be giving up
$14 million if it uses the building for the project. Therefore, the $14 million that would be foregone
as an opportunity cost should be charged to the project.
If an old machine is replaced with a new one, what is the opportunity cost? The opportunity cost
here is the cash flows that the old machine would generate.
If $20 million is invested, what is the opportunity cost? The $20 million itself is the opportunity cost
here since it could have been invested elsewhere.

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PRINCIPLE: The opportunity cost of capital for an investment project is the expected rate of
return demanded by investors in common stocks or other securities subject to comparable risks as the project.
DISCOUNT RATE/TIME VALUE OF MONEY
Discount rate is the interest rate used to calculate the present value of future cash flows. It essentially flows
from the concept of time value of money, which says that, other things being equal, due to its potential
earning power, a given sum of money has higher worth now than it would be in future. The discount rate
takes into account the time value of money and the risk or uncertainty associated with future cash flows.
The discount rate applicable to a capital project depends on many factors such as the riskiness of the project,
the weighted average cost of capital of a firm, etc.
EXAMPLE: For e.g., An instrument which returns Rs. 100 each at end of next two years would have a
present value of 173.55 when the discount rate is 10%
=

100
100
+
= 173.55
(1 + 0.1)
(1 + 0.1)2

PRINCIPLE: Money available now is worth more than the same amount available in the future.
This is taken into account while measuring the value of future cash flows of the firm.
CANNIBALIZATION
Cannibalization takes place when an investment results in one part of a company taking away customers and
sales from another part. An externality is defined as the effect that an investment has on other things
besides the investment itself and cannibalization is one such externality. The lost cash flows due to
cannibalization should be charged to the new project. However, it often turns out that if the company would
not have produced the new product, some other company would have and hence, the old cash flows would
have been lost anyway. In this case, no charge should be assessed against the new project. All this makes
determining the cannibalization effect difficult, because it requires estimates of changes in sales and costs,
and also of the timing when those changes will occur.
EXAMPLE: Apples introduction of the iPod Nano caused some people who were planning to purchase a
regular iPod to switch to a Nano. The Nano project generates positive cash flows, but it also reduces some of
the companys current cash flows. This is a manifestation of the cannibalization effect because the new
business eats into the companys existing business.

PRINCIPLE: Cannibalization can be important, so its potential effects should be considered and
any significant lost cash flows due to it should be charged to the new project.

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INCREMENTAL CASH FLOWS
An incremental cash flow is a cash flow that is the result of a specific decision made: the cash flow with a
decision minus the cash flow without that decision. If opportunity costs are correctly assessed, the
incremental cash flows provide a sound basis for capital budgeting. (Corporate Finance and Portfolio
Management)Most managers naturally hesitate to throw good money after bad. For instance, they are
reluctant to invest more money in a losing division. But occasionally turnaround opportunities can be
encountered in which the incremental NPV on investment in a losing division is strongly positive
EXAMPLE: Suppose that a railroad bridge is in urgent need of repair. With the bridge the railroad can
continue to operate; without the bridge it cannot. In this case, the payoff from the repair work consists of all
the benefits of operating the railroad. The incremental NPV of such an investment may be enormous.

PRINCIPLE: The value of a project depends on all the additional/incremental cash flows that
follow from project acceptance and hence, incremental cash flows provide a sound basis for capital
budgeting.

PROJECT VALUATION METHODS:

PAYBACK PERIOD
The payback period is the number of years required to recover the initial investment in a project. This
period is sometimes referred to as "the time that it takes for an investment to pay for itself." The basic
premise of the payback method is that the more quickly the cost of an investment can be recovered, the
more desirable is the investment.
EXAMPLE:
Year

Investment

Cash Inflow

$4,000

$1,000

2,000

2,000

1,000

500

3,000

2,000

2,000

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What is the payback period on this investment? The answer is 5.5 years, but to obtain this figure it is
necessary to track the unrecovered investment year by year. The steps involved in this process are shown
below:
Year

Beginning
Unrecovered
Investment

Investment

Cash Inflow

Ending
Unrecovered
Investment
(1) + (2) - (3)

$4,000

$1,000

$3,000

3,000

3,000

3,000

2,000

1,000

1,000

1,000

2,000

2,000

500

1,500

1,500

3,000

2,000

2,000

2,000

By the middle of the sixth year, sufficient cash inflows will have been realized to recover the entire
investment of $6,000 ($4,000 + $2,000).
The drawbacks of the payback period are apparent. Since the cash flows are not discounted at the projects
required rate of return, the payback period ignores the time value of money and the risk of the project.
Additionally, the payback period ignores cash flows after the payback period is reached. Thus this method
provides a good measure of payback and not of profitability. But its simplicity and easy calculation make it
useful as an indicator of project liquidity. Thus a project with a two-year payback may be more liquid than a
project with a longer payback.
The discounted payback period partially addresses the shortcomings in the payback period method. It takes
the cumulative discounted cash flows from the project into consideration while calculating the number of
years it takes to recover the original investment. Thus, it takes the time value of money and risk of the
project into account, but this method also ignores the cash flows that occur after the discounted payback
period is reached. For a project with negative NPV, there will not be any discounted payback period since it
never recovers its original investment. The discounted payback period must be greater than the payback
period without discounting.
PROFITABILITY INDEX
The profitability index (PI) is the present value of a projects future cash flows divided by the initial cash
outlay. It can be expressed as:
=

= 1 +

Thus, it can be seen that PI is closely related to NPV. The PI is the ratio of the PV of future cash flows to the
initial investment, whereas the NPV is the difference between the PV of future cash flows and the initial

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investment. Whenever the NPV is positive, the PI will be greater than 1; conversely, whenever the NPV is
negative, the PI will be less than 1.
The investment decision for PI is as follows:
Invest if

PI > 1

Do not invest if

PI < 1

EXAMPLE: In the example discussed for NPV and IRR above, the company had an outlay of $70 million, a
present value of future cash flows of $70.2274 million, and an NPV of $0.2274 million.
The Profitability Index = 70.2274/70 = 1.0032
Because the Profitability Index > 1, this investment is profitable.
Thus the PI indicates nothing but the value received when we invest one unit of currency. Although the PI not
used as often as the NPV and IRR, it is sometimes considered better for Capital Rationing; because unlike
NPV, it takes the size of the project also in account. Therefore it is a useful tool for ranking projects because
it allows you to quantify the amount of value created per unit of investment.
AVERAGE ACCOUNTING RATE OF RETURN (AAR)
The average accounting rate of return (AAR) can be defined through the following formula:
AAR = Average net income/ Average book value
EXAMPLE: Suppose a company has an average net income of $20000 each year during a five-year period
from an asset. The initial book value of the asset is $250000, depreciating by $50000 per year until the final
book value is 0. The average book value for this asset is (250000 0)/2 = 125000. The average accounting
rate of return is
AAR = 20000/125000 = 16%
The advantages of the AAR are that it is simple to compute and understand. But, the AAR suffers from some
important conceptual limitations in that it uses accounting concepts like net income instead of cash flows.
The time value of money is also ignored. This is no specific rule or cut-off number in ARR that can be applied
to distinguish between profitable and unprofitable investments. Thus sound methods like NPV and IRR
should be used over ARR, wherever possible.
The above-mentionedmetrics usually provide a simplistic measure to evaluate a project and their merit is in
their ease of calculation. The most comprehensive and often used measures of judging the profitability of a
project are the net present value (NPV) and internal rate of return (IRR).
NET PRESENT VALUE (NPV)
For a project with a single initial investment outlay, the net present value (NPV) is the present value of
the future after-tax cash inflows discounted at the relevant discount rateminus the investment outlay,

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=
=1

0
(1 + )

where
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on the investment
n = the project/investment's duration in years.
EXAMPLE: Suppose a company is considering an investment of $70 million in a capital project that will
return after-tax cash flows of $20 million per year for the next three years plus another $30 million in
year 4. The required rate of return is 10 percent.
Here, the NPV would be
NPV= 20/1.1 + 20/1.1^2 +20/1.1^3 + 30/1.1^4 70
= 70.2274 70 = $0.2274 million.
Thus the investors wealth is expected to increase by a net of $0.2274 million. This indicates the decision
rule for NPV:
Invest if

NPV > 0

Do not invest if

NPV < 0

Positive NPV investments increase investor wealth whereas negative NPV investments decrease it. Many
investments have cash outflows that occur not only at time zero, but also at future dates. In this case, all
cash outflows are taken as negative inflows and discounted at the required rate of return just as in the
case of positive cash inflows at different points of time.
INTERNAL RATE OF RETURN (IRR)
For a project with one initial investment outlay, the IRR is the discount rate that makes the present value
of the expected incremental after-tax cash inflows equal to the investment outlay. In other words, it is
that discount rate that will cause the net present value of a project to be equal to zero or

Where
CF = the cash flow generated in the specific period (the last period being n)
r = the IRR
In the above example given for NPV, the IRR is the discount rate that solves the following equation:

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70 +

20
20
20
20
+
+
+
(1 + )1 (1 + )2 (1 + )3 (1 + )4

Algebraically, this equation would be very difficult to solve. Normally, trial and error method is resorted
to, systematically plugging various discount rates until one, the IRR, satisfies the equation. But financial
calculators and spreadsheet software have routines that calculate IRR easily, so the trial and error
method can be avoided. The IRR is 10.14 percent here.
The decision rule for the IRR is to invest if the IRR exceeds the required rate of return for a project:
Invest if

IRR > r

Do not invest if

IRR < r

In the above example, since the IRR of 10.14 percent exceeds the projects required rate of return of 10
percent, the company should invest.
However there are several shortcomings with the IRR,
First, there is an implicit assumption while calculating IRR that interim positive cash flows are reinvested
at the same rate of return as that of the project that generated them. This is usually an unrealistic
scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost
of capital. The IRR therefore often gives an unduly optimistic picture of the projects under study.
E.g. if you invest Rs. 100 today to receive Rs. 10 at the end of first year and Rs. 110 at the end of second
year, your IRR on this investment is 10%. However, if you are able to reinvest the Rs. 10 received at the
end of 1st year at only 3%, then the total amount you receive at the end of 2 years is 110 + 10*1.03 = Rs.
120.3. This implies an annual return of 9.7% (which is less than the IRR).
Sometimes the cash flows during the project lifetime are negative (i.e. the project operates at a loss or
the company needs to contribute more capital). This is known as a "non-normal cash flow", and such
cash flows will give multiple IRRs or No IRRs, which leads to confusion and ambiguity.

COMPARISON BETWEEN NPV AND IRR

Assume that a company needs to purchase a new machine for its manufacturing plant. It has narrowed it
down to two machines that meet its criteria (Machine A and Machine B), and now it has to choose one of
the machines to purchase. Further, it has assumed the following analysis on which to base its decision:

Figure 11.6: Potential Machines

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We first determine the NPV for each machine as follows:

NPV-A = ($5,000) + $2,768 + $2.553 = $321
NPV-B = ($10,000) + $5,350 + $5,106 = $456
According to the NPV analysis alone, Machine B is the most appropriate choice for It to purchase.
The next step is to determine the IRR for each machine using our financial calculator. The IRR for
Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%.
According to the IRR analysis alone, Machine A is the most appropriate choice for purchase.
(Source: investopedia.com)
The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the
timing of the cash flows for each project as well as the size differential between the two projects. The
differentiating qualities of each metric are:
NPV is a theoretically sound method that provides a direct measure of the expected increase in firm
value. However, its main drawback is that it does not take the size of the project into consideration,
which the IRR does. Therefore, I ncase of no constraint of constraint capital, project B should be
chosen as it has a higher NPV.
Nevertheless, IRR provides information about how much below the IRR (estimated return) the
actual project return could fall, in percentage terms, before the project becomes uneconomic (has a
negative NPV). In the above case, the discount rate is 7.75%. Thus, the IRR reflects the margin of
safety in Project A is 3.25% and in Project B is 5.25% that the NPV does not.

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WHY MERGERS & ACQUISITIONS?

There are several reasons why companies enter into M&A activity. The prominent ones include:
1. Growth
Companies wanting to grow into bigger companies or enter into new avenues are most likely to
enter into M&A. It is typically faster for companies to acquire companies to grow themselves,
rather than invest money and resources in developing from within (organic growth). Its always
less risky to acquire an established player rather than enter an unfamiliar market on ones own.
Example: Indian Generic Pharma companies have become the target of many inbound M&A
deals as the foreign players look to protect their bottom line in wake of their drugs going off
patent. They increasingly see India as a potential market where they could leverage their sales
and distribution skills to expand their market share.
2. Synergies
Synergies occur when the combined company is worth more than the sum of the parts. Synergy
is a theoretical term and usually denotes enhanced revenues by means of cross selling or
reduced costs via economies of scale. Companies often end up paying huge amounts for targets
if they feel it can provide benefits in the long run. For example, Sanofi when it first made a bid
for Genzyme back in July 2010, its offer price was $69 - a 38% premium over Genzymes share
price of $50.
3. Increase Market Power
M&A that is done from the sole point of increasing market power is called Horizontal Mergers. In
it companies acquire firms in the same market. It is most likely to attract the ire of the regulator
as such mergers are looked as stifling competition.

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4. Unlock Hidden Value
When an acquirer feels that the target company is underperforming for the moment, and it feels
it has the capability to unlock its potential. Companies engage M&A from this perspective if they
feel they can acquire the company for less than the Break Up value or the value obtained from
dividing the company and selling its assets.
5. Diversification
Companies enter into fields that are not at all related to their current field of activity to diversify
and shore up revenues in bad times. Diversification is sometimes viewed negatively by investors
because it doesnt add to shareholder value as they are free to diversify their stock holdings
themselves. Example: BHP Biliton, a world leader in mining made a bid for Canadian Potash
manufacturer, Potash. The deal could not be consummated because of concerns from the
Canadian government.
6. Acquiring unique capabilities and resources
When companies feel they can no longer internally create cost effective capabilities needed to
grow, they engage in M&A, to acquire the desired capability. Companies believe they can get
resources for less than Replacement Value. Example: Low cost drug manufacturing and technical
expertise of most Indian Pharma companies have generated substantial foreign interest.

M&A DEFINITIONS
Mergers: When one (smaller) company is absorbed by another (bigger) company and the smaller
company ceases to exist.
Acquisitions: When one defined segment of a company, assets of or the entire company is acquired
by another it is termed an acquisition. Example: Abbott India acquiring the domestic formulations
business of Piramal Healthcare solutions.
Reverse Mergers: Similar to a merger but the bigger company ceases to exist as it acquires the
smaller companys name. Usually done when the smaller company has a more well-known brand
name. Example: ICICI Bank reverse merger back in 2001.
Consolidations: A consolidation is similar to a merger except that both companies lose their previous
legal existence and form a new legal entity. Example: The Indian telecom tower sector has seen a
wave of consolidations this past year as smaller players look to exit the market owing to lack of scale
and efficiency.
METHODS OF VALUATION
A very important part of any M&A is valuation of a firm. When you go to buy a second hand car, you try to
estimate its value using factors like age, miles driven, price of similar second-hand cars etc. and then based
on this estimate you negotiate a price with the dealer. Similarly when you set out to acquire a firm, you need
to figure out its value and it is based on that estimate that you quote a price at which youll purchase that
firm. There are several methods for valuation and depending on the industry different methods are the goldstandard when it comes to valuing companies. In this section we will look at some of the most common
methods, discuss what is right and wrong about them and in which sector they are used the most.

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REPLACEMENT COST
This method is used to value the firm by totaling the cost incurred in replacing the assets of the firm today
with similar assets. This method reflects current price conditions and is quite effective in valuing firms during
periods of high inflation. The replacement cost value is usually higher than the book value because
depreciation is not taken into account. Total Replacement cost minus Liabilities equals the value of the
business. Depreciated Replacement cost method of valuation, however, takes into account the depreciation
of the asset to be replaced.
But this method is not without its share of disadvantages replacement cost is the cost of replacing assets
today, but usually managers dont expect the old designs/assets to continue in the future. Besides being
subjective, it is also problematic to value intangible assets.
MARKET PRICE BASED
The market price of the firm is simply the sum of market values of firms debt and equity. Market value of
equity can be obtained by multiplying share price with the number of shares whilst the market value of debt
can be calculated by using present value of estimated debt cash flows. In some cases book value of debt
(from balance sheet) is used as a proxy for market value of debt.
As the market prices reflect what is known, this method is a logical place to start valuation if the shares are
actively traded in the market and the market is efficient i.e. the prices reflect all public information available
about the firm. It is therefore a useful metric for merger negotiations.
BOOK VALUE BASED
Book value of a firm is derived from the books of accounting. It is a simple method for valuing firms with
audited financial reports. An advantage is that it reflects the principle of conservatism as accounting relies on
the same principle. The failings of this method include inability to value intangible assets (such as brand
value, employee skills etc.), based on past market information. Also, Book value is a backward looking figure,
whereas valuation needs to be forward looking.
CASH FLOW BASED
There are different cash flows that can be used to calculate the value of the firm. Free Cash Flow for the firm
(FCFF) and Free Cash Flow to Equity (FCFE) are two most common methods.
Cash flow based methods are excellent for valuation because they can be used for valuing a firm from a
control perspective which Discounted Cash Flows (DCF) doesnt allow.
DCF
We know that NPV of any project is the present value of cash flows. Thus, NPV of a firm can be calculated as
the present value of Free Cash Flow to the Firm with the hurdle rate being the cost of capital for the firm
(WACC). This model of valuing a firm is called the Discounted Cash Flow Model. The value of a business is
usually computed as discounted value of Free Cash Flows till valuation horizon, plus present value of the
forecasted value of business at the time horizon. Thus, the present value of a firm is given by
1
2

=
+
+ +
+
1
2

(1 + )
(1 + )
(1 + )
(1 + )
Where FCFi represents Free cash flow to firm (see definition below) in period i, and H is the horizon. PVH is
the expected value of firm after period H, the horizon chosen for valuation.
Valuation horizons are used because it would be impractical and error prone to try and calculate cash flows
till infinity. PVH is effectively an estimate of discounted cash flows from year H+1 onwards. It can be
calculated in many ways, some of which are constant growth method, based on P/E ratio etc.

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

FCFF/FCFE, DIVIDEND, RESIDUAL INCOME
Cash flow, as the name suggests, concerns the inflows and outflows of cash (liquidity) in a business. While
cash flows do not always convey much information about the profitability of the firm, they are of prime
importance as they indicate the ability of firm to finance its operating capital and investment needs, and its
requirements of debt. For a growing firm, cash flows are usually negative because of high investment
demands but they become positive as the business matures.
Free cash Flow is the surplus cash available to the firm after making all its expenditures including investments
both in assets as well as in working capital.
Free Cash Flow = EBIT*(1-t) + Depreciation/Amortization Changes in Working Capital
Investment in fixed assets (t= tax rate)

This cash flow is also called the Free Cash Flow for the Firm (FCFF) and is available to all the security holders
of the organization including equity and debt holders alike (hence interest not subtracted from FCFF). Since
debt holders also have a claim on the cash flow described above, we can further find out cash flow available
to equity holders called Free Cash Flow to Equity (FCFE). FCFE additionally takes into consideration
repayment of debt as well as new debt capital raised by the firm. It is given by:
FCFE = FCFF + New debt Debt Repayment Preferred Dividends- Interest*(1-t)

Example: Following are the details for a firm: Net Income = $2,176 Million, Capital Expenditures = $494
Million, Depreciation = $ 480 Million, Change in Non-Cash Working Capital = $ 35 Million.
FCFE = 2176 + 480 494 35
FCFE = $2127 million
(Source: Damodaran)
FCFF It is a measure of companys profitability (net cash generated) after taking into consideration
its expenses, taxes and investments.
A positive value of FCFF suggests that company generated sufficient cash to cover its expenses and
investment activities, while a negative value of FCFF indicates otherwise. If FCFF is negative, the
investors should investigate the actual reasons for the same to unearth any bigger problem in the
company.
FCFE It measures the amount of cash that can be paid to equity shareholders after accounting for
expenses, tax, investments and debt repayments.
FCFE has become increasingly popular of late owing to doubts over the effectiveness of the Dividend
Discount Model.

Now, that we know what is the surplus cash available to the equity holders, the question arises as to what
does firm do with this cash? There are two options for the firm, either to invest further in the business or to
pay out the cash to equity holders in the form of dividends. Dividend is basically the portion of earnings of

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

the firm paid out to equity holders. In this context we define payout ratio as the ratio of earnings of the firm
distributed to equity holders.
Payout ratio = Dividend per share / Earnings per share

Example: Consider a firm that has EPS of $2.5 and pays out $0.5 as dividend Then payout ratio = 0.5/2.5 = 0.2
The dividends are of particular interests to shareholders since that is the only way they get paid back for the
equity capital invested in the firm (except liquidation). Thus, dividends are instrumental in finding the value
of equity shares of a firm as we will see later.
So far, we have discussed about the cash flows available to firm and the equity holders. If, however, we want
get a better idea of the kind of returns shareholders are getting, we use another measure called residual
value or Economic Value Added (EVA)

EVA = income earned opportunity cost of capital * capital employed

The advantage of using EVA is that it does not just look at the earnings of the firm but also takes into
consideration the returns on capital required or the opportunity cost of the capital. If a firm/division has a
positive income but negative EVA, it means that the profits earned are not enough to cover the cost of
capital and thus the capital can be better employed elsewhere.
Example: Consider a firm which made an income of $130 million and employed capital of $1000 million.
Furthermore, the cost of capital is 10%. Then EVA = 130 - .1*1000 = $30 million
(Source: BMA)

VALUE OF A FIRM
We take a look at how the financing policy of a firm (how much should be debt or equity?) affects the valuation of
a firm.
RETURN ON ASSETS
The source of a firms value is the cash-flows which its assets can generate. These assets are financed by a
mixture of debt and equity. The value of a firm depends on its cash-flow generating real assets (like
machines, patents etc.) The value of a firms debt and equity is equal to the value of the firm. So a question
which arises is: can we produce any changes in the value of a firm by merely changing its debt to equity
mixture? How does the expected return on equity of the firm change if we, say, increase the debt and reduce
the equity? Modigliani & Miller have tried to answer these questions (under certain assumptions) below:
MODIGLIANI MILLER THEOREMS
Modigliani and Miller said that under the assumptions of perfect and frictionless markets (described below),
no transaction costs, no default risk, no taxation, both firms and investors can borrow at the same rD interest
rate; the value of a firm is same regardless of its financing decision i.e. firm value is independent of D/E
ratio. In simple terms, the value of a firm depends on its current and future earning potential and risk of its

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

underlying assets, and is independent of the way company decides to finance itself. This is the first
proposition of Modigliani Miller Theorem. The MM theorem further states that:
a. Proposition2: The expected rate of return on equities of a levered firm increases linearly
with the debt/equity ratio, given the return on capital employed is higher than the interest
paid to debt holders.
b. Proposition3: The firms dividend policy does not affect its value, it only changes the mix of
debt and equity.
c. Proposition4: For new investment to be feasible, the marginal cost of new capital should
equal the average one.
Perfect market The market where stock prices reflect all available, relevant information, and the matching
of buyers and sellers occurs immediately. It is assumed that all the investors have the same inforamtion
available to make decisions.
Frictionless market The market where all the costs and restrains related to the transactions are absent. In
practical markets, however, transactions costs like commissions, and restraints like tax implications are
present.
Example: Consider a firm A, that is unlevered and firm B which has a Debt-equity ratio of 1. Let V denote the
value of firm, D denote debt, E the equity, P denote profit, and rD be the interest on debt. Suppose there are
100 shares of A each of price 1Re and firm B has 50 shares at price 1Re and the other 50 comes from debt.
Now if one buys 10% of shares for company A then his return on investment would be .1*P. Compared to
this if one purchases the same fraction of debt AND equity from firm B his returns would be: 0.1*(P-interest)
+ 0.1*interest = 0.1*P, which is the same as in previous case. Thus, in a perfect market both firms would be
valued equally as long as investers can lend (or borrow) money on same terms as the firm.
What implication does Modigliani Miller theorem have for the Expected return on assets ra? Since a firms
borrowing decision does not affect its total market value, it does not affect the expected return on firms
assets, ra. The expected return thus, is simply a weighted average of expected returns on individual holdings.
Expected return on assets,

Where, D is the market value of the Debt, E is the market value of the Equity, and rD and rE are the cost of
debt and equity respectively.
WEIGHTED AVERAGE COST OF CAPITAL
In the absence of taxes, ra is also the Weighted Average Cost of Capital (WACC). With the presence of tax,
however, the interest paid by the firm on its debt is tax deductible and thus the after tax cost of debt
becomes rD*(1-T) and thus for the firm, the weighted average cost of capital comes out to be

WACC = + (1 ) +

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

Where, D is the market value of the Debt, E is the market value of the Equity, T is the Tax rate and rD and rE
are the cost of debt and equity respectively.
Example: Consider a firm for which cost of debt = 8%, cost of equity = 15%, tax rate = 35% & D/E =
9.According the formula, WACC = 0.08*(1-0.35)(0.9)+0.15*0.1 = 0.62 = 6.2%
In order to gain a better understanding of WACC, let us explore each of the terms further.
COST OF DEBT
Cost of debt (rD) is the rate of interest that has to be paid on the debt capital issued by the firm. Usually, it
depends on the leverage ratio (D/E) of the firm and the default risk. If the D/E ratio increases, then the
probability that creditors will not get fully reimbursed if the firm is dissolved increases which leads to a rise in
cost of debt. Thus, the cost of debt can be modeled as a risk free rate plus a risk premium which incorporates
the risk of default. Since cost of debt is composed of interest paid, it is fairly easy to calculate.
COST OF EQUITY
Cost of Equity (rE) is the rate of return demanded by the investors. It is effectively the opportunity cost of
investing in the firm for equity holders. Since, creditors have the first claim on the assets of the company;
cost of equity is greater than the cost of debt. Estimation of cost of equity presents considerably more
challenge compared to the cost of debt. For estimating rE we can use the Capital Asset Pricing Model (CAPM).
According to CAPM,

Expected return on stock = rf + (rm rf)

Where rf is the risk free rate of return, rm is the expected rate of return on market portfolio and beta is the
measure of market risk on the stock i.e how sensitive it is to movements in market.
Since, cost of equity is greater than cost of debt, one may wonder if it is possible to reduce overall WACC by
taking more and more debt. The answer ofcourse is that it cannot be done and the reason comes from
Modigliani Miller theorem. With increase in leverage, the cost of equity rises (since with rising debt, the risk
for equity holders increases). Exactly how much does the cost of equity increase can be calculated as follows:
The firms asset Beta can be written as

a = D *(D/D+E) + E*(E/D+E)
Now, when D/E ratio changes, since ra does not depend on financing decision of the firm (MM), a remains
unchanged. Thus, for the original D/E ratio and using original E, calculate the a. This is called unlevering the
.
Equity for new leverage ratio can then be calculated as

= + ( )

This process is called relevering the . Once we have the new equity , we can calculate the new cost of
equity (using CAPM) and then calculate the new WACC.
INTEREST TAX SHIELD
If the return on debt is rD and the market value of debt is D then:
Interest Payment I = rD*D

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

This interest is tax deductible, which leads to following implications. If interest were not tax deductible we
would have had to pay entire I from EBIT *(1-T) and thus out net income would have been, net income = EBIT
(1-T) I
Now, due to the tax laws, we can play interest from EBIT and they pay taxes, therefore
Net income = (EBIT I)*(1-T) = EBIT (1-T) I + I*T
The difference between of I*T is called the interest tax shield. It arises because interest paid on debt is tax
deductible. Furthermore,
PV (tax shield) = T*I/rD = T*D
Thus, the effective payment becomes rD*D T*D = (rD-T)*D and hence, we see that effective cost of debt
become rD*(1-T) as was mentioned earlier.
Now, that we have a deeper understanding of each of the components of WACC, let us see what exactly does
WACC signify. WACC essentially is the hurdle rate or the discount rate for the firm. It is the rate of return the
firm must be able to achieve to justify investment of capital. WACC can also be used as a discount rate for
any new projects that the form might take, but only if the D/E ratio for the new project is same as firm D/E
and project is as risky as firms other assets are on an average.
VALUATION METHODS CONTINUED
DCF
DCF has already been discussed at length under cash flow based valuation methods.
DDM
Another method for valuing a firm would be to calculate the value of equity and then add the value of debt.
To calculate the value of Equity, we need the price of a share. Let us see how it can be calculated. We know
that price of any project/investment is equal to the discounted cash flows in future years. For an equity
investor (who does not sell his share) the cash flows from equity investment are the dividends and thus the
value of share is the discounted present value of all the future dividends. This is known as the dividend
discount model. Under this model, if DIV1 is the dividend paid out at the end of first term, r is the hurdle rate
and g is the rate of growth of dividends, then current price

P0 = DIV1/(r-g)

And why do the dividends grow? That is because the firms do not pay out all of the earnings as dividends.
Some of the earnings are reinvested into the business and earn incremental income leading to growth in
dividends as well. Recall, that the ratio of earnings paid out as dividends is called the payout ratio = DIV/EPS
(where EPS is earnings per share).
Thus, 1- DIV/EPS represents the fraction of income reinvested in the business. This is called the plowback
ratio. The ploughed back capital would earn a return equal to the Return on Equity earned by the company
and thus if the payout ratio stays constant, the income and hence the dividend would grow at:
g = plowback ratio * ROE

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

A major assumption that we have made in the above discussion is that all these ratios remain constant which
is rarely the case in real life scenarios. For stocks with variable growth rates we find dividends for each year
separately and then sum the discounted value to get the price of stock. The process is similar to that in DCF.

0 =

1
2

+
+ +
+
1
2

(1 + )
(1 + )
(1 + )
(1 + )

Where DIVi represents dividend in ith period and PH is the expected price of stock at the end of period H.
Usually H is chosen to be the time when the firms growth is expected to stabilise.
Example: Consider a firm that has an EPS of Rs. 10 and a payout ratio of 0.5. Furthermore, the ROE is 15%,
and discount rate is 10%Then, g = 0.5*0.15 = 0.075;P = Price of share = 10*0.5/(.1-0.075) = Rs. 200
MULTIPLES BASED
Multiple It measures a specific aspect of the companys financial health. It is calculated by dividing one financial
metric by another. Numerator is generally greater than the denominator. For Example: P/E, the price per share to
earnings per share (EPS) ratio, is a multiple that measures how much the investors value the companys stock
relative to its earnings. If P/E =15, then investors are ready to pay a multiple of 15 times the current EPS of the
company.
Multiples approach - A valuation method which states that when firms are comparable, then the value of one
firm can be used to find the value of another similar firm.
Trading VS Transactional Multiples
o
o

Both are examples of Relative Valuation, whose aim is to calculate the value of a given asset
in line with the current market values of similar assets.
Analysis of trading multiples factors both a companys current trading price and the current
trading prices of its competitors to arrive at a valuation that is in line with valuation multiples
of comparable public traded companies. Common Multiples used for trading analysis are
P/E, EV/EBITDA.
Transactional Multiples relies on transactions of similar firms in the market to obtain the
valuation of the desired firm. It requires data actual prices and multiples, for acquisition of
similar firms in the market. Data can often be hard to get as most acquisitions are done in
private. Secondly, it is hard to describe similar firms. Thirdly, data should not be very old,
as they would reflect different market conditions.
Advantages
It can be undertaken quicker and is more efficient than DCF valuation.
The intuitive nature of relative valuation is attractive to prospective investors than the
technical nature of DCF.
Disadvantages
For some companies, it is difficult to find true value because of low trading pattern and
small market capitalization.
Also, volatile market sentiments may lead to stock prices that are not true reflection of a
companys intrinsic value.

Financial
Here we will see both price and enterprise multiples.

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

Price Multiples: It is the ratio that measures share price of a company with a per share factor. Few
common Price Multiples are Price to Earnings Ratio (P/E), Price to Book ratio (P/BV), and Price to sales
Ratio (P/S).
o P/E
Price-to-earnings ratio is the most common financial multiple and measures what
price an investor pays for 1$ of earnings.
The numerator is the price of the firm scrip, and the denominator is the Earnings per
share (EPS).
P/E can be trailing, based on the preceding 12 months (or 4 quarters), or forward
looking, based on the estimated 12 month or 4 quarter forward earnings.
Advantages
Ideally one would like to compare like-for-like. The Price in the numerator is
the market price and Earnings are what are used to pay out dividends to
shareholders.
Disadvantages
EPS can be negative or zero, and in such cases P/E doesnt make sense
EPS can be distorted by managers which affects the comparability among
peer companies.
o P/BV
Ratio of price per share to book value per share.
It reflects investment made by common shareholders in the company.
Advantages
Book Value is positive unlike EPS which can be negative or zero.
Book Value is more stable than earnings
Book Value is primarily beneficial for companies that are no longer expected
to be a going concern, in other words are expected to be liquidated.
Disadvantages
P/B may be misleading when the level of assets employed are different
Intangible assets are not included. Many-a-time acquisitions are done to
acquire the human capital which BV omits.
Book Value reflects the historical cost of asset acquisitions. Hence P/B
doesnt reflect the present scenario very well.
Enterprise Multiples (also, EBITDA multiple): It measures the Enterprise value of a firm, as given below,
with other financial metrics such as EBITDA, sales etc. Since it takes debt into account, hence it is a better
representative of a firms value than P/E as any potential acquirer would have to assume the debt as
well.
o EV/EBITDA
This is the most common enterprise multiple.
Enterprise Value (EV) is calculated as sum of market values of common equity, debt
and preferred stock minus cash and short term investments. Short term investments
are subtracted as the acquirer must buyout both equity and debt and then receives
cash. It reflects the value that acquirer has to pay for acquisition of the firm.
EBITDA is a measure of pre-interest, pre-tax operating cash flow to both debt and
equity holders; hence it makes sense to use Enterprise Value and not Price in the
numerator. EBITDA is frequently positive.
Advantages
EV/EBITDA is better than P/E when the levels of financial leverage differ

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

EBITDA excludes depreciation and amortization while EPS is post both.

Hence, for capital intensive business (subject to depreciation) EV/EBITDA is
much better.

EV/S
Enterprise Value-to-Sales is a better alternative to Price-to-Sales ratio because not all
sales are attributed to the equity investors. Also in a debt financed company, P/S is
not meaningful because share price does not take into account debt situation of the
firm.

Non-Financial
Besides the set of financial ratios discussed above there are certain industry-specific ratios that are
non-financial in nature and are useful places to start valuation. Ideally one would want to use nonfinancial ratios to triangulate the valuation rather than using it as a primary measure.
o

Retail Companies
Same stores sales
Sales per square meter
Service Sectors
Revenues per employee
Net income per employee
Hotel/ Hospitals
Average daily rate
Occupancy rate
Financial Firms
Current Account Savings Account
Net Interest Margins
Monetary reserves

FINANCING
THE PECKING ORDER THEORY OF FINANCE
As per the Pecking Order Theory of Finance, a firm prefers to utilize internal sources of funding i.e. retained
earnings over external sources of funding. Further, in the latter case, a firm would prefer to issue debt over
equity. The theory is based on the idea that information asymmetry between a firms managers and
shareholders and transaction costs incurred in raising funds from external sources influence the firms choice
of capital structure.
Consider a firm which needs funds for a project. It can raise debt or equity or use internal accruals. If the
firms prospects are more positive as compared to its current market valuation, it would prefer to issue debt
rather than issuing equity as it is undervalued. On the contrary, another firm which has poorer prospects vis-vis its current market valuation would prefer to issue equity over debt to avoid worsening its financial
position.
However, there is information asymmetry between investors who are external to the firm and the managers
who run the business. Consequently, investors tend to draw inferences from the actions of the managers.
Rational investors would conclude that an equity issuing firm has an overvalued share price and debt issuing
firms have an undervalued one. Hence, the share price of an equity issuing firm would fall. To avoid this fate,
the manager of the firm with poorer prospects would issue debt as well. Therefore, while raising external
financing a firm irrespective of its prospects would prefer issuing debt to issuing equity. However, both

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

managers would prefer internal accruals over external sources of financing as it doesnt incur any transaction
costs & carries no signaling risks.
A conclusion of this theory is that, the more profitable the firm the higher its reliance on internal accruals
and lesser its recourse to debt. On the contrary, a less profitable firm will issue more debt as its internal
accruals would be inadequate to meet its capital requirements. Therefore, within an industry there will be
inverse relation between the profitability and debt-equity ratio of companies.
DEBT: TRANCHES AND SENIORITY
A debt is an obligation to repay money.
Debt can be secured or unsecured. Secured debt is collateralized with assets which are pledged by the
borrower to provide protection to the creditor. In case of default, the creditor can sell the collateral to
recover the outstanding dues. On the contrary, unsecured debt has no underlying collateral and hence
carries more risk for the creditor. Due to this, for the same borrower, secured debt is cheaper than
unsecured debt.
Debt is also classified as senior or subordinated. Senior debt is the debt that gets priority in repayment in
case of a default. It is ranked higher in the corporate debt hierarchy as compared to junior or subordinated
debt. Due to its junior status and unsecured nature, subordinated debt is riskier and carries a higher interest
rate.
A subordinated debt is typically issued to the promoters of the company as external creditors would demand
a risk premium for holding unsecured debt.
Mezzanine debt is debt that has the characteristics of both debt and equity. It has equity characteristics in
the form of embedded equity based options and is ranked lowest in the debt hierarchy just above preferred
stock. Mezzanine debt is issued to finance acquisitions and is issued quickly without thorough due diligence.
Consequently, it carries a very high rate of interest.

Seniority in the capital structure:

Priority
1
a
b
c
d
2
3

Instrument
Debt
Senior Secured Debt
Senior Unsecured Debt
Subordinated Debt
Mezzanine Debt
Preferred Stock
Ordinary Shares

EQUITY: TRANCHES AND SENIORITY

There are two main types of equity: preferred stock and common stock.
Preferred stocks or preference shares are senior to common stocks as they have preference over common
stocks in dividend payouts arising from liquidation or distribution of earnings. A preferred stock usually
carries no voting rights and may have no fixed maturity. If a preference share has no fixed maturity, it is a
called a perpetual preference share. Due to their fixed dividend, a preference share usually holds less
possibility for appreciation as compared to a common stock.

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

Depending on whether the dividend payable on a preferred stock is deferrable or not they are classified as
cumulative and non-cumulative. Depending on whether a prefer stock is callable or not they are classified as
redeemable or irredeemable preference shares. If the preferred stock is convertible into equity, it is called a
convertible preferred stock.
Unlike common stocks preferred stocks have no voting rights.
Common stocks
Common stocks or ordinary shares are the least secured claims in the capital structure of a company. They
are ranked lower to all types of debt and preferred stock and form the residual claim on a companys assets
during liquidation. Consequently, equity holders are the last to be paid off during distribution of profits.
Common stocks usually carry voting rights. These rights enable shareholders to vote at meetings, nominate
directors and decide the corporate policy of the company. However, unlike preferred stock, there is no fixed
dividend payable to common stock holders which makes their returns volatile. A major attraction of common
stocks is the potential for capital appreciation which they offer. Common stocks are perpetual in nature and
extinguish only on liquidation of the company.
IPO INITIAL PUBLIC OFFERING
When a company offers its shares for subscription to the public for the first time, the offering is called an
Initial Public Offering. An IPO could be dilutive or non-dilutive or a mix of the two. In a dilutive offering, fresh
shares are issued to new subscribers which dilute the EPS and shareholding for the existing shareholders. In
non-dilutive offering existing shareholders sell some or all of their shares as part of the offering thereby
keeping total number of shares & EPS constant.
An IPO involves taking a private company public. Reasons for undertaking an IPO include lower cost of
capital, greater liquidity for shareholders, opening up newer sources of funding, greater prestige related to
being a public company, raising funds without reducing control (loss of Board seats).
An IPO is undertaken through underwriters who form a syndicate to sell the issue to the public. The
underwriters also buy the non-subscribed portion of shares in case actual subscription is below expectations.
The pricing of an IPO is a contentious issue for both the company and investors. An underpriced issue could
lead to oversubscription but will also imply that the company has left too much money on the table. An
overpriced issue would lead to under subscription and could lead to losses on listing to investors which is
also not desirable.
Some of the recent oversubscribed IPOs include Coal India, MOIL, Punjab & Sind Bank Ltd. The IPO of A2Z
Maintenance was under-subscribed 0.33 times.

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

Appointment of
I-bankers &
Registrars
Submission of
Draft Offer
Prospectus

Actual Listing

Step 1

Processing of
Applications by
Registrar

SEBI Approves
Draft Offer
Prospectus

Price Fixed
based on bids

Submit
Prospectus to
Stock Exchange

Issue open for

Subscription

Distribution of
RHP & Forms to
Investors
Steps in IPO process

FPO- FOLLOW-ON PUBLIC OFFER

Any public issue of shares by a company subsequent to an IPO is called a follow-on public offer (FPO).
NTPC and NMDC came out with FPOs recently.
SEO-SEASONED EQUITY OFFERING
A Seasoned Equity Offering is a FPO by an established company whose shares have substantial liquidity and
trading volume in the secondary markets
A seasoned equity offering could be either dilutive or non-dilutive.
RIGHTS ISSUE
A rights issue is an invitation to the existing shareholders to buy more shares of the company. The number of
shares offered in a rights issue is in a fixed proportion to their current holdings. The rights are similar to a call
option as they vest in the rights owner the right to buy a specified number of shares at a pre-specified price
on a stated maturity date. The rights holder can exercise the rights, allow them to lapse or sell them to other
investors. The intrinsic value of the rights helps to compensate the shareholder for the subsequent dilution.
However, if the rights are Non-renounceable they will not be tradable.

BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

Rights issues are usually preferred by companies with weak balance sheets when they are unable to borrow
money. The rights issue was also preferred as a source of funding during the credit crisis when external
funding sources dried up. However, rights issues are also made by companies with strong balance sheets to
meet capital expenditure plans and to fund acquisitions.
SBI is planning a Rs 20,000 crore rights issue to bolster its capital ratios. Industrial & Commercial Bank of
China Ltd recently concluded a $1.68bn rights issue.
QIP- QUALIFIED INSTITUTIONAL PLACEMENT
A QIP is a means of raising capital in which a listed company issues securities directly to Qualified
Institutional Buyers (QIB). QIBs are sophisticated investors who due to their expertise and financial strength
need less protection from issuers as compared to retail investors. The securities issued under a QIP can be
equity shares or any other securities convertible to equity shares except warrants.
QIPs involve few procedural & regulatory requirements and hence are a quicker mode of raising capital as
compared to other options. Indian companies were found to prefer foreign markets for fund raising due to
their less complicated requirements. To prevent excessive dependence on foreign capital, QIPs were
introduced in India. During the credit crisis, cash strapped Indian companies issued a number of QIPs to
repair their debt laden balance sheets.
Adani Enterprises (Rs 4,000 crore) and Tata Motors (Rs 3,350 crore) are some of the recently concluded QIPs.
AUCTIONS
Dutch Auction:
A Dutch auction is a type of auction in which the auctioneer lowers the asking price till a bid is obtained. In
case of a securities offering, a Dutch auction is used by the issuer to achieve a lower interest rate in case of
bonds and a higher share price in case of equities. The issuer invites bids from investors within a prespecified price range. Once the total bids at every price point are listed, the share price is lowered from the
higher end of the price range till the desired amount of subscription is obtained. The price at which this
happens is called the cutoff price. In case of bonds the bids are listed in ascending order as per the interest
rate demanded. The interest rate is increased from the lowest interest rate onwards till the issue is fully
subscribed. The price/ interest rate so fixed is applicable to all bidders whose bids have been accepted. In
case the total eligible subscription exceeds the number of shares/ bonds offered, the allocation can be made
on a pro rata basis. In case the subscription is inadequate the offer can be scrapped.
French Auction:
In a French auction, the issuer sets a minimum reserve price below which no subscriber can bid. Once the
bids have been received, the issuer and the securities regulator check the bids and decide a minimum and
maximum price range for eligible bids. All bids above the maximum price range are disqualified. Allocation is
made to bidders within the price range on a pro-rata basis.
Unlike the book-building route in which the upper level of the price band is also fixed, a French auction has
no upper price cap which leads to better price discovery.
The French auction was used during the NTPC and REC FPOs.
PAYOUT
In this section we will discuss what choices the firms have while paying its shareholders.
STOCK SPLITS
A stock split increases the number of shares held by investors by reducing the face value of existing shares.
Consequently, though the number of shares increases, the proportional ownership of each shareholder in
the company remains constant. Also as the market capitalization remains the same, the share price falls in
inverse proportion to the stock split ratio.

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For e.g. a 2:1 stock split of a share with face value 10 and market price 100 will create 2 shares with face
value 5 each and market price 50 respectively.
Companies undertake stock splits to improve the liquidity of their shares by making them more affordable.
Hence, stock splits are undertaken by companies whose shares have risen to high levels. Usually, the postsplit fall in the share price increases demand for the shares driving up the stock price.
The stock of LIC Housing Finance recently underwent a 5:1 stock split.
A reverse split is a form of stock split in which companies increase their currently low share prices by
reducing the number of shares issued. This is done by reverse splitting or merging shares thereby
increasing face value as well as market value of the share. Reverse-splitting is undertaken by companies to
gain a respectable share price or to mitigate the risk of delisting due to currently low stock price.
BONUS SHARE
When a company gives free additional shares to its shareholders, it is called a bonus share. In a bonus issue,
the shares are awarded in fixed ratio per existing share thereby maintaining the same proportional
shareholding as before. Unlike a stock split, post bonus issue the face value per share remains constant.
However, other per share metrics such as EPS and book value per share fall proportionately.
The accounting effect of a bonus issue is to convert reserves and surplus into paid up share capital.
The Board of Directors of ONGC Ltd has recently announced a 1:1 bonus issue.
STOCK REPURCHASES
In a stock repurchase a company buys back its own shares from shareholders in exchange for cash. The
bought back shares are either extinguished or held in a treasury account for resale after the share price
appreciates.
The various modes of share repurchase include:
1. Open market repurchase: In this mode of repurchase, the company may either notify its intention to
repurchase or post-facto declare the amount of shares repurchased.
2. Fixed Price tender: In this, the company specifies the single price at which it will repurchase shares
along with disclosures about maximum number of shares sought, duration of tender offer etc.
3. Dutch auction: Shareholders are invited to offer their shares within a pre-specified price range. The
offer price is fixed at that price at which the offers tendered cumulatively satisfy the firms buy-back
requirement. All offers at and below this price are accepted and paid the offer price. If the number of
shares tendered exceeds the buy-back requirement, shares may be bought on a pro rata basis.
The various reasons for undertaking share repurchase are to:
1. Pay excess cash to investors by buying out their shareholding.
2. Benefit from depressed share prices by buying shares for treasury portfolio
3. Signal undervaluation by repurchasing shares at a premium to market price
4. Improve the EPS by reducing number of shares outstanding.
5. Share repurchases are a more tax efficient way of payout in certain jurisdictions with double taxation
of dividends.
DIVIDEND (PAYOUT POLICY)
Dividends are distributions of earnings to shareholders. Dividends are usually in cash or shares but can be in
the form of assets such as products or services. We will look at cash dividends. Cash dividends are necessarily
paid out of the retained earnings of a company and cannot be paid from the paid up share capital.
Dividends are perceived by the market as signaling mechanisms which indicate the health of the business. A
cut in the dividend could be perceived to reflect deterioration in business fundamentals and consequently
punished with mass selling of shares. Consequently, company executives are reluctant to change the
dividend unless and even borrow to meet dividend expectations. Also, managers avoid making dividend

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increases which they may be to reverse later. Consequently, dividend increases usually lag sustainable
growth in profits. Also executives prefer to distribute transitory earnings or cash hoards through share
repurchases rather than dividends.

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