Professional Documents
Culture Documents
Introduction
Barter Non-Barter
Study
Study of
of Time
Time Value
Value of
of Money
Money Helps
Helps in
in Consistent
Consistent Measurement…
Measurement…
Learning from Economic Theory Money As a Resource…
Labor Product
Capital Services
Raw
Material
Financial
Financial Market
Market Provides
Provides Capital
Capital for
for aa Price
Price and
and Firms
Firms Create
Create
Assets
Assets with
with the
the Help
Help of
of Capital
Capital to
to Generate
Generate Wealth…
Wealth…
Understanding the Financial Market
funds
Surplus Business Deficit Business
Unit (SBU) Unit (DBU)
(Households, (Government,
Corporate)
claim Corporate)
Assets Liabilities
FUNDS CLAIMS
or
DEBT or borrowed capital
or
EQUITY or owners capital
A
A Firm
Firm Need
Need to
to Use
Use its
its Scare
Scare Resources
Resources (Capital)
(Capital) Optimally
Optimally to
to
Achieve
Achieve the
the Goal…
Goal…
Firms Operates in Markets
Finance
Finance Manager
Manager Plays
Plays an
an Important
Important Role
Role to
to Make
Make Sure
Sure the
the Firm
Firm Meets
Meets the
the
Goal
Goal itit has
has Aimed
Aimed for…
for…
What are the questions Financial Mangers deal with?
• How big the firm should be?
• How to minimize the expenditure without affecting the growth of the firm?
Finance
Finance Strategy
Strategy is
is Driven
Driven by
by Objective
Objective of
of the
the Firm,
Firm, Business
Business
Opportunity,
Opportunity, Cost
Cost of
of Capital
Capital for
for the
the Firm…
Firm…
Organization Structure
CEO
CFO
Treasurer Controller
• Manages the cash • Prepare the accounts
• Planning and capital • Manage the expenditure
budgeting • Internal audit
• Raising the money • Reporting and preparing
• Managing the external balance sheet and P&L
relationship
• Managing the credit
and fraud issues
Financial
Financial Management
Management Objective
Objective is
is to
to Maximize
Maximize Value
Value of
of the
the Firm
Firm by
by
Balancing
Balancing Between
Between Risk
Risk and
and Reward..
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?
• Regulatory Framework
• Taxes
• Financial system
Financial
Financial Management
Management maximizes
maximizes value
value with
with the
the external
external
regulatory
regulatory environment…
environment…
How regulatory framework affects financial decisions?
There
There is
is Uncertainty
Uncertainty (Risk)
(Risk) over
over the
the Real
Real Rate
Rate of
of Return
Return even
even ifif the
the Nominal
Nominal
Return
Return is
is Certain
Certain due
due to
to Uncertainty
Uncertainty over
over Inflation…
Inflation…
Uncertainty and Risk Aversion…
• 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 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
Effective
Effective Rate
Rate is
is Appropriate
Appropriate Rate
Rate to
to Measure…
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?
Future Value (FV) at the end of first year = Rs. 10,000 + 0.10*Rs. 10,000
P(1+rN)
P(1+r)N
Where;
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)
Two
Two Nominal
Nominal Rates
Rates Compounded
Compounded at at Different
Different Intervals
Intervals are
are Equivalent
Equivalent ifif they
they
Yield
Yield the
the Same
Same Effective Rate …
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
Effective
Effective Rate
Rate is
is Nothing
Nothing But
But Compounding
Compounding Rate
Rate When
When Interest
Interest Rate
Rate Conversion
Conversion
Period
Period is
is Different
Different From
From Measurement
Measurement Period…
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
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.
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.
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.
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.
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 4th
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 4.5 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 4th 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
• 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?
• TheThe Present
present value of RsValue Approach
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:
FV 1 r FV A1 r A
N
FV 1 r FV A 1 r 1
N
FVr A 1 r
N
1
A
FV 1 r
r
N
1 Where
A = Regular Annuity
r = interest rate
Present Vale of Annuity
A A A A
PV
1 r 1 r 2 1 r 3 1 r N
A A A
PV 1 r A
1 r 1 r 2 1 r N 1
A A A A A
PV 1 r A
1 r 1 r 2 1 r N 1 1 r N 1 r N
A
PV 1 r A PV
1 r N
A
PV 1 r PV A
1 r N
A
PVr A 1 N
1 r
A A Where
PV 1
r 1 r N A = Regular Annuity
r = interest rate
Understanding Annuities
Present Value Interest Factor of Annuity Future Value Interest Factor of Annuity
(PVIFA) (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
The Present
Present Value
Value of
of Annuity
Annuity would
would Decrease
Decrease ifif the
the Interest
Interest Rate
Rate
Goes
Goes Up
Up and
and Increases
Increases with
with the
the ## of
of Years
Years of
of Payment
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
The Future
Future Value
Value of
of Annuity
Annuity would
would Increase
Increase ifif the
the Interest
Interest Rate
Rate Goes
Goes
Up
Up and
and Increases
Increases with
with the
the ## of
of Years
Years ofof Payment
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 = 10,000xPVIFAAD(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 = 10,000xFVIFAAD(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
The Value
Value of
of the
the Perpetuity
Perpetuity would
would Decrease
Decrease ifif the
the Required
Required Rate
Rate of
of
Return
Return Increases
Increases and
and Value
Value would
would Increase
Increase ifif the
the Payment
Payment Increases
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 – 16: Amortization Schedule
• 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 – 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
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 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 – 1 / 2.1589]
= 1000 * 0.53681 = Rs.536.81
• The company is going to pay Rs.1000 at the end of 10th 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 – 1 / 2.3579] = 800 * 0.57590 = Rs.460.72
• 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+0.1)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 – 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 – 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 – 1 / 1.6895] = 1333.333 * 0.40810 =
Rs.544.14
• 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+0.06)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 – 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 – 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 – 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 issuer’s 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 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
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
• 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 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 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:
• 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
The SML Approach
• From our valuation of equity classed we know that
– Ri = Rf + βi * (Rm – Rf)
– Where;
• 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
• βi 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 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
• 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 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, 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.40……..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%
• RE = 5 + .75 x 10 = 12.5% and RD = 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 – 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 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 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 – 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
= 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
= OCF 166,000
OCF= NI+ DEP + INT= TR- FC-VC-TAX- INT., exclude non cash
charges.
An Example…
At what price (per apartment) Operating CF is zero?
= Operating CF 166,000
= Operating CF 166,000
Estimating the Cash Flows – Base Case
The tax-shield approach
= -545,254 + 556,458
= 11,204
Scenario Analysis: Worst-Case NPV
Project-LcH Special CF CFs at Special CF
at t =0 t=1 t=2 … t=5 at t= 5
-530,000 +30,000
-60,000 +60,000
OCF OCF … OCF
= -379,245
*Derive this under most unfavorable figures for units sold, price, variable cost, and fixed cost
Scenario Analysis: Best-Case NPV
Project-LcH Special CF CFs at Special CF
at t =0 t=1 t=2 … t=5 at t= 5
-530,000 +30,000
-60,000 +60,000
OCF OCF … OCF
= 460,502
*Derive this under most favorable figures for units sold, price, variable cost, and fixed cost
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 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, 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
• - inventory period( inventory supplied – 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