You are on page 1of 408

IBS Gurgaon

Financial Management
Semester I – Batch of 2019

Prepared by: Arun K Agarwal, ACA, ACS


Sl
No Main Topic Sub Topics
i.
Syllabus
Definition – Evolution - Objectives – Function & Scope
Introduction to Fin
1 ii. Interface of Fin Management with other functional areas
Management iii. Environment of Corporate Finance
i. What are Financial Markets – Functions & Classification
ii. Money Market: Forex Market – Govt Securities Market – Primary
& Secondary Markets for G Securities
Overview of Financial iii. Call Money Markets: Treasury Bill Market, Commercial Paper and
2 Markets Certificate of Deposits
iv. Corporate Debt Market – Recent Developments
v. Capital Markets: Derivatives
vi. International Capital Markets - participants
i. Definitions
ii. Primary Markets: How do these work?
Primary & Secondary  IPOs –
3  Rights Issues
Markets
 Loan Syndication, Venture Financing, Private Equity
 M&A
iii. Structural Analysis of Investment Banking Industry
i. Equity Capital – Public Issue by listed companies, Rights Issue,
Sources & Raising Long ii. Preferential Allotment, Venture Capital
4 Debentures – Term Loans and Deferred Credit
Term Funds iii. Govt Subsidies
iv. Emerging Sources of Finance – Private Equity, FDI, FCCB
Sl Main Topic
No Sub Topics Syllabus
Raising Finance from i. Intermediaries – Euro Dollar Market
5 ii. Instruments in International Finance: ADR / GDR, FCCB
International Markets iii. ECB – Regulatory Aspects
i. Risk and Return Concept;
Introduction to Risks and ii. Risk in Portfolio Context
6 Returns iii. Relationship between Risk and Return – CAPM and Dividend
Capitalization Models
i. Concept – Risk and Return, Relationship
Introduction to Risk &
7 ii. Risk in Portfolio Context
Return iii. CAPM and Dividend Capitalization Model
i. Cash Flow
ii. Future Value of Single Cash Flow
8 Time Value of Money iii. Present Value of a Single Cash Flow
iv. Multiple Cash Flows and Annuity
v. Perpetuity and Growing Perpetuity
i. Concept of valuation
ii. Bond Valuation
9 Valuation of Securities iii. Equity Valuation
iv. Dividend Capitalization Approach
v. Ratio Approach
Sl Main Topic Sub Topics
No Syllabus
i. Concept and importance
ii. Cost of debenture
iii. Term Loans
10 Cost of Capital iv. Equity Capital and Retained Earnings
v. Calculation of Weighted Average Coat of Capital
vi. Weighted Marginal Cost of Capital Schedule
i. Suzlon Energy – Financial Problems
11 Case studies ii. Unilever Ltd – Transforming the finance function
Introduction to Financial Management
i. Definition – Objectives – Function & Scope
ii. Interface of Fin Management with other functional areas
iii. Environment of Corporate Finance
Definition – Objectives – Function & Scope

In simple words, Financial Management is the management of finances of an


enterprise. In a nutshell, Financial Management is all about optimizing the use
and costs of funds in the running of an enterprise.

The decisions of Financial Management have an all pervading impact on the


entire organization and encompasses all other functions. Some of the key
decisions in Financial Management are:
i. Determining the Project Cost of a business;
ii. Determining the Funding Pattern of the Project Cost of a business;
iii. Identifying and obtaining the most economical funding options for a
business – both long term and short term;
iv. Determining pricing patterns for the products of the business;
v. Determining procurement strategies particularly relating to liability clauses,
prices, terms of purchases etc;
vi. Determining strategies for utilization, distribution and retention of earnings
of an enterprise;
vii. Compliances with taxes and other levies applicable to the enterprise.
viii. Strategizing and negotiating for costs of all nature incurred by an enterprise
Key Requirements for Finance Management

A good Financial Manager must have a sound knowledge of the following


concepts:
i. Financial Accounting
ii. Cost of Capital
iii. Cost of debt
iv. Avenues, Methods and Procedures of raising Long Term Funds
v. Sources, Methods and Procedures for raising Short Term Funds
vi. Profits and returns
Financial Management is the Art & Science of Managing Money

Fundamental Functions of Financial Management

Best Sourcing of Money Controls & Systems Best Utilization of Money

 Planning & Budgeting


 Internal Controls A. Project Funding
A. Equity - Capital Markets  Audits B. Funding for Expansions &
i. Primary Markets  Reviews Diversification
ii. Secondary Markets C. Funding for Working Capital
B. Debt Markets – Debentures & D. Distribution vs Retaining of
Bonds Profits
C. Money Markets – short term E. Ensuring “No Idle Funds”
instruments
D. Banks and Financial Institutions
i. Long Term Funding
ii. Short Term Funding
Interface of Finance Management with other Functions

Examples
i. Interface with Marketing Function
 Discount on products and services;
 Pricing of products and services;
 Payment Terms to customers;
 Receivable Management
ii. Interface with Production Function
 Stock Levels – Raw Materials and Finished Goods
 Cost of production targets;
 Cost economies and improvements in processes and machines;
 R & D budget and utilization;
iii. Interface with Administration Function
 Expense budgets and managing overheads;
 Company policy on expense management – travel policy etc
Interface of Finance Management with other Functions

Examples
iv. Interface with Board of Directors
 Project identification, funding and profitability;
 Profits Distribution Policy;
 Compliances;
 Budgets and Business Planning
i. Interface with HR Function
 Manpower budgeting – numbers and costs
 Employee retention policy – cost management;
 Remuneration Policy – cost management;
 HR Budget;
ii. Interface with Legal Function
 Policy for seeking legal redressal – choice of lawyers, cost negotiations,
terms of retention, data management for representation etc;
Environment of Corporate Finance

 Corporate finance is the area of finance which deals with all aspects of
the business of a company with the main objective of increasing the value
of the firm to its shareholders. The primary goal of corporate finance is to
maximize or increase shareholder value.
 Maximizing shareholder value requires managers to be able to balance
and optimize capital funding between investments in projects that
increase the firm's long term profitability and sustainability on the one
hand AND paying out excess cash in the form of dividends to
shareholders.
 The environment in which Corporate Finance operates in the present
times may be explained with the example of the following key features:
 Increased competition;
 Increased focus on Corporate Governance
 Increased focus on compliances – stiff penalties for non compliances;
 Freedom to the Corporates and their Board of Directors to run their
businesses in the best possible manner;
 Minimization of bureaucracy and procedural bottlenecks
Overview of Financial Markets
i. What are Financial Markets – Functions & Classification
ii. Money Market: Forex Market – Govt Securities Market – Primary &
Secondary Markets for G Securities
iii. Call Money Markets: Treasury Bill Market, Commercial Paper and
Certificate of Deposits
iv. Corporate Debt Market – Recent Developments
v. Capital Markets: Derivatives
vi. International Capital Markets - participants
Overview of Financial Markets

Money Markets Capital Markets

For Raising Short Term Funds For Raising Long Term Funds

Instruments Markets Domestic International


Capital Capital Markets
 Money at Call  Forex Markets
 Treasury Bills Markets
 Govt Securities
 Commercial Market
Papers
 Bills discounting
Understanding the Financial Markets

 It is a basic fact of economics and finance that money always flows from
the surplus sector to the deficit sector. This means that persons and
institutions having money in excess of their requirements lend it to
those who need money to fulfill their own requirement. The period for
which such money is lent is determined by the period for which money
is surplus with the lender and the period for which the borrower
requires the money.

 In business sectors the surplus money flows from the investors and
lenders to the businessmen for the purpose of meeting their
requirements for production and sale of goods and services.

 So, we find two different groups, one who invest money or lend money
and the others, who borrow or use the money. Now the question that
arises is, how these two groups meet and transact with each other. The
financial markets act as a link between these two different groups.
Financial Markets facilitates this function by acting as an intermediary
between the borrowers and lenders of money.
Understanding the Financial Markets

 A financial market may be defined as ‘a transmission mechanism


through which transfer of funds is facilitated between investors (and
lenders) of funds and the borrowers (or users) of such funds’. It consists
of individual investors, financial institutions and other intermediaries
who are linked by formal trading rules and communication network for
trading the various financial assets and credit instruments.

 The main functions of a financial market may be mentioned as under:


 It provides a platform for interaction between the investors and
the borrowers.
 It provides pricing information resulting from the interaction
between buyers and sellers in the market when they trade in
financial assets.
 It provides security for dealings in financial assets.
 It ensures liquidity by providing a mechanism for an investor to
easily sell the financial assets.
 It ensures low cost of transactions and information.
Understanding the Financial Markets

TYPES OF FINANCIAL MARKETS


A financial market consists of two major segments:
(a) Money Market; and
(b) Capital Market.

While the money market deals in short-term credit, the capital market handles
the medium term and long-term credit.

In the financial marketplace, a distinction is made between the capital markets


and the money markets. The capital market is a source of intermediate-term
to long-term financing in the form of equity or debt securities with maturities
of more than one year.
Understanding the Financial Markets

MONEY MARKET
The money market is where financial instruments with high liquidity and very
short maturities are traded. It is used by participants as a means for borrowing
and lending in the short term, with maturities that usually range from
overnight to just under a year. Money market instruments give businesses,
financial institutions and governments a means to finance their short-term cash
requirements.

Characteristics
Three important characteristics are:
Liquidity - Since they are fixed-income securities with short-term maturities of
a year or less, money market instruments are extremely liquid.

Safety - They also provide a relatively high degree of safety because their
issuers have the highest credit ratings.

Discount Pricing- A third characteristic they have in common is that they are
issued at a discount to their face value.
Understanding the Financial Markets

MONEY MARKET
 The money market is a market for short-term funds - deals in financial
assets whose period of maturity is upto one year.
 Money market does not deal in cash or money but in credit instruments
such as bills of exchange, promissory notes, commercial paper, treasury
bills, etc which act as close substitutes of money. These instruments
enable the business units, other organizations and the Government to
borrow the funds to meet their short-term requirement.
 Money market does not imply any specific market place but refers to the
whole network of financial institutions dealing in short-term
instruments, which provides a profitable outlet to lenders and a source
of supply of such funds to borrowers.
 The Indian money market consists of Reserve Bank of India, Commercial
banks, Co-operative banks, and other specialized financial institutions.
Some Non-Banking Financial Companies (NBFCs) and financial
institutions like LIC, GIC, UTI, etc. also operate in the Indian money
market.
1. MONEY MARKET INSTRUMENTS

Following are some of the important money market instruments or securities.


 Call Money: Call money is mainly used by the banks to meet their temporary
requirement of cash. They borrow and lend money from each other normally
on a daily basis. It is repayable on demand and its maturity period varies in
between one day to a fortnight. The rate of interest paid on call money loan
is known as call rate.

 Treasury Bill: A treasury bill is a promissory note issued by the RBI to meet
the short-term requirement of funds. Treasury bills are highly liquid
instruments, that means, at any time the holder of treasury bills can transfer
or get it discounted from RBI. These bills are normally issued at a price less
than their face value; and redeemed at face value. So the difference between
the issue price and the face value of the treasury bill represents the interest
on the investment. These bills are secured instruments and are issued for a
period of not exceeding 364 days. Banks, Financial institutions and
corporations normally play major role in the Treasury bill market.
MONEY MARKET INSTRUMENTS

 Commercial Paper: Commercial paper (CP) is a popular instrument for


financing working capital requirements of companies. The CP is an unsecured
instrument issued in the form of promissory note. This instrument was
introduced in 1990 to enable the corporate borrowers to raise short-term
funds. It can be issued for period ranging from 15 days to one year.
Commercial papers are transferable by endorsement and delivery. The highly
reputed companies (Blue Chip companies) are the major player of
commercial paper market.

 Certificate of Deposit: Certificate of Deposit (CDs) are short-term


instruments issued by Commercial Banks and Special Financial Institutions
(SFIs), which are freely transferable from one party to another. The maturity
period of CDs ranges from 91 days to one year. These can be issued to
individuals, co-operatives and companies.
MONEY MARKET INSTRUMENTS

 Trade Bill: Normally the traders buy goods from the wholesalers or
manufactures on credit. The sellers get payment after the end of the credit
period. But if any seller does not want to wait or in immediate need of
money he/she can draw a bill of exchange in favour of the buyer. When
buyer accepts the bill it becomes a negotiable instrument and is termed as
bill of exchange or trade bill. This trade bill can now be discounted with a
bank before its maturity. On maturity the bank gets the payment from the
drawee i.e., the buyer of goods. When trade bills are accepted by
Commercial Banks it is known as Commercial Bills. So trade bill is an
instrument, which enables the drawer of the bill to get funds for short period
to meet the working capital needs.
2. The Key Money Markets

 Forex Market
 Govt Securities Market
Forex Markets

1. Provide the physical and institutional structure through which the money of one
country is exchanged for that of another country, the rate of exchange between
currencies is determined, and foreign exchange transactions are physically completed.
The foreign exchange market is the mechanism by which a person or firm transfers
purchasing power from one country to another, obtains or provides credit for
international trade transactions, and minimizes exposure to foreign exchange risk.
2. Geographically, the foreign exchange market spans the globe, with prices moving and
currencies traded somewhere every hour of every business day.
3. Functions of the Foreign Exchange Market
i. Transfer of Purchasing Power: This is necessary because international
transactions normally involve parties in countries with different national
currencies. Each party usually wants to deal in its own currency, but the
transaction can be invoiced in only one currency.
ii. Provision of Credit: Because the movement of goods between countries takes
time, inventory in transit must be financed.
iii. Minimizing Foreign Exchange Risk: The foreign exchange market provides
"hedging" facilities for transferring foreign exchange risk to someone else.
Forex Markets

4. Participants in a Forex Market


a. Importers and exporters, international portfolio investors, multinational
firms, tourists, and others use the foreign exchange market to facilitate
execution of commercial or investment transactions.
Some of these participants use the foreign exchange market to hedge
foreign exchange risk.
b. Foreign Exchange Dealers:
i. Banks, and a few nonbank foreign exchange dealers, operate in
both the interbank and client markets. They profit from buying
foreign exchange at a bid price and reselling it at a slightly higher
ask price.
ii. Worldwide competitions among dealers narrows the spread
between bid and ask and so contributes to making the foreign
exchange market efficient in the same sense as securities markets.
iii. Dealers in the foreign exchange departments of large international
banks often function as market makers. They stand willing to buy
and sell those currencies in which they specialize by maintaining an
inventory position in those currencies.
Forex Markets – Participants contd…
c. Speculators and Arbitragers:
 Speculators and arbitragers seek to profit from trading in the market.
They operate in their own interest, without a need or obligation to serve
clients or to ensure a continuous market.
 Speculators seek all of their profit from exchange rate changes and the
exchange rate differences in different markets.

d. Central Banks and Treasuries:


Central banks and treasuries use the market to acquire or spend their country's
foreign exchange reserves as well as to influence the price of their own
currency.

e. Foreign Exchange Brokers:


i. Foreign exchange brokers are agents who facilitate trading between
dealers without themselves becoming principals in the transaction. For
this service, they charge a small commission, and maintain access to
hundreds of dealers worldwide via open telephone lines.
ii. It is a broker's business to know at any moment exactly which dealers
want to buy or sell any currency. This knowledge enables the broker to
find a counterpart for a client quickly without revealing the identity of
either party until after an agreement has been reached.
Govt Securities Market

Holding of cash in excess of the day-to-day needs of a bank does not give any return to
it. Investment in gold has attendant problems in regard to appraising its purity,
valuation, safe custody, etc. Therefore, investing in Government securities is the most
commonly option available to banks and has the following advantages:
• Besides providing a return in the form of coupons (interest), Government
securities offer the maximum safety as they carry the Sovereign’s commitment
for payment of interest and repayment of principal.

• They can be held in book entry, i.e., dematerialized/ scripless form, thus,
obviating the need for safekeeping.

• Govt securities are available in a wide range of maturities from 91 days to as


long as 30 years to suit the duration of a bank's liabilities.
• Government securities can be sold easily in the secondary market to meet cash
requirements.

• Government securities can also be used as collateral to borrow funds in the


repo market.
Govt Securities Market

• The settlement system for trading in Government securities, which is based on


Delivery versus Payment (DvP), is a very simple, safe and efficient system of
settlement. The DvP mechanism ensures transfer of securities by the seller of
securities simultaneously with transfer of funds from the buyer of the
securities, thereby mitigating the settlement risk.

• Government security prices are readily available due to a liquid and active
secondary market and a transparent price dissemination mechanism.

• Besides banks, insurance companies and other large investors, smaller


investors like Co-operative banks, Regional Rural Banks, Provident Funds are
also required to hold Government securities
CAPITAL MARKETS
For Raising Medium and Long Term Funds

CAPITAL MARKETS
Capital Market may be defined as a market dealing in medium and long-term
funds. It is an institutional arrangement for raising medium and long-term
funds and which provides facilities for marketing and trading of securities. So it
constitutes all long-term borrowings from banks and financial institutions,
borrowings from foreign markets and raising of capital by issue various
securities such as shares debentures, bonds, etc.

The market where securities are traded known as Securities market. It consists
of two different segments namely,
 Primary and
 Secondary market.
The primary market deals with new or fresh issue of securities and is,
therefore, also known as new issue market; whereas the secondary market
provides a place for purchase and sale of existing securities and is often termed
as stock market or stock exchange.
CAPITAL MARKETS

PRIMARY MARKET
 The Primary Market comprises of the platform or market, which
facilitates the raising of long term funds by companies by making fresh
issue of shares and debentures.
 Companies make fresh issue of shares and/or debentures at their
formation stage and, if necessary, subsequently for the expansion of
business. It is usually done through private placement to friends,
relatives and financial institutions or by making public issue.
 In order to raise funds in the Primary Market, companies have to follow a
well-established legal procedure and involve a number of intermediaries
such as underwriters, brokers, banks etc. who form an integral part of
the primary market.
 Many initial public offers (IPOs) have been made recently by a number of
public sector undertakings such as ONGC, GAIL, NTPC and the private
sector companies like Tata Consultancy Services (TCS), Biocon, Jet-
Airways and so on.
CAPITAL MARKETS

SECONDARY MARKET
 The secondary market known as the stock market or stock exchange plays
an equally important role in mobilizing long-term funds by providing the
necessary liquidity to holdings in shares and debentures.

 It provides a platform where securities can be en cashed without any


difficulty and delay through regular trading with high degree of
transparency and security.

 An active secondary market facilitates the growth of primary market as


the investors in the primary market are assured of a ready market for
liquidating their holdings at a short notice.

 The major players in the primary market are merchant bankers, mutual
funds, financial institutions, and the individual investors; and in the
secondary market in addition to all these there are also the stockbrokers
who are members of the stock exchange and who engage in the trading
in securities.
Capital Markets
DISTINCTION BETWEEN PRIMARY MARKET AND SECONDARY MARKET
The main points of distinction between the primary market and secondary
market are as follows:
a. Function: While the main function of primary market is to raise long-
term funds through fresh issue of securities, the main function of
secondary market is to provide continuous and ready market for the
existing long-term securities.
b. Participants: While the major players in the primary market are financial
institutions, mutual funds, underwriters and individual investors, the
major players in secondary market are all of these plus the stockbrokers
who are members of the stock exchange.
c. Listing Requirement: While only those securities can be dealt with in the
secondary market, which have been approved for the purpose i.e. listed
by the Stock Exchange, there is no such requirement in a primary market.
d. Determination of prices: In case of primary market, the prices are
determined by the management with due compliance with SEBI
requirement for new issue of securities. But in case of secondary market,
the price of the securities is determined by forces of demand and supply
of the market and keeps on fluctuating.
Understanding the Financial Markets

DISTINCTION BETWEEN CAPITAL MARKET AND MONEY MARKET


The Capital Market differs from Money Market in the following ways:
a. The money market is related to short-term funds whereas the capital
market is related to long term funds.
b. While money market deals in securities like treasury bills, commercial
paper, trade bills, deposit certificates, etc., the capital market deals in
shares, debentures, bonds and government securities.
c. The participants in money market are Reserve Bank of India, commercial
banks, non-banking financial companies, etc. whereas the participants in
a capital market are stockbrokers, underwriters, mutual funds, financial
institutions, and individual investors.
d. While the money market is regulated by Reserve Bank of India, the capital
market is regulated by Securities Exchange Board of India (SEBI).
Corporate Debt Market
What Pushes
Growth

Govt
Spending
1.
on Welfare 5.
Increased
Employment Projects Increased
& Incomes supply keeps
the price /
inflation in
check
2. Increased
Increased Economic
Demand for Activity 4.
Goods & Creation of
Services Added
3. Capacity to
Upward meet
pressure increasing
on prices demand
Corporate Debt Market - Genesis

Financing Growth

Through Equity Through Debt

Debt / Credit
Equity Markets
Markets

Primary Secondary Primary Secondary

Primary Markets are crucial in directly funding growth and equity and debt are
raised for project and other investments in this market
Secondary Markets though not funding growth directly are a key player as they
provide liquidity on investments made in the Primary Markets and hence make
investments in the Primary Markets viable in the first place.
Corporate Debt Market – Concepts

Constituents of
Debt Market

Short Term Long Term


< 1 year > 1 year

Bank Limits Bank Loans

Commercial Corporate
Papers Bonds

Corporate Bonds supplement bank


borrowings and provide companies
with cheaper option of raising funds
Corporate Debt Market – Concepts

The bond market (also known as debt market or credit market) is a financial
market where companies, governments and other participants can issue
i. new debt, known as the primary market,
ii. or buy and sell debt securities, known as the secondary market.

The Debt is usually issued in the form of bonds, but may include notes, bills, and so
on.

Bonds are issued by governments and companies when they want to raise money
to finance some long term project. Issue of bonds involves the offering of bonds of
a specified face value carrying a specified rate of interest at a specified price for a
specified period whereby the buyers of such bonds are paid periodic interest
during the currency of the bonds and the repayment of the face value of the bond
on maturity.

Bonds can be issued at a discount and redeemed at a premium.

Bonds may also be converted wholly or partially into Equity Shares of the company.
Corporate Debt Market – Recent Developments

In present times, when India is endeavoring to sustain its high growth rate, it is
imperative that financing constraints in any form be removed and alternative financing
channels be developed in a systematic manner for supplementing traditional bank
credit.

While the equity market in India has been quite active, the size of the corporate debt
market is very small in comparison to not only developed markets, but also some of
the emerging market economies in Asia such as Malaysia, Thailand and China.

A liquid corporate debt market can play a critical role by supplementing the banking
system to meet the requirements of the corporate sector for long-term capital
investment and asset creation.

A comparison of corporate funding split with other economies shows a higher reliance
of India on loans from banks and other financial institutions. Traditionally, bank
finance coupled with equity markets and external borrowings has been the preferred
funding source for Indian corporates.

The long-term debt market consists largely of government securities. In 2011, in terms
of size, Indian corporate debt market stood at Rs. 9 trillion ($147 bn approx.) which
was only 31% of Govt Securities . (SEBI 2012).
Corporate Debt Market – Recent Developments

The figures and statistics potentially demonstrate a huge funding gap that can be
bridged by developing a well-functioning corporate bond market. Among other
things, as India aims to regain its erstwhile high growth rates of the early 2000s,
there is bound to be a lot of pressure on infrastructure financing which is currently
done primarily through budgetary support or bank credit and this is where a well-
developed corporate debt market can play a significant role.

According to the 12th Five-Year Plan, during 2012-2017, $1 trillion is supposed to


be spent on infrastructure projects in India and for this the infrastructure
companies could tap the corporate bond market to raise long-term capital instead
of depending on the banking sector that is already overstretched and burdened
with non-performing assets.

However the corporate bond market itself faces several challenges


Corporate Debt Market – Recent Developments

Main issues & Challenges


Development of the domestic corporate debt market in India is thwarted by a
number of factors, the prominent ones being:
i. low primary issuance of corporate bonds leading to illiquidity in the
secondary market,
ii. narrow investor base leading to high costs of issuance,
iii. lack of debt market accessibility to small and medium enterprises,
iv. dearth of a well-functioning derivatives market that could have absorbed
risks emanating from interest rate fluctuations and default possibilities,
v. excessive regulatory restrictions on the investment mandate of financial
institutions,
vi. large fiscal deficit, high interest rates and the dominance of issuances
through private placements and AAA2 rated bonds which in turn also prevent
retail participation and aggravate the dependence on bank financing.

Apart from the supply-side constraints, there are also several demand-side issues.
For instance, the investment norms of insurance companies, banks and pension
funds in India are heavily skewed towards investment in government and public
sector bonds.
Corporate Debt Market – Recent Developments

Total corporate bond issuance in India is highly fragmented because bulk of the debt
raised (more than 90%) is through private placements.

In 2005, a High Powered Expert Committee (HPEC) on Corporate Bonds and


Securitization was formed under Dr. R. H. Patil.

i. The Patil Committee Report (Patil 2005) highlighted


ii. ease of issuance, cost efficiency and institutional demand as key reasons for the
dominance of private placements.

The disclosure requirements for debt securities are provided by the SEBI Issue and Listing
of Debt Securities Regulations 2008. While the private placement disclosure and
documentation requirements are viewed by the market to be comprehensive, disclosure
requirements for public issuance of debt are viewed by the market as being extremely
onerous and difficult to comply with.
Corporate Debt Market – Recent Developments

Conclusion
Development of long-term debt markets is critical for the mobilization of the huge
funding required to finance potential businesses as well as infrastructure expansion.

Despite a plethora of measures adopted by the authorities over the last few years,
India has been distinctly lagging behind other developed as well as emerging
economies in developing its corporate debt market. The domestic corporate debt
market suffers from deficiencies in products, participants and institutional
framework.

For India to have a well-developed, vibrant, and internationally comparable


corporate debt market that is able to meet the growing financing requirements of
the country’s dynamic private sector, there needs to be effective co-ordination and
co-operation between the market participants that include investors and Corporates
issuing bonds as well as the regulators. Issues such as crowding of debt markets by
government securities cannot be addressed by market participants and regulators
alone.
Corporate Debt Market – Recent Developments

Conclusion
Better management of public debt and cash could result in a reduction in the debt
requirements of the government, which in turn would provide more market space
and create greater demand for corporate debt securities.

Clearly, the market development for corporate bonds in India is likely to be a gradual
process as experienced in other countries.

It is important to understand whether the regulators have sufficient willingness to


shift away from a loan-driven bank-dependent economy and also whether the
corporations themselves have strong incentives to help develop a deep bond market.

Only a conjunction of the two can pave the way for the systematic development of a
well-functioning corporate debt market which will lead to the high rate of GDP
growth the government is aspiring for.
Corporate Debt Market – Practice Questions

i. Which of the two markets contribute directly to the GDP growth in an economy,
Primary or Secondary?

ii. Give a comparative importance of the Primary and the Secondary Debt Markets
in India.

iii. Mention the key reasons why the Debt Market growth in India is sluggish. What
remedial measures will you suggest to improve the debt markets in India?

iv. How will a vibrant Debt Market benefit and contribute to India’s GDP growth?
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market


1. Growth in Financial Intermediation
The Indian capital market has grown due to innovation of the
mechanism of indirect financing. This innovation has enhanced the
efficiency of flow of funds from ultimate savers to ultimate users
through newly established financial intermediaries like UTI, LIC and
GIC. Financial intermediaries like LIC, UTI and GIC have activated the
growth process of Indian capital market.

2. Growth in Underwriting of Securities


In recent years, the volume and amount of securities underwritten
have tremendously increased owing to increasing participation of
specialized financial institutions like LIC and UTI and the developed
banks like 1FC1,1CICI and IDBI in underwriting activities. This is
enabled companies to adopt the Capital Market route of fund raising.
The growing response to public issues has strengthened the Indian
capital market.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market

3. Growth of Merchant Banking


 The emergence of a strong merchant banking activity within the
commercial banks in the country and in the Financial Institutions
has strengthened the institutional base of Indian capital market.
 The merchant banking division of commercial banks advises the
companies about economic viability, financial viability and
technical feasibility of projects. They conduct the initial ‘spade
work’ to find out the investment climate to advise the company
whether the public issue floated would be fully subscribed or
under-subscribed. The merchant banks in India act as the
underwriter as well as the manager of new issues of securities.
 The Securities and Exchange Board of India (SEBI) regulates all
merchant banks as far as their operations relating to issue activity
are concerned.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market


4. Growth of Credit Rating Agencies
Of late, credit rating agencies have emerged in the financial sectors. This is an
important development for the growth of Indian capital market. Investment
Information and Credit Rating Agency of India (ICRA) rates bonds, debentures,
preference shares, CDs (Corporate Debentures) and CPs (Commercial Papers).

5. Growth of Mutual Funds


 Mutual fund companies are investment trust companies. Mutual funds
schemes are designed to mobilize funds from individuals and
institutional investors, by selling “units” at the prevailing NAV at the time
of purchase. These “Units” can be redeemed at any time by the buyers
(at the then prevailing NAV) thereby bringing in a high degree of liquidity
in the investment in units. Moneys raised by sale of units are invested in
the capital markets in order to provide gains to the investors.
 Mutual Funds have provided a huge growth in capital markets
participation by small savers.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market

6. Stock Exchange Regulations Act


 The growth of capital market would not have been possible had
the Government of India not legislated suitable laws to protect
the investors and regulate the Stock Exchanges. Some of the
measures for investor protection are discussed later.
 Under this Act, only recognized stock exchanges are allowed to
function. This Act has empowered the Government of India to
enquire into the affairs of a Stock Exchange and regulate it’s
working.
 The Government of India established the Securities and Exchange
Board of India (SEBI) on April 12, 1988 through an extra ordinary
notification in the Gazette of India. In April 1992, SEBI was
granted statutory recognition by passing an Act. Since 1991, SEBI
has been evolving and implementing various measures and
practices to infuse greater transparency in the capital market in
the interest of investing public and orderly development of the
securities market.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market

7. Liberalization Measures
Foreign Institutional Investors (FII) have been allowed access to
Indian capital market. Investment norms for NRIs have been
liberalized, so that NRIs and Overseas Corporate Bodies can buy
shares and debentures, without prior permission of RBI. This was
expected to internationalize Indian capital market.

To sum up, the Indian capital market has registered an impressive


growth since 1951. However, it is only since the early -1990s that
new institutions, new financial instruments and new regularity
measures have led to speedy growth of the capital market. The
liberalization measures under New Economic Policy (NEP) gave a
further boost to the growth of Indian capital market.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market

6. Stock Exchange Regulations Act: Key Thrust Areas towards protection


of investors:
 Introduction of Circuit Breakers
This is another recent development in Indian Capital Market. Excessive
speculation is always risky for every investor. Hence, for reducing it, SEBI
has introduced circuit breakers.

A circuit breaker is the system which stops the trade in a particular stock
when its price reaches a specific level of movement. For example, if a
stock is at Rs. 100 and circuit breaker is fixed at 5%, then stock trading will
stop if it hit of Rs. 95 or Rs. 105. There are mainly two types of circuit
breakers. One is index wise circuit breakers and other is stock wise circuit
breakers.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market

6. Stock Exchange Regulations Act: Key Thrust Areas towards


protection of investors:
 Limit on Intraday Trading
Intraday Trading, also known as Day Trading, is the system where one
takes a position on a stock and release that position before the end of
that day's trading session. SEBI has imposed limits to the intra day trades
which can be done by a trader.
 Mark to Market Margin
MTM margin is imposed to cover the loss that a member may incur, in
case the transaction is closed at a closing price different from a price at
which the transaction has been entered.

It is just collection in cash for all futures contracts and adjusted against
the available Liquid Net Worth for option positions. In the case of futures
Contracts MTM may be considered as Mark to Market Settlement.
Recent Developments
Capital Markets – Derivatives Market – International Capital Markets

Key Developments in the Indian Capital Market

6. Stock Exchange Regulations Act: Key Thrust Areas towards protection


of investors:
 Investigations
SEBI has become more watchful to ensure compliances by both the
corporates and the traders and to order investigations where ever
violations happen.
 Investor Awareness Campaigns
For making Indian capital market more secure for Indian and foreign
investors, SEBI has started investors awareness campaign.

 Ban on Insider Trading


Insider trading is the trading of a corporation's stock or other securities
(e.g. bonds or stock options) by individuals with potential access to non-
public information about the company. This gives them an unfair
advantage at the cost of the investing public. In most countries, trading by
corporate insiders such as officers, key employees, directors. SEBI has
banned insider trading in India as well.
International Capital Markets
Participants
Primary & Secondary Markets

i. Definitions
ii. Primary Markets: How do these work?
 Procedural Aspects
 IPO - Pricing & Timing of Public Issues, Pre Issue concerns, Regulatory Aspects,
 Rights Issues
 Loan Syndication, Venture Financing, Private Equity
 Venture Financing
 Corporate Advisory Services
 M&A
iii. Structural Analysis of Investment Banking Industry
Primary Markets
i. Definitions:
The primary market is the part of the capital market that deals with issuing of new
securities. ... In a primary market, companies, governments or public sector
institutions can raise funds through bond issues and can raise capital through the
sale of new shares through an initial public offering (IPO).

Primary Markets are the platforms for raising funds for new projects by companies.

In India both Primary and Secondary markets are regulated by the Securities
Exchange Board of India

The difference between the primary capital market and the secondary capital market
is that in the primary market, investors buy securities directly from the company
issuing them, while in the secondary market, investors trade securities among
themselves, and the company with the security being traded does not participate in
the transaction.
Primary Markets

ii. Different Ways of raising Capital in Primary Markets


 IPO
Initial offer of sale of securities to the public by an unlisted company to raise
money from the Primary Market.

 FPO (Further Offer for Sale)


An existing listed company brings out sale of securities to the public

 Offer for Sale


An offer for sale (OFS) is the way by which stakeholders of a company sell their
holding. OFS enables promoters to dilute their holdings in listed companies in a
transparent manner with a wider participation through exchange based
bidding platform. An OFS is an auction and the proceeds go to promoters
Primary Markets

ii. Different Ways of raising Capital in Primary Markets


 QIP
A qualified institutional placement (QIP) occurs when the SEBI allows an
Indian company to issue securities in India without providing preliminary filings
regarding the issue.

QIPs are similar to private placements in the United States. Indian companies
that are listed on an Indian stock exchange are generally eligible to offer QIPs
only to qualified institutional buyers (QIBs).

Some limitations exist. For example, an issuer can raise no more than five
times its net worth via QIPs in a year. It must also prepare a placement
document containing relevant material disclosures, and a merchant banker
must manage each QIP.
Primary Markets - IPO

Initial Public Offer (IPO) is a process through which an unlisted Company can
be listed on the stock exchange by offering its securities to the public in the
primary market.

The object of an IPO may be relating to expansion of existing activities of the


Company or setting up of new projects or any other object as may be specified
by the Company in its offer document or just to get its existing equity shares
listed by diluting the stake of existing equity shareholders through offer for
sale.
Primary Markets – IPO - Process

The procedure for bringing out an IPO is as under:


i. Fulfilling the eligibility criteria
 The paid up equity capital of the applicant shall not be less than 10
crores and the capitalization of the applicant's equity shall not be less
than 25 crores.
Explanation 1: For this purpose, the post issue paid up equity capital for
which listing is sought shall be taken into account.
Explanation 2: For this purpose, capitalization will be the product of the
issue price and the post issue number of equity shares.
 For this purpose, the applicant or the promoting company shall submit
annual reports of three preceding financial years to NSE and also provide
a certificate to the Exchange in respect of the following:
 The company has not been referred to the Board for Industrial and
Financial Reconstruction (BIFR).
 The net worth of the company has not been wiped out by the
accumulated losses resulting in a negative net worth. (Provided this
criteria shall not be applicable to companies whose proposed issue
size is not less than Rs.500 crores)
 The company has not received any winding up petition admitted by
a court.
Primary Markets – IPO - Process

i. Fulfilling the eligibility criteria…contd


 The applicant company or promoters of the applicant company must
satisfy SEBI on the track record of Director(s) of the Company
In respect of the track record of the directors, relevant disclosures may
be insisted upon in the offer document regarding the status of criminal
cases filed or nature of the investigation being undertaken with regard to
alleged commission of any offence by any of its directors and its effect on
the business of the company, where all or any of the directors of issuer
have or has been charge-sheeted with serious crimes like murder, rape,
forgery, economic offences etc.

ii. Hiring the Lead Managers to the issue– single or multiple with a lead manager: In
consultation with the company the lead manager first of all determines the
following aspects of the IPO:
 Size of the issue
 Timing of the issue – fixing the opening and the closing dates
 Pricing of the issue
 Underwriting arrangements
Primary Markets – IPO - Process

iii. Getting SEBI approval: Application has to be made in the prescribed


form together with copies of required documents. SEBI may after
examining the application and making such enquires as it deems fit
approve the issue requiring the company to make such disclosures in
the prospectus as it deems fit.

iv. Bringing out a prospectus – by the company in consultation with the


Lead Manager

v. Opening of the issue

vi. Close of issue

vii. Allotment of shares

viii. Opening of trading in the stock exchange

ix. Filing of documents with the Registrar of Companies


Primary Markets – IPO
Filing of Red Herring Prospectus
 A red herring prospectus, as a first or preliminary prospectus, is a document
submitted by a company (issuer) as part of a public offering of securities (either
stocks or bonds). Most frequently associated with an initial public offering
(IPO), must be filed with SEBI.
 A red herring prospectus is issued to potential investors, but does not have
complete particulars on the price of the securities offered and quantum of
securities to be issued.
 The front page of the prospectus displays a bold red disclaimer stating that
information in the prospectus is not complete and may be changed, and that
the securities may not be sold until the registration statement, filed with the
market regulator, is effective.
 Potential investors may not place buy orders for the security, based solely on
the information contained within the preliminary prospectus. Those investors
may, however, express an "indication of interest" in the offering, provided that
they have received a copy of the red herring at least 48 hours prior to the
public sale.
Primary Markets – IPO - Pricing

i. Indian primary market ushered in an era of free pricing in 1992.


ii. SEBI does not play any role in price fixation. The issuer in consultation
with the merchant banker on the basis of market demand decides the
price.
iii. The offer document contains full disclosures of the parameters which are
taken in to account by merchant Banker and the issuer for deciding the
price. The parameters include EPS, PE multiple, return on net worth and
comparison of these parameters with peer group companies.
iv. On the basis of pricing, an issue can be further classified into fixed price
issue or book building issue.
 In case of a fixed price issue the issuer at the outset decides the
issue price and mentions it in the Offer Document, whereas
 in case on a book built issue the price of an issue is discovered on
the basis of demand received from the prospective investors at
various price levels.
Primary Markets – IPO - Pricing

v. The book building method is more efficient as it solves the "leakage" of


value often seen with fixed priced IPOs. Here the issuer sets a price range
within which the investor is allowed to bid for shares. The range is based
on where comparable companies are trading and an estimate of the
value of the company that the market will bear. The investors then bid to
purchase an agreed number of shares for a price which they feel reflects
fair value. By compiling a book of investors, the issuer can ascertain what
price range the shares should be valued at, based on the demand of the
people who are going to buy them, the investors. In this process supply
and demand are matched.
vi. Globally, the book building method is favored for its mutually beneficial
nature. Investors get the shares at a fair price that typically has potential
upside, and the issuing company receives fair compensation.
vii. In the longer-term, however, efficient pricing should be seen as a sign of
the growing maturity of the capital markets in the region.
Primary Markets – IPO
Difference between Fixed Price & Book Building

Features Fixed Price Issue Book Building Pricing


Pricing Price at which the Price at which securities will be
securities offered/ allotted is not known in
are offered/ allotted is advance to the investor. Only an
known indicative price range is known
in advance to the investor

Demand Demand for the securities Demand for the securities offered
offered is known only after can be known everyday as the
the closure of the issue book is built.
Payment Payment if made at the Payment only after allocation
time of subscription
wherein refund is given
after allocation
Primary Markets - IPO
Book Building Process
 Book building is a process of price discovery. The issuer discloses a
price band or floor price before opening of the issue of the securities
offered.

 On the basis of the demands received at various price levels within the
price band specified by the issuer, the Book Running Lead Manager
(BRLM) in close consultation with the issuer arrives at a price at which
the security offered by the issuer, can be issued.

 The price band is a band of price within which investors can bid. The
spread between the floor and the cap of the price band cannot be
more than 20 percent.

 A floor price or price band within which the bids can move is disclosed
at least two working days before opening of the issue in case of an IPO
and at least one day before opening of the issue in case of an FPO
(Further Public Offer).
Primary Markets - IPO

Book Building Process… Contd


 The price band can be revised. If revised, the bidding period is
extended for a further period of three days, subject to the total bidding
period not exceeding thirteen days.

 The applicants bid for the shares quoting the price and the quantity
that they would like to bid at. After the bidding process is complete,
the ‘cut-off’ price is arrived at based on the demand of securities.

 The basis of allotment is then finalized and allotment/refund is


undertaken.

 The final prospectus with all the details including the final issue price
and the issue size is filed with Registrar of Companies (ROC), thus
completing the issue process.
Primary Markets - IPO

Book Building Process…Contd


 Only the retail investors have the option of bidding at ‘cut-off’ price.
Cut-off” option is available for only retail individual investors i.e.
investors who are applying for securities worth up to Rs.2,00,000/-
only. Such investors are required to tick the cut-off option which
indicates their willingness to subscribe to shares at any price
discovered within the price band.

 Unlike price bids (where a specific price is indicated) which can be


invalid, if price indicated by applicant is lower than the price
discovered, the cut-off bids always remain valid for the purpose of
allotment.
Primary Markets - IPO

Types of investors
Investors can broadly be classified into the following categories:
i. Retail Investors
In retail individual investor category, investors can not apply for more
than two lakh (` 2,00,000) in an IPO. Retail Individual investors have an
allocation of 35% of shares of the total issue size in Book Build IPO's.

ii. Non Institutional Investors (NIIs)


All applicants, other than QIBs or individuals applying for less than Rs.
2,00,000 are considered as NIIs

iii. Qualified Institutional Investors


Institutional investors include banks, insurance companies, pensions,
hedge funds, REITs, investment advisors, endowments, and mutual
funds.
Primary Markets – IPO
Distribution of Issue under Book Building Process

In the case of issue of 100% of the securities offered to the public under the
Book Building Process the distribution of the securities shall be as under:
i. Retail Investors:
Not less than 35% of the total size of the issue

ii. Non Institutional Investors


Not less than 15 percent of the net offer to the public shall be available
for allocation to non-institutional investors i.e. investors other than
retail individual investors and Qualified Institutional Buyers

iii. Qualified Institutional Investors


Not more than 50 percent of the net offer to the public shall be
available for allocation to Qualified Institutional Buyers
Primary Markets - QIP
Qualified institutional placement (QIP) is a capital-raising tool, primarily used in India and
other parts of southern Asia, whereby a listed company can issue equity shares, fully and
partly convertible debentures, or any securities other than warrants which are convertible
into equity shares to a qualified institutional buyer (QIB).

Apart from preferential allotment, this is the only other speedy method of private
placement whereby a listed company can issue shares or convertible securities to a select
group of persons. QIP scores over other methods because the issuing firm does not have
to undergo elaborate procedural requirements to raise this capital.

The specified securities can be issued only to QIBs, who shall not be promoters or related
to promoters of the issuer. The issue is managed by a Sebi-registered merchant banker.
There is no pre-issue filing of the placement document with Sebi. The placement
document is placed on the websites of the stock exchanges and the issuer, with
appropriate disclaimer to the effect that the placement is meant only QIBs on private
placement basis and is not an offer to the public.

Qualified institutional buyers (QIBs) are those institutional investors who are generally
perceived to possess expertise and the financial muscle to evaluate and invest in the
capital markets.
Reliance Power Public Issue
A Case Study

 During January 2008, the maiden public issue of Reliance Power Limited, India, was
oversubscribed 73 times and garnered an astronomical $190 billion. It created
many world records. It was the largest subscription of any IPO (initial public
offering) anywhere in the history of global capital markets with a record five million
applicants. It became 10 top listed companies in India with the largest number of
shareholders in any listed company in the world.
 The high growth Reliance Group companies are known for producing stock-market
gains from the moment they are listed. No issue since its inception in the year 1965
had failed to date in the stock market. So the highly over - subscribed issue was
keenly awaited to open on February 11, 2008 in the twin stock exchanges National
Stock Exchange (NSE) and Bombay Stock Exchange (BSE) of Mumbai, India.
 But for the first time in history of Indian stock markets the Reliance magic did not
work. For a few moments on the opening day, Reliance Power surged 19% to 538
rupees ($10.94) from the IPO price of 450 rupees ($9.15). After the initial surge of
four minutes the dream vanished and RPL dived to 355rupees ($7.23) per share
never to return even close to the issue price. By the close of the day, it was down
17% at 372.50 ($7.57) rupees, Four billion of its market capitalization wiped out
and with it billions of rupees of investors’ wealth.
Reliance Power Public Issue
A Case Study

The aftermath
 In the following days, the nightmare worsened as another $5 billion of the
market capitalization was lost. The blow was severe and went far beyond
Reliance Power. The listing affected all the group companies of the Reliance
Group.
 As a face saving measure Reliance Power Ltd issued free bonus shares to all
categories of shareholders, excluding the promoter group (comprising of
Reliance Energy Ltd.(REL) and the ADA Group), in the ratio of 3 shares for every 5
shares held. The proposed bonus offering resulted in reduction of the cost of
Reliance Power shares with an offer price of Rs. 269 ($5.47) per share for retail
investors, 40% lower than the IPO price of Rs. 430($8.74) and Rs. 281($5.71) per
share for other investors, and 37% lower than the IPO price of Rs. 450 ($9.15).
 REL announced buyback of the shares to prevent the shares to slide further
which didn’t happen although.
 The performance of Reliance Power Ltd. after the IPO was good but not so
excellent to support this exorbitantly high IPO Pricing.
Reliance Power Public Issue
A Case Study

The aftermath
 The aftermath In the following days, the nightmare worsened as another $5
billion of the market capitalization was lost.
 The blow was severe and went far beyond Reliance Power. The listing affected all
the group companies of the Reliance Group.
 As a face saving measure Reliance Power Ltd issued free bonus shares to all
categories of shareholders, excluding the promoter group (comprising of
Reliance Energy Ltd.(REL) and the ADA Group), in the ratio of 3 shares for every 5
shares held.
 The proposed bonus offering resulted in reduction of the cost of Reliance Power
shares with an offer price of Rs. 269 ($5.47) per share for retail investors, 40%
lower than the IPO price of Rs. 430 ($8.74) and Rs. 281 ($5.71) per share for
other investors, and 37% lower than the IPO price of Rs. 450 ($9.15).
 REL announced buyback of the shares to prevent the shares to slide further
which didn’t happen although.
 The bonus issue resulted in the holding of the promoters coming down.
Reliance Power Public Issue
A Case Study

Background of the Issue - Power Sector in India


 The Indian power sector has grown significantly since 1947 and India today is
the third largest producer of power in Asia.
 The power generating capacity has increased from 1,362 MW in 1947 to over
160,000 MW by mid of 2010.
 Despite significant growth in electricity generation over the years, the shortage
of power continues to exist primarily on account of growth in demand for power
outstripping the growth in generation and capacity additions in power
generation.
 According to projections made in the National Electricity Plan, demand for
power is expected to grow at an average annual rate of 9% during the 11th Plan
period (2007-12) and at an average annual rate of 7% during the 12th Plan
period (2012-17).
 The gap between demand and supply has not decreased in the last few years,
leading to persistent power shortages. The prevailing and expected electricity
demand and supply imbalance in India presents significant opportunities in the
power generation sector.
Reliance Power Public Issue
A Case Study

Background of the Issue - Power Sector in India


 Indian power sector has been regulated for almost a century through ‘The
Electricity Act 1910’ and subsequently ‘The Electricity (Supply) Act 1948’. By and
large it was state controlled through the state electric boards and the
performance of power sector was dismal during this period.
 As the Indian Economy started opening up to private sector and foreign players
power sector also attracted lot of investment. The year 2003 marked a new
beginning of reforms in the Electricity Sector in India with enactment of the
Electricity Act with lot of regulatory changes. The Central Government came out
with National Electricity Policy on 6th February 2005.
 Now 100 percent Foreign Direct Investment (FDI) is allowed in generation,
transmission and distribution segments. Incentives are given to the sector
through waiver of duties on capital equipment under the Mega Power Policy.
 These policy initiatives have resulted in building up investor confidence in the
power sector and have created an ideal environment for increased participation
by the private sector.
Reliance Power Public Issue
A Case Study

Analysis of RPL IPO Case


Several analysis and reasons were ascribed to the Reliance Power debacle.
• Reliance Power was a new company. It had almost no assets and cash flow. It
was riding on the Reliance brand name and also the euphoria in India's stock
markets. This was further aggravated through the exorbitant price quoted in the
grey market before the issue. The “Power On, India On" slogan created hype
and tried to portray over dependence of India’s economic growth on availability
of power.
• Indian investor considers IPO as a means of making quick money. The shares
are sold out immediately on opening of the issue. This may be a reason of the
Reliance Power debacle.
• The IPO was not helped by a souring in global market mood as the
reverberations of the US subprime and credit crisis swept around the world.
Between January 4, when the IPO was announced, and the listing date of
February 11, the benchmark Sensex index fell over 4,000 points, or almost 20%,
from historic highs of around 20,686 points to 16,630.91 points.
• It was observed that few Mauritius-based foreign institutional investors (FIIs)
and a domestic bank offloaded almost their entire shareholding in the company
within minutes of the opening bell.
Reliance Power Public Issue
A Case Study

Analysis of RPL IPO Case


Several analysis and reasons were ascribed to the Reliance Power debacle.
• Trading data indicated that as much as 23.77 million shares, 10.4% of the total
228 million shares sold through the Reliance Power IPO, changed hands on the
twin bourses of Mumbai (Bombay Stock Exchange and National Stock Exchange)
within the first four minutes. Sell orders were made at progressively declining
prices. It was pointing towards a pre-mediated manipulation in the dealings
although an investigation by Securities Exchange Board of India (the regulatory
body of Indian Stock Market) cleared the dealings as genuine.
Reliance Power Public Issue
A Case Study

Analysis of RPL IPO Case


Several analysis and reasons were ascribed to the Reliance Power debacle.
• Reliance Power's downfall was linked to aggressive pricing of the IPO. Analysts
suggested that it was overvalued when compared with peer companies in India.
For instance, the IPO price was 450 against the price of NTPC, (the government
power company) at Rs.250/-. RPL was planning a 28000 MW power plant in
2017 and did not have a single operational power plant whereas NTPC had
27350 MW of operational power plant in the year 2007. (Annexure I).
Comparison of the financials of Tata Power and NTPC also did not show a very
promising picture of RPL. (Annexure II) On the contrary, it was advocated that
the retail investors may have been swayed by the hype, but that cannot be told
about the Foreign Institutional Investors (who have got all the expertise and
knowhow of valuation of shares).

The vicious manner in which the IPO shares were offloaded at declining prices to
cause havoc on the RPL shares indicates a planned move from interested quarters to
deliberately kill the success of the issue.
Reliance Power Public Issue
A Case Study

Main questions on the Case Study

a. What were the reasons for the heavy oversubscription to the RPL issue?
b. What indicates the failure or a success of a public issue?
c. What factors contributed to the failure of the issue?
d. How did Reliance Power attempt to meet the crisis?
Reliance Power Public Issue
Key Learnings

The book building process of Initial Public Offer (IPO)


 The very first sale of stock to the general public is called an IPO. The issuer may
be a new company or an old company.

 The issuer and the investment banker jointly decide the price band of the new
issue and once the price band is determined the investment banker managed
the IPO through book building process.

 Till early 1990’s the new issue in India was governed by the Controller of
Capital Issue (CCI) where the company decides one price to issue the share
after taking the due approval from CCI. This was known as Fixed Price regime.

 After the abolition CCI, the book building process was introduced, which is a
mechanism in between fixed price and free price.
Reliance Power Public Issue
Key Learnings

The Book Building Process


• The company first appoints a book runner or an investment banker.
• The investment banker prepares and submits a draft document to SEBI for
approval.
• The issuer and the investment banker jointly decide the share price with a price
band.
• The investment banker takes up all the promotional activities to sell the shares.
• Offers regarding the demand for security at different price level are invited
from different market participants (Financial Institutions, Brokers, Mutual
funds, Foreign Institutional investors, Individual investors, etc).
• Based on the bid received, the issuer and the investment banker jointly decide
a Cut-Off Price.
• In 100% book building – proportional allotment- 50% Qualified Institutional
Bidders, 15% High Net-worth Individual and 35% Retail investors.
• If any portion is over subscribed, allotment is done on proportional basis.
Reliance Power Public Issue
Key Learnings

Pros & Cons of book building process.


 Book building process is considered to be the superior process as compared to
the fixed price process.
 Under fixed price process the investors have no say over the price of an IPO.
The price is determined by the company. The company does not consider
feedback from the investors while determine the IPO price.
 The book building process considers the investors decision and feed-back
partially (if not full). The complete investors feed-back regarding price are
possible only in case of free price mechanism, which has a practical problem of
extremely divergent view of price by the investor’s community.
 Therefore, the company decides an initial price band (floor and ceiling price is
decided by the company) and the investors decide a particular price within the
price band based on his perception and valuation about the stock. He is allowed
to change the price during the issue opens. As investors feed-back is taken in
this process, the price discover in this process is high and the possibility of large
price fluctuation after listing is not so high.
Reliance Power Public Issue
Key Learnings

The role of key players in IPOs in the Indian Context

Lead Managers
 Lead managers are independent financial institutions appointed by the company
going public to manage the IPO. They are the main body responsible for most of
the IPO processing.
 Lead managers examine company documents including financial documents,
documents relating to litigation like commercial disputes, patent disputes,
disputes with collaborators, etc. and other materials, in connection with the
finalization of the draft red herring prospectus for the IPO.
 Lead managers are responsible to write the Red Herring Prospectus (RHP) and get
it approved by SEBI.
 [A red herring prospectus, as a first or preliminary prospectus, is a document
submitted by a company (issuer) as part of a public offering of securities (either
stocks or bonds). A red herring prospectus is issued to potential investors, but does
not have complete particulars on the price of the securities offered and quantum of
securities to be issued]
Reliance Power Public Issue
Key Learnings

The role of key players in IPOs in the Indian Context

Lead Managers
 SEBI contacts the lead managers for any irregularities or lapses in RHP and ask
them to clarify, add or review certain sections of the document. Lead managers
certifies to SEBI that all the disclosers made in Draft Red Herring Prospectus are
true, correct, adequate and comply with SEBI guidelines to help investors in
making a well-informed decision.

In brief Lead Manager’s responsibilities include, initiate the IPO processing, write draft
herring prospectus and get it approve by SEBI, help company in selling the IPO Shares
and road shows, help company in finalize the issue price, issue opening & closing dates,
listing date etc. Lead Manager’s are also known as Book Running Lead Manager and Co-
Book Running Lead Managers. Issuer Company can appoint more than one lead
manager to manage big IPO's.
Reliance Power Public Issue
Key Learnings

IPO Registrar
IPO Registrars are independent financial institutions registered with stock exchanges and
appointed by the company going public for mainly to keep record of the issue and
ownership of company shares.
Responsibility of a registrar at the time of IPO involves, processing of IPO applications,
allocate shares to applicants based on SEBI guidelines, process refunds and transfer
allocated shares to investors de-mat accounts.
Investors can contact the Registrar to the Issue in case of any pre-Issue or post-Issue
related problems such as non-receipt of letters of allotment, credit of allotted shares in
the respective beneficiary accounts, refund orders etc the full name of the sole or First
Bidder, Bid cum Application Form number, Bidders Depository Account Details, number
of Equity Shares applied for, date of bid form, name and address of the member of the
Syndicate where the Bid was submitted and cheque or draft number and issuing bank
thereof.
Reliance Power Public Issue
Key Learnings

Syndicate Member
 Issuer Company with the help of lead manager appoints underwriters or syndicate
members for the IPO. Lead managers are responsible for examining the worth of
underwriters and there capabilities to buy the shares and assure the same to SEBI.

 Syndicate members are commercial or investment banks responsible for


underwriting IPO's.

 Syndicate members are usually registered with SEBI or registered as brokers with
BSE / NSE Stock Exchanges.
IPOs
Case Study: Mahanagar Gas Ltd. – IPO- 2016

Mahanagar Gas Limited is one of the largest city gas distribution companies in India.
Established in 1995, the company has more than 20 years of experience in supplying
natural gas in Mumbai and is presently the sole authorized distributor of
compressed natural gas (CNG) and piped natural gas (PNG) in Mumbai, its adjoining
areas and the Raigad district in the state of Maharashtra.

Mahanagar Gas is a joint venture (JV) between GAIL (Gas Authority of India Ltd) and
BGAPH (BG Asia Pacific Holdings Pte. Limited) with each party owning 49.75% of its
equity shares. GAIL is a Maharashtra public sector undertaking and the largest
natural gas transmission company in India while Singapore based BGAPH is a part of
Royal Dutch Shell.
IPOs
Case Study: Mahanagar Gas Ltd. – OFS - 2016

Issue Background
 The Initial Public Offer comprised of an offer for sale of 24.7 mn equity shares
(including a reservation of 200,000 equity shares for subscription by eligible
employees) of Rs.10 each aggregating upto Rs. 9.4 - 10.4 bn (at lower price band
– higher price band) at a price to be decided through a 100% book-building
process by the promoters.
 The bid/issue opened on 21 June 2016 and closed on 23 June 2016.
 The IPO price band is fixed at Rs.380 – Rs.421 per share.
 The objects of the issue are
 to achieve the benefits of listing the equity shares on the Stock Exchanges
and
 for the sale of equity shares by the existing Shareholder. The Company will
not receive any proceeds from the offer for sale and the proceeds will go to
selling shareholders.
IPOs
Case Study: Mahanagar Gas Ltd. – IPO- 2016

Percentage Percentage
Name of shareholder Equity Shares
(%) after IPO (%)
GAIL 44,449,990 45 32.5
BGAPH (British Gas/Royal
44,449,960 45 32.5
Dutch Shell)
Public 0 0 35
Government of Maharashtra 9,877,778 10 0
Total 98,777,778 100 100

Mahanagar Gas Limited was listed on the exchanges at Rs 540 per share, up 28
percent from its issue price of Rs 421 per share. The country's second largest
CNG retailer had raised Rs 1040 crore through its IPO with price band at Rs
380-421.
The initial share sale of Mahanagar Gas was oversubscribed 64.54 times.
IPOs
Offers for Sale

What is OFS
 OFS, introduced by the Securities and Exchange Board of India, or Sebi, in
February 2012, helps promoters of listed companies dilute stake through
an exchange platform. The promoters are the sellers. The bidders can
include market participants such as individuals, companies, qualified
institutional buyers and foreign institutional investors. The facility is
available on the Bombay Stock Exchange and the National Stock
Exchange (NSE).
 Only top 200 companies by market capitalization in any of the four
completed quarters can use the facility.
 Non-promoters holding at least 10% share capital can also sell shares
through this route. In this case, promoters can act as bidders.
 The minimum offer size is Rs 25 crore. It can be less if the aim of the issue
is meeting the public shareholding norm (25% for private companies and
10% for government ones).
IPOs
Offers for Sale

Why OFS?
"One of the aims of using the OFS route is meeting the public shareholding
requirement. Promoters could also use it to ensure wider ownership of the
company,“
The option benefits issuers too by reducing the time taken to raise funds as
they otherwise have to follow a long procedure that includes issuing a draft
prospectus and an application process involving a lot of formalities.

There have been more than 60 OFS issues so far, as per the NSE website.
Structural Analysis of Investment Banking Industry
Two Arms of Investment Banking
Commercial Banks
Provide deposits and Loans services through a wide network of branches
Provide Merchant Banking Services
Lend money through credit cards
Structural Analysis of Investment Banking Industry
Commercial Banks vs Investment Banks

 The line between the two is slowly disappearing


 Most of the Commercial Banks today are operating both as commercial
banks and investment banks, such as ICICI Bank, Kotak Mahindra Bank,
HDFC Bank, Citibank, Deutsche Bank and BNP Paribas.
Structural Analysis of Investment Banking Industry
Role of Investment Banks as Intermediary

 Investment Bankers act as Intermediaries in Financial and Capital Markets


 Raise and supply capital to corporation;
 Provide advisory services:
 On Asset Management;
 Market Research and Analysis;
 Facilitation of Mergers and Acquisition (M & A) deals;
 Etc etc
 Provides asset management services ;
 Act as intermediaries between the firms raising funds and investors;
 Help in the issuance of equity and bonds;
 Arrange debt for clients ;
 Often purchase debt and equities on their own
Sources of Raising Long Term Finance

i. Equity Capital – Public Issue by listed companies, Rights Issue, Preferential


Allotment, Venture Capital
ii. Preference Capital
iii. Debentures – Term Loans and Deferred Credit
iv. Term Loans
v. Govt Subsidies
vi. Emerging Sources of Finance – Private Equity, FDI, FCCB
Introduction to Equity Capital

i. Public Issue - Already discussed


 IPO
 Offer for Sale
 FPO

ii. Rights Issue

iii. Preferential Allotment


Raising Equity Capital
Rights Issue

A rights issue is a mode of raising additional capital by a listed company.


However, instead of going to the public, the company gives its existing
shareholders the right to subscribe to newly issued shares in proportion
to their existing holdings.

A rights issue is a grant of subscription rights to buy additional securities


in a company made to the company's existing security holders. It is a non-
dilutive pro rata way to raise capital.

Rights issues are typically sold via a prospectus or prospectus supplement.


With the issued rights, existing security-holders have the privilege to buy a
specified number of new securities from the issuer at a specified price
within a subscription period.
Raising Equity Capital
Preferential Allotment of Shares

Preferential Allotment is the process by which allotment of securities/shares is done on


a preferential basis to a select group of investors.

For raising funds, it is not always preferable or feasible for a company to issue securities
to the public at large as it is time consuming as well as an expensive option. In such
situations, the securities can be offered to a comparatively smaller group of individuals,
such as the directors or the existing shareholders. This entire process is known as
preferential allotment.

Through preferential allotment of shares a company can issue following type of shares /
securities:
 Issuance of Equity shares.
 Issuance of Fully or partly convertible debentures
 Issuance of any other securities convertible into equity shares
Raising Equity Capital
Preferential Allotment of Shares

Conditions for Preferential Allotment of Securities (Section 62 of the


Companies Act 2013)

A. Offer to be previously approved by Special Resolution passed at a meeting of


members;

B. The Offer of securities on Preferential Allotment basis must be authorized by the


Articles of Association of the Company;

C. The maximum number of persons to whom offer can be made shall not exceed
200 people in a financial year. The 200 people limit excludes Qualified
Institutional Buyers and Employees and the limit of 200 people is calculated
individually for each kind of security.

D. The restriction of 200 member would be reckoned individually for each kind of
shares / security i.e. (equity share, preference share or debenture).
Raising Equity Capital
Preferential Allotment of Shares

Conditions for Preferential Allotment of Securities (Section 62 of the Companies


Act 2013)

E. Time period for completion of the Allotment: The allotment of securities on a


preferential basis shall be completed within a period of twelve months from the
date of passing of the special resolution. If the allotment of securities is not
completed within twelve months from the date of passing of the special
resolution, another special resolution shall be passed for the company to
complete such allotment thereafter.
OR
The company making an offer or invitation under this section shall allot its
securities within sixty days from the date of receipt of the application money.
Whichever is earlier.

F. Application Form:
The offer letter shall be accompanied by an application form serially numbered
and addressed specifically to the person to whom the offer is made and shall be
sent to him, either in writing or in electronic mode, within thirty days of
recording the names of such persons at extra ordinary general meeting.
Raising Equity Capital
Preferential Allotment of Shares

Conditions for Preferential Allotment of Securities (Section 62 of the Companies


Act 2013)

G. Value of Offer and invitation:


The value of the Offer per person shall not be less than INR 20,000 of ‘face
value’ of securities. The shareholder can accept less value of shares.

H. Any offer or invitation not in compliance with the provisions of this section shall
be treated as a public offer and all provisions of this Act, and the Securities
Contracts (Regulation) Act, 1956 (42 of 1956) and the Securities and Exchange
Board of India Act, 1992 (15 of 1992) shall be required to be complied with
Raising Debt

The key sources of Debt


i. Debentures
ii. Term Loans
iii. Loan Syndication
iv. venture Capital & Deferred Credit,
v. Leasing & Hire Purchase
Loan Syndication

Loan syndication is the process of involving several different lenders in providing


various portions of a loan. Loan syndication most often occurs in situations where a
borrower requires a large sum of capital that may be too much for a single lender to
provide or outside the scope of a lender's risk exposure levels.

A syndicated loan, also known as a syndicated bank facility, is a loan offered by a group
of lenders – referred to as a syndicate – that work together to provide funds for a
single borrower. The borrower could be a corporation, a large project or a sovereignty,
such as a government.

In the financial world, a consortium refers to several lending institutions that group
together to jointly finance a single borrower. These multiple banking arrangements are
very similar to a loan syndication, although there are structural and operational
differences between the two.
Loan Syndication

While a loan syndication involves multiple lenders and a single borrower, the term is
generally reserved for loans that involve international transactions, different currencies
and a necessary banking cooperation to guarantee payments and reduce exposure. A
loan syndication is headed by a managing bank that is approached by the borrower to
arrange credit. The managing bank is generally responsible for negotiating conditions
and arranging the syndicate. In return, the borrower generally pays the bank a fee.

The managing bank in a loan syndication is not necessarily the majority lender, or
"lead" bank. Any of the participating banks may act as lead or assume the
responsibilities of the managing bank depending on how the credit agreement is drawn
up.
Loan Syndication

Consortium
Like a loan syndication, consortium financing occurs for transactions that might not take
place with a single lender. Several banks may agree to jointly supervise a single borrower
with a common appraisal, documentation and follow-up. Consortiums are not built to
handle international transactions such as a syndication loan; instead, a consortium may
arise because the size of the project at hand is simply too large or too risky for any single
lender to assume. Sometimes the participating banks form a new consortium bank that
functions by leveraging assets from each institution and disbands after the project is
complete.
Venture Financing

Start up companies with a potential to grow need a certain amount of investment.


Wealthy investors like to invest their capital in such businesses with a long-term
growth perspective. This capital is known as venture capital and the investors are
called venture capitalists.

Such investments are risky as they are illiquid, but are capable of giving impressive
returns if invested in the right venture. The returns to the venture capitalists
depend upon the growth of the company. Venture capitalists have the power to
influence major decisions of the companies they are investing in as it is their
money at stake.

All companies start as a piece of paper idea and can grow into billions of dollars of
revenues from there. And, there are specific types of investors that help investors
along each step of the way. All the way from venture capital, at a company's very
early stages, to private equity capital through its middle stages, mezzanine capital
which is typically a bridge to the next stage, which is an initial public offering or
some other liquidity event. We are going to focus on the very early stages in this
post, which is truly the venture capital stage.
Stages of Venture Financing

Even within venture financing, there are investors that focus on different stages
therein.

 "Seed stage" venture investors help get a company off the ground;

 "Early stage" venture investors focus on taking a company that has successfully
proven its concept, and help them to accelerate their sales and marketing
efforts;

 "Growth stage" venture investors basically pour kerosene on top of a company


that is already "on fire“;

Seed stage investors think in the range of say top line of Rs 5 Million whereas early
stage investors may think of the top line growth upto Rs 5 Crores while growth stage
investors may work on a top line growth to Rs 30 Crores and above.

And, at each stage herein, most investors have some type of industry expertise that
they focus on.
Form of Venture Financing

Within the venture capital space, the two most typically used structures are;
 Equity; and
 Debt.

Equity is the most common form of Venture Capital Financing of a new start up
project. Once invested, equity is owned outright until some type of sale or
liquidity event of the company takes place. However, it may be liquidated by
way of a public offer.

Debt, may comprise of either non convertible debt or convertible debt.


 Non convertible debt instrument has a maturity date and does need to be
repaid at some point in the future.
 On the other hand convertible debt investors in venture capital are
treating their investment like equity, and are prepared to "convert" their
debt into equity of the company at a predetermined time.

Debt venture financing is often a "bridge" financing to an early stage or growth


stage financing, in a way that doesn't have to set a formal equity valuation of
the company.
Government Subsidies

Government subsidies or grants are a significant source of funding projects


of public importance. A project which the government considers to be of
high public importance or in national interest may be encouraged through
the grant of subsidies.

Government subsidies are payable only when the conditions set by the Govt
are fulfilled;

Govt subsidies may be given by the Central Govt or any State Govt or by any
arm of the Central or State Govt such as the Indian Railways etc;

Govt subsidies may be given in two forms:


a. As part of the capital investment in the project; or / and
b. As a relief on prices to the end consumer where the end consumer
needs support, such as fertilizer subsidy to farmers. In this case the
company sells the product to the consumer at a low price and the
difference in price is paid by the Govt as subsidy,
Emerging Sources of Finance
Private Equity, FDI, FCCB

What is the difference between venture capital, growth capital and private
equity?

The businesses invested in by private equity range from early-stage ventures, usually
termed venture capital investments, through businesses requiring growth or
development capital to the purchase of an established business in a management
buy- out or buy-in. In this sense private equity is a generic term that incorporates
venture, growth and buy-out capital. However, although all these cases involve
private equity, the term is now generally used to refer to later-stage development
capital but mostly buy-outs and buy-ins of established businesses. Private equity
therefore usually contrasts with venture capital, which is used to describe early-stage
investments.
Emerging Sources of Finance
Private Equity, FDI, FCCB

Private equity
Private Equity is a risk capital provided outside the public markets.
Much, of the investing done in the private equity market is by private equity funds. A
private equity fund is a form of ‘investment club’ in which the principal investors are
institutional investors such as pension funds, investment funds, banks, as well as the
private equity fund managers themselves.

The objective of a private equity fund is to invest in equity or risk capital in a portfolio
of private companies which are identified and researched by the private equity fund
managers.

Private equity funds are generally designed to generate capital profits from the sale
of investments rather than income from dividends, fees and interest payments. A
private equity fund may take minority or majority stakes in its investments, though
generally it will be the latter in the larger buy-outs. At the same time that a private
equity fund makes an investment in a private company, there is usually some bank
debt or other debt capital raised to meet part of the capital required to fund the
acquisition. This debt is the ‘leverage’ of a leveraged buy-out. Private equity is
predominantly about generating capital gains.
Emerging Sources of Finance
Private Equity, FDI, FCCB

What is the difference between venture capital, growth capital and private
equity?

The businesses invested in by private equity range from early-stage ventures, usually
termed venture capital investments, through businesses requiring growth or
development capital to the purchase of an established business in a management
buy- out or buy-in. In this sense private equity is a generic term that incorporates
venture, growth and buy-out capital. However, although all these cases involve
private equity, the term is now generally used to refer to later-stage development
capital but mostly buy-outs and buy-ins of established businesses. Private equity
therefore usually contrasts with venture capital, which is used to describe early-stage
investments.
Emerging Sources of Finance
Private Equity, FDI, FCCB

External Commercial Borrowings

External commercial borrowing (ECBs) are loans in India made by non-resident


lenders in foreign currency to Indian borrowers. They are used widely in India to
facilitate access to foreign money by Indian corporations and PSUs.

ECBs include commercial bank loans, buyers' credit, suppliers' credit, securitized
instruments such as floating rate notes and fixed rate bonds etc, and commercial
borrowings from the private sector window of multilateral financial Institutions such
as International Finance Corporation (Washington), ADB etc.

ECBs cannot be used for investment in stock market or speculation in real estate.

The DEA (Department of Economic Affairs), Ministry of Finance, Government of India


along with Reserve Bank of India, monitors and regulates ECB guidelines and policies.
Emerging Sources of Finance
Private Equity, FDI, FCCB

External Commercial Borrowings

Most of these loans are provided by foreign commercial banks and other institutions.

During the 2012, contribution of ECBs was between 20 to 35 percent of the total
capital flows into India. Large number of Indian corporate and PSUs have used the
ECBs as sources of investment.

For infrastructure and greenfield projects, funding up to 50% (through ECB) is


allowed.

According to a report in The Hindu in January 2013, the Reserve Bank of India raised
the ECB limit "for non-banking finance companies (NBFCs) classified as infrastructure
finance companies (IFCs) from 50 per cent to 75 per cent of owned funds, including
outstanding ECBs". In telecom sector too, up to 50% funding through ECBs is allowed.
Emerging Sources of Finance
Private Equity, FDI, FCCB

External Commercial Borrowings

Borrowers can use 25 per cent of the ECB to repay rupee debt and the remaining 75
per cent should be used for new projects.

A borrower can not refinance its entire existing rupee loan through ECB.

The money raised through ECB is cheaper given near-zero interest rates in the US and
Europe, Indian companies can repay part of their existing expensive loans from that.
Emerging Sources of Finance
Private Equity, FDI, FCCB

FDI

Foreign direct investment (FDI) is an investment made by a company or individual in


one country in business interests in another country, in the form of either
establishing business operations or acquiring business assets in the other country,
such as ownership or controlling interest in a foreign company.

Foreign direct investment (FDI) in India is the major monetary source for economic
development in India. Foreign companies invest directly in fast growing private
Indian businesses to take benefits of cheaper wages and changing business
environment of India.

However, such FDI is governed by the policies and guidelines of the Government
issued at various points in time. At present the government of India is inviting FDI in
a big way to invest in India and deliver growth.
Emerging Sources of Finance
Private Equity, FDI, FCCB

FDI

Foreign direct investment (FDI) is an investment made by a company or individual in


one country in business interests in another country, in the form of either
FDI depends on a large number of factors such as:
 Ease of doing business;
 Political stability;
 Taxation policies;
 Developed financial markets;
Emerging Sources of Finance
Private Equity, FDI, FCCB

FCCB

A foreign currency convertible bond (FCCB) is a type of convertible bond issued in a


currency different than the issuer's domestic currency. In other words, the money
being raised by the issuing company is in the form of a foreign currency.

A convertible bond is a mix between a debt and equity instrument.


Raising Finance From International Markets

i. Intermediaries – Euro Dollar Market


ii. Instruments in International Finance: ADR / GDR, FCCB
iii. ECB – Regulatory Aspects
Intermediaries in International Financing

A financial intermediary is an institution or individual that serves as a


middleman for different parties in a financial transaction. According to classical
as well as most mainstream economists, a financial intermediary is typically a
bank that consolidates deposits and uses the funds to transform them into
loans. This however, is a restrictive definition of the Financial Intermediary.

A financial intermediary is a financial institution such as bank, insurance


company, investment bank or pension fund which offers a service to help an
individual, firm or any association of persons to save money and on the other
hand channelizes such savings into borrowings by those in need of funds.

Financial intermediaries bring together those economic agents who have


surplus funds and who want to lend /invest and those with a shortage of funds
who want to borrow. Through the process of financial intermediation, certain
assets or liabilities are transformed into different assets or liabilities.
Intermediaries in International Financing

Financial Intermediaries offer the benefits of maturity and risk


transformation. Specialist financial intermediaries are ostensibly enjoying a
relative cost advantage in offering financial services, which not only enables
them to make profit, but also raises the overall efficiency of the economy.

According to the dominant economic view of monetary operations, the


following institutions are or can act as financial intermediaries in the
developed economies which are active in International Financing:
 Banks.
 Mutual Funds
 Financial advisers or brokers.
 Insurance companies.
Euro Dollar Market

 By Euro-dollars is meant all U.S. dollar deposits in banks outside the


United States, including the foreign branches of U.S. banks.

 A Euro-dollar is, however, not a special type of dollar. It bears the


same exchange rate as an ordinary U.S. dollar has in terms of other
currencies.

 Euro-dollar transactions are conducted by banks not resident in the


United States. For instance, when an American citizen deposits
/lends his funds with a U.S. Bank in London, and that fund may again
be used to give loans to a business enterprise in the U.S., then such
transactions are referred to as Euro-dollar transactions.

 All Euro-dollar transactions are, however, unsecured credits

Euro-dollars have two basic characteristics:


 first, they are short term obligations to pay dollars;
 second, they are obligations of banking offices located outside the U.S.
Euro Dollar Market

Euro Dollars in simple words may be defined as USDs deposited in banks outside
the US. Such dollars are used as an international currency for trading by almost all
countries excluding the US itself and hence have a high degree of mobility in
International Trade.

The benefits of Euro Dollar Markets to countries operating in such markets:


1. They provide a ready international short-term capital market whereby they:
 enable importers and exporters to borrow dollars for financing trade, at
cheaper rates than otherwise obtainable;
 enlarge the facilities available for short term investment
 enable financial institutions in adjusting their cash and liquidity positions.

2. They promote and facilitate foreign trade among countries

3. It has enabled monetary authorities with inadequate reserves to increase their


reserves by borrowing Euro-dollar deposits.

4. It has caused the levels of national interest rates more akin to international
influences.
Euro Dollar Market

Positive effects of Euro-dollar Market on International Financial System


i. The position of dollar has been strengthened temporarily, since borrowing
of dollars has become more profitable rather than its holdings.
ii. It facilitates the financing of balance of payments surpluses and deficits.
Especially, countries having deficit balance of payments tend to borrow
funds from the Euro- dollar Market, thereby, lightening the pressure of their
foreign exchange reserves.
iii. It has promoted international monetary cooperation.
iv. Over the last decade, the growth of Euro-dollar has helped in easing the
global liquidity problem.

Major shortcomings of the Euro-dollar Market


v. It may lead banks and business firms to over-trade in Euro Dollars thereby
weakening discipline within the banking communities .
vi. It involves a grave danger of sudden large-scale withdrawal of credits by a
country – This however is more of a theoretical constraint than a real one.
vii. It has rendered official monetary policies less effective for the countries
involved.
Euro Currency Market

Euro Currency Markets are different from Euro Dollar Markets.


The Euro Currency Markets are a broader term having the following key
features:

 These comprise of any freely convertible currency, such as $, € or Yen


deposited in a bank outside its country of origin.
 It is the residency of the bank and not its nationality that determines the
“euro” nature of the deposit. Hence, if a Japanese investor deposits Yens in
the Bank of Tokyo, London Branch, the Yen so deposited will constitute a
Euro Currency.
 Euro Currency Markets are the most important international financial
markets today.
 The Euro Currency Markets are composed of euro banks who
accept/maintain deposits of foreign currencies which are freely convertible.
 The dominant currency which is traded in the Euro Currency Markets is the
US$.
 Hence, we may say that the Euro Dollar Market is a constituent of the Euro
Currency Markets.
Instruments used in International Financing
ADR / GDRs, ECCB

A global depository receipt (GDR) is a certificate issued by a depository bank,


which purchases shares of foreign companies and deposits it on account.

GDRs represent ownership of an underlying number of shares of a foreign


company and are commonly used to invest in companies from developing or
emerging markets by investors in developed markets. Typically, 1 GDR is equal to
10 underlying shares, but any ratio can be used.

Several international banks issue GDRs, such as JPMorgan Chase, Citigroup,


Deutsche Bank, The Bank of New York Mellon. GDRs are often listed in the
Frankfurt Stock Exchange, Luxembourg Stock Exchange, and the London Stock
Exchange, where they are traded on the International Order Book (IOB).

Prices of global depositary receipt are based on the values of related shares, but
they are traded and settled independently of the underlying share. GDRs enable
a domestic company, to access investors in capital markets outside its home
country.
Instruments used in International Financing
ADR / GDRs, ECCB

An example of how does a GDR work:

John a British citizen, purchases 1,000 shares of ITC Ltd at Rs 250 per share and
mandates JP Morgan Chase Bank to buy the same on his behalf. JP Morgan
Chase purchase the shares and issue a GDR to John on the ratio of 1:10. This
means the GDR is for 100 underlying units [comprising of 1,000 shares of ITC]
with the cost of each unit being 2,500. The GDR will be traded in the London
Stock Exchange on the basis of the price ruling for ITC shares in India. If the price
of ITC shares goes up to Rs 300 per share the GDR value will also be around Rs
3,000 per GDR. Mr John may decide to sell the GDRs and book the profit.

From the above, the shares of ITC Ltd have been indirectly traded in the London
Stock Exchange and have been invested in by foreign investors.

Similarly, when an Indian Company wants to raise funds from the foreign
markets, it can sell shares to a foreign bank and get GDRs from it. Such GDRs will
be traded on any of the Stock Exchanges abroad and will provide liquidity to the
holder thereby creating a demand for shares in domestic companies.
Instruments used in International Financing
ADR / GDRs, ECCB

ADRs or American Depository Receipts


Before the GDRs came into existence, the American Depository Receipts were in
existence. The GDRs developed on the same lines as the ADRs and both work in the
same manner. The distinguishing features of ADRs from the GDRs are as under:
i. ADRs are issued only by U.S. banks for foreign stocks that are traded on a
U.S. exchange.
ii. The underlying security of the ADRs is held by an American financial
institution overseas rather than by a global institution. ADRs help reduce
the administration and duty costs that would otherwise be levied on each
transaction. However, ADRs do not reduce the currency and economic risks
for the underlying shares.
iii. They are a great way to buy shares in a foreign company. Dividend
payments or sale proceeds are converted into American dollars, net of
conversion expenses and foreign taxes. This is done in accordance with the
deposit agreement.
iv. ADRs are listed on various stock exchanges , such as the New York Stock
Exchange, the American Stock Exchange and Nasdaq, as well as trading
over the counter.
Instruments used in International Financing
ADR / GDRs, ECCB

FCCB or Foreign Currency Convertible Bonds:


A foreign currency convertible bond (FCCB) is a type of convertible bond which
is issued in a currency different than the issuer's domestic currency. In other
words, the money being raised by the issuing company is in the form of a
foreign currency.

A convertible bond is a hybrid instrument between debt and equity. It acts like a
bond by making regular coupon [means interest] and principal payments, but
these bonds also give the bondholder the option to convert the bond into
shares.

These types of bonds are attractive to both investors and issuers. The investors
receive the safety of guaranteed interest payments on the bond and are also
able to take advantage of any large price appreciation in the company's stock.
Instruments used in International Financing
ADR / GDRs, ECCB

FCCB or Foreign Currency Convertible Bonds:


Bondholders take advantage of this appreciation by means of “warrants”. These
“warrants” are activated when the price of the stock reaches a predefined level.
On such activation, the bonds are converted into equity shares at the
predefined price.

On conversion the coupon [interest] payments on the bond no longer are


payable thereby, reducing its debt-financing costs.
Instruments used in International Financing
ADR / GDRs, ECCB

Example of Convertible Bond


An Indian company issues at $1,200 face value, convertible bonds in the US,
paying 4% annual interest with a convertible ratio of 100 shares of the
company for every convertible bond and a maturity of 10 years. The bonds
will be converted into equity shares at the price of $ 12 per share when the
price of Equity shares hit the level of $ 13 per share.

At the end of year five, the company's shares trade at $13. At that stage the
warrant attached to the bond will get activated and the bond holder will get
100 shares in the company. No interest will be payable thereafter on the
bond.

The investor may either remain invested in the Equity of the company or sell
the shares and book a profit of $ 100 on the shares
ECB and its Regulatory Aspects
Introduction to Risk and Return

Risk and Returns Concepts


Risks in Portfolio Context
Relationship between Risk and Return
CAPM and Dividend Capitalization Methods
Total Risk & its Factors – Concepts & components of Total Risk - Security
Returns: Historical & Expected Returns - Systematic & unsystematic risk

1. Risk is inherent in every investment.


2. Return is the most fundamental motivation for making an investment.
Return represents the reward for undertaking the investment.
3. Investment involves sacrificing consumption and hence is driven by the
lure of return on such investment.
4. Risk is therefore, reflected in returns on investment and measuring of
returns becomes vital and necessary to assess the success of the
investment.
Types of Risks

1. Business Risk: Associated with the business of the company, such as:
i. Obsolescence Risk – continuous R & D for product improvement;
ii. Government Policy;
iii. International Factors – Foreign companies coming into India
2. Financial Risk
i. Leveraging Risk – Overburden of debts
ii. Credit risk
iii. Liquidity risk
3. Operational Risk
4. Legal Risk
People take risks to
increase profits.

Low Risk Low Returns High Risk High Return


Sources of Risks in Investment in Securities
Total Risks and its Factors
Unique Risk

Unique Risk – Firm Specific Risks


Systematic & Unsystematic Risks
Measuring Systematic Risks

1. We use the beta coefficient to measure systematic risk.

2. A beta of 1 implies the asset has the same systematic risk


as the overall market.
3. A beta < 1 implies the asset has less systematic risk than
the overall market.
4. A beta > 1 implies the asset has more systematic risk than
the overall market
Calculating Annualized Return
A trader invests Rs 95 in 91 day treasury bills. What will be his
annualized return on due date?

Face value of T Bill Rs 100

Cost to the trader Rs 95

Period of investment days 91

Return earned - on investment Rs 5 5.26%

No of days in which return is earned days 91

Return in one year will be % 21.11%

Annualized Return = % Return Earned / No of days in which return


earned X 365
Calculating the discount

In the above example what is the discount on the T bill?

Face value of T Bill Rs 100

Cost to the trader Rs 95

Period of investment days 91

Discount – will be calculated on Face Value Rs 5 5.00%

No of days in which return is earned days 91

Annualized Discount will be % 20.05%

Annualized Return = % Discount/ No of days in which return earned X 365


Calculating the discounted rate of a security

Calculate the Discounted Rate of the Treasury Bill from the following information:

Face value of T Bill Rs 100

Annualized Discount Rate Rs 20.05%

Period of investment days 91

Discount for the period of investment will be Rs 5.00

The discounted rate will be (FV - Discount) Rs 95

1. Discounted Rate = Face Value - Discount


2. Discount = Face Value X Annualized Disc / 365 X Investment Period
Measuring Total Risks

1. Total risk = systematic risk + unsystematic risk

2. The standard deviation of returns is a measure of total risk

3. Unsystematic risk can be diversified away. Therefore, for well-diversified


portfolios, the residual unsystematic risk is very small.

4. Consequently, the total risk for a diversified portfolio is essentially


equivalent to the systematic risk

5. Systematic risk cannot be diversified away. In other words, investors need


to be compensated by a certain risk premium for bearing systematic risk.
Beta is the indication of Systematic Risk of a security
Interpreting Risks

Consider the following information:


Standard Deviation Beta
– Security C 20% 1.25
– Security K 30% 0.95

From the above example, give your view on:


a. Which security has more total risk? Security K
b. Which security has more systematic risk? Security C
c. Which security should have the higher expected return? Security K
Measuring Historical Returns

Calculate the annualized return on the investment as on 31 st May 2015,


from the following information:
a. Mr. A purchased 1,000 shares of ITC Ltd on 1st Jan 2015 at Rs 275 per share;
b. In April 2015 he received dividend at the rate of Rs 8 per share
c. On 31st May 2015 the shares of ITC closed at Rs 310 on the NSE.

Total amt invested = Rs 2,75,000/-


Dividend Received by Mr A = Rs 8,000
Capital Appreciation = (Rs 310 – Rs 275) X1,000 = Rs 35,000
Total Return = Rs 8,000 + Rs 35,000 = Rs 43,000
Percentage return = 43,000 / 2,75,000 * 100 = 15.6%
Annualized return = (15.6 / 5 * 12) % = 37.5%
Measuring Historical Returns

Formula for measuring historical return

Return = (Cash income received during the period + Capital


Appreciation ) / Cost of investment

Capital Appreciation = Market value of investment – Purchase value of


investment

Capital Appreciation includes both realized and unrealized appreciation.


Realized appreciation arises where the securities have been sold at a profit
whereas, unrealized appreciation arises when the securities are still in hand.
Measuring Historical Returns

Should the historical return on investment be computed after including


the unrealized capital gain. In the above question, if Mr A has not sold
the ITC shares on 31st May 2015, should the appreciation in the price be
included in the return on his investment? Justify your answer.

AA View
Unrealized gains should not be considered in the return on investment as
it is possible that when the securities are actually sold at a later date, the
price may have fallen and the return shown earlier will be wiped out.
Secondly, the return should not be recognized until realized. It is against
the concept of accounting.
In the given problem therefore, the return will be only Rs 8,000 upto 31 st
May which translates to 2.9% for the period upto May and to 7% on
annualized basis.
Measuring Expected (or Ex Ante) Returns

Frequently, securities are purchased in the Stock Exchanges from the


perspective of expected returns and not historical returns. The investor
chooses a particular share based on his expected returns from various
available options.
Measuring Expected (or Ex Ante) Returns

Example: Mr A wants to choose which share to buy out of the following


2: ITC Ltd at Rs 350 per share and Colgate Rs 900 per share. His expected
returns are as under:
ITC Ltd 16% return on 30% probability
11% return on 50% probability
6% return on 20% probability

Colgate 40% return on 30% probability


10% return on 50% probability
20% return on 20% probability

Expected return for ITC = (16 X 30 + 11 X 50 + 6 X 20) / 100 = (480 + 550 +


120) / 100 % = 1150/100 % = 11.5%
Similarly the expected return for Colgate = (1,200 + 500 + 400) / 100 % =
21%
Hence, Mr A should opt for Colgate share as its expected
return in higher.
Expected Return of a Portfolio of Securities
Expected return of a “Portfolio” of securities is the weighted average of
the aggregate of the return expected from the individual securities in the
“portfolio”.
Weighted Average is arrived at on the basis of funds invested in each
security.
Let us examine the Expected Return on ITC and Colgate shares as
determined in the earlier slide.
Expected Investment Weighted
Return Value Return / INR
ITC 11.5% Rs 2 Lakhs 23,000
Colgate 21.0% Rs 4 Lakhs 84,000

Weighted Return 17.83%Rs 6 Lakhs 1,07,000


QQ 1

10 Equity Shares of X Ltd can be bought for Rs 100 each.. The probability
distribution of overall returns from X Ltd's shares is as under:

Cost per
Economic Conditions Return Probability
share

High Growth 100 22% 30%


Low Growth 100 16% 40%
Stagnation 100 14% 20%
Recession 100 8% 10%

a. Calculate the average return that can be expected from investing in the
above security.
b. In case your opportunity cost is 14% p.a. will you invest in the shares of X
Ltd.
c. Calculate the Standard Deviation
Sol
10 Equity Shares of X Ltd can be bought for Rs 100 each.. The probability distribution of
overall returns from X Ltd's shares is as under:

Return X Variance Sq of
Cost per Sq of
Economic Conditions share Return Probability
Probability Variances X
RXP in R X P Variance Probablity
from Avg
High Growth 100 22% 30% 6.60% (12) 144 43.20
Low Growth 100 16% 40% 6.40% (2) 4
1.60
Stagnation 100 14% 20% 2.80% (8) 64 12.8
Recession 100 8% 10% 0.80% 28 784 78.4
The expected return = 16.60% Total 136.0
The Average return on the investment in shares of X Ltd will be 16.6%
As the return expected from investment in shares of X Ltd is 16.6% which is higher than the
opportunity cost, I shall invest in the same
Calculation of Standard Deviation The SD is the square root of the Sq of
Variances X Probability
The Standard Deviation will be = Sq root of 136 =
11.6619
Understanding Risk
Suppose we are evaluating between two shares M and N for purposes of
investment. We have collected the data of returns on these shares for the
last 5 years as under:
Share Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Share M 30% 28% 34% 32% 31%
Share N 26% 13% 48% 11% 57%

Which of the two shares will we choose to invest in?


One approach will be to go for the share whose average return is higher.
But if the average return is equal for the two shares, like in this case the
average return of both M and N is 31%.
We therefore, have to look at another indicator. The other indicator will
be which share is less risky in its returns.
The answer is obviously share M as the volatility of share N’s returns
seems to be high as indicated by the fluctuations and hence will not be
preferred for investment.
Riskiness of Returns

In the context of investment analysis, the risk is interpreted


essentially in terms of the variability in returns from a particular
security.
Standard Deviation – the tool for measuring variation in returns
1. Standard Deviation of returns measures the extent of deviation
of returns from the average return.
2. The Standard Deviation of returns is the square root of [the
average of squares of deviations of the observed returns times
probability ].
3. Deviations are the difference between expected value of
returns and the observed returns
4. The square of standard deviation is called “variance”. In other
words the “variance” of the returns of a security is the average
value of the squares of deviation of the returns from that
security over the observed period of time.
Riskiness of Returns
Standard Deviation – the tool for measuring variation in returns

1. A portfolio manager will prefer to invest in stocks whose


Standard Deviations are low.
2. In case of multiple stocks, the risk of the portfolio is
determined by looking at the covariation of the returns among
individual stock and the coefficient of corelation of the
portfolio.
3. The covariation of returns of different stocks is calculated by
the formula:
Covariation = Product of the deviation of returns of individual
securities multiplied by the respective probability
QQ 1 Assessment of Returns

The observed return on the shares of XYZ Ltd under 3 scenarios is


given below:
Scenario or Return Probability
stages of %
observation

1 36% 25%
17.83%

2 26% 50%

3 12% 25%

Total 100%

1. From the above data calculate the average expected return.


2. Calculate the Standard Deviation of the returns
Sol QQ 1 Assessment of Returns
Scenario or Observed Probability Probable Variance Square of Probable
stages of Return % Returns % in Returns Variance Square of
observation Col 2 X 3 in Returns Variance%
%

Col 1 Col 2 Col 3 Col 4 Col 5 Col 6 Col 7


1 36% 25% 9% 11 121 30.25

2 26% 50% 13% 1 1 0.50


17.83%
3 12% 25% 3% -13 169 42.25

Total 100% 25% 73%

Ans to QQ 1: Average expected return = 25% (As Calculated in Col 4 Above)


Col 5: Variance is seen between the observed returns and the average expected
returns under all the 3 scenarios which is 25%
Col 7: Gives the Square of Variance i.e. col 6 multiplied by the probability factor.
Ans to QQ 2: Standard Deviation = Sq Root of Square of Variance = Sq Root of
73.00 = 8.54%
QQ 2 Assessment of Returns
Mr A makes the following investment plan for his savings:
i. 25% of the total savings to be invested in the equity shares of his
employer at an expected return of 9%;
ii. 25% of his total savings in equity shares of companies at an expected
return of 12%; and
iii. the balance in Govt Treasury Bills at an expected return of 6%

From the above investment pattern calculate the average expected return on
the total investments of Mr A.
Sol QQ 2 Assessment of Returns

Investment Avenue Proportion of Expected Return on Overall


Investment % Return % Investment
Col 2 X 3

Col 1 Col 2 Col 3 Col 4


Equity shares - Employer 25% 9% 2.25%

Market Equity 25%


17.83% 12% 3.00%

Govt T Bills 50% 6% 3.00%

Total 100% 8.25%

Ans: The Average expected return = 25% (As Calculated in Col 4 Above)
QQ 3

The returns from 2 assets under the following 4 scenarios are given below:
Scenario Return on Asset 1 Return on Asset 2 Probability
1 -5% 10% 0.20
2 15% 12% 0.30
3 18% 14% 0.40
4 22% 18% 0.10

a. Calculate the average returns of the two assets.


b. Calculate the standard deviation of the return of the two assets
c. Calculate the covariance between the returns on asset 1 and asset 2.
d. Which asset will you buy and why?
Sol: QQ 3

Asset 1

Probable XVariance in R Square of Standard


Return on Probability P of Asset 1
Scenario Return on over Average Variance in Deviation of
Asset 1 Asset 1 RXP Returns
Return

f = Sq root of
Column No: a b c=aXb d e total of e

-5.0% 0.20 -1.0% -17.90 320.41


1

15.0% 0.30 4.5% 2.10 4.41


2

18.0% 0.40 7.2% 5.10 26.01


3

22.0% 0.10 2.2% 9.10 82.81


4

Total 12.9% 433.64 20.82


Sol: QQ 3

Asset 2

Probable XVariance in R Square of Standard


Return on Probability P of Asset 1
Scenario Return on over Average Variance in Deviation of
Asset 1 Asset 1 RXP Returns
Return
Column f = Sq root
a b c=aXb d e
No: of total of e
10.0% 0.20 2.0% -3.00 9.00
1
12.0% 0.30 3.6% -1.00 1.00
2
14.0% 0.40 5.6% 1.00 1.00
3
18.0% 0.10 1.8% 5.00 25.00
4
Total 13.0% 36.00 6.00
Sol: QQ 3

Covariation of Returns
Variance Variance
Return Return Probable Probable in R X P of in R X P of Covarianc
Scenario on on Asset Probabili Return on Return Asset 1 Asset 2 e of
Asset 1 2 ty Asset 1 on Asset over over returns on
2 Average Average Asset 1
Return Return and 2
Column h=cXfX
a b c d=aXc e=bXc f g
No: g
-5.0% 10.0% 0.20 -1.0% 2.0% -17.90 -3.00 10.7
1
15.0% 12.0% 0.30 4.5% 3.6% 2.10 -1.00 (0.6)
2
18.0% 14.0% 0.40 7.2% 5.6% 5.10 1.00 2.0
3
22.0% 18.0% 0.10 2.2% 1.8% 9.10 5.00 4.6
4

12.9% 13.0%
16.70
The covariance of returns of Asset 1 and Asset 2 is 16.70
Sol: QQ 3

Answers
a. Calculate the average returns of the two assets
Average Return on Asset 1 is 12.9% and of Asset 2 = 13%

b. Calculate the standard deviation of the return of the two assets


Standard Deviation of returns on Asset 1 is 20.82 and of Asset 2 is 6.0

c. Calculate the covariance between the returns on asset 1 and asset 2.


The covariance of returns on assets 1 and 2 is 16.70

d. Which asset will you buy and why?


I will buy asset 2 as its return is slightly better at 13.0% and also because
its standard deviation of returns is much less at 6.0
Quantifying Portfolio Risk and Return
Benefits of Diversification

Portfolio: is a combination of securities held by an entity. Thus, if Mr A holds


the shares of ITC Ltd, Nestle, RIL, TCS and Tata Steel, his
“portfolio” will be the complete basket of all shares held by him.
The value of a portfolio may be expressed in terms of cost or the
market value off the shares or securities held in the portfolio.
The value and profitability of a portfolio depends largely on the
risk profile of the assets held therein.
Risk & Return on a Portfolio

1. The return from a portfolio needs to be assessed with the associated


risk in the assets forming part of the portfolio.
2. The objective of investors and, particularly, portfolio managers is to
attain the optimal trade off between the risk of a portfolio and the
return expected from it.
3. In the portfolios built from a variety of assets or financial securities, the
risk and return characteristics would change with the composition of
the portfolio..
Risk & Return on a Portfolio

4. The portfolio that is expected to generate the maximum return at a


particular level of risk, or alternatively stated, the portfolio of securities
that would minimize the rise for a particular level of return, is termed as
an optimal portfolio.
5. The technique of reducing the risk by investing in different types of
assets is termed “diversification”. In other words, diversification is a
process of risk management that takes into account a broad selection of
investments within a portfolio.
Diversification – Reducing Risk

6. Diversification implies the purchase of different kinds of assets (stocks,


bonds, securities, real estate, etc.) and by the purchase of stocks or
bonds of more than one company or industry.

7. The concept of portfolio diversification is based on the fact that the


cumulative risk of a portfolio is less than the summation of the risks of
the individual assets included in the portfolio.

8. For instance, a particular security has high risk if held individually but a
reduced amount of risk when comprised in a portfolio
Diversification – Reducing Risk

9. However, risk cannot be reduced to zero even by diversification as some


level of risk associated with the economy and the markets would always
remain with investment. By definition, investment cannot be “zero risk”.

10. For well-diversified portfolios, unsystematic risk is very small as the


company specific risks are spread out through diversification;

11. Consequently the total risk for a diversified portfolio is essentially


equivalent to the systematic risk or company specific risk.
Hedging – Reducing Risk

1. Hedging means investing in different class of assets to reduce the risk


under a particular class of asset. For example, in order to hedge the risk
of stock market trade the investor may also trade in the derivative
market.
2. Unlike diversification, hedging involves covering the risk through
investment in another class of asset and not in other asset options within
the same class as is the case in diversification. Thus when an investor
buys shares of different companies across industries, he is reducing his
risk through diversification of his portfolio, but when he invests in bonds
or fixed deposits or real estate to reduce his risk on share market trades,
he is hedging his risk.
The Concepts of Alpha & Beta in Security Analysis

1. Alpha and beta are both risk ratios that investors use as a tool to
calculate, compare and predict returns.

2. You are most likely to see alpha and beta referenced with mutual funds.
Both measurements utilize benchmark indices, such as the BSE Sensex,
Nifty, S & P 500 etc and compare them against the individual security to
highlight a particular performance tendency of a portfolio or stock.

3. Alpha and beta are two of the five standard technical risk calculations;
the three other numbers are standard deviation, R-squared and Sharpe
ratio.
4. Alpha is a measurement of a portfolio manager's aptitude or skill. For
example, an 8% return on a growth mutual fund is impressive when
equity markets as a whole are returning 4%, but it is far less impressive
when other equities are earning 15%. In the first case, the portfolio
manager would have a relatively high alpha, while that would not be
true in the second case.
The Concepts of Alpha & Beta in Security Analysis

1. If a capital asset pricing model analysis indicates that the portfolio


should have earned 5% (based on risk, economic conditions and other
factors), but instead earned only 3%, then the alpha of the portfolio
would be -2%. Investors would prefer an investment with a high alpha.

2. Beta (sometimes referred to as the "beta coefficient") is supposed to


gauge the volatility of a specific security by comparing it to the
performance of a related benchmark over a period of time. In short,
investors are looking to see how much downside capture they can
expect from an investment. CAPM analysis is also used to calculate beta.

3. The baseline number for alpha is zero (investment performed exactly to


market expectations), but the baseline number for beta is one. A beta of
one is an indication that the security's price moves exactly as the market
moves. If the beta is less than one, the security experiences less severe
price swings than the market. Conversely, a beta above one means that
the security's price has been more volatile than the market as a whole.
The following points may be noted:
a. The risk of a particular asset is denoted by its “Beta” factor. If the Beta =
1 the risk is neutral, if Beta is > 1 the risk is high and if Beta is < 1 the risk
is low.
b. However, it must be noted that risk is directly related to return, which
means that if risk is high the expected return is also high and vice versa.
c. However, in portfolio management a balance is strived to be stuck in the
overall basket so that a reasonably high return may be earned.
d. There is no concept of “maximum” return and such a figure cannot be
determined.
Value Invested
Sl No Portfolio Constituents Beta Factor Product
/ Rs
1 ITC Ltd 1,00,000 0.80 80,000
2 HLL Ltd 1,00,000 1.00 1,00,000
3 RIL 1,00,000 1.20 1,20,000
4 SBI 1,00,000 0.90 90,000
5 PNB 1,00,000 0.85 85,000
6 IOB 1,00,000 0.70 70,000
7 Colgate Palmolive Ltd 1,00,000 0.95 95,000
8 Nestle India Ltd 1,00,000 1.00 1,00,000
9 ICICI Bank Ltd 1,00,000 1.10 1,10,000
10 Axis Bank 1,00,000 1.15 1,15,000
11 Tata Motors Ltd 1,00,000 1.20 1,20,000
12 Bajaj Auto Ltd 1,00,000 1.05 1,05,000
Total Portfolio 12,00,000 0.99 11,90,000
In the example on the preceding slide the following conclusions may be
drawn:
a. The weighted average “beta” of the portfolio is 0.99 which means the
risk has been lowered as most of the individual stocks have a “beta” of
>1 denoting higher risk.
b. By bringing in a basket of safer stocks the portfolio’s overall risk is
reduced.
In the example on the preceding slide the following conclusions may be
drawn:
a. The weighted average “beta” of the portfolio is 0.99 which means the
risk has been lowered as most of the individual stocks have a “beta” of
>1 denoting higher risk.
b. By bringing in a basket of safer stocks the portfolio’s overall risk is
reduced.
Calculation of Historical Beta
Calculate the Beta of X Ltd and Y Ltd from the data given below:

Year Return on X Ltd Return on Y Ltd Return on Market


(%) (%) Index (%)

1 12.5 17.0 15.5

2 11.0 19 16.0

3 -9.0 -10 -8.0

4 16.0 15 14.0

5 14.5 19 18.0

Sol
Step 1 – Calculate simple averages of the returns
Average return on X Ltd = (12.5 + 11.0 -9.0 + 16.0 +14.5) / 5 = 45 / 5 = 9.0
Average return on Y Ltd = (17.0 + 19.0 – 10.0 + 15.0 + 19.0 )/ 5= 60 / 5 = 12.0
Average Return on Mkt Index = (15.5 + 16.0 -8.0 + 14.0 + 18.0) /5 = 55.5 / 5 = 11.1
Calculation of Historical Beta
Sol … Contd…
Step 1 – Calculate simple averages of the returns
Average return on X Ltd
= (12.5 + 11.0 -9.0 + 16.0 +14.5) / 5 = 45 / 5 = 9.0
Average return on Y Ltd
= (17.0 + 19.0 – 10.0 + 15.0 + 19.0 )/ 5= 60 / 5 = 12.0
Average Return on Mkt Index
= (15.5 + 16.0 -8.0 + 14.0 + 18.0) /5 = 55.5 / 5 = 11.1

Step 2 – Calculate Beta in the usual way

Beta of X Ltd = 9 / 11.1 = 0.81


Beta of Y Ltd = 12 / 11.1 = 1.08
The CAPM Model

 CAPM is a model that describes the relationship between risk and


expected return and that is used in the pricing of risky securities.
 The model was introduced by Jack Treynor, William Sharpe, John
Lintner and Jan Mossin independently, building on the earlier work of
Harry Markowitz on diversification and modern portfolio theory.
 The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk

 CAPM EQUATION is
E(ri) = Rf + βi(E(rm) – Rf) where,
E(ri) = return required on financial asset
Rf = risk-free rate of return
βi = beta value for financial asset
E(rm) = average return on the capital market
Modern Portfolio Theory and diversification

• Rational investors use diversification to optimize their portfolios


• Diversification reduces portfolio risk (assets that are not perfectly
correlated)
• Efficient Portfolio
Beta vs. standard deviation

• Standard deviation includes systematic and unsystematic risk; not used


because unsystematic risk diversified away

• Beta: A standardized measure of the risk of an individual asset, one that


captures only the systematic component of its volatility; measures how
sensitive an individual security is to market movements; measure of
market risk
Unsystematic vs. systematic risk

• Unsystematic risk: risk that can be eliminated through diversification


– Unique risk, residual risk, specific risk, or diversifiable risk

• Systematic risk: risk that cannot be eliminated through diversification


– market risk or undiversifiable risk
Security Market Line

• Line representing the relationship between expected return and market


risk; shows expected return of an overall market as a function of
systematic risk

• Security Market Line is the graphical representation of CAPM

• You should compare a single asset to the SML (and see if it falls below,
above, or on the line)
Security Market Line
The Capital Asset Pricing Model (CAPM)

• CAPM Model is used to determine the following:


– Expected rate of return on a particular asset given the expected
return on market portfolio;
– Expected return on market portfolio given the expected return on
a particular asset;
– Whether an asset is overpriced or underpriced in relation to the
associated risk
The Capital Asset Pricing Model (CAPM)

• Given that
– some risk can be diversified,
– diversification is easy and costless,
– rational investors diversify,

• There should be no premium associated with diversifiable risk.

• The question becomes: What is the equilibrium relation between


systematic risk and expected return in the capital markets?

• The CAPM is the best-known and most-widely used equilibrium model


of the risk/return (systematic risk/return) relation.
CAPM Intuition: Recap

• E[Ri] = RF (risk free rate) + Risk Premium


= Appropriate Discount Rate and also the expected rate of return
• Risk free assets earn the risk-free rate of return (think of this as a
rental rate on capital).
• If the asset is risky, we need to add a risk premium.
– The size of the risk premium depends on the amount of
systematic risk for the asset (stock, bond, or investment project)
and the price per unit risk.
Capital Asset Pricing Model (CAPM)

The expected return on a specific asset equals the risk-free rate plus a
premium that depends on the asset’s beta and the expected risk premium
on the market portfolio.

In the above equation,


Expected return of specific asset: E(Ri)
Risk-free rate: Rf
Expected risk premium: E(Rm) - Rf
Practice Problem #1

• If the risk-free rate equals 4% and a stock with a beta of 0.75 has an
expected return of 10%, what is the expected return on the market
portfolio?

Answer:
The equation is

• 10% = 4% + 0.75(return on market portfolio – 4%)


• 8% = return on market portfolio – 4%
• 12% = return on market portfolio
Practice Problem #1A

• If the risk-free rate equals 4% and a stock with a beta of 0.8 has an
expected return of 10%, what is the expected return on the market
portfolio?
Practice Problem #2

• A particular asset has a beta of 1.2 and an expected return of 10%. Given
that the expected return on the market portfolio is 13% and the risk-free
rate is 5%, the stock is:
A. appropriately priced
B. underpriced
C. overpriced

In this question, the expected return from the market portfolio is given as 13%. If the
expected return from the particular asset under review is > than the expected return from
the market portfolio then the asset is under priced and if the expected return from the
particular asset under review is < than the expected return from the market portfolio then
the stock is overpriced.

Hence, in such a question we need to calculate the expected return from the particular
asset by applying the CAPM formula.
Practice Problem #2: answer

• A particular asset has a beta of 1.2 and an expected return of 10%. Given that the
expected return on the market portfolio is 13% and the risk-free rate is 5%, the
stock is:
A. appropriately priced
B. underpriced
C. overpriced;
Answer:
expected return from the asset under review will be equal to:
Risk Free Return + Risk Premium
Risk Premium = Beta X ( Expected Return from market portfolio – Risk free return
Hence, Expected Return will be equal to
5% + [1.2 X (13% - 5%)] = 5% + 1.2 X 8% = 5% + 9.6% = 14.6%
In this case, the expected return from the particular asset is 14.6% which is greater
than the expected return from the market portfolio. Hence, it is underpriced.
Practice Problem #3

Last year the actual returns delivered by the 3 firms and their respective Betas were as
under:
• Firm A: return: 10%, beta: 0.8
• Firm B: return: 11%, beta: 1.0
• Firm C: return: 12%, beta: 1.2
• Given that the risk-free rate was 3% and market return was 11%, which firm had
the best performance?

Answer
The expected rate of returns of the three firms by the CAPM equation was as under:
Firm A: 3% + 0.8(11%-3%) = 9.4%
Firm B: 3% + 1.0(8%) = 11%
Firm C: 3% + 1.2(8%) = 12.6%

Against the above expected returns the actual return delivered on the portfolio was
11%.
Against the above expected returns the actual return delivered on the portfolio was
11%. Therefore, Firm A performed the best because it exceeded the expected return.
Asset pricing

• Future cash flows of the asset can be discounted using the expected
return calculated from CAPM to establish the price of the asset
• If observed price > CAPM valuation  overvalued (paying too much for
that amount of risk)
• If observed price < CAPM valuation  undervalued
Asset pricing

• Future cash flows of the asset can be discounted using the expected
return calculated from CAPM to establish the price of the asset
• If observed price > CAPM valuation  overvalued (paying too much for
that amount of risk)
• If observed price < CAPM valuation  undervalued
The CAPM Model

IMPLICATIONS AND RELEVANCE OF CAPM

 Investors will always combine a risk free asset with a market portfolio of
risky assets.
 Investors will invest in risky assets in proportion to their market value.
Investors can expect returns from their investment according to the risk
they take in their investments
 This implies a liner relationship between the asset’s expected return
and its beta.
 Investors will be compensated only for that risk which they cannot
diversify. This is the market related (systematic) risk
The CAPM Model

IMPLICATIONS AND RELEVANCE OF CAPM

 Investors will always combine a risk free asset with a market portfolio of
risky assets.
 Investors will invest in risky assets in proportion to their market value.
Investors can expect returns from their investment according to the risk
they take in their investments
 This implies a liner relationship between the asset’s expected return
and its beta.
 Investors will be compensated only for that risk which they cannot
diversify. This is the market related (systematic) risk
The CAPM Model

Assumptions of CAPM Model

 An investor can lend and borrow unlimited amounts at the risk free rate
of interest

 Individuals seek to maximize the expected utility of their portfolios over


a single period planning horizon.

 All information is available at the same time to all investors

 The market is perfect: there are no taxes; there are no transaction costs;
securities are completely divisible; the market is competitive.

 The quantity of risky securities in the market is given.


The CAPM Model

QQ
Calculate the Required Rate of Return from the stock of X Ltd and Y Ltd from
the following data:
Particulars X Ltd Data Y Ltd Data
Risk Free Return 4% 4%
Actual Average Return 9% 12%
Beta 0.81 1.08

Sol
Expected Return = Risk Free Return + Beta X (Actual Return – Risk Free Return
For Security of X Ltd
= 4% + 0.81 ( 9% – 4%) = 4% + 4.05% = 8.05%

For Security of Y Ltd


= 4% + 1.08 ( 12% – 4%) = 4% + 8.64% = 12.64%
Time Value of Money

i. Introduction
ii. Types of Cash Flows :
 Future Value of:
 a single cash flow,
 multiple cash flows and annuity
 Present Value of:
 A single cash flow
 Multiple cash flows and annuity
iii. Growing annuity; and
iv. Perpetuity and growing annuity
Introduction

The time value of money (TVM) may be defined as the measurement of fall in
the value of money over a period of time.

The value of money is linked closely with time and with passage of time the
value of money falls.

This simply means that the future value of a Rs 100 note will always be less
than the value today. Hence, if by investing today the future earnings will
always be less if we factor the fall in value of money to the future earnings.

This is a very important concept in financial management and is used in


evaluating investment options. Hence, Time Value of Money is a very
important concept in Capital Budgeting.
Introduction

The time value of money (TVM) is the idea that money available at the present
time is worth more than the same amount in the future due to its potential
earning capacity. This core principle of finance holds that, provided money can
earn interest, any amount of money is worth more the sooner it is received.
Time Value of Money (TVM) is an important concept in financial management.
It can be used to compare investment alternatives and to solve problems
involving loans, leases, savings. Introduction.

TVM [Time Value of Money] helps us in knowing the value of money invested
today at various points in time in the future. Any project set up today gives rise
to revenues continually into the future. The project cost is incurred today
whereas the returns or profitability arise in the future. The TVM concept
enables the enterprise to evaluate the feasibility of a project accurately after
factoring in the fall in future values of money.

As time changes value of money invested on any project/ firm also changes.
And its present value is calculated by using “mathematical formula”, which tell
us the value of money with respect of time.
Decomposing Interest Rates

We often view interest rates as compensation for bearing risk.


• Interest rates can then be viewed as
compensation for
– Delaying consumption “risklessly” (the risk-free real
rate, Rf)
– Bearing inflation risk over the life of the instrument
(inflation risk premium,
or IRP)
– The possibility that the borrower will not make the
promised payments at the promised time (default
Nominal Risk-Free Rate (approximately)
risk premium, or DRP) 205
The Time value of Money

Compounding is the process of moving cash flows forward in time.


Discounting is the process of moving cash flows back in time.

• Time value of money problems help us assess equivalency of differing cash


flow streams across time, including
– The value today (present value, or PV) of a single amount we will
receive in the future (future value, or FV)
– The value today (PV) of a stream of equally sized cash flows to be
received at uniform increments of time in the future (payments or
annuity, PMT or A)
– The value today (PV) of a stream of unequally sized and/or timed cash
flows in the future (CF)
– The future values of the above
– The annuitized values of the above
Discounting
Time
Compounding
Different Interest Rates

The frequency with which interest is calculated is known as compounding.

• Simple interest is the amount of principal multiplied by the stated rate of


interest for a single period with no compounding.
– If the period of time for which we are examining simple interest is less
than a year, the interest rate for a single period is known as a periodic
rate.
• If the instrument pays interest more than once a year, the interest rate will
generally be known as a stated annual interest rate or a quoted interest
rate.
– The expression of the rate will then typically be followed by an
indication of how often interest is calculated.
– For example: 12% compounded monthly
• By convention, we can then calculate the monthly rate of simple interest
(also known as the monthly periodic rate) as 0.12/12 = 0.01 or 1%
Comparing Interest Rates on compounding

• You may encounter investments with different stated rates of interest and
• different compounding frequencies.
• To compare such rates, you need a common reference time period and a
method for combining the rates and compounding periods such that a
comparison is accurate.
• The equivalent annual rate (EAR) is just such a rate. Once calculated, EAR
represents the interest rate across one year that would have been earned
on an equivalent stated rate of interest with no intrayear compounding.

where m is the number of times compounding will occur in one year


Comparing Interest Rates on Compounding
Focus On: Calculations
No. of
Periodic Rate EAR [Est Avg
Periodic Compounding
Stated Annual Rate in Decimals Returns]
Rate in % Periods in 1 Yr
10%
monthly 0.8333% 0.008333 12 10.4713%
compounding
10%
quarterly 2.5% 0.025 4 10.3813%
compounding
10%
semiannual 5% 0.05 2 10.25%
compounding
10%
annual 10% 0.1 1 10%
compounding

If No of Compounding in a year = 12
EAR = [(1+.008333)¹² – 1] X 100 % = 10.47%
AND SO ON For all other number of compounding periods
Calculating PV and FV for multiple cash flows

In reality cash flows are not single but multiple. Multiple cash flows arise for
any of the following reasons:

i. Investments are made in a number of periodic buckets such as every six


months or every year for a certain number of years;
ii. Interests are compounded periodically within a year such as monthly or
quarterly etc
iii. Realizations on maturity may be staggered over time;
iv. There may be annuities including perpetual annuities
v. Etc….

The formulas for calculating both PV and FV are the same for both single
cash flow and multiple cash flows only the computation of “r” and “n”
changes in multiple cash flow situations]
Calculating PV and FV for multiple cash flows

Step 1: Converting the stated Annual Rate into Periodic Rates [Calculating
the value of “r”].
i. This is done by applying the formula Stated Rate of Return divided by
the number of compounding periods in a year.
ii. For example, a rate of return of 10% per annum compounded
monthly will become 10% / 12 = 0.8333% or 0.00833

Step 2: Making a suitable adjustment to the time index or period to


account for the compounding frequency [Calculating “n”].

iii. This is done by applying the formula number of compounding


frequency X number of years.
iv. For example, if the investment is for 3 years and the interest is
compounded half yearly, the adjusted time index will be = 2 X 3 = 6
Calculating PV and FV for multiple cash flows

Example
Calculate the Present Value of $ 1,500 which will be received at the end of 2
years on which the stated rate of interest is 6% compounded half yearly.

Ans:
Step 1: Calculate “r” = stated rate of interest / number of compoundings in a
year = 6% / 2 = 0.06/2 = 0.03

Step 2: Calculate “n” = No of compoundings in a year X No of Years of


investment = 2 X 2 = 4

The Present Value is calculated by the formula:


PV = FV divided by (1 + r) to the power n, where
r = the rate of return or opportunity cost in decimals and not % and
n = number of years

[The formulas for calculating both PV and FV are the same for both single cash flow
and multiple cash flows only the computation of “r” and “n” changes in multiple cash
flow situations]
Calculating PV and FV for multiple cash flows

Ans (Contd…):

PV = FV divided by (1 + r) to the power n


= $ 1,500 / (1 + 0.03) to the power 4 = 1,500 / (1.03) to the power 4
= $ 1,500 / 1.12551 = $ 1,332.73
Calculating PV and FV for multiple cash flows

Example
Calculate the Present Value of $ 1,500 which will be received at the end of 4
years on which the stated rate of interest is 12% compounded quarterly.

Ans:
Step 1: Calculate “r” = stated rate of interest / number of compoundings in a
year = 12% / 4 = 0.12/4 = 0.03

Step 2: Calculate “n” = No of compoundings in a year X No of Years of


investment = 4 X 4 = 16

PV = FV divided by (1 + r)ⁿ
= $ 1,500 / (1 + 0.03)¹⁶ = 1,500 / (1.03)¹⁶
= 1,500 / 1.604706 = $ 934.75
Calculating PV and FV for multiple cash flows

Example 2
Calculate the Present Value of Rs 4,000 which will be received at the end of 4
years on which the stated rate of interest is 12% compounded half yearly.

Ans:
Step 1: Calculate “r” = stated rate of interest / number of compoundings in a
year = 12% / 2 = 0.12/2 = 0.06

Step 2: Calculate “n” = No of compoundings in a year X No of Years of


investment = 2 X 4 = 8

PV = FV divided by (1 + r)ⁿ
= Rs 4,000 / (1 + 0.06)⁸ = 4,000 / (1.06)⁸
= 4,000 / 1.593848 = Rs 2,509.65
Calculating Future Value (FV) from Present Value
For a Single Cash Flow

From a given a present value (PV), we can calculate its future value (FV) by
compounding the PV by applying the following formula:

FV = PV X (1+R) to the power n, where


R = the rate of interest in decimals; AND
n = the number of years

Example:
If $ 1,000 is invested today at an annual return of 12% for a period of 2
years, what will be the future value of the total money that is invested
today?
Calculating the Present Value (PV) from a given Future Value
For a single cash flow

From a given a future value (FV), we can calculate the Present Value (PV)
by discounting it [FV] to arrive at its present value (PV). The following
formula will have to be applied:

PV = FV divided by (1 + r)ⁿ ; where


r = the rate of return or opportunity cost in decimals and not % and
n = number of years

Example:
If the maturity value of an investment made for 3 years is $ 25,000 and
the opportunity cost is 9% per annum, calculate its Present Value.

Answer:
PV = 25,000 / (1+0.09)³ = 25,000 / (1.09)³
= 25,000 / 1.295029 = $ 19,304.59
Calculating PV and FV for multiple cash flows
Compounding of Interest

In reality cash flows are not single but multiple. Multiple cash flows arise for
any of the following reasons:

i. Investments are made in a number of periodic buckets such as every six


months or every year for a certain number of years;
ii. Interests are compounded periodically within a year such as monthly or
quarterly etc
iii. Realizations on maturity may be staggered over time;
iv. There may be annuities including perpetual annuities
v. Etc….

The formulas for calculating both PV and FV are the same for both single
cash flow and multiple cash flows only the computation of “r” and “n”
changes in multiple cash flow situations]
Calculating PV and FV for multiple cash flows
Compounding of Interest

Step 1: Converting the stated Annual Rate into Periodic Rates [Calculating
the value of “r”].
i. This is done by applying the formula Stated Rate of Return divided by
the number of compounding periods in a year.
ii. For example, a rate of return of 10% per annum compounded
monthly will become 10% / 12 = 0.8333% or 0.00833

Step 2: Making a suitable adjustment to the time index or period to


account for the compounding frequency [Calculating “n”].

iii. This is done by applying the formula number of compounding


frequency X number of years.
iv. For example, if the investment is for 3 years and the interest is
compounded half yearly, the adjusted time index will be = 3 X 2 = 6
Calculating PV and FV for multiple cash flows
Compounding of Interest
Example
Calculate the Present Value of $ 1,500 which will be received at the end of 2
years on which the stated rate of interest is 6% compounded half yearly.

Ans:
Step 1: Calculate “r” = stated rate of interest / number of compoundings in a
year = 6% / 2 = 0.06/2 = 0.03

Step 2: Calculate “n” = No of compoundings in a year X No of Years of


investment = 2 X 2 = 4

The Present Value is calculated by the formula:


PV = FV divided by (1 + r) ⁿ ; where
r = the rate of return or opportunity cost in decimals and not % and
n = number of years

[The formulas for calculating both PV and FV are the same for both single cash flow
and multiple cash flows only the computation of “r” and “n” changes in multiple cash
flow situations]
Calculating PV and FV for multiple cash flows
Compounding of Interest

Ans (Contd…):

In the given example, therefore,

PV = FV divided by (1 + r) ⁿ
= $ 1,500 / (1 + 0.03)⁴ = 1,500 / (1.03)⁴
= $ 1,500 / 1.12551 = $ 1,332.73
Calculating PV
Calculating PV and FV for multiple cash flows
Compounding of Interest

Example
Calculate the Present Value of $ 1,500 which will be received at the end of 4
years on which the stated rate of interest is 12% compounded quarterly.

Ans:
Step 1: Calculate “r” = stated rate of interest / number of compoundings in a
year = 12% / 4 = 0.12/4 = 0.03

Step 2: Calculate “n” = No of compoundings in a year X No of Years of


investment = 4 X 4 = 16

PV = FV divided by (1 + r) to the power n


= $ 1,500 / (1 + 0.03) to the power 16 = 1,500 / (1.03) to the power 16
= 1,500 / 1.604706 = $ 934.75
Calculating the FV and PV of an Annuity (A)

An “Annuity” may be defined as a series of equal periodic payments made


at regular intervals either as investments or as returns.

In the case of “annuities” we calculate the Present Value or the Future


Value of the series of regular payments which are made at regular intervals.
Calculating the FV of an Annuity (A)

In calculating the Future Value of an “annuity” the following formula is


applied:

FV = Payment Per Period × [(1 + r)ⁿ – 1]


r
Calculating the FV of an Annuity (A)

Example:
What is the maturity value of $ 10,000 invested annually for 2 years @ 11% pa.

Ans:

FV = $ 10,000 X [(1 + .11)² -1] / .11


= $ 10,000 X [1.2321 – 1] / .11 = $ 10,000 X (0.2321 / .11) = $ 10,000 X 2.11
= $ 21,100
Calculating the PV of an annuity (A)

In calculating the present value of a series of regular payments received at


regular intervals the following formula will be applied:
Calculating the PV of an annuity (a)

If you expect to receive $10,000 each year for two years starting in one
year, and your opportunity cost is 11%, how much is it worth today?

Answer

The Present Value Formula is


Growing Annuity

A growing annuity refers to a series of regular payments that increase in amount


with each payment at a particular rate.

For example, assume that the initial payment is $100 and the payments are
expected to grow each period at 10%.

In this case, the first payment is $100, then the second payment would be $110
calculated as ($100 x [1 + 0.1)] = $ 100 X 1.1 = $ 110.
The third payment would be $ 121 calculated as
($110 X [1 + 0.1]). = $ 110 X 1.1 = $121

And so on year after year/


Growing Annuity

Payments
By definition, the amounts of the payments of a growing annuity go up with time.
The first payment of a growing annuity is the lowest amount and the last payment
is the highest amount you will receive from it. You usually get these payments
regularly. The time between two payments varies depending on the annuity itself.
For example, you may get the payments each week, each month or each year.

Time Period
A growing annuity has a definite starting date and a definite end date. The
payments start one period after the beginning of the start of the growing annuity.
For example, if you buy an investment that pays you regularly each month, you will
make the initial investment today and earn the first payment next month. You will
then earn one payment every month until the last day of the term of the annuity.
Growing Annuity

Rates
Two rates determine the amount of payments you get each payment period. The
interest rate determines the amount of the payments for all types of annuities,
even those in which the payments remain at the same level throughout the entire
term of the annuity. The growth rate shows the amount by which each payment is
higher than the previous payment. When making calculations for a growing
annuity, these rates should match the time period between payments.

For example, if you have annual growth and interest rates but get monthly
payments, you have to divide the rates by 12 to get the monthly rates.
Growing Annuity

The formula used to calculate the initial payment of a series of periodic


payments that grow at a proportionate rate is given below. This formula is
used when the Present Value of the “Annuity” is known.
Growing Annuity

Growing Annuity
A growing annuity, is a stream of cash flows for a fixed period of time, t, where
the initial cash flow, C, is growing (or declining, i.e., a negative growth rate) at a
constant rate g. If the interest rate is denoted with r, we have the following
formula for the present value (=price) of a growing annuity:
PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ],

where:
PV = Present Value of the growing annuity
C = Initial cash flow
r = Interest rate
g = Growth rate
t = # of time periods
Growing Annuity

Example I:
Suppose you have just won the first prize in a lottery. The lottery offers you two
possibilities for receiving your prize. The first possibility is to receive a payment of
$10,000 at the end of the year, and then, for the next 15 years this payment will be
repeated, but it will grow at a rate of 5%. The interest rate is 12% during the entire
period. The second possibility is to receive $100,000 right now. Which of the two
possibilities would you take?

Answer:
You want to compare the PV of the growing annuity to the PV of receiving $100,000
right now (which is, obviously just $100,000). The present Value will be computed by
the formula:
PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ],
Growing Annuity

Answer:
You want to compare the PV of the growing annuity to the PV of receiving $100,000
right now (which is, obviously just $100,000). The present Value will be computed by
the formula:

PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ], where,

Initial Cash Flow or C = $10,000


Interest Rate or “r” = 0.12
Rate of Growth or “g” = 0.05
Total Time Period for receiving payments or “t” = 16

The Present Value =


PV = 10,000 [(1/0.07) - (1/0.07)*(1.05/1.12)16] = $91,989.41

Since the Present Value of the growing annuities is < $100,000, therefore, you would
prefer to be paid out right now.
Growing Annuity

Example II:
Assume the same situation as in Example I, but with the difference that you can
now make a choice between receiving a payment of 10,000 at the end of year 1,
which will then grow at 5% per year, and be paid out to you for the next 15
years. Or, you can receive $85,000 right now. What would you do?

Answer:
We know from Example I that the present value of the growing annuity is equal
to $91,989.41. However, the annuity starts only at the end of year 1, and hence,
we need to bring this value back one additional period before we can compare it
to the $85,000 to received right now. Thus:
PV = $91,989.41 / (1.12) = $82,133.40 which is less than $85,000 receivable
immediately. So we still prefer to be paid out immediately.
Growing Perpetuity

Perpetuity. ... A perpetuity is a type of annuity that receives an infinite amount of


periodic payments. An annuity is a financial instrument that pays consistent
periodic payments for a determined period of time. However, in the case of a
“Perpetuity” the amount under “Annuity” is received for an infinite period.

In such a situation, as with any annuity, the perpetuity value of an annuity is the
sum total if the present value of future cash flows.
Growing Perpetuity

A growing perpetuity is the same as a regular perpetuity (C/r), but just like we saw
earlier, the cash flow is growing (or declining) each year. A perpetuity has no limit
to the number of cash flows, it will go indefinitely. The growing perpetuity is in that
way just the same as a growing annuity with an extremely large t.

PV = C / (r-g),
where:
PV = Present Value of the growing perpetuity
C = Initial cash flow
r = Interest rate
g = Growth rate
Growing Perpetuity

Example I:
What would you be willing to pay (given that you could live forever, and
hence could receive all the cash flows) for a preferred share of stock in the
University of Pittsburgh, that promises you to pay a cash dividend to you at
the end of the year of $25, which will increase every year by 1%, forever. The
interest rate is fixed at 4.75%.

Answer:
The amount I would be willing to pay will be the PV of the future cash flows.
PV = C / (r-g),
where:
PV = Present Value of the growing perpetuity
C = Initial cash flow
r = Interest rate
g = Growth rate

PV = 25 / (0.0475 - 0.01) = 25 / 0.0375 = $666.67


Growing Perpetuity

Example II:
What would you be willing to pay if the share of stock paid out its first $25
right now, and everything else being the same?

Answer:
PV = 25 + [(25 * 1.01) / (0.0475 - 0.01)]
= 25 + (25.25 / 0.0375)
= 25 + 673.33
= $698.33
Solving for unknown values in TVM Problems
Example

You have decided to start your own firm. Being prudent, you want to have
enough money saved to use for living expenses for two years before you quit.
You can currently put away $45,000 a year. You know that you will have living
expenses of $75,000 a year for each of the two years (paid at the end of the
year, simplifying assumption). You would like to quit in three years. If you put
$45,000 into an account bearing 5% interest each of the next two years, how
much must you put into the account at the end of Year 3 so that you can
quit?
Key Points in the QQ
 Savings will be for two years;
 In the 3rd year no savings are there but the cumulative money at the end
of the 2nd year will general interest in the 3rd year as the person plans to
quit after 3rd year;
 Year 4 – spend $ 75,000 at the year end and earn interest on money
cumulated upto year 3 end
 Year 5 – spend $ 75,000 at the end of the year and earn interest on
money left at the end of Year 4
SOLVING FOR UNKNOWN VALUES IN TVM PROBLEMS
Focus On: Calculations – Mathematical Method

• Solution 1: Realize that the total amount of


inflows = total outflows at any point in time
once you have accounted for timing (interest)
differences.

Compound out Compound out


Discount Discount
• Solution 2: Group the positive and negative
back back
Solving for unknown values in TVM

Solution – Table Method

Year Opning Balance Cash Flow in Closing Balance Interest Closing Balance at
the Yr before Interest year end

1 - 45,000 45,000 45,000


2 45,000 45,000 90,000 2,250 92,250
3 92,250 92,250 4,613 96,863
4 96,863 (75,000) 21,863 4,843 26,706
5 26,706 (75,000) (48,294) 1,335 (46,959)
Shortfall at the end of 5 years will be Rs 46,959/-

The question is what money should be invested at the end of three years which will just meet the
shortfall. In other words, that money will fetch interest for 2 years, year 4 and yr 5. In other words,
what is the present value of the future money Rs 46,959 at a discounting rate of 5% for 2 years.

Formula, PV = FV / (1 + r) to the power n;


or PV = Rs 46,959 / (1 + 0.5) to the power 2;
or PV = Rs 46,959 / (1.05) to the power 2 = Rs 46,959 / 1.1025 = Rs 42,593
Solving for unknown values in TVM

Solution – Verification of Table Method

Year Opning Balance Cash Flow in Closing Balance Interest Closing Balance at
the Yr before Interest year end

1 - 45,000 45,000 45,000

2 45,000 45,000 90,000 2,250 92,250

3 92,250 42,593 134,843 4,613 139,456

4 139,456 (75,000) 64,456 6,973 71,428

5 71,428 (75,000) (3,572) 3,571 (0)


Valuation of Securities

i. Concept of Valuation
ii. Bond Valuation
iii. Equity Valuation
 Dividend Capitalization Method
 Ratio Method
Bond Valuation Methods

i. Present Value Method


Under this method the Value of the Bond = NPV of interests + NPV of
the redemption value Note: to be discounted at the desired rate of
return;

ii. Current Yield Method


Under this method the value of Bond will be the Price at which the
coupon rate will deliver the desired yield %. The formula will be:

Coupon rate X 100 = Desired Yield in %


Face Value of the Bond

iii. Yield to Maturity Method


Present Value Model & Bond Valuation
Valuation of Tax – Sheltered Investments
Under the Present Value method of valuing a “Bond” the valuation is
done by determining the present value of the interest receivable on the
bond upto its maturity + the present value of the redemption value on
maturity. In other words, the value of the bond = the NPV of all returns
from it i.e. both interest and redemption value.

The value of the Bond is represented by the following equation:

Interest per year X Present Value Annuity Factor + Redemption Value


on maturity X PV Discount Factor.

The Present Value Annuity Factor is the Cumulative present value of Rs


1 receivable or payable at the end of each year for n years at the
desired rate of return. It has to be taken from the NPV tables.

The discount factor is the present value of an amount received in the


future based on the no of years and the rate of discount or interest.
Present Value Model – Bond Valuation
Illustration 1:
The Present Value of a 14% debenture of Rs 100 each, redeemable after
6 years at a premium of 2%, on a desired return of 16% pa will be
calculated as under:
On this debenture the following payments will be received by the
investor:
A. Interest at 14% of Face Value = Rs 14 for each year for 6 years; And
B. Redemption value of Rs 100 + 2% premium = Rs 102

Under the Present Value Model the Debenture value will be the NPV of
the above receipts at the desired rate of return of 16% and will be
calculated as under:

Rs 14 X 3.685 + Rs 102 X 0.41 = Rs 51.59 + Rs 41.82 = Rs 93.41.

Hence the investor in this debenture will sell it for a price above Rs
93.41 and the buyer will get his desired 16% return if he gets it at Rs
93.41.
The above can be solved in the following manner…

Extract from NPV Tables

PV Disc PV of Int Maturity PV Disc PV of Int


Int Recd /
Year Factor @ Factor @ Recd /
Rs 16% Recd / Rs Value / Rs 16% Rs

1 14 0.862 12.068
2 14 0.743 10.402
3 14 0.641 8.974
4 14 0.552 7.728
5 14 0.476 6.664
6 14 0.410 5.74 102 0.410 41.82
3.684 51.576 0.41 41.82
Illustration 2:
Calculate the value of a Rs 100 debenture issued for 6 years at a coupon
rate of interest at 14% pa payable half yearly if the desired return is 8%
for six months.
On this debenture the following payments will be received by the
investor:
A. Interest at 14% of Face Value = Rs 14 for each year payable half yearly
for 6 years;
B. Interest payable for six months is Rs 14 / 2 = Rs 7
C. Redemption Value = Rs 100 (at par)
NPV on 6 monthly basis will mean 12 semi annual periods at a
discounting rate of 8% per six months. Hence, Bond Value will be equal
to:
Rs 14 /2 X 7.536 + 100 X0.397 = Rs 52.75+ Rs 39.70 = Rs 92.45

Hence the investor in this debenture will sell it for a price above Rs
92.45 and the buyer will get his desired 8% return half yealry, if he gets
it at Rs 92.45.
The above can be solved in the following manner…
Extract from NPV Tables
PV Disc PV of Int Maturity PV Disc PV of Int
Int Recd /
Year Factor @ Recd / Rs Value / Rs Factor @ Recd / Rs
Rs 16% 16%
1 7 0.926 6.482 0.926
2 7 0.857 5.999 0.857
3 7 0.794 5.558 0.794
4 7 0.735 5.145 0.735
5 7 0.681 4.767 0.681
6 7 0.630 4.410 0.630
7 7 0.583 4.081 0.583
8 7 0.540 3.780 0.540
9 7 0.500 3.500 0.500
10 7 0.463 3.241 0.463
11 7 0.429 3.003 0.429
12 7 0.397 2.779 100 0.397 39.7

7.535 52.745 7.535 39.7


Return on Bonds
Current Yield Method
The Current Yield simply speaking means the return from interest
vis a vis the market price of a bond. Return from interest is called
the “Coupon Rate” of the bond. Hence,
Current Yield = Coupon rate / market price of bond

Thus, if an 8% bond (FV Rs 100) redeemable after 5 years if is selling


in the market at Rs 96, then the Current Yield from the bond will be
equal to Rs 8 / 96 *100 % = 8.33% p.a.

QQ. Calculate the price at which a person should buy a 9% Rs 100


bond redeemable after 6 years, if his desired current yield is 12% p.a.
Solution
Coupon Rate/Price * 100 = Desired Current Yield
9/P*100 = 12 or 900 /P = 12 or 12 P = 900 or P = 75
Hence, the person should buy the bond at Rs 75 to earn a current
yield of 12%
Return on Bonds
Yield to Maturity Method

1. The Current Yield method takes into consideration only the


current interest and not the total cash flows in determining the
return on bonds.
2. The correct method of computing the return on any asset
would be to compute the Internal Rate of Return after
considering the entire sequence of cash flows and their
respective timings.
3. The IRR will be equal to the rate at which the present value of
cash outflows = the present value of all cash inflows.
4. The IRR gives the true return on the bond and such return is
called the Yield to Maturity Or YTM.
5. IRR = The Discounting Rate at which the NPV of Cumulative
Cash Outflows and Cumulative Inflows add up to ZERO.
The key assumptions underlying the Yield to Maturity Method are
as under:
1. All coupons (i.e. interest) and the redemption amounts are
paid on due dates;
2. The bonds are held upto maturity;
3. The interests received during the currency of the bond are
reinvested instantaneously at the rate of return which is
identical to the Yield to Maturity rate
What is the return earned by an investor who buys a 10.78% fully
redeemable Rs 100 bond on 1st July 2012 at Rs 80.60 and holds it till
maturity which is on 1st July 2015?

Cash Flow Particulars 2012 2013 2014 2015


Cash Outflow -80.6
Cash Inflow - Interest 10.78 10.78 10.78
Cash Inflow - 100
Redemption
Net Cash Flow -80.6 10.78 10.78 110.78
Discounting Factor 20% 0.833 0.694 0.579
Computation of NPV -80.6 8.97974 7.48132 64.14162 0.00
The Yield to Maturity Return will therefore be 20% at which the
NPV of Cash Outflow and Cash Inflow add up to ZERO
Calculate the Yield to Maturity Rate of a 13% bond (face value Rs 200)
redeemable after 5 years at a premium of 5% which is currently selling
at Rs 191.50

1. The YTM rate is the discount rate at which the Present Value of the
Net Cash Flow = Zero

2. In other words, the rate of discount at which the NPV of outflow =


NPV of inflows.

3. In the given case, the outflow is the price which is Rs 191.50 and its
NPV will be the same as it is paid upfront.

4. Inflows will be computed year wise.

5. In the present case, therefore, the calculation will be done as


under:
Particulars Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Price - Outflow -191.50
Inflow - Interest 26 26 26 26 26
- Redemption 210
Total Inflow 26 26 26 26 236
NPV Factor on yield of 12% for 5 Yrs 1.00 0.893 0.797 0.712 0.636 0.567
NPV of Total Cash Inflows 212.80 23.22 20.72 18.51 16.54 133.81
If we take the IRR to be 12% then the NPV of inflows = Rs 212.8 which is higher than the NPV of outflow of Rs
191.50. Hence, the discounting rate or the IRR should be increased to make the NPV of inflows = NPV of
outflows. We therefore look at 14% IRR

NPV Factor on yield of 14% for 5 Yrs 1.00 0.877 0.769 0.675 0.592 0.519

198.22 22.80 19.99 17.55 15.39 122.48


At 14% IRR the NPV of inflows at Rs 198.22 is still higher than the NPV of Outflow which is Rs 191.5. Hence, we
need ot increase the IRR further. We therefore, look at an IRR of 15%

NPV Factor on yield of 15% for 5 Yrs 1.00 0.870 0.756 0.658 0.572 0.497

191.55 22.62 19.66 17.11 14.87 117.29


At 15% IRR the NPV of inflows is Rs 191.55 which is approximately the same as the NPV of outflows. Hence the
YTM rate of return is close to 15%.
The same question can be solved in another manner:
Cash outflow on purchase Rs 191.5. Since this cash outflow takes place at
the beginning of the term of the bond its NPV will also be Rs 191.5

Now inflow on the investment in Bonds will be two fold:


a. Interest @ 13% per annum which will be Rs 26 every year for 5 years PLUS
b. Redemption of the bond at a premium of 5% at the end of the 5 th year
which will be Rs 10 and total redemption will be Rs 210.

a. NPV of interest will be determined from the NPV Tables. Rs 1 received


every year for 5 years at 15% discounting rate will have a NPV of Rs 3.352.
Hence the NPV of interest of Rs 26 will be Rs 26 X 3.352 = 87.152.

b. Similarly, the NPV of Rs 1 received at the end of 5 years at a discounting


rate of 15% will be Rs 0.497. Hence the NPV of the amt received on
redemption of Rs 210 will be Rs 210 X 0.497 = Rs 104.37

c. The total NPV of all cash inflows at 15% discounting rate = Rs 87.152 + Rs
104.37 = Rs 191.52 which is almost equal to the NPV of cash outflow.
Hence the YTM will be 15%
1. In the above illustration, the YTM yield was around 15% subject to
one major assumption, i.e. the interest which was earned annually,
i.e. Rs 26 was reinvested every year at exactly the same rate of
return i.e. 15%.

2. Hence, if in reality the interest was reinvested at varying returns,


the realized yield will be different from the YTM rate.

3. Secondly, the redemption value of the bond of Rs 210 will be


realized only if the bondholder holds it till maturity, i.e. for 5 years.

4. In reality however, the bond holder may choose to sell the bond
before its date of maturity in which case he will have to calculate
the sale price in order to earn a return of 15%.
Quiz

Calculate the price of a 13% bond (face value Rs 200) redeemable after
5 years at a premium of 5% at an YTM of 15%

1. The price will be the NPV of all cash inflows on the above bond at a
discounting rate of 15%.
2. The total inflows are on account of interest and redemption of the
bond on maturity.
3. The NPV of interest which is Rs 26 per year for 5 years. The NPV of
Rs 26 at 15% discounting rate for 5 years will be = Rs 26 X 3.352 =
Rs 87.15 (refer to Annuity Table)
4. The NPV of the redemption value of Rs 210 received at the end of
5 years at 15% rate of discounting is Rs 210 X 0.497 = Rs 104.37
5. Hence the price will be the sum of Rs 87.15 + Rs 104.37 = Rs
191.52

Note: Please check the values from Annuity Table for NPV of interest
and from NPV Table for NPV of redemption value.
Quiz

A Rs 100 par value bond bearing a coupon rate of 12% will mature
after 5 years. What is the value of the bond if the discounting rate is
15%.
1. The value will be the NPV of all cash inflows on the above bond at
a discounting rate of 15%.
2. The total inflows are on account of interest and redemption of the
bond on maturity.
3. The NPV of interest which is Rs 12 per year for 5 years discounted
at 15% discounting rate = Rs 12 X 3.352 = Rs 40.22 (refer to
Annuity Table as the payment is received every year)
4. The NPV of the redemption value of Rs 100 received at the end of
5 years at 15% rate of discounting = Rs 100 X 0.497 = Rs 49.70
(refer to NPV Table for this as the payment is received once)
5. Hence the price will be the sum of Rs 40.22 + Rs 49.70 = Rs 89.92
Quiz

The market price of a Rs 1,000 par value bond carrying a coupon rate
of 14% and maturing after 5 years is 1,050. What is the Yield to
Maturity of the bond?

Yield to Maturity is the IRR at which the NPV of all cash flows from the
bond = 0. In other words, the NPV of cash outflow = NPV of cash inflows.

Since YTM is the IRR, it has to be computed on hit and trial method.

The Formula is:


Present Value = NPV of Interest payments + NPV of Redemption value
1050 = NPV of Rs 140 received annually for 5 years + NPV of Rs 1000
received after 5 years; or
Quiz
The Formula is:
Present Value = NPV of Interest payments + NPV of Redemption value
1050 = NPV of Rs 140 received annually for 5 years + NPV of Rs 1000
received after 5 years; or

Assuming the discounting rate of 13% the equation will be:


1050 = 140 X 3.517 + 1000 X 0.543 OR
1050 = 492.38 + 543 Or 1050 – 492.38 – 543 = 14.62.
IF the YTM or the IRR were 13% the residual value of all cash flows
should have been 0. Hence, the IRR is less than 13%.

Let us now assume the discounting rate of 12%


The equation will now be:
1050 = 140 X 3.605 + 1000 X 0.567 OR 1050 = 504.7 + 567 OR
1050- 504.7 – 567 = -21.7
NOTE: The values will be taken from Annuity Tables for annual payments
of interest and from NPV table for redemption amount at the end
of 5 years.
Quiz

From the above workings it is clear that the IRR is between 13 and 12
percent.
At 13% the NPV = 14.6
At 12% the NPV = -21.7
Hence, the difference = 36.3 for 1%
At 12% the NPV of cash flow is 21.7

Hence, the difference of 21.7 will be for 1 X 21.7 / 36.3 % = 0.6%


Therefore, the IRR = 12% + 0.6% = 12.6% = Yield to Maturity on the Bond
Valuation of Equity Shares

i. Discounted Cash Flow Models


 Dividend Discounted Models
 One Stage or Gordon Discounting Model
 Two Stage Discounting Model
 H Model
 Free Cash Flow Model
 Residual Income Model

ii. Beta for levered and un levered firm relative valuation


techniques – EPS, P/E, P/CR, P/BV

iii. Balance Sheet valuations


Valuation of Equity under Discount Models
Dividend Discount Model – H Model

1. Valuation of Equity Shares is more difficult than Bond Valuation because


equity shares do not have a finite maturity date and the future dividends
declared thereon are not specified.

2. Therefore, different methods for valuation of equity shares are used.


Some of them are as under:
a. Balance - Sheet Valuation: Under this method, the value of equity
shares is determined on the basis of Book Value which is the Net
Worth per share.
b. Dividend capitalization or discounting models
i. Gordon Dividend Discounting Method;
ii. Two Stage Discounting Model;
iii. Three Stage Discounting Model
iv. H Model
c. Earnings capitalization method – EPS, P/ E, Price / BV
d. Free Cash Flow to Equity Model (FCFE Model)
e. Value Added Concept
Balance Sheet Equity Valuation Methods

Analysts often look at the balance sheet of the firm to get a view on its
equity valuation. The three key methods of valuing equity of a company
from the Balance Sheet are as under:
i. Book Value of Intrinsic Value Method
The most common valuation measure is book value. The book value
per share is simply the net worth of the company (which is equal to
paid up equity capital plus reserves and surplus) divided by the
number of outstanding equity shares.

ii. Liquidation Value Method;


Under this method the value of equity share is the residual amount
left for distribution to equity shareholders after the payment of all its
external debt, preference share capital dues and liabilities from the
amount received on liquidation of its assets or in other words the
market value of its assets. The residual amount left for equity
shareholders divided by the number of equity shares outstanding
will be the value of each equity share, under this method.
Balance Sheet Equity Valuation Methods

iii. Replacement Cost Method


Under this method, the equity value of a business is determined by
“the replacement cost of its assets less liabilities”. The use of this
method is based on the premise that the market value of a firm
cannot deviate too much from the replacement cost of its assets
minus liabilities.

Example of Liquidation Method


Let us assume that Pioneer Industries would be able to realize Rs 45
million from the liquidation of its assets and will have to pay Rs 18
million to its creditors and preference shareholders in full settlement of
their claims. If the number of outstanding equity shares of Pioneer is 1.5
million, calculate its value per equity share.

The liquidation value per share will work out to:


Rs 45mn- Rs 18mn = Rs 27mn / 1.5mn = Rs 18.00
Discounted Cash Flow Models
Choice of Discounted Cash Flow Models
The Dividend Discount Valuation Method

1. Dividend discount models are designed to compute the intrinsic value of


a share under the specific assumption of the expected growth pattern of
future dividends and the appropriate discount rate to employ.

2. Merrill Lynch, CS First Boston, and a number of other investment banks


routinely make such calculations based on their own particular models
and estimates.

3. Dividend Discounting Method is the basic model for valuing equity. There
are many variants of this model, some of which are:
a. Gordon Model or Constant Growth Model;
b. Two stage dividend discount model
c. H Model
d. Three stage dividend discount model

4. According to the Dividend Discounting Method of valuing Equity Shares


the intrinsic value of a security is equal to the present value of the
expected dividends to be received in future + present value of terminal
value of the share.
5. The key inputs for valuing equity under the dividend discounting or
capitalization methods are as under:
a. Future growth rate in earnings and dividends;
b. Required rate of return on the share or the capitalization rate;
c. Dividend per share in the future years
d. Future price of the share
Discount rate determination

Various Interpretations of the Discount Rate for NPV Calculations

i. Any rate used in finding the present value of a future cash flow

ii. Risk premium: compensation for risk, measured relative to the


risk-free rate

iii. Required rate of return: minimum return required by investor to


invest in an asset

iv. Cost of equity: required rate of return on common stock


The Gordon Dividend Discounting Model

Under the Gordon Model, a constant growth rate is assumed over a long term.
The equity is valued by applying the following formula:

Value of share = Dividend Per Share during the next Year ; where,
r–g

r = Required rate of return on stock per rupee and


g = the growth rate in dividends (per rupee) for an infinite period

Limitations of Gordon Model


i. This model assumes a constant rate of growth in earnings and dividends
which is not realistic;
ii. In case the actual growth rate is higher than the required rate of return
on stock, then the value of equity will be negative which is absurd
iii. On the other hand if the growth rate is equal to the required rate of
return the value of equity will be = infinity.
The Gordon Dividend Discounting Model

Illustration
X Ltd had an earning of Rs 12 per share in the previous year and paid out 55%
of the earnings as dividends. Its earnings and dividends had grown at 6% per
year in the last 4 years and are expected to grow at the same rate in the long
run. Compute the value of the stock using the Gordon’s model if the required
rate of return on the share of X Ltd is 14%.

Ans:
In the given question, EPS = Rs 12. Dividend payout @ 55% = Rs 6.60.
Dividend payable next year = Rs 6.60 X 1.06 = Rs 7.00
The expected growth rate of dividends is 6% p.a. = Rs 0.06 and the required
rate of return was = Rs 0.14 per rupee.

Hence value of Equity = Rs 7.00 / (0.14 – 0.06) = Rs 7.00 / 0.08


= Rs 87.50 per share.
The Two Stage Dividend Discount Model

This model assumes two stages of growth, the first stage is where the growth
rate is high and the second stage represents a steady state in which the growth
rate is assumed to be stable which is assumed to last for a long term.

Under this model,


Value of Stock = PV of dividends during high growth period + PV of terminal
price.

The equity is valued by applying the following formula:

a. Calculate Pn which is the price of share at the end of the 1 st stage;


b. Calculate the PV of Terminal Price by applying the following formula:
c. Calculate the PV of dividend received during high growth period
d. Value of share = value under b + value under c

Terminal Value of share = Pn / (1 + r)ⁿ


The Two Stage Dividend Discount Model

Where,
Pn = the price of share at the end of the 1 st stage of growth and is calculated
by the formula :

DPS X (1+ g)ⁿ X (1+gn)


r – gn

Where,
DPS = Dividend per share during high growth period;
= EPS X Dividend Payout %
r = Required rate of return on stock per rupee
n = no of years in high growth phase
n = no of years in high growth phase
Pn = Price at the end of the year “n” i.e. end of no of years in stage 1
g = the extraordinary growth rate for the first n years, i.e. no of years
in stage 1
gn = Growth rate for ever after year “n” i.e. in the 2 nd stage
The Two Stage Dividend Discount Model

Illustration
A Ltd had an EPS of Rs 10.16 in the previous year. It had a high growth period
of 4 years during which the growth was 4% per year and paid out 52% of its
earnings as dividend. Thereafter it had a stable growth period for the future
during which the growth was 3% per year and the dividend payout was 60%.
The required rate of return on the share of A Ltd is 12%. Compute the value of
the share of A Ltd.

Solution
Current EPS = Rs 10.16
Growth rate in high growth period = 4%
Period of high growth rate = 4 years
Payout during high growth period = 52%
Required rate of return = 12%
Expected growth rate in the stable period = 3%
The Two Stage Dividend Discount Model

Solution b/f

Step 1: Calculate Pn i.e. Price at the end of the year n = year 4.

DPS X (1+g)⁴ X (1+gn)


r – gn

= [0.52 X 10.16] X (1+ 0.04)⁴ X 1.03


0.12 – 0.03

= 5.2832 X 1.17 X 1.03 = 6.367 / 0.09 = Rs 70.74


0.09

Step 2: Calculate the terminal price of the share


Pn = Rs 70.74
(1+r)ⁿ (1+0.12)⁴

= Rs 70.74 / (1.12)⁴ = Rs 70.74 / 1.573519


= Rs 44.96
The Two Stage Dividend Discount Model

Solution b/f

Step 3: Calculation of PV of dividends during high growth period

Div Per Share Div Growth in NPV at 12% PV of Div /


Year / Yr the yr discounting Share
1 5.28 1.04 0.893 4.72
2 5.49 1.04 0.797 4.38
3 5.71 1.04 0.712 4.07
4 5.94 1.04 0.636 3.78
16.94

Step 4: Value of Equity = Value as per Step 3 + Value as per Step 2

= Rs 44.96 + Rs 16.94
= Rs 61.90
The Two Stage Dividend Discount Model

Limitations of Two Stage Dividend Discount Model

i. Defining the length of high growth period: is too subjective and


impractical. Growth rate varies year on year due to diverse factors.
ii. The accuracy of the high growth rate and then the stable rate is highly
theoretical and cannot be predicted accurately.
iii. This model is to a large extent based on Gordon’s Model as the rates in
the two stages are constant, which is highly theoretical.
The H Model

This model is similar to the two stage model except that under this model
there is a gradual change in earnings growth rate rather than a sudden
change as assumed in the two stage model.

The key assumptions under this model are:


a. The growth rate of earnings starts at a high initial rate and declines
during the high growth phase gradually or linearly; and
b. Dividend payout is constant over a period of time and not affected by
the shifting growth rates.

Limitation of the H Model


i. The decline in growth rate is assumed to follow a strict structure based
on the initial growth rate, the stable growth rate and the length of the
high or super normal growth period. This is highly subjective.
ii. Large deviations from the assumed rates may affect the values very
substantially;
iii. When growth rate declines during the high growth period the pay out
ratio should increase as a general rule but in this model the
assumption of constant payout ratio is contrary to the general rule.
The H Model

The value of stock under this model is termed as the Present Value of the
share and is represented as Po. Under this model:

Po = DPSo X (1+Gn) + DPSo X H X (Ga – Gn)


r – Gn r – Gn

In the above model, the first equation represents the Stable Growth Phase
while the second equation represents the Supernormal Growth phase.

The equation is explained as under:


Po = Present Value of the Share;
DPSo = Dividend per share in the previous year;
H = Period of decline of “super normal growth” / Rate of decline in
growth during the “super normal growth” phase
r = Required rate of rerun on equity;
Ga = Initial growth rate; and
Gn = Growth rate at the end of “High Growth” period i.e. stable rate
of growth (which extends to perpetuity or infinite period)
The H Model – Illustrative Quiz

X Ltd was expected to earn an EPS of Rs 2 in the previous year and payout a
dividend of Rs 1 in the same year. The earnings had grown at the rate of 18%
a year for the previous 5 years but is expected to decline at the rate of 2% per
year for the next 6 years to a stable growth rate of 6% from thereon. The
decline in growth is attributed to a variety of factors such as competition,
market conditions and growth in the size of the company. Calculate the value
of the share of X Ltd under the H Model, if the expected rate of return on
equity is 13%.

Solution
The facts given in the present case are as under:
i. Current EPS = Rs 2
ii. Current DPS = Rs 1
iii. Current Growth Rate = 18%
iv. Length of Transition Period = 5 Years
v. Period of declining growth = 6 years
vi. Rate of decline in growth p.a. = 2%
vii. Stable growth rate = 6% p.a.
viii. Required rate of return on Equity = 13% p.a.
The H Model – Illustrative Quiz

Value of Share = Value during stable phase + Value during super normal growth
phase

Value during stable growth phase = DPSo X (1+gn)


r – Gn

= 1 X (1 +0.06) / (0.13 – 0.06) = 1.06 / 0.07 = Rs 15.14

Value during super normal growth phase = DPSo X H X (Ga – Gn)


r – Gn
= 1 X 6 / 2 X (0.18 – 0.06) = 1 X 3 X 0.12 = 0.36 / 0.07
(0.13 – 0.06) 0.07

= Rs 5.14
Value of Equity Share = Rs 15.14 + Rs 5.14 = Rs 20.28
P/E Ratio and Liquidity

Other things being equal, stocks which are highly liquid command higher
P/E multiples and Stocks which are highly illiquid command lower P/E
multiples. The reason for this is that the Investors value liquidity just the
way they value safety and return and hence are willing to give higher P/E
multiples to liquid stocks.

Let us analyse impact of growth on price, earnings and P/E ratio.


The expected growth rates of companies differ widely. Some companies are
expected to remain virtually stagnant or grow slowly; other companies are
expected to show normal growth; still others are expected to achieve
supernormal growth rate.

Assuming a constant total required return, differing expected growth rates


mean differing stock prices, dividend yields and price-earnings ratios.
Measures of Relative Value
P/E, P/BV and Price to Sales

The three widely used measures of determining the relative value of equity are:
i. Price to Earnings Multiple or P/E Multiple;
ii. Price to Book Value or P/BV Ratio; and
iii. Price to Sales Ratio or P/Sales Ratio

Price / Earnings Multiple or P/E Ratio; The dividend discount model can be
used to determine the Price to Earnings multiple. However, the P/E multiple is
computed for a firm with stable growth or a firm with high growth.

P/E computation for a firm with stable growth rate i.e. firm which is growing
at a rate comparable to the normal growth rate in the economy in which it is
operating, will be computed by the following formula:

Dividend Payout ratio in next year / (r-gn)


where, r = expected return and gn is the rate of long term growth
both in decimals;
Payout ratio in the next year = Div Payout in decimals X (1 +
Growth rate in decimals)
P/E Ratios – How to calculate P/E Multiple

P/E Multiple is calculated by the following formula:

d/ (k -g) where,
d = dividend payout ratio
k = cost-of-capital (or, risk-adjusted discount rate)
g = EPS growth rate
P/E Example

From the following information calculate the price of an equity share


Cost of Capital is = 12.5%
EPS = Rs 6.50
Growth in EPS = 9%
Dividend Payout = 40%

Solution
Step 1: Calculate the P/E Multiple
Step 2: Price of Share = EPS X PE Multiple

P/E Multiple = Dividend Payout Rate / (Cost of Capital – Growth Rate of EPS)
P/E Multiple = 0.40 / (0.125 – 0.090) = 0.40 / 0.035 = 11.4

Share Price = EPS X PE Multiple = Rs 6.50 X 11.4 = Rs 74.10


Price to Earnings Ratio

Illustration
A Ltd had an EPS of Rs 2.75 last year and it paid 50% of its earnings as
dividends that year. The growth rate in earnings and dividends in the long
term is expected to be 5% and the required return on equity for A Ltd is 12%.
Calculate the P/E ratio. If the share is trading at Rs 30 per share is it
overpriced?

Solution
P/E Multiple or Ratio = Payout Ratio in the next year / (r –gn)
In the given illustration:
= 0.5 X 1.05 / (0.12 – 0.05) = 0.525 / 0.07 = 7.5
Hence, the P/E ratio is 7.5
Value of the share should be = 2.75 X 7.5 = Rs 20.625

At the price of Rs 30 the share is overpriced as its value should be Rs 20.625


Investment Strategies that compare
P/E to Expected Growth Rate

1. P/E Ratios are compared with expected growth rates of companies by the
portfolio managers to identify undervalued and overvalued shares.
2. If P/E ratio reflects a lesser than the expected growth rate, the stock is
deemed to be undervalued and vice versa.

Limitations of P/E Ratios


a. P/E ratios are not meaningful if the EPS is negative;
b. P/E ratios may have wide variations over a period of time depending on
the variability of earnings;
c. P/E ratios become unreliable when operator activity is very high
Cost of Capital
i. Concept and importance
ii. Cost of debt
 Debentures / Bonds
 Term Loans
iii. Equity Capital and Retained Earnings
 Cost of Equity
iv. Weighted Average Cost of Capital
v. Weighted Marginal Cost of Capital Schedule
Introduction

• The cost of capital is the cost of using the funds from lenders and owners.
• Creating value requires investing in capital projects that provide a return
greater than the project’s cost of capital.
– When we view the firm as a whole, the firm creates value when it
provides a return greater than its cost of capital.
• Estimating the cost of capital is challenging.
– We must estimate it because it cannot be observed.
– We must make a number of assumptions.
– For a given project, a firm’s financial manager must estimate its cost of
capital.
2. Cost of capital

 The cost of capital is the rate of return that the suppliers of capital—
bondholders and equity holders require as compensation for their
contributions of capital in an enterprise.
 This cost reflects the opportunity costs of the suppliers of capital.

 The cost of capital is a marginal cost: the cost of raising additional


capital.

 The weighted average cost of capital (WACC) is the cost of raising


additional capital, with the weights representing the proportion of
each source of financing that is used i.e. components of Debt and
Equity.
 Also known as the marginal cost of capital (MCC).
Weighted Average Cost of Capital or WACC

WACC = wdrd (1  t) + wprp + were (3-1)

where
wd is the proportion of debt that the company uses when it raises new funds
rd is the before-tax marginal cost of debt
t is the company’s marginal tax rate
wp is the proportion of preferred stock the company uses when it raises new
funds
rp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises new
funds
re is the marginal cost of equity
Example: WACC
Suppose the Widget Company has a capital structure composed of the
following, in billions:
Debt Rs 10
Equity Rs 40
If the before-tax cost of debt is 9%, the required rate of return on equity is
15%, and the marginal tax rate is 30%, what is Widget’s weighted average cost
of capital?
Solution: Formula Driven
WACC = [(0.20)(0.09)(1 – 0.30)] + [(0.8)(0.15)]
= 0.0126 + 0.120
= 0.1325, or 13.25%

Solution: Table Driven – On Next Slide


Example: WACC

Solution: Table Driven


Example: WACC

Interpretation:
When the Widget Company raises Rs 1 more of capital, it will raise this
capital in the proportions of 20% debt and 80% equity, and its cost will be
13.25%.

In other words, the WACC will remain the same for incremental raising of
capital as long as the proportion of debt and equity remains unchanged.
Taxes and the Cost of capital

Interest on debt is tax deductible; therefore, the cost of debt must be


adjusted by the tax incidence to reflect the correct cost.

The correct cost of debt = Cost of pre tax debt – tax incidence on such
cost. If for example, the interest cost on debt is 12% and the income tax
incidence is 30%. Then the correct cost of debt = 12% minus 30% of 12%
which is = 12% - 3.6% = 8.4%.

On the other hand payments to owners are not tax deductible and
hence do not require the tax adjustment. So the required or desired or
expected rate of return on equity is the cost of equity capital.
Weights of the Weighted Average

• The weights should reflect how the company will raise additional capital.
• Ideally, we would like to know the company’s target capital structure,
which is the capital structure that is the company’s goal, but we cannot
observe this goal.
• Alternatives
– Assess the market value of the company’s capital structure
components.
– Examine trends in the company’s capital structure.
– Use capital structures of comparable companies (e.g., weighted
average of comparables’ capital structure).
Applying the Cost of capital to capital Budgeting and Security
Valuation

• The investment opportunity schedule (IOS) is a representation of the


returns on investments.
• We assume that the IOS is downward sloping: the more a company
invests, the lower the additional opportunities.
– That is, the company will invest in the highest-returning investments
first, followed by lower-yielding investments as more capital is
available to invest.
• The marginal cost of capital (MCC) schedule is the representation of the
costs of raising additional capital.
– We generally assume that the MCC is upward sloping: the more funds
a company raises, the greater the cost.
Optimal Investment Decision

Marginal cost of capital Investment opportunity schedule

Cost
or
Return

Optimal
Capital
Budget

Amount of New Capital


Using the MCC in capital Budgeting and Analysis

• The WACC is the marginal cost for additional funds and, hence, represents
the cost of additional investments.
• In capital budgeting
– We use the WACC, adjusted for project-specific risk, to calculate the
net present value (NPV).
– Using a company’s overall WACC in evaluating a capital project
assumes that the project has risk similar to the average project of the
company.
• In analysis
– Analysts can use the WACC in valuing the company by discounting
cash flows to the firm.
The cost of Debt

Alternative approaches
1. Yield-to-maturity approach: Calculate the yield to maturity on the
company’s current debt.

2. Debt-rating approach: Use yields on comparably rated bonds with


maturities similar to what the company has outstanding.
Example: Cost of debt

Yield-to-Maturity Approach Debt-Rating Approach


Consider a company that has $100 Consider a company that has non
million of debt outstanding that has a traded $100 million of debt
coupon rate of 5%, 10 years to outstanding that has a debt-rating of
maturity, and is quoted at $98. What AA. The yield on AA debt is currently
is the after-tax cost of debt if the 6.2%. What is the after-tax cost of
marginal tax rate is 40%? Assume debt if the marginal tax rate is 40%?
semi-annual interest. Solution:
Solution: In this case the current yield will be
The yield to maturity in this case will used which is 6.2% or 0.062. The cost
be 5.26% or 0.0526 [calculate of debt will be as under:
separately] Hence, the after tax cost rd = 0.062 (1 – 0.4) = 3.72%
of debt will be as under: The cost of debt capital is 3.72%
rd = 0.0526 (1 – 0.4) = 3.156%
The cost of debt capital is 3.156%
Issues in estimating the cost of debt

• The cost of floating-rate debt is difficult because the cost depends not only
on current rates but also on future rates.
– Possible approach: Use current term structure to estimate future
rates.
• Option-like features affect the cost of debt.
– If the company already has debt with embedded options similar to
what it may issue, then we can use the yield on current debt.
– If the company is expected to alter the embedded options, then we
would need to estimate the yield on the debt with embedded options.
• Nonrated debt makes it difficult to determine the yield on similarly
yielding debt if the company’s debt is not traded.
– Possible remedy: Estimate rating by using financial ratios.
• Leases are a form of debt, but there is no yield to maturity.
– Estimate by using the yield on other debt of the company.
Summary

• The weighted average cost of capital is a weighted average of the after-tax


marginal costs of each source of capital.
• An analyst uses the WACC in valuation. For example, the WACC is used to
value a project using the net present value method.
• The before-tax cost of debt is generally estimated by means of one of two
methods: yield to maturity or bond rating.
• The yield-to-maturity method of estimating the before-tax cost of debt
uses the familiar bond valuation equation.
• Because interest payments are generally tax deductible, the after-tax cost
is the true, effective cost of debt to the company.
• The cost of preferred stock is the preferred stock dividend divided by the
current preferred stock price.
• The cost of equity is the rate of return required by a company’s common
stockholders. We estimate this cost using the CAPM (or its variants) or the
dividend discount method.
Summary (continued)

• The CAPM is the approach most commonly used to calculate the cost of
common stock.
• When estimating the cost of equity capital using the CAPM when we do
not have publicly traded equity, we may be able to use the pure-play
method, in which we estimate the unlevered beta for a company with
similar business risk and then lever that beta to reflect the financial risk of
the project or company.
• It is often the case that country and foreign exchange risk are diversified so
that we can use the estimated  in the CAPM analysis. However, in the
case in which these risks cannot be diversified away, we can adjust our
measure of systematic risk by a country equity premium to reflect this non
diversified risk:
• The dividend discount model approach is an alternative approach to
calculating the cost of equity.
Summary (continued)

• We can estimate the growth rate in the dividend discount model by using
published forecasts of analysts or by estimating the sustainable growth
rate:
• In estimating the cost of equity, an alternative to the CAPM and dividend
discount approaches is the bond yield plus risk premium approach.
• The marginal cost of capital schedule is an illustration of the cost of funds
for different amounts of new capital raised.
• Flotation costs are costs incurred in the process of raising additional
capital. The preferred method of including these costs in the analysis is as
an initial cash flow in the valuation analysis.
• Survey evidence indicates that the CAPM method is the most popular
method used by companies in estimating the cost of equity.
The Cost of Equity

Two Major approaches for cost of equity


1. Capital asset pricing model or CAPM
Under this approach of determining the cost of capital the basic
concept is that the expected return from an investment must equal
the Risk Free Return + Risk Premium %

2. Arbitrage Pricing Theory (APT) [ Not in Syllabus]


Cost of Equity – Under CAPM

Under the Capital Asset Pricing Model


Cost of Equity = Total Equity Funds / Total Capital X [Risk Free Rate of
Return + Beta X Risk Premium]
Where,
Total Capital = Equity Funds + Long Term Debts
Risk Free Return = Rate of Return from high grade secured investments,
such as RBI Bonds, AAA rated long term govt securities
etc.
Risk Premium = Expected Return – Risk Free Return
Beta = Rate of change in share price / Rate of change in Stock
Market Index.
Using the CAPM to estimate the Cost of Equity

The capital asset pricing model (CAPM) states that the expected return on
equity, E(Ri) , is the sum of the risk-free rate of interest, RF, and a premium for
bearing market risk, i [E(RM) – RF]:

E(Ri) = RF + i [E(RM) – RF]


where
i is the return sensitivity of stock i to changes in the market
return
E(RM) is the expected return on the market
E(RM) – RF is the expected market risk premium or equity risk premium
(ERP)
Cost of debt under CAPM

Cost of Debt = Total Debt Funds / Total Capital X [(1- tax %) X Cost of
servicing debt i.e. interest rate]
Where,
Total Capital = Equity Funds + Long Term Debts
Cost of servicing debt = interest cost
Problem:
a. Total Capital of a Co is Rs 5 Crs out of which Equity
is Rs 2 Crs and Debt is 3 Crs.
b. The risk free return on investments is 8%;
c. while the expected return is 15%.
d. The beta factor of the Co’s share is 1.2
e. The interest on debt is 14% pa and
f. the income tax rate is 30%
Calculate:
g. the cost of equity;
h. cost of debt; and
i. the cost of total capital
Solution: a. the cost of equity
Cost of Equity = Total Equity Funds /
Values / Rs Total Capital X [Risk
Calculation components Free Rate of Return
Lakhs
+ Beta X Risk
A. Total Equity Funds 200 Premium]
Where,
Total Capital = Equity Funds + Long
B. Total Debt Funds 300 Term Debts
Risk Free Return = Rate of Return from
Total Capital 500 high grade secured
investments, such
C. Risk Free Return 8.0% as RBI Bonds, AAA
rated long term
D. Expected Return 15.0% govt securities etc.
Risk Premium = Expected Returns –
E. Risk Premium 7.0%
Risk Free Returns
F. Beta 1.2

G. Product of Risk Prem & Beta Cost of Equity = 200 / 500 X [8% + 1.2 X 7%]
8.4%
2 / 5 X [8% + 8.4% ]
Cost of equity 6.56% 0.4 X 16.4 % = 6.56%
Solution: b. the cost of debt Cost of Debt = Total Debt
Funds / Total

Calculation Values / Capital X [(1- tax


components Rs Lakhs %) X Cost of
servicing debt
A. Total Equity Funds i.e. interest rate]
200
Where,
B. Total Debt Funds Total Capital = Equity Funds +
300
Long Term Debts
Cost of servicing debt = interest cost
Total Capital 500
C. Interest on Debt 14.0%
Cost of Debt = 300 / 500 X [14% X (1 – 30%)]
D. Income Tax % 30.0% 0.6 X [14% X 70% ]
E. Interest on Debt 0.6 X 9.8 % = 5.88%
9.8%
(net of tax)
Cost of equity 5.88%
Solution: c. cost of total capital

Cost of Total Capital Cost of Equity + Cost of Debt


6.56% + 5.88% = 12.44%

Cost of Total Capital comes to 12.44%


The following data is furnished to you by a company in respect of a new project it is setting
up at a cost of Rs 100 Crores.
Year
Particulars (All Values are in Rs / Crs)
1 2 3 4 5 6

Profit before interest & taxes 18 20 24 27 29 31

The applicable income tax rate works out to 22% of its PBT

The company is proposing to finance the project as


follows: Rs / Crs
Rights Issue of Rs 10 shares to existing equity 25.00
shareholders at Rs 25 each
Term Loan from banks @ 11% p.a. interest payable
annually at the end of each year repayable equally 35.00
from 3rd year in 5 annual instalments at end of year
Fully convertible 6% bonds of Rs 100 each, 25%
convertible at the end of 2nd year, 50% at the end of 40.00
4th year and 25% at the end of 5th year.

The risk free return is 8% p.a. Assume Beta of the share at 1.2
From the above information provided, you are required to work out the cost of equity, debt
and total capital for each of the six years.
The Dividend Discount Valuation Method

1. Dividend discount models are designed to compute the intrinsic value of


a share under the specific assumption of the expected growth pattern of
future dividends and the appropriate discount rate to employ.

2. Merrill Lynch, CS First Boston, and a number of other investment banks


routinely make such calculations based on their own particular models
and estimates.

3. Dividend Discounting Method is the basic model for valuing equity. There
are many variants of this model, some of which are:
a. Gordon Model or Constant Growth Model;
b. Two stage dividend discount model
c. H Model
d. Three stage dividend discount model

4. According to the Dividend Discounting Method of valuing Equity Shares


the intrinsic value of a security is equal to the present value of the
expected dividends on the share.
5. The key inputs for valuing equity under the dividend discounting or
capitalization methods are as under:
a. Future growth rate in earnings and dividends;
b. Required rate of return on the share or the capitalization rate;
c. Dividend per share in the future years
d. Future price of the share
Using the Dividend Valuation Model
to Estimate the Cost of Equity

• The dividend discount model (DDM) assumes


that the value of a stock today is the present
value of all future dividends, discounted at the
required rate of return.
• Assuming a constant growth in dividends:

which we can rearrange to solve for the required rate


of return:
(3-6)
Where, g is the growth rate.
• We can estimate the growth rate, g, by using
Using the Dividend Discounting Model
to estimate the cost of Equity

•Problem
Suppose the Gadget Company has a current
dividend of £2 per share. The current price of a
share of Gadget Company stock is £40. The
Gadget Company has a dividend payout of 20%
and an expected return on equity of 12%. What
is the cost of Gadget common equity?

Solution
Using the dividend payout and the return on
The Gordon Dividend Discounting Model

Under the Gordon Model, a constant growth rate is assumed over a long term.
The equity is valued by applying the following formula:

Value of share = Dividend Per Share during the next Year ; where,
r–g

r = Required rate of return on stock per rupee and


g = the growth rate in dividends (per rupee) for an infinite period

Limitations of Gordon Model


i. This model assumes a constant rate of growth in earnings and dividends
which is not realistic;
ii. In case the actual growth rate is higher than the required rate of return
on stock, then the value of equity will be negative which is absurd
iii. On the other hand if the growth rate is equal to the required rate of
return the value of equity will be = infinity.
The Gordon Dividend Discounting Model

Illustration
X Ltd had an earning of Rs 12 per share in the previous year and paid out 55%
of the earnings as dividends. Its earnings and dividends had grown at 6% per
year in the last 4 years and are expected to grow at the same rate inn the long
run. Compute the value of the stock using the Gordon’s model if the required
rate of return on the share of X Ltd is 14%.

Ans:
In the given question, EPS = Rs 12. Dividend payout @ 55% = Rs 6.60.
Dividend payable next year = Rs 6.60 X 1.06 = Rs 7.00
The expected growth rate of dividends is 6% p.a. = Rs 0.06 and the required
rate of return was = Rs 0.14 per rupee.

Hence value of Equity = Rs 7.00 / (0.14 – 0.06) = Rs 7.00 / 0.08


= Rs 87.50 per share.
The Two Stage Dividend Discount Model

This model assumes two stages of growth, the first stage is where the growth
rate is high and the second stage represents a steady state in which the growth
rate is assumed to be stable which is assumed to last for a long term.

Under this model, Value of Stock = PV of dividends during high growth period
+ PV of terminal price.

The equity is valued by applying the following formula:

a. Calculate Pn
b. Calculate the PV of Terminal Price by applying the following formula:
c. Calculate the PV of dividend received during high growth period
d. Value of share = value under b + value under c

Terminal Value of share = Pn


(1 + r) to the power n
The Two Stage Dividend Discount Model

Pn = the price of share at the end of the 1 st stage of growth and is calculated
by the formula :

DPS X (1+ g) to the power n X (1+gn)


r – gn

Where,
DPS = Dividend per share during high growth period;
r = Required rate of return on stock per rupee
Pn = Price at the end of the year “n” i.e. end of no of years in stage 1
g = the extraordinary growth rate for the first n years, i.e. no of years
in stage 1
gn = Growth rate for ever after year n i.e. in the 2nd stage
The Two Stage Dividend Discount Model

Illustration
A Ltd had an EPS of Rs 10.16 in the previous year. It had a high growth period
of 4 years during which the growth was 4% per year and paid out 52% of its
earnings as dividend. Thereafter it had a stable growth period for the future
during which the growth was 3% per year and the dividend payout was 60%.
The required rate of return on the share of A Ltd is 12%. Compute the value of
the share of A Ltd.

Solution
Current EPS = Rs 10.16
Growth rate in high growth period = 4%
Period of high growth rate = 4 years
Payout during high growth period = 52%
Required rate of return = 12%
Expected growth rate in the stable period = 3%
The Two Stage Dividend Discount Model

Solution b/f

Step 1: Calculate Pn i.e. Price at the end of the year n = year 4.

DPS X (1+g) to the power 4 X (1+gn)


r – gn

= 0.52 X 10.16 X (1.04) to the power 4 X 1.03


0.12 – 0.03

= 5.2832 X 1.17 X 1.03 = 6.367 / 0.09 = Rs 70.74


0.09

Step 2: Calculate the terminal price of the share


Pn = Rs 70.74
(1+r) to power n (1+0.12) to power 4

= Rs 70.74 / (1.12) to power 4 = Rs 70.74 / 1.573519


= Rs 44.96
The Two Stage Dividend Discount Model

Solution b/f

Step 3: Calculation of PV of dividends during high growth period

Div Per Share Div Growth in NPV at 12% PV of Div /


Year / Yr the yr discounting Share
1 5.28 1.04 0.893 4.72
2 5.49 1.04 0.797 4.38
3 5.71 1.04 0.712 4.07
4 5.94 1.04 0.636 3.78
16.94

Step 4: Value of Equity = Value as per Step 3 + Value as per Step 2

= Rs 44.96 + Rs 16.94
= Rs 61.90
The Two Stage Dividend Discount Model

Limitations of Two Stage Dividend Discount Model

i. Defining the length of high growth period: is too subjective and


impractical. Growth rate varies year on year due to diverse factors.
ii. The accuracy of the high growth rate and then the stable rate is highly
theoretical and cannot be predicted accurately.
iii. This model is to a large extent based on Gordon’s Model as the rates in
the two stages are constant, which is highly theoretical.
Marginal Cost of Capital

The marginal cost of any item is the cost of another unit of that item. For
example, the marginal cost of labor is the cost of adding one additional
worker. The marginal cost of labor may be $25 per person if 10 workers are
added but $35 per person if the firm tries to hire 100 new workers, because
it will be harder to find 100 people willing and able to do the work.

The same concept applies to capital. As the firm tries to attract more new
dollars, the cost of each dollar will at some point rise. Thus, the marginal cost
of capital (MCC) is defined as the cost of the last dollar of new capital the
firm raises, and the marginal cost rises as more and more capital is raised
during a given period.
Marginal Cost of Capital

Can a company raise an unlimited amount of new capital at its present cost
of capital? The answer is no. As a practical matter, as a company raises larger
and larger sums during a given time period, the costs of debt, preferred
stock, and common equity begin to rise, and as this occurs, the weighted
average cost of each new dollar also rises.

Thus, just as corporations cannot hire unlimited numbers of workers at a


constant wage, they cannot raise unlimited amounts of capital at a constant
cost.

At some point, the cost of each new dollar will increase. The key question is
at what point the Marginal Cost of Capital will begin to increase. The point at
which the cost of capital begins to increase is called the “break point”.
Marginal Cost of Capital

The Upward-Sloping Marginal Cost of Capital Schedule


• Break points occur because of limits on the issuance of a security
• We can estimate a break point by comparing the capital at which a source’s cost may
change with the proportion of the source in the capital structure.
• There may be many break points.
Derivative Markets
Options and Futures
Options - Basics
1. An option is a contract
a. to buy or sell a specific financial product;
b. officially known as the option’s underlying instrument or
underlying interest,
c. at a specific price, called the strike price,
d. at which the contract may be exercised, or acted upon
e. Within the expiration date mentioned in the contract

2. For equity options, the underlying instrument is a stock, exchange-


traded fund (ETF), or similar product.

3. An option may be bought or sold. Selling an option is also called


“writing” an option.

4. “Options” contracts are of two types:


a. “Call” Options
b. “Put” Options
Options - Basics

5. Buying a “call” means the right to buy the instrument before


the expiration date at the “strike price” i.e. the price agreed
upfront, irrespective of the prevailing market price.

6. Similarly when a “put” is bought the seller has a right to sell


the instrument before the expiration date at the “strike price”.

7. Selling a (Call or Put) option means “writing” an option.

8. Unlike the rights of the buyer of an options (who has the right
but no obligation to “buy”), the seller in an options contract is
under an obligation to fulfill his promise to sell.
Option “Premium”

1. An “Options” contract gives the buyers the rights but no


obligations But commits the seller or writer of the option to
his obligations…

2. Hence, the writer or the seller of an “options” contract


whether “call” or “put” is placed at a disadvantage.

3. Due to this disadvantageous position the writer of an option


charges the buyer an upfront fee which is called the “Option
Premium” or the “Option Price”.

4. The “Option Premium or Price” is different from the strike


price which the price of the options instrument payable by
the buyer in case he exercises his right to buy.
Exercising the right to “buy”

1. From the point of view of the buyer of a “call option”, he


will exercise his right to buy only if the market price is
higher than the strike price.

2. For example, let us suppose that Mr A has purchased a “call


option” on 1,000 shares of RIL at Rs 850 on 1st May 2015
and the expiration date is 31st May 2015. Suppose the price
of RIL shares on 20th May 2015 goes up to Rs 930 per share.
Mr A will immediately exercise his right to buy the 1,000
shares and by immediately selling them in the market will
earn a profit of Rs 80 per share.
Exercising the right to “buy”

3. On the other hand, the buyer of a “put option” has the right
but not an obligation to sell at the strike price before the
expiration date.

4. He will exercise his right to sell only if the strike price is


higher than the market price. This is so because if the
market price is higher, the buyer of a put option will find it
more profitable to sell in the market rather than under the
“put option”
Certain Terms in “Options” Trade

1. Terms to indicate the profitability from the point of view of


the buyer of an “Option”:
a. In the Money: means that (1) in the case of call option,
the market price > the exercise price and (2) in case of
put option, the market price is < the exercise price. In
short, “in-the-money” denotes that it is profitable from
the option buyer’s viewpoint if the option is exercised
immediately.
b. Out of Money: is the opposite of “in the Money”. It
indicates a losing proposition if the buyer exercises his
option immediately.
c. At the Money: indicates a situation when the exercise
price = the market price.
Certain Terms in “Options” Trade

2. Intrinsic Value: is the value of the call or put option, if


exercised by its holder immediately. Such intrinsic value
may be positive or profitable or may be negative or
unprofitable from the viewpoint of the holder of the
option. The gain or loss is measured by comparing the
strike price with the asset’s current market price.
Certain Terms in “Options” Trade

1. Exercise Price: At the time of entering into a contract, the parties (buyer
and seller / writer) agree upon a price at which the underlying asset
may be bought or sold depending on the nature of the option. This
agreed price is called the Exercise Price or the Strike Price.

2. Expiration Period: is the period of time fixed by an exchange during


which an option can be exercised. At the time of introducing an
“options” contract, the exchange specifies the period (not exceeding
nine months from the date of introduction of the contract) during
which the option can be exercised. An option contract can be exercised
even on the last date of the expiration period but on the expiry of the
last date the contract expires.

3. Margins: In order to relieve, the Options Clearing Corporation (OCC) as


well as the brokers, of the legal complexities and the burden in case of
defaults, margin requirements have been set in place by the exchanges
where options are traded
Margins in Options Trading

In order to relieve, the Options Clearing Corporation (OCC) as well as the


brokers, of the legal complexities and the burden in case of defaults,
margin requirements have been set in place by the exchanges where
options are traded.

This gives ample scope to brokers to impose even stricter margin


requirements on their clients as in the final settlement the brokers are
responsible to the OCC for settlement of outstanding dealings.

In case of option writers (or sellers), margin requirements assume


importance as the writer of the option has to deliver the stock in case the
buyer exercises his right under the option. Hence, margins are imposed on
the writers of options to make sure that there is no loss to the broker,
buyer or the clearing house. The writer of, say a call option, is asked to
deposit an amount calculated in accordance with the rules of the
exchange. This margin is calculated in such a manner that the price
fluctuations in the underlying stock in a day is not more than the margin
amount.
Margins in Options Trading

1. Covered Call Writing: An option contract is said to be a covered call option


when the writer of the option deposits the shares of the company on
which the option is written in an escrow account maintained by the
Brokerage Firm. Therefore, in such cases, the writer or the seller of the
option does not have to deposit any margin. On the receipt of the exercise
notice by the broker, the shares are delivered to the exchange.

2. Naked Call Writing: If a trader writes a call option without owning the
underlying security, it is called naked call writing. When the writer does
not own the underlying stock he has to deposit the necessary amount of
margin with the brokerage firm who in turn deposits the same with the
Exchange. Sometimes the broker may take a higher margin from his client
though the margin payable to the exchange may be lower. This is to
protect his own interest against default by the writer of the option.

3. Naked Put Writing: In this case the brokerage firm does not have either
the cash or the stock of other companies as security deposited by the
writer of the put option.
Calculation of Margins
in Options Trading
The method of calculating margin on options trade differs from exchange to
exchange.

Methods of calculation of initial Margin for Naked Options:


If the investor writes a naked call or put option, which is out of money, the
margin is calculated in the following two ways and the higher of the two is
deposited as the margin.
The First Method: To be calculated by following the under mentioned Steps:
i. Calculate the option premium for 100 shares (each option contract is
on 100 shares);
ii. Compute 20% of the market value of the 100 shares;
iii. Compute the amount by which the contract is “out of money”
iv. Margin = i + ii – iii

Under the Second Method the Margin is calculated as:


100XOption Premium per share +0.10 X (Stock’s Market Price /100)
Calculation of Margins in Options Trading

Illustration 1
An option trader writes a single naked call option where the option premium is
Rs 2 and the stock price and the exercise price are Rs 52 and Rs 55
respectively. Calculate the margin he will be required to deposit.

In the given case the option is “out of money” by Rs 3/-. Out of money means
the current price is lower than the strike price, hence it does not make sense to
exercise the option .
The value of the margin will be calculated as under:
First Method:
i. Option premium for 100 shares = Rs 2 X 100 = Rs 200
ii. 20% of the Market Price = Rs 0.20 X 52 X 100 = Rs 1.040
iii. Amt by which the contract is out of money = Rs (55 – 52) * 100 = Rs 300
iv. Margin = i + ii – iii = Rs 200 + 1,040 – 300 = Rs940/-
Second Method: Margin = Option Premium of 100 shares + 10% of market
price of 100 shares = Rs (2 X 100) + (0.1 X 52 X100) = Rs 200 + Rs 520 = Rs 720

SINCE THE VALUE OF MARGIN IS HIGHER UNER THE FIRST METHOD THE
MARGIN TO BE DEPOSITED WILL BE RS 940/-.
Calculation of Margins in Options Trading

Illustration 2
An option trader writes a single Put Option at a premium of Rs 3.50 and the
stock market and the exercise price are Rs 35 and Rs 32 respectively. Calculate
the margin he will be required to deposit.

The value of the margin will be calculated as under:


First Method:
i. Option premium for 100 shares = Rs 3.50 X 100 = Rs 350
ii. 20% of the Market Price = Rs 0.20 X 35 X 100 = Rs 700
iii. Amt by which the contract is out of money = Rs (35 – 32) * 100 = Rs 300
iv. Margin = i + ii – iii = Rs 350 + 700 – 300 = Rs 750/-
Second Method: Margin = Option Premium of 100 shares + 10% of market
price of 100 shares = Rs (3.50 X 100) + (0.1 X 35 X100) = Rs 350 + Rs 350 = Rs
700

SINCE THE VALUE OF MARGIN IS HIGHER UNER THE FIRST METHOD THE
MARGIN TO BE DEPOSITED WILL BE RS 750/-.
Rationale of Options Trading

1. The rationale of an “Options” contract is seen from the buyer of


the “Option” as the seller is committed to his obligation whereas
the buyer may or may not exercise his right, as he chooses.

3. The potential returns from buying options on an underlying asset


are much higher and the risk much lower compared to buying
futures. This is because for buying an option, the buyer has to
pay to the option seller only a relatively small fee, called option
premium. The maximum loss for the buyer is limited to the
amount of premium paid by him to the option writer. A futures
contract can involve higher loss.
Trading in Futures
Forward & Futures Contracts
1. Man by nature is a cautious being. He has always tried to
minimize his risks and that is why the concept of storing
goods came into existence. Historically, man stored
provisions for this requirement to protect himself from the
risk of “inflation” and the risk of “non availability” due to
crop failures.

2. Forward contracts were a natural process which evolved in


the effort to mitigate risk. In an agricultural society, the
crops were dependant entirely on the weather conditions
and crop failures meant starvation for the consumers and
loss of profits for the traders.
Forward & Futures Contracts
3. Hence, the concept of “forward contracts” came into
existence.

4. Under a forward contract the buyer entered into an


agreement with the farmer much before the harvesting of
the crop to buy a specific quantity and quality of the crop
when harvested, to be delivered on a specified date, the
place of delivery and the price to be paid.

5. In other words, the buyer tried to save himself from the risk
of high prices in case the produce was less due to bad
weather conditions.

6. Subsequently, forward contracts also covered other goods


and assets.
Forward & Futures Contracts

7. A forward contract therefore, is unique and hence not


tradable.

8. A simple example of a forward contract is a contract for


the supply of wheat flour by a flour-miller to a bakery.
Such a contract is intended to give and take actual delivery
of the particular goods at prices agreed in advance and as
per agreed schedule.

9. This helps in:


a. Better planning for businesses in maintaining production;
b. Maintaining price stability of goods and commodities
Evolution of Futures Trading

1. However, a major drawback of the forward contracts was


the inability of trading on such contracts.
2. This led to the development of the “Futures Trading”
market. The system of “futures contracts” is a great
advancement over the much older system of “forward
contracts”.
3. An important characteristic of a futures contract is that it
is standardized in order to make it a tradable contract. It is
not intended to acquire the asset or goods but only to
transfer the price risk to other market participants. The
price risk in question is the risk due to fluctuations in the
asset value. A futures contract is thus a risk management
tool.
Features of Futures Contract

A futures contract is standardized in terms of


1. The contract size;

2. Tenure – It has a fixed tenure at the end of which the


contract expires. Different futures contracts have different
tenures, such as 1 month, 2 months, 3 months or longer. A
futures contract is identified by the month in which it is to
expire. For example, the contract expiring in June is
known as June futures.

3. The type as well as the quality or grade of the underlying


asset, i.e., the asset on which it is based.
Features of Futures Contract

4. The value of a futures contract moves with the value of the


asset underlying it, i.e., the asset on which it is based.

5. The underlying asset may be a financial asset (like equities,


bonds, or foreign currency) or a commodity. We thus have
equity futures, bond futures, currency futures, wheat
futures, corn futures, oil futures, gold futures and many
others.
Difference between
Forward & Futures Contract
Sl Element of Forward Contract Futures Contract
Difference

1 Settlement By actual delivery by the By paying the difference


seller to the buyer in price

2 Terms of Contract As settled between the Standardized terms


two contracting parties

3 Tradability on the Not Tradable Tradable in the Futures


“Futures Market” Market

4 Risk of default Exists Does not exist due to the


“Central Clearing
Corporation”
Futures Trading Mechanism

1. The trading mechanism of the “Futures” contracts is called


“hedging”.

2. In simple words, hedging means protecting against a


specific risk.

3. Hedging against the risk of “fall in prices” will work as


follows:
Suppose an investor has 1,000 shares of Infosys which
he has purchased on 15 May 2014 and wants to sell in
June 2014. He has purchased the shares at Rs 500 each
and wants to cover his risk so that he does not incur a
loss at the time of sale (in June) due to prices having
fallen).
Futures Trading Mechanism
He will cover his risk by selling the “Infosys” June futures at current
price in the “Futures” Market. Let us say the current futures price for
Infosys is Rs 498. He will sell at the confirmed price of Rs 498 in the
June “Futures” Market.

Let us assume, that on the expiration date the price of Infosys share
is Rs 450/- each.

He will sell his 1,000 shares for Rs 450/- and incur a loss of Rs 50 per
share = Rs 50,000/-

On the other hand he will get the sale proceeds from his future sale
at Rs 498 minus the current price of Rs 450 thereby making a profit
of Rs 48/- = Rs 48,000/-.

Hence, he has hedged his risk by limiting his loss to a nominal value =
Rs 2,000.
Futures Trading Mechanism

On the other hand let us assume that the price in June is not Rs 450
but Rs 550 per share of Infosys.

In this case, he will sell his 1,000 shares for Rs 550/- and earn a profit
of Rs 50 per share = Rs 50,000.

On the other hand he will get the sale proceeds from his future sale
at Rs 498 minus the current price of Rs 550 thereby incurring a loss
of Rs 52/- per share = Rs 52,000/-.

Hence, he has again limited his loss to a nominal value of Rs 2,000/-.


Futures Trading Mechanism

Similarly in order to protect himself or hedge against the risk of a


price rise in the future, the investor will instead of selling in the
futures market, buy in the futures market at the prevailing price and
will protect himself from a higher price.
Case Studies

Unilever Limited
Transforming the Finance Function
Unilever Limited
Transforming the Finance Function
Unilever Limited
Transforming the Finance Function
And the best of
luck…
The capital budgeting process
Identifying Opportunities
Costs: include or exclude?

1. A sunk cost is a cost that has already occurred, so it cannot be part


of the incremental cash flows in a capital budgeting analysis.
2. An opportunity cost is what would be earned on the next-best use
of the assets.
3. An incremental cash flow is the difference in a company’s cash
flows with and without the project.
4. An externality is an effect that the investment project has on
something else, whether inside or outside of the company.
i. Cannibalization is an externality in which the investment
reduces cash flows elsewhere in the company (e.g., takes sales
from an existing company project).
Investment Decision Criteria

Net Present Value (NPV)


Project Appraisal Steps
In Capital Budgeting

1. Estimate Cash Flows – both inflows & outflows


2. Assess riskiness of Cash Flows
3. Determine k = WACC or Weighted Average Cost of Capital (adj.).
4. Compute NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
Net Present Value (NPV)

1. NPV is one of the tools that companies use for capital budgeting
purposes.
2. Companies calculate NPV by determining expected cash inflows and
outflows for a project over a period of time (say 5 years) and then
discounting all of those cash flows with a discount rate. The discount rate
is the rate at which the value of money falls in each successive year.
3. The advantage of NPV over IRR is that it has more inputs and more
flexibility; however, it does require more work and estimates to perform
the analysis. The discount rate has a number of inputs including cost of
capital and the risk of a project. The discount rate directly correlates with
the risk of a project.
4. If the NPV of a project is negative, that means that the project will
decrease value.
5. If it is positive, that means that the project will help the company create
value.
Net Present Value (NPV) - Adjusting for Inflation

Net present value (NPV) is a technique that involves estimating future


net cash flows of an investment, discounting those cash flows using a
discount rate reflecting the risk level of the project and then subtracting
the net initial outlay from the present value of the net cash flows. It
helps in identifying whether a project adds value or not.

Inflation is a phenomenon that results in decrease in purchasing power


and results in increases in revenue and costs. It affects estimates of
future cash flows. In order to make better decision, accurate capital
budgeting calculations are important, which are possible only when all
the financial variables are taken care of.
Net Present Value (NPV) - Adjusting for Inflation

Methods of making adjustments in NPV for inflation


There are two ways in inflation can be accounted for while calculating NPV:
Nominal method: converting real cash flows to nominal cash flows and
discounting them using nominal discount rate; OR
Real method: estimating real cash flows and discounting them using real
discount rate;

The final net present value is same under both methods.

Under the nominal method,


net cash flows = Real Cash Flows × (1 + Inflation Rate)t

Under the real method, real cash flows and real discount rate are used.

Relationship between nominal discount rate, real discount rate and inflation is
given below:
Real Discount Rate = (1 + Nominal Discount Rate) ÷ (1 + Inflation Rate) – 1
Nominal Discount Rate ≈ Real Discount Rate + Inflation Rate
Net Present Value (NPV) - Adjusting for Inflation

Steps in calculation of NPV under Nominal Method


i. Take the year wise real cash flows and convert them into year wise Nominal
Cash Flows by applying the formula: Real Cash Flow X (1 + Inflation Rate) t .

ii. Discount the year wise Nominal Cash Flows using nominal discount rate

Steps in calculation of NPV under Real Method


iii. In this case the cash flow used will be the real cash flows which are the
actual cash flows generated.

iv. The Real Discounting Rate will have to be calculated from the Nominal
Discounting Rate by using the formula:
Real Discount Rate = [(1 + Nominal Discount Rate) ÷ (1 + Inflation Rate)] – 1

v. Year wise cash flows have to be discounted by the Real Discounting Rate as
calculated above to arrive at the yearly NPV.
Net Present Value (NPV) - Adjusting for Inflation

Example 1: Inflation adjustment using nominal cash flows

X Ltd is considering a project that is expected to generate $10 million at the end of
each year for 5 years. The initial outlay required is $25 million. A nominal discount
rate of 9.2% is appropriate for the risk level. Inflation is 5%. You are the company’s
financial analyst. The company’s CFO has asked you to calculate NPV using a
schedule of future nominal cash flows.

Solution
Nominal cash flows are calculated for each year as follows:
Year 1 = $10 million × (1+5%)1 = $10.50 million
Year 2 = $10 million × (1+5%)2 = $11.30 million
Year 3 = $10 million × (1+5%)3 = $11.58 million
Year 4 = $10 million × (1+5%)4 = $12.16 million
Year 5 = $10 million × (1+5%)5 = $12.76 million

The above nominal cash flows are to be discounted at the nominal discount rate,
which is 9.2% as shown in the table on the next slide.
Net Present Value (NPV) - Adjusting for Inflation

Year 1 2 3 4 5 Total

Nominal cash 10.5 11.30 11.58 12.16 12.76


inflows
PV on discount rate
of 9.2% nominal rate 0.916 0.839 0.768 0.703 0.644
[See Note below]

NPV of cash inflows 9.62 9.25 8.89 8.55 8.22 44.52

From the above calculation the ‘Net present Value’ of the nominal cash
flows (i.e. input and outflow)= $44.52 – $25 million = $19.52 million
Note: the discount value will be determined for 9% and 10% and then proportionately
calculated for 9.2% . At 9% in Yr 1 the discounted PV will be 0.917 and at 10% it will be
0.909. Thus, 1% discounting rate difference is = 0.008. For 0.2% the difference in PV will
be = 0.008 X .2 / 1 = 0.0016. Hence the disc value at 9.2% in Yr 1 will be = 0.9170 –
0.0016 = 0.9154 or 0.916 as has been considered above. Similarly, PV rate will be
calculated for other years.
Net Present Value (NPV) - Adjusting for Inflation

Example 2: In the problem considered in example 1, we shall make


the Inflation adjustment using real cash flows and real discount rate

Under the real method, we discount real cash flows using real
discount rate.

The relationship between nominal discount rate, real discount rate


and inflation can be rearranged as follows:
Real discount rate = (1 + nominal discount rate) ÷ (1+inflation rate) – 1
≈ nominal discount rate – inflation rate = (1+ 9.2%) ÷ (1+5%) – 1 =
(1.092 ÷ 1.05) – 1 = 1.04 – 1 = 0.04 = 4%
Net Present Value (NPV) - Adjusting for Inflation

Year - All Values 1 2 3 4 5 Total


in $ Million

Real cash inflows 10 10 10 10 10

PV discount rate 0.962 0.925 0.889 0.855 0.822


@ 4% real
PV of cash 9.62 9.25 8.89 8.55 8.22 44.52
inflows

1. Net present value of real cash flow discounted at 4% = $44.52


million – $25 million = $19.52 million (Please see next slide)
2. From the above two examples it can be seen that the net
present value is the same under both methods.
Net Present Value (NPV) - Adjusting for Inflation

Delta company manufactures chip boards to be used in small electronic devices. The
company is considering to reduce its cost by automating some manufacturing tasks.
The automation requires installation of a new equipment. The relevant information for
net present value (NPV) analysis of this investment is given below:
Cost of equipment $72,000
Annual cost savings to be provided by new equipment $40,000
Useful life of the equipment 6 years
Salvage value at the end of 6 years Zero
Cost of capital or Nominal Discounting Rate 23.20%
Expected inflation rate in cash flows associated with the 10%
new equipment

Required:
1. What would be the net present value of new equipment if:
(a) inflation is considered under the Nominal Method?
(b) inflation is considered under the Real Valuation Method?
2. Should Delta company invest in new equipment?
Net Present Value (NPV) - Adjusting for Inflation
Solution:
1 Computation of net present value:
(a). If inflation is not considered:
First, we need to compute real cost of capital. It is computed below:
Real Cost of Capital = (Cost of capital – Inflation)/(1+Inflation)
= (23.2% – 10%)/(1 + 10%) = (13.2%)/1.1 = 12%

Year (All Values in $) 0 1 2 3 4 5 6 Total

Cost of equipment -72,000

Annual Cost Savings 40,000 40,000 40,000 40,000 40,000 40,000

Discounting Rate 1.000 0.893 0.797 0.712 0.636 0.567 0.507


=12% Rate

Net Cash Flow -72,000 35,720 31,880 28,480 25,440 22,680 20,280 92,480
Net Present Value (NPV)
Solution: - Adjusting for Inflation
1 (a). If inflation is considered:
Discounting
Price Index Price- NPV of
Particulars (All Values Amount of Rate on
Years (Inflation adjusted Cash
in $) Cash Flows Cash Flows
adjusted) cash flows Flows
23.2%

Cost of equipment 0 -72,000 1.000 -72,000 1.000


-72,000
Annual cost savings 1 40,000 1.100 44,000 0.812
35,728
2 40,000 1.210 48,400 0.659
31,896
3 40,000 1.331 53,240 0.535
28,483
4 40,000 1.464 58,564 0.434
25,417
5 40,000 1.611 64,420 0.352
22,676
6 40,000 1.772 70,862 0.286
20,267
Net present value 2,67,487 92,466

Note: The difference in net present value computed with inflation and without
inflation is due to rounding error.
2 Conclusion: The positive net present value indicates that the project is
acceptable.
Net Present Value (NPV)

1. NPV = Present Value of inflows minus today’s cost = Net


Present Value = Net increase in wealth

2. Acceptance of a project with a NPV > 0 will add wealth / value


to the firm.

3. Decision Rule:
1. Accept if NPV > 0,
2. Reject if NPV < 0
Internal Rate of Return (IRR)
1. Internal Rate of Return is a project’s expected rate of return on its
investment.
2. IRR is the interest or discounting rate at which the NPV of the inflows
equals the NPV of the outflows.
3. In other words, the IRR is the rate where a project’s NPV = 0.
4. Decision Rule: Accept a project or capital investment where the IRR >
k (cost of capital).
5. Non-normal projects have multiple IRRs. Don’t use IRR to decide on
non-normal projects.

Normal vs. Non Normal Projects


 Normal Projects are those where :
◦ Cost of project will have negative Cash Flow followed by a series of positive
annual cash inflows from operations. There is only one change of signs.
 On the other hand Non-normal Projects are those which have two or more
changes of signs.
◦ Most common Non Normal projects will have: Project Cost (negative CF), then
string of positive CFs from operations, then again a cost (negative CF) to close
project.
◦ For example: Nuclear power plant, strip mine.
Internal Rate of Return: IRR

0 1 2 3
CF1 CF2 CF3
CF0 = Cost
of Project Inflows

i. IRR is the discount rate that forces PV inflows = cost. This is the same
ii. Rate at which NPV = 0.
iii. Companies use IRR to calculate the feasibility of a project by finding
the rate of the return the project has to earn to break even.
iv. If the IRR is higher than the required rate of return, then that means
that the project will create value. An IRR lower than the required rate
of return decreases value.
v. IRR has no discount rate or risk assumptions.
The underlying assumption of ‘reinvestment rate’

1. In both NPV and IRR there is a basic underlying assumption, which is that the
yearly cash flows are reinvested at the ‘reinvestment rate’.
2. Reinvestment rate is the rate of investment of yearly cash flows. The NPV
method of project evaluation assumes that the yearly cash flows are
reinvested at the discounting rate at which the NPV is computed till the end
of the evaluation period.
3. In the IRR method, the reinvestment rate is assumed to be = to the IRR.
4. The IRR rate being very high generally, gives an unrealistically high
reinvestment rate which renders the IRR method unreliable and ineligible in
the evaluation of mutually exclusive projects, which means that one project is
to be selected from a number of projects.
5. Hence, the reinvestment rate is a major factor in the conflict between the
NPV and IRR indicators.
6. NPV is a more useful technique, but also more complicated with more inputs
and assumptions. It is also a better tool for comparing different projects at
different time horizons. The IRR technique is quicker for a company to
calculate. The company can also adjust IRR for risk in two different ways: the
company can risk adjust cash flows and can adjust the IRR after calculation for
a risk premium.
Conflict between NPV and IRR

1. When you are analyzing a single conventional project, both NPV and IRR will
provide you the same indicator about whether to accept the project or not. In
other words, for normal independent projects, both methods give same
accept/reject decision. In such cases

NPV > 0 yields IRR > k in order to lower NPV to 0.

2. However, when comparing two projects, the NPV and IRR may provide
conflicting results. It may be so that one project has higher NPV while the
other has a higher IRR. This difference could occur because of the different
cash flow patterns in the two projects.
The following example (all figures assumed) illustrates this point:
Project A Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Investment in Project -5,000
Inflow from Project 2,000 2,000 2,000 2,000 2,000
NPV Factor at 10% 0.909 0.826 0.751
0.683 0.621
Year Wise NPV - 5,000 1,818 1,652 1,502 1,366 1,242
Net NPV after 5 years 2,580
IRR 29%

Project B Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Investment in Project -5,000
- - - -
Inflow from Project 15,000
NPV Factor at 10% 0.909 0.826 0.751 0.683 0.621
- - - -
Year Wise NPV -5,000 9,315
Net NPV after 5 years 4,315
IRR 25%

T he above example assumes a discount rate of 10%. As we can see, Project A has
higher IRR, while Project B has higher NPV. The conflicting results of NPV and IRR in
the above illustration are due to differing cash flow patterns.
1. In the previous example, If the two projects were independent, it
wouldn’t matter much because the firm can accept both the projects.

2. However, in case of mutually exclusive projects, the firm needs to decide


one of the two projects to invest in.

3. When facing such a situation, how should the project be chosen?

4. The project with a higher NPV should be chosen because there is an


inherent reinvestment assumption. In our calculation, there is an
assumption that the cash flows will be reinvested at the same discount
rate at which they are discounted.

5. In the NPV calculation, the implicit assumption for reinvestment rate is


10%.

6. In IRR, the implicit reinvestment rate assumption is of 29% or 25%. The


reinvestment rate of 29% or 25% in IRR is quite unrealistic compared to
NPV. This makes the NPV results superior to the IRR results.

7. In this example, therefore, project B should be chosen.


The conflicting results between NPV and IRR can also occur because of the size
and investment of the projects. A small project may have low NPV but higher IRR.
Let us look at another example:

Project A Project B
Year 0 – Investment in the Project -5,000 -20,000
Year 1 – Operational Inflows 2,000 7,000
Year 2 2,000 7,000
Year 3 2,000 7,000
Year 4 2,000 7,000
Year 5 2,000 7,000

NPV at discount rate of 10% $2,581.57 $6,535.51


IRR 29% 22%

In the above case, Project A has lower NPV compared to Project B but has higher
IRR.
Again, if these were mutually exclusive projects, we should choose the one with
higher NPV, that is, project B.
Selecting a Project with conflicting NPV and IRR results

1. From the above examples, it is clear that in case of mutually exclusive


projects, that is where only one project has to be selected for
implementation, where NPV and IRR indicate conflicting results, the
project with higher NPV will be chosen. IRR will not be considered as
the deciding factor.

2. The reason for this is that the reinvestment rate is more realistic in the
case of NPV rather than IRR. If the reinvestment rate is taken at the IRR
rate, the basic assumption will be faulty and far fetched.

3. NPV is a more useful technique, but also more complicated with more
inputs and assumptions. It is also a better tool for comparing different
projects at different time horizons. The IRR technique is quicker for a
company to calculate. The company can also adjust IRR for risk in two
different ways: the company can risk adjust cash flows and can adjust
the IRR after calculation for a risk premium.
Capital Investment Decisions
Replacement of Assets
Problem 1
The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it
would be disposed off (scrap value nil). Profit before depreciation, interest and taxes
(PBIT) is estimated to be Rs. 1,75,000 p.a. and the tax rate is 30%. You are required to
compute the NPV (using a discounting rate of 9%) and give your opinion on whether the
project should be taken up?
Computation of Projected Cash Flows
Particulars Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Cash Outflow -5,00,000
Cash Inflow – Year wise
Profit before depn, int and tax 1,75,000 1,75,000 1,75,000 1,75,000 1,75,000
Less: Depn - SLM over 5 years
1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Profit before tax 75,000 75,000 75,000 75,000 75,000
Tax @ 30% 22,500 22,500 22,500 22,500 22,500
Profit after tax 52,500 52,500 52,500 52,500 52,500
Add: Depn - non cash charge 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Cash inflow from operations 1,52,500 1,52,500 1,52,500 1,52,500 1,52,500
Total Cash Flow -5,00,000 1,52,500 1,52,500 1,52,500 1,52,500 1,52,500
NPV factor @ disc rate of 9% 1.000 0.917 0.842 0.772 0.708 0.650
NPV of Cash Flows -5,00,000 1,39,843 1,28,405 1,17,730 1,07,970 99,125
The NPV of Cash Flows over the life time of the project is = Rs 93,073
Problem 2
The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it
would be disposed off (scrap value nil). Profit before depreciation, interest and taxes
(PBIT) is estimated to be Rs. 1,75,000 p.a. and the tax rate is 30%. You are required to
compute IRR assuming the weighted cost of capital to be 11% and give your opinion on
whether the project should be taken up?
Problem 3
A cosmetic company is considering to introduce a new lotion. The manufacturing
equipment will cost Rs.5,60,000. The expected life of the equipment is 8 years. The
company is thinking of selling the lotion in a single standard pack of 50 grams at Rs.
12 each pack. It is estimated that variable cost per pack would be Rs. 6 and annual
fixed cost Rs. 4,50,000. Fixed cost includes (straight line) depreciation of Rs. 70,000
and allocated overheads of Rs. 30,000. The company expects to sell 1,00,000 packs
of the lotion each year. Assume that tax is 45% and straight line depreciation is
allowed for tax purpose.
Calculate the following:
a. the NPV of Cash Flows (assuming a discounting rate of 9%);
b. Payback Period of the investment;
c. Payback Period based on NPV of cash flows; and
d. the IRR (assuming the weighted cost of capital at 12%); and
e. give your views on the acceptability of the project.
Solution of Problem 3 Projections of Cash Flows of Lotion Company
Cash Flows Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8

Investment -5,60,000

Sales = 1,00,000 X 12 = Rs 12 12,00,000 12,00,000 12,00,000 12,00,000 12,00,000 12,00,000 12,00,000 12,00,000
L
Variable Cost = 1,00,000 X 6 =
Rs 6 L 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000
Less: Fixed Costs = 4,50,000 -
30,000 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000

Profit before Tax 1,80,000 1,80,000 1,80,000 1,80,000 1,80,000 1,80,000 1,80,000 1,80,000

Less: Income Tax @ 45% 81,000 81,000 81,000 81,000 81,000 81,000 81,000 81,000

Profit after Tax 99,000 99,000 99,000 99,000 99,000 99,000 99,000 99,000

Add: Depn - Non Cash Charge 70,000 70,000 70,000 70,000 70,000 70,000 70,000 70,000

Cash Flow from Operations 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000

Total Cash Flows -5,60,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000

Note: The allocated overheads of Rs. 30,000 have been removed from the Fixed Overheads as they are irrelevant for the
purpose of the income tax and cash flow computation. The cash flow on account of these overheads has taken place at
another point where they have been actually incurred.
Solution of Problem 3 (Contd)

Projections of Cash Flows of Lotion Company

Cash Flows Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8
Sl No

Total Cash Flows - B/f -5,60,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000

A NPV of Cash Flows - Disc Rate 9% 1.000 .917 .842 .772 0.708 0.650 0.596 0.547 0.502

NPV of Cash Flows -5,60,000 1,54,973 1,42,298 1,30,468 1,19,652 1,09,850 1,00,724 92,443 84,838

Net NPV of Cash Flows = 3,75,246

B Calculation of 'Payback period'

a. Outflow -5,60,000

b. Cum Inflows 1,69,000 3,38,000 5,07,000 6,76,000 8,45,000 10,14,000 11,83,000 13,52,000

c. The inv is recovered in the 4th Bal to be recovered Cash Flow in 365 days = 1,69,000 days
Yr at the end of 3 yrs = 53,000 hence Rs 53,000 will be 114.47
recovered in
1 Mth = 365 / 12 days = 30.4 Mths = 3 Mths & 0.77 X 30.4 days = 3 Mths
d. Payback period = 3 yrs 3 Mths and 23 days days 3.77 and 23 days
Solution of Problem 3 (Contd)

Projections of Cash Flows of Lotion Company

Sl Cash Flows Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8
No

C Calculation of NPV based "payback Period"

a. Outflow -5,60,000

b. Cum Inflows - NPV Based 1,54,973 2,97,271 4,27,739 5,47,391 6,57,241 7,57,965 8,50,408 9,35,246

C. The inv is recovered in the 5th Bal to be recovered at the


Yr end of 4 yrs 12,609

d. Payback period = 4 yrs and 7 No of days to recover balance amount


days in Yr 5 = 7 days
Solution of Problem 3 (Contd)
Projections of Cash Flows of Lotion Company
Sl NoCash Flows - Computation of IRR Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8

Total Cash Flows - B/f -5,60,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000

A NPV of Cash Flows - Disc Rate 9% 1.000 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502

NPV of Cash Flows -5,60,000 1,54,973 1,42,298 1,30,468 1,19,652 1,09,850 1,00,724 92,443 84,838

Net NPV of Cash Flows = 3,75,246

Total Cash Flows - B/f -5,60,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000

C NPV of Cash Flows - Disc Rate 1.000 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233
20%

NPV of Cash Flows -5,60,000 1,40,777 1,17,286 97,851 81,458 67,938 56,615 47,151 39,377

Net NPV of Cash Flows = 88,453

Total Cash Flows - B/f -5,60,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000 1,69,000

D NPV of Cash Flows - Disc Rate 1.000 0.799 0.638 0.510 0.408 0.326 0.260 0.208 0.166
20.11%

NPV of Cash Flows -5,60,000 1,35,031 1,07,890 86,204 68,877 55,033 43,971 35,133 28,071

Net NPV of Cash Flows = 210

Hence, the IRR = 20.1% approximately as at this rate the NPV = 0 or NPV or Cash Outflow = NPV of Cash Inflows
Solution of Problem 3 (Contd)

In the given case, the indicators are as under:


Sl No Indicator Value Comment
1 NPV of Net Cash Rs 3,75,000/- As the NPV > 0 the project should be
Flows taken up for implementation
2 Payback Period 3 Yrs 3 Mths and The payback period of 3 Yrs + is very
23 days favorable for the project to be taken up
3 NPV based Payback 4 yrs and 7 days The NPV based Payback period is higher
Period at 4 yrs but is still favorable
4 IRR 20.1% The IRR of 20.1% is very high and
normally such a high IRR with a
reinvestment return of 20.1% is too high
and the IRR is unfavorable. However, the
weighted cost of capital of 12% gives an
IRR over cost of capital of 8.1%.
Normally, a project is viable if IRR > the
weighted cost of capital.

All the above indicators lead us to conclude that the project should be implemented.
Problem 4

XYZ is interested in assessing the cash flows associated with the replacement of an
old machine by a new machine. The old machine bought a few years ago has a
book value of Rs. 90,000 and it can be sold for Rs. 90,000. It has a remaining life of
five years after which its salvage value is expected to be nil. It is being depreciated
annually at the rate of 20 per cent (written down value method).The new machine
costs Rs. 4,00,000. It is expected to fetch Rs. 2,50,000 after five years when it will
no longer be required. It will be depreciated annually at the of 33 1/3 per cent
(written down value method). The new machine is expected to bring a saving of Rs.
1,00,000 in manufacturing costs. Investment in working capital would remain
unaffected. The tax rate applicable to the firm is 50%. Find out the relevant cash
flow for this replacement decision. (Tax on capital gain / loss to be ignored).
Solution to Problem 4
Computation of Projected Cash Flows of XYZ Ltd
Particulars Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Cash Flow - investment net of -3,10,000
salvage value of old m/c
Savings in mannuf cost from
replacement of machine 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Less: Incremental depn 1,15,333 70,889 41,259 21,506 8,337
Addn profit before tax -15,333 29,111 58,741 78,494 91,663
Tax @ 50% -7,667 14,556 29,370 39,247 45,831
Profit after tax -7,667 14,556 29,370 39,247 45,831
Add: Depn being non cash charge 1,15,333 70,889 41,259 21,506 8,337
Cash inflow from operations 1,07,667 85,444 70,630 60,753 54,169
Add: Cash inflow - salvage value 2,50,000
after 5 yrs
Total Cash Inflow - year wise 1,07,667 85,444 70,630 60,753 3,04,169
Total Cash Flow -3,10,000 1,07,667 85,444 70,630 60,753 3,04,169
NPV factor @ disc rate of 9% 1.000 0.917 0.842 0.772 0.708 0.650
NPV of Cash Flows -3,10,000 98,730 71,944 54,526 43,013 1,97,710
The NPV of Cash Flows over the life time of the project is = Rs 1,55,923
Solution to Problem 4 – Working Notes

Calculation of Incremental Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Depreciation
Old Machine 90,000 72,000 54,000 36,000 18,000
Depn for complete w/o in 5 yrs 18,000 18,000 18,000 18,000 18,000
-
WDV of the Machine 72,000 54,000 36,000 18,000

New Machine - Cost 4,00,000 2,66,667 1,77,778 1,18,519 79,012


Depn for complete w/o in 5 1,33,333 88,889 59,259 39,506 26,337
years- 33.33% pa WDV
WDV of the Machine 2,66,667 1,77,778 1,18,519 79,012 52,675

Incremental Depreciation 1,15,333 70,889 41,259 21,506 8,337

Conclusion: Since the NPV is > 0 the project will be taken up for implementation.
Problem 5

ABC and Co. is considering a proposal to replace one of its plants costing Rs. 60,000 and
having a written down value of Rs. 24,000. The remaining economic life of the plant is 4
years after which it will have no salvage value. However, if sold today, it has a salvage
value of Rs. 20,000. The new machine costing Rs. 1,30,000 is also expected to have a
life of 4 years with a scrap value of Rs. 18,000. The new machine, due to its
technological superiority, is expected to contribute additional annual benefit (before
depreciation and tax) of Rs. 60,000. Find out the differential cash flows associated with
this decision given that the tax rate applicable to the firm is 40%. (The capital gain or
loss may be taken as not subject to tax). Calculate the NPV on an assumed discounting
rate of 11%.
Cash Flows on account of New Machine Solution to Problem 5 Rs
Cost of New Machine 1,30,000
Less: Salvage value of old machine 20,000
Net Cash Outlfow on purchase of new machine 1,10,000
Cash Inflow
Additional benefit from new machine 60,000
less: Depreciation 22,000
PBT 38,000
Income Tax @ 40% 15,200
Profit after Tax 22,800
Add: Depn being non cash charge 22,000
Additional Cash Flow from new machine 44,800

Calculation ofAddintional Depn on New Machine Rs


A. Cost of New Machine 1,30,000
Less: Salvage value at end of life 18,000
Depreciable Value 1,12,000
Depn on SLM - per annum 28,000
B. Depn on old machine
WDV of Rs 24000 / 4yrs of bal life 6,000
Additional depn on new machine 22,000
Cash Flows on account of New Machine Solution to Problem 5 Rs
Cost of New Machine 1,30,000
Less: Salvage value of old machine 20,000
Net Cash Outlfow on purchase of new machine 1,10,000
Cash Inflow
Additional benefit from new machine 60,000
less: Depreciation 22,000
PBT 38,000
Income Tax @ 40% 15,200
Profit after Tax 22,800
Add: Depn being non cash charge 22,000
Additional Cash Flow from new machine 44,800

Calculation ofAddintional Depn on New Machine Rs


A. Cost of New Machine 1,30,000
Less: Salvage value at end of life 18,000
Depreciable Value 1,12,000
Depn on SLM - per annum 28,000
B. Depn on old machine
WDV of Rs 24000 / 4yrs of bal life 6,000
Additional depn on new machine 22,000

You might also like