Topic-1: Course Objectives Learning Outcome Statements

BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Topic-1
Financial Management Course
1
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Course Objectives Learning Outcome Statements

No. Learning Outcomes
No. Objectives LO1 Able to analyze and interpret the three key Financial Statements so as to assess the health of a firm/
business.
Gain basic understanding of the underlying concepts and building blocks related to financial
CO1 Apply Time Value of Money concepts for valuation.
management. Develop understanding of the tools relevant to financial management LO2
including time value of money and financial statements analysis. Distinguish between the different types of risk faced by a firm and express the relationship between
LO3
Understand business risk, financial risk, break even analysis, and impact of leverage on risk. risk and return.
CO2
Understand the relationship between risk and return and the drivers of risk. LO4 Able to calculate all the components of cost of capital as well as the overall WACC for a firm.
Understand the application of cost of capital and do the necessary calculations of the
CO3 LO5 Able to evaluate Capital Budgeting projects and make Accept/ Reject decisions based on NPV/ other
components of cost of capital and WACC; Basic principles of capital budgeting, categories business rules.
of capital budgeting projects, discounted and non-discounted cash flow evaluation
LO6 Able to formulate corporate Financial Policies in the areas of Working Capital/ Cash Management,
methods and their limitations, analysis of risks involved in capital budgeting projects.
Capital Structure, and Dividend Policy so as to maximize firm value.
Definition of working capital; Composition and determination of working capital; Financing
CO4 LO7 Demonstrate solutions to "real" business/ financial problems by employing excel/ financial modeling in
and management of current assets; Cash management. a optimal/ effective manner.
Understanding the major theories of capital structure and their implications; How to set
CO5 LO8 Analyze/ Evaluate real life business/ financial situations and identify/ apply the appropriate
target capital structure; Dividend policy and its impact on firm value. framework/ concepts to solve it in a optimal/ effective manner.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956 BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Textbook/ Resources Evaluation Scheme
T1 Fundamentals of Financial Management, 6th Edition

No Name Type Duration Weight Day, Date, Session, Time
(2014), by Prasanna Chandra, published by McGraw Hill
EC-1 Quiz-I Online - 5%
Education (India) Private Limited Quiz-II Online - 5%
R1 Financial Management Theory and Practice, Edition 8th Quiz-III Online - 15%
(2012), by Prasanna Chandra, published by McGraw Hill

Education (India) Private Limited EC-2 Mid-Semester Test Closed
Book
2 hours 30%
R2 Financial Management and Policy, 13th Edition (2009), by

EC-3 Comprehensive Exam Open Book 3 hours 45%
Van Horne J.C., published by PHI Learning
R3 In addition (for some sessions) we will be referring to
selected articles from top journals, selected case studies,
and simulations. Links and/ or references to the same will
be provided during the course.
Finance
BITS Pilani
• Finance is the study of how people and

businesses evaluate investments and raise capital
to fund them
Fundamentals of Financial Management

Introduction

Why Study Financial Management?
Financial Management - Overview
(What’s in it for me?)
• Knowledge of finance is critical for making good decisions (professional/ personal )

Suppose you are planning to start your own business (Say
• Finance is an integral part of corporate world Manufacturing business), you will have to address the following
• Marketing questions:
• Budgets, marketing financial products (or marketing research)
• Management 1. What capital investments should you make? Example:
• Strategic thinking, job performance, profitability
Buildings, Plant and Machinery, Equipments, etc.
• Financial Goals and Metrics Help Firms Implement Strategy and Track Success
2. What will be the source of financing those proposed capital
• Example: Few years back, GM made the strategic decision to invest $740 million to
produce the Chevy Volt (electric+ car) investments? Example: Debt or Equity.
•Such decisions require the expertise of various management disciplines including 3. Investments required for managing day to day operational
marketing, accounting, operations management, and finance and not just technology!
activities? Example: Debtors, Creditors, Inventories of goods
• Most key personal decisions require financial knowledge/understanding etc.
• Example: buying a house or car, planning for retirement, children’s education, etc.
Financial Decisions in a Firm Goal of Financial Management
Three main functions or broad areas of financial Management: • The primary goal of financial management is to maximize the
1. Capital Budgeting: This is referred to as strategic planning and value of the firm or shareholder’s wealth.
it has a significant bearing on how capital is allocated in the • In other words, maximization of the wealth of equity
long term assets of the firm. Capital investments or investments shareholder’s as reflected by the market value of equity or share
in fixed assets. price.
2. Capital Structure: How much debt and equity finance should • Other short term goals maximization of profit, EPS and ROE.
the firm employ? What is the optimal debt- equity ratio for the
firm? Cost of capital consideration.
3. Working Capital Management: Concerned with the short term
assets of the firm or current assets. Technical insolvency
concern. What is the optimal level of inventories, Credit period
of both debtors and creditors, collection period and payment
period, cash in hand etc.
Fundamental Principle of Financial
Management Function of Financial Manager
A business proposal – regardless of whether it is a new investment 1a.Raising funds
2.Investments
or acquisition of another company – raises the value of the firm
only if: Financial
• The present value of the future stream of net cash benefits Operations 1b.Obligations Financial
Manager Markets
expected from the proposal is greater than the initial cash (plant, (stocks, debt
outlay required to implement the proposal (NPV of the equipment, securities) (investors,
3.Cash from i.e. people
project). projects) operational
• NPV or Net present value = Present value of future cash activities
with
benefits – Initial cash outlay. 4.Reinvesting 5.Dividends or surplus
interest funds)
payments
Key role of Finance function is to manage the cash flow

14
Why Study Financial Management?

Relationship of Finance to Economics
(What’s in it for me?)
• Both Macro and micro-economic factors of the economy affects

the financing decision making of the firm.
• Example of macro-economic factors like GDP growth rate,

inflation rate, interest rate, exchange rate etc. (External
environment of the firm).
• The principle of marginal analysis of micro economic guide the

financial decision making by making a comparison of incremental
benefits and costs. (Internal environment of the firm or factors
specific to the firm like process improvement etc.)
Relationship of Finance to Accounting Forms of Business Organizations:
• Score keeping Vs. Value Maximizing. Sole Proprietorship

• Accrual Method Vs. Cash Flow Method. • A sole proprietorship firm is a business owned by a single person.
• Certainty Vs. Uncertainty or Past Vs. Future. • Legal and tax point of view, a sole proprietorship firm has no
separate status apart from its owners.
– The owner realizes all profits and bears all the losses.
– The owner has unlimited liability for the debts of the business.
– There is no distinction between personal and business income.
All business income is taxed as personal income.
– Equity capital of a firm is limited to the personal wealth of the
owner.
– The transfer of ownership requires the sale of entire business to
the buyer.
Forms of Business Organizations (Cont’d): Forms of Business Organizations (Cont’d):
Partnership Cooperative Society

• A partnership firm is a business owned by two or more persons. • A cooperative society may be defined as a society which has its
• It may be viewed as an extension of sole proprietorship. The objective to promote the economic interest of its members in
partners bears the risks and reap the rewards of the business. accordance with cooperative principles.
(Unlimited liability). • Minimum members: 10 and Maximum: No limit.
• However as per Indian partnership act 1932, a partnership firm is a • The members are its owners.
separate legal entity. It can pay interest and remuneration to its • The management is appointed by managing committee. One
partners and claim the same as business expense. member one vote.
• The tax rate applicable to the net profit of partnership firm is 30%. • The liability of the members is limited.
• Recently, Limited Liability Partnership (LLP) was introduced in India.
• The distinctive feature of LLP is the limited liability of its partners
other things remains the same.
Forms of Business Organizations (Cont’d): Forms of Business Organizations (Cont’d):
Company Company
• A company is collectively owned by the shareholders who entrust • Setting up and managing a company is very complicated than
the task of management to their elected representatives called the setting other forms of business organizations.
directors. • Companies are governed by Indian companies act 1956 and 2013.
• The company is a separate legal entity. It can own assets, incur • A company can be private or public limited.
liabilities, enter into contracts, sue and be sued in its name. • Shareholders, Private company (Min: 2 and Max 200) and Public
• The liability of the shareholders is limited to the share capital company (Min: 7 and Max: No limit)
subscribed by them. • A public company can go for public issue of its shares whereas
• A company pay corporate taxes (25% less than 50 crore turnover – private company cannot do so.
30% more than 50 crores) and then pay dividends to its • Free transfer of shares in public company whereas there are
shareholders from net profits. The shareholders are required to pay restrictions on such transfer in private company.
taxes on dividends received by them. So in effect, there is double
taxation.
Financing decisions Financial markets
Financing
decisions • The main goal of financial markets is to
take the savings from those who do not
Internal corporate
financing
External sources
of funds wish to consume (savings surplus units
Direct financing Indirect financing
or suppliers of funds) and to channel
Retained
earnings
(financial markets
Instruments)
(financial
Intermediaries) them to those who wish to invest more
than what they presently have (saving
Stocks Loans
deficit units or demanders of funds)
Debt instruments
(bonds, CPs etc.)
Financial markets and
Functions of the financial system
financial system
• Provides payment system for the exchange of goods and services.
Example Banks and Credit card companies.
• Enables the pooling of funds for undertaking large scale enterprises

or operations.
• Provides a mechanism for transfer of resources. Inflow and outflow

of capital.
• Helps in risk management. Examples insurance or forward contract.
• Enables decentralized decision making. Example: Interest rates are

used by households in making their consumption-savings decisions.
Financial markets Primary and secondary

markets
• Primary market – primary issues of
securities are sold, allows governments,
Financial markets
banks, corporations to raise money by
directly selling financial instruments to the
public. Such issues are referred as IPO’s
Organized
Primary markets Money market exchanges
Secondary markets Capital market Over-the-counter • Secondary market – allows investors to
trade financial securities among
themselves. Examples: BSE, NSE, etc.
Money and capital markets Organized exchanges and
over-the-counter
Money market instruments – short-term assets • Organized exchanges – most stocks, bonds and
(typically maturity less than 1 year): derivatives are traded on organized exchanges. It has a
• Certificates of deposits (CDs) trading floor where floor traders execute transactions in
• Commercial papers (CPs) the secondary market for their clients.
• Treasury bills
• Stocks not listed on the organized exchanges are traded
in the over-the-counter (OTC) market. OTC market
Capital markets – long-term assets (maturity longer
than 1 year) are traded: facilitates secondary market transactions and unlike an
organized exchange, the OTC market doesn’t have a
• Stocks trading floor. The buy and sell orders are typically
• Corporate bonds completed through a telecommunications/ computer
• Long-term government bonds network.
Recent Developments Indian Financial System
• Digital Disruption! (Affecting the existing system •Banking - RBI, Commercial banks, Co-operative banks, Post
through technologies) office savings banks
•Non-banking - LIC, GIC, UTI, Housing development finance

• Peer to Peer Lending (P2P) – Online platform that companies-HDFC, HUDCO
eliminates the middle man or financial institution.
•Developmental financial institutions - ICICI, IDBI, IFCI,
• Instead of the bank acting as a intermediary, the NABARD, SIDBI, Tourism finance corporation SFCs
platform brings lenders and borrowers together so
•Regulatory Institutions - SEBI, RBI, IRDA- Insurance Regulatory
that both can benefit. and Development Authority, etc.
• Example in India: i2ifunding.com
Understanding the Financial
Purpose of Financial Statements
Statements
Financial Statements helps investors/ stakeholders to understand the
1. Balance Sheet performance of the company in the most recent period and answers basic
questions such as:
2. Income Statement
• What is the company’s current financial status?
3. Statement of Retained Earnings
4. Cash flow Statement •What was the company’s operating results for the period?
• How did the company obtain and use cash during the period?
Key points:
• Only public source of financial data (regulatory and voluntary)

• Main external communication tool (to all stake holders)
• Subject to verification by external experts – auditors, etc.
Balance Sheet Basic Accounting Entity
The Balance Sheet provides a summary of the financial position of a company as of a

particular date.
Assets = Liabilities + Owners’ Equity
It lists the following details:
Assets: cash, accounts receivable, inventory, land, buildings, equipment and intangible Resources Sources of Funding
items
Liabilities: accounts payable, notes payable and mortgages payable
Owners’ Equity: net assets after all obligations have been satisfied
Resources Creditors’ Owners’
It helps answer the following questions: used to claims claims
What are the resources of the company? generate = against + against
revenues resources resources
What are the company’s existing obligations?
What are the company’s net assets?
Sample Balance Sheet Classified and Comparative
Balance Sheets
Assets Liabilities
Classified Balance Sheet:
Cash $ 50 Accounts payable $ 100
Accounts receivable 100 Notes payable 200 A classified balance sheet arranges the balance sheet into a format that is useful for
investors and stakeholders.
Land 300 $ 300
•A typical arrangement distinguishes between:
Owners’ Equity •Current and long-term assets
Total assets $450 •Current and long-term liabilities
Capital stock $ 100
•They are listed in decreasing order of liquidity
Must Retained earnings 50
Equal $ 150 Comparative Balance Sheet:
• A comparative balance sheet presents side by side information about a firm’s assets,
Total liabilities
liabilities and equity across multiple points of time.
and owners’ equity $ 450
This form of presentation is also
referred to as Horizontal BS •Such a statement helps stakeholders to identify significant changes over time.
Classified and Comparative

Limitations of Balance Sheet
Balance Sheets
• Assets recorded at historical value
• Assets depreciated using accounting rules
• Above two features leads to BV not reflecting MV
• Additionally, estimations are required for valuing certain assets and liabilities (example:
net realizable value of accounts receivable, cost of warranty, etc.)
• Only recognizes assets that can be expressed in monetary terms
• In some organizations (consulting, etc.) Human Resources may be the most critical
assets but may not be reflected on the BS!
• Does not include off balance sheet liabilities
Income Statement Balance Sheet Vs. Income Statement
The Income Statement shows the results of a company’s operations over a period of
time, and answers questions such as:
Snapshot
• What goods were sold or services performed that provided revenue for the
company? Balance sheet Balance sheet Balance sheet Balance sheet
31/12/2011 31/12/2012 31/12/2013 31/12/2014
• What costs were incurred in normal operations to generate these revenues?
Income Income Income
• What are the earnings or company profit? statement 2012 statement 2013 statement 2014
“Flow” data
Income Statement - Components Sample Income Statement
Revenues 2014 2013

Assets (cash or AR) created through business operations Revenue:
Expenses Sales $150 $ 125
Assets (cash or AP) consumed through business operations Other revenue 50 25
Total revenues $200 $150
Net Income or (Net Loss)
Revenues - Expenses Expenses:
Cost of goods sold $ 100 $ 90
Operating & admin. 40 30
Income tax 20 15
Total expenses $ 160 $ 135
Net Income $ 40 $ 15
Typical Income Statement Typical Income Statement
Income statement for period 2014

$ ’000
Sales 5,356
Cost of sales (2,601)
2,755
1
Distribution costs 382
Administrative expenses 874 (1256)
Profit before interest and tax 1,499
Interest (362)
2 Profit before taxation 1,137
Taxation (384)
Profit available for shareholders 753
Note: 1) Operating result 2) Return to other stakeholders (other than owners)

Statement of Retained Cash Flow Statement

Earnings
• This financial statement outlines the changes in retained earnings from one The cash flow statement reports the amount of cash collected
accounting period to the next and paid out by a company during a particular period of time
and is usually classified into three buckets, namely: operating,
investing and financing activities.
Beginning retained earnings
+ Net income It helps answer two important questions:
– Dividends paid
• How did the company receive cash?
= Ending retained earnings
• How did the company use its cash?
• The cash flow statement complements the income statement

and gives an indication of the ability of a company to continue
in business and generate income in the future.
Cash flow Statement Classification of Cash Flows
Cash inflows: Operating activities – Transactions and events that factor into
the determination of net income.
• Sell goods or services
• Sell other assets or by borrowing Investing activities – Transactions and events that involve the
purchase and sale of securities, property, plant, equipment,
• Receive cash from investments by owners and other assets not generally held for resale, and cash
advances and collections on loans made to other entities.
Cash outflows:
Financing activities – Transactions and events where resources
are obtained from (or repaid to) owners and creditors.
• Pay operating expenses
• Expand operations, repay loans
• Pay owners a return on investment
Operating Activities Investing Activities
Cash Inflow Cash Outflow Cash Inflow Cash Outflow

• Sale of goods or • Inventory payments • Sale of plant assets • Purchase of plant assets
services • Interest payments • Sale of securities, other • Purchase of securities,
• Sale of investments than trading securities other than trading
• Wages
in trading securities • Collection of principal securities
• Utilities, rent on loans (made to other
• Interest revenue • Making of loans to other
• Taxes entities)
• Dividend revenue entities
Financing Activities Cash Flow Statement
Cash Outflow
Operating Investing Financing
Cash Inflow
• Dividend payments
Activities Activities Activities
• Issuance of own stock
• Borrowing • Repayment of debt (i.e. CASH
principal borrowed) INFLOWS Inv
• Equity repurchases Ops
(Treasury stock) CASH ON
Fin HAND
CASH
OUTFLOWS
Sample Cash Flow Statement Sample Cash Flow Statement
Best Consultants Ltd.

Statement of Cash Flow
December 31, 2014
Cash Flows From Operating Activities:

Receipts 50
Payments (45) 5
Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)
Cash Flows Used By Financing Activities:

Receipts 12
Payments (6) 6
Net Cash Flow 7
Cash Flow - Interpretation Cash Flow - Interpretation
Operating Investing Financing Interpretation Operating Investing Financing Interpretation

Building up a pile of cash; possibly looking to Operating cash flow problems covered by
1 + + + make an acquisition 5 ─ + + sale of fixed assets, borrowing and owner
contributions.
Operating cash flow being used to buy fixed Rapid growth, short falls in operating cash
2 + ─ ─ assets and pay down debt
6 ─ ─ + flow; purchase of fixed assets.
3 Operating cash flow and sale of fixed assets 7 Sale of fixed assets is financing operating
being used to pay down debt cash flow shortages.
+ + ─ ─ + ─
Operating cash flow and borrowed Company is using reserves to finance cash
4 + ─ + money being used to expand the business
8 ─ ─ ─ flow short falls.
Manipulations of the bottom line or financial

Notes to Financial Statements
statements
• Notes are used to convey information required by GAAP or to provide
more detailed explanations • Corporate managers have some influence in measurement and reporting of
• The notes help investors to better understand and interpret the these statements. Examples:
numbers presented in the main financial statements
– Inflate the sales for the current year by advancing the sales from the following
Four general types of notes: year.
• Summary of significant accounting policies such as key assumptions and – Other income includes sale of assets and investments.
estimates
• Additional information about the summary totals • Companies do manipulations or manage bottom line to project company
• Disclosure of important information that is not recognized in the financial more profitable or less risky or better long term prospects of the firm or to
statements
• Supplementary information required by accounting rules or investment or other attract potential investors or management incentives.
regulations
BITS Pilani
Topic-2
Financial Management Module 1
61
Understanding the Financial

Purpose of Financial Statements
Statements
Financial Statements helps investors/ stakeholders to understand the
1. Balance Sheet performance of the company in the most recent period and answers basic
questions such as:
2. Income Statement
• What is the company’s current financial status?
3. Statement of Retained Earnings
4. Cash flow Statement •What was the company’s operating results for the period?
• How did the company obtain and use cash during the period?
Key points:
• Only public source of financial data (regulatory and voluntary)

• Main external communication tool (to all stake holders)
• Subject to verification by external experts – auditors, etc.
Balance Sheet Basic Accounting Entity
The Balance Sheet provides a summary of the financial position of a company as of a

particular date.
Assets = Liabilities + Owners’ Equity
It lists the following details:
Assets: cash, accounts receivable, inventory, land, buildings, equipment and intangible Resources Sources of Funding
items
Liabilities: accounts payable, notes payable and mortgages payable
Owners’ Equity: net assets after all obligations have been satisfied
Resources Creditors’ Owners’
It helps answer the following questions: used to claims claims
What are the resources of the company? generate = against + against
revenues resources resources
What are the company’s existing obligations?
What are the company’s net assets?
Sample Balance Sheet Classified and Comparative

Balance Sheets
Assets Liabilities
Classified Balance Sheet:
Cash $ 50 Accounts payable $ 100
Accounts receivable 100 Notes payable 200 A classified balance sheet arranges the balance sheet into a format that is useful for
investors and stakeholders.
Land 300 $ 300
•A typical arrangement distinguishes between:
Owners’ Equity •Current and long-term assets
Total assets $450 •Current and long-term liabilities
Capital stock $ 100
•They are listed in decreasing order of liquidity
Must Retained earnings 50
Equal $ 150 Comparative Balance Sheet:
• A comparative balance sheet presents side by side information about a firm’s assets,
Total liabilities
liabilities and equity across multiple points of time.
and owners’ equity $ 450
This form of presentation is also
referred to as Horizontal BS •Such a statement helps stakeholders to identify significant changes over time.
Classified and Comparative
Limitations of Balance Sheet
Balance Sheets
• Assets recorded at historical value
• Assets depreciated using accounting rules
• Above two features leads to BV not reflecting MV
• Additionally, estimations are required for valuing certain assets and liabilities (example:
net realizable value of accounts receivable, cost of warranty, etc.)
• Only recognizes assets that can be expressed in monetary terms
• In some organizations (consulting, etc.) Human Resources may be the most critical
assets but may not be reflected on the BS!
• Does not include off balance sheet liabilities
Income Statement Balance Sheet Vs. Income Statement
The Income Statement shows the results of a company’s operations over a period of
time, and answers questions such as:
Snapshot
• What goods were sold or services performed that provided revenue for the
company? Balance sheet Balance sheet Balance sheet Balance sheet
31/12/2011 31/12/2012 31/12/2013 31/12/2014
• What costs were incurred in normal operations to generate these revenues?
Income Income Income
• What are the earnings or company profit? statement 2012 statement 2013 statement 2014
“Flow” data
Income Statement - Components Sample Income Statement
Revenues 2014 2013

Assets (cash or AR) created through business operations Revenue:
Expenses Sales $150 $ 125
Assets (cash or AP) consumed through business operations Other revenue 50 25
Total revenues $200 $150
Net Income or (Net Loss)
Revenues - Expenses Expenses:
Cost of goods sold $ 100 $ 90
Operating & admin. 40 30
Income tax 20 15
Total expenses $ 160 $ 135
Net Income $ 40 $ 15
Typical Income Statement Typical Income Statement
Income statement for period 2014

$ ’000
Sales 5,356
Cost of sales (2,601)
2,755
1
Distribution costs 382
Administrative expenses 874 (1256)
Profit before interest and tax 1,499
Interest (362)
2 Profit before taxation 1,137
Taxation (384)
Profit available for shareholders 753
Note: 1) Operating result 2) Return to other stakeholders (other than owners)

Statement of Retained Cash Flow Statement
Earnings
• This financial statement outlines the changes in retained earnings from one The cash flow statement reports the amount of cash collected
accounting period to the next and paid out by a company during a particular period of time
and is usually classified into three buckets, namely: operating,
investing and financing activities.
Beginning retained earnings
+ Net income It helps answer two important questions:
– Dividends paid
• How did the company receive cash?
= Ending retained earnings
• How did the company use its cash?
• The cash flow statement complements the income statement

and gives an indication of the ability of a company to continue
in business and generate income in the future.
Cash flow Statement Classification of Cash Flows
Cash inflows: Operating activities – Transactions and events that factor into
the determination of net income.
• Sell goods or services
• Sell other assets or by borrowing Investing activities – Transactions and events that involve the
purchase and sale of securities, property, plant, equipment,
• Receive cash from investments by owners and other assets not generally held for resale, and cash
advances and collections on loans made to other entities.
Cash outflows:
Financing activities – Transactions and events where resources
are obtained from (or repaid to) owners and creditors.
• Pay operating expenses
• Expand operations, repay loans
• Pay owners a return on investment
Operating Activities Investing Activities
Cash Inflow Cash Outflow Cash Inflow Cash Outflow

• Sale of goods or • Inventory payments • Sale of plant assets • Purchase of plant assets
services • Interest payments • Sale of securities, other • Purchase of securities,
• Sale of investments than trading securities other than trading
• Wages
in trading securities • Collection of principal securities
• Utilities, rent on loans (made to other
• Interest revenue • Making of loans to other
• Taxes entities)
• Dividend revenue entities
Financing Activities Cash Flow Statement
Cash Outflow
Cash Inflow
• Dividend payments
• Issuance of own stock
• Borrowing • Repayment of debt (i.e. CASH
principal borrowed) INFLOWS Inv
• Equity repurchases Ops
(Treasury stock) CASH ON
Fin HAND
CASH
OUTFLOWS
Sample Cash Flow Statement Sample Cash Flow Statement
Best Consultants Ltd.

Statement of Cash Flow
December 31, 2014
Cash Flows From Operating Activities:

Receipts 50
Payments (45) 5
Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)
Cash Flows Used By Financing Activities:

Receipts 12
Payments (6) 6
Net Cash Flow 7
Cash Flow - Interpretation Cash Flow - Interpretation
Operating Investing Financing Interpretation Operating Investing Financing Interpretation

Building up a pile of cash; possibly looking to Operating cash flow problems covered by
1 + + + make an acquisition 5 ─ + + sale of fixed assets, borrowing and owner
contributions.
Operating cash flow being used to buy fixed Rapid growth, short falls in operating cash
2 + ─ ─ assets and pay down debt
6 ─ ─ + flow; purchase of fixed assets.
3 Operating cash flow and sale of fixed assets 7 Sale of fixed assets is financing operating
being used to pay down debt cash flow shortages.
+ + ─ ─ + ─
Operating cash flow and borrowed Company is using reserves to finance cash
4 + ─ + money being used to expand the business
8 ─ ─ ─ flow short falls.
Manipulations of the bottom line or financial
Notes to Financial Statements
statements
• Notes are used to convey information required by GAAP or to provide
more detailed explanations • Corporate managers have some influence in measurement and reporting of
• The notes help investors to better understand and interpret the these statements. Examples:
numbers presented in the main financial statements
– Inflate the sales for the current year by advancing the sales from the following
Four general types of notes: year.
• Summary of significant accounting policies such as key assumptions and – Other income includes sale of assets and investments.
estimates
• Additional information about the summary totals • Companies do manipulations or manage bottom line to project company
• Disclosure of important information that is not recognized in the financial more profitable or less risky or better long term prospects of the firm or to
statements
• Supplementary information required by accounting rules or investment or other attract potential investors or management incentives.
regulations
Objective of Financial Statements

BITS Pilani Analysis
Financial statement analysis helps various stakeholders (such as investors,

lenders, etc.) to make better decisions by assessing the present condition of
the firm and comparing it to past periods or to industry peers.
Internal Stakeholders:
• Managers
• Officers
• Internal Auditors
External Stakeholders:
Financial Statement Analysis •Shareholders

•Lenders
•Customers

Internal Financial Analysis External Financial Analysis
• To evaluate the performance of employees and determine their pay raises • Banks and other lenders deciding whether to lend money to the firm.
and bonuses
• Suppliers who are considering whether to grant credit to the firm.
• To compare the financial performance of the firm’s different divisions
• Credit-rating agencies trying to determine the firm’s creditworthiness.
• To prepare financial projections, such as those associated with the launch
of a new product • Investment analysts who work for investment companies considering investing in
the firm or advising others about investing in the firm.
• To evaluate the firm’s financial performance in light of its competitors and
• Individual investors deciding whether to invest in the firm.
determine how the firm might improve its operations
Tools and Techniques Common size analysis

1) Common size/ Vertical financial statements analysis: • For common size income statement analysis, we divide each entry in the income
• This is a standardized version of a financial statement in which all entries are statement by the company’s sales
converted into percentages of a key financial statement component
• A common size financial statement helps to compare entries in a firm’s financial
statements, even if the firms are not of equal size. • For common size balance sheet analysis, we divide each entry in the balance
2) Horizontal financial statements analysis: sheet by the firm’s total assets
• Here also all entries are presented in percentages
• However the focus is on trends over time
• Horizontal financial statements analysis helps a financial statement user to see
relative changes over time and identify both positive and negative trends
3) Ratio Analysis
• Ratio Analysis is another method for standardizing the financial information on
the income statement and balance sheet.
• A ratio is typically compared to:
• Ratios from previous years
• Ratios of peers (other firms in the same industry)
• If differences are significant a more in-depth analysis will help uncover the drivers
Common Size Income Common Size Income
Statement Analysis Statement Analysis
Key take-away’s:
• Cost of goods sold make up 75% of the firm’s sales resulting in a gross
profit of 25%
• Selling expenses account for about 3% of sales. Income taxes account for
4.1% of the firm’s sales
• After accounting for all expenses, the firm generates net income of 7.6%
of the firm’s sales
Essentially this type of analysis helps answer questions such as:
• What percentage of revenues is the cost of goods sold?

• What is the gross profit percentage?
• What is the mix of expenses (in terms of percentages) that the company has
incurred in this period?
• What is the net profit percentage?
Common Size Balance Sheet Common Size Balance Sheet

Analysis
Key take-away’s:
• Total current assets account for 32.6% of firm’s assets in 2010, showing an
increase of 5.6%
• Similarly total current liabilities account for 14.6% of firm’s total liabilities and
equity (which is equal to assets) in 2010, showing a decline of 2%
• Long-term debt account for 39.2% of firm’s assets in 2010, showing a decline
of 1.7%
Essentially this type of analysis helps answer questions such as:
• What percentage of total assets (or liabilities + equity) is classified as current
assets (or current liabilities)?
• What percentage of total assets is classified as inventory? Is this changing
over time? If it is increasing does this mean the firm is facing difficulty in selling
its inventory? If yes, is that because of competition or obsolescence?
• What percentage of total assets is classified as accounts receivable? If it is
increasing does this mean the firm is having difficulty in collections? If it is
decreasing, is it because of a tighter credit policy? Is this leading to lost sales?
• What is the composition of the capital structure?
Horizontal Analysis Ratio Analysis - Introduction
• In horizontal analysis, typically a base year is selected and the dollar amount of
each financial statement item in subsequent years is converted to a percentage of • Financial ratios provide an alternative method for
the base year dollar amount standardizing the financial information on the income
statement and balance sheet
Example in Excel!
• A ratio by itself may not be very informative
• Typically a ratio is compared to

• Ratios from prior years
• Ratios of peers (other firms in the same industry)
• If the differences are significant then more detailed analysis is

done to identify the underlying drivers and the implications
Financial Ratio Analysis – Key

Liquidity Ratios
Building Blocks
• Liquidity ratios help answer the question:
• How liquid is the firm?
Ability to meet Ability to
short-term generate future
Liquidity and • A firm is financially liquid if it is able to pay its bills on time
obligations and to Activity/ revenues and
Solvency
efficiently generate Efficiency meet long-term
revenues obligations • We typically analyze a firm’s liquidity from two perspectives:
• Overall or general firm liquidity
Ability to provide
financial rewards Ability to •Liquidity of specific current asset accounts
sufficient to attract Profitability Valuation generate (these are sometimes also classified as turnover ratios or
and retain positive market activity ratios or efficiency ratios)
financing expectations
Overall Liquidity Turnover ratios
• Overall liquidity is analyzed by comparing the firm’s current assets to the
firm’s current liabilities
Accounts Receivable Turnover Ratio measures how many times
accounts receivable are “turned over or rolled over” during a year
• The two key ratios used in this analysis are:
• Current ratio (sometimes referred to as working capital ratio)
• Acid-test ratio
Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current
(short-term) liabilities
Inventory turnover ratio measures how many times the company
turns over its inventory during the year. Shorter inventory cycles
lead to greater liquidity since the items in inventory are converted
• Acid-Test (Quick) Ratio: This ratio excludes the inventory from current assets since to cash more quickly.
inventory is usually not as liquid as cash or other current assets
Ratios (Con’t) Liquidity guidelines
Average Collection Period measures the number of days it takes • A high investment in liquid assets will enable the firm to repay its
the firm to collect its receivables. current liabilities in a timely manner.
• However, too much investment in liquid assets may not be a

good thing as it can be very costly for the firm since liquid assets
= 365 ÷ Accounts Receivable turnover ratio (such as cash) generate minimal return
• Inventory Processing Period: We can express the inventory

turnover ratio in terms of the number of days the inventory sits
unsold on the firm’s shelves
• This is also called Days’ Sales in Inventory
Inventory Processing Period = 365 ÷ inventory turnover ratio

Solvency ratios Profitability ratios
• Solvency ratios speak to the risk and leverage of a firm Profitability ratios address a very fundamental question: Has the firm earned adequate
returns on its investments?
• Creditors are especially interested in these ratios. Typically we answer this question by looking at two types of ratios:
• A rising debt-to-equity ratio means higher interest expenses Profit margin: which predicts the ability of the firm to control its expenses
and beyond a certain point it will impact the company’s credit Rate of return on investments: which tells us the return on the investment
rating, making it expensive to raise additional debt • Gross Profit margin = Gross Profit ÷ Sales
• Debt to Equity ratio = Debt ÷ Equity
• Net Profit margin = Net Profit ÷ Sales
• Debt to assets = Total debt ÷ Total assets
• Return on Equity = Net Income ÷ Common Equity
Return on Equity ratio measures the accounting return on the
common stockholders’ investment.
Valuation or Market Value ratios Market Value ratios
Market value ratios address the question, how are the firm’s shares valued in the stock Market-to-Book Ratio measures the relationship between the market value and the
market? accumulated investment in the firm’s equity.
Two market value ratios are:

Price-Earnings Ratio
Market-to-Book Ratio
Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1
of reported earnings.
Key Ratios Formula
Ratios Formula Du Pont Analysis
Liquidity 1) Current Assets / Current Liabilities
1) Current Ratio 2) Current Assets – Inventories / Current Liabilities
2) Quick ratio or Acid Test Ratio
Leverage 1) Total Debt / Shareholders Funds
DuPont method analyzes the firm’s ROE by decomposing it into
1) Debt – Equity Ratio 2) EBIT / Interest expense three parts: profitability, efficiency and an equity multiplier.
2) Interest coverage ratio or Times 3) Total Liabilities / Total Assets
interest earned
3) Debt Ratio ROE = Profitability × Efficiency × Equity Multiplier or Leverage Multiplier
Turnover 1) COGS or Sales / Inventory
1) Inventory turnover 2) Credit Sales / Debtors
2) Debtor’s turnover 3) Sales / Total Assets • Equity multiplier captures the effect of the firm’s use of debt
3) Total Assets turnover 4) Sales / Fixed Assets
4) Fixed Assets turnover
financing on its return on equity. The equity multiplier increases in
Profitability 1) Gross Profit / Sales value as the firm uses more debt.
1) Gross Profit margin 2) Net Profit / Sales
2) Net Profit margin 3) PAT / Total Assets
3) Return on assets (ROA) 4) (PAT – preference dividends, if any) or Equity earnings /
4) Return on Equity (ROE) Shareholders funds
5) Return on capital employed (ROCE) 5) EBIT (1-T) / Total Assets
6) Earning Power 6) EBIT / Total Assets
7) Operating margin 7) EBIT / Sales
8) Earnings per share (EPS) 8) Equity earnings / number of equity shares outstanding
Market Value 1) Market price per share / earnings per share
1) PE ratio or Price to earnings 2) Market price per share / book value per share
2) Market to book or Price to book
Limitations of Financial Ratio

Analysis
• Picking an industry benchmark can sometimes be difficult.
• Published peer-group or industry averages are not always representative of the

firm being analyzed.
•
An industry average is not necessarily a desirable target or norm.
Accounting practices differ widely among firms.

Topic-3
• Many firms experience seasonal changes in their operations.
• Financial ratios offer only clues. We need to analyze the numbers in order to fully
understand the ratios.
• The results of financial analysis are dependent on the quality of the financial
statements.
116
Time value of money
BITS Pilani
• How much it costs to rent money A dollar today
– Keeping the money at home creates an opportunity cost
is worth more
– Interest rate is a measure of this opportunity cost
– Price of impatience and the value of waiting than a dollar
tomorrow
• Example: Assume you have $100 and interest rate is 10%
– PV = $100
• At the end of year 1, FV = PV + r(PV) = PV(1+r) = $110; Where:

– FV = Future Value
– PV = Present Value
– r = interest rate (or discount rate)
• At the end of year 2, FV = $110 x 1.1 = $121
– Interest on interest = $1 = Compound Interest
Time Value of Money
• In general, FV = PV(1+r)^n; where n = number of time periods
• Reversing the logic: PV = FV/ (1+r)^n
Single Sum - Future & Present

Value
Single Sum – FV & PV Formulas
FV3 = (1+i)3PV
FV2 = (1+i)2PV
FV1 = (1+i)PV
PV
FVn = PV(1 + i )n for given PV

n
0 1 2 3 FVn æ 1 ö÷
PV = n = FVn ç
• Assume one can invest the PV at interest rate i to receive future sum, FV
• Similar reasoning leads to Present Value of a Future sum today. (1+ i) è 1+ iø
FV1 FV2 FV3
PV Calculation for $100 received in 3 years
0 1 2 3 if interest rate is 10%
PV = FV1/(1+i) æ 1 ö3
PV = $100 ç ÷
PV = FV2/(1+i)2
è 1.10 ø
= $100 (0.7513 ) = $75.13.
PV = FV3/(1+i)3
Single Sum – FV & PV Formulas Question on PV of a given FV
Ex 1. An investor wants to have $1 million when she retires in 20 years. If

FVn = PV(1 + i )n for given PV she can earn a 10 percent annual return, compounded annually, on her
investments, the lump-sum amount she would need to invest today to
reach her goal is closest to:
n
FVn æç 1 ö÷ A. $100,000.
PV = = FV B. $117,459.
(1+ i)n n
è 1+ iø C. $148,644.
D. $161,506.
PV Calculation for $100 received in 3 years
if interest rate is 10%
æ 1 ö3
PV = $100 ç ÷
è 1.10 ø
= $100 (0.7513 ) = $75.13.
Question on PV of a given FV Frequency of compounding
• Certain investment products pay interest more than once a year
Ex 1. An investor wants to have • In these cases, by convention the stated or quoted annual interest rate is (periodic
$1 million when she retires in • This is a single payment to be rate x # of periods in a year)
20 years. If she can earn a 10 turned into a set future value
percent annual return, FV=$1,000,000 in N=20 years • FVN = PV(1 + r s/m)(m x n)
compounded annually, on her time invested at r=10% interest
investments, the lump-sum • Where: r s is the stated interest rate; m is the # of compounding periods in a year and
rate. N is the # of years
amount she would need to
invest today to reach her goal PV =[ 1/(1+r) ]N FV
is closest to: • Effective interest rate = (1 + r s/m)(m ) - 1
PV = [ 1/(1.10) ]20 $1,000,000
A. $100,000.
PV10 = [0.14864]($1,000,000)
B. $117,459.
C. $148,644. PV10 = $148,644
D. $161,506.
Frequency of compounding - Examples Annuity
How much does a deposit of Rs 5,000 grow to at the end of 6 years, if the nominal Annuity: An annuity is a series of periodic cash flows (payments or receipts) of equal
rate of interest is 12% and the frequency of compounding is 4 times a year? amounts. Example: Insurance premium payments, Loan EMI etc.
nxm 6x4
Ans: FV = PV (1+r/m) = 5000 x (1 + 0.12/4) • Two types of annuities:
24 – Ordinary or Regular or deferred annuity: At the end of the each period
= 5000 x (1.03) = Rs 10,164 (Payments or receipts)
m 4 4 – Annuity due: At the beginning of the each period (Payments or receipts)
Also, Effective rate of interest = (1+r/m) – 1 = (1 + .12/4) – 1 = (1.03) – 1 = 12.55%
• Our discussion will focus on a regular annuity.
Regular Annuity – FV and PV Regular Annuity – FV and PV
• Ordinary Annuity - Equal Cash Flows or Even Cash Flows Example: Suppose you receive Rs 1000 annually for next 3 years. What will
be the present value of these receipts if the discount rate is 10% p.a. ?
n
§ FV = A x [ (1+r) -1] / r n 3
PV = A x [(1 – 1/(1+r) ]/ r = 1000 x [(1 – 1/(1+.1) ]/ .1 = 1000 x 2.487 = Rs 2487
n
§ PV = A x [(1 – 1/(1+r) ]/ r or Loan EMI Formula
Loan EMI Calculation:
Example: Suppose you deposit Rs 1000 annually in a bank for 5 years. Rate Suppose X takes a housing loan of Rs 10,00,000 carrying an interest of 12%
of interest is 10% p.a. What will be the value at the end of 5 years assuming p.a. The loan is to be repaid in 15 years. What is the EMI or Equated Monthly
each deposit occurs at the end of the year? Installment?
Ans: r = 12% p.a. or 12%/12 = 1% per month, n = 15 years or 15 x 12 = 180
n 5
FV = A x [ (1+r) -1] / r = 1000 x [ (1+.1) -1] / .10 = 1000 x 6.105 = Rs 6105 months. PV = Rs 10,00,000,
n
A or EMI = ? 180
PV = A x [(1 – 1/(1+r) ]/ r; 10,00,000 = A x [(1 – 1/(1+.01) ]/ .01
10,00,000 = A x 83.322
Therefore, A or EMI = 10,00,000 / 83.322 = Rs 12,000 per month.
Perpetuities Basics of Bond Valuation
Perpetuity is a series of constant payments, A, each period forever.

• The value of the bond is equal to the present value of the cash flows generated by the
bond ...
A A A A A A A
T
å
Ct Face
0 1 2 3 4 5 6 7 PO = +
PV1 = A/(1+r) (1 + r)t (1 + r)T
PV2 = A/(1+r)2 t= 1
PV3 = A/(1+r)3
Where:
PV4 = A/(1+r)4
etc.
Ct = coupon payment at time t
etc.
r = yield to maturity required by the market
PVperpetuity = å[A/(1+i)t] = A å[1/(1+i)t] = A/i Face = face value of the bond to be repaid at the maturity date T
Intuition:
Present Value of a perpetuity is the amount that must invested today at the
interest rate i to yield a payment of A each year without affecting the value
of the initial investment.
130
Bond Valuation Example Bond Valuation Example
What’s the value of a 10-year, 10% coupon bond if What’s the value of a 10-year, 10% coupon bond if
kd = 10%, Face Value = $1000? kd = 10%?
0 1 2 10 0 1 2 10
10% 10%
... ...
VB = ? $100 $100 ($100 + $1,000) VB = ? $100 $100 $100 + $1,000
$100 $100 $1,000

VB = 1 + . . . + 10 + 10
(1+ k d ) (1+ k d ) (1+ k d )
= $90.91 + . . . + $38.55 + $385.54

= $1,000. or Bond Price
Defining Return on an equity stock
BITS Pilani
Income received on n an investment

inv plus any
change in market price,
price, usually
u expressed
as a percent of the
e beginning market price
of the investment.
Risk and Return Dt + ((P

Pt+1
1 - Pt )
+1
R=
Pt
Return Example Return Example
The stock price for Stock A wass $10 per share The stock price for Stock A wass $10 per share
1 yea
year ago. The stock is currently trading at 1 yea
year ago. The stock is currently trading at
$9.50
9.50 p
per share and shareholders just received $9.50
9.50 p
per share and shareholders just received
a $1 dividend. What return was earned over a $1 dividend. What return was earned over
the past year? the past year?
$1.00 + (($
$9.50 - $
$10.00 )
R= = 5%
$10.00
Geometric vs. Arithmetic Geometric vs. Arithmetic
Average Rates of Return Average Rates of Return (cont.)
• There are two commonly used ways to • The geometric average rate of return
calculate the average returns: answers the question, “What was the
– Arithmetic growth rate of your investment?”
– Geometric
• Arithmetic average may not always • The arithmetic average rate of return
capture the true rate of return realized on answers the question, “what was the
an investment. In some cases, geometric average of the yearly rates of return?
or compound average may be a more
appropriate measure of return. Example: Refer excel
Defining Risk of an equity Determining Expected

stock Return of an equity stock
n
The variability
ability of returns from those R = S ( Ri )( Pi )
i=1
that are expected. R is the expected return for the asset,
Whatt ratee of return do you expect on youryo Ri is the return for the ith possibility,
investment (savings)
( g ) this year?
y
Pi is the probability of that return occurring,
What rate will you y actuallyy earn?
n is the total number of possibilities.
Does it matter if it is a bank de
deposit or a share
of stock?
How to Determine the Expected Return Determining Standard Deviation
and Standard Deviation (Refer Excel) (Risk Measure)
n
Stock BW
Ri Pi (Ri)(Pi)
s= S ( Ri - R )2( Pi )
i=1
The
-.15 .10 -.015 expected Standard Deviation, n, s, is a statistical measure
-.03 .20 -.006 return, R, of the variability of a distribution around its
.09 .40 .036 for Stock mean.
.21 .20 .042 BW is .09 or
9% It is the square root of variance.
.33 .10 .033
Sum 1.00 .090
How to Determine the Expected Return Determining Standard Deviation

and Standard Deviation (Refer Excel) (Risk Measure) (Refer Excel)
n
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
s= S
i=1
( Ri - R ) 2( P )
i
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288 s= .01728
.09 .40 .036 .00000
.21 .20 .042 .00288 s= .1315 or 13.15%
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Market Risk Vs. Unique Risk
Unique Risk or Diversifiable Risk or Unsystematic Risk

stems from firm specific factors like development of new
product or labor strike or competition etc. It can be
minimized through diversification or Stock Portfolio.
Risk and Return on Portfolio
(Refer Excel) Market Risk or Non-diversifiable Risk or Systematic
Risk stems from economy wide factors like GDP growth
rate, inflation rate, interest rate, exchange rate etc.
Total Risk = Unique Risk + Market Risk
Market Risk Vs. Unique Risk
Topic-4
148
Agenda
BITS Pilani
• Break even analysis
• Business Risk
• Operating Leverage
• Financial Risk
• Financial Leverage
• Total Leverage
Break-Even Analysis and Leverage Analysis
Break-Even Analysis Break-Even Chart
Total Revenues
Break
ak-
k-Even Analysis – A technique for studying Profits
VENUES AND COSTS

250
the relationship among fixed costs,
cost variable costs, COS
d profits. Also called
sales volume, and ($ thousands) Total Costs
175
cost/volume/profit analysis (C/V/P) analysis.
REVENUES
100 Fixed Costs

Losses
– When studying operating leverage, 50
Variable Costs
“profits” refers to operating profits before

taxes (i.e., EBIT) and excludes debt 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000
interest and dividend payments. QUANTITY PRODUCED AND SOLD
Break-Even Point Break-Even Point
(Quantity) (Quantity at operating cost level)
Brea
Break
ak-
a k-Even
k Even Poin
Ev Point
nt – T
The sales volume required so
that total revenues and total costs are equal;
equ may Breakeven occurs when EBIT = 0
be in units or in sales dollars. Q ((P – V)) – FC = EBIT
How to find the quantity break-even point: QBE (P – V)) – FC = 0
QBE (P – V) = FC
EBIT = P(Q
P(Q)
P(
P Q) – V
Q V(Q)
V((Q) – F
FC
EBIT = Q
Q((P – V) – FC
QBE = FC / (P – V)
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units
(units) a.k.a. Unit Contribution Margin
produced and sold
Break-Even Point (Sales) Break-Even Point- Example
How to find the sales break-even point:
EBIT = P(
P(Q)
( ) – V(
V(Q)
( ) – FC India
dia Handicrafts wants to dete
determine
eteerrmine both
= Sales – V
V((Q) – FC the
e quantity and sales break
ak-
k-even points
when:
For break-even, EBIT =0
• Fixed costs are
e $100,000
è Sales – V(
V(Q) – FC = 0 • Baskets are sold for
or $43.75
5 each
• Variable costs are
e $18.75 per basket
è SBE = FC + (QBE )(
) V)
Break-Even Point- Example Break-Even Chart
Breakeven occurs when:
QBE = FC / (P – V)
V Total Revenues
QBE = $100,000 / ($43.75 – $18.75)
Profits
VENUES AND COSTS

250
COS
QBE = 4,000 Units
($ thousands)
Total Costs
175
REVENUES
Fixed Costs
SBE = (Q
(QBE )(
)V V)) + FC 100
Losses
SBE = (4,000 )(
)($18.75)
( + $100,000 Variable Costs
50
SBE = $175,000 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD
Drivers of business risk Operating leverage
• Uncertainty about demand (sales). Operating Leverage e re

refers
efers to the use
• Uncertainty about output prices. of fixed operating costs by the firm.
• Uncertainty about costs.
• Product, other types of liability. – One potential “effect” caused by the
• Competition. presence of operating leverage is that
• Operating leverage. a change in the volume of sales
results in a “more than proportional”
change in operating profit (or loss).
Operating leverage Effect of operating leverage
• Large operating leverage leads to higher
• OL is defined as (%change in
EBIT)/(%change in sales) business risk because a small sales decline
causes a huge decline in profits
• Operating leverage is high if the
production requires higher fixed costs and $ Rev. $ Rev.
low variable costs. TC } Profit
TC
• Key point: High fixed costs translate small FC
increases in sales into large increases in FC
EBIT
QBE Sales QBE Sales
Financial leverage and

Operating leverage Financial risk
Low operating leverage

• Financial leverage is defined as
Probability (%change in PBT) / (% change in
High operating leverage EBIT)
• High usage of debt can cause
small increases in EBIT to lead to
EBITL EBITH large increases in net income.
• Financial leverage increases with
• Higher operating leverage leads to higher
increasing levels of debt
E(EBIT), but risk also increases.
Financial risk? Summary
• Financial risk is the additional risk Operating Financial Business Financial

concentrated on common stockholders as a Leverage Leverage Risk Risk
result of financial leverage. %change in %change in Variability in Additional
EBIT/%change in PBT/%change in the firm’s variability in net
– More debt, more financial leverage, more financial sales EBIT expected EBIT. income to
risk. common
shareholders.
– More debt will concentrate business risk on Increases with Increases with Increases with Increases with
stockholders because debt holders do not bear higher fixed cost higher debt high OL. high FL.
business risk (in case of no bankruptcy). If a firm already has high business risk, then it may be advisable to use less debt
to lower the financial risk. If a firm has less business risk, then it may be able to
afford higher financial risk.
Total leverage
Degree of Total Leverage – The percentage

change in a firm’s PBT resulting from a 1
percent change in output (sales).
Percentage change in
Topic-5
DTL at Q units
(or S dollars) of PBT
output (or = Percentage change in
sales) output (or sales)
DTL
L Q units (or S dollars) = L Q units (or S dollars) ) x ( DFL
( DOL L EBIT of X dollars )
168
Agenda
BITS Pilani
• Cost of Capital
• Cost of Debt
• Cost of Preferred
• Cost of Equity
• WACC
• Floatation Costs
Cost of Capital
Cost of Capital Sources of long-term

capital
• The cost of capital represents the overall cost of

financing to the firm Long-Term
• The cost of capital is normally the relevant Capital
discount rate to use in analyzing an investment
• The overall cost of capital is a weighted average of Long-Term Preferred Common
the various sources, including debt, preferred Debt Stock Stock
stock, and common equity:
WACC = Weighted Average Cost of Capital Retained New Common
Earnings Stock
Calculating the weighted average Should we use historical costs or
cost of capital market value?
WACC = wd(pretax kd)(1-Tax rate) + wpkp + • The cost of capital is used primarily to
weke + wrkr make decisions that involve raising new
• The w’s refer to the firm’s capital structure capital for funding new projects.
weights. • So we should focus on today’s market
• The k’s refer to the cost of each value.
component. • Also, weights can be calculated using both
book value and market value.
WACC Formula WACC Inputs 1
• D = market value of all debt

D P E
WACC = k D (1 - T ) + k P + k E • P = market value of preferred stock
V V V • E = market value of common stock
• V = D + P + E = Market value of the entire firm

• It is important to understand the inputs to the
WACC formula • D/V, P/V, and E/V are the capital structure
weights – the proportion of the firm financed by
debt, preferred and common stock
WACC Inputs 2 Weighting example
• kD = cost of debt Bonds 40

• kP = cost of preferred stock Pref. Stock 100
• kE = cost of common stock Common 100
Ret. Earn. 160
• T = marginal corporate tax rate Total L & E 400
What is weight of each component?
• We will learn how to estimate all of these
Weighting example Cost of debt - Irredeemable debt
• Interest is tax deductible, so

Bonds 40
aftertax kd = pretax kd (1-T)
Pref. Stock 100
= 10% (1 - 0.40) = 6%
Common 100
Kd = Coupon rate or Interest rate given.
Ret. Earn. 160
Total L & E 400
T = tax rate = 40%
Bonds = 40/400 = 10%

Pref. Stock = 100/400 = 25%
Cost of debt - Redeemable debt Cost of Preferred Equity
A company has bonds outstanding with 15 years to maturity and are
currently priced at $800. The face value or maturity value of the bond is For Irredeemable Pref. Equity
$1000. If the bonds have a coupon rate of 8.5 percent, then what is the kp = Dividend rate
after-tax cost of debt if the marginal tax rate is 30%?
Ans: 7.82% or [85 + (1000 – 800)/15] / (0.6x800 + 0.4x1000)
For Redeemable Pref. Equity
YTM or Yield to Maturity Approx. Formula:
Kp = [D + (F – P0)/n] / (0.6P0 + 0.4F)
Pre-tax Kd = [I + (F – P0)/n] / (0.6P0 + 0.4F)
Where, P0 = current market price of the pref. stock,
After-tax Kd = Pre-tax Kd (1-T) D = annual dividend payments, n = number of
years left to maturity, F = maturity value or face
Where, P0 = current market price of the bond, I = annual interest
payments, n = number of years left to maturity, F = maturity value or value of the Pref. stock.
face value of the bond
Cost of Equity (Common) and Retained Cost of Equity (Common) and Retained
Earnings Earnings
CAPM Approach or Capital Asset Pricing Model Gordon’s Dividend Constant Growth Model
Cost of Equity or ke = RF + β(RM – RF) Cost of Equity or Ke = D1 + g
P0(1-F)
Where;
D1 = Expected dividend from now
RF = Risk Free Rate P0 = Current share price
Β = Beta of Equity g = Constant dividend growth rate
RM = Return from the market or Market Return F = Percentage flotation cost incurred in issuing new equity, if given or
available
Market Risk Premium = RM – RF
Example: Current share price Rs 80. Expected dividend Rs 4.
Constant growth rate 10%. Issuing cost 8%. What is the cost of
Example: Risk free rate 7%, Beta of equity 1.2 and market risk premium 8%.
equity?
Ke = 7% + 1.2 x 8% = 16.6%
Ans: Ke = 4/[80(1-.080] + .10 = 15.43%
WACC (Also Refer Excel) Average Flotation Costs
• You are analyzing the cost of capital for a • The Wichita Manufacturing company has a
firm that is financed with 60 percent equity target capital structure of 80% equity and 20%
and 40 percent debt. The after-tax cost of debt.
debt capital is 10 percent, while the cost of • The flotation costs for equity issues are 20% of
equity capital is 20 percent for the firm. the amount raised; the floatation costs for debt
What is the overall cost of capital for the issues are 6%.
firm? • If company needs $65 million for a new
• (.6 x .2) + (.4 x .1) = 16% manufacturing facility, what is the true cost
including flotation costs?
Equity + Debt
Solution
• The % flotation cost is a weighted average based on the

average cost of issuance for each funding source and
the firm’s target capital structure:
% f(A) = (E/V)* f(E) + (D/V)* f(D)

= (80%) x (0.2) + (20%) x (0.06) = 17.2%
Topic-6
Therefore the true cost of setting up the new
manufacturing facility (including floatation costs)
= $65 / (1 - 17.2%) = $78.5 million
Hence floatation costs = $78.5 - $65 = $13.5 Million
188
Risk - Definition
BITS Pilani
• Risk may be defined as “ exposure

to uncertainty”
• Favourable or unfavourable
outcomes
• Risk management aims at
mitigating the loss
Risk Management • Focus is on managing the risk
rather than on eliminating it
Risk management is a four step Risk can be broken out into

process three broad categories
• Credit risk
• Identifying the risk
• Measuring the risk (i.e. quantifying) • Market risk
• Managing the risk
• Controlling, monitoring and reviewing • Operational risk
the risk exposures on a periodic basis
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• Commodity Prices
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– 3HRSOH significantly such that it results in a loss.
– 6\VWHPVRU
– ([WHUQDOHYHQWV For example, if one has an investment in a foreign currency
and that currency changes in value, it may adversely affect the
investment's value.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956 BITS Pilani, Deemed to be University under Section 3, UGC Act
Risk Profile Risk profile for an oil producer
• The increase in the volatility of prices and rates may or may not
be a matter of concern to a firm.
• It depends upon the nature of its operations and financing.
Example: Exchange rate fluctuations are a great concern for a
mainly export-oriented company but are of much less concern to a
firm with little or no international activity.
• Risk profile is a basic tool for measuring a firm’s exposure to • It is a relationship
nsshipp between chang
changes
ges in the valu
value ue of the firm (ΔV)
financial risk. and unanticipated
pated changes in oil prices (Δ((ΔP
Poill))..
• It is a graph showing the relationship between changes in the • There is a positive
sitive relationship (upwards sloping
sloping) i.e. the value of
prices of some good or service and changes in the value of the the firm increases
eases when oil price increases.
firm. • Also, the slopepe is fairly steep, implying the firm has a significant
exposure to oilil price fluctuation.
i fl i
BITS Pilani, Deemed to be University under Section 3, UGC Act BITS Pilani, Deemed to be University under Section 3, UGC Act
Managing Financial Risk Forward Contracts
• A derivative is a contract between two or more parties whose • A forward contract represents an agreement between two parties to
exchange an asset for cash at a predetermined future date (settlement
value is based on an agreed-upon underlying financial asset (like date) for a price that is specified today.
a security) or set of assets (like an index). Common underlying Example: If you agree on January 1 to buy 100 bales of cotton on July 1
instruments include bonds, commodities, currencies, interest at a price of Rs 800 per bale from a cotton dealer, you have entered into a
rates, stocks etc. Common derivatives are: forward contract with the cotton dealer.
• Forward contracts • You have bought forward cotton or long position. Long position
which commits the buyer to purchase an item at the contracted price
• Futures contracts on maturity.
• SWAP contracts • Cotton dealer has sold forward cotton or short position. Short
• Option contracts position which commits the seller to deliver an item at the contracted
price on maturity.
• No money or cotton changes hand when the deal is signed. A forward
contract only specifies the terms of a transaction that will occur in
future.
Forward Contracts – The Payoff Profile Hedging with Forward Contracts
Let us consider the case of a power company that uses oil as fuel.
• Assuming that the tariff this company can charge cannot be
adjusted quickly in the short run.
• Therefore, a sudden change in the price of oil is a source of risk.
• Risk profile for an oil buyer is
What are the payoffs to the forward buyer and forward seller?
• When the spot price (P) > contract price (C), the forward buyer’s gain is:
spot price – contract price.
• When the spot price (P) < contract price (C), the forward buyer’s loss is:
contract price – spot price.
• The payoff to the seller of a forward contract is the mirror image of the
payoff to the buyer.
• The gain of the buyer is the loss of the seller and vice versa.
Hedging with Forward Contracts Forward Contracts - Conclusion
• Thus, forward contract protects against the risk of an

adverse price change, but it also eliminates the potential
gain from a favorable price change.
• At the time a forward contract is initiated, no money
changes hand. There is no upfront cost.
• However, since a forward contract involves future
obligations, it carries a credit risk.
What should this company do to cope with its oil risk?
• On the settlement date, the party on the losing side of the
• It should buy a forward contract.
contract has an incentive to renege on the agreement.
• The forward contract reduces the power company’s net exposure
to oil price fluctuations to zero.
• If the oil prices rises, the damage from the higher price is offset
by the gains on the forward contract and vice versa.
Futures Contracts Futures Contracts
• A futures contract is a standardized forward contract. The • The “Marking-to-Market” feature of futures contract is the most
key differences between forwards and futures are as follows: distinctive feature.
Forward Contracts Futures Contracts Example: Suppose on Monday morning you take a long position in
a futures contract that matures on Friday afternoon. The agreed
• Tailor-made contract i.e. the • Standardized contract i.e. quantity,
terms are negotiated between the date and delivery conditions are upon price is Rs 100. At the close of trading on Monday, the future
buyer and seller. standardized. price rises to Rs 105. The marking-to-market feature means that
• No secondary market. • Traded on organized exchanges. three things occur:
• End with deliveries. • Only cash settled. • First, you will receive a cash profit of Rs 5.
• Second, the existing futures contract with a price of Rs 100 is
• No collateral is required. • Margin is required.
cancelled.
• Settled on maturity date. • “Marking-to-Market” on a daily • Third, you will receive a new futures contract at Rs 105.
basis i.e. profits and losses on
futures contracts are settled daily. Thus, the marking-to-market feature implies that the futures
contracts are settled every day.
Futures Contracts and Exchanges Futures and Hedging

Broadly, there are two types of futures: Commodity futures and financial futures Example: Suppose a coffee plantation firm expects a harvest of
• A commodity futures is a contract in commodity like aluminum, gold, coffee, sugar 1000 tons of coffee three months from now. If the uncertainty
etc.
• A financial futures is a contract in a financial instrument like treasury bill, currency,
about the future price bothers it, it can sell a futures contract for
stock etc. 1000 tons. Such a simple hedge eliminates the risk of price
Commodity Exchange Financial Futures Exchange fluctuation.
Futures
Aluminum MCX, NCDEX BSE Sensex BSE
Cashew NCDEX S&P CNX Nifty NSE
Gold MCX, NCDEX NSE Bond Futures NSE
Coffee NMCE, NCDEX USDINR NSE
Sugar MCX, NCDEX,
NMCE
MCX: Multi Commodity Exchange of India Ltd; NCDEX: National Commodity and
Derivatives Exchange Ltd; NMCE: National Multi Commodity Exchange of India Ltd;
BSE: Bombay Stock Exchange; NSE: National Stock Exchange
SWAP Contracts Currency Swaps
• A SWAP contract is an agreement between the two parties to • In a currency swap, two parties agree to exchange a specific
exchange one set of cash flows for another. amount of one currency with a specific amount of another at
certain dates in future.
• In essence, it is a portfolio of forward contracts. A forward Example:
contract involves one exchange whereas a swap contract entails Indian Railway Finance Corporation (IRFC) and Banks did a
multiple exchanges over a period of time. currency swap.
• Under this swap, banks would pay USD 80 million to IRFC in 5
Types of SWAP Contracts: equal installments of USD 16 million each.
• Currency Swaps • In return, IRFC would pay banks the rupee equivalent in
• Interest Rate Swaps installments at a predetermined conversion rate.
• Commodity Swaps • IRFC needed USD 80 million to repay a Euro-currency loan.
Interest Rate Swaps Commodity Swaps and Swap Dealers

• An interest rate swaps is a transaction involving an exchange of one • A commodity swap is a contract to exchange a specified quantity of
stream of interest obligations for another. a commodity at a specified price at fixed times in future.
• It effectively translates a floating rate borrowing into a fixed rate Example: An oil user needs 100,000 barrels every quarter. It can
borrowing and vice versa. The net interest differential is paid or enter into a commodity swap contract with an oil producer to supply
received as the case may be.
the quantity it requires at a specified price over the next 2 years.
• There is no exchange of principal repayment obligations.
• Swap contracts are not standardized contracts i.e. they are not
• It is structured as a separate contract distinct from the underlying
loan agreement. traded on an organized exchange.
• It is applicable to new as well as existing borrowings. • Therefore, a firm interested in a swap agreement typically contacts
• It is treated as an off-balance sheet item. a swap dealer i.e. Commercial banks are the dominant swap
dealers to take the other side of the swap agreement.
Interest rate and currency swaps may be combined. A company
may obtain floating rate interest in a particular currency and • The swap dealer in turn will try to enter into an offsetting
swap with a fixed rate interest in another currency. transaction with some other party or dealer. Otherwise it may cover
its exposure using future contracts.
Interest Rate Swap: An Example Interest Rate Swap: An Example
Consider the following data:
Information Company P Company Q
Desired Funding Fixed Rate; $10 million Floating Rate; $10 million
Cost of Fixed Rate Funding 8% 8.75%
Cost of Floating Rate Funding LIBOR + 100bp LIBOR + 250bp
Both the companies have approached a swap banker for arranging a

swap in such a way that the savings is split equally among all the
three. Show diagrammatically how you will arrange such a swap.
Option Contracts Option Payoffs Profiles

• An option contract is an agreement under which the seller (or Payoff Profiles for Call option: The horizontal axis shows the
writer) of the option grants the buyer (or holder) the right, but not difference between the market value of the asset and the exercise price
the obligation, to buy or sell (depending on whether it is call option of the option; the vertical axis shows the payoffs from the options.
or a put option) some asset at a predetermined price during a Part A shows the payoff profile of a call option from the buyer’s point
specified period. of view and Part B from seller’s point of view. The seller’s payoff
• Clearly, the buyer (or holder) of an option has to pay a premium to profile is exactly the mirror image of the buyer’s.
the enjoy the right.
• In a forward contract both parties are obligated to transact in
future. In an option contract the transaction occurs only if the
buyer (or holder) of the option chooses to exercise it.
• No money changes hand in a forward contract. On the other hand,
the buyer of the option contract pays option premium to the seller
of the option.
Option Payoffs Profiles Hedging with Options
Payoff Profiles for Put option: Part C shows the payoff profile of a Suppose a firm has a risk profile of the kind shown below. What should it do
put option from the buyer’s point of view and Part D from seller’s if it wishes to use options to hedge against adverse price movements?
point of view. The put option gives the right to sell an asset at the
exercise price. If market value of the asset falls below the strike price,
it is the buyer profits because the seller of the put option is obliged to
pay the exercise or strike price.
• Looking at the payoffs, it appears that buying a put option suit this firms.
• By buying a put option the firm eliminates the “downside” risk while
retaining the upside potential.
• The put option serves like an insurance policy. However, like any
insurance it costs money because the firm has to pay the option premium.
Option Contracts - Conclusion

• Investors buy calls if they think the stock is going up in the future
or if they sold the stock short and want to hedge against a possible
surge in price.
• Investors buy puts if they think the stock is going down or if they
own the stock and want to hedge against a possible price decline.
• In general, the closer the stock price is to the exercise price, the
higher the option premium or price.
Topic-7
• The option premium is driven by its value, and as soon as the stock
hits the exercise price it becomes valuable.
• Options expire either in the money or out of the money.
• In-the-money options have triggered the exercise price and are
valuable, and out-of-the money options expire without triggering
the exercise price and are not valuable.
220
BITS Pilani, Deemed to be University under Section 3, UGC Act BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Capital Budgeting: Introduction
BITS Pilani
• Capital budgeting is the process of selecting the most profitable (or rather
value adding) long term projects.
• It involves a capital expenditure decision. Example: Investment in a new

plant, R&D programme, etc.
• The basic characteristic of a capital expenditure is that it involves a current

outlay of funds (Current cash outflows) in the expectation of a stream of
benefits extending far into future (Future cash inflows).
• Other characteristics include long term consequences, irreversible etc.
• Capital budgeting is also considered as strategic asset allocation as it

reflects the allocation of company capital in terms of its strategy and
Capital Budgeting Techniques business.
Capital budgeting process Capital Budgeting : Categories
Categories of the capital budgeting process :

1. Idea Generation or Search for investment opportunities. This
process will vary among firms and industries but aims to – Replacement projects
Two types:
identify candidate projects. 1. To maintain the business at its current level
2. For cost reduction
– Ex. Should we replace a machine that is obsolete but usable or not?
2. Analyze project proposals:
– Estimate all cash flows for each project. – Expansion Projects
• These are undertaken to expand the business
– New product or market developments or R&D
– Evaluate the cash flows. a) Payback period b) ARR c) Net Present
• This involves complex decision making process as it has a lot of uncertainty
Value. d) Internal Rate of Return.
– Mandatory projects
• These are typically mandated by governmental agencies, regulators or insurance
– Make the accept/reject decision. companies eg: pollution control equipment's, fire fighting machines etc.
• Independent projects: Accept/reject decision for a project is not – Other projects
affected by the accept/reject decisions of other projects. • These include pet projects of senior management or a high risk endeavor that is
• Mutually exclusive projects: Selection of one alternative difficult to analyze with typical capital budgeting assessment methods eg:
precludes another alternative. executive aircrafts, recreational facilities, interior decoration etc.
3. Periodically reevaluate past investment decisions.

Capital Budgeting : Key considerations Capital Budgeting Techniques: Investment Criteria
• Key principles of Capital Budgeting

– Decisions are based on cash flows, not accounting Income
• Incremental cash flows are only considered here
• And it is after tax cash flows that we are interested in
– Cash flows are based on opportunity cost
• Opportunity cost is the cash flow generated by the asset , the company
already owns and which will be forgone if the project is undertaken
– Financing costs are part of the project’s required rate of return (in the
denominator, not in the numerator)
• The discount rate used here is the firm’s cost of capital (since we are
analyzing at firm level)
– Timing of cash flow is important
• Time value of money is crucial as cash flow earned earlier is more important
than cash flow to be received later
NET PRESENT VALUE (NPV METHOD) NET PRESENT VALUE (NPV METHOD)
• The NPV of a project is the sum of the present values of all the cash
flows (Positive or Negative) that are expected to occur over the life of
the project.
So, When NPV value is Decision Rule is

Positive Accept
Negative Reject
Zero Indifferent
Also, when comparing two or more projects, a project with the highest NPV
would be selected (in case of cash inflows or returns).
In case of cost, a project with the lowest NPV would be selected. (Machines
selection criteria).
Benefit Cost Ratio or Profitability Index Benefit Cost Ratio or Profitability Index
• Profitability Index = PVB / I , where PVB = present value of • Profitability Index = PVB / I , where PVB = present value of
benefits, I = Initial investment. benefits, I = Initial investment.
So, When PI value is Decision Rule is So, When PI value is Decision Rule is
>1 Accept >1 Accept
<1 Reject <1 Reject
=1 Indifferent =1 Indifferent
Internal Rate of Return (IRR) Internal Rate of Return (IRR)
• IRR of a project is the discount rate which makes its NPV

equal to zero. In other words, it is the discount rate which
equates the present value of future cash flows with the
initial investment.
• Low Discount rate with positive NPV (R1)

• High Discount rate with negative NPV (R2)
The decision rule for IRR is that an investment should only be selected where the
cost of capital (WACC) is lower than the IRR.
Payback Period Method Accounting Rate of Return (ARR)
The payback period is the length of time required to recover the initial Accounting rate of return or Average rate of return =
cash outlay on the project. Average profit after tax / Average book value of the
Example: If a project involves a cash investment of Rs 6,00,000 and investment.
generates cash inflows of Rs 1,00,000, Rs 1,50,000, Rs 1,50,000 and
Rs 2,00,000 in the first, second, third and fourth years respectively, its
payback period is 4 years as sum of cash inflows during the 4 The higher the accounting rate of return, the better the
years is equal to the initial cash investment.
project.
In case of constant cash inflows, payback period = Initial Investment /
constant cash inflow.
Example: a project with initial investment of Rs 10,00,000 and a This method is based on accounting profit, not cash
constant annual cash inflow of Rs 3,00,000 has a payback period of flow.
10,00,000 / 3,00,000 = 3.33 years.
Thus, the shorter the payback period is, the more desirable is the
project.
BITS Pilani
Topic-8
Capital Structure & Its Planning
235
Capital Structure Capital Structure Approaches –
Assumptions and Definitions
• The two principal source of finance for a business firm are • There is no income tax, corporate or personal.
equity and debt. • The firm pursues a policy of paying all its earnings as dividends
• Capital Structure Puzzle: What should be the mix of both (100% dividend payout ratio).
debt and equity in the capital structure of the firm? • Perfect disclosure of information (risk and growth of company).
• Or how much financial leverage (Debt/Equity) should a firm • No transaction cost i.e. a firm can change its capital structure
employ? almost instantly.
• The key objective of FM is wealth maximization. Therefore, Kd = Cost of debt = Annual interest charges (F) / market value of
what is the relationship between capital structure and firm value? debt (B).
Or Capital structure Vs Cost of capital. Ke = cost of equity = Equity earnings (E) / market value of equity
• There is an inverse relationship between valuation and cost of (S).
capital.
Capital Structure Approaches – Net Income Approach

Assumptions and Definitions
Ko = net operating income (O) / market value of the firm (V). According to this approach, Kd and Ke remains constant when
V = B + S, K0 is the overall capitalization rate of the firm (WACC). B/S, the degree of leverage, varies. It means that Ko declines as
B/S increases. This happens because when financial leverage (B/S)
increases, Kd which is lower than Ke, receives a higher weight in the
calculation of Ko.
What happens to Ko, Ke and Kd, when financial leverage

(B/S), changes?
Net Income Approach Net Operating Income Approach
(David Durand)
Unlevered Levered According to this approach, Kd and Ko remains constant for all
Particulars Firm A Firm B degrees of leverage. It says that there is no impact of leverage
Interest on Debt ( F ) - 3,000 on firm’s value or cost of capital.
Equity Earnings ( E ) 10,000 7,000
As a result, with an increase in the use of debt (cheaper source) is
MV of Debt ( B ) - 50,000
MV of Equity ( S ) 100,000 70,000
offset by an increase in the Ke because equity investors seek higher
return as they are exposed to greater risk arising from increase in
WACC the degree of leverage.
Firm A = 10% The market value of the firm depends on its net operating income
Firm B = 9.5% and business risk.
Thus, the Firm B with debt has lower Ko and higher firm Follows MM proposition.
value.
Net Operating Income Approach Net Operating Income Approach

(David Durand) (David Durand)
Ke
Firm A = 15.9%
Firm B = 19.1%
Thus, the Firm B with higher debt has higher Ke value.
Traditional Approach Traditional Approach
The principal implication of the traditional approach is that

the Ko is dependent on the capital structure and there is an
optimal capital structure which minimizes the cost of capital.
At the optimal capital structure, the real marginal cost of debt

and equity is the same.
Before the optimal point, the real marginal cost of debt is less
than the real marginal cost of equity.
Beyond the optimal point, the real marginal cost of debt is

more than the real marginal cost of equity.
Traditional Approach Modigliani and Miller (MM) Approach
In 1958, MM proposed irrelevance theory which states that

firm value is independent of its capital structure.
Assumptions:
• Capital markets are perfect.
• Perfect disclosure of information.
• Personal leverage and corporate leverage are perfect
substitutes.
• No transaction costs.
• Investors are rational and balanced.
• No corporate income tax
Modigliani and Miller (MM) Approach MM Arbitrage Process
MM Propositions
Levered to Unlevered Case (Arbitrage Process)

Unlevered Levered
Particulars A B
EBIT 20,000 20,000
Debt - 100,000
Ke 10% 11.5%
Kd - 7.0%
MM Arbitrage Process MM Arbitrage Process

Levered to Unlevered case Levered to Unlevered case
Example: An equity investor who owns 10% equity in firm B would to well to:
(Firm A) Value of Equity (S) = EBIT – Interest / Ke = 20,000 – 0 /
• Sell his equity in Firm B for Rs 11,304.3
10% = Rs 2,00,000.
• Existing return in Firm B (20,000-7000) @10% = Rs 1300.
Debt Value (B) = 0, Value of Firm A = B + S = Rs 2,00,000 • Borrow Rs 10,000 at 10% stake of debt@7% on personal account.
• Total resource available to invest in Firm A 10,000 + 11,304.3 = Rs 21,304.3.
(Firm B) Value of Equity (S) = 20,000 – 7000 / 11.50% = Rs 1,13,043, • Investment in Firm A = 10% of Rs 2,00,000 (S) = Rs 20,000.
Value of Debt (B) = 1,00,000. Value of Firm B = B + S = 1,13,043 + • Return in Firm A = 10% of Profit = 20,000 x 10% = Rs 2000.
• Cost of borrowings on personal account = 10,000 x 7% = Rs 700.
1,00,000 = Rs 2,13,043
• Net Return in Firm A = Rs 2000 – Rs 700 = Rs 1300 same as Firm B
• However, there is a surplus of Rs 1304.30 (21,304.3 – 20,000) with him.
The value of the levered firm B is higher than that of the unlevered • Therefore by moving from B to A, his position has improved as he is getting same
firm A. Such a situation MM argues cannot persist because equity return with surplus.
investors would do well to sell their equity investment in Firm B Thus, with arbitrage process, the value of the firm (value creation) has not
affected by debt and equity component of the firm.
and invest in the equity of firm A with personal leverage.
MM Arbitrage Process MM Arbitrage Process
Levered to Unlevered case Unlevered to Levered case
When investors sell their equity in Firm B and buy the equity in Firm A with Unlevered Levered
personal leverage, Particulars X Y
EBIT 20,000 20,000
• The market value of equity of Firm B tends to decline and the market Debt - 100,000
value of Firm A tends to rise. Ke 10% 18.0%
• This arbitrage process continues until the total market values of both the Kd - 7.0%
firms become equal and as a result, the cost of capital for both the firms is
(Firm X) Value of Equity (S) = EBIT – Interest / Ke = 20,000 – 0 / 10% = Rs
the same.
2,00,000.
• Thus, as per MM (in the absence of corporate tax and transaction cost),
Debt Value (B) = 0, Value of Firm X = B + S = Rs 2,00,000
the Value of levered firm = Value of unlevered firm, irrespective of their
capital structures.
(Firm Y) Value of Equity (S) = 20,000 – 7000 / 18% = Rs 72,222, Value of Debt
(B) = 1,00,000. Value of Firm Y = B + S = 72,222 + 1,00,000 = Rs 1,72,222.
The value of the unlevered firm X is higher than that of the levered firm Y.
MM Arbitrage Process MM with Corporate Taxes

Unlevered to Levered case (Imperfections)
Example: An equity investor who owns 10% equity in firm X would to well to:
• Sell his equity in Firm X for Rs 20,000
• Existing return in Firm X (20,000) @10% = Rs 2000.
• Total resource available to invest in Firm Y Rs 20,000.
• Investment in Equity shares of Firm Y = 10% of Rs 72,222 (S) = Rs 7,222.
• Investment in Debt of Firm Y = 10% of Rs 1,00,000 = Rs 10,000.
• Total investment in Firm Y = Rs 17,222 and there is a surplus of Rs 2788
(20,000 – 17,222).
• Return in Firm Y (Shares) = 10% of Profit = (20000-7000)=13000 x 10% = Rs 1300.
• Return in Firm Y (Debt) = 10,000 x 7% = Rs 700.
• Total Return in Firm Y = Rs 1300 + Rs 700 = Rs 2000 same as Firm X.
• Therefore by moving from X to Y, his position has improved as he is getting same
return with surplus.
Thus, with arbitrage process, the value of the firm (value creation) has not
affected by debt and equity component of the firm.
Other Imperfections and Capital Structure Trade-off Theory
Thus, the presence of taxation and other imperfections ignores the MM While choosing the debt-equity ratio, financial mangers often look at the
hypothesis. It suggest that firm value and cost of capital are affected by the trade-off between the tax shelter provided by debt and the cost of financial
capital structure or leverage of the firm. distress.
According to the TOT, profitable firms with stable, tangible assets would have
higher debt-equity ratios. On the other hand, unprofitable firms with risky,
intangible assets tend to have lower debt-equity ratios.
Pecking Order Theory Key Factors affecting Capital Structure
According to this theory, there is a pecking order of financing which goes as • Asset Structure or Tangibility
follows: • Revenue Stability or Growth
1. Internal Finance (Retained earnings) • Operating Leverage or Business Risk
2. Debt Finance • Profitability
3. Equity Finance (External) • Taxes
• Control
There is no well defined target debt-equity ratio. This theory explains why
profitable firms generally use less little debt. They borrow less as they don’t
need much external finance. They borrow only when their financing needs
exceed retained earnings.
Break-even EBIT Level or EBIT Indifference
EBIT – EPS Analysis
Point
This analysis helps to understand the sensitivity of EPS in relation to changes The EBIT indifference point for two alternative financing plans is the level of
in EBIT under different financing alternatives. EBIT for which the EPS is the same under both the financing plans.
Case (EBIT – EPS Analysis, EBIT Case (EBIT – EPS Analysis, EBIT
Indifference Level) Indifference Level)
ABC Ltd.
Existing Capital Structure: 1 million equity shares of Rs 10 each.
Tax rate: 50%.
The company plans to raise additional capital of Rs 10 million for financing
an expansion project. In this context, it is evaluating two alternative financing
plans:
1. Issue of equity shares ( 1 million shares at Rs 10 per share)
2. Issue of 14% debentures.
What will be the EPS under the two alternative financing plans for two levels
of EBIT, say Rs 4 million and Rs 2 million? Advice the company on the
financial plan to be selected.
Also, calculate the indifference EBIT level for the two alternative financing
plans.
Break-even EBIT Level or EBIT Indifference Break-even EBIT Level or EBIT Indifference
Point Point
BITS Pilani
Topic-9
Dividend Policy and Share Valuation
267
Dividend Policy Dividend Policy: Stability
Concern
• The dividend policy of the company determines its dividend payout • Stable dividend Payout Ratio
ratio (dividend payment) and the retention ratio (retained earnings) • Stable dividends or steadily changing dividends
from its earnings. • Pure Residual Approach (Dividends = Earnings – Investment Needs)
• The principal objective of financial management is to maximize the
equity share price.
• A company can pay only cash dividends (except bonus shares).
• What is the relationship between dividend policy and market
value of equity shares?
• Some of the factors affecting the dividend policy are Liquidity,
Access to external sources of financing, shareholder preference,
control, taxes etc.
• The dividend policy is considered as an important means to
conveys information about the prospects of the firm. Hence,
dividend stability is very important from the view of an equity
investors.
Other Aspects Other Aspects
Other Aspects Other Aspects
Lintner Model of Corporate Traditional Approach

Dividend Behaviour
According to Lintner model, the amount of current dividend depends According to the traditional approach, the stock market places
partly on current earnings and partly on previous year’s dividend. considerable more weight on dividends than on retained earnings.
Valuation Model
Traditional Approach Walter Model
According to Walter, the dividend policy of the firm has a bearing on share
valuation.
Model Assumptions:
• Retained earnings are the only source of financing for the firm.
• Return on firm’s investment is constant.
• Cost of capital remains constant.
• The firm has an infinite life.
Valuation Model
Walter Model Gordon Model

According to Gordon, the dividend policy of the firm has a bearing on
share valuation.
Model Assumptions:
• Retained earnings are the only source of financing for the firm.
• Return on firm’s investment is constant.
• Growth rate is the product of retention ratio and rate of return
• Cost of capital remains constant.
• The firm has an infinite life.
Gordon Model MM Approach
Overall Picture
Topic-10
284
BITS Pilani, Deemed to be University under Section 3, UGC Act BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
BITS Pilani Working Capital Basics
• Working Capital
– Assets/liabilities required to operate business
on day-to-day basis
• Cash
• Accounts Receivable
• Inventory
• Accounts Payable
• Accruals
Working Capital Management
– Short-term in nature—turn over regularly
Working Capital and the Working Capital and

Current Accounts Funding Requirements
• Gross working capital = Current assets • Working Capital Requires Funds

– Gross Working Capital (GWC) represents – Maintaining working capital balance requires
investment in current assets permanent commitment of funds
• Example: Firm will always have minimum level of
Inventory, Accounts Receivable, and Cash—this
• (Net) working capital = requires funding
Current assets – Current liabilities
287 288
Working Capital and Objective of Working Capital
Funding Requirements Management
• To run firm efficiently with as little money
• Net working capital is Gross Working Capital – as possible tied up in Working Capital
Current Liabilities (including spontaneous – Involves trade-offs between easier operation
financing) and cost of carrying short-term assets
• Benefit of low working capital
– Money otherwise tied up in current assets can be
– Reflects net amount of funds needed to support invested in activities that generate higher payoff
routine operations – Reduces need for costly financing
• Cost of low working capital

– Risk of shortages in cash, inventory
289
Working Capital Trade-offs Working Capital Trade-offs

Inventory Accounts Receivable
High Levels Low Levels High Levels (favorable credit terms) Low Levels (unfavourable
terms)
Benefit: Cost:
• Happy customers • Shortages Benefit: Cost:
• Few production delays (always have needed • Dissatisfied customers • Happy customers • Dissatisfied customers
parts on hand) Benefit: • High sales • Lower Sales
Cost: • Low storage costs Cost: Benefit:
• Expensive • Less risk of obsolescence • Expensive • Less expensive
• High storage costs • High collection costs
• Risk of obsolescence • Increases financing costs
Cash Accounts Payable and Accruals
High Levels Low Levels
Benefit: Benefit: High Levels Low Levels
• Reduces risk • Reduces financing costs Benefit: Benefit:
Cost: Cost: • Reduces need for external finance--using a • Happy suppliers/employees
• Increases financing costs • Increases risk spontaneous financing source Cost:
Cost: • Not using a spontaneous
• Unhappy suppliers financing source
Working Capital Trade-offs Inventory Management
• Inventory management— establishes a balance
between carrying enough inventory to meet
sales or production requirements while
minimizing inventory costs
Current Assets High Level Low Level
Profitability Lower Higher • Inventory usually managed by manufacturing or

Risk Lower Higher operations
Liquidity Higher Lower – However, finance department has an oversight
responsibility
• Monitor level of lost or obsolete inventory
• Supervise periodic physical inventories
293
Inventory Management Inventory Management

• Cost of maintaining inventory: • Total inventory maintenance costs (carrying
1. Carrying costs: all costs associated with carrying costs plus ordering costs) vary inversely.
inventory – Carrying costs increase with increases in average
• Storage, handling, loss in value due to obsolescence and inventory levels and therefore argue in favor of low
physical deterioration, taxes, insurance, financing levels of inventory in order to hold these costs down.
2. Ordering costs: – Ordering costs decrease with increases in average
• Cost of placing orders for new inventory (fixed cost: same inventory levels and therefore firm wants to carry high
dollar amount regardless of quantity ordered) levels of inventory so that it does not have to reorder
• Cost of shipping and receiving new inventory (variable inventory as often as it would if it carried low levels of
cost: increase with increases in quantity ordered)
inventory.
Inventory Costs and the
Inventory Management EOQ
• Economic order quantity (EOQ) model: Cost ($)
mathematical model designed to Total
Cost
determine optimal level of average
inventory that firm should maintain to Carrying
Cost
minimize sum of carrying costs and
ordering costs (total cost inventory
Ordering
maintenance cost) Cost
EOQ Q (Order Size)
Economic Order Quantity

EOQ - Example
(EOQ) Model
• EOQ model is: Q= [ ]

2FD
c
½ Q: The Richond Corp. buys a part that costs $5. The carrying
cost of inventory is approximately 20% of the part’s dollar value
per year. It costs $50 to place, process and receive an order.
The firm uses 900 of the $5 parts per year.
where What ordering quantity minimizes inventory costs?
Q= order size in units How many orders will be placed each year if that order quantity
is used?
D= annual quantity used in units What inventory costs are incurred for the part with this ordering
quantity?
F= cost of placing one order
C= annual cost of carrying one unit in stock
½ denotes square root
EOQ - Example Accounts Receivable Management
A: Annual carrying cost per unit is 20% x $5 = $1 • Accounts receivable management requires
balance between cost of extending credit
Q = [ 2 ( 50 )( 900 )
1
]
½
•
and benefit received from extending credit.
No universal optimization model to determine
EOQ = 300 units credit policy for all firms since each firm has
The annual number of reorders is 900 ¸300 = 3
Ordering costs are $50 x 3 = $150 per year
unique operating characteristics that affect its
Average inventory is 300 ¸ 2 = 150 units credit policy.
Carrying costs are 150 x $1 = $150 a year
Total inventory cost of the part is $300
• However, there are numerous general
techniques for credit management.
Accounts Receivable Accounts Receivable

Management Management
• Industry conditions • “Five Cs” of credit analysis” used to decide
whether or not to extend credit to particular customer:
– Manufacturing firms and wholesalers 1. Character: moral integrity of credit applicant and whether
generally extend credit terms borrower is likely to give his/her best efforts to honoring credit
obligation
– Retailers commonly extend consumer credit, 2. Capacity: whether borrowing form has financial capacity to
either through store-sponsored charge plan or meet required account payments
3. Capital: general financial condition of firm as judged by
acceptance of external credits cards analysis of financial statements
– Small retailers cannot afford cost of 4. Collateral: existence of assets (i.e. inventory, accounts
receivable) that may be pledged by borrowing firm as security
maintaining credit department and thus do not for credit extended
offer store-sponsored charge plans 5. Conditions: operating and financial condition of firm
Accounts Receivable Accounts Receivable
Management Management
• Commercial credit services • Three types of cost:
– National credit services provide credit reports 1.Financing accounts receivable
on potential new accounts that summarize 2.Offering discounts
firm’s financial condition, past history, and 3.Bad-debt losses
other key business information
– Must analyze relationship of these costs to
– Local credit associations profitability
– Marginal cost of credit must be compared to
expected marginal profit resulting from credit
terms
Case Case Solution
Management of Cash and
Management of Cash and Marketable Securities
Marketable Securities
• Firms hold cash balances in checking 2. Precautionary motive: Firms maintain
accounts. Why?
cash balances to meet precautionary
1. Transaction motive: Firms maintain cash
balances to conduct normal business liquidity needs.
transactions. For example, • Two major categories of liquidity needs:
• Payroll must be met 1. To bridge the gaps between cash inflow and cash
• Supplies and inventory purchases must be paid outflow
• Trade discounts should be taken if financially • In order to predict these gaps we need to construct a
attractive detailed cash budget
• Other day-to-day expenses of being in business 2. To meet unexpected emergencies
must be met
Management of Cash and Management of Cash and

Marketable Securities Marketable Securities
3. Speculative motive: Firms maintain 4. Firms using bank debt are required to
maintain a compensating balance with the
cash balances in order to “speculate” – bank from which they have borrowed the
money.
that is, to take advantage of • Compensating balance: when a bank makes a
unanticipated business opportunities that loan to a firm, the bank requires this minimum
balance in a non-interest-earning checking account
may come along from time to time. equal to a specified percentage of the amount
borrowed
• The nature of these opportunities may vary. • Common arrangement is a compensating balance equal to
5-10% of amount of loan
• Bankers maintain that existence of compensating balance
prevents firms from overextending cash flow position
because it forces them to maintain a reasonable minimum
cash balance.
• Marketable securities: short-term, high-quality 1. Safety
debt instruments that can be easily converted
into cash. • Implies that there is negligible risk of default
of securities purchases
• In order of priority, three primary criteria for
selecting appropriate marketable securities to • Implies that marketable securities will not be
meet firm’s anticipated short-term cash needs subject to excessive market fluctuations due
(particularly those arising from precautionary to fluctuations in interest rates
and speculative motives):
1. Safety
2. Liquidity
3. Yield

2. Liquidity • Safety, liquidity, and yield criteria severely restricts range
of securities acceptable as marketable securities.
• Requires that marketable securities can be sold
• Most major corporations meet marketable securities
quickly and easily with no loss in principal value due
needs with U.S. Treasury bills or with corporate
to inability to readily locate purchaser for securities commercial paper carrying highest credit rating.
3. Yield – These securities are short-term, highly liquid, and have
reasonably high yields.
• Requires that the highest possible yield be earned – Treasury bills are default-risk free.
and is consistent with safety and liquidity criteria – High-quality commercial paper carries miniscule default risk.
• Least important of three in structuring marketable • Firms that have sought to achieve higher potential yields
securities portfolio via money market funds invested in asset-backed
securities have learned that those higher potential
yields carried higher risk.
Improving Cash Flow Improving Cash Flow
• Actions firm may take to improve 2. Expedite check-clearing process,
cash flow pattern: slow disbursements of cash, and
1. Attempt to synchronize cash inflows and maximize use of “float” in corporate
cash outflows
– Common among large corporations
checking accounts
– E.g. Firm bills customers on regular schedule • But new developments in financial services
throughout month and also pays its own bills industry such as electronic funds clearing
according to a regular monthly schedule. This
enables firm to match cash receipts with cash
(NEFT, etc.) have reduced the value of this
disbursements. approach
Sources of Short-term Financing

Sources of Short-term Financing
• Three major sources of short-term 1. Trade credit (“spontaneous financing”): form of “free”
financing in the sense that no explicit interest rate is
financing: charged on outstanding accounts payable
1. Trade credit (accounts payable) – Accounts payable arise spontaneously during normal
course of business
2. Commercial bank loans – Commercial firms buy inventory and supplies in open
account from their suppliers on whatever credit terms are
3. Commercial paper available rather than cash payments.
– Two costs associated with trade credit:
1. Cost of missed discounts
2. Cost of financing outstanding accounts receivable (firm
offers trade credit) increases cost of doing business over
what it would be if firm sold on cash terms only.
Sources of Short-term Financing Sources of Short-term Financing
2. Commercial bank loans (continued)
2. Commercial bank loans – Two possible structures:
– Employed to finance inventory and accounts 1. Note for a fixed period of time
– At end of note term (maturity date), face amount of note must be repaid
receivable or note must be renewed (“rolled over”).
Bank and borrower may enter into formal/informal agreement to renew
– Used as source of funds to enable firm to take –
note at maturity at specified rate, which is tied to prime interest rate (rate
discounts on accounts payable when cost of missed charged to bank’s best corporate customers).
o Ex. Interest rate at prime plus some percentage over prime: “prime
discounts exceeds interest cost of bank debt plus 2%”
– Size of premium above interest rate is determined by bank’s assessment
of risk involved in making loan
o Higher risk, higher premium
– As prime rate changes, bank’s cost of obtaining funds changes, so
requiring firm to roll over its notes allows bank to change interest rate on
note.

2. Commercial bank loans (continued)
2. Commercial bank loans (continued) • Unsecured loan: “full faith and credit” obligation of
– Two possible structures borrowing firm
2. Line of credit (“revolver”) – No specific assets are pledged as collateral for loan, but bank
has general claim against firm’s assets if firm defaults on loan
– Bank establishes upper limit on amount firm may
borrow and firm draws whatever money it needs • Secured loan: firm pledges specific asset as collateral
against credit line up to maximum. for loan (i.e. accounts receivable, inventory)
– Interest rate may be fixed or float with prime or LIBOR – If firm defaults on loan, asset may be seized by bank and
rate. liquidated to satisfy loan balance
– Interest is charged only on amount actually borrowed, – Any excess bank receives above amount of principal and
not total amount available. interest due on loan must be returned to borrower
• 3. Commercial paper: short-term Financing Accounts Receivable
corporate IOU that is sold in large dollar • Accounts receivable: used as collateral
amounts through commercial paper for short-term loans
dealers • Three methods of accounts receivable
– Sold by large corporations
financing:
– Usually purchased by other corporations (as an outlet
for marketable securities) or by financial institutions 1. Pledging
(i.e. banks, money market mutual funds) 2. Assigning
– Not available means of financing for small business
3. Factoring
organizations

Financing Accounts Receivable Financing Accounts Receivable
1. Pledging 2. Assigning
– Bank or other lender makes loan of some percentage of value of
– Borrowing firm signs over its right to collect account to lender
receivables but does not take possession of them
– Receivables merely serve as collateral in the event of default – Lender advances money to borrower up to some
– If loan is not paid on time, bank has right to take possession of
predetermined percentage of accounts receivable and then
receivables and collect amount necessary to satisfy loan principal and collects directly from customer account
interest due – Payments received in excess of amount loaned are property of
– Any excess money collected above amount owed must be returned to borrower (treated as part of “circulating pot” of money from
borrower which borrower may draw funds as needed)
– Banks commonly loan 50-80% of face amount of receivables – Lenders commonly lend 75-90% of face value of receivables
– Amount loaned depends mainly on credit reputation of borrower and assigned
quality of receivables pledged – Percentage loaned is a function of credit rating of borrower and
– Quality of receivables is a function of credit rating of customer quality of accounts receivable
accounts and age of receivables
Financing Accounts Receivable Financing Accounts Receivable
• Pledging/Assigning (continued) 3.Factoring
– Lender has recourse to borrower if account – Lender buys accounts receivable outright
fails to pay from borrower at discount from face value
– Lender only acts as supplier of funds so if and assumes burden of collecting
borrower defaults, borrower suffers bad-debt receivables
loss, not lender • Burden includes assumption of bad-debt losses
• If account does not pay, lender has no recourse
– Cost of pledging and assigning are about on borrowing firm
equal
Sources of Short-term Financing BITS Pilani

Financing Accounts Receivable

3.Factoring (continued)
• Lenders provides three services
1. Provide financing of accounts receivable for
borrowing firms
2. Act as borrowing firm’s credit department
3. Assumes risk of bad-debt losses
• Transfers risk from borrowing firms to factor Revision and Doubt Session
• Most expensive form of accounts receivable financing

Financial Management
• Financial Management – Overview
• Financial Statement Analysis
• Break Even and Leverage Analysis
• Time Value of Money
• Risk and Return
• Capital Budgeting
• Cost of Capital
• Capital Structure
• Dividend Policy
• Working Capital Management
333

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BITS Pilani

Course Objectives Learning Outcome Statements

T1 Fundamentals of Financial Management, 6th Edition

(2012), by Prasanna Chandra, published by McGraw Hill

R2 Financial Management and Policy, 13th Edition (2009), by

• Finance is the study of how people and

Fundamentals of Financial Management

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• Knowledge of finance is critical for making good decisions (professional/ personal )

Financial Decisions in a Firm Goal of Financial Management

Key role of Finance function is to manage the cash flow

Why Study Financial Management?

• Both Macro and micro-economic factors of the economy affects

• Example of macro-economic factors like GDP growth rate,

• The principle of marginal analysis of micro economic guide the

• Score keeping Vs. Value Maximizing. Sole Proprietorship

Forms of Business Organizations (Cont’d): Forms of Business Organizations (Cont’d):

Partnership Cooperative Society

Financing decisions Financial markets

• Enables the pooling of funds for undertaking large scale enterprises

• Provides a mechanism for transfer of resources. Inflow and outflow

• Helps in risk management. Examples insurance or forward contract.

• Enables decentralized decision making. Example: Interest rates are

Financial markets Primary and secondary

Recent Developments Indian Financial System

•Non-banking - LIC, GIC, UTI, Housing development finance

• Only public source of financial data (regulatory and voluntary)

Balance Sheet Basic Accounting Entity

The Balance Sheet provides a summary of the financial position of a company as of a

Liabilities: accounts payable, notes payable and mortgages payable

Classified and Comparative

• Assets depreciated using accounting rules

• Above two features leads to BV not reflecting MV

• Only recognizes assets that can be expressed in monetary terms

• Does not include off balance sheet liabilities

Income Statement - Components Sample Income Statement

Revenues 2014 2013

Income statement for period 2014

Note: 1) Operating result 2) Return to other stakeholders (other than owners)

Statement of Retained Cash Flow Statement

• The cash flow statement complements the income statement

Operating Activities Investing Activities

Cash Inflow Cash Outflow Cash Inflow Cash Outflow

Sample Cash Flow Statement Sample Cash Flow Statement

Best Consultants Ltd.

Cash Flows From Operating Activities:

Cash Flows From Investing Activities:

Cash Flows Used By Financing Activities:

Net Cash Flow 7

Operating Investing Financing Interpretation Operating Investing Financing Interpretation

Manipulations of the bottom line or financial

Four general types of notes: year.

Understanding the Financial

• Only public source of financial data (regulatory and voluntary)

The Balance Sheet provides a summary of the financial position of a company as of a

Liabilities: accounts payable, notes payable and mortgages payable

Sample Balance Sheet Classified and Comparative

• Assets depreciated using accounting rules

• Above two features leads to BV not reflecting MV