Learning Note

Hello learner!

We hope you're having a great time learning with upGrad. We have designed this course a bit
differently, keeping in mind the nature of the subject. The complexity of the course will increase
gradually and a diverse set of activities will be presented to you along the way.

Accounting and Finance requires a fair amount of practice and cannot be mastered by watching
the videos once. You may need to watch some videos multiple times. It is also crucial that you
solve the questions and activities diligently. Do not get discouraged if you struggle with some of
them initially. Making mistakes is an important part of learning.

Some of you have never been exposed to Accounting and Finance before and might be sceptical
about your ability to learn it all within a month. Do not worry! We have arranged for doubt
resolution and problem-solving sessions throughout the course. Participate in these sessions as
much as possible. Use the discussion forum extensively. You will gain confidence in the subject
over time.

You would need to spend more time on this course compared to the previous one. But it will be
worth it.

Happy learning,

Team upGrad

Course Expectations

Select the correct course expectation based on the information in this segment.

I am expected to understand all the concepts taught in the videos in a single watch
I am expected to watch the videos multiple times whenever needed

✓ Correct

Feedback:

The concepts in Accounting and Finance include lots of terms, numbers, and technical concepts.
Some concepts cannot be absorbed through a single viewing. You may need to watch some
videos multiple times.

I am expected to skip videos whenever needed

Course and Module Overview

Welcome to this course on Accounting and Finance I.

The backbone of any business is its financial health. With the right techniques of financial analysis,
you can assess a firm’s current performance, compare it with previous years and even forecast its
position in the upcoming quarters.

In this course, you will learn about financial statements, understand how to read them and
understand how to make business decisions based on financial data.

Course Overview

The overall objective of this course is not to turn you into accountants but to help you make better-
informed decisions. The course is divided into the following four modules:

• Accounting Fundamentals: This module will outline the necessity to analyse a company’s
performance in the light of its three main financial statements: income statement, cash flow
statement and balance sheet. It will help you understand how different business events
impact the different financial statements with the help of activities. Furthermore, the
module will cover the basic structure and concepts of income statements and balance sheets
in detail.
• Financial Analysis: This module will help you identify the operating levers that can boost
the financial performance of an entity. Through a couple of key metrics, you will be able
to interpret a company’s performance, measure its achievements and run a benchmark
 analysis. This module will also help you understand the overall framework that helps
fundholders determine the financial value creation in a company.
• Project Evaluation: This module will help you understand the concept of the ‘time value
of money’ and how it can be applied to different cases of annuity and uneven cash flows.
You will also learn about the various techniques of project evaluation and the risks related
to projects, which will aid in capital budgeting decisions.
• New Heritage Doll Company: Through this simple simulation, you will apply your
learnings of ‘Accounting and Finance’ to take project-funding decisions for the New
Heritage Doll Company. The budget constraints and resources available will challenge
your skills to choose the most viable option from the list of available opportunities and
therefore enhance your business decision-making capability.

Module Overview

In this module, Accounting Fundamentals, you will be introduced to the world of financial
statements. Through an activity, you will analyse the impact of financial events on the different
financial statements.

In the first session, Introduction to Financial Statements, you will get an overview of the three
financial statements that will act as a foundation for the upcoming sessions. The three financial
statements you will learn about are as follows:

1. Income statement
2. Cash flow statement
3. Balance sheet

In the second session, Financial Statements Exercise: Pizza Food Truck, you will learn about
various accounting concepts through an exercise. You will understand the impact of business
decisions on the three financial statements and the link between these statements.

In the third session, Income Statement and Balance Sheet, you will learn the basic structure and
components of the income statement. You will also learn the basic structure and concept of the
balance sheet. Furthermore, you will understand the link between the three financial statements.

This module will take you through a journey of understanding the key financial concepts and
financial statements. You will be able to apply these concepts to analyse a company’s performance
in the light of its three main financial statements.
We wish you a fruitful, interactive and fun experience!

Let’s get started.

Note: Throughout this course, you will see examples of different brands and institutes. These have
been chosen from specific cases in a way that would aid in demonstrating concepts. These do not
reflect the current performance of any company. Any opinion expressed is strictly for educational
purposes.

Session Overview
Welcome to the first session of this module! This is a small introductory session for learners who
are being introduced to the world of Accounting and Finance for the first time. The session helps
in laying the foundations for the upcoming sessions in this module.

This is an ungraded session, meant to be an introduction only.

In this session

The following topics and concepts will be covered:

• Overview of the income statement that reports the profit and loss of a company over a
period of time,
• Overview of the cash flow statement that segregates the cash inflows and outflows into
various categories,
• Overview of the balance sheet that determines the financial position of a company at a
particular point in time.

Guidelines for graded questions

Note that graded questions are given in a separate segment labelled 'Graded Assessments' at the
end of this session. These questions will adhere to the following guidelines:

First Attempt Marks Second Attempt Marks

Questions with 2 Attempts 10 5
Questions with 1 Attempt 10 0

People you will hear from in this session

Faculty

Marie-Lys Leschiera

Marie-Lys Leschiera has been teaching Finance and Management, mainly for executives and
occasionally for undergraduates, for over 15 years, in several European, US and Indian business
institutions. She is also the President of ML2 Formation & Conseil, a company that develops and
teaches programs for Executives. Drawing from her diverse background and intensive exposure
to international environments, she brings a practical and down-to-earth approach to her courses,
through the use of custom-made cases, exercises and/or management simulation games.

Basics of Cash Flow Statement

You learnt about the income statement. However, the income statement does not capture all the
financial events carried out by a business. This raises the need for other financial statements.

In the upcoming video, our faculty, Marie-Lys will introduce you to the next fundamental financial
statement: the cash flow statement.

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In this video, you learnt the following:

• A cash flow statement indicates the amount of cash inflow and outflow of a company over a
period of time.

• The cash inflows and outflows of a company are generated by its operating, investing, and
financing activities.
Cash Flow Statement

The total cash flow generated

= Cash at the end of the period - Cash at the beginning of the period
= Cash inflow - Cash outflow

Net cash flow=CFO−CFI+CFF

where,

CFO = Cash generated from operations

CFI = Cash spent in investments

CFF = Cash received from financing activities

Attempt the following questions to reinforce your learning from this segment.

Basics of Cash Flow Statement

Company A is a textile manufacturing industry. Which of the following activities will be recorded
in the cash flow statement of company A? (Note: More than one answer can be correct)

Company A acquired company B by paying $2.5 billion in cash and $0.5 billion in shares.
✓ Correct

Feedback:

The cash flow statement records the inflow and outflow of cash. Hence, paying cash to acquire
another company will result in a cash outflow

Company A sold a button-making textile machine at a loss of $25,000.

✓ Correct

Feedback:

The cash flow statement records the inflow and outflow of cash. The sale of a machine will result
in a cash inflow, which will be recorded in the cash flow statement.

Company A's brand recognition increased.

Company A took a loan from the bank at 6.5% interest rate.

✓ Correct

Feedback:

The cash flow statement records the inflow and outflow of cash. The payments on the loan amount
with a 6.5% interest rate will result in cash outflow from the company, and hence this will be
recorded in the cash flow statement.

Basics of Cash Flow Statement

Suppose, at the end of the year, Zeta Limited reported a cash balance of $5 million. However, the
cash flow statement reveals that the total cash generated by the company during that period was
$6.8 million. What does this indicate?

The company had a negative cash balance at the beginning of the current year.

✓ Correct
Feedback:

While the total cash generated during the year was $6.8 million, the year-end balance was less than
$6.8 million. This indicates that the opening balance was a negative cash balance of -$1.8 million.
This also indicates that the company had a negative cash balance at the end of the preceding year.

The company has a cash outflow greater than the cash inflow in the current year.

The company had a positive total cash generated and cash balance at the beginning of the previous
year.

The company had a negative cash flow from operations in the current year.

Basics of Balance Sheet

While the income statement and cash flow statement try to capture the performance of a company
over a period of time, there is a need for another financial statement that can show the financial
position of a company at the end of the period. This financial statement is known as the balance
sheet.

So, let’s watch the upcoming video to know more about this financial statement.

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In this video, you learnt the following:

• The shareholders, bankers and suppliers are the fund holders of a company.
o The suppliers are a part of the core operations of a company. They grant credits.
o The bankers and shareholders are investors who are interested in a return on their
investments. They are not involved in the operations of a company.
• The procured funds are invested in the assets.
• The balance sheet shows the sources of funds acquired by a company and the uses of those
funds. It indicates the amount of money it owns, the amount it owes to external parties, and
the amount invested by the shareholders of a company.
• A typical balance sheet has two sides:
 1. Assets
It represents what the company owns.

2. Liabilities and a. Liability: It represents what the company owes to the external
Equity parties.
b. Equity: It represents what the company owes to the shareholders.

• The balance sheet is formulated on one basic rule: Assets=Liabilities+Equity

Attempt the following questions to reinforce your learning from this segment.

Balance Sheet

What information does a balance sheet provide?

A company’s financial performance over a period of time.

✕ Incorrect

Feedback:

Recall the usage of each financial statement and attempt the question again.

A company’s financial position at a particular point in time and performance over a period of
time.

A company’s financial position at a particular point in time.

✓ Correct

Feedback:

A balance sheet is a statement that provides information about the financial position of a company
at a particular point in time. For instance, a company’s balance sheet would be prepared as on 31
March 2021 and not from 01 April 2020 to 31 March 2021. This means the balance sheet would
indicate the company’s financial position at that particular point in time, rather than over a longer
period of time.
Balance Sheet

If there is an increase in the value of an asset owing to a business transaction, which of the
following actions may balance this effect? Select all the appropriate options. (Note: More than
one option may be correct).

Increase in the value of liability

✓ Correct

Feedback:

The accounting equation states that for any company, Assets = Liability + Equity. If the value of
assets increases, then it can be compensated for by an equal increase in the value of liability in
order to balance out both sides of the equation.

Decrease in another asset

✓ CorrectYou missed this!

Feedback:

The accounting equation states that for any company, Assets = Liability + Equity. If the value of
assets increases, then it can be compensated for by an equal decrease in another asset in order to
nullify the effect of increase in the asset value.

Decrease in equity

Balance Sheet

Which of the following statements about shareholders and bankers is true?

They are part of the core operations of a company.

They are interested in assessing a company’s return on investment.

✓ Correct

Feedback:

The shareholders and bankers, both are fundholders of the company. They have invested in the
company to earn some return, and hence they will be interested in assessing a company’s return
on investment.

The amount invested by the shareholders and bankers can be traced on a company’s income
statement.

The amount of money invested by the shareholders and bankers are classified as shareholder’s
equity.

Key Learnings on Financial Statements

In the previous segment, you learnt briefly about the three financial statements. In the upcoming
video, our faculty will recap the key takeaways for the three financial statements.

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In this video, you saw that the three financial statements answer the following questions.

Income statement How does a company generate wealth over a period of time?
Cash flow
How does a company generate cash during the same period of time?
statement
What are the company’s sources of funds, and how does the company use its
Balance sheet
funds?

You will practice all the concepts you have learnt so far through exercises in the next session.

Before moving on, attempt the following questions to reinforce your learning from this segment.
Financial Statements

Suppose you want to invest in a company that has very little short-term liability. Which of the
following financial statements of a prospective company would you primarily look at in order to
gather this information?

Cash flow statement

Balance sheet

✓ Correct

Feedback:

The balance sheet shows the financial position of a company. It helps you understand what the
company owes to others. Hence, the amount of short-term liability outstanding with the company
can be easily seen on the company’s balance sheet.

Income statement

✕ Incorrect

Feedback:

An income statement would help you to understand the interest payments, and other expenses
pertaining to the current year. But it will not help you in identifying the amount of short-term
liability owed by the company.

sSession Summary
You can go through the Summary Document attached below to reinforce your understanding of
the topics covered in this session.

Session Summary: Overview- Financial Statements

Download

Answer the following questions to test your learnings from this session. Note that these questions
will not be graded.
Comprehension

Ajitabh has joined as a new intern at Finprov Consultancy Limited. His boss handed him the
accounting data of one of its clients, Karpy Limited. Ajitabh was asked to go through the
statements provided before joining the discussion meeting with the client.

Overview of Financial Statement

During the discussion, Ajitabh was asked whether the company managed to generate wealth.
Where will Ajitabh find this information? Choose the correct option from those given below.

The information can be ascertained with the help of the income statement.

✓ Correct

Feedback:

Wealth generated means the profit earned by the company. Profit is earned when the sales revenue
is more than the cost incurred towards it during the year. Ajitabh can find the information in the
income statement of the company.

The information can be ascertained using the cash flow statement.

The information can be ascertained using the balance sheet.

No, the information provided above is insufficient to ascertain the wealth of the company.

Overview of Financial Statement

The client had borrowed money from the bank for the tenure of five years. Choose the correct
option from those given below.

The loan payments are part of expenses and can be traced in the profit and loss statement.
The loans borrowed are part of the assets under the balance sheet.

The loans borrowed are part of the liabilities under the balance sheet.

✓ Correct

Feedback:

The balance sheet is a snapshot of the financial position of a company. It shows the balances of
amounts owed and owned by the company as on one particular date. Bank loans are amounts that
the company owes to others and hence can be seen under the head of liabilities in the balance sheet.

Overview of Financial Statement

When Ajitabh mentioned the total amount of wealth generated, the client was surprised. The actual
cash earned differed and was lower than the amount mentioned. Is this possible? Choose the correct
option from those given below.

No, it means that the financial statements prepared are incorrect. The amount of profit earned and
the actual cash in business should be the same.

Yes, the amount of profit and cash can differ. The actual cash earned in a period can be traced in
the cash account under the asset side of the balance sheet.

Yes, the amount of profits earned can differ from the actual cash receipts. The actual cash inflows
and outflows can be tracked in the cash flow statement.

✓ Correct

Feedback:

Yes, the profits earned during the year can differ from the actual cash earned. The actual cash
inflows and outflows can be tracked in the cash flow statement.
No, this gap cannot be identified, as there is a limitation in the financial accounting system.

Session Overview
Welcome to the second session. Here, you will be learning more concepts related to financial
statements through an exercise.

In this session

You will understand:

• The impact of business decisions on the three financial statements,

• The link between the three financial statement

Note: There are a lot of ‘Try it’ questions before every new concept. They may make you feel
uncomfortable and you may not get them right on the first attempt. Do not get discouraged. Making
mistakes is a crucial part of learning. The mistakes will give you an opportunity to ask yourselves
questions and feel the need to be introduced to a new accounting principle or a more
comprehensive metric or concept. Remember, there is no penalty for mistakes in ungraded
questions.

Guidelines for graded questions

Note that graded questions are given in a separate segment labelled 'Graded Assessments' at the
end of this session. These questions will adhere to the following guidelines:

First Attempt Marks Second Attempt Marks

Questions with 2 Attempts 10 5
Questions with 1 Attempt 10 0

People you will hear from in this session

Faculty
Marie-Lys Leschiera

Trainer & Consultant

Marie-Lys Leschiera has been teaching Finance and Management, mainly for executives and
occasionally for undergraduates, for over 15 years, in several European, US and Indian business
institutions. She is also the President of ML2 Formation & Conseil, a company that develops and
teaches programs for Executives. Drawing from her diverse background and intensive exposure to
international environments, she brings a practical and down-to-earth approach to her courses,
through the use of custom-made cases, exercises and/or management simulation games.

Disclaimer

upGrad does not endorse or advocate the use of any product/service covered in the session, and
the examples are solely meant for illustration purposes.

Preparing for the Case

Hello there!

Before we start going through the content, here is a small example to give you a brief idea of how
to record a typical financial event.

Suppose you want to buy a motorcycle worth Rs 20 lakhs. You have your savings worth Rs 10
lakhs only. You decide to take a loan from your friend for Rs 10 lakhs. Finally, you buy the
motorcycle.

In this situation, the motorcycle is your asset with a value of Rs 20 lakhs. However, this asset is
purchased using your money Rs 10 lakhs which is recorded as the equity while the borrowed sum
of Rs 10 lakhs becomes your liability.

Now after you purchase your motorcycle, you need to pay for the petrol to keep it running. This
petrol is your expense.
Now, you want to earn some money from your motorcycle and hence you start delivering food
using the motorcycle and get commission per order. This commission is your income.

So, any financial event impacts either or a combination of the following elements:

• Assets
• Liability
• Equity
• Expense
• Income

Some of the examples of these elements are:

Elements

Attempt the following questions to reinforce your learnings from the segment.

Note: Do not get discouraged if you do not get the answer right in the first place. Read through
the feedback carefully to understand the concepts again.

Elements

Suppose Ram purchased a truck in cash ₹2 Lakhs. Which of the following elements will be
impacted?
Asset and equity

✓ Correct

Feedback:

The purchase of a truck will lead to the ownership of it. Hence, it will be treated as an asset.
Moreover, it is funded by his own cash, hence it will be his own equity.

Asset and expense

Asset and liability

✕ Incorrect

Feedback:

Think about the ownership factor of the financial event.

Income and expense

Elements

Virat runs a clothing business. To manufacture the goods, he took a piece of machinery on rent
worth ₹20 lakhs. How will this event be recorded?

Expense

✓ Correct

Feedback:

The asset is taken on rent. Hence, the business needs to pay rent on it. This rent is an expense for
the business.
Asset

✕ Incorrect

Feedback:

The asset is not taken on ownership. The business needs to pay rent for it. Hence, it is not an
asset.

Income

Liability

Understanding Accounting Terms

Suppose you want to buy a house in Mumbai. The cost of the house is ₹1 crore. You have ₹40
lakhs with you, and you decide to take a housing loan of ₹60 lakh. What is the value of your
asset, liability, and equity in this case?

Asset: ₹60 lakh, Equity: ₹40 lakh, Liability: ₹1 crore

Asset: ₹1 crore, Equity: ₹40 lakh, Liability: ₹60 lakh

✓ Correct

Feedback:

Assets are resources that you own. Here, the house will be owned by you and, therefore, it will
be your asset. Since the worth of the house is ₹1 crore, you own assets worth ₹1 crore.
Liabilities are resources that you owe to others. Here, since you have taken a loan to buy the
house, it is a liability. Since the loan taken is worth ₹60 lakh, you have liabilities worth ₹60
lakh.
Equity refers to the amount that is invested by you or a shareholder to buy an asset; hence, the
equity here is worth ₹40 lakh.

Asset: ₹40 lakh, Equity: ₹1 crore, Liability: ₹60 lakh

Basic Accounting Terms

Match the financial events with relevant accounting terms.

Financial Event Accounting terms

(A) You have raised ₹50 crores from investors. 1. Equity
(B) You have taken a loan of ₹70 crores from the 2. Income
bank, which is to be repaid after 7 years.
(C) You have made a sale worth ₹20 crores 3. Expense
(D) The cost of the raw material used in your 4. Liability
manufacturing processes was ₹15 crores.

A1, B2, C3, D4

A1, B4, C2, D3

✓ Correct

Feedback:

Equity refers to the money that is invested by owners or raised through funding. Hence, raising
₹50 crore from investors falls under equity.

Liability refers to the money that a company owes to others. The ₹70 crore that is taken from the
bank is a loan that needs to be repaid after 7 years. Hence, it is categorised under ‘Liabilities’.

A sale results in cash generation from the business activity and, hence, it falls within the purview
of ‘Income’.

The cost of the material used in manufacturing is an ‘Expense'.

A4, B1, C2, D3

A3, B1, C3, D4

Case Introduction
In business, every financial event, big or small, impacts the financial statements and the financial
prospects of the company.

The upcoming exercise will help you understand the basics of accounting and the impact of
different financial events on the financial health of a company. The exercise revolves around a
pizza food truck business.

In the upcoming video, our faculty member Marie-Lys will introduce you to the situation in detail.

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Note: Download the following excel file. This file will help you participate in the activity
throughout the session.

The Pizza Food Truck Exercise

Download

In the video, you learnt the following:

• The cash injected by the food truck owner into the business is called the ‘share capital’.
• The raw materials purchased to manufacture the pizza will be recorded as ‘inventory’.
• The ‘cash balance’ on the assets side of the balance sheet is the ‘cash at the end’ value
from the cash flow statement.
• The ‘total of assets’ is always equal to the ‘total of liabilities and equity’.

In the next segment, you will see how different activities for the month of January impacts the
three financial statements.

Financial Statements: January

But before going through the debrief video for the month of January, attempt the following
questions.
Refer to the excel file provided to fill in the three financial statements based on the transactions
given.

Concept: Break-Even Point

In the previous segment, you saw how the operations in January translated into the financial
statements of the pizza food truck business.

Do you think the pizza food truck must continue its operations? Well, a business can continue to
operate only if it is able to cover all its expenses. But how do you know whether you are selling
enough to cover all the expenses?

The ‘break-even point' is a financial tool that helps in determining the number of units to be sold
in order to cover all expenses. Let’s see how to calculate the break-even point for the pizza food
truck business.

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In this video, you learnt that the break-even point is the point where the revenue is equal to the
total cost. In this exercise, it represents the minimum number of pizzas that needs to be sold in
order to generate profits.

You also saw that cost can be of two types:

Fixed cost Does not depend on the level of output

Variable cost Varies with the level of output

You learnt the formula to calculate the break-even point for a business:

• Break even point=Fixed costVariable margin

o Variable margin = Selling price - Variable cost

In the next segment, you will see how different activities in the month of February impact the three
financial statements.
Attempt the following questions to reinforce your learning from this segment.

Financial Statements: February

In the previous segment, you learnt how to calculate the break-even point for the pizza food truck
business. Let’s resume our exercise in this segment.

In the upcoming video, our faculty member will brief the operations carried out in the month of
February.

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Now that you are aware of the operations carried out in February, use the excel file 'The Pizza
Food Truck Exercise' and try to fill in the three financial statements based on the transactions
given. Answer the following questions based on your excel activity.

In this video, you learnt the following:

• Sales revenue is recorded on the basis of the ‘Realisation of sales’ principle. This principle
states that the sales should be recognised as the sales revenue when the goods/service
becomes the property of the company’s customer irrespective of the receipt of cash for
them.
• ‘Sales on credit’ translate into ‘Accounts receivable’ on the asset side of the balance sheet.
• The cumulative undistributed profits or losses of the company for the previous period is
recorded as the ‘Retained earnings’ for the current period.

In the next segment, you will learn how to analyse the performance of the pizza food truck for
February.

Analysis of Financial Statements: February

In the previous segment, you saw how the operations in February translated into the financial
statements of the pizza food truck business. Let’s recap our learnings so far.

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Key learnings:

• Retained earnings represent the cumulative undistributed profits or losses of a company

since its inception.
 • Sales should be recognised in the sales revenue as soon as goods/services become the
property of the company’s customer.
• In the balance sheet, assets should not be overvalued and liabilities should not be
undervalued. This is known as the Prudence principle.
• Inventory should be valued at 'purchasing price' or 'market value', whichever is lower.

But here is the key question: Do you think the company performed well in February?

In the upcoming video, our faculty member, Marie-Lys, will analyse the performance of the pizza
food truck business for the month of February.

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In this video, you saw that in February, the pizza food truck business had made a profit and was
operating above its break-even point. However, the cash flow generated during the month was
0 (zero).

On analysing further, you saw that the majority of the cash is blocked in ‘Accounts receivable’
and ‘Inventory’. The cash flow is 0 due to two reasons;

• The nature of the business was changing

• Growth required additional funding

In such situations, it is important to further understand the following

1. The solvency status of the customers in order to avoid losses in future

2. The ability to procure additional funds to finance the accounts receivable and subsequently
generate more profits using these additional funds

Since the business has a high variable margin, the ability to earn profits is very high. Overall the
business seems profitable and the performance seems satisfactory.

Attempt the following questions to reinforce your learning from this segment.

Financial Statements: March

In the upcoming video, our faculty member will brief you about the operations carried out in
March.

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Now that you are aware of the operations carried out in March, use the excel file "The Pizza Food
Truck Exercise", provided at the beginning of the session, and try to fill in the three financial
statements based on the transactions given. Based on the excel sheet provided above, answer the
following questions.

In this video, you learnt the following:

• The truck purchased in March will be recorded as an asset as it is going to provide future
economic benefits to the company for 3 years.
• Partial payment for the truck is to be made in April; hence, this is a future liability for the
business.
• Since the truck is going to be used for 36 months, as per the matching principle, 1/36 of
the purchase value of the truck must be expensed in the income statement for the current
period. This is known as depreciation.
o It is an operating cost as it is linked to operations.
o It is a non-cash expense.
o The value of depreciation is subtracted from the gross value of the truck to
determine the net value of the truck.
• The truck’s insurance is a recurring cost that the company needs to pay every month. This
value would be expensed in the income statement irrespective of the cash or credit purchase
of the truck.
• Owner’s equity is the sum of share capital, retained earnings and profit for the current
period.

In the next segment, you will get to see how different activities for the month of April impact the
three financial statements.

Financial Statements: April

In the previous segment, you saw how the operations in March translated into the financial
statements of the pizza food truck business.

In the upcoming video, our faculty member Marie-Lys will brief the operations carried out in
April.

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Now that you have an idea of the operations carried out in April, use the excel file "The Pizza
Food Truck Exercise", provided at the beginning of the session, and try to fill in the three
financial statements based on the transactions given. Based on the Excel sheet provided above,
answer the following questions.
Question 4/4
Mandatory
Question 1CorrectQuestion 2CorrectQuestion 3IncorrectQuestion 4Submitted

Now, let’s hear from our faculty member Marie-Lys as she debriefs the operations carried out in
April and how it translates into the financial statements.

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In this video, you saw that the sales and profits for April are higher than those in March. You also
saw that the value of the truck has decreased due to depreciation, while the value of accounts
receivable has increased.

The total cash generated for April is negative as the cash at the end of the month is less than the
cash at the beginning of the month. On further analysing the cash flow statement, you saw that the
cash flow from operations is not sufficient to self-finance the investments, leading to a negative
cash flow for the period.

But it is expected that the accounts receivable will be paid in the coming months, bringing the
company back to a satisfactory level of operations.

Overall, the pizza food truck has performed well in its four months of operations.

The following file shows the financial statements of the Pizza food truck business throughout the
4 months.

Session Summary
You can go through the Summary Document attached below to reinforce your understanding of
the topics covered in this session.

Session Summary
Download

The financial statements will be covered in more detail in future sessions.

Answer the following questions to test your learnings from this session. Answers to these
questions will not be graded.

Class Opinion

What is more important for a business: generating profit or maintaining a positive cash flow?

370 Responses
MJ
Manu John

I think there must be a balance between generating profit and maintaining a positive cash flow. A
high profit figure with zero or negative cash flow would land the business in trouble to meet its
current expenses.

PR
Pratibha Rajpurohit

It depends on the stage at which the business is operating. A company with high profits but
zero/negative cash flow cannot be termed as a financially sick company. This is because the
company may be opting for cash burnout in the current stage with a view to reap benefits in the
long run. This is typically seen in the companies at their early stage

Your response has been recorded! Session Overview

Welcome to the third session of the Accounting Fundamentals module. You will now dive deeper
into the Income Statement and Balance Sheet.

In this session

The following topics and concepts will be covered further:

• The basic structure of the income statement

• The key metrics to look for in an income statement
• The basic structure of the balance sheet
• Dividends
• The link between the financial statements

Guidelines for graded questions

Note that graded questions are given in a separate segment labelled 'Graded Assessments' at the
end of this session. These questions will adhere to the following guidelines:
 First Attempt Marks Second Attempt Marks
Questions with 2 Attempts 10 5
Questions with 1 Attempt 10 0

People you will hear from in this session

Faculty

Marie-Lys Leschiera

Marie-Lys Leschiera has been teaching Finance and Management, mainly for executives and
occasionally for undergraduates, for over 15 years, in several European, US and Indian business
institutions. She is also the President of ML2 Formation & Conseil, a company that develops and
teaches programs for Executives. Drawing from her diverse background and intensive exposure to
international environments, she brings a practical and down-to-earth approach to her courses,
through the use of custom-made cases, exercises and/or management simulation games.

Disclaimer

upGrad does not endorse or advocate the use of any product/service covered in the session, and
the examples are solely meant for illustration purposes.

Income Statement - I

Suppose a company has earned a high revenue in the current year. However, at the same time, you find
that it has reported a loss. How is this possible?

One possible reason could be the high cost of producing the goods. As a manager, what should you do
to solve this problem? To answer such questions, you need to analyse the company’s income statement.
The income statement, also known as the profit and loss statement, records the income and expenses
that your firm has incurred over a period of one financial year.

In the upcoming video, our faculty Marie-Lys will help you understand the basic structure and key
metrics in an income statement.
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In this video, you learnt about the following principles of accounting:

Matching • The cost of goods sold should represent the items that are recorded in the
principle sales revenue for the same time period.

Consistency • A company must follow the same accounting principles and methods across
principle all its financial statements for several periods.

You learnt about the following items of the income statement:

• It is recorded as per the ‘realisation of sales principle’.

Sales revenue
• Sales revenue=Quantity sold ∗ Price per unit

Cost of goods sold • It is recorded as per the ‘matching principle’ and ‘consistency
(COGS) principle’.

• It includes the cost of marketing, legal, HR, R&D, depreciation and

Fixed operating cost
amortisation, etc.

Depreciation and
• It is a non-cash operating cost.
amortisation

You also learnt about the following few key metrics to look for while analysing the company’s income
statement:

• It is the difference between sales revenue and the variable cost of

production.

• If the variable margin is more than the company’s fixed cost, then the
Variable margin
company is said to be operationally efficient.

• It is often computed as a percentage of sales revenue to enable comparison

among companies and benchmarking with the industry average.
EBIT (Earnings • It shows the profit from a company’s operations. Operations are the
before interest core revenue-generating activities of a business.
and tax) • EBIT=Sales revenue−Operating expenses

• It shows a company’s cash operating income.

EBITDA • EBITDA=Sales revenue−Operating expenses(except for depreciation and
amortisation).

EBITDA is a better indicator of cash operating performance as compared to EBIT because of the
following:

• It helps in benchmarking the operating performance of companies with varying ages of fixed
assets. It is free from the bias of depreciation and amortization accounting methods.

• It strongly correlates with the generation of cash.

Before you go further, attempt the following questions to reinforce your learning from this segment.

Income Statement - II
In the previous segment, you learnt about the operating aspect of the income statement. However,
to determine the company’s overall profitability, you need to account for other key elements such
as financing costs and taxes.

In the upcoming video, our faculty Marie-Lys will help you understand the non-operating
elements of the income statement.

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Note: Usually 'interest income' is reported under the heading of 'other income', but for simplicity,
our faculty has taken the aggregate of 'interest income' and 'interest expense' under the heading of
'net interest payment'.

In this video, you learnt about the following items of the income statement:

• It is the difference between interest income and interest expense.

Net interest
• Interest expense arises on the loans borrowed from external parties.
 • Interest income arises from the investment in the financial assets of
other companies like bonds.

Earnings • It is the basis for calculating taxes.

before tax
• It is the amount of money to be paid to the government.
Tax

• It is the profit left for the company’s shareholders after accounting for
Net income all expenses and paying all other stakeholders.

Before you go further, attempt the following questions to reinforce your learning from this
segment.

Balance Sheet
A balance sheet gives you a snapshot of a company’s financial position at a particular point of
time. In fact, if you want to apply for a business loan from a bank, you will need to submit your
company’s balance sheet.

In the upcoming video, our faculty Marie-Lys will help you understand the basic structure of a
balance sheet in detail.

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In this video, you learnt about the following line items of a balance sheet:

Assets
• Value of tangible, intangible and financial fixed assets
Fixed assets

• Value of raw materials, work-in-progress and finished goods to be

used for production or sales, respectively
Inventory • Long production process leads to work-in-progress goods staying for
a longer period in the inventory
 Accounts • Fraction of sales revenue yet to be cashed in
receivable
• Amount of money in the company’s bank account
Cash

You also learnt that the prudence principle is applied while valuing inventory. The value of
inventory must be the lowest of the purchase price or estimated market value.

Furthermore, you learnt the following items on the liabilities and equity side:

Liabilities and Equity

• Amount invested by the owners in the company
Share capital plus the additional issue of capital

Owners’ • Accumulated undistributed profits and losses

equity Retained earnings since the company’s inception

Net income for the • Net profit for the current year
current period
• The maturity period of the debt is longer than one
Long-term debt year

• The maturity period of the debt is less than one

Liabilities
Short-term debt year

• Cash owed to the suppliers

Accounts payable

To draw inferences about a company’s financial health, you need to compare the balance of two
subsequent periods. Before you go any further, attempt the following questions to reinforce your
learning from this segment.

Question 2/2

Mandatory
Question 1CorrectQuestion
2CorrectDividends
In the previous segment, you learnt about the basic structure of the balance sheet. Owner’s equity
is a major component of the balance sheet. Analysing the owner’s equity portion of the balance
sheet will reveal the company’s dividend pay-outs.

Let’s learn more about this in the upcoming video.

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In this video, you learnt that in the case of zero dividends, you can calculate retained earnings by
using the formula:

Retained earnings for a current year=Retained earnings of the previous year

+Profit of previous year

If the company has distributed dividends, the dividend for the current year can be calculated using
the formula:

Dividend for current year=Retained earnings for a current year −

(Retained earnings of the previous year+Profit of previous year)

To keep the balance sheet balanced, dividends decrease the 'retained earnings of a current
year' from the liabilities and equity side and the ‘cash’ from the assets side.

Now, based on the learnings from this segment, attempt the following questions.

Financial Triangle
The accounting equation states that the assets must always be equal to liabilities plus equity.
The balance is maintained through the help of income statements and cash flow statements. Hence,
the three financial statements are interconnected.

In the upcoming video, our faculty Marie-Lys will help you understand the relationship between
the three statements in detail.

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In this video, you learnt the following:

• The bottom line of the cash flow statement ‘cash at end’, is transferred to the asset side in
the balance sheet.
• The bottom line of the income statement, ‘net profit’, is transferred to the owner's equity
section of the balance sheet.

The three financial statements are linked like the three ends of a triangle known as the 'financial
triangle'. In order to have a comprehensive view of a company’s financial health during any
period, it is important to analyse all three statements.

Now, attempt the following questions to reinforce your learning from this segment.

Question 1/1

Mandatory

Question 1Correct

Financial Framework of Businesses

In the previous segment, you have learnt about the link between the three financial statements.

In this video, our faculty Marie-Lys will discuss a framework on the working of a business that
applies to every company.

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In this video, you learnt the following business framework:

Framework of Business

Now, based on the learnings from this segment answer the following question.

Class Opinion

Suppose you want to start a business (for example: logistics, bakery, manufacturing, trading,
financial firm, etc). List down the activities you would undertake at the initial stage to get your
business started.

350 Responses

AG

Abhishek Gulati

I want to start a salon. For this, I would undertake the following activities:

• Invest my funds and procure some more money from people

• Take a space on rent to build the salon
• Hire 1 employee
• Purchase the necessary tools

PR
Pratibha Rajpurohit

I want to start a healthy snack manufacturing plant. For this, I would undertake the following
activities:

• Procure funds from people

• Invest my savings
• Purchase a food manufacturing plant and equipment
• Find a supplier to procure the raw materials required

Your response has been recorded! Session

Summary
You can go through the Summary Document attached below to reinforce your understanding of
the topics covered in this session.

Session Summary

Download
Module Activity

Answer the following questions to test your learnings from the overall module. Note that these
questions will not be graded.

Mr. Aryan started a chocolate manufacturing business, Chococera Limited, in April. Following
are the transactions that took place for the months of April and May in his company.

April:

• He invested ₹2,00,000 to start the business.

• He bought raw materials from a supplier for ₹20,000. As he is new in the business, the
supplier did not provide any credit period to him.

May:

• Sold 400 pieces of chocolate. The selling price per piece was ₹100.
• To increase the social media reach, Aryan paid ₹8,000 for sponsor ads on the social media
platforms. (This is a fixed cost per month.)
• He took a manufacturing machine on rent for ₹5,000 per month. (This is a fixed cost per
month.)
• Raw material cost: ₹25/piece.
• Water and electricity: ₹15/ piece.

Aryan wants to understand his online business's financial health and performance.

Answer the following question to help Aryan build the financial statements and analyse the
financial health of his company.

Note: This question will require you to create the financial statements. Please follow the same
steps as you did in the Pizza Food Truck case. The consolidated answer is provided in the Excel
sheet after the assessments. Please refer to it only after you attempt the questions.
Question 7/7

Mandatory

Question 1CorrectQuestion 2CorrectQuestion 3CorrectQuestion 4CorrectQuestion 5CorrectQuestion

6CorrectQuestion 7Correct

For your reference, the Financial statements of Chococera Limited is attached below:

Financial Statements: Chococera Limited

Download

Module Overview
In this module on Financial Analysis, you will be introduced to the key operating levers that you
need to evaluate a company's performance. You will understand the importance of managing
working capital. You will also learn how to analyse the cash flows of a company.

In the first session, Profitability Analysis, you will understand the key ratios of a company. You
will learn the concept of an economical balance sheet and understand how to use it to perform ratio
analysis. You will then understand the overall framework that companies’ fundholders use to
determine financial value creation.

In the next session, Working Capital Analysis, you will learn about the drivers of operating
working capital and the different factors that affect it. You will also understand the key concepts
to keep in mind while funding operating working capital. Finally, you will learn about the most
important driver, inventory management, in detail.

In the last session, Cash Flow Statement Analysis, you will learn about the different sources of
cash flow for a company. You will also understand how to interpret a cash flow profile of a
company to draw meaningful conclusions.

This module will take you through a journey of understanding the key financial metrics to look for
in a company while deterring the financial health of the company.
We wish you a fruitful, interactive and fun experience! Let’s get started.

Note: Throughout this course, you will see examples of different brands and institutes. These have
been chosen from specific cases in a way that would aid in demonstrating concepts. These do not
reflect the current performance of any company. Any opinion expressed is strictly for educational
purposes.

Session Overview
Welcome to the first session of this module: ‘Profitability Analysis’.

In this session

The following topics and concepts will be covered:

• Economical balance sheet, capital employed and invested capital

• Operating working capital
• Key metrics to analyse the performance of a company, such as operating margin, return on
capital employed (RoCE), return on average capital employed (RoACE) and return on
equity (RoE) and financial leverage

Guidelines for graded questions

Note that the graded questions are given in a separate segment labelled 'Graded Assessments' at
the end of this session. These questions will adhere to the following guidelines:

First Attempt Marks Second Attempt Marks

Questions with 2 attempts 10 5

Questions with 1 attempt 10 0

People you will hear from in this session

Faculty

Marie-Lys Leschiera

Marie-Lys Leschiera has been teaching Finance and Management, mainly for executives and
occasionally for undergraduates, for over 15 years, in several European, US and Indian business
institutions. She is also the President of ML2 Formation & Conseil, a company that develops and
teaches programs for Executives. Drawing from her diverse background and intensive exposure to
international environments, she brings a practical and down-to-earth approach to her courses,
through the use of custom-made cases, exercises and/or management simulation game

s.

For your reference, the transcript for the session is attached below:

Transcription: Profitability Analysis

Download

Report an error

Framework: Profitability Analysis

Peter Drucker, a famous author and management consultant, said the following:

"Profitability is the sovereign criterion of the enterprise."

The main objective of every business enterprise is to earn profits, which is necessary for ensuring
a company's survival and growth. Therefore, profitability becomes the foremost metric when you
analyse the performance of any company or organisation. While everyone is mostly concerned
with whether a company is profitable or not, for business managers and investors, profitability has
a different context. They need to analyse profitability using various elements, such as sales
revenue, capital employed, competitor performance etc.
In the upcoming video, our faculty Marie-Lys will introduce you to the basic profitability
framework used for running a business. This framework helps in building ratios for analysing the
performance of any company.

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In this video, you learnt about the framework that can be used to build ratios and analyse the
performance of a company, which is illustrated below.
Framework: Profitability analysis

The capital raised is invested to run the day-to-day operations of a company. The raised capital is
employed in the following resources:

Resources Description
• Tangible assets
Fixed assets • Intangible assets

• Money required to fund the operating cycle.

Operating working • Operating working capital = Accounts receivable + Inventory -
capital Accounts payable

You also learnt about the operating cycle, which is illustrated in the image given below.
Operating Working Cycle

Now that you know how this business framework can be used to build ratios, in the upcoming
video, our faculty will introduce you to the key ratios that help in analysing the performance of a
company.

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As you learnt in this video, the main stakeholders of a business are the shareholders. They are
interested in comparing the net income with the owner's equity to ascertain their return on
investment. This measure is called return on equity (RoE).

However, the net income of a company is highly dependent on the operations of a company.
Therefore, it is quite important to first determine the operating profit margin of the company.

Another important aspect that needs to be determined is the resources employed by the company
in generating the operating profit. Therefore, the operating profit of a company needs to be
compared with the resources employed by the company in order to determine the efficiency of the
company. This measure is called return on capital employed (RoCE).

In the next segment, you will learn about the economical balance sheet of a company.

But first, attempt the questions given below to reinforce your learnings from this segment.

Question 3/3

Mandatory

Question 1Correct

Question 2Correct

Question 3Correct

Report an error

Economical Balance Sheet

A typical balance sheet is an accounting tool that segregates the ‘Assets’ (what a company owns)
from the ‘Liabilities and equity’ (what the company owes to others).
However, managers are often more interested in segregating the resources utilised by the
operations from the resources invested in the business. This segregation helps in computing the
invested capital or capital employed in a business, which is required for analysing the performance
of a company.

An economical balance sheet separates the operating items and financing items of a balance sheet.

In the upcoming video, our faculty Marie-Lys will explain how to transform a simple balance sheet
into an economical balance sheet.

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Correction note: In the video below, the 'total assets' and 'total liabilities and equity' are 20100.

As you learnt in this video, the balance sheet is the closest financial statement that can be used to
compute capital employed. However, both the sides of a balance sheet have mixed items, i.e., both
the sides have operating and financing items. Some of the common operating and financing items
in a balance sheet are given in the table below.

Operating Items Financing Items

• Property, plant and equipment
• Accounts receivable • Cash
Assets
• Inventory

• Owner’s equity
• Accounts payable • Long-term debt
Liabilities and equity
• Short-term debt

By segregating the operating and financing items in a balance sheet, we can transform it into an
economical balance sheet. An economical balance sheet helps in computing the following
measures:
 • The total of operating items
Capital employed • Property, plant and equipment + Operating working capital

• The total of financing items

Invested capital • Owner’s equity + Net debt

Similar to a simple balance sheet, the two sides of an economical balance sheet are also always
balanced.

In the next segment, you will learn about the key metrics used for analysing the performance of a
company.

But first, attempt the questions given below to reinforce your learnings from this segment.

Operating Margin
Various key metrics are computed to monitor the performance delivered by the operations of a
company. These metrics are then compared against their competitors and the industry standard to
draw conclusions. The top three metrics are as follows:

• Operating margin
• Return on capital employed (RoCE)
• Return on equity (RoE)

In the upcoming video, our faculty Marie-Lys will explain the first metric, i.e., operating margin.

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As you learnt in this video, the operating margin helps in determining the operating profit per unit
of sales revenue. It is calculated using the following formula:

Operating margin=Operating incomeSales revenue

You also saw the operating margin of five years of five different companies from the automotive
industry. This type of analysis helps in determining the performance of a company in comparison
to its peers and the industry standard.

In the next segment, you will learn about the second metric, i.e., return on capital employed
(RoCE). But first, attempt the assessment given below to reinforce your learning from this
segment.

Class Opinion

Analyse the Operating Margin of Different Companies in an Industry.

Kindly perform the exercise using the following steps:

1. Go to the Investor Relations section of any company in any industry of your choice.
2. Download its P&L statement for at least three years.
3. Compute the operating margin of the company for those three years.
4. Repeat the same exercise for two other companies in the same industry.
5. Comment on the operating performance of the companies. Which company performed
better?

Note: Please use the discussion forum to discuss your findings with your peers.

334 Responses

NS

Nikita Shindolkar

I have selected the steel industry. On computing the operating margin for the year 2019-19,
2019-20 and 2020-21, it can be observed that Tata Steels has consistently outperformed its
competitors in the industry, while SAIL has improved its performance over the years from 8.56%
to 12.48% and has underperformed compared to its competitors in these three years.

JSW Steels Tata Steels SAIL

2019 17.44% 21.87% 8.56%

2020 11.66% 15.85% 9.55%

2021 20.46% 26.12% 12.48%

Bhavesh P

I have selected the steel industry. On computing the operating margin for the year 2019-19, 2019-20
and 2020-21, it can be observed that Tata Steels has consistently outperformed its competitors in the
industry, while SAIL has improved its performance over the years from 8.56% to 12.48% and has
underperformed compared to its competitors in these three years. JSW Steels Tata Steels SAIL 2019
17.44% 21.87% 8.56% 2020 11.66% 15.85% 9.55% 2021 20.46% 26.12% 12.48%

Your response has been recorded! Return on

Capital Employed (RoCE)
In this segment, our faculty Marie-lys will explain the next key metric used in analysing the
performance of the operations of a company, i.e., return on capital employed (RoCE).

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As you learnt in this video, return on capital employed (RoCE) is the most comprehensive indicator
of the operating performance.

Return on capital employed helps in determining the resources employed in generating the
operating margin. The key points related to Return on Capital Employed are:

• It shows the operating profit per unit of capital employed.

• It can be calculated as follows:
Return on Capital Employed=Operating incomeCapital employed

The Return on Capital Employed and operating margin are interlinked. Their relationship can be
understood using the following equation:

Relationship: RoCE, Operating Margin and Capital Employed Turnover Ratio

This equation reveals the following drivers of RoCE:

 • Maximise the operating income to maximise the operating
margin and RoCE
Operating Margin
• Shows the margin factor

• Minimise the resources utilised to maximise the capital

Capital employed employed turnover ratio and RoCE
turnover ratio • Shows the efficiency factor

In the next segment, you will learn about return on average capital employed (RoACE). But first,
attempt the exercise given below to reinforce your learnings from this segment.

Return on Average Capital Employed

(RoACE)
While the return on capital employed is the most comprehensive indicator of the operating
performance of a company, it is not the best indicator of the return earned by the investors of
capital.

This is because RoCE is based on the operating profit of a company. The operating profit is not
directly distributed to the fundholders of a company; hence, the return on capital employed
calculations must be modified to calculate the return on average capital employed.

In the upcoming video, our faculty Marie-lys will explain the return on average capital employed
(RoACE).

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Some of the important points from the video above can be summarised as follows:

• Return on average capital employed=Adjusted net operating incomeAverage capital employed

o Net operating income indicates the operating income after paying taxes.
o Adjusted net operating income indicates the operating income after paying taxes
and excluding non-recurring items.
o Average capital employed = (Opening capital employed+Closing capital employed)2
• The drivers of return on average capital employed are the operating margin and capital
employed turnover ratio.
With the help of the example of the TOTAL group, you learnt that analysing the RoACE of a
company reveals the actual operating performance of the company.

In the next video, you will learn about the drivers of RoCE for the different business units of the
TOTAL group of companies.

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As you learnt in this video, a company aims to maximise both its efficiency and its margin in order
to maximise its RoACE.

As you saw in the video, analysing the drivers of RoACE for the different business units revealed
the area of low performance in that unit. Some units were high on margin but low on efficiency,
and some were low on margin but high on efficiency.

Such an analysis helps the management to take the necessary actions to improve the low-
performing driver for a unit, with the aim to increase the overall RoACE for the company.

In the next segment, you will learn about value creation. But first, attempt the question given below
to reinforce your learnings from this segment.

Value Creation and WACC

When fundholders invest capital in a business, they expect some return on their investment. This
return is calculated as RoCE. But how will you determine whether the company has generated
enough RoCE?

This opens up the discussion on value creation. In the upcoming video, Marie-Lys will explain the
concept of value creation in detail.

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In this video, you learnt the following stakeholders have claim on the RoCE:
 • In the form of taxes
Government

• In the form of dividends and interest

Shareholders and bankers

Therefore, there is a need to calculate the after-tax RoCE, which will be directly available as a
reward to the shareholders and bankers.

You also learnt the following criteria for value creation:

If the after-tax RoCE is higher than or equal to the return expected by The company
shareholders and banks creates value
If the after-tax RoCE is less than the return expected by shareholders The company destroys
and banks value

In the upcoming video, our faculty, Marie-Lys will explain how to quantify the minimum return
expected by the shareholders and bankers.

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As you learnt in this video, the minimum return required by shareholders and bankers is known as
the weighted average cost of capital (WACC). WACC can be calculated using the following
equation:

• WACC = Cost of debt x Proportion of debt + Cost of equity x Proportion of equity

Note: You will learn about WACC in detail in upcoming modules.

The cost of equity depends on the risk perceived by the investors. If the share price of a company
is highly volatile during crisis situations, investors perceive their investment in such companies as
risky, and the required return on equity for such a company will be very high.
You also saw that the TOTAL group had an after-tax RoCE of 9.8%, and comparing this against
the WACC of the oil and gas industry revealed that the company had generated value for the year
2019. You also saw the RoCE and value creation graph for the company ATOS.

In the next segment, you will learn about return on equity. But first, attempt the question given
below to reinforce your learnings from this segment.

Question 1/1

Mandatory

Question 1Correct

Return on Equity and Financial Leverage

Equity shareholders are the owners of a company. They enjoy the residual profit, after all the other
stakeholders are rewarded for their investment.

In the upcoming video, you will learn how to measure the return on the investment made by the
equity shareholders.

Note: EAT is Earnings After Tax.

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As you learnt in this video, shareholders are interested in evaluating the net income generated per
unit of equity investment, which can be calculated using the following formula:

Return on equity=Net incomeOwners′ equity

In order to analyse the performance of a company, it is important to benchmark the RoE of the
company across multiple years and against its competitors.
The RoE of a company is highly related to the operations of the company. RoE can be increased
in the following cases:

• By minimising interest expense

Increase net income
• By minimising taxes

• By borrowing more
Decreasing owner’s equity

If you borrow more, the net income will decrease, and if you borrow less, the owner's equity will
increase. Hence, there is a need to find an optimum point between the percentage of debt that you
want to borrow and the interest rate on this debt. You need to operate near the optimum point.

You also learnt about the following factors that are multiplied with the RoCE to arrive at the RoE:
Drivers of RoE

The equation above reveals the following:

• Cost of debt
EBTEBIT • Higher is better
Financial leverage
• Proportion of debt
Capital employedOwner′s equity • Higher is better

• Tax expenses
Tax implications EATEBT • Lower is better

To understand the concept of financial leverage better, kindly download the following document:

upGrad Simple Guides: Financial Leverage

Download

Now, attempt the questions given below to reinforce your learnings from this segment.

Module Overview
Welcome to this module on ‘Project Evaluation’.

• In this module, you will learn about the concept of the "time value of money" and how it can be
applied to different cases of annuity and uneven cash flows.
• You will also learn how to about the various techniques of project evaluation and the risks
related to projects.

In this session

We will focus on the core concept of project evaluation and discuss the following topics:

1. Time value of money for a single cash flow

2. Time value of money for multiple cash flows: Annuity
3. Time value of money for multiple cash flows: Uneven cash flows
Guidelines for graded questions

Note that graded questions are given in a separate segment labelled 'Graded Quizzes', at the end of
the last session. These graded questions will adhere to the following guidelines:

First Attempt Marks Second Attempt Marks

Questions with 2 attempts 10 5

Questions with 1 attempt 10 0

People you will hear from in this session

Prof. Puja Aggarwal

Assistant Professor, Finance, IMT Ghaziabad
Puja Aggarwal is currently an assistant professor of Finance and Accounting at IMT Ghaziabad.
She has five years of teaching experience and is an excellent team player with a proven track
record. She is a motivated professional, with an extensive postgraduate-level education, and is also
a result-oriented individual with expertise in dealing with skill-oriented courses, such as those on
communication skills, interpersonal skills and presentation skills.

Srinivas Mantripragada
Ex Director-Finance, Yahoo India
A chartered accountant by qualification, Srinivas is a transformational senior finance
professional with 28 years of experience in consulting, manufacturing, information technology
and internet companies, including start-ups. He has extensive experience in strategy; business
and financial modelling, planning and analysis; process improvements; P&L management;
controllership, India, US GAAP and IFRS; taxation, contracts, legal and statutory compliances;
M&A and due diligence; IT systems, SAP, Oracle, QuickBooks, salesforce and project
management; and SOX, internal controls, governance and risk management. In addition, he has
also been in various leadership roles, including the Director of Finance for companies such as
Yahoo India and Unisys. Currently, he is also a visiting faculty member at NMIMS, Bangalore.

Dhaval Doshi
Founder, Smarthome NX
Dhaval is a serial entrepreneur with 11 years of wide-ranging experience in marketing, advertising
and e-commerce. He has chalked out successful strategies, managed large-scale campaigns,
created champion ventures and built winning teams from scratch. His previous stints have been
with e-commerce ventures and, most recently, with Indigo Consulting (Leo Burnett), managing
digital marketing mandates for brands such as Bajaj, Axis Bank and Amazon Prime Video. He has
now stepped into the world of IoT and automation with Smarthome NX, with like-minded people
who share his vision to make homes better and smarter with technology.

A Simple Guide to TVM

Before proceeding with this session, please spend some time going through the following
document. It will help you develop an intuitive understanding of the core concept in this session.

A Simple Guide to Time Value of Money

Download
Question 1/1
Mandatory
Question 1Submitted
Time Value of Money

Is receiving a rupee today the same as receiving it a year later?

The answer to this question lies in the time value of money. A rupee that is invested earns interest upon
its value. This interest makes receiving a rupee today more valuable than receiving it a year later. Hence,
if you choose to receive the rupee a year later, then you lose out on the interest that you would have
earned had you chosen to receive it today and invested it.

In other words, if you choose to receive the money today rather than a year later, then you will become
richer by an amount equal to the interest for one year. This concept is known as the time value of
money.

The concept of the time value of money aims to equip you with an understanding of how to value your
investments. Let’s discuss this concept further in the upcoming video.

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In this video, you learnt that it is more beneficial to receive a certain amount of money now than later.
This is because of the concept of the time value of money.

The concept of time value of money suggests that the money earned today has more value than the
same amount of money earned in the future. This is due to the potential earning capacity of the given
amount of money. The interest rates by which the value of your investment compounds and discounts
are known as the compound rate and the discount rate, respectively.
In the previous video, you also got an idea of the following two terms related to the time value of
money:

• Present value: This refers to the current value of money.

• Future value: This refers to the value of money after a certain period of time, depending on the
rate of interest.

The relationship between the present value and the future value can be depicted as follows:

• Future value=Present value∗(1+R)T where,

o R: The rate of interest

o T: The time period

The process of converting the present value of a given amount of money to its future value is termed
‘compounding’. On the other hand, the process of arriving at the present value of an investment using
the interest rate that it can earn is known as ‘discounting’. Both these processes are commonly used in
the field of corporate finance.

Now that you have gained an understanding of the principles of compounding and discounting, let’s dive
into their application in real-life scenarios for making an investment choice.

In the next video, our expert will explain the time value of money further with the help of an investment
example.

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Note: At 3:36 in the video above, the calculation shown is for the scenario with quarterly compounding.

In this video, you learnt how to arrive at the present value and the future value of a given investment.
Essentially, compounding and discounting are done on an annual basis. However, sometimes, they can
be done at a different frequency, such as monthly, quarterly, or half-yearly. In such cases,

Future value=Present value∗(1+Rn)(T∗n)

Here, n denotes the number of compounding intervals per time period.

For example, if you have an annual interest rate of 12%, given that the money is compounded quarterly,
R will be 12% and n will be 4.

In the next video, you will learn how to use Microsoft Excel functions to quickly arrive at the present
value for a given future value, interest rate and time period. So, let’s hear from Srinivas as he explains
how to go about it.

The excel formula that Srinivas will use is:

=PV(rate, nper, pmt, fv, type)

Here,
rate: The rate of interest
nper: The number of payment periods
pmt: The recurring cash flow
fv: The future value of the cash flows
type: The timing of cash flow. This input is optional; it takes the default value as follows:
0: If the payment is made at the end of the period
1: If the payment is made at the beginning of the period

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In this video, you learnt how to calculate the present value for a given single future cash flow using the
PV function in Excel. It is calculated using the following formula:

=PV(rate, nper, pmt, fv, type)

Parameter Explanation

rate=5.9%/4 The rate for each quarter is the annual rate divided by 4

nper = 16 There are 16 quarters in 4 years

pmt = 0 There is no recurring money being deposited

Here, Srinivas is assigning a negative sign to amounts paid by the bank, and a positive sign to amounts
fv=-500000
paid by you. Because the bank is supposed to pay you Rs. 500000, it carries a negative sign.

type = 0 We are assuming that payments are made at the end of the periods
The signs of PV and FV will depend on how you use the excel function. Remember to always interpret
them according to the usage.

For example, in this same scenario, you could use the opposite sign convention. You could assign a
negative sign to amounts paid by you, and a positive sign to amounts paid by the bank. The formula will
then become:

=PV(5.9%/4, 16, 0, 500000, 0)=−395572

Here, the negative sign in the result indicates that it is an amount that you will need to pay to the bank
today. The signs of PV and FV will always be opposite while using this excel function.

Annuity

Certain investment opportunities involve multiple cash flows instead of one-time cash inflow and cash
outflow.

You must be aware of the EMI (equal monthly installment) scheme commonly offered by automobile
and electronic manufacturers. This scheme allows a customer to pay a fixed sum of money at regular
intervals, which can be yearly, quarterly or monthly, and at a fixed interest rate, instead of paying up the
lump-sum purchase price at once.

Such a fixed cash flow for a fixed period of time is known as an annuity.

But how do you arrive at the present value of these annuity payments or annuity receipts? Let’s take a
look at the next video to learn how to discount or compound annuities.

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In this video, you learnt how to calculate the present value of a periodic set of equal amounts of cash
flows, i.e., annuity. This can be calculated using the following formula:

• PV=∑nT=1CF(1+Rate)T , where

o Rate: The rate of interest, and

o T: The number of payment periods

o Σ: This is a mathematical operator, which simply means we are adding the terms by
varying T from '1' to 'n', i.e.

PV=CF(1+Rate)1+CF(1+Rate)2+...+CF(1+Rate)n
You also learnt that in order to make a decision regarding any project, you need to compare the total
present value (sum of individual present values of cash flows) with the initial investment. The decision
can be made based on the following points:

• If the initial investment > the total present value of cash inflows, then you should reject the
project.

• If the initial investment < the total present value of cash inflows, then you should accept the
project.

• The total present value indicates the maximum amount of money that you should invest in a
project. Any amount that is greater than the total present value would result in a loss from the
project.

In the next video, you will learn how to use Excel functions to calculate the present and future values of
an annuity.

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In this video, you learnt how the PV and FV functions in Excel can be used to arrive at the present value
and the future value of an annuity, respectively.

Further, you learnt that the present value of an annuity can be calculated using the PV function in
Microsoft Excel.

• The syntax for the function is as follows: =PV(rate, nper, pmt, fv, type) ,where

o rate: The rate of interest,

o nper: The number of payment periods,

o pmt: The recurring cash flow,

o fv: The future value of the cash flows, and

o type: This input is optional; it takes the default value as 0. But it can be changed to:

▪ 0: If the payment is made at the end of the period

▪ 1: If the payment is made at the beginning of the period

• For a future annuity cash flow, the PV function will give you a present value of the opposite sign
of the future cash flow. This is due to the Excel convention.

• The absolute value of the result derived using the PV function should be compared with the
absolute value of the initial investment in order to make an investment decision.
 o If the absolute value of the initial investment > the absolute value of the present value
of cash inflows, then you should reject the project.

o If the absolute value of the initial investment < the absolute value of the present value
of cash inflows, then you should accept the project.

You also learnt that the future value of an annuity can be calculated using the FV function in Microsoft
Excel.

• The syntax for the function is as follows: =FV(rate, nper, pmt, pv, type) ,where

o rate: The rate of interest,

o nper: The number of payment periods,

o pmt: The recurring cash flow,

o pv: The present value of the cash flows, and

o type: This input is optional; it takes the default value as 0. But it can be changed to:

▪ 0: If the payment is made at the end of the period

▪ 1: If the payment is made at the beginning of the period

• If the input is a positive cash flow, then the FV function will give you a future value of the
opposite sign of the input cash flow. This is due to the Excel convention mentioned earlier.

You can learn more about the PV and FV functions from here: PV and FV.

Let's move on to the next concept.

Suppose you want to buy a flat worth ?25,00,000 five years from today. How much money should you
invest monthly to have a corpus amount of ?25,00,000 at the end of the fifth year, given that the
interest rate is 5.90% compounded monthly?

Let’s hear from Srinivas as he explains how to find the annuity value in such cases.

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In this video, you learnt that if the fixed future value, the interest rate and the time period are given,
then the annuity value can be calculated using the following equation:

Annuity=Future value[(1+R)N−1]/R

where,
 • R: The rate of interest, and

• N: Time Period.

Uneven Cash flow

Suppose you are a manager at an Indian FMCG firm. The company wants to expand into a new
division of manufacturing low-fat snack foods. It has decided to set up a new plant that will be
operational for 20 years. After this period, this plant can be sold.

Now, setting up the new plant would involve huge investments. As a manager, you are asked to
perform a cost-benefit analysis of this investment using the present value technique based on the
expected cash inflows from this plant. Would the expected cash flows be of an equal amount for
all the years?

Well, no. The sales amount cannot be of the same value for each year. The cash flows will vary.
Therefore, the PV function in Excel cannot be used in this case.

Then, how do you calculate the present value of variable cash flows?

Let’s take a look at the next video to learn how to arrive at the present value of variable cash flows.

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In this video, you learnt about the following two methods of calculating the present value (PV) of
uneven cash flows:

• Method 1: This involves calculating the PV of each cash inflow individually.

o The total PV of all the cash inflows will be the sum of the individual present values of the
cash flows for the given duration of a project.
o This is done by multiplying the cash flow with the present value factor (PVF) for that
particular year. The PVF can be calculated by:
▪ Using this formula: 1(1+Rate)Time

• Method 2: This involves calculating the PV of uneven cash flows using the NPV function in Excel.
o The syntax for the function is as follows: =NPV(rate, range of values), where,
▪ Rate is the interest rate, and
▪ The range of values is the cash flows that need to be discounted.
 • The value derived from the net present value (NPV) function must be compared with the initial
investment to make an investing decision.
• The total PV also gives the maximum value that must be paid for an investment today based on
the future return on the investment. Any amount that is greater than the total PV will lead to a
loss from the project.

You also learnt about the following method to calculate the FV for uneven cash flows:

• This involves calculating the FV of each cash inflow individually.

o The total FV of all the cash inflows will be the sum of the individual future values of the
cash flows for the given duration of a project.
o This is done by multiplying the cash flow with the compound value factor (CVF) for that
particular year. The CVF can be calculated by:
▪ Using this formula: (1+Rate)Time where,
▪ Rate: The rate of interest
▪ Time: The time period for which the present value needs to be
compounded.

The aforementioned principles can be applied to a variety of investment opportunities. In the

upcoming video, let’s hear from Srinivas about some of the most common investment
opportunities where the concept of time value of money is relevant.

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In this video, you learnt about the different types of investment options, which are as follows:

• One-time investment, which involves a single outflow and inflow

• Recurring deposit, where annuity payments are made to receive a one-time cash inflow
• Annuity, where a one-time deposit is made to receive annuity receipts
• Recurring deposit and annuity, where annuity payments are made to receive annuity receipts

Session Summary
So what did you learn in this session?

In this session:

• You learnt that the time value of money shows how that the money earned today has more
value than the same amount of money earned in the future. This concept is used to find the
present and future value of a sum of money. The discount rate and compound rate is used for
discounting and compounding a certain sum of money.
 • You also learnt that the a fixed cash flow for a fixed period of time is known as an annuity. You
also learnt how the concept of time value of money can be used to find the present value of
annuity, the annuity amount for a fixed future corpus, using excel functions and formulas.
• Finally, you learnt how the time value of money can be applied to uneven cash flows.

Cost of Capital

Various inputs are required for evaluating projects. One of the various inputs that were discussed in the
previous session was the discount rate. This is also known as the cost of capital.

The cost of capital is a crucial element in the process of investment decision making. If a company
invests in projects where the return is greater than the cost of capital, then there is value creation. On
the other hand, if the return is less than the cost of capital, then there is value destruction. So, how do
firms evaluate the cost of capital of a project?

Before you get down to the nitty-gritty of estimating the cost of capital for a project, you must first learn
about the sources of capital that can be used for funding the investments. There are certain costs
associated with the sources of funds, which are then used to estimate the cost of capital for a project.
Let’s watch the following video and hear Prof. Puja as she explains the different sources of capital
available for funding a project.

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In this video, you learnt that a company acquires the required capital from various sources, such as by
borrowing from outsiders or using funds from owners. Borrowed funds are known as debt and the
owner’s funds are known as equity. Both of these sources together form the capital structure of a
company.

A company has to pay the following charges to both the sources for the risk that they assume by
investing their capital in the company:

• Cost of debt: If a company raises capital through debt, then it has to pay interest on its
borrowings. The amount of interest that a company pays on debt is called the cost of debt. This
can be calculated using as:
Total interest payable by the companyTotal debt undertaken by the company

• Cost of equity: The charges paid against the owner’s fund is known as the cost of equity. Cost of
equity is the theoretical return that a company must give back to its investors to compensate for
the risk that they have undertaken by investing in the company.

o Return for equity is of two types, which are as follows:

 ▪ Appreciation in the value of their investment: This means that if a shareholder
had invested ?5,00,000 in a company but he is able to sell off their stake for
?5,10,000, then there is a capital appreciation in the value of their holding.

▪ Dividend: Since the shareholders are the owners of a company, they are
entitled to the profits of the company. The share of profits given to
shareholders is known as dividend.

You also learnt that equity owners are the recipients of residual profit, and debt providers receive a
fixed charge in the form of interest irrespective of the profit status of the company. Hence, the risk
assumed by debt providers is lower than the risk assumed by equity owners. Therefore, the cost of debt
is lower than the cost of equity.

Now that you have learnt about the sources of funds for a company, do you know how the capital
structure helps in estimating the weighted average cost of capital of a company?

Let’s learn about it in the next video.

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In this video, you learnt how to estimate the weighted average cost of capital (WACC) for a company on
the basis of its capital structure. Some of the key points regarding the estimation of WACC and its
components are:

• The costs of debt and equity together make up the cost of capital. The formula for calculating
the weighted average cost of capital is as follows:
kc=kd∗Wd+ke∗We

• The components of the equation given above are as follows:

o kd is the cost of debt,

o ke is the cost of equity,

o Wd is the weight of debt, which is calculated as: DebtDebt+Equity , and

o We is the weight of equity, which is calculated as: EquityDebt+Equity.

• The cost of debt is relevant to debt providers, and the cost of equity, to equity holders.

• Note that the cost of capital for a company is different from the cost of capital for the projects
taken up by that company.

• A subsidiary can also be considered equivalent to a project from a financial angle. The cost of
capital for Bajaj Group is different from that of Bajaj Finserv and Bajaj Auto. This is because of
the difference between the two subsidiaries/projects in terms of the industry risk involved.
 However, the combined cost of capital for both Bajaj Finserv and Bajaj Auto will be equal to that
of Bajaj Group, assuming that the company has only these two projects.

• The weighted average cost of capital (WACC) is compared to the return on investment to
determine the feasibility of a project.

o If WACC > Return on investment (ROI) or rate of return (ROR), then the project is
expected to be unprofitable.

o If WACC < Return on investment (ROI) or rate of return (ROR), then the project
is expected to be profitable.

Post this, you also learnt that any change in the government regulations may impact the cost of debt
and the cost of capital of a company.

Now, let’s watch the next video and hear Srinivas explain some of the sources of capital that are
available to a company such as Tata Steel.

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In this video, you learnt that in addition to debt and equity, a third source of capital may be available to
a company, that is, preference share capital.

Preference share capital providers get fixed payment as interest at a fixed rate.

Because equity shareholders assume a higher risk, they demand higher returns. On the other hand, debt
providers incur a lower risk and, hence, demand lower returns. Preference share capital providers
assume a higher risk than debt providers but a lower risk than equity shareholders and, hence, demand
a return higher than debt providers but lower than equity shareholders.

Project Evaluation Techniques - I

Capital is a scarce and expensive resource. Hence, it must be used judiciously. Also, the basic aim of a
company is to maximise its shareholder’s wealth. In order to do so, the company needs to invest its
scarce resources in the most profitable investment opportunity out of all the available opportunities.
But how does a company ensure that an investment opportunity is profitable?

Well, the techniques of project evaluation help in identifying whether the investment opportunity is
profitable or not. Some of the key techniques of project evaluation are as follows:

1. The NPV technique

2. Profitability index

3. The IRR method

 4. Payback period

Suppose you are the manager of a construction company. The company has a piece of land in Mumbai,
which can be used to build either a residential complex or a commercial complex. Both the projects will
require heavy initial investment. If both projects are profitable, how will you decide which one to
choose, given that there is only a single piece of land?

Well, the NPV technique is one of the four project evaluation techniques that helps in evaluating the
feasibility of a project. It helps in choosing the project that will maximise the shareholder’s wealth. Let’s
watch the following video and learn about the NPV technique in detail.

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In this video, you learnt that net present value (NPV) is the present value of the future cash flows minus
the present value of initial investment. In other words, net present value = Present value of all cash
outflows + present value of all cash inflows.

• NPV can be calculated using the following formula:

o NPV=C0+C1(1+r)+C2(1+r)2+...+Cn(1+r)n , where,

o n = Time period

o r = Cost of capital

o Cn= Cash flow for year n

• According to the NPV technique of project evaluation,

o If the NPV > 0, then the project should be accepted.

o If the NPV < 0, then the project should be rejected.

• If there are two projects with positive NPV and only one can be chosen, then the project with
the higher NPV should be selected.

• The addition property of NPV states that if you have two projects, say A and B, then the net
present value of the combined investment is calculated as:

o NPV(A+B)=NPV(A)+NPV(B)

Microsoft Excel has an inbuilt function that can be used to calculate the net present value of an
investment opportunity. So, let’s watch the next video and hear from Srinivas on how to apply the NPV
function for decision making.

In this video, you will also learn about an additional technique of project evaluation: profitability index
over and above the techniques mentioned in the previous video.
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In this video, you learnt about the NPV function of Microsoft Excel.

You can arrive at the NPV of an investment using the

formula: =NPV(rate,range of values)−initial investment, where range of values = cash flows which needs
to be discounted

You also learnt about profitability index (PI). Profitability index is measured as the ratio of the present
value of cash flows to the initial investment.

• It can be calculated as follows:

o PI = PV of future cash inflowsInitial investment

• According to the PI technique of project evaluation,

o If the PI > 1, then the project must be accepted.

o If the PI < 1, then the project must be rejected.

• If there are two projects with positive PI and only one can be chosen, then the project with the
higher PI value must be selected.

Project Evaluation Techniques - II

Consider a situation where you are planning to invest ?1,00,000 in the stock market, expecting a 15%
return a year later. But, what if you do not have the amount at your disposal and are looking to borrow
from a bank? What is the interest rate that you will be willing to pay the bank?

Considering the return of 15%, it would make sense for you to borrow the money as long as the interest
rate charged by the bank is less than 15%. If the interest rate is more than 15%, your investment
opportunity will not be profitable.

Companies or business entities always want their return on investment to be more than the cost of
capital for the investment. The higher the returns, the more is the profitability. So, they use the internal
rate of return (IRR) technique to determine the effective rate of return for the cash flows. Let's watch
the next video and learn about this technique in detail.

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In this video, you learnt that the rate of return at which the present value of cash outflows is equal to
the present value of cash inflows is known as the internal rate of return.

• IRR can be calculated using the following formula:

 o NPV=C0+C1(1+r)+C2(1+r)2+Cn(1+r)n , by substituting the value of NPV = 0

o You can also use the excel formula

= IRR(Range of value),
where 'range of values' contains initial investment and cash inflows

• According to the IRR technique of project evaluation,

o If the IRR from the project > Cost of capital used to fund that project, then the project
should be accepted.

o If the IRR from the project < Cost of capital used to fund that project , then the project
should be rejected.

Now that you have learnt about the multiple techniques of project evaluation, you must be wondering
what is the need for having multiple techniques. How do project managers decide whether to employ
the NPV technique or the IRR technique to evaluate a project?

Well, there are certain principles of project evaluation that help in choosing the right technique for
evaluating projects in certain situations. Let’s watch the following video and learn about them in detail.

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In this video, you learnt about the following general principles of project evaluation:

• Use the NPV technique instead of the IRR technique when there are multiple changes in signs of
cashflow over the duration of a project. This is because if the sign of a cash flow changes more
than once, then there can be two values of the IRR.

• Use the NPV over the IRR to evaluate two projects that have unequal durations.

• Use the NPV method for larger companies and the IRR method for smaller companies.

• Use cash inflows and outflows instead of accounting profit to estimate the NPV and IRR of a
project. The accounting profit is adjusted for non-cash expenses, such as depreciation, salvage
value received at the end of the project and working capital changes to arrive at the cash flow.

You also learnt about another technique of project evaluation that does not consider the concept of
time value of money. This technique is known as the payback period. The payback period of an
investment refers to the time taken to recover the full cost of the investment.

Let’s take a look at the following example to understand this technique better.

Suppose you want to buy machinery worth ?50,000. The machinery will lead to the following cost
savings:

Year 1 Year 2 Year 3 Year 4 Year 5

Cash Inflow / Savings (?) 10,000 5,000 15,000 30,000 8,000

In this case, it can be seen that by the third year, the cumulative cash flow is ?30,000, which is less than
the initial investment of ?50,000. But after the fourth year, the cumulative cash flow is ?60,000, which is
more than the initial investment of ?50,000. Hence, the payback period will lie somewhere between the
third and the fourth year. Out of the fourth year's cash flow of ?30,000, only ?20,000 is required to
cover up the initial investment. Therefore, the payback period can be calculated as: 3 + (20/30) years,
which is 3.67 years.

However, this technique has the following drawbacks:

• It ignores the cash flows after the payback period.

• It does not take into account the time value of money.

Project-Related Risks
Every project comes with its own set of risks. Some of the risks are visible to a project manager at
the beginning of the project, while some risks are encountered while undertaking the project. These
risks have the ability to alter a project’s NPV, thereby transforming the project from a beneficial
one to a damaging one for the company.

There have been many such cases in history; one such case is of India’s car manufacturer Tata
Motors, which was trying to set up a car manufacturing line in Singur, West Bengal. The company
experienced public outrage against the project.

Do you think that the company foresaw that they would face so much outrage from the local
population in Singur that they would have to completely move the plant from West Bengal to
Gujarat? Obviously not. Let’s look at more examples in the following video.

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In this video, you learnt that no project is devoid of risk. Hence, while evaluating any project, you
should be aware of the possible risks plaguing the project and work out ways to analyse the risks.
You also learnt about different types of internal risks faced by an organisation. These are risks that
can be controlled by the organisation. The different types of internal risks are as follows:

• Operational risk: These risks affect the operational activities of a project. A few examples of
operational risks and their mitigation strategies are provided in the table given below:

Risk Mitigation
Machine breakdown Alternative machine on standby
Resignation of a critical resource Provision of another resource who can step in
Cap on days in the contract by which the
Delay in project deliverables due to late
customer must respond or Include change order
customer inputs
mechanisms

• Financial risk: These risks are related to the financial aspect of the company and its projects. A
few examples of financial risks and their mitigation strategies are provided in the table given
below:

Risk Mitigation
Requirement of additional resources for a Detailed planning and estimation of specific
company constructing a flyover project-wise requirements
Agreeing on a fixed exchange rate based on
Fluctuations in exchange rates historical data and making all future
transactions based on it
Adding a contingency factor to pricing or
Cost overrun due to an increase in the
accounting for changes in costs or negotiating a
interest rate
fixed rate of interest with banks

There may be some risks that cannot be controlled. These are known as external risks. Let’s look
at the next video to learn more about external risks.

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In this video, you learnt about the different types of external risks, which are as follows:

• Natural risk: These risks are associated with natural disasters. An example of a natural risk and its
mitigation strategy is provided in the table given below:

Risk Mitigation
Damage due to natural calamities Insuring the project against the damage caused

• Regulatory risk: These risks occur due to the environment in which they are operating. A few
examples of regulatory risks and their mitigation strategies are provided in the table given below:
 Risk Mitigation
Reduction in dependency on the US market,
Decertification of Ranbaxy by the US FDA Involving a local legal firm to advise on local
environment
Contract clause to stipulate the reimbursement
Delay in the project due to political
of sunk costs due to any change in the
interference
contract

• Market risk: These risks occur due to a sudden change in market conditions in which your firm
operates. An example of market risk and its mitigation strategy is provided in the table given
below:

Risk Mitigation
Reliance Jio eating into Vodafone’s market
Leveraging the brand equity of Vodafone to
share with its free voice calls and cheap data
turn around the situation
packs
Risk Evaluation Techniques

Now that you have learnt about the various types of risks that can plague a project, don’t you think it
would be better if there was a method to prioritise the risks? Well, there are certain risk evaluation
techniques that can help a manager prioritise the risks affecting their project, thus enabling them to
come up with mitigation strategies in order to counter the risk.

A business is full of uncertainties. A project is evaluated at its initiation based on several assumptions.
However, these assumptions may change while the project is in its operating stage. What will happen to
the NPV of the project?

Well, a change in assumptions will affect the NPV of the project. So, how should you account for such
changes before investing in the project?

There are two techniques that can be used to evaluate the risks of a project. They are as follows:

• Sensitivity analysis

• Scenario analysis

Let’s watch the next video and learn about sensitivity analysis in detail.

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In this video, you learnt that sensitivity analysis refers to observing changes in the NPV by changing
one input variable at a time.

• It is used to prioritise risks associated with a project

 • There is a ‘base case’ where the NPV of the project is calculated without considering any risks.
Then, the NPV is re-calculated after adding one risk to the project.

• The change in the NPV of a project reveals how critical that risk is.

However, in real life, it is possible that more than one input variable may change at one time. What
should you do then?

Well, scenario analysis helps in dealing with such situations. In the next video, you will learn about
scenario analysis in detail.

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In this video, you learnt that scenario analysis refers to observing changes in the NPV by changing
multiple input variables at a time.

• There is a base-case (expected scenario for a project) situation, a best-case (scenario with no
risks) situation and a worst-case (scenario with multiple major risks) situation.

• A firm assigns probabilities to the NPV values for all the scenarios to calculate the risk-adjusted
NPV for a project. For this risk adjusted NPV:

o The probabilities are assigned based on the firm’s historical exposure to the several
types of risks identified.

o Risk-adjusted NPV is calculated as the sum of the products of the assigned probability
and the NPV in each case.

o A project is deemed profitable if the risk-adjusted NPV > zero.

Comprehension Question

Maruti Suzuki plans to set up a battery manufacturing facility in Gujarat to service electric cars. The
project manager has projected the cash flows , which are provided in the table given below.

Year 1 2 3 4 5 6 7

Net Cash Flow (in ? crore) -400 -200 -200 250 900 1,100 1,500

There are multiple risks that the manager is planning for. The next Gujarat elections will take place in
year 5. Any change in the government may lead to unforeseen sanctions. The projected cash flows in
such a case are provided in the table given below.
Year 1 2 3 4 5 6 7

Net Cash Flow (in ? crore) -400 -200 -200 250 500 500 700

The manager also builds a conservative scenario in which the electric car industry does not perform the
way Maruti Suzuki projected. The net cash flows in such a case are provided in the table given below.

Year 1 2 3 4 5 6 7

Net Cash Flow (in ? crore) -400 -300 -300 200 400 700 900

Based on this information, answer the questions given below. It is strongly advised that you use a
spreadsheet software (such as Microsoft Excel) to solve the following questions. Consider the WACC rate
for Suzuki to be 10%. All the cash flows will occur at the end of the year.

Session Summary
So what did you learn in this session?

In this session,

• You learnt how to calculate the cost of capital for a project. This cost of capital is used to
discount the cash flows of a project to arrive at the present value.
• There are four types of project evaluation techniques which are used to evaluate the feasibility
of a project.
• Each technique lays out a criteria for acceptance of the project.
o If the NPV > positive, the project should be accepted.
o If the IRR> cost of capital, then the project should be accepted.
o If the PI > 1, then the project should be accepted.
o A project with the lowest payback period must be accepted.
• Projects are full of risks. These risks can be either operational, financial, natural, legal, regulatory
and market risk.
• To evaluate project risks, there are two risk evaluation techniques: Sensitivity and scenario
analysis.

For your reference, the summary for this session is attached below:
Session Summary

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Answer the following questions to test your learnings from this session. Answers to these
questions will not be graded.