Corporate Finance Lecture

8/6/2019 Corporate Finance Lecture

http://slidepdf.com/reader/full/corporate-finance-lecture 1/125



Opportunities of a Business Entity depends on nature of intended business

Example: Air line Industry wants to add an aircraft that generate more Cash Flows. (i.e.Opportunity and acquire an asset Plane)

Cargo Company - TrawlersPoints keep in view by Financial Manager & CB

Size of Investment Risk Timing

Evaluating Size, timing of CF and Risk associated with CF is essence of CB

QUESTION # 2:Where to get money from to Finance Investment?

Ans: CAP

IT

AL & IT

S ST

RUCT

URE Two ways to finance an Investment:

Owner¶s Equity Loans or External Sources

Terminology in Capital Raising

IPO¶s IPO¶s stands for Initial Public Offerings Company lunch their shares in market Offer general Public Share allotted on Draw

QUESTION # 3 How to manage routine financial activities?

Working Capital Basically Interaction between Current Assets & Current Liabilities Working Capital needs to meet financial expenses Current Assets + Current Liabilities = WC



Vendors

Finished Goods

Raw Material

Cash from Customers

Sales to Customer

OPERATING CYCLE

Cash Flow from Customers used to

Pay Off Vendors

Cash Payment

from Customers

Working CapitalPolicies

Level of Inventory Investment Credit extension policy

Types of Business Sole Proprietor Partnership Limited Liability Business:

Private Company Public Un-listed Company

Limited Liability Business & MarketsTypes of Markets:

Primary Market

Secondary MarketPrimary Markets

Original Sale of Securities and shares

No tangible Shape General Public offerings Private placements IPO¶s in Primary Market

Secondary Markets Subsequent to first sale or Subsequent to original sale. Trading of Securities & Shares



Tangible Markets Example stock Exchange

FINANCIAL STATEMENTS &COR PORATE FINANCE

THREE BASIC STATEMENTS

BALANCE SHEET INCOME STATEMENT CASH FLOW STATEMENT

BALANCE SHEET

Is a Statement of resources controlled by the business entity and obligations on a specificdate.

Contents of Balance Sheet

Assets = Fixed (tangible & intangible)& current assets

Liabilities = Long Term Liability + Current Or Short Term Liability Equity = shareholders¶ contribution + earnings

Fixed Assets: Earning assets Fixed Assets e.g. Plant, Machinery, Vehicles etc

Current Assets: Inventory, Prepayments, Cash & Bank Balance, Short Term Investment etc

Balance Sheet Format

Format of B/S in Pakistan is Governed by International Financial Reporting Standard or International Accounting Standard

B/S construction is Non-liquid or Illiquid Asset is at top

Two Conventions for B/S Construction

1st as in Pakistan IAS or IFRS 2nd Convention GAAP (General Accepted Accounting Principle) applicable in United

States GAAP ± In B/S top item is highly liquid asset i.e. cash or near money

Current Liabilities ingredients

Creditor, Accrued Liabilities, Short Term Finances Current Assets combine Current liabilities equal Working Capital

Liquidity

Conversion into cash without losing its value. Timing Loss of value



Example: Bonds

Equity & Long Term Liabilities Equity

Paid up Capital

Reserves Profit & Loss Long Term Liabilities

Loans OR Financial Leverage



BALANCE SHEET

AS AT 30 JUNE 2003

NOTES 2003 2002

RUPEES RUPEES

OPERATING ASSETS

Fixed asset s ( at cost l ess accumulated depreci at ion) 3 125,138 ,737 109 ,101,363

DEFERRED COST 4 12,653,681 18,514,377

LONG TERM DEPOSITS (against Lease) 2,930,337 827,737

140,722,755 128,443,477

CURRENT ASSETS

Stores & spares 7,347,476 11,215,891

Stocks -do- 5 22,628,137 19,231,731

Trade debtors 6 2,149,858 3,211,998

Advances, deposits, prepayments and

other receiveables 7 26,089,950 17,450, 008

Cash and bank balances 8 107,524 110,421

58,322 ,945 51 ,220 ,049

CURRENT LIABILITIES

Current maturity portion of lease liabili ty 9 (6,794,240) (2,821,322)

Current maturity portion of Long Term Loans (8,004,000) - Short term borrowings 10 (6,760,139) (19,270,244)

Creditors, accruals and other liabili ties 11 (30,831,550) (44,786,359)

TOTAL ASSETS LESS CURRENT LIABILITIES 146,655,771 112,785,601

LONG TERM LIABILITIES

Deferred Income (1,692,510) -

Due to directors and relatives (37,056,700) (21,693,585)

Provident fund trust and gratuity payable 12 (926,457) (926,457)

Long term loans 13 (27,828,000) (47,500,000)

Dealers&Distributors securities 14 (23,871,350) (19,398,600) Long term portion of leasehold assets (12,710,887) (1,936,847)

(104,085,904) (91,455,489)

TOTAL NET ASSETS 42,569,867 21,330,112

REPRESENTED BY :

Share capital (5,980,000) 15 59,800,000 39,800,000

Profit & (loss) account (27,457,311) (29,697,066)

Surplus on revaluation of fixed assets 8,227,178 8,227,178

Share deposit money 2,000,000 3,000,000

42,569 ,867 21 ,330 ,112



Corporate finance lecture No. 02

FINANCIAL STATEMENT &COR PORATE FINANCE

Management to Corporate Finance

Market Value Book Value

Market Value Negotiation or Dealing at Arm Length Contrary to Market Value financial statements are prepared on Book Value Book Value is not reflective of worth of assets.

Book Value

Cost minus Accumulated DepreciationIncome Statement

Work out Profit Three Terminologies interchangeably used

Sales Turnovers Revenues

In Profit Statement line item vary Organization to Organization , Industry toIndustry, there is no Rule of Thumb

Revenue ± Expenses = Profit Cash Flow Statement Generation of cash from different activities and its application Three Broad segment Operating Cash Flows Investing Cash Flows Financing cash flows

CASH FLOW STATEMENT

FOR THE YEAR ENDED TH JUNE 2 .

2003 2002 CASH FLOW FROM OPERATINGACTIVITIES

RUPEES RUPEES

Loss /profit before taxation 2 27 7 2 64 6

Adjustment of non cash Items:

Depreciation 929 9 6627 9





Amortization of deferred income

Gratuity / wppf payable

Financial charges

Operating prof it before work ing capital changes

Change in Working Capital

(Increase)/Decrease in current assets

Stores and spares

Stocks

Trade debts

Advances, deposits, Prepayments and

other recei vables

Increase/(Decrease) in current liabilitiesCreditors, accruals and other liabilities

Cash Generated from operations

Financial charges paid

Income Tax paid

Net cash flow from Operating

Activities

CASH FLOW FROM INVESTING ACTIVITIES

Capital expenditures 67 6 4 22 66 29

Proceeds from disposal of fixed assets 6 2 792 4 6

Deferred cost - 466 444

Long Term Deposits Paid 2 26 4

Net cash used in investing activites (2492842) (26788573)

CASH FLOW FROM FINANCING ACTIVITIES

Liability subject to finance lease paid 294 2

Increase in share capital/deposit money 9



Increase in long term loans - -

Repayment of long term loans 66 -

Due to directors and relatives 6 7947 47

Provident fund trust - -

Dealers & Distributor's securities 44727 6 2

Increase/ decrease in short term loans 2 6 294

Net cash outflow / inflow from financing

activities 11302466 21784711

NET INCREASE/ DECREASE IN CASHEQUIVALENTS

6 6 62 7

2 97

CASH AND CASH EQUIVALENTS AT THE BEGININGOF THE PERIOD 42 2662

CASH AND CASH EQUIVALENTS AT THE END

OF THE PERIOD 1471982 110421

COMPARING OF FINANCIAL STATEMENT

COR PORATE FINANCE MODULE # 1Comparing of Financial Statement

Problem in Comparing Size Reporting Currency

Tools to compare Financial Statement Common Size Statement Ratio Analysis

Common Size StatementBalance sheet

All line items of Asset side can be expressed in %age. Total Assets 100% thenwhat is the weight age of Current Asset, Fix Assets etc

Same is the case in Liabilities

BALANCE SHEET

AS AT 30 JUNE 2003



OPERATING ASSETS

Fixed assets at cost less accumulateddepreciation

DEFERRED COST

LONG TERM DEPOSITS against Lease

CURRENT ASSETS

Stores & spares

Stocks -do-Trade debtors

Advances deposits prepayments and

other receiveables

Cash and bank balances

CURRENT LIABILITIES

Current maturity portion of lease liability

Current maturity portion of Long Term Loans

Short term borrowings

Creditors accruals and other liabilities

NET CURRENT ASSETS

TOTAL ASSETS LESS CURRENT LIABILITIES




Deferred Income

Due to directors and relatives

Provident fund trust and gratuity payable

Long term loans

Dealers&Distributors securities

Long term portion of leasehold assets

TOTAL NET ASSETS

CURRENT LIABILITIES

Current maturity portion of lease liability

Current maturity portion of Long Term LoansShort term borrowings

Creditors accruals and other liabilities



NET CURRENT ASSETS

TOTAL ASSETS LESS CURRENT LIABILITIES


Deferred Income

Due to directors and relatives

Provident fund trust and gratuity payable

Long term loans

Dealers&Distributors securities

Long term portion of leasehold assets

TOTAL NET ASSETS

2003 2002 2003 2002

REPRESENTED BY : RUPEES RUPEES

Sharecapital 9 9 422

Profit &loss account -2747 -2969766 79 6Surplusonrevaluationof fiedassets 2277 2277 4 4

Sharedeposit money 2 6

426967 2 2

Theanneednotesformanintegral part of theseaccounts

LAORE -9947 - 27 6 100.00100.0DATED

Common Size Income Statement

All line items are expressed as sale %age i.e. Sales 100%



2003 2002 2003 2002

RS. RS. RS. RS.

116,811,832 109,030,501 100 100

(60,117,579) (58,812,941) (51.47) (53.94)

56,694,253 50,217,560 48.53 46.06

(56,105,424) (53,414,839)

Adm inistrative (8,691,429)(9,173,201) (7.44) (8.41)

Selling, distribution and amortization (37,385,642) (31,684,350) (32.01) (29.06)

Financial charges (10,028,353) (12,557,288) (8.59) (11.52)

588,828 (3,197,279)

2,387,106 360,873 2.04 0.33

2,975,934 (2,836,406)

(148,797) - (0.13) 0.00

2,827,137 (2,836,406) 2.42 (2.43)

(587,382) (545,152) (0.50) (0.50)

2,239,755 (3,381,558)

(29,697,066) (26,315,508)

(27,457,311) (29,697,066)

PROFIT AND LOSS ACCOUNT

FOR THE PERIOD ENDED 30TH JU NE, 2003.

SALES

COST OF SALES

PARTICULARS

GROSS PROFIT

OPERATING EXPENSES

OPERATING PROFIT/(LOSS)

OTHER INCOME/(LOSS)

PROFIT/(LOSS) BEFORE TAXATION

PROFIT/(LOSS) BROUGHT FORWARD

PROFIT/(LOSS) CARRIED OVER TO

BALANCE SHEET

WORKERS PROFIT PARTICIPATION

PROFIT/(L0SS) BEFORE TAXATION

PROVISION FOR TAXATION

PROFIT/(L0SS) AFTER TAXATION

Base Year Analysis OR Horizontal Analysis

Common Size Statements are also called Vertical AnalysisBASE Y EAR /HORIZONTAL ANALYSIS

BALANCE SHEE T

EXAMPLE HORIZONTAL ANALYSIS BASE

YEAR

ASSETS 2006 2005 2004 2003 2002 2001

FIXED ASSETS 160,000.00 155,000.00 145,000.00 145,000.00 125,000.00 100,000.00

160.00 155.00 145.00 145.00 125.00 100.00

CURRENT ASSETS 70,000.00 65,000.00 56,000.00 58,000.00 55,000.00 50,000.00

140.00 130.00 112.00 116.00 110.00 100.00

TOTAL ASSETS 230,000.00 220,000.00 201,000.00 203,000.00 180,000.00 150,000.00

153.33 146.67 134.00 135.33 120.00 100.00

CAPITAL & LIAB ILITIES

CURRENT LAIBILITIES 22,000.00 21,500.00 19,000.00 17,000.00 16,000.00 15,000.00

146.67 143.33 126.67 113.33 106.67 100.00

LONG TERM LIABILITIES 15,000.00 13,000.00 12,000.00 11,500.00 10,500.00 10,000.00

150.00 130.00 120.00 115.00 105.00 100.00

EQUITY 193,000.00 185,500.00 170,000.00 174,500.00 153,500.00 125,000.00

154.40 148.40 136.00 139.60 122.80 100.00

T OT AL C APIT AL & LB TIES 230,000.00 220,000.00 201,000.00 203,000.00 180,000.00 150,000.00

153.33 146.67 134.00 135.33 120.00 100.00

Ratio Analysis Ratio is relationship between two or more different figures or amounts

Different categories in Ratio Analysis



Current Ratio Long Term Ratio Profitability Ratio Markup Ratio

Current Ratio Or Short Term Solvency Ratio Or Working Capital Ratio

Current Ratio is a relationship between Current Asset & CurrentLiabilities

Current Ratio = Current Assets / Current Liabilities Prudent Ratio is 2 : 1

2003 2002

CURRENT RATIO 1.11 0.77

B ALANCE SHEET 2003 2002

AS AT 30 JUNE 2003 RUPEES RUPEES

OPERATING ASSETS

Fixed ass ets (at co st les s accu m ulat ed d ep reciat io n) 125,138,737 109,101,363

DEFERRED COST 12,653,681 18,514,377


140,722,755 128,443,477

CURRENT ASSETS

Stores & s pares 7,347,476 11,215,891

Sto cks 22,628,137 19,231,731

Trade debtors 2,149,858 3,211,998

Advances, depos its, prepayments and

other receiveab les 26,089,950 17,450,008

Cash an d b an k b alan ces 107,524 110,421

58,322,945 51,220,049

CURRENT LIA BILITIES

Current matu rity po rtion of lease liability (6,794,240) (2,821,322)

Current m aturity portion of Long Term Loans (8,004,000) -

Short term borrowings (6,760,139) (19,270,244)

Creditors, accruals and oth er liabilities (30,831,550) (44,786,359)

(52,389,929) (66 ,877,925)

Acid Test Ratio Or Quick Ratio

Relation between Current Asset & Current Liabilities But we less Inventory Items from Current Assets Formula

Q.R = C.A ± Inventories / C.L



2003 2002

QUICK RATIO (0.54) (0.31)

BALANCE SHEET 2003 2002


OPERATING ASSETS

Fixed assets (at co st less accu m ulated dep reciatio n) 125,138,737 109,101,363

D EFE RRE D COST 12,653,681 18,514,377


140,722,755 128,443,477

CURRENT ASSETS

Stores & spares 7,347,476 11,215,891

Stocks 22,628,137 19,231,731

Trade debtors 2,149,858 3,211,998

Advances, deposits, prepayments and

other receiveables 26,089,950 17,450,008

Cash and bank balances 107,524 110,421

58,322,945 51,220,049

CURRENT LIABILITIES

Current m aturity portion of lease liability (6,794,240) (2,821,322)

Current m aturity portion of Long Term Loans (8,004,000) - Short term borrowings (6,760,139) (19,270,244)

Creditors, accruals and o ther liabilities (30,831,550) (44,786,359)

(52,389,929) (66 ,877,925)

Long Term Solvency Ratio

Basically Showing Financial Leverage & also show the abilities of firm to pay its long termliabilities

Total Debt Ratio: T.D.R = Total Debt / Total Asset

OR

= (Total Assets - Total Equity) / Total Assets



TOTAL DE ¢ T RATIO 2003 2002

Total Debts / Total Assets 0.31 0.40

OR

Total Assets - Equity 0.79 0.88

Total Assets

CURRENT LIA

£

ILITIESRUPEES RUPEES

Current maturity portion of lease liability (6,794,240) (2,821,322)

Current maturity portion of Long Term Loans (8,004,000) -


Creditors, accruals and other liabil ities (30,831,550) (44,786,359)

(52,389,929) (66,877,925)

NET CURRENT ASSETS 5,933,016 (15,657,876)


LONG TERM LIA ¤ ILITIES



Provident fund trust and gratuity payable (926,457) (926,457)

Long term loans (27,828,000) (47,500,000)

Dealers&Distributors securities (23,871,350) (19,398,600) Long term portion of leasehold assets (12,710,887) (1,936,847)

(104,085,904) (91,455,489)

BALANCE SHEET 2003 2002


OPERATING ASSETS

Fixed assets (at co st les s accu m u lated d ep reciatio n) 125,138,737 109,101,363

D EFE RRE D CO ST 12,653,681 18,514,377


140,722,755 128,443,477

CURR ENT ASSETS

Stores & s pares 7,347,476 11,215,891

Sto cks 22,628,137 19,231,731

Trade debtors 2,149,858 3,211,998

Advances, deposits, p repaym ents and

other receiveables 26,089 ,950 17 ,450 ,008

Cash and bank balances 107,524 110,421

58,322,945 51,220,049

R EPR ESENTED BY :

Share capital (5,980,000) 59,800,000 39,800,000

Profit & (loss) account (27,457,311) (29,697,066)

Surplus on revaluat ion of fixed as set s 8,227 ,178 8 ,227,178

Share deposit m oney 2,000,000 3,000,000

42,569,867 21,330,112

DEBT EQUITYRATIO

FORMULA

Debt Equity Ratio = Total Debt / Equity



DEBT EQUITY RATIO 2003 2002

Total Debts / Equity (1.46) (3.35)

CURRENT LIABILITIES RUPEES RUPEES

Current maturity portion of lease liability (6,794,240) (2,821,322)

Current maturity portion of Long Term Loans (8,004,000) -


Creditors, accruals and other liabilities (30,831,550) (44,786,359)

(52,389,929) (66,877,925) NET CURRENT ASSETS 5,933,016 (15,657,876)





Provident fund trust and gratuity payable (926,457) (926,457)

Long term loans (27,828,000) (47,500,000)

Dealers&Distributors securities (23,871,350) (19,398,600)

Long term portion of leasehold assets (12,710,887) (1,936,847)

(104,085,904) (91,455,489)

TOTAL NET ASSETS 42,569,867 21,330,112

REPRESENTED BY :

Share capital (5,980,000) 59,800,000 39,800,000

Profit & (loss) account (27,457,311) (29,697,066)Surplus on revaluat ion of fixed asset s 8,227,178 8,227,178

Share deposit money 2,000,000 3,000,000

42,569,867 21,330,112

TIME INTEREST EARNED RATIO FORMULA:

= Earning before Tax / Interest Expense

YEARS TIME INTEREST EARNED RATIO

2003 0.30

2002 0.23INVENTORY TURNOVER RATIO

FORMULA: =Cost of Gods Sold/Average Inventory

YEARS INVENTORY TURNOVER RATIO



2003 (2.87)

2002 (3.06)MARKET RATIOS


2003 0.47

2002 (0.71)PAYABLE TURNOVER RATIO FORMULA:

=Cost of Gods Sold/Trade Creditors


2003 (2.42)

2002 (1.61)




COR PORATE FINANCE - MODULE # 2VALUATION OF FUTURE CASH FLOWSCHEME OF STUDIES

THIS MODULE INCLUDES:

TIME VALUE OF MONEY - BASICS DISCOUNTED CASH FLOW VALUATION BOND VALUATION COMMON STOCK VALUATION

COR PORATE FINANCE - MODULE # 2VALUATION OF FUTURE CASH FLOW TIME VALUE OF MONEY

FUTURE VALUE

PRESENT VALUE

ANNUITIES

PERPETUITIESFUTURE VALUE

Depends on three factors

Size of Investment Time Period Interest Rate

FUTURE VALUE

TIME VALUE DEFINED A dollar or Rupee received today is better than a dollar or rupee to be received

after a year. Why?

Because the dollar or rupee received today will start earning profit right fromtoday

FUTURE VALUE

FV = (Investment, Time, Interest Rate)This can be written asFV = PV x (1 + r)t

(1 + r) t is known as Present Value Investment Factor (PVIF)



r = Rate of Interestt = Time periodExampleYou invest Rs. 1000 today and will get Rs. 1100 at the end of one year, if interest rate is 10% p.a.

= 1000 X (1 + 0.10)= 1100At the end of second year your investment is worth:

1100 x (1 + 0.10) = 1210

Alternatively: 1000 x (1 + 0.10)2 = 1210COMPOUND INTEREST

After One year: 1000 X (1.10) = 1100

After two years: 1100 X (1.10) = 1210

At the end of 2nd year total Investment 1210 that means we earned 210 in terms of Interest.

210 = 100+100+1010 is basically Compound InterestCOMPOUND INTEREST

This 1210 has four parts: 1000 original investment 100 interest ± 1 year 100 interest ± 2 year 10 interest on Year 1 interest

Earning interest on interest is know as compoundingInterest over period is reinvested to earn moreinterest.LONG PERIOD EXAMPLE : (Future Value)

An investment opportunity pays 12% pa and a business entity intends to invest 500,000.What will be the worth of this investment in 7 years time? How much interest will thecompany earn in this period? What portion of total interest represents compound interest?

Solution

Worth after 7 years:

FV = PV x (1 + r)t



FV =500000 x (1.12)7 =1105350

(1.12)7 = 2.21072nd Question: How much Interest will the Company earn in this period?

Total interest earned:1105350 ± 500000 = 605350Compound Interest:500000 x 12% x 7 = 420000=605350 ± 420000 = 185350

2nd Question: How much Interest will the Company earn in this period?

Total interest earned:1105350 ± 500000 = 605350Compound Interest:

500000 x 12% x 7 = 420000=605350 ± 420000 = 185350

PRESENT VALUE

You know that you will get 10000 at the end of 3rdyear from now. The interest rate is 10%. What is thePV of 10000 now?

FV = PV x (1+r)310000= PV x (1.10)3PV = 10000/ (1.10)3= 7513.14

We can find PV the other way too:PV = FV / (1 + r)t

1 / (1.10)3 = known as PVDFPV = FV X PVDFPV = 10000 X 0.7513*

= 7513

* From table A-3Comparison between two options

Option 1= Pay 4000 today and 6000 after 2 years to buy a computer

Option 2= Pay all today a get a credit of 500. (Net price today is 9500)

Interest rate is 10% at present. Which option is better?Option 1:



Finding PV:PV = 4000 + (6000 / (1.10)2PV = 4000 + 4958.68 = 8958.68

It means that 4958.68 invested today @ 10% will yield 6000 at the end of year 2,

enabling you to pay off your liability.Option 2:

PV = 9500Option 1 is better because it cost 8958.68 as compared to 9500 of option 2.

So far we come across four factors of Time Value of Money: PV FV Interest factor or discount factor Time period

Given three we can find the fourth.Finding interest rate

An opportunity requires 1000 investment today that will double at the end of 8th year.What is the implicit interest rate?

PV = FV / (1 +r)81000 = 2000 / (1 +r)8(1 +r)8 = 2000/1000(1 +r)8 = 2

r =9%

Three Ways to Solve: Mathematical Equation Financial Calculator Time Value of Money Tables

Look FV table 8 year row select and move towards right unless under the interest Rate%age you read 2 or nearest to 2.

Implicit Interest Rate = 9%PER PETUITYDefined: Stream of equal cash payments equally spaced that continues for ever.If you wish to help a welfare trust by providing 100,000/- per annum forever and the interestrate is 10%, how much amount must be set-aside today?Formula:

PV of Perpetuity = C/r = 100000/0.10= 1,000,000/-

And if you wish to start payments after 3rd year, then what is the PV of this delayedPerpetuity?

PV of Perpetuity = 1,000,000 / (1.10)3



= 751315ANNUITIES

Series of equal amount and equally spaced payments for limited period of time but not unlimited.

Valuation of Annuities: Using FV/PV tables Using formula

Example:You want to buy an asset for your business that willcost you 4000 per year for next three years.Assume interest rate of 10%. Find out the PV of thisannuity?Using table4000 x 1/(1.10)

4000 x 1/(1.10)24000 x 1/(1.10)3 = 9947.41Using Formula:

PV= Annuity x 1/0.1 ± 1/ 0.10(1.10)3

= 4000 x 2.4869 = 9947.60




CASH FLOW VALUATIONS

Means that at the end of every time period the cash flow level or cash flow amount isdifferent.Example:

An investment returns 10000 after first year, 13000, 15000 & 18000 after 2nd to 4thyear respectively. If the prevailing interest is 10% what is the present value of cash flow.

Equations:FV = PV x (1 + r)tPV = FV / (1 + r)t

YEAR CASH FLOW FVIF @ 10%=

1/(1.10)t

PV=

Cash Flow /FVIF

1 10000 =1/1.10 9,090.91

2 13000 =1/1.21 10,743.80

3 15000 =1/1.331 11,269.72

4 18000 =1/1.4641 12,294.24

TOTAL 56000 Ü43,398.68

Effective Annual Rate ± EAR

EAR basically depend on Compounding More period of Compounding total interest

will be more

Effective Annual Rate ± EAExample:

Bank A pays 15% interest on deposit, that is compounded monthly.



Bank B pays 15% interest on deposit, which is compounded quarterly.

Bank C pays 15% interest on deposit, which is compounded half yearly.

Formula to find EAR

Bank A (Monthly Compounding)

EAR = 1 + i/n n - 1

Bank A = 1 + .15/12 12 - 1

=1.16075 ± 1= 16.075%

Bank B (Quarterly Compounding)

Bank B = 1 + .15/4 4 - 1=(1.0375) 4 ± 1

= 1.15865 ± 1

= 15.865%

Bank C (Half Yearly Compounding)

Bank C = (1 + .15/2) 2 - 1

= (1.075) 2 - 1

= 1.155625 ± 1

= 15.5625%

Example:

A bank offers 12% compounded quarterly. If you place 1000 in an account today, howmuch you have at the end of two years?

What is EAR (Effective Rate of Interest)?Solution:

EAR =(1 + i/n)n - 1

EAR = (1 + .12/4)4 ± 1= 12.55%= (1.1255)2 X 1000 = 1266.75

OR Quarterly interest is 12/4 = 3%



=(1.03)8 X 1000 = 1.2667 X 1000 =1266.77BOND VALUATION

� It¶s a debt security� Whenever Company needs Capital, different sources to raise Capital

IPO¶s of Shares in Primary Market Bank Loan

Bond Debt Financing (Different from bank loan)� Bonds have maturity date� Normally Bonds are Long Term like 10 years, 20 years & 30 years

Main Characteristics:

How much Interest will be paid? How many times?

MaturityTerminologies:

Coupon Payments: stated annual interest amounte.g. A Bond which pays Rs. 100 every year. So Coupon payment i.e. Rs. 100 per year.

Coupon Rate:Coupon Interest Rate = Interest / Investment

Face value: Also Par value, shows the nomination value. Maturity Date: date on which Companies pay back the principal Investment. Discount Bond: A bond which is sold less than the face or par value is discount

bond. Also called Zero Coupon Or Zeros. Premium Bond: A bond which has a price over and above its face value or its par

value is Premium Bond. Yield to Maturity (YTM): Interest rate required in market on a bond.

Or A Market phenomenon, Interest rate on particular Investment Current yield: Annual coupon payment(s) divided by bond price.




Present Value of Bond Depends

� T

ime to Maturity� Yield to Maturity or Market Interest Rate� Face Value� Coupon Payment or Coupon Interest

There are Two segments when we are working to find out the Present Value of Bond

Coupon Payments

Principle RepaymentsEXAMPLE

A Bond is issued for 10 years with a coupon payments of Rs.80 per year. Marketrate is 8% for similar risk. Face value is Rs. 1000/- What should be the selling price

of the bond?Solution:

There are two components need valuation:

1 ± Annuity: Rs. 80/yr for 10 years

2 ± Principal repayment after 10 years

PV Of Annuity = 80 x [(1-1/(1.08)10/0.08]= 80 x 6.7101= 536.81 or 537

PV of Principal = 1000/(1.08)10= 463.19

Adding both components (Selling Price)= 1000

The reason was the YTM of Market Interest Rate of this type of Bond and Coupon Payment Rate is thesame which is 8%.HOW TO VALUE A BOND:AFTER ONE YEAR

Time to maturity = 9 years YTM: Risen to 10%



Other terms & conditions unchangedPV of Principal = 1000/(1.10)9

= 424.10

PV of Annuity = 80 x (1 ± 1/(1.10)9

= 460.72

Adding both components

PV of Bond = 885.00 (rounded off to nearest rupee)

Why 885?

Market rate of YTM move up to 10% or 100 per year.Current coupon payment is 80 per year.Investor would be getting 20 per year less for the rest of nine years.

Fitting 20 per year in formula returns:= 20 x ((1 ± 1/(1.10)9 /0.1)

= 115.xx

This is the amount of discount the investor will get at maturity.

Let¶s see another variation

Time to Maturity = 9 years YTM: Drops to 6% Coupon Rate is 8% Other terms unchanged What is the value of Bond?

Present Value= 1000/(1.06)9= 591.89

PV Of Annuity = 80 x(1-1/(1.06)9/0.06= 544.14

Adding both componentsPV of bond =1136.

136 over & above the face value.136 is basically is premium, which is demanded in market on face value.Again, why 136?

This can be found:

=(80-60) x [(1-1(1.06)9/0.06]= 136



Summary:

YTM & Coupon Rate were same Result PV of Bond was exactly equal to the FV

YTM greater than Coupon Rate Results PV of the Bond less than the FV

YTM lower than Coupon Rate Result PV of the Bond was greater than FV

CONCLUSION:

A Bond will be sold on a discount when YTM is greater than coupon rate.

A bond will be sold on premium when YTM is lower than the coupon rate.

Current Yield Vs YTM

For a bond selling above the face value is said to sell at premium. It meansinvestor who buys it at a premium face a capital loss over the life of bond. Soreturn on bond will be less than the current yield.

For a bond selling below the face value is said to sell at discount. This meanscapital gain at maturity. The return on this bond is greater than its current yield.

EFFECTIVE YIELD

A bond pays semi-annual interest payments i.e., twice a year. Face value is Rs.1000/- andcoupon rate is 12%. This means two six-monthly payments of Rs. 60/- each. Bond matures in 7years and yield to maturity is 14%. What is the effective annual yield on this bond?1-PV = 1000/(1.07)14

= 1000 / 2.5785= 387.82

2- PV of annuity == 60 x (1 ± 1/(1.07)14/0.07= 60 x 8.745395= 524.72

Total PV of bond = 387.82+524.72= 912.55

Effective Yield = (1 + .07)2= 14.49%

NOMINAL & REAL INTEREST RATE



Interest Rate: Inflation adverse effects on valuation Inflation persistent increase in general price level

Real Interest rate: Nominal Interest Rate adjusted for inflation becomes Real Interest Rate

Relationship between Nominal and Real Interest Rates is known as Fisher Effect

Example ± Fisher Effect

Today you can buy one unit of a product at Rs. 5/-. It means you can buy 20 unitsin Rs. 100/-. Inflation rate is 5%. And nominal interest rate is 15.5%. What is realrate of return?

Solution:

Your buying power at the end of one year is: 100 + 5 =105/20 = 5.25

Your investment of Rs 100 after one year is: 100 x (1.1550) = 115.50 Then: 115.50/5.25= 22

Real increase:A year ago you could buy 20 units and now you can buy22 units ± increase of 10% (22-20)/20.Solution with Formula

Fisher¶s Formula 1 + R = (1+r) x (1+h)

Where:R= Nominal interest rater = real interest rateh = inflation rate

Putting Values Solution with formula:

1 + R= (1+r) x (1+h)1 + 0.1550 = (1+r) x (1+0.05)

(1 + r) = 1.1550/1.05 = 1.10r = .10 or 10%

Example ± Fisher Effect

You need to invest an amount today to produce Rs. 100/- after a year. Nominal interest rate is10% and inflation rate is 7%. What is the ³exact´ real interest rate?



Solution:PV of Rs. 100= 100/(1.10)

=90.91If inflation rate is 7%, real value of Rs. 100 is therefore

= 100 / 1.07

= 93.46Real Interest Rate =1 + Nominal/1+Inflation= 1.10 / 1.07= 1.028 or 2.80%

If we discount real value of our Rs. 100 investment (93.46) by 2.8%, we get

PV = 93.46/1.028= 90.91

Point to Remember

Current Cash Flow must be discounted by NOMINAL INTEREST RATE

Real Cash Flow must be discounted byREAL INTEREST RATE




TERM STRUCTURE OF INTEREST RATES

Interest Rates in Short & Long terms are different.

Relationship between LT & ST Rates is known as Term Structure of Interest.

Term Structure tells us Nominal Interest Rate on default free securities.

When:LT > ST

Term Structure will be upward sloping



When:ST > LT Term Structure will be downward sloping

FACTORS OF TERM STRUCTURE

Real Interest Rate

Inflation Rate

Interest Rate Risk

REAL INTEREST RATEReal Interest Rate is basic component of Term Structure.When Real Interest Rate is high, all Interest Rates are high.Real Interest Rate remains constant regardless of maturity.

Real Interest Rates do not influence the shape of Term Structure of Interest.INFLATION RATEInflation Rate reduces the Time Value or Value of Money.If Interest Rate is high, Nominal Interest will increase.Due to Inflation, Investors demand compensation of the lost value. This is known asInflation Premium.Inflation Rate strongly influences the Term Structure of Interest.INTEREST RATE RISK

The fluctuation in Interest Rate also influences the Term Structure significantly.

Any slight fluctuation in Interest Rate can have a huge change in PV value due tocompounding effect.

Investors demand extra Risk Premium for change in Interest Rate. This is known as InterestRate Risk.

Yield Curve ± Coupon Based Bonds Three Factors Influence Yield Curve StructureDefault Risk Premium:

Coupon Base Bond is a promise with a risk that company may fail to pay interest.Taxability Premium:

Dividend bears TaxReturns are reduced by TaxesInvestor need this Premium

Liquidity Premium:If bond is more liquid, expected rate of return is low. For less liquid bonds,compensation is required as Liquidity Premium

TERM STRUCTURE YIELD CURVEMain Points:



Interest Rate Risk Inflation PremiumReal Interest RateDefault Risk PremiumTaxability Premium

Liquidity PremiumCOMMON STOCK VALUATION

Features:

No promised Cash Flow for Dividend No redemption or No Date of MaturityProblems in Determining Rate of Return

Expected Returns:

Total Return = Dividends + Capital Gains

= D1 + (P1 ± P0) / P0

Where:D1 = Dividend after 1 Year P1 = Price of Stock after Year 1P0 = Price of Stock Period 0 or Current Price

Expected Returns:

Total Return = Dividends + Capital Gains

= D1 + (P1 ± P0) / P0

Where:D1 = Dividend after 1 Year P1 = Price of Stock after Year 1P0 = Price of Stock Period 0 or Current Price

For Example:P0 = Rs. 20/-Dividend1 = Rs. 2 per shareP1 = Rs. 23/-

Then expected return is:= 2 + (23 ± 20) / 20=5 / 20= 25%

Putting it the other way:We are trying to calculate the price today if the expected rate of return is 25%:

Price Today = D1 + P1 / 1 + r



= 2 + 23 / 1.25= 25 / 1.25= 20

Putting it the other way:

We are trying to calculate the price today if the expected rate of return is 25%:

Price Today = D1 + P1 / 1 + r

= 2 + 23 / 1.25= 25 / 1.25= 20

If:Today Price > Rs. 20

Then the expected return should have been lower than

other shares of equivalent risk. If demand will lower, peopledispose off this share. It forces the price to settle on Rs. 20.

If:Today Price < Rs. 20

Then the expected return should have been higher thanother shares of same risk. Everyone will rush to buy it, thusforcing price to settle on Rs. 20.CONCLUSION

At each point in time of all shares of samerisk are priced to offer the same expectedrate of return.DIVIDEND DISCOUNT MODEL

It is not an easy job to predict or forecast Future Stock Price.

Dividend Discount Model states that today¶s Price is equal to the Present Value of all futureDividendsAfter One year:

P0 = Div + P1 / (1 + r)After 2 years the value of stock is:

=Div1/(1+r) + Div2+P2/(1+r)2After 3 years the value of stock is:=Div1/(1+r) + Div2/(1+r)2 + Div3 + P3/(1+r)3

When the time horizon is infinitely far, then we donot consider the final price as it has no Present



Value today.Present Value of Common Stock relay on streamsof future Dividend.DIVIDEND GR OWTH MODELS

Assumptions:Assume NO GR OWTH by the Company.

Company pays out all as Dividend what it earns every year.

It means that NOTHING is reinvested in business.

It means that Investors may forecast that future Dividends will not increase.Dividends over the years are at the same level ± PER PETUITY DIVIDEND GR OWTH MODELSNO GR OWTHMODEL

If the value of stock is the PV of all future Dividend then:PV = DIV / r

When company pays out everything as Dividend then earnings and Dividend will be equaland PV can be calculated as:

PV = EPS / rCONSTANT GR OWHT MODEL

Assume that Dividends will grow at a Constant GrowthRate. For example, 5% per year.It means that Dividend of Rs. 2 per share at 5%Constant Growth Rate will be:First year:

Div1 = 2Second year:

Div2 = 2 x 1.05 = 2.10Third year:

Div3 = 2 x (1.05)2 = 2.205By fitting these values into formula we get:

= D1/1+r + D1(1+g)/(1+r)2+ D1(1+g)2/(1+r)3 «.

= 2 /1.12 + 2.10/(1.12)2 + 2.205/(1.12)3

=1.79 + 1.67 + 1.57 + «.



Although the number of terms is infinite, the PV of Dividend is proportionately smaller thanthe preceding term and this will continue as long as Growth Rate is less than the DiscountRate.

Because the far Distant Dividends will be close to Zero, the sum of all of these terms is finite

despite of the fact that an infinite number of Dividends will be paid out.

Corporate finance lecture No. 07 DIVIDEND DISCOUNT MODEL CONSTANT GROWTHSo we can write equation as:

P0 = D1 x (1+g) / (r ± g)

This is known as Constant-Growth Dividend Discount Model Or Gordon Growth Model.

1. First calculate growth rate2. Than calculate price P03. Note that next dividend D1 has been used for valuation

Example:

The next dividend of a company will be Rs 4 per share. Investors demand 16 percent return onshare having same risk level as of this company. The dividend growth is 6% per year.



Calculate the value of this Company¶s stock today and in four years using Dividend GrowthModel.Solution:

Next Dividend has already been given:P0 = D1 / (r - g)

P0 = 4 /( .16 - .06)P0 = 40Price in 4 years: D4 = 4 x (1.06)3 = 4.764 Formula: P4 = D4 x (1+g) / (r ± g)

P4 = 4.764 x (1 + .06) / (0.16 - 0.06) = 50.50Non-Constant Growth

Example:Dividends for first, second and third year are expected in the amount of Rs. 1, 2 and 2.50respectively and after that dividends will grow at a constant rate of 5 % per year. Required rate is10%.

Calculate the value of stock after 3 years & today.Solution:P3 = D3 x (1+g) / (r - g) = 2.50 X 1.05 / (0.10 ± 0.05) P3 = Rs. 52.50Today¶s Price:

= d1/(1 + r) + d2 /(1+r)2 + d3/(1+r)3 + P3/ (1+r)3= 1/1.10 + 2/(1.10)2 + 2.50/(1.10)3+52.50/(1.10)3

Value of Stock today = Rs. 43.88

GR OWTH & INCOME STOCKS/SHARES

Investors trade stocks or share for two reasons:

y Capital Gains or Growth Stock y Dividends or Income Stock

GR OWTH & INCOME STOCKS/SHARES 1) Retention Policy:Retention of profit and then plowback or re-invest in the business.

2)P

ayout Ratio:Percent age of profit at which Dividend is declared by the business.Example:

Dividend1 = Rs. 3.50 per share r = 12%g = 7%EPS = Rs. 5 per share



Payout Ratio = 70%Retention Ratio= 30%

Company requires 20% Return on Plowback.If Payout is 100% or no Retention, and it means no growth:

g = 0 then P0: P0 = DIV / r ± g= 5 / .12 - 0 = 41.67

Mean that:EPS = div

Therefore we used:div = 5no growth = 0

If retention of 30% applied, and expected return is 12% (existing), then P0:

P0 = 3.50 / .12 - .036 = 41.67

0.036 or 3.60% is calculated as:= 0.30 x 12% = 3.60

If retention of 30% applied, and expected return is 20% on retention, then P0 :P0 = 3.50 / .12 - .06= 58.33

CONCLUSION

Plowing back earnings does not add value to current stock price, if thatreinvestment is not expected to earn higher returns than expected by investors.

Plowing earnings back will only push the current prices of the stock up if greater returns are expected by the investors.

Example:Div1 = Rs. 1Div2 = 1.20Div3 = 1.44 after that it grows 5% per year EPS3= 3.78

r = 10%P/E ratio = 8 for shares of same risk level

Price of stock after 3 years and today?Price today:

P0 = PV(div1-3) + PV(P3)PV(div1-3) = 1/1.10 + 1.2/(1.10)2+1.44/(1.10)3

= 2.98PV of P3 = P/E x EPS

= 8 x 3.78= 30.24= 30.24/(1.10)3



= 22.72Putting value of PV(div1-3) & PV of P3 in the main formula:

= 2.98 + 22.72P0 = 25.70

We can calculate P3 with Dividend Model:P

3 = div4 / (r ± g)

Div4 = div3 x (1+g)= 1.44 x 1.05 = 1.512

Putting value of Div4 in formula:P3 = 1.512 / (0.12 - .05)= 30.24

OTHER TOOLS OF STOCK EVALUATION

TECHNICAL ANALYSIS:

T

echnical analysis studies supply and demand in a market in a attempt todetermine what direction or trend will continue in future

Study of Market Sentiments

TECHNICAL ANALYSIS

Evaluating security by analyzing the statistics generated by market activity suchas Past Prices and Volume

Charts and other tools are used to identify patterns that suggest future activityTRENDS

A trend shows the general direction in which a security or market is headed

Types:Up-TrendsDown TrendsHorizontal Trends

TRENDS LENGTH Short TermMedium TermLong Term

Support & Resistance

Support is the lower ceiling price of a stock Resistance is the upper ceiling of stock



CHAR T

A series of prices over a time period presented graphicallyTime scale: intraday, daily, weekly, monthly & yearlyPrice scale: change in price presented as absolute terms. Change shown in % is known

as Logarithmic ScaleCHAR T PATTERN

A distinct formation of point on chart that create trading signals or a sign of future movementHead & Shoulder: reversal pattern when formed, and signals that the security islikely to move against the previous trendCups & handle: continuation of bullish patternCONCLUSION

Technical Analysis method of evaluating stocks by analyzing statistics generatedby market activity.Technical traders take a short term approach to analyzing chart.Product of Technical Analysis is a trend.


COMMON STOCK VALUATIONFUNDAMENTAL ANALYSIS:

Analyst is trying to reach near the intrinsic value of company¶s share by reading andanalyzing the financial, non-financial information and industry comparison.Three step process:Economic indicators: GDP, Interest Rates, Inflation, Exchange RateIndustry Comparison and CompetitionIndividual Company Analysis

FinancialsCEO ReportAudited AccountsAuditors Report

CAPITAL BUDGETINGDefinition:It is a process in which we can evaluate the investment opportunities in order toacquire some capital asset. Types:

New ProjectExpansion Project



Modernization / ReplacementOther / social responsibility ± Pollution control etc

Research & DevelopmentExploration

Capital Budgeting ProcessCB decisions are irreversible in nature

SWOT Analysis :S ± StrengthW ± WeaknessO ± OpportunitiesT ± Threats

CB targeted towards potential opportunitiesInvestment Opportunitie(s) is/are identifiedDifferent alternatives are considered

Every alternative is evaluatedThe best option (s) is/are undertakenPROJECT EVALUATION

Relevant Costs:Incremental costs and benefits are relevantCost incidental to the undertaking of a project

Non-Relevant Costs:Sunk Cost:

Which has been incurred in the pastCommitted Cost:

Future costOpportunity Cost:

Existing benefit surrendered in favor of next best alternativeOpportunity Cost is also a relevant cost

Profit Vs Cash Flow NET PRESENT VALUE NPV = Discounted Benefits ± Initial Investment

Example:An investment in an asset of Rs. 40,000 today returns 10000 after first year,13000, 14000 & 15000 after 2nd to 4th year respectively.If the prevailing interest is 6% what is the net present value of cash flow?

EVALUATING TECHNIQUES NET PRESENT VALUE / DCF

INTERNAL RATE OF RETURN ± IRR

PAYBACK PERIOD

DISCOUNTED PAYBACK PERIOD



ACCOUNTING RATE OF RETURN ±ARR

PROFITABILITY INDEX NET PRESENT VALUE

YEAR CASH FLOW FVIF @ 6% = 1/(1.06)t PV

0 -40,000 = 1.0000 -40,000.001 10,000 =1/1.060 9,433.962 13,000 =1/1.124 11,565.843 14,000 =1/1.191 11,754.824 15,000 =1/1.262 11,885.89TOTAL NPV Ü 4,640.52

NET PRESENT VALUE & other issues:

Initial Investment & Working CapitalSalvage / Residual ValueIncidental CostOpportunity CostRelevant Vs Non-relevantTaxDepreciationInflationDiscount RateWACC (Weight age Average Cost of Capital)



Corporate finance lecture No. 09Weighted Average Cost of Capital:

EXAMPLE:CAPITAL STRUCTURE OF A COMPANY CONSIST OF:

LO

NGT

ERM LO

ANS 157,500 @ 12%SHOR T TERM LOANS 67,500 @ 08%EQUITY 225,000NEXT DIVIDEND / SHARE Rs. 3/ SHARECURRENT SHARE MARKET PRICE Rs 40/-DIV GR OWTH RATE 5%

CALCULATE WACC?SOLUTION:

BEFORE CALCULATION WACC, WE NEED TO FIND OUT COST OF EQUITY.

DIV GR OWHT MODEL EQUATION:P0 = D1 / r ± gOrr = D1/P0 + g

r = 3 / 40 + 0.05= 0.125 or 12.50%

Weighted Average Cost of CapitalTotal Capital= 450,000

Weighted Average Cost of Capital

PAR TICULARS Rs.

Interest Rate

Weight Weighted Int. Rate

LONG TERMLOANS 157,500 12.00% 0.35 0.0420

SHOR T TERMLOANS 67,500 8.00% 0.15 0.0120

EQUITY 225,000 12.50% 0.50 0.0625

450,000 0.1165 11.65%

Example: With Opportunity Cost

M/s Dark Cloud Ltd., is considering an investment opportunity to manufacture a new product³Silver-Lining´ which would involve use of both new and existing plant.

Example: With Opportunity Cost



The new plant having 5 years useful economic life will cost Rs. 1,450,000/-. The existingmachine was acquired two years ago at a cost of Rs. 1,000,000/-. This machine has amplesurplus capacity or is under-utilized at present. The new product annual sales are estimated to5000 units per year and the selling price would be Rs. 320/- per unit.

The unit cost will be as under:

Direct Materials Rs. 70Direct Labor (4 hrs x Rs.20/hr) Rs. 80Fixed Costs including depreciation Rs. 90

The new plant life is 5 years and after that it could be sold for Rs. 145,000/-.The skilled labor required for the manufacturing of silver-lining is in short supply and labor resources would have to be switched over to this project. The labor is earning contributionmargin of Rs. 15.00 per hour.

Working capital of Rs. 150,000 will be required in first year and shall be recovered at the endof project life. The company¶s cost of capital is 20%. Assess whether project is financiallyviable?

Solution: Opportunity Cost

Year InitialInvestment

WorkingCapital

NetBene

Unit Price 320

DM 70 0 (1,450,000.00) (150,000.00) (1,60

DL 80 1 550,0

4Hrs x Rs.20 2 550,

Fixed Cost 90 3 550,0

240 4 550,0

5 145,000.00 150,000.00 550,0

CM Foregone/Per Hr 15

Contribution Margin Earned - New Product 170.00

Additional Units to be produced 5,000.00

Total CM - New Product



CM surrendered

Labor hour required for New Product 20,000.00

CM lost / Hr 15.00

Total CM lost

Net CM - Benefit

CAPITAL BUDGETING

Year Initial Investment

Working Capital

NetBenefit CM

0 (1,450,000.00) (150,000.00) (1,600,000.00)

1 550,000.00 2 550,000.00

3 550,000.00

4 550,000.00

5 145,000.00 150,000.00 550,000.00

ExampleM/s Hi-Mountain Ltd., - specialized chemical manufacturer are looking an untappedinvestment opportunity. This involves manufacturing of a new chemical to be used intextile industry. For this, the company must add a piece of plant with estimated life of 5 years, costing Rs. 2 million.

Other acquisition cost would be Rs. 50,000/- at the end of first year. Aconsultant would be hired for technical aspect of the project at a cost of Rs.50,000/-.

However, if the project does not turn out financially feasible, his contract would becancelled by paying him Rs. 15,000/-.

Working capital requirement would be Rs. 300,000/- in first year and rising toRs. 400,000/- in second year.

All the working capital would be recovered at the end of fifth year. Due totechnological obsolescence the plant will not be useable after fifth year and thesalvage value is estimated around Rs. 125,000/-.

Cash flow emerging from the additional sales would be Rs. 600,000 in firstand second years each, Rs. 550,000/- in third year, Rs. 700,000/- in forth andRs. 750,000/- in last year.

The company shall depreciate the asset on straight line over its useful life. Tax rate is20%.



Company requires 10% rate of return on such projects.

EVALUATE THE PROJECT IS WORTH UNDERTAKING?

SOLUTION:

CAPITAL BUDGETING

Year Initial Cost

Capital W. Capital Consultant Others

0 (2,000,000.00) (300,000.00)

1 (100,000.00) (35,000.00) (50,000.00)

2

3

4

5 125,000.00 400,000.00

RevenueRevenue& Capital

Depreciation Net benefitTax purposes Tax 20%

Benefitafter Tax

TotalBenefit

- - - - (2,300,000.00)

(375,000.00) 225,000.00 45,000.00 555,000.00 455,000.00

(375,000.00) 225,000.00 45,000.00 555,000.00 555,000.00

(375,000.00) 175,000.00 35,000.00 515,000.00 515,000.00

(375,000.00) 325,000.00 65,000.00 635,000.00 635,000.00

(375,000.00) 375,000.00 75,000.00 675,000.00 1,200,000.00

AssumptionsTaxes are paid in the same year of benefit occurring.Consultant and Other costs are supposed to occur at the end of first year.Inflation assumed 0% .

Corporate finance lecture No. 06CAPITAL BUDGETING



Which has been incurred in the past



Committed Cost:Future cost

Opportunity Cost:Existing benefit surrendered in favor of next best alternativeOpportunity Cost is also a relevant cost



Which has been incurred in the pastCommitted Cost:

Future costOpportunity Cost:

Existing benefit surrendered in favor of next best alternativeOpportunity Cost is also a relevant cost

NET PRESENT VALUEDecision Rule:Accept the Project with Positive NPV

In case of more than one projectThe Project with Higher NPV can be under taken

INTERNAL RATE OF RETURN

Rate of Return that is used to calculate the EXACT DCF Rate of Return which the project isexpected to achieve. A rate at which NPV is zero.

If the IRR of a project is lower than the target return, the project is deemed unfeasible.

If the IRR of a project is greater than the target return, the project is deemed feasible.

Example ± IRR

Without computer program IRR is found by method called interpolationCalculate NPV using a whole number If positive, calculate second NPV using a higher discount rate that, preferably returnsthe NPV in negativeThen plug in these values in to formulaFormula to Learn:

IRR = a + [{A/(A-B)} x (b-a)}%

Where:a = Lower discount rate used to calculate NPV



b = Higher discount rate used to calculate NPVA = NPV obtained with discount rate a (lower)B = NPV obtained with discount rate b (higher)

A company intends to buy a new piece of equipment which will save Rs. 20,000 per year for

five years and this will cost Rs. 80,000/- and has an estimated residual value of Rs. 10,000/-after 5th year.

The company only undertakes such project if IRR is above 10%. Find out the projectviability.

SOLUTION: INTERNAL RATE OF RETURN ± IRR Step I

INTERNAL RATE OF RETURN ± IRR Step I: Let's use 9% Discount Factor

Year Cash Flow DF 9% PV of CF

0 (80,000.00) 1.00 (80,000.00)

1-5 20,000.00 3.89 77,800.00

5 10,000.00 0.65 6,499.00

NPV 4,299.00

Step II Since NPV is positive at 9%, we need other NPV preferably in negative.This means that higher discount rate can return negative.Let's try 12% (Guess 100%)

INTERNAL RATE OF RETURN ± IRR Step II: Let's use 12% discount factor

Year Cash Flow DF 12% PV of CF

0 (80,000.00) 1.00 (80,000.00)

1-5 20,000.00 3.61 72,100.00

5 10,000.00 0.57 5,670.00

NPV (2,230.00)



Step III: Calculate IRR IRR = a + [{A/(A-B)} x (b-a)]%

IRR = 9 + [{4299/(4299+2230)} x (12-9)]%

IRR = 10.975 % Or 11%

NPV vs IRR NPV is comparatively complex as compared to IRR

IRR is more easily understandableIRR dependable on NPVManagers may confuse IRR with ROCE (Return On Capital Employed) & other AccountingMeasuresIRR ignores the relative size of investment

Ü ProjectA

ProjectB

Initial Investment 350,000 35,000

Annual Saving 100,000 10,000

IRR of both Projects is 18%.

When discount rate varies over the life of a project, it becomes difficult toincorporate such change if using IRR, however, NPV is flexible over thisissue.

NPV is technically superior than IRR.PAYBACK PERIOD TIME REQUIRED FOR CUMULATIVE EXPECTED CASH FLOWS FROM ANINVESTMENT OPPORTUNITY TO EQUAL INITIAL UP-FRONT CASH FLOW.

Example:A company is considering to undertake an investment opportunity from one of thefollowing options:Option A: Initial investment is Rs. 103,000/- and cash flow from the opportunity will be Rs. 45,000, Rs. 40,000, Rs. 36,000, Rs.20,000 and Rs. 10,000 for year one to five.Option B: Initial investment of Rs. 103,000/- will generate cash flow of Rs. 15,000/-,25,000/-, 35,000/-, 54,000/- & 60,000/- from year one to five.



SOLUTION: PAYBACK PERIODOption A

Years Cash Flow Cum. CF Pay Back Months Years

0 (103,000.00)

1 45,000.00 45,000.00 12 1

2 40,000.00 85,000.00 24 2

3 36,000.00 121,000.00 3,000.00 6 2.5

4 20,000.00 141,000.00

5 10,000.00 151,000.00SOLUTION: PAYBACK PERIODOption B

Cash Flow Cum. CF Pay Back Months Years

(103,000.00)

Ü

Ü

Ü

15,000.00 15,000.00Ü 12 1

25,000.00 40,000.00Ü 24 2

35,000.0075,000.00

Ü 36 3

54,000.00129,000.00 4,500.00 6.22 3.60

60,000.00189,000.00

Ü

Ü

Ü

Decision Rule

If the company has policy to accept the project having less than three years of P.B periodthen the company would go for project A or option A

If the company has policy to undertake a project, having P.B period of less than four years, both project fall in green zone. Then to decide what project should undertakeOption A: 30 months recovering initial Investment

Option B: 42 months recovering Initial Investment



Option A is preferable

Payback Very simple and easy to understandIgnores time value of money

Ignores size of Investment (Project)Ignores cash flows after payback.Can be used as rough or crude measure of appraisalCan be used for project filtration in case of more than one project.

Corporate finance lecture No. 11DISCOUNTED PAYBACK METHOD

The only difference between simple and discounted Pay Back is discounting.Cash Flows expected over period of time are discounted using a Discount Rate.Interestingly, if a project Pays Back on a discounted basis, then it must have a positive NPV.

Example:A company is considering to undertake an investment opportunity from one of thefollowing options;Option A: Initial investment is Rs. 103,000/- and cash flow from the opportunity will be Rs. 45,000, Rs. 40,000, Rs. 36,000, Rs.20,000 and Rs. 10,000 for year one to five.Option B: Initial investment of Rs. 103,000/- will generate cash flow of Rs. 15,000/-,25,000/-, 35,000/-, 54,000/- & 60,000/- from year one to five.SOLUTION: DISCOUNTED PAYBACK PERIODOption A

Years Cash Flow Cum. CF DF 10% PV of CF Pay Back Month Year

0 (103,000)Ü

(103,000.00)

Ü

Ü

Ü

1 45,000 45,000 0.909040,905.00

Ü12 1

2 40,000 85,000 0.826433,056.00

Ü12 2



3 36,000 121,000 0.751327,046.80 12 3

4 20,000 141,000 0.683013,660.00 1,666.67 1.20

Ü

5 10,000 151,000 0.62096,209.00

Ü

Ü

Ü

Ü

Ü

Ü

Ü

17,876.80

Ü37.20

Ü

SOLUTION: DISCOUNTED PAYBACK PERIODOption B

Years Cash Flow Cum. CF DF 10% PV of CF Pay Back Month Year

0 (103,000) 1

Ü

Ü

Ü

Ü

1 15,000 15,000 0.91 13,635.00

Ü 12 1

2 25,000 40,000 0.83 20,660.00

Ü 12 2

3 35,000 75,000 0.75 26,295.50 12 3

4 54,000 129,000 0.68 36,882.00

Ü 12 4

5 60,000 189,000 0.62 37,254.00 5,000.00 1.11

Ü

Ü

Ü

Ü

Ü 17,876.80

Ü 49.1055

Ü

ACCOUNTING RATE OF RETURN ± ARR ALSO AVERAGE ACCOUNTING RATE ± AAR

ARR = Average Net Income/Average Investment

Some Issues relevant to ARR Its Simple and needed information is readily availableIts ignores time value of moneyIts based on book valuesIts not a true appraisal method

Profitability Index



Profitability Index is a relationship between present value of all future cash flows and initialinvestment.Cost-Return Ratio or Benefit-Cost Ratio of an investment opportunity¶s present value of future cash flow to initial investment cost.

F

ormula:PI = PV of Future Cash Flows Initial InvestmentDecision Rule:If PI is greater than 1, project land in green zone or can be undertaken otherwise it is notviable.Accept the project if PI is greater than 1, which means that NPV is positive.Example: Capital Budgeting NPV = Rs 137,997Total PV of Cash Flow = 2.437 millionInitial Investment = 2.00 million

PI = PV of Future Cash FlowsInitial InvestmentPI = 2.437/2.00PI = 1.221.22 > 1Acceptance Rule:Benefit Cost Ratio > 1Project is undertakenEvaluation Method NPVIRR Pay Back Period MethodDiscounted Pay Back PeriodAccounting Rate of Return (ARR)Profitability Index NPV states, if NPV is positive then project is under taken.In case of more than one project, the project with higher NPV can be undertaken.If the project has negative NPV, it does not add value to the company so rejected.Internal Rate of Return Decision RuleIf IRR is grater than targeted return the project is viable, we can undertake the project.If project yield less than targeted rate of return then it is not accepted.Decision RuleIf IRR is grater than targeted return the project is viable, we can undertake the project.If project yield less than targeted rate of return then it is not accepted.Pay Back Period Method Acceptance RuleIf it return you the initial investment to cash flows then it is acceptable and if it is not rejectthe project.Profitability Index



Relationship between Cash Flows and initial Investment.PI = PV of Future Cash Flows

Initial InvestmentBenefit cost ratio greater than 1 project land in green zone or can be undertaken otherwise itis not viable.

Advance EvaluationAdvance tool of Project Evaluation

Sensitivity AnalysisBreak Even AnalysisDegree of Operating Leverage

Advance EvaluationSensitivity Analysis:Slight change in the factor brings magnified effects on the overall viability of a project, this

is known as critical or sensitive factor of project.Like cash Flow, Cost Estimation, Taxes, Cost of Capital or Discounted Rate, Exchange Rateetc.Example:Initial Investment Rs. 7.10 millionVariable Costs = Rs. 2.0 million per year Inflows Rs. 6.50 million per year Project life 2 yearsCost of capital 8%.

Conduct Sensitivity analysis of this project.

Solution: Sensitivity Analysis

Year Initialinvestment

Variablecost Inflows

NetCF

0 (7,100,000.00)

1 (2,000,000.00) 6,500,000.00 4,500,000.00

2 (2,000,000.00) 6,500,000.00 4,500,000.00

Year DF 8%

PV of Initialinvestment

PV of Variable cost

PV of Inflows PV of Net CF

0 1 (7,100,000.00) (7,100,000.00)



1 0.926 (1,852,000.00) 6,019,000.00 4,167,000.00

2 0.857 (1,714,000.00) 5,570,500.00 3,856,500.00

1.783 (7,100,000.00) (3,566,000.00) 11,589,500.00 923,500.00Sensitivity Analysis

Change in: Note PV % OriginalValues %change

Sales - 1year 1

923,500/11,589,500=7.97

923,500/0.926=997,300.22 15.34

Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-

year 1 3

923,500/3,566,000

=25.90

923,500/0.926

=997,300.22 49.87

Cost (VC)-year 2 4

923,500/0.857=1,077,596.27 53.88

InitialInvestment 5 923,500.00 (13.01)

Interestrate 6 18.64Sensitivity Analysis

Change in: Note P

V %

Original

Values %change

Sales - 1year 1

923,500/11,589,500=7.97

923,500/0.926=997,300.22 15.34

Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-year 1 3

923,500/3,566,000=25.90

923,500/0.926=997,300.22 49.87

Cost (VC)-year 2 4

923,500/0.857=1,077,596.27 53.88


Interestrate 6 18.64Sensitivity Analysis: Note 1 (First Year Inflow/Sales Change)



NetCF



0 (7,100,000.00)

1 (2,000,000.00)

6,500,000.00-997,300.22=5,502,699.78 3,502,699.78

2 (2,000,000.00) 6,500,000.00 4,500,000.00

Year DF 8%


PV of Variable cost


0 1 (7,100,000.00) (7,100,000.00)

1 0.926 (1,852,000.00) 5,095,500.00 3,243,500.00

2 0.857 (1,714,000.00) 5,570,500.00 3,856,500.00

1.783 (7,100,000.00) (3,566,000.00) 10,666,000.00 NilSensitivity Analysis


Sales - 1year 1

923,500/11,589,500=7.97

923,500/0.926=997,300.22 15.34

Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-year 1 3

923,500/3,566,000=25.90

923,500/0.926=997,300.22 49.87

Cost (VC)-year 2 4

923,500/0.857=1,077,596.27 53.88


Interestrate 6 18.64Sensitivity Analysis: Note 2 (2nd Year Inflow/Sales Change)



NetCF

0 (7,100,000.00)

1 (2,000,000.00) 6,500,000.00 4,500,000.00



2 (2,000,000.00)

6,500,000.00-1,077,596.27=5,422,403.73 3,422,403.73

Year DF 8%


PV of Variable cost


0 1 (7,100,000.00) (7,100,000.00)

1 0.926 (1,852,000.00) 6,019,000.00 4,167,000.00

2 0.857 (1,714,000.00) 4,647,000.00 2,933,000.00

1.783 (7,100,000.00) (3,566,000.00) 10,666,000.00 NilSensitivity Analysis


Sales - 1year 1

923,500/11,589,500=7.97

923,500/0.926=997,300.22 15.34

Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-year 1 3

923,500/3,566,000=25.90

923,500/0.926=997,300.22 49.87

Cost (VC)-year 2 4

923,500/0.857=1,077,596.27 53.88


Interestrate 6 18.64Sensitivity Analysis: Note 3 (Change in Variable Cost- Year 1)

Year

Initialinvestment


NetCF

0(7,100,000.00)

1

(2,000,000.00)+(997,300.22)=(2,997,300.22)

6,500,000.00

3,502,699.78

2 (2,000,000.00) 6,500,000.0 4,500,000.0



0 0

Year

DF 8%

PV of Initialinvestment PV of Variable cost

PV of Inflows

PV of NetCF

0 1(7,100,000.00)

(7,100,000.00)

10.926 (2,775,500.00)

6,019,000.00

3,243,500.00

20.857 (1,714,000.00)

5,570,500.00

3,856,500.00

1.78

3

(7,100,000.0

0) (4,489,500.00)

11,589,500.

00 NilSensitivity Analysis


Sales - 1year 1

923,500/11,589,500=7.97

923,500/0.926=997,300.22 15.34

Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-year 1 3

923,500/3,566,000=25.90

923,500/0.926=997,300.22 49.87

Cost (VC)-year 2 4 -

923,500/0.857=1,077,596.27 53.88

InitialInvestment 5 - 923,500.00 (13.01)

Interestrate 6 - 18.64Sensitivity Analysis: Note 4 (Change in Variable Cost- Year 2)

Year

Initialinvestment


NetCF

0(7,100,000.00)

1 (2,000,000.00)6,500,000.00

4,500,000.00



2

(2,000,000.00)+(1,077,596.27)=(3,077,596.27)

6,500,000.00

3,422,403.73

Yea

r

DF

8%

PV of Initial

investment PV of Variable cost

PV of

Inflows

PV of Net

CF

0 1(7,100,000.00)

(7,100,000.00)

10.926 (1,852,000.00)

6,019,000.00

4,167,000.00

20.857 (2,637,500.00)

5,570,500.00

2,933,000.00

1.783

(7,100,000.00) (4,489,500.00)

11,589,500.00 Nil




Sensitivity Analysis

Example:Initial Investment Rs. 7.10 millionVariable Costs = Rs. 2.0 million per year

Inflows Rs. 6.50 million per year Project life 2 yearsCost of capital 8%.

Conduct Sensitivity analysis of this project.

Solution: Sensitivity Analysis


VariableCost Inflows

NetCF

0 (7,100,000.00)

1 (2,000,000.00) 6,500,000.00 4,500,000.00

2 (2,000,000.00) 6,500,000.00 4,500,000.00

Year DF 8%

PV of InitialInvestment

PV of Variable Cost


0 1 (7,100,000.00) (7,100,000.00)

1 0.926 (1,852,000.00) 6,019,000.00 4,167,000.00

2 0.857 (1,714,000.00) 5,570,500.00 3,856,500.00

1.783 (7,100,000.00) (3,566,000.00) 11,589,500.00 923,500.00Sensitivity Analysis

Change in: Note PV % OriginalValues %Change

Sales - 1

year 1

923,500/11,589,500

=7.97

923,500/0.926

=997,300.22 15.34Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-year 1 3

923,500/3,566,000=25.90

923,500/0.926=997,300.22 49.87

Cost (VC)-year 2 4

923,500/0.857=1,077,596.27 53.88




Interestrate 6 18.64Sensitivity Analysis: Note 05 (Changes in Initial Investment)



NetCF

0

7,100,000+923,500=(8,023,500.00)

1(2,000,000.00) 6,500,000.00 4,500,000.00

2(6,500,000.00) 6,500,000.00 -

Year

DF 8%


PV of VariableCost

PV of Inflows

PV of NetCF

0 1 (8,023,500.00)(8,023,500.00)

10.926

(1,852,000.00) 6,019,000.00 4,167,000.00

20.857

(5,570,500.00) 5,570,500.00 3,856,500.00

1.783 (7,100,000.00)

(7,422,500.00)

11,589,500.00 0

Sensitivity Analysis

Change in: Note PV % OriginalValues %Change

Sales - 1year 1

923,500/11,589,500=7.97

923,500/0.926=997,300.22 15.34

Sales - 2year 2 -

923,500/0.857=1,077,596.27 16.58

Cost (VC)-year 1 3

923,500/3,566,000=25.90

923,500/0.926=997,300.22 49.87



Cost (VC)-year 2 4

923,500/0.857=1,077,596.27 53.88


Interestrate 6 18.64Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)



NetCF

0 (7,100,000.00)

1 (2,000,000.00) 6,500,000.00 4,500,000.00

2 (2,000,000.00) 6,500,000.00 4,500,000.00

Year DF 20%


PV of Variable Cost


0 1 (7,100,000.00) (7,100,000.00)

1 0.8333 (1,666,600.00) 5,416,450.00 3,749,850.00

2 0.6944 (1,388,800.00) 4,513,600.00 3,124,800.00

1.5277 (7,100,000.00) (3,055,400.00) 9,930,050.00 (225,350.00)Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)



NetCF

0 (7,100,000.00)

1 (2,000,000.00) 6,500,000.00 4,500,000.00

2 (2,000,000.00) 6,500,000.00 4,500,000.00

Year DF 20%


PV of Variable Cost


0 1 (7,100,000.00) (7,100,000.00)

1 0.8333 (1,666,600.00) 5,416,450.00 3,749,850.00



2 0.6944 (1,388,800.00) 4,513,600.00 3,124,800.00

1.5277 (7,100,000.00) (3,055,400.00) 9,930,050.00 (225,350.00)Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)

1023 is present value of a amount that will add value to the company if project isundertaken This is converted into future value - equivalent to first years' sale, that is 1023/0.926 1023 is converted to future value by dividing it by discount factor or 0.857 We calculate IRR Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%) 1023 is present value of a amount that will add value to the company if project is

undertaken This is converted into future value - equivalent to first years' sale, that is 1023/0.926 1023 is converted to future value by dividing it by discount factor or 0.857 We calculate IRR

IRR = a + [{A/(A-B)} x (b-a)}]% = 8 + [ {923,500/(1,148,850)} x 12} % = 8 + 9.65 = 17.65%

a = 8 b = 20.00 A = 923,500.00 B = 225,350.00 A+B = 1,148,850.00Conclusion Most sensitive area is Cash Inflows.

Less changes in cash inflow brings NPV down to Zero. Criticism ± Sensitivity Analysis

Change in the factors is considered in isolation, at one time effect of change inone variable.

Does not provide any decision rule. Probabilities are not considered in sensitive analysis.

PR OBABILITY ANALYSIS

Expected cash flow can be estimated by recognizing several outcomes are

possible Always equal to one Define two extremes Risk can be calculated by considering worst case Attaching probability is subjective matter

Example: Probability analysis



Year Cash Flow Probability ExpectedValue Period EV

0 (120,000.00) 0.40 (48,000.00)

(140,000.00) 0.50 (70,000.00)

(160,000.00) 0.10 (16,000.00) (134,000.00)

1 50,000.00 0.35 17,500.00

60,000.00 0.40 24,000.00

70,000.00 0.25 17,500.00 59,000.00

2 60,000.00 0.30 18,000.00

40,000.00 0.40 16,000.00

45,000.00 0.30 13,500.00 47,500.00

3 56,000.00 0.45 25,200.00

64,000.00 0.35 22,400.00

76,000.00 0.20 15,200.00 62,800.00

BREAK EVEN Accounting Break Even Economic Break Even BE is a point at which the company earns no profit or no loss Total Cost = Total Sale or Revenue Fixed Cost remain constant Higher the FC, higher the Break Even point or higher the Output level The project must operate right to break even point This is an accounting measure TC = FV + VC TR > TC Profit

TR < TC Loss

TC = Total Cost FC = Fix Cost VC = Variable Cost TR = Total RevenueExample: Accounting Break Even



Sale Price 15

Variable Cost / unit 8

Contribution Margin /unit 7

Initial Investment 100,000 OUTPU

T LEVEL FC VC TC=FC+ TC

TR=Qtyx SP CM PR OFIT

3000100,000.00

24,000.00

124,000.00

45,000.00

21,000.00

(79,000.00)

6000100,000.00

48,000.00

148,000.00

90,000.00

42,000.00

(58,000.00)

9000100,000.00

72,000.00

172,000.00

135,000.00

63,000.00

(37,000.00)

12000100,000.00

96,000.00

196,000.00

180,000.00

84,000.00

(16,000.00)

15000100,000.00

120,000.00

220,000.00

225,000.00

105,000.00 5,000.00

18000100,000.00

144,000.00

244,000.00

270,000.00

126,000.00 26,000.00

21000100,000.00

168,000.00

268,000.00

315,000.00

147,000.00 47,000.00

BE in Units = FC/CM= 100,000/7

= 14,285.71 or 14,286 units BE revenue = FC/CS ratioContribution margin over sale C/S ratio

= 7/15 = 0.47 or 47% of sale



BE revenue = FC/CS ratio= 100,000/0.47= 214,285.71 or 214,286

Targeted Profit We assume profit 250,000

We need to produce:Targeted output level = FC + Targeted Profit/CM=100,000+ 250,000/7= 50,000 units

Corporate finance lecture No. 13BREAK EVEN Accounting Break Even Economic Break EvenEconomic Break Even Vs Accounting Break Even Economic Break Even recovers cost of capital Accounting Break Even does not recover cost of capital.

BE is a point at which the company earns no profit or no loss Total Cost = Total Sale or Revenue Fixed Cost remain constant Higher the FC, higher the Break Even point or higher the Output level The project must operate right to break even point This is an accounting measureBREAK EVEN ANALYSIS TC = FV + VC TR = TC Break Even TR > TC Profit TR < TC Loss TC = Total Cost FC = Fix Cost VC = Variable Cost TR = Total Revenue



ECONOMIC BREAK EVEN

Accounting break even does not cover cost of capital. It means that accounting break even does not add value to the organization at break even point.

That¶s why companies often stress on value addition ± to find a level where the

project breaks even after returning the cost of capital along with fixed cost.

Example: Economic break even

Initial investment = Rs. 5.4 million Variable cost = 80% of sales Fixed cost = Rs. 2.00 million Project life = 12 years Cost of capital = 8% Tax rate = 40%

Solution: Break Even

Initial Investment 5,400,000.00

Variable Cost 80.00

Fixed Cost 2,000,000.00

Project life 12.00

Cost of Capital 0.08

Tax Rate 0.04Solution: Accounting Break Even

Fixed Cost 2,000,000.00

Initial Investment 5,400,000.00

Depreciation 5,400,000/12 = 450,000.00

Fixed Cost with Dep. 2,450,000.00CS Ratio 0.2 or 20% or sale

Ü Ü

Break Even 12,250,000.00 p.a.

Variable Cost 80% 9,800,000.00



Fixed Cost 2,000,000.00

Dep. 450,000.00

Profit -

Tax 40% - Fixed Cost = 2,450,000.00

Contribution Margin over sale Variable Cost 80% of sale so CS Ratio = 0.20 or 20% of sale

Economic Break EvenAnnual annuity of investment overproject life:

= initial investment =716,560.518% factor -12 years Ü

Annual depreciation:

= initial investment =450,000.00

Project life Ü

Depreciation reduces the CapitalCharge by

Cost of Capital =266,560.51

Economic Profit is:Accounting profit - 266,560.51 -

Pre tax Profit= (Sales x 0.20) -FC(2.45)

Tax= 0.40 x (Sales x 0.20)

- FC(2.45)

After tax (Accounting Profit)= 0.60 x (Sales x 0.20)

- FC(2.45)

Cost of Capital = 266,560.51

Economic value added=0.60 x [(Sales x 0.20) -(2.45)] - 266,560.51

Economic value added=0.60 x [(Sales x 0.20)

- (2.45)] - 266,560.51

Solve for sales=0.60 x [(Sales x 0.20)

- (2.45)] = 266,560.51



=0.12 x Sales =

1470000+266560.51=0.12 x Sales =

1736560.51Sales =

1736560.51/0.12Ü Sales = 14,471,337.58

Economic Break EvenCheck

Sales 14,471,337.58

CM Ratio0.2 or 20% of Sale

=2,894,267.52

Fixed Cost 2,450,000.00

Pre Tax Profit 444,267.52

Less Tax 0.40 177,707.00

Ü 266,560.51

Less Cost of Capital 266,560.51

Profit Nil O

perating Leverage

Leverage:

How efficiently a company utilizes fixed cost in its production process Degree of operating leverage ± DOL DOL= % Change in profit given a % change in sales Higher the FC, higher the DOL or High proportion of FC, a short fall in sales will lead to magnified effect on profits. OL = Degree to which costs are fixed

DO

L: Example HIGH FIXED COST HIGH VARIABLE COST < AVGBelowAVG

AVGNormal

>AVGAboveAVG

< AVGBelowAVG

AVGNormal

>AVGAboveAVG

SALES 12,000.0 15,000.0

18,000.0

12,000.0

15,000.0

18,000.0



0 0 0 0 0 0

VC 8,400.0010,500.00

12,600.00

10,200.00

12,750.00

15,300.00

FC 3,000.00 3,000.00 3,000.00 750.00 750.00 750.00

TC 11,400.00

13,500.00

15,600.00

10,950.00

13,500.00

16,050.00

PR OFITS 600.00 1,500.00 2,400.00 1,050.00 1,500.00 1,950.00

DOL = 1+FC/Profit DOL = 1+FC/Profit

= 1+ 3,000/1,500 = 1+ 750/1,500

DOL = 3 DOL = 1.5

DOL: Example

Change in Sale 1% results changein Profit 3%

Change in Sale 1% results changein Profit 1.5%

CHANGE INSALES 10%

SALES 16,500.00 16,500.00

VC 11,550.00 14,025.00

FC 3,000.00 750.00

PR OFITS 1,950.00 1,725.00% Change inProfit 30 15.00

IT MEANS THAT 10% INCREASE IN SALES RESULTS IN30% INCREASE IN PROFIT



Change in Sale 1% results changein Profit 3%

Change in Sale 1% results changein Profit 1.5%

CHANGE INSALES 10%

SALES 16,500.00 16,500.00

VC 11,550.00 14,025.00

FC 3,000.00 750.00

PR OFITS 1,950.00 1,725.00

% Change inProfit 30 15.00

IT MEANS THAT 10% INCREASE IN SALES RESULTS IN30% INCREASE IN PROFIT

TOTAL INVESTMENT 45,000.00

CONTRIBUTION MARGIN 2.70

Qty 20,000.00

Fixed Cost 45,000.00

TOTAL CONTRIBUTION MARGIN 54,000.00

PROFIT 9,000.00

DOL 6 DOL = 1+FC/Profit = 1+ 45,000/9,000 DOL = 6

A change in sale of 1% will lead change in Profit of 6%.

IF QUANTITY IS INCREASED BY 5%



Qty 21,000.00

TOTAL CM 56,700.00

PROFIT 11,700.00

CHANGE IN PROFIT 2,700.00

% CHANGE IN PROFIT 30

PUTTING THE OTHER WAY

30PR OJECT RANKING & CAPITAL RATIONINGCAPITAL RATIONING When a firm has limited availability of Investment Funds or the Investment Funds are in

scarcity. How we can use those available funds effectively and efficiently.

Definitions Independent Project: A project whose acceptance or rejection does not prevent

the acceptance of other projects under consideration. Dependent Project: Whose acceptance or rejection is based on the acceptance or

rejection of one or more other project being considered. Mutually exclusive Project: A project whose acceptance will lead to rejection

the other project (s). At a given time only one project can be undertaken.Capital Rationing A situation where a company has scarcity of funds to invest in potential opportunities andthese opportunities are compared with one another in order to allocate resources mosteffectively and efficiently.

In other words:If a company is confronted with the situation of capital rationing then it means that projects even having positive NPV would not be undertaken by the company.

Types of Capital Rationing SOFT RATIONING:

Arises due to internal factors HARD RATIONING:

Arises due to external factors

SOFT RATIONING Arises due to internal factors

Management is reluctant to issue new share because of the fear of outsider takingcontrol of company.

Dilution of EPS Increased interest payments in case of debt financing



Company¶s will to maintain limited investment level that can be financed thruretained earnings.

HARD RATIONING Arises due to external factors

- If share prices are depressed or market is bearish, raising capital is very difficult.- Restriction on lending by Banks.- High interest rate- High cost associated with issuance of share / debt instrument.

Corporate finance lecture No. 14CAPITAL RATIONING

A situation where a company has scarcity of funds to invest in potential opportunitiesand these opportunities are compared with one another in order to allocate resources mosteffectively and efficiently.

Types of Capital Rationing SOFT RATIONING:

Arises due to internal factors HARD RATIONING:

Arises due to external factors

SOFT RATIONING Arises due to internal factors

Management is reluctant to issue new share because of the fear of outsider takingcontrol of company.

Dilution of EPS Increased interest payments in case of debt financing Company¶s will to maintain limited investment level that can be financed thru

retained earnings.

HARD RATIONING Arises due to external factors

- If share prices are depressed or market is bearish, raising capital is very difficult.- Restriction on lending by Banks.



- High interest rate- High cost associated with issuance of share / debt instrument.

CAPITAL RATIONINGTwo situations

Current or Single Period CR Multiple Period CR Current or Single Period CR Single Period CR:

This means that shortage of capital is only for current period, and there is no suchscarcity of funds in the following period. Multiple Period CR: Sacristy of funds more than one period.Capital Rationing

Criticism: Normally projects are not divisible.

If the case above, then project selection will be on absolute NPV. Strategic values of each project are ignored PI ignores the size of project. Projects may have different cash flow pattern.

Profitability Index Profitability Index is a relationship between present value of all future cash flows and

initial investment. Decision Rule PI > 1 Undertake the project.Single Period CR Assumptions:

- Projects cannot be deferred or postponed. If a project is not undertaken, the opportunity islost.

- Complete certainty about each project.- Projects are divisible ± say 60% of project A and 40% of project B can be undertaken.

RANKING OF PR OJECTS:

- Ranking projects in terms of NPV leads to selection of heavy or large projects. We can usePI with NPV for ranking projects.

Single Period Capital Rationing

PR OJECTS

INITIAL INVESTMENT

PV OF CASH FLOW

NPV PI RANKING NPV

RANKING PI



A (10,000.00)13,000.00

3,000.00

1.30 3.00 1.00

B (15,000.00)

16,200.0

0

1,200.0

0

1.0

8 5.00 5.00

C (20,000.00)22,900.00

2,900.00

1.15 4.00 3.00

D (28,000.00)34,500.00

6,500.00

1.23 1.00 2.00

E (40,000.00)45,000.00

5,000.00

1.13 2.00 4.00

Single Period Capital Rationing

Assumptions: - Capital Available (70,000.00) - Projects are divisible

Project Selection based on NPV

PR OJECTS

INITIAL INVESTMENT

PVOF CASH FLOW

NPV PI RANKING NPV

RANKING PI

D (28,000.00)6,500.00 1.00

Ü

E (40,000.00)5,000.00 2.00

Ü

A (2,000.00) 600.000.20 3.00

Ü

TOTAL NPV (70,000.00)

12,100.00

Ü

Project Selection based on PI

PR OJECTS

INITIAL INVESTMENT

PVOF CASH FLO

NPV PI RANKING NPV

RANKING PI



W

A (10,000.00)3,000.00 1.00

Ü

D (28,000.00)6,500.00 2.00

Ü

C (20,000.00)2,900.00 3.00

Ü

E (12,000.00)1,500.00

0.30 4.00

Ü

(70,000.00)13,900.00

Ü

Multi-period Capital Rationing When capital availability is in short supply in more than one period, then we can

not rank projects by profitability index.

When capital availability is in short supply in more than one period, then we cannot rank projects by profitability index.

We use linear programming technique. Under this we assume only two variables ± using graphical method. For more than two variables, we use simplex method, which is beyond the course

of our outline.

Example: Multi-period Capital Rationing

PERIOD 1 PERIOD 2 PERIOD 3

PR OJECT PV OF OUTFLOW

PV OF OUTFLOW

PV OF OUTFLOW

NPV

Rs. µ000¶ Rs. µ000¶ Rs. µ000¶Rs.µ000¶



X 30 10 10 50

Y 20 6 4 10

Capital Investment -Availability

PERIOD 1 36

PERIOD 2 10

PERIOD 3 8

Projects are divisibleSolution: Multi-period Capital Rationing Let x = Portion of project X Let y = Portion of project Y Establishing Constraints

PERIOD 1 =30x+Y20<=36 PERIOD 2 =10x + 6y<=10 PERIOD 3 =10x + 4y<= 8

Where: x & y <= 1 Means that portion of project is less than one or equal to one

x & y >= 0 Portion of project must be greater than equal to 0

Objective Function:

Maximize 50x + 10y

x y

1.20 1.80

1.00 1.67



0.80 2.00 Limitation of LP Projects are not divisible

Ignores the relative size of the Investment Assumes variables have linear relation Uncertainty is ignored Constraints are independent

RISK VS UNCERTAINTY RISK : Refers to a situation having several possible outcomes, and we can assign Probabilities to outcomes based on our past experience.

UNCER

T

AINIT

Y: Refers to a situation where Probability of a outcome cannot be assigned.

Corporate finance lecture No. 15Expected Return or Returns

RISK & RETURN Measuring Returns:Two components of Gains:

Capital Gains ± Price AppreciationIncome ± Dividends

Total Gain = Capital Gains + Dividends

Return = Total Gains / Initial Investment

RISK VS UNCERTAINTY RISK : Refers to a situation having several possible outcomes, and we can assign Probabilities to outcomes based on our past experience.

UNCER TAINITY: Refers to a situation where Probability of a outcome cannot be assigned.

Two Phases: Past Performance



Expected or Future ReturnsMeasuring Risk ± Past Performance In investing business you need to measure how far the return may be from the average. Return volatility or variability can be measured with variance. Statistical Tools:

Variance Standard Deviation

Variance is the average value of squared deviations from the average or mean.

Standard Deviation is also used for measuring return variations.

Individual Stock Variance Over Time Investment X

Year Actual Return

AVG Return Deviations

Squared Deviations

1 0.1 0.0825 0.0175 0.0003063

2 0.15 0.0825 0.0675 0.0045563

3 0.02 0.0825 -0.0625 0.0039063

4 0.06 0.0825 -0.0225 0.0005063

Total 0.33 0 0.009275Individual Stock Variance Over Time Var. = Sq. Deviation/(n-1) = 0.009275/4 -1 = 0.003092

Var. = 0.003092 SD = 0.0556 or 5.56%Market Variance ± Past Performance

Year Return % Deviations

Squared

Deviations

2000 18.56 (0.43) 0.18

2001 27.98 8.99 80.82

2002 19.40 0.41 0.17

2003 24.00 5.01 25.10



2004 10.00 (8.99) 80.82

2005 14.00 (4.99) 24.90

113.94 211.99

AVG Return 18.99 Var. = Sq. Deviation/(n-1) = 211.99/6-1 Var. = 42.40 SD = 6.51%

RISK SYSTEMATIC Economy-wide sources of Risk that effects all the stocks being traded in market.

systematic risk influences large number of assets and is also known as market risk. UNSYSTEMATIC It affects only specific assets or a firm. it is also known as Diversifiable or Unique or

Asset- specific Risk. DIVERSIFICATION Splitting investment across number of assets having different level of Risk is known as

Diversification. UNSYSTEMATIC OR UNIQUE RISK: It can be eliminated by Diversification therefore, a Portfolio with many assets has almost

zero Unsystematic Risk.

PORTFOLIO & DIVERSIFICATIONPOR TFOLIO: A group of assets in which investor has investment. A combination of securities of investment.

POR TFOLIO variability does not equal to the average variation of its underlyingcomponents. Why?

Diversification reduces variability.

DIVERSIFICATION: A course of investment in which risk is reduced by spreading theinvestment across different securities.

VARIANCE & FUTURE RETURN We can observe that how the expected return from an investment will vary by attaching

probability to each outcome. We can observe that how the expected return from an investment will vary by attaching

probability to each outcome. Example:

Assuming two stocks A & B. Stock A is expected to yield 35% return and stock B - 25%in the same period under Boom. However, stock A will have -10% & B - 8% return under recession.

Further assuming that we can foresee or predict two economic states: Boom & RecessionFinally, we expect that there are 50% chances of each State of Economy i.e., Boom &

Recession.



Solution: Expected Return Variance

State of Economy (SOE)

Probability(SOE)

Stock A Stock B

Expected

Return if SOEoccurs

Expected Value of Return

Expected

Return if SOEoccurs


BOOM 0.5 0.35 0.175 0.25 0.125

RECESSION 0.5 -0.1 -0.05 0.08 0.04

InvestmentLevel 0.4 0.6

Solution: Expected Return Variance Expected Return-A = 0.50 x 35% + 0.50 x -10% = 0.125 or 12.50 Expected Return ± B = 0.50 x 25% + 0.50 x 8% = 0.165 or 16.50

A B Total Portfolio Return 5.00 9.90 14.90DIVERSIFICATION

DIVERSIFICATION works because prices of securities underlying a portfolio do notchange with same rate.

Putting the other way, the change in Prices are less than perfectly correlated.

Diversification returns much better results when returns from Portfolio securities arenegatively correlated.

Portfolio Expected Return Variance & SD

State of Economy

Probability (SOE)

Return if StateOccurred

Portf olio

ER undereachSOE

Deviations fromER

Deviations Squared

Weigh

ted SquaredDeviations =Variance

SD

Stock X

Stock Y

Stock Z

(SOE)

1 2 3 4 5 6 7 8



(7 X 1)

BOOM 0.4 11 16 19 14.50 5.6131.4721

12.58884

RECESSION 0.6 7 5 2 5.15 (3.74) 13.9876 8.39256

20.9814

4.58

InvestmentLevel

0.45

0.30

0.25

Equally weighted portfolio Portfolio Expected Return Variance & SD

Expected Return %

Stock X 8.60

Stock Y 9.40

Stock Z 8.80

Expected Return (ER) of Portfolio 8.89

Corporate finance lecture No. 16RISK

RISK : Refers to a situation having several possible outcomes, and we can assign Probabilities to outcomes based on our past experience.

PORTFOLIO & DIVERSIFICATION

POR TFOLIO: A group of assets in which investor has investment. A combination of securities of investment.

POR TFOLIO variability does not equal to the average variation of its underlyingcomponents. Why?

Diversification reduces variability.



DIVERSIFICATION: A course of investment in which risk is reduced by spreading theinvestment across different securities

DIVERSIFICATION works because prices of securities underlying a portfolio do notchange with same rate.

Putting the other way, the change in Prices are less than perfectly correlated.

Diversification returns much better results when returns from Portfolio securities arenegatively correlated.


State of Economy

Probability (SOE)

Return if State Occurred Portfolio ER undereachSOE

Deviations fromER

Deviations Squared

Stock X

Stock Y

Stock Z

(SOE) 1 2 3 4 5 6 7

BOOM 0.4 11 16 19 14.50 5.61 31.4721 RECESSION 0.6 7 5 2 5.15 (3.74) 13.9876

Investmen

t Level 0.45 0.30 0.25


Expected Return %

Stock X 8.60

Stock Y 9.40

Stock Z 8.80

Expected Return (ER) of Portfolio 8.89RISK SYSTEMATIC



Economy-wide sources of Risk that effects all the stocks being traded in market.systematic risk influences large number of assets and is also known as market risk.

UNSYSTEMATIC It affects only specific assets or a firm. it is also known as Diversifiable or Unique or

Asset- specific Risk.

DIVERSIF

ICAT

IO

N Splitting investment across number of assets having different level of Risk is known asDiversification.

UNSYSTEMATIC OR UNIQUE RISK: It can be eliminated by Diversification therefore, a Portfolio with many assets has almost

zero Unsystematic Risk.

BETA Systematic Risk is measured by Beta Coefficient or Beta.

Beta measure the systematic risk inherent in an asset relative to the market as whole.

DIVERSIFICATION - PORTFOLIO SELECTION

State of Economy(SOE)

STOCK T STOCK W

Rate of Return

Deviationfrom ER

SquaredDeviation

Rate of Return

Deviationfrom ER

SquaredDeviation

Boom 18.00 13.00 169.00 (20.00) (21.00) 441.00Recessio

n (8.00) (13.00) 169.00 20.00 19.00 361.00

Normal 5.00 - - 3.00 2.00 4.00

ExpectedReturns(ER) 5.00 1.00

VarianceAVG SquaredDeviation 112.67 268.67StandardDeviation 10.61 16.39

Probability of

Return %

Portfolio

Portfolio

Portfolio

Stock T

Stock W



SOE Returns

Deviations

DeviationsSquare

Boom 0.33

18.0

0

(20.0

0) 8.50 4.50 20.25

Recession 0.33

(8.00) 20.00 (1.00) (5.00) 25

Normal 0.33 5.00 3.00 4.50 0.50 0.25

45.5Investment Level 0.75 0.25Expecte

dReturns 5.00 1.00 4.00

Variance 112.67

268.67 15.015

StandardDeviation 3.87Portfolio Beta

Stock Investment Investment weight ExpectedReturn Beta Portfolio ER Portfolio BETA

G 2,000.00 0.14 6.00 0.70 0.86 0.1

H 4,000.00 0.29 11.00 1.20 3.14 0.3428571

I 3,000.00 0.21 8.00 0.90 1.71 0.1928571

J 5,000.00 0.36 12.00 1.40 4.29 0.5

14,000.00 10.00 1.1357143 VARIANCE & FUTURE RETURN Example:

Assuming two stocks A & B. Stock A is expected to yield 35% return and stock B - 25%in the same period under Boom. However, stock A will have -10% & B - 8% return under recession.

Further assuming that we can foresee or predict two economic states: Boom & Recession



Finally, we expect that there are 50% chances of each State of Economy i.e., Boom &Recession.

Solution: Individual Stock Expected Return Variation

State of EconomySOE)

Probability(SOE)

Stock A Stock B

ExpectedReturn if SOEoccurs


Deviation Squared Deviation

Variance ExpectedReturn if SOEoccurs

BOOM 0.5 0.35 0.175 0.225 0.050625 0.0253125 0.25

RECESSION 0.5 -0.1 -0.05 -0.225 0.050625 0.0253125 0.08

0.25 0.050625 0.33AVGRETURN 0.125 0.165

StandardDeviation 0.225

22.50CONCLUSION Investors care about the Expected Return and Risk of their Portfolio Assets. Overall Risk

of Portfolio is measured by Standard Deviation.

Standard Deviation of individual stock measure how risky it would be if held in Isolation.But an investor is interested how individual stock would effect the whole Portfolio.

AVERAGE BETA Average Beta is equal to 1.

If any stock has a Beta of 0.50 it means that the stock carries half of Market Risk.

A Beta of 2 is considered to have twice of Market Risk.

AGGRESSIVE STOCKS Aggressive stocks have high Beta.

Greater than 1 Beta.DEFENSIVE STOCKS Aggressive stocks have low Beta.

Less than 1 Beta.AGGRESSIVE AND DEFENSIVE STOCKS Aggressive Stocks have high betas, greater than 1, meaning that their return is more than

one-to-one to changes in return of overall market.

Defensive stock are less volatile to change in market return and have beta of less than oneSECURITY MARKET LINE



HOW RISK IS REWARDED IN MARKET?Assumptions Capital Market is fraction-less or no additional cost, no charges etc. Relevant information available to all participants i.e. homogenous expectations.

No participant is large or influence the prices of securities.

Firms have fixed Capital Budgeting Program or Capital Structure.

Assumptions Capital Market is fraction-less or no additional cost, no charges etc. Relevant information available to all participants i.e. homogenous expectations.

No participant is large or influence the prices of securities.

Firms have fixed Capital Budgeting Program or Capital Structure.

EXAMPLE A Portfolio consists of two assets: A and B. Asset B is risk free. Stock a ³ER´ is

18% and beta of 1.50. Risk free rate is 8%. Investment in stock A is 25%

SECURITY MARKET LINE

SECURITY ER BETA INVESTMENT % PO

R TFO

LIO

150%

INVESTMENT A

ER BETA ER BETA

A 18 1.5 0.25 4.5 0.375 27 2.25 B - RISK FREE 8 0 0.75 6 0 4 0

10.5 0.375 23 2.25 A RISK FREESECURITY HASBETA OF ZER O

SECURITY MARKET LINE ASSUME: Investment in a is increased to 150%. This means there will be 50% reduction in Risk Free Investment.



What happened when we invested 150% in Risky Investment A. Our Portfolio's ER Rate increased to 23% from 10.50%. Portfolio's Beta jumped to 2.25 from 0.375.

Now we can see the various investment combinations of.

Stock 'A' and Risk Free 'Bµ.

Corporate finance lecture No. 17SECURITY MARKET LINE HOW RISK IS REWARDED IN MARKET:EXAMPLE

A Portfolio consists of two assets: A and B. Asset B is risk free. Stock a ³ER´ is18% and beta of 1.50. Risk free rate is 8%. Investment in stock A is 25%

CHANGE IN INVESTMENT OF A SECURITY IN PORTFOLIOPart A



% OF POR TFOLIO INVESTMENT IN STOCK A

POR TFOLIO ER

POR TFOLIO BETA

CURVESLOPE

8

0 8.00 - -

25 10.50 0.3750 6.67

50 13.00 0.7500 6.67

75 15.50 1.1250 6.67

100 18.00 1.5000 6.67

125 20.50 1.8750 6.67

150 23.00 2.2500 6.67 Reward to Risk = ( ER a - ER rf )/Beta a

= 0.066666667 or = 6.67

A R F

0 100 0.18 1.5

25 75 0.08 0

50 50

75 25

100 0

125 -25

150 -50SECURITY MARKET LINEPortfolio Expected Return



SLOPE OF STRAIGHT LINE ERa - Rf

Beta

AT investment of 75 % , the slope is = 15.50 ± 8 / 1.13 = 6.67 At every investment in stock A, the slope of line returns the same value. ERa ± Rf is the Risk Premium on stock A6.67 is reward to risk ratio. Stock A contains risk premium of 6.67 % per unit of systematic risk.CHANGE IN INVESTMENT OF A SECURITY IN PORTFOLIOPart B

% OF POR TFOLIO INVESTMENT IN STOCK A

POR TFOLIO ER

POR TFOLIO BETA

CURVESLOPE

8

0 8.00 - -

ERa

Portfolio Beta

X

Y

Portfolio Expected Return

Rf=8%

0

18%

1.50

Investment in A

ERa ± Rf/ Beta

Slope = 6.67



25 9.50 0.28 5.45

50 11.00 0.55 5.45

75 12.50 0.83 5.45

100 14.00 1.10 5.45

125 15.50 1.38 5.45

150 17.00 1.65 5.45CHANGE IN INVESTMENT OF A SECURITY IN PORTFOLIO Reward to Risk = ( ER a - ER rf )/Beta a

= 0.0545 or = 5.45

A R F

0 100 0.14 1.1

25 75 0.08 0

50 50

75 25

100 0

125 -25150 -50



CONCLUSION THE REWARD TO RISK RATION MUST BE THE SAME FOR ALL THE

STOCKS IN THE MARKET.

FUNDAMENTAL OUTCOME Since stock A is offering better Reward-to-Risk Ratio as compared to stock B, the

situation will not persist in a well established market. Investors will rush to stock A & stock B will not be traded much. This situation will push stock A¶s price up and the expected return of stock will reduce. On the other side, with less attractions, stock B¶s price will fall increasing the ER and this

will bring the both stocks on the same line. That means both stocks will offer the same reward for bearing risk. When both stock offer same reward to risk, we can state as under: ERA - Rf / beta A = ERB - Rf / beta B

ERa

Portfolio Beta

X

Y

Portfolio Expected Return

Rf=8%

0

14%

1.10

Investment in B

Slope= 5.45




Because all the assets being traded in mar¥

et¦ ff er

same § eward t ¦ § isk § ati ¦ and theref ¦ re, must lie ¦ nthe same line.

In ab¦ v e chart, if a st

¦ ck is ab

¦ v e the line at p

¦ int

̈

f ¦ r st

¦ ck ¶

̈ ·, its price w ill rise due t

¦ increased

demand and the ER w ill f all. ©

his w ill continue till itfinds it place on the market line.

If any stock like D in the abo v e chart is being below to the line, its price w ill decrease until its ER is the same as all of the stocks being traded in market.


ER

Portfolio Beta

X

Y

Stock Expected Return

Rf

0

ER-A

b- A

ERa ± Rf/ Beta

b - B

ER - B

b - C

ER-C

b - D

C

D



SECURITY MARKET LINE POSITIVELY SLOPPED LINE REVEALING THE RELATIONSHIP OF

ER AND BETA.

CAPITAL ASSETS PRICING MODEL

Assuming thatP

ortfolio is made up of all the stocks in the market, known as MarketPortfolio. As just seen, all assets in market must lie on SML and Beta of this Portfolio must be

equal to 1 or average. Slope of Security Market Line should be:

=ERm ± Rf = ERm ± Rf = ERm ± Rf Beta m 1

ERm - Rf ± is called Market Risk Premium.

If ERi and Betai represent Expected Return and Beta of ³Any´ asset in marketthen:

ERi ± Rf = ERm ± Rf beta i

³Any´ asset must also lie on SML. Re-arranging the above equation: ERi = Rf + {ERm ± Rf} x Beta I

This is known as Capital Asset Pricing Model (CAPM) Equation.WHAT CAPM TELLS US

Time value of money: Risk Free Rate ³Rf´ is a rate when you don¶t take risk. It is just

waiting for money.

Reward for Risk: The equation ³ERm ± Rf´ presents reward for taking average

systematic risk in addition to waiting.

Systematic Risk: It is measured by Beta. this measure the systematic risk present in an assets

or Portfolio, relative to average asset. Time value of money:

Risk Free Rate ³Rf´ is a rate when you don¶t take risk. It is justwaiting for money.

Reward for Risk: The equation ³ERm ± Rf´ presents reward for taking average

systematic risk in addition to waiting.



Systematic Risk: It is measured by Beta. this measure the systematic risk present in an assets

or Portfolio, relative to average asset. DETERMINING THE SECURITY VALUE

EITHER THE SECURITY IS OVER OR UNDER VALUED

EXAMPLE: RISK & RETURN

RISK FREERATE 4.00

ER on Stock µA¶ at B =1.3

ER on Stock µA¶ at B =2.6

MARKET RISK PREMIUM 8.60 Ü Ü

STOCK "A"BETA 1.30 15.18 26.36

Erm 12.60 Ü

REQUIRED:

-ER ON STOCK "A" ?

-ER ON STOCK "A" IF BETA GOES DOUBLE?

ERi = Rf + {ERm ± Rf} x Beta I

= 4 + (8.6 x 1.3)

= 15.18 Under/Over Valued Stocks

STOCK ER BETA

Risk to Reward Ratio

ABC 15 1.5 5.33

XYZ 11 0.9 4.44

Risk Free Rate 7

SLOPE OF SML:

ERa ± Rf/ Beta

ABC 5.33

XYZ 4.44



Under/Over Valued Stocks We can interpret that stock XYZ offers an insufficient Expected Returns for the level of

risk relative to ABC. Its ER is low and price is high and this is a overvalued stock relative to ABC. We can also state that ABC is undervalued stock.

RECAP Total Risk of an investment is measured by Standard Deviation or Variance.

Total Return has two components ± expected and unexpected.

Systematic Risk: Systematic risks are unanticipated that effects all the assets to some degree. It is

non-diversifiable.

Unsystematic Risk or Unique Risk: It affects only specific assets or a firm. it is also known as Diversifiable or Unique

or Asset- specific Risk. It can be eliminated by Diversification therefore, aPortfolio with many assets has almost zero Unsystematic Risk. Diversification:

A course of investment in which risk is reduced by spreading the investmentacross different securities.

BETA ± Measure of Systematic Risk: Reward for bearing risk depends only on the level of systematic risk, which is

measured by Beta. Security Market Line:

Reward to risk ratio for all assets will be same and all assets ER will lie on sameline.

CAPITAL ASSETS PRICING MODEL CAPM has three main points: Pure Time Value Market Risk Premium Beta of Asset




COST OF CAPITAL & CAPITAL STRUCTURE Cost of capital is sum of cost of following items:

Equity Debt ± loans and debts instruments

Equity Compliance of SECP and Companies Ordinance 1984 IPO¶s in Primary Markets Prospectus in case of Listed Companies Underwriting

ISSUING SHARES TO PUBLIC, PRIVATE PLACEMENT Company must be listed on Stock Exchange Must be registered with Security & Exchange Commission of Pakistan ± SECP Company issues Prospectus Underwriting the share issue:

Underwriter refers to a firm that act as intermediary between a company issuingshares and the public.

Underwriter normally perform following services Devising method for issuing shares Setting the price of new shares Marketing / selling of securities

ISSUING SHARES TO PUBLIC, PRIVATE PLACEMENT Underwriters may buy securities for less than the price set by the company and

then selling them to public. If any amount of shares not subscribed by the publicthen underwriter takes up the under-subscribed shares.

Often Underwriter forms a group to share the risk, known as Syndicate.COST OF CAPITAL & CAPITAL STRUCTURE

Equity: How to calculate the cost of equity?

Dividend growth model Security Market Line SML

SOURCES OF FUNDS RAISING Debt Financing Leasing Preferred Stocks or Shares

DIVIDEND GROWHT MODEL



P0 = D0 x (1 x g) / RE ± gThis can be state as:

P0 = D1 / RE ± gWhere:

P0 = Price in current period

RE = Required return on stock D0 = Dividend in P0D1 = Dividend to be after one year g = Growth rate

We can re-arrange this equation to solve for RE:

RE = D1 / P0 + g

RE is the return that shareholders require on the stock or it is the Cost of Equity of the

firm.

Three things needed to calculate RE Dividend Price of Current Period Growth Rate

EXAMPLE No-one limited paid last dividend of Rs. 5 per share. Current market value of its share is

Rs.50 per share and company expect a constant growth in dividend of 6% per annum.Calculate Return on Equity.

SINCE MARKET VALUE AND DIVIDEND VALUES CAN BE DETERMINED OR NORMALLY ACTUAL FIGURES ARE AVAILABLE. BUT PROBLEMS ARE WITHESTIMATING GROWTH (g).

WE CAN USE AVERAGE GROWTH OR USE STATISTICAL TECHNIQUES TOESTIMATE g.

LET SEE BOTH OF THESE METHODS OF ESTIMATING g.Solution: Dividend Growth Model

D0 5 per share

D1 = D0 x ( 1 + g ) 5.3

Re = D1 / Po + g

D1= 5.3

Po= 50



Re = 0.166 16.6 Dividend and price can be observed directly, but Growth g must beestimated.

For estimating g:We can use average of dividend as dividend growth over a period of time.

OR

Can estimated using statistical techniques.Cost of Equity

YEAR DIV (Rs) Variation Rs % Change

2000 1.20 - -

2001 1.50 0.30 25.00

2002 1.40 (0.10) (6.67)

2003 1.60 0.20 14.29

2004 1.90 0.30 18.75

2005 1.80 (0.10) (5.26)

2006 2.00 0.20 11.11

8.17

Cost of Equity- Estimated Growth Rate Dividend Growth Rate

YEAR DIV = y x xy x2

2000 9.4 0 0 0

2001 11.2 1 11.2 1

2002 9.01 2 18.02 4

2003 12.56 3 37.68 9

2004 10.5 4 42 16

2005 7.45 5 37.25 25

2006 11.34 6 68.04 36

Total 71.46 21 214.19 91

2007 10.1746



Regression Equation:y = a + b (x)

=10.17464

b = n (Exy) ± ExEy / n Ex2 - (Ex)2= -0.0067857

n = 7

a = Ey /n ± bEx / n=

10.23MERITS & DEMERITS OF DIVIDEND GROWHT MODEL- Simple to understand.- Easy to calculate.- Only used for companies who pay dividend, so not useable for other companies who do

not pay dividends.- Assumption of constant growth is unrealistic.- Does not consider risk.

- Simple to understand.- Easy to calculate.- Only used for companies who pay dividend, so not useable for other companies who do

not pay dividends.- Assumption of constant growth is unrealistic.- Does not consider risk.

SECURITY MARKET LINE METHOD OF CALCULATING COST OF EQUITY SML tells us three things:

Risk Free Rate = Rf Market Risk Premium = ERM - Rf Systematic Risk Measurement Unit = BETA

SML: ER = Rf + B x (ERM ± Rf) Let e stands for Equity

RE = Rf + BE x (RM ± Rf)SML ± COST OF EQUITY EXAMPLE: Share of M/s Risky Limited has a beta of 1.2 and Risk Free Rate is 5%. Market Risk

Premium is 8%. Last dividend paid was Rs.3 per share and growth in dividend isexpected to be 7%. The current stock price in market is Rs. 50. Work out the cost of equity using dividend model and security market line method.

We can find out cost of equity using SML and Dividend Model.



SECURITY MARKET LINE ± COST OF EQUITY RE = Rf + BE x (RM ± Rf)

Putting values:RE = 5% + (1.2 x 8%) = 14.6%

DIVIDEND GR O

WTH

MO

DEL

RE = D1 / P0 + gD1 = 3 x 1.07 = 3.21

RE = (3.21 / 50) + .07= 13.42%

MERITS & DEMERITS ± SML It explicitly adjust for Risk Applicable in situations where no steady Dividend Growth is observed. Estimation of Market Risk Premium and Beta if turn out poor then result will be

inaccurate.

Past data is used to predict future. COST OF DEBT Three items an e classified under Debt

1. PREFERRED SHARES2. DEBT INSTRUMENTS ± BONDS3. LOANS & LEASES

1. PREFERRED STOCK:As we know that Preferred Stocks carry fixed dividend every period. There¶s no variation

in dividend level. This means that dividend from Preferred Stock is essentially Perpetuity. Cost of Preferred Stock can be calculated from the following:

R P = D / P0

For example if the dividend is Rs. 3.50/- per share and Current Market Price is Rs.40/-,then the Rp will be:

R P = 3.50 / 40 = 8.75%

LONG TERM CAPITAL STRUCTURE Ways to raise Capital:

VENTURE CAPITAL ISSUING SHARE TO PUBLIC ± IPOs SUBSEQUENT ISSUE OF SHARE ± RIGHT ISSUE PRIVATE PLACEMENT OF SHARES BANK LOANS DEBT INSTRUMENTS



LEASESISSUING SHARES TO PUBLIC, PRIVATE PLACEMENT

Underwriters may buy securities for less than the price set by the company andthen selling them to public. If any amount of shares not subscribed by the publicthen underwriter takes up the under-subscribed shares.

Often Underwriter forms a group to share the risk, known as Syndicate.




Venture CapitalIndividual or Firms who lend their money and services to others in return for profit or stakein the business.

Limited Market Introduction market: It works on personal contacts. Expertise Raise funds on their own behalf. Venture Capitalist must be financially strong. Exit strategy must be finalized. It is a debt instrument that is issued by the company to raise its capital.

Maturity Period Fixed amount of Interest

COST OF DEBT ± BONDS A company may have several outstanding Bond issue at a point of time with varying

terms like Coupon Rate, Face Value, Term etc. Market value and Book value of issue may be different. How can we come to a single cost figure?

Do we use book or market values to work out cost of debt? We need to calculate the weighted average of cost of debt. Share of each issue from total

debt capital is multiplied by yield to maturity of each issue.LOANS Term loans are less complicated issue of raising capital. Banks require collateral or security for granting loans. Interest is negotiated and banks also have some charges or fee.

LEASES Normally more expensive than loans. Collateral other than assets being leases is not required.EXAMPLE ± WEIGHTED AVERAGE COST OF DEBT

ISSUE Book Value

%of BV

MV of Bonds

%of MV

YTM

WeightedAverage

BV MV

D 500.00 0.33 501.50 0.35 6.24 2.09 2.18

F 496.00 0.33 440.50 0.31 8.36 2.78 2.56

R 200.00 0.13 206.90 0.14 7.31 0.98 1.05



T 297.00 0.20 287.40 0.20 7.90 1.57 1.58

1,493.00 1,436.30 7.42 7.37

Tax Tax is an outflow. It is an expense charge on Profit or Income. Interest is a tax deductible expense.

AFTER TAX COST OF DEBT Since interest paid to investors on bonds and on loans is tax deductible, therefore

we need to work out after tax cost of debt.

Suppose we borrow Rs 100,000/- at 8% Interest. Tax rate is 40%. What is after tax Cost of Debt?

Total interest for a year will be Rs 8,000/- and this is tax deductible. This willreduce the tax liability of company by:

8,000 x .40 = 3,200/- After tax cost of debt will be: 8,000 ± 3,200 = 4,800 or 4,800/100,000 = 4.8% We can work out 4.80% in a different fashion. Interest rate 8% x (1 - 0.4) = 4.80%

LOANS AND LEASE A company may have obtained different loans at different interest rates. Like debt instruments we need to find out the weighted average rate of loan.

Secondly, we are interested in after tax cost of loans (Weighted Average).

Now we can calculate the Weighted Average Cost Of Capital (WACC). Weighted Average Cost Of Capital (WACC)Weighted Average Cost Of Capital (WACC)

SHARES O/S

1 COMMON STOCK 1,000,000.002 BOND ISSUES:

Issue # 721

Issue # 722



Issue # 723

Issue # 724

3 PREFERRED STOCK 100,000.00

Ü Ü

4 LOANS - Term Loan 1 - Term Loan 2 - Term Loan 3

- Term Loan 4

TAX RATE LAST YEAR's DIVIDEND GR OWTH RATE - DIVIDEND

PAR VALUE PER SHARE MARKET VALUE /SHARE

Required: Calculate the Weighted Average Cost of Capital (WACC)

SHARES O/S BV

COMMON STOCK 1,000,000.00 10,000,000.00

BOND ISSUES:

Issue # 721 4,000,000.00

Issue # 722 3,500,000.00

Issue # 723 3,000,000.00

Issue # 724 2,600,000.00

13,100,000.00



PREFERRED STOCK 100,000.00 2,500,000.00LOANS

- Term Loan 1 1,200,000.00

- Term Loan 2 2,000,000.00

- Term Loan 3 1,500,000.00

- Term Loan 4 2,500,000.00

7,200,000.00TOTALCAPITALIZATION Ü 32,800,000.00

OTHER INFORMATION

TAX RATE 40%

LAST YEAR's DIVIDEND PER SHARE 1.5

GR OWTH RATE - DIVIDEND 0.0

PAR VALUE PER SHARE 10

MARKET VALUE /SHARE 15

PREFERRED STOCK 25

DIVIDEND ON PREFERRED STOCK 3

Cost of Component

Weight ageOf IndividualComponentsBV

Weight ageOf Individual ComponentsMV

WACCBV

WACCMV

Re = Di / Po+ g 17.09Di = 1.57 x

1.06 1.66COST OF EQUITY 17.09 0.30 0.39 5.21 6.73

2.34



1.83

1.73

1.57

BONDDEBT WeightedAvg Cost 7.47 0.40 0.35 1.79 1.58PreferredStock DividendCost 12.00 0.08 0.07 0.91 0.79

1.83

1.94

2.92

4.17LOAN

WEIGHTEDAVERAGE 10.86 0.22 0.19 1.43 1.23 9.35 10.32Weighted Average Cost Of Capital (WACC)

W eighted Average Cost Of Capital ( W ACC)

WACC=

(17.09*0.30)+((7.47*0.4)(1-0.40))+(12*0.08)+((10.86*0.22)(1-0.40)

C

N

CK X

H

B

ND X

!

"

H#

X#

AX

$ R % R

R

D&

#

CK X

!

"

H#

' AN X

H



USING WACC IN CAPITAL BUDGETING EXAMPLE: A company intends to undertake a project that will yield after tax saving of Rs. 4 million

at the end of year one. However, after that these savings are estimated to grow at 6 percent.

The debt equity ratio of 0.5 or 2/3 (debt 2/3 and equity 1/3). Cost of equity is 25% andcost of debt is 11%.

This project has the same level of risk as the existing company business. Advise companyon the financial viability of project. Assume tax rate of 40 percent.

WACC = 2/3 x 25 + 1/3 x 11(1- 40) = 18.86

PV = BENEFIT / WACC - g PV = 4,000,000 /0 .1886 ± 0.06 = 31,104,199/-


Weighted Average Cost of Capital (WACC) WACC of a company reflects the level of risk and WACC is only appropriate discount

rate if the intended investment is replica of company¶s existing activities ± having samelevel of risk.

Using WACC as discount rate when the intended project has different risk level as of company then it will lead to incorrect rejections and/or incorrect acceptance.

For example, a company having two strategic units and one unit having lower risk thanthe other, using WACC to allocate resource will end up putting lower funds to high risk and larger funds to low risk division.

PURE PLAY When a unit or division of a firm has different risk level than the firm, we can look for

other companies (like of division in question) to know the beta, debt/equity capitalstructure so we could develop a discount rate for the division in question.

Pure Play refers to estimating the required return on investment that is unique to aspecific project, based on the projects similar to line of business.



When an intended project has a different (Systematic) risk level from the existing, thenwe need to calculate the systematic risk of new project to find out WACC based on thecost of equity and debt to be used in the intended project.

EXAMPLE

M/S Riskless Limited have been contemplating a new diversified project. Current Beta of the firm is 1.2, however, the average Beta of diversified project industry is 1.7 anddebt/equity ratio is 30:70Debt is considered to be risk free and interest rate is 12%. Market risk rate is 20% and

corporate tax rate is 35%.Required: Work out appropriate discount rate for new project, if the new project is

a) All equity financed. b) D/E is 30:70 c) D/E is 40:70

Solution: Pure Play.xls

PURE PLAYProject Variables:

Gbeta 1.7 a) c)

E 70 E 100 D 0.4

D 30 Rm 20 E 0.6

T 0.35 E 0.7

Int. rate Rf 12 D 0.3

We need to calculate a discount rate that is representative of systematic risk -Business and Financial risk.Solution:a) All equity financed New Project

The industry in which the intended project falls has a equity Beta of 1.70, which has D /E of 30:70, but this is all-equity financed and therefore, we need to eliminate thefinancial risk from the Beta of (new industry).

To Un-gear the beta - for all equity financing: Formula to un-gear equity Beta = Gbeta x (E / E + D(1-t))

= 1.3296

Where: Gbeta = Geared Beta E = Weighted of equity in capital structure D = Weight of debt in capital structure



T = Tax rate Using CAPM equation to calculate the cost of equity: Re = Rf + B (Rm-Rf)

= 22.6369

This project, if only equity financed, must be evaluated using 22.6369% discount rate.

This is WACC for Un-geared firm where cost of equity is overall cost of capital.

Solution: b) New Project if financed with D /E of 30 : 70

Since the systematic risk (business and financial risk) of new industry are same as of thisscenario, no adjustment to Beta is necessary.

Cost of Equity: Re = Rf + B (Rm-Rf) = 25.6

Cost of Debt: Kd = I x (1-t) = 7.8 WACC = 20.26 This should be the discount rate for the intended project.

Solution:c) New Project if financed with D 40 and Equity 60

We need to re-gear the Beta to reflect the proposed financing. For D/E of 30/70 financingthe Beta as calculated above:

Formula to un-gear equity Beta = Gbeta x (E / E + D(1-t)) 1.3296 = Gbeta X 60 / 60 + 40 (1-t) 1.3296 = Gbeta X 0.697674419

Gbeta = 1.91 Now we can calculate WACC under this financing arrangements. We first calculate the

cost of equity capital: Re = Rf + B (Rm-Rf)

= 27.25 Cost of Debt:

Kd = 7.8 WACC = 19.47

CAPITAL STRUCTURE & FINANCIAL LEVERAGE A capital structure that lowers WACC is required to increase the value of firm. That would be the optimal capital structure because it results in the lowest possible

WACC. Changes in capital structure.

EXAMPLE: FIN LEVRAGE 1.xls



Capital Structure - No Debt

M/s SAFE-WAYS LIMITED

CURRENT STATUS PR OPOSED STATUS

ASSETS 6,000,000.00 6,000,000.00

DEBT - 3,000,000.00

EQUITY 6,000,000.00 3,000,000.00

DEBT/EQUITY RATIO - 1.00

SHARE PRICE 20.00 20.00SHARESOUTSTANDING 300,000.00 150,000.00

INTEREST RATE 10.00 10.00

CAPITAL STRUCTURE & FINANCIAL LEVERAGE

NO DEBT SITUATION NORMAL BOOM

EBIT 800,000.00 1,200,000.00

Interest - -

Net Income 800,000.00 1,200,000.00

ROE 13.33 20.00

EPS 2.67 4.00

DEBT = 3 MILLION

EBIT 800,000.00 1,200,000.00

Interest 300,000.00 300,000.00

Net Income 500,000.00 900,000.00

ROE 16.67 30.00

EPS - D 3.33 6.00NO DEBT SITUATION NORMAL NORMAL NORMAL NORMAL

EBIT 300,000.00 600,000.00 900,000.00 1,200,000.00

Interest - - - 0

Net Income 300,000.00



600,000.00 900,000.00 1,200,000.00

ROE 5.00 10.00 15.00 20.00

EPS 1.00 2.00 3.00 4.00

DEBT = 3MILLION Ü

EBIT 300,000.00 600,000.00 900,000.00 1,200,000.00

Interest 300,000.00 300,000.00 300,000.00 300,000.00

Net Income - 300,000.00 600,000.00 900,000.00

ROE - 10.00 20.00 30.00

EPS - D - 2.00 4.00 6.00

EPS

EB (

)

600,000

2

N0

DEB1

DEB1

-2

300000

+ FIN LEVERA2

E

-IVE FIN LEVERA2

E

X

3

BE

WHAT DOES GRAPH TELLS US?



Break even EBIT is 600,000, at this level EPS under both no-debt and debt situations is2. This is denoted as point BE in the above graph.

Area on the left or below BE representing negative impact on loan. Area right or above of BE point, represent positive impact of Financial leverage or

employment of loan.

CONCLUSION Financial leverage effect depends on the EBIT. Higher the EBIT, leverage is beneficial. Under normal scenario leverage increases the returns to shareholders ± measured by EPS

and ROE. Also shareholders are exposed to more risk under debt-equity structure.

corporate finance lecture No. 21

CAPITAL STRUCTURE & COST OF EQUITYMODIGLIANI AND MILLER MODEL

CAPITAL STRUCTURE & COST OF EQUITYMODIGLIANI AND MILLER MODEL Value of firm: Whatever the capital structure the operating income and value of its assets

will remain same or unchanged.

Proposition 1 of MM Model, says value of a firm is independent of its capital structure.CAPITAL STRUCTURE

OPTION1 OPTION 2Equity 40% 60%Loan ± debt 60% 40%Total capital 100% 100%

A firm may employ any of the above options of capital structure, the value of firm is notaffected as long as the capital is fixed (does not exceed 100%). This is because the operatingincome will remain constant and nothing positive (additional income) will increase the equityand share price.

WACC does not depend on debt equity ratio. Because it is the function of relative costsof debt & equity, and any change in debt and equity mix will change the cost of eachcomponent accordingly, making no movement in overall WACC.



For example ± take one Pizza, slice it in four quarters and then half each quarter to make8 pieces of Pizza. Even you have 8 pieces but you don't have more Pizza.

How is it possible? Let¶s see.

WACC remain constant at every combination of Debt Equity

CURRENT STATUS CAPITAL STRUCTURECOMBINATIONS

ASSETS 6,000,000.00

6,000,000.00

6,000,000.00

6,000,000.00

6,000,000.00

DEBT -2,000,000.00

3,000,000.00

4,000,000.00

5,000,000.00

EQUITY

6,000,000.

00

4,000,000.

00

3,000,000.

00

2,000,000.

00

1,000,000.

00DEBT/EQUITY RATIO - 0.50 1.00 2.00 5.00SHAREPRICE 20.00 20.00 20.00 20.00 20.00SHARESOUTSTANDING 300,000.00 200,000.00 150,000.00 100,000.00 50,000.00INTEREST RATE 10.00 10.00 10.00 10.00 10.00

EBIT 800,000.00 800,000.00 800,000.00 800,000.00 800,000.00

R OE 13.33 15.00 16.67 20.00 30.00

EPS 2.67 4.00 5.33 8.00 16.00

WACC 13.33 13.33 13.33 13.33 13.33PROPOSITION II OF MM MODEL It tells us three things:

Required Return of a Assets Cost of Debt and

Debt /Equity Ratio

Expected rate of return on the common stock of a levered firm increases in proportion tothe debt-equity mix (market values to be used).

this means that for an un-levered firm, Return on equity (RE) is equal to return on asset.





Financial risk is determined by the financial policy. As debt weight is increased financialrisk increases.

M & M MODEL WITH TAXES Taxes are reality of business environment.

How taxes effect the firm and M&M Model? Does taxes have any effect on value of firm?

Let¶s take an Example:

EXAMPLE: M&M WITH TAXES Assume two firms which are identical on the assets side of balance sheet. Firm µA¶ is all

equity financed and firm µB¶ is all debt financed. EBIT is estimated at Rs.100,000/- per year forever and tax rate is 40%. Firm µB¶ pays

10% loan on the debt. For the sake of simplicity there is no depreciation. Cost of capitalfor firm µA¶ is 12%.

Taxes and M&M

PAR TICULARS

FIRM "A"UN-GEARED(NO-DEBT)

FIRM "B"GEARED(ALL DEBT)

EBIT 100,000.00 100,000.00INTEREST EXPENSE - 10,000.00

TAXABLE PROFIT 100,000.00 90,000.00

TAX ON PROFIT 40% 40,000.00 36,000.00

NET PROFIT 60,000.00 54,000.00IMPACT OF TAXES ON THE CASH FLOW IN TERMS OF CASH FLOW TO SHARE/BOND HOLDERS

FIRM "A" UN-GEARED (NO-DEBT)

FIRM "B" GEARED (ALL DEBT)

EBIT 100,000.00 100,000.00LESS: TAXES 40,000.00 36,000.00TOTAL 60,000.00 64,000.00

WE OBSERVE:

Even assets of both companies are identical. After tax cash flow of both firms is not same. Hence the value of both firms is not equal. The difference in cash flow or value is Rs. 4,000. We can reach at Rs. 4,000 in an other way: Total Interest x Tax Rate = 10,000 x 0.40 = 4,000



Since interest is tax deductible, it generates saving called ³Interest Tax Shield´. Since debt is for ever, the value of firm µB¶ levered firm, will always be greater than firm

µA¶ by the present value of interest tax shield.

Present value of interest tax shield can be calculated as:

PV = Rs. 4000 / 0.1 = Rs. 40,000

M&M Model proposition 1 says: VL = VU + T X x D

Value of un-geared firm µA¶ can be worked out as under:

Vu = EBIT x (1-t) / Ru EBIT and taxable income of this firm is same.

Vu = 100,000 x (1 - 0.4)/ 0.12 = 500,000

We now find out the value of geared firm: VL = VE + Tx x D

= 500,000 + (100000 x 0.40) = 540,000 It means that for every Re. 1, the value of firm will increase by (Re.1 x tx) or 0.40.

Taxes do effect capital structure, therefore, we incorporate tax effect in proposition 1 of the Model:

V of Levered Firm = V of Un-levered Firm + Tax on Debt We also need to incorporate tax in Proposition II of M&M Model:

WACC = E/V(RE) + D/V (RD) x (1 ± t)Where t is the tax rate.

To find out Cost of Equity:

RE = RU + (RU ± RD) X D/E X (1 ± t)

Continuing our example to Proposition II Value of geared or levered firm was Rs. 540,000 because the debt is Rs.100,000 then the

equity must be 440,000.

Return on equity of levered or geared firm is then:

RE = RU + (RU ± RD) X D/E X (1 ± t)



= .12 + (.12 - .10) x (100000/440000) x 0.4= 12.27%

WACC is:

= (4400/5400) x 12.27 + (1000/5400) x 0.1 x (1 ± 0.40) = 11.11%

AIDING UNDERSTANDING OF M&M MODEL Example M & M Model

EBIT = 80,000 Tax = 40% Debt = 50,000 Rate of Return (un-levered) firm = 20% Interest rate = 10%

Required: a) What is value of firm¶s equity? b) What is the cost of equity capital? c) What is WACC?

M&M MODELa) VALUE OF UN-LEVEREDFIRM VuWITH NO DEBT =EBIT x ( 1 - t) / Ru Vu = 240,000.00From MM proposition I, Value of

firm with Debt = VL VL = Vu + D x t 260,000.00Because this is the value of Leveredfirmthen, the equity value is:

E = VL - D

210,000.00b) Based on MM proposition 2,with tax cost of equity is:

RE = Ru + (Ru - Rd) x(D/E) x (1 - t)

0.21 21.438437.5

c) WACC

WACC = E/V(RE) + D/V(RD) x (1 ± t) 0.18 18.46

This shows that the WACC of a levered firm is lesser than that of un-levered.



The WACC of un-levered firm was 20% and of levered firm is 18.46%.

This means that debt financing carries financial advantage.

corporate finance lecture No. 22

PROBLEMS ASSOCIATED WITH HIGH GEARING M&M Model says that debt financing increases the value of firm due to tax

shield.

However, there are certain aspects of high gearing that discourage borrowing.

BANKRUPTCY COSTS

Direct bankruptcy costs Indirect bankruptcy costs

FINANCIAL RELEVANCY COSTS These aspect are:

BANKRUPTCY COSTS: As debt increases chances of default of repayment of principal and interest

increases.

Direct Bankruptcy Costs: In case of liquidation disposal of assets will fetch less than going concern value of

assets. And there are other. Costs like liquidation and redundancy costs. The loss in value is normally borne

by the debt holders .

INDIRECT BANKRUPTCY COSTS When a firm goes into liquidation or approaches near bankruptcy because under sever

financial distress. Employees leaving Vendors refusing to supply goods on credit. Customers even leaving fearing firm will not be able to honor its warranty and

after sales services commitments. Value of firm down as sale decline. TAX POSITION:



Firm must ensure that it will pay tax in future because the value increase isincidental with paying of taxes. High gearing reduces the taxable income againstwhich to off set interest expense.

DEPRECIATION:

Depreciation is also tax deductible and also affects the EBIT.OPTIMAL CAPITAL STRUCTURE

Debt has a magic in it. It increases the risk and reward to the firm and investors. Static theory of capital structure says that a firm should borrow to the extent where the

tax shield benefit is at least equal to the bankruptcy and financial distress costs incidentalto high gearing.

We can see the optimal combination of debt and value of the firm in graphical form. DIVIDEND POLICYOP TIMAL STRUCTURE

STATIC THEORY OF CAPITAL STRUCTURE

TOTAL DEBT

OPTIMAL DEBT LEVEL

VALUE OF FIRM

VL= VU + T x D

D

MAX

FIRM

VALUE

VL

PV OF TAX SHEILD

ACTUAL FIRM VALUE

Bankruptcy & FD

Value of No-Debt FirmVU

DIVIDEND POLICY

DVIDENDS HIGH & LOW PAYOUT DIVIDEND STRATEGIES

Two Components of Incomes:

Capital Gains ± Price AppreciationIncome ± Dividends

TYPES OF DIVIDENDS Cash dividends Stock dividends



CASH & STOCK DIVIDENDS

Declaration date: The date on which dividend is announced. Ex-dividend date: to ensure dividend goes to right persons, this is two business

days before the record date. Record Date: On which the share register of the firm is updated for shareholdersrecord.

Date of Payment: On which the dividend cheques are sent to shareholders.

Ex-Dividend: For example, the Board of Directors declares dividend and recorddate is set to Monday 18 September 2006, then the ex-date will be Thursday 14September 2006. If someone buys the share in question on 13th Sept 2006, he/shewill be entitled to receive the dividend just declared. Someone buying the shareon 14th will not be.

WHY DIVIDEND POLICY IS IMPORTANT?

a) Affects shareholders attitude. b) Dividend policy has implications on capital budgeting program.c) It reduces cash flow position.d) It effects Debt Equity Ratio.

DIVIDEND POLICIES STABLE DIVIDEND PER SHARE:

per share fixed amount of dividend paid every year. Look favorably by investors and implies low risk firm. Investors can easily forecast and predict their earnings. Aid in financial planning.

CONSTANT DIVIDEND PAYOUT(DIV PER SHARE/EPS)

A fixed %age is paid out as dividend. Under this policy the dividend amount will vary because the net income is not constant.

HYBRID DIVIDEND POLICY This contains feature of both the above mentioned policies. Dividend consists of stable base amount and %age of increment in FAT income years. This is more flexible policy but increases uncertainty of future cash flow or return to

investors. The extra slice of %age is only paid when there is high jump in income. So it is not

regularly paid.FLUCTUATING DIVIDENDS

When the firm is having investment opportunities on its plate or unstable capitalexpenditure, then Dividends are of residual amount i.e. amount left after meeting capitalexpenditure.

FACTORS INFLUENCING DIVIDEND POLICY GROWTH OF FIRM



STABLE EARNINGS DEGREE OF FINANCIAL LEVERAGE AVAILABILITY OF EXTERNAL FINANCING CONTROL

IRRELEVANCE OF DIVIDEND POLICY M&M assumes Perfect Capital Markets with no cost, no floatation cost to companies andno taxes.

Also, future profits are known with certainty According to M&M: As long as the firm¶s capital budgeting program and debt policy is

fixed, dividend policy is irrelevant and does not add some value to the company or firm. The dividend irrelevance simply states the PV of dividends remains unchanged even

though div policy may change the amount and timing of dividends.Example: Firm¶s Dividend Policy is fixed %age of Dividend payout i.e. 50% of EPS paid out asDividend.

EPS

DIV/SHARE

TIME

VALUE

X

@ FIRM A ± DIV PAA

OUT

1.50

3

EXAMPLE: STABLE DIVIDEND POLICY

POINTS TO REMEMBER

Firm A¶s pay out ratio is 50%. It means whatever it earns, half of is paid asdividend.

Firm B although has the same earning level, but maintains stable dividend overtime.

Total dividend $ value is same under both situations. There may be more value for firm b for maintaining stable dividend because

investors may perceive more value.



Brokerage fee, Floatation Cost and transaction cost are also consider.

EPS

DIVB

SHARE

TIME

VALUE

X

C

FIRM B ± DIV PAD

OUT

1.50

3

Documents

Corporate Finance Lecture