WEEK 1

Importance of Financial Management

Financial management is mainly concerned with the effective fund management in a business.

Financial planning is a process of framing objectives, policies, procedures, programs, and budgets regarding the financial
activities of a concern. This ensures effective adequate financial and investment policies. the importance of financial
planning is as follows:

· Financial planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is
maintained

· Adequate funds have to be ensured

· Financial planning ensures that the suppliers of funds are easily investing in companies which exercise financial
planning

· Functions of Financial Management

Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements
of the company. This will depend upon expected costs and profits and future programs, and

· policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of
enterprise.

· Determination of capital composition: Once the estimation has been made, the capital structure have to be
decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity
capital a company is possessing and additional funds which have to be raised from outside parties.

· Choice of sources of funds: For additional funds to be procured, a company has many choices like-

· Issue of shares and debentures

· Loans to be taken from banks and financial institutions

· Public deposits to be drawn like in form of bonds.

· Choice of factor will depend on relative merits and demerits of each source and period of financing
· Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is
safety on investment and regular returns is possible.

· Disposal of surplus: The net profits decision has to be made by the finance manager. This can be done in two ways:

· Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.

· Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification
plans of the company.

· Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required
for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors,
meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc.

· Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to
exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost
and profit control, etc.

Organization of finance functions

1.Investment decisions includes investment in fixed assets (called as capital budgeting).

1. Investment in current assets are also a part of investment decisions called as working capital decisions.

Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on
type of source, period of financing, cost of financing and the returns thereby.

Dividend decision - The finance manager has to take decision with regards to the net profit distribution

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of financial resources of a
concern. The objectives can be-

To ensure regular and adequate supply of funds to the concern.

To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share,
expectations of the shareholders.

To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at
least cost.
To ensure safety on investment, i.e. funds should be invested in safe ventures so that adequate rate of return can be
achieved.

To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained
between debt and equity capital

TYPES OF FINANCIAL MANAGEMENT

There are three main types of finance:

(1) personal

(2) corporate

(3) public/government

Personal finance is the process of planning and managing personal financial activities such as income generation,
spending, saving, investing, and protection. The process of managing one’s personal finances can be summarized in a
budget or financial plan.

Corporate finance -deals with the capital structure of a corporation, including its funding and the actions that
management takes to increase the value of the company. Corporate finance also includes the tools and analysis utilized
to prioritize and distribute financial resources.

The ultimate purpose of corporate finance is to maximize the value of a business through planning and implementation
of resources, while balancing risk and profitability
Public finance is the management of a country’s revenue, expenditures, and debt load through various government and
quasi-government institutions. This guide provides an overview of how public finances are managed, what the various
components of public finance are, and how to easily understand what all the numbers mean. A country’s financial
position can be evaluated in much the same way as a business’ financial statements

WEEK 2
Financial statements represent a formal record of the financial activities of an entity. These written reports quantify the
financial strength, performance, and liquidity of a company. A company’s financial statements can paint detailed
pictures about how the business is doing or performing. business has value because of its profitability, cash flow and
potential for future wealth.” The whole aim of accounting is to keep systematic records of financial transactions so they
can be communicated to the various stakeholders. And the main way this information is communicated to the relevant
parties is through financial statements. So, let us take a look at the features and the utmost importance of a financial
statement.

FINANCIAL STATEMENT
A financial statement is an organized and systematic representation of a collection of financial data. These statements
represent the financial performance of the entity and its current fiscal position as well. A financial statement is prepared
by following certain logical and consistent accounting principles, assumptions and methodologies.

So, the term financial statements generally refer to three important statements. They are:

i. The Balance Sheet (position statement)

The Profit and Loss Account (income statement)

ii. Cash Flow Statement Financial statements are prepared for a period of time which is arbitrarily one year. We call this
the accounting year/period.

So, these statements will reflect the monetary transactions for the said period. The data contained in them is a
combination of four aspects. Let us take a look

I. Recorded Facts: This is the information gathered from the accounting records. These accounts (cash account, debtors,
creditors, fixed asset account, etc.) are maintained at the original cost or historical cost. The marketable value is not
recorded. So, since such accounts are taken as a part of the statements, they do show the current fiscal condition of the
entity

II. Accounting Principles: Again, when preparing these statements certain accounting principles, standards, methods
have been followed. These get reflected in a financial statement. Incorporation of such accounting principles makes the
financial statement uniform, more reliable and comparable as well.

iii. Assumptions: When recording financial transactions an enterprise will make certain postulates or assumptions.

The three common ones are going concern, accrual, and consistency.

i. Personal Judgement: While the accounting principles, conventions and assumptions have to be followed, there are
certain things which are left to the judgment of the accountant. Like whether to defer expenses, provision for debts, a
method of inventory calculation (FIFO, LIFO, etc.). This personal judgment decisions of the accountant will be reflected in
the financial statements.

4.2 IMPORTANCE- Having a solid understanding of your business’s financial reports can help when it’s time to speak
with lenders and financial professionals about getting a line of credit or a small business loan. By analyzing your financial
statements, you can look across your organization and spot any areas of profitability or excessive cost you may need to
examine further When you thoroughly understand the economic drivers of your company’s financial performance, you
can optimize working capital and gain more insights. To drive the-profitable “business activities” to achieve more growth
and revenue. You can start to derive financial ratios from the statements that can indicate the condition of the business.

4.3 CHARACTERISTICS –

Qualitative Characteristics of Financial Statement

Financial statements are quantitative statements, based on numbers. However, the information they provide to the
users have some important qualitative characteristics. let us take a look.

· Understandability One of the most important features of a financial statement is that it should be easily
understood by the user. We assume that the user has a basic understanding of finance and accounting. So, the
information should be presented in such a manner that he understands and comprehends it. But no information about
materiality or relevance should be left out of the statement because it is deemed too complex. Even if the information is
difficult to understand it must be included if it is of importance.
 ● Relevance. The financial statements must contain relevant information for them to be useful to the users. For
such users, any information that helps their decision making about investing is useful information. Such
information should help them evaluate past, present or even future events. The information can be predictive or
confirmatory and usually both. Say for example information about the dividend paid in the last year is valuable
information for a potential investor. Similarly, information about the asset structure of the company can help a
user evaluate the future of a company.
● Reliability.The information communicated to the users will be worthless if it is not reliable and trustworthy. For
the information to be reliable it must be error-free and free of any form of material bias. Say, if the information
is important but a reliable estimate cannot be made. In such a case the information can be included in the notes
to accounts. So, if litigation is ongoing and the company predicts they will have to pay a fine. However, the
amount of the fine is not predictable. This is important information, so it should be disclosed.
● Comparability. Firstly, the users should be able to compare the financial statements of an enterprise over a
period of time (a few years). This will enable them to do trend analysis and better understand the finances of the
company. This is important for their investment decision.
● Another important qualitative characteristic is that the users should be made aware of the accounting policies
being followed. They should be informed if any major accounting policy change has taken place that has a
material effect on these statements. One way to ensure that the accounts are comparable over time is
stringently following the accounting standards. But the need for comparability should not tamper with the
company’s ability to represent their accounts in the best manner possible. The qualitative characteristics of
relevance and reliability dictate that if it is inappropriate to continue with the same policies, they should be
changed.

4.4 THE FINANCIAL STATEMENTS GENERALLY INCLUDE FIVE STATEMENT:

A Complete Set of Financial Statement is made up of five components, namely

• Income Statement- An accounting of sales, expenses, and net profit for a given period. an income statement depicts
what happened over a month, quarter, or year. It is based on a fundamental accounting equation (and shows the rate at
which the owner’s equity is changing for better or worse

●
 Balance Sheet- - A quantitative summary of a company's financial condition at a specific point in time, including assets,
liabilities and net worth. The first part of a balance sheet shows all the productive assets a company owns, and the
second part shows all the financing methods (such as liabilities and shareholders' equity).

Statement of Cash Flows- A summary of the actual or anticipated incomings and outgoings of cash in a firm over an
accounting period (month, quarter, year) • Notes to Financial Statement Notes to the financial statements disclose the
detailed assumptions made by accountants when preparing a company's: income statement, balance sheet, statement
of changes of financial position or statement of retained earnings. The notes are essential to fully understanding these
documents.

Statements of Changes in Equity A statement of changes in equity reflects all changes in equity between the beginning
and the end of the reporting period arising from transactions with owners in their capacity as owners (I e. owner
changes in equity) reflecting the increase or decrease in net assets in the period.
WEEK 3
ANALYZING FINANCIAL STATEMENTS

The financial statements of a company record important financial data on every aspect of a business’s activities. As such
they can be evaluated on the basis of past, current, and projected performance.

In general, financial statements are centered around generally accepted accounting principles (GAAP) in the U.S. These
principles require a company to create and maintain three main financial statements: the balance sheet, the income
statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting.
Public companies must follow GAAP standards which requires accrual accounting. 1 Private companies have greater
flexibility in their financial statement preparation and also have the option to use either accrual or cash accounting. 2
Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques
include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by
analyzing values of line items across two or more years. Vertical analysis looks at the vertical affects line items have on
other parts of the business and also the business’s proportions. Ratio analysis uses important ratio metrics to calculate
statistical relationships

Financial Statements

As mentioned, there are three main financial statements that every company creates and monitors: the balance sheet,
income statement, and cash flow statement. Companies use these financial statements to manage the operations of
their business and also to provide reporting transparency to their stakeholders. All three statements are interconnected
and create different views of a company’s activities and performance.

Balance Sheet

The balance sheet is a report of a company's financial worth in terms of book value. It is broken into three parts to
include a company’s assets, liabilities, and shareholders' equity. Short-term assets such as cash and accounts receivable
can tell a lot about a company’s operational efficiency. Liabilities include its expense arrangements and the debt capital
it is paying off. Shareholder’s equity includes details on equity capital investments and retained earnings from periodic
net income. The balance sheet must balance with assets minus liabilities equaling shareholder’s equity. The resulting
shareholder’s equity is considered a company’s book value. This value is an important performance metric that increases
or decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue a company earns against the expenses involved in its business to
provide a bottom line, net income profit or loss. The income statement is broken into three parts which help to analyze
business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to
identify gross profit. It then moves to operating profit which subtracts indirect expenses such as marketing costs, general
costs, and depreciation. Finally, it ends with net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin,
and net profit margin which each divide profit by revenue. Profit margin helps to show where company costs are low or
high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from operating activities, investing activities,
and financing activities. Net income is carried over to the cash flow statement where it is included as the top line item
for operating activities. Like its title, investing activities include cash flows involved with firmwide investments. The
financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much
cash a company has available.

Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a
company. Free cash flow statements arrive at a net present value by discounting the free cash flow a company is
estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially
going public.

● Financial statement analysis is used by internal and external stakeholders to evaluate business performance and
value.
● Financial accounting calls for all companies to create a balance sheet, income statement, and cash flow
statement which form the basis for financial statement analysis.
● Horizontal, vertical, and ratio analysis are three techniques analysts use when analyzing financial statements.

Vertical, horizontal and Ratio analysis

Horizontal analysis compares account balances and ratios over different time periods. Horizontal analysis (also known
as trend analysis) is a financial statement analysis technique that shows changes in the amounts of corresponding
financial statement items over a period of time. It is a useful tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest period is usually used as the base
period and the items on the statements for all later periods are compared with items on the statements of the base
period. The changes are generally shown both in dollars and percentage.

Example:

current assets 2008 = $550 000

2007 = $ 533 000 increase(decrease) = $17 000 percent = 3.2%

550 000 - 533 000 =$17 000 { $17 000 / 533 000} x 100 = 3.2%

Vertical analysis restates each amount in the income statement as a percentage of sales. This analysis gives the
company a heads up if cost of goods sold or any other expense appears to be too high when compared to sales.
Reviewing these comparisons allows management and accounting staff at the company to isolate the reasons and take
action to fix the problem(s).

Vertical analysis expresses each amount on a financial statement as a percentage of another amount.

· The vertical analysis of a balance sheet results in every balance sheet amount being restated as a percent of total
assets.

· The vertical analysis of an income statement results in every income statement amount being restated as a
percent of net sales.

Example of Vertical Analysis of a Balance Sheet

If a company's inventory is $100,000 and its total assets are $400,000 the inventory will be expressed as 25% ($100,000
divided by $400,000). If cash is $8,000 then it will be presented as 2% ($8,000 divided by $400,000). The total of the
assets' percentages will add up to 100%. If the accounts payable are $88,000 they will be restated as 22% ($88,000
divided by $400,000). If owner's equity is $240,000 it will be shown as 60% ($240,000 divided by $400,000). The sum of
the liabilities and owner's equity will also be 100%.

Example of Vertical Analysis of an Income Statement

If a company's net sales were $ 1, 000,000 they will be presented as 100% ($1,000,000 divided by $1,000,000). If the cost
of goods sold amount is $780,000 it will be presented as 78% ($780,000 divided by sales of $1,000,000). If interest
expense is $50,000 it will be presented as 5% ($50,000 divided by $1,000,000).
FINANCIAL PERFORMANCE

Financial statements are maintained by companies daily and used internally for business management. In general both
internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and
evaluating overall financial performance.

When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate
horizontal analysis. Each financial statement is also analyzed with vertical analysis to understand how different
categories of the statement are influencing results. Finally, ratio analysis can be used to isolate some performance
metrics in each statement and also bring together data points across statements collectively.

COMMON RATIO METRICS:

Income statement: gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest
coverage. Income Statement is also known as the Profit and Loss Statement or the P&L statement.

It is one of the most important financial statements showing company’s position over a specific accounting period in
terms of expenses and revenues. It categorizes the sources of revenue and reasons for expenses in detail under
various headings.

Basic equation: Profit = Revenue - Expenses

It generally derives the net income or loss for the period by deducting total expenses from the revenue. Further, a
look at EPS is extracted with the help of P&L statement by dividing the net income with the number of shares
outstanding.

Components of the P&L Statement /or Income Statement

· Revenue from Operations- it represents revenue from sales of products and services. In concern of financial
companies this revenue may be in form of interest and financial services.

· Other income- it consists of the income from interest except for financial companies, net gain or loss on sale of
investments, dividend income and any other non-operating income.

· Expenses- it is the cost incurred in course of business resulting in outflow of money.

· Material expenses- it is cost of raw material consumed in production process

· Finance cost-it includes the interest and other borrowing expenses

· Employee expenses- it consists of salaries, provident fund, welfare expenses etc.

· Depreciation expense-it is the amount deducted as an expense with uses of fixed asset losing its value over
lifetime

Selling and distribution expenses-it includes expenses like sales commission, advertising and promotional cost,
transportation cost, salaries of personnel, etc.

· Provisions-provisions are created as reserves to meet various unexpected obligation or demand like sales
allowances, bad debts, pensions, audit expenses etc.

Cash Flow: Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be
shown on a per share basis.

What is Earnings Before Interest, Taxes, Depreciation, and Amortization – EBITDA?

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company's overall financial
performance and is used as an alternative to net income in some circumstances. EBITDA, however, can be misleading
because it strips out the cost of capital investments like property, plant, and equipment.

This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings.
Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the
influence of accounting and financial deductions.

Simply put, EBITDA is a measure of profitability. While there is no legal requirement for companies to disclose their
EBITDA, according to the U.S. generally accepted accounting principles (GAAP), it can be worked out and reported using
the information found in a company's financial statements.

The earnings, tax, and interest figures are found on the income statement, while the depreciation and amortization
figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate
EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT) and then add back
depreciation and amortization.

● EBITDA is a widely used metric of corporate profitability

● EBITDA can be used to compare companies against each other and industry averages.
● Also, EBITDA is a good measure of core profit trends because it eliminates some extraneous factors and allows a
more "apples-to-apples" comparisons.
● EBITDA can be used as a shortcut to estimate the cash flow available to pay the debt of long-term assets.

EBITDA=Net Income +Interest +Taxes +D+A where: D=Depreciation A=Amortization

EBITDA=Operating Profit + DE + AE where: DE=Depreciation expense AE=Amortization expense

EBITDA vs. EBT and EBIT

EBIT (earnings before interest and taxes) is a company's net income before income tax expense and interest expense
have been deducted. EBIT is used to analyze the performance of a company's core operations without tax expenses and
the costs of the capital structure influencing profit. The following formula is used to calculate EBIT:

EBIT=Net Income +Interest Expense +Tax Expense

What Is Return on Assets—ROA?

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager,
investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings.
Return on assets is displayed as a percentage.

● Return on Assets (ROA) is an indicator of how well a company utilizes its assets, by determining how profitable a
company is relative to its total assets.
● ROA is best used when comparing similar companies or comparing a company to its previous performance.
● ROA takes into account a company’s debt, unlike other metrics, such as Return on Equity (ROE).

The Basics of Return on Assets—ROA

Businesses (at least the ones that survive) are ultimately about efficiency: squeezing the most out of limited resources.
Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to
earn them cuts to the very feasibility of that company's’ existence. Return on assets (ROA) is the simplest of such
corporate bang-for-the-buck measures.

ROA is calculated by dividing a company’s net income by total assets. As a formula, it would be expressed as:

Return on Assets=Total Assets /Net Income

What Is Return on Equity (ROE)?

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity.
Because shareholders' equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.
ROE is considered a measure of how effectively management is using a company’s assets to create profits.

● Return on equity (ROE) measures how effectively management is using a company’s assets to create profits.
● Whether a ROE is considered satisfactory will depend on what is normal for the industry or company peers.
● As a shortcut, investors can consider a ROE near the long-term average of the S&P 500 (14%) as an acceptable
ratio and anything less than 10% as poor.

Net profitability: Net Income/Net Sales—measures the overall profitability of the company, or how much is being
brought to the bottom line. Strong gross profitability combined with weak net profitability may indicate a problem with
indirect operating expenses or non-operating items, such as interest expense. In general terms, net profitability shows
the effectiveness of management.

Comprehensive: Return on assets (ROA) and return on equity (ROE). Also DuPont Analysis.

Balance sheet: asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity. The
balance sheet is one of the major fundamental financial statements used to serve various purposes of financial analysis,
accounting, and financial modelling.
The balance sheet shows the financial condition of a business at a specific point of time categorizing financial sheet of
the firm under two major heads “Equity and Liabilities” and Assets.

Components of the balance sheet:

Equity and liabilities-represents what the firm owes, the burden of debt, such as Shareholders’ funds, non-current
liabilities and current liabilities.

Equity-is a degree of ownership in any asset after deducting all the debts associated with that asset. It represents the
shareholders’ stake/ownership in the company.

Liabilities are defined as a company’s financial debts or obligations that arise during the course of business operations.

Shareholders’ funds-represent the contribution made by shareholders in the form of financing the business. It includes
share capital and reserves as well as surplus

Share capital-it consists of funds raised by a company in exchange for shares issued or either equity capital or
preference capital of stock.

Reserves and surplus- it represents the accumulated profit or retained earning kept as provision. It comprises of general
reserves, surplus, capital reserves, debenture redemption reserves, etc.

WEEK 4
The Investment Pyramid is an asset allocation tool that investors can use in

selecting different assets classes to diversify their portfolio according to their risk tolerance and expected return.

The base of the pyramid contains the lowest risk investments. These investments have the

lowest risk but they generate the lowest rates of returns. These investments are represented by the pyramid’s wide base
as low-risk investments should in general constitute the bulk of your portfolio. These investments include cash and cash
equivalents, money market account and money market funds, treasury bills, certificate of deposits as well as high-rated
government and corporate bonds
Middle of the Pyramid: Moderate Risk. The middle of the pyramid contains investments of a moderate risk. Although
they are riskier than the assets at the bottom of the pyramid, these investments should still be relatively safe. These
investments generally offer a stable return and capital appreciation in the long term. These investments include income
stocks and growth stocks as well as mutual funds, index funds and real estate.

Top of the Pyramid: High Risk. The top of the pyramid represents high risk investments. These investments may yield
large gains but may also yield large losses. Because of their speculative nature, you should only allocate money to high-
risk investments if you can afford to lose them without serious repercussions. These investments include futures,
options, commodities, penny stocks as well as alternative investments like precious metals and gems, collectibles, peer-
to-peer lending and cryptocurrencies.

The purpose of Financial Statement Analysis (Ratio Analysis) is to evaluate management performance in Profitability,
Efficiency and Ri k Although financial statement information is historical, it is used to project future performance.
Financial Statement Analysis (Ratio analysis) can be done using three methods.

Three Methods:

Vertical Analysis -shows relationship of each item to a base amount on financial statements. Where in Income
statements, each item is expressed as percentage of net sales, while in the balance sheet, each item is expressed as
percentage of total assets.

Historical and trend analysis-compares two financial statements to determine dollar and percentage changes. It
computes the dollar changes and percentage changes.

Ratio Analysis – puts numbers in perspective with other numbers. Helps control for different size of firms.

Ratios provide meaningful relationships between individual values in the financial statements. Ratio analysis is a
mathematical method in which different financial ratios of a company, taken from the financial sheets and other publicly
available information, are analyzed to gain insights into company’s financial and operational details.

Ratio Analysis of Financial Statements – This is the most comprehensive guide to Ratio Analysis / Financial Statement
Analysis

4.2 Before going further, it is important to understand the terms that we will often meet in making a decision in a
business venture.

WHAT IS ‘RISK AND RETURN’?

The risk-return tradeoff states that the potential return rises with an increase in risk. According to the risk-return
tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the
effects/implications of an activity with respect to something that people value (such as health, well-being, wealth,
property or the environment), often focusing on negative, undesirable consequences.

In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand
with increased risk.

Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and
market risk.

• Market risk is what happens when there is a substantial change in the particular marketplace in which a company
competes.
• Credit risk is when companies give their customers a line of credit; also, a company's risk of not having enough funds
to pay its bills.

• Operational risks emerge as a result of a company's regular business activities and include fraud, lawsuits, and
personnel issues.

• Liquidity risk refers to how easily a company can convert its assets into cash if it needs funds; it also refers to its daily
cash flow.

Return refers to either gains and losses made from trading a security. The return on an investment is expressed as a
percentage and considered a random variable that takes any value within a given range. Several factors influence the
type of returns that investors can expect from trading in the markets.

Yield - The most common form of return for investors is the periodic cash flows(income) on the investment, either
interest from bonds or dividends from stock

Capital Gain – the appreciation (or depreciation) in the price of the asset, commonly called the capital Gain (Loss).

Diversification allows investors to reduce the overall risk associated with their portfolio but may limit potential returns.
Making investments in only one market sector may, if that sector significantly outperforms the overall market, generate
superior returns, but should the sector decline then you may experience lower returns than could have been achieved
with a broadly diversified portfolio.

4.3 DCF or Discounted Cash Flow mathematics are very closely related to finance that is familiar to most people:
calculations for interest growth and compounding.

The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the
future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest,
any amount of money is worth more the sooner it is received.

1. Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of
return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present
value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash
flows, whether they be earnings or obligations investments are represented by i
Example the value in the present of a sum of money, in contrast to some future value it will have when it has been
invested at compound interest. "$110 due in 12 months' time has a present value of $100 today, if invested at an annual
rate of 10 percent"

PV Formula and Calculation

where: FV=Future Value , r=Rate of return, n=Number of periods

2. Future Value Compared with PV- A comparison of present value with future value (FV) best illustrates the principle of
the time value of money and the need for charging or paying additional risk-based interest rates. Simply put, the money
today is worth more than the same money tomorrow because of the passage of time. In many scenarios, people would
rather have a $1 today versus that same $1 tomorrow. Future value can relate to the future cash inflows from investing
today's money, or the future payment required to repay money borrowed today.

Future Value vs. Present Value Future value (FV) is the value of a current asset at a specified date in the future based on
an assumed rate of growth. The FV equation assumes a constant rate of growth and a single upfront payment left
untouched for the duration of the investment. The FV calculation allows investors to predict, with varying degrees of
accuracy, the amount of profit that can be generated by different investments.

Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return.
Present value takes the future value and applies a discount rate or the interest rate that could be earned if invested.

Future value tells you what an investment is worth in the future while the present value tells you how much you'd need
in today's dollars to earn a specific amount in the future

NET PRESENT VALUE (NPV)

What is Net Present Value (NPV)? Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning
to analyze the profitability of a projected investment or project.

Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust for the risk of an
investment opportunity, and (2) to account for the time value of money (TVM).
A positive net present value indicates that the projected earnings generated by a project or investment - in present
dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will
be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net
Present Value Rule, which dictates that only investments with positive NPV values should be considered.

NET PRESENT VALUE VS. INTERNAL RATE OF RETURN

Internal rate of return (IRR) is very similar to NPV except that the discount rate is the rate that reduces the NPV of an
investment to zero. This method is used to compare projects with different lifespans or amount of required capital.

For example, IRR could be used to compare the anticipated profitability of a three-year project that requires a $50,000
investment with that of a 10-year project that requires a $200,000 investment. Although the IRR is useful, it is usually
considered inferior to NPV because it makes too many assumptions about reinvestment risk and capital allocation.

What Is a Rate of Return (ROR).

A rate of return (ROR) is the net gain or loss of an investment over a specified time period, expressed as a percentage of
the investment’s initial cost. When calculating the rate of return, you are determining the percentage change from the
beginning of the period until the end.

The Formula for Rate of Return (ROR)

The formula to calculate the rate of return (ROR) is:

Rate of return= [Initial value (Current value −Initial value)] ×100

This simple rate of return is sometimes called the basic growth rate, or alternatively, return on investment (ROI). If you
also consider the effect of the time value of money and inflation, the real rate of return can also be defined as the net
amount of discounted cash flows (DCF) received on an investment after adjusting for inflation The rate of return using
discounted cash flows is also known as the internal rate of return (IRR). The internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows from a particular project or investment equal to zero.

IRR calculations rely on the same formula as NPV does and utilizes the time value of money (using interest rates).

The formula for IRR is as follow

0 = CF0 + CF1 + CF2 + … + CF n

(1 + IRR)1 (1 + IRR)2 (1 + IRR)n

Where:

CF0 = initial investment or outlay

CF, CF1, CF2, CF n = Cash Flows

n = each period (year)

N = holding period (how many years will the project go)

NPV = Net Present Value

IRR = Internal Rate of Return

WEEK 5
MEANING AND CONCEPT OF CAPITAL STRUCTURE:

The term ‘structure’ means the arrangement of the various parts. So capital structure means the arrangement of capital
from different sources so that the long-term funds needed for the business are raised. Thus, capital structure refers to
the proportions or combinations of equity share capital, preference share capital, debentures, long-term loans, retained
earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its
business.

Capital structure refers to the proportion of long-term debt and equity in the total capital of a company. On the other
hand, financial structure refers to the net worth or owners’ equity and all liabilities (long-term as well as short-term)

The term capitalization means the total amount of long-term funds at the disposal of the company, whether raised from
equity shares, preference shares, retained earnings, debentures, or institutional loans.

IMPORTANCE OF CAPITAL STRUCTURE: The importance or significance of Capital Structure:

1. Increase in value of the firm: A sound capital structure of a company helps to increase the market price of shares and
securities which, in turn, lead to increase in the value of the firm.

2. Utilization of available funds: A good capital structure enables a business enterprise to utilize the available funds
fully.

A properly designed capital structure ensures the determination of the financial requirements of the firm and raise the
funds in such proportions from various sources for their best possible utilization.

A sound capital structure protects the business enterprise from overcapitalization and under capitalization.

3. Maximization of return: A sound capital structure enables management to increase the profits of a company in the
form of higher return to the equity shareholders i.e., increase in earnings per share. This can be done by the mechanism
of trading on equity i.e., it refers to increase in the proportion of debt capital in the capital structure which is the
cheapest source of capital. If the rate of return on capital employed (i.e., shareholders’ fund + long- term borrowings)
exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on equity.
4. Minimization of cost of capital: A sound capital structure of any business enterprise maximizes shareholders’ wealth
through minimization of the overall cost of capital. This can also be done by incorporating long-term debt capital in the
capital structure as the cost of debt capital is lower than the cost of equity or preference share capital since the interest
on debt is tax deductible.

5. Solvency or liquidity position: A sound capital structure never allows a business enterprise to go for too much raising
of debt capital because, at the time of poor earning, the solvency is disturbed for compulsory payment of interest to the
debt-supplier.

6. Flexibility: A sound capital structure provides a room for expansion or reduction of debt capital so that, according to
changing conditions, adjustment of capital can be made.

7. Undisturbed controlling: A good capital structure does not allow the equity shareholders control on business to be
diluted.

8. Minimization of financial risk: If debt component increases in the capital structure of a company, the financial risk
(i.e., payment of fixed interest charges and repayment of principal amount of debt in time) will also increase. A sound
capital structure protects a business enterprise from such financial risk through a judicious mix of debt and equity in the
capital structure.

FACTORS DETERMINING CAPITAL STRUCTURE:

The following factors influence the capital structure decisions:

1. Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Capital is one of
the basic factors of production along with land and labor. It is the accumulated assets of a business that can be used to
generate income for the business.
· Capital includes all goods that are made or created by humans and used for producing goods or services.

· Capital can include physical assets, such as a production plant, or financial assets, such as an investment portfolio.

· Some treat the knowledge, skills and abilities that employees contribute to the generation of income as human capital.

· Capital can also refer to money invested in a business to purchase assets. Businesses can raise capital through owner
contributions of cash or property, which are called equity contributions, or through loans, called loan capital.

2. Risk in variation of earnings. The higher the debt content in the capital structure of a company, the higher will be the
risk of variation in the expected earnings available to equity shareholders. If return on investment on total capital
employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the shareholders get a higher return.
On the other hand, if interest rate exceeds return on investment, the shareholders may not get any return at all.

3. Cost of capital means cost of raising the capital from different sources of funds. It is the price paid for using the
capital. A business enterprise should generate enough revenue to meet its cost of capital and finance its future growth.
The finance manager should consider the cost of each source of fund while designing the capital structure of a company

TYPES OF CAPITAL

1. Financial Capital

The most common forms of financial capital are debt and equity.

· Debt is a loan or financial obligation that must be repaid in the future.

· Equity is an ownership stake in a company, and equity investors will receive the residual value of the company in the
event it is sold or wound-down. Unlike debt, it does not have to be repaid and doesn’t have an interest expense
associated with it.

Equity is used to fund the business and purchase assets to generate revenue.

2. Human: Human capital is used by businesses to create products and perform services that can be used to generate
revenue for the company. Companies don’t “own” people they way they do other assets.

The most common types of human capital are intellectual and skills/talents.

3. Natural capital can also be used by businesses to generate income and increase production. Many businesses use
natural resources such as water, wind, solar, animals, trees, plants, and crops to operate their company and increase
value over time.

4. Control: The consideration of retaining control of the business is an important factor in capital structure decisions. If
the existing equity shareholders do not like to dilute the control, they may prefer debt capital to equity capital, as
former has no voting rights.
5.Trading on equity: The use of fixed interest- bearing securities along with owner’s equity as sources of finance is
known as trading on equity. It is an arrangement by which the company aims at increasing the return on equity shares
by the use of fixed interest-bearing securities (i.e., debenture, preference shares etc.).If the existing capital structure of
the company consists mainly of the equity shares, the return on equity shares can be increased by using borrowed
capital. This is so because the interest paid on debentures is a deductible expenditure for income tax assessment and
the after-tax cost of debenture becomes very low. Any excess earnings over cost of debt will be added up to the equity
shareholders. If the rate of return on total capital employed exceeds the rate of interest on debt capital or rate of
dividend on preference share capital, the company is said to be trading on equity.

6. Government policies: Capital structure is influenced by Government policies, rules and regulations of SEBI and lending
policies of financial institutions which change the financial pattern of the company totally. Monetary and fiscal policies of
the Government will also affect the capital structure decisions.

7. Size of the company: Availability of funds is greatly influenced by the size of company. A small company finds it
difficult to raise debt capital. The terms of debentures and long-term loans are less favorable to such enterprises. Small
companies have to depend more on the equity shares and retained earnings.

8. Needs of the investors: While deciding capital structure the financial conditions and psychology of different types of
investors will have to be kept in mind. For example, a poor or middle- class investor may only be able to invest in equity
or preference shares which are usually of small denominations, only a financially sound investor can afford to invest in
debentures of higher denominations. A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility: The capital structures of a company should be such that it can raise funds as and when required. Flexibility
provides room for expansion, both in terms of lower impact on cost and with no significant rise in risk profile

10. Period of finance: The period for which finance is needed also influences the capital structure. When funds are
needed for long-term (say 10 years), it should be raised by issuing debentures or preference shares. Funds should be
raised by the issue of equity shares when it is needed permanently.

11. Nature of business: It has great influence in the capital structure of the business, companies having stable and
certain earnings prefer debentures or preference shares and companies having no assured income depends on internal
resources.

12. Legal requirements: The finance manager should comply with the legal provisions while designing the capital
structure of a company.

13. Purpose of financing: Capital structure of a company is also affected by the purpose of financing. If the funds are
required for manufacturing, purposes, the company may procure it from the issue of long- term sources. When the
funds are required for nonmanufacturing purposes i.e., welfare facilities to workers, like school, hospital etc. the
company may procure it from internal sources.
14. Corporate taxation: When corporate income is subject to taxes, debt financing is favorable. This is so because the
dividend payable on equity share capital and preference share capital are not deductible for tax purposes, whereas
interest paid on debt is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest charges
reduces the cost of debt funds.

15. Cash inflows: The selection of capital structure is also affected by the capacity of the business to generate cash
inflows. It analyses solvency position and the ability of the company to meet its charges.

16. Provision for future: The provision for future requirement of capital is also to be considered while planning the
capital structure of a company.

17. EBIT-EPS analysis: If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT is high
from EPS point of view, debt financing is preferable to equity. If ROI is less than the interest on debt, debt financing
decreases ROE. When the ROI is more than the interest on debt, debt financing increases ROE.

Debt- the financial form of borrowing. It could be short-term such as in bank loans or long-term such as in corporate
bonds. It is a major type of financial leverage used by firms

Leasing- another form of financial leverage and may be used in place of debt financing. The opportunity cost of lease
financing is the after-tax cost of debt, since both are tax deductible

Financial Leverage creates additional risk called financial risk which reflects the likelihood of bankruptcy as a firm’s
use of debt as well as the use of other fixed cost capital rises. Rising Financial Risk causes rise in debt (Rd) and
therefore WACC to rise.

Leverage refer to the amount of debt a firm uses to finance its business / assets. It arises from the existence of fixed
cost It is an investment strategy to use borrowed money If a business is leveraged, it means that the firm has used
borrowed money to finance the purchase of its assets.
1. Operating Leverage- it arises with the presence of firm’s fixed operating costs such as salaries, rent, depreciation,
utility expense, etc.

2. Financial Leverage – it arises with the presence of firm’s fixed financing costs such as interest expenses on debt and
preference shares.

3. Combined Leverage- product of operating and financial leverage.

ANALYSIS OF CAPITAL STRUCTURE

Capital Structure with EBIT - EPS analysis EBIT (Earnings before interest and tax)

EBT (Earnings before tax )

EAT (earnings after tax)

EPS (Earnings per share)

Or:

Sales – Variable cost = Contribution

Contribution – Fixed cost = Earning before Interest and tax (EBIT)

Earning before Interest and Tax – Interest = Earning before Tax (EBT)

Earning before Tax – Tax = Earnings after tax (EAT)

Earnings per share = Earnings After tax (EAT) / Number of Shares

A percentage change in the profits resulting from a percentage change in the sales is called Degree of Operating
Leverage while in the Financial Leverage, a percentage change in taxable profit is the result of percentage change in
EBIT.

Trading on Equity is not possible while the company is on operating leverage, while Trading on equity is possible only
when the company uses Financial leverage under Financial leverage.

Operating leverage depends upon fixed costs and variable costs while Financial leverage depends upon the operating
profits.
Tax rates and interest rates will not affect the operating leverage while change due to tax rate and interest rate will
affect the Financial leverage.

CHANGES AFFECTING OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Degree of Operating Leverage = Contribution / EBIT

Degree of Operating Leverage = % change in EBIT / % change in sales

Degree of financial leverage = EBIT /EBT

Degree of Financial Leverage = % change in EPS / % change in EBIT

Degree of Combined Leverage = OL x FL

Degree of combined leverage = % change in EPS / % change in Sales

PATTERNS OF CAPITAL STRUCTURE

I. Equity share capital only

II. Equity share capital and preferential share capital

III. Equity share capital and long- term debt

IV. Equity, preferential share capital and long- term debt

CALCULATION OF EARNINGS AVAILABLE TO EQUITY SHARE HOLDERS

Determine which alternative is best to adopt as capital structure.

Steps to follow:

1) Given the data, begin by determining the EBIT or Earnings Before Interest and Taxes

2) Subtract interest on Debt

3) The difference is the EAT or Earnings after Tax

4) Subtract Preferential Dividends or profits available to share/equity holders

5) Find EPS or Earnings per Share from the formula:

EPS = Earnings available to Equity shareholders/ Number of Equity Shares Or if no shareholders, use: EPS = _ _EAT_ _ /
No. of Equity Shares

Sample Problem: Alison Ltd., a widely known company is considering a major expansion of its production facilities and
the following financing alternatives are available

Expected rate of return before tax is 20%. corporate taxation is 35%. Which of the alternatives are you going to you
choose?
Solution:

1) determine EBIT for each alternative $1 000 000 (0.20) = 200 000

a) Find the Interest on debentures @12%=0.12 from company C and D

(200 000) (0.12) = 24 000 for company C

(500 000) (0.12) = 60 000 for company D

2) Subtract interest on debt (EBT): there’s no interest on debt for Company A and B

200 000 -24 000 = 176 000

200 000–60 000 = 140 000

3) from EBT subtract tax @35%

(200 000) (0.35) = 70 000

(200 000) (0.35) = 70 000

(176 000) (0.35) = 61 600

(140 000) (0.35) = 49 000

4) subtract the preferential share of 10% from the companies that give the option, B and C from EAT

(500 000) (0.10) = 50 000 (130 000) – (50 000) = 80 000

(300 0) (0.10) = 30 000 (114 400) – (30 000) = 84,400

5) Find the total number of shares for each alternative: @$10/share

1 000 000 500 000 500 000 500 000

10 10 10 10

=100 000 50 000 50 000 50 000

6) EPS = EAT/ No. of Shares (for each of the company)

130 000 80 000 84 000 84 000

100 000 50 000 50 000 50 000

1.3 1.6 1.68 1.82

Company D has the highest EPS, so choose company D

Financial Leverage magnifies gains/losses to shareholders

Homemade Leverage- personal borrowing or lending to increase or decrease leverage respectively. (It

can be done by an individual shareholder when the company owner does not want to engaged in borrowing to finance
the business)
Increase Leverage: Stock (Unlevered) + Personal Borrowing = Levered Cash Flows (the shareholder

would borrow money so that he can receive a levered- cash flow (Personal borrowings to buy more stock

and receive levered cash flow)

Decrease Leverage: Stock(levered) + Personal Borrowing = Unlevered Cash flow (get a portion of your stocks from the
levered company and use the money to lend it to others company to receive an unlevered cash flow)

Homemade Leverage can be done on two assumptions, that

1) Individuals and corporations can borrow and lend money at the same interest rate; and

2) the borrowings are tax- free

Sample Problem

You own 150 shares of a company that is all equity financed with 9000 shares outstanding and each share sells for
$42.the EBIT is $40,000. The company is debating of converting into a 40% debt capital structure with 8% interest.
Ignore Tax

.We start our solution by looking at our balance sheet

Old Structure from the Balance Sheet Proposed Structure in the Balance Sheet

Asset = Debt + Equity Asset = Debt + Equity

=0 + (9 000) ($42) $378,000 = ($378,000) (0.40) + Equity

= $378,000

$ 378,000 - ($378,000) (0.40) = Equity

$ 378,000 - $151,200 = Equity

$ 226,800 = New Equity

New added shares = $226,800/$42 = 5,400 shares

What is the cash flow to you as a shareholder under both capital structure?

Solution: your shares = 150

Under the old structure, we look at your Income statement

$40 000/ 9000 = 4.44 $27,904 /5,400 = 5.167

Your cash flow = (Number of Shares) (Earnings per share)

= (150) ($4.44) = $666 (150) (5.167) = $775.05

WEEK 7
Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond valuation includes
calculating the present value of a bond's future interest payments, also known as its cash flow, and the bond's value
upon maturity, also known as its face value or par value. Because a bond's par value and interest payments are fixed, an
investor uses bond valuation to determine what rate of return is required for a bond investment to be worthwhile.

Understanding Bond Valuation

A bond is a debt instrument that provides a steady income stream to the investor in the form of coupon payments. At
the maturity date, the full face value of the bond is repaid to the bondholder. The characteristics of a regular bond
include:

● Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid to bondholders
semi-annually. The coupon rate is the fixed return that an investor earns periodically until it matures.
● Maturity date: All bonds have maturity dates, some short-term, others long-term. When a bond matures, the
bond issuer repays the investor the full face value of the bond. For corporate bonds, the face value of a bond is
usually $1,000 and for government bonds, the face value is $10,000. The face value is not necessarily the
invested principal or purchase price of the bond.
● Current Price: Depending on the level of interest rate in the environment, the investor may purchase a bond at
par, below par, or above par. For example, if interest rates increase, the value of a bond will decrease since the
coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will trade at a
discount, that is, below par. However, the bondholder will be paid the full- face value of the bond at maturity
even though he purchased it for less than the par value.

BOND VALUATION IN PRACTICE

Since bonds are an essential part of the capital markets, investors and analysts seek to understand how the different
features of a bond interact in order to determine its intrinsic value. Like a stock, the value of a bond determines whether
it is a suitable investment for a portfolio and hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon payments. The theoretical
fair value of a bond is calculated by discounting the present value of its coupon payments by an appropriate discount
rate. The discount rate used is the yield to maturity, which is the rate of return that an investor will get if s/he reinvested
every coupon payment from the bond at a fixed interest rate until the bond matures. It takes into account the price of a
bond, par value, coupon rate, and time to maturity.

Compounding and Discounting: The Foundation for All Time Value of Money Problems
All time value of money problems involved two fundamental techniques: compounding and discounting. Compounding
and discounting are processes used to compare dollars in our pocket today versus dollars we have to wait to receive at
some time in the future. Before we dive into the specific time value of money examples, let’s first review these basic
building blocks.

Compounding is about moving money forwards in time. It’s the process of determining the future value of an
investment made today and/or the future value of a series of equal payments made over time (periodic payments).

The initial investment compounds because it earns interest on the principal amount invested, plus it also earns interest
on the interest.

Discounting is about moving money backward in time. It’s the process of determining the present value of money to be
received in the future (as a lump sum and/or as periodic payments). Present value is determined by applying a discount
rate (opportunity cost) to the sums of money to be received in the future.

THE 5 COMPONENTS OF ALL-TIME VALUE OF MONEY PROBLEMS

Periods . The total number of compounding or discounting periods in the holding period.

Rate (i). The periodic interest rate or discount rate used in the analysis, usually expressed as an annual percentage.

Present Value (PV). Represents a single sum of money today.

Payment (PMT). Represents equal periodic payments received or paid each period. When payments are received, they
are positive, when payments are made, they are negative.

FUTURE VALUE - THE TIME VALUE OF MONEY TIMELINE

Time value of money problems can always be visualized using a simple horizontal or vertical timeline. When you’re first
learning how to solve time value of money problems, it’s often helpful to draw the 5 components of each problem out
on a timeline so you can visualize all of the moving pieces.
As shown below, the 5 components of the time value of money problems (PV, FV, PMT, i, n) can be illustrated on a
simple horizontal timeline. It’s also common to see a vertical timeline as well:

When drawing out a timeline for a time value of money problem, simply fill in the 4 known components so you can
clearly identify and solve for the unknown component. Here’s a timeline for the example compounding problem above
showing the 4 known components

COUPON BOND VALUATION

Calculating the value of a coupon bond factors in the annual or semi-annual coupon payment and the par value of the
bond.

The present value of expected cash flows are added to the present value of the face value of the bond as seen in the
following formula:

where:

C=future cash flows, that is, coupon payments

r=discount rate, that is, yield to maturity

F=face value of the bond

t=number of periods

T=time to maturity

For example, let’s find the value of a corporate bond with an annual interest rate of 5%, making semi-annual interest
payments for 2 years, after which the bond matures and the principal must be repaid. Assume a YTM of 3%.

F = $1000 for corporate bond

Coupon rate annual = 5%, therefore, Coupon rate semi-annual = 5%/2 = 2.5%

C = 2.5% x $1000 = $25 per period

t = 2 years x 2 = 4 periods for semi-annual coupon payments

T = 4 periods

Present value of semi-annual payments = 25/ (1.03)1 + 25/ (1.03)2 + 25/ (1.03)3 + 25/ (1.03)4

= 24.27 + 23.56 + 22.88 + 22.21

= 92.93

Present value of face value = 1000/ (1.03)4

= 888.49

Therefore, value of bond = $92.93 + $888.49 = $981.42

ZERO-COUPON BOND VALUATION

A zero-coupon bond makes no annual or semi-annual coupon payments for the duration of the bond. Instead, it is sold
at a deep discount to par when issued. The difference between the purchase price and par value is the investor’s
interest earned on the bond. To calculate the value of a zero-coupon bond, we only need to find the present value of the
face value.

Following our example above, if the bond paid no coupons to investors, its value will simply be:

$1000/ (1.03)4 = $888.49

Under both calculations, a coupon-paying bond is more valuable than a zero-coupon bond.

ANNUITY:

An annuity is a cashflow, either income or outgoings, involving the same sum in each period. An annuity is the payment
or receipt of equal cashflows per period for a specified amount of time. For example, when a company set aside a fixed
sum each year to meet a future obligation, it is using annuity.

The time period between two successive payments is called ‘payment period or ‘rent period. The word ‘annuity’ is
broader in sense, which includes payments which can be annual, semiannual, quarterly or any other fixed length of time.
Annuity does not necessarily mean payment taken to be one year.

Future Value of Ordinary Annuity – An ordinary annuity is one in which the payments or receipts occur at the end of
each period. In a five- year ordinary annuity, the last payment is made at the end of the fifth year.
Where,

A = Annual or future value which is the sum of the compound amounts of all payments

P = Amount of each installment

i = Interest rate per period

n = Number of periods

PRESENT VALUE FORMULA FOR BOND VALUATION

Present Value n = Expected cash flow in the period n/ (1+i) n

Here,

i = rate of return/discount rate on bond

n = expected time to receive the cash flow

By this formula, we will get the present value of each individual cash flow t years from now. The next step is to add all
individual cash flows.

Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n

Example: A bond that matures in four years, has a coupon rate of 10% and has a maturity value of US$ 100. The bond
pays interest annually and has a discount rate of 8%.

Solution:

The cash flow of this bond is:

The present value of each cash flow is:

Year 1 – Present Value (PV1) = $10/ (1.08)1 = US$ 9.26

Year 2 – Present Value (PV2) = $10/ (1.08)2 = US$ 8.57

Year 3 – Present Value (PV3) = $10/ (1.08)3 = US$ 7.94

Year 4 – Present Value (PV4) = $110/ (1.08)4 = US$ 80.85

Now adding all cash flows

Thus, the Present Value of Bond = 9.25+8.57+7.94+80.85 = US$ 106.62

There are other approaches to bond valuation such as the relative price approach, arbitrage-free pricing approach, and
traditional approach. But this present value approach is the most widely used approach to bond valuation.

Example:

Mr. X is depositing $2,000 in a recurring bank deposit which pays 9% p.a. compounded interest. How much amount Mr.
X will get at the end of 5th year.

Illustration 12:

Find the future value of ordinary annuity Rs. 4,000 each six months for 15 years at 5% p.a. compounded semiannually.

Solution:

A = P/I [1+I) n-1]

Where, P = Rs. 4,000

i = 0.05/2 = 0.025

n = 15 x 2 =30

A = 4,000/0.025 [(1 + 0.025)30 – 1]

A = 4,000/ 0.025 [(1.025)30-1]

A = 4,000 /0.025 (2.094 – 1)

A= 1,60,000 x 1.094 = Rs. 1,75,040

PRESENT VALUE OF ORDINARY ANNUITY:

The present value of an ordinary annuity is the sum of the present value of a series of equal periodic payments.

V = P/I [1-(1+i)-n]

Where, V = Present value of annuity

Illustration 13:

Mr. Y is depositing $ 8,000 annually for 4 years, in a post office savings bank account at an interest of 5% p.a. Find the
present value of annuity.

Solution:

V = P/I [1- (1+i)-n]

P = $. 8,000 i = 0.05 n=4

PV = 8,000/0.05 [1-(1+0205)-4]

= 1,60,000 [1 – (1.05) -4]

PV = 1,60,000 x (1 – 0.8226)

PV = 1,60,000 x .1774 = $. 28,384

PRESENT VALUE OF DEFERRED ANNUITY – An annuity where the first payment is delayed beyond one year, the annuity
is called a ‘deferred annuity’.

The present value ‘PV’ of a deferred annuity ‘P’ to begin at the end of ‘m’ years and to continue for ‘n’ years is given
by:

PV = P * { 1 – (1 + i) ^ - (n + d) / i - 1-(1 + i) ^-d / i } if the first payment is due at the end of a specified interval, the
formula for d is d= m*k -1

If the first payment is due on the next interval, the formula for d is d= m*k

Example:

Find the present value of a deferred annuity on regular payment of $1 000 semi-annually for 3 years that is deferred
for 1 year at a rate of 2.5% compounded semi-annually.

Solution: Specify the variables from the situation

P = $1 000 r = 2.5% = 0.025 k = 1 * 2 (semi-annually) = 2 i = r/k = 0.025 / 2 = 0.0125

t = 3 years n = t * k = 3*2 = 6 m = 1year d = m*k = 1 * 2 = 2

Substitute the values to the formula:

PV = P * { 1 – (1 + i) ^ - (n + d) / i - 1-(1 + i) ^-d / i }

PV = 1000 * { 1-– (1 + 0.0125) ^ - (6 + 2) / 0.0125 - 1-(1 + i0.0125) ^-2 / 0.0125}

PV = 1000 ( 7.568 -1.963) = 5606.01

WEEK 8
A Stock (also known as equity) is a security that represents the ownership of a fraction of a corporation.
Units of stock are called "shares."
Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well,
and are the foundation of many individual investors' portfolios. Stocks are securities that represent an
ownership share in a company. For companies, issuing stock is a way to raise money to grow and invest in
their business. ... When you own stock in a company, you are called a shareholder because you share in
the company's profits. A stock is a general term used to describe the ownership certificates of any
company. A share, on the other hand, refers to the stock certificate of a particular company. Holding a
particular company's share makes you a shareholder.

Description: Stocks are of two types— common and preferred.

 The difference is while the holder of the former has voting rights that can be exercised in corporate decisions, the
latter doesn't. However, preferred shareholders are legally entitled to receive a certain level of dividend payments
before any dividends can be issued to other shareholders.

FACTS ABOUT COMMON STOCK

• Represents ownership
• Ownership implies control
• Stockholders elect the board of directors
• Directors elect management

Management’s goal is to maximize the stock price. If the Stock Security is undervalued you buy.

Overvalued -you sell if the orange line is above the intrinsic value Intrinsic Value
and Stock Price Outside investors, corporate insiders, and analysts use a
variety of approaches to estimate a stock’s intrinsic value (P0) In equilibrium, we
assume that the stock’s price equals its intrinsic value.

Time Value of Money-Stocks and their Valuation

Outsiders estimate intrinsic to help determine which stocks to buy or to sell. Stocks above or below their intrinsic value
are undervalued or over-valued. (see the graph, the orange line is the market value and the gray line is the intrinsic
value)
Stock valuation is the process of determining the intrinsic value of a share of the common stock of a company. There are
two approaches to value a share of common
stock: a) the absolute valuation, i.e. the DiscountedCash Flow Method, and b) Relative Valuation (also called the
comparable approach). The purpose of stock valuation is to find the value of a share of common which is justified by the
company earnings and growth potential, identify undervalued and overvalued stocks, overweight and underweight
them in an investment portfolio and generate alpha, i.e. excess return

DISCOUNTED CASH FLOW METHODS-The absolute valuation approach attempts to find

the intrinsic value of a stock by discounting future cash flows at a discount rate that reflects the risks inherent in the
stock. Hence, it is also called discounted cash flow approach. Common Discounted Cash Flow Valuation model includes
single-stage dividend discount model (also called Gordon Growth Model), multi-stage dividend discount, and free cash
flow valuation.

CONSTANT GROWTH DIVIDEND DISCOUNT MODEL- (also called single-stage dividend discount model or Gordon Growth
Model is appropriate for the valuation of a minority stake in mature dividend-paying companies. stock value under the
DDM equals the discounted present value of dividends per share expected to grow at a constant rate.

Stock Value = Do x (1 + g) / r – g
Where:
Do = the current dividend per share per annum
retention ratio ( 1 – dividend payout ratio) and return on equity ROE:

FREE CASH FLOW MODELS can be used to value a majority i.e. controlling ownership based on free cash flows of the
company which equals the cash flow from operating activities less any expected changes in working capital less any
expected capital expenditure.

The single-stage free cash flow model discounts the expected free cash flows at the end of Year 1 at the weighted
average cost of capital (WACC).

where:
FCF1is the free cash flow at the end of Year1, WACC is the weighted average cost of capital and g is the growth rate of
the free cash flow

Stock value under the multi-stage free cash flow models is the total firm value and the market value of debt, and can be
determined by the formula: the value determined
using the free cash flow model is the total firm value and the market value of debt must be subtracted to arrive at the
equity value there are two other free cash flow models which discount free cash flow to equity (FCFE) (instead of the
free cash flow to firm) using the required return on equity (instead of the WACC). The value determined
using Free Cash Flow to Equity (FCFE) model is the equity value.

RELATIVE VALUATION – in relative valuation, the value of the stock is determined with reference to the market value of
comparable stocks. Price multiples of comparable companies such as price to earnings (P/E) ratio, price to book ratio,
price to sales ratios are calculated and the average is multiplied with earnings per share, book value per share, or sales
per share of the company respectively to arrive at the stocks relative value.

IMPORTANT FORMULAS IN STOCK VALUATION

WEEK 9
By definition, investing is the act of putting money into something (business, property, bonds, shares, mutual funds,
financial schemes, etc.) with the expectation of achieving a return while taking a risk. Thus, the concepts of risk and
return are two of the most important factors that your need to consider when it comes to investing.

RETURN ON INVESTMENT

The returns of an investment are usually made up of two components –Capital Gain and Income.

Capital Gain (or Capital Loss) refers to the appreciation (or depreciation) of the value of an investment over time in
comparison to the purchase price of the investment.

Income refers to the interest or dividend payment received from the investment.

When expressed as a percentage of the purchase price of the investment, it is known as the yield of the investment.

There is a difference between expected return and actual return in investing. When you make an investment, you expect
a certain level of return. However, the actual return may be different from the expected return. This is where the risk of
investing comes in.
RISKS OF INVESTMENT

Risks can be classified into two broad categories

Systematic risk and Non-systematic risk.

Systematic Risks are factors that affect the market in general (for example, general economic conditions). This type of
risk cannot be avoided in investing.

Non-systematic Risks are factors that only affect the investment itself but not others (for example, the sustainability of a
company’s business model). In investing, this type of risk can be reduced by spreading over a number of different
investments.

The Risk and Return trade-off is an important principle in investing. Low risks are associated with low expected returns.
High risks are associated with high expected returns. Thus, investors who are not willing to take high risks have to be
contented with lower returns. On the other hand, investors who want to achieve higher returns must be prepared to
bear higher risks.

The risk / Return trade-off Principle should be used to achieve a balance between the desire for the lowest possible risk
and the highest expected return. As an investor, you will need to ask yourself two very important questions before
making any investments: two very important questions before making any investments: (1) How much returns do I
expect from my investment? (2) How much risks am I willing to tolerate? Calculating a Return on a Stock Stocks have
two return components: 1) dividends, 2) Stock price appreciation

Percentage Return = Ending Price – Beginning Price + Dividend

Beginning Price Beginning Price

Percentage Return = Capital Gains Yield + Dividend Yield

Example:

Assume we purchased one share of a stock at$25 and received $2 in dividends during the year. After one year the stock
price increased to $31. What is the percentage return we achieved?

Calculation:

Percentage Return = Capital Gains Yield + Dividend Yield

= ($31 - $25) / $25 + $2 / $25 = 24% + 8% = 32%

This is what actually happened, and we call it a historic return. But before we had this return, we expected maybe a 50%
return? So, we fall short of our expectations but had we expected only a little return like 12%, the actual return
exceeded our expectations.

Risk- an uncertainty of meeting our expectation and in finance we look at the volatility of the stock in the

market. Volatility is a a statistical measure of the dispersion of returns for a given security or market index. In most
cases, the higher the volatility, the riskier the security. ...

For example, when the stock market rises and falls more than one percent over a sustained period of time, it is called a
"volatile" market.

Stock B is riskier because the factors/data are farther away from the mean

The larger the volatility (standard deviation or variance), the riskier the investment is.

Example: Using the following returns calculate the average return, the variance and the standard deviation.
Solution: Average Return

(Mean = 𝑥 ̅= 𝛴𝑥/𝑛

= 10+4-8+13+5 / 5 = 4.80%

ẟ^2 = [(10 -4 .8) ^2 + (4 - 4,8) ^2 + (-8 -4.8) ^2 + (13- 4.8) ^2 + (5 – 4.8) ^2 / (5 -1) = 64.70

ẟ = √64.70 = 8.04%

DIVERSIFYING RISKS: PORTFOLIOS-

we can reduce volatility for a given level of return by grouping assets into portfolios.

“don’t put all your eggs in one basket” a market the portfolio would still have uncertainty and risk but it would be greatly
reduced compared to just one asset or even a group of related assets we can think of a risk as having two components:
firm-specific risk which can be diversified away and Market level risk that cannot be eliminated.

Diversifying risks are also called Market risks are also called

• Diversifiable risk Systematic risk

• Asset Specific risk Market risk

• Idiosyncratic risk Non-diversifiable risk

• Unsystematic risk
Diversification comes when stocks are subject to different kinds of events such that their returns differ over time, i.e.
the stock’s returns are not perfectly correlated. Their price movements often counteract each other. By contrast, if two
stocks are perfectly positively correlated, diversification has no effect on risk.

2 nd method of measuring risk: Beta

ß- a measure of non-diversifiable risk

ß1 = (ẟ1 / ẟM) * (ρ1M)

RISK PREMIUM -the reward investors require for taking on the risk of investing in the stock

CAPM- a combination of the beta and risk premium calculation and is most widely used by professionals Required
Return on Stock = Risk-free rate + (Market Risk Premium) * (Stock’s Beta confidence)

= r RF + bi (r PM)

= r RF + bi (r M -r RF)
The CAPM allows us to estimate any stock’s required return (rate of return) once we have determined the stock’s beta,
risk-free rate, and market risk premium. Example: Let’s say we expect the market portfolio to earn 12% and treasury
bond yields are 3.5%. If Home Depot has a beta of 1.08, we can calculate the

the required return for holding that stock as follows:

r HD = r RF + bi (r M -r RF)

r HD = 3.5% + 1.08 (12% -3.5%)

= 12.68%

WEEK 10
The financial market is a very broad term that primarily refers to a marketplace where buyers and sellers participate in
the trade, i.e., buying and selling of assets. Simply saying, it is a platform that facilitates traders to buy and sell financial
instruments and securities. These instruments and securities can be shares, stocks, bonds, commercial papers, bills,
debentures, cheques, and more.

Financial markets are known for transparent pricing, strict regulations, costs and fees, and clear guidelines. One big
characteristic of such markets is that the market forces determine the price of the assets. Also, a financial market may or
may not have a physical location, meaning investors can buy and sell assets over the Internet or phone.

IMPORTANCE
Financial markets are common to each country, and they play a major role in the economic growth of the country. Some
countries have small markets, while some have big financial markets, like NASDAQ. Such markets act as an intermediary
between savers and investors, or they help savers to become investors. On the other hand, they also help businesses to
raise money to expand their business.

It won’t be wrong to say that investors and businesses access the financial markets to raise money and also to make
more money. Moreover, they also help in lowering unemployment as these markets create massive job opportunities.

FUNCTIONS

Price Determination: Demand and supply of an asset in a financial market helps to determine their price. Investors are
the supplier of the funds, while the industries are in need of the funds. Thus, the interaction between these two
participants and other market forces helps to determine the price.

Mobilization of savings: For an economy to be successful it is crucial that the money does not sit idle. Thus, a financial
market helps in connecting those with money with those who require money.

Ensures liquidity: Assets that buyers and sellers trade in the financial market have high liquidity. It means that investors
can easily sell those assets and convert them into cash whenever they want. Liquidity is an important reason for
investors to participate in trade.

Saves time and money: Financial markets serve as a platform where buyers and sellers can easily find each other without
making too much effort or wasting time. Also, since these markets handle so many transactions it helps them to achieve
economies of scale. This results in lower transaction cost and fees for the investors
CLASSIFICATION OF THE FINANCIAL MARKET

As we mentioned before that financial is a very broad term, so just mentioning their types will not give readers a good
idea of the financial markets. That is why we are mentioning classification and giving type under each category.

BY NATURE OF CLAIM

Debt Market: In this market, investors buy and sell fixed claims or debt instruments, like debentures or bonds

Equity Market: It is a market where investors deal in stocks or other equity instruments. It is basically the market for
residual claims.

BY NATURE OF ASSETS

Stock market: This is the market where shares of the company are listed and traded after their IPO.

Bond market: This market allows companies and the government to raise money for a project or investment. Investors
buy bonds from a company, which later returns the amount of bond with the agreed interest.

Commodities market: In this market, investors buy and sell natural resources or commodities, like corn, oil, meat, and
gold.
Derivatives market: This market deals in derivatives or contracts, whose value is based on the underlying asset being
traded.

Money Market: The markets where investors buy and sell securities that mature within a year are the money market.
Assets that investors buy and sell in this market are commercial paper, certificates of deposits, treasury bills, and more.

Capital Market: Markets, where investors buy and sell medium-and-long term financial assets is a capital market. There
are two types of capital market: Primary Market (where a company issues its shares for the first time (IPO), or already
listed company issues fresh shares) and Secondary Market or Stock Market (where buyers and sellers trade already
issued securities in the primary market).
BY TIMING OF DELIVERY

Cash Market: It is the market where transactions are settled in real-time.

Futures Market: In this market, settlement and delivery take place at a future specified date.

BY ORGANIZATIONAL STRUCTURE

Exchange-Traded Market: A market with centralized authority and set regulations are Exchange Traded Market, like
NYSE, NASDAQ.

Over-the-Counter Market (OTC): Markets with customized procedures and decentralized organization is an OTC market.
It is a type of secondary market. Smaller organizations prefer this market as it has fewer regulations and is less expensive
WEEK 11
ordinary annuity: An investment with fixed-payments that occur at regular intervals paid at the end of each period.

● For an annuity-due, the payments occur at the beginning of each period, so the first payment is at the inception
of the annuity, and the last one occurs one period before the termination.
● For an ordinary annuity, however, the payments occur at the end of the period. This means the first payment is
one period after the start of the annuity, and the last one occurs right at the end. There are different FV
calculations for annuities due and ordinary annuities because of when the first and last payments occur.
The formula for an ordinary annuity is as follows:

A=m [(1+r/ n) ^ nt−1] / r/ n

where m is the payment amount, r is the interest rate, n is the number of periods per year, and t is the length of time in
years.

In contrast, the formula for an annuity-due is as follows:

A=m [(1+r/ n) ^ n t+1−1] r/n] −m

Provided you know m, r, n, and t, therefore, you can find the future value (FV) of an annuity.

● The PV for both annuities -due and ordinary annuities can be calculated using the size of the payments, the
interest rate, and the number of periods.
● The PV of perpetuity can be found by dividing the size of the payments by the interest rate.
● Payment size is represented as p, pm t, or A; interest rate by i or r; and number of periods by n or t.

Perpetuity: An annuity in which the periodic payments begin on a fixed date and continue indefinitely.

Recall that the first payment of an annuity-due occurs at the start of the annuity, and the final payment occurs one
period before the end. The PV of an annuity-due can be calculated as follows:

where P is the size of the payment (sometimes A or pm t), ii is the interest rate, and n is the number of periods

where P is the size of the payment (sometimes A or pm t), ii is the interest rate, and n is the number of periods

An ordinary annuity has annuity payments at the end of each period, so the formula is slightly different than for an
annuity-due. An ordinary annuity has one full period before the first payment (so it must be discounted) and the last
payment occurs at the termination of the annuity (so it must be discounted for one period more than the last period in
an annuity-due). The formula is:

where, again, PP, ii, and n n are the size of the payment, the interest rate, and the number of periods,

respectively.

Example 1

Suppose you have won a lottery that pays $1,000 per month for the next 20 years. But you prefer to have the entire
amount now. If the interest rate is 8%, how much will you accept?
Consider for argument purposes that two people, Mr. Cash, and Mr. Credit, have won the same lottery of $1,000 per
month for the next 20 years. Now, Mr. Credit is happy with his $1,000 monthly payment, but Mr. Cash wants to have the
entire amount now. Our job is to determine how much Mr. Cash should get. We reason as follows: If Mr. Cash accepts x
dollars, then the x dollars deposited at 8% for 20 years should yield the same amount as the $1,000 monthly payments
for 20 years. In other words, we are comparing the future values for both Mr. Cash and Mr. Credit, and we would like
the future values to be equal.

Since Mr. Cash is receiving a lump sum of x dollars, its future value is given by the lump sum formula:

Since Mr. Credit is receiving a sequence of payments, or an annuity, of $1,000 per month, its future value is given by the
annuity formula

Both annuities-due and ordinary annuities have a finite number of payments, so it is possible, though cumbersome, to
find the PV for each period.

For perpetuities, however, there is an infinite number of periods, so we need the formula to find the PV. The formula for
calculating the PV is the size of each payment divided by the interest rate.

Example 2

Find the monthly payment for a car costing $15,000 if the loan is amortized over five years at an interest rate of 9%.

Again, consider the following scenario: Two people, Mr. Cash and Mr. Credit go to buy the same car that costs $15,000.
Mr. Cash pays cash and drives away, but Mr. Credit wants to make monthly payments for five years. Our job is to
determine the amount of the monthly payment.

We reason as follows: If Mr. Credit pays x dollars per month, then the x dollar payment deposited each month at 9% for
5 years should yield the same amount as the $15,000 lump sum deposited for 5 years. Again, we are comparing the
future values for both Mr. Cash and Mr. Credit, and we would like them to be the same.

Since Mr. Cash is paying a lump sum of $15,000, its future value is given by the lump sum formula:
Mr. Credit wishes to make a sequence of payments, or an annuity, of x dollars per month, and its future value is given by
the annuity formula:

We set the two future amounts equal and solve for the unknown:

Generally speaking, annuities and perpetuities will have consistent payments over time. However, it is also an option to
scale payments up or down, for various reasons.

Variables

This gives us six simple variables to use in our calculations:

1. Present Value (PV) – This is the value of the annuity at time 0 (when the annuity is first created)

2. Future Value (FV) – This is the value of the annuity at time n (i.e. at the conclusion of the life of the annuity).

3. Payments (A) – Each period will require individual payments that will be represented by this amount.

4. Number of Payments – The number of payments (A) will equate to the number of expected periods of payment
over the life of the annuity.

5. Interest (i) – Annuities occur over time, and thus a given rate of return (interest) is applied to capture the time
value of money.

6. Growth (g) – For annuities that have changes in payments, there is a growth rate applied to these payments over
time.
CALCULATING ANNUITIES

With all of the inputs above at hand, it’s fairly simple to value various types of annuities. Generally, investors, lenders,
and borrowers are interested in the present and future value of annuities.

Present Value

The present value of an annuity can be calculated as follows:

For a growth annuity (where the payment amount changes at a predetermined rate over the life of the annuity), the
present value can be calculated as follows:

Future Value

The future value of an annuity can be determined using this equation:

In a situation where payments grow over time, the future value can be determined using this equation:

Various Formula Arrangements It is also possible to use existing information to solve for missing information. Which is
to say, if you know interest and time, you can solve for the following (given the following):

Annuities Equations: This table is a useful way to view the calculation of annuities variables from a number of directions.
Understanding how to manipulate the formula will underline the relationship between the variables, and provide some
conceptual clarity as to what annuities are.

Future Value, Multiple Flows

To find the FV of multiple cash flows, sum the FV of each cash flow.

● The FV of multiple cash flows is the sum of the FV of each cash flow.
● To sum the FV of each cash flow, each must be calculated to the same point in the future.

If the multiple cash flows are a fixed size, occur at regular intervals, and earn a constant interest rate, it is an annuity.
There are formulas for calculating the FV of an annuity.

cash flow: The sum of cash revenues and expenditures over a period of time.

annuity: A specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in
consideration of a stipulated premium paid either in prior installment payments or in a single payment. For example, a
retirement annuity paid to a public office following his or her retirement.

incremental cash flows: the additional money flowing in or out of a business due to a project

The first step in finding the FV of multiple cash flows is to define when the future is. Once that is done, you can
determine the FV of each cash flow using the formula. Then, simply add all of the future values together.
Present Value, Multiple Flows

The PV of multiple cash flows is simply the sum of the present values of each individual cash flow.

● To find the PV of multiple cash flows, each cash flow much be discounted to a specific point in time and then
added to the others.
● To discount annuities to a time prior to their start date, they must be discounted to the start date, and then
discounted to the present as a single cash flow.
● Multiple cash flow investments that are not annuities, unfortunately, cannot be discounted by any other
method but by discounting each cash flow and summing them together.

discount: To find the value of a sum of money at some earlier point in time. To find the present value.

net present value: the present value of a project or investment the decision determined by summing the discounted
incoming and outgoing future cash flows resulting from the decision

Sample Problem

A corporation must decide whether to introduce a new product line. The new product will have start-up expenditures,
operational expenditures, and then it will have associated incoming cash receipts (sales) and disbursements (Cash paid
for materials, supplies, direct labor, maintenance, repairs, and direct overhead) over 12 years. This project will have an
immediate (t=0) cash outflow of 100,000 (which might include all cash paid for the machinery, transportation-in and set-
up expenditures, and initial employee training disbursements.) The annual net cash flow (receipts less disbursements)
from this new line for years 1-12 is forecast as follows: -54672, -39161, 3054, 7128, 25927, 28838, 46088, 77076, 46726,
76852, 132332, 166047, reflecting two years of running deficits as experience and sales are built up, with net cash
receipts forecast positive after that. At the end of the 12 years, it’s estimated that the entire line becomes obsolete and
its scrap value just covers all the removal and disposal expenditures. All values are after-tax, and the required rate of
return is given to be 10%. (This also makes the simplifying assumption that the net cash received or paid is lumped into a
single transaction occurring on the last day of each year.)

The present value (PV) can be calculated for each year:

T=0: −100,000 / (1+0.10)0=100,000 −100,000/ (1+0.10)0=100,000

T=1: −54672 / (1+0.10)1=−49701.81818 −54672 / (1+0.10)1=−49701.81818

T=2: −39161 / (1+0.10)2=−32364.46281 −39161/ (1+0.10)2=−32364.46281

T=3: 3054 / (1+0.10)3=2294.515402 3054/ (1+0.10)3=2294.515402

T=4: 7128 / (1+0.10)4=4868.51991 7128/ (1+0.10)4=4868.51991

T=5: 25927 / (1+0.10)5=16098.62714 25927/ (1+0.10)5=16098.62714

T=6: 28838 / (1+0.10)6=16278.29919 28838/ (1+0.10)6=16278.29919

T=7: 46088 / (1+0.10)7=23650.43135 46088/ (1+0.10)7=23650.43135

T=8: 77076 / (1+0.10)8=35956.52284 77076/ (1+0.10)8=35956.52284

T=9: 46726 / (1+0.10)9=19816.38532 46726/ (1+0.10)9=19816.38532

T=10: 76852 / (1+0.10)10=29629.77288 76852/ (1+0.10)10=29629.77288

T=11: 132332 / (1+0.10)11=46381.55871 32332/ (1+0.10)11=46381.55871

T=12: 166047 / (1+0.10)12=52907.69139 66047/ (1+0.10)12=52907.69139

The sum of all these present values is the net present value, which equals 65,816.04. Since the NPV is greater than zero,
it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is
no alternative with a higher NPV.

PV and FV are related, which reflects compounding interest (simple interest has n multiplied by i instead of as the
exponent). Since it’s really rare to use simple interest, this formula is the important one.

Calculating Perpetuities

The present value of a perpetuity is simply the payment size divided by the interest rate and there is no future value.

● Perpetuities are a special type of annuity; perpetuity is an annuity that has no end, or a stream of cash payments
that continues forever.

To find the future value of perpetuity requires having a future date, which effectively converts the perpetuity to an
ordinary annuity until that point.
Perpetuities with growing payments are called Growing Perpetuities; the growth rate is subtracted from the interest rate
in the present value equation.

growth rate: The percentage by which the payments grow each period.

Perpetuities are a special type of annuity; perpetuity is an annuity that has no end, or a stream of cash payments that
continues forever. Essentially, they are ordinary annuities but have no end date. There aren’t many actual perpetuities,
but the United Kingdom has issued them in the past.

LOANS AND LOAN AMORTIZATION

When borrowing money to be paid back via a number of installments over time, it is important to understand the time
value of money and how to build an amortization schedule.

When lending money (or borrowing, depending on your perspective), it is common to have multiple payback periods
over time (i.e. multiple, smaller cash flow installments to pay back the larger borrowed sum). In these situations, an
amortization schedule will be created. This will determine how much will be paid back each period, and how many
periods of repayment will be required to cover the principal balance. This must be agreed upon prior to the initial
borrowing occurs, and signed by both parties.

TIME VALUE OF MONEY

Now if you add up all of the separate payments in an amortization schedule, you’ll find the total exceeds the amount
borrowed. This is because amortization schedules must take into account the time value of money. The time value of
money is a fairly simple concept at its core.

PRINCIPLE AND INTEREST

As a result of this calculation, amortization schedules charge interest over time as a percentage of the principal
borrowed. The calculation will incorporate the number of payment periods , the principal (P), the amortization
payment (A), and the interest rate (r).

Let’s say you find a dream house, at the reasonable rate of $100,000. Unfortunately, a bit of irresponsible borrowing in
your past means you must pay 8% interest over a 30- year loan, which will be paid via a monthly amortization schedule
(12 months x 30 years = 360 payments total). If you do the math, you should find yourself paying $734 per month 360
times. 360 x 734 will leave you in the ballpark of $264,000 in total repayment. that means you are paying more than 2.5
times as much for this house due to time value of money!

Amortization Schedule Example: This shows the first few installments in the example discussed above (i.e. borrowing
$100,000 at 8% interest paid monthly over 30 years).
CALCULATING THE YIELD OF AN ANNUITY The yield of an annuity is commonly found using either the percent change in
the value

● The yield of an annuity may be found by discounting to find the PV, and then finding the percentage change
from the PV to the FV.
● The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment equals 0.
● The IRR calculates an annualized yield of an annuity

yield: In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does
not include the price variations, at the difference of the total return. Yield applies to various stated rates of return on
stocks (common and preferred, and convertible), fixed income instruments (bonds, notes, bills, strips, zero-coupon), and
some other investment type insurance products

Internal Rate of Return (IRR): The discount rate that will cause the NPV of an investment to equal 0.

Net Present Value (NPV): The present value of a project or investment the decision determined by summing the
discounted incoming and outgoing future cash flows resulting from the decision.

Suppose you have a potential investment that would require you to make a $4,000 investment today but would return
cash flows of $1,200, $1,410, $1,875, and $1,050 in the four successive years. This investment has an implicit rate of
return, but you don’t know what it is. You plug the numbers into the NPV formula and set NPV equal to 0. You then solve
for r, which is your IRR (it’s not easy to solve this problem by hand. You will likely need to use a business calculator or
Excel). When r = 14.3%, NPV = 0, so therefore the IRR of the investment is 14.3%.

From PV to FV, or the internal rate of return

WEEK 13
MEANING OF CAPITAL BUDGETING- it is the process of analyzing, evaluating and deciding whether resources should be
allocated to a project or not. It addresses the issue of strategic long-term investment decisions. The process of capital
budgeting ensures optimal allocation of resources and helps management work towards the goal of shareholder wealth
maximization.

IMPORTANCE OF CAPITAL BUDGETING

· It involves massive investment of resources

· It is not easily reversible

· It involves uncertainty and risk for the firm

· It has a long-term implication on the firm

· Due to these factors, capital budgeting decisions become critical and must be evaluated very carefully. Any Firm
that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not
be acting in the best interest of the shareholders.

TYPICAL BUDGETING DECISIONS

Screening decisions-does a proposed project meet some present standard of acceptance?

· Should a firm add a new product to their existing product line?

· Should they expand into a new market?

· Should they replace their existing machinery?

· Should they outsource components and parts?

· Where to locate the manufacturing facility

Preference Decisions-selecting from among several competing courses of action.

APPROACH

Payback Period Approach

Discounted Payback Period Approach

Net Present Value Approach

Internal Rate of Return Approach

Profitability Index

Time value of Money- the capital budgeting techniques that best recognize the time value of money are those that
involve discounted cash flows.
WHICH TECHNIQUE SHOULD WE FOLLOW?

A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization
if

It is based on cash flows

It considers all cash flows

It considers time value of money and

It is not biased in selecting the project

PAYBACK PERIOD APPROACH- the amount of time needed to recover the initial investment. The number of years it
takes including a fraction of the year to recover the initial investment.

To compute the payback period, we keep adding the cash flows till the sum equals the initial investment. It is the
simplest to perform but it is not consistent with wealth maximization because it does not consider the principle of the
time value of money.

Payback period is usually expressed in years.

Start by calculating Net Cash Flow for each year:

Net Cash Flow Year 1 = Cash Inflow Year 1 – Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 +
Net Cash Flow Year 2 + Net Cash Flow Year 3… etc.)

Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

Example. Year 0: -1000, year 1: 4000, year 2: -5000, year 3: 6000, year 4: -6000, year 5: 7000. The sum of all cash
outflows = 1000 + 5000 + 6000 = 12000.

Payback Period = Amount to be initially invested / Estimated Annual Net Cash Inflow
DISCOUNTED PAYBACK PERIOD-

It is similar to payback period approach but it considers the time value of money. the amount of time needed to recover
initial investment given the present value of cash inflows. Here, we keep adding the discounted cash flows till the sum
equals initial investment. It has the same drawbacks as the payback period because although it considers the time value
of money, it is not consistent with shareholders’ wealth maximization

A project costs $10,000. It will return $2,000 each year in profit (after all expenses and taxes). This means that it’ll take a
total of 5 years without a time value of money discount being applied. However, applying time value of money is a fairly
simple process, and can be accomplished utilizing the discounted cash flow analysis equation:

DCF=CF1 /(1+r) ^1 + CF2/(1+r) ^2 + ⋯+ CF n /(1+r) ^n

NET PRESENT VALUE (NPV) is used to estimate each potential project’s value by using a discounted cash flow (DCF)
valuation. This valuation requires estimating the size and timing of all the incremental cash flows from the project.
The NPV is greatly affected by the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is
critical to making the right decision.

To determine the Net Present Value

Calculate the present value of cash inflows

calculate the present value of cash outflows

subtract the present value of the outflows from the present value of the inflows we

The net present value (NPV) is simply the sum of the present values (PVs) and all the outflows and inflows:
NPV = PV Inflows+ PV Outflows

Also recall that PV is found by the formula

PV=FV / (1+i) ^t

where FV is the future value (size of each cash flow),

i is the discount rate, and

t is the number of periods between the present and future.

The PV of multiple cash flows is simply the sum of the PVs for each cash flow.

discount rate: The interest rate used to discount future cash flows of a financial instrument; the annual interest rate
used to decrease the amounts of future cash flow to yield their present value.

variable: something whose value may be dictated or discovered.

cash flow: The sum of cash revenues and expenditures over a period of time.

IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments; the higher IRR,
the more desirable the project.

Cost of capital: the rate of return that capital could be expected to earn in an alternative investment of equivalent risk

Net present value profile: a graph of the sum of all cash inflows and outflows adjusted for the time value of money at
different discount rates

For example, if an investment may be given by the sequence of cash flows:

The Internal Rate of Return (IRR) is the rate of return promised by an investment project over its useful life. It is
computed by finding the discount rate that will cause the net present value of a project be zero If the annual cash flows
are not identical, a trial and error process must be used to find the internal rate of return.

We accept the project if the IRR is > than the cost of capital

Calculating IRR: Cash flows and time

MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

The modified internal rate of return (MIRR) is a financial measure of an investment ‘s attractiveness.

It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification
of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

More than one IRR can be found for projects with alternating positive and negative cash flows, which leads to confusion
and ambiguity. MIRR finds only one value.

MIRR = {[FV (positive cash flows, reinvestment rate) /-PV (negative cash flows, finance rate)] ^ (1/n)}-1.

Cost of capital: the rate of return that capital could be expected to earn in an alternative investment of equivalent risk

Reinvestment rate: The annual yield at which cash flows from an investment can be reinvested.

MIRR is calculated as follows:

MIRR: The formula for calculating MIRR.

Where n is the number of equal periods at the end of which the cash flows occur (not the number of cash flows), PV is
present value (at the beginning of the first period), and FV is future value (at the end of the last period).

Example.

If an investment project is described by the sequence of cash flows: Year 0: -1000, year 1: -4000, year 2: 5000, year 3:
2000. Then the IRR is given by: NPV = -1000 – 4000 * (1+r)-1 + 5000*(1+r)-2 + 2000*(1+r)-3 = 0. IRR can be 25.48%, -
593.16% or -132.32%.

To calculate the MIRR, we will assume a finance rate of 10% and a reinvestment rate of 12%. First, we calculate the
present value of the negative cash flows (discounted at the finance rate): PV (negative cash flows, finance rate) = -1000 –
4000 *(1+10%)-1 = -4636.36.

Second, we calculate the future value of the positive cash flows (reinvested at the reinvestment rate): FV (positive cash
flows, reinvestment rate) = 5000*(1+12%) +2000 = 7600.

Third, we find the MIRR: MIRR = (7600/4636.36) ^ (1/3) – 1 = 17.91%.

Exercise 1/ Activity 1

INTERNAL RATE OF RETURN METHOD

1) Decker Company wants to purchase a new machine at a cost of $104 320 that will save $20 000 per year in cash
operating costs. The machine has 10-year life. (in this case, the cash flows are constant)

PV Factor of the internal = Investment Required = $104 000 = 5.216

Rate of Return IRR Annual Net Cash Flow $20 000

2) The expected annual net cash flow from a project is $22 000 over the next 5 years. The require investment now
$79 310. What is the internal rate of return on the project? (Try and down load a dollar annuity table after computing
the PV factor to find the percentage of the IRR)

Exercise 2 / Activity 2

The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it
generates.

When the annual cash inflow is the same each year, this formula can be used to compute the payback period:

Payback Period = Investment Required

Annual Net Cash Flow

Example

1) Management at the Daily Grind wants to install an espresso bar in its restaurant that costs $140 000 and has a 10-
year life. It will generate annual net cash inflows of $35 000. Management requires a payback period of 5 years or less
on all investments. What is the payback period for the espresso bar? Is the management justified of choosing to put up
the espresso bar? What is the simple rate of return?
 2) SK Manufacturing Company uses discounted payback period to evaluate investments in capital assets. The
company expects the following annual cash flows from an investment of $3,500,000:

No salvage/residual value is expected. The company’s cost of capital is 12%.

Required:

Compute discounted payback period of the investment.

Is the investment desirable if the required payback period is 4 years or less.

Solution:

(1) Computation of discounted payback period:

In order to compute the discounted payback period, we need to compute the present value of each year’s cash flow.

Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash flow during the
year

= 5 + (**$255,500/$456,300)

= 5 + 0.56

= 5.56 years

*Value from “present value of $1 table”

**Unrecovered cost at start of 6th:

= Initial cost – Cumulative cash inflow at the end of 5th year

= $3,500,000 – $3,244,500

= $255,500
(2) Conclusion:

Because the discounted payback period is longer than 4-year period, the investment is not desirable.

WEEK 14