Professional Documents
Culture Documents
Financial Management
Semester I – Batch of 2019
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
For Raising Short Term Funds For Raising Long Term Funds
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
While the money market deals in short-term credit, the capital market handles
the medium term and long-term credit.
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
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
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
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.
• Government security prices are readily available due to a liquid and active
secondary market and a transparent price dissemination mechanism.
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.
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
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
Debt / Credit
Equity Markets
Markets
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
Commercial Corporate
Papers Bonds
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 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.
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.
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.
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.
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
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.
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
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
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
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.
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
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
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 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
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.
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
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
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
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 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
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
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 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
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
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
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
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
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
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;
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.
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;
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
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.
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.
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
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) 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
FCCB
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.
4. It has caused the levels of national interest rates more akin to international
influences.
Euro Dollar Market
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
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
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
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
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.
Calculate the Discounted Rate of the Treasury Bill from the following information:
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
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
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%
1 36% 25%
17.83%
2 26% 50%
3 12% 25%
Total 100%
From the above investment pattern calculate the average expected return on
the total investments of Mr A.
Sol QQ 2 Assessment of Returns
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
Asset 1
f = Sq root of
Column No: a b c=aXb d e total of e
Asset 2
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%
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
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
2 11.0 19 16.0
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
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
• 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)
• Given that
– some risk can be diversified,
– diversification is easy and costless,
– rational investors diversify,
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.
• 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
• 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
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
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
An investor can lend and borrow unlimited amounts at the risk free rate
of interest
The market is perfect: there are no taxes; there are no transaction costs;
securities are completely divisible; the market is competitive.
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%
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.
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
• 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.
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:
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
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
[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…):
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
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
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:
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:
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:
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
Ans:
Step 1: Calculate “r” = stated rate of interest / number of compoundings in a
year = 6% / 2 = 0.06/2 = 0.03
[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…):
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
Example:
What is the maturity value of $ 10,000 invested annually for 2 years @ 11% pa.
Ans:
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
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
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
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:
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
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
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
Year Opning Balance Cash Flow in Closing Balance Interest Closing Balance at
the Yr before Interest year end
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.
Year Opning Balance Cash Flow in Closing Balance Interest Closing Balance at
the Yr before Interest year end
i. Concept of Valuation
ii. Bond Valuation
iii. Equity Valuation
Dividend Capitalization Method
Ratio Method
Bond Valuation Methods
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:
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…
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
1. The YTM rate is the discount rate at which the Present Value of the
Net Cash Flow = Zero
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.
NPV Factor on yield of 14% for 5 Yrs 1.00 0.877 0.769 0.675 0.592 0.519
NPV Factor on yield of 15% for 5 Yrs 1.00 0.870 0.756 0.658 0.572 0.497
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%.
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.
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
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.
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
i. Any rate used in finding the present value of a future cash flow
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
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.
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.
Where,
Pn = the price of share at the end of the 1 st stage of growth and is calculated
by the formula :
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
Solution b/f
= Rs 44.96 + Rs 16.94
= Rs 61.90
The Two Stage Dividend Discount 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 value of stock under this model is termed as the Present Value of the
share and is represented as Po. Under this model:
In the above model, the first equation represents the Stable Growth Phase
while the second equation represents the Supernormal Growth phase.
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
= 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.
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:
d/ (k -g) where,
d = dividend payout ratio
k = cost-of-capital (or, risk-adjusted discount rate)
g = EPS growth rate
P/E Example
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
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
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.
• 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.
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%
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
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
Cost
or
Return
Optimal
Capital
Budget
• 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.
• 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 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
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]:
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
The applicable income tax rate works out to 22% of its PBT
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
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
•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
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.
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.
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
Pn = the price of share at the end of the 1 st stage of growth and is calculated
by the formula :
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
Solution b/f
= Rs 44.96 + Rs 16.94
= Rs 61.90
The Two Stage Dividend Discount Model
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.
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
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”
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.
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. 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.
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.
SINCE THE VALUE OF MARGIN IS HIGHER UNER THE FIRST METHOD THE
MARGIN TO BE DEPOSITED WILL BE RS 750/-.
Rationale of Options Trading
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.
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/-.
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. 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
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
ii. Discount the year wise Nominal Cash Flows using nominal discount rate
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
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
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
Under the real method, we discount real cash flows using real
discount rate.
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%
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%
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)
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.
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
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.
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
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
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)
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
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)
Sl Cash Flows Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8
No
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
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
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
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
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)
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
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