Corporate finance lecture No.

01

COURSE TITLE:
Corporate Finance
COURSE CODE:
(FIN 622)
PROFESSOR:
Muzaffar Hashmi

Recommended Books
 Fundamental of Corporate Finance (7th Edition)
By: Richard A Brealey, Stewart C Myers
 Principle of Corporate Finance (4th Edition)
By: Richard A Brealey, Stewart C Myers
 Essential of Corporate Finance
By: Stephen A Ross, Randolph W Westerfield,
Bradford D Jordan
Corporate Finance

Scheme of Studies:
 MODULE # 1 : OVERVIEW OF CORPORATE FINANCE
 MODULE # 2 : VALUATIONS OF FINANCIAL INSTRUMENTS LIKE STOCKS
SHARES & BONDS
 MODULE # 3 : CAPITAL BUDGETING
 MODULE # 4 : RISK STRATEGIES & MANAGEMENT
 MODULE # 5: COST OF CAPITAL
 MODULE # 6 : SHORT TERM FINANCE & CAPITAL STRUCTURE
 MODULE # 7 : SPECIAL TOPICS – MERGERS & ACQUISITIONS
 MODULE # 8 : INTERNATIONAL OPERATIONS

TO START A BUSINESS - THREE QUESTIONS ARISES:

 1. What type of assets do we needs?
 2. Where the money will come from to buy these particular assets?
 3. Day to day or Routine financial expenses, how to meet them?
QUESTION # 1: SELECTION OF ASSETS:
CAPITAL BUDGETING

 CB is defined as process of planning, analyzing and acquiring of capital.

 CB decisions are irreversible in nature
 SWOT Analysis :
 S – Strength
 W – Weakness
 O – Opportunities
 T – Threats
 CB targeted towards potential opportunities
  Opportunities of a Business Entity depends on nature of intended business

 Example: Air line Industry wants to add an aircraft that generate more Cash Flows. (i.e.
Opportunity and acquire an asset Plane)
 Cargo Company - Trawlers
Points keep in view by Financial Manager & CB

 Size of Investment
 Risk
 Timing

 Evaluating Size, timing of CF and Risk associated with CF is essence of CB

QUESTION # 2:Where to get money from to Finance Investment?

Ans: CAPITAL & ITS STRUCTURE

 Two ways to finance an Investment:

 Owner’s Equity
 Loans or External Sources

Terminology in Capital Raising

IPO’s
 IPO’s stands for Initial Public Offerings
 Company lunch their shares in market
 Offer general Public
 Share allotted on Draw

QUESTION # 3
 How to manage routine financial activities?

 Working Capital Basically Interaction between Current Assets & Current Liabilities
 Working Capital needs to meet financial expenses
 Current Assets + Current Liabilities = WC
OPERATING CYCLE
Cash Flow from Customers used to
Vendors Pay Off Vendors

Raw Material

Finished Goods

Sales to Customer
Cash Payment
from Customers
Cash from Customers

Working Capital
Policies

 Level of Inventory Investment

 Credit extension policy

Types of Business
 Sole Proprietor
 Partnership
 Limited Liability Business:
 Private Company
 Public Un-listed Company
Limited Liability Business & Markets
Types of Markets:

 Primary Market

 Secondary Market
Primary Markets
 Original Sale of Securities and shares
 No tangible Shape
 General Public offerings
 Private placements
 IPO’s in Primary Market

Secondary Markets
 Subsequent to first sale or Subsequent to original sale.
 Trading of Securities & Shares
  Tangible Markets
 Example stock Exchange
FINANCIAL STATEMENTS &
CORPORATE FINANCE
 THREE BASIC STATEMENTS
 BALANCE SHEET
 INCOME STATEMENT
 CASH FLOW STATEMENT

BALANCE SHEET

 Is a Statement of resources controlled by the business entity and obligations on a specific

date.
Contents of Balance Sheet

 Assets = Fixed (tangible & intangible)& current assets

 Liabilities = Long Term Liability + Current Or Short Term Liability
 Equity = shareholders’ contribution + earnings

Fixed Assets:
 Earning assets
 Fixed Assets e.g. Plant, Machinery, Vehicles etc
Current Assets:
 Inventory, Prepayments, Cash & Bank Balance, Short Term Investment etc
Balance Sheet Format

 Format of B/S in Pakistan is Governed by International Financial Reporting Standard or

International Accounting Standard
 B/S construction is Non-liquid or Illiquid Asset is at top

Two Conventions for B/S Construction

 1st as in Pakistan IAS or IFRS

 2nd Convention GAAP (General Accepted Accounting Principle) applicable in United
States
 GAAP – In B/S top item is highly liquid asset i.e. cash or near money
Current Liabilities ingredients

 Creditor, Accrued Liabilities, Short Term Finances

 Current Assets combine Current liabilities equal Working Capital
Liquidity

 Conversion into cash without losing its value.

 Timing
 Loss of value
  Example: Bonds

Equity & Long Term Liabilities

 Equity
 Paid up Capital
 Reserves
 Profit & Loss
 Long Term Liabilities
 Loans OR Financial Leverage
 BALAN CE SHEET
AS AT 30 JUNE 2003
NOTES 2003 2002
RUPEES RUPEES
O PERATING ASSETS
Fixed assets (at cost less accumulated depreciation) 3 125,138,737 109,101,363

DEFERRED CO ST 4 12,653,681 18,514,377

LONG TERM DEPOSITS (against Lease) 2,930,337 827,737
140,722,755 128,443,477
CURRENT ASSETS

Stores & spares 7,347,476 11,215,891

Stocks -do- 5 22,628,137 19,231,731
Trade debtors 6 2,149,858 3,211,998
Advances, deposits, prepayments and
other receiveables 7 26,089,950 17,450,008
Cash and bank balances 8 107,524 110,421
58,322,945 51,220,049
CURRENT LIABILITIES
Current maturity portion of lease liability 9 (6,794,240) (2,821,322)
Current maturity portion of Long Term Loans (8,004,000) -
Short term borrowings 10 (6,760,139) (19,270,244)
Creditors, accruals and other liabilities 11 (30,831,550) (44,786,359)

TOTAL ASSETS LESS CURRENT LIABILITIES 146,655,771 112,785,601

LONG TERM LIABILITIES

Deferred Income (1,692,510) -
Due to directors and relatives (37,056,700) (21,693,585)
Provident fund trust and gratuity payable 12 (926,457) (926,457)
Long term loans 13 (27,828,000) (47,500,000)
Dealers&Distributors securities 14 (23,871,350) (19,398,600)
Long term portion of leasehold assets (12,710,887) (1,936,847)
(104,085,904) (91,455,489)

TOTAL NET ASSETS 42,569,867 21,330,112

REPRESENTED BY :
Share capital (5,980,000) 15 59,800,000 39,800,000
Profit & (loss) account (27,457,311) (29,697,066)
Surplus on revaluation of fixed assets 8,227,178 8,227,178
Share deposit money 2,000,000 3,000,000
42,569,867 21,330,112
 Corporate finance lecture No. 02
FINANCIAL STATEMENT
&
CORPORATE FINANCE

Management to Corporate Finance

 Market Value
 Book Value

 Market Value
 Negotiation or Dealing at Arm Length
 Contrary to Market Value financial statements are prepared on Book Value
 Book Value is not reflective of worth of assets.
 Book Value
 Cost minus Accumulated Depreciation

Income Statement
 Work out Profit
 Three Terminologies interchangeably used
 Sales
 Turnovers
 Revenues
 In Profit Statement line item vary Organization to Organization , Industry to
Industry, there is no Rule of Thumb
 Revenue – Expenses = Profit
 Cash Flow Statement
 Generation of cash from different activities and its application
 Three Broad segment
 Operating Cash Flows
 Investing Cash Flows
 Financing cash flows


CASH FLOW STATEMENT

FOR THE YEAR ENDED 30TH JUNE, 2003.
2003 2002
CASH FLOW FROM OPERATING RUPEES RUPEES
ACTIVITIES
(Loss)/profit before taxation 2827137 (2836406)
Adjustment of non cash Items:
Depreciation 9290339 6627895
Deferred Cost amortized 5860696 5860696
Gain on sale of fixed assets (3080793) 482408
Amortization of deferred income (846255)
Gratuity / wppf payable 148797 382736
Financial charges 10028353 12557288
Operating profit before working capital 24228274 23074617
changes
Change in Working Capital
(Increase)/Decrease in current assets
Stores and spares 3868415 702074
Stocks (3396406) (5332231)
Trade debts 1062140 (1917498)
Advances, deposits, Prepayments and
other receivables (7763225) (7049512)
Increase/(Decrease) in current liabilities
Creditors, accruals and other liabilities (12310807) 8581075
(18539883) (5016092)
Cash Generated from operations 5688391 18058525

Financial charges paid (11672355) (12067383)

Income Tax paid (1464099) (1003487)
Net cash flow from Operating Activities (7448063) 4987655

CASH FLOW STATEMENT

FOR THE YEAR ENDED 30TH JUNE, 2003.

CASH FLOW FROM OPERATING ACTIVITIES

(Loss)/profit before taxation
Adjustment of non cash Items:
Depreciation
Deferred Cost amortized
Gain on sale of fixed assets
Amortization of deferred income
Gratuity / wppf payable
Financial charges
Operating profit before working capital changes
Change in Working Capital
(Increase)/Decrease in current assets
Stores and spares
Stocks
Trade debts
Advances, deposits, Prepayments and
other receivables
Increase/(Decrease) in current liabilities
Creditors, accruals and other liabilities

Cash Generated from operations

Financial charges paid

Income Tax paid

Net cash flow from Operating

Activities

CASH FLOW FROM INVESTING ACTIVITIES

Capital expenditures (16716034) (22566329)
Proceeds from disposal of fixed assets 16325792 540600
Deferred cost - (4661444)
Long Term Deposits Paid (2102600) (101400)

Net cash used in investing activites (2492842) (26788573)

CASH FLOW FROM FINANCING ACTIVITIES

Liability subject to finance lease paid (3355294) (1351882)
Increase in share capital/deposit money 19000000 3000000
Increase in long term loans - -
Repayment of long term loans (11668000) -
Due to directors and relatives 15363115 7947147
Provident fund trust - -
Dealers & Distributor's securities 4472750 6101152
Increase/(decrease) in short term loans (12510105) 6088294
Net cash (outflow)/ inflow from financing
activities 11302466 21784711
NET INCREASE/(DECREASE) IN CASH 1361561 (16207)
EQUIVALENTS
(2897)
CASH AND CASH EQUIVALENTS AT THE BEGINING
OF THE PERIOD 110421 126628
CASH AND CASH EQUIVALENTS AT THE END
OF THE PERIOD 1471982 110421

COMPARING OF FINANCIAL STATEMENT

CORPORATE FINANCE MODULE # 1

Comparing of Financial Statement
 Problem in Comparing
 Size
 Reporting Currency
 Tools to compare Financial Statement
 Common Size Statement
 Ratio Analysis

Common Size Statement

Balance sheet

 All line items of Asset side can be expressed in %age. Total Assets 100% then
what is the weight age of Current Asset, Fix Assets etc
 Same is the case in Liabilities
BALANCE SHEET      
AS AT 30 JUNE 2003      
       
       
OPERATING ASSETS      
Fixed assets (at cost less accumulated      
depreciation)
       
DEFERRED COST      
LONG TERM DEPOSITS (against Lease)      
       
CURRENT ASSETS      
       
Stores & spares      
Stocks   -do-  
Trade debtors      
Advances, deposits, prepayments and      
other
  receiveables    
Cash and bank balances      

       
CURRENT LIABILITIES      

Current maturity portion of lease liability      

Current maturity portion of Long Term Loans      

Short term borrowings      

Creditors, accruals and other liabilities      

       
       

NET CURRENT ASSETS

TOTAL ASSETS LESS CURRENT LIABILITIES

LONG TERM LIABILITIES

Deferred Income
Due to directors and relatives
Provident fund trust and gratuity payable

Long term loans

Dealers&Distributors securities

Long term portion of leasehold assets

TOTAL NET ASSETS

       
       
CURRENT LIABILITIES      
Current maturity portion of lease liability      
Current maturity portion of Long Term Loans      
Short term borrowings      
Creditors, accruals and other liabilities      
       
       
NET CURRENT ASSETS      
       
TOTAL ASSETS LESS CURRENT LIABILITIES      
LONG TERM LIABILITIES      
 Deferred Income      
Due to directors and relatives      
Provident fund trust and gratuity payable      
Long term loans      
Dealers&Distributors securities      
Long term portion of leasehold assets      
       
       
TOTAL NET ASSETS      
  2003 2002 2003 2002
     

REPRESENTED BY : RUPEES RUPEES

Share capital 59,800,000 39,800,000 30.04 22.15
Profit & (loss) account -27,457,311 -29,697,066 13.79 16.53
Surplus on revaluation of fixed assets 8,227,178 8,227,178 4.13 4.58
Share deposit money 2,000,000 3,000,000 1.00 1.67
42,569,867 21,330,112
The annexed notes form an integral part of these accounts.
LAHORE -199,045,700 -112,785,601 100.00 100.00
DATED
Common Size Income Statement

 All line items are expressed as sale %age i.e. Sales 100%
 PROFIT AN D LOSS ACCOUN T
FOR THE PERIOD EN DED 30TH JUN E, 2003.

2003 2002 2003 2002

PARTICULARS RS. RS. RS. RS.
SALES 116,811,832 109,030,501 100 100
COST OF SALE S (60,117,579) (58,812,941) (51.47) (53.94)

GROSS PROFIT 56,694,253 50,217,560 48.53 46.06

OPE RATING E XPE NSE S (56,105,424) (53,414,839)

Administrative (8,691,429) (9,173,201) (7.44) (8.41)

Selling, distribution and amortization (37,385,642) (31,684,350) (32.01) (29.06)
Financial charges (10,028,353) (12,557,288) (8.59) (11.52)

OPE RATING PROFIT/ (LOSS) 588,828 (3,197,279)

OTHE R INCOME / (LOSS) 2,387,106 360,873 2.04 0.33

PROFIT/ (LOSS) BE FORE TAXATION 2,975,934 (2,836,406)

WORKE RS PROFIT PARTICIPATION (148,797) - (0.13) 0.00

PROFIT/ (L0SS) BE FORE TAXATION 2,827,137 (2,836,406) 2.42 (2.43)

PROVISION FOR TAXATION (587,382) (545,152) (0.50) (0.50)

PROFIT/ (L0SS) AFTER TAXATION 2,239,755 (3,381,558)

PROFIT/ (LOSS) BROUGHT FORWARD (29,697,066) (26,315,508)

PROFIT/ (LOSS) CARRIE D OVER TO

BALANCE SHE ET (27,457,311) (29,697,066)

Base Year Analysis OR Horizontal Analysis

Common Size Statements are also called Vertical Analysis

BASE YEAR / HORIZONTAL ANALYSIS
BALANCE SHEET
EXAMPLE HORIZONTAL ANALYSIS BASE
YEAR
ASSETS 2006 2005 2004 2003 2002 2001

FIXED ASSETS 160,000.00 155,000.00 145,000.00 145,000.00 125,000.00 100,000.00

160.00 155.00 145.00 145.00 125.00 100.00
CURRENT ASSETS 70,000.00 65,000.00 56,000.00 58,000.00 55,000.00 50,000.00
140.00 130.00 112.00 116.00 110.00 100.00
TOTAL ASSETS 230,000.00 220,000.00 201,000.00 203,000.00 180,000.00 150,000.00
153.33 146.67 134.00 135.33 120.00 100.00
CAPITAL & LIABILITIES

CURRENT LAIBILITIES 22,000.00 21,500.00 19,000.00 17,000.00 16,000.00 15,000.00

146.67 143.33 126.67 113.33 106.67 100.00
LONG TERM LIABILITIES 15,000.00 13,000.00 12,000.00 11,500.00 10,500.00 10,000.00
150.00 130.00 120.00 115.00 105.00 100.00
EQUITY 193,000.00 185,500.00 170,000.00 174,500.00 153,500.00 125,000.00
154.40 148.40 136.00 139.60 122.80 100.00
TOTAL CAPITAL & LBTIES 230,000.00 220,000.00 201,000.00 203,000.00 180,000.00 150,000.00
153.33 146.67 134.00 135.33 120.00 100.00
Ratio Analysis
 Ratio is relationship between two or more different figures or amounts
 Different categories in Ratio Analysis
  Current Ratio
 Long Term Ratio
 Profitability Ratio
 Markup Ratio
Current Ratio Or Short Term Solvency Ratio Or Working Capital Ratio

 Current Ratio is a relationship between Current Asset & Current

Liabilities
 Current Ratio = Current Assets / Current Liabilities
 Prudent Ratio is 2 : 1
2003 2002
CURREN T RATIO 1.11 0.77
BALAN CE SHEET 2003 2002
AS AT 30 JUNE 2003 RUPEES RUPEES

OPERATING ASSE TS
Fixed assets (at cost less accumulated depreciation) 125,138,737 109,101,363

DEFE RRE D COST 12,653,681 18,514,377

LONG TE RM DE POSITS (against Lease) 2,930,337 827,737
140,722,755 128,443,477
CURREN T ASSETS
Stores & spares 7,347,476 11,215,891
Stocks 22,628,137 19,231,731
Trade debtors 2,149,858 3,211,998
Advances, deposits, prepaym ents and
other receiveables 26,089,950 17,450,008
Cash and bank balances 107,524 110,421
58,322,945 51,220,049
CURREN T LIABILITIES
Current maturity portion of lease liability (6,794,240) (2,821,322)
Current maturity portion of Long Term Loans (8,004,000) -
Short term borrowings (6,760,139) (19,270,244)
Creditors, accruals and other liabilities (30,831,550) (44,786,359)
(52,389,929) (66,877,925)

Acid Test Ratio Or Quick Ratio

 Relation between Current Asset & Current Liabilities

 But we less Inventory Items from Current Assets
 Formula
 Q.R = C.A – Inventories / C.L
 2003 2002
QUICK RATIO (0.54) (0.31)
BALAN CE SHEET 2003 2002
AS AT 30 JUNE 2003 RUPEES RUPEES

OPE RATING ASSETS

Fixed assets (at cost less accumulated depreciation) 125,138,737 109,101,363

DE FE RRED COST 12,653,681 18,514,377

LONG TERM DE POSITS (against Lease) 2,930,337 827,737
140,722,755 128,443,477
CURREN T ASSETS
Stores & spares 7,347,476 11,215,891
Stocks 22,628,137 19,231,731
Trade debtors 2,149,858 3,211,998
Advances, deposits, prepayments and
other receiveables 26,089,950 17,450,008
Cash and bank balances 107,524 110,421
58,322,945 51,220,049
CURREN T LIABILITIES
Current maturity portion of lease liability (6,794,240) (2,821,322)
Current maturity portion of Long Term Loans (8,004,000) -
Short term borrowings (6,760,139) (19,270,244)
Creditors, accruals and other liabilities (30,831,550) (44,786,359)
(52,389,929) (66,877,925)
Long Term Solvency Ratio

Basically Showing Financial Leverage & also show the abilities of firm to pay its long term
liabilities

 Total Debt Ratio:

 T.D.R = Total Debt / Total Asset
OR
= (Total Assets - Total Equity) / Total Assets
 TOTAL DEBT RATIO 2003 2002
Total Debts / Total Assets 0.31 0.40
OR
Total Assets - Equity 0.79 0.88
Total Assets
CURRENT LIABILITIES RUPEES RUPEES
Current maturity portion of lease liability (6,794,240) (2,821,322)
Current maturity portion of Long Term Loans (8,004,000) -
Short term borrowings (6,760,139) (19,270,244)
Creditors, accruals and other liabilities (30,831,550) (44,786,359)
(52,389,929) (66,877,925)
NET CURRENT ASSETS 5,933,016 (15,657,876)
TOTAL ASSETS LESS CURRENT LIABILITIES 146,655,771 112,785,601
LONG TERM LIABILITIES
Deferred Income (1,692,510) -
Due to directors and relatives (37,056,700) (21,693,585)
Provident fund trust and gratuity payable (926,457) (926,457)
Long term loans (27,828,000) (47,500,000)
Dealers&Distributors securities (23,871,350) (19,398,600)
Long term portion of leasehold assets (12,710,887) (1,936,847)
(104,085,904) (91,455,489)

BALAN CE SHEET 2003 2002

AS AT 30 JUNE 2003 RUPEES RUPEES

OPERATING ASSETS
Fixed assets (at cost less accumulated depreciation) 125,138,737 109,101,363

DEFERRED COST 12,653,681 18,514,377

LONG TERM DEPOSITS (against Lease) 2,930,337 827,737
140,722,755 128,443,477
CURREN T ASSETS
Stores & spares 7,347,476 11,215,891
Stocks 22,628,137 19,231,731
Trade debtors 2,149,858 3,211,998
Advances, deposits, prepayments and
other receiveables 26,089,950 17,450,008
Cash and bank balances 107,524 110,421
58,322,945 51,220,049
REPRESEN TED BY :
Share capital (5,980,000) 59,800,000 39,800,000
Profit & (loss) account (27,457,311) (29,697,066)
Surplus on revaluation of fixed assets 8,227,178 8,227,178
Share deposit money 2,000,000 3,000,000
42,569,867 21,330,112 DEBT EQUITY
RATIO

FORMULA

 Debt Equity Ratio = Total Debt / Equity

 DEBT EQUITY RATIO 2003 2002
Total Debts / Equity (1.46) (3.35)
CURRENT LIABILITIES RUPEES RUPEES
Current maturity portion of lease liability (6,794,240) (2,821,322)
Current maturity portion of Long Term Loans (8,004,000) -
Short term borrowings (6,760,139) (19,270,244)
Creditors, accruals and other liabilities (30,831,550) (44,786,359)
(52,389,929) (66,877,925)
NET CURRENT ASSETS 5,933,016 (15,657,876)
TOTAL ASSETS LESS CURRENT LIABILITIES 146,655,771 112,785,601
LONG TERM LIABILITIES
Deferred Income (1,692,510) -
Due to directors and relatives (37,056,700) (21,693,585)
Provident fund trust and gratuity payable (926,457) (926,457)
Long term loans (27,828,000) (47,500,000)
Dealers&Distributors securities (23,871,350) (19,398,600)
Long term portion of leasehold assets (12,710,887) (1,936,847)
(104,085,904) (91,455,489)
TOTAL NET ASSETS 42,569,867 21,330,112
REPRESENTED BY :
Share capital (5,980,000) 59,800,000 39,800,000
Profit & (loss) account (27,457,311) (29,697,066)
Surplus on revaluation of fixed assets 8,227,178 8,227,178
Share deposit money 2,000,000 3,000,000
42,569,867 21,330,112

TIME INTEREST EARNED RATIO

FORMULA:
= Earning before Tax / Interest Expense

YEARS TIME INTEREST EARNED RATIO

2003 0.30

2002 0.23
INVENTORY TURNOVER RATIO
FORMULA:
=Cost of Gods Sold/Average Inventory

YEARS INVENTORY TURNOVER RATIO

2003 (2.87)
2002 (3.06)
MARKET RATIOS

YEARS INVENTORY TURNOVER RATIO

2003 0.47

2002 (0.71)
PAYABLE TURNOVER RATIO
FORMULA:
=Cost of Gods Sold/Trade Creditors

YEARS INVENTORY TURNOVER RATIO

2003 (2.42)

2002 (1.61)

Corporate finance lecture No. 03

CORPORATE FINANCE - MODULE # 2
VALUATION OF FUTURE CASH FLOW
SCHEME OF STUDIES

THIS MODULE INCLUDES:

 TIME VALUE OF MONEY - BASICS

 DISCOUNTED CASH FLOW VALUATION
 BOND VALUATION
 COMMON STOCK VALUATION

CORPORATE FINANCE - MODULE # 2

VALUATION OF FUTURE CASH FLOW
TIME VALUE OF MONEY

 FUTURE VALUE

 PRESENT VALUE

 ANNUITIES

 PERPETUITIES
FUTURE VALUE

Depends on three factors

 Size of Investment
 Time Period
 Interest Rate

FUTURE VALUE

TIME VALUE DEFINED

 A dollar or Rupee received today is better than a dollar or rupee to be received
after a year. Why?

 Because the dollar or rupee received today will start earning profit right from
today
FUTURE VALUE

FV = (Investment, Time, Interest Rate)

This can be written as
FV = PV x (1 + r)t
(1 + r) t is known as Present Value Investment Factor (PVIF)
r = Rate of Interest
t = Time period
Example
You invest Rs. 1000 today and will get Rs. 1100 at the end of one year, if interest rate is 10%
p.a.

= 1000 X (1 + 0.10)= 1100

At the end of second year your investment is worth:
1100 x (1 + 0.10) = 1210

Alternatively: 1000 x (1 + 0.10)2 = 1210

COMPOUND INTEREST

 After One year:

 1000 X (1.10) = 1100

 After two years:

 1100 X (1.10) = 1210

At the end of 2nd year total Investment 1210 that means we earned 210 in terms of Interest.

210 = 100+100+10
10 is basically Compound Interest
COMPOUND INTEREST

This 1210 has four parts:

 1000 original investment
 100 interest – 1 year
 100 interest – 2 year
 10 interest on Year 1 interest

Earning interest on interest is know as compounding

Interest over period is reinvested to earn more
interest.
LONG PERIOD EXAMPLE : (Future Value)

An investment opportunity pays 12% pa and a business entity intends to invest 500,000.
What will be the worth of this investment in 7 years time? How much interest will the
company earn in this period? What portion of total interest represents compound interest?

Solution

Worth after 7 years:

FV = PV x (1 + r)t

FV =500000 x (1.12)7 =1105350

 (1.12)7 = 2.2107
2nd Question: How much Interest will the Company earn in this period?

Total interest earned:

1105350 – 500000 = 605350
Compound Interest:
500000 x 12% x 7 = 420000
=605350 – 420000 = 185350

2nd Question: How much Interest will the Company earn in this period?

Total interest earned:

1105350 – 500000 = 605350
Compound Interest:
500000 x 12% x 7 = 420000
=605350 – 420000 = 185350

PRESENT VALUE

You know that you will get 10000 at the end of 3rd
year from now. The interest rate is 10%. What is the
PV of 10000 now?

FV = PV x (1+r)3
10000= PV x (1.10)3
PV = 10000/ (1.10)3= 7513.14
We can find PV the other way too:
PV = FV / (1 + r)t
1 / (1.10)3 = known as PVDF
PV = FV X PVDF
PV = 10000 X 0.7513*
= 7513

* From table A-3

Comparison between two options

Option 1= Pay 4000 today and 6000 after 2 years to buy a computer

Option 2= Pay all today a get a credit of 500. (Net price today is 9500)

 Interest rate is 10% at present.

 Which option is better?
Option 1:

Finding PV:
PV = 4000 + (6000 / (1.10)2
 PV = 4000 + 4958.68 = 8958.68

It means that 4958.68 invested today @ 10% will yield 6000 at the end of year 2,
enabling you to pay off your liability.
Option 2:

PV = 9500
Option 1 is better because it cost 8958.68 as compared to 9500 of option 2.
 So far we come across four factors of Time Value of Money:
 PV
 FV
 Interest factor or discount factor
 Time period

 Given three we can find the fourth.

Finding interest rate
 An opportunity requires 1000 investment today that will double at the end of 8th year.
What is the implicit interest rate?
PV = FV / (1 +r)8
1000 = 2000 / (1 +r)8
(1 +r)8 = 2000/1000
(1 +r)8 = 2
r =9%

Three Ways to Solve:

 Mathematical Equation
 Financial Calculator
 Time Value of Money Tables

 Look FV table 8 year row select and move towards right unless under the interest Rate
%age you read 2 or nearest to 2.
 Implicit Interest Rate = 9%
PERPETUITY
Defined: Stream of equal cash payments equally spaced that continues for ever.
If you wish to help a welfare trust by providing 100,000/- per annum forever and the interest
rate is 10%, how much amount must be set-aside today?
Formula:
PV of Perpetuity = C/r
= 100000/0.10
= 1,000,000/-
 And if you wish to start payments after 3rd year, then what is the PV of this delayed
Perpetuity?

 PV of Perpetuity = 1,000,000 / (1.10)3

= 751315
ANNUITIES
Series of equal amount and equally spaced payments for
limited period of time but not unlimited.

Valuation of Annuities:
 Using FV/PV tables
 Using formula
Example:
You want to buy an asset for your business that will
cost you 4000 per year for next three years.
Assume interest rate of 10%. Find out the PV of this
annuity?
Using table
4000 x 1/(1.10)
4000 x 1/(1.10)2
4000 x 1/(1.10)3 = 9947.41
Using Formula:

PV= Annuity x 1/0.1 – 1/ 0.10(1.10)3

= 4000 x 2.4869 = 9947.60

Corporate finance lecture No. 04

CASH FLOW VALUATIONS

Means that at the end of every time period the cash flow level or cash flow amount is
different.
Example:
An investment returns 10000 after first year, 13000, 15000 & 18000 after 2nd to 4th
year respectively. If the prevailing interest is 10% what is the present value of cash flow.
Equations:
FV = PV x (1 + r)t
PV = FV / (1 + r)t

YEAR CASH FLOW FVIF @ 10%= PV=

1/(1.10)t Cash Flow /
FVIF
1 10000 =1/1.10 9,090.91

2 13000 =1/1.21 10,743.80

3 15000 =1/1.331 11,269.72

4 18000 =1/1.4641 12,294.24

TOTAL 56000  䦋㌌㏒㧀좈໱琰茞 ᓀ 43,398.68

㵂Ü

Effective Annual Rate – EAR

 EAR basically depend on Compounding

 More period of Compounding total interest
will be more

Effective Annual Rate – EA

Example:
 Bank A pays 15% interest on deposit, that is compounded monthly.

 Bank B pays 15% interest on deposit, which is compounded quarterly.

  Bank C pays 15% interest on deposit, which is compounded half yearly.

Formula to find EAR

Bank A (Monthly Compounding)

EAR = 1 + i/n n -1

Bank A = 1 + .15/12 12 - 1

=1.16075 – 1
= 16.075%

 Bank B (Quarterly Compounding)

Bank B = 1 + .15/4 4 - 1

=(1.0375) 4 – 1

= 1.15865 – 1

= 15.865%

Bank C (Half Yearly Compounding)

Bank C = (1 + .15/2) 2 - 1

= (1.075) 2 - 1

= 1.155625 – 1

= 15.5625%

Example:

A bank offers 12% compounded quarterly. If you place 1000 in an account today, how
much you have at the end of two years?
What is EAR (Effective Rate of Interest)?
Solution:
EAR =(1 + i/n)n - 1

EAR = (1 + .12/4)4 – 1= 12.55%

= (1.1255)2 X 1000 = 1266.75
OR
Quarterly interest is 12/4 = 3%
=(1.03)8 X 1000 = 1.2667 X 1000 =1266.77
BOND VALUATION
 • It’s a debt security
• Whenever Company needs Capital, different sources to raise Capital
 IPO’s of Shares in Primary Market
 Bank Loan
 Bond Debt Financing (Different from bank loan)
• Bonds have maturity date
• Normally Bonds are Long Term like 10 years, 20 years & 30 years

Main Characteristics:

 How much Interest will be paid?

 How many times?
 Maturity
Terminologies:

 Coupon Payments: stated annual interest amount

e.g. A Bond which pays Rs. 100 every year. So Coupon payment i.e. Rs. 100 per year.
 Coupon Rate:
Coupon Interest Rate = Interest / Investment
 Face value: Also Par value, shows the nomination value.
 Maturity Date: date on which Companies pay back the principal Investment.
 Discount Bond: A bond which is sold less than the face or par value is discount
bond. Also called Zero Coupon Or Zeros.
 Premium Bond: A bond which has a price over and above its face value or its par
value is Premium Bond.
 Yield to Maturity (YTM): Interest rate required in market on a bond.
Or
 A Market phenomenon, Interest rate on particular Investment
 Current yield: Annual coupon payment(s) divided by bond price.

Corporate finance lecture No. 05

Present Value of Bond Depends

• Time to Maturity
• Yield to Maturity or Market Interest Rate
• Face Value
• Coupon Payment or Coupon Interest
There are Two segments when we are working to find out the Present Value of Bond

 Coupon Payments

 Principle Repayments
EXAMPLE

 A Bond is issued for 10 years with a coupon payments of Rs.80 per year. Market
rate is 8% for similar risk. Face value is Rs. 1000/- What should be the selling price
of the bond?
Solution:

There are two components need valuation:

1 – Annuity: Rs. 80/yr for 10 years

2 – Principal repayment after 10 years

PV Of Annuity = 80 x [(1-1/(1.08)10/0.08]
= 80 x 6.7101
= 536.81 or 537

PV of Principal = 1000/(1.08)10
= 463.19

Adding both components (Selling Price)

= 1000

The reason was the YTM of Market Interest Rate of

this type of Bond and Coupon Payment Rate is the
same which is 8%.
HOW TO VALUE A BOND:
AFTER ONE YEAR

 Time to maturity = 9 years

 YTM: Risen to 10%
 Other terms & conditions unchanged
PV of Principal = 1000/(1.10)9
 = 424.10

PV of Annuity = 80 x (1 – 1/(1.10)9
= 460.72

Adding both components

PV of Bond = 885.00
(rounded off to nearest rupee)
Why 885?

Market rate of YTM move up to 10% or 100 per year.

Current coupon payment is 80 per year.
Investor would be getting 20 per year less for the rest of nine years.
Fitting 20 per year in formula returns:

= 20 x ((1 – 1/(1.10)9 /0.1)

= 115.xx

This is the amount of discount the investor will get at maturity.

Let’s see another variation

 Time to Maturity = 9 years

 YTM: Drops to 6%
 Coupon Rate is 8%
 Other terms unchanged
 What is the value of Bond?
Present Value= 1000/(1.06)9
= 591.89

PV Of Annuity = 80 x(1-1/(1.06)9/0.06
= 544.14
Adding both components
PV of bond =1136.

136 over & above the face value.

136 is basically is premium, which is demanded in market on face value.
Again, why 136?

 This can be found:

=(80-60) x [(1-1(1.06)9/0.06]
= 136
Summary:
  YTM & Coupon Rate were same
 Result PV of Bond was exactly equal to the FV
 YTM greater than Coupon Rate
 Results PV of the Bond less than the FV
 YTM lower than Coupon Rate
 Result PV of the Bond was greater than FV
CONCLUSION:

 A Bond will be sold on a discount when YTM is greater than coupon rate.

 A bond will be sold on premium when YTM is lower than the coupon rate.

 Current Yield Vs YTM

 For a bond selling above the face value is said to sell at premium. It means
investor who buys it at a premium face a capital loss over the life of bond. So
return on bond will be less than the current yield.
 For a bond selling below the face value is said to sell at discount. This means
capital gain at maturity. The return on this bond is greater than its current yield.

 EFFECTIVE YIELD

A bond pays semi-annual interest payments i.e., twice a year. Face value is Rs.1000/- and
coupon rate is 12%. This means two six-monthly payments of Rs. 60/- each. Bond matures in 7
years and yield to maturity is 14%. What is the effective annual yield on this bond?
1-PV = 1000/(1.07)14
= 1000 / 2.5785
= 387.82

2- PV of annuity =
= 60 x (1 – 1/(1.07)14/0.07
= 60 x 8.745395
= 524.72

Total PV of bond = 387.82+524.72

= 912.55
Effective Yield = (1 + .07)2
= 14.49%

NOMINAL & REAL INTEREST RATE

 Interest Rate:
  Inflation adverse effects on valuation
 Inflation persistent increase in general price level
 Real Interest rate:
 Nominal Interest Rate adjusted for inflation becomes Real Interest Rate
Relationship between Nominal and Real Interest Rates is known as Fisher Effect

Example – Fisher Effect

 Today you can buy one unit of a product at Rs. 5/-. It means you can buy 20 units
in Rs. 100/-. Inflation rate is 5%. And nominal interest rate is 15.5%. What is real
rate of return?
 Solution:

 Your buying power at the end of one year is:

 100 + 5 =105/20 = 5.25
 Your investment of Rs 100 after one year is:
 100 x (1.1550) = 115.50
 Then:
 115.50/5.25= 22
Real increase:
A year ago you could buy 20 units and now you can buy
22 units – increase of 10% (22-20)/20.
Solution with Formula

Fisher’s Formula
1 + R = (1+r) x (1+h)

Where:
R= Nominal interest rate
r = real interest rate
h = inflation rate

Putting Values
 Solution with formula:

1 + R= (1+r) x (1+h)
1 + 0.1550 = (1+r) x (1+0.05)

(1 + r) = 1.1550/1.05 = 1.10
r = .10 or 10%
Example – Fisher Effect

You need to invest an amount today to produce Rs. 100/- after a year. Nominal interest rate is
10% and inflation rate is 7%. What is the “exact” real interest rate?

Solution:
 PV of Rs. 100= 100/(1.10)
=90.91
If inflation rate is 7%, real value of Rs. 100 is therefore
= 100 / 1.07
= 93.46
Real Interest Rate =1 + Nominal/1+Inflation
= 1.10 / 1.07
= 1.028 or 2.80%
 If we discount real value of our Rs. 100 investment (93.46) by 2.8%, we get

PV = 93.46/1.028
= 90.91
 Point to Remember

 Current Cash Flow must be discounted by NOMINAL INTEREST RATE

 Real Cash Flow must be discounted by

REAL INTEREST RATE
Corporate finance lecture No. 06

TERM STRUCTURE OF INTEREST RATES

Interest Rates in Short & Long terms are different.

Relationship between LT & ST Rates is known as Term Structure of Interest.

Term Structure tells us Nominal Interest Rate on default free securities.

When:
LT > ST
Term Structure will be upward sloping

When:
ST > LT
Term Structure will be downward sloping

FACTORS OF TERM STRUCTURE

Real Interest Rate

Inflation Rate

Interest Rate Risk

REAL INTEREST RATE

Real Interest Rate is basic component of Term Structure.
When Real Interest Rate is high, all Interest Rates are high.
Real Interest Rate remains constant regardless of maturity.
Real Interest Rates do not influence the shape of Term Structure of Interest.
INFLATION RATE
Inflation Rate reduces the Time Value or Value of Money.
If Interest Rate is high, Nominal Interest will increase.
Due to Inflation, Investors demand compensation of the lost value. This is known as
Inflation Premium.
Inflation Rate strongly influences the Term Structure of Interest.
INTEREST RATE RISK

The fluctuation in Interest Rate also influences the Term Structure significantly.

Any slight fluctuation in Interest Rate can have a huge change in PV value due to
compounding effect.

Investors demand extra Risk Premium for change in Interest Rate. This is known as Interest
Rate Risk.

Yield Curve – Coupon Based Bonds

Three Factors Influence Yield Curve Structure
Default Risk Premium:
Coupon Base Bond is a promise with a risk that company may fail to pay interest.
Taxability Premium:
Dividend bears Tax
Returns are reduced by Taxes
Investor need this Premium
Liquidity Premium:
If bond is more liquid, expected rate of return is low. For less liquid bonds,
compensation is required as Liquidity Premium
TERM STRUCTURE YIELD CURVE
Main Points:
Interest Rate Risk
Inflation Premium
Real Interest Rate
Default Risk Premium
Taxability Premium
Liquidity Premium
COMMON STOCK VALUATION

Features:

No promised Cash Flow for Dividend

No redemption or No Date of Maturity
Problems in Determining Rate of Return
Expected Returns:

Total Return = Dividends + Capital Gains

= D1 + (P1 – P0) / P0

Where:
D1 = Dividend after 1 Year
P1 = Price of Stock after Year 1
P0 = Price of Stock Period 0 or Current Price
Expected Returns:

Total Return = Dividends + Capital Gains

= D1 + (P1 – P0) / P0

Where:
D1 = Dividend after 1 Year
P1 = Price of Stock after Year 1
P0 = Price of Stock Period 0 or Current Price
For Example:
P0 = Rs. 20/-
Dividend1 = Rs. 2 per share
P1 = Rs. 23/-

Then expected return is:

= 2 + (23 – 20) / 20
=5 / 20
= 25%
Putting it the other way:
We are trying to calculate the price today if the expected rate of return is 25%:

Price Today = D1 + P1 / 1 + r
 = 2 + 23 / 1.25
= 25 / 1.25
= 20
Putting it the other way:
We are trying to calculate the price today if the expected rate of return is 25%:

Price Today = D1 + P1 / 1 + r

= 2 + 23 / 1.25
= 25 / 1.25
= 20
If:
Today Price > Rs. 20

Then the expected return should have been lower than

other shares of equivalent risk. If demand will lower, people
dispose off this share. It forces the price to settle on Rs. 20.

If:
Today Price < Rs. 20

Then the expected return should have been higher than

other shares of same risk. Everyone will rush to buy it, thus
forcing price to settle on Rs. 20.
CONCLUSION

At each point in time of all shares of same

risk are priced to offer the same expected
rate of return.
DIVIDEND DISCOUNT MODEL

It is not an easy job to predict or forecast Future Stock Price.

Dividend Discount Model states that today’s Price is equal to the Present Value of all future
Dividends
After One year:
P0 = Div + P1 / (1 + r)
After 2 years the value of stock is:
=Div1/(1+r) + Div2+P2/(1+r)2
After 3 years the value of stock is:
=Div1/(1+r) + Div2/(1+r)2 + Div3 + P3/(1+r)3

When the time horizon is infinitely far, then we do

not consider the final price as it has no Present
Value today.
Present Value of Common Stock relay on streams
of future Dividend.
DIVIDEND GROWTH MODELS

Assumptions:
Assume NO GROWTH by the Company.

Company pays out all as Dividend what it earns every year.

It means that NOTHING is reinvested in business.

It means that Investors may forecast that future Dividends will not increase.
Dividends over the years are at the same level – PERPETUITY
DIVIDEND GROWTH MODELS
NO GROWTH MODEL

If the value of stock is the PV of all future Dividend then:

PV = DIV / r

When company pays out everything as Dividend then earnings and Dividend will be equal
and PV can be calculated as:

PV = EPS / r
CONSTANT GROWHT MODEL

Assume that Dividends will grow at a Constant Growth

Rate. For example, 5% per year.
It means that Dividend of Rs. 2 per share at 5%
Constant Growth Rate will be:
First year:
Div1 = 2
Second year:
Div2 = 2 x 1.05 = 2.10
Third year:
Div3 = 2 x (1.05)2 = 2.205
By fitting these values into formula we get:

= D1/1+r + D1(1+g)/(1+r)2+ D1(1+g)2/(1+r)3 ….

= 2 /1.12 + 2.10/(1.12)2 + 2.205/(1.12)3

=1.79 + 1.67 + 1.57 + ….

Although the number of terms is infinite, the PV of Dividend is proportionately smaller than
the preceding term and this will continue as long as Growth Rate is less than the Discount
Rate.
 Because the far Distant Dividends will be close to Zero, the sum of all of these terms is finite
despite of the fact that an infinite number of Dividends will be paid out.

Corporate finance lecture No. 07

DIVIDEND DISCOUNT MODEL CONSTANT GROWTH
So we can write equation as:

P0 = D1 x (1+g) / (r – g)

This is known as Constant-Growth Dividend Discount Model Or Gordon Growth Model.

1. First calculate growth rate

2. Than calculate price P0
3. Note that next dividend D1 has been used for valuation

Example:

The next dividend of a company will be Rs 4 per share. Investors demand 16 percent return on
share having same risk level as of this company. The dividend growth is 6% per year.
Calculate the value of this Company’s stock today and in four years using Dividend Growth
Model.
Solution:
 Next Dividend has already been given:
P0 = D1 / (r - g)
P0 = 4 /( .16 - .06)
P0 = 40
Price in 4 years: D4 = 4 x (1.06)3 = 4.764
Formula: P4 = D4 x (1+g) / (r – g)
P4 = 4.764 x (1 + .06) / (0.16 - 0.06) = 50.50
Non-Constant Growth

Example:
Dividends for first, second and third year are expected in the amount of Rs. 1, 2 and 2.50
respectively and after that dividends will grow at a constant rate of 5 % per year. Required rate is
10%.
Calculate the value of stock after 3 years & today.

Solution:
P3 = D3 x (1+g) / (r - g) = 2.50 X 1.05 / (0.10 – 0.05) P3 = Rs. 52.50
Today’s Price:

= d1/(1 + r) + d2 /(1+r)2 + d3/(1+r)3 + P3/ (1+r)3

= 1/1.10 + 2/(1.10)2 + 2.50/(1.10)3+52.50/(1.10)3

Value of Stock today = Rs. 43.88

GROWTH & INCOME STOCKS/SHARES

Investors trade stocks or share for two reasons:

 Capital Gains or Growth Stock

 Dividends or Income Stock

GROWTH & INCOME STOCKS/SHARES

1) Retention Policy:
Retention of profit and then plowback or re-invest in the business.

2) Payout Ratio:
Percent age of profit at which Dividend is declared by the business.
Example:

Dividend1 = Rs. 3.50 per share

r = 12%
g = 7%
EPS = Rs. 5 per share
Payout Ratio = 70%
Retention Ratio= 30%
Company requires 20% Return on Plowback.
If Payout is 100% or no Retention, and it means no growth:
g=0
then P0: P0 = DIV / r – g
= 5 / .12 - 0 = 41.67
Mean that:
EPS = div
Therefore we used:
div = 5
no growth = 0
If retention of 30% applied, and expected return is 12% (existing), then P0:

P0 = 3.50 / .12 - .036 = 41.67

0.036 or 3.60% is calculated as:
= 0.30 x 12% = 3.60

If retention of 30% applied, and expected return is 20% on retention, then P0 :

P0 = 3.50 / .12 - .06
= 58.33
CONCLUSION

Plowing back earnings does not add value to current stock price, if that
reinvestment is not expected to earn higher returns than expected by investors.

Plowing earnings back will only push the current prices of the stock up if
greater returns are expected by the investors.
Example:
Div1 = Rs. 1
Div2 = 1.20
Div3 = 1.44 after that it grows 5% per year
EPS3= 3.78
r = 10%
P/E ratio = 8 for shares of same risk level

Price of stock after 3 years and today?

Price today:
P0 = PV(div1-3) + PV(P3)
PV(div1-3) = 1/1.10 + 1.2/(1.10)2+1.44/(1.10)3
= 2.98
PV of P3 = P/E x EPS
= 8 x 3.78
= 30.24
= 30.24/(1.10)3
= 22.72
Putting value of PV(div1-3) & PV of P3 in the main formula:
= 2.98 + 22.72
 P0 = 25.70
We can calculate P3 with Dividend Model:
P3 = div4 / (r – g)

Div4 = div3 x (1+g)

= 1.44 x 1.05 = 1.512
Putting value of Div4 in formula:
P3 = 1.512 / (0.12 - .05)
= 30.24
OTHER TOOLS OF STOCK EVALUATION

TECHNICAL ANALYSIS:

Technical analysis studies supply and demand in a market in a attempt to

determine what direction or trend will continue in future

Study of Market Sentiments

TECHNICAL ANALYSIS

Evaluating security by analyzing the statistics generated by market activity such

as Past Prices and Volume

Charts and other tools are used to identify patterns that suggest future activity
TRENDS

A trend shows the general direction in which a security or market is headed

Types:
Up-Trends
Down Trends
Horizontal Trends
TRENDS LENGTH
Short Term
Medium Term
Long Term

Support & Resistance

Support is the lower ceiling price of a stock

Resistance is the upper ceiling of stock
CHART

A series of prices over a time period presented graphically

Time scale: intraday, daily, weekly, monthly & yearly
Price scale: change in price presented as absolute terms. Change shown in % is known
as Logarithmic Scale
CHART PATTERN

A distinct formation of point on chart that create trading signals or a sign of

future movement
Head & Shoulder: reversal pattern when formed, and signals that the security is
likely to move against the previous trend
Cups & handle: continuation of bullish pattern
CONCLUSION

Technical Analysis method of evaluating stocks by analyzing statistics generated

by market activity.
Technical traders take a short term approach to analyzing chart.
Product of Technical Analysis is a trend.

Corporate finance lecture No. 08

COMMON STOCK VALUATION

FUNDAMENTAL ANALYSIS:

Analyst is trying to reach near the intrinsic value of company’s share by reading and
analyzing the financial, non-financial information and industry comparison.
Three step process:
Economic indicators: GDP, Interest Rates, Inflation, Exchange Rate
Industry Comparison and Competition
Individual Company Analysis
Financials
CEO Report
Audited Accounts
Auditors Report
CAPITAL BUDGETING
Definition:
It is a process in which we can evaluate the investment opportunities in order to
acquire some capital asset.
Types:
New Project
Expansion Project
Modernization / Replacement
Other / social responsibility – Pollution control etc
Research & Development
 Exploration

Capital Budgeting Process

CB decisions are irreversible in nature

SWOT Analysis :
S – Strength
W – Weakness
O – Opportunities
T – Threats
CB targeted towards potential opportunities
Investment Opportunitie(s) is/are identified
Different alternatives are considered
Every alternative is evaluated
The best option (s) is/are undertaken
PROJECT EVALUATION
Relevant Costs:
Incremental costs and benefits are relevant
Cost incidental to the undertaking of a project
Non-Relevant Costs:
Sunk Cost:
Which has been incurred in the past
Committed Cost:
Future cost
Opportunity Cost:
Existing benefit surrendered in favor of next best alternative
Opportunity Cost is also a relevant cost
Profit Vs Cash Flow
NET PRESENT VALUE
NPV = Discounted Benefits – Initial Investment

Example:
An investment in an asset of Rs. 40,000 today returns 10000 after first year,
13000, 14000 & 15000 after 2nd to 4th year respectively.
If the prevailing interest is 6% what is the net present value of cash flow?
EVALUATING TECHNIQUES
NET PRESENT VALUE / DCF

INTERNAL RATE OF RETURN – IRR

PAYBACK PERIOD

DISCOUNTED PAYBACK PERIOD

ACCOUNTING RATE OF RETURN –ARR

 PROFITABILITY INDEX
NET PRESENT VALUE
YEAR CASH FLOW FVIF PV
@ 6% = 1/(1.06)t
0 -40,000 = 1.0000 -40,000.00
1 10,000 =1/1.060 9,433.96
2 13,000 =1/1.124 11,565.84
3 14,000 =1/1.191 11,754.82
4 15,000 =1/1.262 11,885.89
TOTAL NPV 䦋㌌㏒㧀좈໱琰茞 ᓀ 4,640.52
㵂Ü
NET PRESENT VALUE
& other issues:
Initial Investment & Working Capital
Salvage / Residual Value
Incidental Cost
Opportunity Cost
Relevant Vs Non-relevant
Tax
Depreciation
Inflation
Discount Rate
WACC (Weight age Average Cost of Capital)

Corporate finance lecture No. 09

Weighted Average Cost of Capital:
EXAMPLE:
CAPITAL STRUCTURE OF A COMPANY CONSIST OF:
LONG TERM LOANS 157,500 @ 12%
SHORT TERM LOANS 67,500 @ 08%
EQUITY 225,000
NEXT DIVIDEND / SHARE Rs. 3/ SHARE
CURRENT SHARE MARKET PRICE Rs 40/-
DIV GROWTH RATE 5%

CALCULATE WACC?
SOLUTION:

BEFORE CALCULATION WACC, WE NEED TO FIND OUT COST OF EQUITY.

DIV GROWHT MODEL EQUATION:

P0 = D1 / r – g
Or
r = D1/P0 + g
r = 3 / 40 + 0.05
= 0.125 or 12.50%
Weighted Average Cost of Capital 
Total Capital= 450,000

Weighted Average Cost of Capital  

PARTICULAR Interes Weigh Weighte
S t t d
Rs. Rate Int. Rate
LONG TERM 157,50
LOANS 0 12.00% 0.35 0.0420
SHORT TERM
LOANS 67,500 8.00% 0.15 0.0120
225,00
EQUITY 0 12.50% 0.50 0.0625
450,00 11.65
0 0.1165 %
Example: With Opportunity Cost

M/s Dark Cloud Ltd., is considering an investment opportunity to manufacture a new product
“Silver-Lining” which would involve use of both new and existing plant.

Example: With Opportunity Cost

The new plant having 5 years useful economic life will cost Rs. 1,450,000/-. The existing
machine was acquired two years ago at a cost of Rs. 1,000,000/-. This machine has ample
surplus capacity or is under-utilized at present. The new product annual sales are estimated to
5000 units per year and the selling price would be Rs. 320/- per unit.

The unit cost will be as under:

Direct Materials Rs. 70

Direct Labor (4 hrs x Rs.20/hr) Rs. 80
Fixed Costs including depreciation Rs. 90

The new plant life is 5 years and after that it could be sold for Rs. 145,000/-.
The skilled labor required for the manufacturing of silver-lining is in short supply and labor
resources would have to be switched over to this project. The labor is earning contribution
margin of Rs. 15.00 per hour.

Working capital of Rs. 150,000 will be required in first year and shall be recovered at the end
of project life. The company’s cost of capital is 20%. Assess whether project is financially
viable?

Solution: Opportunity Cost

Initial Working Net

Year Investment Capital Benefit CM
Unit Price 320
DM 70 0 (1,450,000.00) (150,000.00) (1,600,000.0
DL 80 1 550,000.00
4Hrs x Rs.20 2 550,000.00
Fixed Cost 90 3 550,000.00
240 4 550,000.00
5 145,000.00 150,000.00 550,000.00
CM Foregone/Per Hr 15

Contribution Margin Earned - New Product 170.00

Additional Units to be produced 5,000.00

Total CM - New Product

CM surrendered

Labor hour required for New Product 20,000.00

CM lost / Hr 15.00

Total CM lost

Net CM - Benefit

CAPITAL BUDGETING
Initial Working Net Disco
Year Investment Capital Benefit CM Facto
0 (1,450,000.00) (150,000.00) (1,600,000.00) 1.00
1 550,000.00 0.83
2 550,000.00 0.69
3 550,000.00 0.58
4 550,000.00 0.48
5 145,000.00 150,000.00 550,000.00 0.40

Example
M/s Hi-Mountain Ltd., - specialized chemical manufacturer are looking an untapped
investment opportunity. This involves manufacturing of a new chemical to be used in
textile industry. For this, the company must add a piece of plant with estimated life of
5 years, costing Rs. 2 million.
Other acquisition cost would be Rs. 50,000/- at the end of first year. A
consultant would be hired for technical aspect of the project at a cost of Rs.
50,000/-.
However, if the project does not turn out financially feasible, his contract would be
cancelled by paying him Rs. 15,000/-.

Working capital requirement would be Rs. 300,000/- in first year and rising to
Rs. 400,000/- in second year.
All the working capital would be recovered at the end of fifth year. Due to
technological obsolescence the plant will not be useable after fifth year and the
salvage value is estimated around Rs. 125,000/-.

Cash flow emerging from the additional sales would be Rs. 600,000 in first
and second years each, Rs. 550,000/- in third year, Rs. 700,000/- in forth and
Rs. 750,000/- in last year.
The company shall depreciate the asset on straight line over its useful life. Tax rate is
20%.
Company requires 10% rate of return on such projects.

EVALUATE THE PROJECT IS WORTH UNDERTAKING?

SOLUTION:
CAPITAL BUDGETING
Benefit
Year Initial Cost
Capital W. Capital Consultant Others
0 (2,000,000.00) (300,000.00) -
1 (100,000.00) (35,000.00) (50,000.00) 600,000
2 600,000
3 550,000
4 700,000
5 125,000.00 400,000.00 750,000

Revenue
Revenue & Capital
Net benefit Benefit Total df @
Depreciation Tax purposes Tax 20% after Tax Benefit 10%
- - - -  (2,300,000.00) 1.0000
(375,000.00) 225,000.00 45,000.00 555,000.00 455,000.00 0.9091
(375,000.00) 225,000.00 45,000.00 555,000.00 555,000.00 0.8264
(375,000.00) 175,000.00 35,000.00 515,000.00 515,000.00 0.7513
(375,000.00) 325,000.00 65,000.00 635,000.00 635,000.00 0.6830
(375,000.00) 375,000.00 75,000.00 675,000.00 1,200,000.00 0.6209
NPV
Assumptions
Taxes are paid in the same year of benefit occurring.
Consultant and Other costs are supposed to occur at the end of first year.
Inflation assumed 0% .

Corporate finance lecture No. 06

CAPITAL BUDGETING
Relevant Costs:
Incremental costs and benefits are relevant
Cost incidental to the undertaking of a project
Non-Relevant Costs:
Sunk Cost:
Which has been incurred in the past
Committed Cost:
Future cost
Opportunity Cost:
Existing benefit surrendered in favor of next best alternative
Opportunity Cost is also a relevant cost
Relevant Costs:
 Incremental costs and benefits are relevant
Cost incidental to the undertaking of a project
Non-Relevant Costs:
Sunk Cost:
Which has been incurred in the past
Committed Cost:
Future cost
Opportunity Cost:
Existing benefit surrendered in favor of next best alternative
Opportunity Cost is also a relevant cost
NET PRESENT VALUE
Decision Rule:
Accept the Project with Positive NPV

In case of more than one project

The Project with Higher NPV can be under taken

INTERNAL RATE OF RETURN

Rate of Return that is used to calculate the EXACT DCF Rate of Return which the project is
expected to achieve. A rate at which NPV is zero.

If the IRR of a project is lower than the target return, the project is deemed unfeasible.

If the IRR of a project is greater than the target return, the project is deemed feasible.

Example – IRR

Without computer program IRR is found by method called interpolation

Calculate NPV using a whole number
If positive, calculate second NPV using a higher discount rate that, preferably returns
the NPV in negative
Then plug in these values in to formula
Formula to Learn:

IRR = a + [{A/(A-B)} x (b-a)}%

Where:
a = Lower discount rate used to calculate NPV
b = Higher discount rate used to calculate NPV
A = NPV obtained with discount rate a (lower)
B = NPV obtained with discount rate b (higher)
A company intends to buy a new piece of equipment which will save Rs. 20,000 per year for
five years and this will cost Rs. 80,000/- and has an estimated residual value of Rs. 10,000/-
after 5th year.

The company only undertakes such project if IRR is above 10%. Find out the project
viability.

SOLUTION: INTERNAL RATE OF RETURN – IRR

Step I
INTERNAL RATE OF RETURN – IRR
Step I: Let's use 9% Discount Factor
Ye Cash PV of
ar Flow DF 9% CF
(80,000. (80,000.
0 00) 1.00 00)
20,000.0 77,800.0
1-5 0 3.89 0
10,000.0
5 0 0.65 6,499.00

N
P
V 4,299.00
Step II
Since NPV is positive at 9%, we need other NPV preferably in negative.
This means that higher discount rate can return negative.
Let's try 12% (Guess 100%)
INTERNAL RATE OF RETURN – IRR
Step II: Let's use 12% discount factor
Ye Cash PV of
ar Flow DF 12% CF
(80,000. (80,000.
0 00) 1.00 00)
20,000.0 72,100.0
1-5 0 3.61 0
10,000.0
5 0 0.57 5,670.00

N
P (2,230.0
V 0)
Step III: Calculate IRR
 IRR = a + [{A/(A-B)} x (b-a)]%

IRR = 9 + [{4299/(4299+2230)} x (12-9)]%

IRR = 10.975 % Or 11%

NPV vs IRR
NPV is comparatively complex as compared to IRR
IRR is more easily understandable
IRR dependable on NPV
Managers may confuse IRR with ROCE (Return On Capital Employed) & other Accounting
Measures
IRR ignores the relative size of investment
䦋㌌ ㏒ 㧀좈໱琰茞 Proje Proje
ᓀ㵂Ü ct A ct B

Initial Investment 350,0 35,00

00 0

Annual Saving 100,0 10,00

00 0

IRR of both Projects is 18%.

When discount rate varies over the life of a project, it becomes difficult to
incorporate such change if using IRR, however, NPV is flexible over this
issue.

NPV is technically superior than IRR.

PAYBACK PERIOD
TIME REQUIRED FOR CUMULATIVE EXPECTED CASH FLOWS FROM AN
INVESTMENT OPPORTUNITY TO EQUAL INITIAL UP-FRONT CASH FLOW.

Example:
A company is considering to undertake an investment opportunity from one of the
following options:
Option A: Initial investment is Rs. 103,000/- and cash flow from the opportunity will
be Rs. 45,000, Rs. 40,000, Rs. 36,000, Rs.20,000 and Rs. 10,000 for year one to five.
Option B: Initial investment of Rs. 103,000/- will generate cash flow of Rs. 15,000/-,
25,000/-, 35,000/-, 54,000/- & 60,000/- from year one to five.
 SOLUTION: PAYBACK PERIOD
Option A

Years Cash Flow Cum. CF Pay Back Months Years

0 (103,000.00)

1 45,000.00 45,000.00 12 1

2 40,000.00 85,000.00 24 2
3 36,000.00  121,000.00  3,000.00  6 2.5
4 20,000.00 141,000.00

5 10,000.00 151,000.00
SOLUTION: PAYBACK PERIOD
Option B

Cash Cum.
Flow CF Pay Back Months Years
(103,000. 䦋㌌㏒㧀좈໱琰茞 䦋㌌㏒㧀좈໱琰茞 䦋㌌㏒㧀좈໱琰茞
00) ᓀ㵂Ü ᓀ㵂Ü ᓀ㵂Ü
15,000.0 䦋㌌㏒㧀좈໱琰茞
15,000.00 0 ᓀ㵂Ü 12 1
40,000.0 䦋㌌㏒㧀좈໱琰茞
25,000.00 0 ᓀ㵂Ü 24 2
75,000.0 䦋㌌㏒㧀좈໱琰茞
35,000.00  0  ᓀ㵂Ü 36 3
129,000.
54,000.00 00 4,500.00  6.22 3.60
189,000. 䦋㌌㏒㧀좈໱琰茞 䦋㌌㏒㧀좈໱琰茞 䦋㌌㏒㧀좈໱琰茞
60,000.00 00 ᓀ㵂Ü ᓀ㵂Ü ᓀ㵂Ü
Decision Rule
If the company has policy to accept the project having less than three years of P.B period
then the company would go for project A or option A

If the company has policy to undertake a project, having P.B period of less than four years,
both project fall in green zone. Then to decide what project should undertake
Option A: 30 months recovering initial Investment

Option B: 42 months recovering Initial Investment

Option A is preferable
Payback
 Very simple and easy to understand
Ignores time value of money
Ignores size of Investment (Project)
Ignores cash flows after payback.
Can be used as rough or crude measure of appraisal
Can be used for project filtration in case of more than one project.

Corporate finance lecture No. 11

DISCOUNTED PAYBACK METHOD

The only difference between simple and discounted Pay Back is discounting.
Cash Flows expected over period of time are discounted using a Discount Rate.
Interestingly, if a project Pays Back on a discounted basis, then it must have a
positive NPV.
Example:
A company is considering to undertake an investment opportunity from one of the
following options;
Option A: Initial investment is Rs. 103,000/- and cash flow from the opportunity will
be Rs. 45,000, Rs. 40,000, Rs. 36,000, Rs.20,000 and Rs. 10,000 for year one to five.
Option B: Initial investment of Rs. 103,000/- will generate cash flow of Rs. 15,000/-,
25,000/-, 35,000/-, 54,000/- & 60,000/- from year one to five.
SOLUTION: DISCOUNTED PAYBACK PERIOD
Option A
PV of
Years Cash Flow Cum. CF DF 10% CF Pay Back Month Year
䦋㌌㏒㧀 䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀
좈 ໱ 琰 茞 ᓀ (103,0 좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ
0 (103,000) 㵂Ü 00.00) 㵂 Ü 㵂Ü 㵂Ü
䦋㌌㏒㧀
40,905 좈 ໱ 琰 茞 ᓀ
1 45,000 45,000 0.9090 .00 㵂Ü 12 1
䦋㌌㏒㧀
33,056 좈 ໱ 琰 茞 ᓀ
2 40,000 85,000 0.8264 .00 㵂Ü 12 2
27,046
3 36,000 121,000  0.7513 .80 12 3
 䦋㌌㏒㧀
13,660 좈໱琰茞 ᓀ
4 20,000 141,000 0.6830 .00 1,666.67 1.20 㵂Ü
䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀
6,209. 좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ
5 10,000 151,000 0.6209 00 㵂Ü 㵂Ü 㵂Ü
䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀 䦋㌌㏒㧀 䦋㌌㏒㧀
좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ 좈 ໱ 琰 茞 ᓀ 17,876 좈 ໱ 琰 茞 ᓀ 좈໱琰茞 ᓀ
㵂Ü 㵂Ü 㵂Ü 㵂Ü .80 㵂Ü 37.20 㵂Ü
SOLUTION: DISCOUNTED PAYBACK PERIOD
Option B

Years Cash Flow Cum. CF DF 10% PV of CF Pay Back Month Year

䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀
좈໱琰茞 ᓀ 좈໱琰茞 ᓀ 좈໱琰茞 ᓀ 좈໱琰茞 ᓀ
0 (103,000) 1 㵂Ü 㵂Ü 㵂Ü 㵂Ü
䦋㌌㏒㧀
좈໱琰茞 ᓀ
1 15,000 15,000 0.91 13,635.00 㵂 Ü 12 1
䦋㌌㏒㧀
좈໱琰茞 ᓀ
2 25,000 40,000 0.83 20,660.00 㵂 Ü 12 2
3 35,000 75,000  0.75 26,295.50 12 3
䦋㌌㏒㧀
좈໱琰茞 ᓀ
4 54,000 129,000 0.68 36,882.00 㵂 Ü 12 4
䦋㌌㏒㧀
좈໱琰茞 ᓀ
5 60,000 189,000 0.62 37,254.00 5,000.00 1.11 㵂Ü
䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀䦋 ㌌ ㏒ 㧀 䦋㌌㏒㧀 䦋㌌㏒㧀
좈໱琰茞 ᓀ 좈໱琰茞 ᓀ 좈໱琰茞 ᓀ 좈໱琰茞 ᓀ 좈໱琰茞 ᓀ 좈໱琰茞 ᓀ
㵂Ü 㵂Ü 㵂Ü 㵂Ü 17,876.80 㵂Ü 49.1055 㵂Ü
ACCOUNTING RATE OF RETURN – ARR
ALSO AVERAGE ACCOUNTING RATE – AAR

ARR = Average Net Income/Average Investment

Some Issues relevant to ARR

Its Simple and needed information is readily available
Its ignores time value of money
Its based on book values
Its not a true appraisal method
Profitability Index
Profitability Index is a relationship between present value of all future cash flows and initial
investment.
Cost-Return Ratio or Benefit-Cost Ratio of an investment opportunity’s present value of
future cash flow to initial investment cost.

Formula:
PI = PV of Future Cash Flows Initial Investment
Decision Rule:
If PI is greater than 1, project land in green zone or can be undertaken otherwise it is not
viable.
Accept the project if PI is greater than 1, which means that NPV is positive.
Example: Capital Budgeting
NPV = Rs 137,997
Total PV of Cash Flow = 2.437 million
Initial Investment = 2.00 million

PI = PV of Future Cash Flows

Initial Investment
PI = 2.437/2.00
PI = 1.22
1.22 > 1
Acceptance Rule:
Benefit Cost Ratio > 1
Project is undertaken
Evaluation Method
NPV
IRR
Pay Back Period Method
Discounted Pay Back Period
Accounting Rate of Return (ARR)
Profitability Index
NPV states, if NPV is positive then project is under taken.
In case of more than one project, the project with higher NPV can be undertaken.
If the project has negative NPV, it does not add value to the company so rejected.
Internal Rate of Return
Decision Rule
If IRR is grater than targeted return the project is viable, we can undertake the project.
If project yield less than targeted rate of return then it is not accepted.
Decision Rule
If IRR is grater than targeted return the project is viable, we can undertake the project.
If project yield less than targeted rate of return then it is not accepted.
Pay Back Period Method
Acceptance Rule
If it return you the initial investment to cash flows then it is acceptable and if it is not reject
the project.
Profitability Index
Relationship between Cash Flows and initial Investment.
PI = PV of Future Cash Flows
 Initial Investment
Benefit cost ratio greater than 1 project land in green zone or can be undertaken otherwise it
is not viable.
Advance Evaluation
Advance tool of Project Evaluation

Sensitivity Analysis
Break Even Analysis
Degree of Operating Leverage

Advance Evaluation
Sensitivity Analysis:
Slight change in the factor brings magnified effects on the overall viability of a project, this
is known as critical or sensitive factor of project.
Like cash Flow, Cost Estimation, Taxes, Cost of Capital or Discounted Rate, Exchange Rate
etc.
Example:
Initial Investment Rs. 7.10 million
Variable Costs = Rs. 2.0 million per year
Inflows Rs. 6.50 million per year
Project life 2 years
Cost of capital 8%.

Conduct Sensitivity analysis of this project.

Solution: Sensitivity Analysis

Initial Variable Net
  Year investment cost  Inflows CF

  0 (7,100,000.00)      

  1   (2,000,000.00) 6,500,000.00 4,500,000.00

  2   (2,000,000.00) 6,500,000.00 4,500,000.00

DF PV of Initial PV of PV of
Year 8% investment Variable cost Inflows PV of Net CF

0 1 (7,100,000.00)     (7,100,000.00)

1 0.926   (1,852,000.00) 6,019,000.00 4,167,000.00

2 0.857   (1,714,000.00) 5,570,500.00 3,856,500.00

  1.783 (7,100,000.00) (3,566,000.00) 11,589,500.00 923,500.00
Sensitivity Analysis
Original
Change in: Note PV % Values %change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4   =1,077,596.27 53.88
Initial 923,50
Investment 5   0.00 (13.01)
Interest
rate 6     18.64
Sensitivity Analysis
Original
Change in: Note PV % Values %change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4   =1,077,596.27 53.88
Initial 923,50
Investment 5   0.00 (13.01)
Interest
rate 6     18.64
Sensitivity Analysis: Note 1 (First Year Inflow/Sales Change)
Yea Initial Variable Net
  r investment cost  Inflows CF
(7,100,0
  0 00.00)      
6,500,000.0
(2,000,0 0- 3,502,6
  1   00.00) 997,300.22 99.78
 =5,502,699.
78
(2,000,0 6,500,0 4,500,0
  2   00.00) 00.00 00.00
PV of PV of
Yea DF Initial Variable PV of PV of Net
r 8% investment cost Inflows CF
(7,100,0 (7,100,0
0 1 00.00)     00.00)
0.92 (1,852,0 5,095,5 3,243,5
1 6   00.00) 00.00 00.00
0.85 (1,714,0 5,570,5 3,856,5
2 7   00.00) 00.00 00.00
1.78 (7,100,0 (3,566,0 10,666,0
  3 00.00) 00.00) 00.00 Nil
Sensitivity Analysis
Original
Change in: Note PV % Values %change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4   =1,077,596.27 53.88
Initial 923,500
Investment 5   .00 (13.01)
Interest
rate 6     18.64
Sensitivity Analysis: Note 2 (2nd Year Inflow/Sales Change)
Yea Initial Variable Net
  r investment cost  Inflows CF
(7,100,0
  0 00.00)      
(2,000,0 6,500,000.0 4,500,000.0
  1   00.00) 0 0
6,500,000.0
0-
1,077,596.2
(2,000,0 7
  2   00.00) =5,422,403. 3,422,403.73
 73
PV of
Yea DF PV of Initial Variable PV of PV of Net
r 8% investment cost Inflows CF
(7,100,0 (7,100,0
0 1 00.00)     00.00)
0.92 (1,852,0 6,019,0 4,167,0
1 6   00.00) 00.00 00.00
0.85 (1,714,0 4,647,0 2,933,0
2 7   00.00) 00.00 00.00
1.78 (7,100,0 (3,566,0 10,666,0
  3 00.00) 00.00) 00.00 Nil
Sensitivity Analysis
Original
Change in: Note PV % Values %change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4   =1,077,596.27 53.88
Initial 923,500
Investment 5   .00 (13.01)
Interest
rate 6     18.64
Sensitivity Analysis: Note 3 (Change in Variable Cost- Year 1)

Yea Initial Variable Net

  r investment cost  Inflows CF
(7,100,0
  0 00.00)      
(2,000,000.00)+(997,300.
22) 6,500,0 3,502,6
  1   =(2,997,300.22) 00.00 99.78
6,500,0 4,500,0
  2   (2,000,000.00) 00.00 00.00
PV of
Yea DF Initial PV of PV of Net
r 8% investment PV of Variable cost Inflows CF
(7,100,0 (7,100,0
0 1 00.00)     00.00)
 0.92 6,019,0 3,243,5
1 6   (2,775,500.00) 00.00 00.00
0.85 5,570,5 3,856,5
2 7   (1,714,000.00) 00.00 00.00
1.78 (7,100,0 11,589,5
  3 00.00) (4,489,500.00) 00.00 Nil
Sensitivity Analysis
Original
Change in: Note PV % Values %change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4 -  =1,077,596.27 53.88
Initial 923,50
Investment 5 -  0.00 (13.01)
Interest
rate 6 -   18.64
Sensitivity Analysis: Note 4 (Change in Variable Cost- Year 2)
Initial
Ye investme Variable Net
  ar nt cost  Inflows CF
(7,100
  0 ,000.00)      
6,500,000 4,500,00
  1   (2,000,000.00) .00 0.00
(2,000,000.00)+(1,07
7,596.27) 6,500,00 3,422,403
  2   =(3,077,596.27) 0.00 .73
PV of
DF Initial
Ye 8 investme PV of PV of
ar % nt PV of Variable cost Inflows Net CF
(7,100 (7,100
0 1 ,000.00)     ,000.00)
0.9 6,01 4,16
1 26   (1,852,000.00) 9,000.00 7,000.00
0.8 5,57 2,93
2 57   (2,637,500.00) 0,500.00 3,000.00
  1.7 (7,100 (4,489,500.00) 11,58 Nil
 83 ,000.00) 9,500.00

Corporate finance lecture No. 12

 Sensitivity Analysis

 Example:
Initial Investment Rs. 7.10 million
Variable Costs = Rs. 2.0 million per year
Inflows Rs. 6.50 million per year
Project life 2 years
Cost of capital 8%.

Conduct Sensitivity analysis of this project.

Solution: Sensitivity Analysis

Yea Initial Variable Net
  r Investment Cost  Inflows CF
(7,100,0
  0 00.00)      
 (2,000,0 6,500,0 4,500,0
  1   00.00) 00.00 00.00
(2,000,0 6,500,0 4,500,0
  2   00.00) 00.00 00.00
PV of PV of
Yea DF Initial Variable PV of PV of Net
r 8% Investment Cost Inflows CF
(7,100,0 (7,100,0
0 1 00.00)     00.00)
0.92 (1,852,0 6,019,0 4,167,0
1 6   00.00) 00.00 00.00
0.85 (1,714,0 5,570,5 3,856,5
2 7   00.00) 00.00 00.00
1.78 (7,100,0 (3,566,0 11,589,5 923,5
  3 00.00) 00.00) 00.00 00.00
Sensitivity Analysis
Original
Change in: Note PV % Values %Change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4   =1,077,596.27 53.88
Initial 923,50
Investment 5   0.00 (13.01)
Interest
rate 6     18.64
Sensitivity Analysis: Note 05 (Changes in Initial Investment)
Yea Initial Variable Net
  r Investment Cost  Inflows CF
7,100,000+923
,500=
  0 (8,023,500.00)      
(2,000,0 6,500, 4,500,
  1   00.00) 000.00 000.00
(6,500,0 6,500,
  2   00.00) 000.00 -
PV of
Ye DF PV of Initial Variable PV of PV of Net
ar 8% Investment Cost Inflows CF
 (8,023,500.0 (8,023,5
0 1 0)     00.00)
0.9 (1,852,0 6,019, 4,167,
1 26   00.00) 000.00 000.00
0.8 (5,570,5 5,570, 3,856,
2 57   00.00) 500.00 500.00
1.7 (7,100,000.0 (7,422,5 11,589,
  83 0) 00.00) 500.00 0
Sensitivity Analysis
Original
Change in: Note PV % Values %Change
923,500/11
Sales - 1 ,589,500 923,500/0.926
year 1 =7.97 =997,300.22 15.34
Sales - 2 923,500/0.857
year 2 -  =1,077,596.27 16.58
Cost (VC)- 923,500/3,566,000 923,500/0.926
year 1 3 =25.90 =997,300.22 49.87
Cost (VC)- 923,500/0.857
year 2 4   =1,077,596.27 53.88
Initial 923,50
Investment 5   0.00 (13.01)
Interest
rate 6     18.64
Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)
Initial Variable Net
  Year Investment Cost  Inflows CF
(7,100,0
  0 00.00)      
(2,000,0 6,500, 4,500,0
  1   00.00) 000.00 00.00
(2,000,0 6,500, 4,500,0
  2   00.00) 000.00 00.00
PV of PV of
Yea DF Initial Variable PV of PV of Net
r 20% Investment Cost Inflows CF
(7,100,0 (7,100,0
0 1 00.00)     00.00)

0.833 (1,666,6 5,416, 3,749,850.0

1 3   00.00) 450.00 0
0.694 (1,388,8 4,513, 3,124,800.0
2 4   00.00) 600.00 0
 1.527 (7,100,0 (3,055,4 9,930,0 (225,
  7 00.00) 00.00) 50.00 350.00)
Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)
Initial Variable Net
  Year Investment Cost  Inflows CF
(7,100,0
  0 00.00)      
(2,000,0 6,500, 4,500,0
  1   00.00) 000.00 00.00
(2,000,0 6,500, 4,500,0
  2   00.00) 000.00 00.00
PV of PV of
Yea DF Initial Variable PV of PV of Net
r 20% Investment Cost Inflows CF
(7,100,0 (7,100,0
0 1 00.00)     00.00)

0.833 (1,666,6 5,416, 3,749,850.0

1 3   00.00) 450.00 0
0.694 (1,388,8 4,513, 3,124,800.0
2 4   00.00) 600.00 0
1.527 (7,100,0 (3,055,4 9,930,0 (225,
  7 00.00) 00.00) 50.00 350.00)
Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)
 1023 is present value of a amount that will add value to the company if project is
undertaken
 This is converted into future value - equivalent to first years' sale, that is 1023/0.926
 1023 is converted to future value by dividing it by discount factor or 0.857
 We calculate IRR
Solution: Sensitivity Analysis (Lets try a higher discount rate of 20%)
 1023 is present value of a amount that will add value to the company if project is
undertaken
 This is converted into future value - equivalent to first years' sale, that is 1023/0.926
 1023 is converted to future value by dividing it by discount factor or 0.857
 We calculate IRR
 IRR = a + [{A/(A-B)} x (b-a)}]%
 = 8 + [ {923,500/(1,148,850)} x 12} %
 = 8 + 9.65
 = 17.65%
 a= 8
 b= 20.00
 A = 923,500.00
 B= 225,350.00
 A+B = 1,148,850.00
Conclusion
 Most sensitive area is Cash Inflows.
 Less changes in cash inflow brings NPV down to Zero.
 Criticism – Sensitivity Analysis

 Change in the factors is considered in isolation, at one time effect of change in

one variable.
 Does not provide any decision rule.
 Probabilities are not considered in sensitive analysis.

 PROBABILITY ANALYSIS

 Expected cash flow can be estimated by recognizing several outcomes are

possible
 Always equal to one
 Define two extremes
 Risk can be calculated by considering worst case
 Attaching probability is subjective matter

Example: Probability analysis

Expected
Year Cash Flow Probability Value Period EV
(120,000.0 0.4 (48,000.0
0 0) 0 0)  
(140,000.0 0.5 (70,000.0
  0) 0 0)  
(160,000.0 0.1 (16,000.0 (134,000.0
  0) 0 0) 0)
50,000.0 0.3 17,500.0
1 0 5 0  
60,000.0 0.4 24,000.0
  0 0 0  
70,000.0 0.2 17,500.0 59,000.0
  0 5 0 0
60,000.0 0.3 18,000.0
2 0 0 0  
40,000.0 0.4 16,000.0
  0 0 0  
45,000.0 0.3 13,500.0 47,500.0
  0 0 0 0
56,000.0 0.4 25,200.0
3 0 5 0  
64,000.0 0.3 22,400.0
  0 5 0  
76,000.0 0.2 15,200.0 62,800.0
  0 0 0 0
BREAK EVEN
 Accounting Break Even
 Economic Break Even
 BE is a point at which the company earns no profit or no loss
 Total Cost = Total Sale or Revenue
 Fixed Cost remain constant
 Higher the FC, higher the Break Even point or higher the Output level
 The project must operate right to break even point
 This is an accounting measure
 TC = FV + VC
 TR > TC Profit
 TR < TC Loss

 TC = Total Cost
 FC = Fix Cost
 VC = Variable Cost
 TR = Total Revenue
Example: Accounting Break Even

Sale Price 15

Variable Cost / unit 8

Contribution Margin /unit 7

Initial Investment 100,000

OUTP
UT
LEVE TC=FC TR=Qty PROFI
L FC VC + TC x SP CM T
100,00 24,00 124,00 45,00 21,00 (79,000
3000 0.00 0.00 0.00 0.00 0.00 .00)
100,00 48,00 148,00 90,00 42,00 (58,000
6000 0.00 0.00 0.00 0.00 0.00 .00)
100,00 72,00 172,00 135,00 63,00 (37,000
9000 0.00 0.00 0.00 0.00 0.00 .00)
100,00 96,00 196,00 180,00 84,00 (16,000
12000 0.00 0.00 0.00 0.00 0.00 .00)
 100,00 120,00 220,00 225,00 105,00 5,000
15000 0.00 0.00 0.00 0.00 0.00 .00
100,00 144,00 244,00 270,00 126,00 26,000
18000 0.00 0.00 0.00 0.00 0.00 .00
100,00 168,00 268,00 315,00 147,00 47,000
21000 0.00 0.00 0.00 0.00 0.00 .00
BE in Units = FC/CM
  = 100,000/7
= 14,285.71 or 14,286 units
BE revenue = FC/CS ratio
Contribution margin over sale C/S ratio
= 7/15 = 0.47 or 47% of sale
BE revenue = FC/CS ratio
= 100,000/0.47
= 214,285.71 or 214,286    
 Targeted Profit
 We assume profit 250,000
 We need to produce:
Targeted output level = FC + Targeted Profit/CM
=100,000+ 250,000/7
= 50,000 units

Corporate finance lecture No. 13

BREAK EVEN
 Accounting Break Even
 Economic Break Even
Economic Break Even Vs Accounting Break Even
 Economic Break Even recovers cost of capital
 Accounting Break Even does not recover cost of capital.

 BE is a point at which the company earns no profit or no loss

 Total Cost = Total Sale or Revenue
 Fixed Cost remain constant
 Higher the FC, higher the Break Even point or higher the Output level
 The project must operate right to break even point
 This is an accounting measure
BREAK EVEN ANALYSIS
 TC = FV + VC
 TR = TC Break Even
 TR > TC Profit
 TR < TC Loss
 TC = Total Cost
 FC = Fix Cost
 VC = Variable Cost
 TR = Total Revenue
ECONOMIC BREAK EVEN

 Accounting break even does not cover cost of capital. It means that accounting
break even does not add value to the organization at break even point.
 That’s why companies often stress on value addition – to find a level where the
project breaks even after returning the cost of capital along with fixed cost.

Example: Economic break even

 Initial investment = Rs. 5.4 million

 Variable cost = 80% of sales
 Fixed cost = Rs. 2.00 million
 Project life = 12 years
 Cost of capital = 8%
 Tax rate = 40%
Solution: Break Even

Initial Investment 5,400,000.00

Variable Cost 80.00

Fixed Cost 2,000,000.00

Project life 12.00

Cost of Capital 0.08

Tax Rate 0.04

Solution: Accounting Break Even
Fixed Cost 2,000,000.00
Initial Investment 5,400,000.00
Depreciation 5,400,000/12 = 450,000.00
Fixed Cost with Dep.  2,450,000.00
CS Ratio 0.2 or 20% or sale
 䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü  䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü
Break Even 12,250,000.00 p.a.
Variable Cost 80% 9,800,000.00
Fixed Cost 2,000,000.00
Dep. 450,000.00
Profit -
Tax 40% -
 Fixed Cost = 2,450,000.00

 Contribution Margin over sale

 Variable Cost 80% of sale so
 CS Ratio = 0.20 or 20% of sale

Economic Break Even

Annual annuity of investment over
project life:  
= initial investment =716,560.51
 䦋㌌㏒㧀좈໱琰茞 ᓀ
8% factor -12 years 㵂Ü
Annual depreciation:  
= initial investment =450,000.00
 䦋㌌㏒㧀좈໱琰茞 ᓀ
Project life 㵂Ü
Depreciation reduces the Capital
Charge by  
 Cost of Capital  =266,560.51
Economic Profit is:  
 Accounting profit - 266,560.51 -
   
= (Sales x 0.20) -
Pre tax Profit FC(2.45)
= 0.40 x (Sales x 0.20)
Tax - FC(2.45)
 = 0.60 x (Sales x 0.20)
After tax (Accounting Profit) - FC(2.45)
Cost of Capital = 266,560.51
=0.60 x [(Sales x 0.20) -
Economic value added (2.45)] - 266,560.51
=0.60 x [(Sales x 0.20)
Economic value added - (2.45)] - 266,560.51
=0.60 x [(Sales x 0.20)
Solve for sales - (2.45)] = 266,560.51
=0.12 x Sales =
  1470000+266560.51
=0.12 x Sales =
  1736560.51
Sales =
  1736560.51/0.12
 䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü Sales = 14,471,337.58
Economic Break Even
Check

Sales 14,471,337.58
0.2 or 20% of Sale
CM Ratio =2,894,267.52

Fixed Cost 2,450,000.00

Pre Tax Profit 444,267.52

Less Tax 0.40 177,707.00

 䦋㌌㏒㧀좈໱琰茞 ᓀ
㵂Ü 266,560.51

Less Cost of Capital 266,560.51

Profit Nil
Operating Leverage

 Leverage:

How efficiently a company utilizes fixed cost in its production process

 Degree of operating leverage – DOL
 DOL= % Change in profit given a % change in sales
 Higher the FC, higher the DOL or
 High proportion of FC, a short fall in sales will lead to magnified effect on profits.
 OL = Degree to which costs are fixed
DOL: Example

  HIGH FIXED COST HIGH VARIABLE COST

< AVG AVG >AVG < AVG AVG >AVG
Below Norma Above Below Norma Above
  AVG l AVG AVG l AVG

12,000. 15,000. 18,000. 12,000. 15,000. 18,000.

SALES 00 00 00 00 00 00

8,400.0 10,500. 12,600. 10,200. 12,750. 15,300.

VC 0 00 00 00 00 00

3,000.0 3,000.0 3,000.0

FC 0 0 0 750.00 750.00 750.00

11,400. 13,500. 15,600. 10,950. 13,500. 16,050.

TC 00 00 00 00 00 00

PROFI 1,500.0 2,400.0 1,050.0 1,500.0 1,950.0

TS 600.00 0 0 0 0 0
DOL = 1+FC/Profit     DOL = 1+FC/Profit
= 1+ 3,000/1,500 = 1+ 750/1,500
DOL = 1.5
DOL = 3  
DOL: Example

Change in Sale 1% results change Change in Sale 1% results change

in Profit 3% in Profit 1.5%
CHANGE IN
SALES 10%      

SALES 16,500.00   16,500.00

VC 11,550.00   14,025.00

FC 3,000.00   750.00

PROFITS 1,950.00   1,725.00

% Change in
Profit 30   15.00
 
 IT MEANS THAT 10% INCREASE IN SALES RESULTS IN
30% INCREASE IN PROFIT
 

Change in Sale 1% results change Change in Sale 1% results change

in Profit 3% in Profit 1.5%
CHANGE IN
SALES 10%      

SALES 16,500.00   16,500.00

VC 11,550.00   14,025.00

FC 3,000.00   750.00

PROFITS 1,950.00   1,725.00

% Change in
Profit 30   15.00
 
 IT MEANS THAT 10% INCREASE IN SALES RESULTS IN
30% INCREASE IN PROFIT
 

TOTAL INVESTMENT 45,000.00

CONTRIBUTION MARGIN 2.70

Qty 20,000.00

Fixed Cost 45,000.00

TOTAL CONTRIBUTION MARGIN 54,000.00

PROFIT 9,000.00

DOL 6
 DOL = 1+FC/Profit
 = 1+ 45,000/9,000
 DOL = 6

 A change in sale of 1% will lead change in Profit of 6%.

IF QUANTITY IS INCREASED BY 5%  
   
Qty 21,000.00
TOTAL CM 56,700.00
PROFIT 11,700.00
CHANGE IN PROFIT 2,700.00
% CHANGE IN PROFIT 30
   
PUTTING THE OTHER WAY  
  30  
PROJECT RANKING & CAPITAL RATIONING
CAPITAL RATIONING
 When a firm has limited availability of Investment Funds or the Investment Funds are in
scarcity.
 How we can use those available funds effectively and efficiently.
Definitions
 Independent Project: A project whose acceptance or rejection does not prevent
the acceptance of other projects under consideration.
 Dependent Project: Whose acceptance or rejection is based on the acceptance or
rejection of one or more other project being considered.
 Mutually exclusive Project: A project whose acceptance will lead to rejection
the other project (s). At a given time only one project can be undertaken.
Capital Rationing
A situation where a company has scarcity of funds to invest in potential opportunities and
these opportunities are compared with one another in order to allocate resources most
effectively and efficiently.
In other words:
If a company is confronted with the situation of capital rationing then it means that
projects even having positive NPV would not be undertaken by the company.

Types of Capital Rationing

 SOFT RATIONING:
 Arises due to internal factors
 HARD RATIONING:
 Arises due to external factors

SOFT RATIONING
 Arises due to internal factors

 Management is reluctant to issue new share because of the fear of outsider taking
control of company.
 Dilution of EPS
  Increased interest payments in case of debt financing
 Company’s will to maintain limited investment level that can be financed thru
retained earnings.

HARD RATIONING
 Arises due to external factors

- If share prices are depressed or market is bearish, raising capital is very difficult.
- Restriction on lending by Banks.
- High interest rate
- High cost associated with issuance of share / debt instrument.

Corporate finance lecture No. 14

CAPITAL RATIONING

 A situation where a company has scarcity of funds to invest in potential opportunities

and these opportunities are compared with one another in order to allocate resources most
effectively and efficiently.

Types of Capital Rationing

 SOFT RATIONING:
 Arises due to internal factors
 HARD RATIONING:
 Arises due to external factors

SOFT RATIONING
 Arises due to internal factors

 Management is reluctant to issue new share because of the fear of outsider taking
control of company.
 Dilution of EPS
 Increased interest payments in case of debt financing
 Company’s will to maintain limited investment level that can be financed thru
retained earnings.

HARD RATIONING
 Arises due to external factors

- If share prices are depressed or market is bearish, raising capital is very difficult.
 - Restriction on lending by Banks.
- High interest rate
- High cost associated with issuance of share / debt instrument.

CAPITAL RATIONING
Two situations

 Current or Single Period CR

 Multiple Period CR
Current or Single Period CR
 Single Period CR:
This means that shortage of capital is only for current period, and there is no such
scarcity of funds in the following period.
 Multiple Period CR:
 Sacristy of funds more than one period.
Capital Rationing

 Criticism:
 Normally projects are not divisible.
 If the case above, then project selection will be on absolute NPV.
 Strategic values of each project are ignored
 PI ignores the size of project.
 Projects may have different cash flow pattern.
Profitability Index
 Profitability Index is a relationship between present value of all future cash flows and
initial investment.
 Decision Rule
 PI > 1
 Undertake the project.
Single Period CR
Assumptions:
- Projects cannot be deferred or postponed. If a project is not undertaken, the opportunity is
lost.
- Complete certainty about each project.
- Projects are divisible – say 60% of project A and 40% of project B can be undertaken.

RANKING OF PROJECTS:

- Ranking projects in terms of NPV leads to selection of heavy or large projects. We can use
PI with NPV for ranking projects.

Single Period Capital Rationing

PROJECT INITIAL PV OF RANKIN RANKIN
S INVESTMEN CASH NPV PI G G
  T FLOW     NPV PI

(10,000. 13,00 3,00 1.3 3.0 1.0

A 00) 0.00 0.00 0 0 0

(15,000. 16,20 1,20 1.0 5.0 5.0

B 00) 0.00 0.00 8 0 0

(20,000. 22,90 2,90 1.1 4.0 3.0

C 00) 0.00 0.00 5 0 0

(28,000. 34,50 6,50 1.2 1.0 2.0

D 00) 0.00 0.00 3 0 0

(40,000. 45,00 5,00 1.1 2.0 4.0

E 00) 0.00 0.00 3 0 0
Single Period Capital Rationing
 Assumptions:
 - Capital Available (70,000.00)
 - Projects are divisible

Project Selection based on NPV

PV
OF
CAS
PROJEC INITIAL H RANKI
TS INVESTME FLO NPV PI NG RANKING
  NT W     NPV PI
(28,00 6,50 1.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
D 0.00)   0.00   00 茞ᓀ㵂Ü
(40,00 5,00 2.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
E 0.00)   0.00   00 茞ᓀ㵂Ü

(2,00 60 0.2 3.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
A 0.00)   0.00 0 00 茞ᓀ㵂Ü
TOTAL (70,00 12,10  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
NPV 0.00)   0.00     茞ᓀ㵂Ü
Project Selection based on PI
PV
OF
PROJEC INITIAL CAS RANKI
TS INVESTME H NPV PI NG RANKING
  NT FLO     NPV PI
 W
(10,00 3,00 1.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
A 0.00)   0.00   00 茞ᓀ㵂Ü
(28,00 6,50 2.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
D 0.00)   0.00   00 茞ᓀ㵂Ü
(20,00 2,90 3.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
C 0.00)   0.00   00 茞ᓀ㵂Ü

(12,00 1,50 0.3 4.  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰

E 0.00)   0.00 0 00 茞ᓀ㵂Ü
(70,00 13,90  䦋 ㌌ ㏒ 㧀 좈 ໱ 琰
  0.00)   0.00     茞ᓀ㵂Ü
Multi-period Capital Rationing
 When capital availability is in short supply in more than one period, then we can
not rank projects by profitability index.

 When capital availability is in short supply in more than one period, then we can
not rank projects by profitability index.

 We use linear programming technique.

 Under this we assume only two variables – using graphical method.
 For more than two variables, we use simplex method, which is beyond the course
of our outline.

Example: Multi-period Capital Rationing

  PERIOD 1 PERIOD 2 PERIOD 3  

PROJECT PV OF PV OF PV OF NPV
  OUTFLOW OUTFLOW OUTFLOW  
Rs.
  Rs. ‘000’ Rs. ‘000’ Rs. ‘000’ ‘000’

         

X 30 10 10 50

Y 20 6 4 10

Capital Investment -
Availability  

PERIOD 1 36
PERIOD 2 10

PERIOD 3 8

   

Projects are divisible  

Solution: Multi-period Capital Rationing
 Let x = Portion of project X
 Let y = Portion of project Y
 Establishing Constraints

 PERIOD 1 =30x+Y20<=36
 PERIOD 2 =10x + 6y<=10
 PERIOD 3 =10x + 4y<= 8

 Where:
 x & y <= 1 Means that portion of project is less than one or equal to one

 x & y >= 0 Portion of project must be greater than equal to 0

 Objective Function:

 Maximize 50x + 10y

x y

1.20 1.80

1.00 1.67

0.80 2.00
 Limitation of LP
 Projects are not divisible
 Ignores the relative size of the Investment
 Assumes variables have linear relation
 Uncertainty is ignored
 Constraints are independent

RISK VS UNCERTAINTY
  RISK :
 Refers to a situation having several possible outcomes, and
 we can assign Probabilities to outcomes based on our past experience.

 UNCERTAINITY:
 Refers to a situation where Probability of a outcome cannot be assigned.

Corporate finance lecture No. 15

Expected Return or Returns
RISK & RETURN
 Measuring Returns:
Two components of Gains:
Capital Gains – Price Appreciation
Income – Dividends

Total Gain = Capital Gains + Dividends

Return = Total Gains / Initial Investment

RISK VS UNCERTAINTY
 RISK :
 Refers to a situation having several possible outcomes, and
 we can assign Probabilities to outcomes based on our past experience.

 UNCERTAINITY:
 Refers to a situation where Probability of a outcome cannot be assigned.
 Two Phases:
 Past Performance
 Expected or Future Returns
Measuring Risk – Past Performance
 In investing business you need to measure how far the return may be from the average.
 Return volatility or variability can be measured with variance.
 Statistical Tools:

 Variance
 Standard Deviation
 Variance is the average value of squared deviations from the average or mean.

 Standard Deviation is also used for measuring return variations.

Individual Stock Variance Over Time
 Investment X

  Actual AVG Squared

 Year Return Return Deviations Deviations

 1 0.1 0.0825 0.0175 0.0003063

2  0.15 0.0825 0.0675 0.0045563

3  0.02 0.0825 -0.0625 0.0039063

4  0.06 0.0825 -0.0225 0.0005063

Total  0.33    0 0.009275

Individual Stock Variance Over Time
 Var. = Sq. Deviation/(n-1)
 = 0.009275/4 -1
 = 0.003092

 Var. = 0.003092
 SD = 0.0556 or 5.56%
Market Variance – Past Performance
      Squared
Year Return % Deviations Deviations
2000 18.56 (0.43) 0.18
2001 27.98 8.99 80.82
2002 19.40 0.41 0.17
2003 24.00 5.01 25.10
2004 10.00 (8.99) 80.82
2005 14.00 (4.99) 24.90
  113.94   211.99
AVG Return 18.99    
 Var. = Sq. Deviation/(n-1)
 = 211.99/6-1
 Var. = 42.40
 SD = 6.51%

RISK
 SYSTEMATIC
 Economy-wide sources of Risk that effects all the stocks being traded in market.
systematic risk influences large number of assets and is also known as market risk.
 UNSYSTEMATIC
 It affects only specific assets or a firm. it is also known as Diversifiable or Unique or
Asset- specific Risk.
 DIVERSIFICATION
 Splitting investment across number of assets having different level of Risk is known as
Diversification.
 UNSYSTEMATIC OR UNIQUE RISK:
 It can be eliminated by Diversification therefore, a Portfolio with many assets has almost
zero Unsystematic Risk.

PORTFOLIO & DIVERSIFICATION

PORTFOLIO: A group of assets in which investor has investment. A combination of
securities of investment.

 PORTFOLIO variability does not equal to the average variation of its underlying
components. Why?
 Diversification reduces variability.

 DIVERSIFICATION: A course of investment in which risk is reduced by spreading the

investment across different securities.
VARIANCE & FUTURE RETURN
 We can observe that how the expected return from an investment will vary by attaching
probability to each outcome.
 We can observe that how the expected return from an investment will vary by attaching
probability to each outcome.
 Example:
Assuming two stocks A & B. Stock A is expected to yield 35% return and stock B - 25%
in the same period under Boom. However, stock A will have -10% & B - 8% return under
recession.
Further assuming that we can foresee or predict two economic states: Boom & Recession
Finally, we expect that there are 50% chances of each State of Economy i.e., Boom &
Recession.

Solution: Expected Return Variance

Stock A Stock B
  Expected Expected
State of   Return if Expected Return if Expected
Economy Probability SOE Value of SOE Value of
(SOE) (SOE) occurs Return occurs Return
           
BOOM 0.5 0.35 0.175 0.25 0.125
RECESSION 0.5 -0.1 -0.05 0.08 0.04
           
Investment
Level     0.4 0.6  
Solution: Expected Return Variance
 Expected Return-A = 0.50 x 35% + 0.50 x -10%
 = 0.125 or 12.50


 Expected Return – B = 0.50 x 25% + 0.50 x 8%
 = 0.165 or 16.50

 A B Total
 Portfolio Return 5.00 9.90 14.90
DIVERSIFICATION
 DIVERSIFICATION works because prices of securities underlying a portfolio do not
change with same rate.

 Putting the other way, the change in Prices are less than perfectly correlated.

 Diversification returns much better results when returns from Portfolio securities are
negatively correlated.

Portfolio Expected Return Variance & SD

Weigh
Portf ted
olio Squar
ER ed
unde Deviat Deviat Deviat
r ions ions ions
Return if State each from Squar =Vari S
Occurred SOE ER ed ance D
State of Probab Sto Sto Sto
Econom ility ck ck ck
y (SOE) X Y Z
(SOE)                
  1 2 3 4 5 6 7 8  
                (7 X 1)  
                   
31.472 12.588
BOOM 0.4 11 16 19 14.50 5.61 1 84  
RECESS 13.987 8.3925
ION 0.6 7 5 2 5.15 (3.74) 6 6  
                20.981 4.
4 5
 8
Investme 0.4 0.3 0.2
nt Level   5 0 5          
Equally weighted portfolio 
Portfolio Expected Return Variance & SD

Expected Return %

Stock X 8.60

Stock Y 9.40

Stock Z 8.80

   
Expected Return (ER) of
Portfolio 8.89

Corporate finance lecture No. 16

RISK
 RISK :
 Refers to a situation having several possible outcomes, and
 we can assign Probabilities to outcomes based on our past experience.

PORTFOLIO & DIVERSIFICATION

 PORTFOLIO: A group of assets in which investor has investment. A combination of
securities of investment.

 PORTFOLIO variability does not equal to the average variation of its underlying
components. Why?
 Diversification reduces variability.

 DIVERSIFICATION: A course of investment in which risk is reduced by spreading the

investment across different securities
 DIVERSIFICATION works because prices of securities underlying a portfolio do not
change with same rate.

 Putting the other way, the change in Prices are less than perfectly correlated.

 Diversification returns much better results when returns from Portfolio securities are
negatively correlated.

Portfolio Expected Return Variance & SD

State of Probabilit Return if State Occurred Portfoli Deviat Deviation Weig
 o ER
under ions
y Stock Stock Stock each from s Squar
Economy (SOE) X Y Z SOE ER Squared Devia
(SOE)               =Var
  1 2 3 4 5 6 7 8
                (7 X 1
                 
BOOM 0.4 11 16 19 14.50 5.61 31.4721 12.58
RECESSI
ON 0.6 7 5 2 5.15 (3.74) 13.9876 8.392
                20.98
Investment
Level   0.45 0.30 0.25        

Portfolio Expected Return Variance & SD

Expected Return %

Stock X 8.60

Stock Y 9.40

Stock Z 8.80

   
Expected Return (ER) of
Portfolio 8.89
RISK
 SYSTEMATIC
 Economy-wide sources of Risk that effects all the stocks being traded in market.
systematic risk influences large number of assets and is also known as market risk.
 UNSYSTEMATIC
 It affects only specific assets or a firm. it is also known as Diversifiable or Unique or
Asset- specific Risk.
 DIVERSIFICATION
 Splitting investment across number of assets having different level of Risk is known as
Diversification.
 UNSYSTEMATIC OR UNIQUE RISK:
 It can be eliminated by Diversification therefore, a Portfolio with many assets has almost
zero Unsystematic Risk.

BETA
 Systematic Risk is measured by Beta Coefficient or Beta.

 Beta measure the systematic risk inherent in an asset relative to the market as whole.

DIVERSIFICATION - PORTFOLIO SELECTION

STOCK T STOCK W
  Square
State of Deviatio d
Economy Rate of Deviation Squared Rate of n Deviati
(SOE) Return from ER Deviation Return from ER on

Boom 18.00 13.00 169.00 (20.00) (21.00) 441.00

Recessio
n (8.00) (13.00) 169.00 20.00 19.00 361.00

Normal 5.00 - - 3.00 2.00 4.00

             
Expected
Returns
(ER) 5.00     1.00    
             
Variance
AVG
Squared
Deviation     112.67     268.67
Standard
Deviatio
n     10.61     16.39
Return %
Portfoli
  Portfol Portfoli o
Probabili io o Deviatio
  ty of Stoc Stoc Return Deviatio ns
  SOE kT kW s ns Square

18.0 (20.0
Boom 0.33 0 0) 8.50 4.50 20.25

Recessio (8.00
n 0.33 ) 20.00 (1.00) (5.00) 25

Normal 0.33 5.00 3.00 4.50 0.50 0.25

            45.5
Investme   0.75 0.25      
 nt Level
Expected
Returns   5.00 1.00 4.00    
112. 268.6
Variance   67 7     15.015
Standar
d
Deviatio
n           3.87
Portfolio Beta

 
    Investment Expected   Portfolio Portfolio
Stock Investment weight Return Beta ER BETA

G 2,000.00 0.14 6.00 0.70 0.86 0.1

H 4,000.00 0.29 11.00 1.20 3.14 0.3428571

I 3,000.00 0.21 8.00 0.90 1.71 0.1928571

J 5,000.00 0.36 12.00 1.40 4.29 0.5

  14,000.00       10.00 1.1357143

VARIANCE & FUTURE RETURN
 Example:
Assuming two stocks A & B. Stock A is expected to yield 35% return and stock B - 25%
in the same period under Boom. However, stock A will have -10% & B - 8% return under
recession.
Further assuming that we can foresee or predict two economic states: Boom & Recession
Finally, we expect that there are 50% chances of each State of Economy i.e., Boom &
Recession.

Solution: Individual Stock Expected Return Variation

Stock A Stock B
  Expected Expected
State of   Return if Expected Deviation Squared Variance Return if Expec
Economy Probability SOE Value of   Deviation   SOE Value
(SOE) (SOE) occurs Return       occurs Retur
BOOM 0.5 0.35 0.175 0.225 0.050625 0.0253125 0.25 0.125
RECESSION 0.5 -0.1 -0.05 -0.225 0.050625 0.0253125 0.08 0.04
    0.25       0.050625 0.33  
AVG
RETURN   0.125         0.165  
                 
Standard
Deviation           0.225    
            22.50    
CONCLUSION
 Investors care about the Expected Return and Risk of their Portfolio Assets. Overall Risk
of Portfolio is measured by Standard Deviation.

 Standard Deviation of individual stock measure how risky it would be if held in Isolation.
But an investor is interested how individual stock would effect the whole Portfolio.
AVERAGE BETA
 Average Beta is equal to 1.

 If any stock has a Beta of 0.50 it means that the stock carries half of Market Risk.

 A Beta of 2 is considered to have twice of Market Risk.

AGGRESSIVE STOCKS
 Aggressive stocks have high Beta.

 Greater than 1 Beta.

DEFENSIVE STOCKS
 Aggressive stocks have low Beta.

 Less than 1 Beta.

AGGRESSIVE AND DEFENSIVE STOCKS
 Aggressive Stocks have high betas, greater than 1, meaning that their return is more than
one-to-one to changes in return of overall market.

 Defensive stock are less volatile to change in market return and have beta of less than one
SECURITY MARKET LINE
 HOW RISK IS REWARDED IN MARKET?
Assumptions
 Capital Market is fraction-less or no additional cost, no charges etc.
 Relevant information available to all participants i.e. homogenous expectations.

 No participant is large or influence the prices of securities.

 Firms have fixed Capital Budgeting Program or Capital Structure.

Assumptions
 Capital Market is fraction-less or no additional cost, no charges etc.
 Relevant information available to all participants i.e. homogenous expectations.

 No participant is large or influence the prices of securities.

 Firms have fixed Capital Budgeting Program or Capital Structure.

EXAMPLE
 A Portfolio consists of two assets: A and B. Asset B is risk free. Stock a “ER” is
18% and beta of 1.50. Risk free rate is 8%. Investment in stock A is 25%

SECURITY MARKET LINE

150%

INVESTMEN
PORTFOLI TA
SECURIT O
Y E BET INVESTMEN BET
  R A T% ER A ER BETA

A 18 1.5 0.25 4.5 0.375 27 2.25

B - RISK
FREE 8 0 0.75 6 0 4 0
10.
        5 0.375 23 2.25
A RISK FREE
SECURITY HAS
BETA OF ZERO
             
SECURITY MARKET LINE
 ASSUME:
 Investment in a is increased to 150%.
 This means there will be 50% reduction in Risk Free Investment.

 What happened when we invested 150% in Risky Investment A.

 Our Portfolio's ER Rate increased to 23% from 10.50%.
 Portfolio's Beta jumped to 2.25 from 0.375.

 Now we can see the various investment combinations of.

 Stock 'A' and Risk Free 'B‘.
Corporate finance lecture No. 17
SECURITY MARKET LINE
 HOW RISK IS REWARDED IN MARKET:
EXAMPLE
 A Portfolio consists of two assets: A and B. Asset B is risk free. Stock a “ER” is
18% and beta of 1.50. Risk free rate is 8%. Investment in stock A is 25%

CHANGE IN INVESTMENT OF A SECURITY IN PORTFOLIO

Part A
% OF
PORTFOLIO
INVESTMENT PORTFOLIO PORTFOLIO CURVE
IN STOCK A ER BETA SLOPE
      8
0 8.00 - -
25 10.50 0.3750 6.67
50 13.00 0.7500 6.67
75 15.50 1.1250 6.67
100 18.00 1.5000 6.67
125 20.50 1.8750 6.67
150 23.00 2.2500 6.67
 Reward to Risk = ( ER a - ER rf )/Beta a

= 0.066666667 or
= 6.67

A RF    

0 100 0.18 1.5

25 75 0.08 0

50 50    

75 25    

100 0    

125 -25    

150 -50    
SECURITY MARKET LINE
Portfolio Expected Return

Portfolio Expected Return

Y Investment in A

ERa – Rf/ Beta

ERa 18%
Slope = 6.67

Rf=8%

0 X
1.50

Portfolio Beta
SLOPE OF STRAIGHT LINE
 ERa - Rf
Beta

 AT investment of 75 % , the slope is

 = 15.50 – 8 / 1.13 = 6.67
 At every investment in stock A, the slope of line returns the same value.
 ERa – Rf is the Risk Premium on stock A
6.67 is reward to risk ratio.
 Stock A contains risk premium of 6.67 % per unit of systematic risk.
CHANGE IN INVESTMENT OF A SECURITY IN PORTFOLIO
Part B

% OF CURVE
PORTFOLIO PORTFOLIO PORTFOLIO SLOPE
INVESTMENT ER BETA  
IN STOCK A      
      8
0 8.00 - -
25 9.50 0.28 5.45
50 11.00 0.55 5.45
75 12.50 0.83 5.45
100 14.00 1.10 5.45
125 15.50 1.38 5.45
150 17.00 1.65 5.45
CHANGE IN INVESTMENT OF A SECURITY IN PORTFOLIO
 Reward to Risk = ( ER a - ER rf )/Beta a

= 0.0545 or
= 5.45

A RF    

0 100 0.14 1.1

25 75 0.08 0

50 50    

75 25    
100 0    

125 -25    

150 -50    

Portfolio Expected Return

Y Investment in B

ERa
14%
Slope= 5.45

Rf=8%

0 X
1.10

Portfolio Beta

CONCLUSION
 THE REWARD TO RISK RATION MUST BE THE SAME FOR ALL THE
STOCKS IN THE MARKET.

FUNDAMENTAL OUTCOME
 Since stock A is offering better Reward-to-Risk Ratio as compared to stock B, the
situation will not persist in a well established market.
 Investors will rush to stock A & stock B will not be traded much.
 This situation will push stock A’s price up and the expected return of stock will reduce.
 On the other side, with less attractions, stock B’s price will fall increasing the ER and this
will bring the both stocks on the same line.
 That means both stocks will offer the same reward for bearing risk.
 When both stock offer same reward to risk, we can state as under:
 ERA - Rf / beta A = ERB - Rf / beta B

SECURITY MARKET LINE

 Because all the assets being traded in market offer

same Reward to Risk Ratio and therefore, must lie on
the same line.

 In above chart, if a stock is above the line at point C

for stock ‘C’, its price will rise due to increased
demand and the ER will fall. This will continue till it
finds it place on the market line.

 If any stock like D in the above chart is being below to

the line, its price will decrease until its ER is the same
as all of the stocks being traded in market.
 SECURITY MARKET LINE

Stock Expected Return

C
ER-C ERa – Rf/ Beta
D
ER ER - B

ER-A

Rf
b-D

0 X
b- A b-B b-C

Portfolio Beta

SECURITY MARKET LINE

 POSITIVELY SLOPPED LINE REVEALING THE RELATIONSHIP OF
ER AND BETA.

CAPITAL ASSETS PRICING MODEL

 Assuming that Portfolio is made up of all the stocks in the market, known as Market
Portfolio.
 As just seen, all assets in market must lie on SML and Beta of this Portfolio must be
equal to 1 or average.
 Slope of Security Market Line should be:

 =ERm – Rf = ERm – Rf = ERm – Rf

 Beta m 1

 ERm - Rf – is called Market Risk Premium.

 If ERi and Betai represent Expected Return and Beta of “Any” asset in market
then:

 ERi – Rf = ERm – Rf
beta i
 “Any” asset must also lie on SML.
 Re-arranging the above equation:
 ERi = Rf + {ERm – Rf} x Beta I
  This is known as Capital Asset Pricing Model (CAPM) Equation.
WHAT CAPM TELLS US
 Time value of money:
 Risk Free Rate “Rf” is a rate when you don’t take risk. It is just
waiting for money.

 Reward for Risk:

 The equation “ERm – Rf” presents reward for taking average
systematic risk in addition to waiting.

 Systematic Risk:
 It is measured by Beta. this measure the systematic risk present in an assets
or Portfolio, relative to average asset.
 Time value of money:
 Risk Free Rate “Rf” is a rate when you don’t take risk. It is just
waiting for money.

 Reward for Risk:

 The equation “ERm – Rf” presents reward for taking average
systematic risk in addition to waiting.

 Systematic Risk:
 It is measured by Beta. this measure the systematic risk present in an assets
or Portfolio, relative to average asset.
 DETERMINING THE SECURITY VALUE

 EITHER THE SECURITY IS OVER OR UNDER VALUED

EXAMPLE: RISK & RETURN

RISK FREE ER on Stock ‘A’ at B = ER on Stock ‘A’ at B =

RATE 4.00 1.3 2.6
MARKET RISK  䦋㌌㏒㧀좈໱琰茞 ᓀ  䦋㌌㏒㧀좈໱琰茞 ᓀ
PREMIUM 8.60 㵂Ü 㵂Ü
STOCK "A"
BETA 1.30 15.18 26.36

Erm 12.60  䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü

REQUIRED: 
-ER ON STOCK "A" ? 
-ER ON STOCK "A" IF BETA GOES DOUBLE?
ERi = Rf + {ERm – Rf} x Beta I
 = 4 + (8.6 x 1.3)

= 15.18
Under/Over Valued Stocks
Risk to
      Reward
STOCK ER BETA Ratio
       
ABC 15 1.5 5.33
XYZ 11 0.9 4.44
Risk Free Rate 7    
SLOPE OF SML:
ERa – Rf/ Beta

ABC 5.33

XYZ 4.44
Under/Over Valued Stocks
 We can interpret that stock XYZ offers an insufficient Expected Returns for the level of
risk relative to ABC.
 Its ER is low and price is high and this is a overvalued stock relative to ABC.
 We can also state that ABC is undervalued stock.
RECAP
 Total Risk of an investment is measured by Standard Deviation or Variance.

 Total Return has two components – expected and unexpected.

 Systematic Risk:
 Systematic risks are unanticipated that effects all the assets to some degree. It is
non-diversifiable.

 Unsystematic Risk or Unique Risk:

 It affects only specific assets or a firm. it is also known as Diversifiable or Unique
or Asset- specific Risk. It can be eliminated by Diversification therefore, a
Portfolio with many assets has almost zero Unsystematic Risk.
 Diversification:
 A course of investment in which risk is reduced by spreading the investment
across different securities.
 BETA – Measure of Systematic Risk:
 Reward for bearing risk depends only on the level of systematic risk, which is
measured by Beta.
 Security Market Line:
 Reward to risk ratio for all assets will be same and all assets ER will lie on same
line.
CAPITAL ASSETS PRICING MODEL
 CAPM has three main points:
 Pure Time Value
 Market Risk Premium
 Beta of Asset

Corporate finance lecture No. 18

COST OF CAPITAL & CAPITAL STRUCTURE

 Cost of capital is sum of cost of following items:
 Equity
 Debt – loans and debts instruments

Equity
 Compliance of SECP and Companies Ordinance 1984
 IPO’s in Primary Markets
 Prospectus in case of Listed Companies
 Underwriting

ISSUING SHARES TO PUBLIC, PRIVATE PLACEMENT

 Company must be listed on Stock Exchange
 Must be registered with Security & Exchange Commission of Pakistan – SECP
 Company issues Prospectus
 Underwriting the share issue:
 Underwriter refers to a firm that act as intermediary between a company issuing
shares and the public.
 Underwriter normally perform following services
 Devising method for issuing shares
 Setting the price of new shares
 Marketing / selling of securities
ISSUING SHARES TO PUBLIC, PRIVATE PLACEMENT
 Underwriters may buy securities for less than the price set by the company and
then selling them to public. If any amount of shares not subscribed by the public
then underwriter takes up the under-subscribed shares.

 Often Underwriter forms a group to share the risk, known as Syndicate.

COST OF CAPITAL & CAPITAL STRUCTURE
 Equity: How to calculate the cost of equity?

 Dividend growth model

 Security Market Line SML

SOURCES OF FUNDS RAISING

 Debt Financing
 Leasing
 Preferred Stocks or Shares

DIVIDEND GROWHT MODEL

 P0 = D0 x (1 x g) / RE – g
This can be state as:
P0 = D1 / RE – g
Where:
P0 = Price in current period
RE = Required return on stock
D0 = Dividend in P0
D1 = Dividend to be after one year
g = Growth rate

 We can re-arrange this equation to solve for RE:

 RE = D1 / P0 + g

 RE is the return that shareholders require on the stock or it is the Cost of Equity of the
firm.

 Three things needed to calculate RE

 Dividend
 Price of Current Period
 Growth Rate

EXAMPLE
 No-one limited paid last dividend of Rs. 5 per share. Current market value of its share is
Rs.50 per share and company expect a constant growth in dividend of 6% per annum.
Calculate Return on Equity.

 SINCE MARKET VALUE AND DIVIDEND VALUES CAN BE DETERMINED OR

NORMALLY ACTUAL FIGURES ARE AVAILABLE. BUT PROBLEMS ARE WITH
ESTIMATING GROWTH (g).

 WE CAN USE AVERAGE GROWTH OR USE STATISTICAL TECHNIQUES TO

ESTIMATE g.

 LET SEE BOTH OF THESE METHODS OF ESTIMATING g.

Solution: Dividend Growth Model
D0 5 per share
D1 = D0 x ( 1 + g ) 5.3  
Re = D1 / Po + g    
D1= 5.3  
Po= 50  
Re = 0.166 16.6
Dividend and price can be observed directly, but Growth g must be
estimated.
For estimating g:
We can use average of dividend as dividend growth over a period of
time.
OR

Can estimated using statistical techniques.

Cost of Equity
YEAR DIV (Rs) Variation Rs % Change
2000 1.20 - -
2001 1.50 0.30 25.00
2002 1.40 (0.10) (6.67)
2003 1.60 0.20 14.29
2004 1.90 0.30 18.75
2005 1.80 (0.10) (5.26)
2006 2.00 0.20 11.11
      8.17
Cost of Equity- Estimated Growth Rate
Dividend Growth Rate
YEAR DIV = y x xy x2
2000 9.4 0 0 0
2001 11.2 1 11.2 1
2002 9.01 2 18.02 4
2003 12.56 3 37.68 9
2004 10.5 4 42 16
2005 7.45 5 37.25 25
2006 11.34 6 68.04 36
Total  71.46 21 214.19 91
         
2007 10.1746      

Regression Equation:
y = a + b (x) = 10.17464

=
b = n (Exy) – ExEy / n Ex2 - (Ex)2 -0.0067857

n=7  

=
a = Ey /n – bEx / n 10.23
MERITS & DEMERITS OF DIVIDEND GROWHT MODEL
- Simple to understand.
- Easy to calculate.
- Only used for companies who pay dividend, so not useable for other companies who do
not pay dividends.
- Assumption of constant growth is unrealistic.
- Does not consider risk.

- Simple to understand.
- Easy to calculate.
- Only used for companies who pay dividend, so not useable for other companies who do
not pay dividends.
- Assumption of constant growth is unrealistic.
- Does not consider risk.

SECURITY MARKET LINE METHOD OF CALCULATING COST OF EQUITY

 SML tells us three things:
 Risk Free Rate = Rf
 Market Risk Premium = ERM - Rf
 Systematic Risk Measurement Unit = BETA

 SML: ER = Rf + B x (ERM – Rf)

 Let e stands for Equity

 RE = Rf + BE x (RM – Rf)
SML – COST OF EQUITY
 EXAMPLE:
 Share of M/s Risky Limited has a beta of 1.2 and Risk Free Rate is 5%. Market Risk
Premium is 8%. Last dividend paid was Rs.3 per share and growth in dividend is
expected to be 7%. The current stock price in market is Rs. 50. Work out the cost of
equity using dividend model and security market line method.
 We can find out cost of equity using SML and Dividend Model.
SECURITY MARKET LINE – COST OF EQUITY
 RE = Rf + BE x (RM – Rf)
Putting values:
RE = 5% + (1.2 x 8%) = 14.6%

DIVIDEND GROWTH MODEL

RE = D1 / P0 + g
D1 = 3 x 1.07 = 3.21
RE = (3.21 / 50) + .07
= 13.42%
MERITS & DEMERITS – SML
 It explicitly adjust for Risk
 Applicable in situations where no steady Dividend Growth is observed.
 Estimation of Market Risk Premium and Beta if turn out poor then result will be
inaccurate.
 Past data is used to predict future.
 COST OF DEBT
 Three items an e classified under Debt

1. PREFERRED SHARES
2. DEBT INSTRUMENTS – BONDS
3. LOANS & LEASES

1. PREFERRED STOCK:
As we know that Preferred Stocks carry fixed dividend every period. There’s no variation
in dividend level. This means that dividend from Preferred Stock is essentially Perpetuity.
 Cost of Preferred Stock can be calculated from the following:

 RP = D / P0

 For example if the dividend is Rs. 3.50/- per share and Current Market Price is Rs.40/-,
then the Rp will be:

 RP = 3.50 / 40
 = 8.75%

LONG TERM CAPITAL STRUCTURE

 Ways to raise Capital:
 VENTURE CAPITAL
 ISSUING SHARE TO PUBLIC – IPOs
 SUBSEQUENT ISSUE OF SHARE – RIGHT ISSUE
 PRIVATE PLACEMENT OF SHARES
 BANK LOANS
 DEBT INSTRUMENTS
 LEASES
ISSUING SHARES TO PUBLIC, PRIVATE PLACEMENT
 Underwriters may buy securities for less than the price set by the company and
then selling them to public. If any amount of shares not subscribed by the public
then underwriter takes up the under-subscribed shares.

 Often Underwriter forms a group to share the risk, known as Syndicate.

Corporate finance lecture No. 19

Venture Capital
Individual or Firms who lend their money and services to others in return for profit or stake
in the business.
 Limited Market
 Introduction market: It works on personal contacts.
 Expertise
 Raise funds on their own behalf.
 Venture Capitalist must be financially strong.
 Exit strategy must be finalized.
 It is a debt instrument that is issued by the company to raise its capital.
 Maturity Period
 Fixed amount of Interest
COST OF DEBT – BONDS
 A company may have several outstanding Bond issue at a point of time with varying
terms like Coupon Rate, Face Value, Term etc.
 Market value and Book value of issue may be different.
 How can we come to a single cost figure?
Do we use book or market values to work out cost of debt?
 We need to calculate the weighted average of cost of debt. Share of each issue from total
debt capital is multiplied by yield to maturity of each issue.
LOANS
 Term loans are less complicated issue of raising capital.
 Banks require collateral or security for granting loans.
 Interest is negotiated and banks also have some charges or fee.
 LEASES
 Normally more expensive than loans.
 Collateral other than assets being leases is not required.
EXAMPLE – WEIGHTED AVERAGE COST OF DEBT
  Weighted
    %   Average
    %   of YT M
ISSU Book of MV of M M BV V
E Value BV Bonds V      
               

0.3 0.3 2.0 2.1

D 500.00 3 501.50 5 6.24 9 8

0.3 0.3 2.7 2.5

F 496.00 3 440.50 1 8.36 8 6

0.1 0.1 0.9 1.0

R 200.00 3 206.90 4 7.31 8 5

0.2 0.2 1.5 1.5

T 297.00 0 287.40 0 7.90 7 8

1,493.0 1,436.3 7.4 7.3

  0   0     2 7
Tax
 Tax is an outflow.
 It is an expense charge on Profit or Income.
 Interest is a tax deductible expense.

AFTER TAX COST OF DEBT

 Since interest paid to investors on bonds and on loans is tax deductible, therefore
we need to work out after tax cost of debt.

 Suppose we borrow Rs 100,000/- at 8% Interest. Tax rate is 40%. What is after

tax Cost of Debt?
 Total interest for a year will be Rs 8,000/- and this is tax deductible. This will
reduce the tax liability of company by:
 8,000 x .40 = 3,200/-
 After tax cost of debt will be:
 8,000 – 3,200 = 4,800 or
 4,800/100,000 = 4.8%
 We can work out 4.80% in a different fashion.
 Interest rate 8% x (1 - 0.4) = 4.80%
LOANS AND LEASE
 A company may have obtained different loans at different interest rates.
 Like debt instruments we need to find out the weighted average rate of loan.
 Secondly, we are interested in after tax cost of loans (Weighted Average).

Now we can calculate the Weighted Average Cost Of Capital (WACC).

 Weighted Average Cost Of Capital (WACC)
Weighted Average Cost Of Capital (WACC)

   
   
    SHARES
    O/S

1 COMMON STOCK 1,000,000.00

2 BOND ISSUES:  

  Issue # 721  

  Issue # 722  

  Issue # 723  

  Issue # 724  

3 PREFERRED STOCK 100,000.00

 SHARES
    O/S

 䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü  䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü  䦋㌌㏒㧀

4 LOANS  
  - Term Loan 1  
  - Term Loan 2  
  - Term Loan 3  
  - Term Loan 4  
     
     
  TAX RATE  
  LAST YEAR's DIVIDEND PER SHA
  GROWTH RATE - DIVIDEND  
     
  PAR VALUE PER SHARE  
  MARKET VALUE /SHARE  
Required: Calculate the Weighted Average Cost of Capital (WACC)
  SHARES BV BV
  O/S   %
      of Total

COMMON STOCK 1,000,000.00 10,000,000.00  

       
BOND ISSUES:      

Issue # 721   4,000,000.00 0.305

Issue # 722   3,500,000.00 0.

Issue # 723   3,000,000.00 0.

Issue # 724   2,600,000.00 0.

    13,100,000.00  
       

PREFERRED STOCK 100,000.00 2,500,000.00  

LOANS      

- Term Loan 1   1,200,000.00 0.

- Term Loan 2   2,000,000.00 0.

- Term Loan 3   1,500,000.00 0.

- Term Loan 4   2,500,000.00 0.

    7,200,000.00  
TOTAL  䦋㌌㏒
CAPITALIZATION  䦋㌌㏒㧀좈໱琰茞 ᓀ 㵂 Ü 32,800,000.00 Ü
OTHER INFORMATION    
TAX RATE   40%
LAST YEAR's DIVIDEND PER SHARE 1.57
GROWTH RATE - DIVIDEND   0.06
PAR VALUE PER SHARE   10
MARKET VALUE /SHARE   15
PREFERRED STOCK   25
DIVIDEND ON PREFERRED STOCK   3
     
Weight age Weight age
    Of Of  
    Cost of Individual Individual      
    Componen Component Component WAC WAC  
    t s BV s MV C BV C MV  
Re = Di / Po
+g 17.09            
Di = 1.57 x
1.06 1.66            
COST OF
EQUITY   17.09 0.30 0.39 5.21 6.73  
               

    2.34          

    1.83          

    1.73          

    1.57          
BOND
DEBT Tax
Weighted Adjuste
Avg Cost   7.47 0.40 0.35 1.79 1.58 d
Preferred
Stock
Dividend
Cost   12.00 0.08 0.07 0.91 0.79  

    1.83          

    1.94          

    2.92          

    4.17          
LOAN
WEIGHTE Tax
D Adjuste
AVERAGE   10.86 0.22 0.19 1.43 1.23 d
          9.35 10.32  
 Weighted Average Cost Of Capital (WACC)
Weighted Average Cost Of Capital (WACC)

 WACC= BV

 (17.09*0.30)+((7.47*0.4)(1-0.40))+(12*0.08)+((10.86*0.22)(1-0.40)

COMMON
BOND X
STOCK X
WEIGHT
WEIGHT X TAX
PREFER
RED LOAN X
STOCK X WEIGHT
WEIGHT

USING WACC IN CAPITAL BUDGETING

 EXAMPLE:
 A company intends to undertake a project that will yield after tax saving of Rs. 4 million
at the end of year one. However, after that these savings are estimated to grow at 6
percent.
 The debt equity ratio of 0.5 or 2/3 (debt 2/3 and equity 1/3). Cost of equity is 25% and
cost of debt is 11%.
 This project has the same level of risk as the existing company business. Advise company
on the financial viability of project. Assume tax rate of 40 percent.
 WACC = 2/3 x 25 + 1/3 x 11(1- 40) = 18.86

 PV = BENEFIT / WACC - g
 PV = 4,000,000 /0 .1886 – 0.06 = 31,104,199/-
 Corporate finance lecture No. 20

Weighted Average Cost of Capital (WACC)

 WACC of a company reflects the level of risk and WACC is only appropriate discount
rate if the intended investment is replica of company’s existing activities – having same
level of risk.

 Using WACC as discount rate when the intended project has different risk level as of
company then it will lead to incorrect rejections and/or incorrect acceptance.
 For example, a company having two strategic units and one unit having lower risk than
the other, using WACC to allocate resource will end up putting lower funds to high risk
and larger funds to low risk division.
PURE PLAY
 When a unit or division of a firm has different risk level than the firm, we can look for
other companies (like of division in question) to know the beta, debt/equity capital
structure so we could develop a discount rate for the division in question.
 Pure Play refers to estimating the required return on investment that is unique to a
specific project, based on the projects similar to line of business.

 When an intended project has a different (Systematic) risk level from the existing, then
we need to calculate the systematic risk of new project to find out WACC based on the
cost of equity and debt to be used in the intended project.

EXAMPLE
 M/S Riskless Limited have been contemplating a new diversified project. Current Beta of
the firm is 1.2, however, the average Beta of diversified project industry is 1.7 and
debt/equity ratio is 30:70
Debt is considered to be risk free and interest rate is 12%. Market risk rate is 20% and
corporate tax rate is 35%.
Required: Work out appropriate discount rate for new project, if the new project is
 a) All equity financed.
 b) D/E is 30:70
 c) D/E is 40:70
Solution: Pure Play.xls

PURE PLAY
Project Variables:

Gbeta 1.7   a)     c)  

E 70   E 100   D 0.4

D 30   Rm 20   E 0.6
T 0.35   E 0.7      

Int. rate Rf 12   D 0.3      

We need to calculate a discount rate that is representative of systematic risk -

Business and Financial risk.
Solution:
a) All equity financed New Project
 The industry in which the intended project falls has a equity Beta of 1.70, which has D /
E of 30:70, but this is all-equity financed and therefore, we need to eliminate the
financial risk from the Beta of (new industry).
 To Un-gear the beta - for all equity financing:
 Formula to un-gear equity Beta = Gbeta x (E / E + D(1-t))
= 1.3296

 Where:
 Gbeta = Geared Beta
 E = Weighted of equity in capital structure
 D = Weight of debt in capital structure
 T = Tax rate
 Using CAPM equation to calculate the cost of equity:
 Re = Rf + B (Rm-Rf)
= 22.6369

 This project, if only equity financed, must be evaluated using 22.6369% discount rate.

 This is WACC for Un-geared firm where cost of equity is overall cost of capital.

Solution:
b) New Project if financed with D /E of 30 : 70
 Since the systematic risk (business and financial risk) of new industry are same as of this
scenario, no adjustment to Beta is necessary.
 Cost of Equity:
 Re = Rf + B (Rm-Rf)
 = 25.6
 Cost of Debt:
 Kd = I x (1-t)
 = 7.8
 WACC = 20.26
 This should be the discount rate for the intended project.
Solution:
c) New Project if financed with D 40 and Equity 60
  We need to re-gear the Beta to reflect the proposed financing. For D/E of 30/70 financing
the Beta as calculated above:
 Formula to un-gear equity Beta = Gbeta x (E / E + D(1-t))
 1.3296 = Gbeta X 60 / 60 + 40 (1-t)
 1.3296 = Gbeta X 0.697674419
Gbeta = 1.91
 Now we can calculate WACC under this financing arrangements. We first calculate the
cost of equity capital:
 Re = Rf + B (Rm-Rf)
= 27.25
 Cost of Debt:
 Kd = 7.8
 WACC = 19.47

CAPITAL STRUCTURE & FINANCIAL LEVERAGE

 A capital structure that lowers WACC is required to increase the value of firm.
 That would be the optimal capital structure because it results in the lowest possible
WACC.
 Changes in capital structure.

 EXAMPLE: FIN LEVRAGE 1.xls

Capital Structure - No Debt

M/s SAFE-WAYS LIMITED
  CURRENT STATUS PROPOSED STATUS
     
ASSETS 6,000,000.00 6,000,000.00
DEBT - 3,000,000.00
EQUITY 6,000,000.00 3,000,000.00
DEBT/EQUITY RATIO - 1.00
SHARE PRICE 20.00 20.00
SHARES
OUTSTANDING 300,000.00 150,000.00
INTEREST RATE 10.00 10.00
     
CAPITAL STRUCTURE & FINANCIAL LEVERAGE
NO DEBT SITUATION NORMAL BOOM
EBIT 800,000.00 1,200,000.00
Interest - -
     
Net Income 800,000.00 1,200,000.00
ROE 13.33 20.00
 EPS 2.67 4.00
     
DEBT = 3 MILLION    
     
EBIT 800,000.00 1,200,000.00
Interest 300,000.00 300,000.00
     
Net Income 500,000.00 900,000.00
ROE 16.67 30.00
EPS - D 3.33 6.00
NO DEBT
SITUATION NORMAL NORMAL NORMAL NORMAL

EBIT 300,000.00 600,000.00 900,000.00 1,200,000.00

Interest - - - 0
         

Net Income 300,000.00 600,000.00 900,000.00 1,200,000.00

ROE 5.00 10.00 15.00 20.00

EPS 1.00 2.00 3.00 4.00

         
DEBT = 3  䦋㌌㏒㧀좈໱琰茞 ᓀ
MILLION 㵂Ü      

EBIT 300,000.00 600,000.00 900,000.00 1,200,000.00

Interest 300,000.00 300,000.00 300,000.00 300,000.00

         

Net Income - 300,000.00 600,000.00 900,000.00

ROE - 10.00 20.00 30.00

EPS - D - 2.00 4.00 6.00

 Y DEBT
EPS
NO DEBT

BE
+ FIN LEVERAGE
2

X
300000 600,000

EBIT

-2
-IVE FIN LEVERAGE

WHAT DOES GRAPH TELLS US?

 Break even EBIT is 600,000, at this level EPS under both no-debt and debt situations is
2. This is denoted as point BE in the above graph.

 Area on the left or below BE representing negative impact on loan.

 Area right or above of BE point, represent positive impact of Financial leverage or
employment of loan.

CONCLUSION
 Financial leverage effect depends on the EBIT. Higher the EBIT, leverage is beneficial.
 Under normal scenario leverage increases the returns to shareholders – measured by EPS
and ROE.
 Also shareholders are exposed to more risk under debt-equity structure.
corporate finance lecture No. 21

 CAPITAL STRUCTURE & COST OF EQUITY

MODIGLIANI AND MILLER MODEL
CAPITAL STRUCTURE & COST OF EQUITY
MODIGLIANI AND MILLER MODEL
 Value of firm: Whatever the capital structure the operating income and value of its assets
will remain same or unchanged.

 Proposition 1 of MM Model, says value of a firm is independent of its capital structure.

CAPITAL STRUCTURE
OPTION1 OPTION 2
Equity 40% 60%
Loan – debt 60% 40%
Total capital 100% 100%

A firm may employ any of the above options of capital structure, the value of firm is not
affected as long as the capital is fixed (does not exceed 100%). This is because the operating
income will remain constant and nothing positive (additional income) will increase the equity
and share price.

 WACC does not depend on debt equity ratio. Because it is the function of relative costs
of debt & equity, and any change in debt and equity mix will change the cost of each
component accordingly, making no movement in overall WACC.
 For example – take one Pizza, slice it in four quarters and then half each quarter to make
8 pieces of Pizza. Even you have 8 pieces but you don't have more Pizza.

 How is it possible? Let’s see.

WACC remain constant at every combination of Debt Equity

CAPITAL STRUCTURE
CURRENT STATUS COMBINATIONS  

6,000,000. 6,000,000. 6,000,000. 6,000,000. 6,000,000.

ASSETS 00 00 00 00 00

2,000,000. 3,000,000. 4,000,000. 5,000,000.

DEBT - 00 00 00 00

6,000,000. 4,000,000. 3,000,000. 2,000,000. 1,000,000.

EQUITY 00 00 00 00 00
DEBT/EQUIT
Y RATIO - 0.50 1.00 2.00 5.00
SHARE
PRICE 20.00 20.00 20.00 20.00 20.00
SHARES
OUTSTANDI
NG 300,000.00 200,000.00 150,000.00 100,000.00 50,000.00
INTEREST
RATE 10.00 10.00 10.00 10.00 10.00
EBIT 800,000.00 800,000.00 800,000.00 800,000.00 800,000.00

ROE 13.33 15.00 16.67 20.00 30.00

EPS 2.67 4.00 5.33 8.00 16.00

WACC 13.33 13.33 13.33 13.33 13.33

PROPOSITION II OF MM MODEL
 It tells us three things:
 Required Return of a Assets
 Cost of Debt and
 Debt /Equity Ratio

 Expected rate of return on the common stock of a levered firm increases in proportion to
the debt-equity mix (market values to be used).

 this means that for an un-levered firm, Return on equity (RE) is equal to return on asset.

 In other words, a firm’s cost of equity is positive linear function of the firm’s capital
structure.
PROPOSITION II OF MM MODEL
WACC = D/V(RD) + E/V(RE)
Renaming the equation:
r ASSETS = r DEBT x D/V + r EQUITY x E/V
Re-arranging the equation for r EQUITY:
r EQUITY = r ASSETS + D/E (r ASSETS - r DEBT )
 M & M; PROPOSITION 2

 In other words, a firm’s WACC & CAPITAL STRUCTURE

cost of equity capital is a Y
positive linear function of 35.00
the firm’s capital
ROE
structure. 30.00

25.00

COST OF CAPITAL %
20.00 INTEREST RATE
ROE
15.00 WACC
WACC

10.00
INT RATE

5.00

- X
1 2 3 4 5
DEBIT EQUITY RATIO

BUSINESS & FINANCIAL RISK

 PROPOSITION II shows that cost of equity of a firm is a function of two components:
 1) r ASSETS is overall return on assets and depends on firm’s operations. In other
words, it is the systematic risk of firm’s assets. This is also called as business risk faced
by firm’s equity.
 2) Second component (Ra – Rd) x D/E emerges from the capital structure at a given
time. For an un-levered firm, this part is zero, therefore, Ra = Re =WACC. The reason
being, debt increases the risk by shareholder. This extra risk arising from using debt is
called financial risk.
POINTS TO REMEMBER
 Systematic risk is the sum of business risk and financial risk.

 Business risk arises from assets and operations of the firm and has nothing to do with
capital structure of the firm.

 Financial risk is determined by the financial policy. As debt weight is increased financial
risk increases.
M & M MODEL WITH TAXES
 Taxes are reality of business environment.

 How taxes effect the firm and M&M Model?

 Does taxes have any effect on value of firm?

Let’s take an Example:

EXAMPLE: M&M WITH TAXES
 Assume two firms which are identical on the assets side of balance sheet. Firm ‘A’ is all
equity financed and firm ‘B’ is all debt financed.
 EBIT is estimated at Rs.100,000/- per year forever and tax rate is 40%. Firm ‘B’ pays
10% loan on the debt. For the sake of simplicity there is no depreciation. Cost of capital
for firm ‘A’ is 12%.

Taxes and M&M

FIRM "A" FIRM "B"
UN-GEARED GEARED
 PARTICULARS (NO-DEBT) (ALL DEBT)
EBIT 100,000.00 100,000.00
INTEREST EXPENSE - 10,000.00
     
TAXABLE PROFIT 100,000.00 90,000.00
     
TAX ON PROFIT 40% 40,000.00 36,000.00
     
NET PROFIT 60,000.00 54,000.00
IMPACT OF TAXES ON THE CASH FLOW
IN TERMS OF CASH FLOW FIRM "A" FIRM "B"
TO SHARE/BOND HOLDERS UN-GEARED GEARED
  (NO-DEBT) (ALL DEBT)
EBIT 100,000.00 100,000.00
LESS: TAXES 40,000.00 36,000.00
TOTAL 60,000.00 64,000.00
 WE OBSERVE:

 Even assets of both companies are identical.

 After tax cash flow of both firms is not same. Hence the value of both firms is not equal.
 The difference in cash flow or value is Rs. 4,000.
 We can reach at Rs. 4,000 in an other way:
 Total Interest x Tax Rate
 = 10,000 x 0.40 = 4,000
 Since interest is tax deductible, it generates saving called “Interest Tax Shield”.
 Since debt is for ever, the value of firm ‘B’ levered firm, will always be greater than firm
‘A’ by the present value of interest tax shield.

 Present value of interest tax shield can be calculated as:

 PV = Rs. 4000 / 0.1 = Rs. 40,000

 M&M Model proposition 1 says:

 VL = VU + TX x D
  Value of un-geared firm ‘A’ can be worked out as under:

 Vu = EBIT x (1-t) / Ru
 EBIT and taxable income of this firm is same.

 Vu = 100,000 x (1 - 0.4)/ 0.12 = 500,000

 We now find out the value of geared firm:

 VL = VE + Tx x D

= 500,000 + (100000 x 0.40) = 540,000

 It means that for every Re. 1, the value of firm will increase by (Re.1 x tx) or 0.40.

 Taxes do effect capital structure, therefore, we incorporate tax effect in proposition 1 of

the Model:

V of Levered Firm = V of Un-levered Firm + Tax on Debt

 We also need to incorporate tax in Proposition II of M&M Model:

 WACC = E/V(RE) + D/V (RD) x (1 – t)

Where t is the tax rate.

To find out Cost of Equity:

RE = RU + (RU – RD) X D/E X (1 – t)

Continuing our example to Proposition II

 Value of geared or levered firm was Rs. 540,000 because the debt is Rs.100,000 then the
equity must be 440,000.

 Return on equity of levered or geared firm is then:

 RE = RU + (RU – RD) X D/E X (1 – t)

= .12 + (.12 - .10) x (100000/440000) x 0.4
= 12.27%

WACC is:

 = (4400/5400) x 12.27 + (1000/5400) x 0.1 x (1 – 0.40)

 = 11.11%

AIDING UNDERSTANDING OF M&M MODEL

 Example M & M Model
  EBIT = 80,000
 Tax = 40%
 Debt = 50,000
 Rate of Return (un-levered) firm = 20%
 Interest rate = 10%

 Required: a) What is value of firm’s equity?

 b) What is the cost of equity capital?
 c) What is WACC?

M&M MODEL
a) VALUE OF UN-LEVERED
FIRM Vu  
WITH NO DEBT =EBIT x ( 1 - t) / Ru    
Vu = 240,000.00    
From MM proposition I, Value of
firm with Debt = VL VL = Vu + D x t    
  260,000.00    
Because this is the value of Levered
firm E = VL - D    
then, the equity value is:      
  210,000.00    
b) Based on MM proposition 2, RE = Ru + (Ru - Rd) x
with tax cost of equity is: (D/E) x (1 - t)    

  0.21 21.43  
      8437.5
c) WACC      
       
WACC = E/V(RE) + D/V(RD) x (1
– t) 0.18 18.46  
 This shows that the WACC of a levered firm is lesser than that of un-levered.

 The WACC of un-levered firm was 20% and of levered firm is 18.46%.

 This means that debt financing carries financial advantage.

corporate finance lecture No. 22

PROBLEMS ASSOCIATED WITH HIGH GEARING
 M&M Model says that debt financing increases the value of firm due to tax
shield.
 However, there are certain aspects of high gearing that discourage borrowing.

 BANKRUPTCY COSTS

 Direct bankruptcy costs

 Indirect bankruptcy costs

 FINANCIAL RELEVANCY COSTS

 These aspect are:

 BANKRUPTCY COSTS:
 As debt increases chances of default of repayment of principal and interest
increases.

 Direct Bankruptcy Costs:

 In case of liquidation disposal of assets will fetch less than going concern value of
assets. And there are other.
 Costs like liquidation and redundancy costs. The loss in value is normally borne
by the debt holders .

INDIRECT BANKRUPTCY COSTS

 When a firm goes into liquidation or approaches near bankruptcy because under sever
financial distress.
 Employees leaving
 Vendors refusing to supply goods on credit.
 Customers even leaving fearing firm will not be able to honor its warranty and
after sales services commitments.
 Value of firm down as sale decline.
 TAX POSITION:

 Firm must ensure that it will pay tax in future because the value increase is
incidental with paying of taxes. High gearing reduces the taxable income against
which to off set interest expense.

 DEPRECIATION:

 Depreciation is also tax deductible and also affects the EBIT.

OPTIMAL CAPITAL STRUCTURE
 Debt has a magic in it. It increases the risk and reward to the firm and investors.
 Static theory of capital structure says that a firm should borrow to the extent where the
tax shield benefit is at least equal to the bankruptcy and financial distress costs incidental
to high gearing.
  We can see the optimal combination of debt and value of the firm in graphical form.
 DIVIDEND POLICY
OPTIMAL STRUCTURE

STATIC THEORY OF CAPITAL STRUCTURE

VALUE OF FIRM
PV OF TAX SHEILD VL= VU + T x D

Bankruptcy & FD

VL

ACTUAL FIRM VALUE

MAX
FIRM VU
VALUE Value of No-Debt Firm

TOTAL DEBT
D
OPTIMAL DEBT LEVEL

DIVIDEND POLICY
 DVIDENDS
 HIGH & LOW PAYOUT
 DIVIDEND STRATEGIES
Two Components of Incomes:

Capital Gains – Price Appreciation

Income – Dividends

TYPES OF DIVIDENDS
 Cash dividends
 Stock dividends

 CASH & STOCK DIVIDENDS

 Declaration date: The date on which dividend is announced.

 Ex-dividend date: to ensure dividend goes to right persons, this is two business
days before the record date.
 Record Date: On which the share register of the firm is updated for shareholders
record.
 Date of Payment: On which the dividend cheques are sent to shareholders.

 Ex-Dividend: For example, the Board of Directors declares dividend and record
date is set to Monday 18 September 2006, then the ex-date will be Thursday 14
 September 2006. If someone buys the share in question on 13th Sept 2006, he/she
will be entitled to receive the dividend just declared. Someone buying the share
on 14th will not be.
WHY DIVIDEND POLICY IS IMPORTANT?
a) Affects shareholders attitude.
b) Dividend policy has implications on capital budgeting program.
c) It reduces cash flow position.
d) It effects Debt Equity Ratio.
DIVIDEND POLICIES
 STABLE DIVIDEND PER SHARE:
 per share fixed amount of dividend paid every year.
 Look favorably by investors and implies low risk firm.
 Investors can easily forecast and predict their earnings.
 Aid in financial planning.

CONSTANT DIVIDEND PAYOUT

(DIV PER SHARE/EPS)
 A fixed %age is paid out as dividend.
 Under this policy the dividend amount will vary because the net income is not constant.

HYBRID DIVIDEND POLICY

 This contains feature of both the above mentioned policies.
 Dividend consists of stable base amount and %age of increment in FAT income years.
 This is more flexible policy but increases uncertainty of future cash flow or return to
investors.
 The extra slice of %age is only paid when there is high jump in income. So it is not
regularly paid.
FLUCTUATING DIVIDENDS
 When the firm is having investment opportunities on its plate or unstable capital
expenditure, then Dividends are of residual amount i.e. amount left after meeting capital
expenditure.
FACTORS INFLUENCING DIVIDEND POLICY
 GROWTH OF FIRM
 STABLE EARNINGS
 DEGREE OF FINANCIAL LEVERAGE
 AVAILABILITY OF EXTERNAL FINANCING
 CONTROL

IRRELEVANCE OF DIVIDEND POLICY

 M&M assumes Perfect Capital Markets with no cost, no floatation cost to companies and
no taxes.
 Also, future profits are known with certainty
 According to M&M: As long as the firm’s capital budgeting program and debt policy is
fixed, dividend policy is irrelevant and does not add some value to the company or firm.
  The dividend irrelevance simply states the PV of dividends remains unchanged even
though div policy may change the amount and timing of dividends.
Example: Firm’s Dividend Policy is fixed %age of Dividend payout i.e. 50% of EPS paid out as
Dividend.

Y FIRM A – DIV PAY OUT

EPS

3 DIV/SHARE

VALUE

1.50

TIME

 EXAMPLE: STABLE DIVIDEND POLICY

POINTS TO REMEMBER
 Firm A’s pay out ratio is 50%. It means whatever it earns, half of is paid as
dividend.

 Firm B although has the same earning level, but maintains stable dividend over
time.
 Total dividend $ value is same under both situations.
 There may be more value for firm b for maintaining stable dividend because
investors may perceive more value.
 Brokerage fee, Floatation Cost and transaction cost are also consider.
 Y FIRM B – DIV PAY OUT

EPS

VALUE

DIV/SHARE
1.50

TIME