Finance addresses the ways in which individuals and organizations raise and allocate monetary resources over time,

, taking into account the risks entailed in their projects. The word finance may incorporate any of the following:

The study of money and other assets The management and control of those assets Profiling and managing project risks

Fundamental Financial Concepts Arbitrage In economics and finance, arbitrage /rbtr/ is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost. People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds,
stocks, derivatives, commodities and currencies.

Arbitrage-free If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. Arbitrage equilibrium is a

precondition for a general economic equilibrium. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral price for derivatives. Conditions for arbitrage Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally possible only with securities and financial products that can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a lower price) is called 'execution risk' or more specifically 'leg risk'. In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other. Examples

Suppose that the exchange rates (after taking out the fees for making the exchange) in London are 5 = $10 = 1000 and the exchange rates in Tokyo are 1000 = $12 = 6. Converting 1000 to $12 in Tokyo and converting that $12 into 1200 in London, for a profit of 200, would be arbitrage. In reality, this arbitrage is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are much more common.

One example of arbitrage involves the New York Stock Exchange and the Security Futures Exchange One Chicago (OCX). When the price of a stock on the NYSE and its corresponding futures contract on OCX are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences

between the prices are likely to be small (and not to last very long), this can be done profitably only with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers (i.e. lowest latencies to respond to the market) and the most expertise take advantage of series of small differences that would not be profitable if taken individually.

Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some that require command of English are going to India and the Philippines. In popular terms, this is referred to as offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.)

Price convergence Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge. The speed at which they do so is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high (as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets). Arbitrage moves different currencies toward purchasing power parity. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, then sell them in Canada. Canadians would have to buy American dollars to buy the cars and Americans would have to sell the Canadian dollars they received in

exchange. Both actions would increase demand for US dollars and supply of Canadian dollars. As a result, there would be an appreciation of the US currency. This would make US cars more expensive and Canadian cars less so until their prices were similar. On a larger scale, international arbitrage opportunities in commodities,

goods, securities and currencies tend to change exchange rates until the purchasing power is equal. In reality, most assets exhibit some difference between countries. These, transaction costs, taxes, and other costs provide an impediment to this kind of arbitrage. Risks Execution risk Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. However, this is not necessarily the case. Many exchanges and inter-dealer brokers allow multi legged trades. Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position. Mismatch Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as a convergence trade. In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses. Merger Arbitrage also called risk arbitrage, merger arbitrage generally consists of buying/holding the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.

Usually the market price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates. The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed. The risk is that the deal "breaks" and the spread massively widens. Capital asset pricing model In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical riskfree asset. Cash flow Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, limited period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation. Cash flow can be used, for example, for calculating parameters:

to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return and net present value.

to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even while profitable.

as an alternative measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. For instance, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a

case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance.

cash flow can be used to evaluate the 'quality' of income generated by accrual accounting. When net income is composed of large non-cash items it is considered low quality.

to evaluate the risks within a financial product, e.g., matching cash requirements, evaluating default risk, re-investment requirements, etc.

Cash flow is a generic term used differently depending on the subject. It may be defined by users for their own purposes. It can refer to past flows or projected future flows. It can refer to the total of all flows involved or a subset of those flows. Subset terms include net cash flow, operating cash flow and free cash flow.

Statement of cash flow in a business' financials The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to the change in cash balance over this period: positive if the cash balance increases (more cash becomes available), negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas: 1. Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term this must be net positive if the company is to remain solvent. 2. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets). 3. Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments.

Ways Companies Can Augment Reported Cash Flow Common methods include:

Sales - Sell the receivables to a factor for instant cash. (leading) Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging)

Sales Commissions - Management can form a separate (but unrelated) company and act as its agent. The book of business can then be purchased quarterly as an investment.

Wages - Remunerate with stock options. Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work

Equipment Leases - Buy it Rent - Buy the property (sale and lease back, for example). Oil Exploration costs - Replace reserves by buying another company's. Research & Development - Wait for the product to be proven by a start-up lab; then buy the lab.

Consulting Fees - Pay in shares from treasury since usually to related parties Interest - Issue convertible debt where the conversion rate changes with the unpaid interest.

Taxes - Buy shelf companies with Tax Loss Carry Forward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.

Discounted cash flow

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)the sum of all future cash flows, both incoming and outgoing, is thenet present value (NPV), which is taken as the value or price of the cash flows in question.

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite processtaking cash flows and a price and inferring a discount rate, is called the yield.

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

Financial capital Financial capital is money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based, i.e. retail, corporate, investment banking, etc. Financial modelling Financial modelling is the task of building an abstract representation (a model) of a financial decision-making situation.[1] This is a mathematical model designed to

represent (a simplified version of) the performance of a financial asset or portfolio of a business, project, or any other investment. Fixed income analysis Fixed income analysis is the valuation of fixed income or debt securities, and the analysis of their interest rate risk, credit risk, and likely price behavior

in hedging portfolios. The analyst might conclude to buy, sell, hold, hedge or stay out of the particular security. Fixed income products are generally bonds issued by various government treasuries, companies or international organizations. Bond holders are usually entitled to coupon payments at periodic intervals until maturity. These coupon payments are generally fixed amounts (quoted as percentage of the bond's face value) or the coupons could float in relation to LIBOR or another reference rate.

Gap financing Gap Financing is a term mostly associated with mortgage loans or property loans. It is an interim loan given to finance the difference between the floor loan and the maximum permanent loan as committed.

Hedge (finance) A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization.

hedge

can

be

constructed

from

many

types

of

financial

instruments,

including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

Investment Investment has different meanings in finance and economics. In economics, investment is related to saving and deferring consumption. Investment is involved in many areas of the economy, such as business

management and finance whether for households, firms, or governments. In finance, investment is putting money into something with the expectation of gain, usually over a longer term. Traditional investments refer to the investing stocks, bonds, cash, or real estate. Real estate In real estate, investment money is used to purchase property for the purpose of holding, reselling or leasing for income and there is an element of capital risk. Residential real estate Investment in residential real estate is the most common form of real estate investment measured by number of participants because it includes property purchased as a primary residence. In many cases the buyer does not have the full purchase price for a property and must engage a lender such as a bank, finance company or private lender. Different countries have their individual normal lending levels, but usually they will fall into the range of 7090% of the purchase price. Against other types of real estate, residential real estate is the least risky. Commercial real estate Commercial real estate consists of multifamily apartments, office buildings, retail space, hotels and motels, warehouses, and other commercial properties. Due to the higher risk of commercial real estate, loan-to-value ratios allowed by banks and other lenders are lower and often fall in the range of 5070%.

An alternative

investment is

an investment product

other

than

the traditional

investments of stocks, bonds, cash, or real estate. The term is a relatively loose one and includes tangible assets such as precious metals,[1] art, wine, antiques, coins, or stamps[2] and some financial assets such as commodities, equity, hedge, carbon credits,[3] venture capital, forests/timber,[4][5][6] film production[7] and financial derivatives. The Merrill Lynch/Cap Gemini Ernst & Young World Wealth Report 2003, based on 2002 data, showed high net worth individuals, as defined in the report, to have 10% of their financial assets in alternative investments. For the purposes of the report, alternative investments included "structured products, luxury valuables and collectibles, hedge funds, managed futures, and precious metals".[8] By 2007, this had reduced to 9%.[9] No recommendations were made in either report about the amount of money investors should place in alternative investments. Interest Rate An interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from a lender. Specifically, the interest rate (I/m) is a percent of principal (P) paid a certain amount of times (m) per period (usually quoted per annum). For example, a small company borrows capital from a bank to buy new assets for its business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year. The nominal interest rate is the amount, in percentage terms, of interest payable. For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum. The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.

Annual percentage rate The term annual percentage rate (APR), also called nominal APR, and the term effective APR, also called EAPR,[1] describes the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate.[2] Those terms have formal, legal definitions in some countries or legal jurisdictions, but in general:[1]

The nominal APR is the simple-interest rate (for a year). The effective APR is the fee + compound interest rate (calculated across a year).

Effective Interest Rate The effective interest rate, effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears. It is used to compare the annual interest between loans with different compounding terms (daily, monthly, annually, or other). The effective interest rate differs in two important respects from the annual percentage rate (APR):[1] 1. the effective interest rate generally does not incorporate one-time charges such as front-end fees;

2. the effective interest rate is (generally) not defined by legal or regulatory authorities (as APR is in many jurisdictions).[2] By contrast, the effective APR is used as a legal term, where front-fees and other costs can be included, as defined by local law. The effective interest rate is calculated as if compounded annually. The effective rate is calculated in the following way, where r is the effective annual rate, the nominal rate,

and n the number of compounding periods per year (for example, 12 for monthly compounding):

For example, a nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%. 6% compounded monthly is credited as 6%/12 = 0.005 every month. After one year, the initial capital is increased by the factor (1 + 0.005)12 1.0617. When the frequency of compounding is increased up to infinity the calculation will be:

The effective interest rate is a special case of the internal rate of return. If the monthly interest rate j is known and remains constant throughout the year, the effective annual rate can be calculated as follows:

Leverage (finance) In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.[2] Important examples are:

A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[3]

A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.

Position (finance) In financial trading, a position is a binding commitment to buy or sell a given amount of financial instruments, such as securities, currencies or commodities, for a given price. The term "position" is also used in the context of finance for the amount of securities or commodities held by a person, firm, or institution, and for the ownership status of a person's or institution's investments. In derivatives trading or for financial instruments, the concept of a position is used extensively. There are two basic types of position: a long and a short. Traded options will be used in the following explanations. The same principle applies for futures and other securities. For simplicity, only one contract is being traded in these examples.

Long position When a trader buys an option contract that he has not already written (i.e. sold), he is said to be opening a long position. When a trader sells an option contract that he already owns, he is said to be closing a long position. When a trader is 'long', he/she wins when the price increases, and loses when the price decreases.

Short position

When a trader writes (i.e. sells) an option contract that he does not already own, he is said to be opening a short position.

When a trader buys an option contract that he has written (i.e. sold), he is said to be closing a short position.

When a trader is 'short', he/she wins when the price decreases, and loses when the price increases.

The long and the short of it is that: buyers are referred to as the long; and sellers are referred to as the short.

Net position Net position is the difference between total open long (receivable) and open short (payable) positions in a given assets (security, foreign exchange currency, commodity, etc...) held by an individual. This also refers the amount of assets held by a person, firm, or financial institution as well as the ownership status of a person's or institution's investments.

Long (finance) n finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long [1] is the more conventional practice of investing and is contrasted with going short. An options investor goes long on the underlying instrument by buying call options or writing put options on it. Short (finance) In contrast, a short position in a futures contract or similar derivative means that the holder of the position will profit if the price of the futures contract or derivative goes down. Market liquidity In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs.

Mark-to-market accounting Mark-to-market or fair value accounting refers to accounting for the "fair value" of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed "fair" value. Mark-to-market accounting can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. Mark-to-market accounting can become inaccurate if market prices fluctuate greatly or change unpredictably. Example: If an investor owns 10 shares of a stock purchased for $4 per share, and that stock now trades at $6, the "mark-to-market" value of the shares is equal to (10 shares * $6), or $60, whereas the book value might (depending on the accounting principles used) only equal $40. Similarly, if the stock decreases to $3, the mark-to-market value is $30 and the investor has lost $10 of the original investment.

Microfinance Microfinance is usually understood to entail the provision of financial services to microentrepreneurs and small businesses that lack access to banking and related services due to the high transaction costs associated with serving these client categories. The two main mechanisms for the delivery of financial services to such clients are (1) relationship-based banking for individual entrepreneurs and small businesses; and (2) group-based models, where several entrepreneurs come together to apply for loans and other services as a group.

Microcredit Microcredit is the extension of very small loans (microloans) to impoverished borrowers who typically lack collateral, steady employment and a verifiable credit history. It is designed not only to support entrepreneurship and alleviate poverty, but also in many cases to empower women and uplift entire communities by extension.

Micropayment A micropayment is a financial transaction involving a very small sum of money and usually one that occurs online. PayPal defines a micropayment as a transaction of less than 12 USD[1] while Visa prefers transactions under 20 Australian dollars,[2] and while micropayments were originally envisioned to involve much smaller sums of money, practical systems to allow transactions of less than 1 USD have seen little success. [3] One problem that has prevented the emergence of micropayment systems is a need to keep costs for individual transactions low,[4] which is impractical when transacting such small sums[5] even if the transaction fee is just a few cents.

Reference rate A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate. Parties to the contract choose a reference rate that neither party has power to manipulate. E.g. the most common use of reference rates is that of short term interest rates such as LIBOR in floating rate notes, loans, swaps, short term interest rate futures contracts, etc. The rates are calculated by an independent organisation, such as the British Bankers Association (BBA) as the average of the rates quoted by a large panel of banks, to ensure independence. Time Value of Money The time value of money is the value of money with a given amount of interest earned or inflation accrued over a given amount of time. The ultimate principle suggests that a certain amount of money today has different buying power than the same amount of money in the future. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up, thus changing the "value" of the money. The time value of money is the central concept in finance theory. Compounding is the process of investing money as well as reinvesting the interest earned thereon. Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee.[1] Essentially, the party that owes money in the present purchases the right to delay the payment until some future date.[2] The discount, or charge, is simply the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt. The discount is usually associated with a discount rate, which is also called the discount yield. The discount yield is simply the proportional share of the initial amount owed (initial liability) that must be paid to delay payment for 1 year. Discount Yield = Charge" to Delay Payment for 1 year / Debt Liability It is also the rate at which the amount owed must rise to delay payment for 1 year.

Since a person can earn a return on money invested over some period of time, most economic and financial models assume the "Discount Yield" is the same as the Rate of Return the person could receive by investing this money elsewhere (in assets of similar risk) over the given period of time covered by the delay in payment. The Concept is associated with the Opportunity Cost of not having use of the money for the period of time covered by the delay in payment.

Annuity In finance theory, an annuity is a terminating "stream" of fixed payments, i.e., a collection of payments to be periodically received over a specified period of time.[1] The valuation of such a stream of payments entails concepts such as the time value of money, interest rate, and future value. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments and monthly insurance payments. Annuities are classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other interval of time. Annuity Immediate An annuity is a series of payments made at fixed intervals of time. If the number of payments is known in advance, the annuity is an annuity-certain. If the payments are made at the end of the time periods, so that interest is accumulated before the payment, the annuity is called an annuity-immediate or ordinary annuity or deferred annuity. Mortgage payments are annuity-immediate, interest is earned before being paid. Annuity - due An annuity-due is an annuity whose payments are made at the beginning of each period. Deposits in savings, rent or lease payments, and insurance premiums are examples of annuities due. Perpetuity Perpetuity is an annuity for which the payments continue forever. Present value The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the

discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.

Note that this series can be summed for a given value of n, or when n is . Present value of an Annuity An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due.

Present value of a growing annuity In this case each cash flow grows by a factor of (1+g). Similar to the formula for an annuity, the present value of a growing annuity (PVGA) uses the same variables with the

addition of g as the rate of growth of the annuity (A is the annuity payment in the first period). This is a calculation that is rarely provided for on financial calculators.

Present value of a perpetuity

Present value of a growing perpetuity When the perpetual annuity payment grows at a fixed rate (g) the value is theoretically determined according to the following formula. In practice, there are few securities with precise characteristics, and the application of this valuation approach is subject to various qualifications and modifications. Most importantly, it is rare to find a growing perpetual annuity with fixed rates of growth and true perpetual cash flow generation. Despite these qualifications, the general approach may be used in valuations of real estate, equities, and other assets. This is the well known Gordon Growth model used for stock valuation. The dividend discount model (DDM) is a method of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. [1] In other words, it is used to value stocks based on the net present value of the future dividends. The equation most widely used is called the Gordon growth model.

The variables are:

is the current stock price.

is the constant growth rate in

perpetuity expected for the dividends. company.

is the constant cost of equity for that

is the value of the next year's dividends. There is no reason to use a

calculation of next year's dividend using the current dividend and the growth rate, when management commonly disclose the future year's dividend and websites post it.

Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. The future value (FV) formula is similar and uses the same variables.

Future value of an annuity

Future value of a growing annuity

Accounting
Accountancy, or accounting, is the production of information about an enterprise and the transmission of that information from people who have it to those who need it. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in selecting the information that is relevant to the user and is representationally faithful. The principles of accountancy are applied to business entities in three divisions of practical art, named accounting, bookkeeping, and auditing. The American Institute of Certified Public Accountants (AICPA) defines accountancy as "...the art of recording, classifying, and summarizing in a significant manner and in terms of money..." transactions and events that are at least partly financial in character, and interpreting the results. The AAA (American Association of Accounting) defines accounting as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.

Branches of Accounting Financial Accounting Cost Accounting Management/Managerial Accounting Auditing Taxation

Financial Accounting It is the process of recording, classifying, summarising and communicating business information to aid users decision making. Original Form of Accounting Confined to Preparation of Financial Statements Objective is to Calculate Profit / Loss made during the year & to exhibit Financial Position of the Business Cost Accounting Function of cost accounting is to ascertain the cost of the product and to help the management in the control of cost. Costing is a technique of ascertaining cost of a particular product or service.

Management Accounting It is an accounting for management Provides information to the management (within the organization) It is reproduction of financial accounts in such a way as will enable the management to take decisions & control various activities Auditing Examination of books, accounts, vouchers and other records by a practicing Chartered Accountant appointed for the purpose. Reporting to the members / management whether the B/S & P/L A/c as on particular date shows true & fair view of the state of affairs of the business

Taxation Computation of Taxable Income & Tax Payable thereon Reconciliation between accounting profit & taxable profit Statutory compliance

FINANCIAL ACCOUNTING

Book Keeping It is the art of recording business dealings in a set of books. Objectives of Book Keeping: To have date-wise record To have account-wise record To calculate & know yearly profit or loss To know year-end financial position To analyse, interpret & communicate the accounting information

Accounting Concepts

The Entity Concept A business is an artificial entity distinct & separate from its owner. For accounting purposes a business & its owner are two separate persons.

Money Measurement Concept For accounting purposes each transaction & event must be expressible in monetary terms. The Cost Concept - Assets such as Land, Buildings, Plant & Machinery etc. and obligations such as Loans, Public Deposits etc. should be recorded at historical cost (acquisition)

The Going Concern Concept It is assumed that the business organization would continue its operations for a long time. Periodicity Concept The results of operations of entity are measured periodically i.e. in each accounting period. Calendar Year January to December Fiscal Year April to March. As per Income Tax Act, Accounting Period should always be starting from April March.

Accrual Concept Incomes & Expenses should be recognized as and when they are earned and incurred, irrespective of whether the money is received or paid in connection thereof. E.g. Rent paid for 15 months in advance on January 2009. In this case Rent for 3 months should be recognized in FY 08-09 & Rent for 12 months should be recognized in FY 09-10

Concept of Prudence It states that anticipate no profits but provide for all possible losses. Prudence is the inclusion of a degree of caution in the judgment of estimates. Expected losses should be accounted for but not anticipated gains

Matching Concept Revenue earned in an accounting year is matched with all the expenses incurred during the same period to generate that revenue. Matching concept suggest that to find out the profitability, the expenses incurred to generate revenue are to be matched against that revenue

Important Terms CAPITAL EXPENDITURE Expenditure for obtaining an asset is known as capital expenditure. It is an expenditure having future benefits. It is an expenditure with long term use (more than 1 year) REVENUE EXPENDITURE Expenditure on obtaining goods and services is known as revenue expenditure. It is expenditure for running the business. It is an expenditure with short term use (1 year or less than 1 year). DEFERRED REVENUE EXPENDITURE To defer means to postpone. It is that expenditure which is carried forward as it will be of benefit over subsequent period e.g. heavy advertisement expenditure to launch a new product. The proportionate cost related to current year is taken as expense. The balance cost is carried forward and written off in next year. CASH DISCOUNT It is concession allowed by the seller to the buyer to encourage him to pay payment promptly. (Recorded in books of accounts) TRADE DISCOUNT It is allowance allowed by a manufacturer or wholesaler to the retailer. (Not recorded in books of accounts) What is an Account An account is defined as a systematic and summarised record of transactions pertaining to one person, one property or one head of expense/loss or gain. It is ledger account opened in a ledger on separate pages.

Types of Accounts PERSONAL ACCOUNTS Accounts of all persons like Dena Bank a/c, Garware Institute A/c, Mumbai University A/c, Sachin Tendulkar A/c etc.

REAL ACCOUNTS Accounts of all properties & assets like CASH Account, Plant & Machinery A/c, Building A/C etc. NOMINAL ACCOUNTS Accounts of all expenses & losses and Incomes & gains like Telephone charges a/c, Interest Recd A/C, Electricity charges a/c, Salary account etc.

Golden Rules Personal Account: Debit - The Receiver Credit The Giver

Real Account: Debit What Comes In Credit What Goes Out Nominal Account: Debit All Expenses & Losses Credit All Incomes & Gains Single Entry System Form of incomplete double-entry system Cash accounts and personal accounts are maintained and impersonal accounts are ignored. Lack of double aspects of transactions does not assure correctness of accounting.

Double Entry System Recording of transactions & events follows a definite rule. Each transaction or event has two aspects DEBIT (Dr.) & CREDIT (Cr.) Every Debit has an equal & opposite Credit Every transaction should be recorded in such a way that it affects two sides DEBIT & CREDIT

Accounting Cycle

STEPS: 1. SELECTION OF TRANSACTION Select only those transactions which are Financial in nature and Which arise in the course of the business

2. ANALYSIS OF TRANSACTION Analyse the transaction to find out Whether the business has received any benefit such as goods, services or assets and in return, any amount is paid in cash or is payable Whether any such benefit has gone out of business and in return any amount is received in cash or is receivable 3. CLASSIFICATION OF ACCOUNTS Find out which items or persons are involved in the transaction and classify them in to 3 main types such as Personal A/c

Real A/c Nominal A/c

4. APPLYING RULES OF DEBIT OR CREDIT - Depending upon the nature of a transaction DEBIT The A/c receiving the benefit or amount CREDIT The A/c giving the benefit or amount

5. RECORDING IN JOURNAL OR SUBSIDIARY BOOKS Transactions are recorded as and when they occur, in a daily book called Journal including subsidiary books like Cash Book, Bank Book, Purchase Register, Sales Register etc.

6. POSTING AND TOTALLING OF LEDGER ACCOUNTS - From the journal, the amounts debited or credited are transferred (posted) to the debit and credit of the concerned accounts in a book called Ledger.

Ledger Accounts normally having Dr. and Cr. Balances

7. TRIAL BALANCE At the end of the year trial balance is prepared which shows the closing balances of all accounts in the ledger.

8. PROFIT & LOSS A/C The balances of Income and Expenses accounts at the end of the year are summarized in the P/L A/c. The difference between the income & expenses shows the profit or loss for the year.

9. BALANCE SHEET The balances of assets, liabilities and capital accounts at the end of the year are summarized in the Balance Sheet. Benefits of Financial Accounting Maintaining systematic records Meeting legal requirements

Protecting and safeguarding business assets Facilitates rational decision-making Communicating and reporting

Limitations of Financial Accounting No clear idea of operating efficiency Weakness not spotted out by collective results Not helpful in price fixation No classification of expenses and accounts No data for comparison for data and decision-making No control on cost No standards to assess the performance Provides only historical information No analysis of losses Inadequate information for reports No answer to certain questions

Accounting Standards It refers to Policy documents issued by recognized accountancy body prescribing various aspects of measurement, treatment presentation and disclosure of accounting transactions. Main objective of accounting standards is to standardize the different accounting policies and practices followed by different business concerns Benefits Reduces variations in accounting treatments of many items such as valuation of stock, depreciation etc. Helps comparison of financial statements Many standards require additional disclosure which help the users to take important decisions Generally Accepted Accounting Principles (GAAP) includes Accounting conventions Accounting rules Accounting Procedures

Accounting Standards Accepted accounting practices

COST ACCOUNTING Types of Costing Historical Costing: Determination of costs after they have been actually incurred Standard Costing: Determination of standard costs and applying them for measuring the variations from the standard cost. (To control cost) Uniform Costing: System designed by trade associations and followed by business units. Marginal Costing: It is a system in which total cost is classified into two

categories viz. fixed and variable. (Fixed cost is not treated as product cost only variable cost is considered) Functions of Cost Accounting Ascertainment of Cost (Finding out the Cost of the product) Cost Control Reporting or Presentation

Classification of Costs On the basis of behaviour of cost Fixed Cost: It refers to the portion of cost that remains constant irrespective of output up to capacity limit. It is also referred as standby cost or capacity cost or period cost. Variable Cost: It is the cost that varies according to the output i.e. changes according to the changes in the output. It is also called as product cost. Semi-variable cost: It remains constant up to a certain level and registers change afterwards. On the basis of time: Historic and Pre-determined Costs On the basis of controllability: Controllable and Non-controllable Costs

On the basis of elements of cost: Direct Cost: Direct Materials, Direct Labour or Wages, Direct Expenses Indirect Cost: Indirect Materials, Indirect Labour, Indirect Expenses, Overheads Classification of Overheads (O/H) On the basis of functions Factory O/H, Administrative or Office O/H, Selling and Distribution O/H On the basis of Behaviour: Fixed, Variable and Semi-variable Divisions of Cost Prime Cost (also called Flat cost) = Direct Materials + Direct Labour + Direct Expenses Works Cost (factory cost or cost of manufacture) = Prime Cost + Factory O/H Cost of Production = Factory or Works Cost + Administrative or Office O/H Total Cost = Cost of Production + Selling and Distribution O/H Selling Price = Total Cost + Profit (- Loss) Marginal Costing It ascertainment of marginal costs and the effect on profit, changes in volume or type of output by differentiating between fixed and variable costs. Marginal Cost In economics and finance, marginal cost is the change in the total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. Concept of Profit: Profit (P) = Contribution (C) - Fixed Cost (F)

Contribution (C) = Sales (S) Variable Cost (V) Profit / Volume Ratio (P-V ratio): Expresses the relationship between contribution and sales. P-V ratio = [C/S] * 100 Break-Even Point (B.E. point) Total revenue equals total cost B.E.P = Fixed Cost / Contribution per unit (in terms of output) B.E.P = Fixed Cost / P-V Ratio (in terms of sales value) Margin of Safety (M/s): It is the excess of present sales value over the break-even sales M/s = Sales units Break-even units M/s = Profit / P-V Ratio Cost Volume Profit (CVP) Analysis Cost-Volume-Profit is a simplified model, useful for elementary instruction and for short-run decisions.

Cost-volume-Profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analysis. The components of Cost-Volume-Profit Analysis are:

Level or volume of activity Unit Selling Prices Variable cost per unit Total fixed costs Sales mix

CVP assumes the following: Constant sales price

Constant variable cost per unit Constant total fixed cost Constant sales mix Units sold equal units produced

Benefits of Cost Accounting 1) Classification and Subdivision of Costs 2) Adequacy or Inadequacy of Selling Prices:

Unit cost of production, administration and safe made possible by cost accounting aids management in deciding the adequacy or inadequacy of selling prices i.e. neither too high detracting business, nor too low resulting in losses to the concern.

In period of depressions, slumps, or in case of competition management forced to lower prices even below cost of production and sale. In such circumstances, cost accounting will help management in deciding the proper reduction.

3)

Disclosure

of

profitable

Products:

Cost Accounting will disclose activities, departments, products and territories, which bring profit and those that result in losses. Management will use this information to decide which products are making profits or loss thus making a decision which one to be kept and which ones are to be excluded. 4) Control of Material and Supplies:

In a good costing system materials and supplies must be accounted for in terms of departments, jobs, units of production or service. This will eliminate altogether or reduce to the minimum misappropriations, embezzlements, deterioration, obsolescence, and losses from defective, spoiled, scrap and out of date materials and supplies.

5)

Maintenance

of

Proper

Investment

in

Inventories:

A costing system will help in the maintenance of various inventory items of materials and supplies in line with production and sale requirements. If these quantities are too small, production may stop or sales may be lost. On the other hand, if quantities of such materials and supplies are in excess of the production and sales requirements, too much working capital may unnecessarily tie up in inventories. The detailed quantity information furnished by the cost accountant at all times will go a long way in reducing or eliminating this possibility.

6)

Correct

Valuation

of

Inventories:

Cost Accounting plays a basic role in the correct valuation of inventories of finished

goods, work in process, materials and supplies. The book inventory method (as opposed to physical inventory method) made possible by cost accounting system will involve the operation of the various inventory control accounts in such a manner that the balances of these accounts will be inventory valuations required for periodic financial statements. This enables the preparation of monthly financial statements without the trouble and expense of taking monthly physical inventories.

7)

Whether

to

Manufacture

or

Purchase

from

Outsiders:

Cost records furnish information regarding the cost of manufacturing of different finished parts, which assist management in making a decision whether to purchase these parts from outside manufacturers or manufacture them in the factory.

8)

Control

of

Labour

Cost:

Orders, jobs, contracts, departments, processes, or services record cost of labour. In many manufacturing enterprises, daily time reports are prepared showing the number of hours and minutes spent and the wage rate for each worker per job or operation. This enables management to compare the current cost of labour per job or operation with some previously incurred or determined cost thus measuring the efficiency or inefficiency of the labour force and assigning the work to employees best suited for it.

9)

Use

of

Company-wide

Wage

Incentive

Plans:

When labour cost is accounted for by jobs and operations, it is possible to use effectively wage incentive plans or bonus schemes for the remuneration of labour force. Carefully planned and administered incentive schemes are an effective means of enforcing superior performance and cost reduction. Workers are more co-operative, responsive and productive when some form of incentive offered to them for surpassing stipulated standards of perfection and performance 10) Controllable and Uncontrollable Cost:

Cost accounting exhibits at each stage of production and sale the controllable and uncontrollable items in the manufacturing, selling and administrative cost thus enabling management to concentrate attention on those costs, which can reduced or eliminated. 11) Use of Standards for Measuring Efficiency:

A complete cost accounting system, generally, has a well-developed plan of standards

to measure the efficiency of the organization in the use of materials, incurrence of labour and other manufacturing cost. 12) Reduction of Losses Due to Seasonal Conditions:

Cost accounting provides data for making a complete analysis of losses due to idle plant and equipment or due to the use of plant and equipment beyond normal capacity, irregular employment of labour, wastes in the use of materials. It indicates cost variations between active and inactive periods and seasonal conditions in the business or industry. 13) Budgeting:

In a good cost accounting system, preparation of various budgets periods in advance of actual production and sale of goods is necessary. These budgets include budgeted statement of profits, budgeted cost of plant improvements, budgeted cost of production, budgeted cash receipts and payments, and so forth. These budgets show the plans of the management for future periods and they reflect the expected results of these plans. In other words, budgeting, inculcates the habit of thinking and calculations before taking decisions.

14)

Reliable

Check

on

General

Accounting:

Finally, an efficient and proper system of cost accounting is a most reliable and independent check on the accuracy of the financial accounts. Limitations of Cost Accounting a) Based on estimates: Indirect costs are not charged fully to a product or process. It is charged to all the products and processes on the basis of estimates. Actual cost varies from estimated cost. Due to these limitations, all cost accounting results are taken as mere estimates. b) Lack of uniformity: Procedures of cost accounting followed by different organisations are different for different products. There is no uniformity. There is also possibility of difference in pricing material issues for production. All these lead to different cost results for the same operation. c) Many conventions: There are many conventions for classification of costs, pricing of material issues, apportionment of indirect costs, adoption of marginal or standard cost,

etc. These create difficulty in determining the exact cost, because no one type of cost is suitable for all purposes and in all circumstances. d) Expensive: Cost accounting is expensive. It involves lots of clerical won for maintaining various costing records for different purposes. For medium and small size concern, the benefit derived from costing system may not justify the cost involved. e) Result requires reconciliation: Information and results provided by financial accounting and cost accounting may be different for the given activity. This requires reconciliation to find out correctness of the two before taking any decision. f) Dependent: It is not an independent system of accounting. It depends on other accounting systems. g) Does not include all items of expense and income: Items of purely financial nature such as interest, financial charges, discount and loss on issue of shares and debentures, etc. are not taken into consideration in Cost Accounting. h) Not an exact science: Like other accounting system, it is not an exact science but an art that has developed through theories and practices.

Management Accounting Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control functions. It is the process of measuring and reporting information about economic activity within organisations to be used by managers in planning, performance evaluation and operational control. Management accounting information is proprietary. This means that it is not mandatory for public companies to disclose management accounting data or many specifications about the systems that generate this information. Usually, companies disclose very little management accounting information to investors and analysts beyond what is contained in the financial reporting requirements. A company discloses such kind of essential

information like unit sales by major product category or product costs or product type only when the management is sure about the fact that the voluntary disclosure of this information will be viewed as good news by the marketplace. Scope of Management Accounting Planning Performance Evaluation Operational Control

In addition, the management accounting system usually feeds into the financial accounting system. In particular, the product costing system is generally used to determine inventory Balance Sheet amounts and the cost of sales for the income statement. Management accounting information is usually financial in nature and Rupee denominated, although increasingly, management accounting systems collect and report nonfinancial information as well.

Budgetary Control There are two types of control, namely budgetary and financial. Budgetary control is defined by the Institute of Cost and Management Accountants (CIMA) as: "The establishment of budgets relating the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision".

Budgetary Control Method 1. Budget A formal statement of the financial resources is reserved for carrying out specific activities in a given period of time. It helps to co-ordinate the activities of the organisation. An example would be an advertising budget or sales force budget.

2. Budgetary control It is a control technique whereby actual results are compared with budgets.

Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets.

3. Responsibility Centres These enable managers to monitor organisational functions. A responsibility centre can be defined as any functional unit headed by a manager who is responsible for the activities of that unit. There are four types of responsibility centres: Revenue centers: Organisational units in which outputs are measured in monetary terms but are not directly compared to input costs Expense centers: Units where inputs are measured in monetary terms but outputs are not. Profit centers: Units where performance is measured by the difference between revenues (outputs) and expenditure (inputs) Investment centers: Where outputs are compared with the assets employed in producing them, i.e. ROI

Advantages of Budgeting and Budgetary Control It compels the management to weigh the future, which is probably the most important feature of a budgetary planning and control system. It promotes coordination and communication. It clearly defines areas of responsibility. Such a control provides a basis for performance appraisal (variance analysis). Control is provided by comparisons of actual results against budget plan.

Problems in Budgeting Budgets can be seen as pressure devices imposed by management, thus resulting in o Bad labour relations o Inaccurate record keeping Departmental conflict arises due to o Disputes over resource allocation o Departments blaming each other if targets are not attained

Steps in Budget Preparation Selecting a budget period Setting or ascertaining the objectives Preparing basic assumptions and forecasts Understanding the need to consider any limiting factor Finalizing forecasts Implementing the budget Reviewing forecasts and plans

Type of Budgets Sales budget: A sales budget is a detailed plan showing the expected sales for the budget period. The sales budget is the starting point in preparing the master budget. All other items in the master budget, including production, purchase, inventories and expenses depend on it in one way or another. The sales budget is constructed by multiplying the budgeted sales in units by the selling price.

Production budget: The production budget is prepared after the sales budget. The production budget lists the number of units that must be produced during each budget period to meet sales needs and to provide for the desired ending inventory.

Purchase budget: Manufacturing firms prepare production budget but Purchase budget shows the amount of goods to be purchased during the period. The format of Purchase Budget is as under:

Labour Budget: The direct labor budget is developed from the production budget. Direct labor requirements must be figured out so that the company will know whether sufficient labor time is available to meet the budgeted production needs.

Cash budget: Cash budget is a meticulous plan showing how cash funds will be acquired and used over some specific time. Cash budget is composed of four major sections. Receipts Disbursements Cash excess or deficiency Financing

The cash receipts section consists of a listing of all of the cash inflows, except for financing, expected during the budgeting period. Generally, the major source of receipts will be from sales. The disbursement section consists of all cash payment that is planned for the budgeted period.

Master Budget: The master budget is a summary of company's plans that sets specific targets for sales, production, distribution and financing activities. It generally concludes into cash budget, a budgeted income statement and a budgeted Balance Sheet. In short, this budget represents a widespread expression of management's plans for future and of how these plans are to be accomplished. The components or parts of master budget are as under: Sales Budget Production Budget Material Budgeting/Direct Materials Budget Labour Budget Manufacturing Overhead Budget Ending Finished Goods Inventory Budget Cash Budget Selling and Administrative Expense Budget Purchases Budget for a Merchandising Firm Budgeted Income Statement Budgeted Balance Sheet

Zero-based budgeting Zero-based budgeting is an approach to planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting (Historic Budgeting), departmental managers justify only variances versus past years, based on the assumption that the "baseline" is automatically approved. By contrast, in zero-based budgeting, every line item of the budget must be approved, rather than only changes.[1] During the review process, no reference is made to the previous level of expenditure. Zero-based budgeting requires the budget request be re-evaluated thoroughly, starting from the zero-base. This process is independent of whether the total budget or specific line items are increasing or decreasing. The term "zero-based budgeting" is sometimes used in personal finance to describe "zero-sum budgeting", the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. Zero based budgeting also refers to the identification of a task or tasks and then funding resources to complete the task independent of current resourcing.

Comparison of Financial, Cost and Management Accounting

Financial Accounting External Vs. Internal: A financial accounting system produces information that is used by parties external to the organization, such as shareholders, bank and creditors. Financial accounting statements are required to be produced for the period of 12 months. The main objectives of financial accounting are :i) to disclose the end Objectives: results of the business, and ii) to depict the financial condition of the business on a particular date. Accounting process: Follows a full process of recording, classifying, and summarising for the purpose of analysis and interpretation of the financial information. the financial accounting , the origin of preservation of knowledge Centre of gives emphasis on recording keeping on a whole firm basis for the

Time span:

importance: purpose of decisions by all the users of accounting information, both external and internal.

Cost Accounting External Vs. Cost Accounting is Internal: Time span: that branch of accounting information system

which records, measures and reports information about costs. Cost Accounting emphasizes on the preservation of current years costing reports. The primary purpose of the Cost Accounting is cost ascertainment and its use in decision-making performance evaluation. Cost Accounting preserves cost accounts by maintaining doubleentry accounting process if felt necessary. Cost Ledger is used under it.

Objectives:

Accounting process:

Cost Accounting is mainly concerned with the costing and provision Centre of of more accurate cost data to the management. The main focus of

importance: cost accounting is costing, cost assignment, cost variance analysis, costing reports, budgeting, etc.

Management Accounting External Vs. A management accounting system produces information that is used Internal: Time span: within an organization, by managers and employees. No specific time span is fixed for producing financial statements. The main Objectives: objectives of Management Accounting are to help

management by providing information that used by management to plan, evaluate, and control.

Accounting process:

Cost accounts are not preserved under Management Accounting but analyses necessary data from financial statements and cost ledgers. Management accounting uses cost data for provision of information for

Centre of

strategic management decisions. It is mainly concerned with the

importance: provision of help to the managers to asses them in the process of decision making and design business strategies.

FINANCIAL ANALYSIS Financial Statements Financial statements are summarized reports of accounting transactions They are P & L Statement, Balance Sheet Statement, Cash Flow Statement, Funds Flow Statement FS are the indicators of PROFITABILITY and FINANCIAL SOUNDNESS of enterprise Analysis of FS means a systematic and specialized treatment of the information found in the financial statements so as to derive useful conclusions on the profitability and solvency of the business concerned Use of Financial Statements

Objectives of Financial Statements To communicate quantitative and objective information to the interested users Financial statements provide base for tax assessments

To provide reliable information about the earnings of business & ability to operate at a profit at future

Providing information for predicting the future earning power of the enterprise Provides information regarding changes in economic resources Intended to meet specialized needs of conscious creditors & investors

Type of Financial Analysis

Intra Firm Analysis Analysis of performance of the organization over number of years Inter Firm Analysis Comparison of two or more organizations in terms of various financial variables. Standard Analysis Only one set of financial statements of an organization is analyzed on the basis of standard set for the firm or industry Horizontal Analysis Comparison of figures of two or more consecutive accounting period Vertical Analysis Comparing figures in the financial statements of a single period. Figures are converted to a common unit by expressing them as percentage of a key figure

Characteristics / Features of Financial Statements Internal Audience FS are intended for those who have an interest in a given enterprise. They have to be prepared on the assumption that the user is generally familiar with business practices & meaning & implication of the terms used in that business Articulation The basic FS are interrelated and therefore are said to be articulated. Balance in P/L A/c is transferred to B/S Historical Nature FS generally report what has happened in the past Legal & Economic Consequences FS reflect elements of both economics & law. Technical Terminology Since the FS are products of a technical process called accounting, they involve the use of technical terms Summarization & Classification Volume of business transactions are so vast that only summarization & classification will help in understanding the FS Money Terms All business transactions are quantified, measured and related in monetary terms Valuation Methods Valuation methods are not uniform for all items found in a balance sheet e.g. Stocks at cost or market price whichever is low, fixed assets at cost less depreciation, cash at current exchange value etc. Accrual Basis Most financial statements are prepared on accrual basis i.e. considering all incomes due but not received and all expenses due but not paid

Estimates & Judgments In many circumstances, the facts & figures in the FS are based on estimates, personal opinions and judgments Verifiability It is essential that the facts presented thru FS are susceptible to objective verification, so that the reliability of these statements can be improved Conservatism Estimates should be based on a conservative basis to avoid any possibility of overstating the assets and income

Qualities of Ideal Financial Statements Clarity Simplicity Independence (Neutrality) Emphasis on Materiality Accuracy and Brevity Systematic Classification of heads & items Consistency

Methods / Devices used in Financial Statement Analysis Comparative Financial Statements Common Size/Measurement Statements Trend Percentages Accounting Ratios Statement of Changes in Working Capital Funds Flow Statements Cash Flow Statements Specialized Analysis

Limitations of Financial Statements Absence of complete set of principles Accounting principles does not comprise a complete and consistent body of guidelines that would guarantee solution to any problem an accountant might have to face. In fact rules are based on specific topics about which controversy arose at sometime or other in the past Lack of agreement on principles Interpretation of accounting principles differ from country to country & from accountants to accounting bodies Difference in application of principles In case of stock valuation, depreciation methods etc. different alternative treatments are permitted as per GAAP. Tax regulations too may influence the method of disclosed reporting. Hence much of the information in financial statements are based on personal judgments, management policy, legal & tax regulations etc. Accounting statements are necessarily monetary Financial statements limit themselves to information that can be expressed in terms of money. They fail to disclose certain significant non monetary events like prolonged strike, death of an able executive which may affect the business performance etc. FS do not show possible impacts of future contingent events such as pending law suit & sometime the amount involved may not be possible to estimate FS fail to reveal the strength, adequacy or otherwise scarcity of working capital Lack of general utility FS since prepared for the use of an average reader do not satisfy the requirements of varied users, for special purposes like merchant bankers, collaborators, Investment analysis etc The financial position of a business concern is affected by several factorseconomic, social and financial, but financial factors are being recorded in these financial statements. Economic and social factors are left out. Thus the financial position disclosed by these statements is not correct and accurate. Facts which have not been recorded in the financial books are not depicted in the financial statement. Only quantitative factors are taken into account. But qualitative factors such as reputation and prestige of the business with the public,

the efficiency and loyalty of its employees, integrity of management etc. do not appear in the financial statement. Balance sheet is only a historical document The values of assets contained in the balance sheet do not reflect the current values. The balance sheet is not affected by falling value of rupee & this has serious effects on the quality of information FS are essentially Interim Reports An enterprise is considered to be a continuing entity i.e. its life is indefinite. It exists for a long time. Financial statements are however, prepared periodically for interim periods and cannot be considered final. The exact position and profitability of a business enterprise can be known only after a reasonable length of time. Omission of special information FS do not show the effect of discovery, values of minerals and value of manpower resources Sacrifice of Simplicity As FS are prepared to disclose the results of diverse economic activities of the business, high degree of summarization is involved. In this process, simplicity, clarity and comprehensiveness are lost Choice of accounting year may also influence the accounting information. E.g. highly seasonal industry like sugar, if the B/S is prepared during off season, the FS may show good liquidity position. But if the accounting date coincides with the cutting crop season, it will show an adverse liquid position, due to large investment in inventories. Balance Sheet The balance sheet, also known as the statement of financial condition, offers a snapshot of a company's health. It tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets" or "shareholders equity". The balance sheet tells investors a lot about a company's fundamentals: how much debt the company has, how much it needs to collect from customers (and how fast it does so), how much cash and equivalents it possesses and what kinds of funds the company has generated over time.

State of finances at a snapshot in time Vertical Form of Balance Sheet

Components of Balance Sheet

Income Statement (Profit or Loss Statement) The income statement shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain time period. When it comes to analyzing fundamentals, the income statement lets investors know how well the companys business is performing - or, basically, whether or not the company is making money. Changes to finances over a particular period

Components of Income Statement

Differences between Balance Sheet and Income Statement While income statement reflects current years performance of the company, balance sheet contains information from the start of the business up to the financial year ended. Income statement tells current profit and loss whereas balance sheet reflects the financial health of the company telling its overall assets and liabilities. New formats of Balance Sheet and Income Statement

Connecting the Income Statement and Balance Sheet When an accountant records a sale or expense entry using double-entry accounting, he or she sees the interconnections between the income statement and balance sheet. A sale increases an asset or decreases a liability, and an expense decreases an asset or increases a liability. Therefore, one side of every sales and expense entry is in the income statement, and the other side is in the balance sheet. You cant record a sale or an expense without affecting the balance sheet. The income statement and balance sheet are inseparable, but they arent reported this way. The following figure shows the lines of connection between income statement accounts and balance sheet accounts. When reading financial statements, in your minds eye, you should see these lines of connection.

Heres a quick summary explaining the lines of connection in the figure, starting from the top and working down to the bottom:

Making sales (and incurring expenses for making sales) requires a business to maintain a working cash balance.

Making sales on credit generates accounts receivable. Selling products requires the business to carry an inventory (stock) of products. Acquiring products involves purchases on credit that generate accounts payable. Depreciation expense is recorded for the use of fixed assets (long-term operating resources).

Depreciation is recorded in the accumulated depreciation contra account (instead decreasing the fixed asset account).

Amortization expense is recorded for limited-life intangible assets. Operating expenses is a broad category of costs encompassing selling, administrative, and general expenses:

Some of these operating costs are prepaid before the expense is recorded, and until the expense is recorded, the cost stays in the prepaid expenses asset account.

Some of these operating costs involve purchases on credit that generate accounts payable.

Some of these operating costs are from recording unpaid expenses in the accrued expenses payable liability. Borrowing money on notes payable cause interest expense. A portion (usually relatively small) of income tax expense for the year is unpaid at

year-end, which is recorded in the accrued expenses payable liability. Earning net income increases retained earnings. Cash Flow Statement It is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. In simple words it shows the changes in the

cash position of an organization between two periods. (It records the amounts of cash and cash equivalents entering and leaving a company) Cash would include cash in hand and savings, current a/c balances with banks & cash equivalents. Cash equivalents are short term & highly liquid investments that are readily convertible into cash. An investment would normally be called a cash equivalent only when it has a short term maturity of say 3 months or less from the date of acquisition. (Credit and debit card receivables often are included in cash equivalents) The main reason for the preparation of the Cash Flow Statement is that the income statement of an enterprise is always prepared on an Accrual basis and it may show profits in the income statement but the cash received out of these profits may be low to run the business or vice-versa. As per AS-3 the cash flow statement should report cash flows during the period classified by: Operating Activities The cash flows generated from major revenue producing activities of the entities are covered under this head. Cash flow from operating activities is the indicator of the extent to which the operations of the enterprise have generated sufficient cash to maintain the operating capability to pay dividend, repay loans & make new investments. Investing Activities These are the acquisition and disposal of long term assets and other investments not included in cash equivalents. This represents the extent to which the expenditures have been made for resources intended to generate future incomes & cash flows. Usually cash changes from investing are a "cash out" item, because cash is used to buy new equipment, buildings or short-term assets such as marketable securities. However, when a company divests of an asset, the transaction is considered "cash in" for calculating cash from investing.

Financing Activities Financing activities are the activities that result in changes in the size and composition of the owners capital and borrowings of the enterprise. Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the company is reducing its cash.

Major Cash Inflows Issue of new shares for cash Receipt of short term & long term loans from banks, financial institutions etc Sale of assets & investments Dividend & Interest received Cash generated from operations

Major Cash Outflows Redemption of preference shares Purchase of fixed assets or investments Repayment of long term and short term borrowings Decrease in deferred payment liabilities Loss from operations Payment of tax, dividend etc.

Benefits of a Cash Flow Statement Efficient Cash Management manage the cash resources in such a way that adequate cash is available for meeting the expenses Internal Financial Management useful for internal financial management as it provides clear picture of cash flows from operations Knowledge of change in Cash Position It enables the management to know about the causes of changes in cash position Success or Failure of Cash Planning Comparison of actual & budgeted cash flow helps the management to know the success or failure in cash management It is a supplement to fund flow statement as cash is a part of fund Cash Flow Statement is a better tool of analysis for short term decisions

Limitations of Cash Flow Analysis Misleading Inter Industry Comparison Cash flow does not measure the

economic efficiency of one company in relation to another company Misleading Inter Firm Comparison - The terms & conditions of purchases & sales of different firms may not be the same. Hence inter firm comparison becomes misleading.

Influence of Management Policies Management policies influence the cash easily by making certain payments in advance or by postponing certain payments. Cannot be equated with Income Statement Cash flow statement cannot be equated with income statement. Hence net cash flow does not mean income of the business.

CFS cannot substitute the B/S & Funds Flow

Connecting Balance Sheet Changes with Cash Flows The numbers in the statement of cash flows are derived from the changes in a businesss balance sheet accounts during the year. Changes in the balance sheet accounts drive the amounts reported in the statement of cash flows. The lines of connection between changes in the businesss balance sheet accounts during the year and the information reported in the statement of cash flows are shown in the following figure. Note that the $155,000 net increase in retained earnings is separated between the $405,000 net income for the year and the $250,000 cash dividends for the year: $405,000 net income $250,000 dividends = $155,000 net increase in retained earnings

Balance sheet account changes are the basic building blocks for preparing a statement of cash flows. These changes in assets, liabilities, and owners equity accounts are the amounts reported in the statement of cash flows, or the changes are used to determine the cash flow amounts (as in the case of the change in retained earnings, which is separated into its net income component and its dividends component). Note in the cash flow from operating activities section in the figure that net income is listed first and then several adjustments are made to net income to determine the amount of cash flow from operating activities. The assets and liabilities included in this section are those that are part and parcel of the profit-making activity of a business. For example, the accounts receivable asset is increased (debited) when sales are made on credit. The inventory asset account is decreased (credited) when recording cost of goods sold expense. The accounts payable account is increased (credited) when recording expenses that havent been paid. The rules for cash flow adjustments to net income are:

An asset increase during the period decreases cash flow from profit A liability decrease during the period decreases cash flow from profit An asset decrease during the period increases cash flow from profit A liability increase during the period increases cash flow from profit

Following the third listed rule, the $191,000 depreciation expense for the year is a positive adjustment, or add-back to net income. Recording depreciation expense reduces the book value of the fixed assets being depreciated. To be more precise, recording depreciation increases the balance of the accumulated depreciation contra account that is deducted from the original cost of fixed assets. Recording depreciation does not involve a cash outlay. The cash outlay occurred when the business bought the assets being depreciated, which could be years ago. Working Capital Management Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is

considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's shortterm assets and its short-term liabilities (i.e. involves managing inventories, accounts receivable and payable, and cash). The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Management will use a combination of policies and techniques for the management of working capital. Cash management: Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity Debtors management: Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa) Short term financing: Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

Working Capital Changes Increase in Current Assets Increase in Working Capital Increase in Current Liabilities Decrease in Working Capital Decrease in Current Assets Decrease in Working Capital Decrease in Current Liabilities Increase in Working Capital

Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable. The aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. The standard of payment of credit purchase or getting cash from debtors can be changed on the basis of reports of cash conversion cycle.

Important

Taking these four transactions in pairs, analysts draw attention to five important intervals, referred to as conversion cycles (or conversion periods):

the Cash conversion cycle emerges as interval CD (i.e. disbursing cash collecting cash).

the Payables conversion period (or "Days payables outstanding") emerges as interval AC (i.e. owing cash disbursing cash) the Operating cycle emerges as interval AD (i.e. owing cash collecting cash)

the Inventory conversion period or "Days inventory outstanding" emerges as interval AB (i.e. owing cash being owed cash)

the Receivables conversion period (or "Days sales outstanding") emerges as interval BD (i.e. being owed cash collecting cash)

Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period.)

A -> B -> C -> D Owing Cash -> Being Cash Owed -> Disbursing Cash -> Collecting Cash

Hence, interval {C D} CCC days) (in = = interval {A B} Inventory conversion period + interval {B D} + Receivables conversion period interval {A C} Payables conversion period

Funds Flow Statement It is statement prepared to analyse the reasons for changes in the financial position of a company between two balance sheets. It shows the inflow and outflow of funds i.e. sources and application of funds for a particular period. (How the funds are obtained and employed). In other words, it is prepared to explain the changes in the working capital position of the company. Funds Flow analysis includes: 1. Working Capital Analysis (Statement of changes in WC ,Statement of Funds flow from Operations) 2. Cash Flow Analysis (Statement of Sources and Application of Cash) Steps to prepare Funds flow statement Prepare a schedule of changes in working capital Analyse the changes in non-current assets and non-current liabilities to find out inflow or outflow of funds Find out funds from operation Prepare statement of Sources & Application of Funds (Funds Flow Statement)

Benefits of the Funds Flow Statement Funds Flow Statement is useful for Long term Analysis. It is very useful in the hands of the management for judging the financial and operating performance of the company. 1. The Funds Flow Statement helps in answering the following questions: Where have the profits gone?

Why there is an imbalance existing between liquidity position and profitability position of an enterprise? Why is the business financially solid despite losses?

2. The Funds Flow Statement analysis helps the management to test the working capital has been effectively used or not and the working capital level is adequate or inadequate for the requirements of the business. (Working capital position helps management in taking policy decisions regarding payment of dividend etc)

3. It helps investors to decide whether the company has managed the funds properly also indicates the Credit Worthiness of a company which help the lenders to decide whether to lend money to the company or not.

Components of Funds Flow Statement Sources of Funds Issue of Equity & Preference Shares Receipt of Securities Premium Issue of Debentures Receipt of Long Term Loans from Banks & Other Financial Institutions Receipt of Public Deposits & other Unsecured Loans Sales of Fixed Assets Sale of Investments Extraordinary receipt awarded in legal suit Income from long term investments Funds from operations Decrease in Working Capital

Application of Funds Redemption of Preference share capital Redemption of Debentures Premium paid on redemption of debentures and preference shares Repayment of temporary loans, secured & unsecured

Purchase of Fixed Assets Purchase of Investment Extraordinary payments and non recurring losses like loss by fire & damages paid Payment of Dividend & Interim Dividend Payment of Tax Increase in Working Capital

Difference between Standalone and Consolidated Financial Statements Standalone financial statement of a company means financial statements excluding the results of its subsidiaries. Wholly-owned subsidiary: Company owning 100% stake. Subsidiary: Company owning greater than 50% stake but less than 100% stake. (Majority stake) Affiliate or Associate: Company owning less than 50% stake (minority stake) It is further classified as Company holding greater than or equal to 20% shares but less than 50% shares of a subsidiary. Company holding less than 20% shares of a subsidiary.

The GAAP says when a company publishes consolidated financial results; it should follow the following rules: 1. If a company holds more than 50% stake in a subsidiary company, the consolidated financial results of the company should add all the revenue, expenditure, profits and other items to its financial results in respective items but the profits; that does not belong to the company due to minority shareholders owning shares of subsidiary, should be shown as minority interest. Thus if a company owns 100% in a subsidiary company, minority interest is 0. 2. If a company holds more than 20% stake in a subsidiary company but less than 50%, the consolidated financial results of the company should add the proportionate revenue, expenditure, profits and other items to its financial results in respective items, i.e. If a company A owns 25% stake in company B, B's 25% revenue, 25% expenditure, 25% profits etc. should be added to the respective items of A's standalone results to get the consolidated results. 3. If a company holds less than 20% stake in a subsidiary company, the consolidated financial results of the company should not be any different from its standalone results.

Let's understand this by example. Look at L&T (LNT 1403.85 -0.41%)'s Standalone results and Consolidated results for FY2008. L&T has many subsidiaries like L&T Infotech, L&T Finance and L&T has very different shareholding for each of its subsidiaries. When the L&T creates it's consolidated results, it follows the above three GAAP principles to add the revenue, expenditure, profits and other items to its standalone numbers to get the consolidated results. Because of case 3, P/E of some company sometimes may not reflect the true picture of the company's valuations. There is one significant example of this in Indian stock market, HDFC holds 19.xx% in HDFC Bank, thus HDFC's consolidated results do not include the profits, revenue and other items from HDFC Bank. HDFC Bank is valued at around 50K Crore, 19.xx% of it is around 10K Crore. HDFC itself is valued at 60K Crore with a P/E of 26. But if you remove HDFC Bank's valuations from it, P/E comes down to 22. I am not sure if the market is adding HDFC Bank's valuations to HDFC.

Ratio Analysis Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements is computed determined & presented. It is an attempt to derive quantitative measures or guides concerning the financial health and profitability of a business enterprise.

Liquidity Ratios Liquidity ratios are the ratios that measure the ability of a company to meet its short term debt obligations. These ratios measure the ability of a company to pay off its short-term liabilities when they fall due. The liquidity ratios are a result of dividing cash and other liquid assets by the short term borrowings and current liabilities. They show the number of times the short term debt obligations are covered by the cash and liquid assets. If the value is greater than 1, it means the short term obligations are fully covered. Generally, the higher the liquidity ratios are, the higher the margin of safety that the company posses to meet its current liabilities. Liquidity ratios greater than 1 indicate that the company is in good financial health and it is less likely fall into financial difficulties. Current Ratio (Working Capital Ratio) The current ratio is balance-sheet financial performance measure of company liquidity. The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio is also known as the working capital ratio.

The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio. Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow.

If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management. All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months. Acid-test Ratio (Quick Ratio) The quick ratio is a measure of a company's ability to meet its short-term obligations using its most liquid assets (near cash or quick assets). Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Quick ratio is viewed as a sign of a company's financial strength or weakness; it gives information about a companys short term liquidity. The ratio tells creditors how much of the company's short term debt can be met by selling all the company's liquid assets at very short notice. The quick ratio is also known as the acid-test ratio or quick assets ratio.

The higher the quick ratio, the better the position of the company will be. The commonly acceptable current ratio is 1, but may vary from industry to industry. A company with a quick ratio of less than 1 cannot currently pay back its current liabilities; it's the bad sign for investors and partners. (Examples of Quick assets: stocks, life insurance policies, marketable securities, accounts receivable, and actual cash itself) Operating Cash Flow Ratio

Cash Ratio Cash ratio (also called cash asset ratio) is the ratio of a company's cash and cash equivalent assets to its total liabilities. Cash ratio is a refinement of quick ratio and indicates the extent to which readily available funds can pay off current liabilities. Potential creditors use this ratio as a measure of a company's liquidity and how easily it can service debt and cover short-term liabilities. Cash ratio is the most stringent and conservative of the three liquidity ratios (current, quick and cash ratio). It only looks at the company's most liquid short-term assets cash and cash equivalents which can be most easily used to pay off current obligations.

(Numerator = Cash & Cash Equivalent + Current Investments) Cash ratio is not as popular in financial analysis as current or quick ratios, its usefulness is limited. There is no common norm for cash ratio. In some countries a cash ratio of not less than 0.2 is considered as acceptable. But ratios that are too high may show poor asset utilization for a company holding large amounts of cash on its balance sheet. Cash Flow Coverage Ratio
Monthly Cash Inflows Monthly Cash Outflows

Finance Charge Coverage Ratio

Net Operating Cash Flow Finance Charge

Dividend Coverage Ratio

Operating Cash Flow - Finance Charge Interim Dividend + Final Dividend

Proprietary Ratio
Proprietors' Funds Total Assets (CA+ FA+ Investments)

Solvency (Leverage Ratios) Financial leverage ratios (debt ratios) measure the ability of a company to meet its financial obligations when they fall due (repaying principal amount of its debts, pay interest on its borrowings, and to meet its other financial obligations). They also give insights into the mix of equity and debt a company is using. Debt Ratio Debt ratio is a ratio that indicates the proportion of a company's debt to its total assets. It shows how much the company relies on debt to finance assets. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets. The higher the ratio, the greater the risk associated with the firm's operation. A low debt ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk.

The optimal debt ratio is determined by the same proportion of liabilities and equity as a debt-to-equity ratio. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt. Maximum normal value is 0.6-0.7. But it is necessary to take into account industry in which the firm is operating. Debt-Equity Ratio The debt-to-equity ratio (debt/equity ratio, D/E) is a financial ratio indicating the relative proportion of entity's equity and debt used to finance an entity's assets. This ratio is also known as financial leverage.

Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company's financial standing. It is also a measure of a company's ability to repay its obligations. When examining the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio is increasing, the company is being financed by creditors rather than from its own financial sources which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. Thus, companies with high debt-to-equity ratios may not be able to attract additional lending capital.

Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very industry specific because it depends on the proportion of current and noncurrent assets. The more non-current the assets (as in the capital-intensive industries), the more equity is required to finance these long term investments. For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5 (it's typical for other countries too). In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring. Long-term Debt to Equity (or Total Assets) Long Term Debt to Total Asset Ratio is the ratio that represents the financial position of the company and the companys ability to meet all its financial requirements. It shows the percentage of a companys assets that are financed with loans and other financial obligations that last over a year. As this ratio is calculated yearly, decrease in the ratio would denote that the company is fairing well, and is less dependent on debts for their business needs.

Long-term Debt = Equity + Non - Current Liabilities excluding deferred tax liabilities and non-current provisions. For Example, a company has total assets worth $15,000 and $3000 as long term debt then the long term debt to total asset ratio would be = 3000/15,000 = 0.2 This means that the company has $0.2 as a long term debt for every dollar it has in assets. Debt Service Coverage Ratio (DSCR) or Debt Coverage Ratio (DCR) It is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition or covenant. Breaching a DSCR covenant can, in some circumstances, be an act of default.

PAT + Depreciation + Other non-cash charges + Interest on term loan + Lease Rentals Interest on term loan + Lease Rentals + Repayment of term loan

The ratio is considered to be ideal if it is above 1 thus indicating that the property is producing income which is sufficient to pay back its debts. A debt service coverage ratio which is below 1 indicates a negative cash flow. For example, a debt service coverage ratio of 0.92 indicates that the companys net operating income is enough to cover only 92% of its annual debt payments. However, in personal finance context, it indicates that

the borrower would have to look into his/her personal income and funds every month so as to keep the project afloat. The lenders, however, usually frown on a negative cash flow while some might allow it if, in case, the borrower is having sound income outside. The debt service coverage ratio is, therefore, a benchmark used to measure the cash producing ability of a business entity to cover its debt payments. Debt Assets Ratio It measures the extent to which borrowed funds support the firms assets. Debt / Assets or (Debt/ Equity) / 1 + (Debt/Equity) Limit: 0.67:1 Interest Coverage Ratio (Times Interest Earned) The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments. Interest coverage ratio is equal to earnings before interest and taxes (EBIT) for a time period, often one year, divided by interest expenses for the same time period. The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its EBIT. It determines how easily a company can pay interest expenses on outstanding debt.

or The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default. A lower ICR means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)). A higher ratio indicates a better financial health as it means that the company is more capable to meeting its interest obligations from operating earnings. On the other hand, a

high ICR may suggest a company is "too safe" and is neglecting opportunities to magnify earnings through leverage. Fixed Charges Coverage Ratio Fixed charge coverage ratio is the ratio that indicates a firms ability to satisfy fixed financing expenses such as interest and leases. This means that the fixed charges that a firm is obligated to meet are met by the firm.
EBIT + Depreciation Interest + { Repayment of loan / (1 - tax rate)}

Or (EBIT + Fixed charge before tax) / (Fixed charge before tax + Interest) For example, a company has $13,000 as EBIT and $2,000 as lease payments and $1,000 as interest payments the fixed charge coverage ratio is measured as: Fixed charge coverage ratio = (13,000+2,000) / (1,000+2,000) = 15,000/3000 = 5 This means that the company has earned five times its fixed charges, the company is able to pay the fixed charges of the company. Capital Gearing Ratio (Net Gearing Ratio)
Capital not bearing fixed rate of return Capital bearing fixed rate of return

Capital gearing ratio = (Capital not bearing Risk) :( Capital bearing risk)

Capital not bearing risk includes equity share capital. Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate).

Therefore we can also say, Capital gearing ratio= (shareholders' funds): (Debentures +Preference share capital) If Ratio < 1 Highly geared, Ratio = 1 Perfectly geared, Ratio > 1 Lowly geared

Profitability Ratios Profitability ratios measure a companys ability to generate earnings relative to sales, assets and equity. These ratios assess the ability of a company to generate earnings, profits and cash flows relative to some metric, often the amount of money invested. They highlight how effectively the profitability of a company is being managed. Profit Margin Net profit margin (or profit margin, net margin, return on revenue) is a ratio of profitability calculated as after-tax net income (net profits) divided by sales (revenue). Net profit margin is displayed as a percentage. It shows the amount of each sales dollar left over after all expenses have been paid. A higher net profit margin means that a company is more efficient at converting sales into actual profit.

Gross Margin Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of sales) to sales revenue. It is the percentage by which gross profits exceed production costs. Gross margins reveal how much a company earns taking into consideration the costs that it incurs for producing its products or services. Gross margin is a good indication of how profitable a company is at the most fundamental level, how efficiently a company uses its resources, materials, and labour. It is usually expressed as a percentage, and indicates the profitability of a business before overhead costs; it is a measure of how well a company controls its costs. Gross margin measures a company's manufacturing and distribution efficiency during the production process. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations, the better the company is thought to control costs. Investors use the gross profit margin to compare companies in the same industry and also in different industries to determine what are the most profitable. A company that boasts a higher gross margin than its competitors and industry is more efficient.

Operating Margin Operating margin (operating income margin, return on sales) is the ratio of operating income divided by net sales (revenue).

(In Numerator, EBIT or Operating Profit can be used when the firm has no non-operating income) Operating Expense Ratio Operating expense ratio (OER) is a helpful tool in carrying out the comparisons between the expenses of analogous properties. If a particular property piece features a high OER, an investor should take it as a warning signal and look into the matter for why is the OER high. The investors using this ratio can further compare any type of expense including insurance, utilities, taxes and maintenance, to the gross income, and the sum of all expenses to the gross income. The main items included in the operating expense include property management, property taxes, utilities, wages, insurance, fees, supplies, repairs and maintenance, advertising, accounting fees, attorney fees, pest control, trash removal, and similar more. However, the items not included in operating expenses are personal property, loan payments, and capital improvements.
Operating Cost Net Sales

(Denominator can be Effective Gross Income)

Return on Capital Employed (RoCE) Return on capital employed (ROCE) is a measure of the returns that a business is achieving from the capital employed, usually expressed in percentage terms. Capital employed equals a company's Equity plus Non-current liabilities (or Total Assets Current Liabilities), in other words all the long-term funds used by the company. ROCE indicates the efficiency and profitability of a company's capital investments. ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice versa; a good ROCE is one that is greater than the rate at which the company borrows.

In Denominator, it can be Equity+ Non-Current liabilities or Total Assets Current Liabilities & NOPAT = EBIT x (1-T) One limitation of ROCE is the fact that it does not account for the depreciation and amortization of the capital employed. Because capital employed is in the denominator, a company with depreciated assets may find its ROCE increases without an actual increase in profit. Return on Equity (RoE) Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. It measures how profitable a company is for the owner of the investment, and how profitably a company employs its equity.
Net Profit Avg Equity

RoE Du Point Formula

Return on Investment (RoI) Return on investment (ROI) is performance measure used to evaluate the efficiency of investment. It compares the magnitude and timing of gains from investment directly to the magnitude and timing of investment costs. If an investment has a positive ROI and there are no other opportunities with a higher ROI, then the investment should be undertaken. A higher ROI means that investment gains compare favourably to the investment costs. ROI is an important financial metric for: asset purchase decisions (such as computer systems, machinery, or service vehicles) approval and funding decisions for projects and programs of different types (for example marketing programs, recruiting programs, and training programs) traditional investment decisions (for example management of stock portfolios or the use of venture capital).

Gain - Cost Cost (of Investment)

It should be noted that the definition and formula of return on investment can be modified to suit the circumstances - it all depends on what is included as returns and costs. For example to measure the profitability of a company the following formula can be used to calculate return on investment.

Net Profit x 100 Investment

(In Denominator, Total Assets can be used) One drawback of ROI is that it by itself says nothing about the likelihood that expected returns and costs will appear as predicted. Neither does it say anything about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the expected results. Therefore, a good investment analysis should

also measure the probabilities of different ROI outcomes. It is important to consider both the ROI magnitude and the risks that go with it. Net Interest Margin The Net Interest Margin can be expressed as a performance metric that examines the success of a firms investment decisions as contrasted to its debt situations. A negative Net Interest Margin indicates that the firm was unable to make an optimal decision, as interest expenses were higher than the amount of returns produced by investments. Thus, in calculating the Net Interest Margin, financial stability is a constant concern.
Investment Returns - Interest Expenses Avg Earning Assets

The use of net interest margin is helpful in tracking the profitability of a banks investing and lending activities over a specific course of time. One of the drawbacks of Net Interest Margin is that it does not measure the total profitability of the bank as most of them earn fees and other non-interest income through services like brokerage and deposit account services, without taking account operating expenses, such as personnel and facilities costs, or credit costs. Besides, net interest margin of two banks cant be compared as both the banks are poles apart in their own way, like in the nature of their activities, composition of customer base, and similar more. Return on Capital (RoC) The ratio is estimated by dividing the after-tax operating income (NOPAT) by the book value of invested capital.
EBIT(1 - T) BV of Invested Capital

Risk-adjusted Return on Capital Risk-adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses.

RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, it is a buffer against expected shocks in market values. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR.
Expected Return Economic Capital Expected Return Value at Risk

RAROC system allocates capital for two basic reasons: Risk management Performance evaluation

For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structurethat is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit. Cash Flow Return on Investment (CFRoI) Cash flow return on investment is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings. CFROI is compared to a hurdle rate to determine if investment/product is performing adequately. The hurdle rate is the total cost of capital for the corporation calculated by a mix of cost of debt financing plus investors expected return on equity investments. The CFROI must exceed the hurdle rate to satisfy both the debt financing and the investors expected return.

Or it can be written as, CFROI = Gross Cash Flow / Gross Investment

Efficiency Ratio The efficiency ratio, a ratio that typically applies to banks, in simple terms is defined as expenses as a percentage of revenue (expenses / revenue), with a few variations. A lower percentage is better since that means expenses are low and earnings are high. It relates to operating leverage, which measures the ratio between fixed costs and variable costs.

Return on Assets (RoA) The return on assets (ROA) percentage shows how profitable a company's assets are in generating revenue. It measures the amount of profit made by a company per dollar of its assets. It also shows the company's ability to generate profits before leverage, rather than by using leverage. Unlike other profitability ratios, such as return on equity (ROE), ROA measurements include all of a company's assets including those which arise from liabilities to creditors as well as those which arise from contributions by investors. So, ROA gives an idea as to how efficiently management use company assets to generate profit, but is usually of less interest to shareholders than some other financial ratios such as ROE. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry. Capital-intensive industries (such as railroads and thermal power plant) will yield a low return on assets, since they must possess such valuable assets to do business. Shoestring operations (such as software companies and personal services firms) will have a high ROA: their required assets are minimal. The number will vary widely across different industries. This is why, when using ROA as a comparative measure, it is best to compare it against a company's previous ROA figures or the ROA of a similar company.

ROA by DuPont

Return on Net Assets (RoNA) The return on net assets (RONA) is a measure of financial performance of a company which takes the use of assets into account. Higher RONA means that the company is using its assets and working capital efficiently and effectively. Net assets or net worth is the company assets minus liabilities.

Return on Operating Assets

Operating Profit Avg Operating Assets

Earning Power
EBIT Avg Total Assets

Turnover Ratios (Activity or Efficiency Ratios) Operating Asset Turnover Ratio

Revenue from Sale of goods and services Avg Operating assets

In numerator, we can write Total Revenue - Non-Operating Income

Asset Turnover Ratio Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. Companies in the retail industry tend to have a very high turnover ratio due mainly to cutthroat and competitive pricing.

"Average Total Assets" is the average of the values of "Total assets" from the company's balance sheet in the beginning and the end of the fiscal period. It is calculated by adding up the assets at the beginning of the period and the assets at the end of the period, then dividing that number by two. There is no set number that represents a good total asset turnover value because every industry has varying business models. It also depends on the proportion of labour costs in relation to the capital required, i.e. whether the process is labour intensive or capital intensive. The higher the number, the better. If there is a low turnover, it may be an indication that the business should either utilize its assets in a more efficient manner or sell them. But it also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. It should be noted that the asset turnover ratio formula does not look at how well a company is earning profits relative to assets. The asset turnover ratio formula only looks at revenues and not profits. This is the distinct difference between return on assets (ROA) and the asset turnover ratio, as return on assets looks at net income, or profit, relative to assets Working Capital Turnover Ratio
Total Revenue Avg Working Capital

Raw Materials Turnover Ratio

R/M Consumed Avg. R/M Inventory

WIP Turnover Ratio

Cost of Production Avg Working in Progress Inventory

Stock Turnover (Inventory Turnover or F/G Turnover Ratio) Inventory turnover is a measure of the number of times inventory is sold or used in a given time period such as one year. It is a good indicator of inventory quality (whether the inventory is obsolete or not), efficient buying practices, and inventory management. This ratio is important because gross profit is earned each time inventory is turned over.

There is no general norm for the inventory turnover ratio; it should be compared against industry averages. A relatively low inventory turnover may be the result of ineffective inventory management (that is, carrying too large an inventory) and poor sales or carrying out-of-date inventory to avoid writing off inventory losses against income. Normally a high number indicates a greater sales efficiency and a lower risk of loss through un-saleable stock. However, too high an inventory turnover that is out of proportion to industry norms may suggest losses due to shortages, and poor customerservice. A high value for inventory turnover usually accompanies a low gross profit figure. This means that a company needs to sell a lot of items to maintain an adequate return on the capital invested in the company.

Inventory Conversion Period (Average days to sell inventory)

Inventory * 365 days COGS

Days Inventory Outstanding (DIO) It is an average inventory level expressed in days. Days inventory outstanding = 365 / Inventory turnover

Debtors Turnover Ratio (Accounts Receivables Turnover Ratio) The receivable turnover ratio (debtors turnover ratio, accounts receivable turnover ratio) indicates the velocity of a company's debt collection, the number of times average receivables are turned over during a year. This ratio determines how quickly a company collects outstanding cash balances from its customers during an accounting period. It is an important indicator of a company's financial and operational performance and can be used to determine if a company is having difficulties collecting sales made on credit. Receivable turnover ratio indicates how many times, on average, account receivables are collected during a year (sales divided by the average of accounts receivables).

There is no general norm for the receivables turnover ratio it strongly depends on the industry and other factors. The higher the value of receivable turnover the more efficient is the management of debtors or more liquid the debtors are, the better the company is in terms of collecting their accounts receivables. Similarly, low debtors turnover ratio implies inefficient management of debtors or less liquid debtors. But in some cases too high ratio can indicate that the company's credit lending policies are too stringent, preventing prime borrowing candidates from becoming customers.

Average Collection Period (Receivables or Debtors Collection Period) The average collection period (also called Days Sales Outstanding (DSO)) is the number of days, on average, that it takes a company to collect its accounts receivables, i.e. the average number of days required to convert receivables into cash.
Avg Sundry Debtors Avg daily Credit Sales

or

Days Sales Outstanding (DSO) It is the average collection period in days. It is expressed as: Days sales outstanding = 365 / Receivables Turnover Ratio Creditors Turnover Ratio (Accounts Payables Turnover Ratio)
Credit Purchases Average Creditors

Average Payment Period (Payables Conversion Period)

Avg Sundry Creditors Avg daily Purchases

Or

Days Payment Outstanding (DPO) It is the accounts payable period in days. It is expressed as: Days Payable Outstanding (DPO) = 365 /Accounts payable turnover ratio Degree of Operating Leverage (DOL) Operating leverage is a measure of how revenue growth translates into growth in operating income.

Cash Conversion Cycle (Operating Cycle) The cash conversion cycle (CCC or Operating Cycle) is the length of time between a firm's purchase of inventory and the receipt of cash from accounts receivable. It is the time required for a business to turn purchases into cash receipts from customers. CCC represents the number of days a firm's cash remains tied up within the operations of the business. A cash flow analysis using CCC also reveals in, an overall manner, how efficiently the company is managing its working capital. The cash conversion cycle is also referred to as the cash cycle, asset conversion cycle or net operating cycle. CCC = Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period Cash Conversion Cycle (CCC) = DIO + DSO DPO A short cycle allows a business to quickly acquire cash that can be used for additional purchases or debt repayment. The lower the cash conversion cycle, the more healthy a company generally is. Businesses attempt to shorten the cash conversion cycle by speeding up payments from customers and slowing down payments to suppliers. CCC can even be negative; for instance, if the company has a strong market position and can dictate purchasing terms to suppliers (i.e. can postpone its payments). Valuation Ratios Valuation, in finance means the process by which the value of something is estimated. In case of businesses, the value of financial assets and liabilities are usually estimated. Valuation of both tangible and intangible assets is done. Valuation is used by the participants of financial markets for determination of prices which can be paid or received willingly to consummate a business sale. Earnings per Share (EPS) Earnings per share (EPS) are the amount of earnings per each outstanding share of a company's stock.

Net Earnings No. of Outstanding Equity Shares

Dividend Payout Ratio Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends. The part of earnings that is not paid out in dividends is used for reinvestment and growth in future earnings. Investors who are interested in short term earnings prefer to invest in companies with high dividend payout ratio. On the other hand, investors who prefer to have capital growth like to invest in companies with lower dividend payout ratio. Dividend payout ratio differs from company to company. Mature, stable and large companies usually have higher dividend payout ratio. Companies which are young and seeking growth have lower or modest dividend payout ratio. The dividend payout ratio should not be too high. If the company pays high levels of dividends it may become for it to maintain such levels of dividends if the earnings fall in the future. Dividends are paid in cash; therefore, high dividend payout ratio can have implications for the cash management and liquidity of the company.

Dividend Payout Ratio = Dividend per Share / Earnings per Share (EPS) x 100% It should be noted that the dividends are not paid from earnings; in fact they are paid from the cash. Dividend payout ratio compares dividends to the earnings, not to the cash. A company will not be able to pay dividends if it does not have sufficient cash even if it has a high level of earnings. Dividend Cover Dividend cover is the ratio of company's earnings (net income) over the dividend paid to shareholders, calculated as earnings per share divided by the dividend per share. It is the inverse of Dividend Payout Ratio.

Dividend Yield Dividend yield is the amount that a company pays to its share holders annually for their investments. It is expressed as a percentage and indicates attractiveness of investing in a companys stocks. Dividend yield is considered as ROI for income investors who are not interested in capital gains or long-term earnings.
Dividend Market Capitalisation

Dividend

Yield

Ratio

Dividend

per

Share

Market

Value

per

Share

Dividend yield indicates how much you are earning for each dollar invested in a company. Investors widely use this ratio in trend analysis and consider their past dividend yield ratios to decide whether to invest in the company or not. Market value of shares affect dividend yield ratio. Owners/Directors of the company may leak out some fake information to play with the market value of shares. Once the market value of share fluctuates, dividend yield ratio gets adjusted accordingly. Cash Flow Ratio (Price/Cash Flow Ratio) The price/cash flow ratio (also called price-to-cash flow ratio or P/CF), is a ratio used to compare a company's market value to its cash flow. It is calculated by dividing the company's market cap by the company's operating cash flow in the most recent fiscal year (or the most recent four fiscal quarters); or, equivalently, divide the per-share stock price by the per-share operating cash flow. In theory, the lower a stock's price/cash flow ratio is, the better value that stock is.

Price/ Book Value Ratio (P/B Ratio) Price/book value ratio is an investment valuation ratio used by investors or finance providers to compare market value of a companys shares to its book value (Shareholder Equity). This ratio indicates how much shareholders are contributing/ paying for a companys net assets. Book value provides an estimated value of a company if it is to be liquidated. It is the value of a companys assets expressed in the Statement of Financial Position (B/S). It is calculated by subtracting companys liabilities from its assets (Assets-Liabilities). In simple words it shows what shareholders will get after the company is sold and all its debts are paid off. Low ratio represents a good sign for the company. The price to book or price/book value ratio helps investors to compare the market value, or the price they are normally paying per share, to the traditional measure of the firms value. This ratio is best suitable for companies that possess a large number of tangible fixed assets as it does not account for intangible assets. Companies having buildings, factories, machineries, equipments, and other fixed assets can use this ratio to check the exact company position. This ratio is best suited to banks and insurance companies as they have a large number of financial assets. Price/Book Value Ratio = Stock Price per Share / Shareholders Equity per Share One of its major limitations is that it does not consider intangible assets like Goodwill which leads to low book value and high artificial price/book ratio. The book value considers original purchase price of an item not the current market price which leads to measurement inaccuracies. Another limitation is that in case of different accounting methods are used, e.g. USGAP and IFRS, it gives different asset values which make the comparison even harder. Price to Sales Ratio (P/S Ratio) Price to sales ratio compares the price of a share to the revenue per share. This ratio is usually used for valuation of shares. It takes into account the past performance of a company for valuation of its shares.

Price to sales ratio is calculated for the trailing twelve months, unless stated otherwise. A lower price/sales ratio is usually considered to be a better investment because the investors have to pay less money for each unit of sales. Price to sales ratio can vary substantially from industry to industry or sector to sector. Therefore, it is better to use it for comparison with the companies operating within the same industry or sector. Price/Sales Ratio = Price per Share / Revenue per Share or Price to Sales Ratio = Market Capitalization / Sales Revenue Price to sales ratio should be used with caution. It do not present the complete picture because it do not take into account the expenses and liabilities of a company. Besides, a lower price/sales ratio is not always a positive indicator because the company might be unprofitable with a lower price/sales ratio. This ratio is usually calculated for the loss-making companies because price earnings ratio (P/E Ratio) cannot be calculated for such companies. Price to Earnings Ratio (P/E Ratio) The price to earnings ratio (P/E ratio) is the ratio of market price per share to earnings per share. It is also sometimes known as earnings multiple or price multiple. Though Price-earnings ratio has several imperfections but it is still the most acceptable method to evaluate prospective investments. It is calculated to estimate the appreciation in the market value of equity shares. P/E ratio indicates what amount an investor is paying against every dollar of earnings.
P/E Ratio (Trailing) MPS EPS (most recent) MPS EPS (immediately succeeding)

P/E Ratio (Forward)

The P/E ratio tells how much the market is willing to pay for a companys earnings. A higher P/E ratio means that the market is more willing to pay for the earnings of the company. Higher price to earnings ratio indicates that the market has high hopes for the future of the share and therefore it has bid up the price. On the other hand, a lower price

to earnings ratio indicates the market does not have much confidence in the future of the share. The average P/E ratio is normally from 12 to 15 however it depends on market and economic conditions. P/E ratio may also vary among different industries and companies. A higher P/E ratio indicates that an investor is paying more for each unit of net income. So P/E ratio between 12 and 15 is acceptable. A higher P/E ratio may not always be a positive indicator because a higher P/E ratio may also result from overpricing of the shares. Similarly, a lower P/E ratio may not always be a negative indicator because it may mean that the share is a sleeper that has been overlooked by the market. Therefore, P/E ratio should be used cautiously. Investment decisions should not be based solely on the P/E ratio. It is better to use it in conjunction with other ratios and measures. The most obvious and widely discussed problem in P/E ratio is that the denominator considers non-cash items. Earnings figure can easily be manipulated by playing with non cash items, for example, depreciation or amortization. If it is not manipulated deliberately, earnings figure is still affected by non cash items. That is why a large number of investors are now using Price/Cash Flow Ratio which removes non-cash items and considers cash items only. PEG Ratio The PEG ratio which is the price/earnings to growth ratio is used to determine the relative trade-off between price of stock, earnings per share (EPS) and the expected growth of the company. Generally, a company that has a higher rate of growth will have a higher P/E ratio. So, if only the P/E ratio is used for a company which has higher growth rate then it will appear to be overvalued as compared to the others. Therefore, if the P/E ratio is divided by the earnings growth rate then the resulting ratio will be more suitable for comparing different companies having different rates of growth. The PEG ratio was first developed by Mario Farina in the year 1969. This was mentioned in his book A Beginners Guide to Successful Investing in The Stock Market. However, in 1989, this was made popular by Peter Lynch in his book, One up On Wall

Street, where he wrote that the P/E ratio of a company which is priced fairly will equal its growth rate, which means that the PEG ratio will be equal to 1 for any company that is fairly priced.

The PEG is commonly used for indicating the possible true value of a stock. PEG ratio is similar to PE ratio in the way that lower ratios of both means undervalued stock. Since PEG takes into account the growth aspect, it is sometimes chosen over the P/E ratio. When the PEG ratio is 1 then it reflects that the stock is valued reasonably considering the expected growth. When the PEG values are between 0 and 1, then it may give higher returns. The PEG ratio is also sometimes negative. This may happen when there is a possibility of the earnings to decline. The PEG components should be analyzed for devising a successful investment strategy. Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio is less appropriate for measuring companies without high growth. Yield
Dividend + Price Change Initial Price

Enterprise Value (EV) The enterprise value (EV) measures the value of the ongoing operations of a company. It attempts to measure the value of a company's business instead of measuring the value of the company. It is the measure for calculating how much it would cost to buy a companys business free of its debts and liabilities. The enterprise value is used as an alternative to market capitalization. It is a more accurate estimate of the takeover price of a company than the market capitalization.

Enterprise Value = Market Capitalization +Debt +Preferred Share Capital + Minority Interest - Cash and cash equivalents Market Capitalization: Is the market value of common shares of a company. It is calculated by multiplying the current market price per share by the total number of equity shares of the company. Debt: Includes the bonds and bank loans. Items such as trade creditors are not included. Ones a business is acquired, its debts become the responsibility of the acquirer. The acquirer will have to repay the debts from the cash flows of the business; therefore, they are added to the calculation of enterprise value. Preferred Shares: Redeemable preferred shares are in substance debt. They are debt to all intents and purposes. Therefore, the existence of such preferred shares represents a claim on the business that must be factored into enterprise value (EV). Minority Interest: It is a non-current liability that represents the proportion of subsidiaries owned by minority shareholders. Cash and Cash Equivalents: These include cash in hand, cash at bank, and the short term investments which are highly liquid and can be easily converted to cash. They are subtracted for the calculation of enterprise value because they serve to reduce the acquisition price. EV- EBITDA Ratio It is a valuation multiple used in finance and investment to measure the value of a company. It compares the value of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses. This ratio is also known as enterprise multiple and EBITDA multiple. The enterprise multiple can be used compare the value of one company to the value of another company within the same industry. A lower enterprise multiple can be indicative of an undervaluation of a company. EV/EBITDA Ratio = EV / EBITDA

The EV/EBITDA ratio is a better measure than the P/E ratio because it is not affected by changes in the capital structure. Consider a scenario in which a company raises equity finance and uses these funds to repay the loans. This will usually result in lower earnings per share (EPS) and therefore a higher P/E ratio. But the EV/EBITDA ratio will not be affected by this change in capital structure i.e. it cannot be manipulated by the changes in capital structure. Another benefit of the EV/EBITDA ratio is that it makes possible fair comparison of companies with different capital structures. Another positive aspect to the EV/EBITDA ratio is that it removes the effect of non-cash expenses such as depreciation and amortization. These non-cash items are of less significance to the investors because they are ultimately interested in the cash flows. The EV/EBITDA ratio is not usually appropriate for the comparison of companies in different industries. Capital requirements of other industries are different. Therefore, the EV/EBITDA ratio may not give reliable conclusions when comparing different industries. EV/Sales Ratio Enterprise value/sales is a financial ratio that compares the total value (as measured by enterprise value) of the company to its sales. Generally, the lower the ratio, the cheaper the company is. Some investment professionals believeas enterprise value and sales both consider debt and equity holdersEnterprise Value/Sales is superior to the oft quoted price/sales ratio.

Q Ratio
Q Ratio Market Value of Equity and Liabilities Estimated replacement cost of assets

CORPORATE FINANCE Capital Budgeting Capital Structure & Dividend Decisions Working Capital Management

Capital Budgeting Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Capital Budgeting Process The specific capital budgeting procedures that the manager uses depend on the manger's level in the organization and the complexities of the organization and the size of the projects. The typical steps in the capital budgeting process are as follows: Brainstorming: Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or functional area, or from outside the company. Generating good investment ideas to consider is the most important step in the process. Project analysis: This step involves gathering the information to forecast cash flows for each project and then evaluating the project's profitability. Capital budget planning: The Company must organize the profitable proposals into a coordinated whole that fits within the company's overall strategies, and it also must consider the projects' timing. Some projects that look good when considered in isolation may be undesirable strategically. Because of financial and real resource issues, the scheduling and prioritizing of projects is important. Performance monitoring: In a post-audit, actual results are compared to planned or predicted results, and any differences must be explained. For example, how do the revenues, expenses, and cash flows realized from an investment compare to the

predictions? Post-auditing capital projects is important for several reasons. First, it helps monitor the forecasts and analysis that underlie the capital budgeting process. Systematic errors, such as overly optimistic forecasts, become apparent. Second, it helps improve business operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations if at all possible. Finally, monitoring and post-auditing recent capital investments will produce concrete ideas for future investments. Managers can decide to invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing. Complexity of Capital Budgeting Process The budgeting process needs the involvement of different departments in the business. Planning for capital investments can be very complex, often involving many persons inside and outside of the company. Information about marketing, science, engineering, regulation, taxation, finance, production, and behavioural issues must be systematically gathered and evaluated. The authority to make capital decisions depends on the size and complexity of the project. Lower-level managers may have discretion to make decisions that involve less than a given amount of money, or that do not exceed a given capital budget. Larger and more complex decisions are reserved for top management, and some are so significant that the company's board of directors ultimately has the decision-making authority. Like everything else, capital budgeting is a cost-benefit exercise. At the margin, the benefits from the improved decision making should exceed the costs of the capital budgeting efforts. Need for Capital Budgeting As large sum of money is involved this influences the profitability of the firm making capital budgeting an important task. Long term investment once made cannot be reversed without significance loss of invested capital. The investment becomes sunk and mistakes, rather than being readily rectified, must often be borne until the firm can be withdrawn through depreciation charges or liquidation. It influences the whole conduct of the business for the years to come.

Investment decision are the base on which the profit will be earned and probably measured through the return on the capital. A proper mix of capital investment is quite important to ensure adequate rate of return on investment, calling for the need of capital budgeting.

The implication of long term investment decisions are more extensive than those of short run decisions because of time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than short run decision.

Project or Capital Budgeting Classification Mandatory Investments: Expenditures required complying with statutory requirements. E.g. Investments in pollution control equipments, medical dispensary, fire-fighting equipment etc. Replacement Projects: Replacing obsolete and insufficient equipments for reducing costs, increasing yield and quality. Expansion Projects: Increasing capacity and widening the distribution network. Diversification Projects: Investments aimed at producing new products or services or entering new geographical areas. R&D Projects: Funding R&D projects, especially in knowledge intensive industries. Miscellaneous Projects: This is catch-all category that includes items like interior decoration, recreational facilities, executive aircrafts etc. CSR Projects or contributions can also be included. However, there is no standard approach for evaluating such projects and decisions are based on personal preferences of top management. Capital Budgeting Evaluation Methods When evaluating a project or long term investment of company, it is important to reach right decisions based on the capital budgeting methods. Analysts often use several important criteria to evaluate capital investments.

Understanding the Project Types One of the key things in evaluating the project is to estimate the future cash flow of the projects, however, several types of project interactions make the future cash flow analysis challenging. The following are some of these interactions: Independent versus mutually exclusive projects: Independent projects are projects whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. For example, if Projects A and B are mutually exclusive, you can choose A or B, but you cannot choose both. Sometimes there are several mutually exclusive projects, and you can choose only one from the group. Project sequencing: Many projects are sequenced through time, so that investing in a project creates the option to invest in future projects. For example, you might invest in a project today and then in one year invest in a second project if the financial results of the first project or new economic conditions are favourable. If the results of the first project or new economic conditions are not favourable, you do not invest in the second project. Unlimited funds versus capital rationing: -An unlimited funds environment assumes that the company can raise the funds it wants for all profitable projects simply by paying the required rate of return. Capital rationing exists when the company has a fixed amount of funds to invest If the company has more profitable projects than it has funds for, it must allocate the funds to achieve the maximum shareholder value subject to the funding constraints. Following are some methods of evaluation: Accounting rate of return Payback period Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity Real options valuation Benefit Cost Ratio
Discounting Criteria

Non discounting Criteria

(Most widely used are NPV, IRR and Payback Period) Accounting Rate of Return (Average Rate of Return or ARR) The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

Payback Period Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite the recognized limitations described below. First, it is a measure of payback and not a measure of profitability. By itself the payback period would be a dangerous criterion for evaluating capital projects.

Secondly, the payback period may also be used as an indicator of project liquidity. A project with a two-year payback may be more liquid than another project with a longer payback. Because it is not economically sound, the payback period has no decision rule like that of the NPV or IRR. If the payback period is being used (perhaps) as a measure of liquidity, analysts should also use an NPV or IRR to ensure that their decisions also reflect the profitability of the projects being considered. Net Present Value (NPV) The net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity. NPV can be described as the difference amount between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account. Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,

Where, - the time of the cash flow - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital - the net cash flow i.e. cash inflow cash outflow, at time t . For educational purposes, Ro is commonly placed to the left of the sum to emphasize its role as (minus) the investment. The NPV is given by:

Where, N is the total no of periods. Decision Making NPV > 0 NPV < 0 rejected NPV = 0 the investment will result in neither gain nor loss to the value for the firm. the investment would add value to the firm the project may be accepted the investment would subtract value from the firm the project should be

We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the calculation. Discount Rate The rate used to discount future cash flows to the present value is a key variable of this process. A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk, opportunity cost, or other factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt. Another approach to choosing the discount rate factor is to decide the rate which the capital needed for the project could return if invested in an alternative venture. If, for example, the capital required for Project A can earn 5% elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between Project A and the alternative. Reinvestment rate can be defined as the rate of return for the firm's investments on average. When analyzing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate rather than the firm's weighted average cost of capital as the discount factor. It reflects opportunity cost of investment, rather than the possibly lower cost of capital.

An NPV calculated using variable discount rates (if they are known for the duration of the investment) may better reflect the situation than one calculated from a constant discount rate for the entire investment duration. Limitations of NPV Rule: NPV is expressed in absolute terms rather than relative terms and hence does not factor in the scale of investment. Example, project A may have an NPV of Rs. 5000 while project B has an NPV of Rs. 2500, but project A may require an investment of Rs.50000 while project B may require an investment of Rs. 10000. NPV does not consider the life of the project. Hence, when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of the longer term project. Profitability Index Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project: If PI > 1 then accept the project If PI < 1 then reject the project

Internal Rate of Return The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or the rate of return (ROR).[1] In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation). The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. It can also be defined as the discount rate at which the present value of all future cash flow is equal to the initial investment or in other words the rate at which an investment breaks even. The IRR of an investment is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.

Where, n is a positive integer N is the total number of periods r is the internal rate of return IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first. If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

NOTE: NPV and IRR

Relation: The IRR is the point at which NPV crosses the x-axis. The slope of the NPV profile indicates how sensitive the project is to discount rate changes. IRR and NPV Rules lead to identical decisions provided two conditions are satisfied. 1. The cash flows must be conventional, implying that the first cash flow (initial investment) is negative and the subsequent cash flows are positive. 2. The project must be independent, meaning that the project can be accepted or rejected without reference to any other project. Problems with IRR 1) Single discount rate to evaluate every investment (IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them.)

Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1% and 12% in the last 20 years, so clearly the discount rate is changing. Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary. The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others. 2) Non Conventional Cash Flows In this case, basic IRR calculation is ineffective for a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which marketers must reinvent the style every couple of years to stay current in a fickle, trendy niche market. If the project has cash flows of $50,000 in year one (initial capital outlay), returns of $115,000 in year two and costs of $66,000 in year three because the marketing department needed to revise the look of the project, a single IRR can't be used. Recall that IRR is the discount rate that makes a project break even. If market conditions change over the years, this project can have two or more IRRs, as seen below.

Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are multiple rates of return for the project that produce multiple IRRs. Moreover,

there can also be a case where the project P has positive NPV for all discount rates and hence no IRR. 3) Discount Rate is not known (Arbitrary discount rate) Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If the discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to be financially worthwhile. NPV uses the correct rate, i.e., the cost of capital, to discount the cash flows, rather than an arbitrary rate, i.e., the IRR, that makes NPV =0. 4) Mutually Exclusive Projects While considering the mutually exclusive projects, IRR technique can be misleading. Investment projects are said to be mutually exclusive if only one project could be accepted and others would have to be rejected. NPV and IRR methods for project evaluation leads to conflicting results under following conditions: The pattern of cash inflows plays an important role in project evaluation while using IRR method. I.e. The cash flows of one project may increase over time, while those of others may decrease and vice versa. The major drawback with the IRR method is that for mutually exclusive projects, it can give contradictory investment decision when compared with NPV.

In the above example A and B are mutually exclusive projects. Both projects require an initial outlay of $ 1,000,000.00 but the pattern of cash inflows is different. Cash inflows for Project A are increasing over the period of time while for Project B these are declining. IRR decision rule leads to select Project A as Project A IRR>Project B IRR. But decision on the basis of NPV evaluation implies that project B is more viable. Thus on the basis of mere IRR the company may select less profitable project. Why companies prefer IRR over NPV Simplicity If NPV calculation uses different discount rates, then it produces different results for the same project. But, IRR always gives the same result. For the same reason, given a choice between NPV vs IRR, managers generally prefer IRR because it is easier and less confusing whereas NPV is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc.

Easier for Comparison The net present value is an indicator of the magnitude of an investment (currency) whereas the internal rate of return is a rate quantity (%); it is an indicator of the efficiency, quality, or yield of an investment and thus managers find it easier to compare investments of different sizes in terms of percentage rates of return than by currency of NPV.

Modified Internal Rate of Return (MIRR) 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.

MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR. Firstly, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them. This is usually an unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost of capital. The IRR therefore often gives an unduly optimistic picture of the projects under study. Generally for comparing projects more fairly, the weighted average cost of capital should be used for reinvesting the interim cash flows. Secondly, 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.

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), 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 Cash flow 0 1 2 3 -1000 -4000 5000 2000

then the IRR is given by

. In this case, the answer is 25.48% (the other solutions to this equation are -593.16% and -132.32%, but they will not be considered meaningful IRRs).

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):

Second, we calculate the future value of the positive cash flows (reinvested at the reinvestment rate):

Third, we find the MIRR:

(Wrong) The calculated MIRR (17.91%) is significantly different from the IRR (25.48%). Limitation: Like the internal rate of return, the modified internal rate of return cannot be validly used to rank-order projects of different sizes, because a larger project with a smaller modified internal rate of return may have a higher present value. Equivalent Annual Cost (EAC) In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its entire lifespan. EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespan. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless neither project could be repeated.

EAC is calculated by dividing the NPV of a project by the present value of an annuity factor. Equivalently, the NPV of the project may be multiplied by the loan repayment factor.

The use of the EAC method implies that the project will be replaced by an identical project. Example: A manager must decide on which machine to purchase: Machine A Investment cost $50,000 Expected lifetime 3 years Annual maintenance $13,000 Machine B Investment cost $150,000 Expected lifetime 8 years Annual maintenance $7,500 The cost of capital is 5%. The EAC for machine A is: ($50,000/) +$13,000=$31,360 The EAC for machine B is: ($150,000/) +$7,500=$30,708 The conclusion is to invest in machine B since it has a lower EAC. Note: The loan repayment factors (A values) are for t years (3 or 8 years) and 5% cost of capital. is given by = 2.723 and is given by = 6.463. (See ordinary annuity formulae for

a derivation.) The larger an A value is, the greater the present value is on a succession of future annuity payments, thus contributing to a smaller annual cost. Alternative method: The manager calculates the NPV of the machines: Machine A EAC=$85,400/=$31,360 Machine B EAC=$198,474/=$30,708 Note: To get the numerators add the present value of the annual maintenance to the purchase price. For example, for Machine A: 50,000 + 13,000/1.05 + 13,000/(1.05)^2 + 13,000/(1.05)^3 = 85,402. The result is the same, although the first method is easier it is essential that the annual maintenance cost is the same each year. Real Options Valuation Real options valuation, also often termed real options analysis (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself, is the right but not the obligation to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively. Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security. Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to "real-life" decisions. Example: Where the projects scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.

Option to expand: Here the project is built with capacity in excess of the expected level of output so that it can produce at higher rate if needed. Management then has the option (but not the obligation) to expand i.e. exercise the option should conditions turn out to be favourable. A project with the option to expand will cost more to establish, the excess being the option premium, but is worth more than the same without the possibility of expansion. This is equivalent to a call option. Option to contract: The project is engineered such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future expenditures constitutes option exercise. This is the equivalent to a put option, and again, the excess upfront expenditure is the option premium. Option to expand or contract: Here the project is designed such that its operation can be dynamically turned on and off. This option is also known as a Switching option. Cost-Benefit Analysis (CBA) [Economic IRR] Cost benefit analysis (CBA), sometimes called benefitcost analysis (BCA), is a systematic process for calculating and comparing benefits and costs of a project, decision or government policy. CBA has two purposes: To determine if it is a sound investment/decision (justification/feasibility), To provide a basis for comparing projects. It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much. Steps: 1. List alternative projects/programs. 2. List stakeholders. 3. Select measurement(s) and measure all cost/benefit elements. 4. Predict outcome of cost and benefits over relevant time period. 5. Convert all costs and benefits into a common currency. 6. Apply discount rate. 7. Calculate net present value of project options.

8. Perform sensitivity analysis. 9. Adopt recommended choice. Valuation: CBA attempts to measure the positive or negative consequences of a project, which may include: Effects on users or participants Effects on non-users or non-participants Externality effects Option value or other social benefits

Risk Analysis in Capital Budgeting Sensitivity Analysis Scenario Analysis Break-even Analysis Decision Tree Analysis

Sensitivity Analysis Sensitivity analysis is the study of how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be apportioned to different sources of uncertainty in its inputs. Scenario Analysis (What-If Analysis) Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes. Break-Even Analysis An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point.

Decision Tree Analysis A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. It is one way to display an algorithm. In decision analysis a decision tree and the closely related influence diagram is used as a visual and analytical decision support tool, where the expected values (or expected utility) of competing alternatives are calculated. A decision tree consists of 3 types of nodes: Decision nodes - commonly represented by squares Chance nodes - represented by circles End nodes - represented by triangles

Cost of Capital The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity; one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required. Cost of Debt (Kd or Rd) When companies borrow funds from outside or take debt from financial institutions or other resources the interest paid on that amount is called cost of debt. The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term

structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate) (1-T), where T is the corporate tax rate and Rf is the risk free rate. {Rd = Rf +credit risk rate} Cost of Preference (Kp or Rp) Preference stock is considered much like a bond with fixed commitments. Preference dividend is not tax deductible (not produce any tax saving) and moreover companies in India have to pay a dividend distribution tax. Cost of Equity (Ke or Re) Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market

{CAPM Model} Where: Re or Es - The expected return for a security Rf - The expected risk-free return in that market (government bond yield) s - The sensitivity to market risk for the security Rm - The historical return of the stock market/ equity market (Rm-Rf) - The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. WACC = Wp*Kp + We*Ke + Wd*Kd (1-T) Factors affecting WACC: Outside firms control o Level of Interest Rates o Market Risk Premium o Tax Rates Within Firms Control o Investment Policy ( Investment in assets which may/ may not be risky) o Capital Structure Policy o Dividend Policy Sources of Positive NPV Economies of Scale Product Differentiation Cost Advantage Marketing Reach Technological Edge Government Policy

Capital Structure Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. In reality, capital structure may be highly complex and include dozens of sources. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or borrowed funds in the financing mix of a company. Financial Structure The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to which total funds are available to finance the total assets of the business. Financial Structure = Total liabilities Or Financial Structure = Capital Structure + Current liabilities.

Optimal Capital Structure Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and therefore the value of the firm is maximum.

Factors determining the Capital Structure Leverage It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is closely related to the overall cost of capital Cost of Capital (specified earlier) Government Policy Promoter contribution is fixed by the company Act. It restricts to mobilize large, long-term funds from external sources. Hence the company must consider government policy regarding the capital structure. Capital Structure Theories

Net Income Approach Net income approach suggested by the Durand. The theory suggests increasing value of the firm by decreasing overall cost of capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having higher proportion of debt, which is a cheaper source of finance compared to equity finance. According to Net Income Approach, change in the financial leverage of a firm will lead to corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in leverage (proportion of debt),

the WACC decreases and the value of a firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis--vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would have a positive impact on value of the business and thereby increase the value per share.

Assumptions: Net Income Approach makes certain assumptions which are as follows: Increase in debt will not affect the confidence levels of the investors. The cost of debt is less than cost of equity. There are no taxes levied.

Net Operating Income Approach

Net Operating Income Approach suggests that change in debt of the firm/company or the change in leverage fails to affect the total value of the firm/company. As per this approach, the WACC and total value of a company are independent of the capital structure decision or financial leverage of a company. As per this approach, the market value is dependent on the operating income and the associated business risk of the firm. Both these factors cannot be impacted by the financial leverage. Financial leverage can only impact the share of income earned by debt holders and equity holders but cannot impact the operating incomes of the firm. Therefore, change in debt to equity ratio cannot make any change in the value of the firm. It further says that with the increase in the debt component of a company, the company is faced with higher risk. To compensate that, the equity shareholders expect more returns. Thus, with increase in financial leverage, the cost of equity increases.

Assumptions: Net Operating Income Approach makes certain assumptions which are as follows: The overall cost of capital remains constant There are no corporate taxes The market capitalizes the value of the firm as a whole

Traditional Approach Traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum. As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in reduction in value of the firm. It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement.

Assumptions under Traditional Approach: The rate of interest on debt remains constant for a certain period and thereafter with increase in leverage, it increases. The expected rate by equity shareholders remains constant or increase gradually. After that the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily. As a result of activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.

ModiglianiMiller Approach This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble to that of Net Operating Income Approach. Modigliani and Miller advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component in the financing mix, it has no bearing on the value of a firm. Modigliani and Miller Approach further states that the market value of a firm is affected by its future growth prospect apart from the risk involved in the investment. The theory stated that value of the firm is not dependent on the choice of capital structure or financing decision of the firm. If a company has high growth prospect, its market value is higher and hence its stock prices would be high. If investors do not see attractive growth prospects in a firm, the market value of that firm would not be that great. Assumptions of Modigliani and Miller Approach There are no taxes. Transaction cost for buying and selling securities as well as bankruptcy cost is nil. There is symmetry of information. This means that an investor will have access to same information that a corporate would and investors would behave rationally. The cost of borrowing is the same for investors as well as companies. Debt financing does not affect companies EBIT.

Modigliani and Miller Approach indicates that value of a leveraged firm (firm which has a mix of debt and equity) is the same as the value of an unleveraged firm (firm which is wholly financed by equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm. Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The ModiglianiMiller theorem states that the value of the two firms is the same. Modigliani and Miller Approach: Two Propositions without Taxes

Proposition I: VL (Value of levered firm) = Vu (Value of unlevered firm) To see why this should be true, suppose an investor is considering buying one of the two firms U or L, instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt. (If there exist two firms having the same operating income but different capital structure then there will be arbitrage and it will continue until the market values of the firms equals) Proposition II:

Ko Overall cost of capital A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC). These propositions are true assuming the following assumptions: no transaction costs exist, and individuals and corporations borrow at the same rates

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off Theory of Leverage) Proposition I:

Tc Tax Rate and D value of Debt; the term TcD assumes debt is perpetual This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible. Proposition II:

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%. The following assumptions are made in the propositions with taxes: corporations are taxed at the rate on earnings after interest,

no transaction costs exist, and individuals and corporations borrow at the same rate

Trade-Off Theory of Capital Structure The Trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. Trade-off theory of capital structure basically entails offsetting the costs of debt against the benefits of debt. Trade-off theory of capital structure primarily deals with the two concepts - cost of financial distress and agency costs. An important purpose of the trade-off theory of capital structure is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Cost of Capital v/s Capital Structure

The above figure shows that the after-tax cost of debt has an upward slope due to the increasing costs of financial distress that come with additional leverage. As the cost of debt increases, the cost of equity also increases because some of the costs of financial distress are effectively borne by equity holders. The optimal proportion of debt is reached at the point when the marginal benefit provided by the tax shield of taking on additional debt is equal to the marginal costs of financial distress incurred from the additional debt. This point also represents the firm's optimal capital structure because it is the point that minimizes the firm's WACC and therefore maximizes the value of the firm. Firm Value v/s Capital Structure

Leverage Leverage is a practice which can help a business drive up its gains / losses. (Investing with borrowed money as a way to amplify potential gains (at the risk of greater losses)). In business language, if a firm has fixed expenses in P/L account or debt in capital

structure, the firm is said to be levered. Now-a-days, almost no business is away from leverage but very few have struck a balance. In finance, leverage is very closely related to fixed expenses. We can safely state that by introduction of expenses which are fixed in nature, we are leveraging a firm. By fixed expenses, we refer to the expenses, the amount of which remains unchanged irrespective of the activity of the business. For example, amount of investment made in fixed assets or interest paid on loans does not change with a normal change in the amount of sales. Neither they decrease with decrease in sales and nor they increase with increase in sales. Classification of Leverage There are different basis for classifying business expenses. For our convenience, let us classify fixed expenses into operating fixed expenses such as depreciation on fixed expenses, salaries etc, and financial fixed expenses such as interest and dividend on preference shares. Similar to them, leverages are also of two types financial leverage and operating leverage.

Financial Leverage Financial leverage is a leverage created with the help of debt component in the capital structure of a company. Higher the debt, higher would be the financial leverage because with higher debt comes the higher amount of interest that needs to be paid. Financial

leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share. The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity. Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds. Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage. Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Where, FL = Financial leverage OP = Operating profit (EBIT) PBT = Profit before tax (PBT) Degree of Financial Leverage (DFL) Degree of financial leverage is nothing but a measure of magnification that happens due to debt capital in the structure .It may be defined as the percentage change in taxable profit (PBT) as a result of percentage change in earnings before interest and tax (EBIT). This can be calculated by the following formula:

Or

Uses of Financial Leverage Financial leverage helps to examine the relationship between EBIT and EPS. Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT. Financial leverage locates the correct profitable financial decision regarding capital structure of the company. Financial leverage is one of the important devices which are used to measure the fixed cost proportion with the total capital of the company. If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease. Operating Leverage The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the companys ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage it means it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis.

Where, OL = Operating Leverage C = Contribution

OP = Operating Profits (EBIT) Degree of Operating Leverage (DOL) The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula:

Uses of Operating Leverage Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company. If any change in the sales, it will lead to corresponding changes in profit. Operating leverage helps to identify the position of fixed cost and variable cost. Operating leverage measures the relationship between the sales and revenue of the company during a particular period. Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities. Operating leverage describes the overall position of the fixed operating cost.

Combined Leverage In this case, the company uses both financial and operating leverage to magnification of any change in sales into a larger relative changes in earning per share. Combined leverage is also called as composite leverage or total leverage. Combined leverage expresses the relationship between the revenue in the account of sales and the taxable income.

Where, CL = Combined Leverage OL = Operating Leverage FL = Financial Leverage C = Contribution OP = Operating Profit (EBIT) PBT= Profit before Tax Degree of Combined Leverage (DCL) The percentage change in a firms earning per share (EPS) results from one percent change in sales. This is also equal to the firms degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales.

WORKING CAPITAL LEVERAGE One of the new models of leverage is working capital leverage which is used to locate the investment in working capital or current assets in the company. Working capital leverage measures the sensitivity of return in investment with the changes in the level of current assets.

If the earnings are not affected by the changes in current assets, the working capital leverage can be calculated with the help of the following formula.

Where, CA = Current Assets TA = Total Assets DCA = Changes in the level of Current Assets Advantages of Higher Leverage: Take operating leverage, the operating profits can see a sharp increase with a small change in sales as most part of the expenses are stagnant and cannot further increase with sales. Likewise, if we consider financial leverage, the earnings share of each shareholder will increase significantly with an increase in operating profits. Here, higher the degree of leverage, higher will be percentage increase in operating profits and earnings per share. Disadvantages of Higher Leverage: Leverage inherits the risk of bankruptcy along with it. In case of operating leverage, fixed expenses extend the breakeven point for a business. Financial leverage increases the minimum requirement of operating profits to meet with the expense of interest. In any case, if the required activity level not achieved, bankruptcy or cash losses become certain. Looking at the pros and cons of leverage, it seems that a balance is required between the rewards and risks associated with leverage. The degree of leverage should not be too high which invites the bankruptcy and on the contrary it should not be too low that we lose out on the benefits and the viability of a business itself comes under question. Dividend Decision Dividend is part of the profit of a business concern, which is distributed among its shareholders. Types of Dividend:

Types of Dividend Theories

Factors determining Dividend Policy Profitable Position of the Firm Dividend decision depends on the profitable position of the business concern. When the firm earns more profit, they can distribute more dividends to the shareholders. Uncertainty of Future Income Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular income, the firm should maintain regular dividend policy. Legal Constrains The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.

Liquidity Position Liquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend. Sources of Finance If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for retained earnings. Growth Rate of the Firm High growth rate implies that the firm can distribute more dividends to its shareholders. Tax Policy Tax policy of the government also affects the dividend policy of the firm. When the government gives tax incentives, the company pays more dividends. Capital Market Conditions Due to the capital market conditions, dividend policy may be affected. If the capital market is prefect, it leads to improve the higher dividend. Walters Model (Dividend policy affects the value of the firm) Walter's model shows the relevance of dividend policy and its bearing on the value of the share. Assumptions: Retained earnings are the only source of financing investments in the firm, there is no external finance involved. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new investments decisions are taken, the risks of the business remains same. The firm's life is endless i.e. there is no closing down.

Basically, the firm's decision to give or not give out dividends depends on whether it has enough opportunities to invest the retain earnings i.e. a strong relationship between investment and dividend decisions is considered. Dividends paid to the shareholders are reinvested by the shareholder further, to get higher returns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for the firm. Another situation where the firms do not pay out dividends is when they invest the profits or retained earnings in profitable opportunities to earn returns on such investments. This rate of return r, for the firm must at least be equal to ke. If this happens then the returns of the firm is equal to the earnings of the shareholders if the dividends were paid. Thus, it's clear that if r, is more than the cost of capital ke, then the returns from investments is more than returns shareholders receive from further investments. Walter's model says that if r<ke then the firm should distribute the profits in the form of dividends to give the shareholders higher returns. However, if r>ke then the investment opportunities reap better returns for the firm and thus, the firm should invest the retained earnings. The relationship between r and k are extremely important to determine the dividend policy. It decides whether the firm should have zero payout or 100% payout. In a nutshell: If r>ke, the firm should have zero payout and make investments. If r<ke, the firm should have 100% payouts and no investment of retained earnings. If r=ke, the firm is indifferent between dividends and investments.

Where, P = Market price of the share D = Dividend per share r = Rate of return on the firm's investments

ke = Cost of equity E = Earnings per shares' Therefore, the market value of a share is the result of expected dividends and capital gains according to Walter. Gordons Model (Dividend policy affects the value of the firm) Assumptions: Gordon's assumptions are similar to the ones given by Walter. However, there are two additional assumptions proposed by him: The product of retention ratio b and the rate of return r gives us the growth rate of the firm g. The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g. Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains; therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating a higher value of the share. In short, when retention rate increases, they require a higher discounting rate. Gordon has given a model similar to Walter's where he has given a mathematical formula to determine price of the share.

where, P = Market price of the share E = Earnings per share b = Retention ratio (1 - payout ratio) r = Rate of return on the firm's investments

ke = Cost of equity br = Growth rate of the firm (g) Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share. Modigliani and Miller Model Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later). Argument of this Model By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds.

MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. Investors are indifferent between dividend and retained earnings imply that the dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital would be independent of its dividend-payout ratio. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

Limitations of MM model: The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs.

Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price. Working Capital

Fixed capital means that capital, which is used for long-term investment of the business concern. For example, purchase of permanent assets. Normally it consists of nonrecurring in nature. Working Capital is another part of the capital which is needed for meeting day to day requirement of the business concern. For example, payment to creditors, salary paid to workers, purchase of raw materials etc., normally it consists of recurring in nature. It can be easily converted into cash. Hence, it is also known as short-term capital. Concept of Working Capital Gross working capital is the capital invested in total current assets of the business concern. (GWC = CA) Net Working Capital is the excess of current assets over the current liability of the concern during a particular period. (NWC = C A CL)

Component of Working Capital

Types of Working Capital

Permanent Working Capital It is also known as Fixed Working Capital. It is the capital; the business concern must maintain certain amount of capital at minimum level at all times. The level of Permanent

Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not change irrespective of time or volume of sales. Temporary Working Capital It is also known as variable working capital. It is the amount of capital which is required to meet the Seasonal demands (Seasonal Working Capital) and some special purposes such as launching of extensive marketing campaigns for conducting research etc (Special Working Capital). Semi Variable Working Capital Certain amount of Working Capital is in the field level up to a certain stage and after that it will increase depending upon the change of sales or time.

Needs of Working Capital Purchases of raw material and spares Payment of wages and salary Day-to-day expenses Provide credit obligations

Sources of Working Capital

Factors determining Working Capital Requirements Nature of Business If the business concerns follow rigid credit policy and sell goods only for cash, they can maintain lesser amount of Working Capital. A transport company maintains lesser amount of Working Capital while a construction company maintains larger amount of Working Capital. Production Cycle If less is the length of the production cycle lesser is the amount required to maintain the working capital. Business Cycle Business fluctuations lead to cyclical and seasonal changes in the business condition and it will affect the requirements of the Working Capital. Production Policy If the company maintains the continuous production policy, there is a need of regular Working Capital. If the production policy of the company depends upon the situation or conditions, Working Capital requirement will depend upon the conditions laid down by the company.

Credit Policy If the company maintains liberal credit policy to collect the payments from its customers, they have to maintain more Working Capital. If the company pays the dues on the last date it will create the cash maintenance in hand and bank. Growth and expansion Working Capital requirements are higher, because it needs some additional Working Capital and incurs some extra expenses at the initial stages. Availability of raw materials Major parts of the Working Capital requirements are largely depend on the availability of raw materials. Raw materials are the basic components of the production process. Earning capacity If the business concern consists of high level of earning capacity, they can generate more Working Capital, with the help of cash from operation. Methods for Estimation of Working Capital 1) Estimation of components of Working Capital method 2) Percent of Sales Method Based on the past experience between Sales and Working Capital requirements, a ratio can be determined for estimating the Working Capital requirement in future. 3) Operating Cycle The operating cycle begins with the acquisition of raw material and ends with the collection of receivables. Operating cycle consists of the following important stages: 1. Raw Material and Storage Stage, (R) 2. Work in Process Stage, (W)

3. Finished Goods Stage, (F) 4. Debtors Collection Stage, (D) 5. Creditors Payment Period Stage (C)

Working Capital Management (WCM) Working capital management is an act of planning, organizing and controlling the components of working capital like cash, bank balance inventory, receivables, payables, overdraft and short-term loans. Working capital management is concerned with the problems that arise in attempting to manage the current asset, current liabilities and the interrelationship that exist between them. WCM policies (Determining the Finance Mix) 1. Conservative working capital policy Conservative Working Capital Policy refers to minimize risk by maintaining a higher level of Working Capital. This type of Working Capital Policy is suitable to meet the seasonal fluctuation of the manufacturing operation.

2. Moderate working capital policy Moderate Working Capital Policy refers to the moderate level of Working Capital maintenance according to moderate level of sales. It means one percent of change in Working Capital is equal one percent change in sales.

3. Aggressive working capital policy Aggressive Working Capital Policy is one of the high risky and profitability policies which maintain low level of Aggressive Working Capital against the high level of sales, in the business concern during a particular period.

Determining the Finance Mix Under this decision, the relationship among risk, return and liquidity are measured and also which type of financing is suitable to meet the Working Capital requirements of the business concern. There are three basic approaches for determining an appropriate Working Capital finance mix. Hedging Approach When the business follows matching approach, long-term finance shall be used to fixed assets and permanent current assets and short-term financing to finance temporary or variable assets.

Conservative Approach Under this approach, the entire estimated finance in current assets should be financed from long-term sources and the short-term sources should be used only for emergency requirements. This approach is called as Low Profit Low Risk concept.

Aggressive Approach Under this approach, the entire estimated requirement of current assets should be financed from short-term sources and even a part of fixed assets financing be financed

from short- term sources. This approach makes the finance mix more risky, less costly and more profitable.

Inventory Management A proper planning of purchasing of raw material, handling, storing and recording is to be considered as a part of inventory management. Inventory management means, management of raw materials and related items. Inventory management considers what to purchase, how to purchase, how much to purchase, from where to purchase, where to store and when to use for production etc. In accounting language, inventory means stock of finished goods. In a manufacturing point of view, inventory includes, raw material, work in process, stores, etc. Kinds of Inventories: Raw Materials Work In Progress Consumables(materials needed to smooth running of the manufacturing process) Finished Goods Spares

Techniques based on the order quantity of inventories

Stock Level Minimum Level (Below which work will stop due to shortage of material understocking) Re-order Level (Level where business concern makes fresh order) Re-order level= Maximum consumption Maximum Re-order period.

Maximum Level (Exceeding this level will lead to overstocking) Maximum level = Re-order level + Re-order quantity (Minimum consumption Minimum delivery period) Danger Level (Level below the minimum level - leads to stoppage of the production process) Average Stock Level (Minimum stock level + of re-order quantity maximum level) Lead Time (time normally taken in receiving delivery after placing orders with suppliers includes processing time and executing time)

Safety Stock Safety stock implies extra inventories that can be drawn down when actual lead time and/ or usage rates are greater than expected. Safety stocks are determined by opportunity cost and carrying cost of inventories. If the business concerns maintain low level of safety stock, it will lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying costs. Economic Order Quantity (EOQ) Economic order quantity is the order quantity that minimizes total inventory holding costs (carrying costs) and ordering costs.

Where, a = Annual usage of inventories (units) b = Buying cost per order c = Carrying cost per unit Technique based on classification of inventories A-B-C Analysis It is the inventory management techniques that divide inventory into three categories based on the value and volume of the inventories.

Aging Schedule of Inventories Inventories are classified according to the period of their holding and also this method helps to identify the movement of the inventories. Hence, it is also called as, FNSD analysis where,

VED Analysis This technique is ideally suited for spare parts in the inventory management like ABC analysis.

HML Analysis Under this analysis, inventories are classified into three categories on the basis of the value of the inventories.

Techniques on the basis of records A. Inventory budget It is a kind of functional budget which facilitates the estimated inventory required for the business concern during a particular period. This budget is prepared based on the past experience.

B. Inventory reports Preparation of periodical inventory reports provides information regarding the order level, quantity to be procured and all other information related to inventories. On the basis of these reports, Management takes necessary decision regarding inventory control and management in the business concern. Methods for Valuation of Inventories 1. First in First Out Method (FIFO) 2. Last in First Out Method (LIFO) 3. Highest in First Out Method (HIFO) 4. Nearest in First Out Method (NIFO) 5. Average Price Method 6. Base Stock Method 7. Standard Price Method 8. Market Price Method Cash Management Management of cash consists of cash inflow and outflows, cash flow within the concern and cash balance held by the concern etc. Motives for Holding Cash Transaction Motive (Financing Routine Cash Transactions) Precautionary Motive (Meeting unexpected contingencies) Speculative Motive (For Capitalizing on opportunities) Compensating Motive (e.g. for paying off loans)

Cash Management Techniques Speedy Cash Collections Prompt payment by customers (Offering discounts, offers for avoiding payment delays) Early conversion of payments into cash (Using bank float, deposit float, processing float etc)

Concentration banking (Payments are deposited in collection centres of banks) Lock Box System (Cheques/payments are collected by the firms bank from the post office lock box and are deposited into the firms account)

Slowing Disbursements Avoiding the early payment of cash The firm should pay its payable only on the last day of the payment. If the firm avoids early payment of cash, the firm can retain the cash with it and that can be used for other purpose.

Centralised disbursement system Decentralized collection system will provide the speedy cash collections. Hence centralized disbursement of cash system takes time for collection from our accounts as well as we can pay on the date.

Receivable Management Receivables are also one of the major parts of the current assets of the business concerns. It arises only due to credit sales to customers, hence, it is also known as Account Receivables or Bills Receivables. Management of account receivable is defined as the process of making decision resulting to the investment of funds in these assets which will result in maximizing the overall return on the investment of the firm. Costs associated with the extension of credit and accounts receivables Collection Cost (cost incurred in collecting the receivables from the customers) Capital Cost (use of additional capital to support credit sales which alternatively could have been employed elsewhere) Administrative Cost (additional administrative cost for maintaining account receivable in the form of salaries to the staff kept for maintaining accounting records relating to customers, cost of investigation etc) Default Cost (over dues that cannot be recovered because of the inability of the customers)

Supply Chain Management Supply chain management (SCM) is the management of an interconnected or interlinked between network, channel and node businesses involved in the provision of product and service packages required by the end customers in a supply chain. Supply chain management spans the movement and storage of raw materials, work-in-process inventory, and finished goods from point of origin to point of consumption. It is also defined as the "design, planning, execution, control, and monitoring of supply chain activities with the objective of creating net value, building a competitive infrastructure, leveraging worldwide logistics, synchronizing supply with demand and measuring performance globally." SCM draws heavily from the areas of operations management, logistics, procurement, and information technology, and strives for an integrated approach.

Just in Time Approach Just in time (JIT) is a production strategy that strives to improve a business return on investment by reducing in-process inventory and associated carrying costs. To meet JIT objectives, the process relies on signals or Kanban (signboard or billboard) between different points in the process, which tell production when to make the next part. Kanban are usually 'tickets' but can be simple visual signals, such as the presence or absence of a part on a shelf. Implemented correctly, JIT focuses on continuous improvement and can improve a manufacturing organization's return on investment, quality, and efficiency. To achieve continuous improvement key areas of focus could be flow, employee involvement and quality. Sources of Finance A) Long Term Capital Market Capital market denotes an arrangement whereby transactions involving the procurement and supply of long-term funds take place among individuals and various organisations. Equity Capital (Ownership Capital) Authorised share capital (registered capital): It is the total of the share capital which a limited company is allowed (authorised) to issue. It presents the upper boundary for the actually issued share capital. Shares authorised = Shares issued + Shares unissued

Issued share capital is the total of the share capital issued (allocated) to shareholders which may be less or equal to the authorised capital. Shares outstanding are those issued shares which are not treasury shares. These are all the shares held by the investors in the company. Treasury shares are those issued shares which are held by the issuing company itself, the usual result of a buyback. Shares issued = Shares outstanding + Treasury shares

Issued capital can be subdivided in another way, examining whether it has been paid for by investors:

Subscribed capital is the portion of the issued capital, which has been subscribed by all the investors including the public. This may be less than the issued share capital as there may be capital for which no applications have been received yet ("unsubscribed capital").

Called up share capital is the total amount of issued capital for which the shareholders are required to pay. This may be less than the subscribed capital as the company may ask shareholders to pay by instalments.

Paid up share capital is the amount of share capital paid by the shareholders. This may be less than the called up capital as payments may be in instalments ("calls-in-arrears").

Preference Capital Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security which may have any combination of features not possessed by common stock including properties of both equity and a debt instruments, and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). Debentures A debenture is a document that either creates a debt or acknowledges it, and it is a debt without collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Special Financial Institutions A large number of financial institutions have been established in India for providing longterm financial assistance to industrial enterprises. There are many all-India institutions like Industrial Finance Corporation of India (IFCI); Industrial Credit and Investment Corporation of India (ICICI); Industrial Development Bank of India(IDBI) , etc. At the State level, there are State Financial Corporations (SFCs) and State Industrial

Development Corporations (SIDCs). These national and state level institutions are known as 'Development Banks'. Besides the development banks, there are several other institutions called as 'Investment Companies' or 'Investment Trusts' which subscribe to the shares and debentures offered to the public by companies. These include the Life Insurance Corporation of India (LIC); General Insurance Corporation of India (GIC); Unit Trust of India (UTI), etc. Leasing Companies Manufacturing companies can secure long-term funds from leasing companies. For this purpose a lease agreement is made whereby plant, machinery and fixed assets may be purchased by the leasing company and allowed to be used by the manufacturing concern for a specified period on payment of an annual rental. At the end of the period the manufacturing company may have the option of purchasing the asset at a reduced price. The lease rent includes an element of interest besides expenses and profits of the leasing company. Foreign Sources Foreign Collaborators If approved by the Government of India, the Indian companies may secure capital from abroad through the subscription of foreign collaborator to their share capital or by way of supply of technical knowledge, patents, drawings and designs of plants or supply of machinery.

Raising Capital in International Markets o Euromarkets Euromarkets refer to a collection of international banks that help firms in raising capital in a global market which is beyond the purview of any national regulatory body. An Indian firm can access the euro markets to raise a eurocurrency loan or issue a eurobond or issue global depository receipts or issue eurocurrency convertible bonds. Eurocurrency: A eurocurrency is simply a deposit of currency in a bank outside the country of the currency.

Eurocurrency Bonds: Firms using the euromarkets for debt financing can take out loans (called eurocurrency loans) or sell bonds (referred to as eurocurrency bonds). GDR / ADR: In the depository receipts mechanism, the shares issued by a firm are held by a depository, usually a large international bank, who receives dividends, reports, etc. and issues claims against these shares. In euromarkets they are called GDRs and in American markets they are called as ADRs o Domestic markets of various countries A second way to raise money internationally is to sell securities directly in the domestic capital markets of foreign countries. E.g. German firm may issue yen-denominated bonds in the Japanese capital market. FCCB: Foreign currency convertible bonds (FCCBs) are a special category of bonds. FCCBs are issued in currencies different from the issuing company's domestic currency. Corporates issue FCCBs to raise money in foreign currencies. These bonds retain all features of a convertible bond, making them very attractive to both the investors and the issuers. Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specified period. thus a holder of FCCB has the option of either converting it into equity share at a predetermined price or exchange rate, or retaining the bonds.

International Financial Institutions World Bank and International Finance Corporation (IFC) provide long-term funds for the industrial development all over the world. The World Bank grants loans only to the Governments of member countries or private enterprises with guarantee of the concerned Government. IFC was set up to assist the private undertakings without the guarantee of the member countries. It also provides them risk capital.

Non-Resident Indians Persons of Indian origin and nationality living abroad are also permitted to subscribe to the shares and debentures issued by the companies in India.

Retained Profits or Reinvestment of Profits An important source of long-term finance for ongoing profitable companies is the amount of profit which is accumulated as general reserve from year to year. To the extent profits are not distributed as dividend to the shareholders, the retained amount can be reinvested for expansion or diversification of business activities. Retained profit is an internal source of finance. Hence it does not involve any cost of floatation which has to be incurred to raise finance from external sources. B) Short Term Trade Credit It is the credit which the firms get from its suppliers. It does not make available the funds in cash, but it facilitates the purchase of supplies without immediate payment. No interest is payable on the trade credits. The period of trade credit depends upon the nature of product, location of the customer, degree of competition in the market, financial resources of the suppliers and the eagerness of suppliers to sell his stocks. Instalment Credit Firms may get credit from equipment suppliers. The supplier may allow the purchase of equipment with payments extended over a period of 12 months or more. Some portion of the cost price of the asset is paid at the time of delivery and the balance is paid in a number of instalments. The supplier charges interest on the instalment credit which is included in the amount of instalment. The ownership of the equipment remains with the supplier until all the instalments have been paid by the buyer. Accounts Receivable Financing Under it, the accounts receivables of a business concern are purchased by a financing company or money is advanced on security of accounts receivable. The finance companies usually make advances up to 60 per cent of the value of the accounts receivable pledged. The debtors of the business concern make payment to it which in turn forwards to the finance company.

Customer Advance Manufacturers of goods may insist the customers to make a part of the payment in advance, particularly in cases of special order or big orders. The customer advance represents a part of the price of the products that have been ordered by the customer and which will be delivered at a later date. Bank Credit Commercial Banks play an important role in financing the short-term requirements of business concerns. Loans When a bank makes an advance in lump sum, the whole of which is withdrawn to cash immediately by the borrower who undertakes to repay it in one single instalment, it is called a loan. The borrower is required to pay the interest on the whole amount.

Cash Credit When a borrower is allowed to borrow up to a certain limit against the security of tangible assets or guarantees, it is known as secured credit but if the cash credit is not backed by any security, it is known as clean cash credit. In case of clean cash credit the borrower gives a promissory note which is signed by two or more sureties. The borrower has to pay interest only on the amount actually utilised.

Overdrafts Under this, the commercial bank allows its customer to overdraw his current account so that it shows the debit balance. The customer is charged interest on the account actually overdrawn and not on the limit sanctioned.

Discounting of Bills Commercial banks finance the business concern by discounting their credit instruments like bills of exchange, promissory notes and hundies. These documents are discounted by the bank at a price lower than their face value.

Methods of Raising Long Term Finance

IPO SPO or FPO Rights Issue Private Placement Venture Capital & Private Equity Term Loan

(Refer PC for more details) Important Intermediaries of the Indian Financial System

Intermediary Stock Exchange

Market Capital Market

Role Secondary securities Corporate advisory services, Issue of securities to unsubscribed Market to

Investment Bankers

Capital Market, Credit Market Capital Market Market,

Underwriters

Money Subscribe

portion of securities Issue securities to the

Registrars, Custodians

Depositories,

Capital Market

investors on behalf of the company and handle share transfer activity

Primary Dealers

Dealers

Satellite

Money Market

Market making in government securities Ensure currencies exchange ink

Forex Dealers

Forex Market

Process & methodology followed by a rating agency to rate a financial instrument Credit Rating Process Following are the steps: 1. Receipt of the request: The rating process begins, with the receipt of formal request for rating from a company desirous of having its issue obligations under proposed instrument rated by credit rating agencies. An agreement is entered into between the rating agency and the issuer company. 2. Assignment to analytical team: On receipt of the above request, the CRA assigns the job to an analytical team. The team usually comprises of two members/analysts who have expertise in the relevant business area and are responsible for carrying out the rating assignments. 3. Obtaining information: The analytical team obtains the requisite information from the client company. The analytical team analyses the information relating to its financial statements, cash flow projections and other relevant information. 4. Plant visits and meeting with management: To obtain classification and better understanding of the clients operations, the team visits and interacts with the companys executives. Plants visits facilitate understanding of the production process, assess the state of equipment and main facilities, evaluate the quality of technical personnel and form an opinion on the key variables that influence level, quality and cost of production. 5. Presentation of findings: After completing the analysis, the findings are discussed at length in the Internal Committee, comprising senior analysts of the credit rating agency. All the issue having a bearing on rating are identified. An opinion on the rating is also formed. The findings of the team are finally presented to Rating Committee.

6. Rating committee meeting: This is the final authority for assigning ratings. The rating committee meeting is the only aspect of the process in which the issuer does not participate directly. The rating is arrived at after composite assessment of all the factors concerning the issuer, with the key issues getting greater attention. 7. Communication of decision: The assigned rating grade is communicated finally to the issuer along with reasons or rationale supporting the rating. The ratings which are not accepted are either rejected or reviewed in the light of additional facts provided by the issuer. 8. Dissemination to the public: Once the issuer accepts the rating, the credit rating agencies disseminate it through printed reports to the public. 9. Monitoring for possible change: Once the company has decided to use the rating, CRAs are obliged to monitor and review the accepted ratings over the life of the instrument. The CRA constantly monitors all ratings with reference to new political, economic and financial developments and industry trends. Credit Rating Methodology The rating methodology involves an analysis of all the factors affecting the creditworthiness of an issuer company e.g. business, financial and industry characteristics, operational efficiency, management quality, competitive position of the issuer and commitment to new projects etc. A detailed analysis of the past financial statements is made to assess the performance and to estimate the future earnings. Following are the main factors that are analysed into detail by the credit rating agencies: 1. Business Risk Analysis 2. Financial Analysis 3. Management Evaluation 4. Geographical Analysis 5. Regulatory and Competitive Environment 6. Fundamental Analysis

1. Business Risk Analysis This includes an analysis of industry risk, market position of the company, operating efficiency of the company and legal position of the company. a. Industry risk: The rating agencies evaluates the industry risk by taking into consideration various factors like strength of the industry prospect, nature and basis of competition, demand and supply position, structure of industry, pattern of business cycle etc. b. Market position of the company: Rating agencies evaluate the market standing of a company taking into account: i. Percentage of market share ii. Marketing infrastructure iii. Competitive advantages iv. Selling and distribution channel v. Diversity of products vi. Customers base vii. Research and development projects undertaken to identify obsolete products viii. Quality Improvement programs etc. c. Operating efficiency: Favourable locational advantages, management and labour relationships, cost structure, availability of raw-material, labour, compliance to pollution control programs, level of capital employed and technological advantages etc. affect the operating efficiency of every issuer company and hence the credit rating. d. Legal position: Legal position of a debt instrument is assessed by letter of offer containing terms of issue, trustees and their responsibilities, mode of payment of interest and principal in time, provision for protection against fraud etc.

e. Size of business: The size of business of a company is a relevant factor in the rating decision. Smaller companies are more prone to risk due to business cycle changes as compared to larger companies. Smaller companies operations are limited in terms of product, geographical area and number of customers. Whereas large companies enjoy the benefits of diversification owing to wide range of products, customers spread over larger geographical area. 2. Financial Analysis Financial analysis aims at determining the financial strength of the issuer company through ratio analysis, cash flow analysis and study of the existing capital structure. This includes an analysis of four important factors namely: a. Accounting quality b. Earnings potential/profitability c. Cash flows analysis d. Financial flexibility The areas considered are explained as follows: a. Accounting quality: As credit rating agencies rely on the audited financial statements, the analysis of statements begins with the study of accounting quality. For the purpose, qualification of auditors, overstatement/ understatement of profits, methods adopted for recognising income, valuation of stock and charging depreciation on fixed assets are studied. b. Earnings potential/profitability: Profitability ratios like operating profit and net profit ratios to sales are calculated and compared with last 5 years figures or compared with the similar other companies carrying on same business. As a rating is a forward-looking exercise, more emphasis is laid on the future rather than the past earning capacity of the issuer.

c. Cash flow analysis: Cash flow analysis is undertaken in relation to debt and fixed and working capital requirements of the company. It indicates the usage of cash for different purposes and the extent of cash available for meeting fixed interest obligations. d. Financial flexibility: Existing Capital structure of a company is studied to find the debt/equity ratio, alternative means of financing used to raise funds, ability to raise funds, asset deployment potential etc. 3. Management Evaluation Any companys performance is significantly affected by the management goals, plans and strategies, capacity to overcome unfavourable conditions, staffs own experience and skills, planning and control system etc. Rating of a debt instrument requires evaluation of the management strengths and weaknesses. 4. Geographical Analysis Geographical analysis is undertaken to determine the locational advantages enjoyed by the issuer company. An issuer company having its business spread over large geographical area enjoys the benefits of diversification and hence gets better credit rating.

5. Regulatory and Competitive Environment Credit rating agencies evaluate structure and regulatory framework of the financial system in which it works. While assigning the rating symbols, CRAs evaluate the impact of regulation/ deregulation on the issuer company. Causes for Industrial unit becoming sick and revival programme for the same Financial Management in PSUs & Rationale for disinvestment for the same (Refer PC for above Topics)

MANAGEMENT CONTROL SYSTEMS Concepts of EVA (also called as Economic Profit) In corporate finance, Economic Value Added or EVA is an estimate of a firm's economic profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. Economic value added (EVA) is a theory developed and trademarked by Stern Steward and Co. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. EVA can also be said as an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders or lenders at comparable risk. Steps for Calculation: There are four steps in the calculation of EVA: 1. Calculate Net Operating Profit after Tax (NOPAT) -> EBIT (1-T) 2. Calculate Total Invested Capital (TC) 3. Determine a Cost of Capital (WACC) 4. Calculate EVA = NOPAT WACC% * (TC) EVA is measured as NOPAT less a firm's cost of capital. NOPAT is obtained by adding interest expense after tax back to net income after-taxes, because interest is considered a capital charge for EVA (and not an operating expense). Interest expense will be included as part of capital charges in the after-tax cost of debt calculation. EVA is also defined as the difference between the return on invested capital and the cost of capital (the return spread) multiplied by the invested capital. EVA = (return on invested capital - cost of capital) invested capital

Advantages of EVA Unlike accounting profit, such as EBIT, Net Income and EPS, EVA is Economic and is based on the idea that a business must cover both the operating costs as well as the capital costs and hence it presents a better and true picture of the company to the owners, creditors, employees, shareholders and all other interested parties. Goal congruence of managerial and shareholder goals achieved by tying compensation of managers and other employees to EVA measures Relatively easy to calculate Unlike Market-based measures such as MVA, EVA can be calculated at divisional (SBU) level. Unlike Stock measures, EVA is a flow and can be used for performance evaluation over time. Disadvantages of EVA Highly subject to accounting anomalies and analyst adjustments Does not necessarily measure shareholder value Requires an accurate estimate of after tax cost of capital Very easily abused by deceitful or ignorant users. Takes no account of the effects of inflation, investment profile or currency effects on accounting value of capital and accounting profit.

Market Value Added (MVA) Market Value Added (MVA) is the difference between the current market value of a firm and the capital contributed by investors. A high MVA indicates the company has created substantial wealth for the shareholders. A negative MVA means that the value of management's actions and investments are less than the value of the capital contributed to the company by the capital market (or that wealth and value have been destroyed). The amount of value added needs to be greater than the firm's investors could have achieved investing in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market. The formula for MVA is:

Where: MVA is market value added V is the market value of the firm, including the value of the firm's equity and debt K is the capital invested in the firm MVA is not a performance metric like EVA, but instead is a wealth metric; measuring the level of value a company has accumulated over time. (MVA is one method of firm valuation, while EVA is one method estimating profit) MVA EVA EVA calculation measures the

The MVA calculation offers a summary of The

how well the company has maximized performance of a company over a period. shareholder value since its inception. It This way, you can calculate performance offers a judgment on the company's past, for a given year and compare it with other present and future use of investment years. A higher number is better because it capital. A higher number is better because demonstrates that there has been an it shows that shareholder value has increase in the flow of profit for the period increased over the life of the company. It is in question. Unlike the MVA, you can an aggregate figure because it provides calculate the EVA units within the company

information on the company as a whole. instead

of

the

entire

company.

For

This is because figures such as market example, you can compute the EVA of value and total investment apply to the departments and product lines. This allows entire firm. more detailed analysis and comparisons.

Free Cash Flow A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. FCF is cash flow available for distribution among all the securities holders of a corporate entity. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on. FCFF FCFF is a metric used to determine a firm's financial health and profitability by measuring how much cash is available for all claim holders in the firm (debt holders and share holders) after all taxes and needs for reinvestment have been met.

This model assumes that there is no interest expense or tax benefit from that interest expense.

Positive FCFF implies that there is sufficient cash to either service debt (through interest payments or principal repayments) and / or service the equity holders (through dividends or share repurchases). On the other hand, negative FCFF means that the firm has not generated sufficient revenue to cover its costs and will have to raise more cash, either through issuing more debt or selling more equity. FCFE FCFE is a measure used to determine how much cash is available to pay to a company's equity shareholders after accounting for all expenses, reinvestment, and debt repayment. FCFE is commonly used to gauge the health of companies. FCFE = Net Income - Net Capex - Change in Net Working Capital + New Debt - Debt Repayment.

Positive FCFE indicates what can be paid out to equity holders (as a dividend or repurchased stock) without harming the firm's operations or growth opportunities while negative FCFE, it implies that the firm must issue new equity to raise cash. Uses of FCF 1. Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax interest expense. 2. Repay debt holders, that is, pay off some of debt. 3. Pay dividends to shareholders. 4. Repurchase stock from shareholders.

5. Buy marketable securities or other non operating assets. Difference between Net Income and FCF The first is the accounting for the consumption of capital goods. The Net Income measure uses depreciation, while the Free Cash Flow measure uses last period's net capital purchases. The second difference is that the Free Cash Flow measurement deducts increases in net working capital, where the net income approach does not. Free cash flow is calculated on a purely cash basis whereas net income is calculated on an accrual basis in accordance with generally accepted accounting principles (GAAP).

Responsibility Centre A responsibility centre is a part or subunit of a company for which a manager has authority and responsibility. The companys detailed organization chart is a logical source for determining responsibility centers. Responsibility centers define exactly what assets and activities each manager is responsible for. How to classify any given department depends on which aspects of the business the department has authority over. Managers prepare a responsibility report to evaluate the performance of each responsibility centre. This report compares the responsibility centres budgeted performance with its actual performance, measuring and interpreting individual variances. Responsibility reports should include only controllable costs so that managers are not

held accountable for activities they have no control over. Using a flexible budget is helpful for preparing a responsibility report.

Revenue Centres Revenue centers usually have authority over sales only and have very little control over costs. To evaluate a revenue centres performance, look only at its revenues and ignore everything else. Revenue centers have some drawbacks. Their evaluations are based entirely on sales, so revenue centers have no reason to control costs. This kind of free rein encourages Al the concession manager to hire extra employees or to find other costly ways to increase sales (giving away salty treats to increase drink purchases, perhaps).

Cost or Expense Centres Cost centers usually produce goods or provide services to other parts of the company. Because they only make goods or services, they have no control over sales prices and therefore can be evaluated based only on their total costs.

One way for a cost centre to reduce costs is to buy inferior materials, but doing so hurts the quality of finished goods. When dealing with cost centers, you must carefully monitor the quality of goods. Examples include research and development, production department, marketing, customer service etc. In a contact centre, for example, metrics such as average handle time, service level and cost per call are used in conjunction with other calculations to justify current or improved funding.

Engineered Expense Centre Engineered expense centre have the following characteristics: Their inputs can be measured in monetary terms. Their output can be measured in physical terms. The optimal dollar amount of input required to produce one unit of output can be established.

Engineered expense centre usually are found in manufacturing operations. Warehousing, distribution, trucking and similar units in the marketing organization also may be engineered expense centre and so many certain responsibility centre within administrative and support department. In an engineered expense centre the output multiplied by the standard cost of each unit produced represents what the finished product should have cost. When this cost is compared to actual costs, the difference between the two represents the efficiency of the organization unit being measured. Discretionary Expense Centre The output of discretionary expenses centre cannot be measured in monitory terms. They include administration and support units research and development organization and most marketing activities. The term discretionary does not mean that management judgment is capricious or haphazard. Management has decided on certain policies that should govern the operation of the company. The difference between budgeted and actual expense is not a measure of efficiency in a discretionary expense centre it is simply the difference between the budgeted input and the actual input. It in no way measures the value of the output. if actual expense do not exceed the budget amount, the manager has lived within the budget however ,because by definition the budget does not purport to measure the optimum amount of spending we cannot say that living within the budgeted is efficient performance. Profit Centres A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit. A profit centre is a big segment of activity for which both revenues and costs are accumulated: A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre. The output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case, the revenue is realized when the sales are made. That is, when the output is meant for outsiders, then the revenue will be measured from the price charged from customers. If the output is meant for other responsibility centre, then management takes a decision whether to treat the centre as profit centre or not. In fact, any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. For instance, in case of a process industry, the output of one process may be transferred to another process at a profit by

taking into account the market price. Such transfers will give some profit to that responsibility centre. Although such transfers do not increase the Companys assets, they help in management control process.

Investment Centre An investment centre goes a step further than a profit centre does. Its success is measured not only by its income but also by relating that income to its invested capital, as in a ratio of income to the value of the capital employed. In practice, the term investment centre is not widely used. Instead, the term profit centre is used indiscriminately to describe centers that are always assigned responsibility for revenues and expenses, but may or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in which inputs are measured in terms of cost / expenses and outputs are measured in terms of revenues and in which assets employed are also measured. A responsibility centre is called an investment centre, when its

manager is responsible for costs and revenues as well as for the investment in assets used by his centre. He is responsible for maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre. Return on investment (ROI) is used as the performance evaluation criterion in an investment centre. Measurement of assets employed poses many problems. It becomes difficult to determine the amount of assets employed in a particular responsibility centre. Investment centers are generally used only for relatively large units, which have independent divisions, both manufacturing and marketing, for their individual products.

Transfer Pricing (Transfer Cost) The price at which divisions of a company transact with each other is called as Transfer Price. Transactions may include the trade of supplies or labour between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. In managerial accounting, when different divisions of a multi-entity company are in charge of their own profits, they are also responsible for their own "Return on Invested Capital". Therefore, when divisions are required to transact with each other, a transfer price is used to determine costs. Transfer prices tend not to differ much from the price in the market because one of the entities in such a transaction will lose out: they will either be buying for more than the prevailing market price or selling below the market price, and this will affect their performance. In particular the transfer price should be designed so that it accomplishes the following objective:

It should provide each segment with the relevant information required to determine the optimum trade-off between company cost and revenues. It should induce goal congruent decisions that is the system should be so designed that decision improve business unit to earn more profit. It should help measure the economic performance of the individual profit centre.

Goal Congruence Theory Goal congruence is the term which describes the situation when the goals of different interest groups coincide. A way of helping to achieve goal congruence between shareholders and managers is by the introduction of carefully designed remuneration packages for managers which would motivate managers to take decisions which were consistent with the objectives of the shareholders. Agency theory sees employees of businesses, including managers, as individuals, each with his or her own objectives. Within a department of a business, there are departmental objectives. If achieving these various objectives also leads to the achievement of the objectives of the organization as a whole, there is said to be goal congruence. Achieving Goal Congruence Goal congruence can be achieved, and at the same time, the agency problem can be dealt with, providing managers with incentives which are related to profits or share price, or other factors such as: 1. Pay or bonuses related to the size of profits termed as profit-related pay. 2. Rewarding managers with shares, e.g.: when a private company goes public and managers are invited to subscribe for shares in the company at an attractive offer price. 3. Rewarding managers with share options. In a share option scheme, selected employees are given a number of share options, each of which gives the right (after a certain date) to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up. Such measures might encourage management in the adoption of creative accounting methods which will distort the reported performance of the company in the service of the managers own ends. However, creative accounting methods such as off-balance sheet

finance present a temptation to management at all times given that they allow a more favourable picture of the state of the company to be presented than otherwise, to shareholders, potential investors, potential lenders and others. An alternative approach is to attempt to monitor managers behaviour, for example, by establishing Management audit procedures, to introduce additional reporting requirements, or to seek assurance from managers that shareholders interests will be foremost in their priorities. Balance Scorecard Approach The Balanced Scorecard (BSC) is a performance management tool which began as a concept for measuring whether the smaller-scale operational activities of a company are aligned with its larger-scale objectives in terms of vision and strategy. By focusing not only on financial outcomes but also on the operational, marketing and developmental inputs to these, the Balanced Scorecard helps provide a more comprehensive view of a business, which in turn helps organizations act in their best long-term interests. Organizations were encouraged to measurein addition to financial outputswhat influenced such financial outputs. For example, process performance, market share / penetration, long term learning and skills development, and so on. The underlying rationale is that organizations cannot directly influence financial outcomes, as these are "lag" measures, and that the use of financial measures alone to inform the strategic control of the firm is unwise. Organizations should instead also measure those areas where direct management intervention is possible. In so doing, the early versions of the Balanced Scorecard helped organizations achieve a degree of "balance" in selection of performance measures. In practice, early Scorecards achieved this balance by encouraging managers to select measures from three additional categories or perspectives: "Customer," "Internal Business Processes" and "Learning and Growth." The balance scorecard suggests that we view the organization from four perspectives, and to develop metrics, collect data and analyze it relative to each of these perspectives:

The learning and growth perspective: To achieve our vision, how will we sustain our ability to change and improve? The business process perspective: To satisfy our shareholders and customers what business processes must we excel at? The customer perspective: To achieve our vision, how should we appear to our customer? The financial perspective: To succeed financially, how should we appear to our shareholders?

Implementing a Balanced Scorecard: We can summarize the implementation of a balanced scorecard in four general steps: 1. Define strategy. 2. Define measure of strategy. 3. Integrate measures into the management system. 4. Review measures and result frequently. Each of these steps is iterative, requiring the participation of senior executive and employees throughout the organization.

Define Strategy The balance scorecard builds a link between strategy and operational action. As a result it is necessary to begin the process of defining a balanced scorecard by defining the organization goals are explicit and what that targets have been developed. Define Measures of Strategy The next step is to develop measures in support of the articulate strategy. It is imperative that the organization focuses on a few critical measures at this point; otherwise management will be overloaded with measures. Also, it is important that the individual measures be linked with each other in a cause effect manner. Integrated Measures into the management system The balanced scorecard must be integrated with the organization formal and informal structure, its culture, and its human resources practice. While the balanced Scorecard gives some means for balancing measures, the measures can still become unbalanced by others system in the organization such as compensation policies that compensate the manager strictly based on financial performance. Review Measures and Results Frequently Once the balance scorecard is up and running it must be consistently reviewed by senior management. The organization should be looking for the following How do the outcome measures say the organization is doing? How do the driver measures say the organization is doing? How has the organizations strategy changed since the last review? How has the scorecard measures changed?

The most important aspects of these reviews are as follows; They tell management whether the strategy is being implemented correctly and how successfully the strategy is working. They show that management is serious about the importance of these measures. They maintain alignment of measure to ever changing strategies.

Difficulties in implementing Balanced Scorecard Poor correlation between nonfinancial measures and result Fixation on financial result. No mechanism for improvement. No mechanism for improvement. Measures overload.

VALUATION INTRODUCTION TYPES OF VALUATION Dividend Discount Model (DDM) Single Stage Model (Gordon Growth Model) Two Stage Model (H-Model) Three Stage Model Discounted Cash Flow Model (DCF) Relative Valuation Contingent Claim Valuation Asset Based Valuation VALUATION OF FREE CASH FLOWS Using DCF Using Multiples VALUATION IN ACQUISITIONS VALUING PRIVATE COMPANIES Using Comparable Company Analysis Using Estimated DCF

VALUATION In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation. Valuation of financial assets is done using one or more of these types of models: 1. Absolute value models that determine the present value of an asset's expected future cash flows. These kinds of models take two general forms: multi-period models such as discounted cash flow models or single-period models such as the Gordon model. These models rely on mathematics rather than price observation. 2. Relative value models determine value based on the observation of market prices of similar assets. 3. Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. The most common option pricing models are the BlackScholes-Merton models and lattice models. Common terms for the value of an asset or liability are market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock's intrinsic value is greater (less) than its market price, an analyst makes a "buy" ("sell") recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts.

TYPES OF VALUATION

Dividend Discount Models (DDM) General Model When an investor buys stock, she generally expects to get two types of cash flows dividends during the period she holds the stock and an expected price at the end of the holding period. Since this expected price is itself determined by future dividends, the value of a stock is the present value of dividends through infinity

The rationale for the model lies in the present value rule - the value of any asset is the present value of expected future cash flows discounted at a rate appropriate to the riskiness of the cash flows. There are two basic inputs to the model - expected dividends and the cost on equity. To obtain the expected dividends, we make assumptions about expected future growth rates in earnings and payout ratios. The required rate of return on a stock is determined by its riskiness, measured differently in different models - the market beta in the CAPM, and the factor betas in the arbitrage and multi-factor models. The model is flexible enough to allow for time-varying discount rates, where the time variation is caused by expected changes in interest rates or risk across time. 1) Gordon Growth Model (Single Stage) The dividend discount model (DDM) is a method of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to value stocks based on the net present value of the future dividends. The equation most widely used is called the Gordon growth model. In DDM the share of stock represents what were valuing, and all future dividends represent all future cash flows of that share. The value of the stock is equal to the sum of the net present value of all future dividends. For example, lets say youre analyzing a share of stock that pays $0.50 in dividends per quarter, or $2.00 per year. Furthermore, its a dividend aristocrat that has raised the dividend consecutively every single year for 25 years or more. You look over its history, and find that it has increased the dividend by an average of 8% per year over the course of several decades, but that the growth is slowing down. So, you estimate that the dividend will continue to grow by an average of only 5% per year going forward. If you desire an 11% rate of return on your money, which would represent pretty good returns, then you can use that as your discount rate. So for example, when the $2 in dividends goes up to $2.10 next year (because it grew by 5%), this $2.10 is only worth $1.89 to you today, because if you had $1.89 today, then you could turn it into $2.10 in a year if you could compound it by 11% during that period.

The following chart shows the estimated value of dividend payments over the next forty years.

The orange values are the actual dividends you expect to be paid if the dividend grows by 5% per year. The blue values are the discounted versions of those dividends; the dividends translated into todays value based on your discount rate of 11%. As can be seen, if this chart continues forever, the sum of all dividends would be infinite, but the sum of all discounted dividends is finite, because the discount rate is larger than the dividend growth rate. To use a dividend discount model (DDM) to value a stock the company must have a dividend paying history, the dividend policy must be directly tied to the earnings of the company, and the investor in the stock must be a minority shareholder (if the investor is a majority shareholder another valuation method must be used such as the Capitalized Earnings approach) To calculate the fair value of this stock, we need to sum up all of those discounted dividends. It can be done with fancy math, but after a number of mathematical cancellations, the accurate equation is extremely simple, and this is called the Gordon Growth Model:

Derivation of Equation The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor's required total return. Consider the dividend growth rate as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the company's cost of equity capital as a proxy for the investor's required total return.

In the formula, P is the fair price of the stock. D1 is next years expected dividend, which would be $2.10 in this case. r is the discount rate, which is 1.11, and g is the dividend growth rate, which is 1.05. When you plug everything into the equation, you get $35. Thats the fair value of this hypothetical stock, assuming that the current dividend of $2.00 really grows at that 5% per year into the future, and assuming an 11% rate of return is desirable to you. The math shows that it would be fair to trade $35 in present value for the sum value of all future dividends, because when they are discounted by 11% per year, the sum of all of them is $35. If your estimates are correct, youll get a nice double-digit long-term rate of return. The formula can also be written as:

Where V0 is the stocks fundamental value; D0 is the most recently paid dividend; D1 is the dividend expected to be paid in one year; r is the required rate of return on the stock; and g is the dividend growth rate. The required rate of return (r) must be more than the dividend growth rate (g); if it isnt, another valuation method must be chosen. Properties of Model:

Shortcomings The first flaw of the Gordon Growth Model is that it assumes a constant dividend growth rate; its a constant growth model. This may be an acceptable estimate for a fairly high yielding mature company, but for stocks with lower dividend yields and higher dividend growth, this may not be appropriate. To fix this, you can move towards a more general two-stage or multi-stage Dividend Discount Model. The math gets a bit more tedious at this point, but a multi-stage DDM allows you to estimate that the dividend will grow at a certain rate for a number of years and then slow down to another growth rate after that. The second flaw of both the Gordon Growth Model and the whole Dividend Discount Model is that its quite sensitive to the accuracy of the inputs because dividend growth rates tend to be fairly high (higher than core company net income growth usually, due to share buybacks), even minor variances between the estimated dividend growth and the real dividend growth. This is why you should always have a margin of safety in your estimates. This also means that the DDM tends to be better for high yielding dividend stocks with lower dividend growth, rather than lower yielding stocks with higher dividend growth rates.

Two-Stage DDM (Used when growth g exceeds cost of equity r) The two-stage growth model allows for two stages of growth - an initial phase where the growth rate is not a stable growth rate and a subsequent steady state where the growth rate is stable and is expected to remain so for the long term. While, in most cases, the growth rate during the initial phase is higher than the stable growth rate, the model can be adapted to value companies that are expected to post low or even negative growth rates for a few years and then revert back to stable growth. In the dividend discount model, the value of equity can be written as: Value of Stock = PV of Dividends during extraordinary phase + PV of terminal price

Where V0 is the stocks intrinsic value; D0 is the most recent dividend paid; gs is the short- term dividend growth rate; gL is the long-term dividend growth rate; r is the required rate of return; t is the year (i.e., 1st year, 2nd year, etc.); and n is the growth period in years. 3) H Model for valuing growth The H model is a two-stage model for growth, but unlike the classical two-stage model, the growth rate in the initial growth phase is not constant but declines linearly over time to reach the stable growth rate in steady stage. This model was presented in Fuller and Hsia (1984) and is based upon the assumption that the earnings growth rate starts at a high initial rate (ga) and declines linearly over the extraordinary growth period (which is assumed to last 2H periods) to a stable growth rate (gn). It also assumes that the dividend payout and cost of equity are constant over time and are not affected by the shifting growth rates.

Shortcomings: First, the decline in the growth rate is expected to follow the strict structure laid out in the model --it drops in linear increments each year based upon the initial growth rate, the stable growth rate and the length of the extraordinary growth period. While small deviations from this assumption do not affect the value significantly, large deviations can cause problems.

Second, the assumption that the payout ratio is constant through both phases of growth exposes the analyst to an inconsistency -- as growth rates decline the payout ratio usually increases. The allowance for a gradual decrease in growth rates over time may make this a useful model for firms which are growing rapidly right now, but where the growth is expected to decline gradually over time as the firms get larger and the differential advantage they have over their competitors declines. The assumption that the payout ratio is constant, however, makes this an inappropriate model to use for any firm that has low or no dividends currently. Thus, the model, by requiring a combination of high growth and high payout, may be quite limited in its applicability. 4) Three-stage DDM The three-stage dividend discount model combines the features of the two-stage model and the H-model. It is the most general of the models because it does not impose any restrictions on the payout ratio and assumes an initial period of stable high growth, a second period of declining growth and a third period of stable low growth that lasts forever.

The value of the stock is then the present value of expected dividends during the high growth and the transitional periods and of the terminal price at the start of the final stable growth phase.

It is best suited for firms which are growing at an extraordinary rate now and are expected to maintain this rate for an initial period, after which the differential advantage of the firm is expected to deplete leading to gradual declines in the growth rate to a stable growth rate. Practically speaking, this may be the more appropriate model to use for a firm whose earnings are growing at very high rates, are expected to continue growing at those rates for an initial period, but are expected to start declining gradually towards a stable rate as the firm become larger and loses its competitive advantages. DDM models are rarely used in practice!! Approaches to Valuation In general terms, there are three approaches to valuation. The first, discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset. The second, relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable such as earnings, cashflows, book value or sales. The third, contingent claim valuation uses option pricing models to measure the value of assets that share option characteristics. Some of these assets are traded financial assets like warrants, and some of these options are not traded and are based on real assets projects, patents and oil reserves are examples. The latter are often called real options. There can be significant differences in outcomes, depending upon which approach is used. Discounted Cash Flow Valuation While discounted cash flow valuation is one of the three ways of approaching valuation and most valuations done in the real world are relative valuations, we will argue that it is the foundation on which all other valuation approaches are built. To do relative valuation correctly, we need to understand the fundamentals of discounted cash flow valuation. To apply option pricing models to value assets, we often have to begin with a discounted cash flow valuation. Discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or

price of the cash flows in question. Present value may also be expressed as a number of years' purchase of the future undiscounted annual cash flows expected to arise. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite processtaking cash flows and a price and inferring a discount rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management. The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

Where, DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt; FV is the nominal value of a cash flow amount in a future period; i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full; d is the discount rate, which is i/(1+i), i.e., the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year; n is the time in years before the future cash flow occurs.

Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:

For each future cash flow (FV) at any time period (t) in years from the present time, summed over all time periods. The sum can then be used as a net present value figure. If the amount to be paid at time 0 (now) for all the future cash flows is known, then that amount can be substituted for DPV and the equation can be solved for i, that is the internal rate of return. All the above assumes that the interest rate remains constant throughout the whole period. In BRIEF:

Categorizing DCF Models 1) Equity Valuation, Firm Valuation and Adjusted Present Value (APV) Valuation There are three paths to discounted cashflow valuation -- the first is to value just the equity stake in the business, the second is to value the entire firm, which includes, besides equity, the other claimholders in the firm (bondholders, preferred stockholders, etc.) and the third is to value the firm in pieces, beginning with its operations and adding the effects on value of debt and other non-equity claims. While all three approaches discount expected cashflows, the relevant cashflows and discount rates are different under each. The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, reinvestment needs, tax obligations and net debt payments (interest, principal payments and new debt issuance), at the cost of equity, i.e., the rate of return required by equity investors in the firm.

Where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity The dividend discount model is a specialized case of equity valuation, where the value of the equity is the present value of expected future dividends. The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses, reinvestment needs and taxes, but prior to any payments to either debt or equity holders, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.

Where, CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital The value of the firm can also be obtained by valuing each claim on the firm separately. In this approach, which is called adjusted present value (APV), we begin by valuing equity in the firm, assuming that it was financed only with equity. We then consider the value added (or taken away) by debt by considering the present value of the tax benefits that flow from debt and the expected bankruptcy costs. Value of firm = Value of all-equity financed firm + PV of tax benefits + Expected Bankruptcy Costs While the three approaches use different definitions of cashflow and discount rates, they will yield consistent estimates of value as long as you use the same set of assumptions in valuation. The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm. (Read examples from Damodaran) 2) Total Cash Flow versus excess Cash Flow Models The conventional discounted cash flow model values an asset by estimating the present value of all cash flows generated by that asset at the appropriate discount rate. In excess return (and excess cash flow) models, only cash flows earned in excess of the required return are viewed as value creating, and the present value of these excess cash flows can be added on to the amount invested in the asset to estimate its value. To illustrate, assume that you have an asset in which you invest $100 million and that you expect to generate $12 million per year in after-tax cash flows in perpetuity. Assume

further that the cost of capital on this investment is 10%. With a total cash flow model, the value of this asset can be estimated as follows: Value of asset = $12 million/0.10 = $120 million With an excess return model, we would first compute the excess return made on this asset: Excess return = Cash flow earned Cost of capital * Capital Invested in asset = $12 million 0.10 * $100 million = $2 million We then add the present value of these excess returns to the investment in the asset: Value of asset = Present value of excess return + Investment in the asset = $2 million/0.10 + $100 million = $120 million Note that the answers in the two approaches are equivalent. Why, then, would we want to use an excess return model? By focusing on excess returns, this model brings home the point that it is not earning per se that create value, but earnings in excess of a required return. (E.g. EVA Concept) Advantages of DCF Valuation 1. DCF Valuation is based on assets fundamentals and less exposed to markets moods and perceptions and hence gives something which is closer to intrinsic value. 2. DCF valuation forces you to think about the underlying characteristics of the rm, and understand its business. Disadvantages of DCF Valuation 1. Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. 2. These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants.

Applicability of DCF Valuation

Limitations of DCF Valuation The further we get from this idealized setting, the more difficult discounted cashflow valuation becomes. The following list contains some scenarios where discounted cashflow valuation might run into trouble and need to be adapted. 1) Firms in trouble: A distressed firm generally has negative earnings and cashflows. It expects to lose money for some time in the future. For these firms, estimating future cashflows is difficult to do, since there is a strong probability of bankruptcy. For firms which are expected to fail, discounted cashflow valuation does not work very well, since we value the firm as a going concern providing positive cashflows to its investors. Even for firms that are expected to survive, cashflows will have to be estimated until they turn positive, since obtaining a present value of negative cashflows will yield a negative value for equity or the firm. 2) Cyclical Firms: The earnings and cashflows of cyclical firms tend to follow the economy - rising during economic booms and falling during recessions. If discounted cashflow valuation is used on these firms, expected future cashflows are usually smoothed out, unless the analyst wants to undertake the onerous task of predicting the timing and duration of economic recessions and recoveries. Many cyclical firms, in the depths of a recession, look like troubled firms, with negative earnings and cashflows. Estimating future cashflows then becomes entangled with analyst predictions about

when the economy will turn and how strong the upturn will be, with more optimistic analysts arriving at higher estimates of value. This is unavoidable, but the economic biases of the analyst have to be taken into account before using these valuations. (3) Firms with unutilized assets: Discounted cashflow valuation reflects the value of all assets that produce cashflows. If a firm has assets that are unutilized (and hence do not produce any cashflows), the value of these assets will not be reflected in the value obtained from discounting expected future cashflows. The same caveat applies, in lesser degree, to underutilized assets, since their value will be understated in discounted cashflow valuation. While this is a problem, it is not insurmountable. The value of these assets can always be obtained externally, and added on to the value obtained from discounted cashflow valuation. Alternatively, the assets can be valued assuming that they are used optimally. 4) Firms with patents or product options: Firms often have unutilized patents or licenses that do not produce any current cashflows and are not expected to produce cashflows in the near future, but, nevertheless, are valuable. If this is the case, the value obtained from discounting expected cashflows to the firm will understate the true value of the firm. Again, the problem can be overcome, by valuing these assets in the open market or by using option pricing models, and then adding on to the value obtained from discounted cashflow valuation. 5) Firms in the process of restructuring: Firms in the process of restructuring often sell some of their assets, acquire other assets, and change their capital structure and dividend policy. Some of them also change their ownership structure (going from publicly traded to private status) and management compensation schemes. Each of these changes makes estimating future cashflows more difficult and affects the riskiness of the firm. Using historical data for such firms can give a misleading picture of the firm's value. However, these firms can be valued, even in the light of the major changes in investment and financing policy, if future cashflows reflect the expected effects of these changes and the discount rate is adjusted to reflect the new business and financial risk in the firm. 6) Firms involved in acquisitions: There are at least two specific issues relating to acquisitions that need to be taken into account when using discounted cashflow valuation models to value target firms. The first is the thorny one of whether there is synergy in the merger and if its value can be estimated. It can be done, though it does

require assumptions about the form the synergy will take and its effect on cashflows. The second, especially in hostile takeovers, is the effect of changing management on cashflows and risk. Again, the effect of the change can and should be incorporated into the estimates of future cashflows and discount rates and hence into value. 7) Private Firms: The biggest problem in using discounted cashflow valuation models to value private firms is the measurement of risk (to use in estimating discount rates), since most risk/return models require that risk parameters be estimated from historical prices on the asset being analyzed. Since securities in private firms are not traded, this is not possible. One solution is to look at the riskiness of comparable firms, which are publicly traded. The other is to relate the measure of risk to accounting variables, which are available for the private firm. The point is not that discounted cash flow valuation cannot be done in these cases, but that we have to be flexible enough to deal with them. The fact is that valuation is simple for firms with well defined assets that generate cashflows that can be easily forecasted. The real challenge in valuation is to extend the valuation framework to cover firms that vary to some extent or the other from this idealized framework.

Relative Valuation While we tend to focus most on discounted cash flow valuation, when discussing valuation, the reality is that most valuations are relative valuations. The value of most assets, from the house you buy to the stocks that you invest in, are based upon how similar assets are priced in the market place. Relative valuation is a generic term that refers to the notion of comparing the price of an asset to the market value of similar assets.

Categorizing Relative Valuation Models Analysts and investors are endlessly inventive when it comes to using relative valuation. Some compare multiples across companies, while others compare the multiple of a company to the multiples it used to trade in the past. While most relative valuations are based upon comparables, there are some relative valuations that are based upon fundamentals. 1) Fundamentals versus Comparables In discounted cash flow valuation, the value of a firm is determined by its expected cash flows. Other things remaining equal, higher cash flows, lower risk and higher growth should yield higher value. Some analysts who use multiples go back to these discounted cash flow models to extract multiples. Other analysts compare multiples across firms or time, and make explicit or implicit assumptions about how firms are similar or vary on fundamentals. a) Using Fundamentals The first approach relates multiples to fundamentals about the firm being valued growth rates in earnings and cashflows, payout ratios and risk. This approach to

estimating multiples is equivalent to using discounted cashflow models, requiring the same information and yielding the same results. Its primary advantage is to show the relationship between multiples and firm characteristics, and allows us to explore how multiples change as these characteristics change. For instance, what will be the effect of changing profit margins on the price/sales ratio? What will happen to price-earnings ratios as growth rates decrease? What is the relationship between price-book value ratios and return on equity? b) Using Comparables The more common approach to using multiples is to compare how a firm is valued with how similar firms are priced by the market, or in some cases, with how the firm was valued in prior periods. As we will see in the later chapters, finding similar and comparable firms is often a challenge and we have to often accept firms that are different from the firm being valued on one dimension or the other. When this is the case, we have to either explicitly or implicitly control for differences across firms on growth, risk and cash flow measures. In practice, controlling for these variables can range from the nave (using industry averages) to the sophisticated (multivariate regression models where the relevant variables are identified and we control for differences). 2) Cross Sectional versus Time Series Comparisons In most cases, analysts price stocks on a relative basis by comparing the multiple it is trading to the multiple at which other firms in the same business are trading. In some cases, however, especially for mature firms with long histories, the comparison is done across time. a) Cross Sectional Comparisons When we compare the price earnings ratio of a software firm to the average price earnings ratio of other software firms, we are doing relative valuation and we are making cross sectional comparisons. The conclusions can vary depending upon our assumptions about the firm being valued and the comparable firms. For instance, if we assume that the firm we are valuing is similar to the average firm in the industry, we would conclude that it is cheap if it trades at a multiple that is lower than the average multiple. If, on the other hand, we assume that the firm being valued is riskier than the average firm in the industry, we might conclude that the firm should trade at a lower

multiple than other firms in the business. In short, you cannot compare firms without making assumptions about their fundamentals. b) Comparisons across time If you have a mature firm with a long history, you can compare the multiple it trades today to the multiple it used to trade in the past. Thus, Ford Motor Company may be viewed as cheap because it trades at six times earnings, if it has historically traded at ten times earnings. To make this comparison, however, you have to assume that your firm has not changed its fundamentals over time. For instance, you would expect a high growth firms price earnings ratio to drop and its expected growth rate to decrease over time as it becomes larger. Comparing multiples across time can also be complicated by changes in the interest rates over time and the behaviour of the overall market. For instance, as interest rates fall below historical norms and the overall market increases, you would expect most companies to trade at much higher multiples of earnings and book value than they have historically.

Advantages of Relative Valuation

Disadvantages of Relative Valuation

Applicability of Relative Valuation

Contingent Claim Valuation Perhaps the most significant and revolutionary development in valuation is the acceptance, at least in some cases, that the value of an asset may not be greater than the present value of expected cash flows if the cashflows are contingent on the occurrence or non-occurrence of an event. This acceptance has largely come about because of the development of option pricing models. While these models were initially used to value traded options, there has been an attempt, in recent years, to extend the reach of these models into more traditional valuation. There are many who argue that assets such as patents or undeveloped reserves are really options and should be valued as such, rather than with traditional discounted cash flow models. Basis for Approach A contingent claim or option pays off only under certain contingencies - if the value of the underlying asset exceeds a pre-specified value for a call option, or is less than a prespecified value for a put option. Much work has been done in the last twenty years in developing models that value options, and these option pricing models can be used to value any assets that have option-like features.

The following diagram illustrates the payoffs on call and put options as a function of the value of the underlying asset:

An option can be valued as a function of the following variables - the current value, the variance in value of the underlying asset, the strike price, the time to expiration of the option and the riskless interest rate. This was first established by Black and Scholes (1972) and has been extended and refined subsequently in numerous variants. While the Black-Scholes option pricing model ignored dividends and assumed that options would not be exercised early, it can be modified to allow for both. A discrete-time variant, the Binomial option pricing model, has also been developed to price options. An asset can be valued as an option if the payoffs are a function of the value of an underlying asset. It can be valued as a call option if the payoff is contingent on the value of the asset exceeding a pre-specified level. It can be valued as a put option if the payoff increases as the value of the underlying asset drops below a pre-specified level. Underpinnings for Contingent Claim Valuation The fundamental premise behind the use of option pricing models is that discounted cash flow models tend to understate the value of assets that provide payoffs that are contingent on the occurrence of an event. As a simple example, consider an undeveloped oil reserve belonging to Exxon. You could value this reserve based upon

expectations of oil prices in the future, but this estimate would miss the two nonexclusive facts. 1. The oil company will develop this reserve if oil prices go up and will not if oil prices decline. 2. The oil company will develop this reserve if development costs go down because of technological improvement and will not if development costs remain high. An option pricing model would yield a value that incorporates these rights. When we use option pricing models to value assets such as patents and undeveloped natural resource reserves, we are assuming that markets are sophisticated enough to recognize such options and to incorporate them into the market price. If the markets do not, we assume that they will eventually, with the payoff to using such models comes about when this occurs. Categorizing the Option Pricing Models The first categorization of options is based upon whether the underlying asset is a financial asset or a real asset. Most listed options, whether they are options listed on the Chicago Board of Options or convertible fixed income securities, are on financial assets such as stocks and bonds. In contrast, options can be on real assets such as commodities, real estate or even investment projects. Such options are often called real options. A second and overlapping categorization is based upon whether the underlying asset is traded on not. The overlap occurs because most financial assets are traded, whereas relatively few real assets are traded. Options on traded assets are generally easier to value and the inputs to the option models can be obtained from financial markets relatively easily. Options on non-traded assets are much more difficult to value since there are no market inputs available on the underlying asset. Applicability of the Option Pricing Models and Limitations There are several direct examples of securities that are options - LEAPs, which are long term equity options on traded stocks that you can buy or sell on the American Stock Exchange. Contingent value rights which provide protection to stockholders in

companies against stock price declines and warrants which are long term call options issued by firms. There are other assets that generally are not viewed as options but still share several option characteristics. Equity, for instance, can be viewed as a call option on the value of the underlying firm, with the face value of debt representing the strike price and term of the debt measuring the life of the option. A patent can be analyzed as a call option on a product, with the investment outlay needed to get the project going representing the strike price and the patent life being the time to expiration of the option. There are limitations in using option pricing models to value long term options on nontraded assets. The assumptions made about constant variance and dividend yields, which are not seriously contested for short term options, are much more difficult to defend when options have long lifetimes. When the underlying asset is not traded, the inputs for the value of the underlying asset and the variance in that value cannot be extracted from financial markets and have to be estimated. Thus the final values obtained from these applications of option pricing models have much more estimation error associated with them than the values obtained in their more standard applications (to value short term traded options). Advantages of using Option Pricing Models Option pricing models allow us to value assets that we otherwise would not be able to value. For instance, equity in deeply troubled rms and the stock of a small, bio-technology rm (with no revenues and prots) are difficult to value using discounted cash ow approaches or with multiples. They can be valued using option pricing. Option pricing models provide us fresh insights into the drivers of value. In cases where an asset is deriving it value from its option characteristics, for instance, more risk or variability can increase value rather than decrease it. Disadvantages of using Option Pricing Models When real options (which include the natural resource options and the product patents) are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, projects do not trade and thus getting a current value for a project or a variance may be a daunting task.

The option pricing models derive their value from an underlying asset. Thus, to do option pricing, you rst need to value the assets. It is therefore an approach that is an addendum to another valuation approach.

Finally, there is danger of double counting assets. Thus, an analyst who uses a higher growth rate in discounted cash ow valuation for a pharmaceutical rm because it has valuable patents would be double counting the patents if he values the patents as options and adds them on to his discounted cash ow value.

Asset Based Valuation Models (Fourth Approach to Valuation) There are some who add a fourth approach to valuation to the three that we describe in this chapter. They argue that you can argue the individual assets owned by a firm and use that to estimate its value asset based valuation models. In fact, there are several variants on asset based valuation models. The first is liquidation value, which is obtained by aggregating the estimated sale proceeds of the assets owned by a firm. The second is replacement cost, where you evaluate what it would cost you to replace all of the assets that a firm has today. While analysts may use asset-based valuation approaches to estimate value, we do not consider them to be alternatives to discounted cash flow, relative or option pricing models since both replacement and liquidation values have to be obtained using one or more of these approaches. Ultimately, all valuation models attempt to value assets the differences arise in how we identify the assets and how we attach value to each asset. In liquidation valuation, we look only at assets in place and estimate their value based upon what similar assets are priced at in the market. In traditional discounted cash flow valuation, we consider all assets including expected growth potential to arrive at value. The two approaches may, in fact, yield the same values if you have a firm that has no growth assets and the market assessments of value reflect expected cashflows.

Free Cash Flow Valuation

Cash flows into the firm in the form of revenue as it sells its product and cash flows out as it pays its cash operating expenses (e.g., salaries and taxes. but not interest expense, which is a financing and not an operating expense). The firm takes the cash that's left over and makes short-term net investments in working capital (e.g., inventory and receivables) and long-term investments in property, plant, and equipment (PP&E). The cash that remains is available to pay out to the firm's investors: bondholders and common shareholders {let's assume for the moment that the firm has not issued preferred stock). That pile of remaining cash is called free cash flow to the firm (FCFF) because it's free to pay out to the firm's investors (see Figure 1). The formal definition of FCFF is the cash available to all of the firm's investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short and long-term investments. What does the firm do with its FCFF? First, it takes care of its bondholders because common shareholders are paid after all creditors. So it makes interest payments to

bondholders and borrows more money from them or pays some of it back. However, making interest payments to bondholders has one advantage for common shareholders: it reduces the tax bill. The amount that's left after the firm has met all its obligations to its other investors is called Free Cash Flow to Equity (FCFE), as can be seen in Figure I. However, the board of directors still has discretion over what to do with that money. It could pay it all out in dividends to its common shareholders, but it might decide to only pay out some of it and put the rest in the bank to save for next year. That way, if FCFE is low the next year, it won't have to cut the dividend payment. So FCFE is the cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements. Valuing using DCF We will use the typical discounted cash flow technique for free cash flow valuation, in which we estimate value today by discounting expected future cash flows at the appropriate required return. What makes this complicated is that we'll end up with two values we want to estimate (firm value and equity value), two cash flow definitions (FCFF and FCFE), and two required returns [weighted average cost of capital (WACC) and required return on equity]. The key to this question on the exam is to know which cash flows to discount at which rate, to estimate which value. The value of the firm is the present value of the expected future FCFF discounted at the WACC. Firm value = FCFF discounted at the WACC The weighted average cost of capital is the required return on the firm's assets. It's a weighted average of the required return on common equity and the after-tax required return on debt. The value of the firm's equity is the present value of the expected future FCFE discounted at the required return on equity: Equity value = FCFE discounted at the required return on equity Given the value of the firm, we can also calculate equity value by simply subtracting out the market value of the debt:

Equity value = firm value - market value of debt The differences between FCFF and FCFE account for differences in capital structure and consequently reflect the perspectives of different capital suppliers. FCFE is easier and more straightforward to use in cases where the company's capital structure is not particularly volatile. On the other hand, if a company has negative FCFE and significant debt outstanding, FCFF is generally the best choice. We can always estimate equity value indirectly by discounting FCFF to find firm value and then subtracting out the market value of debt to arrive at equity value.

Note that net income does not represent free cash flows defined as FCFF, so we have to make four important adjustments to net income to get to FCFF: noncash charges, fixed capital investment, working capital investment, and interest expense. Noncash charges: Noncash charges are added back to net income to arrive at FCFF because they represent expenses that reduced reported net income but didn't actually result in an outflow of cash. The most significant noncash charge is usually depreciation. Here are some other examples of noncash charges that often appear on the cash flow statement: Amortization of intangibles Restructuring charges and other noncash losses Income from restructuring charge reversals and other noncash gains Amortization of a bond discount Deferred taxes, which result from differences in the timing of reporting income and expenses for accounting versus tax purposes

Fixed capital investment: Investments in fixed capital do not appear on the income statement, but they do represent cash leaving the firm. FCInv = capital expenditures - proceeds from sales of long-term assets

Working capital investment: The investment in net working capital is equal to the change in working capital, <excluding cash, cash equivalents not payables and the current portion of long-term debt. Note that there would be a + sign in front of a reduction in working capital; we would add it back because it represents a cash inflow. Interest expense: Interest was expensed on the income statement, but it represents a financing cash flow to bondholders that is available to the firm before it makes any payments to its capital suppliers. Therefore, we have to add it back.

(Almost} FCFF = (NI + NCC- WCInv) - FCInv = CFO- FCInv (Actual) FCFF = (NI + NCC- WCinv) + Int(l -tax rate) - FCinv = CFO + Int(l - tax rate) FCinv FCFE = FCFF - Int(1 - tax rate) + net borrowing Calculating FCFF from EBIT: FCFF = [EBIT x (I-tax rate)] + Dep - FCinv- WC!nv where: EBIT = earnings before interest and taxes and Dep = depreciation Calculating FCFF from EBITDA: FCFF = [EBITDA x (l-tax rate)] + (Dep x tax rate) - FC!nv - WC!nv

Calculating FCFF from CFO: FCFF=CFO + [lnt x (l-tax rate)] FCInv FCFE = FCFF- [Int x (1-tax rate)] + net borrowing Where: Net borrowing = long and short-term new debt issues - long and short-term debt repayments Calculating FCFE from net income: FCFE = NI + NCC - FCinv - WCinv + net borrowing Calculating FCFE from CFO: FCFE = CFO - FC!nv + net borrowing

Single-Stage FCFF Model The single-stage FCFF model is analogous to the Gordon growth model and is useful for stable firms in mature industries. The formula should look familiar; it's the Gordon growth model with FCFF replacing dividends and WACC replacing required return on equity.

Single-Stage FCFE Model

The single-stage FCFE model is often used in international valuation, especially for companies in countries with high inflationary expectations when estimation of nominal growth rates and required returns is difficult. In those cases, real (i.e., inflation-adjusted) values are estimated for the inputs to the single-stage FCFE model: FCFE, the growth rate, and the required return. For Multi-Stage Models refer CFA Notes FCFF vs. FCFE FCFF is the cash available to all of the firm's investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short- and long-term investments. FCFE is the cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements. The value of the firm is the present value of the expected future FCFF discounted at the WACC. The value of the firm's equity is the present value of the expected future FCFE discounted at the required return on equity. FCFE is easier and more straightforward to use in cases where the company's capital structure is not particularly volatile. On the other hand, if a company has negative FCFE and significant debt outstanding, FCFF is generally the best choice.

Valuation using MULTIPLES Valuation using multiples or relative valuation is a method of estimating the value of an asset by comparing it to the values assessed by the market for similar or comparable assets. The process consists of: Identifying comparable assets (the peer group) and obtaining market values for these assets. Converting these market values into standardized values relative to a key statistic, since the absolute prices cannot be compared. This process of standardizing creates valuation multiples. Applying the valuation multiple to the key statistic of the asset being valued, controlling for any differences between asset and the peer group that might affect the multiple. A valuation multiple is simply an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. To be useful, that statistic whether earnings, cash flow or some other measure must bear a logical relationship to the market value observed; to be seen, in fact, as the driver of that market value. In stock trading, one of the most widely used multiples is the price-earnings ratio (P/E ratio or PER) which is popular in part due to its wide availability and to the importance ascribed to earnings per share as a value driver. However, the usefulness of P/E ratios is lessened by the fact that earnings per share is subject to distortions from differences in accounting rules and capital structures between companies. Other commonly used multiples are based on the enterprise value of a company, such as (EV/EBITDA, EV/EBIT, EV/NOPAT). These multiples reveal the rating of a business independently of its capital structure, and are of particular interest in mergers, acquisitions and transactions on private companies. Not all multiples are based on earnings or cash flow drivers. The price-to-book ratio (P/B) is a commonly used benchmark comparing market value to the accounting book value of the firm's assets. The price/sales ratio and EV/sales ratios measure value relative to

sales. These multiples must be used with caution as both sales and book values are less likely to be value drivers than earnings. Less commonly, valuation multiples may be based on non-financial industry-specific value drivers, such as enterprise value / number of subscribers for cable or telecoms businesses or enterprise value / audience numbers for a broadcasting company. In real estate valuations, the sales comparison approach often makes use of valuation multiples based on the surface areas of the properties being valued. Pros and Cons of Multiples: Pros: 1. Usefulness: Making Value judgements. 2. Simplicity: Ease of calculation using user-friendly method for assessing value. 3. Relevance: Multiples focus on the key statistics that other investors use. Cons: 1. Simplistic: Encourages simplistic and possibly erroneous interpretation by combining many value drivers into a point estimate. 2. Static: A multiple represents a snapshot of where a firm is at a point in time, but fails to capture the dynamic and ever-evolving nature of business and competition. 3. Difficulties in comparisons: Multiples are primarily used to make comparisons of relative value but there are cases where different accounting policies can result in diverging multiples for otherwise identical operating businesses. 4. Dependence on correctly valued peers: If the peer group as a whole is incorrectly valued (such may happen during a stock market "bubble") then the resulting multiples will also be misvalued. 5. Short-term: Multiples are based on historic data or near-term forecasts. Valuations base on multiples will therefore fail to capture differences in projected performance over the longer term.

Different Industries Automobile: TAMO, M&M, TVS, BAJAJ Auto, Bharat Forge, Apollo Tyres, Exide Industries Banking Capital Goods: ABB, BHEL, Thermax

Cement: Ultratech, ACC, Ambuja, JP FMCG: HUL, ITC, Britannia, Colgate, Dabur, Nestle Infrastructure: L&T, HCC, IRB, Information Technology Media: DB Corp, HT Media, PVR, Sun TV Metals (& Mining): Coal India, NALCO, TATA Steel Oil & Gas: Cairn India, GAIL, ONGC, RIL

Pharmaceutical: Cipla, DRL, Ranbaxy, Sun Pharma Power: TATA Power, NTPC Real Estate: DLF, HDIL Telecom:

Valuation in Acquisitions Investors in a company that are aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth. Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can. There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them: Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers: Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-tosales ratio of other companies in the industry. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the

sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method. Synergy: The Premium for Potential Success For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy. Let's face it; it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:

In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss in part five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.

What to Look For It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria: A reasonable purchase price - A premium of, say, 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests. Cash transactions - Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock is used as the currency for acquisition, discipline can go by the wayside. Sensible appetite An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers. Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.

Valuing Private Companies Comparable Company Analysis The simplest method of estimating the value of a private company is to use comparable company analysis (CCA). To use this approach, look to the public markets for firms which most closely resemble the private (or target) firm and base valuation estimates on the values at which its publicly-traded peers are traded. To do this, you will need at least some pertinent financial information of the privately-held company. For instance, if you were trying to place a value on an equity stake in a mid-sized apparel retailer, you would look to the public sphere for companies of similar size and stature who compete (preferably directly) with your target firm. Once the "peer group"

has been established, calculate the industry averages. This would include firm-specific metrics such as operating margins, free-cash-flow and sales per square foot (an important metric in retail sales). Equity valuation metrics must also be collected, including price-to-earnings, price-to-sales, price-to-book, price-to-free cash flow and EV/EBIDTA among others. Multiples based on enterprise value should give the best interpretation of firm value. By consolidating this data you should be able to determine where the target firm falls in relation to the publicly-traded peer group, which should allow you to make an educated estimate of the value of an equity position in the private firm. Additionally, if the target firm operates in an industry that has seen recent acquisitions, corporate mergers or IPOs, you will be able to use the financial information from these transactions to give an even more reliable estimate to the firm's worth, as investment bankers and corporate finance teams have determined the value of the target's closest competitors. While no two firms are the same, similarly sized competitors with comparable market share will be valued closely on most occasions. Estimated Discounted Cash Flow Taking comparable analysis one-step further, one can take financial information from a target's publicly-traded peers and estimate a valuation based on the target's discounted cash flow estimations. The first and most important step in discounted cash flow valuation is determining revenue growth. This can often be a challenge for private companies due to the company's stage in its lifecycle and management's accounting methods. Since private companies are not held to the same stringent accounting standards as public firms, private firms' accounting statements often differ significantly and may include some personal expenses along with business expenses (not uncommon in smaller familyowned businesses) along with owner salaries, which will also include the payment of dividends to ownership. Dividends are a common form of self-payment for private business owners, as reporting a salary will increase the owner's taxable income, while receiving dividends will lighten the tax-burden. What's important to remember is that estimating future revenue is only a best guess estimate and one estimate may differ wildly from another. That is why using public

company financials and future estimates is a good way to augment your estimates, making sure that the target's sales growth is not completely out of line with its comparable peers. Once revenues have been estimated, free cash flow can be extrapolated from expected changes in operating costs, taxes and working capital. The next step would be to estimate the target firm's unlevered beta by gathering industry average betas, tax rates and debt/equity ratios. Next, estimate the target's debt ratio and tax rate in order to translate the industry averages to a fair estimate for the private firm. Once an unlevered beta estimate is made, the cost of equity can be estimated using the Capital Asset Pricing Model (CAPM). After calculating the cost of equity, cost of debt will often be determined by examining the target's bank lines for rates at which the company can borrow. Determining the target's capital structure can be difficult, but again we will defer to the public markets to find industry norms. It is likely that the costs of equity and debt for the private firm will be higher than its publicly-traded counterparts, so slight adjustments may be required to the average corporate structure to account for these inflated costs. Also, the ownership structure of the target must be taken into account as well as that will help estimate management's preferred capital structure as well. Often a premium is added to the cost of equity for a private firm to compensate for the lack of liquidity in holding an equity position in the firm. Lastly, once an appropriate capital structure has been estimated, calculate the weighted average cost of capital (WAAC). Once the discount rate has been established it's only a matter of discounting the target's estimated cash flows to come up with a fair value estimate for the private firm. The illiquidity premium, as previously mentioned, can also be added to the discount rate to compensate potential investors for the private investment. The valuation of a private firm is full of assumptions, best guess estimates and industry averages. With the lack of transparency involved in privately-held companies it is a difficult task to place a reliable value on such businesses. Several other methods exist that are used in the private equity industry and by corporate finance advisory teams to help put a value on private companies. With limited transparency and the difficulty in

predicting what the future will bring to any firm, private company valuation is still considered more art than science. ALSO Read Industry Book

IPO Process We all know what an IPO is and what the purpose of an IPO is for the company issuing the share. But, not many of us know the different requirements that a company must satisfy in order to go public and the different stages in the life cycle of an IPO. The purpose of this article is to elaborate on this. So, lets get started. What is an IPO To Refresh An IPO stands for Initial Public Offering, wherein a company issues its shares to the public for the first time. Investors can place requests to buy these shares and once done, the share gets listed in a registered stock exchange and the company uses the share issue proceeds for its development/growth. Before we take a look at the steps in an IPO process, lets take a look at the entry norms for an IPO. Entry Norms for an IPO: Not all companys can issue shares to the public. SEBI has provided a list of requirements that need to be met by a company if they wish to go public. A company that wishes to go public needs to meet all of the below mentioned criteria Entry Norms I or EN I: 1. Net Tangible assets of atleast Rs. 3 crores for 3 full years 2. Distributable profits in atleast 3 years 3. Net worth of atleast 1 crore in 3 years 4. If there was a change in name, atleast 50% of the revenue in the preceding year should be from the new activity

5. The issue size should not exceed 5 times the pre-issue networth of the company To provide sufficient flexibility and also to ensure that genuine companies do not suffer on account of rigidity of the above mentioned rules, SEBI has provided 2 alternate routes to companies that do not satisfy the criteria for accessing the primary market. They are as follows: Entry Norms II or EN II: 1. Issue shall be only through the book building route with atleast 50% allotted mandatorily to Qualified Institutional Buyers (QIBs) 2. The minimum post issue face value capital shall be Rs. 10 crores or there shall be a compulsory market-making for atleast 2 years Or Entry Norms III or EN III: 1. The Project is appraised and participated to the extent of 15% by FIs/Scheduled Commercial Banks of which atleast 10% comes from the appraiser(s). 2. The minimum post issue face value capital shall be Rs. 10 crores or there shall be a compulsory market-making for atleast 2 years 3. In addition to the above mentioned 2 points, the company shall also satisfy the criteria of having atleast 1000 prospective allotees in future. Steps in an IPO Process: Let us now have a look at how an initial public offering process is initiated and reaches its conclusion. The entire process is regulated by the 'Securities and Exchange Board of India (SEBI)', to prevent the possibility of a fraud and safeguard investor interest. Selection of Investment Bank The first thing that company management must do when they have taken a unanimous decision to go public is to find an investment bank or a conglomerate of investment banks that will act as underwriters on behalf of the company. Underwriter's buy the

shares of the company and resell them to the general public. The company must also hire lawyers that can guide them through the legal maze that an IPO setup can be. It must be ready with detailed financial records for intensive fiscal health scrutiny that SEBI would perform. Some companies may also opt to directly sell their shares through the stock market, but most prefer going through the underwriters. Step 1: Preparation of Registration Statement To begin an IPO process, the company involved must submit a registration statement to the SEBI, which includes a detailed report of its fiscal health and business plans. SEBI scrutinizes this report and does its own background check of the company. It must also see that registration statement fulfils all the mandatory requirements and satisfies all rules and regulations. Step 2: Getting the Prospectus Ready While awaiting the approval, the company, with assistance from the underwriters, must create a preliminary 'Red Herring' prospectus. It includes detailed financial records, future plans and the specification of expected share price range. This prospectus is meant for prospective investors who would be interested in buying the stock. It also has a legal warning about the IPO pending SEBI approval. Step 3: The Roadshow Once the prospectus is ready, underwriters and company officials go on countrywide 'roadshows', visiting the major trade hubs and promote the company's IPO among select few private buyers (Usually corporates or HNIs). They are fed with detailed information regarding company's future plans and growth potential. They get a feel of investor response through these tours and try to woo big investors. Step 4: SEBI Approval & Go Ahead Once SEBI is satisfied with the registration statement, it declares the statement to be effective, giving a go ahead for the IPO to happen and a date to be fixed for the same. Sometimes it asks for amendments to be made before giving its approval. The prospectus cannot be given to the public without the amendments suggested by SEBI.

The company needs to select a stock exchange where it intends to sell its shares and get listed. Step 5: Deciding On Price Band & Share Number After the SEBI approval, the company, with assistance from the underwriters decide on the final price band of the shares and also decide the number of shares to be sold. There are two types of issues: Fixed Price and Book Building Fixed Price In a Fixed price issue the company decides the price of the share issue and the number of shares being sold. Ex: ABC Ltd public issue of 10 lakh shares of face value Rs. 10/- each at a premium of Rs. 55/- each is available to the public thereby generating Rs. 6.5 Crores. Book Building A Book building issue helps the company discover the price of the issue. The company decides a price band and it gives the investor an option to choose the price at which he/she wishes to bid for the company shares. Ex: ABC Ltd issue of 10 lakh shares of face value Rs. 10/- each at a price band of Rs. 60 to 70 is available to the public thereby generating upto Rs. 7 Crores. Here the amount generated through the issue would depend on the highest amount bid by most investors. Step 6: Available to Public for Purchase On the dates mentioned in the prospectus, the shares are available to public. Investors can fill out the IPO form and specify the price at which they wish to make the purchase and submit the application. This open period usually lasts for 5 working days which is a SEBI requirement. Step 7: Issue Price Determination & Share Allotment Once the subscription period is over, members of the underwriting banks, share issuing company etc will meet and determine the price at which shares are to be allotted to the prospective investors. The price would be directly determined by the demand and the bid price quoted by investors. Once the price is finalized, shares are allotted to investors based on the bid amounts and the shares available.

Note: In case of oversubscribed issues, shares are not allotted to all applicants. Step 8: Listing & Refund The last step is the listing in the stock exchange. Investors to whom shares were allotted would get the shares credited to their DEMAT accounts and for the remaining the money would be refunded.

Difference between IPO in India and Abroad: 1. In India the book is built directly but in the west the underwriter takes the shares on his books and then allots shares to the investors. 2. In India the book building process is transparent whereas in the US it is confidential. 3. In India the book has to be open for a minimum of 5 business days and the period needs to be revised if the price band is revised whereas it can be opened and closed anytime abroad. 4. Abroad, the price band is soft meaning the bidder can bid for a price outside the price band too whereas in India the band is fixed. 5. Retail investors in India have to put in a cheque or block an equivalent amount corresponding to the IPO bid in their DEMAT accounts but QIBs do not pay any margin. Whereas abroad, neither category needs to pay any margin.

Other Questions: What will happen if the company does not receive a minimum subscription of atleast 90% of the net offer to the public including devolvement of underwriters within 60 days of issue closure? The company will have to refund the entire subscription amount received within 8 days. Can a company whose listing is due raise additional capital?

No. Should the Red Herring prospectus disclose the exact price of the issue? No. What is the maximum price in a price band? The cap price should not be more than 20% of the floor price. For Ex: if the floor price is Rs. 100/- the cap price can be at max Rs. 120/- an issue with price band Rs. 100 150 is not possible Can the issue price be revised? Yes, provided the revision on either side is not beyond 20% What is the time limit an IPO may remain open? An IPO cannot remain open for more than 7 working days which can be extended to upto 10 days in case the offer price band was revised If your net worth is Rs. 10 crores, how much IPO can you go for? 50 10 = 40 crores. You can go for upto 40 crores to ensure that your post issue net worth does not go beyond 5 times your pre issue worth. Who should the investors approach in case of delay of refund order? SEBI