CORPORATE FINANCE

Study Session 11, Reading 35 - Capital Budgeting

LOS (F) COMPANY'S VALUE IE. MARKET CAP = NO. OF SHARES × SHARE PRICE
The objective of a finance mgr is to take financial decisions in such a manner that shareholder's
wealth (Reqd: Market Cap) is maximized.

Let us acknowledge the Standard discounted Cash Flow (DCF) framework According to this
framework,
Value today = PV of Future Cash Flows
CF1 CF2 CF3
V0    ......
1  r  1  r   1  r 3
2

In Capital Budgeting, we have LONG - TERM sources of finance ie Equity and Long term Debt
investing in a project. Suppose, the Net Cash Flows associated with the project are as follows -
Years 0 1 2 3
Cash Flows (600) 150 300 700 → in $ billion

Let us first analyse the finding aspect of this project:

 60% of 600 ie $360 billion is contributed by LTD @ int 10% (Tax rate - 30%)
Interest on debt is tax deductible, post tax cost of debt (kd)
Kd = i (1 - t) = 10% (1 - 0.3) = 7%
 40% of 600 = $240 b contributed by Equity
This is ownership capital or Risk Capital which obv, has a higher cost. Suppose ke = 15% [No tax
deductibility]
Hence, weighted avg "WACC" = 0.6 × 7 + 0.4 × 15
Cost of Capital = 10.2%

INTERPRETATION - This is the min rate of return reqd by long term sources of finance (why min
?) Also, it is the rate of return that a firm must earn to maintain its market value.
Now that the funding aspect is over. let us determine whether this project is at all viable -
For this to happen, it has to cross this huddle of 10.2%
To check this out, one of the most popular decision making criteria is NET PRESENT VALUE
(NPV)
Years CF Unrecovered
1 150 (- 600 × 1.102) + 150 = - 511.2
2 300 ( - 511.2 × 1.102) + 300 = - 263.34
3 700 ( - 263.34 × 1.102) + 700 = 409.8

So, we find that Net Future Value (NFV) = $ 409.86

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Assuming no information a symmetry (full transparency), markets today will see a rise in dd for the
firm's share. This will result in higher share price and market cap of the firm today will rise to the
409.8
extent of P0   $306.216  NPV
 1.102 
3

Calci
CF 2nd CE/C
CF0  CF1  CF2  CF3 
CPT NPV → I → Enter 
NPV → CPT
Operationally, it can be calculated
Yrs CF PV
1 150 150
 136.12
1.102
2 300 300
 247.03
 1.102 
2

3 700 523.06
NPV = (600) - '''''
= 306.21

NPV Interpretation - It shows the Net Addition to the wealth of the equity shareholders ie net
increase in market cap. If the firm has 40 b shares outstanding, share price should go up by
306.21
 $7.66
40
 Does this actually happen is real life?
- No because of Information Asymmetry and market inefficiency
Eg: X ltd. presently has 20 m equity shares trading at $300 each. A new project is announced with an
NPV of $60 m. What will be the new share price in a hypothetical would?
$60m
Sol:  $3  Increase in share price
20m
 New share price = $ (300 + 3) = $ 303
Note: The focus of real life application of this LOS is that -
The project announcement should be new info which was not anticipated by the market earlier.

LOS (A)
 CAPITAL BUDGETING refers to the process of identifying and evaluating new business
opportunities.
 CAPITAL BUDGETING decisions are important because they involve significant amt, they
are irreversible in nature, they have strategic consequences.
 The PRINCIPLES used in capital budgeting are equally applicable in other disciplines like
mergers & acquisition, refunding callable debt etc.
Note 1: When A ltd acquires B Ltd, it needs to pay purchase consideration and expects incremental
cash flows.

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Note 2: Callable bonds are long term bonds where the company issuer enjoys the right to refund the
bonds prior to maturity.
 Administrative Steps in the Capital Budgeting Process
1. Idea Generation
2. Through Analysis - Financial + Marketing + Technical + Risk analysis
3. Firm - wide optimal capital budget: Projects should not be accepted or rejected in isolation.
Projects might be interdependent such that firms should look at them collectively and choose
the best set of projects which has the highest NPV.
4. Monitoring and Post Audit: This is comparison of actual with projections to remove systematic
errors in projections & decision making, improve business operations control cost
Does Not eliminate potentially profitable but risky projects.

 Categories of Capital Projects

 Replacement for maintenance
 Replacement for cost reduction
 Expansion
 New Product launch
 Pet project of senior mgmt / R & D project: There are diff than normal capital budgeting
staff & may require a diff technique of evaluation altogether.
 Regulatory/ Environment related projects

average net income

Average Accounting rate of return 
average BV
op  cl
bv  Net Cash Flow (less: dept, tax deductibility)
2

LOS (B) BASIC PRINCIPLES OF CAPITAL BUDGETING

We don't have to prepare project cash flows
However, Principles in preparing cash flows used to be observed.
Revenue 600
(-) Operating cost excl. dept 200
EBDIT 400
(-) Depreciation 60
EBIT 340
EBIT (1 - t) 238
Ie. Net operating Profit after
Tax - NOPAT
Add: Depreciation 60
Cash flow After tax CFAT 298

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The Principles are:
1. Incremental Principle - Consider opportunity cost of scarce resources

Ignore Sunk Consider Externalities

Eg: R & D expenditure already This project may positively or
paid existing expenditure, negatively impact firm's existing
not incremental activities
Eg of negative impact: CANNIBALIZATION
(Same company) (Diet Coke)
2. Cash Flow Principle
We are preparing cash flows not accounting income. Hence, non cash expenses like
depreciation, amortization, etc should NOT be deducted.
However, tax earning on account of these expenses should be considered. This is accomplished
by deducting depreciation at the PRE - TAX stage and adding it back at the POST - TAX stage.
3. Post - tax Principle
Since WACC is post tax cash flows need to be post tax.
4. Exclusion of financing Cost Principle
Who invested money in the project?

Long term Source (LTD + Equity)

What do they want?
→ Kc (WACC)
Since cash flows are discounted at kc while computing NPV, financing cost is already
incorporated in the NPV calculation. So, do not deduct interest while computing cash flows.
5. Timing of the Cash Flows
Consider the following two projects:
Yrs A B
0 (800) (800)
1 300 300
2 500 500
3 600 300
Obviously, Project B would be preferred over project A.

LOS (C)
1. Mutually Exclusive Projects - If two projects are mutually exclusive, they cannot be
simultaneously undertaken
Let us define the following terms:
Independence - two projects are said to be independent if the acceptance or rejection of one does
not affect the other. An extreme from of interdependency is mutual exclusiveness - if you accept
one project, you have to reject the other.
2. Project Sequencing - This means that if we accept project X today, it will give us an opportunity
to move into project Y later. This is often called Real Option.

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3. Capital Rationing - It refers to a situation where Funds available < Funds required
Hence, all projects NPV with positive cannot be under taken firm will need to priorities and
accept that set of projects which has the highest NPV.
Note: Example for building thought process on the application of mutual exclusiveness and
capital rationing.
A firm is facing the fell project opportunities
Invst reqd PV of Futures CFs NPV
A 300 430 130
B 400 560 160
C 500 680 180
D 200 270 70

The Fall project interdependence exist -

 A and B are mutually exclusive
 A cannot be undertaken without C
 If we accept both C and D, a common plant can be used such final initial investment would
come down to $600 m.
 If we accept B and C, there will be some synergy in terms of future CFs, such that, PV of FCFs
would $1300m.
Advise the firm wide optimum capital budget given a budget limit of $1100 m . You have to accept
at least 2 projects.
Sol:
Set IR PV of FCFs NPV
A%C 800 1110 310
B&C 900 1300 400
B&D 600 830 230
C&D 600 950 350
A&C&D 900 1380 480
B, C & D 1000 1570 570

Conclusion: The optimal capital budget for the firm is B, C & D.

This would create additional value of $ 570 m.

LOS (D)
Given the cash flows of a project derived as per the principles of los (b) flow do you decide whether
to accept or rejected a project?

Selection Criteria

Discounted Criteria Non Discounted Criteria

Considers Time Value of Money (TVM) Ignores TVM
 NPV Pay Back Period (PBP)
 IRR

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  Discounted Pay Back Period (DPBP)
 PI ( Profitability Index

Q1 Consider a project with the follwing net cash flows

Yrs 0 1 2 3
NCFs (600) 300 400 200

Reqd return ie kc (cost of cap) = 14%

Let us use each criteria to evaluate their project
1. NPV NPV = PV of Cash inflows - PV of cash outflows

Amount
 300 400 200 
NPV     3
 600
 1.14  1.14   1.14  
2

Price willing to pay today (in case of shares)

Caci
CF 2nd CE/c
CF0  CF1  CF2  CF3 Enter
CPT ADPV → I = 14 
NPV → CPT = $105.94 m
Interpretation: NPV directly shows the additional value created as a result of the project. In fact,
firm is new value equal to existing value + NPV.
NPV
New share price = Existing share price +
No.of shares
Hence, NPV is considered to be the best criterion as it focuses on the very objective of financial
mgmt ie. shareholders wealth maximization.
Decision Rule
If NPV > 0 → Accept
NPV < 0 → Reject

PV of Cash inf lows

2. PI 
PV of Cash outflows

705.94
  1.18m Relative Considering the size of the project
600

Shortcut
*  PV of cash outflow
Actual NPV

This was computed by deducting outflows PV.

Interpretation - It is the benefit per spent in the project

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Decision Rule -
If PI > 1 - Accept
PI < 1 - Reject
NPV   PI  1   Initial Investment

relative consider the size of project

3. Internal Rate of Return (IRR)
- It is that discount rate at which NPV = 0
ie. when PV of inflows = PV of outflows
IRR = 24.81% → Calci
Decision Rule
If IRR > Kc → Accept
IRR < Kc → Reject

Since all these three ie NPV, IRR and PI are based on DCF technique, they give the same
accept/reject decision.
NPV > 0  PI > 1  IRR > Kc Accept
NPV < 0  PI < 1  IRR < Kc Reject

Q2.
unconventional - Cash Flows
Yrs NCF
- investment twice (more than once)
0 300
1 200 - more than 1 change of sign.
2 100
3 250
4 300
5 200
6 400

Cost of Cap k c  13%

Flow ever the project is risky than the coverage risk of the firm.
So, there will be 2% add risk premium.
Evaluate, the project on the basis of:
a. NPV
b. IRR
c. PI
Sol: Reqd return on this project = k c + addl risk prem = 13 + 2 = 15%
a. NPV = $ 406.57 m → Market cap goes up by 406.57
b. IRR = 47.24%
PV of cash inflows
c. PI 
PV of cash outflows
406.57  375.61

375.61

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 782.18

375.61
= 2.08
 NPV > 0, IRR > Reqd return, PI > I - Project is viable

Q3.
Yrs NCF
0 500
1 200
2 200
3 200
4 300
5 300

k c  10%
Since the project is less risky than the avg. risk of the firm, reqd return would be 1% less.
Sol:
NPV = $413.76 m
IRR = 34.63%
413.76  500
PI   1.827
500
4. Pay Back Period (PBP)
- It is the no. of years in which the project will pay back the initial investment ignoring time value of
money. The mgmt fixes a cut off. Say N, All projects with PBP less than N are accepted.
Eg: Consider the fall project
Yrs 0 1 2 3 4
NCF 800 300 100 200 500

By inspection, PBP = 3.4 years

If mgmt's cutoff is 2.5 yrs - This project is rejected

Drawbacks of PBP
 It ignores TVM
 It ignores cash flow beyond the PBP
 It has a judgmental cutoff.
 It is not a profitability measure.
Hence, PBP is not a measure of profitably at all. It is a measure of liquidity (advantage) - How soon
do you get your money back?

Conclusion: Any firm that focuses on liquidity takes on less risk. Hence, would advice firms to use
PBP as a screening/filtering device.
Step 1 - Shortcut those projects whose PBP is less than N*
Step 2 - Out of the shortlisted projects, determine the optimal capital budget wing NPV.

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5. Discounted Pay Back Period
- It is the no. of years in which the project pays back initial investment in Present Value (PV) terms.
Eg: Consider the follwing project.
Yrs 0 1 2 3 4
NCF 600 300 200 500 400
If k c  12% Calculate discounted pay back period and comment on projects acceptance/rejected. If
the cutoff period is 3.5 yrs.
Use TVM mode PV, 1/4, N CPT → PV
Sol:
Yrs 0 1 2 3 4
NCF 600 300 200 500 400
PV 600 267.85 159.44 355.89 254.21

427.29
172.74
 0.49
355.89
DPBP → 2.49 yrs
 This is less than the cutoff of 3.5 yrs - Project is accepted

Common Sense OBS - DPBP is always more than PBP.

LOS (E) NPV PROFILE

We know that NPV is equal to PV of cash flows discounted at Required rate of return - Initial
Investment.
Hence, Higher the reqd return (discount rate), lower the NPV. A tabular or graphical relationship
between discount rate and NPV is known as NPV profile.
Yrs Proi
A
0 600
1 200
2 300
3 400

NPV Profile as follows

K NPV
0% 300 - I - 0
5% 208.12
10% 130.28
15% 63.76
20.61% 0 [IRR]
25% - 43.2
30% - 86.57

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Q. Consider a project whose NPV profile is shown below
It is a 3 year project whose 1st Year CF is 70m, 2nd yr's CF is 90m and 3rd yrs CF is 140 m. Calculate
NPV at k c  12%

At 14% dise rate, PV of the cash inflow = Initial Investment

= $ 225.15 m
NPV at k c  12%  PV of cash inflows = $ 233.89 m
 NPV = (233.89 - 225.15) m
= $ 8.7 m at k c  12%
Consider the follwing project
Yrs Proi
B
0 600
1 400
2 300
3 170

Let us look at its NPV profile

K NPV
0 270
5 199.91
10 139.29
15 86.45

10
 20.61 34.77
24.876 0 [IRR]
25 0.96
30 37.41

Compare Proi A and Proi B's NPV Profile

 These two projects are comparable because they are of the same size (600 m) & Same life (34 yrs)
 The main difference b/w the two projects is cash flow and CF timing pattern (better for B)
 As discount rate rises, project A's NPV falls at a higher rate because proj A has unfavorable
timing pattern ie. higher CFs towards the end than the beginning. So, as k increases, it is
penalized more and falls at a greatest speed.
 Cross - Over Rate known as the Fisherian Rate of Return calculation i* is the discount rate at
which NPAA = NPVB
200 300 400
 600   
 1  i *   1  i *   1  i * 3
2

400 300 170

 600   
 1  i *   1  i *   1  i * 3
2

230 200
 
1  i *
2
1  i *
230
 1  i * 
2

200
1/2
 230 
 i*    1
 200 
= 7.23%

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CALCI
200 given at t = 0 (say) → after 2 years becomes 230
 200 ± PV
2N CPI 1/4 = 7.23%
230 FV

 If k c  i * which project has higher NPV?

- The project with higher cash flow and poor turning ie Project A.
If k c  i * project B has higher NPV because TVM is very imp. Hence, pattern (CF Timing) is
dominant ie Better timing, poor Cf.
 State True/False
There is no conflict b/w NPV and IRR if k c is greatest than i* - TRUE
NPV maybe confused about whether A is better or B is better IRR is always clear ie it will
prefers the project with better pattern ie project B. Luckily, at k c  i * NPV also prefers B because
TVM imp (Timing precedence)
So, No conflict b/w NPV & IRR above the fisherian rate of Ret.
  
A firm has k c  6% ie k c  i * , which project should be chosen if they are mutually exclusive.

There is a conflict b/w NPV and IRR. NPvA  NPVB But IRR B  IRR A . If the projects would
be Independent - Both would be accepted (+ve NPV), however since they are mutually
exclusive, we will accept project A ie the one with the higher NPV.

2. Conflict b/w NPV and IRR

Eg: k c  18%
Project A Project B
NPV 40 m 75 m
IRR 30% 26%
Initial In just 300 m 700 m

 For a Single Project - No Conflict

 For two or more mutually exclusive projects - conflict can occurs
Situation 1: CF Timing Disparity
- refer prev eg on NPV profiling
Situation 2: Size Disparity
- NPV is biased in favors of bigger projects
(Refer the eg. on previous page)
 If these projects are independent - accept both value of the firm will go up by (40 + 75) = $ 115 m
 If these projects are mutually exclusive - accept project B as it would be better to create addl
wealth of $75 m instead of only $ 40 m (always choose higher NPV)
Drawback - What about size of project?
- We are investing 700 m in B instead of 300 m in A.
Situation 3: Life Disparity ie projects of unequal life
- Not our focus area.

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 Problems of NPV - ignores size of project (blasted towards bigger size)
 Problems of IRR
 There may be multiple IRR or no IRR.

All this happens in case of NON - CONVENTIONAL cash flows.

Also, the no. of IRRs of a project will be equal to the no. of chages to sign
0 1 2 3 4 5 6
(200) 80 220 (70) 40 50 (10)
No. of IRRs = 4
 IRR is based on the assumption that the intermediate CFs of a project are re invested at IRR
itself. This is a very aggressive and unrealistic assumption. How can we expect the firm to
have projects where IRR > k c ? Instead, NPV is based on a very realistic assumption that re
investment rate is k c
 IRR can many a times conflict with NPV for mutually exclusive projects.
Note: The author states that unlike NPV, IRR as a profit ability measure shows MOS.
Thus, if k c = 18%
IRR = 24%
Thus, MOS = 6%
 Schweser Question
X → IRR = 14%
Y → IRR = 17%
NPV X >0
If k c  10%
NPY Y > 0

State T/F, Is NPVy  NPVx ~ Net Necessarily because NPV depends on the amount of money
invested in project but IRR is a% (ignores errors, millions and so on).

Give Spore

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 COST OF CAPITAL

Every firm has two independent finance divisions:-

 Financing Division - Responsible for the procurement of funds
 Investment Division - Responsible for the deployment of funds

In order for the investment division, to calculate NPV of a project, there is a requirement of WACC
or MCC (Marginal Cost of Capital). This has to be supplied by the financing division.
The financing division has to study the market and decide upon the optimal capital structure - The
optimum mix of capital components which minimizes WACC.
In deciding upon the optimum capital structure, the primary thought process runs like this
 Debt is chapter than equity bcoz debt holders demand a lower return and interest on debt is tax
deductible
 However, as a firm takes on more and more debt, equity shareholders are exposed to higher &
levels of financial risk in addition to business risk. So, cost of equity rises. Somewhere an
optimum balance b/w these two forces is struck andan optimum capital structure is
determined.

Give Spore
Eg: The target capital structure of a firm is:
Equity → 40% long term debt → 50%
Preference → 10%
Component Cost of Capital
The cost of various capital components are -
k e  22% k d  Yield on debt   15%
k p  18% Tax rate → 30%
Calculate "WACC"
Sol: k c  0.4  22  0.1  8  0.55  15  1  0.3 
 8.8  1.8  5.25  15.85%

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Interpretations -
1. It is the min rate of return reqd by the capital components and is hence used as the hurdle rate
or the reqd rate of return, it is the rate of return that a firm must use to maintain its market
value. WACC is the cost of financing firms is assets & can be viewed as an opportunity cost.

LOS (B) EFECT OF TAXES

This los is highlighting the tax deductibility of debt ie. k d  1  t  ,

LOS (C) TARGET WEIGHTS

 In order to minimize issuance cost, capital is raised in bulk amount while at the same time
adhering to target weights in the Long Run
Eg: For instance, a firm has target debt equity ratio of 1 : 1
Stage 1: Firm requires $40 m for a project
k d  14%, tax = 30%, k e  18%
Firm raises entire 40m via equity to minimize flotation cost. If this project has an average risk,
what should be the discount rate.
Sol: Discount rate ≠ k e  18%
1 1
Instead it will be k e   18   14  0.7
2 2
= 13.9%
Stage 2: After 6 months, firm has another project requiring investment of $40m. This time firm
decides to raise the entire $40 m via debt. What should be the discount rate assuming average
risk project?
Sol: Discount rate would still be 13.9%
Conclusion: Irrespective of how specific project is financed, k c must always be computed
using target weights.
 How do we get target weights?
 Supplied/Specified by mgmt
 Take weights as per current market values (with BVs) to be suitablg adjusted to capture any
trend of leveraging or deleveraging

*Equity
Mks value - Effect of reserves incl on shares price
BV - We have to take reserves bcoz net incl.
Eg: X ltd has not defined any target capital structure, An extract of X ltd's Balance Sheet is as follows
-
Equity share capital $ 200m
[ 20m shares of $ 10 FV]
Reserves & Surplus $ 300 m
BV of equity/Net Worth 500
Preference Capital $ 500 m
[ 5m shares @ 100/-]
Bonds [ 2m @ 100] $ 200 m

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 $ 300 m
Capital employed/ Invested Capital 1500 m

Equity share price = $ 120

Preference share price = $ 102
Bond market price = $ 95
Market value of term loan = $ 270 m
What weights should be taken in computing WACC?
Sol: Since target capital structure is not defined, we should take mkt value weights assuming that
the current mkt value reflects the targets
Source of Finance Market Value Weights
Equity* (20 × 120) = $2400 m 2400/3370 = 71.21%
Preference (5 × 102) = $510 m 15.13%
Bond (2 × 95) = $195 m 5.64%
Term loan $ 270 m 8.01%
$ 3370 m ~ 100

LOS (D)
 MCC Schedule - As we raise more and more funds, k c would be rising [The math of it would
be done in LOS (k)]
 As we search for more & move money to be deployed in projects, IRR would falling -
Downward Sloping Investment opportunity schedule (IOS)

Given the wealth maximization objective, firm's optimal capital budget is achieved at the point of
intersection of the MCC & IOS as shown below:

LOS (E) USE OF KC (MCC) IN NPV

 Firm's Kc represents existing business risk and target capital structure. So, if a cement firm is
evaluating a 5 yr cement project and the target capital structure over the next 5 yrs will remain
the same - only then can the firm's existing kc be used as Reqd rate of return.
 If the cement firm is going for a software project, firm's kc cannot be used as required return.
1. WACC is the appropriate discount rate for projects having same level of risk as the firm's
existing project. Because the component costs of capital used to calculate WACC are based on
firm's existing level of average risk.
If project has higher avg risk then firm, kc > WACC & Vice Vessa.

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 2. Assm: The capital structure of firm will remain at the target capital structure over the life of
the project.

Issues to Calculate Kd
 Company's current o/s bonds contain embedded options
 Company uses leases as a source of finance.

LOS (F) COST OF DEBT

We had earlier acknowledged that interest on debt in tax deductible.
So, Post - tax Kd = Int rate (1 - t)
Interest Rate - It is not the coupon rate on the bond. It is not the old contractual rate at which bond
right have been issued. Instead, it is the current int rate at which bond can be issued.

Case I: Bond is traded on one or more stock exchange.

- Take YTM (Yield to Maturity) as Int rate.
Eg: X ltd has the follwing bond outstanding. [Credit Rating - AA]
Price = 960, FV = 1000, Coupon Rate = 10%, Maturity - 5 yrs, Tax Rate - 30%.
Calculate Post tax cost of debt.
Sol: 2nd CLR TVM
960 ± PV 5N
1000 FV CPT - 1/4 = 11.08%
100 PNT
So, Post tax Kd = 11.08 × 0.7 = 7.7%

Case II: Debt Rating Approach

- Suppose the bond in the previous eg is not traded.
So, we do not know its price.
Suppose we search for AA rated 5 yrs bond available in the next @ yield of 12%.
So post tax Kd = 12 × 0.7 = 8.4%
Note: If the bond under consideration has some differential feature (say, callable) its yield should be
adjusted upward.
(Say putable), its should be adjusted downwards.
This similar yield concept based on credit rating and maturity is known as Matrix - Pricing.

LOS (G) COST OF PREFERENCE CAPITAL (KP)

 If preference share is perpetual,
D
Kp   100
P
D: Dividend - PMT
P : Price
 If preference share is redeemable, PV = $1000 + Prem. (if any)
Kp is taken as the YTM (No tax deductibility)

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LOS (H) COST OF EQUITY (Ke)
Equity also called common stock
 Ke is the rate of return reqd by equity shareholders.
Kc  R c
To digest this, think of the following situation -

Q. A firm has earned $ 500m Net Income this year. Out of this amount, $200 m is distributed as
dividend.
The remaining amt ie $ 300 m is plowed back in business. who does this amt belong to? -
Obv, equity, shareholders. They require a certain return (Re)
So, firm must earn that Re for them. Hence, Ke = Re
There are 3 methods of computing Re
Method I
Re = Bond Yield + Risk prem
Eg: X ltd has outstanding bonds which yield 9%. Since, shareholders are exposed to higher risk as
compared to bond holders, they require 2% higher return.
Sol: So, Re = 9 + 2 = 11%

Method II Dividend Discount Model (DDM)

As per constant growth DDM (Popularly known as GGM ) -
Gordan Growth Model
D1
P0 
Re  g
D1
 Re  g
P0
ie R e  Dividend Yield  Capital Yield
of course, this formula assumes Equal
Eg: X ltd has a constant pay out ratio of 80%. It has a constant ROE (Ret on Equity) of 30%. The
stock is trading at $200 m & is expected to pay dividend of $8 next year. What is the rate of return
reqd. by equity shareholders as per GGM?
Sol: Step 1 - Sustainable growth rate
g=B×R B: Retention rate/ (1 - payout rate)
= 20% × 30% R : ROE
= 6%
Step 2 - As per GGM,
D1
Re  G
P0
8
  0.06  10%
200
Eg: The dividend yield on a stock is expected to be 7%. Payout ratio is 80%. Expected Return on
book equity is 30% what is the equity capitalization rate as per DDM.

18
Sol: g = B × R
= 20% × 30%
= 6%
As per DDM,
Re = Dividend yield + Capital gains yield (g)
= 7% + 6%
= 13%
Eg: A stock is trading in equilibrium. The constant growth DDM is applicable to the stock. Equity
capitalization rate is 18%. If sustainable growth rate 5%, what is the expected Dividend Yield (DY)
on the stock.
Sol: Re = DY + g
18% = DY + 5% → DY = 13%
Eg: A stock is presently trading at an equal price of $500m. It is expected to pay dividend of $75m
next year. If sustainable growth is 6%, what is the equity capitalization as per Gordan Growth
Model (GGM) ?
D1 75
Sol: R e  G   0.06
P0 500
 0.15  0.06
 21%

Method III Capital Asset Pricing Model (CAPM)

- Extended version in the portfolio topic
This is a model with a strong theoretical underpinning (framework) we will develop it in stages -
Stage I: CAPM assumes that investors are rational [Contrast this to normal (BAPM)] Thus means
that investors are risk averse. Hence, Reqd, return firm on eq stock is:
Re = Rf + Risk Prem
Where RF : Yield on treasury securities of the same maturity as the project.
Risk Premium: Extra return reqd for the risk involved in the stock

Stage II: There are two types of risk -

 Systematic Risk: Economy related - It affects all stocks in the same direction - Cannot be
diversified away (killed by diversification cannot)
 Unsystematic Risk: Firm specific internal risk - it is unique risk which affects only that
company. ie you face it only if you invest in a single stock or an undiversified portfolio.

Stage III: There is a model called Behavioral Asset Pricing Model (BAPM) which assumes that
investors are normal. This means that investors consider themselves to be equity savvy and select a
group of stocks resulting in undiversified portfolio. They face both SR and USR.

However, CAPM assumes that investors are rational. They invest in a diversified portfolio where
USR is gone. The only risk relevant in the CAPM would is SR.
So We have,

19
R e  R f  Syst risk prem
Where, SRP - Extra return reqd for systematic risk of that stock.

Stage IV: Let us quantify systematic risk of a stock:

It is the sensitivity of the stock to the economy captured by Beta ()

If  of a stock = 2. It means that when the economy changes by 1%, the stock is expected to change
by 2%. Obv, cyclical stocks with high financial leverage (debt) will have high beta.
Defensive stocks like consumer staples and pharmaceutical with low financial leverage have low
beta.
A projects Beta is quantitative measure of its systematic risk or market risk
 Beta tends to revert to 1 overtime

Give Spore
 Betas of small companies should be adjusted upward to reflect greatest risk
 It is calculated by regressing stock's returns against the market's returns [net vice versa]
Stage V: Economy - As per CAPM< Economy is captured by
The Market Portfolio

Market portfolio is a portfolio comprising all risky assets.

 Such a portfolio does not exist.

 So we take a well published stock market index such as the SENSEX or NIFTY in India or the
DJIA (DOW Jones' Industrial Average) or S & P 500 Index as a proxy for the market portfolio.

Hence, if Beta of Microsoft = 1.2, it means that for a 1% change in the S & P 500 Index, the stock of
Microsoft is expected to change by 1.2%
Note: Any hint regarding how  is calculated?
Step 1: Select a past period (say 5 yrs) - Why not 10?
Step 2: Select frequency of returns (say annual) - why not monthly?
Step 3: Plot a scatter diagram.
Period Ret on S & P (x) Ret on Microsoft (y)
1 11% 14%
2 - 4% - 7%
3 20% 30%
4 10% 15%
5 2% - 2%

20
2nd DATA 2nd CE/C
XO1 Enter  YO1 Enter ............. cont.
2nd STAT 

Until we reach b = 1.597

~ 1.6 (beta)
This means that if S & P changes by 1%, Microsoft is expected to change by 1.6%

Stage VI: Systematic Risk Premium (SRP) = Price of (PR) × Quantity of Risk (QR)

Compensation reqd for 1 unit of

risk ie extra return reqd for  = 1
Net Stock Specific

Treasury has a  = 0 and a return = Rf

Market portfolio has a Po = 1 and return = Rm
So, PR  R m  R f - We call it Market Risk Premium (constant)
QR is the Beta of specific stocks.
 SRP   R m  R f  
Hence, R f  R f   R m  R f  
Eg: Treasury securities are presently yielding 4%
Market Risk Prem = 5.5%
What is the equity capitulations rate for a stock with a Beta of 2.
Sol: R e  R f   R m  R f  
= 4% + (5.5) 2
= 15%

LOS (I) CALCULATE  AND KC OF A PROJECT

 We would like to use CAPM to determine KC of a project. However, a project is not tradable so
its is not readily available.
 We choose proxy companies which are in the same line of business as the project. Thus, if a
project is an IT project. The proxy companies may be Infosys and WIPRO - Pure play method
because we begin with the  of a company that are purely engaged in a business similar to
that of the project & is thus comparable to the project.
 Since both Infosys and WIPRO are traded, their data are available inf osys  1.6; WIPRO  1.9

Challenges of Beta
  is estimated using historical returns - sensitive to the length of time used and frequency of
data.
 Estimate affected by the index chosen to represent market return

21
  They tend to result to 1 overtime - adjustment reqd because of this.

However, these s don't' only reflect IT business systematic risk but also reflect the financial risk of
these firms.
 Infosys has a debt - equity ratio = 0.4
D/E of WIPRO = 0.5
Tax rate = 30%
So we have to unlevered the  of Infosys and WIPRO. This means we have to remove the
effect of debt eq ratio.
 The relationship b/w levered and unlevered Beta is given by:
 D 
L   u  1   1  t  
 E 
L
 u 
 D 
1  E  1  t  
 Infosys
1.6 1.6
u    1.25
1  0.4  0.7 1.28
Wipro
1.9 1.9
u    1.41
1  0.5  0.7 1.35
Average
1.25  1.41
u   1.33
2
 This can be taken as the  of the IT project provided the project is wholly financed by equity.
 Suppose this is not the case - the project has a debt eq ratio of 0.2. So, we need to relever.
L  1.33  1  0.2  0.7 
= 1.33 × 1.14 = 1.51
 Suppose, Rf = 6%, Market risk premium = 5%
So cost of equity for the project (Ke) = Rf + (Rm - Rf) 
= 6 + 5 × 1.51
= 13.55%
Suppose the pre tax cost of debt is 15%
ie Post tax (kd) = 15 × 0.7 = 10.5%
 Cost of capital for the project = wd k d  we k e
0.2 1
  10.5   13.55
1.2 1.2
= 1.75 + 11.29
= 13.04%
Q. X ltd - an IT company is evaluating a project in the food processing industry. [Can x ltd's present
Kc be used for this project? - NO]

22
X ltd presently has a debt eq ratio = 0.7 - Irrelevant But food processing industry project can sustain
a debt eq ratio = 0.9
[Which one is relevant? - 0.9]
Effective tax rate for x ltd is 32%
The firm has decided to use CAPM to determine the project's cost of capital. Two proxy firms in the
food processing industry have been selected -
Firms  D/E Efft
A 1.3 0.3 27%
B 1.1 0.2 35%

The food processing project will have a pretax Kd = 12%

Treasury yield - 5% Market risk prem = 5.5%
Determine the project's cost of capital.
Sol: Step 1 - Unlever Beta of proxy firms
1.3 1.3
A  V    1.06
1  0.3  0.73 1.219
1.1 1.1
B  u    0.97
1  0.2  0.65 1.13
Step 2 - Since the food processing project u proposed to be financed with a D/E of 0.9. We have to
Relever
L  1.015  1  0.9  0.68 
= 1.015 × 1.612 = 1.636

Step 3 - k e  R f   R m  R f  
= 5 + 5.5 × 1.636
= 13.99 %
~ 14%
Step 4 - Post tax Kd = 12 × 0.68
= 8.16%
 K c = wd k d  w e k e
0.9 1
  8.16   14
1.9 1.9
= 3.87 + 7.37
= 11.24%
Q. L  1.7, wd  40%, t  30% Calculate u
L 1.7
Sol: u    1.16
1  D /E  1  t   1  0.4  0.7
0.6

23
LOS (J) COUNTRY RISK PREMIUM
To reflect the increased risk associated with investing in a developing country, CRP is added to
MRP.
 Us company is setting up a project in Karachi
Rf = 6% MRP (Mkt Risk Prem) = 5
of the project = 2
So, k c  R f  MRP 
= 6 + 5 × 2 = 16%
 On second thoughts it is fell that the kc computed above is understated. It needs to
incorporated Country Risk Prem (CRP) ie. the extra return reqd for sovereign risk.
Mathematically, CRP has the same status as MRP.
Both represent the price per unit of risk.
Hence, The revised equation: k c  R f   MRP  CRP  
Thus, if CRP for the Pakistan economy is 3%
k c  6   5  3   2  22%
 How is CRP Computed?
We find that US Treasury Yield = 5%
Pakistan Treasury Yield (denominated in dollars) = 7.2%
Sovereign Yield Spread = 2.2%
We feel like taking this as CRP. However, on second thoughts we relied that we are wanting
to get CRP for the equity market and not bond market.
Sovereign equity
Hence, CRP  
Yield Spread bond
Suppose SDbond  20% while that of equity mkt = 30%
30
 CRP = 2.2%   3.3%
20

LOS (K) MARGINAL COST OF CAPITAL SCHEDULE - WHY UPWARD

SLOPING? AND CALCULATION OF BREAK POINTS
 MCC is the cost of the last dollar of capital by a firm. As we raise more 'n' name funds, kc will
keep on rising. We will land up with the following schedule:
Funds to be RHSED Kc
0 - 149 m 14%
150 - 399 m 16%
400 and above 18%

This is shown below.

24
 MCC increases as add 'capital' raised when:
 Derivations from target capital structure
 Company's existing debt covenants that restrict it from issuing debt with similar seniority.
 Break Points in the MCC schedule occur when any component cost of capital charged. So Break
point is given by:
Amt at which component cos t changes
P 
Weight of the component
Q. A firm has a target debt equity ratio of 3 : 1. The cost of various sources of finance are shown
below:
Debt
Range Pretax kd
0 - 49 10%
50 - 149 11%
150 & ab 12%

Equity
Range Kc
0 - 39 16%
40 & above 17%
Show the marginal cost of capital schedule (Tax Rate = 30%).
50
Sol:  P1   $66.67
3/4
150 Important Part
P2   $200
3/4
40
 P3   $160
1/4
MCC Schedule - Not the focus (not in syllabus)
Funds to Be Raised Kc
0 - 65.67 9.25%
66.67 - 159 9.775%
160 - 199 10.025%
200 and above 10.55%
WN 0 - 65.67
Pre tax Kd = 10

25
So post tax Kd = 10 × 0.7 = 7
Ke = 16
1
 K c  3 / 4  7   16  9.25%
4
66.67 - 159 - Here Kc remains same Check 159 × 1/4 = 39.75
Pre tax Kd = 11
Thus, Post tax Kd = 11 × 0.7 = 77
Ke = 16
3 1
 kc   7.7   16  9.775%
4 4

160 - 199
Pre tax kd = 11, Post tax Kd = 7.7
3 1
Kc = 17% kc   7.7   17  10.025%
4 4
200 and above We got 200 through debt So kd changes.
Pre tax kd = 12%
Post tax kd = 12 × 0.7 = 8.4%
3 1
kc   8.4   17  10.55%
4 4
k c  17%

LOS (I) CORRECT TREATMENT OF FLOATATION COST

are the fees changed by investment bankers when a company raises external
equal by capital

Step 1: Incorrect Treatment of Floatation Cost

Eg: Initial investment in project = $500 m
Project life = 3 years
CF1 = 250, CF2 = 280, CF3 = 340
Target D/E ratio 3 : 2, Pre tax kd = 15%, Tax rate = 40%
Stock price = $80, Floatation cost = 2% of equity capital
Expected dividend = 6, Sustainable growth rate = 5%
Calculate NPV via the incorrect treatment of floatation cost.
Sol: Had there been no floatation cost,

26
 D1 6
ke  g   0.05  12.5%
P0 80
However, due to floatation cost - Net Proceeds per share (Pnet)
 P0  1  f 
= 80 (1 - 0.2)
= 80 × 0.98
= 78.4
 Most authors suggest that the cost of external equity be calculated via (Pnet).
D1
ke  g
Pnet
6
  0.05  12.65%
78.4
 k c  0.6  9  0.4  12.65
Post tax Kd = 15 × 0.6 = 9%
 10.46%
Calculate NPV = 208.07
CF 2nd CLR work
CF1  CF2 .......... I = kc

Step 2: What is Wrong in this?

Floatation cost is incurred just once ie right at the beginning. However, the above method makes
floatation cost a per annum affair which is conceptually wrong.

Step 3: Correct Treatment of Floatation Cost

Floatation cost should be included in the cost of project
Equity = 40% of 500 = $200 m
So, floatation cost = 2% of 200 = $4 m
So, initial cost = $504 m
So,
D1
Kc   g  12.5% k c  0.6  9  0.4  12.5
P0
 10.4%
k d  9%

Calculator
CF0  504  , k c  10.4%  I  rest same
NPV = $ 204.86 m
Note: If the sum specifically mentions that flotation cost is tax deductible, Post tax floatation cost
= 4 (1 - t) = 4 (1 - 0.4) = 4 × 0.6 = $2.4 m
CF0  502.4%  NPV = $206.46 m

27
 Reading No. 37 - Measures of Leverage

LOS (A)
Leverage refers to the risk assuming on a/c of the existence of fixed expenses in business. As a
result of fixed expenses, our earnings become more sensitive to changes in the level of activity.
It is often defined as a double edged sword - It amplifies the financial consequences.
 Business Risk - Variability of EBIT
Source: 1. Sales Risk - Variability of sales
2. Operating Risk - Variability of EBIT on a/c of the existence of fixed expenses in
business.
EBIT = Q (P - V) - F
 The presence of F makes EBIT more sensitive to Q - Operating Risk
 Financial Risk - It is the risk arising out of the use of debt, borne by common stockholders.

EPS 
 EBIT  I  1  t  N: No. of common equity shares
N
When EBIT charges, Interest expense will remain the same, And therefore, EPS will change at a
fasters rate. This is financial leverage or financial risk.

LOS (B)
Leverage is mathematically an elasticity measure.
Irrespective of any discipline, elasticity is explained this way:-
y  f  x 1 , x 2 ..........x n 
Elasticity of y w.r.t x1 ceteris paribus
% change in y

% change in x1
If the answer is 2, it means than when X1, changes by 1%, y changes by 2%
In this topic, we have three stages.
Key determinant of OL = Trade off b/w Fixed and variable costs.
 Stage 1: Operating Fixed Cost (F)
Hence, we would like to calculate the elasticity of EBIT w.r.t. sales (Q) known as Degree of
operating leverage (DOL)
%change in EBIT
DOL   INTERPRETATION
% change in Q
By applying differential calculus, we get a formula for calculating DOL.
Contribution Q P  V
DOL  
EBIT Q P  V   F
certain inferences out of this formula:
i. If a firm has no operating fixed cost, DOL = 1 which means if sales change by 1%, EBIT will
change by 1%
ii. However, if F is present DOL > 1

28
 Eg: Contribution = 50,00,00
Fixed Cost = 1,00,000
 EBIT = 4,00,000
5, 00, 000
 DOL   1.25
4, 00, 000
However, if contribution = 5,00,000
Fixed Cost = 4,00,000
 EBIT = 1,00,000
50, 00, 00
 DOL  5
1, 00, 000
Conclusion: Higher the level of F, higher the sensitivity of operating income to sales ie higher
the DOL.
iii. DOL being an elasticity measure, is different at different levels of sales (activity). At low
levels of Q, DOL is very high. As Q becomes higher and higher, DOL keeps on falling and
tends towards 1 (This language is applicable for the firm operating above the operating
BRP).*

LOS (C)
Operating BEP is the level of qty at which operating profit ie EBIT = 0
Q (P - V) - F = 0
F
Q* 
PV
Note: Below operating BEP, DOL may be negative.
Eg: Fixed Cost = 5,00,000 Variable cost per = 30
Selling price = 40
5, 00, 000
 Q*   50, 000 units
40  30
Now, let us dig inside the behavior of DOL w.r.t Q:-
 If the firm is operating at Q* - DOL is undefined
 If the firm is operating above Q* - DOL a positive and keeps on falling towards 1 as quantity
rises.
 If the firm is operating below Q* - DOL is negative.

Conclusion: You should focus on (2). Also understand the overall theme. High fixed cost results in
higher operating BEP and also result in higher DOL. This is what operating risk is all about.

 Stage 2: Focus in Financial Fixed Expense ie Interest Expense (I)

Degree of Financial Leverage (DFL)
% change in EPS
DFL 
% change in EBIT
Once again by applying differential calculus,
EBIT EBIT
DFL  
PBT EBIT  I

29
 Certain Inferences
1. For an unlevered firm, I = 0  DFL = 1
2. If a firm has high levels of debt, i would be high and therefore DFL would be high.
Eg: EBIT = 2,00,000
Int expense = 10,000
 PBT = 1,90,000
2, 00, 000
 DFL   1.053
1, 90, 000
Now, suppose, EBIT = 2,00,000, Int expense = 60,000
 PBT = 1,40,000
2, 00, 000
 DFL   1.428
1, 40, 000
Financial BEP = Int expense → that level of EBIT where EPS is equal to 0.
 Stage 3: Focus on all Fixed Expenses ie F and I
Degree of Total Leverage (DTL)
% change in EPS
DTL 
% change in Q
Cont r Q P  V
Applying differential calculus, DTL  
PBT Q P  V   F  I
Certain Inferences
i. DTL = DOL × DFL
ii. If F and I = 0, DTL = 1
iii. Higher the levels of F and I, higher the DTL.
iv. Linked to LOS (D).

LOS (D)
Overall BEP (Q**) is that level of quantity at which EPS = 0
Q  P  V   F  I  1  t   0
N

We get,
FI
Q ** 
PV
Hence, the behavior of DTL at different levels of Q can be summarized as follows:
Case 1: At Q**, DTL is undefined
Case 2: If firm is operating above Q**, DLT is positive and keeps on falling towards 1 as Q keeps on
rising.
Case 3: If firm is operating below Q**, DLT is negative.
Eg: Consider the firm's capital structure:-
10 m equity shares of $10 each = $100 m
10% term loan = $400 m = 40 mn
DFL = 1.4 Calculate EBIT.

30
 EBIT EBIT
Sol: DFL   1.4   EBIT  140 m
PBT EBIT  40
Eg: DOL = 3
DFL = 4
Firm is presently operating above the BEP.
By what % must sales fall to wipe out the current EPS.
Sol: DTL = DOL × DFL = 3 × 4 = 12%
Wiping out EPS means making EPS fall by 100%
Thus, for a 12% fall in EPS, % fall in sales required is 1%.
100
Hence 100% fall in EPS, % fall in sales required is
12
LOS (C) EFFECT OF FINANCIAL LEVERAGE
(1) On ROE (Return of Equity)
EBIT
Let us define ROI (Ret on Investment) 
Capital Employed
Compare this with interest rate (i) and the conclusion is obvious:-
Case 1:- ROI > i - Use of financial leverage (debt) will result in higher ROE
Case 2:- ROI < i - Use of financial leverage will result in lower ROE.

(2) The problem in decision making is that ROI in future is uncertain.

If we assume that Case 1 is prevalent, use of FL will result in higher ROE but at the same time a
more volatile ROE.
Eg: Capital employed = $800 m (NW = Net Worth)
EBIT = $ 112 m

Situation 1: Unlevered firm

Taking tax rate as 30%, show the levels of ROE for a 10% stock in EBIT in both directions.
Sol:
Particulars 10%  Same 10% 
a) EBIT 100.8 112 123.2
b) PAT 70.56 78.4 86.24
c) PAT 8.82 9.8% 10.78%
ROE 
NW
Situation 2: Levered Firm
- D/E = 1 : 1 and Int rate on debt = 10%
Particulars 10%  Same 10% 
a) EBIT 100.8 112 123.2
b) Interest@ 10% 40 40 40
c) PBT {a - b} 60.8 72 83.2
d) PAT (70% of PBT) 42.56 50.4 58.24
e) ROE = PAT/NW 10.64% 12.6% 14.56%
(400)
(3) Use of FL will always make ROE more volatile. As to whether ROE will be higher or lower in a
levered situation as compared to unlevered situation will depend upon whether you earn more or
less than the rate on debt.

31
 Dividend and Share Repurchased - Reading 38, SS 11
LOS (A)
* Return of capital, Not tax free unlike other dividends (which is paid out of a company's PAT)

CASH DIVIDEND

Regular Special/extra/irregular Liquidating Dividend

 Announced at the end of  Announced during the  Paid to shareholders as a part
the year. boom phase of the business of liquidation. (These would
Ideally, it should be stable. cycle. be *capital gains tax
- reduces cash and earnings consequence on it)

Effect - These is an outflow of cash. So, market cap of the company will fall by the amount of the
dividend paid. Also, share price will fall, by the amount of DPS (div per sh.)

Leverage Rations
D D
  Cash going to pay dividends - A  Subsequent fall in E
E A
CA 
Liquidity Ratio with fall. 
CL
 3 Accounting Gimmicks

Stock Dividend Stock Split Reverse Stock Split

- decrease in retained earnings Bonus
shares ie. capitalization of reserves.
(shares from reserve transferred to
share capital - both belong to
share holders) These are ratios.
Calculated as a% of shares P/E ratio remains same, Both P and EPS change by same amt.
of capital (no. of shares) No impact on shareholders equity.

Eg: EPS → $40

P/E ratio → 20 times
 Share Price → $800
BV per share → $ 500
No. of shares → 15m
Case 1
Firm announces a stock dividend of 40%. Calculate the effect on EPS, share price, BVPS (BV per
share)

32
Sol: No. of adds shares isued = 40% of 15 m = 6 m
So, no. of o/s shares post stock dividend = 21 m (15 + 6)
All absolute figures will remain the same but the per share figures will fall.
Net Income - Same as earlier - 15 × 40 = $ 600m
600
 EPS   $28.57
21
Market cap - Same as earlier = 15 × 800 = $ 12000 m
12000
Share price   $571.43
21
Net worth/shareholder's fund - same → 15 × 500 = $7500 m
7500
 BVPS   $357.14
21
Case II Company announces a stock split of 2 : 1. So, No. of shares = 15 × 2 = 30 m
Absolute amounts will not be affects. Per share amounts will be halved.
EPS = $20, share price = $400, BVPS = $250

Case III Company announces a reverse stock split of 1 : 4

(Foul existing shares are consolidated into 1 new share)
15
So, we now have no. of shares o/s   3.75m
4
Absolute amounts - Same.
Per share amount → 4 times their current level.
 Considering practical reality. What then is the rationale of these accounting gimmicks?
 Consider a stock that has gone up to levels of around $500. In US, the normal popular
trading range is considered to be $20 - $80. Hence, a stock dividend or stock split is required
to bring the stock to a normal trading range.
 If markets are inefficient, people might be fooled by stock dividend and stock split. If the
proportion of such fools is high, stock price will rise. Of course, when EPS subsequently will
not rise, those who bought the share at such price will have their fingers burnt.
 In fact, a certain school of thought criticizes stock dividend and stock split on the ground
that liquidity of the stock is hurt due to higher transaction cost ie brokerage charged on low
priced stocks.

EFFECT ON MARKET CAP AND FINANCIAL RATIOS - NO EFFECT

Eg: The stock price of a firm has gone down below $5. Ac per the stock exchange listing guidelines,
a stock is to be de listed if it stays below $5 for a month. What do we advise?
- Reverse Stock Split

33
LOS (B) DIVIDEND PAYMENT CHRONOLOGY

5th 14th 16th 25th

To (T2 - T) T2 T3
   
D/V Ex - div Holder Div Payment
Disclosure date of record date
date
Only those who are on the company's record as shareholders on the 16th shall be entitled to receive
dividend.
If (T + 5) - buy latest by 11th, (T2 - 4) ie 12th: Ex div date in a (T + 3) settlement system, you got to
buy the shares latest by 13th to be on record as shareholders on 16th. So, the ex dividend date is 2
days prior to the record date, that is, 14th.
Note: Share price behavior (certain possible) - As soon as dividend is announced on the 5th, share
price rises and we say that the share is quoting with cum dividend.
Thus, on the ex dividend date, share price falls by the amount of the dividend or by an amount d(1 -
t)

LOS (C) SHARE REPURCHASE METHODS

Method 1 Company will buy share from the open market at market price.
Method 2 Tender offer or auction - Company will announce a buyback programme wherein people
can lend their shares at a fixed price above the current market price. If there is oversubscription
these would be pro data allotment.

Dutch Auction - begins with a company communicating to shareholders a specific number of

shares and a range of acceptable price. Descending Price Auction.

Method 3: Negotiated or Block Deal from a single person

Consider a radar (Arun Bajoria) who acquired stake in Bombay Dyeing, this stake was repurchased
from Arun Bajoria at a substantial premium to the prevailing market price. This is called a Green
Mall.

LOS (D) EFFECT OF SHARE REPURCHASE OF EPS

Share repurchase is equivalent dividend of equal amt - Total shareholders wealth remains same
The conclusion in this regard is so intuitive that we better focus on the same:-
Case 1: Share repurchase using debt funds
After tax cost of debt = Kd
Earnings yield = E/P E  EPS
Conclusions:
If Kd = E/P, EPS will be unaffected.
If Kd > E/P, EPS will fall
If Kd < E/P, EPS will rise

34
Proof:
N → 20 m shares
PAT → 500 m
PAT
 EPS   $25
N
Share Price → $300
E
 Earnings Yield   100
P
25
  100  8.33%
300
Firm decides to borrow $600 m and use it to buy back shares at the current market price.
$600m
So, no. of shares bought back  2m shares
300
So, no. of share o/s after buy back = (20 - 2) = 18 m shares

Situation 1: Interest rate on debt - 11.9% and tax rate - 30%

 After tax Kd = 11.9 (1 - 0.3) = 8.33%
New PAT = Old PAT - After tax int. expense on additional debt
= 500 - (8.33% of 600)
= 500 - 50
= $ 450 m
450
New EPS =  $25 - Same as earlier
18
Situation 2: Interest rate on borrowing - 14%
 k d  14  0.7  9.8%  8.33%
New PAT = 500 - (9.8% of 600)
= 500 - 58.8
= $ 441.2
441.2
New BPS   $24.5  25 fall
18
Situation 3: Interest rate = 10%
 k d  10  0.7  7%
New PAT = 500 - (7% of 600) = 500 - 42
= $ 458
458
New EPS   25.44  25 rise
18
Case 2: Share repurchase using surplus (own) funds
Let. After tax yield on the firm's surplus funds -
The remaining staff is same
 If r = E/P - No effect on EPS
 If r > E/P - EPS will fall
 If R < E/P - EPS will rise

35
LOS (E) Effect of share Repurchase on BV per share
Net worth
We know that BVPS 
No. of shares
As a result of buyback - NW will fall by the amount of the funds used for buyback.
 No. of shares will fall by the amount of shares repurchased.
So, Effect on BVPS :-
 If repurchased price = BVPS - BVPS remains same
 If repurchase price > BVPS - BVPS will fall
 If repurchase price < BVPS - BVPS will rise.
Suppose in the previous eg, BVPS is presently $200. This means that Net Worth = $200 × 20m = $
4000m
We are buying back using $600 m at a price of $300.
 New net worth = old net worth - asset used for buyback
= 4000 - 600 = $3400 m
New no. of shares = 18m
3400
 New BVPS   $188.88  Old BVPS of $200
18

LOS (F) EQUIVALENCE OF CASH DIVIDEND V/S SHARE REPURCHASE

Eg: N = 40m P/EPS Ratio = 20 times

PAT = $ 400 m
The company has decided to distribute 75% of profit to shareholders in the form of cash dividend or
share repurchase at the current market price.
Prove that in the absence of tax a symmetry and information a symmetry, both cash dividend and
share repurchase are zero NPV investment opportunities ie they do not have any effect on
shareholders wealth.
400
Sol: EPS   $10
40
 Price = P/E ratio × EPS = 20 × 10 = $200
So, market cap ie. shareholders wealth = 40 × 200 = $8000 m

Case 1 Share repurchase

Amt used for repurchase = 75% of 400 = $ 300 m
Market cap after buy back = (8000 - 300) = $ 7700 m
Buy back price = $200
300m
 No. of shares bought back   $1.5m
200
No of shares O/S after buy back = 40 - 1.5 = 38.5 m
7700
So, share price after buy back   $200 Same as earlier
38.5

36
Case 2 Cash dividend of $300 m
300
 DPS   $7.5
40
7700
New share price   $192.5
40
Add: DPS $ 7.5
Wealth per share $ 200 → Same as earlier

 Repurchases offers shareholders more choices (tendering, not tending) than cash dividends
(payment they can't refuse)
 Some shareholders prefer cash div while others prefer share repurchases.
 Increasing cash dividends due to ↑ short term cash flows - not sustainable confusing to
investors.

37
 Reading 39 - Working Capital Management
LOS (A) Primary and secondary sources of liquidity
Primary
 Cash from normal day to day operations ie sale of goods, collection from debtors, interest
income on investments.
 Share term finance in the form of trade credit, short term bank finance.
 Effective cash management is accelerating cash inflows and decelerating cash outflows.

Secondary
 Sale of short term and long term assets
 Renegotiation with debt providers
 Filling for bankruptcy and recognisation

Note: Obv. primary source of liquidity do not change the operational structure of the firm and are
desirable. Secondary sources are drastic - they hurt the firm's reputation as well as the firm's
operating flexibility.

Factors that Influence Liquidity

DRAGS
Factors that increase the speed of cash
outflows.
Eg: Paying creditors earlier than when they fall
due, repayment of O/S balance due to change
in credit terms.
PULLS
Factors that slow down cash inflows oe
increase interest expense.
Eg: Not being able to collect from A/cs
receivable on time loss of reputation or tight
liquidity condition causes higher int rate on
short term bank borrowing, obsolete inventory
(more than to sell plus at discounts)

Note: In any turnover ratio. turnover is always in nr. combination of IS and B/C figs in a ratio - B/S
fig taken as avg.

LOS (B) Liquidity measures to be compared with peers

CA
1. Current Ratio CR   1 means negative working cap (CA - CL), facing a liquidity crisis.
CL
Cash  Short term Mktable Sec  AR
2. Quick Ratio/Acid Test Ratio QR 
Ag.debtors
Credit Sales /Total Sales
3. Receivables Turnover Ratio DTR 
Avg. debtors
365 365
Receivables Collection DCP    36.5 days
DTR 10  Say 

38
 COGS
4. Cash Sales Inventory Turnovers ITR 
Avg. inventory
Ratio - not affected by credit terms
365
Inventory Conversion/Processing Period ICP 
ITR
Credit purchases /Total purchases
5. Payables Turnover Ratio PTR 
Avg. A /cs payable
365
Payables payment Period PPP 
PTR
Note: All these should be neither high nor low. They should be close to the peers.

Q.1. What is the drawback of having a high ITR?

It implies low inventory which will result in lost sales and stoppage - in - production.

LOS (C) Operating & Cash Conversion Cycle

T0 - Procurement of Raw material

T1* - Payment for R/material
T1 - Production Starts
T 2 - Production Complete
T3 - Finished Goods Sold on credit
T4 - Calculation from debtors
* So Operating Cycle
Starts from the procurement of R/M (T0) and ended with collection from debtors (T4)

Net operating cycle/Cash cycle States with payment for R/Material and ends at T4.
Thus, operating cycle = Inventory period + Receivable period
Cash Cycle = Operating cycle - Payable period.
A firm should carry out time services (Intra firm analysis) as well as cross sectional (Inter firm
analysis) of operating cycle and its components. If a firm has a longer operating cycle as compared
to industry, it represents inefficiency.
Eg: X ltd. furnished the fall. data -

39
Opening inventory = $400 Opening A/cs receivable = $500
Closing inventory = $430 Closing A/cs receivable = $550

Opening A/cs payable = $150 Credit Sales for the year = $2500
Closing A/cs payable = $140 COGS for the year = $ 2000
Credit purchases for the year = $1800
Compute cash cycle.
Avg Inventory
Sol: Inventory Period   Use Logic.
COGS per day
415
  75.74 days
2000 /365
Avg A /cs receivable
A/cs Receivable Period 
Credit sales per day
525
  76.65 days
2500 /365
Avg A /cs payable
A/cs Payable Period 
Credit purchases per day
145  365
  29.4 days
1800
 Cash cycle = 75.74 + 76.64 - 29.4
= 122.99 days
Eg: Suppose in the previous sum, the industry to which x ltd. belongs has the fall operating cycle
and its components.
Inventory Pd = 60 days
A/cs Receivable period = 50 days
A/cs payable period = 40 days.
 Cash Cycle = 60 + 50 - 40 = 70 days

Compare & comment

1. Inventory Period of the firm is higher than the industry. It represents inefficient management of
inventory. The firm may be having obsolete stock. Lower than industry average may imply
inadequate stock on hand.
Los (f) Note: Of course one should carry out a deeps analysis. Perhaps this firm is having a
different business strategy. (Say auto parts deals for antique case) while the auto parts industry
comprises auto parts deals for regular case)

Exam Focus Think in terms of period.

 Liquidity - profitability trade off
 Calculation of inventory turnover ratio & inventory period.
 Link ITR and inventory period with firm's strategy.
 Carry out time services and cross section analysis.
Inventory  Last sales Cash  ie cash is freeing up & can be in relied profitability ↑

40
2. X ltd's Debtors Period = 76.65 days is significantly higher than the industry average = 50 days.
There are two drawbacks of having higher debtors period:
 More funds are blocked in debtors - opportunity cost
 Bad debts would be higher.

A/cs receivable ↑ sales ↑ ie cash ↑ (liquidity ↑) but profitability  (blocked fund's bad debt)
LOS (F)
Note: Regarding receivable management, we got to know -
 Liquidity - profitability tradeoff
 Receivables period
 Ageing Schedule:
Age bracket Receivables in ends Jan % of Receivables % Receivables at end of
Feb
0 - 30 30m 35.3% 50%
34 - 60 40m 47.06% 40%
61 - 90 10m 11.76% 9%
> 90 5m 5.9% 1%
85m

It is a removable improvement -
A higher % is now falling is (0 - 30) and a lower % is falling in > 90
 Weighted average Collection Period
This is a unique figure derived from the ageing schedule. To understand the same, look at the
ageing schedule for Jan end.
If receivables collection period is lower then industry average
 Strict credit policies resulting in lost sales. This does not necessarily mean better credit controls.
High - blocked funds.

Age bracket
(0 - 30)
The breakdown of receivables is:-
Amount % (wr) Days (x) Wx
7 23.33% 11 2.57
15 50% 4 10.5
8 26.67% 23 6.13
30 *19.2 days
* This is a single figure representative of the class 0 - 30 suppose for the age 31 - 60 → The single fig
comes to 42 days similarly, for 61 - 90 - 85 days
> 90 - 108 days

Weighted Avg Collection Period (WACP)

= 0.353 × 19.2 + 0.4706 × 42 + 0.1176 × 85 + 0.059 × 108
= 6.78 + 19.77 + 9.99 + 6.37
= 42.91 → lower the better

41
3. Payables - The firm seems to be paying off creditors faster than the industry ie 29.4 days v/s 40
days.
This might be pure inefficiency, on the other hand, it might be a deliberate policy of the firm to
avail cash disc.
2
IMP Suppose, the supplier effects the fall credit terms - net 60
10
Thus, means that the firm is supposed to pay in 60 days.
If it pays in 10 days, it gets a 2% discount.
The first thing that we understand from these terms is that we should either pay on the 10th day
or 60th day.
Lower avg trade payable - better liquidity & delayed requirement from its suppliers of cash
payment.

Also, if we are not availing discount, it is like taking a loan of 98 on the 10th day and repaying 100
on the 60th day. Funding cost = 2/98 × 100 = 2.04% for 50 days.
So, annualized effective cost of not taking discount
=  1.0204 
365/50
 1  15.89% pa
If the firm's cost of sheet term funds < 15.89% the firm should borrow from other sources and pay
on the 10th day.
Eg: A firm has sheet term funding = 12%.
Its suppliers quote 1/10 net 40. Should it avail the discount?
Sol: Finding cost = 1/99 × 100 = 1.01% fees 30 days
So, annualized eff cost =  1.0101 
365/30
 1  13%
Since, short term funding cost < 13%  Firm should avail the discount and pay on the 10th day.

Los (f)
Note: Payables Management:
 Do not pay easily
 Do not pay late
 Take rational decision regarding utilizing the discount.
 If a firm's creditor's period is increasing regularly, its a sign of liquidity problems.
* Taking trade discount only if firm's annual return on short term investment is less than the
discount percentage.

Not annualized rate
If the annualized eff cost < short term funding cost < No need to avail discount pay on due date.

Los (D) Daily Cash Position

 Firms should have sufficient cash balance to pay for day to day expenses. However, cash has
opportunity cost.
So, we need to strike a trade off.
 Prepare Cash budget
 Short term (Week)

42
  Medium term (monthly for a year)
 Long term (covering several years)
 From the cash budget, firm gets to know its surplus position on deficit position before hand. It
can accordingly plan for the deployment of surplus or the procurement of deficit.
 In the cash budget, typical cash inflows arise from cash sales, collection from credit sales,
interest & dividend income, sale of investments, borrowing etc. Typical cash outflows result
from cash purchases, payment for credit purchases, payment of operating expenses, taxes,
interest, purchase of investments, repayment of loan etc.

Los (E) Various Types of Yield & Short term investment Policy Guidelines
Short term securities in which firm can invest cash:
 Us Treasury bills - 2 to 7 of maturity
 Certificate of Deposits
 Time Deposits
 Commercial Papers
 Money market Mutual Funds

FV  Pr ice
% discount 
FV
FV  P 360
Discount  basis yield  
FV n
Always
 MMY  DBY 
 BEY  DBY  EAY  BEY  MMY  DBY
 
 EAY  BEY 
FV  P 360 360
Money Market Yield (MMY)    Holding Period Yield (HPY) 
P n n
Bond Equivalent Yield FV  P 365 365
   HPY 
BEY P n n
- most appropriate in comparing a company's investments in short term securities.
 % disc 
365/No.of days past disc

Cost of Trade Credit   1    1 
 1  % dise  

43
Notes
1. Limitations of Financial Ratio Analysis (Current Ratio)
 Need to use judgment
 Differences in international accounting practices
 Multiple industries in which firm operates (difficult to find comparable industry ratios)
2. Many ratios are industry specific but not all ratios are important to all industries. Financial
ratios always improve when the economy is strong and vice versa.
3. Inventory Management
 Increase in inventory period may be good inventory management (adequate supplies to
avoid losses on customer's demand) or bad inventory management (poor sales/absolute
stock)

Investment Policy Statement

 Purpose/objective of investment portfolio.
 Types of securities (does not give a list of permissible securities)
 Specific information on who is allowed to purchase
 Procedures to follow if investment guidelines are violated → who all are to comply
 Limitations on the types of securities & their credit ratings and also the proportion of total short
term securities portfolio that can be invested.

Los (g) Short term financing

Category I Banking Channels
a. Line of credit - A bank promises to provide credit up to certain amount & within a certain
period.
i. Uncommitted: Bank can refuse to grant credit if circumstances worsen.
ii. Committed: Bank cannot refuse - So, this is more reliable. It is for a max maturity of 1
year. It is at a floating rate (say LIBOR + spread) where the spread depends upon the
credit risk of the firm.
iii. Revolving: This is for more than a year & is committed. - so it is most reliable.
Note:
1. Firm has to pay commitment bee in cash of (ii) and (iii)
2. The footnote generally contains information regarding (ii) & (iii) This should give confidence to
the analyst and the external would that the firm will not have severs liquidity problems.

b. Pledge - Loan against collateral. For working capital purpose, the collateral is generally
inventory or A/cs receivable. If A/cs receivable (A/R) is the collateral, it is NOT sold. AR
remains in the books of the company and the company services the same.
Note: Sometimes the bank has a blanket lien (ie the right of retention) on all present and future
assets of the company if the primary collateral is insufficient.
c. Factoring - The firm sells its A/cs receivable (AR) to a bank for a discount on a non recourse
basis. This means that bank will have to bear the bad debt loss if any. Also, bank will be
responsible for following up and collections.

44
d. Bankers' Acceptance (discounting of ROE in India)
The firm is an export company, when it exports goods, it draws a bill on the importer who
accepted the same. Then, acceptance now becomes a credible paper. The exporters can discount
that acceptance from any other bank and avail funds.

Category II: Non bank sources

a. Funding from NBFCs (Non - Banking Financing Companies)
- Corporate whose track record is not good have to take finance from NBFCs at a higher rate.
b. Commercial Paper - Corporate with the highest credit rating & strong B/s issue commercial
paper to raise finance for working capital. These are two types of Cps:-
 Dealer Paper that is issued through a broker.
 Direct Paper No dealer or broker involved. (firms sells the paper directly to investors)

CP is comparable to Treasury bill and certificate of Deposit (CD) interest costs are typically less than
the bank.
Conclusion: Firms should decide upon their short term financing policy keeping into consideration
-
 Alternative sources of finance (for large borrowers)
 Flexibility ie freedom to pre pay short term borrowings
 Lower cost.
 It is betters to have higher overall short term funding costs in order to have flexibility &
redundant sources of financing.
NB Lines of credit used by large, financially sound companies. Companies with weaker credit -
Pledge, Factoring.
Smallest firms with poor credit - Non bank finance sources, Large, creditworthy companies issue
CPs, to raise finance.

45