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Profitability Ratios: Margin Ratios (Profits wrt Sales)

Operating Revenue
Less: COGS
Explain with Income Statement
Income Gross Profit • Gross Profit Margin (%) = ×100
statement Less: Operating expenses (other than depreciation and amortization)
Operating Profit before depreciation and amortization
• Operating Profit Margin (%) = ×100
Adjustment for non-operating revenue and expenses
EBITDA (EBIT or EBITDA after non-operating income/expenses
Less: Depreciation and amortisation adjustment)
EBIT
Less: Interest
EBT or PBT • Net Profit Margin (%) = ×100
Less: Taxes
Decision Rule: The higher it is, The better it is.
Net Income or PAT or EAT

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Profitability Ratios: Return Ratios (Profits wrt Capital) Profitability Ratios: Return Ratios (Return on Investment)

• Return on Assets (ROA in %) = ×100 • Return on Equity (ROE in %) = ×100

– Equity=Equity Share Capital + Pref. Share Capital + Reserves
– Total Assets=Current assets + Fixed assets – For a zero-debt company, it is a better measure wrt ROCE
– Or Total Assets=Total Assets in Balance sheet – Fictitious assets – It shows how efficiently a company is using its equity to generate profits.
– It shows how efficiently a company is using its assets to generate profits.

• Return on Equity Shareholders fund (%)

• Return on Capital Employed (ROCE in %) = ×100 ×100
– Capital Employed=Equity Share Capital + Pref. Share Capital + Reserves + Debt – Equity shareholder’s fund=Equity Share Capital + Reserves
– Or Capital Employed=Total Assets - Fictitious assets - Current Liabilities
– Very useful for capital-intensive industries (Infrastructure, power, telecom, etc.). • Earnings Per Share (EPS in Rs.) =
– It includes the impact of Leverage (debt) in capital structure. Hence, for companies
having debt, it is very crucial metric. Note: Denominator in above formulas are average of opening and closing values.
– It shows how efficiently a company is using its capital to generate profits. Comparison with peers is very important.

Note: Denominator in above formulas are average of opening and closing values. Decision Rule: The higher it is, The better it is.
Comparison with peers is very important.

Decision Rule: The higher it is, The better it is.

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Liquidity Ratios (Short-term financial

position) Solvency/Leverage Ratios (Long-term financial position)

• Current Ratio (Times) = • Debt Ratio (Times) =

– Total Debt (Interest bearing)=Long-term debt + Short-term debt
– 2:1 is considered ideal, but may vary according to industry
– Equity=Equity Share Capital + Pref. Share Capital + Reserves
– More or less is not considered good
– Sometimes, investors consider only long-term debt while computing Debt ratio.
– Decision Rule: The lower it is, The better it is.

• Quick Ratio (Times) =

– Quick assets= Current assets - (stock + prepaid expenses) • Debt-Equity Ratio (Times) =
– 1:1 is considered ideal, but may vary according to industry
– Decision Rule: The lower it is, The better it is.

, ,
• Cash Ratio (Times) =
• Interest Coverage Ratio (Times) =
– Decision Rule: The higher it is, The better it is.

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Turnover/Activity/Efficiency Ratios
Valuation Ratios
• Inventory Turnover Ratio (Times) =
– How efficiently the inventory is being converted into Sales • Price/Earnings Ratio (Times) =
• Debtors Turnover Ratio (Times) = – Forward v/s Trailing PE ratio
– Compare current PE with Historical PE of company (Screener.in)
– How fast the debtors/credit sales is converted into cash
– Compare PE with Peers and Industry average benchmark (Tickertape and Screener.in)
• Fixed Asset Turnover Ratio (Times) = – Explain value trap for low PE companies. Understand the business of the company.
– Reference: https://www.youtube.com/watch?v=21STUhQ-
– How efficiently the fixed assets are used to generate revenue iP0&ab_channel=ThePlainBagel

• Total Asset Turnover Ratio (Times) =

• Working Capital Turnover Ratio (Times) =
• Price/Book Ratio (Times) =
– Working Capital = Current Assets – Current Liabilities
– Shows the relationship of Liquidity and Profitability

Decision Rule: The higher it is, The better it is. • Price/Sales Ratio (Times) =

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DU PONT Analysis
DU PONT Analysis (Two-step) (Three-step)
Sales • 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 ×
Net Profit 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜
-
Net Profit
Margin ÷
Expenses 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
Sales = × ×
𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Return on • It combines the ratios of profitability (operating
Assets X
Sales efficiency), asset turnover (asset management
Fixed efficiency), and financial leverage (Equity multiplier).
Assets
Total Assets ÷ • This analysis helps in identifying the source of variation
Turnover + in ROE among companies. You can determine which
Total Assets Current component was great?
Assets

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Practice Solution (Du Pont) Horizontal Analysis

• 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 ×
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 • Financial statements of two/more years compared (generally
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 2 years)
= × × • Comparison of absolute numbers and percentage values
𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
• This analysis helps in identifying the source of variation in ROE among • Simple but very useful (Explain with Trendlyne and
companies. Tickertape)

Company X is better as it is having same ROE with better efficiency (asset • Very helpful in forensic accounting (Focus on
turnover) and lesser leverage. exceptions/items changing more than 10%/15%)
• Identify particular reasons for change in items of financial
Du Pont for X: items in income statement and balance sheet.
20%=10%*1*2 • % change is ×100
Du Pont for Y:
20%=20%*0.2*5

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Trend Analysis (Horizontal analysis) Vertical (common-size) Analysis

• Extension of Horizontal analysis for more • Generally, financial statements of just one year
than 2 years (Explain with Trendlyne and analysed. (Explain with Tickertape Margin view).
However, if required, analysis could be extended
Tickertape) to multiple years to get insights.

• Base year is assigned 100 value. The • Common size statements are prepared
amounts in the following years are expressed – Based on total sales (Income statement)
– Based on total assets (Balance sheet)
as a percentage of the base year value
• All items of statement are expressed in
• To identify the growth (CAGR) percentage with respect to a common base (Total
sales/assets)

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Future Value of a Single Amount Example of FV:

𝑭𝑽𝒏 = PV(𝟏 + 𝒓)𝒏 Example: If you deposit Rs. 1000, today in a bank which
pays 10% interest compounded annually, how much will
Where the deposit grow to after 8 years and 12 years?

𝐹𝑉 = future value n years hence 𝐹𝑉 = PV(1 + 𝑟)

PV = cash today (present value)
r = interest rate per year 𝐹𝑉(1000) = Rs. 1000 (1 + 0.10) = Rs. 2144
n = number of years for which compounding is done
𝐹𝑉(1000) = Rs. 1000 (1 + 0.10) = Rs. 3138

(Explain in Excel)

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Doubling Period Shorter Compounding Period

Rule of 72 : 𝑭𝑽𝒏 = PV(𝟏 + 𝒓/𝒎)𝒎𝑿𝒏

According to this rule of thumb the doubling period is
obtained by dividing 72 by the interest rate. For example, if
the interest rate is 8%, the doubling period is about 9 years Where
(72/8). It gives us an approximation, not the exact answer.
For exact answer, we should always use calculator. 𝐹𝑉 = future value n years hence
PV = cash today (present value)
Q1. If interest rate is 6%, how long will it take to doble the r = nominal annual rate of interest
money. (72/6=12 years) n = number of years for which compounding is done
Q2. If money has doubled in 7 years in an investment m = number of times compounding is done during a
scheme, what is possible rate of return? (72/7=10.3 year
years approx.)

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Future Value of An Annuity

Effective Interest Rate

𝑟 ×
1+ −1
𝑚 (𝟏 𝒓)𝒏 𝟏
𝑭𝑽𝑨𝒏 = CF
𝒓

Where m is number of compounding in a year. For

example, assume 13% annual interest rate and compute Where
EIR, if compounding is done:
𝐹𝑉𝐴 = future value of an annuity which has a duration of
Compounding done: Number of componding in a year (m) EIR n period
Half-yearly 2 13.42% CF = constant periodic cash flow
Quarterly 4 13.65% r = interest rate per period
Monthly 12 13.80%
n = duration of the annuity
Weekly 52 13.86%

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Present Value of a Single Present Value of an Uneven

Amount Series
PV = 𝑭𝑽𝒏 /(𝟏 + 𝒓)𝒏 P𝑽𝒏 = ∑𝒏𝒕
𝑪𝑭𝒕
𝟏 (𝟏 𝒓)𝒕

Where
P𝑉 = Present value of a cash flow stream
𝐶𝐹 = Cash flow occurring at the end of year t
Example: find the present value of Rs. 1000 receivable 6
years hence if the rate of discount is 10%. r = Discount rate
n = Duration of the cash flow stream
PV = 1000/(𝟏 + 𝟎. 𝟏𝟎)𝟔 = Rs. 1000 X 0.564 = Rs. 564

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Present Value of an Uneven

Series Shorter Discounting Period

Example: Calculate present value of the following cash P𝐕 = F𝑽𝒏 /(𝟏 + 𝒓/𝒎)𝒎𝑿𝒏
flow stream if the discount rate is 12%
Year 1 2 3 4 5 6 7 8
Cash
Flow 1000 2000 2000 3000 3000 4000 4000 5000 Where
P𝑉 = present value
Show in excel. 𝐹𝑉 = cash flow after n years
m = number of times per year discounting is done
n = duration of the cash flow stream
r = annual discount rate

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Present Value of Annuity Present Value of a Perpetuity

P𝑽𝑨𝒏 = C𝐅
(𝟏 𝒓)𝒏 𝟏 A perpetuity is an annuity of infinite duration (No maturity).
𝒓(𝟏 𝒓)𝒏

Present Value of a Perpetuity = CF/r

P𝑉𝐴 = present value of an annuity which has a duration of • Such investments products are rare. Example, Perpetual
n period bonds.
CF = constant periodic cash flow • Still this concept is very useful in finance, such as it is
r = discount rate used in dividend discount model of valuation.

Q. What is the present value of a perpetuity that has $300

annual payments using an 8% discount rate? (Solution
300/0.08= $3750

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Equated Monthly Instalment

(EMI) Valuation of Bond with Maturity
EMI can be calculated using PVA formula: • Bond Value = PV of all annual interest payments + PV of
Maturity value
(𝟏 𝒓)𝒏 𝟏 • Example (Do the calculation):
P𝑽𝑨𝒏 = C𝐅
𝒓(𝟏 𝒓)𝒏 (Source: Numerical examples taken from the Book I.M. Pandey)

𝑷𝑽𝑨𝒏
CF = (𝟏 𝒓)𝒏 𝟏
𝒓(𝟏 𝒓)𝒏

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Current Yield Pure Discount Bonds (Zero

Coupon Bonds)
• Current yield is the annual interest divided by the bond’s • Pure discount bond do not carry an explicit rate of
current value. interest.
• It provides for the payment of a lump sum amount at a
future date in exchange for the current price of the bond.
• Current yield does not account for the capital gain or • The difference between the face value of the bond and
loss. its purchase price gives the return or YTM to the
investor.

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Valuation of Preference Shares

Perpetual Bonds
(Same process as bonds)
• No maturity (infinite life). An example of perpetuity.
Rarely found in practice.

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Dividend Capitalisation Multi-period Valuation

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Calculating Total Returns

Perpetual Growth Model (historical)
Income received on an investment plus any change in
market price, usually expressed as a percent of the
beginning market price of the investment.

𝑫𝒕 (𝑷𝒕 𝑷𝒕 𝟏 )
Simple Return (R) =
𝑷𝒕 𝟏
Where,
𝑫𝒕 = Dividend paid
𝑷𝒕 = Price of stock at time t
𝐏𝐭 𝟏 = Price of stock at time t-1

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Geometric Vs. Arithmetic Geometric Vs. Arithmetic Average

Average Rate of Return Rate of Return (historical)

∑(𝒙𝟏 + 𝒙𝟐 + 𝒙𝟑 +………+ 𝒙𝒏 ) Geometric Mean = 𝒏

𝒙𝟏 ∗ 𝒙𝟐 ∗𝒙𝟑 ∗………∗ 𝒙𝒏
Arithmetic Mean =
𝒏
Geometric Rate of Return = 𝒏 𝑹𝟏 ∗ 𝑹𝟐 ∗𝑹𝟑 ∗………∗ 𝑹𝒏
∑(𝑹𝟏 + 𝑹𝟐+ 𝑹𝟑+………+ 𝑹𝒏) The geometric average rate of return answers the question, “What
Arithmetic Rate of Return = was the growth rate of your investment?” (CAGR)
𝒏
The arithmetic average rate of return answers the question,
“what was the average of the yearly rates of return? Adjustment in Geometric Rate of Return is required to calculate
negative return. (Explain with multi-year returns)

Arithmetic average may not always capture the true rate of return
realized on an investment. In some cases, geometric or compound
average may be a more appropriate measure of return.

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Holding period return Expected Return (for future)

(historical) (With probability/scenarios)
• The returns for entire holding period
R = ∑ ( Ri )( Pi )
Where,
• For example, INR 100 investment grown to 150 in 5
years. R is the expected return for the asset,
Ri is the return for the ith possibility,
• Then, holding period return is 50% for this holding period Pi is the probability of that return occurring,
of 5-years. n is the total number of possibilities.

• Refer to Excel • Explain with simple example of 2 scenarios and

probabilities in near future.

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Calculation of Risk (with probability

Calculation of Risk (historical)
given for future scenarios)

∑ ( ) Risk (s) = ∑ (𝑅 − 𝑅) 𝑋 (𝑃 )
Risk (s) =
Standard Deviation, s, is a statistical measure of the
variability of a distribution around its mean.
• First, compute Mean returns (𝑅)
• Then mean deviation squared and apply the formula
It is the square root of variance.
• Explain variance and standard deviation

• Refer to Excel

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Determining Portfolio Return Determining Portfolio Risk

(Two Securities) (Two Securities)
𝑅 =∑ ( Wi )( Ri ) Var(Rp) = 𝑊 Var (𝑅 ) + 𝑊 Var (𝑅 ) + 2𝑊 𝑊 Cov (𝑅 , 𝑅 )
Where, Or
𝑅 is the expected return for the asset, 𝜎 = 𝑊 𝜎 + 𝑊 𝜎 + 2𝑊 𝑊 𝜌 𝜎 𝜎
Wiis the weight (investment proportion) for the ith asset in
the portfolio, s = ∑ ∑ 𝑊𝑊 s

Ri is the expected return of the ith asset,

Where,
n is the total number of assets in the portfolio Wj is the weight (investment proportion) for the jth asset in the portfolio,
Wk is the weight (investment proportion) for the kth asset in the portfolio,
sjk is the covariance between returns for the jth and kth assets in the portfolio

(Explain Covariance and Correlation of securities)

(Explain variance of n-assets portfolio via covariance matrix)

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Illustration: Portfolio Expected

Return and Risk
State of the Probability Return on Return on Return on
Economy Stock A Stock B Portfolio
1 0.2 15% -5% 5%
2 0.2 -5% 15% 5%
3 0.2 5% 25% 15%
4 0.2 35% 5% 20%
5 0.2 25% 35% 30%

(a) What is the expected return and risk if you invest only in stock A?
(b) What is the expected return and risk if you invest only in stock B?
(c) What is the expected return and risk if you invest in a portfolio consisting of
stock A and B in equal proportion?

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Term Structure of Interest

Rates Types of Yield Curve
• The relationship between the term of the security and the market
interest rate is known as the term structure of interest rates or Yield
Curve
• It shows how yield to maturity (YTM) is related to term to maturity for
bonds that are similar in all respects, excepting maturity.
• Term to maturity is the duration of debt instrument.
• The YTM of a bond is the interest rate that makes the present value of
the cash flows receivable from owning the bond equal to the price of
the bond.
P=∑ +
( ) ( )
Where,
P = price of the bond
C = annual interest in rupees
M = maturity value of the bond in rupees
n = number of years left to maturity
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Break-even point (BEP) Target Profit

• BEP is the volume (units) where company is making zero profit. It How many units to be sold to attain a target or desired profit?
is no profit no loss point.
• CVP relationship equation:
Total Fixed Cost + Desired Profit
Total Sales Revenue– Total Variable Costs – Total Fixed Cost = Profit/Loss Target Sales in units =
Contribution margin per unit
• BEP is when Profit is zero, hence
Total Sales Revenue– Total Variable Costs – Total Fixed Cost = 0
Total Fixed Cost + Desired Profit
Target Sales in INR =
Contribution margin ratio
• BEP in units = Total Fixed Cost/Contribution margin per unit
• BEP in INR = Total Fixed Cost/ Contribution margin ratio

• Contribution margin per unit = Selling price per unit– variable cost per unit
• Contribution margin ratio = Contribution margin per unit/ Selling price per unit

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Margin of Safety Practice Questions

• X manufactures soft toys for the European market. The soft toys sell for an
average price of $16. The costs incurred ($) by the firm are as follows:
It is the difference between the budgeted sales revenue and the – Materials (per toy) 5
– Wages (per toy) 4
BEP sales revenue.
– Packaging (per toy) 3
– Rent of premises 5,000
– Machinery hire 3,000
Margin of safety = Budgeted sales revenue - BEP sales
– Marketing and administration 1,000
revenue • Calculate the following:
– Contribution per toy sold
– Break-even in units of output
It gives a sense that how close (safe) budgeted sales is to the – Break-even level of sales revenue
BEP. – Construct a break-even chart showing the break-even level of output

– Source:
https://textbook.stpauls.br/Economics/Business_Textbook/Operations_manageme
nt_student/page_62.htm

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Operating Leverage Financial Leverage

 Emanates from the existence of fixed interest expenses

DOL =
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏  When the firm has fixed interest expenses, 1 % change
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑻𝒂𝒙𝒆𝒔 (𝑬𝑩𝑰𝑻) in EBIT leads to more than 1% change in PBT (or Net
Income).

 Degree of Financial Leverage (DFL) =

=
( )

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Total or Combined Leverage Summary

 Arises from the existence of fixed operating cost and Operating Financial Leverage Business Risk Financial Risk
interest expenses. Leverage

 1% change in revenues leads to more that 1% change in 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝐸𝐵𝐼𝑇 Variability in the Additional variability
PBT. 𝐸𝐵𝐼𝑇 𝑃𝐵𝑇 firm’s expected in net income to
EBIT. common
shareholders.
 Degree of Total Leverage (DTL) =

Increases with higher Increases with higher Increases with Increases with high
fixed cost debt high OL. FL.
Degree of Total Leverage (DTL) = DOL X DFL
If a firm already has high business risk, then it may be advisable to use less debt to lower the
= 5 X 2.5 = 12.5 financial risk. If a firm has less business risk, then it may be able to afford higher financial risk.

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Combination of OL & FL and Calculating Cost of Capital

their combined effect 1. Cost of Debt, 𝒌𝒅
Operating Leverage Financial Leverage Combined Leverage 1. Cost of Debt (𝒌𝒅 ): cost of debt instrument is the yield to maturity of
that instrument.
High High Very dangerous policy, 𝑰 𝑭
must be avoided 𝑷𝟎 = ∑𝒏𝒕 𝟏 (𝟏 𝒌 )𝒕 + (𝟏 𝒌 𝒅 )𝒏
𝒅
Low Low Very cautious policy and Where,
not assuming risk 𝑃 = current market price of the debentures
High Low Adverse effects of OL and I = annual interest payment
are taken care by having n = number of years left to maturity
low FL F = maturity value of the debenture
Low High An ideal situation. The • computation of 𝒌𝒅 requires a trial and error procedure (YTM)
company can follow
aggressive debt policy OR
• You can use following formula which gives a very close approximation
to the correct value
𝑰 (𝑴𝑽 𝑷𝟎 )/𝒏
𝒌𝒅 = 𝟎.𝟔𝑷𝟎 𝟎.𝟒𝑴𝑽

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Cost of Capital Cost of Capital

2. Cost of Preference Shares, 𝒌𝒑 3. Cost of Retained Earnings/Equity, 𝒌𝒆
Cost of Retained Earnings/Equity (𝒌𝒆 ): is the rate of return on equity that
2. Cost of Preference Shares (𝒌𝒑 ): Cost of preference require on equity finance (external equity) that firm obtains by way of
share is equal to its yield. retained earnings (Internal equity)
𝑫 (𝑴𝑽 𝑷𝟎 )/𝒏
𝒌𝒑 =
𝟎.𝟔𝑷𝟎 𝟎.𝟒𝑴𝑽 i) The Dividend Growth Model Approach (Gordon Constant
Where, Growth Model): Price of an equity stock generally depends on the
dividends expected on it. Explain with present value formula for
𝑃 = current market price of the preference share dividend discount model.
D = annual dividend payment 𝑫
𝒌𝒆 = 𝑷 𝟏 + g
n = number of years left to maturity 𝟎
These dividends are expected to grow at a constant rate of g per cent
MV = maturity value of the preference shares 𝑫𝟎 (𝟏 𝒈)
per year. 𝒌𝒆 = +g
𝑷𝟎
Where,
= dividend yield; g = expected growth rate of dividends

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Cost of Capital Cost of Capital

3. Cost of Retained Earnings, 𝒌𝒆 Cost of External Equity, 𝒌𝒆
ii) The Capital Asset Pricing Model (CAPM) Approach: calculates the expected
return on a security based on its level of risk.
Cost of External Equity (𝒌𝒆 ) : The cost of external equity is
higher than the cost of retained earnings because when a
𝒌𝒆 = 𝒓𝒇 + β (𝒓𝒎 - 𝒓𝒇 ) company issues external equity it incurs flotation or issue
Where,
costs.
𝒓𝒇 = risk free rate : this may be estimates as the yield on a long-term government bond 𝑫𝟏
that has a maturity of 10 years or more (Use current Rf) 𝒌𝒆 = +g
𝑷𝟎 (𝟏 𝑭)
β = coefficient of equity: beta is the measure of risk involved with investing in a Where
particular stock relative to the risk of the market. This may be calculated by
regressing the monthly returns on the stock over the monthly returns on the market
index over the past 60 months or more.
𝒌𝒆 = cost of external equity
F = percentage flotation cost incurred in issuing new equity
𝒓𝒎 = return on the market: this may be estimated by a broad stock market index like
the BSE sensex or NSE Nifty 50 (Long-term average to avoid abnormal returns for a
particular year).

𝒓𝒎 - 𝒓𝒇 = market risk premium: this may be estimated as the difference between

average return on the market portfolio and the average risk free rate over the
past 10 to 30 years – the longer the period, the better it is.
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Weighted Average Cost of Estimation of Cash Flow

Capital (WACC)
• Given the cost of specific sources of financing and the • Free Cash Flow (FCF) = Net Profit + Depreciation –
scheme of weighting, the WACC can be readily calculated by Capital Expenditure
multiplying the specific cost of each source of financing by its
proportion in the capital structure and adding the weighted
• Or FCF = Net operating profit after tax + Depreciation –
values. Capital Expenditure
• Or FCF = EBIT (1-T) + Depreciation – Capital Expenditure
WACC = 𝒘𝒆 𝒌𝒆 + 𝒘𝒑 𝒌𝒑 + 𝒘𝒅 𝒌𝒅 (1- t) • Net operating profit after tax (NOPAT) = EBIT (1-T).
Where, Interest is not reduced from profits. Hence, ignore the
interest payments. However, interest after tax is part of
𝒘𝒆 = proportion of equity
discounting rate (WACC) to avoid double counting.
𝒘𝒑 = proportion of preference
• Cash Inflow = Profit + Depreciation (non-cash
𝒘𝒅 = proportion of debt expense)
t = corporate tax rate
• Cash Outflow = Capital Expenditure

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Capital Budgeting Techniques Net Present Value (NPV)

Net Present Value • NPV is based on the economic principle, “Time Value of Money”:
(NPV) Cash flows of the project received earlier has more value than the
cash flows received later.
• It postulates that cash flows arising at different time periods differ
Discounted Cash Internal Rate of in value and are comparable only when their equivalents- present
Flow Criteria Return (IRR) values – are found out.
𝑪𝒕
NPV = ∑𝒏𝒕 𝟏 (𝟏 𝒌)𝒕 − 𝑪𝒐
Profitability Index
Capital Budgeting (PI)
Techniques Where,
𝐶 = net cash inflows in year 1,2,3,….n
Payback Period k = opportunity cost of capital (assumed to be known and constant)
(PB)
Non-discounted 𝐶 = initial cost of the investment
Cash Flow Criteria n = expected life of the investment
Accounting Rate
of Return (ARR)

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Net Present Value (NPV) Internal Rate of Return (IRR)

Acceptance Rule • IRR is based on the economic principle, “Time Value of Money”:
Cash flows of the project received earlier has more value than the
cash flows received later.
• Accept if NPV ˃ 0 • IRR is the rate at which project will have a zero NPV
• Reject if NPV ˂ 0 IRR = ∑𝒏𝒕
𝑪𝒕
𝟏 (𝟏 𝒓)𝒕 − 𝑪𝒐 = 0 NPV
• May be accepted if NPV = 0
Where,
𝐶 = net cash inflows in year 1,2,3,….n
r = rate of return (to be determined using trial and error method)
𝐶 = initial cash outflow
n = expected life of the investment

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Internal Rate of Return (IRR) Internal Rate of Return (IRR)

Using Trial and Error Method, following formula can be used to Acceptance Rule:
find out a close approximation of the rate of return
𝐍𝐏𝐕𝐋𝐃𝐅
IRR = LDF % + (𝑯𝑫𝑭% − 𝑳𝑫𝑭%) • Accept if IRR ˃ required rate of return
𝐍𝐏𝐕𝐋𝐃𝐅 𝐍𝐏𝐕𝐇𝐃𝐅
Where, • Reject if IRR < required rate of return
LDF = Lower discount factor • May be accepted if IRR = required rate of return
HDF = Higher discount factor
NPVLDF = NPV of cash inflows at low discounting factor
NPVHDF = NPV of cash inflows at high discounting factor

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Profitability Index (PI) Payback Period

The method is also called benefit cost ratio. • PB is a non-discounted method of capital budgeting
• It is defined as the number of years required o recover the
𝑪𝒕
original cash outlay invested in a project.
∑𝒏
Profitability Index =
𝒕 𝟏(𝟏 𝒓)𝒕 • If the project generates constant annual cash inflows, the
payback period can be computed as

Acceptance Rule 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝑪𝒐

Payback = =
• Accept if PI˃ 1 𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 𝑪

• Reject if PI ˂ 1
• In case of unequal cash inflow, the payback period can be
• May be accepted if PI = 1 found out by adding up the cash inflows until the total initial
cash outlay.

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Accounting Rate Return or

Payback Period Average rate of return (ARR)
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒇𝒊𝒕 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝒐𝒓(EBIT∗(1−Tax rate))
Acceptance Rule ARR = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
• Accept if PB ˂ Standard PB • The numerator of this ratio may be measured as the average
annual post-tax profit (EBIT*(1-Tax rate)) over the life of the
• Reject if PB ˃ Standard PB investment. No adjustment for interest is needed. However,
depreciation will be reduced to get profits. The denominator is the
average book value of fixed assets committed to the project.
Limitations:
• Rule of acceptance: If the ARR is equal to or greater than the
• A major shortcoming of the conventional payback period is required rate of return, the project is acceptable. If it is less than
that it does not take into account the time value of money. the desired rate, it should be rejected
• Accept if ARR> required rate of return
• All cashflows (after the payback period) are not
• Reject if ARR< required rate of return
considered.
Limitations:
• It is based upon accounting profit, not cash flow.
• It ignores time value of money principle.

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Proportion of CA and FA Economic Oder Quantity

(EOQ) Approach
Current Fixed Assets Industries • According to EOQ approach optimal level of investment
Assets (%) (%) in inventory is one where total cost of inventory
10-20 80-90 Hotel and Restaurants comprising carrying and ordering costs will be minimum.
20-30 70-80 Electricity Generation and Distribution
30-40 60-70 Aluminium, Shipping ∗ ∗
EOQ =
40-50 50-60 Iron and Steel, Basic Industrial
Chemicals
50-60 40-50 Tea Plantation Where, Annual carrying cost per unit can be also calculated
60-70 30-40 Cotton Textiles, Sugar as price per unit X carrying cost per unit in percentage.
70-80 20-30 Edible Oils, Tobacco
80-90 10-20 Trading, Construction
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1. Operating Cycle Approach Financing of Current/Cash

Assets
The length of Operating Cycle of a manufacturing firm can be
calculated…. Long-term Financing Short-term Financing
• Share capital • Bank credit
• Inventory turnover period = /
a. Equity share capital • Transaction credit
b. Preference share capital • Advances from customers
• Debtors (Receivable) turnover period = /
• Debentures • Bank advances
a. Convertible debentures • Loans
• Creditors (Payables) deferral period = /
b. Non-convertible debentures • Overdraft
c. Redeemable debentures • Bills purchase and discounted
• Gross Operating Cycle = Inventory turnover period +
d. Non-Redeemable debentures • Advance against documents of title of
debtors turnover period goods
• Bonds
• Net Operating Cycle = Operating cycle – Creditors deferral • Loans from banks & financial institutions • Term loans by bank
period • Retained earnings • Commercial paper
• If depreciation is excluded from the expenses (in COGS • Venture capital fund for innovative • Bank deposits, etc.
calculation) in the computation of operating cycle, the net projects
operating cycle also represents the cash conversion cycle.

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Cash Receipts & Payments: Cash Receipts & Payments:

Basis of Estimation Basis of Estimation
Items Basis of Estimation
Items Basis of Estimation Payment for purchases Estimated purchases, its division between
Cash Sales Estimated sales and its division between cash cash and credit purchases, and payment
and credit sales terms

Interest and dividend receipts Firm’s portfolio of securities and return Wages and salaries Manpower employed, wages and salaries
expected from the portfolio structure

Increase in loans/deposits and issue of Financing plan Manufacturing expenses Production plan
securities General, admin and selling exp. Admin and sales personnel and proposed
sales promotion and distribution exp.
Sale of assets Proposed disposal of assets
Capital equipment purchases Capital expenditure budget and payment
Cash purchases Estimated purchases, and its division
pattern associated with capital
between cash and credit purchases
equipment purchases

Repayment of loans and retirement of Financing plan

securities

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Assumptions and Definitions Assumptions and Definitions

Based on the discussed assumptions, the analysis focuses • When the dividend pay out ratio is 100 % , and earnings
on the following rates: are constant, 𝑘 , as defined here, represents the cost of
equity capital.
𝑘 = = ; So D =
• 𝑘 = WACC = overall capitalization rate of the firm.
𝑘 = +g; 𝑘 =𝑘 ( )+𝑘 ( )

𝑘 = =
If DPS = EPS (as per assumption) then g = 0
where
Therefore, 𝑘 = +0=
V=D+E
Lets denote 𝑃 = E = Market value of the equity.

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Net Income Approach (NI) Net Income Approach (NI)

• According to this approach, the cost of debt capital, 𝑘 , According to NI approach both the
and the cost of equity capital, 𝑘 , remain unchanged cost of debt and the cost of equity
when Debt ratio (D/(D+E)), the degree of leverage, are independent of the capital
varies. The constancy of 𝑘 and 𝑘 with respect to debt structure; they remain constant
ratio means that 𝑘 , the average cost of capital is regardless of how much debt the
firm uses. As a result, the overall
measured as
cost of capital declines and the firm
value increases with debt. This
= )+ ) approach has no basis in reality;
the optimum capital structure
would be 100 per cent debt
Declines as D/E increases. This happens because when financing under NI approach.
debt ratio increases, 𝑘 , which is lower than 𝑘 , receives a (Debt is assumed to be risk-free The effect of leverage on the cost of
higher weight in the calculation of 𝑘 . and shareholder perceive no risk capital under NI approach
with high debt)

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Net Operating Income

Approach (NOI) Traditional Approach
• According to the NOI approach, the WACC and the Kd remain
constant for all degrees of leverage.

𝑘 = 𝑘 + (𝑘 - 𝑘 )
• The critical premise of this approach is that the market capitalises
the firm as a whole at a discount rate which is independent of
the firm’s degree of leverage.
• As a consequence, the division between debt and equity is
irrelevant.
• An increase in the use of debt funds which are ‘apparently cheaper’
is offset by an increase in the equity capitalisation rate (due to
perceived financial risk).
• This happens because equity investors seek higher compensation
as they are exposed to greater risk arising from increase in the
degree of leverage.
• They raise the capitalisation rate as the degree of leverage
increases. Source: Collegehive

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Traditional Approach: Traditional Approach: Practice

Illustration
A firm increasing debt and impact on WACC and Value. Kd and Ke both A firm increasing debt and impact on WACC and Value. Kd and Ke both
increasing. WACC first decreases (from 10% to 9.68%) then increases (from increasing. WACC first decreases (from 10% to 9.46%) then increases (from
9.68% to 10.25%). 9.46% to 9.82%). Similar impact on Value as well.

Debt 300 Debt 600 Debt 200 Debt 500

Particulars Zero Debt Cr. At 6% Cr. At 7% Particulars Zero Debt Cr. At 5% Cr. At 6%
Net Operating income (EBIT) 150 150 150 Net Operating income (EBIT) 100 100 100
Interest on debt (I) 0 18 42 Interest on debt (I) 0 10 30
Equity earnings (EBT) 150 132 108 Equity earnings (EBT) 100 90 70
Cost of equity capital (Ke), Assumed
Cost of equity capital (Ke), Assumed increasing 10.00% 10.50% 13.50%
increasing 10.00% 10.56% 12.50%
Market value of equity (E)=(EBT/Ke) 1000 857.14 518.52
Market value of equity (E)=(EBT/Ke) 1500 1250 864
Market value of debt (D)= (I/Kd) 0 300 600 Market value of debt (D)= (I/Kd) 0 200 500
Total value of the firm (V) 1500 1550 1464 Total value of the firm (V) 1000 1057.14 1018.52
WACC (k_o)=(EBIT/V) Or Use WACC Formula 10.00% 9.68% 10.25% WACC (k_o)=(EBIT/V) Or Use WACC Formula 10.00% 9.46% 9.82%

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Setting a target Capital

MM’s Basic Propositions Structure : EBIT-EPS Analysis
• Helps in choosing an optimum capital structure.
2. Proposition II : The expected yield on equity is equal to • Analyse how sensitive earnings per share (EPS) is to changes in
𝒌𝒐 plus a premium. This premium is equal to the debt-equity earnings before interest and tax (EBIT) under different financing
ratio times the difference between 𝑘 and the yield on debt alternatives.
(𝑘 ) (Like NOI approach). ( )
EPS = = NI/n

𝑘 = 𝑘 + (𝑘 - 𝑘 ) Where,
EPS = earning per share; EBIT = earning before interest and tax; I = interest
burden; t = tax rate; n = number of equity shares

3. Proposition III : The cut-off rate for investment decision • The indifference point of EBIT for two alternative financing plan is the
making for a firm in a given risk class is not affected by the level of EBIT for which EPS is the same under both the financing
manner in which the investment is financed. Investment and plans.
financing decisions are independent because the average • It can be graphically obtained by plotting the relationship between
cost of capital is not affected by the financing decision. EBIT and EPS under the two financing plans and noting the point of
intersection.

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Setting a target Capital EBIT-EPS: Illustration

Structure : EBIT-EPS Analysis
Falcon Ltd plans to raise additional capital of Rs. 10 million
for financing an expansion project. In this context, it is
evaluating two alternative financing plans.
(i) Issue of equity shares worth 1 million at Rs. 10 per
share, and
(ii) Issue of debenture carrying 14 per cent interest.
What will be the EPS under the two alternative financing
plans for two level of EBIT say Rs. 4 million and Rs. 2
million?
Tax rate is 50%. Existing capital structure includes 1million
equity shares of Rs. 10 each.

Source: Google images

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Dividend Distribution Theories:

EBIT-EPS: Solution
Dividend Policy and Share Valuation
Formula to compute indifference point of EBIT:
∗ ( ) ∗ ( )
=
∗ ( . ) ∗ ( . )
Walter’s Model
=
Relevance
𝑬𝑩𝑰𝑻∗ = 28,00,000 (Where EPS is same in both plans) Gordon’s Model
Theories

• If EBIT is below Rs. 2800000, equity financing is Dividend Policy

Linter’s Model
preferable to debenture financing. Theories

• If EBIT is higher than Rs. 2800000, the opposite Irrelevance

M & M Theory
holds. Theories

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Walter’s Valuation Model Implication of Walter’s Model

• According to Prof. James E. Walter, in the long run, share prices
reflect the present value of future dividends. According to him 1. When the rate of return is greater than the cost of capital
investment policy and dividend policy are interrelated, and (r>k), the price per share increases as the dividend pay-
the choice of an appropriate dividend policy affects the value of an out ratio decreases. That means, the optimal pay-out
enterprise. ratio for a growth firm is nil.
2. When the rate of return is equal to the cost of capital
P= (r=k), the price per share does not vary with changes in
Where, dividend pay-out ratio. Means, the pay-out ratio for a
P = Price per equity share normal firm is irrelevant.
D = Dividend per share 3. When the rate of return is less than the cost of capital
E = Earnings per share (r<k), the price per share increases as the dividend pay-
out ratio increases. That means, the optimal pay-out
(E-D) = Retained earnings per share
ratio for a declining firm it 100%.
r = Internal rate of return on investments
k = cost of capital

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Walter’s Model: Illustration Gordon’s Valuation Model

• Myron Gordon's Dividend Growth Model explains how dividend policy
The earning per share of a firm is Rs.8 and the of a firm is a basis of establishing share value.
• The value of a share, like any other financial asset, is the present value
rate of capitalisation applicable is 10%. The of the future cash flows associated with ownership. On this view, the
firm has before it an option of adopting (i) 50%, value of the share is calculated as the present value of an infinite stream
of dividends.
(ii) 75%; and (iii) 100% dividend pay-out ratio. ( )
Compute the market price of the firm’s quoted 𝑃 = =
shares as per Walter’s model if it can earn a Where,
𝑃 = price per share at the beginning of the year
return of (i) 15%, (ii) 10%, (iii) 5 % on its 𝐸 = earning per share at the end of the year
retained earnings. (1-b) = dividend pay-out ratio
b = retention ratio
k = rate of return required by shareholders
(Refer to Excel) r = rate of return on investment
g= retention ratio * rate of return on investment

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Implication of Gordon’s Model

1. When the rate of return is greater than the cost of capital

(r>k), the price per share increases as the dividend pay-
out ratio decreases. That means, the optimal pay-out
ratio for a growth firm is nil.
2. When the rate of return is equal to the cost of capital
(r=k), the price per share does not vary with changes in
dividend pay-out ratio. Means, the pay-out ratio for a
normal firm is irrelevant.
3. When the rate of return is less than the cost of capital
(r<k), the price per share increases as the dividend pay-
out ratio increases. That means, the optimal pay-out
ratio for a declining firm it 100%.

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