POST MID TERM

180
Real world interpretation of CAPM inputs
 Rf
◼ Return that investors want on their investment even if there is no risk
 Expected Real Growth
 Expected Inflation
 Beta
◼ Measures systemic risk (the risk that matters because it gets rewarded)
◼ Drivers
 Nature of Business
◼ Discretionary products, High operating leverage
 Financing Risk
 Rm-Rf (market risk premium)
◼ Premium investors want per unit of risk (beta)

181
Real world interpretation of CAPM inputs:
What is your risk premium?
 Assume that you are offered two investment options:
1. A riskless investment (say a Government Bond), on which you can
make 7% (Risk free)
2. A Nifty 50 ETF, on which the returns are uncertain (Risky, beta=1)
 How much of an expected return would you demand to shift
your money from the riskless asset to the NIFTY 50?
a. Less than 7%
b. Between 7% - 9%
c. Between 9% - 12%
d. Between 12% - 15%
e. More than 15%
Real world interpretation of CAPM inputs:
Risk Aversion and Risk Premiums
 Market Equilibrium: If our class were the entire market, the risk
premium would be a weighted average of the risk premiums demanded
by each and every investor.

 Dollar weighted democracy: The weights will be determined by the

wealth that each investor brings to the market.

 If investors become more risk averse, you would expect the

“equilibrium” premium to increase or decrease?
◼ http://www.market-risk-premia.com/us.html

183
Real world interpretation of CAPM inputs:
Marginal Investors determine the pricing
 The marginal investor in a firm is the investor who is most likely to
be the buyer or seller on the next trade and to influence the stock
price.
 Generally speaking, the marginal investor in a stock has to own a
lot of stock and also trade that stock on a regular basis.
 Since trading is required, the largest investor may not be the
marginal investor, especially if he or she is a founder/manager of
the firm (Larry Ellison at Oracle, Mark Zuckerberg at Facebook)
 In all risk and return models in finance, we assume that the
marginal investor is well diversified.
Real world interpretation of CAPM inputs:
Marginal investor
Weighted Average Cost of Capital (WACC)
 WACC is the cost of total capital (both debt and
equity) for the firm

𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∗ 𝑘𝑒 + ∗ 𝑘𝑑 1 − 𝑡
𝐸+𝐷 𝐸+𝐷
◼ 𝑘𝑒 is cost of equity, 𝑘𝑑 is cost of debt, 𝑡 is tax rate
and 𝐸 and 𝐷 are market values of equity and debt
186
Cost of Debt
 The cost of debt can be estimated as follows
1. If a company has long term bonds which are actively traded
in the market, the YTM on such bonds can be treated as the
cost of debt
2. If corporate credit ratings of long term debt or bank
loans is available for your company, use that rating.
 Credit rating may be available at
http://www.crisil.com/ratings/credit-ratings-list.jsp, or other
credit rating agencies ICRA, CARE
 It may also be available at your firm’s website or in its
annual report

187
Cost of Debt
3. If your firm is not rated compute the interest
coverage ratio of your firm, and then identify a
synthetic credit rating using the following link
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/
datafile/ratings.htm

On the same link you will find risk premium (spread over
risk free rate) corresponding to the credit rating.

188
Calculating Cost of Debt
4. For Rf, go to CCIL website to get the latest ZCYC curve
◼ https://www.ccilindia.com/RiskManagement/SecuritiesSegment/Pa
ges/ZCYC.aspx

5. An alternative way to find corporate bond spread is to go to

Bloomberg and find out FIMMDA Annualized corporate bond
spreads corresponding to your company’s credit rating for long
term borrowing (just type FIMMDA BB on Bloomberg search)

6. Calculate cost of debt by adding 10 year risk-free rate from the

ZCYC curve + 10 year corporate bond spread for your company
189
190
191
192
Cost of debt for Tata Steel
 Credit rating for long term borrowing BB- (S&P)

 Corporate spread for BB- bonds for 10 year is

5.89% (FIMMDA)

 10-year GOI zero coupon yield is 6.98% (CCIL)

 Cost of Debt for Tata Steel = 5.89% + 6.98% =

12.87%
193
Marriott Case
Discussion
194
Marriott Case
 Primary Objective
◼ Hurdle Rate (WACC) for Marriott and its divisions
◼ Better than Shyamlal’s choice

 Cost of Debt Kd = Risk Free rate + Risk Premium

 What should be the Risk Free rate?
 What should be the market risk premium?

195
Valuing equity (stocks)
 Why not use book value of equity?
 Some B/S items are recorded at fair value
◼ Cash and Cash equivalents
◼ Short term marketable securities
 What about..
◼ Receivables
◼ Inventory
 Some B/S are recorded at historical costs (less accumulated depreciation)
◼ Long-term tangible assets
◼ Purchased Intangibles – Licenses, Patents, Copyrights
◼ Goodwill (Acquired)
 Investments Classification
 Ultimate backward looking number – Book Value of Equity

196
Why not use book value of equity?
 Many intangible assets are not on B/S
◼ Brand Name
◼ Customer Base
◼ Customer Loyalty
◼ Skill of employees
◼ Competency of Managers
◼ Technical knowhow
◼ Collaborations with other firms
◼ Relations with suppliers
◼ Knowledge assets developed internally
197
Why not use book value of equity?
 Because of these differences there can be significant difference
between the book value and market value of equity
 Can Market value of equity become negative?
 Can Book value of equity become negative?
 Can Book value of equity of good companies become negative?
 In June 2005, Amazon.com had total liabilities of $2.6 billion
and a book value of equity of –$64 million. At the same time,
the market value of its equity was over $15 billion. Clearly,
investors recognized that Amazon’s assets were worth far more
than their book value.

198
Why not use market value of equity?
 Markets may not be
correct
 Private stocks are not
traded on an exchange
 To follow the objective
of maximizing value,
we need to understand
the drivers of value

199
Equity valuation approaches
1. Dividend discount models

2. Discounted cashflows (FCF/FCFE)

3. Residual Income valuation

4. Relative valuation

5. Contingent claim valuation

200
Discounting Dividends (DDM)
 Any discounted cashflow based valuation model requires just
three inputs
1. Cashflows
2. Growth rates
3. Discount rates
 “Dividends are the cashflows received by an investor who buys and
holds a share of stock”

 Dividends are less volatile than earnings and other return concepts,
the relative stability of dividends may make DDM values less sensitive
to short-run fluctuations in underlying value

201
DDM valuation approach
 Dividends—Distributions to shareholders authorized by a corporation’s board
of directors
 Are dividends the only method to redistribute capital to shareholders?
 Single period DDM

◼ V0 = the value of a share of stock today, at t = 0

◼ P1 = the expected price per share at t = 1
◼ D1 = the expected dividend per share for Year 1, assumed to be paid at the end of the year
at t = 1
◼ r = the required rate of return on the stock

202
DDM valuation approach
 Suppose that you expect ACME Inc. to pay a Rs. 2 dividend next year and the
price of ACME stock to be Rs. 58 in one year. What is your estimate of the
value of ACME stock if the required rate of return is 10%
 Ans: 54.55
 Multi period DDM

203
DDM with stable perpetual growth:
Gordon growth model
Gordon growth model (Single Stage or Stable growth DDM)
𝐷𝑃𝑆1
𝑉0 =
𝑟−𝑔
 Suppose that an annual dividend of Rs. 5 has just been paid (DPS0 =
5). The expected long-term growth rate in dividends is 5% and the
cost of equity is 8%. Calculate the value of stock
Ans: 175
 Because the model is based on indefinitely extending future dividends,
the model’s required rate of return and growth rate should reflect long-
term expectations.
 Model values are very sensitive to both the required rate of return, r,
and the expected dividend growth rate, g.
204
DDM Types
 Can the stable growth rate be negative? What would it imply for the
value of the firm?
 Value a firm with current DPS of Rs. 5 growing at –5% a year forever
and a cost of equity of 10%
 5(1-.05)/(.1+.05) = Rs. 31.67 per share
 How much would you pay if it was growing by +5% instead?
 5(1+.05)/(.1-.05) = Rs. 105
 What should be the Gordon growth model valuation for Preference
shares
 g = 0 because dividends are fixed for preferred stock
𝐷𝑃𝑆0
𝑉0 =
𝑟

205
DDM with stable perpetual growth:
Gordon growth model
 What about the reinvested earnings? The portion that the firm does
not pay back as dividends. Does DDM ignore it?
◼ Reinvested earnings should increase the future dividends

 Growth can be found out in multiple ways

◼ Historical growth
◼ Analyst estimates
◼ Fundamental growth

206
Fundamental growth in Net Income
(Earnings)
 Growth in NIt = Retention ratiot-1 * ROEt
 ROEt = NIt / BV of Equityt-1
Notice book value of equity is measured at the beginning of the year

◼ Retention ratio = 1 – Payout ratio = 1 – Dividends/Earnings

In per share terms, you can write it as growth in earnings
per share (EPS)
 Growth in EPSt = Retention ratiot-1 * ROEt

207
Fundamental growth in Net Income
(Earnings)
 It is common for companies to have high growth
rates in initial phase (with high retention ratios),
and then stabilize into a low long term growth rate
(with a constant and low retention ratio)
 Growth in NIt = Retention ratiot-1 * ROEt
 Assuming ROE is stable (constant) over years, then
◼ If retention ratio stabilizes in year 3, the Growth rate of
income (and also dividends!) will stabilize from year 4.

208
Discounting Dividends (DDMs)
 Firm paying no dividends
◼ Young firms
◼ High growth firms
 Dividends are distribution of wealth rather than creation of wealth
 Dividend policy can be arbitrary and not linked to value added – “Sticky
dividends”.
 It does not incorporate other ways of returning cash to stockholders
(such as stock buybacks).

209
Is DDM valuation approach relevant?
Use DDM only when dividends bear an understandable and
consistent relation to the company’s profitability
Firm A
EPS 0.41 0.12 −0.36 1.31 1.86 0.39 0.88 1.58 4.26 4.92
DPS 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Payout
ratio 244% 833% NA 76% 54% 256% 114% 63% 23% 20%
Firm B
EPS 0.62 0.66 0.77 0.79 0.52 0.72 0.93 1.11 1.2 1.3
DPS 0.18 0.22 0.25 0.29 0.3 0.39 0.32 0.33 0.35 0.37
Payout
ratio 29% 33% 32% 37% 58% 54% 34% 30% 29% 28%

210
DDM: Gordon growth model
Implied growth rate from market price
 Suppose a company has a beta of 1.1. The risk-free rate is 5.6%
and the market risk premium is 6%. The current dividend of Rs.
2 is expected to grow at 5% indefinitely. What should be the
value of the company’s stock? The price of the stock is Rs.
40.What growth rate would be required to justify the current
market price?
 Ans: V0 = Rs. 29.17 and g = 6.86%
Implied Cost of Equity (Expected return from equity)
𝐷𝑃𝑆1 𝐷𝑃𝑆0 (1 + 𝑔)
r= +𝑔 = +𝑔
𝑃0 𝑃0

211
DDM: Gordon growth model
 Advantages: GGM is useful for
◼ Valuing mature stable companies
◼ Valuing broad portfolios like equity indices
◼ Understanding the relationships among value and growth,
required rate of return, and payout ratio.
◼ Easily used as a component in other more sophisticated
valuation models. For example, it may be used for
 Estimating the expected rate of return given efficient prices
 Estimating terminal value in Free cash flow based DCF models

212
DDM: Gordon growth model
 Disadvantages
◼ Not useful if the firm does not pay dividends
◼ Needs to include stock buyback, but there are some issues
◼ Not relevant if dividends do not bear any relation with
profitability
◼ Valuation: Values are very sensitive to the assumed growth
rate and required rate of return
◼ Implied cost of equity: Market price is same as the intrinsic
value
◼ Stable growth?

213
MULTISTAGE DDMS
 Which Growth pattern is consistent with GGM?

214
Two stage DDM Practice
 A stock is expected to pay a dividend of INR 5 next
year. This dividend will grow at 8% till year 6. The
dividend expected in the seventh year is INR 8.33. It
will continue to grow at 4% thereafter. What is the
value of the stock today if cost of equity is 10%
 Ans: PV of Growing annuity + PV of growing perpetuity
➔Price = 26.063 + 78.368 = 104.431

215
Present Value of Growth Opportunities (PVGO)
 Value of equity= Value of assets already in place + PVGO
◼ Assuming 100% equity based financing
 What are growth opportunities?
◼ Future (new) positive NPV Projects
 A company without positive (expected) NPV projects is a no-growth
company
◼ What should it do with its earnings?
◼ Assuming constant ROE and no further equity infusion, what would
happen to its future earnings?
◼ What will the value of such a firm?

216
Present Value of Growth Opportunities (PVGO)

𝐸𝑃𝑆0
𝑉0 = + 𝑃𝑉𝐺𝑂
𝑟
 If prices reflect value (P0 = V0)
 If PVGO is 80% of your price, the market assigns 80% of the
company’s value to the expectation of future growth
 For a no growth company, assuming that the prices reflect value
(P0 = V0), the earnings yield (EPS0/P0) is equal to the expected
rate of return
r = EPS0 /P0.

217
Relative Valuation
1. Identify comparable firms that have similar operations to the
target firm (whose value you wish to calculate)
2. Identify some fundamental factor (F), such as earnings, sales,
cash flow, that drives the value of the firm
3. Stock Prices (P) are standardized by converting prices into
multiples of earnings, or sales.
◼ Find the P/F multiple for all comparable firms. Examples
◼ Price to Earnings ratio: Market value per share divided by EPS
◼ Price to Sales ratio: Market value per share divided by sales per share
◼ Price to Book Value: Market value per share divided by book value per share

218
Relative Valuation
4. Use the average (or median) multiple of the comparable firms
with the fundamental value of the target firm to get value of the
target firm.
𝑃
× 𝐸𝑃𝑆𝑓𝑖𝑟𝑚 = 𝑃𝑓𝑖𝑟𝑚
𝐸𝑃𝑆 𝑎𝑣𝑔/𝑚𝑒𝑑

P/E ratio= P0/EPS0 (current price/ current earnings)

Forward P/E ratio= P0/EPS1
Forward P/E = current stock price / predicted next period earnings

219
Drivers of Multiples
 There are implicit assumptions about fundamentals (growth rate, risk and cash
flows) in each multiple

 You should understand what assumptions are driving the multiple and are they
realistic

 Ceteris paribus, A company with a 8% growth rate should have a higher PE than
an otherwise similar company with a 4% growth rate. Do you agree?
◼ How much higher

220
What drives P/E
1.The expected growth rate in earnings per share
2.The riskiness of the equity, which determines the cost of equity
3.The efficiency with which the firm generates growth, which is
measured by how much the firm can afford to pay out after the
reinvestment needed to create the growth.

221
P/E Thumb rules
 If the PE ratio today is high relative to the average PE
ratio over the last 10 years, the stock is expensive. Do
you agree?
a. Yes
b. No
 If you do not agree, what factors might explain the
higher PE ratio today?

222
Higher P/E might be justified if..
 Interest rates are lower now than they were in the past. Holding all else constant,
though, this should lower discount rates and raise P/E.
 Investors have perceived that firm is much less risky and demanded a lower risk
premium
 Investors expect promising future expected growth due to lack of competition,
technological superiority.
 The firm has made excess investments capital equipment or working capital in the
past may be able to live off past investment for a number of years, reinvesting little
and generating higher cash flows in future.

223
Justified PE example
 Current stock price = 56.94
 Earnings per share for the current year = 1.837
 Dividends for the current year = 0.575
 Dividend growth rate = 8.18% (assume it can be sustained forever)
 Risk-free rate = 5.34%
 Market risk premium = 5.32%
 Beta = 0.83
 1. What is the justified P/E ?
◼ Ans: 21.4
 2. Based on the justified P/E and the actual P/E, is the stock fairly valued,
overvalued, or undervalued?
◼ Ans: Actual P/E is 30.99, so overvalued

224
Drivers of Multiples Practice problem
 Assume that a company is in stable growth phase and it pays
out a quarter of its earnings as dividend every year
 Current dividend per share DPS0= 4
 Cost of equity r = 15%.
 Current Market price P0= Rs. 50
1. Should I buy the share if the expected growth rate is
(A) 8% (B) 4%
2. What is the growth rate imputed in current market price?
3. What should be the P/E ratio if the expected growth rate is
(A) 8% (B) 4%

225
 EVALUATING
INVESTMENTS
226
Evaluating investment projects
 Value of the project depends only on two things
◼ Forecasted Cashflows
◼ Riskiness of those cashflows (opportunity cost of capital)
 Only future cash flows are relevant for decisions
◼ Past cashflows are not relevant for investment decision
 Irreversible or irrecoverable
◼ Ignore any costs or benefits accrued in the past
 Forget sunk costs
 Estimate all cash flows on incremental basis

227
Incremental cash flows
 How do you identify which cash flow is incremental?
◼ What would be the cash flow is the project is pursued? (With)
◼ What would be the cash flow if the project is not pursued? (Without)

Period t= Cashflow Cashflow Incremental

with project without Cashflow
(1) project (1-2)
(2)
0 -10 3 -13
1 15 3 12
2 15 3 12
228
Incremental cash flows
 Value of the decision is NPV of incremental cashflows
◼ If NPV is positive, you should pursue the project
◼ Otherwise, don’t pursue the project
 Value additivity: NPV(A+B) = NPV(A) + NPV(B)
◼ Take care of incidental effects
◼ Negative effects such as cannibalization
◼ Positive effects such as complementarity
 Be consistent in Cashflows and discount rates

229
Example 1 : Sunk Cost and Incremental Cashflows
 ABC Corporation is deciding whether or not to
invest 3 mn for completing a machine which has
already taken 5 mn investment. If the machine is
not completed it can be sold for 4.5 mn as scrap
today. If it is completed it will yield a cash flow of
10.5 mn next year, and the machine would be
worthless at the end of year 1. What is the NPV of
completing the machine if r = 12%?
 Ans: 1.875 mn
230
Example 2 : Incidental effects
 Pepsi Co. is planning to introduce a new variant of its
flagship brand Pepsi named as Pepsi Grey. The new
variant will cost 5 mn to setup and produce. It will
bring in after tax cashflows of 3 mn each year for the
next four years. In addition, the after tax cashflows of
Pepsi itself will reduce by 1 mn each year. However,
the after tax cashflows of Lays will increase by 0.25 mn
per year for the next two years. What is the NPV of
introducing the project?(r = 12%)
 Ans: 1.497 mn

231
Basic concepts – Project NPV
1. Include opportunity cost
2. Ignore past cashflows
3. Ignore allocated fixed costs and overheads
◼ Share of rent, electricity, security costs etc.
4. Remember to include salvage value / clean-up costs
5. Use after tax cashflows
6. Consider capital gains tax / tax saved on capital loss
7. Consider depreciation tax savings

232
Example 3 : Opportunity cost
 Maruti is planning to start a new assembly line. It is
expected to produce 120 cars a year each of which
generates after tax profits of 3,00,000. The investment
cost is 100 mn. The assembly line will become obsolete
in 5 years. These new cars bring in after tax cashflows
of 10 mn each year for the next 5 years for the Maruti
service stations. What is the NPV of the project if the
land can be rented out for 15 mn every year, if you do
not open this assembly line?
(r = 10%)
 Ans: 17.51 mn

233
Example 4: Overheads
 EVS is planning to start a new department of
Tanzania equity research. The revenues expected
are 2 mn per year, the costs would be 1.6 mn per
year. The accounts office has determined that the
share of rent, security and electricity costs
allocated to the department would be 0.3 mn per
year. If r= 10%, what is the NPV of starting this
new department assuming it continues forever?
 Ans: 4 mn

234
Example 5 : Salvage Value and Depreciation tax savings

 Lakme intends to buy new equipment for one of its

existing plants. The new equipment will cost 150 mn
and can be depreciated at straight line basis for 10
years. The salvage value for depreciation purpose is
assumed to be 10 mn. It is expected that the company
can sell the equipment at the end of 10 yrs for 25 mn.
If the equipment will increase the income by 30 mn per
year, what is the NPV if tax rate is 30% and r = 10%?
 Ans: 12.747 mn

235
Consistency with respect to inflation
 Discount real cash flows at real rates of interest
and nominal cash flows at nominal rates of interest

1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒

𝑅𝑒𝑎𝑙 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 = −1
1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

236
Separate investing and financing cashflows
 The financing cash flows should be ignored while
evaluating whether a project is worth investing
 So even if you have raised capital using debt, do
not include interest and debt repayment as project
cashflows.
 Your financing, along with the risk of the project,
affects your discount rate. Generally, it should not
affect the expected cashflows of your project

237
Investment Timing Decision
 Does a positive NPV project imply that you should
take the project right away?
◼ Not if alternatives available later might increase the pay-
offs

238
Example 6: Timing Decision
 Lumberjack Corp. has purchased rights to cut wood from a
forest. It can cut wood right away or wait for a few years.
The payoffs from sold wood are given below. When should
they cut the wood if the discount rate is

 A. 10% B. 20% C. 18% D. 5%

239
Example 7
 Suppose initial Investment Outlay on a project is 10 crores,
8 crores in Fixed assets and 2 crores in WC.
 Life of the project is 5 years. At the end of 5 years, fixed
assets will fetch a salvage value of Rs.3 crores. WC
increases by 0.5 crores each year and it will be liquidated
at book value at the end of year 5.
 Plant and Machinery will depreciate at 25% Written Down
Value method
 Revenues are 12 crores per year ; costs other than
depreciation, tax and interest are 8 crores. Take tax rate @
30% and r = 10%

240
Equipment with unequal lives
 How do you compare two investments into
equipment with unequal lives?
◼ Equated Annual cost/benefit
◼ LCM of the lives method

241
Example 8
 Machine A costs 15 mn immediately and then the
operating costs are 5 mn for the next 3 years. Machine
B costs 10 mn immediately and the operating costs are
6 mn each year for two years. If r=6%, which is a
better machine to use?
 EAC for machine A: 10.61
 EAC for machine B: 11.45

242
Cost of excess capacity
 Does using excess capacity have any cost?
◼ Yes, if it brings future investments forward

243
Example 9: Excess capacity
 A company is planning to use the excess capacity in
one of its plants to develop a new product. The new
product will advance a machine purchase of 1 million
forward from the 5th year to the 4th year. The machine
has a life of 6 years, and it will be replaced
(perpetually) once it wears out. What is the cost of
using excess capacity today? Assume r=12% p.a. and
the price of the machine remains 1 million in the
future.
 Ans: 138,012.80

244
NPV and other Investment criterion

245
Investment criterion
 Payback Period
 Discounted Payback Period
 Internal Rate of Return
 Net Present Value
 Profitability Index

246
Payback Period
 If we assume that
cashflows occur uniformly
over the course of the year:
 Payback for Project =
2 + (395000/446500) = 2.88
years

 Discounted payback period

(r=12%) = 3.75years
247
Payback and discounted payback
1.Payback period ignores time value of money
2.Which threshold should you use?
◼ Biased towards short-term projects
3.Ignores the cashflows after the payback period
Mutually exclusive projects
A. -1000 500 800 100 B. -1000 100 100 100 1million
4. Require Simple cashflow patterns that involves a large up-front
investment followed by positive operating cash flows.
◼ It breaks down, however, when the investment is spread over time or
when there is no initial investment.

248
Internal Rate of Return
 It is that discount rate at which NPV is equal to zero

 IRR rule: Accept project if

◼ IRR > Project’s cost of capital (discount rate, r)
 Normally, if IRR> r the project will be positive NPV
◼ But there are exceptions

249
IRR Pitfall 1: Lending or borrowing

250
IRR Pitfall 2: Multiple IRR

251
IRR Pitfall 2: Multiple IRR

252
IRR Pitfall 3: Mutually Exclusive Projects

253
IRR Pitfall 4: What Happens When There Is
More than One Opportunity Cost of Capital?

254
Some issues with IRR
1. Can not distinguish between and lending and borrowing
type cashflow patterns
2. Multiple IRRs
3. Multiple discount rates (r1, r2, r3..)
4. Can not handle a comparison between mutually exclusive
projects with different scale
5. Assumes reinvestment of intermediate cashflows at IRR

255
NPV-IRR PROFILE

256
Capital Rationing and Profitability Index
 When capital is constrained and there are multiple positive NPV
projects, we need to choose projects in a way that maximizes
the NPV
 Bang for buck: One method is to use profitability index but it
does not always give perfect answers

◼ Investment is present value (as on t=0) of total investment

257
Capital Rationing Example 1
 A maximum of 10 million can be raised for initial
investment

Project Investment ($) NPV ($) Profitability Index

A 10 21 2.1
B 5 16 3.2
C 5 12 2.4

258
Capital Rationing Example 2
 A maximum of 10 million can be raised annually for
investing in projects.

259
Profitability index does not work when..
 There are multiple constraints on the choice of
projects
 Projects have dependencies
◼ Mutually exclusive
◼ A can be accepted only if B is also accepted
◼ A can be accepted only if B is accepted & C is not accepted
 Some capital is left after the initial choice
 A more general solution
◼ Linear programming (Integer programming)
260
Estimating NPV under uncertainty
 An exploration and production oil and gas firm has an
option to purchase rights to a project for 10 mn. The
project would then require an investment of 1 mn in a test
well. The result of this test well would be known in 1 year.
The probability of finding oil is 40%. If successful, the oil
field will require another investment of 20 mn in year 1,
and it will yield 9 mn worth of cashflows in perpetuity
(starting from year 2). What is the NPV of the project if the
normal discount rate for the oil firm is 15% and there are
no taxes (tax rate =0%).
 Ans: 2.91 mn

261
What is Working capital?
A sample Company Balance Sheet
(Working Capital Accounts in red)

Assets Liabilities and Owners Equity

Current Assets $65,000,000 Current Liabilities $22,500,000
Cash 5,000,000 Accounts Payable 15,000,000
Short-Term Money
15,000,000 Notes Payable 6,000,000
Market Investments
Accounts Receivable 27,500,000 Accrued Expenses 1,500,000
Inventory 15,000,000
Prepaid Expenses 2,500,000 Long-Term Borrowings 36,500,000
Fixed Assets 60,000,000 Owners’ Equity 56,200,000
Total Liabilities and Net
Total Assets $125,000,000 $125,000,000
Worth
262
Liquidity and WC
 What does positive WC mean ?
◼ It means that the Firm has the ability to satisfy both
upcoming operational expenses and maturing short-term debt
 Can WC be negative ?
◼ Yes! Would you prefer your working capital to be negative?
 Potentially liquidity problem
◼ Forced to sell assets at ‘fire sale’ prices to raise cash.
 Running your business on other people’s money
◼ Using supplier’s credit as a source of capital
◼ Large Accrued expenses like wages payable
 Efficient management of Current assets like inventory

263
Negative Working Capital - Walmart
 https://www.wsj.com/market-data/quotes/WMT/financials
 https://www.wsj.com/market-
data/quotes/WMT/financials/annual/balance-sheet

264
Negative Working Capital - Walmart
 Big ticket retailers like Wal-Mart pretty much control the
shelf space which in turn controls what people buy.
 Suppliers of Wal-Mart have to extend liberal trade terms.
◼ Sale or return basis: Wal-Mart must make the payment for the
purchases in 45 days if they are able to sell the inventory.
 Assuming a period of 10-15 days to actually sell the
inventory, Wal-Mart still has one full month of interest free
cash for itself.
◼ Treasury operations

265
H igh WC or Low WC
 Which one would your prefer?
 Working capital traditionally has been considered as a positive
component of the balance sheet
◼ Constitutes a store of value
◼ H ealthy liquidity position

 Modern attitude is that it constitutes a drag on financial

performance
◼ Emphasis now is on reducing current asset accounts so that current
liabilities can be funded from the on-going operations of the business
◼ Requires active management of assets and liabilities

266
Operating and Cash Conversion Cycles
 Operating Cycle (OC) = Inventory Period +
Accounts Receivable Period

 Cash Conversion Cycle (CCC)= Inventory Period +

Accounts Receivable Period – Payables Period

267
Computing the CCC
 OC = DIO + DSO
 CCC = DIO + DSO - DPO

 Days Inventory Outstanding (DIO): H ow many days

it takes to sell the inventory.
◼ DIO = Average inventory/COGS per day
◼ Average Inventory = (beginning inventory + ending
inventory)/2
◼ Inventory turnover = 365 / DIO

268
Computing the CCC
 CCC = DIO + DSO - DPO

 Days Sales Outstanding (DSO): H ow many days it

takes to collect cash payment on sales .
◼ DSO = Average AR / Revenue per day
◼ Average AR = (beginning AR + ending AR)/2
◼ Receivables Turnover = 365 / DSO

269
Computing the CCC
 CCC = DIO + DSO - DPO

 Days Payables Outstanding (DSO): H ow many days can it

defer the cash payment on purchases .
◼ DPO = Average AP / Purchases per day
◼ Purchases = cost of goods sold + ending inventory -
beginning inventory
◼ Average AP = (beginning AP + ending AP)/2
◼ Payables Turnover = 365/DPO

270
Negative CCC – Amazon (2003 to 2012)
2012
 Amazon held inventory for
28.9 days plus 10.6 days
to collect receivables or 40
days in total

 Then pays accounts

payable in 54 days thus
achieving a negative cash
conversion cycle for
Amazon.com of -14 days.

271
“Apple’s cash conversion
cycle stood at -53 days for
FY’15, per our estimates,
implying that it practically
ran its supply chain with
credit extended by its
vendors.”

272
Apple gets paid earlier (Smaller DSO)
 Apple has a sizable retail operation, which means that
it gets paid in cash or via credit card for a large
percentage of its sales. This effectively reduces its days
of sales outstanding.

 Samsung on the other hand relies largely on

distributors for its consumer electronics operations,
while its components business sells to other consumer
electronics vendors, who likely require a credit period.

273
Apple turned over its inventory quickly
 Apple’s inventory turnover is much quicker, likely
driven by its efficient demand planning, its use of
contract manufacturers and its streamlined product
portfolio.

 Samsung on the other hand has a sizable

manufacturing operation and offers a wide array of
products and components, requiring larger sums of
cash to be tied up in inventory.
274
Apple gets better terms from its suppliers
 Apple appears to be able to negotiate better credit terms with its
vendors, since it sources in huge volumes and its products use
largely similar components.
 Apple’s product life cycles are relatively long, making its
business more valuable to vendors.
 Samsung on the other hand deals with a very wide array of
products, implying that volumes to individual vendors could be
smaller.
◼ Additionally, a bulk of the components for its consumer electronics
business come from in-house.

275
H ow has Apple’s CCC changed over time
 http://dashboards.trefis.com/no-login-
required/63m8Dqd5?fromforbesandarticle=how-
has-apples-cash-conversion-cycle-changed-over-
the-years

276
Evaluating Credit Policy – Single Period
 Assume Selling Price = 1100 (received after a year
of making sale) and Cost=800 (incurred at the time
of making the sale)
 If the probability of a customer paying up is 75%,
does it make sense for the company to extend
credit if cost of capital is 10% and Receivable
Period is 1 year?

 NPV = -50
277
Evaluating Credit Policy – Two Period
 Assume Selling Price = 1100
◼ (received after a year of making sales)
 Cost =800
◼ (incurred at the time of making sales)
 If the probability of a customer paying up is 75%, does it
make sense for the company to extend credit assuming
that a customer who pays up the first time has a probability
of 90% of paying up the second time? If a customer
defaults, you do not do any further business with the
customer. Assume discount rate of 10% and Receivable
Period of 1 year.
 NPV = 18.18

278
Evaluating Credit Policy – Multiple Period
 Assume Selling Price = 1100 and Cost =800
 If the probability of a customer paying up on the first
sale is 75%, does it make sense for the company to
extend credit assuming that a customer who pays up
the first time has a probability of 90% of paying up
after that in perpetuity. If a customer defaults, you do
not do any further business with the customer. Assume
discount rate of 10% and Receivable Period of 1 year?
 NPV = 325

279
Trade Credit terminology
1. Trade Credit terms without any discount
 Example net 45
◼ Customer needs to pay within 45 days

2. Trade Credit terms with discount for early payment

 Example 2/20 net 60
◼ Customer needs to pay within 60 days
◼ If they pay within 20 days then they get a 2% discount

280
Cost of Trade Credit
 A company quotes a credit policy of 2/20 net 60. If a
customer decides to pay on the due date (day 60),
what is the cost of trade credit to him assuming 365
day year
 Effective annual rate
(20.24%)

281
Some simplifying assumptions for subsequent
examples on credit policy decisions
 Measure the gains (or losses) at the end of the year
◼ You can also compute NPV, both approaches would give you
the same decision.
◼ Gain at the end of year would mean the decision has a +ive
NPV, and a loss would mean the decision has a –ive NPV
 Assume all benefits and costs are cashflows that occur
at the end of the year (SIMPLIFICATION)
◼ For example, if you give some discount to customers, you can
assume this entire cost is incurred at the end of the year

282
Benefit of Trade Credit – Example 1
 Udaipur Cotton has 3.6 mn in annual sales and has
Receivable Period of 60 days. It plans to introduce
a policy of 1/10 net 60. It expects that 60% of the
customers would take advantage of the discount
given, and the sales will remain 3.6mn. If the cost
of Short term debt is 15%, is it worth to extend the
discount? (Assume 360 day year)
 Ans: Yes, it gains a benefit of 23,400 at the end of
the year

283
Changing credit policy
 Use Incremental cashflows
◼ Imagine a scenario with the old credit policy
◼ Imagine a scenario with the new credit policy
◼ Compute Incremental Benefits and incremental Costs of
switching to new policy

284
Relaxing Credit Policy (Eg: Net 30 to Net 60)
 Benefits
◼ Increased in profits due to new sales

 Costs
◼ More capital tied up in AR
 Liberal credit terms + More Sales
◼ Increased probability of default
 Less creditworthy customers

285
Tightening the credit policy
Example: Net 60 to Net 30
 Benefits
◼ Get money earlier (Less capital tied up in AR)
◼ Lower default rates (More credit-worthy customers)
 Costs
◼ Lower profits due to less sales with a tighter credit policy

286
Setting up a collections department
 Benefits
◼ Receive payments quicker (Low AR tied up)
◼ Less bad debts

 Costs
◼ Cost of running the department

287
Invest on better credit risk assessment of customers
 Benefits
◼ Less bad debts
 Identify customers who are credit worthy and do business only with
those customers.
◼ Lower AR
 Perhaps these customers also pay on time, whereas less credit-worthy
customers tend to be late on their payments
 Costs
◼ Lower sales leading to lower profits
◼ Cost of running a new credit risk department, or cost of hiring
a external vendor to do credit appraisal for your customers
288
Giving a cash discount
 Example: Net 30 to 2/10 Net 30
 Benefits
◼ More profits due to increased sales
◼ Lower AR as customers pay quickly to avail discount
 Cost
◼ Some revenue lost due to discounts given to customers

Remember: You can assume all benefits and costs are

incurred at the end of the year.
289
Relaxed credit policy – Example 2
 Udaipur Cottons is planning to extend the credit limit
for its customers from 1 month to 2 months. This is
expected to increase its sales from 3.6 mn to 4.2 mn.
The COGS of 3 mn is expected to increase
proportionately. Assuming that there is no extra capital
cost for increased sales and the existing customers
continue to pay in 1 month, whereas new customers
pay in 2 months. What is the net benefit (or loss) from
this credit policy relaxation? Assume cost of working
capital finance is 15% and no taxes.
 Ans: 85,000

290
Relaxed credit policy – Example 3
 Udaipur Cottons is planning to extend the credit limit
for its customers from 1 month to 2 months. This is
expected to increase its sales from 3.6 mn to 4.2 mn.
The COGS of 3 mn is expected to increase
proportionately. Assuming that there is no extra capital
cost for increased sales and that all customers take 2
months to pay, what is the net benefit from this credit
policy relaxation? Assume cost of working capital
finance is 15% and no taxes.
 Ans: 40,000

291
Cash discounts – Example 4
 The present credit terms for a company are 1/10 net 30, its
annual sales are 8mn, and current average collection period is
20 days. COGS are 85% of revenues and cost of capital is 10%
and no taxes
 Company is considering a new credit policy of 2/10 net 30. This
is expected to increase sales by 0.5mn, reduce its avg.
collection period to 14 days, and increase the proportion of
discount sales to 80% (on overall sales)
 Assuming a 360 day year, what is the benefit (or loss) of this
policy change at the end of the year
 Ans: -9611.11

292
Default Risk – Example 5
 Udaipur Cottons can extend its credit policy from 1
month to 2 months. This can increase the sales from
3.6 mn to 4.2 mn. The COGS of 3 mn will increase
proportionately. The existing customers have a default
rate of 3% (as earlier) and would continue paying in 1
month. The new customers have a default rate of 12%
and they pay in 2 months. What is the net effect of
increasing the credit period? Assume cost of working
capital finance is 15%.
 Ans: Net gain of 13,000

293
Default Risk – Example 6
 Continued from Default Risk Example 4
 If extending from 2 months to 3 months increase
the sales to 4.5 mn (from earlier 4.2 mn) and new
customers take 3 months to pay and have a default
rate of 15%, what is the net effect of increasing the
credit period.? Assume earlier customers are not
affected and cost of capital is 15%
 Ans: -6250

294
Collection Efforts – Example 7
 Udaipur Cottons currently have sales of 3.6 mn and
a credit period of 3 months. It is planning to
intensify its collection efforts which will reduce the
credit period to 2 months and reduce the default
rate from 5% to 3%. If the cost of working capital
finance is 15% and the intensified collection effort
costs 100,000 (end of year), what is the net benefit
of intensifying the collections?
 Ans: 17,000

295
What is a derivative?
 A financial product whose value is derived from
another underlying (asset/event)
◼ Any instrument which derives its value from another
asset or event

296
Common derivative products
 Forwards
◼ A contract to buy/sell an asset on a future date, at a
particular price (fixed at the time of making the contract)
 Futures
◼ Same as forwards but exchange traded
 Options
◼ A contract which gives the right (without the obligation) to
the contract buyer to buy/sell an asset at a future date but at
a price fixed today
 Swaps
◼ A contract to exchange a series of cash flows in future

297
Futures and Forwards
 Futures and Forwards are obligations to buy or sell
the underlying at a future date and at a fixed price

 Obligation: Both parties commit to something in

the future, and they have to meet that commitment

 Example

298
Margins in Futures
 Both buyer and seller need to maintain a margin
account with the exchange
 As they get into a futures contract they have to pay an
initial margin in their margin account
 There is a defined maintenance margin, that they need
to maintain throughout the life of contract.
 Everyday margin account is adjusted to reflect their
gain or loss for the day, and if margin account balance
is short of maintenance margin they will get a request
to increase their margin account back to initial margin
◼ This is called a Margin Call

299
Illustration
 An investor buys 2 Gold Futures that will expire in 16 days
 The future price at the time of purchase is $1,250 per ounce
 Each gold future has a lot size of 100 ounces
 What is the commitment with investor’s position?
◼ Position: Long 2 Gold Futures
◼ Commitment to buy 200 Ounces of gold at $1250/ounce
 Exchange wants $6000 per future contract as initial margin, and
$4500 per contract as maintenance margin
◼ Initial Margin = 2 x 6000 = $12000
◼ Maintenance margin = 2 x 4500 = $9000

300
Illustration
 Remember
◼ Long position in Futures
 Makes a loss if future price decreases next day
 Makes a gain if future price increases next day
◼ Short position in Futures
 Makes a loss if future price increases next day
 Makes a gain if future price decreases next day

 Example
301
Options
 The main difference between futures/ forwards and
options is that
◼ Options give you a “right to buy or sell” to option buyer
◼ Futures/Forwards are “obligation to buy or sell”

◼ Because options give you this flexibility there is a

premium that you need to pay to buy options
 It is called Option Premium or Option Price

302
Option Characteristics
 Type of Option
◼ Call or Put
◼ American (exercise right any time before maturity) or European (exercise
right only at maturity)
 Exercise price or Strike Price
◼ The fixed price at which the underlying asset is bought/sold when an
option is exercised
 Time to maturity
◼ The time left to maturity of an option
 Option price or Option Premium
◼ The price at which this option can be bought or sold
 Long means Buy , Short means Sell
◼ Long 1 Call Option means bought 1 Call Option

303
Call Option – Right to BUY
 A call option gives the option buyer a
◼ Right to BUY underlying: RIL share
◼ At a fixed price: Strike price or Exercise price, K = 2300
◼ On a future date: Expiry date = 30 December 2021
◼ Current price of call option C = 146 (also called option premium)
◼ Current price of underlying S0 = 2418
◼ Price at expiry St

 The call option buyer has the right to BUY

◼ If the call option buyer decides to exercise her right to
buy, the option seller will have to sell the stock at 2300
on 30 December 2021

304
Gross and Net Payoff of Call Options
 Gross Payoffs (Cashflow at maturity)
Call Buyer Call Seller
St – K , St > K (Exercised) –(St – K) , St > K
0 , St ≤ K 0 , St ≤ K

 Net Payoffs = Gross Payoff + Initial Period Cashflow

Call Buyer Call Seller
St – K – C, St > K (Exercised) –(St – K– C) , St > K
–C , St ≤ K +C , St ≤ K

305
Pur Option – Right to SELL
 A call option gives the option buyer a
◼ Right to SELL underlying: RIL share
◼ At a fixed price: Strike price or Exercise price, K = 2500
◼ On a future date: Expiry date = 30 December 2021
◼ Current price of put option P = 149 (also called option premium)
◼ Current price of underlying S0 = 2382
◼ Price at expiry St

 The put option buyer has the right to SELL

◼ If the put option buyer decides to exercise her right to
SELL, the put option seller will have to buy the stock at
2500 on 30 December 2021
306
Gross and Net Payoff of Put Options
 Gross Payoffs
Put Buyer Put Seller
K – St, St < K (Exercised) –(K – St) , St < K
0 , St ≥ K 0 , St ≥ K

 Net Payoffs = Gross Payoff + Initial Period Cashflow

Put Buyer Put Seller
K – St – P, St < K (Exercised) –(K – St – P) , St < K
–P , St ≥ K +P , St ≥ K

307
Option Payoffs
 Represent Graphically
◼ Refer the payoff diagrams discussed in the class for
graphical payoffs

308
Assume we are standing at maturity
(St = So, current stock price)
 In the money Option (ITM)
◼ An option which produces a positive payoff to the option
buyer if it is exercised immediately
 Out of money option (OTM)
◼ An option which produces a negative payoff to the option
buyer if it is exercised immediately
 At the money option (ATM)
◼ An option which produces no payoff to the option buyer
if it is exercised immediately

309
Assume we are standing at maturity
(St = So, current stock price)
 If K=100, So = 90
◼ Call is out of money (OTM), if exercised right now the
payoff is -10, buy at 100 and sell at 90 in mkt
◼ Put is in the money (ITM), if exercised right now the
payoff is +10, buy at 90 from mkt and sell at 100

 If K=100, So = 100
◼ Both Put and Call are At the money (ATM), if exercised
immediately they will have a payoff of zero

310
Assume we are standing at maturity
(St = So, current stock price)
 If K=100, So = 120
◼ Call is in the money (ITM), if exercised right now the
payoff is 20, buy at 100 and sell at 120 in mkt
◼ Put is out of money (OTM), if exercised right now the
payoff is -20, buy at 120 from mkt and sell at 100

311
Option Strategies – Covered Call
 You have a covered call when you have
◼ Long Stock
◼ Short Call option on the Stock

 When do you use it

◼ When you expect the stock price to remain relatively flat
or increase slightly.

312
Option Strategies – Straddle
 You have a Straddle when you have
◼ Long Put
◼ Long Call

 When do you use it

◼ Pure volatility play (Non-directional)
◼ When you think volatility is going to increase
◼ Stock can move significantly in any direction

313
Option Strategies - Protective Put
 You have a protective put when you have
◼ Long Stock
◼ Long Put option on the stock

 When do you use it

 Bullish on the stock, but want to limit losses in
case the stock falls

314
Put Call Parity
 Call price + PV(K) = Put Price + So
𝐾
Call price + = Put Price + So
(1+𝑟𝑓 )𝑇
◼ Call price is market price of Call (same as Call option premium)
◼ Put price is market price of Put (same as Put option premium)
𝐾
◼ PV(K) is where K is the strike price,
(1+𝑟𝑓 )𝑇

 𝑟𝑓 is the daily risk free rate, and 𝑇 is the number of days from today till
the expiration date
◼ So is the price of underlying today
315
Put Call Parity
 If you know the market price of Put you can determine the
Theoretical Price of Call
◼ Theoretical Price of Call = Put + So – PV(K)
Similarly,
◼ Theoretical Price of Put = Call + PV(K) – So

 Mkt Price of option < Theoretical Price the option is undervalued

 Mkt Price of option > Theoretical Price the option is overvalued

316
Practice problem (Put call parity)
𝐾
 Call price + = Put Price + So
(1+𝑟𝑓 )𝑇

 You create a portfolio with a long position in a share, a long

position in a put and a short position in a call. The exercise
price of the call and put is also INR 100, and both options
will mature after 3 months. What is the value of your
portfolio? Risk free rate is 10% per annum.

317
Impact of different factors on option price
 The following table gives the impact of call and put
option price if the factor increases
This factor increases Call Price Put Price
Underlying Price Increase Decrease
Strike Price Decrease Increase
Time to Maturity Increase Increase
Underlying Volatility Increase Increase
Interest Rate Increase Decrease
Cash Dividends Decrease Increase

318
Relation between Futures Price and Spot price
for stock futures
 The current price of the underlying (spot price) is
related to the futures price as follows
◼ 𝐹0 = 𝑆0 ∗ (1 + 𝑟𝑓 )𝑡 Non-dividend paying stock
 Where 𝐹0 is the futures price
 𝑆0 is the spot price: Current price of the underlying
 𝑟𝑓 is the daily risk-free rate, 𝑡 is the number of days left to
maturity

319
Practice Problem (Arbitrage or riskless profit)
The reason why 𝐹0 = 𝑆0 ∗ (1 + 𝑟𝑓 )𝑡 must hold
Suppose Infosys Share is 1300 (𝑆0 ), current market price of 3-month Infosys future is
1350, one month risk free rate is 1%.
 Theoretical Price of future
𝐹0 = 𝑆0 ∗ (1 + 𝑟𝑓 )𝑡 = 1300*(1.01)3 = 1339.39
 Future is overvalued at 1350, arbitrage or riskless profit is possible
◼ At t=0
 Sell overvalued future at 1350
◼ Commitment to sell Infosys share at 1350 after 3 months
 Borrow 1300 at 𝑟𝑓 for three months and use that to buy Infosys stock today
◼ At maturity (after 3 months)
 Give Infosys stock to the future buyer and receive 1350
 Pay 1300*(1.01)3 = 1339.39 to repay your loan. You make a riskless profit of 10.61

320