UNIT- 1

INTRODUCTION TO FINANCIAL MANAGEMENT

Financial Management
Financial management is defined as the acquisition, financing and management of resources for the business firm by
means of money, with due regard for prices in external economic market. Financial management is decision making
process of these managerial decisions: Investment decision, financing decision and assets management decision.
Modern view of financial management is concerned not only with the financing decision but also with the investment
and asset management decisions. Financial management today is more concerned with the total funds employed by
the business firm with their allocation to different activities and projects.
Finance as an Area of Study
· The history of business finance is not so long.
· It was a part of economics till late 1800s.
· It emerged as a separate discipline in early 1900s.
· Today, it has grown into a matured area of study will full body of knowledge.
It includes following four recognized body as an area of study:
a. Corporate Finance
Corporate finance is that area of study which is concerned with acquisition, management and utilization of
financial resources for business firms. Corporate finance deals with many principles and tools that assist financial
managers to recommend proper course of actions. The principles and tools help financial manager to determine
sources of least cost funds and the activities that provide the greatest return on investment.
b. Investment
Investment is that branch of knowledge associated with finance discipline which is concerned with forming
efficient investment portfolio for individual and institutional investors in security markets. In investment
characteristics of different securities, analyzing risk and returns of securities and way of minimizing risk and
maximizing wealth are studied.
c. Financial Institutions and Markets
FIM deals with phenomena associated with operations and functioning of financial institutions and markets in the
process of transfer of funds from savers to users.
d. International Finance
The study of flows of funds between individuals and organizations across national borders and the development
of methods of handling the flows more efficiently are within the scope of international finance.

THE MANAGERIAL FINANCE FUNCTIONS

Managerial finance functions are the managerial actions required to maximize value of firm or to maximize
shareholders wealth. They include:
a. Investment decision
It refers to acceptance/rejection of long term investment projects based on profitability.
b. Financing decision
It is concerned with selection of appropriate sources of funds and managing them for funds collection.
c. Dividend decision
It is the decision of dividing net profit for dividend to equity shareholders and retained earnings. This decision
depends on profit level, firms fund need, government rules, tax position, investors fund needs etc.
d. Working capital decision
It refers to the commitment of funds to current assets such inventory, bills receivables, cash, prepaid expenses etc.

GOALS OF FINANCIAL MANAGER

a. Profit Maximization Goal
b. Wealth Maximization

AGENCY PROBLEM
 The contradiction between agents in the firm is known agency problem. Shareholders, managers and creditors are
the agents of a firm. These agents have their own interests and the problem is created to fulfill their interests
because sometimes interests are mutual on each other. The agency problems and their treatment are as follows:

a. Agency Problem Between Shareholders and Managers

· Shareholders are passive principals and managers are active agents.
· The goal of shareholders is to maximize wealth where as manager’ s goal is to maximize their salary, facilities,
benefits etc.

Mechanism to Resolve

· Managerial compensation
· The threat of firing
· Direct intervention by shareholders
· The threat of hostile take over
b. Agency problem between shareholders and creditors
· Manager’ s decisions are related to wealth maximization ignoring creditors’interest.
· Creditors don’ t want to bear additional risk of company but they do.
· The position of shareholders is “if head appears I win and if tail appears you lose”
.

Mechanism to Resolve

· Compensate creditors to increase risk

· Proactive term and conditions for creditors

UNIT -2
THE OPERATING ENVIRONMENT OF THE FIRM
The Basic Forms of Business Organizations
1. Sole Proprietorship:
A business organization that is owned, managed and controlled by a single individual is known sole
proprietorship firm. Some features of it are:
· it is easy to establish and dissolve. All profit is enjoyed by the single owner.
· Business income is taxed as personal income.
· The proprietor can maintain high secrecy.
· Small capital and low organizational costs.
2. Partnership Firm:
A business firm run by two pr more individuals under a partnership deed is known as partnership firm. Some
features of partnership firms:
· Business income is taxed as personal income.
· It is easy to form.
· Larger capital investment than sole proprietorship firm.
· Joint idea is used.
· Firm is managed, run and controlled by management body.
3. Corporation:
A corporation is an artificial body created by law of the state which has separate existancee from its owners and
managers and has limited financial liability of the owners. Some features of it are:
· Artificial body created and dissolved by law.
· Issues shares and owners are called shareholders.
· Limited liabilities of shareholders.
· Pays corporate taxes.
 · Transferable and marketable securities.
· The firm is managed, and controlled by management body (BOD).
· Large amount of capital and shareholders.

FINANCIAL MARKETS

Financial market is the market which deals with transactions (trading) of financial instruments and securities. They
are:
On the basis of types of transactions:
a. Primary market b. Secondary Market
Primary Market:
It is the market for first and additional issue of securities by corporation, in which the corporation raise new
capital. The market helps for initial issue of securities.
Secondary Market:
The market which deals with trading of outstanding securities among investors to investoers. Market or trading of
securities or demand and supply of securities determines the price of securities.
On the basis of life span of securities:
a. Money Market b. Capital Market
Money Market:
The market which deals with trading of securities with one year and less than one year of life span is called money
market. Money markets are more liquid. Prices of money market instruments (i.e. short term loan, Treasury bills,
commercial papers, bankers acceptancee, certificate of deposits, promissory notes, bills of exchange etc.) fluctuate
very less.
Capital Market:
Capital market involves the trading of financial assets having a life span greater than one year. All long term
securities issued by corporations and government such as common stock, preferred stock, corporate bonds,
government bonds etc. are the instruments of capital market. The value of these instruments fluctuates widely than
money market instruments.
MONEY MARKET INSTRUMENTS
a. Treasury Bills
Treasury Bills is a short-term security issued by government. It is a debt security of government with the maturity
less than one year. It is issued on discount basis for 28, 91, 180 or 364 days.
Discount Rate = (FV –P)/FV x 360/MP
Bond Equivalent Rate = DR/P x 365/MP
Where, P = Price of T-Bill, FV = Face value, MP = maturity period, DR = discount rate/ promised rate
b. Certificate of Deposits (CDs)
CD is a promissory note issued by Financial Institutions. It has maturity date, simple interest rate and face value.
Interest on CD = FV x T x R /100
Bond Equivalent Rate = I/FV x 365/ MP
c. Commercial Paper
A short-term debt security issued by large well established and credit worthy company. It is issued for maximum
270 days on discount basis. They are generally issued in multiples of Rs 100,000 or more. It is similar to T-bill
for calculation of bond equivalent interest rate.
d. Repurchase Agreement
It is an agreement for sale of securities today for some period and buy them back later. Selling price, repurchase
price and time period is fixed at the time of contract.
Cost for the agreement = (Repurchase Price –Selling Price)/Selling Price x 365/T
e. Bankers’Acceptance
It is a draft that is accepted by the bank and used in financing foreign and domestic trade. The buyer requests its
bank to issue a written promise on its behalf that ensures payment to the seller. It specifies the amount of money,
the date and the person to which the payment is due. It can be sold or discounted in the money market.
 UNIT-3

THE ANALYSIS OF FINANCIAL STATEMENTS

INTRODUCTION

Financial statements are organized summaries of detailed information about financial position and
performance of an enterprise. These statements are prepared at the end of each accounting period.

Financial analysis is the process of analyzing and evaluating the relationship between the component parts
of the financial statement to get better understanding of a firm’
s position and performance.

According to John Mayer “ Financial statement analysis is largely a study of relationship among the various
financial factors in a business as disclosed by a single set of statements and a study of the trend of these
factors as shown in a series of statements”.

Financial statement analysis is the collective name for the tools and techniques that are intended to provide
relevant information to decision-makers. The purpose of such an analysis is to assess a company’ s financial
health and performance. Financial statement consists of comparisons for the same company over periods of
time and for different companies in the same industry or different industries.

It enables investors and creditors to evaluate past performance and financial position and predict future
performance.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is the collective name for the tools and techniques that are intended to provide
relevant information to decision-makers. The purpose of such an analysis is to assess a company’ s financial
health and performance. Financial statement consists of comparisons for the same company over periods of
time and for different companies in the same industry or different industries.

It enables investors and creditors to

· evaluate past performance and financial position; and

· Predict future performance.

Evaluation of past performance and financial position

The starting point in the analysis of a company is to look at the record. Information about past performance
is useful in judging future performance. For example, trend of past sales, earnings, cash flow, profit margin,
and return on investment provide a base for evaluating the efficiency of a company’ s performance and aid
in assessing its prospects. An assessment of current status will show where the company stands at present,
in terms of items such as inventories, borrowings, and cash position. Largely, the expectation of investors
and creditors about future performance are shaped by their evaluation of past performance and current
position.

Individual investors are often passive and they rarely intervene in the working of a company as long as it is
reasonably successful. Their evaluation of the company helps them assess prospects for their investments,
and investors who are dissatisfied with a company’ s performance will typically sell their shares in the
company. In contrast, institutional investors are generally more active and may insist on major management
changes when the company does not fare well. Creditors are concerned with management’ s compliance
with loan indentures and may take legal action if covenants are broken.

Prediction of Future Performance

Investors and creditors use information about the past to assess a company’ s prospects. Investors expect an
adequate return from the company in the form of dividends and market price appreciation. Creditors expect
the company to pay interest and repay the principle in accordance with the terms of lending. Therefore, they
are interested in predicting the earning power and debt paying ability of the company. After analyzing
financial statement, they predict the future performance of a company.

Other objectives:

· To examine the earning capacity and efficiency of various business activities with the help of
income statement;
· To estimate about the performance, efficiency and managerial ability;
· To determine short term and long term solvency of the business concern with the help of balance
sheet.
· To inquire about the financial position and ability to pay of the concerns seeking loans and credit.
· To determine the profitability and future prospects of concern
· To make comparative study of operational efficiency of similar concerns engaged in identical
industry.

RATIO ANALYSIS

Ratio analysis involves establishing a relevant financial relationship between components of financial
statements. Two companies may have earned the same amount of profit in a year, but unless the profit is
related to sales or total assets, it is not possible to conclude which of them is more profitable. Ratio analysis
helps in identifying significant relationships between financial statement items for further investigation. If
used with understanding of industry factors and general economic conditions, it can be a powerful tool for
recognizing a company’ s strength as well as its potential trouble spots. Commonly used financial ratios and
their interpretation are discussed below:

SN Ratios Formula Interpretation

1. Profitability Ratios
a. Gross Profit Margin Gross Profit Greater - favorable
×100
Sales
b. Net Profit Margin Net Profit Greater –favorable
×100
Sales
c. Asset Turnover Ratio Sales Greater –favorable
Total asset
d. Return on assets NPAT Greater –favorable
×100
Total Asset
Or, NPM X TATOR
e. Return on Equity NPAT Greater –favorable
×100
Equity Fund
Or, NPM X TATOR X EM
 Or, ROA X EM
f. Earnings Per Share NPAT-PD Greater –favorable
No.of equity Shares

2. Liquidity Ratios Type equation here.

a. Current Ratio currrent asssets Greater –favorable
current liability
b. Quick Ratio quick asssets Greater –favorable
current liability
c. Cash flow from to current
liabilities
c. Debtor Turnover Ratio credit sales Greater –favorable
average debtors
d. Average Collection Period 365 Smaller - favorable
debtor turnover ratio

e. Inventory Turnover Ratio cost of goods sold Smaller - favorable

average inventory
sales
Or,
inventory

3. Solvency Ratios
a. Debt-to-equity ratio long term debt Greater –more leverage
shareholders equity
b. Liabilities to equity ratio total debt Greater –more leverage
shareholders equity
c. Interest Coverage Ratio NPAT+interest Greater –more operating as
interest exps well financing performance
4. Capital Market Ratios
a. Price-earnings ratio market price
earning per share
b. Dividend yield Ratio dividend per share Greater – better market
average stock price position
c Price-to-book value Ratio market price per share Greater – better market
book value per share position
d TIE ratio EBIT/Interest expenses Greater – better market
position
e. Operating profit ratio EBIT/ Sales Greater – better market
position
f Earning power ratio EBIT/ Total asset Greater – better market
position

UNIT –4
FINANCIAL PLANNING
Financial Planning Process (FPP)
Financial planning is the process of projecting future financial action of a firm that begins with long-run financial
plans, and in turn guides the short- run plans and budgets. Financial planning is the process of projecting some future
financial action based on predetermined standard and identifying and adjusting the process that may be helpful to
improve the financial performance. Cash planning and profit planning are two important aspect of financial planning
process of a firm.

A firm’s FPP largely involves the forecast and use of various types of budgets. These budgets are prepared for every
key area of a firm’
s activities. FPP follows the following steps:

· Setting the Corporate objective

· Preparation of Strategic plan
· Preparation Long run sales forecast
· Setting the Product-mix strategy
· Preparation of Short run sales forecast
· Preparation of Manufacturing, Marketing, R & D, Finance dept. related budgets
· Preparation of Pro-forma Financial Statements
- Cash budget
- Proforma Income Statement
- Proforma Balance Sheet

CASH BUDGET
Cash budget is a schedule of cash receipt and disbursement of the firm during the plan period. It is a useful tool for
determining the timing of cash inflows and cash outflows during a given period typically monthly budget for a year.

Specimen of Cash Budget

Particulars Shawan Bhadra Ashwin

Opening cash balance Xxx xxx xxx
Add: All cash Receipts
Cash sales Xxx xxx xxx
Collection from debtors: current month Xxx xxx xxx
Previous months Xxx xxx xxx
Other cash collections Xxx xxx xxx
Total cash available Xxx xxx xxx
Less: Cash Payments Xxx
Payments to suppliers Xxx xxx xxx
Overheads Xxx xxx xxx
Wages Xxx xxx xxx
Sales commission Xxx xxx xxx
Other expenses Xxx xxx xxx
Other cash payments xxx xxx xxx
Total cash payments xxx xxx xxx
Surplus/ Deficit xxx xxx xxx
Borrowings xxx xxx xxx
Repayment: Principal xxx xxx xxx
Interests
Closing Cash balance xxx xxx xxx

PROFORMA INCOME STATEMENT

Proforma income statement is budgeted income statement preparing on the basis of past information. It is prepared on
the basis of the percentage of sales. Operational costs are directly proportional to sales. Following rules should be
followed:
 · Operational cost changes proportional to the sales (i.e. previous percentage of sales).
· Interest expenses and dividend remain constant ( if information is not given).
· Tax as given rate of earning before tax.

Specimen of income statement

Particulars Amount (Rs)

Sales (old sales x 1+ increase%) Xxx
Less: Operating costs (new sales x % of sales of old) Xxx
Earnings before interest and tax (EBIT) Xxx
Less: Interest (given) Xxx
Earnings Before Tax (EBT) Xxx
Less: Tax (% of EBT) Xxx
Net Income Xxx
Dividend (% given) Xxx
Addition to Retained Earnings Xxx

PROFORMA BALANCE SHEET

Proforma balance sheet is budgeted balance sheet prepared on the basis of previous sales and balance sheet. The
percent of sales method begins with expressing each individual balance sheet item as a percentage of sales. Therefore,
first, we identify those items in balance sheet, which are expected to vary directly with the sales. Following items are
directly related with change of sales:

· Cash, inventory, accounts receivables, accounts payable, fixed assets and other accruals. They are changed
proportionate to change on sales.
v Notes payable, Long-Term Debt and Common Stocks are remain same.
v Additional funds needed (bal. fig) = Total assets –Total of liabilities side
Specimen of Balance Sheet

Liabilities & Equity Amount (Rs) Assets Amount (Rs)

Accounts Payable (O x 1+%) xxx Cash (O x 1+%) xxx
Accruals (O x 1+%) xxx Accounts receivable (Ox1+%) xxx
Notes payables xxx Inventory (O x 1+%) xxx
Long-term debt xxx Fixed assets ( as inform) xxx
Common stock xxx xxx
Retained earnings xxx xxx
Additional funds (bal. fig.) xxx xxx
xxx xxx

Note: Changes in any item depends in given information.

UNIT –5
THEORETICAL FRAMEWORK OF RISK AND RETURN
Meaning and Measurement of Return
 Return is the difference between amount realized from an investment and the amount actually invested. Thus return is
usually expressed as a percentage on initial investment and is called percentage return.
Different Type of Returns
1. Real rate of return (R) = [(P 1 –P0) + D 1]/P0 (if two periods price dividend are given)
2. Average Rate of Return (R) = ∑Ri /n ( if rates of return for number of period are given)
3. Expected Rate of Return E(R) = ∑(Ri . Pi ) (if rates of return with probabilities are given)
4. Portfolio Return (Rp ) = ∑(Ri .Wi )
5. Required Rate of Return (Rj) = Rf + (R m –Rf ).βj
Where,
P 0 = beginning price; D 1 = expected dividend; R i = rate of return of I period
P 1 = ending price; W i = weight of asset i; R f = risk free rate of return
R m = market rate of return βj = beta coefficient

Example N. 1. If you purchase a stock of ABC Co. at Rs 40, at end of a year you receive Rs 5 as dividend and you
can sell the stock at Rs 45. Find the rate of return you earn during the year.
Solution, given,
P 0 = Rs 40; P 1 = Rs 45; D 1 = Rs 5; R=?
Using, Real rate of return (R) = [(P 1 –P0) + D 1]/P0
= [(45 –40) + 5]/40 = 0.25 =25%

CONCEPT AND MEASUREMENT OF RISK

Risk is directly related with uncertainty. If there is certainty of occurrence of an event, there is no risk. Therefore, risk can
be defined as uncertainty or variability in returns. Risk is measured in term of standard deviation, range, variance etc.

Stand-alone Risk
Risk on return on risky assets in isolation is called stand-alone risk.
Portfolio Risk
If we combine the risks of two or more risky assets (portfolio) is known as portfolio risk.
Measurement of risk
1. Standard Deviation (δ) = [∑(R –R)2/n ]0 .5 (if rates of return for periods are given)
2. Standard Deviation (δ) = [∑(R –R)2.Pi ]0 .5 ( if rates of return with probabilities are given)
3. Variance (V) = δ2
4. Coefficient of variation (C.V) = δ/R x100
5. Covariance of Returns of asset A and asset B (δA B) = ∑[(RA –RA ). (R B –RB ) .Pi ]
6. Covariance of Returns of asset A and asset B (δA B) = ∑[(RA –RB). (RA –RB )/n]
7. Correlation of Returns of asset A and asset B (RA B) = δA B/δA . δB
8. Variance of portfolio (δP 2 ) = [WA 2.δA2 +WB 2.δB2 + 2.WA .WB δAB ]
Where,
WA = weight of asset A; W B = weight of asset B
MINIMUM VARIANCE PORTFOLIO
Efficient Portfolio
An efficient set of portfolios are those portfolios which have the highest return for a given level of risk or minimum risk for
a given level of return.
The efficient frontier represents the locus of all portfolios that has the highest return for a given level of risk.

OPTIMAL PORFOLIO
The optimal portfolio will correspond to the point where an indifference curve is just tangent to the efficient frontier.
The portfolio that can satisfy the particular investor is the optimum portfolio. Optimum portfolio is different for
different investors.
Indifference curve is a line that shows the trade off of investor’
s utility and risk and return on the investment.
CAPITAL MARKET LINE
Capital market line shows the market equilibrium trade-off between risk and return of a portfolio. Each point in the
CML gives equilibrium return for the portfolio with given level of risk. The following equation shows the CML:
E(RP )= RF +[(RM –RF )/δ m ]. δP

CAPITAL ASSET PRICING MODEL (CAPM)

Capita asset refers to income generating asset. Pricing model specifies the relationship between the price of an asset and
its determinants. The equation of CAPM is;

Required Rate of Return (Rj) = Rf + (R m –Rf ).βj

UNIT- 6
THE TIME VALUE OF MONEY
Concept of Time Value of Money
Time value of money is a concept to understand the value of cash flows occurred at different point in time.
The money that we receive at future has less purchasing power than the money that we have at present due to
the inflation. Time value of money depends on the inflation, investment opportunity and individual’ s
preference.
Cash Flow Patterns and their Time Values
Present Values
1. Present value of a single amount due at future time
PV = FV/(1+K)n = FV. PVIFk,n
2. Present value of an even cash flow ( an ordinary annuity)
PVa = P . PVIFAk,n = P [1 –1/(1+i)n]/i
3. Present Value of an annuity due ( immediate even cash flow)
PVa = P . PVIFAk,n (1+i)= P [1 –1/(1+i)n] (1+i)/i
4. Present value of uneven cash flow
PVu = ∑(P t x PVIFk,t )
5. Present value of a perpetuity
PVp = P/k
Future Values
6. Future value of a single amount due at future time
FV = PVx(1+K)n = PV. FVIFk,n
7. Future value of an even cash flow ( an ordinary annuity)
FVa = P . FVIFAk,n = P [(1+i)n -1]/i
8. Future Value of an annuity due ( immediate even cash flow)
FVa = P . FVIFAk,n (1+i)= P [(1+i)n -1]/i x (1+i)
9. Future value of uneven cash flow
FVu = ∑(P t x FVIFk,t )

NOTE: To calculate interest rates and time periods, related formulas mentioned above are solved.
GROWING ANNUITIES AND PERPETUITIES
A growing annuity refers to the annuity payments that grow at a constant rate every period for given maturity.
If constant growth is applicable to infinity, then it is called a growing perpetuity.

a. Present Value of a growing annuity =P[{1 –{(1+g)/(1+i)}n}/(1 –g)]

b. Present Value of a growing perpetuity = P/(i –g)
SEMIANNUAL AND OTHER COMPOUNDING PERIODS

If interest is calculated or compounded more than one time in an amount, the effective annual interest rate is
calculated by using the formula:

Effective Annual Rate (EAR) = (1+i/m) m –1

Continuous Compounding

a. Future value of an amount of continuous compounding FV = PV. ei.n

b. Present value of an amount of continuous compounding PV = FV/ ei.n

AMORTIZED LOANS

Amortized loan refers to the loan that is to be repaid in equal periodic installment including both principal
and interest.

a. Annual installment (P) = Loan Amount / PVIFAk,n

b. Monthly installment (P) = Loan/ PVIFAk/12,nx12

Where,

PV = present value
FV = future value
K = interest rate in percent
i = interest rate in decimal
P = amount of annuity
PVIFA = present value interest factor of an annuity
FVIFA = future value interest factor of an annuity
PVIF = present value interest factor of an amount
FVIF = future value interest factor of an amount

UNIT –VII
BOND VALUATION
Definition of Bonds
 A bond is a long –term security or long-term promissory note, promising to pay interest and principal to the
holders of the bond. Generally, bond issuer pays a fixed interest (coupon) payment on specific date each year
until the bond matures. At maturity, the borrower pays back the bondholder the bond’ s face value (principal).
Key Features of Bond
a. Par Value: The par value is the stated face value of the bond, which is paid at maturity by the bond
issuer.
b. Coupon Interest Rate
c. Maturity
d. Indenture : Indenture is a legal document or contract that contains terms and conditions of bond issue. It
includes details of debt issue, description of property pledged (if any), the methods of interest and
principal payment, restrictions or covenants placed on the firm by the lenders, rights and responsibilities
of the borrower and lender etc.
e. Call provision
f. Trustee : A trust company or bank who deals with the issuing firm on behalf of bond holders.
g. Sinking fund : A provision in a bond contract that facilitates the orderly retirement of the bond.
Bond Valuation
There are three types of bond on the basis of valuation:
1. Zero Coupon (Discount ) Bond
The bond which is evaluated on discount basis and face value is paid on maturity date is called zero
coupon bond. Annual interest is not paid and interest is accumulated on the basis of market interest rate.
Following formula is used to calculate its value:
Value of Zero Coupon Bond V0 = M . PVIFk,n = M/(1+k) n
Where,
M = maturity value, k = market interest rate n = remaining maturity
period

à NOTE:- Yield to Maturity for Zero Coupon Bond (YTM or K) is calculated by solving the formula of
valuation.
V0 = M/(1+k)n , here k is YTM.

2. Coupon Bond
The bond on which annual (or periodical) interest (i.e. on the basis of agreement interest rate) is paid
called coupon bond. Following formula is used for valuation:

Ø Value of Bond V0 = I . PVIFAk,n + M . PVIFk,n (for annual coupon bond)

Ø Value of Bond V0 = I/2 . PVIFAk/2, 2n + M . PVIFk/2, 2n (for semi-annual coupon bond)
Where,
M = maturity value, k = market interest rate n = remaining maturity period
I = annual interest

3. Consol (perpetual) Bond

The bond which has infinite life is called consol bond. It has coupon interest and evaluated on the basis
of market interest. Following formula is used for valuation:
Value of Consol Bond V0 = I/k
à Note:- YTM or K = V0/I

BOND YIELDS
The earning rates of bond are called bond yields. The different types of bond yield are calculated as follows:
1. Yield to Maturity (YTM or K)
The actual earning rate on bond investment is called YTM. YTM is the IRR by which interest and
maturity value is discounted to present market value.
 Approximate YTM = [I + ( M –P)/n]/[(M + 2P)/3]
And, actual YTM is calculated with the help of trial method and the interpolation formula given as
below:
Actual YTM or K = LR +[ (PVLR –P0 )/(PVLR –PVHR)] (HR –LR)
Where,
M = maturity value, k = market interest rate n = remaining or maturity period,
I = annual interest, P or P0 = current market price
LR = Lower rate HR = Higher rate PVLR = present value of LR
2. Yield to Call (YTC)
Bond can be called or repaid before its maturity if there is call provision on indenture of bond. The actual
earning rate on bond during call period is called yield to call. It is calculated as similar to YTM where n
is call period. Following formula is used:
Approximate YTC = [I + ( CP –P)/n]/[(CP + 2P)/3]
Where, CP = call price, n = call period
And, actual YTC is calculated with the help of trial method and the interpolation formula given as
below:
Actual YTC or K = LR +[ (PVLR –P0 )/(PVLR –PVHR)] (HR –LR)
3. Current Yield (CY)
Current yield is rate of return of current year which is current interest divided by current price.
CY = I/P0

UNIT –VIII
STOCK VALUATION
Meaning and Features of Common Stocks

Common stock represents ownership of the company. Common stock is a security issued by a company to
raise equity capital. It is one of the major sources of long-term capital. Common stockholders of a company
are its real owners. Their liability, however, is limited to the amount of their investment. Common stock does
not have a maturity date.

Features of Common Stock

a. Par Value: Par Value is stated price in common stock certificates. A recorded value of a share of
common stock in the firm’ s corporate charter is par value.
b. Maturity: Common stock has no maturity date. It exists as long as the firm does.
c. Claim on Income and Assets: Common stockholders have residual claim on income. Common
stockholders are paid after satisfying claims of creditors, bondholders, and preferred stockholders.
d. Voting Rights : Generally, each share of common stock entitles the holder to cast one vote in the
election of directors and in other major decisions. A proxy is a legal document giving one person the
authority to represent on behalf of others.
e. Preemptive rights : Preemptive right is a provision that gives the existing shareholders right to purchase
new share at subscribed price on prorate basis.
f. Limited Liability: Although the common shareholders are the actual owners of the company and have
residual claim on all assets, their liability in case of the liquidation or bankruptcy is limited to the amount
of their investment. The shareholders’liability will not exceed the par value.
g. Classified common stock: Most firms have only one type of common stock. Some companies may
classify common stock as class A, class B and so on for the purpose of control over the management.

BASIC STOCK VALUATION

 Common stock has three values- named Book Value, Market Value and Intrinsic Value. Intrinsic Value is
calculated using following models:
1. Zero Growth model
Value of Stock (P0 ) = D/k = EPS/k
Cost of equity (k) = D/P0 = EPS/k
2. Constant or Normal Growth Model
Value of Stock (P0 ) = D1 /(k –g)
Cost of equity (k) = D1 /P0 + g
3. Super Normal Growth Model
Value of Stock (P0 ) = ∑Dt xPVIFk,t + Dn/(k –g) x PVIFk,n
Where,
D = dividend per share in case of no growth
D1 = dividend of current year or year 1 = D0 (1+g)
D0 = dividend of last year received now
g = constant growth rate
Dt = dividend of year t ( where t is year 1, 2, 3, …..) in case of non-constant growth.
EPS = earnings per share
PVIF = present value interest factor (from table)
n =no of year when constant growth starts.
K = cost of equity
P0 = current value of stock
Following formula is solved to calculate growth rate ( if growth rate is not given)
1. Dn = D0 (1+g)n
Or, Dn = Dt (1 +g)n-t
2. EPSn = EPSt (1 + g)n-t

PREFERRED STOCK VALUATION

Preferred stock, also called preference share, represents the long term source of financing. It occupies
an intermediate position between long-term debt and common stock. In the event of liquidation or
profit distribution, a preferred stockholder’s claim on assets comes after that of creditors but before
that of common stockholders. A fixed rate dividend is paid to the preferred stockholders.
a. Value of Perpetual Preferred Stock

Value of Perpetual Preferred Stock = Dividend/Kps

b. Value of Redeemable Preferred Stock

Value of Redeemable Preferred Stock = D .PVIFAk,n + M . PVIFk,n

Where,
D = dividend per share on preferred stock
K ps = k = cost of preferred stock
N = maturity of preferred stock
M = maturity value

UNIT-9
COST OF CAPITAL
Concept
The permanent fund which is used to run a firm is known capital. The fund is collected from different
sources or different investors. The sources of permanent fund is called components of capital. They are:
a. Debt Capital
b. Preference Share capital
c. Equity Share capital

The rate that must be earned on the firm’ s investment in order to satisfy all the investor’
s required rate of
return is called cost of capital. In other words, firm pays certain amount to the investors for the use of funds
and other related expenses. The sum of expenses is called cost of capital. The cost of capital for each
component is discussed below:

1. Cost of debt(K dt)

a. Cost of discount or zero coupon debt (Kdt): we solve following equation.
M = B0 (1 + K)n
K dt = K (1 –t)
b. Cost of consol bond (K dt) = I/B0
c. Cost of coupon bond (Kdt):
M+B0
I+
n
Cost of Coupon (Kdt)= (1-t)
M+2B0
3
2. Cost of Preferred stock (Kps)
a. Cost of Perpetual Preferred Stock (Kps) = Dp/P0
M+P0
D+
n
b. Cost of redeemable Preferred Stock (Kps )= (1-t)
M+2P0
3
3. Cost of Equity
D1
a. Cost of internal equity/ Retained Earnings (Kr)= +g
P0
D1
b. Cost of external equity (Ke)= +g
P0 -f
4. Weighted Average Cost of Capital (WACC)
WACC = Wd.K dt + Wr . Kr + We . Ke + Wps . Kps
5. Marginal Cost of Capital (MCC)
MCC is the WACC of the capital funded at last.
a. MCC break at Retained Earnings = Retained Earnings/Wr
b. MCC break at new debt = New Debt/Wd
c. MCC break at external equity = new equity/We

(Solve in class Q.N. 1, 2, 3, 4, 13, 23; paper solved Q. N. 5, 16 )

(Assignment Q.N. 6, 7, 8, 9, 10, 11, 12, 14, 15, 17, 18, 19, 20, 21, 22, 24)

Q.N. 5. a. Given,
Face value of a coupon bond (FV and M) = Rs 1000; Coupon interest rate (CPn) = 8.5% p.a.
Selling price (Bo) = Rs 950; underwriting fee = 2% of face value; maturity period (n) = 10 yrs
Corporate tax rate (T) = 30%; Cost of debt after tax (Kdt) =?
Sol.
W.N.(1) NP= Bo –f = 950 –2% of 1000 = 930
M-NP
I+ w.n. (2) I = FV x CPn = 1000 x 8.5% = 85
n
We know, Kdt= x 100 x(1-t)
M+2NP
3
1000 -930
85 +
10
Kdt= x 100 x( 1-0.30) = 6.76% //
1000 + 2x930
3
b. given,
price of perpetual preferred stock (Po) = Rs 47.50; Annual dividend (Dps) = Rs 8 per share
Flotation cost per share (f) = Rs 2.50 per share Cost of preferred stock (Kps) = ?
Sol.
W.N.(1) NP= Po –f = 47.5 –2.50 = 45
Dps 8
We know, Kps = x 100= x 100=17.78% //
NP 45
c. given,
Current dividend of common stock (Do) = Rs 5; Constant growth rate (g) = 8%
Current price (Po) = Rs 40; Cost of equity (Ke) = ?
Sol.
D1 5 (1+0.08)
We know, Ke = + g= + 0.08=21.5% //
Po 40
d. Given,
Expected dividend (D1) = Rs 4.4 Growth rate (g) = 10%; Current price (Po) = Rs 90
Net proceed on new stock (NP) = Rs 88; Cost of retained earnings (Kr)= ?
Cost of external equity (Ke) = ?
Sol.
D1 4.4
We know, cost of retained earning (Kr) = + g= + 0.10=14.89% //
Po 90
D1 4.4
We know, cost of external equity (Ke) = + g= + 0.10=15% //
NP 88

Q.N. 16. Given,

Wd = 25%; Wps = 15%; We = 60%; T = 40%; g = 9%
For common stock: Do = Rs 3.60 Po = Rs 60 f = 10% of Rs 60 = Rs 6
For preferred stock: Po = Rs 100; Dps = Rs 11 f =Rs 5
For debt: Annual interest rate (Cpn = Kd) = 12% , Kdt = 12% (1 - 0.40) = 7.2%
a. Ke, Kr, Kps, and Kdt = ? b. WACC =?
Sol.
D1 3.60(1+0.09)
We know, cost of retained earnings (Kr) = + g= + 0.09=15.54% //
Po 60
D1 3.60(1+0.09)
We know, cost of external equity (Ke) = + g= + 0.09=16.27% //
NP (60-6)
Dps 11
We know, Kps = x 100= x 100=11.58% //
NP (100-5)
Cost of debt after tax (Kdt) = 7.2% //
b. Caln of WACC (assuming common stock financing requirement are all met by retained earnings):
We know, WACC =Wd . Kdt + Wps . Kps + We . Kr = .25 x 7.2 + .15 x 11.58 + .60 x 15.54 = 12.86% //
Caln of WACC (assuming common stock financing requirement are all met by new equity):
We know, WACC =Wd . Kdt + Wps . Kps + We . Ke = .25 x 7.2 + .15 x 11.58 + .60 x 16.27 = 13.30% //
 UNIT-X
LEVERAGE AND CAPITAL STRUCTURE
Concept of Leverage
Leverage refers to position of debt capital in the total capital of a firm. Leverage indicates for Capital structure of a
firm. The term leverage is defined as the use of debt capital in the formation of capital of a firm.
The use of debt use of debt capital offers two advantages. First, interest on debt capital is tax deductible, so use of
debt capital lowers the tax liability of the firm. Second, the debt capital has fixed rate of interest so that the
shareholders do not have to share their profit with bondholders when the firm earns supernormal profit.
Business Risk and Financial Risk
Business risk is the risk associated with the operation of business if no debt capital is used. It is the risk inherent in
operation of business. A firms business risk arises because of uncertainty associated to projections of return on
invested capital (ROIC).
NOPAT
ROIC=
Capital
ROIC with zero debt is calculated as below:
Net income
ROIC=
Capital
Where, NOPAT = Net Operating Profit After Tax = NPAT + Interest (1 –T)
NPAT = net profit after tax
T = income tax rate
The business risk of a firm is measured by the variability in operating income of the firm. Larger variability in
operating income signals larger business risk. Causes of business risk are:
Variability in demand, variability in sales price, uncertainty of input costs, ability to price adjustment, speed
of technological changes and extent of fixed operating costs.
FINANCIAL RISK
Financial risk is the risk placed on common stockholders due to the use of debt financing. Therefore, if the firm use
no debt there would be no financial risk. Financial risk includes both the risk of possible insolvency and the added
variability in earnings per share that is included by the use of debt.
BREAK EVEN ANALYSIS
Break even analysis shows the point of sales(break-even point) at which operating costs are just equal to revenues.
Break-even point is the sales volume at which there is neither profit nor loss.
FC FC
BEP(units)= , BEP(Rs)=
CMPU PV Ratio

CASH BREAK-EVEN POINT

FC-noncah expense FC-noncah expense
BEP(units)= , BEP(Rs)=
CMPU PV Ratio

FINANCIAL BREAK-EVEN POINT

the break-even analysis that considers EBIT, which just covers all financing costs. Financial break-even analysis is
concerned with determining the level of operating income or EBIT, which is just enough to cover all the financial
costs of the firm. FBEP is the EBIT where EPS is zero.
DP
FBEP( EBIT)=I+
(1-T)
OPERATING LEVERAGE
Operating Leverage refers to the potential use of fixed operating cost in a firm. It shows the responsiveness of change
in operating profit to the change in sales volume. Operating leverage can be defined as the use of fixed operating
costs in a firm’
s operation that results into more than proportional changes into firm’ s EBIT for a given change in
sales volume.

CM %change in EBIT
Degree of operating Leverage ( DOL)= or
EBIT %change in Sales

The firm with high BEP and high DOL is exposed to high degree of business risk.
FINANCIAL LEVERAGE
Financial leverage is a quantitative measure of the sensitivity of a firm’
s earning per share to a change in the firm’
s
operating profit.
EBIT % change in EBT
Degree of financial Leverage (DFL)= or
PD %change in EBIT
EBT-
(1-T)
The firm with high BEP and high DFL is exposed to high degree of financial risk.

TOTAL LEVERAGE
The combined use of operating and financial leverage brings about considerable change in ROE, EPS even in
response to a small change in sales. It is also called combined leverage.
CM % change in EBT
Degree of total Leverage (DTL)= or
EBT %change in Sales
Or, DTL = DOL x DFL

FEATURES OF IDEAL CAPITAL STRUCTURE

a. Profitability b. Flexibility c. Conservationd. Solvency e. Control

Optimal Capital Structure

The capital structure, where net profit of the firm is maximum, is called optimal capital structure.

(Solve in class Q.N. 1, 2, 3, 6, 9, 26)

(Assignment Q.N. 6, 7, 8, 10, 11, 12, 14, 15, 17, 18, 19, 20, 21, 22, 24)