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COMPENDIUM – FINANCE

INDIAN INSTITUTE OF FOREIGN TRADE

NEW DELHI

CONTENTS

TOPIC PAGE NO.

1 FINANCIAL ACCOUNTING BASICS 1

2 FINANCIAL STATEMENTS 4

3 RATIO ANALYSIS 12

4 CORPORATE FINANCE 17

5 INTRODUCTION TO SECURITIES MARKET 26

6 METHODS OF CORPORATE VALUATION 39

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FINANCIAL ACCOUTING

Financial accounting (or financial accountancy) is the field of accounting concerned with the

summary, analysis and reporting of financial transactions pertaining to a business. It is the

language of business. Financial accountancy is governed by both local and international

accounting standards. In India accounting standards are prescribed by the Institute of

Chartered Accountants of India.

Accounting principles are the rules and guidelines that companies must follow when reporting

financial data. The common set of U.S. accounting principles is the generally

accepted accounting principles(GAAP).

The need for Generally Accepted Accounting Principles arises from the following needs:

To be logical & consistent

Conform to established practices & procedures

GAAP are:

Accounting Period Income is measured for a specified interval of time called accounting period. Ex. 12 months, financial year.

Going Concern: Business will continue to exist and carry on its operations for an indefinite period and would not liquidate in the foreseeable future.

Cost Concept: It states that the long term assets are shown in the financial statements at their historical cost irrespective of the current realizable or liquidation value.

Separate Entity Business is a separate accounting entity for which accounts are kept ie business and the businessman are separate entities

Money Measurement Only those transactions that can be expressed in terms of money are the subject matter of accounting

Accrual

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Income and expenses are recorded when `accrued’ and not when received or paid ie. to make a record of all the expenses and incomes relating to the accounting period whether actual cash has been disbursed or received or not.

Matching Expenses should be matched against the revenue generated to ascertain profit

Conservatism Anticipate no profit but anticipate all losses ie. recognise gains only when they are reasonably certain and recognise losses even if they are reasonably probable

Materiality Insignificant details should be avoided but all important information must be disclosed

Consistency Accounting methods once chosen must be applied consistently period after period unless there is strong reasons to change and if there is a change the same must be disclosed separately.

Accounting Cycle

JOURNAL ENTRY

Types of Accounts

o Personal Accounts All persons – natural and artificial Receivable/ Payables

o Non-Personal Accounts Real Accounts

Assets Nominal Accounts

Income/ Gains/ Receipts

Expenditure / Losses

Transaction

•Journal Entry

Classification

•Ledger Posting

Summarization

•Trial Balance

•Financial statements

Financial Statements

•P & L Statement

•Balance Sheet

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Recording Rules

Personal Accounts o Debit the receiver o Credit the Giver

Real Accounts o Debit what comes in o Credit what goes out

Nominal Accounts o Debit all expenses/losses o Credit all receipts/ income/ gains

Transaction Analysis

Analyze transactions to identify two or more aspects getting effected

Ascertain the type of account – real, nominal, personal

Apply the recording rule to Debit one or more accounts and Credit one or more accounts in such a way that Total Debit = Total Credit

CLASSIFICATION

It is a process of posting transactions recorded in respective accounts which is called `Ledger Posting’

An account is a `T shaped’ statement with the left hand side called the Debit Side (Dr.) and the right hand side called Credit side (Cr.)

SUMMARIZATION Trial Balance A trial balance is a bookkeeping worksheet in which the balances of all ledgers are compiled

into debit and credit columns. A company prepares a trial balance periodically, usually at the end of

every reporting period. The general purpose of producing a trial balance is to ensure the entries in a

company's bookkeeping system are mathematically correct.

DEBIT(Dr.) CREDIT(C.)

Machinery Account

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Total of Dr. side = Total of Cr.

Side

FINANCIAL STATEMENTS

Profit and Loss/Income Statement

The income statement is one of the major financial statements that is used to show the profitability of a company during the time interval specified in its heading. The period of time that the statement covers is chosen by the business and will vary. It captures two aspects of a business–Revenue & Expenses over a given period (usually 1 year or 1 accounting period) through both operating and non-operating activities Operating activities: All the activities that contribute to generating revenue from the business’s core operations (manufacturing, marketing and selling of goods) are clubbed under this head Non-operating activities: All activities that are not a part of the business’s core operations are called non-operating activities. Items like interest income, dividend income, foreign exchange gains etc. are the business’s non-operating activities Revenue This is income generated by a company from its main business activities (sales of goods or services) and is also called turnover or top line The Income statement has another head called ‘Other Revenue’. This is income generated from its non-operating activities Cost of Goods Sold (COGS) All the expenses that lead to adding value to the raw material/semi-finished goods before the finished product is kept away for storage or is sent out of the factory constitute a part of the head

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‘Cost of Goods Sold. This also includes items like electricity cost at the factory, worker wages, carriage-in cost of the raw material etc. Gross Profit = Revenue- COGS Selling General & Administrative Expenses(SG&A) This head constitutes all the operating expenses like storage costs, selling expenses, employee’s salaries, marketing costs, R&D overheads etc. Selling costs include direct selling expenses such as those that can be directly linked to the sale of a specific unit such as credit, warranty and advertising expenses. SG&A expenses include salaries of non-sales personnel, rent, heat and lights EBITDA = Total Gross Profit–SG&A Depreciation It is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense $100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year Amortization It is similar to depreciation as a concept except that it is applied to only intangible assets. For example, suppose XYZ Biotech spent $30 million dollars on a piece of medical equipment and that the patent on the equipment lasts 15 years, this would mean that $2 million would be recorded each year as an amortization expense • EBIT (Operating Profit) = EBITDA – DA Other Revenue: This includes interest income, dividend income, profit from sale of assets etc. Other Expenses: This includes any non-operating expense or loss. Tax Expenses A tax expense is a liability owing to federal, state/provincial and municipal governments.

Current Tax – tax expected to be paid on current years income

Deferred Tax – net effect of recognizing deferred tax liability / assets o Deferred Tax Assets – higher taxes paid in the current year will result in lower taxes in

future years

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o Deferred Tax Liabilities – tax saved in the current year will reverse and result in higher taxes in future

BALANCE SHEET A Balance Sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. The balance sheet gets its name from the fact that the two sides of the equation below – assets on the one side and liabilities plus shareholders' equity on the other – must balance out.

Assets = Liabilities + Shareholders' Equity

ASSET An asset is anything of value that can be converted into cash. Assets are owned by individuals, businesses and governments.

Assets can be broadly divided into 2 categories: • Current Assets: All assets that are reasonably expected to be converted into cash within one year in the normal course of business Current assets are important to businesses because they are the assets that are used to fund day-to-day operations and pay ongoing expenses Example: Cash, accounts receivable, inventory, prepaid expenses

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• Non-Current Assets: Assets that are expected to be converted into cash in a time frame greater than a year, anything that isn’t a current asset Example: Property, plant and equipment, Intellectual Property, Goodwill

LIABILITY Liabilities are a company's legal debts or obligations that arise during the course of business operations. Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries.

Liabilities can be broadly divided into 2 categories:

Current liabilities are debts payable within one year, ex Interest payable, rent, tax, utilities, wages payable, customer prepayments while

Long-term liabilities are debts payable over a longer period like long term debt and pension fund liability. OWNER’S EQUITY It is the portion of the balance sheet that represents the capital received from investors in exchange for stock (paid-in capital) and retained earnings. A stockholders' equity represents the equity stake currently held on the books by a firm's equity investors

Owner’s Equity = Total Assets–Total Liabilities

Stockholders' equity is often referred to as the book value of the company, and it comes from two main sources • Original source is the money that was originally invested in the company, along with any additional investments made thereafter • The second comes from retained earnings that the company is able to accumulate over time through its operations

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CASH FLOW STATEMENT

The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis.

The cash flow statement reveals the following information:

1. How the company obtains and spends cash 2. Why there may be differences between net income and cash flows 3. If the company generates enough cash from operation to sustain the business 4. If the company generates enough cash to pay off existing debts as they mature 5. If the company has enough cash to take advantage of new investment opportunities

The following terms are used in this Statement with the meanings specified:

Cash comprises cash on hand and demand deposits with banks.

Cash equivalents are short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value.

Cash flows are inflows and outflows of cash and cash equivalents.

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Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise.

Segregation of Cash Flows

The statement of cash flows is segregated into three sections:

1. Operating activities 2. Investing activities

3. Financing activities

Cash Flow from Operating Activities (CFO)

CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.

This includes:

Cash inflow (+) 1. Revenue from sale of goods and services 2. Interest (from debt instruments of other entities) 3. Dividends (from equities of other entities)

Cash outflow (-) 1. Payments to suppliers 2. Payments to employees 3. Payments to government 4. Payments to lenders 5. Payments for other expenses

Examples of cash flows from operating activities are:

(a) Cash receipts from the sale of goods and the rendering of services

(b) Cash receipts from royalties, fees, commissions and other revenue;

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(c) Cash payments to suppliers for goods and services

(d) Cash payments to and on behalf of employees.

(e) Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits

(f) Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities

(g) Cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes.

2. Cash Flow from Investing Activities (CFI) CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets.

This includes:

Cash inflow (+) 1. Sale of property, plant and equipment 2. Sale of debt or equity securities (other entities) 3. Collection of principal on loans to other entities

Cash outflow (-) 1. Purchase of property, plant and equipment 2. Purchase of debt or equity securities (other entities) 3. Lending to other entities

Examples of cash flows arising from investing activities are:

(a) Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalized research and development costs and self-constructed fixed assets,

(b) Cash receipts from disposal of fixed assets (including intangibles).

(c) Cash payments to acquire shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes)

(d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes).

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(e) Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise).

(f) Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise).

(g) cash payments for futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the payments are classified as financing activities.

(h) cash receipts from futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the receipts are classified as financing activities.

3. Cash flow from financing activities (CFF) CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes:

Cash inflow (+) 1. Sale of equity securities 2. Issuance of debt securities

Cash outflow (-) 1. Dividends to shareholders 2. Redemption of long-term debt 3. Redemption of capital stock

Examples of cash flows arising from financing activities are:

(a) Cash proceeds from issuing shares or other similar instruments.

(b) Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings.

(c) Cash repayments of amounts borrowed.

Reporting Noncash Investing and Financing Transactions

Information for the preparation of the statement of cash flows is derived from three sources:

1. Comparative balance sheets 2. Current income statements 3. Selected transaction data (footnotes)

Examples Include:

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Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash. Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.

RATIO ANALYSIS

Financial ratios can be segregated into different classifications by the type of information about the company they provide. One such classification scheme is:

• Activity ratios: This category includes several ratios also referred to asset utilization or turnover ratios (e.g., inventory turnover, receivables turnover, and total assets turnover). They often give indications of how well a firm utilizes various assets such as inventory and fixed assets.

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• Liquidity ratios: Liquidity here refers CO the ability to pay short-term obligations as they come due.

• Solvency ratios: Solvency ratios give the analyst information on the firm's financial leverage and ability to meet its longer -term obligations.

• Profitability ratios: Profitability ratios provide information on how well the company generates operating profits and net profits from its sales.

• Valuation ratios: Sales per share, earnings per share, and price to cash flow per share are examples of ratios used in comparing the relative valuation of companies.

It should be noted that these categories are not mutually exclusive. An activity ratio such as payables turnover may also provide information about the liquidity of a company, for example. There is no one standard set of ratios for financial analysis. Different analysts use different ratios and different calculation methods for similar ratios. Some ratios are so commonly used that there is very little variation in how they are defined and calculated. We will note some alternative treatments and alternative terms for single ratios as we detail the commonly used ratios in each category.

Following are the most critical ratios for most businesses, though there are others that may be

computed.

1. Liquidity Measures a company’s capacity to pay its debts as they come due. There are two ratios for

evaluation liquidity.

Current Ratio - Gauges how able a business is to pay current liabilities by using current assets

only. Also called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1

(or 2:1, or 2/1). However, an industry average may be a better standard than this rule of thumb.

The actual quality and management of assets must also be considered.

The formula is:

Total Current Assets

Total Current Liabilities

Quick Ratio - Focuses on immediate liquidity (i.e., cash, accounts receivable, etc. but specifically

ignores inventory. Also called the acid test ratio, it indicates the extent to which you could pay

current liabilities without relying on the sale of inventory. Quick assets, are highly liquid--those

immediately convertible to cash. A rule of thumb states that, generally, your ratio should be 1

to 1 (or 1:1, or 1/1).

The formula is:

Cash + Accounts Receivable (+ any other quick assets)

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Current Liabilities

2. Solvency Indicates a company’s vulnerability to risk--that is, the degree of protection provided for the

business’ debt. Three ratios help you evaluate safety:

Debt to Worth - Also called debt to net worth. Quantifies the relationship between the capital

invested by owners and investors and the funds provided by creditors. The higher the ratio, the

greater the risk to a current or future creditor. A lower ratio means your company is more

financially stable and is probably in a better position to borrow now and in the future. However,

an extremely low ratio may indicate that you are too conservative and are not letting the

business realize its potential.

The formula is:

Total Liabilities (or Debt)

Net Worth (or Total Equity)

Times Interest Earned – Assesses the company’s ability to meet interest payments. It also

evaluates the capacity to take on more debt. The higher the ratio, the greater the company’s

ability to make its interest payments or perhaps take on more debt.

The formula is:

Earnings Before Interest & Taxes

Interest Charges

Cash Flow to Current Maturity of Long-Term Debt - Indicates how well traditional cash flow (net

profit plus depreciation) covers the company’s debt principal payments due in the next 12

months. It also indicates if the company’s cash flow can support additional debt.

The formula is:

Net Profit + Non-Cash Expenses*

Current Portion of Long-Term Debt

*Such as depreciation, amortization, and depletion.

3. Profitability Measures the company’s ability to generate a return on its resources. Use the following four

ratios to help you answer the question, “Is my company as profitable as it should be?” An

increase in the ratios is viewed as a positive trend.

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Gross Profit Margin - Indicates how well the company can generate a return at the gross profit

level. It addresses three areas: inventory control, pricing, and production efficiency.

The formula is:

Gross Profit Total Sales

Net Profit Margin - Shows how much net profit is derived from every dollar of total sales. It

indicates how well the business has managed its operating expenses. It also can indicate

whether the business is generating enough sales volume to cover minimum fixed costs and still

leave an acceptable profit.

The formula is:

Net Profit Total Sales

Return on Assets - Evaluates how effectively the company employs its assets to generate a

return. It measures efficiency.

The formula is:

Net Profit Total Assets

Return on Net Worth - Also called return on investment (ROI). Determines the rate of return on

the invested capital. It is used to compare investment in the company against other investment

opportunities, such as stocks, real estate, savings, etc. There should be a direct relationship

between ROI and risk (i.e., the greater the risk, the higher the return).

The formula is:

Net Profit

Net Worth

4. Activity Ratios Evaluates how well the company manages its assets. Besides determining the value of the

company’s assets, you should also analyze how effectively the company employs its assets. You

can use the following ratios:

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Accounts Receivable Turnover - Shows the number of times accounts receivable are paid and

reestablished during the accounting period. The higher the turnover, the faster the business is

collecting its receivables and the more cash the company generally has on hand.

The formula is:

Total Net Sales

Average Accounts Receivable

Accounts Receivable Collection Period - Reveals how many days it takes to collect all accounts

receivable. As with accounts receivable turnover (above), fewer days means the company is

collecting more quickly on its accounts.

The formula is:

365 Days

Accounts Receivable Turnover

Accounts Payable Turnover - Shows how many times in one accounting period the company

turns over (repays) its accounts payable to creditors. A higher number indicates either that the

business has decided to hold on to its money longer, or that it is having greater difficulty paying

creditors.

The formula is:

Cost of Goods Sold

Average Accounts Payable

Payable Period - Shows how many days it takes to pay accounts payable. This ratio is similar to

accounts payable turnover (above.) The business may be losing valuable creditor discounts by

not paying promptly.

The formula is:

365 Days

Accounts Payable Turnover

Inventory Turnover - Shows how many times in one accounting period the company turns over

(sells) its inventory. This ratio is valuable for spotting understocking, overstocking,

obsolescence, and the need for merchandising improvement. Faster turnovers are generally

viewed as a positive trend; they increase cash flow and reduce warehousing and other related

costs. Average inventory can be calculated by averaging the inventory figure from the monthly

Balance Sheets. In a cyclical business, this is especially important since there can be wide swings

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in asset levels during the year. For example, many retailers might have extra stock in October

and November in preparation for the Thanksgiving and winter holiday sales.

The formula is:

Cost of Goods Sold

Average Inventory

Inventory Turnover in Days - Identifies the average length of time in days it takes the inventory

to turn over. As with inventory turnover (above), fewer days mean that inventory is being sold

more quickly.

The formula is:

365 Days

Inventory Turnover

Sales to Net Worth - Indicates how many sales dollars are generated with each dollar of

investment (net worth). This is a volume ratio.

The formula is:

Total Sales

Average Net Worth

Sales to Total Assets - Indicates how efficiently the company generates sales on each dollar of

assets. A volume indicator, this ratio measures the ability of the company’s assets to generate

sales.

The formula is:

Total Sales

Average Total Assets

Debt Coverage Ratio - An indication of the company’s ability to satisfy its debt obligations, and

its capacity to take on additional debt without impairing its survival.

The formula is:

Net Profit + Any Non-Cash Expenses

Principal on Debt

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Corporate Finance

Corporate finance is the study of a business's money-related decisions, which are essentially all of a

business's decisions. Despite its name, corporate finance applies to all businesses, not just corporations.

The primary goal of corporate finance is to figure out how to maximize a company's value by making

good decisions about investment, financing and dividends.

Time Value of Money:

So, in addition to being able to understand financial statements, it's important to be able to estimate the

value of an investment in the present and in the future.

The idea that money available at the present time is worth more than the same amount in the future

due to its potential earning capacity is called the time value of money. This core principle of finance

holds that, provided money can earn interest, any amount of money is worth more the sooner it is

received. Thus, at the most basic level, the time value of money demonstrates that, all things being

equal, it is better to have money now rather than later.

But why is this? A $100 bill now has the same value as a $100 bill one year from now, doesn't it?

Actually, although the bill is the same, you can do much more with the money if you have it now

because over time you can earn more interest on your money.

By receiving $10,000 today (Option A), you are poised to increase the future value of your money by

investing and gaining interest over a period of time. If you receive the money three years down the line

(Option B), you don't have time on your side, and the payment received in three years would be your

future value. To illustrate, we have provided a timeline:

If you choose Option A, your future

value will be $10,000 plus any

interest acquired over the three

years. The future value for Option B,

on the other hand, would only be

$10,000. So how can you calculate

exactly how much more Option A is

worth compared to Option B? Let's

take a look.

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Future Value Basics

If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of

your investment at the end of the first year is $10,450, which is calculated by multiplying the principal

amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal

amount:

Future value of investment at end of first year:

= ($10,000 x 0.045) + $10,000

= $10,450

You can also calculate the total amount of a one-year investment with a simple manipulation of the

above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450

Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450

Final equation: $10,000 x (0.045 + 1) = $10,450

Thus, the equation used to calculate FV is:

1) For an asset with simple annual interest: = Original Investment x (1+(interest rate*number of years))

2) For an asset with interest compounded annually: = Original Investment x ((1+interest rate)^number of

years) Consider the following examples:

i) $1000 invested for five years with simple annual interest of 10% would have a future value of

$1,500.00.

ii) $1000 invested for five years at 10%, compounded annually has a future value of $1,610.51.

When planning investment strategy, it's useful to be able to predict what an investment is likely to be

worth in the future, taking the impact of compound interest into account. This formula allows you to do

just that:

Pn = P0(1+r)n

Pnis future value of P0

P0 is original amount invested

r is the rate of interest

n is the number of compounding periods (years, months, etc.)

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Present Value:

Present value, also called "discounted value," is the current worth of a future sum of money or stream

of cash flow given a specified rate of return. Future cash flows are discounted at the discount rate; 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 are earnings or

obligations. If you received $10,000 today, the present value would be $10,000 because present value is

what your investment gives you if you were to spend it today. If you received $10,000 in a year, the

present value of the amount would not be $10,000 because you do not have it in your hand now, in the

present.

To calculate present value, or the amount that we would have to invest today, you must subtract the

(hypothetical) accumulated interest from the $10,000. The equation used for the same is:

Understanding Capital Budgeting and its basics:

Before delving into Capital budgeting, let us cover the basic terms and their definitions that form the

crux of capital budgeting:

Net Present Value and Internal Rate of Return:

Net present value (NPV) is the difference between the present value of cash inflows and the present

value of cash outflows. NPV compares the value of a dollar today to the value of that same dollar in the

future, taking inflation and returns into account. NPV analysis is sensitive to the reliability of future cash

inflows that an investment or project will yield and is used in capital budgeting to assess the profitability

of an investment or project.

NPV is calculated using the following formula:

If the NPV of a prospective project is positive, the project should be

accepted. However, if NPV is negative, the project should probably

be rejected because cash flows will also be negative.

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For example, if a retail clothing business wants to purchase an existing store, it would first estimate the

future cash flows that store would generate, then discount those cash flows into one lump-sum present

value amount, say $565,000. If the owner of the store was willing to sell his business for less than

$565,000, the purchasing company would likely accept the offer as it presents a positive NPV

investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy

the store, as the investment would present a negative NPV.

Internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net

present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a

project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be

used to rank several prospective projects a firm is considering. Assuming all other factors are equal

among the various projects, the project with the highest IRR would probably be considered the best and

undertaken first.

You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of

return that a given project ends up generating will often differ from its estimated IRR rate, a project with

a substantially higher IRR value than other available options would still provide a much better chance of

strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find

any projects with IRRs greater than the returns that can be generated in the financial markets, it may

simply choose to invest its retained earnings into the market.

Both NPV and IRR are primarily used in capital budgeting, the process by which companies determine

whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a

firm needs to decide whether undertaking the investment will generate net economic profits or losses

for the company.

To do this, the firm estimates the future cash flows of the project and discounts them into present value

amounts using a discount rate that represents the project's cost of capital and its risk. Next, all of the

investment's future positive cash flows are reduced into one present value number. Subtracting this

number from the initial cash outlay required for the investment provides the net present value (NPV) of

the investment.

The IRR is the interest rate (also known as the discount rate) that will bring a series of cash flows

(positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested).

Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis.

For example, a corporation will evaluate an investment in a new plant versus an extension of an existing

plant based on the IRR of each project. In such a case, each new capital project must produce an IRR

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that is higher than the company's cost of capital. Once this hurdle is surpassed, the project with the

highest IRR would be the wiser investment, all other factors (including risk) being equal.

Payback Period:

The amount of time required for a firm to recover its initial investment in a project, as calculated from

its cash flows

If PBP < Minimum Acceptable PBP, then accept the project

If PBP > Minimum Acceptable PBP, then reject the project

Pros of PBP:

Simple to compute and easy to understand

Can be viewed as a measure of risk exposure

Cons of PBP:

Minimum Acceptable PBP is set subjectively

Time Value of money is not integrated into PBP calculations

Cash flows that occur after PBP are not considered

Profitability Index:

A profitability index attempts to identify the relationship between the costs and benefits of a proposed

project. The profitability index is calculated by dividing the present value of the project's future cash

flows by the initial investment. A PI greater than 1.0 indicates that profitability is positive, while a PI of

less than 1.0 indicates that the project will lose money. As values on the profitability index increase, so

does the financial attractiveness of the proposed project.

The PI ratio is calculated as follows:

(PV of Future Cash Flows)/(Initial Investment)

A ratio of 1.0 is logically the lowest acceptable measure for the index. Any value lower than 1.0 would

indicate that the project's PV is less than the initial investment, and the project should be rejected or

abandoned. The profitability index rule states that the ratio must be greater than 1.0 for the project to

proceed.

Capital Budgeting:

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Capital budgeting is the process of planning for projects on assets with cash flows of a period greater

than one year.

These projects can be classified as:

·Replacement decisions to maintain the business

·Existing product or market expansion

·New products and services

·Regulatory, safety and environmental

·Other, including pet projects or difficult-to-evaluate projects

Additionally, projects can be classified as mutually exclusive or independent:

Mutually exclusive projects are potential projects that are unrelated, and any combination of those

projects can be accepted.

Independent projects indicate there is only one project among all possible projects that can be

accepted.

Capital budgeting is important for many reasons:

- Since projects approved via capital budgeting are long term, the firm becomes tied to the project and

loses some of its flexibility during that period.

- When making the decision to purchase an asset, managers need to forecast the revenue over the life

of that asset.

- Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan

of the company.

In capital budgeting, there are a number of different approaches that can be used to evaluate any given

project, and each approach has its own distinct advantages and disadvantages.

All other things being equal, using internal rate of return (IRR) and net present value (NPV)

measurements to evaluate projects often results in the same findings. However, there are a number of

projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation

is also its greatest strength: it uses one single discount rate to evaluate every investment.

Although using one discount rate simplifies matters, there are a number of situations that cause

problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate,

predictable cash flows, equal risk and a shorter time horizon, IRR will probably work. The catch is that

discount rates usually change substantially over time. For example, think about using the rate of return

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on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1- 12% in the last 20

years, so clearly the discount rate is changing.

Without modification, IRR does not account for changing discount rates, so it's just not adequate for

longer-term projects with discount rates that are expected to vary.

Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of

multiple positive and negative cash flows. For example, consider a project for which marketers must

reinvent the style every couple of years to stay current in a fickle, trendy niche market. If the project has

cash flows of -$50,000 in year one (initial capital outlay), returns of $115,000 in year two and costs of

$66,000 in year three because the marketing department needed to revise the look of the project, a

single IRR can't be used.

The advantage to using the NPV method here is that NPV can handle multiple discount rates without

any problems. Each cash flow can be discounted separately from the others.

Another situation that causes problems for users of the IRR method is when the discount rate of a

project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be

compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below,

the project is considered infeasible. If a discount rate is not known, or cannot be applied to a specific

project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If

a project's NPV is above zero, then it is considered to be financially worthwhile.

So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a direct

result of its reporting simplicity. The NPV method is inherently complex and requires assumptions at

each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies

projects to a single number that management can use to determine whether or not a project is

economically viable. The result is simple, but for any project that is long-term, that has multiple cash

flows at different discount rates or that has uncertain cash flows - in fact, for almost any project at all -

simple IRR isn't good for much more than presentation value.

Understanding Cost of Capital:

The cost of various capital sources varies from company to company, and depends on factors such as its

operating history, profitability, credit worthiness, etc. In general, newer enterprises with limited

operating histories will have higher costs of capital than established companies with a solid track record,

since lenders and investors will demand a higher risk premium for the former. A firm can raise capital

either using debt or equity and accordingly the cost of capital is calculated.

A firm may raise money for working capital or capital expenditures by selling bonds, bills, or notes to

individual and/or institutional investors. In return for lending money, the individuals or institutions

become creditors & receive promise that the principal and interest on the debt will be repaid. Creditors

have priority over shareholders in receiving interest and repayment of capital. Debt securities include

government bonds, corporate bonds, CDs, municipal bonds, preferred stock, collateralized securities

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and zero-coupon securities. In theory, debt financing generally offers the lowest cost of capital due to its

tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as

debt increases.

The cost of debt is merely the interest rate paid by the company on such debt. However, since interest

expense is tax-deductible, the after-tax cost of debt is calculated as: Yield to maturity of debt x (1 - T)

where T is the company’s marginal tax rate.

A stock or any other security representing an ownership interest is equity. In finance, in general, you can

think of equity as ownership in any asset after all debts associated with that asset are paid off. Equity

capital is classified as

Internal: Profits that are not distributed but retained by the firm in funding the growth, referred to as

internal equity

External: Equity capital raised afresh to fund, called external equity

The cost of equity is more complicated, since the rate of return demanded by equity investors is not as

clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the Capital Asset

Pricing Model (CAPM) = Risk-free rate + (Company’s Beta x Risk Premium). CAPM based determination

of cost of equity considers the risk characteristics that dividend capitalization approach ignores. CAPM

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). Beta measures the amount that

investors expect the stock price to change for each additional percentage change in the market. Beta, a

measure of systematic risk, is defined as ratio of covariance of the asset with the market to the variance

of the market. High beta implies volatile stock and high risk.

The firm’s overall cost of capital is based on the weighted average of these costs. For example, consider

an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10%

and after-tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%. A firm's

WACC is the overall required return on the firm as a whole and, as such, it is often used internally by

company directors to determine the economic feasibility of expansionary opportunities and mergers. It

is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

WACC is a calculation of a firm's cost of capital in which each category of capital is proportionately

weighted. WACC is a composite figure reflecting cost of each component multiplied by the weight of

each component.

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WACC = E/(D+E) * Re + D/(D+E) * Rd * (1-t)

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

E/(D+E) = percentage of financing that is equity

D/(D+E) = percentage of financing that is debt

t = corporate tax rate

After cost of each component is determined they need to be multiplied by the respective proportions to

arrive at WACC. The proportion may be based on marginal, book value or market value. The weights

based on the target capital structure are most appropriate though the current capital structure may not

conform. Use of market value based weights is technically superior than book value reflecting the

current expectations of investors.

In situations where beta is unavailable, we use that of a comparable company. While using beta of a

comparable company, it must be unlevered for the financial leverage to reflect only the business risk

and then re‐levered for the proposed capital structure of the project.

Steps Involved:

1. Identify a sample of comparable listed companies. 2. Find Equity Betas and use company specific capital structures to find an all equity beta, called

unlevering. 3. Calculate the median/average of Asset Betas of comparables. 4. Re‐adjusting for the proposed capital structure of the project, called relevering.

Β(Unlevered) = β (Levered) / (1+(1-t)D/E)

For example,

Assume that observed beta of Pure‐play firm is 1.2. Besides reflecting the business risk the observed

beta also represents the financial risk. This has to be unlevered i.e. converted into β of equity as if it

were all equity financed. If the debt equity ratio based on market values is 1:5 and its marginal tax rate

is 30%, the beta of pure play firm is

Beta (unlevered) = 1.2/{1+0.7 X (1/5)} = 1.0526

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This now needs to be relevered with the proposed financing pattern of the project. This can be done by

incorporating debt equity ratio (D*/E*) and tax rate (T*) of the proposed project. If new project is

proposed with debt equity ratio of 2:5 and with tax rate of 35% the beta of the project is

Beta levered = 1.0526 {1+ 0.65 X (2/5)} = 1.3262

INTRODUCTION TO SECURITIES MARKET

Securities are financial instruments issued to raise funds. The primary function of the securities market

is to enable the flow of capital from those that have it to those that need it. Securities market helps in

transfer of resources from those with idle or surplus resources to others who have a productive need for

them. To state formally, securities market provides channels for conversion of savings into investments.

A security represents the terms of exchange of money between two parties. Securities are issued by

companies, financial institutions or the government. They are purchased by investors who have money

to invest. Security ownership allows investors to convert their savings into financial assets which provide

a return. Security issuance allows borrowers to raise money at a cost. Through Securities Market, a

broader universe of savers with surplus to invest is available to the issuers of securities and a universe of

wider options is available to savers to invest their money in. Thus, the objectives of the issuers and the

investors are complementary, and the securities market provides a platform to mutually satisfy their

goals. Securities are useful because owners can transfer their interest to others without the issuers

being impacted – by providing liquidity, securities allow issuers to raise capital for the long term without

locking in investors.

Broadly stating, Financial Market consists of:

Investors (buyers of securities)

Borrowers/Seekers of funds (sellers of securities)

Intermediaries (providing the infrastructure to facilitate transfer of funds and securities)

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Regulatory bodies (responsible for orderly development of the market)

The term ‘Securities’ include:

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like

nature in or of any incorporated company or other body corporate

2. Derivative

3. Units or any other instrument issued by any collective investment scheme to the investors in

such schemes units or any other such instrument issued to the investors under any mutual

fund scheme

4. Government securities

The investors in the Indian securities market have a wide choice of financial products to choose from

depending upon their risk appetite and return expectations. Broadly, the financial products can be

categorized as equity, debt and derivative products.

Equity Shares:

Issued by: Companies

Investors: Institutional and Individual (Retail and HNI)

Medium: Direct issuance by companies and Stock Exchange

Regulator: SEBI, Regulators under the Companies Act

Equity shares represent the form of fractional ownership in a business venture. Equity shareholders

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collectively own the company. They bear the risk and enjoy the rewards of ownership.

Debentures/Bonds/Notes:

Issued by: Companies, Government, Special Purpose Vehicles (SPVs)

Investors: Institutional and Individual

Medium: Direct issuance by issuers and Stock Exchange

Regulator: RBI, SEBI, Regulators under the Companies Act

Debentures/Bonds/Notes are instruments for raising long term debt. Debentures are either unsecured

or secured (backed by collateral support) in nature. There are variety of debentures/bonds such as fully

convertible, non-convertible and partly convertible debentures.

Fully convertible debentures are fully convertible into ordinary shares of the issuing company. The

terms of conversion are specified at the time of issue itself.

Partly convertible debentures (PCDs) are partly convertible into ordinary shares of the issuing

company under specified terms and conditions as specified at the time of issue itself. The non-

convertible part of these debentures is redeemed as happens in any other vanilla debenture.

Non-Convertible Debentures (NCDs) are pure debt instruments without a feature of conversion. The

NCDs are repayable/redeemable on maturity.

Thus, debentures can be pure debt or quasi- equity, as the case may be. Thus, debentures can be pure

debt or quasi- equity, as the case may be

Further, short-term debt instruments are used to raise debt for periods not exceeding one year. These

instruments include Treasury Bills issued by the government, Commercial Papers issued by the

companies and Certificate of Deposit issued by the banks.

Warrants and Convertible Warrants

Issued by: Companies

Investors: Institutional and Individual

Medium: Direct issuance by companies and Stock Exchange

Regulator: SEBI

Warrants are options that entitle an investor to buy equity shares of the issuer company after a

specified time period at a given price. Only a few companies in Indian Securities Market have issued

warrants till now.

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Indices:

A market index tracks the market movement by using the prices of a small number of shares chosen as a

representative sample. Most leading indices are weighted by market capitalization to take into account

the fact that more the number of shares issued, greater the number of portfolios in which they may be

held. Stocks included in an index are also quite liquid, making it possible for investors to replicate the

index at a low cost. Narrow indices are usually made up of the most actively traded equity shares in that

exchange. Other indices to track sectors or market cap categories are also in use.

The most widely tracked indices in India are the S&P BSE Sensitive Index (S&P BSE Sensex), the MCX-SX

Flagship Index (SX40) and the CNX Nifty (Nifty). The Sensex has been computed as the market cap

weighted index of 30 chosen stocks on the BSE. The SX40 is composed of 40 most representative stocks

listed on MCX Stock Exchange and the CNX Nifty is composed of 51 most representative stocks listed on

the National Stock Exchange. The shares included in these indices are chosen on the basis of factors such

as liquidity, availability of floating stock and size of market capitalization.

The composition of stocks in the index is reviewed and modified from time to time to keep the index

representative of the underlying market. Some of the other common indices in India are listed below

CNX Nifty Junior

CNX 100

CNX 500

S&P BSE-100

S&P BSE- 500

S&P BSE-Midcap

S&P BSE-Small Cap

There are also sector indices for banking, information technology, pharma, fast-moving consumer goods

and such other sectors, created by the exchanges to enable tracking specific sectors.

The major uses of indices are:

The index can give a comparison of returns on investments in stock markets as opposed to asset

classes such as gold or debt.

For the comparison of performance with an equity fund, a stock market index can be the Benchmark.

The performance of the economy or any sector of the economy is indicated by the index.

Real time market sentiments are indicated by indices.

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Indices act as an underlying for Index Funds, Index Futures and Options.

Mutual Fund Units:

Issued by: Mutual Funds

Investors: Institutional and Individual

Medium: Direct issuance by mutual funds and Stock Exchange

Regulator: SEBI, RBI

Mutual Funds (MFs) are investment vehicles that pool together the money contributed by investors

which the fund invests in a portfolio of securities that reflect the common investment objectives of the

investors. Each investor’s share is represented by the units issued by the fund.

The value of the units, called the Net Asset Value (NAV), changes continuously to reflect changes in the

value of the portfolio held by the fund.

MF schemes can be classified as open-ended or close-ended. An open-ended scheme offers the

investors an option to buy units from the fund at any time and sell the units back to the fund at any

time. These schemes do not have any fixed maturity period. The units can be bought and sold anytime

at the NAV linked prices.

The unit capital of closed-ended funds is fixed and they sell a specific number of units. Units of closed-

ended funds can be bought or sold in the Stock Market where they are mandatorily listed

Exchange Traded Funds (ETFs):

Issued by: Mutual Funds

Investors: Institutional and Individual

Medium: Direct issuance by mutual funds and Stock Exchange

Regulator: SEBI, RBI

Exchange Traded Fund (ETF) is an investment vehicle that invests funds pooled by investors to track an

index, a commodity or a basket of assets. It is similar to an index fund in the sense that its portfolio

reflects the index it tracks. But, unlike an index fund, the units of the ETF are listed and traded in demat

form on a stock exchange and their price changes continuously to reflect changes in the index or

commodity prices.

ETFs provide the diversification benefits of an index fund as well as the facility to sell or buy at real-time

prices, even one unit of the fund. Since an ETF is a passively managed portfolio, its expense ratios are

typically lower than that of a mutual fund scheme.

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Hybrids/Structured Products:

Preference Shares:

Preference shares, as their name indicates, are a special kind of equity shares which have preference

over common/ordinary equity shares at the time of dividend and at the time of repayment of capital in

the event of winding up of the company. They have some features of equity and some features of debt

instruments.

Preference shares resemble equity as preference shareholders are called shareholders of the company

(not creditors), payment to them is termed as dividend and the same is paid from the Profit after Tax

and dividend payment is not an obligation. However, unlike common equity shares, preference shares

do not carry voting rights or a right over the residual assets of the company, in case of winding up.

Preference shares resemble debt instruments because they offer pre-determined rate of dividend and

this dividend is payable before any dividend is paid on common equity. Further, in case of winding up of

the company, preference shareholders get paid before common equity holders. In other words, these

shareholders have preference over the common equity holders at the time of distribution of both

earnings and assets.

There are variety of preference shares – cumulative (unpaid dividend is carried forward), noncumulative

(unpaid dividend lapses), convertible partly or fully etc.

Convertible Debentures & Bonds:

Convertible debentures are debt instruments that can be converted into equity shares of the company

at a future date. This security also has features of both debt and equity. It pays periodic coupon/interest

just like any other debt instrument till conversion. And, at a pre-defined time, this debt instrument may

get converted into equity shares

The issuer specifies the details of the conversion at the time of making the issue itself. These will

generally include:

Date on which or before which the conversion may be made

Ratio of conversion i.e. the number of shares that the investor will be eligible to get for each

debenture

Price at which the shares will be allotted to the investor on conversion. Usually, this is at a discount to

the market price

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Proportion of the debenture that will be converted into equity shares (in case of partially convertible

debentures)

The advantage to the issuer of convertible debenture lies in the fact that convertible debentures usually

have a lower coupon rate than pure debt instruments. This is because the yield to the investor in such

debenture is not from the coupon alone but also the possibility of capital appreciation in the investment

once the debentures are converted into equity shares. Moreover, the issuer does not have to repay the

debt on maturity since shares are issued in lieu of repayment. The disadvantage to this is that stakes of

the existing shareholders get diluted when fresh shares are issued on conversion. As more shareholders

come in, the proportionate holding of existing shareholders fall.

The investors in a convertible debenture have the advantage of equity and debt features. They earn

coupon income in the initial stage, usually when the company’s project is in its nascent stage. And, once

the debenture is converted into shares, they may benefit from the appreciation in the value of the

shares.

STRUCTURE OF SECURITIES MARKET

The market in which securities are issued, purchased by investors, and subsequently transferred among

investors is called the securities market. The securities market has two interdependent and inseparable

segments:

Primary Market: The primary market, also called the new issue market, is where issuers raise capital by

issuing securities to investors. Fresh securities are issued in this market.

Secondary Market: The secondary market facilitates trades in already-issued securities, thereby

enabling investors to exit from an investment or new investors to buy the already existing securities.

The primary market facilitates creation of financial assets, and the secondary market facilitates their

marketability/tradability which makes these two segments of Financial Markets - interdependent and

inseparable.

Ways to Issue Securities

Primary Market:

As stated above, primary market is used by companies (issuers) for raising fresh capital from the

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investors. Primary market offerings may be a public offering or an offer to a select group of investors in

a private placement program. The shares offered may be new shares issued by the company, or it may

be an offer for sale, where an existing large investor/investors or promoters offer a portion of their

holding to the public.

Let us understand various terms used in the Primary Market.

Public issue - Securities are issued to the members of the public, and anyone eligible to invest can

participate in the issue. This is primarily a retail issue of securities.

Initial Public Offer (IPO) - An initial public offer of shares or IPO is the first sale of a corporate’s common

shares to investors at large. The main purpose of an IPO is to raise equity capital for further growth of

the business. Eligibility criteria for raising capital from the public investors is defined by SEBI in its

regulations and include minimum requirements for net tangible assets, profitability and net-worth.

SEBI’s regulations also impose timelines within which the securities must be issued and other

requirements such as mandatory listing of the shares on a nationwide stock exchange and offering the

shares in dematerialized form etc.

Follow on Public Offer (FPO) - When an already listed company makes either a fresh issue of securities to

the public or an offer for sale to the public, it is called FPO. When a company wants additional capital for

growth or desires to redo its capital structure by retiring debt, it raises equity capital through a fresh

issue of capital in a follow-on public offer. A follow-on public offer may also be through an offer for sale,

which usually happens when it is necessary to increase the public shareholding in the company to meet

the regulatory requirements.

Private Placement - When an issuer makes an issue of securities to a select group of persons and which

is neither a rights issue nor a public issue, it is called private placement. This is primarily a wholesale

issue of securities to institutional investors. It could be in the form of a Qualified Institutional Placement

(QIP) or a preferential allotment

Qualified Institutional Placements (QIPs) - Qualified Institutional Placement (QIP) is a private placement

of shares made by a listed company to certain identified categories of investors known as Qualified

Institutional Buyers (QIBs). QIBs include financial institutions, mutual funds and banks among others.

SEBI has defined the eligibility criterion for corporates to be able to raise capital through QIP and other

terms of issuance under QIP such as quantum and pricing etc.

Preferential Issue - Preferential issue means an issue of specified securities by a listed issuer to any

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select person or group of persons on a private placement basis and does not include an offer of

specified securities made through a public issue, rights issue, bonus issue, employee stock option

scheme, employee stock purchase scheme or qualified institutions placement or an issue of sweat

equity shares or depository receipts issued in a country outside India or foreign securities. The issuer is

required to comply with various provisions defined by SEBI, which include pricing, disclosures in the

notice, lock-in, in addition to the requirements specified in the Companies Act.

Rights and Bonus Issues - Securities are issued to existing shareholders of the company as on a specific

cut-off date, enabling them to buy more securities at a specific price (in case of rights) or without any

consideration (in case of bonus). Both rights and bonus shares are offered in a particular ratio to the

number of securities held by investors as on the record date. It is also important to understand that

rights are like options and investors may or may not choose to exercise their rights i.e. apply for

additional shares offered to them. On the other hand, in case of bonus, additional shares are conferred

on to the existing shareholders (without any consideration) by capitalization of reserves in the balance

sheet of the company

Offer for Sale (OFS) – An Offer for Sale (OFS) is a form of share sale where the shares offered in an IPO or

FPO are not fresh shares issued by the company, but an offer by existing shareholders to sell shares that

have already been allotted to them. An OFS does not result in increase in the share capital of the

company since there is no fresh issuance of shares. The proceeds from the offer goes to the offerors,

who may be a promoter(s) or other large investor(s). The disinvestment program of the government of

India, where the government offers shares held by it in Public Sector Undertakings (PSUs), is an example

of OFS. It may be stated that OFS is a secondary market transaction done through the primary market

route

Secondary Market:

While the primary market is used by issuers for raising fresh capital from the investors through issue of

securities, the secondary market provides liquidity to these instruments. An active secondary market

promotes the growth of the primary market and capital formation, since the investors in the primary

market are assured of a continuous market where they have an option to liquidate/exit their

investments. Thus, in the primary market, the issuers have direct contact with the investors, while in the

secondary market, the dealings are between investors and the issuers do not come into the picture.

Secondary market can be broadly divided into two segments:

Over-The-Counter Market (OTC Market) - OTC markets are the markets where trades are directly

negotiated between two or more counterparties. In this type of market, the securities are traded and

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settled over the counter among the counterparties directly.

Exchange Traded Markets - The other option of trading in securities is through the stock exchange route,

where trading and settlement is done through the stock exchanges. The trades executed on the

exchange are settled through the clearing corporation, which acts as a counterparty and guarantees the

settlement of the trades to both buyers and sellers.

Kinds of Transactions

We may undertake several kinds of transactions in the securities market ranging for immediate

settlement to the distant settlement. Transaction types also vary based on transactions in the stock

market or outside the stock market (called OTC Trades). A brief description about different kinds of

transaction is given below:

Cash, Tom and Spot Trades/Transactions:

Cash trades are the trades where settlement (payment and delivery) occurs on the same trading day

(T+0, where 0 defines the time gap in days between trade day and settlement day). Cash trades in

Financial Markets are unusual as most contracts are settled between two to three days from the date of

trade. However, we see cash transactions in our normal day to day life all the time when we buy

groceries, vegetables and fruits from the market.

Tom trades are the trades where settlement (payment and delivery) occurs on the day next to the

trading day (T+1, where 1 defines the time gap in days between trade and settlement day). Some of the

transactions in Foreign Exchange Market (FX market) settle on T+1 basis

Spot trades are the trades where settlement (payment and delivery) occurs on the spot date, which is

normally two business days after the trade date. Equity markets in India offer Spot trades. FX markets,

globally, by default, offer spot transactions in the foreign exchange.

Forward transactions

Forward contracts are contractual agreement between two parties to buy or sell an underlying asset at a

certain future date for a particular price that is decided on the date of contract. Both the contracting

parties are committed and are obliged to honour the transaction irrespective of price of the underlying

asset at the time of settlement. Since forwards are negotiated between two parties, the terms and

conditions of contracts are customized. These are Over-the-counter (OTC) contracts.

Futures

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Futures are standardized exchange traded forward contracts. They are standardized as to the market

lots (traded quantities), quality and terms of delivery - delivery date, cash settlement or physical delivery

etc. As these contracts are traded and settled on a stock exchange and the clearing corporation provides

settlement guarantee on them, they are subject to stringent requirements of margins by the clearing

corporations. Futures contracts are available on variety of assets including equities and equity indices,

commodities, currencies and interest rates.

Options

An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset on

or before a stated date and at a stated price. The buyer or holder of the option pays the premium and

buys the right, the writer or seller of the option receives the premium with the obligation to sell or buy

the underlying asset, if the buyer exercises his right.

Based on the type of contract, options can be divided into two types.

Call gives the buyer the right, but not the obligation, to buy a given quantity of the underlying asset, at

a given price on or before a given future date.

Put gives the buyer the right, but not the obligation, to sell a given quantity of the underlying asset at a

given price on or before a given date.

Options can be transacted both in OTC Market and Exchange Traded Markets.

Swaps

A swap in the financial markets is a derivative contract made between two parties to exchange cash

flows in the future according to a pre-arranged formula. Swaps help market participants manage risks

associated with volatile interest rates, currency rates and commodity prices.

Trading, Hedging, Arbitrage:

Trading - Trading or speculating is an act of purchase or sale of an asset in the expectation of a gain from

changes in the price of that asset over a short period of time. Traders or speculators seek to benefit

from acting on information which bring about changes in prices. Their actions increase liquidity in the

market. Traders or Speculators typically leverage their trading activity with borrowed funds, which

magnifies their gains as well as losses.

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Hedging - Hedging is an act of taking position in the financial transactions to offset potential losses that

may be incurred by another position. A hedge can be constructed from many types of financial

instruments, including insurance, forward/futures contracts, swaps, options etc. A hedged position

limits loss as well as gains, since appreciation in one position is squared-off by depreciation in the other

position and vice versa.

Arbitrage - Arbitrage is simultaneous purchase and sale of an asset in an attempt to profit from

discrepancies in their prices in two different markets. Buying a stock in the spot market and

simultaneously selling that in the futures market to benefit from the price differential is an example of

an arbitrage transaction. An important point to understand is that in an efficient market, arbitrage

opportunities may exist only for short period or none at all. The existence of an arbitrage opportunity

will increase buying in the lower-priced market leading to a rise in prices, and increased selling in the

higher-priced market leading to a fall in prices ultimately resulting in closing the gap and elimination of

the arbitrage opportunity between two markets.

Summary:

Financial Markets facilitate the flow of capital from those who have it to those who need it through

creation of securities.

Investors are buyers of the securities. Security ownership allows investors to convert their savings into

financial assets which provide a return. Investors include households, professionals, corporates etc.

Borrowers/Issuers are sellers of the securities. Security issuance allows borrowers/issuers to raise

capital. Borrowers/Issuers include business firms, corporates, Government of India etc.

Intermediaries provide infrastructure to facilitate transfer of funds and securities among the market

participants. Intermediaries include Stock Exchanges, Brokers, Bankers, Investment Bankers,

Depositories, etc.

Stock exchanges provide a regulated platform for trading in securities at current values so that

investors have liquidity in the securities held by them.

Depositories hold securities of investors in electronic form. Depository participants are empanelled

members of a depository who enable investors to hold and trade in securities in dematerialized form.

Stock brokers are registered members of a stock exchange who enable investors to put through

transactions on a stock exchange for a brokerage.

Merchant Bankers are also called investment bankers; they help an issuer access the security market.

Underwriters offer risk cover of subscription in a new issue to issuers

Investment banks help issuers make decisions on capital structure and assist in fund raising activities.

The objectives of the issuers of securities and the investors are complementary and Financial Markets

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provide a platform to mutually satisfy their goals.

Regulatory authorities such as SEBI, RBI, FMC, etc. are responsible for orderly development of overall

Financial Markets.

Equity shares represents fractional ownership in a business. Equity shareholders collectively own the

company, bear the risk of ownership and enjoy the corresponding rewards.

Debentures/ Bonds/ Notes are used for raising long term debt by businesses. They represent lending

rights of investors in a business. There are variety of Debentures/Bonds – Secured, Unsecured,

Convertibles etc.

Mutual fund are investment vehicles where people with similar investment objectives come together

to pool their money and then the funds invest that pool of money based on defined objectives. Units,

issued by the funds to investors, represent latter’s share in the fund. There are variety of schemes

offered by these mutual funds to the investors.

Securities Market has two interdependent and inseparable segments - Primary Market, where

securities are issued for the first time and Secondary Market, which facilitates trading in already issued

securities.

Primary market is the market where securities are first issued by a company, government, banks and

financial institutions, mutual fund and others.

A primary issue of securities may be a public issue, where securities are issued to public investors, or a

private placement where securities are issued to a select group of individual and institutional investors.

A private placement by a listed company is called a preferential allotment. A preferential allotment to

qualified institutional buyers is called a qualified institutional placement.

The first public offer of shares made by a company is called an Initial Public Offer (IPO). An IPO may be

through a fresh issue of shares or an offer for sale.

In an offer for sale, existing shareholders such as promoters or financial institutions offer a part of

their holding to the public investors. The share capital of the company does not change since the

company is not making a new issue of shares.

A follow-on public offer is made by an issuer that has already made an IPO in the past and now makes

a further issue of securities to the public.

In a fixed price issue of shares to the public, the company in consultation with the lead manager would

decide on the price at which the shares will be issued.

In a book building process, the issue price is determined based on the offers received for subscription

at prices within a specified band or floor price. The cut-off price is the price at which the issue is

subscribed from the bids received.

Secondary market is the market to trade in securities already issued. Trades happen between investors

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and there is no impact on the capital of the company.

Secondary markets provide liquidity for investors; enable price discovery, information signaling and a

barometer of economic growth.

Secondary Market has two segments – OTC and Exchange Traded. In Over-The-Counter Market (OTC

Market), trades are directly negotiated between two or more counterparties and securities are settled

bilaterally between them. In Exchange Traded Markets, trades are executed on the Stock Exchanges and

settlement is done through the Clearing Corporation of the exchange, which assumes the credit/default

risk of these transactions.

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Methods of Corporate Valuation

What is my company worth? What are the ratios used by analysts to determine whether a stock is undervalued or overvalued? How valid is the discounted present value approach? How can one value a company as a going concern, and how does this change in the context of a potential acquisition, or when the company faces financial stress?

Finding a value for a company is no easy task -- but is an essential component of effective management. The reason: it's easy to destroy value with ill-judged acquisitions, investments or financing methods. This section includes the process of valuing a company, starting with simple financial statements and the use of ratios, and going on to discounted free cash flow and option-based methods. How a business is valued depends on the purpose, so the most interesting part of implementing these methods will be to see how they work in different contexts -- such as valuing a private company, valuing an acquisition target, and valuing a company in distress. We'll learn how using the tools of valuation analysis can inform management choices.

Outline

Asset-Based Methods Using Comparables Free Cash Flow Methods Option-Based Valuation Special Applications

Asset-Based Methods Asset-based methods start with the "book value" of a company's equity. This is simply the value

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of all the company's assets, less its debt. Whether it's tangible things like cash, current assets, working capital and shareholder's equity, or intangible qualities like management or brand name, equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow, and pay off all its creditors.

The Balance Sheet: Cash & Working Capital Like to buy a dollar of assets for a dollar in market value? Ben Graham did. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market value. First, Graham would look at a company's cash and equivalents and short-term investments. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. Buying a company with a lot of cash can yield a lot of benefits -- cash can fund product development and strategic acquisitions and can pay high-caliber executives. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand. Another measure of value is a company's current working capital relative to its market capitalization. Working capital is what is left after you subtract a company's current liabilities from its current assets. Working capital represents the funds that a company has ready access to for use in conducting its everyday business. If you buy a company for close to its working capital, you have essentially bought a dollar of assets for a dollar of stock price -- not a bad deal, either. Just as cash funds all sorts of good things, so does working capital.

Shareholder's Equity & Book Value Shareholder's equity is an accounting convention that includes a company's liquid assets like cash, hard assets like real estate, as well as retained earnings. This is an overall measure of how much liquidation value a company has if all of its assets were sold off -- whether those assets are office buildings, desks, old T-shirts in inventory or replacement vacuum tubes for ENIAC systems. Shareholder equity helps you value a company when you use it to figure out book value. Book value is literally the value of a company that can be found on the accounting ledger. To calculate book value per share, take a company's shareholder's equity and divide it by the current number of shares outstanding. If you then take the stock's current price and divide by the current book value, you have the price-to-book ratio. Book value is a relatively straightforward concept. The closer to book value you can buy something at, the better it is. Book value is actually somewhat skeptically viewed in this day and age, since most companies have latitude in valuing their inventory, as well as inflation or deflation of real estate depending on what tax consequences the company is trying to avoid. However, with financial companies like banks, consumer loan concerns, brokerages and credit card companies, the book value is extremely relevant. For instance, in the banking industry,

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takeovers are often priced based on book value, with banks or savings & loans being taken over at multiples of between 1.7 to 2.0 times book value. Another use of shareholder's equity is to determine return on equity, or ROE. Return on equity is a measure of how much in earnings a company generates in four quarters compared to its shareholder's equity. It is measured as a percentage. For instance, if XYZ Corp. made a million dollars in the past year and has a shareholder's equity of ten million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. Coca Cola, for instance, does not require constant spending to upgrade equipment -- the syrup-making process does not regularly move ahead by technological leaps and bounds. In fact, high ROE companies are so attractive to some investors that they will take the ROE and average it with the expected earnings growth in order to figure out a fair multiple. This is why a pharmaceutical company like Merck can grow at 10% or so every year but consistently trade at 20 times earnings or more.

Intangibles Brand is the most intangible element to a company, but quite possibly the one most important to a company's ability as an ongoing concern. If every single McDonald's restaurant were to suddenly disappear tomorrow, the company could simply go out and get a few loans and be built back up into a world power within a few months. What is it about McDonald's that would allow it to do this? It is McDonald's presence in our collective minds -- the fact that nine out of ten people forced to name a fast food restaurant would name McDonald's without hesitating. The company has a well-known brand and this adds tremendous economic value despite the fact that it cannot be quantified. Some investors are preoccupied by brands, particularly brands emerging in industries that have traditionally been without them. The genius of Ebay and Intel is that they have built their company names into brands that give them an incredible edge over their competition. A brand is also transferable to other products -- the reason Microsoft can contemplate becoming a power in online banking, for instance, is because it already has incredible brand equity in applications and operating systems. It is as simple as Reese's Peanut Butter cups transferring their brand onto Reese's Pieces, creating a new product that requires minimum advertising to build up. The real trick with brands, though, is that it takes at least competent management to unlock the value. If a brand is forced to suffer through incompetence, such as American Express in the early 1990s or Coca-Cola in the early 1980s, then many can become skeptical about the value of the brand, leading them to doubt whether or not the brand value remains intact. The major buying opportunities for brands ironically comes when people stop believing in them for a few moments, forgetting that brands normally survive the difficult short-term traumas. Intangibles can also sometimes mean that a company's shares can trade at a premium to its

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growth rate. Thus a company with fat profit margins, a dominant market share, consistent estimate-beating performance or a debt-free balance sheet can trade at a slightly higher multiple than its growth rate would otherwise suggest. Although intangibles are difficult to quantify, it does not mean that they do not have a tremendous power over a company's share price. The only problem with a company that has a lot of intangible assets is that one danger sign can make the premium completely disappear

IBM Balance Sheet

Assets $Mil Cash 5,216.6 Other Current Assets 32,099.4 Long-Term Assets 46,640.0 Total 83,956.0

Liabilities and Equity $Mil Current Liabilities 30,239.0 Long-Term Liabilities 31,625.0 Shareholders' Equity 22,092.0 Total 83,956.0

The Piecemeal Company Finally, a company can sometimes be worth more divided up rather than all in one piece. This can happen because there is a hidden asset that most people are not aware of, like land purchased in the 1980s that has been kept on the books at cost despite dramatic appreciation of the land around it, or simply because a diversified company does not produce any synergies. Sears, Dean Witter Discover and Allstate are all worth a heck of a lot more broken apart as separate companies than they ever were when they were all together. Keeping an eye out for a company that can be broken into parts worth more than the whole makes sense, especially in this day and age when so many conglomerates are crumbling into their component parts.

Using Comparables

The most common way to value a company is to use its earnings. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for apples-to-apples comparisons, most people who look at earnings measure them according to earnings per share (EPS). You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has one million shares outstanding and has earned one million dollars in the past 12 months, it has a trailing EPS of $1.00. (The reason it is called a trailing EPS is because it looks at the last four quarters reported -- the quarters that trail behind the most recent quarter reported.

$1,000,000 -------------- = $1.00 in earnings per share (EPS) 1,000,000 shares

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The earnings per share alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, XYZ Corp. was currently trading at $15 a share, it would have a P/E of 15.

$15 share price --------------------------- = 15 P/E $1.00 in trailing EPS

Is the P/E the Holy Grail? There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio. With no regard to any other form of valuation, this group of unfoolish investors blindly plunge ahead armed with this one ratio, purposefully ignoring the vagaries of equity analysis. Popularized by Ben Graham (who used a number of other techniques as well as low P/E to isolate value), the P/E has been oversimplified by those who only look at this number. Such investors look for "low P/E" stocks. These are companies that have a very low price relative to their trailing earnings. Also called a "multiple", the P/E is most often used in comparison with the current rate of growth in earnings per share. The Foolish assumption is that for a growth company, in a fairly valued situation the price/earnings ratio is about equal to the rate of EPS growth. In our example of XYZ Corp., for instance, we find out that XYZ Corp. grew its earnings per share at a 13% over the past year, suggesting that at a P/E of 15 the company is pretty fairly valued. Fools believe that P/E only makes sense for growth companies relative to the earnings growth. If a company has lost money in the past year or has suffered a decrease in earnings per share over the past twelve months, the P/E becomes less useful than other valuation methods we will talk about later in this series. In the end, P/E has to be viewed in the context of growth and cannot be simply isolated without taking on some significant potential for error.

Are Low P/E Stocks Really a Bargain? With the advent of computerized screening of stock databases, low P/E stocks that have been mispriced have become more and more rare. When Ben Graham formulated many of his principles for investing, one had to search manually through pages of stock tables in order to ferret out companies that had extremely low P/Es. Today, all you have to do is punch a few buttons on an online database and you have a list as long as your arm. This screening has added efficiency to the market. When you see a low P/E stock these days, more often than not it deserves to have a low P/E because of its questionable future prospects. As intelligent investors value companies based on future prospects and not past performance, stocks with low P/Es often have dark clouds looming in the months ahead. This is not to say

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that you cannot still find some great low P/E stocks that for some reason the market has simple overlooked -- you still can and it happens all the time. Rather, you need to confirm the value in these companies by applying some other valuation techniques.

The Price-to-Sales Ratio

Every time a company sells a customer something, it is generating revenues. Revenues are the sales generated by a company for peddling goods or services. Whether or not a company has made money in the last year, there are always revenues. Even companies that may be temporarily losing money, have earnings depressed due to short-term circumstances (like product development or higher taxes), or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. Revenue-based valuations are achieved using the price/sales ratio, often simply abbreviated PSR. The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company XYZ Corp. has ten million shares outstanding, priced at $10 a share, then the market capitalization is $100 million. Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies where one has taken out enormous debt that it has used to boast sales and one that has lower sales but has not added any nasty debt either.

Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt The next step in calculating the PSR is to add up the revenues from the last four quarters and divide this number into the market capitalization. Say XYZ Corp. had $200 million in sales over the last four quarters and currently has no long-term debt. The PSR would be:

(10,000,000 shares * $10/share) + $0 debt PSR = ----------------------------------------- = 0.5 $200 million revenues

The PSR is a measurement that companies often consider when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales," you have seen the PSR in use. As this is a perfectly legitimate way for a company to value an acquisition, many simply expropriate it for the stock market and use it to value a company as an ongoing concern.

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Uses of the PSR The PSR is often used when a company has not made money in the last year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern's sales are being valued at a discount to its peers. If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that, if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers. There are some years during recessions, for example, when none of the auto companies make money. Does this mean they are all worthless and there is no way to compare them? Nope, not at all. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings. Another common use of the PSR is to compare companies in the same line of business with each other, using the PSR in conjunction with the P/E in order to confirm value. If a company has a low P/E but a high PSR, it can warn an investor that there are potentially some one-time gains in the last four quarters that are pumping up earnings per share. Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings.

What Level of the Multiple is Right? Multiples may be helpful for comparing two companies, but which multiples is right? Many look at estimated earnings and estimate what "fair" multiple someone might pay for the stock. For example, if XYZ Corp. has historically traded at about 10 times earnings and is currently down to 7 times earnings because it missed estimates one quarter, it would be reasonable to buy the stock with the expectation that it will return to its historic 10 times multiple if the missed quarter was only a short-term anomaly. When you project fair multiples for a company based on forward earnings estimates, you start to make a heck of a lot of assumptions about what is going to happen in the future. Although one can do enough research to make the risk of being wrong as marginal as possible, it will always still exist. Should one of your assumptions turn out to be incorrect, the stock will probably not go where you expect it to go. That said, most of the other investors and companies out there are using this same approach, making their own assumptions as well, so, in the worst-case scenario, at least you won't be alone. A modification to the multiple approach is to determine the relationship between the company's P/E and the average P/E of the S&P 500. If XYZ Corp. has historically traded at 150% of the S&P 500 and the S&P is currently at 10, many investors believe that XYZ Corp. should eventually hit a fair P/E of 15, assuming that nothing changes. The trouble is, things do change.

Key Valuation Ratios for IBM (April 2003)

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Price Ratios Company Industry S&P 500

Current P/E Ratio 38.2 116.7 34.9

P/E Ratio 5-Year High 61.4 184.5 64.2

P/E Ratio 5-Year Low 14.5 9.6 25.7

Price/Sales Ratio 1.67 1.28 1.29

Price/Book Value 5.95 2.83 2.67

Price/Cash

Free Cash Flows Methods

Despite the fact that most individual investors are completely ignorant of cash flow, it is probably the most common measurement for valuing public and private companies used by investment bankers. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, Cyberoptics enjoyed a 15% tax rate in 1996, but in 1997 that rate more than doubled. This situation overstates CyberOptics' current earnings and understates its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits. As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -- a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength.

In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered to be expensive. Some counsel selling companies when their cash flow multiple

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extends beyond 10.0. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBITDA. IBM's Income Statement

Annual Income Statement (Values in Millions) 12/2002 12/2001

Sales 81,186.0 85,866.0

Cost of Sales 46,523.0 49,264.0

Gross Operating Profit 34,663.0 36,602.0

Selling, General & Admin. Expense 23,488.0 22,487.0

Other Taxes 0.0 0.0

EBITDA 11,175.0 14,115.0

Depreciation & Amortization 4,379.0 4,820.0

EBIT 6,796.0 9,295.0

Other Income, Net 873.0 1,896.0

Total Income Avail for Interest Exp. 7,669.0 11,191.0

Interest Expense 145.0 238.0

Pre-tax Income 7,524.0 10,953.0

Income Taxes 2,190.0 3,230.0

Total Net Income 3,579.0 7,723.0

Free Cash Flow goes one step further. A company cannot drain all its cash flow -- to survive and grow is must invest in capital and hold enough inventory and receivables to support its customers. So after adding back in the non-cash items, we subtract out new capital expenditures and additions to working capital. A bare-bones view of IBM's free cash flows is given below.

IBM: Free Cash Flows

Fiscal year-end: December TTM = Trailing 12 Months 1999 2000 2001 TTM Operating Cash Flow 10,111 9,274 14,265 14,615 - Capital Spending 5,959 5,616 5,660 5,083 = Free Cash Flow 4,152 3,658 8,605 9,532

How to Use Cash Flow Cash flow is the only method that makes sense in many situations. For example, it is commonly

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used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies like Time-Warner Cable and TeleCommunications have reported negative earnings for years due to the huge capital expense of building their cable networks, even though their cash flow has actually grown. This is because huge depreciation and amortization charges have masked their ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well. It is also commonly used method in venture capital financings because it focuses on what the venture investor is actually buying, a piece of the future operations of the company. Its focus on future cash flows also coincides nicely with a critical concern of all venture investors, the company's ability to sustain its future operations through internally generated cash flow.

The premise of the discounted free cash flow method is that company value can be estimated by forecasting future performance of the business and measuring the surplus cash flow generated by the company. The surplus cash flows and cash flow shortfalls are discounted back to a present value and added together to arrive at a valuation. The discount factor used is adjusted for the financial risk of investing in the company. The mechanics of the method focus investors on the internal operations of the company and its future.

The discounted cash flow method can be applied in six distinct steps. Since the method is based on forecasts, a good understanding of the business, its market and its past operations is a must. The steps in the discounted cash flow method are as follows:

Develop debt free projections of the company's future operations. This is clearly the critical element in the valuation. The more closely the projections reflect a good understanding of the business and its realistic prospects, the more confident investors will be with the valuation its supports.

Quantify positive and negative cash flow in each year of the projections. The cash flow being measured is the surplus cash generated by the business each year. In years when the company does not generate surplus cash, the cash shortfall is measured. So that borrowings will not distort the valuation, cash flow is calculated as if the company had no debt. In other words, interest charges are backed out of the projections before cash flows are measured.

Estimate a terminal value for the last year of the projections. Since it is impractical to project company operations out beyond three to five years in most cases, some assumptions must be made to estimate how much value will be contributed to the company by the cash flows generated after the last year in the projections. Without making such assumptions, the value generated by the discounted cash flow method would approximate the value of the company as if it ceased operations at the end of the projection period. One common and conservative assumption is the perpetuity

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assumption. This assumption assumes that the cash flow of the last projected year will continue forever and then discounts that cash flow back to the last year of the projections.

Determine the discount factor to be applied to the cash flows. One of the key elements affecting the valuation generated by this method is the discount factor chosen. The larger the factor is, the lower the valuation it will generate. This discount factor should reflect the business and investment risk involved. The less likely the company is to meet its projections, the higher the factor should be. Discount factors used most often are a compromise between the cost of borrowing and the cost of equity investment. If the cost of borrowed money is 10% and equity investors want 30% for their funds, the discount factor would be somewhere in between -- in fact, the weighted-average cost of capital.

Apply the discount factor to the cash flow surplus and shortfall of each year and to the terminal value. The amount generated by each of these calculations will estimate the present value contribution of each year's future cash flow. Adding these values together estimates the company's present value assuming it is debt free.

Subtract present long term and short term borrowings from the present value of future cash flows to estimate the company's present value.

The following table illustrates the computations made in the discounted cash flow method. The chart assumes a discount factor of 13% (IBM's estimated weighted-average cost of capital) and uses the growing perpetuity assumption to generate a residual value for the cash flows after the fifth year.

Valuation for IBM 2-stage growth model

Stage 1

10% Growth Stage 2

5.7% Growth

End of year

2002 2003 2004 2005 2006 2007 2008

Revenue

81.2 89.32 98.252 108.0772 118.8849 130.7734 138.2275 -Expenses

-67.99 -74.789 -82.2679 -90.4947 -99.5442 -109.499 -115.74

-Depreciation

-4.95 -5.445 -5.9895 -6.58845 -7.2473 -7.97202 -6.9413 EBIT

8.26 9.086 9.9946 10.99406 12.09347 13.30281 15.5462

EBIT(1-t)

5.9 6.49 7.139 7.8529 8.63819 9.502009 11.10443 +Depreciation

4.95 5.445 5.9895 6.58845 7.247295 7.972025 6.941298

-CapEx

-4.31 -4.741 -5.2151 -5.73661 -6.31027 -6.9413 -6.9413

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-Change in WC

-0.9 -0.99 -1.089 -1.1979 -1.31769 -1.44946 -1.53208 FCFF

5.64 6.204 6.8244 7.50684 8.257524 9.083276 9.572354

235.2537

Total

6.204 6.8244 7.50684 8.257524 244.3369

PV

5.651872 5.663768 5.67569 5.687636 153.3175

Total PV

175.9964

less debt

-61.864 billion

Equity value

114.1324 billion divided by 1.69 gives 67.53397 per share

Option-Based Methods

Executives continue to grapple with issues of risk and uncertainty in evaluating investments and acquisitions. Despite the use of net present value (NPV) and other valuation techniques, executives are often forced to rely on instinct when finalizing risky investment decisions. Given the shortcomings of NPV, real options analysis has been suggested as an alternative approach, one that considers the risks associated with an investment while recognizing the ability of corporations to defer an investment until a later period or to make a partial investment instead. In short, investment decisions are often made in a way that leaves some options open. The simple NPV rule does not give the correct conclusion if uncertainty can be “managed.” In acquisitions and other business decisions, flexibility is essential more so the more volatile the environment and the value of flexibility can be taken into account explicitly, by using the real-options approach.

Financial options are extensively used for risk management in banks and firms. Real or embedded options are analogs of these financial options and can be used for evaluating investment decisions made under significant uncertainty. Real options can be identified in the form of opportunity to invest in a currently available innovative project with an additional consideration of the strategic value associated with the possibility of future and follow-up investments due to emergence of another related innovation in future, or the possibility of abandoning the project.

The option is worth something because the future value of the asset is uncertain. Uncertainty increases the value of the option, because if the uncertainty is interpreted as the variance, there are possibilities to higher profits. The loss on the option is equal to the cost of acquiring it. If the project turns out to be non-profitable, you always have the choice of non-exercising. More and more, the real options approach is finding its place in corporate valuation.

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Remember- The four valuation models:

All the models have to be considered before computing the valuation amount.

Enterprise Value (also known as EV) is a metric that attempts to reflect the market value of a

firm. It can be used as an alternative to market capitalization.

Essentially, Enterprise Value attempts to provide a more accurate valuation aimed at a buyer.

Whilst a firm's market capitalization will indicate share price x share quantity, the firm may

have a lot of debt which the acquirer would need to pay off (thereby adding the price of the

transaction).

The calculation for Enterprise Value is:

Market Capitalization + Debt + Minority Interest + Preferred Shares - Cash & Cash Equivalents

A football field graph is a graph showing the valuation of a company according to different

methodologies. Some of the methodologies used are:

i) DCF ii) Public Comparables iii) Precedent Transactions

The graph will show the different mean valuations and multiples for the different

methodologies and allow the person who is conducting the valuation (or most likely their MD)

to decide which method to use primarily to achieve the best possible valuation.

Companies are valued using a combination of multiples and future cash flows, and each of

these can be taken in a best, worst and median case. For example, with a discounted cash flow,

you could assume that the company will have a terminal growth rate of x%, x+1% or x-1% and

this would give 3 different final values. Therefore, the discounted cash flow method will give a

range of values for the company. This applies to all valuation methods (you can trade at a high,

low or average multiple of earnings etc.). The best way to show this visually is using a graph,

like the one shown below:

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The following graph shows a variety of valuation ranges based on different methods and

multiples. Straight away you can see that the average of all of these gives a share price of

around $57, but that you could argue it is worth anywhere from $45 to $85.