dushyant mahadik money, banking, corporate finance and governance area centre for economics and...
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DUSHYANT MAHADIKMONEY, BANKING, CORPORATE F INANCE AND
GOVERNANCE AREACENTRE FOR ECONOMICS AND F INANCE
ASCI , TUESDAY, 28 T H FEBRUARY 2012
Financial Aspects of Regulation
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BUSINESS DECISION MAKINGNET PRESENT VALUE
COST OF CAPITAL
Agenda
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FOUNDATIONS OF MANAGEMENTNON-FINANCIAL CRITERIA
FINANCIAL CRITERIA
Business Decision Making
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Foundations of Management
Division of labourCentralization and DecentralizationBusiness PolicyValues and Culture
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Criteria for Making Business Decisions
ProfitabilityStrategic FitLong term sustainabilityBest use of available resourcesEmployee First, Customer SecondTriple Bottom LineAdministrative ReasonsLogistic Convenience
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Financial Criteria
Break Even AnalysisCost-Benefit AnalysisNet Present Value
Economic Value Added Adjusted Present Value
Payback periodRates of return
Return on Investments Accounting Rate of Return Internal Rate of Return
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Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW
Site available to your company on lease is perfectly suited
Entire land mass will get used in the plant and accessories
Your company does not have any cash reserve
Site available to your company on lease is perfectly suited
Entire land mass will get used in the plant and accessories
Your company does not have any cash reserve
Exercise: Limited Power Project
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Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW
Each 10 MW plant costs $3 MN
Accessories and other costs are $1 MN
Over next 10 years, the plants are expected to generate revenue of $35 MN and incur cost worth $15 MN
The plant costs $13 MN
Accessories and other costs are $2 MN
Over next 10 years, the plants are expected to generate revenue of $48 MN and incur cost worth $20 MN
Exercise: Limited Power Project
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Net Present Value
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Discounting the future cash flows
Money today is worth more than having money tomorrow
Ci
Present Value of Ci = -----------------
(1 + r )i
where, r is the discount rate Ci is the net cash flow coming in
during the ith yearMore distant cash flows are more risky, hence
they are discounted more
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Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW
Year 0 1 .. 10
Plant -9 .0
Accessories -1 .0
Revenue 3.5 .. 3.5
Operating Cost
-1.5
.. -1.5
Discounted Value @ 4%
-10.0
1.9 .. 1.4
Exercise: Limited Power Projectall figures in million $
Year 0 1 .. 10
Plant -13.0
Accessories -2.0
Revenue 4.8 .. 4.8
Operating Cost
-2.0 .. -2.0
Discounted Value @ 4%
-15.0
2.7 .. 1.9
NPV = $6.22 M > 0
NPV = $7.71 M > 0
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What is measured ?
Future cash flows – ignore sunk costOperating cash flowsIncremental cash flows over status quoNon-cash expenses like depreciation,
overheads, etc.Changes in capital (working capital)Include opportunity costExpectations about inflationEffects of tax
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Net Present Value
Appreciates time value of moneyOnly cash profits are importantAdditive methodProvides a direct link between management
decision and shareholder valueMutually exclusive projects are handled
betterAble to absorb term structure of interest
rates
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Exercise : Illustrating Timing Differences
Project Year 1 Year 2 Year 3 PV @ 10%
A 100 100 100.0 248.69
B 150 100 39.5 248.69
C 50 100 160.5 248.69
Stakeholders may view the projects differently
Differences in time horizonDifferent perception of riskDifferent tolerance for risk
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INTRODUCTIONWACCCAPM
Cost of Capital
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Cost of Capital
Returns to an operator attract investorsOpportunity Cost of CapitalInvestors may not be attracted for many reasons
Too much debt or too little debt
Management efficiency of the operator
Country/region of the operator
Other risks taken by the operator
Lack of transparency or clarity about future course of action
Discount rate for NPV and Hurdle rate for IRR
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Weighted Average Cost of Capital
Returns for the operator should be greater than the operator’s post-tax WACC
WACC =
where, D – value of debt E – value of equity shares t – corporate tax rate (marginal) rD – average rate of interest on debt rE – returns required by the shareholders
ED rED
Ert
ED
D
)1(
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Cost of Debt for Tata Power Limited
Refer to hand out given (excerpts of annual report 2010-11)
Schedule C: Secured Loans (Rs 47539 MN)Schedule D: Unsecured Loans (Rs 22354 MN)Schedule 3: Interest Charges (Rs 4489.5 MN)
Cost of debt (weighted average) = 6.42%
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Cost of Equity
Cost of EquityDividend discount
models
Capital Asset Pricing Model (CAPM)
Also known as market capitalization rate or required rate of return by equity investors
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Dividend Discount Models
Walter ModelH ModelMulti-stage Growth ModelGordon Growth Model
DIV1Market Capitalization Rate = -------- + Growth
Rate P0
where, DIV1 = dividend to be paid in next year
P0 = Current share price
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Growth Rate for Dividend Discount Models
Security AnalystsIndustry ExpertsFundamentals of the company
Revenue from year n+1 will be more than revenues from year n
To the extent to which operating assets are higher
Growth Rate of Profits = Plough Back Ratio x Return on Equity
What is the reinvestment policy of the company ? Plough back = 50% and Return on equity = 12% Growth = 50% x 12% = 6%
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Capital Asset Pricing Model
Equity Market Risk PremiumExtra Returns (risk premium) from an
investment are dependant on the underlying risks
Security Market Line
r - rf = (rm - rf)
(beta) is the measure of sensitivity of the investment to market movements
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Capital Asset Pricing Model
Assumptions Markets are efficient There is no information asymmetry Transaction costs are negligible, i.e. Borrowing
and lending rates are same There are no taxes
Risk/Return Contribution to a Portfolio Because unique risk is already diversified in a
portfolio
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WACC for Tata Power Limited
WACC = 11%
Equity = 16%, 56% of FV
Dividend Discount, 10.0%
12.5 / 1330 + 9%
CAPM 18.9% with b = 0.8
8% + 0.8 * (21%-8%)
Debt = 4.5%, 44% of FV
6.42% x (1-t)
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Roadblocks to finding WACC
Unlisted company or part of a conglomerate
Nominal vs Real WACC
Marginal WACC and Average WACC
Measurement of risk
Inefficient capital structure
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Back-up Slides
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Economic Value Added
Introduced and popularized by Stern Stewart & Company
EVA in year n = cash inflow (or outflow) minus the cost of capital (cost of financing) Also, any additional investment done in the year n is
to be subtractedTotal EVA by taking the project is the sum of
discounted EVA for each year
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Adjusted Present Value
NPV is calculated by treating the project as an unlevered firm
That is the value of the project on its ownWhen the project is financed with debt, it
helps the firm save taxes because interest is a tax-deductible expense
The present value of all future tax savings are the financing side effects of the project
Adjusted present value = NPV as unlevered firm + PV of Tax Shields
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Dividend Discount Model
Perpetuity formula –Value of perpetuity = periodic payment /
discount rateIf perpetuity is growing –Value of perpetuity = first periodic payment /
(discount rate – growth rate)
So,dividend to be paid in next year
Share Price = ----------------------------------------(required rate) – (growth rate)
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Calculation of Beta
2m
imi
Covariance with the market
Variance of the market
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References
Data about Tata Power Limited taken from http://www.tatapower.com/investor-relations/pdf/
92Annual-report-2010-11.pdfBeta of major Indian companies
http://www.bseindia.com/about/abindices/betavalues.asp
Further reading on the topic is given in the references section of Chapter III: Management and Analysis of Financial and Other Data http://www.regulationbodyofknowledge.org/
documents/bok/chapter3.pdf