Financial Engineering and Structured Finance

FINANCIAL ENGINEERING
AND STRUCTURED Finance

Financial Engineering
Financial engineering uses various mathematical tools
in order to create new investment strategies. The new
products created by financial engineers can serve as
solutions to problems or as ways to maximize returns
from potential investment opportunities.
Factors Contributing to Growth
of Financing Engineering
•Environmental Factors
•Intra-firm Factors
Factors Contributing to Growth of
Financing Engineering
Environmental Factors
•Price Volatility
•Globalization of Industries and Financial Markets
•Tax Asymmetries
•Technological Advances
•Advances in Financial theories
•Regulatory change
•Increased Competition
•Transaction Costs
Factors Contributing to Growth of
Financing Engineering
Price volatility:
• Interaction of demands by consumers and supplies by producers

ultimately decides market clearing price and quantities.
•If the demands and the supplies for a thing change rapidly over
short period of time then market clearing price can change
dramatically.
•This is referred to as Price Volaitility.

Factors Contributing to Growth of Financing
Engineering
Consider four scenarios of Price Volatility:
•If demand increases and supply remains unchanged then price increases.
•If demand decreases and supply remains the same then the price
decreases.
•If supply increases and demand remains unchanged the price decreases.
•If supply decreases and demand remains the same even then price
increases.
Engineering
Price Volatility
Engineering
Elements of Price Volatility

Speed of
Price
Frequency of Price
Change
Change
Magnitude of Price
Change
How frequently the For example

For example the
price changes (for Oil price per
amount (in $) by
example Oil Price per barrel changes
which oil price
barrel changes very very minute
changes per change
frequently)
Factors
Price Volatility
Contributing to Growth
of Financing Engineering
•In today’s financial world the financial information is readily
available about any given company and its current and future
investments projects and this keeps changing hence the price
of stock remains volatile.
•For CAPM Model the risk free rate of return and market risk
premium keeps changing and hence the expectation of
investor from investment in any given company keeps
changing.
Engineering
Globalization of Markets
• Currency exchange rate: companies operating on global basis selling their goods and
services in various economies face of risk of ultimate profits because of currency
volatilities i.e. when profits in one economy are converted back to mother currency
then devaluation or accretion happens because of exchange rate volatilities.
• Debt capital markets: different economies offer different interest rates on debt and
hence the loan taken in one economy to fund operations in another economy can
create a risk of interest rate loss/gain as well as currency exchange loss/gain.
• Equity risk factor for companies operating in many countries would be difficult to
judge as in different economies the cost of equity would be different .
Engineering
Tax asymmetries
•Tax asymmetry exist if two firms are subject to different effective Tax Rate, which is
cleverly exploited by Financial Engineers.
•Reason For Tax Asymmetries:
1. Some industries are granted special Tax Exemptions.
2. Different countries impose different Tax burdens.
3. Past performance has left some

Engineering
Technological Advances:
•Improvement in Computer Technology along with advances in

Telecommunication led to high speed data transmission.
•Synergy of these technologies with software

programming led to advent of spreadsheets programming.
With the introduction of spreadsheet program currency and

interest rate swap blossomed.
Engineering
Advances in financial theory:
•Extensive theoretical contributions from academicians to financial theories

formed the backbone of new financial instruments and their usage.
•Elaborate research on mathematical relationship which exploit discrepancies

in market price led to program trading or future cash arbitrage causing short
run volatility.
•Development of financial theory capable of explaining the valuation of stock

index futures contracts led to Order matching computer system on NYSE
Known as designated order turnaround system.
Engineering
Regulatory change and Increased Competition:
•Increased competitive pressures, better risk management

techniques, coupled with 1980’s atmosphere of deregulation
led to efforts to repeal much of regulation heaped on industry.
•Massive failures in the thrift industry (commercial banking

industry) acted as catalyst for deregulation.
•Commercial banks moving into investment banking.

Engineering
• banks wanted to provide every product to its clients as

one stop shop be in commercial banking, corporate
banking, treasurer, forex, structured and investment
banking products.
Engineering
Transaction Costs
•Enormous technological development

decreased the cost of information, on which many
transactions feed.
•Thus, the cost of transacting itself, declined

significantly during the decade of 1980’s.
Engineering
Intra firm Factors:
• Liquidity
•Risk Aversion
•Agency costs
•Quantitative sophistication and Management Training

Engineering
Liquidity:
•The degree to which an asset or security can be bought or sold in the

market without affecting the asset's price. Liquidity is characterized
by a high level of trading activity. Assets that can by easily bought or
sold, are known as liquid assets.
•The ability to convert an asset to cash quickly. Also known as

"marketability".
•Degree of liquidity can be determined by using various financial

engineering tools like Markov Chain Monte Carlo methods.
Engineering
Risk Aversion: description of an investor who, when faced
with two investments with a similar expected return (but
different risks), will prefer the one with the lower risk.
With the advancement of technology new methods of

determining risk and volatility are developed. These
methods are advanced computer software based and can
be easily used to perform extensive analysis. Some of
these methods are GARCH, ARCH, FARIMA and ARIMA.
Engineering
Agency Costs: type of internal cost that arises from, or must be
paid to, an agent acting on behalf of a principal. Agency costs
arise because of core problems such as conflicts of interest
between shareholders and management. Shareholders wish for
management to run the company in a way that increases
shareholder value. But management may wish to grow the
company in ways that maximize their personal power and wealth
that may not be in the best interests of shareholders.
• The biggest example of Agency Cost analysis is EVA Model

which uses financial engineering fundamentals to come up with
concept of shareholder value maximization.
Engineering
Quantitative Sophistication and Management training.
•With the birth of software like SAS, Matlab,

Mathematica it has become relatively much easier to
perform the most complex analysis is least possible
time. Moreover it doesn’t require a manager to
understand whole fundamental theories behind the
modeling and all the manager is required to understand
are relevant assumptions and interpret results.
Financial Engineering Processes
and Strategies
•Asset Liability Management
•Hedging and Related Risk Management Techniques.
•Corporate Restructuring and the LBO.

Financial Engineering Processes and Strategies
Asset-Liability Management:
Total assets * duration of assets = total liabilities * duration of liabilities
• Asset-liability management is all about matching liabilities to assets. This

means we need to understand how cash flows of any given company vary over
time.
•The financing maturity that is the choice of long term, medium term and
short term debt is completely dependent upon how long term asset cash
flows are.
•Second we examine the choice between fixed and floating rate debt, as how
this choice will affect the way inflation effects cash flows of assets financed by
debt.
Financial Engineering Processes and
Strategies
Asset Liability Management:
•Third, we look at the currency in which the debt is to be

denoted and we link it to the currency in which asset cash flows
are generated.
•Fourth we evaluated when companies should use convertible

debt instead of straight debt.
•Last we analyzed instruments that can be attached to debt and

how these options can be sued to insulate a firm against specific
factors that affect cash flows of assets positively or negatively.
Strategies
Asset Liability Management
•Financing Maturity: we look at how to assess the life of

assets and liabilities and then consider alternative
strategies to mach financing with asset cash flows.
•To do above mentioned we use Duration

and Strategies
Asset-Liability Management:
Duration of an asset or a liability is a weighted maturity

of all the cash flows on that asset or liability in which
the weights are based on both the timing and
magnitude of the cash flows.
Duration = (time * P.V. of cash flow + time * P.V. of Face

value)/(P.V. of cash flow + P.V. Face value)
Modified Duration
Modified Duration:
MD = Duration/ (1+ Y/n)
Y= Yield
N= number of coupon periods in one year.

Strategies
•Duration: it suggest how the bond price would change for small
change in interest rate. For example a duration of 5.2 reflects that the
bond price would decrease by 5.2% for 1% change in interest rate.
• As stated above, it’s the biggest drawback of duration that interest

rate changes and cashflows remains the same. But in reality cashflows
from assets can also change like in cyclical firms and much less in non
cyclical firms.
•Remember it is far more easier and often cheaper to match the

duration of firm’s collective assets to the duration of its collective
liabilities.
Strategies
Fixed/Floating Rate:
• In the recent years banks/financial institutions tend to

issue a variable debt with Libor + Spread. This LIBOR
keeps changing with time depending on liquidity in the
market.
•If the firm not certain about duration of future projects

and have cash flows that move with inflation then
floating rate debt should be used.
Currency Choice:
Processes and Strategies
•If any of firm’s assets or projects create cash flows
denominated in a currency other than the one in which
the equity is denominated, currency risk exists. The
liabilities of a firm can be issued in these currencies to
reduce the currency risk.
Choice between straight and convertible bonds.
Processes and Strategies

•Firms vary in terms of how much of their value comes from projects or
assets they already own and how much comes from future growth. Firms
that derive the bulk of their value from future growth should use different
types of financing and design their financing differently from those that
derive most of their value from assets in place.
•For firms with most of cash flows coming from future projects the
convertible debt would be better option as convertible debt can be used at
lower interest rate. This is because of the fact that later on this convertible
debt can be converted into equity when high growth rate in equity happens.
Strategies
Special Financing situations:
Every firm is exposed to risk, coming from

macroeconomic sources (such as recession), acts of God
(such as the weather), acts of competitors
and/technology shifts. If the firm’s exposure to all of
these risks is substantial, it may choose not to borrow
rather than risk default.
and Strategies
Special Financing features: for example
•Insurance companies, for instance, have issued bonds whose

payments can be drastically curtailed if there is a catastrophe
that creates a substantial liability for the insurance company.
•Companies in commodity business have issued bonds whose

principal and interest payments are tied to the price of
commodity. This is because of the fact that firm’s cash inflows
are directly related to prices of commodity.
and Strategies
Hedging with Futures:
•In finance, a hedge is a position established in the market in an

attempt to offset exposure to price fluctuations in some opposite
position in the market with the goal of minimizing one's
exposure to unwanted risk.
•There are many specific financial vehicles to accomplish this,

including insurance policies, forward contracts, swaps, options,
many types of over-the-counter and derivative products, and
perhaps most popularly, futures contracts
Financial Engineering Processes and Strategies
Hedging Concepts:
• Short Hedging
•Long hedging
Strategies
Short Hedging:
•A short hedge means to hedge by going short in the futures market.
•A hedge who holds the commodity/asset and is concerned about the decrease in its
price might consider hedging with short position in futures.
•If the spot price and futures price move together, the hedge will reduce some of the
risk. For example, if the spot price decreases, the futures price also will decrease. Since
the hedger is short the futures contract, the futures transaction produces a profit that
at least partially offsets the loss on the spot position. This is called short hedge
because hedger is short in futures.
•Another type of short hedge can be used in anticipation of future sale of asset. For
example you want to sell wheat in the market and anticipate that its price may go down
in the near future (when wheat is ready to be sold) and so for this you can take short
hedge position in futures contract so as to hedge the risk of fall in price of wheat.
Financial engineering processes and
strategies
Long Hedging:
•A long hedge means to hedge by going long in the futures market.
•An anticipatory hedge which involves an individual who plans to purchase a

commodity/asset at a later date. Fearing an increase in the commodity/asset price, the
investor might a buy a futures contract. Then if the price of the commodity increases,
the futures price also will increase and produce a profit on the futures position. The
generated profit from futures contract will partially offset the higher cost of purchasing
the commodity.
•Another type of long hedge can be when we sell short the asset and fear that in near
future that the market will go up. Rather than close out the short position, one might
buy a futures contract and earn a profit on the long position in futures contract that
will at least partially offset the loss on the short position in the stock.
Financial engineering processes and strategies
Cross hedging is a scenario of imperfect hedging because of two issues:
Asset mismatch: this arises when the firms wishes to hedge against a particular
asset but no futures contracts of similar specification regarding that asset are
available. (for e.g. no futures contract on copper coins……..so we hedge copper
futures).
Maturity mismatch: underlying assets maturity may not match the futures
expiration date (remember futures are standardized contracts traded on
exchanges). For examples are traders needs jute during particular months of
the year (say august) and there is no jute futures contract available maturing
in august then there is mismatch in maturity date.
Hedging of corporate bond with T-Bond futures is also an example of cross

hedge. The basis risk is much greater than that encountered by hedging
government bonds with T-bond futures.
strategies
Hedge Ratio:
Hedge ratio: is the number of futures contracts one

should use to hedge a particular exposure in the spot
market.
Ideally hedge ratio should be the one in which the

futures profit or loss matches the sport profit or loss.
strategies
Minimum Variance Hedge: in this model we determine the hedge ratio where the variance is
minimal of profitability and unexplained variance.
To develop minimum variance hedge model we take Portfolio prices and determine monthly
return on it. Also we take Futures contract prices and determine monthly return on.
Once the data on returns for portfolio and futures contract is developed, we run regression
analysis to find regression coefficient i.e. slope of the line (also know as Beta).
This beta is similar to the one developed in CAPM and because of the that futures contract is
based on marked index, the beta will be very close probably close enough for our purpose.
So the minimum variance hedge ratio for a stock index futures contract where Beta is beta of
stock portfolio is :
Nf = β * (Portfolio value/futures contract value)

strategies
Minimum variance hedge ratio: This hedge ratio is
widely used in practice even though it ignores a few
problems:
It disregards dividends on the portfolio of stocks.
Also it assumes the futures contract behaves like the

market portfolio or index and hence assumes that the
beta of futures is 1.
Financial Restructuring and LBO:
A leveraged buyout (Bootstrap" transaction) occurs when an

investor, typically financial sponsor, acquires a controlling interest
in a company's equity and where a significant percentage of the
purchase price is financed through leverage (debt).
The assets of the acquired company are used as collateral for the
borrowed capital, sometimes with assets of the acquiring company.
Typically, leveraged buyout uses a combination of various debt

instruments from bank and debt capital markets. The bonds or
other paper issued for leveraged buyouts are commonly considered
not to be investment grade because of the significant risks involved
LBO Candidate:
Given the proportion of debt used in financing a transaction, a financial buyer’s interest in an
LBO candidate depends on the existence of, or the opportunity to improve upon, a number of
factors. Specific criteria for a good LBO candidate include:
•Steady and predictable cash flow
•Divestible assets
•Clean balance sheet with little debt
• Strong management team
•Strong, defensible market position
•Viable exit strategy

•Limited working capital requirements
• Synergy opportunities
•Minimal future capital requirements
•Potential for expense reduction
•Heavy asset base for loan collateral

Determination of Value of Financial
Instruments
Option Valuation is done via Two Methods
• Black-Scholes
• Binomial Model
Instruments
Binomial Model
Binomial Model is also called Two State Model:
•A Binomial distribution model has two outcomes or

states.
•The probability of up or down movement is governed

by the binomial probability distribution.
Instruments
Consider a Stock---S on which call options are available
The call has one period remaining before it expires.
The begininning of the period is today and is referred to

as time 0.
Instruments
Binomial Model Formula
•The formula for Option ( C ) is developed by constructing a risk less

portfolio of stock and options.
•Remember ------------Risk less portfolio will give risk free rate of return.
•The risk less portfolio is called a HEDGE PORTFOLIO.
•Risk less portfolio consists of h shares stocks and a single written

Call.
Instruments
The current value of the portfolio:
V = h * S - Cu
At Expiration the portfolio can have two values:
Vu = h * Su – Cu Or
Vd = h * Sd – Cd
As model based on fact that risk less portfolio will give risk free rate of return then:
Vu = Vd…………..Thus Hedge portfolio of h stocks is
h = (Cu – Cd)/ (Su – Sd )……………….eq. (1)

Instruments
If the potential current value grows at the risk free rate, its value at the
option’s expiration will Vt = V *(1+r) i.e.
(h * S – C) * (1+r)
The above stated reflects:
(h*S-C)*(1+r) = h*Su – C….value of h from eq. (1)
C = (p*Cu + (1-p)*Cd) / (1+r)……….where p = (1+r-d)/(u-d)
First we find the values of call Option Cu and Cd at end of the period. Then
we find the value of call option at the beginning of the period.
Instruments
Two Period Binomial Model:
Cu = (pCu2 + (1-p) * Cud)/ (1+r)
Cd = (pCud + (1-p) * Cd2)/ (1+r)
Hedge ratio changes at end of Period 1
h = (Cu – Cd)/ (Su – Sd)

hu = (Cu2 – Cud)/ (Su2- Sud),
Hd= (Cud-Cd2)/(Sud- Sd2)
First we find the values of Cu2, Cud and Cd2 then find the values of Cu, Cd and
then eventually C.
Instruments
Binomial Model - Put Option
•The principles are essentially the same as hedging with calls,

but instead of selling call to hedge a long position in stock, we
are buying puts.
•The hedge portfolio is built by buying h shares and buying

one put.
•The negative value of the hedge portfolio simply reflects the

opposite moment of the puts to stock.
Determination of Value of
Financial Instruments
Black Scholes
•The Black–Scholes model of the market for a particular equity makes the
following explicit assumptions:
•The risk-free interest rate exists and is constant and same for all maturity dates.
•The short selling of securities with full use of proceeds is permitted.
•It is possible to borrow and lend cash at a known constant risk-free interest rate.
•The price follows a Geometric Brownian motion with constant drift and
volatility.
Instruments
•There are no transaction costs.
•The stock does not pay a dividend (see below for extensions to
handle dividend payments).
•All securities are perfectly divisible (i.e. it is possible to buy any

fraction of a share).
•There are no restrictions on short selling.
•There is no arbitrage opportunity

Put Option Valuation: It can be calculated by two ways
•Using Put option valuation method.
Using Put – Call Parity method.

Put Option Valuation: It can be calculated by two ways
•Using Put option valuation method.
•Using Put – Call Parity method.

Instruments
•P= Ke^(-rt)N(-d2)-SN(-d1)
Put Call Parity
•P = C + Ke^(-rt)- S
Instruments
Put Call Parity is a relationship between European Put and
Call Options have identical assets, strike prices and time to
maturity.
Price of Call Option – Price of Put Option = Price of

Underlying Asset – Present value of exercise price - Present
value of Dividend.
(if we know either call or put then the other one can be
valued from put-call parity equation.
Option Time Value
Option Time Value
•Black-Scholes
•Binomial Model
Option Time Value
•Option value “Likelihood” finishing in the money.
•Higher the expiration date---the longer the time to

exercise ----the higher the option value.
•Option value never lower than Intrinsic value.
•Before expiration option’s market value would exceed

intrinsic value by an amount called time value of option.
Option Time Value
The value of an option consists of two components
•Intrinsic value:
For a call option: value = Max [ (S – K), 0 ]
For a put option: value = Max [ (K – S), 0 ]
•time value
Time value = Option Value – Intrinsic Value

Option Time Value
Absolute and Relative
Valuation
Absolute Valuation:
• DCF including Cash flow based and Earnings based
•Relative Valuation is done using Comparable

companies method.
Relative Valuation
Comparable Company Analysis Steps:
•Step I. Select the Universe of Comparable Companies.
•Step II. Locate the Necessary Financial Information.
•Step III. Spread Key Statistics, Ratios, and Trading Multiples.
•Step IV. Benchmark the Comparable Companies.
•Step V. Determine Valuation.

Relative Valuation
• The selection of a universe of comparable companies for the target is the
foundation for performing trading comps.
•In order to identify companies with similar business and financial

characteristics, it is first necessary to gain a sound understanding of the
target.
•At its base, the methodology for determining comparable companies is

relatively intuitive. Companies in the same sector (or, preferably, “sub-
sector”) with similar size tend to serve as good comparables.
•While this can be a fairly simple exercise for companies in certain sectors, it
may prove challenging for others whose peers are not readily apparent.
Relative Valuation
•For a target with no clear, publicly traded comparables, the banker seeks
companies outside the target’s core sector that share business and financial
characteristics on some fundamental level.
•For example, a medium-sized manufacturer of residential windows may have

limited or no truly direct publicly traded peers in terms of products, namely
companies that produce windows. If the universe is expanded to include
companies that manufacture building products, serve homebuilders, or have
exposure to the housing cycle, however, the probability of locating companies
with similar business drivers is increased.
•In this case, the list of potential comparables could be expanded to include
manufacturers of related building products such as decking, roofing, siding,
doors, and cabinets.
Relative Valuation
Identify Key Characteristics of the Target for
Comparison Purposes :
Business Profile Financial Profile Financial Profile
Sector Size
Products and Services Profitability
Customers and End Markets Growth Profile
Distribution Channels Return on Investment
Geography Credit Profile
Relative Valuation
Step 1……………Sector:
•Sector refers to the industry or markets in which a company operates

(e.g., chemicals, consumer products, healthcare, industrials, and
technology). A company’s sector can be further divided into sub-
sectors, which facilitates the identification of the target’s closest
comparable.
•Within the industrials sector, for example, there are numerous sub-
sectors, such as aerospace and defense, automotive, building products,
metals and mining, and paper and packaging. For companies with
distinct business divisions, the segmenting of comparable companies
by sub-sector may be critical for valuation
Relative Valuation
Products and Services
•A company’s products and services are at the core of its business model.
Accordingly, companies that produce similar products or provide similar
services typically serve as good comparables. Products are commodities or
value-added goods that a company creates, produces, or refines.
•Examples of products include computers, oil, prescription drugs, and steel.

Services are acts or functions performed by one entity for the benefit of
another. Examples of common services include banking, installation,
lodging, logistics, and transportation. Many companies provide both
products and services to their customers, while others offer one or the
other. Similarly, some companies offer a diversified product and/or service
mix, while others are more focused.
Relative Valuation
Customers and End Markets:
Customers:
•A company’s customers refer to the purchasers of its products and services. Companies
with a similar customer base tend to share similar opportunities and risks. For example,
companies supplying automobile manufacturers abide by certain manufacturing and
distribution requirements, and are subject to the automobile purchasing cycles and
trends.
•End Markets
•A company’s end markets refer to the broad underlying markets into which it sells
its products and services. For example, a plastics manufacturer may sell into several end
markets, including automotive, construction, consumer products, medical devices, and
packaging. End markets need to be distinguished from customers. For example, a
company may sell into the housing end market, but to retailers or suppliers as opposed to
homebuilders
Relative Valuation
Customer and End Markets
End Markets
•A company’s end markets refer to the broad underlying markets

into which it sells its products and services. For example, a plastics
manufacturer may sell into several end markets, including
automotive, construction, consumer products, medical devices,
and packaging. End markets need to be distinguished from
customers. For example, a company may sell into the housing end
market, but to retailers or suppliers as opposed to homebuilders
Relative Valuation
Distribution Channels
Distribution channels are the avenues through which a

company sells its products and services to the end user.
As such, they are a key driver of operating strategy,
performance, and, ultimately, value. Companies that
sell primarily to the wholesale channel, for example,
often have significantly different organizational and
cost structures than those selling directly to retailers or
end users.
Relative Valuation
Geography
Companies that are based in (and sell to) different

regions of the world often differ substantially in terms
of fundamental business drivers and characteristics.
These may include growth rates, macroeconomic
environment, competitive dynamics, path(s)-to-
market, organizational and cost structure, and
potential opportunities and risks.
Relative Valuation
Financial Profile:
Size
•Size is typically measured in terms of market valuation (e.g., equity value

and enterprise value), as well as key financial statistics (e.g., sales, gross
profit, EBITDA, EBIT, and net income). Companies of similar size in a given
sector are more likely to have similar multiples than companies with
significant size discrepancies.
•For example, companies with under $5 billion in equity value (or enterprise
value, sales) may be placed in one group and those with greater than $5
billion in a separate group. This tiering, of course, assumes a sufficient
number of comparables to justify organizing the universe into sub-groups.
Relative Valuation
Growth Profile
A company’s growth profile, as determined by its historical and

estimated future financial performance, is an important driver
of valuation. Equity investors reward high growth companies
with higher trading multiples than slower growing peers.
•For mature public companies, EPS growth rates are typically

more meaningful. For early stage or emerging companies with
little or no earnings, however, sales or EBITDA growth trends
may be more relevant.
Relative Valuation
Return on Investment
•Return on investment (ROI) measures a company’s ability to provide

earnings (or returns) to its capital providers. ROI ratios employ a
measure of profitability (e.g., EBIT, net income) in the numerator and
a measure of capital (e.g., invested capital, shareholders’ equity, or
total assets) in the denominator.
•The most commonly used ROI metrics are return on invested capital
(ROIC), return on equity (ROE), and return on assets (ROA). Dividend
yield, which measures the dividend payment that a company’s
shareholders receive for each share owned, is another type of return
metric.
Relative Valuation
Credit Profile
A company’s credit profile refers to its

creditworthiness as a borrower. It is typically measured
by metrics relating to a company’s overall debt level
(“leverage”) as well as its ability to make interest
payments (“coverage”), and reflects key company and
sector-specific benefits and risks.
Relative Valuation
Comparables’ Multiples;
There are two (2) types of trading multiples
•Operating (debt-free)
•Equity
Relative Valuation
Operating (debt-free) multiples (TEV = enterprise value).
TEV / Revenue, EBIT or EBITDA
•TEV = $11,500M; Revenue = $19,426M; EBITDA = $1,369M
• Revenue Multiple = 0.59x
•EBITDA Multiple = 8.4x

Relative Valuation
Why is TEV a part of operating multiples and not
MVE? (MVE = Market Value of Equity).
•“Apples to Apples”
•Remember, TEV ignores specific capital contribution

•Line items before interest are considered debt-free
•MVE is value to only stockholders and is affected by
leverage.
Relative Valuation
Let’s say our subject company, a widget maker, has annual
financials of the following:
•Revenue: $19,426 million

•EBITDA: $1,369 million
Mean trading multiples for publicly-traded widget companies
•TEV / Rev: 0.74x
•TEV / EBITDA: 10.3x

Relative Valuation
What’s is our company’s implied TEV?
•Revenue: $19,426 million

•EBITDA: $1,369 million
•Implied TEV using revenue multiple = $19,426 million *

0.74x = $14,375 million
•Implied TEV using EBITDA multiple = $1,369 million *

10.3x = $14,101 million
• Average Implied TEV = average ($14,375 million, $14,101

million) = $14,238
Relative Valuation
Equity Multiples:
Unlike operating multiples, equity multiples are a function of MVE

(Market Value of Equity)
Since the general public owns common stock and not other
types of securities, analysts speak in P/E ratios
•Price per Share / Earnings per Share
•Market Cap / Earnings
•Again P/E is a function of MVE, which is not a good indicator of

company valuation
Relative Valuation
Equity Multiples:
•Equity multiples require the numerator/denominator

to be below the interest line (i.e. net income)
Again, “Apples to Apples”
•Wrong: TEV / Earnings

•Wrong: Market Cap / EBITDA
Relative Valuation
For MVE:
• Dividend rate = Total Dividends / Net Income
•Dividend Yield = Dividends per share / Share price (this

yields return on investment in equity per dollar
invested).
Relative Valuation
Bench Mark the Comparables:
•Once the initial universe of comparable companies is

selected and key financial statistics, ratios, and trading
multiples are spread, the stage is set to perform
benchmarking analysis.
•Benchmarking centers on analyzing and comparing each of

the comparable companies with one another and the target.
The ultimate objective is to determine the target’s relative
ranking so as to frame valuation accordingly.
Relative Valuation
•First, we benchmark the key financial statistics and
ratios for the target and its comparables in order to
establish relative positioning, with a focus on
identifying the closest or “best” comparables and
noting potential outliers.
•Second, we analyze and compare the trading

multiples for the peer group, placing particular
emphasis on the best comparables.
Relative Valuation
Selected Enterprise Value to EBITDA Multiple Range
Closest Comparable B Closest

Closest Comparable C
Comparable A
6.0x 6.5x 7.0x

Mean
5x 8x
Lowest Median Highest
Selected Multiple Range

Financial Engineering and Structured Finance

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Financial Engineering and Structured Finance

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FINANCIAL ENGINEERING

AND STRUCTURED Finance

•Globalization of Industries and Financial Markets

•Advances in Financial theories

• Interaction of demands by consumers and supplies by producers

•This is referred to as Price Volaitility.

Elements of Price Volatility

How frequently the For example

•Reason For Tax Asymmetries:

1. Some industries are granted special Tax Exemptions.

2. Different countries impose different Tax burdens.

3. Past performance has left some

•Improvement in Computer Technology along with advances in

•Synergy of these technologies with software

With the introduction of spreadsheet program currency and

•Extensive theoretical contributions from academicians to financial theories

•Elaborate research on mathematical relationship which exploit discrepancies

•Development of financial theory capable of explaining the valuation of stock

•Increased competitive pressures, better risk management

•Massive failures in the thrift industry (commercial banking

•Commercial banks moving into investment banking.

• banks wanted to provide every product to its clients as

•Enormous technological development

•Thus, the cost of transacting itself, declined

•Quantitative sophistication and Management Training

•The degree to which an asset or security can be bought or sold in the

•The ability to convert an asset to cash quickly. Also known as

•Degree of liquidity can be determined by using various financial

With the advancement of technology new methods of

• The biggest example of Agency Cost analysis is EVA Model

•With the birth of software like SAS, Matlab,

•Hedging and Related Risk Management Techniques.

•Corporate Restructuring and the LBO.

Total assets * duration of assets = total liabilities * duration of liabilities

• Asset-liability management is all about matching liabilities to assets. This

•Third, we look at the currency in which the debt is to be

•Fourth we evaluated when companies should use convertible

•Last we analyzed instruments that can be attached to debt and

•Financing Maturity: we look at how to assess the life of

•To do above mentioned we use Duration

Duration of an asset or a liability is a weighted maturity

Duration = (time * P.V. of cash flow + time * P.V. of Face

MD = Duration/ (1+ Y/n)

N= number of coupon periods in one year.

• As stated above, it’s the biggest drawback of duration that interest

•Remember it is far more easier and often cheaper to match the

• In the recent years banks/financial institutions tend to

•If the firm not certain about duration of future projects

Processes and Strategies

Every firm is exposed to risk, coming from

•Insurance companies, for instance, have issued bonds whose

•Companies in commodity business have issued bonds whose

•In finance, a hedge is a position established in the market in an

•There are many specific financial vehicles to accomplish this,

•A short hedge means to hedge by going short in the futures market.

•A long hedge means to hedge by going long in the futures market.

•An anticipatory hedge which involves an individual who plans to purchase a

Hedging of corporate bond with T-Bond futures is also an example of cross

Hedge ratio: is the number of futures contracts one

Ideally hedge ratio should be the one in which the

Nf = β * (Portfolio value/futures contract value)

It disregards dividends on the portfolio of stocks.

Also it assumes the futures contract behaves like the

Financial Restructuring and LBO:

(hS-C)(1+r) = h*Su – C….value of h from eq. (1)

C = (pCu + (1-p)Cd) / (1+r)……….where p = (1+r-d)/(u-d)