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Corporate Finance
CREATED BY ADNAN ARSHAD
(Lecturer)
Govt. College University Faisalabad
CONTACT NO: 0301-7120098
EMAIL: adnan_776@yahoo.com
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BRIEF CONTENTS
Topics
Page No
Goal and function of finance
Function of finance. investment decision , finance decision
2
Concept in valuation
time value of money, present value, bond return , dividend discounting
model , measuring risk
5
Market risk and return
Efficient financial markets, security portfolio, capital assets pricing model
15
Investment in assets and required return
Administrative framework, method of evaluation , NPV vs IRR, inflation
capital budgeting
20
Theory of capital structure
Cost of capital, capital structure, taxes,
33
Making capital structure decision
EBIT- EPS analysis
43
Dividend and share repurchase
Procedural aspects of paying dividend
46
Issuing securities
Public offering security
47
Fixed income financing and pension liability
Feature of debt , types of debt financing, proffered stock
48
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Corporate finance CHAPTER 1
Goal and function of finance
Definition of finance
The finance function is the process of acquiring and utilizing funds of a business.
Financing consists of the raising, providing, managing of all the money, capital or funds
of any kind to be used in connection with the business
Financial Management: The process of managing the financial resources, including accounting and financial reporting, budgeting, collecting accounts receivable, risk management, and insurance for a business
Major functions of financial management: 1. Accounting:
Typically includes: (a) planning the program within delegated limits; (b) developing, revising, and/or adapting accounting systems; (c) executing day-to-day ledger maintenance and related operations for the classification and other recording of financial transactions; (d) analyzing the results and interpreting the effects of transactions upon the financial resources of the organization; (e) applying accounting concepts to solve problems, render advice, or to meet other needs of management; and (f) managing the total accounting program, including supervision of subordinate accountants, accounting technicians, voucher examiners, payroll clerks, and other similar supporting personnel. 2. Budgeting: Typically includes: (a) the formulation -- developing instructions, calls for estimates, preparing estimates, reviewing and consolidating estimates; (b) the presentation -- either within the organization or at hearings (within the agency, at the budget bureau, or subcommittee); and (c) the execution -- funds control, program adjustments, review of reports and preparation of reports. 3. Managerial-Financial Reporting:
. Managerial-financial reporting is the process of providing appropriate data to key officials at all levels of management for the purpose of helping to achieve the
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most effective program and financial management. Stress is placed on aiding in the making of management decisions. Normally, much of such data will be of a financial character, developed from the accounting and the budget systems; however, frequently data will be a combination of both financial and non-financial information and, in some cases, the data may be entirely non-financial in nature. In its ideal form, the data are so integrated as to represent a single total data system. Since in good managerial-financial reporting, concern is given to the development of the systems that will provide the essential data, one of the normal responsibilities of the Financial Manager is the development, revision and/or adaptation of the managerial-financial reporting system.
Function of finance
1 -Investment decision.
One of the most important long term decisions for any business relates to investment.
Investment is the purchase or creation of assets with the objective of making gains in the
future. Typically investment involves using financial resources to purchase a machine/
building or other asset, which will then yield returns to an organisation over a period of
time.
Decisions basically concerned with the process of acquiring funds. May be from own
sources (Equity Capital) or loan sources ( Debt Capital).
These decisions are concerned with answers to the following questions
1. what is the scale of the investment - can the company afford it?
2. How long will it be before the investment starts to yield returns? 3
3. How long will it take to pay back the investment?
4. What are the expected profits from the investment?
5. Could the money that is being ploughed into the investment yield higher returns
elsewhere?
2-Financing decisions
Decisions concerning the liabilities and stockholders' equity side of the firm's balance
sheet, such as a decision to issue bonds.
Concerned with utilisation of funds. These decisions relate to the selection of the assets in
which funds should be invested. From the asset perspective these decisions are—
• Capital Budgetting decisions
• Working Capital Management
Capital budgeting decision
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Capital budgeting is the process by which the financial manager decides whether to
invest in specific capital projects or assets. In some situations, the process may entail in
acquiring assets that are completely new to the firm. In other situations, it may mean
replacing an existing obsolete asset to maintain efficiency.
During the capital budgeting process answers to the following questions are sought:
What projects are good investment opportunities to the firm?
From this group which assets are the most desirable to acquire?
How much should the firm invest in each of these assets?
Working capital management
Working capital management involves the relationship between a firm's short-term assets
and its short-term liabilities. The goal of working capital management is to ensure that a
firm is able to continue its operations and that it has sufficient ability to satisfy both
maturing short-term debt and upcoming operational expenses. The management of
working capital involves managing inventories, accounts receivable and payable, and
cash.
3- Asset management
management refers to the professional management of investments such as stocks and
bonds, along with real estate. Typically, asset management is only practiced by the very
wealthy, as the services of a professional firm can demand considerable sums of money,
and successful asset management usually requires a large and diverse portfolio.
Numerous professional firms and investment banks offer asset management services,
which are often handled by a team of financial professionals for the best results. The
firms handling the largest accounts are based in the United States, although several
venerable European firms also work with high volume accounts.
Typically, the investor meets with an asset management team before surrendering control
of the assets to discuss goals and investment styles. In general, the team works with the
investor to set realistic goals to grow the investor's wealth and measure the performance
of the team. The investor also usually expresses directions as to what type of investment
style he would prefer the team to engage in. For example, single young investors
sometimes choose less conservative investment schemes than older individuals or
couples. Meetings with the asset management team are held on a regular basis so that the
investor can be apprised of progress and kept up to date.
__________________________________
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CHAPTER 2
Time value of money
The idea that money available today is worth more than the same amount of money in the
future,
Time value of money is the concept of measuring the value of money over time.
Why do we care, because value of money changes with time and it‘s crucial to analysis of
a real estate investment to be able to measure and solve for those changes.
Everyone knows that money deposited in a savings account will earn interest. Because of
this, the sooner it starts earning interest, the better. For example, assuming a 5% interest
rate, a $100 investment today will be worth $105 in one year ($100 multiplied by 1.05).
Conversely, $100 received one year from now is worth only $95.24 today ($100 divided
by 1.05), assuming a 5% interest rate.
There are two components
Present value
Present value defines what a dollar is worth today.
The current worth of a future sum of money or stream of cash flows given a specified rate
of return. Future cash flows are discounted at the discount rate, and the higher the
discount rate, the lower the present value of the future cash flows. Determining the
appropriate discount rate is the key to properly valuing future cash flows, whether they be
earnings or obligations
PV = FV/ (1+i) ⁿ
Annuity
An annuity is a cash flow, either income or outgoings, involving the same sum in
each period.
An annuity is the payment or receipt of equal cash flows per period for a specified
amount of time. For example, when a company set aside a fixed sum each year to
meet a future obligation, it is using annuity.
The time period between two successive payments is called ‗payment period‘ or
‗rent period‘.
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A = P [ (1+i)ⁿ - 1 / (1+i) ]
A = Annual or future value which is the sum of the compound amounts of all payments
P = Amount of each instalment
i = Interest rate per period
n = Number of periods
Present value of ordinary annuity
The present value of an ordinary annuity is the sum of the present value of a series of
equal periodic payments. An annuity where the first payment is delayed beyond one year,
the annuity is called a ‗deferred annuity‘.
PVA = R [ 1 – (1+i)ⁿ / i ]
Present value of perpetuity
A perpetuity is a financial instrument that promises to pay an equal cash flow per period
forever, that is, an infinite series of payments and principal amount never be repaid. The
present value of perpetuity is calculated with the following formula:
Present value of annuity due
The Present Value of an Annuity Due is identical to an ordinary annuity except that each
payment occurs at the beginning of a period rather than at the end. Since each payment
occurs one period earlier, we can calculate the present value of an ordinary annuity and
then multiply the result by (1 + i).
PVAD = R [ 1 – (1+ i)ⁿ /I ] × ( 1 + i)
Future value
The future value of a sum of money invested at interest rate i for one year is given by:
FV = PV ( 1 + i )
where
FV = future value
PV = present value
i = annual interest rate
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If the resulting principal and interest are re-invested a second year at the same interest
rate, the future value is given by:
FV = PV ( 1 + i ) ( 1 + i )
In general, the future value of a sum of money invested for n years with the interest
credited and re-invested at the end of each year is:
FV = PV ( 1 + i )ⁿ
Future value of ordinary annuity
The future value of an annuity is simply the sum of the future value of each payment. The
equation for the future value of an annuity due is the sum of the geometric sequence:
FV = R [ (1+ i)ⁿ - 1 / i]
Future value of annuity due
FV = R [ (1+ i)ⁿ - 1 / i] × (1 + i)
Valuation of long term security
We are concern with the valuation of firm long term securities bonds, preferred stock,
and common stock
This value is the present value of the cash flow stream provided to the investor,
discounted at a required rate of return appropriate for the risk involved
There are different types of securities
1- Bond valuation A bond is a long-term debt instrument issued by a corporation or government.
A bond is a security that pays a stated amount of interest to the investor, period after
period, until it is finally retired by the issuing company
Terms of bond
Face value
The maturity value (MV) [or face value] of a bond is the stated value. In the case of a
U.S. bond, the face value is usually $1,000.
Coupon rate
The bond‘s coupon rate is the stated rate of interest; the annual interest payment divided
by the bond‘s face value.
Discount rate
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The discount rate (capitalization rate) is dependent on the risk of the bond and is
composed of the risk-free rate plus a premium for risk
Types of bond
Perpetual bond
A perpetual bond is a bond that never matures. It has an infinite life. These are indeed
rare but they help to illustrate the valuation technique in its simplest form
Present value of bond would simply be equal to the capitalized value of an infinite stream
of interest payment
Example
Bond P has a $1,000 face value and provides an 8% annual coupon. The appropriate
discount rate is 10%. What is the value of the perpetual bond?
I = $1,000 ( 8%) = $80.
kd = 10%.
V = I / kd [Reduced Form]
= $80 / 10% = $800.
Non zero coupon paying bond
A non-zero coupon-paying bond is a coupon paying bond with a finite life. If the bond
has a finite maturity then we must not only consider the interst stream but also the
terminal or maturity value ( face value ) in the valuing bond the valuation equation for a
such a bond that pays interest at the end of each years
(1 + kd)1
(1 + kd)2
(1 + kd)V = + + ... +
I I I
= t=1
or I (PVIFA kd, )
V = II / kkdd [Reduced Form]
(1 + kd)t
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Bond C has a $1,000 face value and provides an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the value of the coupon bond?
V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30) = $80 (9.427) + $1,000 (.057)
[Table IV] [Table II]
= $754.16 + $57.00 = $811.16.
Zero coupon bond
A zero coupon bond is a bond that pays no interest but sells at a deep discount from its
face value; it provides compensation to investors in the form of price appreciation
= MV (PVIFkd, nn)
Bond Z has a $1,000 face value and a 30 year life. The appropriate discount rate is 10%.
What is the value of the zero-coupon bond?
V = $1,000 (PVIF10%, 30)
= $1,000 (.057)
= $57.00
2 -Preferred stock valuation
Preferred Stock is a type of stock that promises a (usually) fixed dividend, but at the
discretion of the board of directors. Preferred Stock has preference over common stock
in the payment of dividends and claims on assets.
The payment of preferred stock is similar to an annuity, so the valuation model of a
preferred stock is
V = Dp / Kp
Example
Stock PS has an 8%, $100 par value issue outstanding. The appropriate discount rate is
10%. What is the value of the preferred stock?
Dp = $100 ( 8% ) = $8.00.
Kp = 10%.
(1 + kd)1
(1 + kd)2
(1 + kd)nn V = + + ... +
I I + MV I
= nn
t=1 (1 + kd)
t
I
V = I (PVIFA kd, nn) + MV (PVIF kd, nn)
(1 + kd)nn +
MV
(1 + kd)nn
V = MV
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V = Dp / kp = $8.00 / 10%
= $80
3 -Common stock valuation Common stock is the security that represent the ultimate ownership (and risk) position in
a corporation
The difficult issues of valuation: uncertainty and payment of stock dividend, different
risk levels, etc.
Unlike bond and preferred stock cash flow which are contractually stated much more
uncertainty surrounds the future stream of return connected with common stock
Are the dividend foundation
The value of a share of common stock can be viewed as the discounted value of all
expected cash dividends provided by issuing firm until the end of time
Case 1: hold the stock for a long time
Dt is a cash dividend
Ke is the investor required return
• Case 2: hold the stock for a short time (e.g., 2 years)
• Note: D1, D2…Dn and P2 are all estimates
P2 expected sale price
______________________________________
Chapter 3
Concept in valuation
Dividend discounting models
A procedure for valuing the price of a stock by using predicted dividends and discounting
them back to present value. The idea is that if the value obtained from the DDM is higher
than what the shares are currently trading at, then the stock is undervalued.
In other words, it is used to evaluate stocks based on the net present value of the future
dividends.
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There are 3 models used in the dividend discount model:
zero-growth model
zero growth which assumes that all dividends paid by a stock remain the same; Since the
zero-growth model assumes that the dividend always stays the same, the stock price
would be equal to the annual dividends divided by the required rate of return. Stock‘s
Intrinsic Value = Annual Dividends / Required Rate of Return
This is basically the same formula used to calculate the value of a perpetuity, which is a
bond that never matures, and can be used to price preferred stock, which pays a dividend
that is a specified percentage of its par value. A stock based on the zero-growth model
can still change in price if the capitalization rate changes, as it will if perceived risk
changes, for instance.
Example—Intrinsic Value of Preferred Stock
If a preferred share of stock pays dividends of $1.80 per year, and the required rate of
return for the stock is 8%, then what is its intrinsic value?
Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50.
the constant-growth model, (gordon growth model )
constant growth model which assumes that dividends grow by a specific percent
annually;
The constant-growth DDM (Gordon Growth model, because it was popularized by
Myron J. Gordon) assumes that dividends grow by a specific percentage each year, and is
usually denoted as g, and the capitalization rate is denoted by k.
Constant-Growth Rate DDM Formula
Intrinsic Value = D1
──────
k – g
D1 = Next Year‘s Dividend
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k = Capitalization Rate
g = Dividend Growth Rate
The constant-growth model is often used to value stocks of mature companies that have
increased the dividend steadily over the years. Although the annual increase is not always
the same, the constant-growth model can be used to approximate an intrinsic value of the
stock using the average of the dividend growth and projecting that average to future
dividend increases.
Example—Calculating Next Year‘s Stock Price Using the Constant-Growth DDM
If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually,
then what will be the price of the stock next year, assuming a required rate of return of
12%?
Next Year‘s Stock Price = $4 x 1.06 / (12% - 6%) = 4.24 / 0.06 = $70.67
This Year‘s Stock Price = $4 / 0.06 = 66.67
Growth Rate of Stock Price = $70.67 / $66.67 = 1.06 = Dividend Growth Rate
Note that if both the capitalization rate and dividend growth rate remains the same every
year, then the denominator doesn‘t change, so the stock‘s intrinsic value will increase
annually by the percentage of the dividend increase. In other words, both the stock price
and the dividend amount will increase by the constant-growth factor, g.
variable-growth model, (multi stage growth model )
variable growth model which typically divides growth into 3 phases: a fast initial phase,
then a slower transition phase that ultimately ends with a lower rate that is sustainable
over a long period.
Variable-growth rate models (multi-stage growth models) can take many forms, even
assuming the growth rate is different for every year. However, the most common form is
one that assumes 3 different rates of growth:
an initial high rate of growth, a transition to slower growth, and lastly, a sustainable,
steady rate of growth.
Basically, the constant-growth rate model is extended, with each phase of growth
calculated using the constant-growth method, but using 3 different growth rates of the 3
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phrases. The present values of each stage are added together to derive the intrinsic value
of the stock.
Sometimes, even the capitalization rate, or the required rate of return, may be varied if
changes in the rate are projected.
Measuring risk
Variation in return is called risk . uncertainty in return is called risk
Chance that actual return on investment will be different from the expected return.
This includes the possibility of losing some or all of the original investment. Risk is
usually measured by calculating the standard deviation of the historical returns or average
returns of a specific investment. Many companies now allocate large amounts of money
and time in developing risk management strategies to help manage risks associated with
their business and investment dealings. A key component of the risk management process
is risk assessment, which involves the determination of the risks surrounding a business
or investment.
Expected risk return trade off
The principle that potential return rises with an increase in risk. Low levels of uncertainty
(low risk) are associated with low potential returns, whereas high levels of uncertainty
(high risk) are associated with high potential returns. According to the risk-return
tradeoff, invested money can render higher profits only if it is subject to the possibility of
being lost
Risk free rate of return
The theoretical rate of return of an investment with zero risk. The risk-free rate represents
the interest an investor would expect from an absolutely risk-free investment over a
specified period of time.
Variation in return is called risk . uncertainty in return is called risk
Chance that actual return on investment will be different from the expected return.
This includes the possibility of losing some or all of the original investment. Risk is
usually measured by calculating the standard deviation of the historical returns or average
returns of a specific investment. Many companies now allocate large amounts of money
and time in developing risk management strategies to help manage risks associated with
their business and investment dealings. A key component of the risk management process
is risk assessment, which involves the determination of the risks surrounding a business
or investment.
Market risk
Change in price of security is called market risk
Political risk
Risk face due to political instability in country
Financial risk
The risk face by the business due to more debts used in the business
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International risk and currency risk
The risk face due to exchange the rates of the currency is called currency risk and
exchange rate risk
Individual security analysis
Return = E(R) = ∑ R×P
E(R) = expected return
R= expected return on different time period
P= probability
Risk = S.D= √∑[R-E(R)]² × p
Portfolio risk
Risk reflects the chance that the actual return on an investment may be very different than
the expected return. One way to measure risk is to calculate the variance and standard
deviation of the distribution of returns.
If the answer of correlation of the portfolio is positive it means that the security in that
portfolio are depend on each other and this portfolio is a very risky. Portfolio if the
answer of correlation is negative it mean that the securities in that not depend on each
other and this portfolio is a less risky portfolio
Portfolio Variance and Standard Deviation
The variance/standard deviation of a portfolio reflects not only the variance/standard
deviation of the stocks that make up the portfolio but also how the returns on the stocks
which comprise the portfolio vary together. Two measures of how the returns on a pair of
stocks vary together are the covariance and the correlation coefficient.
The Covariance between the returns on two stocks can be calculated using the following
equation:
where
s12 = the covariance between the returns on stocks 1 and 2,
N = the number of states,
pi = the probability of state i,
R1i = the return on stock 1 in state i,
E[R1] = the expected return on stock 1,
R2i = the return on stock 2 in state i, and
E[R2] = the expected return on stock 2.
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The Correlation Coefficient between the returns on two stocks can be calculated using the
following equation:
where
r12 = the correlation coefficient between the returns on stocks 1 and 2,
s12 = the covariance between the returns on stocks 1 and 2,
s1 = the standard deviation on stock 1, and
s2 = the standard deviation on stock 2
_________________________________________________
Chapter 4
Market efficiency
Market efficiency that prices on traded assets (e.g., stocks, bonds, or property) already
reflect all available information, and instantly change to reflect new information.
Stages of market efficiency
There are three stages of market efficiency
Weak form efficiency
One of the most historical types of information used in assessing security values in
market data, which refers to all past price information. If security price are determined in
market that is weak form efficient, historical price and volume data should already be
reflected in current price should be of no value in predicting future price changes .t
Test of usefulness of price data are called weak form tests of EMH (efficient market
hypotheses). If the weak form of EMH is true past price changes should be unrelated to
future price change.
Semi strong efficiency
A more comprehensive level of market efficiency involves not only known and publicly
available market data, but all publicly known and available data such as earning,
dividend, and stock split announcements, new product developments, financing
difficulties and accounting changes. A market that quickly incorporates all such
information into prices is said to show semi strong efficiency
Strong form of market efficiency
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The most stringent form of market efficiency is strong form which asserts that stock
prices fully reflect all information, public and non public . If market is strong form
efficient no group of investors should be able to earn, over reasonable period of time.
Abnormal rates of return by using publicly available information in a superior manner
Efficient Market Hypothesis (EMH)
Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in
any given time, the prices on the market already reflect all known information, and also
change fast to reflect new information.
Therefore, no one could outperform the market by using the same information that is
already available to all investors, except through luck.
Market risk and return
Capital assets pricing model
A model that describes the relationship between risk and expected return and that is used
in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free (rf)
rate in the formula and compensates the investors for placing money in any investment
over a period of time. The other half of the formula represents risk and calculates the
amount of compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) that compares the returns of the asset to the
market over a period of time and to the market premium (Rm-rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
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required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM for all different risks (betas).
Security market line
The relation between an asset’s risk premium and its market beta is called the “Security Market Line” (SML). K = Rf + ( Km – Rf ) β
K security market line
Rf = risk free rate
Km = expected return on market portfolio
The graph below depicts the SML. Note that the slope of the SML is equal to (E[Rm] -
Rf) which is the market risk premium and that the SML intercepts the y-axis at the risk-
free rate.
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In capital market equilibrium, the required return on an asset must equal its expected
return. Thus, the SML equation can also be used to determine an asset's required return
given its Beta.sumption of capital assets pricing model
The Beta (Bi)
The beta for a stock is defined as follows:
where
sim = the Covariance between the returns on asset i and the market portfolio and
s2m = the Variance of the market portfolio.
Note that, by definition, the beta of the market portfolio equals 1 and the beta of the risk-
free asset equals 0.
An asset's systematic risk, therefore, depends upon its covariance with the market
portfolio. The market portfolio is the most diversified portfolio possible as it consists of
every asset in the economy held according to its market portfolio weight.
Assumption of CAPM
The CAPM is simple and elegant. Consider the many assumptions that underlie the
model. Are they valid?
Zero transaction costs.
The CAPM assumes trading is costless so investments are priced to all fall on the capital
market line.
Zero taxes.
The CAPM assumes investment trading is tax-free and returns are unaffected by taxes.
Yet we know this to be false: (1) many investment transactions are subject to capital
gains taxes, thus adding transaction costs; (2) taxes reduce expected returns for many
investors, thus affecting their pricing of investments; (3) different returns (dividends
versus capital gains, taxable versus tax-deferred) are taxed differently, thus inducing
investors to choose portfolios with tax-favored assets; (4) different investors (individuals
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versus pension plans) are taxed differently, thus leading to different pricing of the same
assets.
Homogeneous investor expectations.
The CAPM assumes invests have the same beliefs about expected returns and risks of
available investments. But we know that there is massive trading of stocks and bonds by
investors with different expectations.
Available risk-free assets.
The CAPM assumes the existence of zero-risk securities, of various maturities and
sufficient quantities to allow for portfolio risk adjustments. But we know even Treasury
bills have various risks: reinvestment risk -- investors may have investment horizons
beyond the T-bill maturity date; inflation risk -- fixed returns may be devalued by future
inflation; currency risk -- the purchasing power of fixed returns may diminish compared
to that of other currencies. (Even if investors could sell assets short -- by selling an asset
she does not own, and buying it back later, thus profiting from price declines -- this
method of reducing portfolio risk has costs and assumes unlimited short-selling ability.)
Borrowing at risk-free rates.
The CAPM assumes investors can borrow money at risk-free rates to increase the
proportion of risky assets in their portfolio. We know this is not true for smaller, non-
institutional investors. In fact, we would predict that the capital market line should
become kinked downward for riskier portfolios (ß > 1) to reflect the higher cost of risk-
free borrowing compared to risk-free lending.
Beta as full measure of risk.
The CAPM assumes that risk is measured by the volatility (standard deviation) of an
asset's systematic risk, relative to the volatility (standard deviation) of the market as a
whole. But we know that investors face other risks: inflation risk -- returns may be
devalued by future inflation; and liquidity risk -- investors in need of funds or wishing to
change their portfolio's risk profile may be unable to readily sell at current market prices.
Moreover, standard deviation does not measures risk when returns are not evenly
distributed around the mean (non-bell curve). This uneven distribution describes our
stock markets where winning companies, like Dell and Walmart, have positive returns
(35,000% over ten years) that greatly exceed losing companies' negative returns (which
are capped at a 100% loss).
________________________
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Chapter 5
Investment in assets and required return
Administrative framework
There are following steps involve in administrative framework
1- Generation of investment proposal
2- Estimation of cash flow for the proposals
3- Evaluation of cash flow
4- Selection of project based on acceptance criterion
5- Continual revaluation of investment project after their acceptance
Method of evaluation ( also called capital budgeting technique )
1- payback period
2- internal rate of return
3- net present value
4- profitability index
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chapter 6
Difference between NPV and IRR
NPV IRR
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NPV is a mathematical tool which uses the
discounting process,
NPV is calculated in terms of currency
NPV Method is preferred over other
methods since it calculates additional
wealth
NPV is used to evaluate the project.
Formula of NPV is
NPV care about the reinvestment o the
inflow from the project
The internal rate of return method is also
known as the yield method. The IRR IRR
of a project/investment is defined as the
rate of discount at which the present value
of cash inflows and present value of cash
outflows are equal
IRR is expressed in terms of the percentage
return a firm expects the capital project to
return;
IRR method does not preferred over other
methods since it can not calculate
additional wealth.
The IRR Method cannot be used to
evaluate projects
Formula of IRR
ICO = CF1 / (1+IRR) 1 + CF2 / (1+IRR)2
+--------+CFn /(1+IRR)n
The IRR does not care about the
reinvestment of the inflows from the
project.
Capital budgeting
Definitions " Capital: Fixed assets used in production
" Budget: Plan of in- and outflows during some period
24
" Capital Budget: A list of planned investment (i.e., expenditures on fixed assets)
outlays for different projects.
" Capital Budgeting: Process of selecting viable investment projects.
"
Technique of capital budgeting
Pay back period:
In this technique, we try to figure out how long it would take to recover the invested
capital through positive cash flows of the business. Reverting back to the cafe example,
an initial investment of Rs. 200,000 is required to start the business; Rs 10,000 per month
are expected to be earned for the first year, and Rs 20,000 would be earned every month
in the second year.
Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000
per month, which make Rs. 120,000 for the year (twelve months). Since you had invested
Rs. 200,000 initially of which Rs. 120,000 have been recovered in the first year, you are
still Rs.80, 000 short of recovering your initial investment. In the second year, you would
be earning Rs. 20,000 per month, so the remaining Rs. 80,000 can be recovered in the
next four months. We can say that the initial invested capital can be recovered in 16
months, or the payback period for this investment is 16 months. The shorter the payback
period of a project, the more an investor would be willing to invest his money in the
project. While the payback period is a simple and straightforward method for analyzing a
capital budgeting proposal, it has certain limitations. First and the foremost problem is
that it does not take into account the concept of time value of money. The cash flows are
considered regardless of the time in which they are occurring. You must have noticed that
we have not used any interest rate while making calculation.
Advantages Of Payback Period
• It is easy to understand and apply. The concept of recovery is familiar to every
decision-maker.
• Business enterprises facing uncertainty - both of product and technology - will
benefit by the use of payback period method since the stress in this technique is
on early recovery of investment. So enterprises facing technological obsolescence
and product obsolescence - as in electronics/computer industry - prefer payback
period method.
• Liquidity requirement requires earlier cash flows. Hence, enterprises having high
liquidity requirement prefer this tool since it involves minimal waiting time for
recovery of cash outflows as the emphasis is on early recumbent of investment.
Disadvantages Of Payback Period
• The time value of money is ignored. For example, in the case of project
• A Rs.500 received at the end of 2nd and 3rd years are given same weight age. Broadly
a rupee received in the first year and during any other year within the payback period is
given same weight. But it is common knowledge that a rupee received today has higher
value than a rupee to be received in future.
• But this drawback can be set right by using the discounted payback period method. The
discounted payback period method looks at recovery of initial investment after
considering the time value of inflows.
25
Management Science-II Prof
• Another important drawback of the payback period method is that it ignores the cash
inflows received beyond the payback period. In its emphasis on early recovery, it often
rejects projects offering higher
total cash inflow.
Return on Investments:
The concept of return on investment loosely defined, as there are a number of ratios that
can be used to analyze return on investment. However, in capital budgeting it implies the
annual average cash flow a business is making as a percentage of investment. In other
words, it is an average percentage of investment recovered in cash every year.
The formula for return on investment is as follows:
ROI= (∑CF/n)/ IO
Return on Investment is also very easy to calculate, but like payback period, it does not
take into account the time value of money concept.
A high ROI ratio is considered better and 90% is a very good rate of return but before
deciding whether or not this project should be taken up,
Accounting Rate Of Return – Advantages
• It Is Easy To Calculate.
• The Percentage Return Is More Familiar To The Executives.
Accounting Rate Of Return – Disadvantages
• The definition of cash inflows is erroneous; it takes into account profit after tax
only. It, therefore, fails to present the true return.
• Definition of investment is ambiguous and fluctuating. The decision could be biased
towards a specific project, could use average investment to double the rate of
return and thereby multiply the chances of its acceptances.
Net Present Value (NPV):
NPV is a mathematical tool which uses the discounting process, something that we have
found missing in the aforementioned capital budgeting techniques. The formula for
calculating NPV is as follows:
NPV =
Where,CF1=cash flows occurring in different time periods
ICO= Initial cash outflow
i=discount /interest rate
n=year in which the cash flow takes place
Initial cash outflow, being an outflow, is always expressed as a negative figure.
26
NPV is considered one of the most popular capital budgeting criteria. The disadvantage
with the
NPV is that it is difficult to calculate since these calculations are based on too many
estimates.
In order to calculate the NPV we need to forecast the future cash flows and sales; the
discount factor is also an estimate. If the NPV of a project is more than zero, it should be
accepted. If two or more projects under contemplation, then the one with the higher NPV,
should be accepted. When a company invests in projects with positive NPV, they raise
the shareholders‘ wealth or company‘s value. This would also increase the market value
added and the economic value added for the firm.
Probability Index:
It is quite similar to the NPV in terms of concept and calculation. Profitability index
may be defined as the ratio of the present value of future cash flows to the initial
investment.
The profitability index can be calculated using the following formula.
PI = CF1/ (1+ K) 1 + CF2 /(1+ K) 2 +-----------+ CFn1+ K) n / ICO
NPV method, would also be acceptable on the profitability index criteria.
So for as accept reject decision are concerned all the three discounted cash flow (DCF)
methods lead to same decision. But in case of ranking mutually exclusive project some
time there will be conflict decision between NPV and IRR. In such situations a choice has
to be made between these methods. Since PI is a relative ranking method, this fits most
suitably for valuating mutually exclusive projects
Therefore, the project is acceptable. Notice that we have taken into consideration the
annualized
return. The same can be calculated using the monthly returns with a slight adjustment in
the formula as we have studied in the previous lectures. If there were two or more
projects that need ranking, the one with the highest profitability index would be
acceptable.
Let us now talk about the fifth and the final capital budgeting criteria of our course,
known as Internal
Internal Rate of Return (IRR):
The internal rate of return method is also known as the yield method. The IRR IRR of a
project/investment is defined as the rate of discount at which the present value of cash
inflows and present value of cash outflows are equal. IRR can be restated as the rate of
discount, at which the present value of cash flow (inflows and outflows) associated with a
project equal zero.
let at be the cash flows (inflow or outflow) in period t
then IRR of the project is found out by solving for the value of 'r' in the following
equation:
• Where t = 0,1,2......
• .... n years
ICO = CF1 / (1+IRR) 1 + CF2 / (1+IRR)2 +--------+CFn /(1+IRR)n
The capital budgeting process
27
There‘re following step involve in capital budgeting process
Strategic planning
A strategic plan is the grand design of the firm and clearly identifies the business the firm
is in and where it intends to position itself in the future. Strategic planning translates the
firm‘s corporate goal into specific policies and directions, sets priorities, specifies the
structural, strategic and tactical areas of business development, and guides the planning
process in the pursuit of solid objectives. A firm‘s vision and mission is encapsulated in
its strategic planning framework.
There are feedback loops at different stages, and the feedback to ‗strategic planning‘ at
the project evaluation and decision stages This feedback may suggest changes to the
future direction of the firm
Identification of investment opportunities
The identification of investment opportunities and generation of investment project
proposals is an important step in the capital budgeting process. Project proposals cannot
be generated in isolation. They have to fit in with a firm‘s corporate goals, its vision,
mission and long-term strategic plan. Of course, if an excellent investment opportunity
presents itself the corporate vision and strategy may be changed to accommodate it. Thus,
there is a two-way traffic between strategic planning and investment opportunities.
These investments normally represent the strategic plan of the business firm and, in turn,
these investments can set new directions for the firm‘s strategic plan.
Some firms have research and development (R&D) divisions constantly searching for and
researching into new products, services and processes and identifying attractive
investment opportunities. Sometimes, excellent investment suggestions come through
informal processes such as employee chats in a staff room or corridor.
Preliminary screening of projects
Generally, in any organization, there will be many potential investment proposals
generated. Obviously, they cannot all go through the rigorous project analysis process.
Therefore, the identified investment opportunities have to be subjected to a preliminary
screening process by management to isolate the marginal and unsound proposals, because
it is not worth spending resources to thoroughly evaluate such proposals. The preliminary
screening may involve some preliminary quantitative analysis and judgments based on
intuitive feelings and experience.
Financial appraisal of projects
This stage is also called quantitative analysis, economic and financial appraisal, project
evaluation, or simply project analysis. This project analysis may predict the expected
future cash flows of the project, analyze the risk associated with those cash flows,
develop alternative cash flow forecasts, examine the sensitivity of the results to possible
changes in the predicted cash flows, subject the cash flows to simulation and prepare
alternative estimates of the project‘s net present value.
Thus, the project analysis can involve the application of forecasting techniques, project
evaluation techniques, risk analysis and mathematical programming techniques such as
linear programming. While the basic concepts, principles and techniques of project
evaluation are the same for different projects, Financial appraisal will provide the
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estimated addition to the firm‘s value in terms of the projects‘ net present values. If the
projects identified within the current strategic framework of the firm repeatedly produce
negative NPVs in the analysis stage, these results send a message to the management to
review its strategic plan.
Qualitative factors in project evaluation
When a project passes through the quantitative analysis test, it has to be further evaluated
taking into consideration qualitative factors. Qualitative factors are those which will have
an impact on the project, but which are virtually impossible to evaluate accurately in
monetary terms. They are factors such as:
_ the societal impact of an increase or decrease in employee numbers
_ the environmental impact of the project
_ possible positive or negative governmental political attitudes towards the project
_ the strategic consequences of consumption of scarce raw materials
_ positive or negative relationships with labor unions about the project
_ possible legal difficulties with respect to the use of patents, copyrights and trade or
brand names
_ impact on the firm‘s image if the project is socially questionable.
The accept/reject decision
NPV results from the quantitative analysis combined with qualitative factors form the
basis of the decision support information. The analyst relays this information to
management with appropriate recommendations. Management considers this information
and other relevant prior knowledge using their routine information sources, experience,
expertise, ‗gut feeling‘ and, of course, judgment to make a major decision – to accept or
reject the proposed investment project.
Project implementation and monitoring
Once investment projects have passed through the decision stage they then must be
implemented by management. During this implementation phase various divisions of the
firm are likely to be involved. An integral part of project implementation is the constant
monitoring of project progress with a view to identifying potential bottlenecks thus
allowing early intervention. Deviations from the estimated cash flows need to be
monitored on a regular basis with a view to taking corrective actions when needed.
Post-implementation audit
Post-implementation audit does not relate to the current decision support process of the
project; it deals with a post-mortem of the performance of already implemented projects.
An evaluation of the performance of past decisions, however, can contribute greatly to
the improvement of current investment decision-making by analyzing the past ‗rights‘
and ‗wrongs‘.The post-implementation audit can provide useful feedback to project
appraisal or strategy formulation.
Inflation The rate at which the general level of prices for goods and services is rising, and,
subsequently, purchasing power is falling. As inflation rises, every dollar will buy a
29
smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of
gum will cost $1.02 in a year.
Measuring inflation is a difficult problem for government statisticians
In North America, there are two main price indexes that measure inflation:
Consumer Price Index (CPI) - A measure of price changes in consumer goods and
services such as gasoline, food, clothing and automobiles. The CPI measures price
change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau
of Labor Statistics.
Producer Price Indexes (PPI) - A family of indexes that measure the average change
over time in selling prices by domestic producers of goods and services. PPIs measure
price change from the perspective of the seller. U.S. PPI data can be found at the Bureau
of Labor Statistics.
CAUSES OF INFLATION
Inflation is caused when the aggregate demand exceeds the aggregate supply
of goods and services. We analyze the factors which lead to increase in demand and
the shortage of supply.
Factors Affecting Demand
Both Keynesians and monetarists believe that inflation is caused by increase in the
aggregate demand. They point towards the following factors which raise it.
1. Increase in Money Supply. Inflation is caused by an increase in the supply of
money which leads to increase in aggregate demand. The higher the growth rate of the
nominal money supply, the higher is the rate of inflation. Modern quantity theorists
do not believe that. true inflation starts after the full employment level. This view is
realistic because all advanced countries are faced with high levels of unemployment
and high rates of inflation.
2. Increase in Disposable Income. When the disposable income of the people
increases, it raises their demand for goods and services. Disposable income may
increase with the rise in national income or reduction in taxes or reduction in the
saving of the people.
3. Increase in Public Expenditure. Government activities have been expanding
much with the result that government expenditure has also been increasing at a
phenomenal rate, thereby raising aggregate demand for goods and services.
Governments of both developed and developing countries are providing more
facilities under public utilities and social services, and also nationalizing indus tries
and starting public enterprises with the result that they help in increasing aggregate
demand.
30
4. Increase in Consumer Spending. The demand for goods and services increases
when consumer expenditure increases. Consumers may spend more due to
conspicuous consumption or demonstration effect. They may also spend more when
they are given credit facilities to buy goods on hire-purchase and installment basis.
5. Cheap Monetary Policy. Cheap monetary policy or the policy of credit
expansion also leads to increase in the money supply which raises the demand for
goods and services in the economy. When credit expands, it raises the money income
of the borrowers which, in turn, raises aggregate demand relative to supply, thereby
leading to inflation. This is also known as credit-induced inflation.
6. Deficit Financing. In order to meet its mounting expenses, the government
resorts to deficit financing by borrowing from the public and even by printing more
notes. This raises aggregate demand in relation to aggregate supply, thereby leading
to inflationary rise in prices. This is also known as deficit-induced inflation.
7. Expansion of the Private Sector. The expansion of the private sector also tends to
raise the aggregate demand. For huge investments increase employment arid income,
thereby creating more demand far goods and services. But it takes time for the output
to enter the market.
8. Black Money. The existence of black money in all countries due to corruption,
tax evasion etc. increases the aggregate demand. People spend such unearned money
extravagantly, thereby creating unnecessary demand for commodities. This tends to
raise the price level further.
9. Repayment of Public Debt. Whenever the government repays its past internal
debt to the public, it leads to increase in the money supply with the public. This tends
to raise the aggregate demand for goods and services.
10. Increase in Exports. When the demand for domestically produced goods
increases in foreign countries, this raises the earnings of industries producing export
commodities. These, in turn, create more demand for goods and services within
the economy.
Factors Affecting Supply
Factors Affecting Supply
There are also certain factors which operate on the opposite side and tend to
reduce the aggregate supply. Some of the factors are as follows:
31
1. Shortage of Factors of Production. One of the important causes affecting
the supplies of goods is the shortage of such factors as labour, raw materials,
power supply, capital etc. They lead to excess capacity and reduction in indus -
trial production.
2. Industrial Dispute. In countries where trade unions are powerful, they also
help in curtailing production. Trade unions resort to strikes and if they happen to
be unreasonable from the employers' viewpoint and are prolonged, they force the
employers to declare lock-outs. In both cases, industrial production falls, thereby
reducing supplies of goods. If the unions succeed in raising money wages of their
members to a very high level than the productivity of labour, this also tends to
reduce production and supplies of goods.
3. Natural Calamities. Drought or floods is a factor which adversely affects
the supplies of agricultural products. The latter, in turn, create shortages of food
products and raw materials, thereby helping inflationary pressures.
4. Artificial Scarcities. Artificial scarcities are created by hoarders and specu-
lators who indulge in black marketing. Thus they are instrumental in reducing
supplies of goods and raising their prices.
5. Increase in Exports. When the country produces more goods for export
than for domestic consumption, this creates shortages of goods in the domestic
market. This leads to inflation in the economy.
6. Lop-sided Production. If the stress is on the production of comfort,
luxuries, or basic products to the neglect of essential consumer goods in the
country, this creates shortages of consumer goods. This again causes inflation.
7. Law of Diminishing Returns. If industries in the country are using old
machines and outmoded methods of production, the law of diminishing returns
operates. This raises cost per unit of production, thereby raising the prices of
products.
8. International Factors. In modern times, inflation is a worldwide pheno-
menon. When prices rise in major industrial countries, their effects spread to
almost all countries with which they have trade relations. Often the rise in the
price of a basic raw material like petrol in the international market leads to rise
in the price of all related commodities in a country.
MEASURES TO CONTROL INFLATION
32
We have studied above that inflation is caused by the failure of aggregate
supply
to equal the increase in aggregate demand. Inflation can, therefore, be controlled
by increasing the supplies and reducing money incomes in order to control
aggregate demand. The various methods are usually grouped under three heads:
Monetary measures, fiscal measures and other measures.
1. Monetary Measures
Monetary measures aim at reducing money incomes.
(a) Credit Control. One of the important monetary measures is monetary
policy. The central bank of the country adopts a number of methods to control
the quantity and quality of credit. For this purpose, it raises the bank rates, sells
securities in the open market, raises the reserve ratio, and adopts a number of
selective credit control measures, such as raising margin requirements and
regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation
is due to cost-push factors. Monetary policy can only be helpful in controlling
inflation due to demand-pull factors.
(b) Demonetization of Currency. However, one of the monetary measures is
to demonetize currency of higher denominations. Such a measure is usually
adopted when there is abundance of black money in the country.
(c) Issue of New Currency. The most extreme monetary measure is the issue
of new currency in place of the old currency. Under this system, one new note is
exchanged for a number of notes of the old currency. The value of bank deposits
is also fixed accordingly. Such a measure is adopted when there is an excessive
issue of notes and there is hyperinflation in the country. It is very effective
measure. But is inequitable for its hurts the small depositors the most.
2. Fiscal Measures
Monetary policy alone is incapable of controlling inflation. It should, there-
fore, be supplemented by fiscal measures. Fiscal measures are highly effective
for controlling government expenditure, personal consumption expenditure, and
private and public investment. The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure. The government should reduce
unnecessary expenditure on non-development activities in order to curb infla tion.
This will also put a check on private expenditure which is dependent upon
government demand for goods and services. But it is not easy to cut government
expenditure. Though economy measures are always welcome but it becomes
33
difficult to distinguish between essential and non-essential expenditure. There-
fore, this measure should be supplemented by taxation.
(b) Increase in Taxes. To cut personal consumption expenditure, the rates of
personal, corporate and commodity taxes should be raised and even new taxes
should be levied, but the rates of taxes should not be so high as to discourage
saving, investment and production. Rather, the tax system should provide larger
incentives to those who save, invest and produce more. Further, to bring more
revenue into the tax-net, the government should penalize the tax evaders by imposing
heavy fines. Such measures are bound to be effective in controlling inflation. To
increase the supply of goods within the country, the government should reduce import
duties and increase export duties.
(c) Increase in Savings. Another measure is to increase savings on the part of the
people. This will tend to reduce disposable income with the people, and hence
personal consumption expenditure. But due to the rising cost of living, people are not
in a position to save much voluntarily. Keynes, therefore, advocated compulsory
savings or what he called `deferred payment' where the saver gets his money back
after some years. For this purpose, the government should float public loans carrying
high rates of interest, start saving schemes with prize money, or lottery for long
periods, etc. It should also introduce compulsory provident fund, provident fund-cum-
pension schemes, etc. compulsorily. All such measures to increase savings are likely
to be effective in controlling inflation.
(d) Surplus Budgets. An important measure is to adopt anti-inflationary budgetary
policy. For this purpose, the government should give up deficit financing and instead
have surplus budgets. It means collecting more in revenues and spending less.
(e) Public Debt. At the same time, it should stop repayment of public debt and
postpone it to some future date till inflationary pressures are controlled within the
economy. Instead, the government should borrow more to reduce money supply with
the public.
Like the monetary measures, fiscal measures alone cannot help in controlling
inflation. They should be supplemented by monetary, non-monetary and non fiscal
measures.
3. Other Measures
The other types of measures are those which aim at increasing aggregate supply
and reducing aggregate demand directly.
(a) To Increase Production. The following measures should be adopted to increase
production:
34
(i) One of the foremost measures to control inflation is to increase the
production of essential consumer goods like food, clothing, kerosene oil, sugar,
vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on
preferential basis to increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose,
industrial peace should be maintained through agreements with trade unions, binding
them not to resort to strikes for some time.
(iv) The policy of rationalization of industries should be adopted as a long-
term measure. Rationalization increases productivity and production of industries
through the use of brain, brawn and bullion.
(v) All possible help in the form of latest technology, raw materials, financial
help, subsidies, etc. should be provided to different consumer goods sectors to
increase production.
(b) Rational Wage Policy. Another important measure is to adopt a rational wage
and income policy. Under hyperinflation, there is a wage-price spiral. To control this,
the government should freeze wages, incomes, profits, dividends, bonus, etc. But such
a drastic measure can only be adopted for a short period and by antagonizing both
workers and industrialists. Therefore, the best course is to link increase in wages to
increase in productivity. This will have a dual effect. It will control wage and at the
same time increase productivity, and hence production of goods in the economy.
(c) Price Control. Price control and rationing is another measure of direct control to
check inflation. Price control means fixing an upper limit for the prices of essential
consumer goods. They are the maximum prices fixed by law and anybody charging
more than these prices is punished by law. But it is difficult to administer price
control.
(d) Rationing. Rationing aims at distributing consumption of scarce goods so as to
make them available to a large number of consumers. It is applied to essential
consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise
the prices of necessaries and assure distributive justice. But it is very inconvenient for
consumers because it leads to queues, artificial shortages, corruption and black
marketing. Keynes did not favour rationing for it "involves a great deal of waste, both
of resources and of employment."
___________________________________
35
Chapter -8
Cost of capital
―It is rate of return to our stock holder and bond against our IRR‖
The required return necessary to make a capital budgeting project, such as building a new
factory, worthwhile
The cost of capital determines how a company can raise money
Component of cost of capital
There are three component of cost of capital
Cost of debt capital
Cost of equity capital
Cost of preferred stock capital
Cost of debt capital
The effective rate that a company pays on its current debt. This can be measured in either
before- or after-tax returnsA company will use various bonds, loans and other forms of
debt, so this measure is useful for giving an idea as to the overall rate being paid by the
company to use debt financing.
Before the tax cost of debt
Before the tax cost of debt is derived by solving for the discount rate kd that equal to
market price of the debt issue with the present value of interest plus principal payments
and by then adjusting the explicit cost obtained for the tax deductibility of interest
payments
Po = It + Pt
---------
( 1 + Kd)
Po is the current market price of debt issue
∑ denotes the summation for period 1 through n
It is the interest payment in period t
Pt payment of principal in period t
Kd discount rate
After the tax cost of debt
After the cost of debt which denote by Ki
Ki = Kd ( 1- t)
Where Kd remains as previously used and t is now defined as the company marginal tax
rate because interest charged are tax deductible to the issuer the after the tax cost of debt
is substantially less than the before tax cost
36
Cost of equity capital
The cost of equity capital is equal to the required rate of return on equity-supplied capital.
n financial theory, the return that stockholders require for a company. The traditional
formula for cost of equity (COE) is the dividend capitalization model
Ke = (D1 / Po ) +g
There are two model
Capital assets pricing model
A model that describes the relationship between risk and expected return and that is used
in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free (rf)
rate in the formula and compensates the investors for placing money in any investment
over a period of time. The other half of the formula represents risk and calculates the
amount of compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) that compares the returns of the asset to the
market over a period of time and to the market premium (Rm-rf).
Dividend discounting model
it is used to evaluate stocks based on the net present value of the future dividends.
There are 3 models used in the dividend discount model:
zero-growth model
37
zero growth which assumes that all dividends paid by a stock remain the same; Since the
zero-growth model assumes that the dividend always stays the same, the stock price
would be equal to the annual dividends divided by the required rate of return. Stock‘s
Intrinsic Value = Annual Dividends / Required Rate of Return
the constant-growth model, (gordon growth model )
constant growth model which assumes that dividends grow by a specific percent
annually;
Intrinsic Value = D1
──────
k – g
D1 = Next Year‘s Dividend
k = Capitalization Rate
g = Dividend Growth Rate
The constant-growth model is often used to value stocks of mature companies that have
increased the dividend steadily over the years. Although the annual increase is not always
the same, the constant-growth model can be used to approximate an intrinsic value of the
stock using the average of the dividend growth and projecting that average to future
dividend increases
Cost of preferred stock capital
Required rate of return on investment of the preferred shareholders of company .
Kp = Dp / Po
Dp = expected dividend per share
Po = per share market price of the stock
38
Weighted average cost of capital
The weighted average cost of capital (WACC) is the rate that a company is expected to
pay on average to all its security holders to finance its assets.
All capital sources - common stock, preferred stock, bonds and any other long-term debt -
are included in a WACC calculation. All else help equal, the WACC of a firm increases
as the beta and rate of return on equity increases, as an increase in WACC notes a
decrease in valuation and a higher risk.
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Or
Cost of capital = Kx (Wx)
Where Kx is after tax cost of xth method of financing
Wx is weight
Limitations of WACC
1.Weighting System
Marginal Capital Costs
―Marginal Cost of Capital (MCC) Schedule is a graph that relates the firm‘s weighted
average cost of each dollar of capital to the total amount of new capital raised.‖
―The marginal cost of capital (MCC) is the cost of the last dollar of capital raised,
essentially the cost of another unit of capital raised.‖
Some sources of capital are more expensive than others; for example, low-grade
subordinated debt would be more expensive to raise (require a higher interest rate)
than unsubordinated debt. Because capital must be raised to finance a new project, the
marginal cost of capital should be the Hurdle Rate used in discounted cash flow
present value analysis, not the average cost of capital.
39
Flotation Costs
Flotation costs are the costs associated with issuing securities such as underwriting, legal,
listing, and printing fees.
a. Adjustment to Initial Outlay
One approach which we refer to as the adjustment to initial outlay method treats the
flotation costs of financing as an addition to initial cash outlay for project according to
this procedure the net present value of project is computed according to
NPV = CFt / (1 + K) t - (ICO + flotation cost)
CFt = project cash flow at time t
ICO = initial cash out lay
K = firm cost of capital
b. Adjustment to Discount Rate
A second more traditional approaches calls for an upward adjustment of cost of capital
when flotation cost are present. This method which we refer to as the adjustment to
discount rate procedure. under this procedure each component cost of capital would be
recalculated by finding the discount rate equates the present value of cash flows to the
suppliers of capital with the net proceed of a security issue rather than the security market
price
Capital structure
Capital structure refers to the combination or mix of debt and equity which a company
uses to finance its long term operations.
Debt comes in the form of bond issues or long-term notes payable, while equity is
classified as common stock, preferred stock or retained earnings. Short-term debt such as
working capital requirements is also considered to be part of the capital structure.
Capital structure theories
There are following theories
Net operating income approach
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A theory of capital structure in which the weighted average cost of capital and total value
of the firm remain constant leverage is changed .
Concept of Leverage
Leverage (or gearing) is the ratio of loan capital plus bank and other borrowings to
capital employed (the funds that are used to operate the business).
Ke = E/S
E = O-I
S= V-B
V = O/Ko
O = net operating income
Ko = overall capitalization rate
V = total value of firm
B = market value of debt
S = market value of stock
Example the firm has 1000 $ in debt at 10 percent interest that the expected annual net
operating income is 1000 $ and that the overall capitalization rate Ko is 15 percent
calculate value of firm
E = O-I = 1000-100 = 900
S = V – B = 1000/15 – 1000 = 5667 $
Ke = 900 $ / 5667 $ = 15.88%
Net operating income or NOI is used in two very important real estate ratios. It is an
essential ingredient in the Capitalization Rate (Cap Rate) calculation that is used to
estimate the value of income producing properties. Another important ratio that is used to
evaluate income producing properties is the Debt Coverage Ratio or DCR. The NOI is a
key ingredient in this important ratio also.
It is also an essential part of an income property's Income Statement and Cash Flow
Statement. It is therefore important to understand how the Net Operating Income is
calculated
Net income approach
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Assumptions of the NI Approach
There are no corporate taxes
The cost of debt is less than the cost of equity
The debt content does not change the risk perception of the investors
Traditional approach
A theory of capital structure in which there exits an optimal capital structure and where
management can increase the total value of the firm through the judicious use of financial
leverage
This approach suggest that the firm can initially lower its cost of capital and raise its total
value through increasing leverage
Assumption
1. Cost of debt remain less constant but after certain limit it start increasing.
2. Similarly cost of equity also remain less constant and increase after certain limit
3. Total cost of capital decrease up to certain point, then become constant & then
start decreasing.
4. The company pays out all its earnings as dividends
5. The leverage of the company can be changed immediately by issuing debt to
purchase shares, or by issuing shares to repurchase debt
Miller and modigilani approach
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Assumption
a) A perfect capital market exists in which
investors have the same information
Upon which they act rationally
To arrive to the same expectations about future earnings and risks
c) There are no taxes or transaction costs
d) Debt is risk-free and freely available at the same cost to investors and companies
alike.
e) Homogeneous expectation
In 1958 Modigliani and Miller proposed
MM Proposition I
The total market value of a company, in the absence of tax will be determined by two
factors
1 Total earnings of the company
2. The level of operating risk attached to those earnings(The total market value would be
computed by discounting the total earnings at a rate that is appropriate to the level of
operating risk. The WACC)
Thus the capital structure has no effect on the
MM justified their approach by the use of arbitrage.
MM Proposition II
1. The cost of debt remains unchanged as the level of leverage increases
2. The cost of equity rises in such a way as to keep the WACC constant.
Factor affecting the capital structure
1. Size of Business
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2. Form of Business Organisations
3. Stability of Earnings
4. Degree of Competition
5. Stage of Life Cycle
6. Credit Standing
7. Corporation Tax
8. State Regulations
9. State of Capital Market
10. Attitude of Management
11. Trading on Equity
12. Interest Coverage Ratio
13. Cash Flow Ability of the Company
14. Cost of Capital
15. Floatation Costs
16. Control
17. Flexibility
18. Leverage Ratios for other Firms
19. Consultation with Invt. Banker & Lenders
20. General Level of Business Activity
Taxes
Definition: Sums imposed by a government authority upon persons or property to pay for
government services
Effects of taxes
Corporate taxes
If your business is organized as a C corporation, you'll be paid a salary like other
employees. Any profit the business makes will accrue to the corporation, not to you
personally. At the end of the year, you must file a corporate income tax return. Corporate
tax returns may be prepared on a calendar- or fiscal-year basis. If the tax liability of the
business is calculated on a calendar year, the tax return must be filed with the IRS no
later than March 15 each year; however, the corporation may file a request for extension
of due date.
Reporting income on a fiscal-year cycle is more convenient for most businesses because
they can end their tax year in any month they choose. A corporation whose income is
primarily derived form the personal services of its shareholders must use a calendar-year
end for tax purposes. In addition, most Subchapter S corporations are required to use
calendar-year ends.
Uncertainty of tax shield benefit
If taxable income should be low or turn negative the tax shield benefir from debt are
reduced or even eliminated. If the firm should go bankrupt and liquidate the future tax
44
saving associated with debt would stop together. As financial leverage increase the
uncertainty associated with the interest tax shield benefit become more and more
important issue
Corporate plus personal taxes
With the combination of corporate taxes and personal taxes on both debt and stock
income the present value of interest tax shield benefit will likely be lowered however the
general consensus is that personal taxes act to reduce but not eliminate the corporate tax
advantage associated with debt
Sales Taxes
Sales taxes are levied by many cities and states at varying rates. Most provide specific
exemptions, as for certain classes of merchandise or particular groups of customers.
Service businesses are often exempt altogether. Contact your state and/or local revenue
offices for information on the law for your area so that you can adapt your bookkeeping
to the requirements.
Levying taxes on all states would present no major difficulties, but since this is not the
case, your business will have to identify tax-exempt sales from taxable sales. Then you
can deduct tax-exempt sales from total sales when filing your sales tax returns each
quarter. Remember, if you fail to collect taxes that should have been collected, you can
be held liable for the full amount of uncollected tax, plus penalties and interest.
Taxes on Proprietorships, Partnerships and Corporations
The first tax issue business owners face is the legal form of your business. You can be a
sole proprietor, a general partner, or the head of your corporation. Your choice has a big
impact on your tax liability, so make sure to get your CPA's advice first.
Sole Proprietorship Taxes
A sole proprietorship is a one-owner business, which has many or few employees. This
form of organization is simple and requires no fancy legal work. You name your business
in accordance with licensing laws, you apply for a federal EIN number if you have
employees, and you're all set. A sole proprietor's income is included on his or her
personal tax return.
Suppose a husband and wife file a joint return. The husband has his own business, while
the wife works part-time for the government and makes $25,000 a year. The husband's
gross income from his business was $100,000, and his business made $20,000 in profits
after business expenses were deducted. His $20,000 profit is included on the individual
return, along with his wife's $25,000. The business income is considered personal income
45
for the sole proprietor, and there are no special business-income taxes other than self-
employment taxes.
Social Security (FICA) Tax
The Federal Insurance Contributions Act, or FICA, provides for a federal system of old-
age, survivors, disability and hospital insurance. The old-age, survivors, and disability
insurance part is financed by the Social Security tax. The hospital insurance part is
financed by the Medicare tax.
FICA requires employers to match and pay the same amount of Social Security tax as the
employee does. Charts and instructions for Social Security deductions come with the IRS
payroll forms. Congress has mandated requirements for depositing FICA and withholding
taxes, and failure to comply with these regulations subjects a business to substantial
penalties. Four different reports must be filed with the IRS regarding payroll taxes (both
FICA and income taxes) that you withhold from your employees' wages:
1. Quarterly return of taxes withheld on wages (Form 941);
2. Annual statement of taxes withheld on wages (Form W-2);
3. Reconciliation of quarterly returns of taxes withheld with annual statement of taxes
withheld (Form W-3);
4. Annual Federal Unemployment Tax return (Form 940).
______________________________________
Chapter -9
Making capital structure decision
EBIT and EPS analysis
EBIT - Earnings Before Interest and Taxes. Accountants like to use the term Net
Operating Income for this income statement item, but finance people usually refer to it as
EBIT. Either way, on an income statement, it is the amount of income that a company
has after subtracting operating expenses from sales (hence the term net operating
income). Another way of looking at it is that this is the income that the company has
before subtracting interest and taxes (hence, EBIT).
EAT - Earnings After Taxes. Accountants call this Net Income or Net Profit After
Taxes, but finance people usually refer to it as EAT.
46
EPS - Earnings Per Share. This is the amount of income that the common stockholders
are entitled to receive (per share of stock owned). This income may be paid out in the
form of dividends, retained and reinvested by the company, or a combination of both.
Calculation of EBIT
Sales : xxxxx
(-)V.C : xxx
=Contribution : xxxxx
(-)F.C : xxxx
=EBIT {Earning Before Interest and Taxes}
Calculation EPS
EBIT : xxxxx
(-)INTERSET : xxx
=EBT : xxxxx
(-)TAX : xx
=Earning for ESH : xxxxx
(÷) No. of E.S : xxx
= EPS {Earning Per Share} xxx
Q: The present capital structure of Gupta Co. ltd. is:
4000, 5% Debentures of Rs 100 each Rs 4,00,000
2000, 8% P. Shares of Rs 100 each Rs 2,00,000
4000, Equity shares of Rs 100 each Rs 4,00,000
Rs 10,00,000
The present earning of the company before interest & taxes are 10% of the invested
capital every year. The company is in need of Rs 2,00,000 for purchasing a new
equipment and it is estimated that additional investment will also produce 10% earning
before interest & taxes every year.
47
The company has asked your advice as to whether the requisite amount be obtained in the
form of 5% Debenture or 8% P. Shares
Or equity shares of Rs 100 each to be issued at par. Examine the problem in all its
bearing and advice firm if the Corporate tax rate is 50%.
Particulars
Present
i
Debenture
ii
P. Share
iii
Eq. Share
EBIT
(-)Interest
1,00,000
20,000
1,20,000
30,000
1,20,000
20,000
1,20,000
20,000
EBT
(-)Tax 50%
80,000
40,000
90,000
45,000
1,00,000
50,000
1,00,000
50,000
EAT
(-)P.
Dividend
40,000
16,000
45,000
16,000
50,000
32,000
50,000
16,000
ESH
(÷) No. of
Equity
Shares
24,000
4,000
29,000
4,000
18,000
4,000
34,000
6,000
EPS
Change in
EPS
Rs 6.00
-
Rs 7.25
+1.25
Rs 4.50
-1.50
Rs 5.67
-0.33
Cash flow ability to service debt
Page 442 (book financial management) (chapter 16) (operating and financial
leverage )
__________________________________________
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Chapter 10
Procedural aspect of paying dividend
What Does Dividend Policy Mean?
The policy a company uses to decide how much it will pay out to shareholders in
dividends.
Procedural aspect of paying dividend
There are following procedure of paying dividend
1- declaration date
2- Ex-dividend date
3- Date of record
4- Date of payment
Declaration date
The date on which the next dividend payment is announced by the directors of a
company. This statement includes the dividend's size, ex-dividend date and payment date.
It is also referred to as the "announcement date".Once it is authorized, the dividend is
known as a declared dividend and it becomes the company's legal liability to pay it.
Example
The declaration date of all listed stock options in the U.S. is on the third Friday of the
listed month. If there is a holiday on the Friday then the declaration date falls on the third
Thursday.
Record date
The date by which a corporate shareholder must be registered in order to be eligible to
receive dividends or to vote on company business.
The record date is the date on which you must be a holder of the stock (i.e., a shareholder
or unit holder) in order to receive the dividends for the upcoming payment date.
Example
This means that if you purchased the stock and the transaction is fully settled in your
brokerage account by February 10th, then you will receive the dividends or distributions
on your most recent purchase on the upcoming payment date (which is usually 7-10 days
later).
Shareholders of record on the record date also receive the annual, semi-annual and other
stockholder voting materials from the record date onwards. Thus, you might receive
some of these in the mail (or your inbox) before you‘ve received the dividend.
Ex-dividend date
The first day of trading when the seller, rather than the buyer, of a stock will be entitled
to the most recently announced dividend payment. The length of time ensuing between
the ex-dividend date and the date of actual payment may be up to a month. If you sell
your stock before the ex-dividend date, you also are selling away your right to the stock
49
dividend. Your sale includes an obligation to deliver any shares acquired as a result of the
dividend to the buyer of your shares, since the seller will receive an I.O.U. or "due bill"
from his or her broker for the additional shares
Date of payment
The date on which a bill is due.
The date on which a dividend will be paid to stockholders or on which interest will be
paid to bondholders by the issuers' paying agents.
The legal payment due date is the date specified in the contract.
The actual payment date is the date the payment is initiated by the payor unless specified
otherwise in the contract.
___________________________________________
Chapter 11
Issuing securities
Public offering securities The sale of equity shares or other financial instruments by an organization to the public in
order to raise funds for business expansion and investment. Public offerings of corporate
securities in the U.S. must be registered with and approved by the SEC and are normally
conducted by an investment underwriter.
Generally, any sale of securities to more than 35 people is deemed to be a public offering,
and thus requires the filing of registration statements with the appropriate regulatory
authorities. The offering price is predetermined and established by the issuing company
and the investment bankers handling the transaction. The term public offering is equally
applicable to a company's initial public offering, as well as subsequent offerings.
Method of public offering of security
There are two methods of public offering securities
1- Traditional underwriting
When investment banking institution buys a security issue it underwriters the sale of the
issue by giving company a check for the purchase price at that time company is reviled of
the risk of not being able to sell the issue at the established price if the issuer dose not sell
well because of an adverse turn in the market or because it is over priced
Best effort offering
An underwriting in which an investment bank, acting as an agent, agrees to do its best to
sell the offering to the public, but does not buy the securities outright and does not
guarantee that the issuing company will receive any set amount of money. Less common
than a firm commitment offering. When an investment bank is hired to underwrite
securities of a company, there are other types of offerings, including the most common,
firm commitment. With a firm commitment offering, the investment bank guarantees the
number of securities it will sell and guarantees its commitment by purchasing the shares
themselves, even if they cannot sell them. The shares that the investment bank is unable
to sell cannot be returned to the company.
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Making a market
Underwriter will make a market for a security after it is issued. in first public offering of
common stock making market is important to investor. In making market the underwriter
maintains a position in stock quotes bid and asked prices, and stand ready to buy and sell
it at those prices. These quotations are based on underlying supply and demand condition
2- Self registration
The distinguish feature of traditional underwriting is that the registration process with
securities and exchange commission take at least several weeks to complete. Large
corporation whose securities are listed on an exchange are able to shortcut the registration
process under rule 415
Flotation cost
Flotation costs are the costs associated with issuing securities such as underwriting, legal,
listing, and printing fees.
a. Adjustment to Initial Outlay
One approach which we refer to as the adjustment to initial outlay method treats the
flotation costs of financing as an addition to initial cash outlay for project according to
this procedure the net present value of project is computed according to
c. Adjustment to Discount Rate
A second more traditional approaches calls for an upward adjustment of cost of capital
when flotation cost are present. This method which we refer to as the adjustment to
discount rate procedure. under this procedure each component cost of capital would be
recalculated by finding the discount rate equates the present value of cash flows to the
suppliers of capital with the net proceed of a security issue rather than the security market
price
________________________________
Chapter 12
Definition of debt financing Debt financing is basically money that you borrow to run your business.
You can think of debt financing as being divided into two categories, based on the type of
loan you are seeking: long term debt financing and short term debt financing.
Long Term Debt Financing usually applies to assets your business is purchasing, such
as equipment, buildings, land, or machinery. With long term debt financing, the
scheduled repayment of the loan and the estimated useful life of the assets extends over
more than one year.
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Short Term Debt Financing usually applies to money needed for the day-to-day
operations of the business, such as purchasing inventory, supplies, or paying the wages of
employees. Short term financing is referred to as an operating loan or short term loan
because scheduled repayment takes place in less than one year. A line of credit is an
example of short term debt financing.
Feature of debt
High yield bonds
A high paying bond with a lower credit rating than investment-grade corporate bonds,
Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds
pay a higher yield than investment grade bonds.
Based on the two main credit rating agencies, high-yield bonds carry a rating of 'BBB' or
lower from S&P, and 'Baa' or lower from Moody's. Bonds with ratings above these levels
are considered investment grade. Credit ratings can be as low as 'D' (currently in default),
and most bonds with 'C' ratings or lower carry a high risk of default; to compensate for
this risk, yields will typically be very high.
Also known as "junk bonds"
Bond ratings
A grade given to bonds that indicates their credit quality. Private independent rating
services such as Standard & Poor's, Moody's and Fitch provide these evaluations of a
bond issuer's financial strength, or its the ability to pay a bond's principal and interest in a
timely fashion.
Bond ratings are expressed as letters ranging from 'AAA', which is the highest grade, to
'C' ("Junk"), which is the lowest grade. Different rating services use the same letter
grades, but use various combinations of upper- and lower-case letters to differentiate
themselves.
Sinking fund
Fund set aside by a corporation or government agency for the purpose of periodically
redeeming bonds, debentures, and preferred stocks. The fund is accumulated from
earnings, and payments into the fund may be based on either a fixed percentage of the
outstanding debt or a fixed percentage of profits. Sinking funds are administered
separately from the corporation's working funds by a trust company or trustee. The
purpose of a sinking fund is to assure investors that provision has been made for the
repayment of bonds at maturity.
Floating rate notes
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money
market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a
rate that remains constant.
52
A note with a variable interest rate. The adjustments to the interest rate are usually made
every six months and are tied to a certain money-market index. Also known as a
"floater".
These protect investors against a rise in interest rates (which have an inverse relationship
with bond prices), but also carry lower yields than fixed notes of the same maturity. It's
essentially the same concept as a adjustable-rate mortgage, except FRNs are investments
(not debt).
Types of debt financing
1 Working Capital Loan:
It is the most popular short-term financing option. It is meant to meet the working needs
like the purchase of raw material, payment of wages and other administrative expenses,
financing inventories, managing internal cash-flows, supporting supply chains, funding
production and marketing operations. Most banks provide these against collaterals.
Companies who borrow from banks are subjected to the discipline of maintenance of
proper accounts and regular repayments of loans. They are subjected to periodical
monitoring through a reporting structure of financial and other statements and also
through analysis of cash flows routed through the banks.
2. Overdraft:
The other short-term debt option is the overdraft facility, by way of which a company
opens a current account with a bank and can overdraw money up to an agreed limit. In
this case, you pay interest only for the time you use the money.
3. Factoring:
The bank buys the customer‘s account receivables in domestic and international trade,
assuming the responsibility of collecting them from the party who owes money.
4. Commercial Papers (CPs):
It is a debt instrument issued by companies at a discount on the face value. Banks,
individuals and mutual funds usually buy commercial papers.
5. Term loans:
Term loans are mostly taker to buy assets and grow business. These loans are term
based, which may vary from three to ten years. The amount, the tenure and interest rates
may vary depending upon the risk profile of the company. Term loans are either asset-
backed or cash-flow backed. In the case of asset-backed term loans, lender institutions
seek assets of the company as collaterals while issuing loans. In the case of cash-flow
53
backed loans, banks carefully scrutinize the balance sheets of a company to study its
cash-flow capability.
6. Syndicated loans:
Syndicated loans are large capital loans raised by big corporations from a group of banks.
These are aimed at acquiring domestic or international companies. In this case, one bank
acts as a lead bank.
7. Project Finance:
Large and long-term infrastructure projects require huge amounts amount of funding both
in the form of debt and equity. In project financing, lenders (banks) rely on the assets
created for the project as security and the cash-flow generated by the project as source of
funds for repaying their dues. These projects include building of roads, dams; ports etc
are sensitive to regulatory and political policies and tariffs.
8. Debentures:
This is a long-term debt instrument issued by a company with the acknowledgement that
it would repay the money at a certain rate of interest to the buyer. These are not shares,
thus the buyer can stake no claim in the share of the company.
9. Inter-corporate deposits:
This is a short-term help provided by one corporate with surplus funds to another in need
of funds. The major disadvantage to lenders is that the money is locked in for the certain
period of time.
10. Personal loans:
Entrepreneurs also take personal loans from banks and financial institutions to fund their
projects.
11 Secured Debt
Secured lenders look for repayment in one of two ways: normal repayment from cash
flow, or liquidation of the assets held as security. When a secured lender looks at your
company, they are looking for enough historical cash flow to pay the loan payment AND
enough tangible security (land, buildings or equipment) to fully repay the loan advance,
plus interest and expenses.
Secured debt is the cheapest to obtain because it is relatively low risk for the lender. It is
also the most widely available. Secured loans can include operating lines of credit, term
loans and mortgages. Lenders include banks, term lenders, asset-based lenders,
franchisers, factoring companies, sales and leaseback sources, export-related sources and
equipment leasing companies.
12 Subordinated Debt
Also known as participating debt, junior debt, mezzanine debt and quasi-equity. Banks
will provide subordinated debt in situations where there is insufficient tangible security to
cover the loan if your historical cash flow is more than sufficient to service future
payments of principal and interest, as well as future capital expenditures to maintain the
54
physical plant in its present condition. Lenders look for a debt service coverage ratio of at
least 1.5 to 1.
Lenders enhance their rate of return by charging bonus interest, or a royalty on sales, or
by participating in the available cash flow. They may request an option or warrants for
common shares in your company.
Because of the higher risk, subordinated debt has higher fees and rates of interest than
secured debt.
13 Unsecured Term Loans
Unsecured loans are granted only to firms with projected and historical financial data to
prove ability to repay. They usually require you to put up 30% to 50% of the funds
needed, depending on the type of business.
14 Real Estate Financing
These include commercial or industrial mortgages for up to 75% of the appraised value of
your property, for terms of 10 to 20 years.
Preferred stock Preferred Stock is a type of stock that promises a (usually) fixed dividend, but at the
discretion of the board of directors. Preferred Stock has preference over common stock
in the payment of dividends and claims on assets.
The payment of preferred stock is similar to an annuity, so the valuation model of a
preferred stock is
V = Dp / Kp
Example
Stock PS has an 8%, $100 par value issue outstanding. The appropriate discount rate is
10%. What is the value of the preferred stock?
Dp = $100 ( 8% ) = $8.00.
Kp = 10%.
V = Dp / kp = $8.00 / 10%
= $80
Types of preferred stock
In addition to the straight preferred, as just described, there is great diversity in the
preferred stock market. Additional types of preferred stock include:
Prior Preferred Stock –
Many companies have different issues of preferred stock outstanding at the same time
and one of them is usually designated to be the one with the highest priority. If the
company has only enough money to meet the dividend schedule on one of the preferred
issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred
55
have less credit risk than the other preferred stocks but it usually offers a lower yield than
the others.
Preference Preferred Stock –
Ranked behind the company's prior preferred stock (on a seniority basis), are the
company's preference preferred issues. These issues receive preference over all other
classes of the company's preferred except for the prior preferred. If the company issues
more than one issue of preference preferred, then the various issues are ranked by their
relative seniority. One issue is designated first preference, the next senior issue is the
second and so on.
Convertible Preferred Stock –
These are preferred issues that the holders can exchange for a predetermined number of
the company's common stock. This exchange can occur at any time the investor chooses
regardless of the current market price of the common stock. It is a one way deal so one
cannot convert the common stock back to preferred stock.
Cumulative preferred stock – If the dividend is not paid, it will accumulate for future
payment.
Exchangeable preferred stock –
This type of preferred stock carries the option to be exchanged for some other security
upon certain conditions.
Participating Preferred Stock –
These preferred issues offer the holders the opportunity to receive extra dividends if the
company achieves some predetermined financial goals. The investors who purchased
these stocks receive their regular dividend regardless of how well or how poorly the
company performs, assuming the company does well enough to make the annual
dividend payments. If the company achieves predetermined sales, earnings or
profitability goals, the investors receive an additional dividend.
Perpetual preferred stock – This type of preferred stock has no fixed date on which
invested capital will be returned to the shareholder, although there will always be
redemption privileges held by the corporation. Most preferred stock is issued without a
set redemption date.
Putable preferred stock –
These issues have a "put" privilege whereby the holder may, upon certain conditions,
force the issuer to redeem shares.
Monthly income preferred stock – A combination of preferred stock and subordinated
debt.
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Non-cumulative preferred stock –
Dividend for this type of preferred stock will not accumulate if it is unpaid. Very
common in TRuPS and bank preferred stock, since under BIS rules, preferred stock must
be non-cumulative if it is to be included in Tier 1 capital.
___--____________________________________________________-____
THE END
Fahad - MBA IV contact number -03338366266
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