Financial Management

Financial Management MGT201 VU
Lesson 01
INTRODUCTION TO FINANCIAL MANAGEMENT
Learning o!ecti"e#$
The purpose of this lecture is to provide you with an overview of financial management. After
finishing this lecture, you would be able to have a better understanding of the following.
Definition of financial management
Significance of financial management for non-finance students and professionals
Important concepts and areas in financial management
The position of financial managers in organizational hierarchy and their respective wor
domains.
Different business legal entities, their advantages and limitations.
The e!ternal and internal business environments and their relevance to financial management.
Different types of financial and real assets marets.
%&at i# FM'
"# is the management of financial resources $ how to best find and use investments and
financing opportunities in an ever-changing and increasingly comple! environment.
%&( #&o)l* C+ ma!or# #t)*( FM'
"irst of all, financial management is a core life sill% almost every one needs to understand some
concepts of finance to manage his&her business ' personal finances.
It is generally and (uite rightfully said, )#oney maes the world go round*. "inance is lie a
life-blood for a company. +ven the best of the companies and ,+-s go out of the business because of
poor financial management policies.
#anagement Information Systems .#IS/ and Information Technology .IT/ are 0ust a part of the
overall corporate strategy which runs on finances, the ma0or resource. So the computer sciences
professionals need to have an understanding of the financial concepts to understand and contribute to
the overall corporate strategy.
"inancial +ngineering is an upcoming field that re(uires people with ,S, math&science, and
finance bacground. "inancial engineering is the application of engineering methods to finance. -ne
important area of study is the design, analysis, and construction of financial contracts to meet the needs
of enterprises. This field is e!periencing an increased demand for professionals, especially those who
are trained in both the underlying mathematics&computer technologies and finance.
De,inition#
Finance$
"inance is the science of managing financial resources in an optimal pattern i.e. the best use of
available financial sources. "inance consists of three interrelated areas1
2/ #oney ' ,apital marets, which deals with securities marets ' financial institutions.
3/ Investments, which focuses on the decisions of both individual and institutional investors as
they choose assets for their investment portfolios.
4/ "inancial #anagement, or business finance which involves the actual management of firms.
Ma!or Area# - Conce.t# o, Financial Management
"ollowing are some of the important areas and concepts of financial management, which would
be discussed in detail in the lectures to come.
Anal(#i# o, Financial +tatement#$
Analysis of financial statement is one of the most common techni(ues of financial analysis, in
which the financial performance and financial health of a company are analyzed based on its past
performance.5
The following financial statements are used in the analysis process.
/ro,it - Lo## +tatement or Income +tatement
Income statement reflects the operating efficiency or profitability of a company as a result
of its operations along with the net profit available to the shareholders for a given year
.usually one accounting period/. This statement provides the analyst with some insight into
the financial performance of the company.
0alance +&eet
6alance Sheet is a snap-shot of an organization7s financial health at a particular time. It
shows what assets are owned by the business and the sources of ac(uiring these assets.
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+tatement o, +&are&ol*er#1 e2)it(
Statement of shareholders7 e(uity provides the share of the owners in the business.
+tatement o, Ca#& Flo3#
Statement of cash flows e!plicitly reflects the cash movement .inflows and outflows/
during the operations in an accounting period.
Taen together, these statements give an accounting picture of the firm7s operations and
financial position. "inancial statements report what has actually happened to the assets, earnings,
and dividends over the years. The analysis of the information contained in these statements help
management of the organization to evaluate the performance and activities of the concern% it also
helps the investors and creditors to have an idea of the profitability potential and creditworthiness of
the business.
In"e#tment Deci#ion# - Ca.ital 0)*geting$
Investment decisions are the most critical as they usually involve huge sums of money and
these decisions are liely to bring prosperity or doom to a business. A company7s future income
depends on how much investment is made, in what type of assets, and how these assets add to the
overall value of the company.
,apital budgeting is a term strictly related to investment in fi!ed assets% here, the term
capital refers to the fi!ed assets that are used in production, while budget is a plan which details
pro0ected cash inflows and outflows over some future period. The following concepts and
techni(ues are employed while analyzing investment decisions.
o Interest rate formulas
o Time 9alue of #oney
o Discounted ,ash "lows
o <et ;resent 9alue
o Internal =ate of =eturn
Ri#4 - Ret)rn$
Investors, individual or institutional, invest their money with the e!pectations of earning a
return on their investment. >hile investors wish and attempt to earn ma!imum return, they are
constrained by ris. ?ow the riss and returns are related and how do investors mae a choice of
their portfolios is important for investment decision maing. "ollowing concepts and theories would
be discussed while discussing the ris-return choices of the investor1
o :ncertainty
o =is
o ;ortfolio Theory
o ,apital Asset ;ricing #odel
Cor.orate Financing - Ca.ital +tr)ct)re$
>hen a firm plans to e!pand, it needs capital or funds. Ac(uisition of funds is considered to
be a primary responsibility of a finance department in an organization. There are numerous ways to
ac(uire funds, i.e., finances can be raised in the form of debt or e(uity. The proportion of debt and
e(uity constitutes the capital structure of the firm. "inancial e!perts attempt to find a combination of
debt and e(uity that could increase the overall value of the company, i.e., they try to find the
optimal capital structure. The following concepts would be used to understand how an optimal
capital structure could be attained.
o ,ost of ,apital
o @everage
o Dividend ;olicy
o Debt Instruments
Val)ation$
Asset or company valuation is important not only for financial managers, but also for
creditors and investors. It is important to now the value of the company or its assets to mae
important financing and investment choices. Different valuation techni(ues and factors that
influence the value of a company or its financial instruments would be discussed in this section.
o Share
o 6ond
o -ption
o ,orporate
%or4ing Ca.ital - In"entor( Management$
>oring capital and inventory management pertains to the effective management of current
assets. As we will see, an optimal and effective utilization of woring capital and inventory
increases the operating efficiency of the firm.
International Finance - Foreign E5c&ange$
>ith the increasing importance of international trade and global marets, the role of
international finance has increased manifold. In a global environment, the finance managers have
more choices pertaining to investing and financing than ever before. ?owever, it is important to
understand the implications of woring in a global environment, since fluctuations in the currency
rates can convert a good financing or investment decision into a bad one. This section of the course
would discuss the international financial environment and the financial implications of woring in a
global environment.

Organi6ational +tr)ct)re
7%&o *oe# t&e FM 3or4'8
0)#ine## Legal Entitie#
A +ole /ro.rietor#&i. $
It is an unincorporated business owned by one individual. Boing into a business as a sole
proprietor is simple $ one merely has to begin business operations. ;roprietorship consists of CDEof
the total number of businesses worldwide.
A*"antage#$
i. It is easily ' ine!pensively formed.
ii. It is sub0ect to few government regulations.
iii. The business pays no corporate income ta!% only personal income ta! is paid by the
proprietor.
)Chief Executive Officer )CEO
)Chief Financial Officer )CFO
Treasurer Controller
Cash & Investment Accounts
Audit Capital Budgeting
Capital Structure
Inventor
Limitation#$
i. It is difficult for a proprietorship to obtain large sums of capital.
ii. The proprietor has unlimited personal liability for the business debts, which can
result in losses hat e!ceed the money invested by him in the business.
iii. The life of the business organized as proprietorship is limited to the life of the
individual who created it.
/artner#&i.$
A partnership e!ists whenever two or more persons associate to conduct a non-corporate
business. It could be registered or unregistered.
A*"antage#$
i. @ow cost involved
ii. +ase of formation.
Limitation#$
i. :nlimited @iability.
ii. @imited life of the organization.
iii. Difficulty of transferring ownership.
iv. Difficulty of raising large amounts of capital.
Cor.oration$
A corporation is a limited company and a separate legal entity registered by the government. It
is separate ' distinct from its owners ' managers. It ,an be ;rivate @imited .;vt. @td./ or ;ublic
@imited .which may be listed on Stoc +!change/. The businesses in the form of corporations control
CDE of global sales of products and services.
A*"antage#$
i9 Unlimite* li,e$
A corporation can continue even after the death of its original owners.
ii9 Ea#( tran#,erailit( o, o3ner#&i. intere#t$
-wnership interests can be divided into shares of stoc, which in turn can be transferred far
more easily than can proprietorship ' partnership interests.
iii9 Limite* Liailit($
The liability of the shareholders is limited up to the e!tent of nominal value of shares held by
them. ,reditors and bans cannot confiscate personal properties of director ' shareholders in case of its
banruptcy.
Limitation#$
i. Double Ta!ation1
,orporate earnings may be sub0ect to double ta!ation $ the earnings of the
corporation are ta!ed at corporate level, and then any earnings paid out as
dividends are ta!ed again as income to the stocholders.
ii. @egal "ormalities1
Setting up a corporation, and filing many official documents, is more comple!
and time consuming than for a proprietor ship or a partnership
A :(ri*# 7Mi5e*8$
?ybrid organizations are specialized types of partnerships, which combine the
limited liability advantage of a corporation with the ta! advantages of a
partnership.
+9T(.e Cor.oration$
S- Type corporations are @imited @iability ,orporations without double
ta!ation. In a regular corporation, the company itself is ta!ed on business
profits. In addition, the owners pay individual income ta! on money that they
draw from the corporation as salaries, bonuses, or dividends. In contrast, in an
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S corporation, all business profits Gpass throughG to the owners, who report
them on their personal ta! returns .as in sole proprietorships, partnerships, and
@imited @iability ,ompanies/. The S corporation itself does not pay any
income ta!, although a co-owned S corporation must file an informational ta!
return lie a partnership or @imited @iability ,ompanies $ to tell the ta!
authorities what each shareholderHs portion of the corporate income is.
LL/$
@imited @iability ;artnership .@@;/ is also a form of partnership with allows
limited liability to the owners and avoids double ta!ation. These organizations
are similar in many ways to the S ,orporations% however, @@;s offer more
fle!ibility and benefits to the owners.
/C$
;ersonal ,orporations .;,/ or ;rofessional ,orporations are generally formed
by professionals to protect them against litigations. ;rofessionals lie doctors,
lawyers and accountants prefer to register their business as ;rofessional
,orporations.
0alance +&eet An FM /er#.ecti"e
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Internal an* E5ternal 0)#ine## En"ironment
Internal 0)#ine## En"ironment$
Internal environment of business normally consists of the following.
i. "inance
ii. #areting
iii. ?uman =esources
iv. -perations .;roduction, #anufacturing/
v. Technology
vi. -ther "unctions .@ogistics, ,ommunications/
E5ternal 0)#ine## En"ironment$
The following business environment factors outside an organization have a profound effect on
the functions and operations of an organization.
i. ,ustomers
ii. Suppliers
iii. ,ompetitors
iv. Bovernment&@egal Agencies ' =egulations
v. #acro +conomy&#arets1
vi. Technological =evolution
An analysis which is used in a business is called +%OT Analysis. S>-T is an acronym where
+ stands for Strengths
% stands for >eanesses
O stands for -pportunities
T stands for Threats
Strengths and weanesses are within an organization, i.e., they pertain to the internal
environment of the organization.
-pportunities and threats, on the other hand, pertain to the e!ternal environment, i.e., outside
the organization.
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Financial Mar4et#
A Ca.ital Mar4et#$
These are the marets for the long term debt ' corporate stocs.
Stoc +!change1
A stoc e!change is a place where the listed shares, Term finance certificates .T",/
and national investment trust units .<IT/ are e!changed and traded between buyers and
sellers.
@ong term bonds1
@ong term government ' corporate bonds are also traded in capital marets.
A Mone( Mar4et#
#oney maret generally is a maret where there is buying and selling of short term li(uid
debt instruments. .Short term means one year or less/. @i(uid means something which is
easily en-cashable% an instrument that can be easily e!changed for cash. "ollowing financial
instruments are traded in money marets.
Short term 6onds
o Bovernment of ;aistan1 "ederal Investment 6onds ."I6/, Treasury-6ills .T-
6ills/
o ;rivate Sector1 ,orporate 6onds, Debentures
,all #oney, Inter-ban short-term and overnight lending ' borrowing
@oans, @eases, Insurance policies, ,ertificate of Deposits .,D7s/
6adlah .money lending against shares/, =oad-side money lenders
A Real A##et# or /&(#ical A##et Mar4et#
"ollowing are the active marets of real and physical assets in ;aistan
o ,otton +!change, Bold #aret, Kapra #aret
o ;roperty .land, house, apartment, warehouse/
o ,omputer hardware, :sed ,ars, >heat, Sugar, 9egetables, etc.
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Lesson 02
O0;ECTIVE+ OF FINANCIAL MANAGEMENT< FINANCIAL A++ET+ AND FINANCIAL
MAR=ET+
Learning o!ecti"e#$
After going through this lecture, you would be able to have a better understanding of the following
concepts.
-b0ectives of financial management as compared to +conomics and "inancial
Accounting
=eal and "inancial assets
Different types and characteristics of financial assets and the similarities and
differences among them
?ow these financial assets are reported in the balance sheet of a company
,oncept of 9alue and different inds of 9alue
Types of financial and real assets marets
>hile studying the course of financial management, we will study, in detail, two important areas of
financial management, nown as1
2. Investments ' ,apital budgeting
3. ,orporate financing.
,oncepts such as interest, time value of money, cash flows, ris ' return, cost of capital,
leverage, financing would be thoroughly discussed. In the later lectures, we will tal about some
specialized areas of finance lie international finance ' woring capital finance.
In the previous lecture, we had discussed the overall organizational hierarchy, and the hierarchy
of the finance department $ the people responsible for the financial management functions.
"urthermore, the different types of business legal entities and their salient characteristics were also
discussed.
In this lecture, we would discuss the differences that e!ist among "inancial #anagement,
+conomics ' "inancial Accounting disciplines.
A O!ecti"e o, Economic#$
The ob0ective of economics, as a sub0ect, is profit ma!imization% however, the scope of
economic profit ma!imization is vast and loosely defined. In economics, we can tal about
profit ma!imization for an individual, the whole society, or a particular class or group. >e
can also tal about profit ma!imization for the whole world in global terms. In social
economics, we may study the social profit ma!imization for the societies, whereas, in
capitalistic economics we may study individual or company7s profit.
A O!ecti"e o, Financial Management 7FM8
In comparison, financial management is more focused. The ob0ective of financial
management, specifically, is to ma!imize the shareholders wealth in the present terms.
"inancial practitioners usually use the discounting and the net present value techni(ues
while calculating the increase in the wealth of shareholders.
A O!ecti"e o, Financial Acco)nting 7FA8$
The ob0ective of financial accounting is to collect accurate, systematic, and timely
financial data and other financial information, and to compile and consolidate it in an organized
and systematic way, according to the principles and rules of accounting, for reporting purpose.
The financial managers use these reports to assess the financial position of the company through
various financial management tools and then the financial position can be compared to, or
benchmared against, the industry norms. The four different financial statements used for the
purpose of reporting and analysis are
2. 6alance Sheet
3. ;&@ or Income Statement
4. ,ash "low Statement
F. Statement of =etained +arnings .or Shareholders7 +(uity Statement/
In financial accounting, assets are recorded on the basis of historical costs in the balance sheet,
i.e., the assets are recorded at their original purchase price. -f course, the depreciation on the asset is
duly subtracted from its original value as the asset remains in use of the business.
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?owever, in financial management, boo value is seldom used and financial managers consider
the maret value and the intrinsic value of assets.
Mar4et "al)e may be defined as the value currently prevailing in the maret or the value at
which the sellers are ready to sell, and buyers are ready to buy a particular asset.
Intrin#ic "al)e or the fair value is calculated by summing up the discounted future cash flows.
In "inancial accounting, we followed the principle of accrual accounting in which e!penses '
incomes are rerecorded when they incur. In "inancial management, we will primarily be interested in
cash ' cash flows. In "inancial management, we will use cash as primary source for calculating value,
although the accrual data would also be useful for analyzing a firm7s financial position.
6efore getting into details, it is important to understand a few concepts that would be fre(uently
used throughout the course.
Real A##et#$
=eal assets are tangible assets that have physical characteristics. "or instance, land, house,
e(uipment, car, wheat, fruits, cotton, computers, etc., are different inds of real assets.
+ec)ritie#$
Security, also nown as a financial asset, is a piece of paper representing a claim on an
asset. Securities can be classified into two categories.
A Direct +ec)ritie#$ Direct securities include stocs and bonds. >hile valuing
direct securities we tae into account the cash flows generated by the
underlying assets.
Discounted ,ash "low .D,"/ techni(ue is often used to determine the value of
a stoc or bond.
A In*irect +ec)ritie#1 Indirect securities include derivatives, "utures and
-ptions. The securities do not generate any cash flow% however, its value
depends on the value of the underlying asset.
>hile in this course, direct securities would be discussed at length, the indirect securities would
only be simmed through in the later chapters.
0on*#$
6onds represent debt. The important features of bonds are given as under.
A Internationally, bonds are the most common way for companies to raise funds.
A A bond is a long-term debt contract .on paper/ issued by the borrower .Issuer of the 6ond i.e., a
company that wishes to raise funds/ to the lenders .bondholders or Investors which may include
bans, financial institutions, and private investors/.
A 6onds issued by a company are usually shown on the liabilities side of the 6alance Sheet.
A A 6ond re(uires the borrower to pay a pre-determined amount of interest regularly to the lender
.bondholder/. The interest rate or the rate of return on a bond can be "i!ed or "loating. If an
investor purchases a bond which is offering a rate of 2D E for the life of the bond, the rate
would be fi!ed at 2D percent. ?owever, if the interest rate on the bond is tied to the maret
interest rates, the rate of interest would be floating. The floating rate implies that the interest
rate would fluctuate with any change in the maret interest rate.
T(.e# o, 0on*#$
A Debentures1:nsecured $ no asset bacing
A #ortgage 6ond1 Secured by real property i.e. @and, house
A -thers1 +urobond, Meros, Nun, etc.
The details on these different types of bonds would be discussed in later lectures.
+toc4# 7or +&are#8$
Stocs .or Shares/ are paper certificates representing ownership in a business. Therefore, if a
company has issued 2 million shares and an investor owns 2 share only, he is a part owner .or
shareholder/ of the company. Stocs or shares are represented in the e(uity section of the balance
sheet. A stoc certificate is perpetuity, i.e., it lasts as long as the company does. Shareholders have a
residual claim .last claim/ on whatever net income .or profit/ and assets are left over after the
bondholders have been fully paid off. It is the most common source of raising funds under Islamic
Shariah. Shares are traded in Stoc maret e.g. Karachi Stoc +!change .KS+/, @ahore Stoc
+!change .@S+/ ' Islamabad Stoc +!change .IS+/.
Di,,erence et3een +&are# - 0on*#$
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O3n 0on*# i##)e*
( com.an( to
rai#e ca#&
O3n +toc4 i##)e*
( com.an( to
rai#e ca#&
+toc4# - 0on*#
/)rc&a#e* a#
In"e#tment
The main difference between shares and bonds is that shares are representation of ownership in
a company while bonds are not representative of ownership.
The second difference is that shares last as long as the company lasts where as bonds have
limited life.
Another difference is that the return on a bond is predetermined, i.e., the investor nows in
advance how much return he would get from a bond. ?owever, a stocholder cannot be certain
about the return on a stoc investment, since the dividends may or may not be paid in a certain year
or the percentage of dividends announced may vary.
T(.e# o, +toc4# 7or +&are#8$
Common +toc4$
,ommon shareholders receive dividends, or portion of the net income which the
management decides, <-T to reinvest into the company in the form of retained earnings.
Dividends are paid in proportion to the number of shares the stocholders own and are
announced by the board of directors, who may opt not to announce a dividend in a particular
year. ,ommon Stocholders have voting rights to elect the board of directors.
/re,erre* +toc4$
It is the stoc with a predetermined or fi!ed dividend. In case, the board of directors
announces dividends, the preferred stocholders would have a priority claim on them, i.e., they
would be paid dividends before any dividends are paid to the common stocholders. ?owever, if the
board opts to retain earnings, the preferred stoc would not yield a dividend, and thus cash flows
from a preferred dividend are not as certain as income of the bondholders.
Dividends are paid out of net income. Shareholders get a part of the net profit of the company
during the year, proportional to their shareholdings, and it is for the management to decide how much of
the profit is to be distributed among the shareholders.
<ow, we will see how these shares and bonds will appear on the face of a balance sheet. >e will have
to loo at these shares and bonds from two aspects, the shares and bonds that the company issues and
the shares and bonds that company invest in. The shares and bonds that a company purchases as an
investment will come on the asset side under the section of maretable securities. These shares and
bonds have been purchased by the company to generate e!tra income. -n the other hand, those shares
and bonds that the company issues to raise funds will appear on the liability side.
If the company has issued bonds, they will be classified as liability. 6ut if the company has issued
e(uity shares, they will appear under the section of common e(uity on liability side in the balance sheet.
>here do bonds ' stocs appear on the 6alance SheetP
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"inally, let7s tal about the most important concept that we will eep on repeating throughout
the course% the concept of Qvalue7. In financial terms, there are different types of values, which are given
as under.
Val)e
A 0oo4 Val)e$
6oo 9alue is the value of an asset as shown on the 6alance Sheet. It is based on
historical cost .or purchase price/ and accumulated depreciation.
A Mar4et Val)e$
#aret value of an asset is as (uoted in the maret, which basically depends on the
supply ' demand of the asset and the negotiations between buyers ' sellers.
A Li2)i*ation Val)e$
The li(uidation value is the value of an asset in a particular situation, where the
company is in the process of wrapping up the business and its assets are valued and sold
individually.
A Fair Val)e or Intrin#ic Val)e$
The most important value concept in this course is of fair value or the intrinsic value. In
order to find the intrinsic value of an asset, the present value of the woring assets7
future cash flows is calculated and summed up. If the intrinsic value of an asset is less
than its maret value, the asset among investors is perceived as )undervalued*.
Financial Mar4et#
A Ca.ital Mar4et#$
These are the marets for the long term debt ' corporate stocs. The maturity of debt
should be more than one year to (ualify it as a capital maret instrument.
+toc4 E5c&ange$
A stoc e!change is a place where the listed shares, Term finance certificates .T",/
and national investment trust units .<IT/ are e!changed and traded between buyers and
sellers.
Long term on*#$
@ong term government ' corporate bonds are also traded in capital marets.
A Mone( Mar4et#
#oney maret generally is a maret where there is buying and selling of short term li(uid
debt instruments. .Short term means one year or less/.@i(uid means something which is
easily en-cashable% an instrument that can be easily e!changed for cash.
+&ort term 0on*#
o Bovernment of ;aistan1 "ederal Investment 6onds ."I6/, Treasury-6ills .T-
6ills/
o ;rivate Sector1 ,orporate 6onds, Debentures
,all #oney, Inter-ban short-term and overnight lending ' borrowing
@oans, @eases, Insurance policies, ,ertificate of Deposits .,D7s/
6adlah .money lending against shares/, =oad-side money lenders
A Real A##et# or /&(#ical A##et Mar4et#
o ,otton +!change, Bold #aret, Kapra .,loth/ #aret
o ,omputer hardware, :sed ,ars, >heat, Sugar, 9egetables, etc.
Lesson 03
ANALYSIS OF FINANCIAL STATEMENTS
Learning O!ecti"e#$
After going through this lecture, you would be able to have a better understanding of the following
concepts.
Anal(#i# o, Financial +tatement#
=e( Financial Ratio#
Limitation o, Financial +tatement# Anal(#i#
Mar4et "al)e a**e* - Economic "al)e a**e*>
Rou have studied in previous lecture
A O!ecti"e o, Economic#$
The ob0ective of economics is profit ma!imization, however, for whom the profit is to be
ma!imized and for what duration may vary.
A O!ecti"e o, Financial Acco)nting 7FA8$
The ob0ective of financial accounting is to record accurate, timely, consistent, and
generalized collection of financial data, consolidating the information and reporting it to the
management for decision-maing. <evertheless, the decision-maers use financial
management techni(ues for a useful interpretation of the consolidated financial data.
A O!ecti"e o, Financial Management 7FM8$
The ob0ective of financial management is to ma!imize the wealth of the
shareholders&owners. -ne way of increasing shareholders7 wealth is by ma!imizing the
stoc price. In financial management when we tal about the profit ma!imization, we
actually imply profit ma!imization for the shareholders of the company. >e can simply
measure it from the share price of the company in the maret.
Another way is to find the best investment and financing opportunities in order to ma!imize
the value of the company. As we will see in the later lectures, the two ways are closely
related to each other. "inancial statements are used to assess the financial position as well as
performance of the company, so that the financing and investing decisions could be taen
accordingly.
Anal(#i# o, Financial +tatement#$
A company7s financial statements need to be studied for signs of financial strengths and
weanesses and then compared to .or benchmared against/ the industry. 6efore getting
into the details of the financial management techni(ues, we would briefly revise some of the
accounting concepts, which are going to help us in comprehending those analysis
techni(ues.
0a#ic Financial +tatement#$
There are four basic financial statements that are prepared by the financial accountants for
the use of the managers, creditors and investors of the company. These statements are
a. 6alance Sheet
b. ;&@ or Income Statement
c. ,ash "low Statement
d. Statement of =etained +arnings .or Shareholders7 +(uity Statement/
The concepts that we are going to discuss here in reviewing financial accounting concepts are
"undamental Accounting +(uation and Double +ntry ;rinciple.
A Assets S+!pense T @iabilities S Shareholders7 +(uity S =evenue
.<ote1 +!pense ' =evenue are Temporary ;&@ accounts $ the others are ;ermanent 6alance Sheet
Accounts/
A @eft ?and Items increase when debited. =ight ?and items increase when credited.
A "or every 0ournal entry, the Sum of Debits T the Sum of ,redits
0alance +&eet$
The following facts about balance sheet are also going to help us in understanding the
financial statements analysis process.
$ A balance sheet is a Qstatic snapshot7 at one point in time .therefore the consolidated
data available is vulnerable to inventory and cash swings, i.e., if the balance sheet of a
firm is showing low inventory and high cash position at the year ending when the
balance sheet is prepared, the company may buy e!cessive inventory against cash the
very ne!t day. The balance sheet prepared a day earlier would not report the new
transaction and the latest financial position of the company would not be nown to the
analyst, unless the company updates him on that./
$ 6alance sheet items or accounts are Qpermanent accounts7 that continue to accumulate
from one accounting cycle to the ne!t.
$ 6alance sheet items are recorded on historical cost basis, i.e., the balance sheet neglects
any increase in value of assets resulting from inflation and reports assets and liabilities
at their boo value. It is a big limitation for financial analysts, since a useful analysis
could only be made by considering the assets and liabilities at their maret value rather
than boo value. <evertheless, there are some approaches by which we can solve this
problem. ,onstant rupee approach is one such remedy.
$ ,onstant =upee Approach1 In constant rupee approach, two balance sheets of the same
company for different times are compared at a specific time and inflationary
ad0ustments are made.
A A##et# 7Le,t :an* +i*e8$
?aving revised certain concepts and limitations of financial accounting process and
financial statements, we would now have a brief overview of the items that appear on the left-hand
side of the balance sheet, nown as assets.
$ Assets are economic and business resources that are used in generating revenue for the
organization1 They can be tangible .inventory/ or intangible .patent, brand value,
license/. Some assets are classified as current .cash, accounts receivable/ and others are
fi!ed .machinery, land, and building/. There are also long-term assets .property, loans
given/ and contingent assets, the value of which can only be assessed in future .legal
claim pending, option/.
$ ,urrent Assets T ,ash S #aretable Securities S Accounts =eceivable S ;re-;aid
+!penses S Inventory
$ The accounts receivable aging schedule is a listing of the customers maing up total
accounts receivable balance. #ost businesses prepare an accounts receivable aging
schedule at the end of each month. Analyzing your accounts receivable aging schedule
may help you identify potential cash flow problems.
$ Inventory value .at any instant in time/ is a very controversial figure which depends on
inventory valuation methodology .i.e. "I"-, @I"-, Average ,ost/ and Depreciation
#ethod .i.e. Straight @ine, Double Declining, Accelerated/. ,ompanies have the
fle!ibility that they can use one methodology for preparing the financial statements '
the different methodology for ta! purposes.
A Liailitie# 7Rig&t :an* +i*e8$
The right hand side of the balance sheet represents liabilities.
$ @iabilities are sources which are use to ac(uire the resources or liabilities are
obligations of two types1
2/ -bligations to outside creditors and
3/ -bligations to shareholders nown as +(uity.
$ @iabilities can be short term debts, long term debt, e(uity, retained earnings, contingent,
unrealized gain on holding of maretable securities
$ ,urrent @iabilities T Account ;ayables S Short Term @oans S Accrued +!penses
$ <et >oring ,apital T ,urrent Assets $ ,urrent @iabilities
$ Total +(uity T ,ommon +(uity S ;aid In ,apital S =etained +arnings .=etained
+arnings is <-T cash always/
$ Total +(uity represents the residual e!cess value of Assets over @iabilities1 Assets $
@iabilities T +(uity T <et >orth
$ -nly cash account represents real cash which can be used to pay your billsUU
/ro,it - Lo## acco)nt or Income +tatement$
$ An income statement is a )flow statement* over a period of time matching the operating
cycle of the business, which reports the income of the firm.
$ Benerally, =evenue $ +!pense T Income
$ =ight hand side receipts .revenues/ are added. @eft hand side payments .e!penses/ are
subtracted.
$ ;&@ Items or Accounts are Qtemporary7 accounts that need to be closed at the end of the
accounting cycle.
$ Sales revenue $ ,ost of Boods Sold T Bross ;rofit .=evenue/
$ ,ost of Boods Sold is a very controversial figure that varies depending on Inventory
9aluation #ethod .i.e., "I"-, @I"-, Average ,ost/ and Depreciation #ethod .Straight
@ine, Double Declining, Accelerated/. Depreciation is treated as an e!pense .although
it is non-cash/
$ Bross =evenue $ Admin ' -perating +!penses T -perating =evenue
$ -perating =evenue $ -ther +!penses S -ther =evenue T +6IT
$ +6IT $ "inancial ,harges ' Interest T +6T <ote1 @easing Treatment
$ +6T $ Ta! T <et Income
$ <et Income $ Dividends T =etained +arnings
$ <et Income is <-T cash .it can7t pay for bills/
/?L +tatement o, Com.an( @AB
Aear En*ing ;)ne C0
t&
20028
.QDDD =s./ .QDDD =s/ .QDDD =s/
<et Sales 2DDD
,ost of Boods Sold .IDD/
Bross ;rofit IDD
Administration +!penses .3DD/
Depreciation +!pense .D/
-perating ;rofit 4DD
-ther +!penses .2CD/
-ther Income .interest/ .D/ .2CD/
+6IT 23D
Ta! .3D/
<et Income 2DD
Ca#& Flo3 +tatement$
A cash flow statement shows the cash position of the firm and the way cash has been
ac(uired or utilized in an accounting period.
A cash flow statement separates the activities of the firm into three categories, which are
operating activities, investing activities and financing activities.
A -perating ,ash "low Statement can be obtained by using two approaches1
2/ Direct
3/ Indirect.
A cash flow statement can be derived from ;&@ or Income Statement and two consecutive year 6alance
Sheets.
A A cash flow statement is not prepared on accrual basis but rather on cash basis1 Actual
cash receipts and cash payments.
A The net income is obtained from the Income Statement of a period of time matching
the operating cycle of the business. Benerally1
=evenue $ +!pense T Income
In order to arrive as the cash flows resulting from operating activities Increases in current assets
are cash payments .-/, i.e., cash outflow
Increases in current liabilities are cash receipts .S/, i.e., cash inflow
=ight ?and Side =eceipts are added.
8 ,opyright 9irtual :niversity of ;aistan 2F
@eft ?and Side payments are subtracted
+tatement o, Retaine* Earning# or +&are&ol*er#1 E2)it( +tatement
Total +(uity T ,ommon ;ar Stoc Issued S ;aid In ,apital S =etained +arnings
.=etained +arnings is the cumulative income that is not given out as Dividend $ it is <-T cash/

@AB
Ca#& Flo3 +tatement
7;)ne C0
t&
2001 ;)ne C0
t&
20028
.QDDD =s/ .QDDD =s/ .QDDD =s/
<et Income FDD
Add Depreciation +!pense 2DD
Subtract Increase in ,urrent Assets1
Increase in Accounts =eceivables .FDD/
Increase in Inventory .LDD/
.22DD/
Add Increase in ,urrent @iabilities1
Increase in A&c ;ayable IDD
,ash "low from -perations .2DD/
,ash "low from Investments D
,ash "low from "inancing IDD
<et ,ash "low from All Activities FDD
<ote 21 Indirect ,ash "low Approach using Income Statement and two consecutive 6alance
Sheets
<ote 31 "inal <et ,ash "low from All Activities should match the difference in the difference in
the closing balances in the 6alance Sheets from Nune 4Dth 3DD2 and Nune 4Dth 3DD3
<ote 41 Investments include all cash sale and purchases of non-current assets and maretable
securities
<ote F1 "inancing includes all cash changes in loans, leasing, and e(uity etc.
+OME FINANCIAL RATIO+$
LIDUIDITA - +OLVENCA RATIO+$
C)rrent Ratio1 ,urrent ratio is a ratio between current assets and liabilities, which tells that for every
dollar in current liabilities, how many current assets do the company possess. Since the current
liabilities are usually paid out of current assets, it maes sense to compare the two figures to assess the
li(uidity of the firm. @i(uidity implies the ease with which the current liabilities can be paid off.
Benerally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive
use of current assets. A ratio of two to one .312/ is considered ideal.
T ,urrent Assets & ,urrent @iabilities
D)ic4?Aci* Te#t ratio1 Vuic ratio is relatively a stringent measure of li(uidity. The ratio is obtained
by subtracting inventory from current assets and dividing the result by current liabilities. Inventory is
the least li(uid of all current assets. 6y subtracting inventory from current assets, we are actually
comparing more li(uid assets with current liabilities. This ratio not only helps in gauging the solvency
of the company, it may also show if the inventories are piling up. A desirable (uic ratio can range from
.D.C12/ to .2.I12/ depending on the nature of the business.
T .,urrent Assets $ Inventory/ & ,urrent @iabilities
8 ,opyright 9irtual :niversity of ;aistan 2I
A"erage Collection /erio*1 Also nown as Days Sales -utstanding, average collection period shows in
how many days the Accounts receivables of the company are converted into cash. #ost of the
companies sell most of their products&services on credit basis, hence it is critical for the company to
now in how much time these receivables could be converted to cash in order to ensure li(uidity at all
times. Average collection period is calculated using the following formula
T Average Accounts =eceivable &.Annual Sales&4JD/
<ote1 Average collection period is usually e!pressed in terms of days. If you find a decimalized answer,
you should round it off to the ne!t integer.
/ROFITA0ILITA RATIO+$
The profitability ratios show the combine effects of li(uidity, asset management, and debt
management on operating result.
/ro,it Margin 7on #ale#8$ -ne of the most commonly used ratios is profit margin on sales. This ratio
tells the percentage of profit for every dollar of revenue earned. This ratio is usually e!pressed in terms
of percentage and the general rule is , the higher the ratio, the better it is. #ost of the companies
compare this ratio to the previous years7 ratios to assess if the company is better off.
T W<et Income & SalesX Y 2DD
Ret)rn on A##et#$ =eturn on assets is another profitability ratio, which shows the profitability of the
company against each dollar invested in total assets. >e can obtain this figure by simply by dividing the
net profit with total assets. Since the assets are economic resources that are used to earn profit, it is
logical to assess if the assets have been used efficiently enough to generate profits. This ratio is also
e!pressed in percentage terms.
T W<et Income & Total AssetsX Y 2DD
Ret)rn on e2)it($ =eturn on e(uity is of special interest to the shareholders, since e(uity
represents the owners7 share in the business. =eturn on e(uity can be obtained by dividing the net
income with the total e(uity. This ratio shows that for each dollar in e(uity how much profit is
generated by the company.
T W<et Income&,ommon +(uityX
A++ET MANAGEMENT RATIO+
These measures show how effectively the firm has been managing its assets.
In"entor( T)rno"er1
Inventory turnover shows the number of times the inventories are replenished within one
accounting cycle. The ratio can be obtained by dividing the sales by inventory. >hile the (uic ratio
measures the li(uidity and points out the inventory piling problem, the inventory turnover confirms
whether or not the ma0or portion of the current assets of the firm are tied up in inventory. This ratio is
also used in measuring the operating cycle and cash cycle of the firm. A higher turnover is desirable as
it reflects the li(uidity of the inventories.
T Sales & inventories
Total A##et# T)rno"er$ An effective use of total assets held by a company ensures greater
revenue to the firm. In order to measure how effectively a company has used its total assets to generate
revenues, we compute the total assets turnover ratios, dividing the sales by total assets.
T Sales & Total Assets
An increasing ratio over the years may show that with an addition of assets, the company has
been able to generate incremental sales in greater proportion.
DE0T 7OR CA/ITAL +TRUCTURE8 RATIO+$
Det9A##et#$ A commonly used ratio to measure the capital structure of the firm is debt to assets ratio.
,apital structure refers to the financing mi! .proportion of debt and e(uity/ of a firm. The greater the
proportion of debt in the financing mi!, the less willing creditors, and investors would be to provide
more finances to the company. In ;aistan, the debt to assets ratio is prescribed in prudential regulations
by the State 6an of ;aistan as a guideline for the bans .creditors/. A ratio greater than D.JJ to 2 is
considered alarming for the providers of funds.
T Total Debt & Total Assets
Det9E2)it(1 Another commonly used ratio, debt to e(uity, e!plicitly shows the proportion to debt to
e(uity. A ratio of JD to FD is used for new pro0ects, i.e., for a pro0ect it is permitted to raise its finances
JD percent from the debt and FD percent from e(uity. Debt to e(uity is computed by the following
formula.
8 ,opyright 9irtual :niversity of ;aistan 2J
T Total Debt & Total +(uity
Time#9Intere#t9Earne*$ Times-interest-earned reflects the ability of a company to pay its financial
charges .interest/. This ratio is obtained by dividing the operating profit by the interest charges.
,onceptually, the interest charges are to be paid from the earnings before interest and ta!es. A ratio of F
to 2 shows that the company covers the interest charges F times, which is generally considered
satisfactory by the management, however, a ratio higher than that, may be more desirable. A high time-
interest-earned ratio is a good sign, especially for the creditors.
T +6IT & Interest ,harges
Mar4et Val)e Ratio#$
#aret value ratios relate the firm7s stoc price to its earnings ' boo value per share. These
ratios give management an indication of what e(uity investors thin of the company7s past performance
' future prospects
/rice Earning Ratio$
It shows how much investors are willing to pay per rupee of reported profits. This ratio reflects
the optimism, or lac thereof, investors have about the future performance of the company.
T #aret ;rice per share & Z+arnings per share
Mar4et ?0oo4 Ratio$
#aret to boo ratio gives an indication how e(uity investors regard the company7s value. This
ratio is also used in case of mergers, ac(uisition or in the event of banruptcy of the firm.
T #aret ;rice per share & 6oo 9alue per share
ZEarning /er +&are 7E/+8$
T <et Income & Average <umber of ,ommon Shares -utstanding

Ratio# &el. )# to com.are *i,,erent )#ine##e# in t&e #ame in*)#tr( an* o, a #imilar #i6e>
Limitation# o, Financial +tatement Anal(#i#$
Despite the fact that ratios are a useful analysis tool, there are certain limitations, which are
important for an analyst to understand before applying this tool, in order to mae his analysis more
meaningful.
A "SA is generally an outdated .because of ?istorical ,ost 6asis/ post-mortem of what has
already happened. It is simply a common starting point for comparison. :se ,onstant =upee &
Dollar analysis to account for inflation.
A "SA is limited by the fact that financial statements are )window dressed* by creative
accountants. >indow dressing refers to the understatement or overstatement of financial facts.
A Different companies use different accounting standards for Inventory, Depreciation, etc.
therefore comparing their financial ratios can be misleading
A "SA 0ust presents a few static snapshots of a business7 financial health but not the complete
moving picture.
A It7s difficult to say based on "inancial =atios whether a company is healthy or not because that
depends on the size and nature of the business.
Di,,erence in Foc)#$
"inancial Statements are prepared by financial accountants with a certain perspective,
however the financial managers[the end users of these financial statements, have a different focus to
draw meaningful conclusions out of these statements. These differences are listed below
A Financial Acco)nting 7FA8 Foc)#$
A :se ?istorical 9alue .assets are booed at original purchase price/
A "ollow Accrual ;rinciple .calculate <et Income based on accrued e!pense and accrued
revenue/
A ?ow to most logically, clearly, and completely represent the financial data.
A Financial Management 7FM8 Foc)#$
A :se #aret 9alue .assets are valued at current maret price/
A "ollow Incremental ,ash "lows because an Asset7s .and a ,ompany7s/ 9alue is
determined by the cash flows that it generates.
A ?ow to pic the best assets and liabilities portfolios in order to ma!imize shareholder
wealth.
8 ,opyright 9irtual :niversity of ;aistan 2L
FM Mea#)re# o, Financial :ealt&$
The financial management measures that are used for assessing the financial health of a company
primarily focus on the basic ob0ective of financial management, i.e., to increase the wealth of the
shareholders. Biven below are the two important measures of financial health.
M>V>A 7Mar4et Val)e A**e*8$
#aret 9alue Added is a measure of wealth added to the amount of e(uity capital provided by
the shareholders. It can be determined by the following e(uation
#9A .=upees/ T #aret 9alue of +(uity $ 6oo 9alue of +(uity ,apital
"ollowing are the characteristics of #9A
A It is a cumulative measure, i.e., it is measured from the inception of the company to
date. #aret 9alue is based on maret price of shares.
A It shows how much more .or less/ value the management has succeeded in adding .or
reducing/ to the company in the eyes of the general public & maret.
A It is used for incentive compensation pacages for ,+-7s and higher level
management.
A E>V>A 7Economic Val)e A**e*8$
+conomic 9alue Added, on the other hand, focuses on the managerial effectiveness in a
given year. It can be obtained by subtracting the cost of total capital from the operating profits of a
company
+9A .=upees/ T +6IT .or -perating ;rofit/ $ ,ost of Total ,apital
+9A has the following characteristics
A It is measured for any one year.
A It is relatively difficult to calculate because -perating ;rofit depends on
Depreciation #ethod, Inventory 9aluation, and @easing Treatment, etc. Also, a
combined ,ost of Total ,apital .Debt and +(uity/ is difficult to compute.
8 ,opyright 9irtual :niversity of ;aistan 2C
Lesson 04
TIME VALUE OF MONEA
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following
concepts.
Main Conce.t# o, FM>
Time Val)e o, Mone(
Intere#t T&eor( an* it# *eterminant#
Aiel* c)r"e t&eor( an* it# *(namic#
FM Conce.t#$
There are certain financial management concepts that should be ept in mind, while maing an analysis
of a financial decision. The one-liners given here would help you in committing these concepts to your
memory.
A A rupee today is worth more than a rupee tomorrow.
Time 9alue of #oney ' Interest
A A safe rupee is worth more than a risy rupee.
- =is and =eturn
A Don7t compare apples to oranges
- Discounting ' <;9
A Don7t put all your eggs in one baset.
- ;ortfolio Diversification
A Bet insurance because you will brea some eggs.
- ?edging ' =is #anagement
Time Val)e o, Mone($
The first concept, time value of money, says that a rupee in your hand today is worth more than
the rupee that you are going to get tomorrow or the day after. This is because if you have a rupee in
hand, you can put it into a ban .invest it/ and can earn interest .return/ on it, and tomorrow you are
going to have more than rupee one, which of course, is more desirable than having 0ust one rupee.
Ri#4 an* Ret)rn$
Investors want to earn ma!imum return on their investment% however, ris is a constraint to this
ob0ective. Investors dislie ris-bearing, unless they are ade(uately compensated for that. <ow the ris
and return concept states that a safe rupee in your hand is better than a risy rupee which is not in your
hand. This may imply that the investors would be willing to bear ris if they are offered more than a
rupee i.e., a certain premium for ris bearing. ?owever, in the absence of this additional compensation,
a safe rupee is better than a risy rupee. The details about the concepts of ris and return would be
discussed in the middle of the course.
Di#co)nting - Net /re#ent Val)e 7N/V8$
The third concept is of discounting and net present value of money. This is a fundamental
mathematical concept and students need to practice it to perfection. >hether discounting for an asset or
a company, we have to see what cash flow would it generate during its future life and then we bring
bac those future cash flow to the present, i.e., we discount the future cash flows to obtain their present
value. This e!ercise is done to mae comparison of cash flows occurring in different time periods, i.e.,
comparing apples to apples, rather than oranges. This concept is relentlessly used throughout the course
in comparing different investment options in different time periods.
/ort,olio Di"er#i,ication$
The fourth concept is of portfolio diversification i.e. how to select different investment options
so as to reduce ris of losing the invested money. "or instance if an investor has a million rupees and he
invests his total wealth in a single company7s share, he would be e!posed to greater ris. If the company
goes out of business or faces serious loss, the investor is liely to lose all his investment. ?owever, if
that investor puts his total wealth into shares of ten different companies, the chances that all the ten
companies would face loss is comparatively lesser and hence the ris for the investor is diversified and
reduced. The rule of finance says do not put all your eggs in one baset, because if you drop the baset
accidentally, you are liely to lose all the eggs.
8 ,opyright 9irtual :niversity of ;aistan 2O
:e*ging - Ri#4 Management$
"inally, there is this fifth concept of hedging and ris management. ?edging is a strategy of
ris management that is employed by investors to reduce or minimize the chances of loss. Insurance is
said to be an effective tools used to manage ris. The concept of hedging and ris management says that
whether you put your eggs in one baset or in different basets, chances are there that you will brea
your eggs so it is better to get the eggs insured Insurance is the best way to avoid loss so that even if the
loss occurs you may get a claim on your damages.
<ow, let7s discuss the concept of interest in detail, first ma0or ' technical area in financial
management. =emember, that the basic ob0ective in financial management is to ma!imize shareholders
wealth.
Intere#t T&eor($
A Economic T&eor($
Interest rate is an e(uilibrium price, e!pressed in percentage terms, at which demand and
supply of funds .or capital/ meet, i.e., the rate at which the lenders are ready to lend and buyers are
ready to buy. 6ut e(uilibrium price .Interest rate/ varies from one maret to another. "or e!ample,
the )price* of capital in the property maret is different from the )price* of capital in the cotton
maret. #arets have different interest rates guided by the supply ' demand of funds in that
maret. Although the interest rates in different marets may differ, however, all the marets in the
country and the interest rates prevailing there are interlined.
<ow, we come to the factors that determine the interest rates. It is important to understand the
factors that mae up an interest rate in the present day business environment. In business when we tal
about the interest, we usually refer to nominal rate of interest which is determined with the help of
following factors.
Factor#
$ i E iRF F g F DR F MR F L/ F +R
$ i is the nominal interest rate generally (uoted in papers. The )real* interest rate T i $ g
?ere i T maret interest rate
g T rate of inflation
D= T Default ris premium
#= T #aturity ris premium
@; T @i(uidity preference
S= T Sovereign =is
The e!planation of these determinants of interest rates is given as under1
Ri#4 Free Intere#t Rate 7RF8$
"actually speaing, there is no such thing as a ris-free rate of return because no investment can
be entirely ris-free. All the investments and securities include a certain amount of ris. A company
may go banrupt or close down. ?owever, if we tal about the relevant ris involved in different
securities, the government-issued securities are considered as ris-free, since the chances of default of a
government are minimal. These government issued securities provide a benchmar for the
determination of interest rates. Internationally the :S T-6ills are considered as ris free rate of return.
In ;aistan, Bovernment of ;aistan T-6ills can be used as a pro!y for ris free rate of return, however,
since ;aistan faces some sovereign ris, the T-bills would not be considered entirely ris-free in the
true sense.
In,lation 7g8$
The e!pected average inflation over the life of the investment or security is usually inculcated in
the nominal interest rate by the issuer of security to cover the inflation ris. "or instance, consider a
bond with a maturity of I years. If the inflation rate in ;aistan is C E and the bond is also offering CE
percent interest rate, the investors would not be willing to invest in the bond since the gains from the
interest rate would be e!actly offset by the inflation rate which is actually eroding the wealth of the
investor. To secure the investor against inflation the issuers, while (uoting nominal interest rates, add
the rate of inflation to the real interest rate.
De,a)lt Ri#4 /remi)m 7DR8$
Default ris refers to the ris that the company might go banrupt or close down ' bonds, or
shares issued by the company may collapse. Default =is ;remium is charged by the investor, as
compensation, against the ris that the company might goes banrupt. ,ompanies may also default on
interest payments, something not very unusual in the corporate world. In :SA, rating agencies lie
#oody7s and S'; grade securities .debt and e(uity instruments/ according to their financial health and
thus identify those companies which have a good ability to pay off their principal lending and interest
charges and those which might default on the payments. The rating from best to worst is1 AAA, AA, A,
666, 66, 6, ,,,, ,,, ,. In ;aistan, ;aistan ,redit =ating Agency .;A,=A/ and 9ital Information
Services .9IS/ are actively conducting analysis of corporate securities and grading them.
Mat)rit( Ri#4 /remi)m 7MR8$
The maturity ris premium is lined to the life of that security. "or e!ample, if you purchase the
long term "ederal Investment 6onds issued by the government of ;aistan, you are assuming certain
ris, because changes in the rates of inflation or interest rates would depreciate the value of your
investment. These changes are more liely in the long term and less liely in the short term. #aturity
=is ;remium is lined to life of the investment. The longer the maturity period, the higher the maturity
ris premium.
+o"ereign Ri#4 /remi)m 7+R8$
Sovereign =is refers to the ris of government default on debt because of political or economic
turmoil, war, prolonged budget and trade deficits. This ris is also lined to foreign e!change ."&!/,
depreciation, and devaluation. <ow-a-days the individuals as well as institutions are investing billions
of rupees globally. If a ban wants to invest in ;aistan, it will have to tae view of ;aistan7s political,
economic, and financial environment. If the ban sees some ris involved it would be willing to lend at
a higher interest rate. The interest rate would be high since the ban would add sovereign ris premium
to the interest rate. ?ere it may be clarified that ;aistan is not considered as risy as many other
countries of Africa and South America.
Li2)i*it( /re,erence 7L/8$
Investor psychology is such that they prefer easily encashable securities. #oreover, they charge
the borrower for forgoing their li(uidity. A higher li(uidity preference would always push the interest
rates upwards.
Aiel* C)r"e T&eor($
Term +tr)ct)re an* Aiel* C)r"e$
Interest rates for any security vary across time horizon. The supply ' demand for funds vary
depending on how long the funds are re(uired. <ormally, short term interest rates are lower than long
term rates, or we can say that the interest rates depend on their term structure. 6ased on the maturity, the
securities can be classified into three categories, although, these classes have been loosely defined.
+&ort Term$ Short term means for the period of one year or less.
Me*i)m Term$ "or the period of any where between one year to five years.
Long Term$ Any where between 2I years to 3D years some people say that medium term is
from I year to ten years and long term from 2D years to 3D years and plus.
Nominal or ).3ar* #lo.ing (iel* c)r"e$
The supply ' demand of funds or capital varies depending upon how long funds are re(uired. "or
e!ample, today the supply and demand for short term money might be different from supply and
demand of the long term money. In another words, the number of borrowers to tae loan for one wee
may be different from the borrowers of loan for one year. Short term interest may be different than the
long term interest% normally, short term interest rates are lower than long term than interest rates
because investors thin that inflation is going to increase. This phenomenon results in nominal or
).3ar* #lo.ing (iel* c)r"e>
Anormal or *o3n3ar* #lo.ing (iel* c)r"e$
Sometimes, the reverse is true. This is nown as the Abnormal .or Downward Sloping/ Rield
,urve. It is the case where the short term raters are higher than long term interest tares. Rou can also
have a mi!ed or ?umped 6ac ,urve.
0
4
8
12
16
Yr 1 Yr 3 Yr 5 Yr 10 Yr 20
Normal
Abnormal
<ow, we go into the reason why the curves have either upward slope or downward slope. "ollowing are
some of the factors that determine the slope of the yield curves.
E5.ectation# T&eor($
Investors normally e!pect inflation .and interest/ to rise with time thereby giving rise to a
normal shaped yield curve.
Li2)i*it( /re,erence T&eor($
Investors prefer easily encashable securities with short maturities. The only problem is that
short term securities are easy to encash but at maturity there is no guarantee that you can renew it .so,
you can find a security today which will give you 3I Eor 4DE per annum they are not always
renewable $ hence unpredictable.
Mar4et +egmentation$
The demand&supply for Short Term securities is different from that of @ong Term securities.
This can easily give rise to an Abnormal Rield ,urve.
<ow let7s tal about the practical types of interest there three inds of interest we will tal about
2-simple interest
3-discrete compound interest
4-continuous compound interest
1> +im.le Intere#t 7or +traig&t Line8$
Simple interest incurs only on the principal. >hile calculating simple interest we eep the
interest and principal separately, i.e., the interest incurred in one year is not added to the principal while
calculating interest of the ne!t period. Simple interest can be calculated using the following formula.
F V E /V F 7/V 5 i 5 n8
E5am.le$ Assume that you have =s 2DD today and you want to invest the amount with a ban for five
years. The ban is offering an interest rate of L percent. >e can obtain the simple interest on the
investment using the aforementioned formula
" 9 T ;9 S .;9 ! i ! n/
?ere "9 is the simple interest accrued for the term of the investment
;9 is the amount invested, i.e., =s 2DD in our e!ample
i stands for the interest rate offered by the ban, i.e., L E T D.DL
n is the term of the investment, which is assumed to be I years
;utting these values in the formula, we get
"9 T 2DD S .2DD ! D.DL ! I/
"9 T 2DD S .L ! I/
"9 T 2DD S .4I/
"9 T =s 24I
?ere =s 24I is the future value of investment after five years and =s 4I is the interest accrued during
five years on the initial investment of =s 2DD.
2> Di#crete Com.o)n* Intere#t$
Discrete compound interest is the most commonly used tool in "inancial #anagement
Discounting and <;9 calculations. :nlie simple interest, compound interest taes into account the
principal as well as interest accrued for a term, while calculating interest incurred during the ne!t term.,
i.e., interest incurred for one year would be added to the principal to calculate the interest for the ne!t
period. ?owever, this compounding of interest taes place in a discrete manner, i.e., the compounding
taes place yearly, semi-annually, (uarterly, or monthly. "or computing the annual compounding, we
use the following formula
Ann)al 7(earl(8 com.o)n*ing$
F V E /V 5 71 F i8
n
?owever, a slight modification in the formula is need if the compounding taes place monthly.
Such a compounding would be calculated using the following formula.
F V E /V 5 71 F 7i ? m8
m 5 n

?ere Qm7 refers to the compounding intervals during the term of the investment. In order to
calculate monthly compounding, the value of Qm7 would be 23% however, for (uarterly compounding
calculation m would be e(ual to F
E5am.le$
Assume that the investor in our previous e!ample is offered a compound return .interest/ on his same
investment, at the same interest rate and term. The future value of the investment is given as under
" 9 T ;9 ! .2 S i/
n
"9 T 2DD ! .2SD.DL/
I
"9 T 2DD ! .2.DL/
I
"9 T 2DD ! .2.FD3II/
"9 T 2FD.3II
?ere the interest accrued on the five year investment is more than what we found out in simple interest.
?owever if the compounding is done every month the future value of investment would be
" 9 T ;9 ! .2 S .i & m//
m ! n

"9 T 2DD ! .2 S .D.DL&23//
23 ! I
"9 T 2DD ! .2 S D.DDIC44//
JD
"9 T 2DD ! .2.DDIC44/
JD

"9 T 2DD ! 2.F2LJ
"9 T 2F2.LJ
>ith more fre(uent compounding, the wealth of the investor increases to a greater degree.
C> Contin)o)# 7or E5.onential8 Com.o)n* Intere#t$
The other type of compound interest is e!ponential compound interest. In this compound interest an
infinite number of times per year at intervals of microseconds.
" 9 .,ontinuous compounding/ T ;9 ! e
i 5 n

?ere e is a constant the derived value of which is 3.L2C
E5am.le$
Assume that the same investor has now the opportunity of investing at continuous compounding with
the same term and interest rate. ?is future wealth after five years is given as under
" 9 T ;9 ! e
i ! n

"9 E 2DD ! 3.L2C
.D.DL!I/
"9 T 2DD ! 2.F2O
"9 T 2F2.O
>e can see that the wealth of the investor is the highest, when he decided to invest in a scheme which
offers continuous compounding.
The difference between simple and compound interest can increase manifold if the term of the
investment is increased. As we see in the following e!ample
E5am.le$
Suppose you deposit =s 2D in a ban today. The ban offers you 2DE per annum .or per year/
interest. ?ow much money will you have in the ban after 2I yearsP
If the ban is offering simple interest1
" 9 T ;9 S .;9 ! i ! n/ T 2DS .2D!D.2D!2I/ T =s. 2G
If the ban is offering discrete compounding1
" 9 T ;9 ! .2S i/
n
E 2D ! .2SD.2D/
1G
T =s. H2 appro!.
6ans do not offer continuous compounding but if they did1
" 9 T ;9 ! e
i5n
T 2D ! .3.L2C/
0>1051G
T =s. HG appro!
!raphical "ie# of Compounding
0
25
50
Yr 1 Yr 5 Yr 10 Yr 15
Simple
Discrete
Compound
Continuous
Compound
The miracle of compounding $ ou earn interest on
interest & principal%
Am
o
u
n
t

)
&
u
p
e
e
s
'
Note: After () ears* Continuous Compounding gives ou almost t#o times more mone
than Simple Interest+ Compound Interest gives ou a,out one-and-a-half times as much%
Lesson 05
FINANCIAL FORECA+TING AND FINANCIAL /LANNING
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following concepts.
Financial Foreca#ting an* Financial /lanning>
Met&o*# o, ,oreca#ting
6efore going into the detailed calculation of cash flow, it is important to now the principles behind
financial forecasting and financial planning.
Although, financial planning and forecasting cannot reduce the uncertainty in our lives, the idea is
simply to acnowledge and identify different points in time, where we e!pect some future occurrences,
and to prepare plans and contingencies in the light of those forecasted happenings. -f course, we cannot
be certain about the future, but we can always plan and arrange for it.
O!ecti"e# o, Financial Foreca#ting$
Although, financial planning and forecasting cannot reduce the uncertainty in our lives, the idea is
simply to acnowledge and identify different points in time, where we e!pect some future occurrences,
and to prepare plans and contingencies in the light of those forecasted happenings. -f course, we cannot
be certain about the future, but we can always plan and arrange for it.
2/ =educe cost of responding to emergencies by anticipating the future occurrences
3/ ;repare to tae advantage of future opportunities
4/ ;repare contingency and emergency plans
F/ ;repare to deal with possible outcomes
/lanning Doc)ment#$
There are three types of documents that are to be prepared while maing a financial plan. These are
2/ ,ash 6udget
3/ ;ro "orma 6alance Sheet
4/ ;ro "orma Income Statement
?ere, the term Qpro forma7 refers to forecasting. These pro forma statements are prepared on the basis of
certain estimates.
Met&o*# o, ,oreca#ting
In order to prepare pro forma statements, two methods are commonly practiced, which are given
as under
$ /ercentage o, +ale#$ Simple
$ Ca#& 0)*get$ Detailed, more complicated
/ercentage o, #ale#$
Step 21 +stimate year-by-year Sales =evenue and +!penses
Step 31 +stimate @evels of Investment <eeds .in Assets/ re(uired meeting estimated sales .using
"inancial =atios/. That how the Assets of the company changes with the change in
Step 41 +stimate the "inancing <eeds .@iabilities/
E5.lanation$
>hile employing percentage of sales method, we would estimate the cash flows based on the
sales revenue. The first step is to forecast the changes in the sales revenue in the successive years.
+!penses incurring in successive period would also be estimated. These e!penses include cost of goods
sold e!pense, administrative, e!pense, mareting e!pense, depreciation e!pense, and other e!penses.
?owever, these revenues and e!penses would be estimated on cash, rather than accrual basis.
After estimating the revenues and e!penses, we need to forecast the anticipated changes in
assets and liabilities as a result of changes in sales. ?aving forecasted the assets and liabilities as a result
of changes in sale, we would be able to identify how much capital the firm has to invest in assets and
how much the company needs to borrow as a result of any shortfall. ?ere, we would e!amine the
various heads of assets and liabilities and their relationship with sales. >e can establish these relations
by identifying the changes in assets and liabilities as a result of change in sales, and to do that certain
assumptions need to be considered.
GENERAL A++UM/TION+
,urrent Assets1 Benerally grow in proportion to Sales.
"i!ed Assets1 Do not always grow in proportion to Sales. As if you need to e!pand property, office
or factory space, machinery in order to achieve your Sales target.
,urrent @iabilities1 Also called Spontaneous "inancing. Benerally grow in proportion to Sale
@ong Term @iabilities1 Also, called Discretionary "inancing does not grow in proportion to Sales
E5.lanation$
,urrent assets include cash, maretable securities, accounts receivable, inventory, and prepaid
e!penses. -ut of these current assets, changes in cash, accounts receivable and inventory can be directly
lined to changes in sales. ?owever, maretable securities and prepaid e!penses are independent of
sales, i.e., changes in sales may not affect these two heads. It is also important to note that the current
assets do not change e!actly in the same proportion as the sales in real life situation, i.e., an increase of
2D percent in sales may not necessarily guarantee that the current assets would also increase by 2D
percent. ?owever, for the sae of simplicity we would assume that the current assets change
proportionally as the sales change.
-n the other hand, fi!ed assets do not change directly with a change in sales. "or e!ample, if
you plan to increase the sales revenue by 3DE then it is not necessary to increase the fi!ed assets by
3DE. 6ut, if a company plans to double its sales in the ne!t three years, the company might have to
increase its fi!ed assets% however, small year-to-year changes in sales do not affect the fi!ed assets.
,urrent liabilities include accounts payable, short term portion of long term liabilities and
accrued e!penses. ,urrent liabilities lie current assets are assumed to grow proportionally with any
growth in sales. If the sales of a company increase by 4D percent, its current liabilities would also
increase by 4D percent. ,urrent liabilities are also called spontaneous financing since they move in
direct relation with changes in sales.
?owever, the long term liabilities, also nown as discretionary financing, do not directly change
in proportion to the changes in sales revenue.
In order to have a better understanding of the aforementioned concepts, let us tae into
consideration a numerical e!ample.
E5am.le$
Assume that you are establishing cafeteria as a new business venture. In order to get your
pro0ect funded you would be needing capital. In addition, you would also need to forecast how your
business would generate revenues and incur e!penses in the coming years.
Suppose you e!pect the Sales =evenue from your ,af\ .or ,anteen/ business to grow from =s
3DD,DDD to =s 4DD,DDD and your +!penses to grow from =s ID,DDD to =s LD,DDD after 2 year. These
forecasts can be based on the business environment in which the business operates, competition faced
by the business, mareting efforts and activities of the business and the target maret.
The first thing we need to calculate here is the sales growth rate. The increase in the sales in =upee
terms is 4DD,DDD-3DD,DDDT=s.2DD, DDD. The sales revenue has increased up to rupees 2DD,DDD rate of
increase is IDE as present sales were =s.3DD, DDD.
This means that the Sales =evenue growth rate is1
.4DD,DDD-3DD,DDD/ & 3DD,DDD T D.I T IDE
Similarly an increase in e!penses of =s 3D,DDD shows that the rate of increase in e!pense is FDE
.i.e., increase of =s 3D,DDD in e!penses divided by the e!penses in year one/.
After forecasting the growth rate in revenues and e!penses, the ne!t step is to estimate the changes in
investment and financing .i.e., changes in assets and liabilities/.
In order to estimate these changes, we would need to calculate a few ratios.
In order to estimate the current assets for the ne!t year, we need to calculate the ratio current
asset to sales for the current year. In order to arrive at the estimate of current assets for the ne!t year we
would simply multiply the estimated sales for the ne!t year with the ratio.
E#timate* c)rrent a##et# ,or t&e ne5t (ear
T W,urrent assets for the current year&,urrent salesX ! +stimated sales for the ne!t year
If we assume the current assets&sales ratio to be 3D percent, putting in the values in the
aforementioned e(uation, we get
,urrent assets for the ne!t year T 4DD,DDD ! .D.3/ T JD,DDD
This shows that with an increase in sales of =s 2DD,DDD, the current assets of the cafeteria are liely to
increase as 3D percent of the sales.
>e will assume here that there is no change in the fi!ed assets. As mentioned earlier, fi!ed
assets do not change with year-to-year changes in sales, however, over a period of time, the fi!ed assets
may be increased as the business re(uires e!pansion.
The ne!t step is to forecast the retained earnings[the amount of profit which would be
reinvested in the business. =etained earning forecasting is important so that any shortfall in cash could
be identified and the amount of e!ternal financing necessary for the business could also be assessed.
=etained earnings can be estimated using the following formula
E5.ecte* E#timate* retaine* earning#
T estimated sales ! profit margin ! plowbac ratio
;low bac ratioT2-pay out ratio
;ay out ratioTdividend&net income
;rofit marginTnet income&sales
?ere, we assume that the profit margin ratio is 3I percent, whereas payout ratio of the cafeteria is ID
percent
+stimated retained earnings T 4DD,DDD ! D.3I ! .2-D.I/
TLI,DDDZ.2-D.I/ T=s.4L, IDD
=s 4L,IDD&- is predicted retained earnings amount which should appear in the pro forma balance sheet. It
shoes that half of the income will be distributed among the owners ' the other half will be reinvested.
<ow let7s forecast the e!ternal or discretionary financing .e!ternal financing/, since we
have estimated the revenues and e!penses of the business, the changes in assets and the part of the net
income that is to be reinvested in the business.
The formula will be used1
E#timate* *i#cretionar( ,inancing
T estimated total assets $ estimated total liabilities $estimated total e(uity
+stimated total e(uity can be found out by adding the retained earnings plus initial
investment. The business was started with an initial investment of =s 2DD,DDD and then after one year of
operations the earnings retained out of the profit, i.e., =s 4L,IDD would be added to the e(uity. ?ence
the total e(uity is =s 24L,IDD.
<ow we can easily solve the above given e(uation
+stimated discretionary financing
T estimated total assets $estimated total liabilities- estimated total e(uity
T2JD,DDD-D-24L,IDDT =s.33, IDD
This is the borrowing that we need to raise in form of loan or the e(uity, as a result of
growth in sales.
After calculating the estimated revenues, e!penses, assets and liabilities, we are in a position to
prepare the pro forma cash flow statement. The owners lie to see the company to grow at a steady rate
rather then high growth ' slump scenario. The shareholders prefer those companies where growth rate
is steady and consistent ' the mangers need to mae sure that the growth rate remains steady.
If you want to maintain the forecasted financial ratios that you have calculated and along with this we
do not want additional personal capital to be invested in the business, then at what rate the business is
growing can be calculated by the following formula
G 7De#ire* Gro3t& Rate8 E ret)rn on e2)it( 5 719 .a( o)t ratio8
;ay out ratio as defined above e(uals, dividends&net income.
=eturn on e(uity is net income& total e(uity.
=eturn on e(uity would be discussed in detail when we would study the rate of return ' capital
budgeting.
Dra3ac4 o, /ercent o, +ale# Met&o*$
Despite the fact that percentage of sales method is widely used method for forecasting, it
has certain disadvantages.
The first and the foremost problem with this method is that it is only a rough appro!imation and
is not very detailed. The other problem is that if there is a change in fi!ed assets during the forecasted
period the percentage of sales method would not yield a very accurate answer. The third problem is that
the lumpy assets are not taen into account while using the percentage of sales method. ?ere, lumpy
assets refer to those assets which can only be ac(uired in large discrete units.
Summarizing the above discussion, we can say that in percentage of sales method of
forecasting pro forma cash flow statement most of the heads in the balance sheet are lined to the sales
growth of the business. "irst of all, we need to now the ratios of assets and liabilities to sales for the
current period. These ratios are then applied to the estimated sales for the ne!t period to get a forecast of
assets and liabilities for the ne!t period.
After understanding the dynamics of percentage of sales method, and having prepared the pro
forma income statement and pro forma balance sheet, we are in a position to discuss the forecasted or
pro forma cash flow statement. A pro forma cash flow statement is 0ust lie an ordinary cash flow
statement% the only difference is that the figures in a pro forma cash flow statement are estimated figures
rather than actual ones. The estimated statement is later compared to the real after-effect cash flow
statement to assess the (uality of the estimate.
After calculating the estimated sales revenue, we have already calculated the estimated net
income of the business, multiplying the estimated figure of sales for the ne!t year with the profit margin
ratio. "orecasted net income gives the starting point for an estimated cash flow statement. If the assets
are 3DE of sales and depreciation is2DE of the assets then the depreciation is 2DE multiply 3DE which
is e(ual to 3E of sales. After calculating depreciation at 3E, you can calculate the forecasted
depreciation this will appear in our forecasted cash flow statement. Afterwards we would see the
increases and decreases in current assets and current liabilities. An increases in current assets and
increase in current liabilities can be calculated using constant percentage of sales approach. >e can
compare the forecasted cash flow with the actual cash flow statement to now how much accurate our
estimates are. If we use indirect cash flow then the first thing is our net income plus depreciation, minus
increase in current assets, plus decrease in current liabilities, would provide us with cash flows from
operations.
/RO FORMA CA+: FLO% +TATEMENT
.QDDD =s/ .QDDD =s/ .QDDD =s/
<et Income FDD
Add Depreciation +!pense 2DD
Subtract Increase in ,urrent Assets1
Increase in ,ash .FDD/
Increase in Inventory .LDD/
.22DD/
Add Increase in ,urrent @iabilities1
Increase in A&c ;ayable IDD
,ash "low from -perations .2DD/
,ash "low from Investments D
,ash "low from "inancing IDD
<et ,ash "low from All Activities FDD
<ote 21 Indirect ,ash "low Approach using Income Statement and two consecutive 6alance
Sheets
<ote 31 "inal <et ,ash "low from All Activities should match the difference in the difference in
the closing balances in the 6alance Sheets from Nune 4Dth 3DD2 and Nune 4Dth 3DD3
<ote 41 Investments include all cash sale and purchases of non-current assets and maretable
securities
<ote F1 "inancing includes all cash changes in loans, leasing, and e(uity etc.
Lesson 06
/RE+ENT VALUE AND DI+COUNTING
Learning o!ecti"e#$
After studying this lecture, you would be able to have a better understanding of the following.
;resent 9alue and Discounting
The Topics of this lecture are covered in the chapter J of our te!t boo called "inancial
#anagement theory and practice by +ugene ". 6righam ' @ouis ,. Bapensi.
O!ecti"e# o, .re#ent "al)e$
The ob0ective of calculating the present value is to translate the future cash flows in to present
terms. The basic principle is to compare apples with apples. "or instance, if you have =s.2D in your
pocet today and then you have may as many rupees ten years after, how can you compare the two. Rou
can do it only by comparing both amounts at the ;resent time.
>e choose the present .today/ as the most convenient point in time where we could compare all
the cash flows taing place at various points in time in future. >e must compare everything at the
SA#+ point in time otherwise% we would be neglecting the Time 9alue of money concept.
"or e!ample, =s 2DI is more than =s 2DD 6:T% =s2DI after 2 year may not necessarily be
more than =s2DD todayU >e first have to first bring all cash flows to the ;resent, or Discount them, and
then compare them. The concept of present value says that we can compare both the amounts in the date
of today we will bring bac future cash flows to the present
Di#co)nting$
)Discounting is defined as bringing the future cash flow to the present time*.
6efore answering which amount is greater in the aforementioned e!ample, we need to have
some concept of interest rates or the cost of money. An interest rate can also be understood as an
opportunity cost.
-ne of the simple ways of estimating what opportunity cost or interest rate should be for our
discounting calculations, we can use interest rate given on the ;@S accounts by the bans. "or e!ample,
if money is deposited in a ban and getting 2DE per annum then it is interest or opportunity cost for
you. This interest on ;@S account becomes minimum rate of return which any investment should be
able to generate. Therefore, the investment pro0ect should offer higher rate of return than the returns on
the ;@S account.
<ow let7s see the answer of the (uestion that =s.2DI will be more one year later or =s.2DD
today, and for this, we need interest or opportunity cost. It is important to understand why interest rate is
called opportunity costP 6ecause, opportunity cost essentially means the cost of taing up one option
while sacrificing the other. "or instance, when you deposit your money in the ban and get interest, you
are sacrificing by
.2/ <ot consuming the money to buy something for yourself and
.3/ <ot investing your money elsewhere at a higher return than the ban interest.
:sually when an investment option is taen up, investors forgo the option of depositing the
money in a ban account and earn interest on that. The opportunity lost in this case is the opportunity
cost. <ow the (uestion is that what ind of interest rate should we useP There are many interest rates
(uoted in the schedules of the ban but for discounting, the most commonly used rate is the nominal
interest rate, or A;=.
Intere#t Rate# ,or Di#co)nting Calc)lation#
Nominal 7or A/R8 Intere#t Rate E i nom
A It is usually published in newspapers .Annual <ominal Interest =ate is (uoted for 2
year by ,redit ,ard ,ompanies and @easing ,ompanies because it understates the
actual .or +ffective/ interest you have to pay, these companies want to create an
impression that the interest charged by them is the minimum in the maret.
/erio*ic Intere#t Rate E i .er
;eriodic interest rate is used in "# for Discounting and ;resent 9alue .;9/
calculations. It is defined as
i
per
T . i nominal Interest rate/ & m
>here
m T no. of times compounding taes place in 2 year i.e.
If semi-annual compounding then m T 3
E,,ecti"e Intere#t Rate E i e,,
It is very useful to compare securities and investments with different life or
compounding cycles but not used for Discounting and ;9.
i eff T W2 S . i nom & m /X
m
$

2
>here m T no. of times compounding taes place in 2 year, the compounding cycle. The shorter the
compounding cycle more fre(uently money compounded ' faster the money grows.
,oming bac to our earlier e!ample where we were trying to figure out whether or not =s 2DD of
today are worth more than =s 2DI a year after, while the periodic interest rate is 2D percent per annum. The
interest rate used here would be the nominal interest rate, i.e., 2D percent. >hen we are going to solve for
the present value we are discounting from the future to the present
;9T"9&.2Si/
n

>here, iTinterest rate
<Tno. of years if we plug in the values
;9T2DI&.2SD.2D/2T=s.OI.FI
<ow we can see that if we discount =s.2DI from future to the present that is only the worth of
=s.OI.FI which is less than =s.2DD. The amount offered in the future is seemingly more but when
converted to present value, the worth it has today, it come out to be less than =s 2DD. Thus, it is clear
that =s2DD today worth more to =s. 2DI one year later. This conclusion is drawn on the assumption that
interest rate is 2DE, but if we change the interest rate, the answer might be different.
>ith the help of the following diagram, we can observe the effect of discounting the cash flows.
<ow the point to understand is that if we discount bac this money from 3 years bac we would have
only appro!imate =s.CL in other words if =s 2DI are to be received after two years, the present value of
would be even lesser
If you discount =s 2DI two years from now, you will have lesser amount than you have one
year from today. It is clear from the slide that as more future cash flow occurs distant in time, the more
its present value decreases.
Time - Arro3 Diagram
1 Aear Di#co)nting o, F)t)re Val)e
Time ' Arrow Diagrams are important in visualizing the concept of Discounting
.r /
Toda
0resent
.r (
Interest1 (/2 pa
Time ).ears'
F" 3 &s+ (/)
0" 3 &s 4)+5)
6iscounting
,ash inflows .Income, other income ' cash profits/ shown with upward pointing arrow
,ash outflows .e!pense/ shown with downward pointing arrow
Di#co)nting Ca#& Flo3# o, a 0)#ine##< In"e#tment< or /ro!ect$
@et7s tal about the discounting cash flow of the business as to how we would estimate the cash
flow business can generateP ?ow can we calculate the maret value and intrinsic value of a business or
woring assetP There are two steps involved
2/ "orecast future cash flows of any business, investment, or pro0ect by using percent of sales
method.
3/ Discount the net cash flows bac to the present time.
The two-step process here can be elaborated by the following hypothetical e!ample.
Ca,e Ca#e +t)*($
Suppose you are thining about starting a small caf\ or canteen inside a university campus. Rou
mae a simple feasibility report showing the estimated initial investment and the forecasted cash flows
for the first Rear .based on e!pected cash receipts from sales and cash payments for e!penses/.
T&e =e( Financial Data i# a# ,ollo3#$
A Initial Investment T =s 2DD,DDD
A "orecasted ,ash =eceipts .end Rear 2/ T =s 3DD,DDD
A "orecasted ,ash ;ayments .end Rear 2/ T =s ID,DDD
A "orecasted "uture Investment .end Rear 2/T=s4D,DDD
A ;eriodic Interest =ate .-pportunity ,ost/ T 2DE p.a.
"irst step is to represent the phenomenon through a diagram in the form of cash out flows.
"irst of all, we can see the initial investment represented by the downward arrow. >e have also
forecasted the sales one year from now that is =s.3DD, DDD. This is a cash inflow for the business and is
represented by an upward arrow% similarly, the e!penses and investments .cash outflows/ that we e!pect
in future, will be shown by the downward arrows. In the diagram there are three arrows, the upward one
is showing forecasted sales .cash inflow/ and two arrows downward show e!penses of =s.ID, DDD and
invest outlay of =s.4D, DDD respectively. <ow the combined effect of the three arrows can be
represented by a single arrow. >e can see that cash inflow of =s.3DD,DDD is having a Sve sign and
e!penses of =s.ID,DDD and investment out lay of =s.4D,DDD have $ve signs and finally, by deducting the
negative signed figures from the positive one we can arrive at the net effect of the cash inflows and
outflows, which is given as under
3DD,DDD-ID,DDD-4D,DDD T=s 23D,DDD.
These different arrows can be added or subtracted because they are occurring at the same point
of time and =s.23D, DDD can be shown by one arrow sign. In order to calculate the present value of
=s.23D, DDD, rate of interest as discount factor should be 2DE per year.
Cash Flo# 6iagram Caf7 Example
.r (
Interest1 (/2 pa
&eceipts 3 &s+ 8//*///
.r /
0aments 3 &s )/*///
Future Investment 3 &s 9/*///
Initial Investment 3 &s (//*///
:se 6o#n#ard 0ointing Arro#s to sho# Cash Outflo#s )Cash
0aments or Investments'+ :se :p#ard 0ointing Arro#s to sho#
Cash Inflo#s )Cash &eceipts'
Simplified Cash Flow Diagram Caf !ample
.r (
Interest1 (/2 pa
;et Cash &eceipts 3 CF( 3 F"(
38//*///$)/*///$9/*/// 3 &s (8/*///
.r /
After com,ining all Cash Flo#s
for .ear 8 into one ;et Cash
Flo# Figure )CF('* ou are
read to no# 6iscount it to the
0resent<
Calc)lating t&e N/V
o, t&e Ca,I 0)#ine## ,or 1#t Aear$
<;9 T <et ;resent 9alue .taing Investment outflows into account/
<;9 T ]Initial Investment S Sum of <et ,ash "lows from +ach "uture Rear.
<;9 T ] Io S;9 .,"1/ S ;9 .,"2/ S ;9 .,"C/ S ;9 .,"H/ S ...S ^
<ote that ;9 .,"1/ means the ;resent 9alue of "uture <et ,ash "low .,"/ taing place at the
end of Rear 2. ," is lie the "9 in our interest formulas. -ur compounding cycle is 2 year so the
;eriodic Interest =ate is 2DE.
;resent 9alue of <et ,ash "low from Rear 2 T
;9 .,"1/ T ,"2 & .2S i/
n
T 23D,DDD & .2SD.2/
1
T =s 2DO,DDD
The value of money has shrin from =s.23D, DDD to 2DO,DDD as the concept of time value of the
money suggests and now we are in position to calculate the net present value of the money1
<;9 T - Io S ;9 .,"1/ T ]2DD,DDD S 2DO,DDD T S =s O,DDD
The <;9 of our 6usiness after 2 Rear is ;ositive =s O,DDD which is a good sign. >e will
discuss this topic in more detail in capital budgeting.
Lesson 07
DI+COUNTING CA+: FLO% ANALA+I+< ANNUITIE+ AND /ER/ETUITIE+
Learning O!ecti"e#$
Di#co)nte* Ca#& Flo3# 7DCF Anal(#i#8
Ann)itie#
/er.et)it(
This lecture is continuation of the previous lecture7s topics. In the previous lecture, we had
discussed the calculation of the <et ;resent 9alue .<;9/ and the use of the value of interest rate or
-pportunity cost in the process. 6an Interest on the ;@S Account represents the #inimum -pportunity
,ost of our investment. A good investment opportunity should, however, offer a higher return than the
6an Interest rate. >e also used the time ' arrow diagram to show the cash flows forecast. In the
diagram, we used upward pointing arrow to represent the cash inflows ' downward pointing arrow are
used to represent the cash outflows. Rou can simplify that diagram by arithmetically solving the upward
' down ward pointing arrows at same point in time by showing it with one arrow. .see "ig/
The arrows in time-and-arrow diagram can be added and subtracted when they are on same
point in time but when these arrows are at the different point of time these cannot be added or
subtracted. <ow, let7s tal about some common cash flow patterns the most common is called annuity.
Ann)it($
An ann)it( is a series of fi!ed payments, which might be over a fi!ed number of years, or over
the lifetime of an individual, or both. The commonly nown types of annuities we see are the monthly
rent, and monthly mortgage payments, or insurance premiums.
There are two types of annuities
1> Or*inar( Ann)it(
An ordinary annuity, also nown as deferred annuity, consists of a series of e(ual payments at the end of
each period.
2> Ann)it( D)e
An annuity due consists of a series of e(ual payments at the beginning of each period.
Cash Flow Diagram Recap of Caf Example
.r (
Interest1 (/2 pa
&eceipts 3 &s+ 8//*///
.r /
0aments 3 &s )/*///
Future Investment 3 &s 9/*///
Use Downward Pointing Arrows to show Cash Outflows (Cash Payments or Expenses
or Investments! Use Upward Pointing Arrows to show Cash Inflows (Cash "e#eipts
ie! Cash "evenue or In#ome
.ear (1 9 Cash Flo# Arro#s
at one point in time can ,e
simplified into ( ;et Cash
Flo# Arro#1 8//*/// $
)/*/// $ 9/*/// 3 =(8/*///
Ann)al Com.o)n*ing 7at en* o, e"er( (ear8$
FV T ,," .2 S i/
n
- 2
"or e!ample, the payment of =s.2D,DDD as monthly rental to the land lord is an annuity which
gives birth to an annuity stream. "uture value of an annuity can be seen as follows1
"uture value of annuity Tcon#tant ca#& ,lo3# 5 71Fi8
n
91?i
>here, iTinterest rate
nTno. of years
>e can write this formula in smaller compounded form which describes a compounding cycle given as
under1
M)lti.le Com.o)n*ing$
"uture 9alue of annuity TCCF 7con#tant ca#& ,lo38J71F 7i?m8
mJn
91?i?n
-nce we have calculated the future value of the annuity, it is very easy to calculate the present
value using the well-nown interest rate formula.
Annual ,ompounding .at end of every year/
/V EFV ? 71 F i 8
n
> n E li,e o, Ann)it( in n)mer o, (ear#
#ultiple ,ompounding1
/V T"9 & W2 S .i&m/X
m5n
i T E interest per year
$ #ore than once per year i.e. #onthly .m T23/, Vuarterly .mTF/, Si!-monthly .mT3/.
n T number of years
<ow let7s tal about another ind of cash flow pattern called perpetuity.
The difference between Annuity and ;erpetuity is that the ;erpetuity is an ongoing concern, it is never
ending stream of annuities, whereas an annuity is for a limited period.
/er.et)it($
)It is defined as an annuity with an infinite life maing continual payments.*
In real life, we see the e!ample of perpetuity in the retirement plan. "or +!ample, you might
plan to save a sufficient amount of money ' invested in a particular security or investment that will give
you steady ' consistent rate of return on every month or (uarter and this represents a constant cash flow
amount that we can assume to go as long as you live. Since we are not sure how far we are going to live
and we mae an infinite series of annuities the formula of "uture value of ;erpetuity is simpler than that
of annuity1
F)t)re "al)e o, .er.et)it(Econ#tant ca#& ,lo3?intere#t rate
As we assume that, it is never ending and on going so time is irrelevant and is simply dropped
out of the e(uation.
Annuit
$alue of Annuity depends on the Constant Cash %lows (CC% (over a limited or finite
period of time and the Dis#ount %a#tor (whi#h is different for Annual or &ultiple
Compounding
Time >ine ).ears'
CCF CCF CCF CCF CCF
.r ( .r 8 .r 9 .r 5 .r )
Ordinar Five .ear Annuit
@et7s do a simple numerical e!ample which will help us what an annuity calculation is lie
E5am.le$
Assume that we need to mae a basic financial decision, whether to purchase a particular asset
or to get it on lease .installments/.
A car has a #aret 9alue today of =s 2ID,DDD. If you get the car on @ease "inancing, then you
are re(uired to pay a fi!ed regular rental at a fi!ed interest rate to the @easing ,ompany. Rou are
allowed to use the car but the ownership of the car stays in the name of the @easing ,ompany until you
complete all your rental payments. T&e 2)e#tion i# whether you should @ease the car or 6uy itP
The @easing ,ompany (uotes =s 23D,DDD every year for 3 years in the form of ,ar @ease
=ental at a <ominal rate of interest .A;= interest rate/ of 3DE pa. Then what is the total "uture 9alue
you would have paid after 3 yearsP Rou would be paying appro!imately =s 3FD,DDD if you do not tae
into account the time value of money.
<ow we calculate the present value of the investment by using Time value of money concept.
"irst, we need to calculate the future value by using annuity formula
"9 T,," W.2Si/
n
- 2X& i
T23D,DDDW.2SD.3/2 -2X&D.3
T =s 3JF,DDD .yearly compounding/
If we deposit the amount annually in a ban at the rate of 3D percent, we would be able to get =s
3JF,DDD at the end of the second year. <ow we will calculate what the present value of this future value
is going to be, and for this, we will use the old interest rate formula
;9 T "9 & .2Si/
n
T 3JF,DDD & .2SD.3/
2

T =s 2C4,444
The resulting amount is about =s 44,DDD more than what we would have originally paid if we
had bought the car rather than lease it
The above calculation, however, was not based on realistic assumptions because car lease
rentals are generally paid monthly, rather than annual payments. In fact, you pay =s 2D,DDD per month
for 3 years. >e use periodic interest rate .i&m/. <ow, what is the future value after 3 yearsP -ur cash
flow diagram should present the monthly installments ' not annual ;ayments.
Commo Cash Flow !a""ers !erpe"#i"$
0erpetuit
;ever-ending Annuit+ It is a 0erpetual or
Infinite stream of Constant Cash Flo#s
)CCF' at regular intervals+
"# 3 CCF
i
;ote1 For 0erpetuit #hose CCF is gro#ing at constant
annual gro#th rate 2 ?g@ 1 "# $ CCF % &i ' g(
CCF CCF CCF CCF CCF
.r ( .r 8 .r 9 .r 5 .r )
CCF
.r A Infinity
CCF
It can be argued that by paying a rental of 2D,DDD monthly, we are actually paying =s 23D,DDD
in a year, so there hardly any difference. 6ut, by not realizing the difference, one is violating the time
value of money because cash flows occurring at different points of time cannot be subtracted or added.
It is the cardinal principle of Time value of money.
If we have to calculate the future value of the annuity on a monthly basis, we would use the
following formula.
T,," Y _W.2Si&m/
n!m
-2X& .i&m/`
<ow the mT 23 compounding cycle in a year
;utting the values in the formula, we obtain the result as under.
"93T=s 3O3,2ID
<ow, we can calculate the present value of the future value of annuity
;9 T "9 & .2Si/ n

T3O32ID&.2S.3&23/3!23
T2OJ,FC2
The present value of annuity can also be called the intrinsic value of the annuity.
The aforementioned techni(ue allows us to compare the amount of money we are paying to
leasing company with the maret value of car. It helps you to decide whether you should buy the car on
maret price or to get it leased. The cost of leasing at 3DE p.a. tell us that you have to pay 3DE interest
' you have to pay more money in leasing as compare to the decision if you buy it .
/er.et)it( E5am.le - =etirement ;lanning
Rou would lie to retire at the age of JD and receive an income of =s. 3DD,DDD every year from
your 6an Account for as long as you live. ?ow much money do you need to deposit in the 6an
Account offering 2DE pa so that the Account will pay you =s 3DD,DDD of interest income every year
forever .even though you will not live forever/U
A ;9 T ,," & i T 3DD,DDD & D.2D T =s 3,DDD,DDD
This also implies that you would be receiving =s 3DD,DDD every year for the rest of your life and
the money would neither finish nor decrease in amount. This would happen so, because what you would
be receiving at the end each year would be interest accrued on the investment that you have made. The
money that you are getting is not a part of the investment% instead, it is the yield on your investment.
This may sound lie a Qbig idea7 for maing money, but in fact, it is not so. Inflation, a macroeconomic
syndrome erodes the value of money constantly. If the prevailing inflation rate is I percent, then your
real return on investment is not 2D percent. If we consider the real rate of return, which is interest rate $
rate of inflation, you would see that you need to invest twice as much to guard yourself against inflation.
Bonthl >ease &entals Example )nnuit* - Cash Flo# 6iagram
Time >ine ).ears'
Rr 2 Rr 3 Rr D
,," T #onthly =entals
T =s 2D,DDD
"93 T =s 3O3,2ID
;9 T =s 2OJ,FC2
Interest T 3DE pa
Step 21 6ring All the ,ash
"lows "orward to Rear 3
.because formula is written
in terms of "9/.
Step31 Discount the
,ombined ,ash "low at
Rear 3 bac to the ;resent
Step 2
Step 3 .3F 0umps bac/
Another e!ample for perpetuity is ,onsol 6onds. ,onsol 6onds were issued by the 6ritish
Bovernment in 2C
th
century to pay off the smaller bonds that were issued to fund the wars against
"rance. Since the purpose of the bond was to consolidate the past debts, it was named as ,onsol. These
bonds were 0ust lie other bonds issued by the government, with the difference that it had no maturity. It
implies that the holder of the bond was to receive regular interest payments for an endless period.
<ow if we have to invest in such a bond we need to now the price or the present value of the
bond. Dividing the interest payment that a ,onsol bondholder would receive, by the interest rate, we can
find the present value of a ,onsol bond. Suppose that the interest rate is at 2D percent and the promised
interest payments to be received are a 2,DDD every year, the price of the bond can be calculated as under
A ;9 T ,," & i T 2,DDD& D.2D T a 2D,DDD
>ith this e!ample, the discussion on discounted cash flows, annuities, and perpetuities is
concluded. >e would study the capital budgeting techni(ues in the ne!t lecture.
Lesson 08
CA/ITAL 0UDGETING AND CA/ITAL 0UDGETING TEC:NIDUE+
Learning O!ecti"e$
Ca.ital 0)*geting
Tec&ni2)e# o, Ca.ital 0)*geting
Today, we will discuss ,apital 6udgeting[one of the most important topics in financial
management.
,apital budgeting is about investment in fi!ed assets. In addition, another type of investment could
be in woring capital, which we would study later. "i!ed assets are the part of long-term assets in the
balance sheet and woring capital is net position of current assets and current liabilities on the balance
sheet.
>e need to understand why capital budgeting is so important and why do we have to invest in fi!ed
assetsP The answer is simple% the e(uipment or machinery and other fi!ed assets depreciate over a
period, they lose their productivity and get obsolete after sometime. These assets need to be replaced
with new assets. This replacement involves investment in fi!ed assets.
#oreover, if a company intends to start a new pro0ect, ,apital 6udgeting techni(ues are employed
to assess the financial viability of the pro0ect. Suppose, for instance, a company wants to introduce a
new soap and launching of the new product demands changes in the manufacturing process, the
company will have to purchase new e(uipment in the form of fi!ed assets. ,apital budgeting is a
techni(ue used to evaluate the value of investment and pro0ects in fi!ed assets. It is also used to assess
the woring capital re(uirements. ,ombined together it helps the company management to decide
whether the new venture should be taen up or not.
,apital budgeting is a decentralized function. In big corporations, this function is not an individual7s
0ob, rather, different departments and teams are assigned to wor on different aspects of capital
budgeting. Department managers prepare the budget for fi!ed assets in coming years, which is (uite
helpful in capital budgeting. 6esides, there are pro0ect managers who mae the budget for a new pro0ect%
the cost accountants Qcount the cost7 and assess the e!penses to be incurred% the maret researches
provide their input about the consumer psychology and sales potential. There may be as many
departments involved in capital budgeting, as there are present in an organization.
The biggest challenge in capital budgeting is to eep finding the valuable pro0ects, i.e., pro0ects that
may add to the value of the firm. Rou must be familiar with the basic ob0ective of financial management
by now, which is to ma!imize shareholders7 wealth. This is possible only by investing in the pro0ects,
which have positive net present value, which in effect will increase the shareholders7 wealth.
#ost of the developed companies operate in an efficient maret environment. >e will discuss
efficient marets at length after studying the concept of ris ain to financial decisions. ?owever, to
give you an idea, e,,icient mar4et# can be described as highly competitive marets where good
business ideas are taen up immediately.
"or instance, in ;aistan, about ten to fifteen years ago there was a video game craze. It was initially
a good business idea, as it re(uired a very low-level investment, good profit margins, and short paybac
periods. ?owever, since the marets in ;aistan are (uite efficient, the information about the business
spread (uicly. #ore and more people started entering into the business and as a result, the profit
margins started shrining and the lucrative business opportunity faded out in three or four years.
The same situation comes across the departmental heads of different companies. They may start a
new lucrative pro0ect, which may sound more than feasible at a given time. ?owever, the competitors
get to now the new business opportunity, and because of maret efficiency, those lucrative profits do
not remain lucrative anymore.
Tec&ni2)e# o, ca.ital )*geting$
,apital budgeting is a mathematical concept in the sense that we have to use different
(uantitative investments criteria to evaluate whether an opportunity is worth investing in or not.
Some of these techni(ues of capital budgeting are as under
2. ;ay bac period
3. =eturn on investment .=-I/
4. <et ;resent 9alue .<;9/
F. ;rofitability Inde! .;I/
I. Internal =ate of =eturn .I==/
>e will assume that the interest rate, or the discount rate, or the re(uired of return, which we use in
calculating the net present value is given, later on, when we will discuss the concept of ris, we would
see how the discount rate is calculated .
"or now, let us tal about the pay bac period.
/a( ac4 .erio*$
In this techni(ue, we try to figure out how long it would tae to recover the invested capital
through positive cash flows of the business.
=everting bac to the cafe e!ample, an initial investment of =s. 3DD,DDD is re(uired to start the
business% =s 2D,DDD per month are e!pected to be earned for the first year, and =s 3D,DDD would be
earned every month in the second year.
<ow according to the aforementioned assumptions, in the first year, you earn =s.2D, DDD per
month, which mae =s. 23D,DDD for the year .twelve months/. Since you had invested =s. 3DD,DDD
initially of which =s. 23D,DDD have been recovered in the first year, you are still =s.CD, DDD short of
recovering your initial investment. In the second year, you would be earning =s. 3D,DDD per month, so
the remaining =s. CD,DDD can be recovered in the ne!t four months. >e can say that the initial invested
capital can be recovered in 2J months, or the paybac period for this investment is 2J months. The
shorter the paybac period of a pro0ect, the more an investor would be willing to invest his money in the
pro0ect.
>hile the paybac period is a simple and straightforward method for analyzing a capital
budgeting proposal, it has certain limitations. "irst and the foremost problem is that it does not tae into
account the concept of time value of money. The cash flows are considered regardless of the time in
which they are occurring. Rou must have noticed that we have not used any interest rate while maing
calculation.
<ow, let us tal about the ne!t budgeting criteria called return on investment.
Ret)rn on In"e#tment#$
The concept of return on investment loosely defined, as there are a number of ratios that can be
used to analyze return on investment. ?owever, in capital budgeting it implies the annual average cash
flow a business is maing as a percentage of investment. In other words, it is an average percentage of
investment recovered in cash every year.
The formula for return on investment is as follows1
ROIE 7KCF?n8?IO
Dividing the average annual cash flow by the initial investment, we can calculate the return on
investment.
E5am.le$
8 ,opyright 9irtual :niversity of ;aistan FD
Taing the same e!ample of a caf\, the initial investment of =s.3DD,DDD, =s 2D,DDD per month
profit in the 2
st
year in =s 3D,DDD per month profit for the second year, we can easily calculate the =-I.
=-IT ..23D,DDDS3FD,DDD/&3/&3DD,DDDT D.OD T ODE
>here, =s 23D,DDDTcash flow for 2
st
year at =s 2D,DDD per month
=s 3FD,DDDTcash flow for the 3
nd
year at =s 3D,DDD per month.
nT3 years
=eturn on Investment is also very easy to calculate, but lie paybac period, it does not tae into
account the time value of money concept.
A high =-I ratio is considered better and ODE is a very good rate of return but before
deciding whether or not this pro0ect should be taen up, we should compare this pro0ect with the
alternative opportunities on hand. It is also important to tae into consideration the prevailing rate of
inflation in the country so that the returns could be ad0usted accordingly. ?owever, we would tal about
the inflation rate and maret interest rate in more detail later.
The ne!t and the most important criteria for evaluating a capital budgeting proposal is net present value.
Net /re#ent Val)e 7N/V8$
<;9 is a mathematical tool which uses the discounting process, something that we have found
missing in the aforementioned capital budgeting techni(ues. <et ;resent 9alue is defined as the value
today of the F)t)re Incremental A,ter9ta5 Net Ca#& Flo3# less the initial investment.
The formula for calculating <;9 is as follows1
N/VE9IOFKCFt? 71Fi8
t
>here,,"
t
Tcash flows occurring in different time periods
-I-T Initial cash outflow
iTdiscount &interest rate
tTyear in which the cash flow taes place
Initial cash outflow, being an outflow, is always e!pressed as a negative figure.
<;9 is considered one of the most popular capital budgeting criteria. The disadvantage with the
<;9 is that it is difficult to calculate since these calculations are based on too many estimates.
In order to calculate the <;9 we need to forecast the future cash flows and sales% the discount factor is
also an estimate. If the <;9 of a pro0ect is more than zero, it should be accepted. If two or more pro0ects
under contemplation, then the one with the higher <;9, should be accepted. >hen a company invests in
pro0ects with positive <;9, they raise the shareholders7 wealth or company7s value. This would also
increase the maret value added and the economic value added for the firm.
E5am.le$
Taing the same e!ample of a caf\, an initial investment of =s.3DD, DDD, =s 2D,DDD per month
profit in the 2
st
year in =s 3D,DDD per month profit for the second year. ?owever, for the calculation of
the <;9 we would be re(uiring another important input[the discount rate. Assume the discount rate is
2D percent. Ten percent is what you at least e!pect to earn from the business. This is the rate of return,
which you can get by simply putting your money with a ban. If the business cannot yield more than 2D
percent, then it is pointless to tae unnecessary headache of setting up a business and running it, since
ten percent can be earned with a no-sweat-effort of placing the money with a ban.
>here,,"
t
Tcash flows occurring in different time periods, i.e., =s 23D,DDD in the first year and =s
3FD,DDD in the second year
-I-T Initial cash outflow T -3DD,DDD
iTdiscount &interest rate T 2D percent
8 ,opyright 9irtual :niversity of ;aistan F2
tT 3 years
;utting in the values in the formula
<;9T-I-Sb,"&i
T-3DD,DDDS23D,DDD&.2SD.2D/S3FD,DDD.2SD.2D/
3
T - 3DD,DDD S 2DO,DO2 S 2OC,4FL
TS=s.2DLF4C
At the end of 3
nd
year, the <;9 is Sve, you can also solve this e!ample by monthly
compounding if you want to have a more precise answer.
The cash flows at the end of the first year and second year will have to be brought bac to the present.
The present value of the cash flows occurring at the end of the first year can be calculated by dividing
the cash flows by 2 plus discount factor as under.
23DDDD&.2SD.2D/ T 2DO,DO2
The cash flow occurring at the end of the second year can be calculated by dividing the cash
flow by one plus discount factor s(uared.
3FD,DDD&2S.D.2D/
3
T 2OC,4FL
<;9T-3DDDDDDS23DDDD&.2SD.2D/S3FDDDD&.2SD.2D/3
T-3DDDDDS2DODO2S2OC4FL
TS=s.2DLF4C at the end of second year <;9is Sve
In other words, according to your cash flow forecast and re(uired return, two years of running this
business is worth =s 2DL,F4C in cash to you today. The following diagram can e!plain the point further.
The ne!t criterion that we would tal about here is the profitability inde!, or the cost-benefit ratio.
/ro,itailit( In*e5$
It is (uite similar to the <;9 in terms of concept and calculation. ;rofitability inde!
may be defined as the ratio of the present value of future cash flows to the initial investment.
The profitability inde! can be calculated using the following formula.
/I E LM CFt ? 71F i8
t
N? IO
Investment Criteria ;+0+" )Caf7 Example $ Cash Flo#
6iagram'
.r / )Toda' .r ( .r 8
CF8 3 &s
85/*///
CF(3&s (8/*///
Io 3 &s
8//*///
i 3 (/2 i 3 (/2
&s (4C*95D
&s (/4*/4(
N"# $ +s
10,-./0
Those pro0ects with a profitability inde! ratio of more than one .;I cT 2.D/ are considered
acceptable. ?ere it is important to mention that those pro0ects, which are raned as acceptable using the
<;9 method, would also be acceptable on the profitability inde! criteria.
E5am.le$ The profitability inde! for the caf\ e!ample can be calculated as under.
;I T W23D,DDDX& .2S D.2/ S W3FD,DDD & .2S D.2/
3
X&3DD,DDD
T .2DO,DO2 S 2OC,4FL/ & 3DD,DDD T 2. IF
;I T 2.IF c 2.D
Therefore, the pro0ect is acceptable. <otice that we have taen into consideration the annualized
return. The same can be calculated using the monthly returns with a slight ad0ustment in the formula as
we have studied in the previous lectures. If there were two or more pro0ects that need raning, the one
with the highest profitability inde! would be acceptable.
@et us now tal about the fifth and the final capital budgeting criteria of our course, nown as Internal
=ate of =eturn .I==/.
Internal Rate o, Ret)rn 7IRR8$
I== is a widely used and an important measure, which is more common in practice than the
<;9. I==, unlie <;9 that is e!pressed in dollar amounts, is always (uoted in terms of percentage,
which maes it comparable to the other maret interest rates or the inflation rate.
== calculation involves the same e(uation that we have earlier used for the calculation of <;9.
The only difference is that while calculating I== we would set the value of <;9 e(ual to zero and then
solve the e(uation for the value if Qi7. In other words, the value of Qi7, at which the net present value of
the pro0ect e(uals zero would be considered as the internal rate of return of the pro0ect.
his is important to remember that unlie <;9 calculation, the value of I== is constant in every
year for the life of the pro0ect. >hile woring out the <;9, we can change the discount rate for every
single, but for I== you would come up with a rate that is constant and fi!ed for every single year in the
life of the pro0ect. Another simplistic e!planation of I== can be that it is the brea-even rate of return.
In other words, at this rate of return, we would be able to recover the initial investment in pro0ect7s
lifetime.
== is calculated by a trial and error method or iteration. "inding the value of an unnown
variable may involve solving of higher degree polynomial e(uations and the easiest way to go about it is
to use trial and error method.
n a trial-and-error method, we tryout a value of Qi7, and see if the e(uation comes to the value of
zero% if it does not, try another value, even if the second value does not bring the e(uation down to zero
and so on. The higher the I==, the better it is considered, however, which value of the I== can be
considered as acceptable is difficult to measure. >e would discuss more details of it in the coming
lectures.
Another important distinction needs to clarification here is that the internal rate of return is
different from the discounting rate that we use in the calculation of the <;9. In the <;9 formula, we
used the discount rate as the re(uired rate of return that we e!pected the pro0ect to generate. In case of
I==, we used the e!isting cash flows to find the forecasted return. These two different interpretations of
Qi7 should be ept in mind while calculating <;9 and I==.
>e can calculate the I== for the caf\ pro0ect in the following manner. :sing the same formula of <;9,
we can put the values in the formula
IRR E2)ation$
<;9T -I- S,"
2
& .2SI==/ S ,"
3
& .2SI==/
3
T DT -3DD,DDD S 23D,DDD& .2SD.2/ S 3FD,DDD& .2SD.2/
3

Solving the e(uation assuming I== to be 2D percent, we have obtained a figure of 2DL,FC4, which was
calculated as our <;9 for the caf\ pro0ect. ?owever, in order to bring the <;9 down to zero, we need
to apply a higher rate as an assumed I==. If we assume I== to be ID percent the e(uation can be solved
as follows.
<;9T -I- S,"
2
& .2SI==/ S ,"
3
& .2SI==/
3
T DT -3DD,DDD S 23D,DDD&.2SD.I/ S 3FD,DDD&.2SD.I/
3

The calculation gives us a figure of -24,444, which is lesser than zero. In order to bring the value e(ual
to zero we would use a rate lesser than ID percent.
Trying out various I== rates, we can finally reach a rate of F4.J percent at which the value of
<;9 would come down to -FC which is close to zero. If we try out I== with more decimal places, we
can bring the value of <;9 e(ual to zero. ?owever, with appro!imation, F4.J percent is the actual I==
of the pro0ect.
Send you (uery to registrar.
#ore details about the I== and the <;9 would be discussed in the ne!t chapter.
8 ,opyright 9irtual :niversity of ;aistan FF
Lesson 09
NET /RE+ENT VALUE 7N/V8 AND INTERNAL RATE OF RETURN 7IRR8
Learning O!ecti"e$
In this lecture, we will discuss in detail the previous lecture topics that are
Net /re#ent "al)e 7N/V8
Internal Rate o, Ret)rn 7IRR8
Net /re#ent "al)e 7N/V8$
The most important sill in this course is to understand the <;9 e(uation and to calculate <;9
as reliably as possible. It is also the most important criteria in capital budgeting. It is very difficult to
calculate because different inputs used in <et present value e(uation are based upon a forecast, which
may or may not be accurate e.g. future cash flows and sales. Similarly, when we tal about the life of
the pro0ect, again we are estimating the duration of the pro0ect. >e also have to choose sub0ectively the
discount rates to be used, including cost of capital, opportunity cost ' re(uired rate of return in the
calculation of <et present value. >e will discuss how to choose the interest rate when we would tal
about ris. In <;9 the idea is to bring bac each cash flow to the present and then to add or subtract
them on present time. The pro0ect or investment, which is offering the highest <;9, gets the highest
ran.
Form)la$
N/V E 9Io F CFt ? 71Fi8
t
E 9Io F CF1?71Fi8 F CF2?71Fi8
2
F CFO ?71Fi8
C
F>>
Im.ortance o, N/V in term# o, o!ecti"e# o, Financial Management$
The ob0ective of "# is to ma!imize the shareholders wealth. <ow, there is a direct lin between
shareholder wealth ma!imization ' <;9. It is mentioned earlier that the value of an asset is determined
by the future cash flows it generates. >e used these future cash flows ' discount them to present and
we call that the <;9. ?ence, there is a direct lin between <;9 and future cash flows.
>hen the management of the company invest in the Sve <;9 pro0ects, they increase the economic
value added .+.9.A/ and they also increase maret value added .#.9.A/. It should be clear by now that
when company invest in Sve <;9 pro0ects they brings in value to the company. Increase in the value of
the company implies increase in shareholders7 wealth.
E5am.le$ @et us suppose that you invest =s 2DD,DDD in a Savings ,ertificate. After 2 Rear you will
receive a coupon payment .or profit/ of =s 23,DDD and you also reclaim your initial investment
.principal/.
+ol)tion$
Step 21 Identify the 9ariables1 Io T =s 2DD,DDD ,"2T=s 23,DDD @ife T nT2year =e(uired =ate
of =eturn T i T2DE .assumed/, Annual compounding. ," I2 T =s 2DD,DDD
?ere, we assume that iT2D because which is the opportunity cost as you can place that money in
a ban and can earn 2DE. Do not forget that you get bac your principal investment after 2 Rear. This
is a positive cash flow and must be discounted bac to the present 0ust lie any other future cash flow/.
Step 31 Solve the <;9 +(uation
N/V E 9Io F CF1 ? 71F i8 F CF I1 ? 71F i8
T -2DD,DDD S 23,DDD& .2SD.2D/ S 2DD,DDD& .2SD.2D/
T -2DD,DDD S 2D,ODO S OD,ODO
T S =s 2,C2C <;9 positive so investment acceptable
NOTE$ /V E N/V F Io T 2,C2C S 2DD,DDD T =s 2D2,C2C
8 ,opyright 9irtual :niversity of ;aistan FI
In diagram initial downward sloping arrow shows the cash out flow and after one year two
upward pointing arrows .2. profit 3.return of initial investment/ show the cash inflows.
<ow let us tal about the Internal =ate of =eturn or I==.
Internal Rate o, Ret)rn or IRR$
I== is a very commonly used criterion for capital budgeting. It is popular with the managers
because it gives a very simple answer in the form of annual percentage and you can compare it to the
inflation rate, cost of capital or financing or to the certain financial accounting ratios. The formula uses
trial ' error method. >e tal about the interpretation of I== in the coming lectures.
The formula is similar to <;9
N/V E 0 E 9Io F CFt ? 71FIRR8
t
E 9Io F CF1?71FIRR8 F CF2?71FIRR8
2
F ..
The value of i where <;9 is zero is the value of I==.
I== represents the 6rea-even =eturn on Investment, but the important thing to remember is the
difference between I== ' <;9. >hen you are raning different pro0ects the raning you get from <;9
may be different from the raning you get from I==, because, there is a ma0or difference of
interpretation of i between <;9 and I==.
The difference is that in the case of <;9% we are e!ternally specifying the discount rate based
on re(uired rate of return. In <;9 calculations, you have an idea of your opportunity cost for the capital
' you use it as Qi7. As mentioned earlier that rate given by the bans on account is considered as
opportunity cost of your capital ' you will invest in any pro0ect, which earns more than the rate offered
by a ban. ?owever, in I== i is derived from the cash flow pattern of the pro0ect. =emember that in
I== pro0ect, we do not e!ternally specify the interest rate but we calculated it from the cash flows.
Therefore, in the I== it is what you called forecasted rate of return or an intrinsic rate of return. This is
an important difference to eep in mind between <;9 ' I==.
E5am.le$
,onsider the Same Savings ,ertificate e!ample for I== calculation. The only difference is that
this time, we will not assume any value for )i* as we had done in the <;9 calculation.
>e set the <;9 T D and solve the e(uation for PiQ 7or IRR8>
<;9 T D T -Io S W,"
2
& .2SI==/X S W,"I
2
& .2SI==/X
>e add =s 23,DDD ' =s 2D,DDD as both appearing at the same time.
D T -2DD,DDD S W.,"
2
S ,"I
2
/ & .2SI==/X
D T -2DD,DDD S W.23,DDDS2DD,DDD/ & .2SI==/X
I==T .223,DDD & 2DD,DDD/ - 2
.<o need for trial ' error because you have one variable ' one unnown/
T 2.23 - 2.DD T D.23 T 23 E per annum
Is that a good I==, a high I== or low I==P These things we will discuss in this ' in the ne!t
lecture. <ow, one very important thing, which you need to consider when you are evaluating an
investment proposal, is to loo at <;9 ' to see how it changes as you change the discount rate .This is
nown as <;9 ;rofile .See "ig./. @ogically, when you increase the discount rate, the denominator
8 ,opyright 9irtual :niversity of ;aistan FJ
'P$ Cash %low Diagram (avings Certifi#ate
Example
Rr D .Today/ Rr 2
,"I2 T =s
2DD,DDD
,"2T =s
23,DDD
Io T =s 2DD,DDD
i T 2DE
=s OD,ODO
=s 2D,ODO
N/V E
R#>1<R1R
becomes larger ' you net present value becomes smaller. >hat you find as a result is a downward
sloping line. The point where the <;9 is zero would be the I== for the pro0ect.
Gra.&ical IRR E#timation
U#ing PN/V /ROFILEQ
:sing a low and a high value for )i*, plot two points on the graph and e!tend the <;9 line. >here the
line cuts the horizontal !-a!is would be reflect the value of the I==.
U#e t&i# Gra.&ical Tec&ni2)e 3&en$
2. The investment or pro0ect life is longer than 3 years.
3. Braphical techni(ue very useful in I== calculations as there are polynomial e(uations that are
time consuming to solve algebraically in terms of )i*.
4. ,omparing the <;97s of 3 or more investments, to study how sensitive the <;97s of the
different investments are to the discount rate )i*
The ne!t issue is the raning of different pro0ects, which means given a choice of more than one
investment, which pro0ect is the best to invest in.
RAN=ING T%O DIFFERENT INVE+TMENT+$
%&ic& In"e#tment i# etter'
@et us ran two #utually +!clusive ' Independent Investments using <;9 and I== criteria
M)t)all( E5cl)#i"e$ means that you can invest in -<+ of the investment choices and having chosen
one you cannot choose another.
In*e.en*ent$ implies that the cash flows of the two investments are not lined to each other
E5am.le$
@et us consider two investment opportunities. -ne Investment is the Savings ,ertificate .which
we described earlier/ and the second investment is a 6an Deposit of =s 2DD,DDD at 2DE interest
compounded annually for two years.
N/V - IRR N)merical
Com.aring t&e 2 In"e#tment#
Since we have calculated the <;9 and I== for the Savings ,ertificate, we would calculate the
<;9 and I== only for the 6an deposit rate.
6an Deposit +!ample
"9 T ;9 .2Si/
n
T 2DD,DDD ! .2.2D/
2
T 232,DDD
8 ,opyright 9irtual :niversity of ;aistan FL
9R000
9S000
9H000
92000
0
2000
H000
S000
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iEGT
iE10T iE1GT iE20T
N/V
IRRE12T
.a
<;9 T -2DD,DDD S 2D,DDD& .2.2/ S 22,DDD& .2.2/
2
S 2DD,DDD&.2.2/
2
T 2DD,DDD S O,DOD S O2,L4J T S =s
C3J
I==1 <;9 T D T -2DD,DDD S 2D,DDD& .2SI==/ S 222,DDD& .2SI==/
2
d by trial ' error I== T 2D.IE
,ompare the Investment 2 .Savings ,ertificate/ to Investment 3 .6an Deposit/1
+a"ing# Certi,icate 0an4 De.o#it
<;9 .iT2DE pa/ S =s 2,C2C S =s C3J
I== 23E pa 2D.IE pa
Savings ,ertificate appears to be a better investment because it offers both a higher <;9 and a higher
I==.
Gra.&ical Com.ari#on o, 2 In"e#tment#
PCRO++9OVER IRRQ
The above diagram shows <;9 ;rofiles of investments intersect at the ,ross -ver ;oint. Slope
of 6an Deposit investment is steeper because larger cash flows .=s 222,DDD/ are taing place later
in time .3 years instead of 2 year for Saving ,ertificates/. Size of the Discounting "actor grows
e!ponentially with time so <;9 graph falls much faster. The I== at this ;oint is C.CE.
At this point, the <;9 of both the investments is e(ual at about S=s 3,OID
>hen I== is less than C.CE .,ross-over I==/ then the <;9 of 6an Deposit is higherU
In"e#tment Criteria
IRR Inter.retation 9 :o3 &ig& i# &ig&>
Macro A#.ect#
In,lation$
An I==, which is considered low for a medium inflation country lie ;aistan, may be
considered high for a low inflation country lie :SA, Napan, and Singapore where inflation is below
IE.
Ri#4 Free Rate o, Ret)rn$
=ecall our discussion from earlier lecture on Interest =ates and #oney #arets.
In ;aistan, we use the Bovernment T-6ill rate, which varies from LE to 23E per annum
depending on the #oney #aret. ,onsidering the ris-free rate of return the I== on investment is
not very good. >e will tal more about this after we study =ISK.
8 ,opyright 9irtual :niversity of ;aistan FC
920000
91G000
910000
9G000
0
G000
10000
1G000

iEGT
iE10T iE1GT iE20T
Cro## O"er /oint
In"e#tment Criteria
IRR Inter.retation 7Micro A#.ect#8
ROA - ROE$
If the Investor has an e!isting running business that generates cash flows, then any new pro0ect
that matches or e!ceeds the returns of the e!isting business is worth considering.
/rolem$ =-A ' =-+ are "inancial Accounting =atios based on <et Income .not cash/ '
?istorical ,ost or 6oo 9alue .not maret value/ whereas I== is based on ,ash and "orecasted #aret
9alue. The financial ratios are calculated based on the profit reported in the income statement, whereas
the I== taes into account the cash flows rather than the accounting profit in the calculations.
%eig&te* A"erage Co#t o, Ca.ital 7%ACC8 or :)r*le Rate$
If the Investors an e!isting operating business that runs on borrowed money .or financing/
then the Investor .the borrower/ bears the cost of interest, say 2CE pa in ;aistan. -bviously, the rate of
cash generation should e!ceed the rate of interest payment. The I== of a new pro0ect should e!ceed the
>A,,. >e will discuss this in detail when we study ,apital Structuring. >hen I== is above the
>A,,, the e!cess return represents surplus that increases shareholders7 wealth. The details on >A,,
would be further discussed in ,apital Structure determination.
8 ,opyright 9irtual :niversity of ;aistan FO
Lesson 10
/RO;ECT CA+: FLO%+< /RO;ECT TIMING< COM/ARING /RO;ECT+< AND MODIFIED
INTERNAL RATE OF RETURN 7MIRR8
Learning O!ecti"e#
After completing this lecture, you would be able to understand
,ash flows relevant to <;9 and I==
;ro0ect timing on the cash flows relationship
Steps involved in preparing pro forma cash flow statement
;ro0ect options
;roblems with I==
#odified Internal =ate of =eturn
;roblems of comparison among pro0ects of une(ual life
Today, we are going to tal about pro0ect cash flows, along with the concepts of net present value
.<;9/ and internal rate of return .I==/, as they relate to the pro0ect cash flows. <;9 and I== are
important and widely used techni(ues of evaluating investment in real assets. 6efore going into details
of these techni(ues, one must have a clear understanding of what these real assets are.
=eal assets pro0ects may also include entire businesses. Investors have the option of investing in
running businesses, which are also a collection of assets. The way a pro0ect can be evaluated using the
I== and <;9 techni(ues, the cash flows being generated from a business can also be evaluated in the
same manner.
The actual <;9 and I== for real assets are not very easy to calculate despite having an easy
formula, because the inputs used in the formula are only estimates. ,ash flows, the basic input is based
on forecasts, hence ma0ority of errors that may tae place in calculating the actual <;9 or I== of any
pro0ect may be because of forecasting errors. The ne!t important challenge is to assess or forecast the
anticipated life of the business, which could only be based on an educated guess. Although, you might
have studied in financial accounting about the perpetual concern, however, in reality businesses have
finite life. Another important input is the discount rate. ;icing the right discount rate is not an easy tas
either. ?owever, we will tal more about discount rates when we would discuss the concept of ris. All
these factors combined together mae the calculation of <;9 very difficult.
@et us begin with a relatively simple formula for calculating net incremental after ta! cash flows.
<et incremental after ta! cash flows T net operating income S depreciation S
Ta! savings from depreciation S net woring capital S other cash flows
<et operating income is obtained from the income statement
Depreciation is added bac since it is a non-cash e!pense
<et woring capital re(uirements for the pro0ect as estimated are also added
-ther cash flows which are associated with <;9
Ot&er Ca#& ,lo3# rele"ant to t&e N/V o, t&e .ro!ect
6roadly speaing, these other cash flows can be categorized into three types
1> O..ort)nit( co#t# rele"ant to t&e ca#& ,lo3# o, t&e .ro!ect
Suppose you are to invest in a new pro0ect, a small production unit with F weaving looms. Rou
would also need to have a piece of land where the machinery would be installed. Suppose
further, that you already have that piece of land. >hile calculating the <;9 for the pro0ect, you
would have to include the value of the land that you are using. Although you are not buying that
land, but that land has a certain maret value. Rou could have sold that land at the maret price
and by not doing so you are incurring an opportunity cost.
2> Ca#& ,lo3# a##ociate* 3it& e5ternalitie#
+!ternalities in financial terms may be defined as incidental cash flows that arise because of the
effect of new pro0ect on the e!isting or running business. "or instance, if a company adds a new
product to its produce line, the launching of the new product can adversely affect the sales
revenue of the e!isting product line. This phenomenon of competition among the brands of the
same company is also nown as cannibalization. >hen an entrepreneur is embaring on a new
pro0ect, he might either hurt or increase the sales of the e!isting products and that is an
e!ternality. >hile calculating the net incremental after ta! cash flows, the incremental effect of
these e!ternalities, whether negative or positive should be included in the calculation.
8 ,opyright 9irtual :niversity of ;aistan ID
C> +)n4 co#t#$
Sun costs need to be e!cluded while calculating the incremental cash flows. Sun
costs are the costs that have already incurred in the past. >hether you decide to invest your
money in the new pro0ect or not, the sunen costs cannot be recovered. "or instance, if a
company has purchased an import&e!port license and a few years after the company decides to
e!port a certain commodity, the cost incurred to purchase the license would not be included in
the cash flows. >hether the company decides to undertae the new e!port pro0ect or not, the
license fee cannot be recovered.
Timing o, t&e .ro!ect#$
The ne!t important issue that we need to loo at is the different times in which pro0ect or
business cash flows have incurred. 6roadly speaing, there are three phases.
2. Initiation of the pro0ect, the time of investment
3. @ife of the pro0ect
4. Termination of the pro0ect
Time o, in"e#tment$
Time of business refers to the initiation time when the initial cash outflow occurs. In addition to
the investment in the fi!ed assets, you may also have net woring capital re(uirements or mobilization
re(uirements to get the pro0ect started. Rou can add these two types of initial cash outflows since they
are occurring at the same point in time. Rou might also have to subtract any ta! paid on the sale of old
assets to get a net figure for the initial cash outlay. As we discussed earlier, we need to invest in new
assets if the old assets become less productive. These old assets, despite losing their productivity have
some maret value at which they can be disposed off. If the maret value of the pro0ect is higher than its
boo value, the company earns as gain on the sale of the asset, which may be ta!able
2
.
Li,e o, t&e .ro!ect$
This second phase encompasses a ma0or duration since it is concerned with the cash flows that
occur during the life of the pro0ect. The relevant cash flows for the period would be the operating cash
flows, in the form of cash receipts from sales revenue and other income, as well as cash e!penses or
payments in the form of operating, mareting and administrative costs. It is important to eep in mind
that all these revenues and costs would be seen on a cash basis. >e would also need to tae into account
if there are any ta! savings that are coming about because of showing increased depreciation. The
change in depreciation taes place as the new assets are included in the business and these new assets
are usually depreciated at an accelerated rate in comparison to the old replaced assets, which were being
depreciated at a low rate in the final year of their useful life. The amount of depreciation could also
increase if the new asset has a high price, the amount of depreciation charged to the asset would also be
high. Since depreciation is a non-cash e!pense, it has to be added bac to the net profit to get the cash
flows. If the new asset has replaced an old one, the difference between the depreciation of the two
would be added to the cash flows.
Termination o, t&e .ro!ect$
Termination of the pro0ect refers to the period when the pro0ect life ends. At this time, we need
to tae into account the salvage value of the pro0ect assets, the price at which the assets can be sold out.
Selling an asset results in a cash inflow[represented by salvage value. In addition, you would also
recover the woring capital that you have invested in the business at the beginning. This would be
another cash flow because of li(uidating accounts receivable and other accrued assets.
+te.# in"ol"e* in .re.aring e#timate* ca#& ,lo3 #tatement$
,ash flow statement is a consolidated statement of changes in financial position. "ollowing are the
steps involved in preparing a cash flow statement.
A <et -perating Income .from ;erforma ;&@/
A Add bac Depreciation .non-cash e!pense/
A Add Additional <et >oring ,apital =e(uired
A Subtract Additional Investments in "i!ed Assets
A Add Any Ta! Savings from ,hange in Depreciation
A Add Any ,ash from Sale of Assets at Salvage 9alue
A Add Any Ta! Savings from Bain on Sale of Assets
2
In certain countries, lie ;aistan, capital gains are not ta!ed at all
8 ,opyright 9irtual :niversity of ;aistan I2
The following e!ample would help you in understanding the composition of a cash flow statement
based on the pro forma profit ' loss account.
/RO FORMA 7FORECA+TED8 CA+: FLO%
A SA#;@+ R+A= I< ;=-N+,T7S @I"+
Amount in =upees
<et -perating Income .from ;ro forma ;&@/1 2,DDD
,ost Savings .3DDD/ S =evenues .2DDD/ $+!penses
.3DDD/
Add bac Depreciation .non-cash e!pense/1 2DD
Add Additional <et >oring ,apital =e(uired 3DD
Subtract Additional Investments in "i!ed Assets .IDD/
Add Any Ta! Savings from ,hange in Depreciation ID
Add Any ,ash from Sale of Assets at Salvage 9alue 2DD
Add Any Ta! Savings from Bain on Sale of Assets ID
NET CA+: FLO%+ 1000
E5.lanation$
The main items we need for preparing is the net operating income, which is an estimated
income as it has been obtained from the pro forma income statement. The net operating income is
calculated by adding revenues to cost savings minus e!penses, which in our e!ample is =s.2DDD. The
ne!t item used in preparing a cash flow statement is the depreciation. Depreciation is added bac to the
net operating income, as it is a non-cash e!pense. Assume the depreciation to be at =s.2DD, which would
be added to the net operating income. Another thing that we need to add to the net operating profit is the
additional woring capital re(uirements, which in our e!ample is assumed =s 3DD.
>e would also need to subtract any additional investment in fi!ed assets. Investments in fi!ed
assets result in cash outflows, which need to be subtracted to get net cash flows. >e would also add any
ta! savings that come about because of changes in depreciation. >hen you show more depreciation,
your ta!able income reduces and as a result, you have to pay lesser ta!es. Depreciation is a non-cash
e!pense but ta! is paid in cash form. 6y paying less ta!, the business is in fact saving ta! by applying a
high depreciation rate. Rou would also add any cash flow resulting from the sales of assets. Assets that
are sold at salvage value represent cash inflows. Any ta! advantage on the gain would also be added.
6ased on these additions and subtractions, we arrive at the net cash flow figure as shown in the
e!ample.
#anagement overestimates the cash flows. They portray a very optimistic picture of the cash flows and
the <;9, which is also nown as an upward bias in <;9 calculations. This is one of the ways of
window-dressing.
/ro!ect O.tion#$
Some of the companies in certain situations accept pro0ects with negative <;9, or <;9 less
than zero. Although, the mathematical details would be discussed in the later lectures, we need to
understand why companies do that.
,ompanies invest in pro0ects with negative <;9 because there is a hidden value in each pro0ect. This
hidden value is an opportunity, which is nown as an option. These opportunities and options carry
some value. "or instance, there are a number multinational companies investing in ,hina these days,
even though, the net present value of there pro0ects might be significantly lower than zero. It is because
they are sacrificing short and medium term cash flows for a long-term maret share. They see ,hina as
a potential maret owing to its huge maret size, and for long-term benefits, they are willing to invest in
pro0ects with negative net present value.
The same concept is true for technology industry. >e can tae the e!ample of Amazon.com, a
web based company where the ,+- and the managers are willing to invest even if the net present value
is negative. The management believes that the growth of the maret is such that the negative net present
value would be compensated in future by heavy downpour of positive cash flows later in the life of the
pro0ect. Rou must eep in mind that these options are hidden and might not be very visible to you.
>hen we tal about the option to abandon a pro0ect, the abandonment too has a value. "or instance, if
you find that one of the pro0ects has started losing money, you would have the option to end the pro0ect
and thereby cutting the losses. This is the abandonment value of the pro0ect. In contrast, for larger
pro0ect the abandonment option might be very difficult to e!ercise. >hen we mae decision of investing
cash in a pro0ect, we bear the opportunity cost of not investing the cash in another pro0ect and thereby
losing option. @ocing up your money ' time in a bad pro0ect today can reduce your -ption 9alue to
invest in better opportunities in future
/rolem# 3it& IRR$
@et us now discuss some problems with the calculations of I==. The problems with calculation
of I== come about when the pro0ect7s useful life is for more than two years. Another problem arises
when there are non-normal cash flows or one or more net cash outflow at some point in future .in
addition to the initial investment outflow/. This creates multiple real roots .or more than one I==7s/ that
bring the <;9 of the pro0ect e(ual to zero.
@et us tae a simple e!ample for e!planation of the concept. "or instance, you have made an initial
investment .outflow/ of =s.2DD, the <et ,ash =eceipts .inflow/ at the end of Rear 2 is of =s.IDD, and
net loss .outflow/ at end of Rear 3 is of =s.IDD. The cash flow pattern can be e!plained in the diagram
below.
In the above diagram, we have a cash
outflow of =s.2DD represented by a
downward arrow in the year D. The
upward arrow represents cash inflow of =s.IDD in the year 2, and the last downward arrow in the second
year represents another cash outflow of =s.IDD. The I== of the pro0ect can be calculated as under
I== +(uation1
<;9 T D T -2DD S IDD& .2SI==/ - IDD&.2SI==/
2
Solve by Iteration .or Trial ' +rror/1
I== T 4CE and 3JDE appro!U
Solving the e(uation, we come up with two values of I==. >hich of the two values is correctP The best
way to deal with this situation is to leave both the found of rates and use another important tool for the
calculation of the I== nown as #odified Internal =ate of =eturn.
Mo*i,ie* Internal Rate o, Ret)rn$
The logic used in this techni(ue is to separate the cash inflows and outflows for each year and
use a maret discount rate )* .or the cost of capital/. ;lotting the cash inflows and outflows on a
diagram, we would eep them separate instead of finding the net cash flow. The ne!t step is to discount
all the future cash outflows and discount them to the present. The third step is to compound the
company7s cash inflows to the future end period, which represents the end of the life of the pro0ect. The
idea of compounding the cash inflows is on the assumption that they are reinvested at the cost of capital.
After doing the compounding and discounting of cash flow, we use a rate at which the future value of
," 2 T S=s.IDD
," 3 T -=s.IDD
Io T - =s.2DD
Rr D Rr 2 Rr 3
Sign ,hange e2
Sign ,hange e3
Note$ More t&an 1 +ign C&ange in
Direction o, Ca#& Flo3 Arro3# #)gge#t#
M)lti.le IRR1#
cash inflows is e(ual to the present value of cash outflows. The rate at which the two e(uate is nown as
the #odified Internal =ate of =eturn. The formula for the #I== is given as under.
Fin* t&e Mo*i,ie* IRR 7MIRR8 )#ing$
71FMIRR8
n
E F)t)re Val)e o, All Ca#& In,lo3#U>
/re#ent Val)e o, All Ca#& O)t,lo3#
71FMIRR8
n
E CF in J 71F48
n9t
CF o)t ? 71F48
t
<ow the (uestion arises as to why are we using two different interest or discount rates in the
e(uation. -ne of the interest rate is the #I== and the other is the discount rate used in the <;9
calculation .opportunity cost of capital/.
Li,e o, t&e .ro!ect$
In our previous e!ample, where we compared a saving certificate to a ban deposit, the lives of
the two investments were not of the same duration. The net present value of the two pro0ects is not
comparable due to the difference in life spans. There are two approaches used to mae two pro0ects with
different life spans comparable.
Common Li,e A..roac&$
In order to mae the two investment opportunities we e(uate the life of the two pro0ects. >e
would repeat the cash flow pattern of each pro0ect over a horizon that matches the least common
multiple of the lives of the two pro0ects. "or instance, if there are two pro0ects, and the life of first
pro0ect is one year and that of the second is two years, the least common multiple would be two and the
cash flow pattern of the pro0ect would be repeated for the ne!t year, in order to mae the two pro0ects
comparable. Similarly, if first pro0ect has a life of two years and second pro0ect has a life of three years,
the least common multiple would be si!. In that case, the cash flows of the first pro0ect would be
repeated thrice and that of the second pro0ect would be repeated twice. ?aving e(uated the lives of the
pro0ect the net present value of both the pro0ects can be calculated and compared.
E2)i"alent Ann)al Ann)it( A..roac&$
The other approach is to calculate the <;9s of the pro0ects and multiply the result with the
annuity factor. This method converts the pro0ects of different lives into annuity of the same duration in
time.
In,lation con#i*eration
A :se Inflation Discount "actor1 #ultiply each future cash flow term in the <;9 e(uation by
the Inflation Discount "actor1 2 & .2Sg/
t
. >here g T E inflation per year and t T number of
years.
8 ,opyright 9irtual :niversity of ;aistan IF
Lesson 11
+OME +/ECIAL AREA+ OF CA/ITAL 0UDGETING
Learning O!ecti"e#$
In this lecture, we will discuss some special areas of capital budgeting in which the calculation
of <;9 ' I== is a bit more difficult. These concepts will be e!plained to you with help of numerical
e!ample.
As it is mentioned in the previous lectures that we are studying the area of capital budgeting as
it relates to pro0ects, which means investments in real assets .land, property etc./ The ma0or difficulty in
the <;9 calculation is your ability to forecast the cash flows. Therefore, it is necessary that one should
spent time on this so that the cash flow forecast is accurate.
>e, have a simple formula to calculate the cash flows. The way we define the net Incremental
after ta! cash flows for the purposes of this course is
Net A,ter9ta5 Ca#& Flo3# E <et -perating Income S Depreciation S Ta! Savings from Depreciation S
<et >oring ,apital re(uired for this pro0ect S -ther ,ash "lows
The things we left out from the formula given above are certain incidental cash flows .Include
-pportunity ,osts and +!ternalities but +!clude Sunen ,osts./
T3o Ma!or Criteria o, Ca.ital 0)*geting$
2. <et ;resent 9alue .<;9/
3. Internal =ate of =eturn .I==/
a. ,ombined 9iew1 <;9 ;rofile .<;9 vs i Braph/
The <;9 is the most important because it has a direct lin with shareholders wealth ma!imization.
@et us discuss in detail about the difficulties faced in <;9 ' I== with the help of certain
numerical e!amples and e!planations.
"irst, we would discuss the case of #ultiple I==s.
M)lti.le IRR$
In this case, you have a pro0ect with certain cash flows that are not normal and when
you try to calculate I== you obtain more than one I== answer. This is the case where you have more
than one sign change taing place in your cash flow diagram. Sign change means that you have two
ad0acent arrows one of them is downward pointing ' the other one is upward pointing. In general, our
cash flow diagram starts with down ward pointing arrow .Investment/ and it is followed with series of
upward pointing arrows .net incoming cash/ during the life of pro0ect. ?owever, during the life of
pro0ect if you have any net cash outflow or downward pointing arrow then that would be second sign
change and you can e!pect to have multiple answer for I==.
In this particular case, calculating the <;9 and setting it e(ual to zero to calculate I== will give
you two answers ' both of them would be wrong.
The alternative is to use #odified I== or #I== approach.
MIRR A..roac&$
The logic behind #I== is that instead of looing at net cash flows you loo at cash inflows and
outflows separately for each point in time. Discount all the -utflows during the life to the present and
,ompound all the Inflows to the termination date. Assume reinvestment at a ,ost of ,apital or Discount
"actor .or =e(uired =eturn/ such as the ris free interest rate.
The #I== represents the discount rate, which will e(uate the "uture 9alue of cash inflows to
;resent 9alue of cash outflows.
"ormula1
.2S#I==/
n
TCF in Z .2S/
n9t
CF out ?.2S/
t
#odified Internal =ate of =eturn .#I==/ would provide us with an answer, which is entirely different
from our previous I== calculations
E5am.le$
A pro0ect with the following cash flows1 Initial Investment T -=s2DD, Rear 2 T S=sIDD, Rear 3 T
-=sIDD
If we use standard <;9 e(uation to calculate the I==
I== +(uation1 <;9 T D T -2DD S IDD& .2SI==/ - IDD& .2SI==/
2

Rou would come up with 3 answers
8 ,opyright 9irtual :niversity of ;aistan II
I== T 4CE and 3JDE
6oth of these answers are incorrect. Therefore, we will use the modified I== approach to calculate the
actual I== for this pro0ect.
#I== Approach .Assume ,ost of ,apital T 2DE/1
.2S#I==/
n
T CF in Z .2S/
n9t
CF out ? .2S/
t
>e use 2.2 as compound factor because we assume )i*T2DE T =is free rate return. ?ereQt7 refers to
the time in which a particular cash flow occurs, while Qn7 is the total life span of the pro0ect.
.2S#I==/
2
T IDD Z .2SD.2/
291

.2DD & 2.2/ S .IDD & .2SD.2/
2
.2S#I==/
2
T IID & I24 T 2.DL
#I== T D.D4FF T 4.FFE
This answer is entirely different from the previous answers that we got from calculating the I==.
?owever, #I== gives you the best possible answer and the most realistic too.
<ow, let us tal about the case of comparing pro0ects with different lives.
N/V o, /ro!ect# 3it& Di,,erent Li"e#$
Suppose that you have two pro0ects having different life spans. It is not entirely accurate to
calculate <;97s in simple manner and to compare them and pic the pro0ect with higher <;9. 6ecause
you are comparing a certain pro0ect that is generating cash flows for a short period of time with another
pro0ect that is yielding cash flows over a longer time. >e use following two approaches to ran these
inds of pro0ects.
1> Common Li,e A..roac&$
In this approach, the idea is (uite simple. Rou need to bring all the pro0ects to the same
length in time. In other words, you are re(uired to convert all the pro0ects to the identical life
span. Rou can do that by finding least common multiple for common life. "or e!ample, if you
are comparing two pro0ects one has life of F years and the other, which has a life of I years, the
least common multiple is 3D years. Setch out the cash flow diagram and repeat the cash flow
for each of the pro0ect such that they fit in e!act number of time in 3D years. In case of pro0ect
with a life of F years, you can replicate the cash flows I times in a period of 3D years. . In case
of pro0ect with a life of I years, you can replicate the cash flows F times in a period of 3D years.
,ompute the <;9 of each pro0ect over the common life and choose the pro0ect with the highest
<;9.
2> E2)i"alent Ann)al ANNUITA 7EAA8 A..roac&$
In this case, our logic is to find out that for a particular pro0ect of limited life giving you
the certain net present value calculated in a simple way, what ind of yearly annuity gives the same
<;9. Rou can then compare annual annuity of each pro0ect and choose the highest. Rou are comparing
cash flow of two pro0ects both of which are taing place in a period of one year only. Rou can also
convert the cash flows of the pro0ect to the perpetuity, which is infinite, and then you can compare the
<;97s lie of different pro0ects. That is also correct since life spans are identically infinite.
E5am.le$
>e have 3 ;ro0ects with following ,ash "lows1
;ro0ect A1 IoT - =s2DD, Rr 2 T S=s3DD
;ro0ect 61 IoT - =s3DD, Rr2T S=s3DD, Rr3T S=s3DD
+im.le N/V Com.)tation 7a##)ming iE10T8$
<;9 ;ro0ect A T -2DD S 3DD&2.2 T S=s C3
<;9 ;ro0ect 6 T -3DD S 3DD&2.2 S 3DD& .2.2/
2
T S=s 2FL
,onclusion from Simple .or <ormal/ <;9 ,alculation is that ;ro0ect 6 is better. It is incorrect because
here we are comparing apples to the oranges since the pro0ect lives are differentU
Common Li,e A..roac&$
,ommon @ife SpanT@east common multiple T 3 Rears .because this is the shortest cycle in which both
pro0ect lives can e!actly be replicated bac to bac/.
8 ,opyright 9irtual :niversity of ;aistan IJ
In this ,ash "low ;attern of A is repeated e!actly 3 times to cover the life of the longer ;ro0ect
6. The pro0ect A7s outflow 2DD ' inflow of 3DD then we replicate it with down ward pointing arrow
with 2DD and upward pointing arrow with 3DD amount in the 3
nd
year. ;ro0ect 6 remains unchanged
Common Li,e 7C>L>8 N/V1#$
;ro0ect A ,.@. <;9 T -2DD S W.3DD-2DD/&2.2X S 3DD& .2.2/
2
T S=s 2IJ
;ro0ect 6 ,.@. <;9 T Same as before T S=s 2FL
<ow our conclusion has changedU After doing the ,ommon @ife <;9, ;ro0ect A loos better. The
Simple <;9 of ;ro0ect A was S =s C3 but after increasing its life to match ;ro0ect 67s, the <;9 of
;ro0ect A increased. It is the correct answer. Also, note that how the <;9 of A increased from C3 to 2IJ
.almost double/ because you double the life of the pro0ect.
<ow we solve this problem with +(uivalent Annual Annuity Approach
E2)i"alent Ann)al Ann)it( A..roac&$
In this we are e!plaining that how we can achieve same <;9 value from an annuity stream.
?ere, we are doing a bac calculation that we new the <;97s but which annuity stream they are
representing with in the life span of the pro0ect. Then we compare the annual annuity of both pro0ects.
The life span remains same
+!ample1
Start with the Simple .or <ormal/ <;97s calculated earlier .at i T 2DE/1
$ ;ro0ect A Simple <;9 T S =s C3
$ ;ro0ect 6 Simple <;9 T S =s 2FL
To ,in* EAA
#ultiply the Simple <;9 of each pro0ect by the +AA "actor
EAA FACTOR E .2S i/
n
& W.2Si/
n
91X where n T life of pro0ect ' iTdiscount rate
;ro0ect A7s +AA "actor T 2.2 & .2.2-2/ T 22
;ro0ect 67s +AA "actor T 2.22 & .2.22-2/ T I.LJ
EAA ,or eac& .ro!ect
;ro0ect A7s +AA T Simple <;9 Z +AA "actor T C3Z22T S =s OD3
;ro0ect 67s +AA T 2FLZI.LJ T S =s CFL
Concl)#ion$ ;ro0ect A is better. Same conclusion as ,ommon @ife Approach but of course the
numbers for +AA and <;9 are different.
/ractical "ie3$
,ompanies and individuals running different types of businesses have to mae the choice of the asset
according to the life span of the pro0ect. "or instance, a tailor shop owner would have to decide whether
to invest in a sewing machine that has a useful life of ten years or to invest in another machine with a
8 ,opyright 9irtual :niversity of ;aistan IL
;ro0ect A1
;ro0ect 61
Rr D Rr 2 Rr 3
Rr D Rr 2 Rr 3
-2DD
-3DD
-2DD
S3DD
S3DD
S3DD S3DD
useful life of three years. These decisions are important since they involve ma0or cash outflows of the
business. There are advantages ' disadvantages associated with different life span.
Di,,erent Li"e# - 0)*get Con#traint$
,ompanies and individuals running different types of businesses have to mae the choice of the
asset according to the life span of the pro0ect.
A*"antage# o, a##et 3it& a long li,e$
The advantage of a longer asset life is that the cash flows from the pro0ect become more
predictable, since there are lesser cash outflows occurring during the life of the pro0ect.
Di#a*"antage o, a##et 3it& "er( long li,e$
It does not give you the opportunity .or option/ to e!tract full value of asset and replace the
e(uipment (uicly in order to eep pace with technology, better (uality, and lower costs.
A*"antage# o, a##et 3it& #&ort li,e
The advantage of a short life asset is that the investor, by maing reinvestment in the asset of a
superior (uality, lowers down the costs and updates the pro0ect to the new technological re(uirements.
Di#a*"antage o, a##et# 3it& "er( #&ort li,e$
The disadvantage is that the money will have to be reinvested in some other pro0ect with an
uncertain <;9 and return so it is risy. If a good pro0ect is not available, the money will earn only a
minimal return at the ris free interest rate.
>hile e!ercising the option of different pro0ect timing, the pro0ects can be compared by applying
,ommon @ife and +AA Techni(ues to (uantitatively.
0)*get Con#traint
>e have been addressing the issue of capital budgeting with very idealistic assumptions. In
practical life, individuals and companies have a limited amount of money and limited human resources
in terms of either sill or numbers. It can be argued that the firm can also meet their re(uirements by
borrowing. I< real life, managers may avoid borrowing to limit their ris e!posure. This prevents them
from undertaing pro0ects with high positive <;9s that would have added to the firm7s value and
ma!imized shareholder wealthU
8 ,opyright 9irtual :niversity of ;aistan IC
Lesson 12
CA/ITAL RATIONING AND INTER/RETATION OF IRR AND N/V %IT: LIMITED
CA/ITAL>
Learning O!ecti"e$
After going through this lecture, you would be able to have an understanding of the following topic
Ca.ital Rationing
IRR an* N/V inter.retation 3it& limite* ca.ital
In this lecture, we would discuss the practical side of capital budgeting addressing the problem of
allocating your money among the different possible pro0ects, where the amount of money to invest is
limited.
,ompanies ration their capital and investments among different opportunities. Similarly, countries
use rationing. "or e!ample, some countries ration food. ,apital =ationing provide practical basis to the
capital budgeting because the decision of capital budgeting are made within limited financial resources
of the company in real life situations.
?ere, the investment in real assets would be discussed. It is mentioned earlier that real assets have
cash flows associated with them. Theses cash flows would be discounted to the present and calculate the
<;9 of the pro0ect. If, the <;9 cD, it will benefit the organization. If the company invest in the pro0ect
with positive <;9 it will bring value to the company and result in ma!imization of shareholders7
wealth.
As we studied in previous lectures how we could estimate the after ta! cash flows. The
Importance of good ,ash "low forecasts and accurate ;roforma ,ash "low Statement
Net A,ter9ta5 Ca#& Flo3# T <et -perating Income S Depreciation S Ta! Savings from Depreciation S
<et >oring ,apital S -ther ,ash "lows
Ot&er Ca#& Flo3#1 Include -pportunity ,osts and +!ternalities but +!clude Sunen ,osts
In capital rationing the most important criterion, which we are using to decide whether to invest
in a pro0ector not is the <;9. The second important criterion, which would be used, is the I==. There is
a new criterion which we loo at in capital rationing is percent budget utilization. In other words, what
percentage of the total money available to invest are you mobilizingP It is important to mobilize as
much money as possible in the pro0ects on which I== is greater then ris free rate if return because you
want to ma!imize the return on your portfolio.
>e have study about certain special situations, which cause comple!ities in calculating I==
using <;9 e(uation. #ultiple I== arises when there is more then one sign changes in cash flow
diagram. In such situations, avoid using <;9 e(uation to calculate the I== because it would not provide
the correct result. To get the correct answer we should use #odified I==. In this, you separate the
Incoming and -utgoing ,ash "lows at each period in time. Discount all the outflows to the present and
compound all the Inflows to the termination date. Assume reinvestment at a ,ost of ,apital or Discount
"actor .or =e(uired =eturn/ such as the ris free interest rate.
#I== is that discount rate which e(uates the future value of cash inflows to the present value of
cash out flows. >e use ,ommon @ife or +AA Approach to ad0ust <;9 of pro0ects with different lives.
<ow, we discuss the capital rationing and see that how the conte!t of problem changes with
budget constraint.
:ntil now, we are discussing about the ideal case with no budget constraint. ;ractically, money
is in short supply ' it is only that much money that a company has to spend in different pro0ects.
Therefore, we need to change our analysis in order to tae into account the limited resources lie money
in maing the investment decisions.
<ow, first thing to now who is responsible for the decisions relating to capital budgeting and capital
rationing. Benerally, the investment decision maing is divided in accordance with the size of the
investment and criticality of the investments.
Man*ator( 7Critical - Nece##ar( ,or 0)#ine## an* Legal8$ CEO
Di#cretionar( 7R-D< Gro3t& /ro!ect#8 In"e#tment#$ ;)nior Mgmt or *i"i#ion &ea*#
Rea#on# ,or Ca.ital Rationing$
>hat are the reasons because of which you do not invest in a pro0ect which provide you highest
returnP There are situations in which after calculating the I==7s and <;97s of different pro0ects you are
forced not to invest in the best pro0ect. Some reasons are
8 ,opyright 9irtual :niversity of ;aistan IO
2. The best pro0ect may have a very high initial investment and you may not have that money. So, you
are forced to re0ect that pro0ect as an option.
3. The company does not have the human resource, nowledge, or talent, which is re(uired to undertae
the pro0ect. The pro0ect might have high <;9 but if you cannot manage it, you are forced not to invest
in that pro0ect.
4. The companies have the prevailing fear of debt. In case of #uslim countries, there is a ma0or issue of
)=iba* .interest/ among #uslim investors and the companies due to this religious constraint choose not
to borrow money. That is the reason that in many #uslim countries capital rationing has an ethical
bases attach to it. :sually, the investors in these countries invest in the e(uity based investments as it
has a ris of profit or loss in that ind of investment. >e will discuss this topic in the upcoming
lectures.
<ow, it is important from you to remember that companies have different constraints, which
eep them from investing in the best pro0ects. The fear of debt is 0ustified because when we discuss
about the ris in upcoming lectures you find out that when a company taes on debt its future cash flows
become more risy. Therefore, there is a possibility of default due to which there is a fear of debt. These
are various reasons due to which company decides not to invest in the pro0ect with the highest <;9 and
some of them involve capital rationing decisions as the following e!ample shows.
E5am.le$
There are F ;ro0ects .mutually e!clusive real asset pro0ects/ to choose from. Total budget is
=s.2, DDD
;ro0ect IoTInvestment .=s/ I== <;9.=s/
A1 3DD FDE 4DD
61 2DD FDE 4DD
,1 4DD 4IE 3DD
D1 CDD 4DE JDD
>hich 4 pro0ects you will choose from the above F real asset pro0ectsP
>e cannot pic all F ;ro0ects because the 6udget ,onstraint is 2DDD and the total investment in
all 4 ;ro0ects is 2FDD .T3DDS2DDS4DDSCDD/.we have to go through capital rationing process ' choose
from among these F different pro0ects. >e have some options, which are as follows.
O.tion 1$
If we pic ;ro0ects A, 6, ' , then we have to consider what will be the combined <;9 of these
pro0ects and what average I== will be of this portfolio or combination of pro0ects. "inally, we have to
loo an interesting parameter for capital rationing which is what percentage of total budget available is
being utilized if we invest in these pro0ects.
6udget :tilization T 3DDS2DDS4DD T JDD .out of 2DDD/
Total <;9 of three pro0ects T 4DDS4DDS3DD T CDD
Simple Average I== T 4CE T .FDSFDS4I/&4 <on-weighted
4CE seems to be attractive I==. <;9 of CDD loos good relatively to the size of investments. "inally,
we loo at percent budget utilization and for this option
6udget :tilization T 3DDS2DDS4DD T JDD
This option is utilizing JDE of total budget.
<ow we repeat the same practice for the other options available to us
O.tion 21 ;ic ;ro0ects A and D because they have the highest <;97s.
6udget :tilization T 3DDSCDD T 2DDD
Total <;9 T 4DDSJDD T ODD
Average I== T 4IE
O.tion C$ ;ic ;ro0ects 6 and D because they have the highest <;97s.
6udget :tilization T 2DDSCDD T ODD
Total <;9 T 4DDSJDD T ODD
Average I== T 4IE
Concl)#ion
+)mmar($
0)*get Utili6ation N/V A"g IRR
8 ,opyright 9irtual :niversity of ;aistan JD
O.tion 1 =s.JDD .JDE/ =s.CDD 4CE
O.tion 2 =s.2DDD .2DDE/ =s.ODD 4IE
O.tion C =s.ODD .ODE/ =s.ODD 4IE
It is clear from the summery that option 3 is best option. It carries the highest <;9 which is =s
ODD and it also has the highest budget utilization at I== of roughly 4I E.
%&( 3e not c&oo#e o.tion 1$
-ption no 2 has the highest I== of 4CE but the problem is that in option 2 our <;9 is not the
highest, rather, it is lower than the option 3 and 4.
Secondly, 6udget utilization is only JDE and the FDE of the money available for investment is
wasted and is lying idle. >hat will you do with this moneyP The idle money available in company
should earn some return on it. If you do not have the attractive pro0ect to invest in, you are forced to
eep it in a ban account that will yield O to 2D percent. So, the percent of budget utilize by any
portfolio is very important as it should be as close to 2DD E as possible.
Thus, we conclude on the basis f ma!imum <;9 and ma!imum budget utilization criterion that option
3
nd
is the best.
C T(.e# o, /rolem# in Ca.ital Rationing$
2> Size Difference of cash flows
3. Timing Difference of cash flows
4. Different .or :ne(ual/ @ives of different pro0ects1
>e have discussed the problem of different lives of the pro0ects in previous lectures.
+i6e Di,,erence 7in In"e#tment O)tla(8$
The differences in initial investment .or outlay/ means different e!tend of budget utilization.
>e compare the pro0ects one with small cash flows taing place at regular interval and the other pro0ect
has large cash flows taing place at different point in time. If two pro0ects have different cash flows,
where do you invest the un-utilized money or leftover portion of the budgetP #oney that is not
generating a good return is being wasted and eaten up by InflationU
E5am.le$ 6udget Size is =s 2,IDD
Two pro0ects are
/ro!ect A
,ash "lows1 IoT =s3DD, Rr 2 T S =s4DD
A <;9 T =s L4 .at iT2DE/ I== T IDE
/ro!ect 0
,ash "lows1 IoT =s2, IDD, Rr 2 T S =s 2,ODD
A <;9 T =s 33L .at iT2DE/ I== T 3LE
If we compare two pro0ects the pro0ects A has higher I== bit we do not mae our decision on
I== because as it is mentioned earlier that the most important criterion would be <;9.
;ro0ect 6 has a highest <;9. Therefore, we choose ;ro0ect 6.I== is lower because you are receiving
the large cash flow at the later point in time in comparison to the pro0ect A.
Timing Di,,erence /rolem#$
A good pro0ect might suffer from a lower I== even though its <;9 is higher. It receives its
larger cash flows later in time.
E5am.le$ 6udget T =s 3,IDD
;ro0ect A ,ash "lows1 IoT -=s2, DDD, Rr2TS=s2DD, Rr3TS=s3DD, Rr4TS=s3,DDD .late
large cash flow/
<;9 T S =s LIC .at iT2DE/ I== T 4IE
;ro0ect 6 ,ash "lows1 IoT -=s2, DDD, Rr2TSJID, Rr3T=sJID, Rr4T=s JID .Annuity/
<;9 T S =s J2J .at iT2DE/ I== T F4E
>e would choose ;ro0ect A on the basis <;9 ,riteria.
Di,,erent Li"e# /rolem$
In comparing two pro0ects or Assets .i.e. Sewing #achines or ;rinting #achines/ with different
lives1
Di#a*"antage o, .ro!ect 3it& "er( long li,e$
8 ,opyright 9irtual :niversity of ;aistan J2
Does not give you the opportunity .or option/ to replace the e(uipment (uicly in order to eep
pace with technology, better (uality, and lower costs
Di#a*"antage o, .ro!ect 3it& "er( #&ort li,e$
Rour money will have to be reinvested in some other pro0ect with an uncertain <;9 and return so it
is risy. If a good pro0ect is not available, the money will earn only a minimal return at the ris free
interest rate.
Rou should use ,ommon @ife and +AA Techni(ues to (uantitatively compare such ;ro0ects. Rou
have studied this topic in detail in the previous lecture.
Lesson 13
0OND+ AND CLA++IFICATION OF 0OND+
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following topic
0on*#
Cla##i,ication# o, on*#
:p to lecture no 23, we have discussed the investment decisions and capital budgeting as it relates
to real assets and properties.
<ow, we discuss about the securities.
Di,,erence et3een Real A##et# - +ec)ritie#
=eal assets are physical property such as @and, #achinery, e(uipments and 6uilding etc. >here
as securities basically, are legal contractual piece of paper.
=in*# o, #ec)ritie#$
>e have discussed about two types of securities.
Direct claim securities1
+toc4# 7+&are#8$
It is defined as e(uity paper representing ownership, shareholding. Appears on @iabilities side
of 6alance Sheet
0on*#$
It is a debt paper representing loan or borrowing. These are long term debt instruments.
Cla##i,ication o, on*# on 0alance #&eet$
-ne should be very careful regarding the classifications of bonds on the balance sheet. 6ecause,
when you are Issuing 6onds .i.e. borrowing money/ then the 9alue of 6onds appears under @iabilities
side .as @ong Term Debt/ of 6alance Sheet. If you are Investing .or buying/ 6onds of other companies
then their 9alue appears under Assets side .as #aretable Securities/ of 6alance Sheet.
The Important thing to remember is that the stocs represent the ownership and bonds represent the
debt. 6oth are the direct claim securities.
>hen a company or investor rising funds he have two possible options available to him.
2/ +(uity
3/ Debt
-ne form of the debt is bonds. 9alue of Direct ,laim Security is directly will be determined by
the value of the underlying =eal Asset. This concept e!plained with the help of the following e!ample1
Te5tile %ea"ing Factor( Ca#e +t)*($
A Te!tile >eaving "actory uses thread to mae cotton fabric and then sells cotton fabric to earn
cash receipts. It needs =s.2 million to mae a ,apital Investment in looms and machinery. It has two
options he can raise money through
2. +(uity, -=
3. Debt
@ets suppose that company decide to tae =s. 2 million in the form of debt It can raise money for a
period of 2 year by Debt "inancing by Issuing a 2 year #ortgage 6ond whereby it pays the @ender .i.e.
Investor or 6ondholder/ 2IE p.a ,oupon Interest =ate. Rou decided to divide 2 million in to 2 thousand
parts and each one of these parts in the form of paper that has a face or par value of =s 2,DDD.+ach 6ond
paper worth =s 2,DDD and the total number of bonds is 2,DDD.+ach bond paper carries the face value
which is printed on it and also carries coupon interest rate. Suppose that coupon interest rate on this
bond is 2IE it means that this company would pay 2IE of the face value to the lender. It is income for
the lender .6ond holder/. The 6ond also has the limited life. In this case we suppose that management
need money for the period of two years. The company pays the coupon rate to the bond holder for two
years and also returns the principle to the lender after two years at maturity date.
The @ender7s .or 6ond ?older7s or Investor7s/ money is protected because the #ortgage 6ond is
6aced .or Secured/ by =eal ;roperty such as the land, factory building, and machinery. :pon
#aturity, after 2 year, the 6ond Issuer will return the ;ar or "ace 9alue .or ;rincipal Amount of =s 2
million/ to the @ender.
<ow, we discuss different concepts which are common in different bonds. There are certain
advantages and disadvantages of raising money either through e(uity or through bonds.
>hy to raise money through a Debt .ie. 6ond/ rather than through +(uity .i.e. Shares or Stocs/P
If the ,ompany raises money using 0on*#< then it will have to pay a fi!ed amount of interest
.or mar-up/ regularly for a limited amount of time. Rou do not share the profits of the company. 6ut
there as legal ris attached to the failure to pay interest can force company to close down.
If the ,ompany raises money using E2)it(< then it is forced to bring in new shareholders who
can interfere in the management and will get a share of the net profits .or dividends/ for as long as the
company is in operationU The amount of dividends can vary.
Val)e o, t&e 0on*$
The 9alue of the 6ond can be calculated from the ,ash "lows attached to the 6ond. 6onds are
direct claim securities. The bond holder will receive the coupon interest rate and he will also receive his
principle amount at the time of maturity. >here are these cash flows come fromP ?ow the company is
able to pay interest to the bond holder. The company is maing cash from operations. Those ,ash "lows
depend on the ,ash "lows from the =eal 6usiness i.e. the te!tile factory7s cash flows from sale of
fabric. 6ond value is coming from the fabric sale. This is why the 6ond is called a Direct ,laim
Security whose value depends on the value of some underlying real asset.
C&aracteri#tic# o, on*#$
In ;aistan, the bonds tae on the form of Term "inance ,ertificates .T",7s/.These are traded
on three stoc e!changes of ;aistan. It is (uite common to trade bonds in the stoc marets. In
;aistan, the ;ar 9alue .or "ace 9alue/ of each T", is generally =s 2,DDD but it can be different. The
@ife of a 6ond is generally limited .or finite/ i.e. J months, 2 year, 4 years, I yearsd.. The bonds can be
issued by any one .;ublic, ;rivate/ who is in need of money. +ven individuals can issue bonds. "or
e!ample, Defense saving certificates, Treasury bills, T 6ills .short term bonds/ ' "I6 .@ong term
bonds/ are also classifieds as the bonds
"ace value is the amount which is mentioned on the bond paper. ;ar value is fi!ed but the bonds are
traded in the marets. As the financial health .cash flows and income/ of the company changes with
time, the #aret 9alue .or ;rice/ of the 6ond changes .even though it7s ;ar 9alue is fi!ed/. #aret
;rices also change depending on the Supply-Demand for the 6ond .or T",/ and Investors7 ;erception.
#a0or reason is the change in interest rate effect the bond price we will discuss it in detail in upcoming
lectures. In case of Te!tile ,ompany this company issued a bond at the fi!ed coupon interest rate is 2I
E of par value. This rate is fi!ed and should be paid by the company. <on payment of this would defult
and result in the closing of the company.
?owever, the maret interest rate eeps moving and it changes on daily basis. >e have discussed the
factors that caused the changes in interest rate in the previous lectures.
0on*#$ De,inition
6ond is a type of Direct ,laim Security .a legal contractual paper/ whose value is secured by =eal
Assets owned by the Issuer. 6ond is issued by the Issuer .or 6orrower/ to the 6ondholder .or @ender or
Investor or "inancier/ in e!change for the cash. 6orrowers and lenders can be individual persons or
companies or governments.
+!amples1 Term "inance ,ertificate .T", issued by ;ublic @isted Industrial ,ompanies/, Defense
Saving ,ertificate .DS, issued by Bovernment/, T-6ill .issued by Bovernment/6ond is a @egal
,ontractual ;aper ,ertificate that represents @ong Term Debt .or @ong-term ;romissory <ote/.6ond
paper contains legal ' numerical points
0on*#$ N)merical Feat)re#
A Mat)rit( or Ten)re or Li,e$ #easured in years. -n the #aturity Date when the bond e!pires,
the Issuer returns all the money .;rincipal&par and Interest&coupon/ to the Investor .thereby
terminating or =edeeming the bond/ ie. J months, 2 year, 4 years, I years, 2D years, d
A /ar Val)e or Face Val)e$ ;rincipal Amount .generally printed on the bond paper/ returned at
maturity ie. =s 2,DDD or =s. 2D,DDD. ,ontrast this to #aret 9alue .or Actual ;rice based on
Supply&Demand/ and Intrinsic or "air 9alue .estimated using 6ond ;ricing or ;resent 9alue
"ormula/
A Co).on Intere#t Rate$ percentage of ;ar 9alue paid out as interest irrespective of changes in
#aret 9alue ie. I E pa, 2D E pa, 2IE pa, d etc. ,oupon =eceipt T ,oupon =ate ! ;ar
9alue. ,oupon =eceipts can be paid out monthly, (uarterly, si!-monthly, annuallydetc.
,ontrast to #aret Interest =ate .macro-economic/.
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0on*#$ C&aracteri#tic# - Legal /oint#
In*ent)reQ$ @ong @egal Agreement between the Issuer .or 6orrower/ and the 6ond Trustee
.generally a ban of financial institution that acts as the representative for all 6ondholders/.
6asically protects 6ondholders from mis-management by the bond issuer, default, other security
holders, etc.
Claim# on A##et# - Income$
6ondholders have the "irst ,laim on Assets in case the company closes down .6efore
Shareholders/. The "inancial ,harges due to 6ond ?olders must be paid out from the Income before
any <et Income can be distributed to Stocholders in the form of Dividends .see ;&@ Statement/. If
Issuer .or 6orrower/ does not pay the interest to the 6ondholder .i.e. Default/, then the firm can be
legally declared Insolvent, 6anrupt, and forced to close down.
+ec)rit($
#ortgage 6onds are baced by real property .ie. @and, building,, machinery, inventory/ whose
value is generally higher than that of the value of the bonds issued. Debentures and Subordinated 6onds
are not secured by real property but they are baced by personal and corporate guarantees and their
security and value is tied to the anticipated future cash in-flows of the business.
Call /ro"i#ion$
The right .or option/ of the Issuer to call bac .redeem/ or retire the bond by paying-off the
6ondholders before the #aturity Date. >hen maret interest rates drop, Issuers .or 6orrowers/ often
call bac the old bonds and issue new ones at lower interest rates.
0on* Rating# - Ri#4
6onds are rated by various =ating Agencies1
Internationally1 #oody7s, S';.
In ;aistan1 ;acra, 9IS.
6ased on future Ri#4 /otential of the company that is the Issuer of the bond.
6ond ris increases with1
-perating losses .chec ,ash "low Statement and ;&@/
+!cessive borrowings or debt .chec 6alance Sheet/
@arge variations in income
Small size of business
,ountry and foreign e!change rate ris
International 6ond =ating Scale .starting from the best or least risy/1 AAA, AA, A, 666, 66, 6, ,,,,
,,, ,, D. Also S is better and - is worse. So AS is better than A. A- is worse than A.
T(.e# o, 0on*#$
Mortgage 0on*#1 baced ' secured by real assets
+)or*inate* Det an* General Cre*it$ lower ran and claim than #ortgage 6onds.
Deent)re#$
These are not secured by real property, risy
Floating Rate 0on*1
It is defined as a type of bond bearing a yield that may rise and fall within a specified range
according to fluctuations in the maret. The bond has been used in the housing bond maret
E)roon*#1 it issued from a foreign country
Bero 0on*# - Lo3 Co).on 0on*#$ no regular interest payments .S for lender/, not callable .S for
investor/
;)n4 0on*# ' :ig& Aiel* 0on*#$ ,orporations that are small in size, or lac an established operating
trac record are also liely to be considered speculative grade. Nun bonds are most commonly
associated with corporate issuers. They are high-ris debt with rating below 66 by S';
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Con"ertile 0on*#$
A convertible bond is a bond which can be converted into the companyHs common stoc. Rou
can e!ercise the convertible bond and e!change the bond into a predetermined amount of shares in the
company. The conversion ratio can vary from bond to bond. Rou can find the terms of the convertible,
such as the e!act number of shares or the method of determining how many shares the bond is converted
into, in the indenture. "or e!ample a conversion ratio of FD12 means that for every bond .with =s.2,DDD
par value/ you hold you can e!change for FD shares of stoc. -ccasionally, the indenture might have a
provision that states the conversion ratio will change through the years, but this is rare. ,onvertibles
typically offer a lower yield than a regular bond because there is the option to convert the shares into
stoc and collect the capital gain. 6ut, should the company go banrupt, convertibles are raned the
same as regular bonds so you have a better chance of getting some of your money bac
8 ,opyright 9irtual :niversity of ;aistan JJ
Lesson 14
0OND+1 VALUATION
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following topic.
0on*# Val)ation an* T&eor(
In the ;revious lecture, we have studied about bonds and their different characteristics.
In this lecture, we would study about the 6onds valuation ' bond pricing.
>e use similar tools for the bond valuation which we have studied in capital budgeting.
0a#ic .rinci.al e&in* Val)ation o, *irect claim #ec)ritie#$
9alue of a Direct ,laim Security such as a 6ond derives from direct cash flows the form of ,oupon
=eceipts and ;ar =ecovery at maturity. The value of the bond is directly tied to the 9alue of the
:nderlying =eal Assets of the 6usiness .whose operations generate cash receipts from sales of goods
and services/. It means that income from the bond starts from the real assets. The coupon payments
made by the company are generated from the cash flows from the real assets of the company.
<ow, we would calculate the value of the bond by using <et ;resent 9alue or ;resent 9alue
formula that we have studied in the capital budgeting. That is called fair or intrinsic value of the bond.
>e compare the fair value with the maret value of that bond. >hether there is a difference between the
fair value and maret value of the bond.
@et7s review the present value formula for the bond in detail.
The relationship between present value and net present value
N/V E 9Io F /V
>hen we tal about the present value it is e(ual to net present value S initial investment.
>e calculate the present value of the direct claim securities because it gives us intrinsic value of that
direct claim security should be. It is the starting point of comparing them
/re#ent Val)e ,orm)la ,or t&e on*$
n
/VT b ,"t & .2SrD/t T,"2&.2SrD/S,"n&.2SrD/2 S..S,"n& .2SrD/ n S;A=& .2SrD/ n
t T2
In this formula
/V T Intrinsic 9alue of 6ond or "air ;rice .in rupees/ paid to invest in the bond. It is the +!pected or
Theoretical ;rice and <-T the actual #aret ;rice.
rD T it is very important term which you should understand it care fully. It is 6ondholder7s .or
Investor7s/ =e(uired =ate of =eturn for investing in 6ond .Debt/.As conservative you can choose
minimum interest rate. It is derived from #acroeconomic or #aret Interest =ate. Different from the
,oupon =ateU
=ecall #acroeconomic or #aret Interest Theory1 i T i=" S g S D= S #= S @; S S=
CF T cash flow T ,oupon =eceipt 9alue .in =upees/ T ,oupon Interest =ate ! ;ar 9alue. =epresents
cash receipts .or in-flow/ for 6ondholder .Investor/. -ften times an A<<:ITR pattern. ,oupon =ate
derived from #acroeconomic or #aret Interest =ate. The "uture ,ash "lows from a bond are simply
the regular ,oupon =eceipt cash in-flows over the life of the 6ond. 6ut, at #aturity Date there are 3
,ash In-flows1 .2/ the ,oupon =eceipt and .3/ the =ecovered ;ar or "ace 9alue .or ;rincipal/
n T #aturity or @ife of 6ond .in years/
In the ne!t lectures, you would study that how the re(uired rate of return is related to maret rate of
return.
The fair value of the bond is the value that we e!pect the bond to be. >e have to compare this value
with the actual price of the bond in the maret. The actual price of the bond .maret value/ varies on the
supply and demand of the bond in the maret and it will vary depending upon the interest rate in the
bond.
-n the basis of above comparison we decide whether to invest in a particular bond or not.
The maret rate of interest prevailing in the maret effects price of the bond. 6ecause, maret rate
of return will have an impact on rD which is the re(uired rate of return e!pect by the investor of the
bond.
>hen #aret Interest =ate .ie. Investors7 =e(uired =ate of =eturn/ Increases, the 9alue .or
;rice/ of 6ond Decreases. ,hec using formula. This is nown as Interest =ate =is. This is a
8 ,opyright 9irtual :niversity of ;aistan JL
simple relationship because rD which will rise and fall with the general interest rate is in the
denominator of the e(uation. So, when interest rate in denominator goes up the present value .price/
will decrease.
>hen #aret Interest =ate have went behind the coupon interest rate. As the coupon interest
rate has been fi!ed by the bond issuer .The issuer have to pay that rate but the maret rate fluctuates
on daily and hourly basis.
So, >hen #aret Interest =ate f ,oupon Interest =ate, #aret 9alue .or ;rice/ of 6ond c ;ar
9alue. 6ecause when maret is offering lower rate of return then the bond then the bond becomes
valuable. This is nown as a ;remium 6ond. If =e(uired =ate T ,oupon =ate then #aret 9alue T
;ar 9alue. ,hec using formula. As #aturity Date approaches, #aret 9alue of 6ond will
approach its ;ar 9alue. <ote1 #aret =ate varies but ,oupon =ate is fi!ed.
6onds have the limited life and as the life of a bond e!pires the bond approaches its maturity
date the maret value of the bond approaches to par value of the bond.
Long 0on* 9 Ri#4 T&eor($
Interest =ate =is for @ong Term 6onds .i.e. 2D year bonds/ is more than the Interest =ate =is
for Short Term 6onds .i.e. 2 year bonds/ provided the coupon rate for the bonds is similar. >hen
investor buy a long term bond he is loced in investment for long term period there are more chances of
fluctuation in interest rate and the inflation rate.
So, the impact of interest rate changes on @ong Term bonds is greater. @ong Term 6ond ;rices
fluctuate more because their ,oupon =ates are fi!ed .or loced/ for a long time even though #aret
Interest =ates are fluctuating daily% therefore the price of @ong 6onds has to constantly eep ad0usting.
;rice of the long term bond fluctuates more as compared to the short term bond. 6ecause, you
have a long term bond with fi! coupon rate but the maret interest rate is fluctuating in between the
years
0on* /ort,olio T&eor($
,hanges in #aret & #acro Interest =ates have 3 #a0or Impacts on the ;ortfolio .collection of bond
investments/ of the 6ondholder1
718 Intere#t Rate Ri#41 In this, the value of 6ond ;ortfolio Drops if interest rates =ise/ and
728 Rein"e#tment Ri#41 In this, the overall =ate of =eturn .or Rield/ on the 6ond ;ortfolio
=ises when interest rates rise the opportunity cost for the bond holder has changed. "or
e!ample, somebody may have bought a short term bond with coupon rate of 2I E for one
year. At maturity there is a ris that bondholder may not find another investment that can
yield as much as 2IE. >hen old bonds mature, bondholders are forced to invest in
bonds at lower coupon rates/. It is higher for short term bonds.
Intere#t Rate Tra*eo,,$
The 3 +ffects ,ancel +ach -ther -ut. >hen maret Interest =ates =ise, 6ond ;rices Drop
.Interest =ate =is Boes :p/ 6:T -verall =eturns on future reinvestment in bonds go up .ie.
=einvestment =is Boes Down/.
0on* Mat)rit( 7Li,e8 Tra*eo,,$
S?-=T-life bonds .ie. 2 year/ have less Interest =ate =is than long 6onds .ie. 2D years/ but
the Short-life bonds have #-=+ =einvestment =ate =is.
0on* Val)ation 9 Ca,I Ca#e +t)*(
+!ample1
Rou do not have enough money to start your business so you approach a ban. The ban offers
to lend you =s 2DD,DDD and you sign a bond paper. The ban ass you to issue a bond in their favour on
the following terms re(uired by the ban1
;ar 9alue T =s 2DD,DDD .ie. @oan ;rincipal Amount/
#aturity T 3 years
,oupon =ate T 2IE mar-up paid at end of each year
Security T ;roperty Deed for the canteen space
<ote1 This is a simplified case where we are treating a short-term ban loan lie a 6ond.
For t&e 0an4< 3&at i# t&e Val)e o, In"e#ting in a 0on* 3it& (o)'
," T ,ash "low T ,oupon 9alue
T ,oupon =ate ! ;ar 9alue
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T 2IE ! =s 2DD,DDD T =s2I,DDD pa.
The ban will receive =s 2I,DDD in interest every year for two years from you because you have
agreed to pay 2IE mar-up.
Assume the 6an7s =e(uired =eturn .rD/ T 2DE pa. The ban7s opportunity cost is 2DE because it
can earn this much by investing ris free in T-bills
<ow compute the ;9 or "air ;rice of 6ond1
$ ;9 T 2I,DDD & 2.2 S 2I,DDD & .2.2/2 S 2DD,DDD & .2.2/2 T 24,J4J S 23,4OL S C3,JFI T
S=s. 2DC,JLC .T ;9 and <-T <;9U/
So, what is the 9alue of this "inancing Deal to the 6anP @ending .ie. negative =s 2DD,DDD/ to you
today at 2IE mar-up for 3 years is worth positive =s 2DC,JLC to the ban today, i.e. A net gain in
value for the ban. 6:T, if some other ban offers to pay =s 22D,DDD to this ban to buy this deal
from them, then this ban should sellU
8 ,opyright 9irtual :niversity of ;aistan JO
Lesson 15
0OND+ VALUATION AND AIELD ON 0OND+
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following topics
0on* Val)ation
Aiel* o, 0on*#
In previous lecture, we studied are bonds are long term debt instruments. @ie Stoc bonds are also
direct claim securities which means that the value of these bonds is determined by the future cash flows
that bond holders will receive. These cash flows are of two basic types
2. ,ash inflow1 in the form of coupon receipt with regular interval over the life of the bond
3. -ther cash flow is the par value of the bond which you will receive at the maturity date of the
bond.
/re#ent Val)e ,orm)la ,or t&e on*$
n
/VT b ,"t & .2SrD/t T,"2&.2SrD/S,"n&.2SrD/2 S..S,"n& .2SrD/ n S;A=& .2SrD/ n
t T2
<;9 T Intrinsic 9alue of 6ond or "air ;rice .in rupees/ paid to invest in the bond. It is the +!pected or
Theoretical 9alue and needs to be compared to the #aret ;rice. It is different from the ;ar .or "ace/
9alue which is printed on the 6ond paper.
rD T 6ondholder7s .or Investor7s/ =e(uired =ate of =eturn for investing in 6ond .Debt/. DI""+=+<T
from the ,oupon =ate and the #aret & #acroeconomic Interest =ateU
T&ere are a#icall( 2 4in*# o, Ca#& Flo3#$
.2/ Annuity from "i!ed =egular ,oupon =eceipts .,"T ,oupon =ate ! ;ar 9alue/ and
.3/ Single ,ash "low from ;ar 9alue .or Initial Investment/ =eturned to the Investor on maturity.
In this e(uation
rD$ It represents the re(uired rate of return. It is the return which is re(uired by the investor based on
his opportunity cost. In case of ;aistan, the investor re(uired a higher return on bond then the rate of
marup offered by the ;@S account in ban. It is different from the ,oupon =ate and the #aret &
#acroeconomic Interest =ate.
Co).on or CF$
It is a fi!ed rate and it is e(ual to
.,"T ,oupon =ate ! ;ar 9alue/
;ar value of the bond is fi!ed but the maret price varies with the change in the supply and demand,
perception of investor for that bond.
E5am.le$
Defense Savings ,ertificates1 Suppose that you invest in a Defense Savings ,ertificate whose ;ar
9alue is =s 2DD,DDD. The 6ond Issuer is the Bovernment of ;aistan. The ,ertificate has small
detachable coupons. Rou .as the 6ondholder or Investor/ can present one ,oupon at the end of
every month and receive =s 2,DDD cash. After 2 year, you will be repaid your ;rincipal Investment
.or ;ar 9alue/ of =s 2DD,DDD. Assume your =e(uired =eturn .rD/ is 2DE pa. >hat is the ;resent
9alue of this Investment to youP
In the previous lectures, we have solved simple version of similar e!ample we solved a problem
similar to this where we had to calculate the <;9 of the Defense Savings ,ertificate with 2 Annual
,oupon payment after 2 year.
>e arrived at the following appro!imate answer1
<;9 T -Io S ,"2 & .2S i/ S ,"I2 & .2S i/
T -2DD,DDD S 23,DDD&.2SD.2D/ S 2DD,DDD&.2SD.2D/
T -2DD,DDD S 2D,ODO S OD,ODO
T 2,C2C
.<-T+1 ;9 T <;9 S Io T 2D,ODO S OD,ODO T 2D2,C2C/
6ut this is not the correct e!act answer to our present e!ample because it ignores monthly
compounding.
Acc)rate +ol)tion 9 Mont&l( Com.o)n*ing$
The Accurate solution to the Savings ,ertificate +!ample with #onthly ,oupons re(uires us to
use a monthly cash flow diagram and do monthly discounting. There is an Annuity Stream of 23
8 ,opyright 9irtual :niversity of ;aistan LD
,oupons .,ash Inflows/ of =s 2,DDD each at the end of every month. There is a final ,ash Inflow worth
the ;ar 9alue of =s 2DD,DDD at the end of the 23th month.
The ,ash "low Diagram for 6onds is a ,ombination of 3 "lows1 .2/ an Annuity Stream .of
,oupon =eceipts/ every month for 23 months and .3/ -ne ;ar =eceipt at the end of the 23th month.
Rou can draw their individual ,ash "low Diagrams and then add them up later. Rou can compute their
;97s separately and then add them up later.
,ash flows from coupons represents by the upward pointing arrows which represents cash
inflows.
In combine diagram, at the end of the year there are two upward pointing arrows. -ne for
coupon rate and the other is for the payment of par value of bond.
,alculate the ;9 of ,oupons from the "9 "ormula for Annuities .with multiple compounding
within 2 year/1
"9 T ,," .2 S rD&m /n!m - 2&rD&m
:se #onthly 6asis for this e!ample. n T 2 year m T 23 months
,," T ,onstant ,ash "low T =s 2,DDD T #onthly ,oupon
rD T Annual <ominal =e(uired =ate of =eturn for investment in 6ond .Debt/ T 2DE
pa.
;eriodic #onthly =e(uired =ate of =eturn is rD&m T 2D&23 T D.C44 E T D.DDC44 p.m.
m T 23 months
,oupon Annuity ,ash "low =eceipts
"9 T 2,DDD ! W.2.DDC44/23- 2X &D.DDC44 T S=s 23,IJJ .at the end of 2 year/
;9 .,oupons Annuity/ T "9 & .2 S rD&m/ n!m
T 23,IJJ & .2.DDC44/23 T S=s 22,4LF
"inal ;ar 9alue ,ash "low =eceipt
FV T 2DD,DDD .at the end of 2 year/
/V 7/ar8 T 2DD,DDD & .2.DDC44/23 T S=s OD,I33
/V T ;9 .,oupons Annuity/ S ;9 .;ar/ T 22,4LF S OD,I33
T S =s 2D2,COJ ."inal Answer/
So this ,ertificate is worth =s 2D2,COJ to you today. It is worth more than the #aret ;rice .=s
2DD,DDD/. So it is a good investment.
<-T+1 -ur answer is slightly higher than what we got when we used Annual compounding .=s
2D2,C2C/.when we consider multiple compounding the present value of the bond increases. Its <;9 is
greater than zero so on the basis of our capital budgeting techni(ues you should invest in that pro0ect.
<ow, we consider over all rate of return on a bond. >e have studied e!pected price of the bond. These
two are complimentary. >hen bonds trader tal about he overall return on a particular bond they
referred to yield to maturity.
8 ,opyright 9irtual :niversity of ;aistan L2
0on* Ca#& Flo3 Diagram Savings ,ertificate +!ample
D 2 3 J
23
Time .#onths/
D 2 3 J
23
Time .#onths/
Co).on Ann)it($
/ar Recei.t $
7at Mat)rit(8
7Mont&l(8
Comine*
Ca#& Flo3
Diagram
D 23
=s 2,DDD
=s 2DD,DDD
3 ,ash "low
Arrows at
SA#+ point in
time can be
added.
0on* Aiel* to Mat)rit( 7ATM8$
>e can calculate the 9alue of our Investment in 6onds. 6ut how can we compute its =ate of
=eturnP 6oth are important whether you are taling about Investment in =eal Assets or Securities.
The most common way to compare the -verall =ate of =eturn of different 6onds is to compare
their ATM1#>
In capital budgeting, you can calculate I== using the <;9 e(uation. Similarly, you can calculate it
by setting the ;9 +(uation for 6ond 9aluation e(ual to the ;resent #aret ;rice and solve for )rD*.
:se Trial and +rror or Iteration. The value of )rD* that gives ;9 T #aret ;rice is the RT# for that
6ond.
/V E 0on* Mar4et /rice T ,"t & .2SrD/t
,"2& .2SrD/ S,"3&.2SrD/2SdS,"n&.2SrD/nS ;A=&.2SrD/n
All variables are nown .ie. ,", ;A=, and n/ +Y,+;T rD .Set ;9 e(ual to the Actual ;resent #aret
;rice of 6ond and solve for rD
RT# T rD
0on* ATM E5am.le$
Term "inance ,ertificate .T",/1 The T", .a ind of 6ond/ of ,ompany A6, is traded in the
Karachi Stoc +!change for =s ODD. The ;ar 9alue of the T", is =s 2,DDD. The ,oupon =ate is fi!ed
at 2IE pa. ,oupons are paid annually. The T", will #ature after e!actly 3 Rears .it is a I Rear 6ond
issued 4 Rears ago/. >hat is the -verall +!pected =ate of =eturn .ie. RT#/ offered by this T",P
#aret ;rice .=s ODD/ is @+SS than its ;ar 9alue .=s 2,DDD/. This 6ond is selling at a Discount. >hyP
;ossibly Interest =ate =is. #aret Interest =ate rises above T",7s "i!ed ,oupon =ate so #aret ;rice
of the T", falls below ;ar. <ote1 when #aret Interest =ates rise, =e(uired =ate of =eturn .rD/ for
Investors rises. 6ut, ,oupon =ate fi!ed by 6ond Issuer at time of issue.
The +!pected .or ;romised/ =ate of =eturn for Investors is the Rield to #aturity .or RT#/.
,ompute the -verall =eturn .or RT#/ for the T", using the -ld I==-lie Approach1
;9 T #aret ;rice T =s ODD
;ar 9alue T=s 2,DDD. =eceive this after 3 Rears .remaining life/
Annual ,oupons T,oupon =ate ! ;ar T2IE!2, DDD T =s 2ID
rD T #inimum =eturn =e(uired by the Investors investing in
The 6ond #aret T RT#.
This is unnown in the e(uation.
;9 T ODD T 2ID & .2S rD/ S 2ID & .2SrD/2 S 2,DDD & .2SrD/2
ODD T 2ID & .2S rD/ S 2,2ID & .2SrD/2 . :se Trial ' +rror
rD V 1GT$ Try rD T 3DE1 ;9 T O3F .close/
Try rD T 32E1 ;9 T ODO .closer/
ATM E 21>WT$ .Bives ;9T=s ODD/
RT#1 RT# is the e!pected rate of return for which the bond holder holds the bond until maturity but if
the bond holder before maturity is called by the issuer or if the holder of the bond decides to sell the
bond before maturity then your answer will change .all the calculation will remain the same only par
value is replaced as n
;9Tb ,"t & .2SrD/t T,"2&.2SrD/S,"3&.2SrD/3SdS,"n&.2SrD/nS,A@@&.2SrD/n
tT2
>here ,A@@ T ;A= 9alue S 2 Rear7s >orth of ,oupon =eceipts
ATM ETotal or O"erall Aiel* E Intere#t Aiel* F Ca.ital Gain# Aiel*
T", +!ample Total Rield T RT# T S32.LE
Intere#t Aiel* or C)rrent Aiel* E Co).on ? Mar4et /rice
T", +!ample Interest Rield T =s 2ID & =s ODD T S2J.LE pa
Ca.ital Gain# Aiel* E ATM 9 Intere#t Aiel*
T", +!ample ,apital Bains Rield T 32.LE - 2J.LE T SI E
n T #aturity or @ife of 6ond .in years/
"9T,,"W.2Sr
D
&m/
n
Z
m
-2X&r
D
&m
<T2 year ,mT no. of intervals in a year T23
,,"Tconstant cash flow T2DDDTmonthly copoun .we can plug the values in this formula to now what
the future value of annuity is going to be Ptae a loo at the copoun annuity 1
"9T2DDDW.2-D.DDC44/23-2X&D.DDC4TS23IJJ at the end of one year what is the present value of this
copoun annuity
;9T"9&.2Sr
D
&m /
nZm
T23IJJ.2.DDC44/
23
TS224LF
This is the present value of cash flow from coupon. <ow we need to calculate the present value of face
value at maturity suppose face value T2DD,DDD then
;9.;A=/T2DD,DDD&.2.DDC44/
23
TSOD,I33
<ow, we combine the present value of coupon interest and present value of par both
i.e.T224LFSODI33T =s.2D2COJ.
>hen we compare the answer with annual cash flows where coupon was not compounded
monthly .it is grater because monthly compounding increase future cash flows as well as the present
value .3
nd
thing is that this <;9 is grater than the initial investment which is =s.2DD,DDDso, we should
under tae this pro0ect because the <;9 is grater .now, the ne!t area is the rate of return so, the
important thing in this regard is yield to maturity .this is abbreviated as RT#.it is easy to understand
because we have discussed I== in capital budgeting .where we set <;9TD and calculated for r .here
maret price is the RT# of the bond and then solving for the variable r
D
Tre(uired rate of return .so,
let7s try to understand RT# using a very simple e!ample ,the e!ample that we will pic out is that of
term finance certificate or T", which is by the stoc e!changes of ;aistan for =s.ODD.let7s assume that
its par value is =s.2DDDfi!ed or coupon interest rate is 2I p.a. and it is paid annually ,total life of the
T", is I years 4 years have already passed and it will mature 3 years from now what will be over all
e!pected rate of return .So, let7s see the e(uation if we compute the over all yield here we can e(uate
;9Tmaret value is the RT# for the bond the ;9TODD which is maret price ;A=T2DDD.
Annual coupon rate Tcoupon rate Zpar T2I&2DDZ2DDDT2ID
r
D
Tminimum return re(uired by the investor in the bond maret TRT# it is unnown P
;9T ODDT2ID&.2Sr
D
/S2ID& .2Sr
D
/
3
S2DDD&.2SrD/
3
we also now that the value of rD should be more than 2IE you will try different values for e!ample if
you try 3DE you will come up with ;9T3F .close/,try rDT32.LE ;9TODD so,
RT# T32.LE TODD
Therefore 32.LE is the yield to maturity for this T", because rDTRT# .RT# is the e!pected
rate of return for which the bond holder holds the bond until maturity but if the bond holder before
maturity is called by the issuer or if the holder of the bond decides to sell the bond before maturity then
your answer will change .all the calculation will remain the same only par value is replaced as call value
so,
,allTpar value SI, year copoun receipts
Another thing to eep in mind is that RT# has two components first is
RT#Tinterest yield on bond Scapital gain yield on bond from his e!ample
RT#T 32.LE so,let7s calculate the interest yield
I<T+=+ST RI+@D Tannual copoun interest &maret price
T2ID&ODD T2J.LE so,
,A;ITA@ RI+@D TRT# $I<T+=+ST RI+@D
T32.LE-2J.LETIE
Lesson 16
INTRODUCTION TO +TOC=+ AND +TOC= VALUATION
Learning O!ecti"e#$
topics
Intro*)ction to +toc4#
+toc4 Val)ation
In previous lectures, we have discussed about one ind of direct claim security which is bonds.
6onds are long term debt instruments. <ow, we will tae in detail about another ind of security which
is nown as Stocs or Shares.
+toc4#$
These are e(uity paper representing ownership. Shareholders are part owners of the company. If
you loo at the balance sheet when the company issues shares to raise money such shares should be
shown on the liability side of the balance sheet of the company. Shareholders are called owners of the
company these are shown under the e(uity section .?owever, the shares that are purchased by the
company are shown on the asset side of the company under the head of maretable securities .Benerally,
when we are taling about the issuance of the shares we refer to shares as liability. 6asically, the share
is a legal contractual piece of paper it shows the name of the company. It shows the par or face value of
the share and it also assures that the shareholder is the part owner of the company.
Rememer t&at Shares are distinguished from the bonds because shares represent the
ownership whereas the bond is a debt instrument. Another thing about the shares is to remember that par
value is the value when they are issued the maret value of the shares changes with investor7s
perception about the company7s future and supply and demand situation. So, do not confuse the par
value with the #aret value of the shares .par value is printed on that share certificate. As we have
studied that 9alue of Direct Claim Security is directly tied to the value of the underlying =eal Asset.
%&( rai#e mone( t&ro)g& E2)it( 7i>e> +&are# or +toc4#8 rat&er t&an Det 7i>e> 0on*# or
Loan8'
>hat are the advantages of raising money through e(uityP
+(uity financing gives the fle!ibility that you do not have to made regular payments. In case of debt or
bond you have under taen a promise to pay a fi!ed rate of return .but in case of shares o fi!ed rate of
interest is paid only dividend is paid on net income according to the decisions of the board of directors
and management. Rou have no obligations to pay fi!ed dividend to common shareholders. 6ut, if the
,ompany raises money using 6onds, then it will have to pay a fi!ed amount of interest .or mar-up/
regularly for 3 Rears. If the ,ompany does <-T pay on time, you are declared Defaulter and your
business can be closed and the @enders .6ondholders/ can sell the company7s assets to recover their
money.
The value of direct claim security because derived from underlying real asset. It can be thought
of as a piece of paper that generates a certain cash flow over the period of time. Share certificate is a
piece of paper that represents some other real assets and it generates future cash flows.
2. Dividend you are received as shareholder.
3. ,apital gain
"or e!ample, if there is a te!tile company which need to raise the amount of =s2 million to
invest in looms. ,ompany can raise this amount either by e(uity or bonds.
In case the company decides to raise it through e(uity. Then it issues the share certificate amounting to
=s 2 million and sells them to various interested investors and receives the capital in the form of e(uity.
>hy do these share certificates carry valueP
This investment for the share holders will generate the cash flow in form of income and the cash
flows in the form of capital gains .These cash flows are generated through the under lying real assets
.what are these real assets .the real assets in this e!ample are the te!tile weaving looms and fabric
prepared by these looms. The cash flows are generated from the sale of this fabric. "rom these cash
flows the company is paying dividend .See diagram/
8 ,opyright 9irtual :niversity of ;aistan LF
+&are Conce.t$
A @imited ,ompany can raise money by Issuing .or selling/ +(uity in the form of Shares. In
;aistan, the ;ar 9alue .or "ace 9alue/ of each share is generally =s 2D. 6ut by in large public listed
companies7 issues shares with par value of =s.2Deach .eep in mind that par value of the share is value
when it was issued when it has gone into maret it has different value. The @ife of a Share is considered
;erpetual .or never-ending )going concern*/ unless of course the company closes down or goes
banrupt.
As the financial health .cash flows and income/ of the company changes with time, the #aret
9alue .or ;rice/ of the Share changes .even though it7s ;ar 9alue is fi!ed/. #aret ;rices also change
depending on the Supply-Demand for the share and also speculation or satta.
Shares of @isted ;ublic @imited ,ompanies are traded in the Stoc +!change lie KS+ .Karachi
Stoc +!change/, @S+ .@ahore/, IS+ .Islamabad/. Rou can buy & sell shares over the phone '&or
computer through your 6roer whose agents & Nobbers are trading at the e!change. Rou mae payments
to your 6roer through a 6roerage Account at one of the bans in the Stoc +!change or through cash
soon after the trade is made.
Shares of ;rivate @imited ,ompanies .which are not listed/ can also be bought and sold
privately and the ,orporate @aw Authority and =egistrar Noint Stoc ,ompanies need to be informed.
T(.e# o, E2)it($
There are two types of e(uity
1> Common +toc4
2> /re,erre* +toc4
Common +toc4$
It is the most common ind of e(uity as compared to preferred stoc. ,ommon Shareholders are
-wners who have 9oting =ights in management decisions. ,ommon Shareholders are owners who
receive a Dividend .share of the ;rofit or <et Income proportionate to their shareholding/ which varies
depending on the <et Income for that year and the decision of the 6oard of Directors regarding how
much to =etain and =einvest. ,ash flows associated with common shares will be used to calculate the
e!pected price of share then we compare it maret value of stoc. There are 3 inds of cash flow
associated with the stocs
2. Dividend you received as shareholder1 In case of common stocs, these are unpredictable
and changing as to bond valuation where the coupon receipts are generally constant and
regular in time interval. Therefore we can use annuity formula. 6ut when we are taling
about common shares dividends are not fi!ed. That7s mae the valuation of common stoc
different from bond valuation
3. ,apital gains
/re,erre* +toc4$
This ind of +(uity is rare. ;referred Shareholders get a preference .or priority/ over the
,ommon Shareholders in recovering their money if the company goes banrupt. Although
;referred Shareholders are owners, they may not get voting rights. It is also nown as ?ybrid
8 ,opyright 9irtual :niversity of ;aistan LI
+&are Val)e - Ca#& Flo3# from
:nderlying =eal Assets
,-#;A<R7S REAL %OR=ING A++ET+
that has issued the Share ie1 >eaving @ooms
,-#;A<R7S O/ERATING CA+: FLO%+
' I<,-#+ ie. =evenue from sale of "abric
.,ompany 9alue/
DIVIDEND - CA/ITAL GAIN CA+:FLO%+
i.e. ,ash pay out to Shareholders
.Share 9alue/
,apital
6udgeting <;9
,riteria
Securities 9aluation
or Share ;ricing
+(uity. As it is a #i! of 6ond and Share. ;referred Shareholders receive a "i!ed =egular
Dividend .similar to the ,oupon for a 6ondholder/.
+&are /rice Val)ation 9 /re,erre* +toc4$
/er.et)al In"e#tment 3it& Fi5e* Reg)lar Di"i*en*#$
;erpetual Investment means you are considering buying this Stoc and eeping it foreverU
/V E /oJ E DIV 1 ? r /E
>here r ;+ T #inimum =e(uired =ate of =eturn on ;referred Stoc +(uity for the individual investor,
;9 T ;resent #aret 9alue .or +stimated ;resent ;rice/ which depends on DI9 2 T "orecasted "uture
Dividend in the ne!t period .ie. Rear 2 and all other years since DI9 2TDI93T DI94T.../ 6asically, it
is a ;erpetuity "ormula.
Finite In"e#tment$
"inite Investment means you plan to buy this Stoc and then sell it in a few days or years .n/. "ormula
similar to 6ond.
/V E /oJ E DIVt ? 71F r/E8 t S ;n & 71F r/E8 n .
tTyear. Sum from t T 2 to n. ;n T "inal +!pected Selling ;rice
/V 7+&are /rice8 E Di"i*en* Val)e F Ca.ital Gain ?Lo##.
The Dividend 9alue derived from Dividend ,ash Stream and ,apital Bain &@oss from Difference
between 6uying ' Selling ;rice.
E5am.le$
,ompany A6, ;referred Stoc is traded in the @ahore Stoc +!change and has a #aret ;rice of
=s 24. The ,ompany has fi!ed the Dividend to be =s 3 per share. The ;ar 9alue of each share is
=s 2D. Rou e!pect the ;rice to be =s 24 after 3 years. As the investor, you e!pect a #inimum
=e(uired =eturn of 2DE because you can earn that much from a ban deposit account almost ris
free. 6:T, Stocs are generally more risy investments than ban deposits S- you will only invest
in risy stoc I" the e!pected return is higher than 2DE - lets say 2IE. ,alculate the "air .or
+!pected/ ;rice of the ;referred Stoc.
NOTE$ %e 3ill *i#c)## RI+= in *etail later in co)r#e
/er.et)al In"e#tment in /re,erre* +toc4
$ /V E DIV 1 ? r /E T =s 3 & 2IE T 3 & D.2I T R# 1C>CC
The "air .or Intrinsic 9alue/ of the Share to Rou is =s 24.44. The #aret 9alue is =s 24. So, the Share
is worth more to Rou than its price in the maret. It is undervalued and you will gain value by buying
it.
Finite In"e#tment in /re,erre* +toc41
$ /V E DIVt ? 71F r/E8 t S ;n & 71F r/E8 n. n T 3 years
T 3 & .2.2I/ S 3 & .2.2I/2 S 24 & .2.2I/2 T R# 1C>0R
In this e!ample, ;erpetual Investment in ;referred Stoc is worth more than "inite Investment in
;referred Stoc because ;resent 9alue of the Infinite Stream of =s 3 Dividends is more than the ;resent
9alue of the e!pected future Selling ;rice .=s 24/.
+&are /rice Val)ation 9 Common +toc4
Finite 7Limite* Li,e8 In"e#tment in Common +toc4
It is more common. <eed to account for ,ash "lows from 9ariable Dividends and +stimated
Selling ;rice .;n/.
<ote that ;n depends on DI9nS2. ;rice at any point in time will always depend on Dividend in the
following yearU "ormula is similar to 6ond 9aluation +(uation.
/er.et)al In"e#tment in Common +toc4$
;9 T DI92&.2SrCE/ SDI93&.2SrCE/2 S..S DI9n&.2SrCE/n S /n?71FrCE8n
;9 T ;oZ T +!pected or "air ;rice T ;resent 9alue of Share, DI92T "orecasted "uture Dividend at
end of Rear 2, DI9 3 T +!pected "uture Dividend at end of Rear 3, d, ;n T +!pected "uture Selling
;rice, r,+ T #inimum =e(uired =ate of =eturn for Investment in the ,ommon Stoc for you .the
investor/. <ote that Dividends are uncertain and n T infinity
/V 7+&are /rice8 E Di"i*en* Val)e F Ca.ital Gain>
Dividend 9alue is derived from Dividend ,ash Stream and ,apital Bain & @oss from Difference
between 6uying ' Selling ;rice.
/er.et)al In"e#tment in Common +toc4$
8 ,opyright 9irtual :niversity of ;aistan LJ
It is an idealized ,ase. The "inal ,ash "low term .containing ;n/ in the e(uation taes place at
Rear n T infinity The last term .containing ;n/ has a ;resent 9alue almost e(ual to Mero because the
Di#co)nt Factor 71FrE8n in the denominator becomes very large when nTinfinity. So, you can ignore
the @ast ,ash "low terms taing place at Rear n.
+im.li,ie* Form)la .;n term removed from the e(uation for large investment durations i.e. n T
infinity/1
;9 T DI92& .2SrE/ S DI93& .2SrE/ 2 S d DI9n&.2SrE/n
T DIVt ? 71F rE8 t> t T year. Sum from t T2 to n
This +(uation is still impractical because need to forecast Dividends for every year foreverUU
E5am.le$
The ,ommon Stoc of ,ompany A6, is being traded in the Islamabad Stoc #aret. Its
#aret ;rice is =s.24. Rou study ,ompany A6,7s Annual =eport, 6alance Sheet, Income Statement,
and ,ash "low Statement and you forecast the future Dividends to be =s 3 in the first year and =s F in
the second year. Rou forecast the #aret ;rice to be =s 24 after 3 years. The ;ar 9alue of each share is
=s 2D. The =is "ree =eturn is 2DE pa. Rour e!pected #inimum =e(uired =eturn from the high-ris
,ommon Stoc of A6, is 20T> ,alculate the "air .or +!pected/ ;rice of the ,ommon Stoc
Common +toc4 Val)ation 7Ri#4( In"e#tment$ rCEE 20T8
2
st
year will be =s.3 and dividend in 3
nd
year will be =s.F assume ris free rate of return is 2DE and high
rate of return to be re(uired is 3DEagain this 3DE is higher than 2DE in a country .and this 3DE
minimum re(uired rate of return is higher than the preferred stoc re(uired by that company is 2I E
.this is because common stoc is considered more risy than preferred stoc and ban deposit in a
country .let7s calculate the value of common stoc for company A6, we will use our old present value
formula for finite investment 1
;9T3&23SF&.2.3/3S2.4&.2.3/3
"inite Investment for 3 Rears1 ;9 T 3&1>2 S F & .2.3/2 S 24 & .2.3/2 T =s 24.FL
This is estimated price for 3
nd
year investment based on forecasted dividend let7s see the long term
investment use present value formula about which we taled earlier on
;erpetual Investment1 ;9 TPP
>e can not determine it because we don7t have Dividend forecast data for every year foreverUU >e need
to use #odels for appro!imating future Dividends ,ash "low Stream1
Mero Browth #odel
,onstant Browth #odel
>e will discuss about these in the ne!t lecture.
8 ,opyright 9irtual :niversity of ;aistan LL
Lesson 17
COMMON +TOC= /RICING AND DIVIDEND GRO%T: MODEL+
Learning O!ecti"e#$
Common +toc4 .ricing
Di"i*en* Gro3t& Mo*el#
In this lecture, we continue our discussion on the topic of stoc price valuation.
In previous lecture, we have discussed that there are two types of Shares .or Stocs or +(uity
Securities/
1> /re,erre* +toc4$
These stocs have regular ,onstant & "i!ed "uture Dividends ,ertain for the ;referred
Shareholders. :se old ;erpetuity ,ash "low ;attern and formulas to estimate theoretical
"air Stoc ;rice.
2> Common +toc4$
Theses stocs have variable future dividends e!pected by the common shareholders. :se Mero
' ,onstant Browth #odels to simplify future Dividend forecasts in estimated Theoretical Stoc ;rice
.or ;9/ e(uation. There dividend depend upon the income earned by the company and also upon the
management decision regarding the dividend declaration.
6oth stocs represent ownership of =eal Assets in ,ompany.
Dividends are the Shareholder7s portion of the Distributed <et Income. The value of direct
securities .piece of paper/ derived from the cash flows generated from the underlying real assets.
There are two types of In"e#tment Time :ori6on#
1> Finite In"e#tment1
In this duration of our investment is limited. ,ash inflow from "orecasted Selling
;rice must be taen into account in price estimate.
3. /er.et)al In"e#tment$
It is very long term horizon for long term investment. It is ;erpetual so "orecasted Selling ;rice not
significant and can be eliminated. If you are planning to buy and hold the share for 3D or 4D years then
you can consider it as a long term assets. Similarly, an investment in the share for the period of one or
two years
9alue of a Share .which is a Direct ,laim Security/ can be estimated based on the ,ash "lows that
is generates. A Share generates ,ash Dividends 0ust lie a =eal Asset ;ro0ect generates ,ash Income.
The "ormulas for the theoretical price valuation vary depending upon the time horizon. As in
previous lectures the formula for preferred shares varies depending on whether your time horizon is
finite or perpetual.
@et us compare both common shares and preferred shares with the help of numerical e!ample.
E5am.le$
,ompany A6, has issued 3 Types of Shares .both of ;ar 9alue T =s 2D/ and you are
considering Investing in both shares for 3 years because you thin the price will rise to =s 24 by then.
The #aret =is "ree =eturn .-pportunity cost/ is 2DE pa.
A0C /re,erre* +&are#$
Dividend "i!ed by the ,ompany at =s 3 per share per year. Rour re(uired rate of return for the
risy preferred shares is 2IE. This is the rate of return that you e!pect to get if you tae ris of
investing the money in preferred shares. ;referred shares are considered to be more risy then the
deposit in the ban. So, our re(uired rate of return in case of preferred stoc should be higher then 2DE.
A0C Common +&are#$
Dividend varies. After analyzing the ,ompany7s Annual =eport, 6alance Sheet, Income ' ,ash
"low Statements, you forecast the future Dividends to be =s 3 in the first year and =s F in the second
year. The re(uired rate of return does not have to be identical to the re(uired rate of return on preferred
shares. As, there is no guarantying you a fi!ed rate of return on common shares. Rour re(uired rate of
return for the more risy common shares is 3DE pa. "inally, based upon the analysis of financial
statements of the company you e!pect that the price of share will rise to =s. 24 after 3 years. Rou
planned to loo at different investment cases you are interested in estimating what the theoretical maret
price of this share should be if you invest perpetually and you are also interested in the price of the share
8 ,opyright 9irtual :niversity of ;aistan LC
if you invested for a short period time. So, for the case of preferred stoc, we calculate the e!pected
maret price for long term investment would be.
+ol)tion$
/re,erre* +toc4 .=isy Investment1 r/ET 2IE c 2DETris free/
;erpetual1 ;9 T DI92& r/E T 3 & 2IE T 3&0>1G T =s 24.44
<ow in case of finite investment
3 Rear ."inite/1 ;9T3?1>1GS 3& .2.2I/2 S1C& .2.2I/2 T=s 24.DC
Common +toc4 Val)ation .#ore =isy Investment1 rCET 3DE/
;erpetual Investment1 ;9 TP >e don7t have enough Dividend forecast data in order to calculate
the value for 3D or 4D years from now. >e discuss the solution of this problem later in the lecture .?ere
2.3 T .2S3DE/. >e use =s 24 because we e!pect to sell these shares for =s.24 after 3 Rears.
3 Rear ."inite/1 ;9 T3&1>2 S F& .2.3/2 S1C&.2.3/2 T =s 24.FL
Inter.retation$
In our e!ample, ,ommon Stoc has higher Intrinsic ;resent 9alue or "air 9alue .or +stimated
#aret ;rice/ than ;referred Stoc because ,ommon Stoc offers higher e!pected Dividends which
more than compensates for the higher ris of the common stoc. >e discuss this in detail when we
study the topic of =is and =eturn.
+&are Val)e#$
Fair Val)e V+ Mar4et /rice
Fair Val)e1
It is estimated from ;9 +(uation. >e calculate this from <;9 e(uation based on a re(uired rate
of return as the discount rate or r in the e(uation. This is very important to understand because the =-=
is our personal =-= and its value varies depending on the investor who is doing the calculation. +very
person has a different =is ;rofile. Therefore, "air 9alue varies depending on the investor who is doing
the calculation and his&her ;ersonal =e(uired =eturn.
Mar4et /rice1
It is actual price at which it is bought or sold. It is determined by Share7s Demand&Supply '
Investor ;erceptions ' ;sychology about the company behind the share. #aret ;rice is almost
identical for everyone.
In E,,icient Mar4et# where investors have almost e(ual information, "air 9alue will basically
match #aret ;rice. 6ut, temporarily they can differ. Then what happensP :sually, you thin that
whether the price of the thing purchased by you have that much price or not. Similar (uestion will be
ased in share trading
If Mar4et /rice X Fair Val)e$ then Stoc is under valued by the #aret. It is a bargain and
investors will rush to buy it. Therefore, Share7s Demand will rise and #aret ;rice will rise to match the
"air 9alue. Dynamic +(uilibrium.
If Mar4et /rice V Fair Val)e then Stoc is -ver 9alued
+&are /rice Val)ation 9/er.et)al In"e#tment in Common +toc4$
/er.et)al In"e#tment in Common +toc4
The ;9 "ormula would re(uire us to mae Dividends "orecast for every year in future. >hich
is not feasible for usP Therefore, we can not use the old version of ;9 formula. >e use 3 approaches to
solve this problem.
Bero Gro3t& Di"i*en*# Mo*el$
In this we assume ;erpetual Dividends at Mero Browth i.e. ,onstant ;erpetual Dividends.
Similar to ;referred Stoc 9aluation "ormula i.e. DI92 T DI9 3 T DI94 In this method the
simplification we made is this
In this there is a "i!ed =egular Dividends ,ash "low Stream for every year in future.
This is very simple method as the dividend for first year and the last year remains identical. It is a
simple perpetuity model. Therefore we use /er.et)it( Form)la. >hich is Similar to ;referred Stocs
.;erpetual Investment/ e!cept ;referred Dividends .which are declared by the ,ompany/ not same as
,ommon Stoc Dividends .which are estimated/.
The "ormula for common stoc
/V E /oZT DI92 & .2S rCE/ S DI92 & .2S rCE/ 3 S DI92 & .2S rCE/ 4 S ... S...
8 ,opyright 9irtual :niversity of ;aistan LO
T DIV 1 ? rCE.
;oZ is the +!pected .Theoretical/ ;resent ;rice. The ;rice depends on DI92 which is the
+!pected "uture Dividend for Rear 2 .and all other years in future/.There is difference in case of
common stoc ' preferred stoc. In common stoc we assume the constant growth but in preferred
stoc the company has assured the preferred stocholder that he will get fi!ed rate of dividend.
Con#tant Gro3t& Di"i*en*# Mo*el$
In this, we need only to forecast the ne!t year dividend and assume constant dividends Browth
at Inflationary Browth =ate )g* which e(uals I - 2DE pa .depending on country/.
DI9tF1 T DI9t ! .2 S g/ t> t T time in years i.e. If g T 2DE
Dividends ,ash "low Stream grows according to the Discrete ,ompound Browth "ormula
DIVtF1 E DIVt 5 71 F g8 t>
t T time in years.
So if you have estimated the present Dividend .DI9o/ or the ne!t year7s Dividend .DI92/ then
you can estimate all future dividends using this formula. In this, the tric is how to pic the right growth
rate. Benerally, we pic the rate of growth of inflation. As common stoc holders we assume that the
dividends are continue to grow at constant rate which is e(ual to rate of growth of inflation. If inflation
rate is 2DE then the dividend will grow at 2DE.you have dividend of =s 2D in first year then you will
have dividend of =s 2D plus 2DE of =s 2D which is e(ual to =s.22.
E#timate Gro3t& Rate E PgQ )#ing$
2. "inancial Statements .calculate Dividends7 growth rate/
3. Inflationary Browth =ate of +conomy .say I - 2DE pa/
Form)la$
/V E /oJ EDIV1 71Fg8 ?71F rCE 8 SDIV1 71Fg82 ? 71F rCE 82 S DIV 1 71Fg8C ? 71F rCE 8C S ...
T DIV 1 ? 7rCE 9 g8
DI9IT dividend for first year
In this we can derive the answer as sum of geometric series. Browing ;erpetuity formula.
E5am.le$
Rou are considering maing a very long term investment in the common stoc of ,ompany A6,.
Rour =e(uired =eturn on the investment .based on ris/ is 3DE .r,+/. The present Dividend
offered by ,ompany A6, is =s F. ;ar 9alue is =s 2D.
Dividend Rield ;ricing for ,ommon Stoc under ;erpetual Investment
Bero Gro3t& Mo*el /ricing
;9 T ;oZ T DI92 & rCE T F & D.3D T =s 3D
Con#tant Gro3t& Mo*el /ricing 7a##)me gE10T8
;9 T ;oZ T DI92 & .rCE -g/ T F & .D.3-D.2/ T =s FD
Inter.retation o, Re#)lt1
,onstant Browth ;ricing gives a higher +stimate of ;resent ;rice because it assumes perpetual
2DE compounded growth in dividends forever
8 ,opyright 9irtual :niversity of ;aistan CD
Lesson 18
COMMON +TOC=+ RATE OF RETURN AND E/+ /RICING MODEL
Learning O!ecti"e#$
Common +toc4# Rate o, Ret)rn
E/+ /ricing Mo*el
In this lecture, we will continue our discussion on share price valuation and we discuss the common
stoc valuation in case of long term or perpetual investment.
"irst, we review what we have studied in the previous lecture. >e have discussed 3 approaches of
perpetual common stoc valuation.
1> Bero gro3t& $
In this we assume zero growth in dividends and our formula is
/oJEDIV1 ? rCE 7/oJ i# eing e#timate*8.
2> Con#tant gro3t& rate$
In this we assume that dividend is growing at constant growth rate .inflationary rate/.we
can also use accounting data to calculate Yg1.
gE .lo3ac4 ratio 5 ROE>
In this particular case of constant growth model the formula for estimation of fair price is
/oJE DI V1? 7rCE 9g8
<ow, we have studied about estimating the fair price of the common shares under a very long
term investment but it is e(ually important to now the =e(uired rate of =eturn .=-=/.
In capital budgeting criterion, we have mentioned that we have to loo both <;9 as well as I==.<;9 is
the price or value of the asset or security and I== is the measure of the rate of return of a particular asset
or pro0ect. So, we have to compute both <;9 and I==. Similarly, for the case of direct claim securities
lie share we can use the same e(uation and we can rearrange them for the re(uired rate of return which
is e(ual to rCE
The +stimated =e(uired =ate of =eturn for Investment in ,ommon +(uity .rCE/ can be
calculated by re-arranging the same e(uation1
Di"i*en*# /ricing Mo*el#$
Bero Gro3t&1 ;oZTDI92 & rCE .;oZ is being estimated/
rCEJE DIV1 ? /o 7rCEJ i# eing e#timate*8
Similarly,
Con#tant Gro3t&$ ;oZT DI 92& .rCE -g/
rCEJE 7 DIV 1 ? /o8 F g
Di" Aiel* Ca.>Gain Aiel*
This particular formula the way it is mentioned above is nown as Gor*on1# ,orm)la an* 3e
)#e t&i# ,orm)la to calc)late t&e re2)ire* rate o, ret)rn>
Gor*on1# Form)la$ +stimated "air ;resent ;rice .or ;resent 9alue/ of Share calculated using
"orecasted "uture ,ash "lows of Dividend ;ayouts to Shareholders and their growth
rCEJE 7DIV 1 ? /o8 F g
In this the first part
.DI9 2 & ;o/ is the dividend yield
g is the ,apital gain yield.
The reason we use these terms is that basically .DI9 2 & ;o/ is the fraction of the present price
which represents by the dividends.
g the capital gain yields is simply the lumped measure of e!pected increase in dividend that you e!pect
in the dividend over the life of the asset.
<ow, if you see the formulas of stoc valuation that we have discussed up till now. These
formulas have used forecasted dividends and that is why we called these formula dividend yield
approach to find the price. >e have use dividends as a direct measure of cash flows that a stoc holder
receives from the security.
>e mentioned that we will calculate value of an asset or security based on cash flows it will
generates in the future. Any woring asset can be valued based on its future cash flows.
So we began valuing shares based on dividend income that a share holder7s receives. There is
another approach for valuing shares.
8 ,opyright 9irtual :niversity of ;aistan C2
Earning# .er +&are 7E/+8 /ricing Mo*el$
In this our perspective is not the direct cash flows generated by the shares rather we value the
shares based on cash flows that are generated by the company whose share we are taing. In other
words, +stimated "air ;resent ;rice of Share calculated based on "orecasted "uture ,ash "lows of
,ompany7s +arnings and growth from ;loughed 6ac =einvestments .from =etained +arnings/. >e can
do that because it is mentioned earlier that for direct claim securities lie bond and stocs the value of
security can be calculated from the cash flows of underlying assets. "or share the underlying assets are
the assets of the company and the cash flows generated by the assets of the company.
That is the logic behind the +;S approach. <ow, let7s see the +;S approach to calculate the price of the
share.
E/+ A..roac&$
In +;S approach, we estimate the price of common stoc under very long term investment.
+;S Stoc ;rice +stimation "ormula
/V E /oJ E E/+ 1 ? rCE F /VGO
/o T +stimated ;resent "air ;rice,
E/+ 1 T "orecasted +arnings per Share in the ne!t year .i.e. Rear 2/,
rCE T =e(uired =ate of =eturn on Investment in ,ommon Stoc +(uity.
/VGO T ;resent 9alue of Browth -pportunities. It means the ;resent 9alue of ;otential
Browth in 6usiness from =einvestments in <ew ;ositive <;9 ;ro0ects and Investments. ;9B- is
perpetuity formula.
The formula is
/VGO E N/V 1 ? 7rCE 9 g8 E L9Io F 7C?rCE8N ? 7rCE 9g8
In this ;9B- #odel1 ,onstant Browth )g*. It is the growth in <;9 of new =einvestment ;ro0ects .or
Investment/.gE .lo3ac4 5 ROE
;erpetual <et ,ash "lows .,/ from each ;ro0ect .or reinvestment/.
Io E Val)e o, Rein"e#tment 7Not .ai* to #&are &ol*er#8
E / 5 E/+
>here ;bT ;lough bac T 2 $ ;ayout ratio
;ayout ration T .DI9&+;S/ and
E/+ Earning# .er +&areT .here <I T <et Income from ;&@ Statement and DI9 T Dividend, =+2T =+oS <I2S DI92
=-+ T <et income &e Shares of ,ommon Stoc -utstanding.
<ow when we loo at the detailed method of calculating the <;9 you will see that
S"oc% (Paper) Dire#t Claim
(e#urity issued *y Company
A+C
Real Asse"s & F#"#re
I'es"me"s i !ro(ec"s of
Company A+C
Forecas"e) Di'i)e)s
(Cash %lows generated *y
(to#,s
Forecas"e) Earigs & Sales
Re'e#e (Cash %lows generated *y
real *usiness operations
!rese" *al#e of Compa$
A+C (with #ertain num*er of
Common (hares Outstanding'
!rese" *al#e of a S"oc%
of Company A+C
DI*IDEND !RICIN+ E,!,S !RICIN+
COMMON STOC- !RICIN+ A!!ROAC.ES
N/V 1 E L9Io F 7C?rCE8N ? 7rCE 9g8
If we compare it with the traditional <;9 formula
-Io T 9alue of initial investment
.,&r,+/ T present value formula for perpetuities where you assume that you are generating the net cash
inflow of , every year.
C E Foreca#te* Net Ca#& In,lo3 ,rom Rein"e#tment T Io ! =-+
>here =-+ T =eturn on +(uity T <I & 6oo +(uity of ,ommon Stoc -utstanding
In the +;S approach, in calculating the fair price of the common stoc our conceptual logic was
we calculate the value of the piece of paper based upon the cash flows the real company generated. >e
do this because the value of direct claim securities can be calculated form the underlying assets.
In +;S approach, we tal abut the company and the cash flows that the company generates but in the
case of dividends approach , we are taling about the cash flows directly generated from the piece of
paper.i.e. dividends/.
The ;9B- in +;S approach formula is different from Qg7.
Qg7 it is the growth rate in dividends
;9B- is potential growth in the value of the business from the future investments in new pro0ects. The
basic model we used to estimate this present value of the company which is coming from investment in
the future pro0ects with Sve <;9 is that we assume that the company saves their part of the net income
in the form of retained earning every year. So, in this particular model we are assuming that these
retained earning is invested in pro0ects that will yield Sve <;9 each year and the cash flows are
constant. It also assumes that <;9 from investment that a company maes in new pro0ects grows at
constant growth rate Qg7 perpetually.
E5am.le$
The ,ommon Stoc of ,ompany A6, is trading in the Islamabad Stoc +!change at a maret
price of =s 2DI. Rou are considering investing in it so you study the company7s Annual =eport,
"inancial Statements, and mae some forecasts. The Data is as follows1
"orecasted Dividend <e!t Rear T =s 2D
+!pected Dividend Browth T 2DE pa
"orecasted +arnings per Share T =s 23
Rour =e(uired =eturn on Investment in A6, ,ommon Stoc T 3DE pa.
,ompute the +stimated ;resent "air ;rice of ,ompany A6,7s ,ommon Stoc.
Di"i*en* /ricing 7Gor*on1#8 A..roac&$
/V E /oJ E DIV1 ? 7rCE 9 g8
E 2D & .3DE-2DE/ T 2D&D.2D
T =s 2DD .+stimated "air ;rice is less than #aret ;rice of =s 22D so share is
o"er"al)e* in the #aret/
Earning# /er +&are 7E/+8 /ricing Mo*el
$ /V E /oJ E E/+ 1? rCE F /VGO
E/+ 1 ? rCE E 23 & D.3D T =s JD
;9B- T <;92 & .r,+ -g/ T W-IoS.c& r,+/X & .r,+ -g/
T W-.;b!+;S/ S .Io!=-+& r,+/X & .r,+ -g/
T W-.2&J ! 23/ S .3 ! J&2D & D.3D/X & .D.3D - D.2D/
T W-3 S JX & D.2D T =s FD
;b T 2 - ;ayout T 2 - DI9 & +;S T 2 - 2D&23 T 2&J
g T ;b ! =-+ T 2DE T 2&2D So =-+ T J&2D
;9 T =s JD S =s FD T =s 2DD .+ame a# Di"i*en* A..roac&/.
+;S Approach shows that FDE .i.e. =s FD out of =s 2DD/ of the 9alue is Browth 6ased .i.e. ;9B-/ $
Gro3t& +toc4$
It is growth share where the value of the share is determined by the potential of this company to
grow its business as oppose to company which have low growth rate.
;articularly, for IT internet companies where we e!pect a high rate of growth for he business the ;9B-
term is large percent of the price of the share.
Lesson 19
INTRODUCTION TO RI+=< RI+= AND RETURN FOR A +INGLE +TOC= INVE+TMENT
Learning O!ecti"e#$
topics
Intro*)ction to Ri#4
Ri#4 an* Ret)rn ,or +ingle +toc4 In"e#tment
6efore discussing this important topic we should go through the area of finance which we have
studied up till now.
/art I 7Intro*)ction an* Ca.ital )*geting8
"# #arets, ,oncepts, Definitions
=eview of Accounting
Interest =ate Theory ' ,alculations
Investment Decisions1 <;9 .9aluation/, I==, ;aybac
,apital 6udgeting1 <;9 ' D,"
,apital =ationing .6udgeting for =eal Assets/
/art II 7+ec)ritie# Val)ation8
9aluation of Stocs ' 6onds .Direct ,laim Securities/
The ,hapter F and I of te!t boo cover the topics of ris and return. It is the fundamental concept to
understand the topics of portfolio theory and ,apital Asset pricing model .,A;#/.In the previous
lectures, we are ignoring the origin of re(uired rate of return.
Ri#4$
,hinese Definition of =is1
It is defined as the combination of danger and opportunity. =is is the combination of both.
>hen we tal about ris with the reference to the investment we are taling about ris in term of the
uncertainty in outcome of our investment. >e are taling about the variability, spread, or volatility that
can tae place in the e!pected future 9alue .,ash "lows/ or =eturns. "or e!ample, we are asing
ourselves if we invest =s 2,DDD for buying a share today then what will be the price of the share one
year from now. There is no guarantee about the price of the share after one year therefore there is an
uncertainty or ris we are taing because we do not now the final outcome. So, the difference or
variation in the possible outcomes of a particular investment also represents the risy ness of a particular
investment.
As we have studied earlier that there are two ma0or categories of assets
2 =eal ;hysical Assets 3 ."inancial Assets .Stoc ' bonds/
=is can be understood with reference to the uncertainty of "uture ,ash "lows produced by
Assets .;hysical ' "inancial Securities/. 6usinesses mae forecasts based on certain assumptions which
we have discussed in lecture I of your course. These forecasts are not 2DDE accurate and there is
uncertainty in the possible outcome. The actual cash flows one or five years from now may be very
different from the forecasted and this to represent ris. >hen we tal about ris in investing in direct
claim securities then we need to eep in mind the distinction between Stand Alone =is .or Single
Investment =is/ as oppose to maret or ;ortfolio =is .or ,ollection of Investments =is/.which is a
ris of particular investment compare to other investments you have made. In ;ortfolio ris we are
interested in overall ris of entire collection of investments that made by the company. >e will study
this topic in the ne!t lectures.
In case of portfolio ris we can further made distinction between Diversifiable =is and #aret
ris
Di"er#i,iale Ri#4$ random ris specific to one company, can be virtually eliminated.
Mar4et Ri#4$ It is defined as uncertainty caused by broad movement in maret or economy. #ore
significant.
Ca)#e# o, Ri#4$
These can be ,ompany-Specific or Beneral. It may be because of ,ash @osses from operations
or poor financial management of the company. This is one possibility but the real (uestion is that why
these losses occurred. -ne of the reasons for the losses might be the company7s Debt, Inflation,
+conomy, ;olitics, >ar or "ate. "inal analysis of ris is that it is a game of fate or chance.
8 ,opyright 9irtual :niversity of ;aistan CF
Mea#)rement o, Ri#4$
It is important to attach different numbers to the ris so that we can ran different investments.
=is is measured in terms of the standard deviation or variance. Rou have studied these terms in the
statistics. =is is still (uite sub0ective even after the numbers you have calculated after standard
deviation. The reason is that you have to eep in mind what ind of ris you are taling about. Are you
Stand Alone =is or ;ortfolio =isP
#aret =is or Diversifiable =isP
Stoc ;rice =is or +arnings =isP
Another important thing is Time ?orizon for which you are measuring the ris. Are you
investing in Stocs over 2 Rear or over 4D RearsP
The level of ris might change as time period of the investment change.
F)n*amental R)le o, Ri#4 - Ret)rn$
This rule can be summed up in saying that <o ;ain - <o Bain. Investors will not tae on
additional #aret =is unless they e!pect to receive additional =eturn which is common sense and
(uite logical. #ost investors are =is Averse. Another important principle that one should to eep in
mind is Diversification.
Di"er#i,ication$
It states that don7t put all your eggs in one baset. Diversification can reduce ris. 6y
spreading your money across many different Investments, #arets, Industries, ,ountries you can avoid
the weaness of each. #ae sure that they are :ncorrelated so that they don7t suffer from the same bad
news. Due to certain change in the interest rates some of the investments in your portfolio may go up
and the others go downward.
E"er( Da( E5am.le# o, Ri#49Ret)rn /air#$
=is @evel =eturn
A ,limbing #ount K3 ?igh PP
A Bambling on ,ricet #atches ?igh ?igh
A -il drilling in 6adin 6loc ?igh ?igh
A Satta & Speculation in Shares ?igh #ed-?igh
A ,onstruction ,ommercial ;laza #edium ?igh
A Investing )6lue ,hip* Stocs #edium #edium
A ,rossing =oad at ;ea Traffic #edium PP
A Investing T",7s #ed-@ow @ow
A Depositing #oney in 6an A&c @ow @ow
A Investing in T-6ills @ow @ow
6efore taing about the ris we first see the different possible outcomes of a particular investment
by analyzing the e!pected return. It is mentioned earlier that once we have an idea of the variation then
we can measure the ris of that investment.
Range o, /o##ile O)tcome#< E5.ecte* Ret)rn$
-verall =eturn on Stoc T Dividend Rield S ,apital Bains Rield .Bordon7s "ormula/
Simply, =eturn is proportional to ,apital Bain which is proportional to Selling ;rice. >e can use
"orecasted Selling ;rice as measure of =eturn. The wider the range of ;ossible -utcomes that can
occur, the greater the =is
The chance that a future event will actually occur is measured using ;robability
E5.ecte* ROR E X r V E .i ri
>here pi represents the ;robability of -utcome )i* taing place and ri represents the =ate of =eturn
.=-=/ if -utcome )i* taes place. The ;robability gives weight age to the return. The +!pected or
#ost @iely =-= is the S:# of the weighted returns for A@@ possible -utcomes.
<ow let us tae a loo of case of investing in the share of the particular company.
Suppose you are deciding whether to invest in the Stoc of ,ompany A6,. Rou7re not sure
because the "uture or "orecasted ;rice of the Stoc after 2 year could reach any one of 4 ;ossible
9alues .or -utcomes/. 6efore you can estimate the most liely or #ean or +!pected "uture ;rice, you
need to guess the ;robability of +ach ;ossible -utcome
8 ,opyright 9irtual :niversity of ;aistan CI
0
0>0G
0>1
0>1G
0>2
0>2G
0>C
0>CG
0>H
0>HG
920 10 H0
/
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7
.
8
Rate o, Ret)rn a,ter 1 Aear X r V
)0ELL*
,urve
PE5.ecte* RORQ or Mo#t
Li4el( or Mean ROR T 2DE
;ossible
-utcomes
O)tcome# 7A,ter 1 Ar8 /roailit( 7T8
P6ull #aret* .Stoc ;rice ;2ZT2FD/ 4DE or D.4
)<ormal #aret* .Stoc ;rice ;2ZT22D/ FDE or D.F
)6ear #aret* .Stoc ;rice ;2ZTCD/ 4DE or D.4
2DDE 2.D
;oT ;resent #aret ;rice =s2DD. ;2ZT"orecasted ;rice.
The Sum of ;robabilities of all ;ossible -utcomes #:ST Add :p to 2DDE .or 2.D/.
/a(o,, Tale - E5.ecte* ROR
/a(o,, Tale ,or In"e#tment in +toc4
-utcomes .2 Rr/ ;rob .p/ =-= frc T .;2Z-;o/&;o/
;rice =ises .;2ZT2FD/ D.4 S FD E T .2FD-2DD/&2DD
;rice Same .;2ZT22D/ D.F S 2D E T .22D-2DD/&2DD
;rice "alls .;2ZTCD/ D.4 - 3D E T .CD-2DD/&2DD
2.D
E5.ecte* ROR o, In"e#tment in +toc4
#ost @iely or >eighted Average or #ean =-= =ate of =eturn f r c
E5.ecte* ROR E X r V E .i ri>
T p2 .r2/ S p3 .r3/ S p4 .r4/
T D.4.FDE/ S D.F.2DE/ S D.4.-3DE/
T 23E S FE - JE T 2DT
/roailit( Di#tri)tion
Foreca#te* Ret)rn# ,or +ingle +toc4 In"e#tment
In the diagram, the probability graphed on y a!is and the rate of return is graphed on ! a!is. All
three outcomes are shown in the form of the bars. In this diagram the largest probability taes place at
the value of the e!pected rate of return which is 2DE. If the top of each vertical bar is connected then
the bell curve is formed. It is easy to calculate the ris after calculating the e!pected rate of return. >e
simply use the formula of standard deviation to calculate the ris
+tan* Alone Ri#4 o, +ingle +toc4 In"e#tment$
The wider the range of ;ossible -utcomes .i.e. the greater the variability in potential returns/
that can occur, the greater the =is
=is #easured using Standard Deviation .<ote1 9ariance T Standard Deviation 3/
=is T Std Dev T . r i - f r i c /3 p i . T
Summed over each possible outcome ) i * with return )r i * and probability of occurrence )p i .* f r i
c is the +!pected .or weighted average/ =eturn
This topic will be discussed in detail in the ne!t lecture
8 ,opyright 9irtual :niversity of ;aistan CJ
Lesson 20
RI+= FOR A +INGLE +TOC= INVE+TMENT< /RO0A0ILITA GRA/:+ AND CO9
EFFICIENT OF VARIATION
Learning O!ecti"e#$
topics
Ri#4 ,or +ingle +toc4 In"e#tment
/roailit( Gra.&# an* Coe,,icient o, "ariation
In this lecture, we will continue our discussion on ris and return. This is very important area of
financial management.
In previous lecture, we have mentioned an e!ample for the investment in share and after one
year the share price has 4 possible outcomes. This uncertainty in future price of the share that leads to
the certain distribution in forecasted share price and this distribution is source of the uncertainty which
allow us to calculate ris.
C /o##ile O)tcome# E5am.le Contin)e*$
#easuring Stand Alone =is for Single Stoc Investment
+t* De" T Z T g b 7r i 9 X r i V8 2 . i>
T .b.r i - f r i c/ 3 . i>// 0>G.
T _W.FD-2D/2 .D.4/X S W.2D-2D/2 .D.F/X S W.-3D-2D/2 .D.4/X ` 0>G .
T _3LD S D S 3LD` 0>G T _Var` 0>G.
T _IFD` 0>G T 34.3F
?ow do we interpret this =esult for =isP
+tan*ar* De"iation Inter.retation
>hat are the units of Standard DeviationP
"or our e!ample where =eturn is being estimated in E terms, the units of
Standard Deviation will also be E.
It tells us that if we assume a <ormal ;robability Distribution and symmetric about e!pected rate of
return, then we conclude that JC.3JE of the time, the Actual =eturn will lie within -2 Standard
Deviation and S2 Standard Deviation of the +!pected .or #ean/ =eturn.
+!pected .or #ean/ =eturn T 2DE
S&- 2 Standard Deviation T 2DE S&- 34.3FE which means from .10T 9 34.3FE/ to .10T S 34.3FE/ i.e.
,rom 91C>2HT to CC>2HT>
There is a JC.3JE chance that the Actual =eturn on our Stoc Investment after 2 year will be
somewhere between -24.3FE and 44.3FE. It is important thing to remember that in normal distribution
the area under the curve from -2 standard deviation to S2 standard deviation is JC.3CE. So, we can be
sure that two thirds of the time the actual value for the return will be in between -24.JCE and S44.3F E.
-24.3FE is not a good sign as it indicates that we are maing loss but remember that re(uired rate of
return is 2DE.
8 ,opyright 9irtual :niversity of ;aistan CL
+raphical S"a)ar) De'ia"io
S2 -2
-24.3FE S44.3FE
;
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a
b
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y

.
p
/
F?9 1 +t* De" covers
SR>2ST o, t&e Area
under the Normal
C)r"e always
=eturn .r/ E
-ur +!ample
-3 S3
+!pected .or #ean/
=eturn T frc T 2DE
In the figure the probability is written on y-a!is and the rate of return is mentioned on the !-
a!is. It shows that higher the standard deviation the higher the ris.
<ow, lets tae a loo another e!ample in which we raw comparing three different investments
which we want to compare in terms of ris and return.
E5am.le$
,omparison of 4 Investments in terms of =is ' =eturn. >hich is the best InvestmentP
Ri#4 7+t* De"8 E5.ecte* Ret)rn
Stoc A 34.3FE 2DE
T-6ill&6ond 6 IE 2DE
;ro0ect , 4DE 4DE
T-6ill is @east =isy .lowest Std Dev TIE/ and ;ro0ect , has ?ighest =eturn .T4DE/.
Biven 3 Investments with Identical +!pected =eturn, choose the Investment with the @ower
=is .or +.rea* or Volatilit( or Standard Deviation/
Biven 3 Investments with Identical =is, choose the Investment with the ?igher +!pected =eturn
If you compare first two investments, both have the same rate of return but the T-bills have less
ris. ,learly, T-6ill 6 is a better investment than Stoc A because their =eturns are identical .2DE/ but
the T-6ill is less risy .2DE/ than the Stoc .34.3FE/.
6ut, which is betterP T-6ill 6 or ;ro0ect ,P T-6ill 6 is @ess =isy but ;ro0ect , promises ?igher
=eturn.
<ow, we conceptually visualize these two types of investment
In the figure, we are showing both investments on the same graph. @eft hand shows the
probability distribution for the T- bills and on the right hand side shows the broader and shorter
probability graph for pro0ect ,. ?ow to visualize which pro0ect have higher e!pected rate of return.
;ro0ect , is on right hand side and therefore it has higher return as to pro0ect 6.The other thing is that
pro0ect 6 form a probability distribution which have a sharp hill or spread of the curve is much narrower
as to pro0ect ,. The standard deviation for pro0ect 6 is much narrower then the standard deviation for
pro0ect , .In pro0ect 6 has less ris whereas ;ro0ect , has a higher e!pected rate return. >e have to
loo at ris and return simultaneously to answer that which option is better. >e can derive the answer
with the help of the coefficient of variation
Com.ari#on o, Di,,erent In"e#tment#
Coe,,icient o, Variation$
,oefficient of 9ariation .=is per unit =eturn/
8 ,opyright 9irtual :niversity of ;aistan CC
Com/ie) Ris% & Re"#r +raphical Compariso of
I'es"me"s
T90ill 01 @ow
=is ' @ow
=eturn
/ro!ect C1 ?igh
=is ' ?igh =eturn
/
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7
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8
Rate o, Ret)rn 7r8 T
=is 6
=is ,
+!p =eturn 6
+!p =eturn ,
It i# *e,ine* a# t&e CV E +tan*ar* De"iation ? E5.ecte* Ret)rn> ,oefficient of 9ariation tells us
about the =is per unit =eturn. The pro0ect which offers lowest per unit ris is the best investment. <ow
we calculate the ,9 for both the pro0ects.
,ompare the ,97s of the ;ro0ects1
,9 T-bill T IE & 2DE T D.I
,9 ;ro0ect , T 4DE & 4DE T 2.D
C&oo#e t&e /ro!ect 3it& t&e Lo3e#t CV. ,hoose the T-6ill because it carries the lowest =is per unit
=eturn
Ri#4 A"er#ion A##)m.tion
Mo#t In"e#tor# are .#(c&ologicall( Ri#4 A"er#e. If two investments offer the same +!pected
=eturn, most Investors would choose the one with the lower =is .or Standard Deviation or Spread
or 9olatility/. In other words, most Investors are not ma0or gamblers. <ote that gamblers would
choose ;ro0ect , which appeals to investor greed by offering an upside return of 4DES2DE T FDE U
Con#e2)ence# on +&are /rice$ The ?igher the =is of a Share, the ?igher its =ate of =eturn and the
@ower its #aret ;rice>
8 ,opyright 9irtual :niversity of ;aistan CO
Lesson 21
29 +TOC= /ORTFOLIO T:EORA< RI+= AND E@/ECTED RETURN
Learning O!ecti"e#$
topics
29+toc4 /ort,olio T&eor(
Ri#4 - E5.ecte* Ret)rn
In this lecture, we will continue our discussion on the ris. -ne of the easiest way of calculating ris
using probability is by understanding the chance that are embedded in the game of cards and the
fundamentals of probability are very easily understood. >e discuss in this lecture calculation of ris
using probability. 6ut first we recap the previous concepts formula and
Reca. o, Ri#4 0a#ic#$
=is1 It arises because of :ncertainty, 9olatility, and Spread in possible out comes. There are many
possible outcomes .pi/ for +!pected =ate of =eturns .r.i/.
It is measured using Standard Deviation or 9ariance.
Ri#4 E +t* De" E [ E \ 7 r i 9 X r i V 82 . i > E P+igmaQ
0ell C)r"e A##)m.tion$ In this it is assumed that the forecasted outcome of events will be distributed
in the shape of a <ormal ;robability Distribution. The advantage we gain from using this that after
calculating the standard deviation for any particular investment we have an idea that what the
distribution or the spread of possible outcomes is going to be lie. If you use normal distribution that we
are sure that JC.3JE of the times the Actual "uture =ate of =eturn will lie within -2h and S2 h range
Coe,,icient o, Variation$ Investment ,omparison ,riterion used to simultaneously account for =is '
=eturn
,9 T h& f r c.
-ur -b0ective is to minimize =is ' ma!imize =eturn.
X r V E E5. or %eig&te* A"g ROR E .i ri
/ort,olio Ri#4 - Ret)rn$
/ort,olio$
;ortfolio is defined as a ,ollection of #ultiple Investments. #ost organization maintains large
collection or portfolio of investments and when we tal about the ris and return then we have to
consider overall ris and return for the entire portfolio. ;ortfolios may have 3 or more stocs, bonds,
other securities and investments or a mi! of all. >e will focus on Stoc ;ortfolios.
8 ,opyright 9irtual :niversity of ;aistan OD
Braphical Standard Deviation
S2 -2
-24.3FE S44.3FE
;
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y

.
p
/
F?9 1 +t* De" covers
SR>2ST o, t&e Area
under the Normal
C)r"e always
=eturn . r / E
-ur +!ample
-3 S3
+!pected .or #ean/
=eturn T frc T 2DE
Ri#4 i# Relati"e$
The =ISK from investing in Stoc of ,ompany A6, usually decreases as you mae more
Investments in other stocs of different unrelated companies. This is a logical fact because when you
tal about one business which is earning you =s 2DD,DDD a month then you not loo only on this
business when you are running another business that is losing you =s 3DD,DDD a month,. Rou have to
loo at all the business and the overall rate of return you are generating, Similarly if you are investing in
the bonds or stocs then you are need to loo at the overall ris and return of the portfolio. The
important thing to remember is that ris of particular share of company A6, will change if you are
investing in that share after you have portfolio of many other stocs. If you already have large number
of investments which you have made and then if you invest in particular share in company A6, will be
different
Di"er#i,ication$
The important thing to remember is that ris of particular share of company A6, will change if
you are investing in that share after you have portfolio of many other stocs. If you already have large
number of investments and then you invest in particular share in company A6, then the ris will be
different. Investing in many Different Shares and 6onds and ;ro0ects of Different ,ompanies in
Different ,ountries can reduce ris. Diversified portfolios can reduce ris. The level of ris generally
reduces as the size of the portfolio increase.
>hat matters is the -verall =is ' =eturn on the entire ;ortfolio .or ,ollection/ of
Investments. The =is ' =eturn of an Individual Investment in a Stoc or 6ond should be seen in
terms of its Incremental +ffect on the -verall ;ortfolio
In"e#tment R)le1
Investor will try to #a!imize ;ortfolio =eturn and #inimize ;ortfolio =is. Investor will <-T
tae on Additional ;ortfolio =is :<@+SS compensated with Additional ;ortfolio =eturn.
T(.e# o, Ri#4# ,or a +toc4$
Types of Stoc-related =iss which cause :ncertainty in future possible =eturns ' ,ash "lows1
Total +toc4 Ri#4 E Di"er#i,iale Ri#4 F Mar4et Ri#4
Di"er#i,iale Ri#4$
It is nown as ,ompany-Specific or :ni(ue or <on-Systematic =is. It is associated with
random events associated with +ach ,ompany whose stocs you are investing in i.e. >inning ma0or
contract, losing a court case, successful mareting campaign, losing a charismatic ,+-,dDiversifiable
=is can be =educed using Diversification. The bad random events affecting one stoc will offset the
good random events affecting another stoc in your portfolio
Mar4et Ri#4$
It is nown as <on-Diversifiable or Systematic .,ountry-wide/ or 6eta =is. It is associated
with #acroeconomic or Socio-;olitical or Blobal events that systematically affect Stoc investments in
every Stoc #aret in the country i.e. Inflation, #acro #aret Interest =ates, =ecession, and >ar.
#aret =is can <-T be reduced by Diversification
8 ,opyright 9irtual :niversity of ;aistan O2
/ort,olio Rate o, Ret)rn
/ort,olio1# E5.ecte* Rate o, Ret)rn$ 7 r/ 8>
It is the weighted average of the e!pected returns of each individual investment in the portfolio.
"ormula is similar to +!pected =eturn for Individual Investment but interpretation is different1
/ort,olio E5.ecte* ROR Form)la$
r/ Z T r1 !1 S r2 !2 S rC !C S d S rn !n .
>here there are )n* different investments .i.e. Stocs, 6onds, ;ro0ects,d/ in your portfolio. r1
represents the e!pected return .in E pa/ on Investment <o. 2 and !1 represents the weight of Investment
<o. 2 .fraction of the =upee value of the total portfolio that Investment <o. 2 represents/.
E5am.le$
+)..o#e t&at (o) &ol* a /ort,olio o, 2 +toc4 In"e#tment#$
Val)e o, In"e#tment 7R#8 E5. In*i"i*)al Ret)rn 7T8
+toc4 A C0 20
+toc4 0 W0 10
Total Val)e E 100
E5.ecte* /ort,olio Ret)rn Calc)lation$
r/ J T rA !A S r0 !0
T 3DE .4D&2DD/ S 2D E. LD&2DD/
T JE S LE
T 1CT
3 Stoc* Investment ;ortfolio =is
;ortfolio =is is generally not the weighted average ris of the Individual Investments. In fact, it is
usually less
Stoc .Investment/ ;ortfolio =is "ormula1
p T g YA2 [ A 2 SY02 [ 0 2 S 3 .YA Y0 [ A [ 0 A08
De,inition o, Term#$
YA is Investment A7s weight in the total value of the ;ortfolio. [
A
is Investment A7s
Individual =is .or standard deviation/. A6 is the ,orrelation ,oefficient that measures the
correlation in the returns of the two investments. @ast term is a ,ovariance term
!or"folio Si0e 's Ris% +raph
/
;
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f
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i
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=
i
s
<umber of Investments .Stocs/ in the ;ortfolio

W 20 H0
#
n
Mar4et or +(#tematic or <on-
Diversifiable or 0eta =is T
#inimum ;ossible ;ortfolio =is
Uni2)e or Di"er#i,iale or
+.eci,ic or <on-Systematic =is
T
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R
i
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4
Note$ A*out -../ of the Diversifia*le "is, (and 0./ of the
1otal "is, #an *e removed *y Diversifi#ation a#ross 2. sto#,s!
3ust 4 #arefully #hosen Un-Correlated (to#,s might *e enough
to remove 5./ of the 1otal "is,!
E5am.le
,omplete 3-Stoc Investment ;ortfolio Data1
Val)e 7R#8 E5. Ret)rn 7T8 Ri#4 7+t* De"8
Stoc A 4D 3D 3DE
Stoc 6 LD 2D IE
Total 9alue T 2DD ,orrelation ,oeff =o T S D.J
29+toc4 /ort,olio Ri#4 Calc)lation$
p T g YA
2
[ A
2
SY0
2
[ 0
2
S 3 .YA Y0 [ A [ 0 A08
T _.4D&2DD8273DE/2 S .LD&2DD827IE/2 S3W.4D&2DD/.LD&2DD/.3DE/.IE/.D.J/X`0>G
T _.D.DO/.D.DF/ S .D.FO/.D.DD3I/ S 3W .D.DD32/ .D.J/ X ` 0>G
T _D.DD4J S D.DD233I S D.DD3I3` 0>G>
T _D.DDFC3I S D.DD3I3` 0>G>
T _D.DDL4FI` 0>G>
T D.DCILTR>GWT
YA
2
[A
2
S Y0
2
[0
2
S 3 .YA Y0 [A [0 A08
Ris% 's, Re"#r +raph Example with 6-(to#, Portfolio
with Positive Correlation
/
Ri#4
r
/
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e
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)
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n
IE OE 2IE 3DE
2DE
24E
2IE
2LE
3DE
23E
A# Ri#4 INCREA+E+<
t&e In"e#tor#1 Re2)ire*
Ret)rn INCREA+E+
Lesson 22
/ORTFOLIO RI+= ANALA+I+ AND EFFICIENT /ORTFOLIO MA/+
Learning O!ecti"e#$
topics
/ort,olio Ri#4 Anal(#i# - E,,icient /ort,olio Ma.#
6efore starting the new concepts we should recap what we have studied in the previous lecture.
Reca.$
;ortfolio is a ,ollection of Investments in different Stocs, 6onds, other Securities or a mi! of
all. Its ob0ective is to invest in Different :n-,orrelated Stocs in order to minimize overall =is '
#a!imize ;ortfolio =eturn. It is mentioned that individuals and companies maintain the portfolio in
order to reduce to reduce the ris
There are 3 Types of Stoc =is
Total +toc4 Ri#4 E Di"er#i,iale F Mar4et Ri#4
Diversification means e!panding the number of investments which cover different inds of
stocs. >e can reduce the ris as random events in one industry can be off set by the random effects in
the other industry. This way you can reduce the company pacific or uni(ue ris. The maret ris arises
because of micro economic or large scale factors such as maret interest rate, inflation etc. These factors
have virtually identical effect on the share prices. "or e!ample, in event of a war stic maret go down
in value which means almost every share went down.W Stocs are a good number for diversification. H0
Stocs are enough for #inimizing Total =is
,alculating +!pected 3-Stoc ;ortfolio =eturn ' =is
E5.ecte* /ort,olio Ret)rn E r/ J E 5A rA F 50 r0
;ortfolio =is is generally not a simple weighted average.
:p to this point we only loo at the portfolio which has only two stocs.
Inter.reting 29+toc4 /ort,olio Ri#4 Form)la1
T g YA2 [ A 2 SY02 [ 0 2 S 3 .YA Y0 [ A [ 0 A08
?ere, is coefficient of correlation which states that how muc the investments are
correlated. The ris of investing in any one share can be reduced if we invest in other shares also. There
have been several e!periment studies that show that if you invest in appro!imately FD different
uncorrelated different shares of different companies then you can entirely eliminate the company pacific
portion of the ris. +ven if you can not diversify across FD different companies but if you diversify 0ust
across L different shares from different companies then you can still you can reduce most of the
diversifiable ris. <o matter what we do we can not eliminate the maret ris that maret ris become
the minimum ris we have to live with in our portfolio. The important thing then to remember is that
how this ris will effected when we tal about portfolio of two stocs or more. The ,orrelation
coefficient needs to be understood in order to understand the ris and return.
Correlation Coe,,icient 7 A0 or PRoQ8$
=is of a ;ortfolio of only 3 Stocs A ' 6 depends on the ,orrelation between those 3 stocs.
The value of =o is between -2.D and S2.D
If =o T D then Investments are :ncorrelated ' =is "ormula simplifies to >eighted Average
"ormula.
If =o T S 2.D then Investments are ;erfectly ;ositively ,orrelated and this means that
Diversification does not reduce =is.
If Ro E 9 1>0, it means that Investments are ;erfectly <egatively ,orrelated and the =eturns .or ;rices
or 9alues/ of the 3 Investments move in +!actly -pposite directions. In this Ideal ,ase, All =is can be
diversified away. "or e!ample, if the price of one stoc increases by IDE then the price of another stoc
goes down by IDE.
In Realit(< O"erall Ro ,or mo#t +toc4 Mar4et# i# ao)t Ro E F 0>S.it is very rough rule of thumb. It
means that correlations are not completely perfect and you should remember that if the correlation
coefficient is S2.D then it is not possible to reduce the diversifible ris.
This means that increasing the number of Investments in the ;ortfolio can reduce some amount of ris
but not all ris
8 ,opyright 9irtual :niversity of ;aistan OF
/ort,olio Ri#4 9 E5am.le Reca.
,omplete 3-Stoc Investment ;ortfolio Data1
9alue .=s/ +!p =eturn .E/ =is .Std Dev/
Stoc A 4D 3D 3DE
Stoc 6 LD 2D IE
Total 9alue T 2DD ,orrelation ,oeff =o T S D.J
29+toc4 /ort,olio Ri#4 Calc)lation$
T g YA2 [ A 2 SY02 [ 0 2 S 3 .YA Y0 [ A [ 0 A08
T _D.DD4J S D.DD233I S D.DD3I3` 0>G T D.DCILT R>GWT
A 3-Stoc ;ortfolio =eturn ,alculation1
r/Z T ! A r A F ! 0 r 0 E J S L T 1CT
Inter.retation o, Re#)lt$
The ;ortfolio =is for our 6aset of 3 Investments is FR>GW T .if =o T S D.J/. >hat does this
meanP
0ell C)r"e A##)m.tion$ If we assume a <ormal ;robability Distribution, then there is a JC.3JE
chance that our future ;ortfolio =eturn will be somewhere between .r;Z- [ / and .r;ZS [ / i.e.
between .24E -C.ILE/ and .24E SC.ILE/ or between SF.F4E and S32.ILE
;ortfolio =is lies between the Individual =iss of the 3 Investments i.e
[ Stoc 6 f [ ; f [ Stoc A or IE f C.ILE f 3DE 7i, Ro E F0>S8
Rou can also come up with more accurate outcome about the actual value of the return on the portfolio
after 2 year if you tae a larger range for the standard deviation. So, if you are taing about the range
from -3 sigma to S3 sigma towards then there is lielihood that actual rate of return of the portfolio is
somewhere in between the two standard deviation.
Note$ If =o T - D.J .<egative ,orrelation/ then ;ortfolio =is T S F.CE which is lower than both
Individual InvestmentsUU
<ow, we consider the case of negatively correlated investments.
Negati"el( Correlate* In"e#tment#
3-Stoc Investment ;ortfolio Data1
+!p Indiv =eturn .r i / Indiv =is .Std Dev i /
Stoc A 3DE 3DE
Stoc 6 2DE IE
Correlation Coe,, Ro E 9 0>S
;ortfolio =is ' =eturn Table .for Different ;ortfolio #i!es/1
Fraction o, +toc4 A ;ortfolio =is +!p ;ortfolio =eturn .r/Z/
2DDE 3DE 3DE
CDE 2IE 2CE T D.C.3D/ S D.3.2D/
IDE OE 2IE T D.I.3D/ S D.I.2D/
4DE F.CE 24E
2IE 4.FE 22.IE
DE.i.e. 2DDE Stoc 6/ IE 2DE
E,,icient /ort,olio Ma.
8 ,opyright 9irtual :niversity of ;aistan OI
E,,icient /ort,olio Inter.retation
+fficient ;ortfolio #ap for 3-Stoc ;ortfolio shows all possible +fficient ,ombinations .#i!es/
of stocs.
E,,icient /ort,olio#1
+fficient ;ortfolios are those whose =is ' =eturn values match the ones computed using
Theoretical ;robability "ormulas. The Incremental =is ,ontribution of a <ew Stoc to a "ully
Diversified ;ortfolio of FD :n-,orrelated Stocs will be the #aret =is ,omponent of the <ew Stoc
only. The Diversifiable =is of the <ew Stoc would be entirely offset by random movements in the
other FD stocs. Adding a <ew Stoc to the e!isting ;ortfolio will create more +fficient ;ortfolio
,urves. The <ew Stoc will contribute its own Incremental =is and =eturn to the ;ortfolio.
r/ J E 5A rA F 50 r0 S 5C rC .4 Stocs/
8 ,opyright 9irtual :niversity of ;aistan OJ
Efficie" !or"folio Map Shows All Com/ia"ios of 12
S"oc% !or"folio Nega"i'e Correla"io 3Ro 4 25,67
+toc4 A
7100T A -
0T 08
+toc4 0
70T A -
100T 08
r
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3DE
2DE
IE 3DE 2IE OE
IDEA
CDEA
C0TA
H>RT
C>HT
1GTA
/oint o, Minim)m
Ri#4
22.IE
24E
2IE
/ort,olio Ri#4
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Effi#ient Portfolio &aps 5-(to#, Portfolio 'egative Correlation
+toc4 C
Stoc 6
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IE 3DE
C>HT
/ort,olio Ri#4
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Stoc A
H0T
3DE
4DE
2>GT
E,,icient Frontier ,or
C9+toc4 /ort,olio
-ld +fficient "rontier for
3-Stoc ;ortfolio of A ' 6
<ow, if we add another stoc in the portfolio we can tae a loo
To compute the /ort,olio Variance for a 4-Stoc ;ortfolio, 0ust add up all the terms in every
bo!. To compute the ;ortfolio =is .Standard Deviation/, simply tae the S(uare =oot of the 9ariance.
Ao) can e5ten* t&i# Matri5 A..roac& to calc)late t&e Ri#4 ,or a /ort,olio con#i#ting o, an(
n)mer o, #toc4#.
Terms in 6o!es on Diagonal .Top @eft to 6ottom =ight/ are called PVARIANCEQ terms associated
with individual magnitude of ris for each stoc.
Terms in all other .or <-<-DIAB-<A@/ 6o!es are called PCOVARIANCEQ terms which account for
affect of one stoc7s movement on another stoc7s movement.
8 ,opyright 9irtual :niversity of ;aistan OL
82S"oc% !or"folio Ris% Form#la 8x8 Ma"rix Approach
Stoc A Stoc 6 Stoc ,
Stoc
A
Y
A
2
A
2
Y
A

Y
0 A

0 A0
Y
A

Y
C A

C AC
Stoc
6
Y
0

Y
A 0

A 0A
Y
0
2
0
2
Y
0

Y
C 0

C 0C
Stoc
,
Y
C

Y
A C

A CA
Y
C

Y
0 C

0 C0
Y
C
2
C
2

Lesson 23
EFFICIENT /ORTFOLIO+< MAR=ET RI+= AND CA/ITAL MAR=ET LINE 7CML8
Learning O!ecti"e#$
topics.
E,,icient /ort,olio#<
Mar4et Ri#4 - CML
"irst we recap the important concepts which we have studied in previous lectures. ;ortfolio theory
is looing at the relationships between the ris and return for portfolios, especially for diversified
portfolios.
Total +toc4 Ret)rn E Di"i*en* Aiel* F Ca.ital Gain Aiel*
Rou should recall this from the Bordon formula that we learnt in the share valuation.
>e spoe about the total ris for the stoc and we said that it is e(ual to the company7s ris plus the
maret ris.
Total Ri#4 E Di"er#i,iale Ri#4 F Mar4et Ri#4
>e mentioned that on the basis of e!perimental studies that if we invest in many stocs which are
not correlated to each other then it is possible to reduce overall ris for your investment as a whole. >e
called this portfolio or collection of stocs. W Stocs are a good number for diversification ' H0 Stocs
are enough for eliminating ,ompany =is ' #inimizing Total =is.
<ow, in the portfolio theory model which we are going to discuss the ma0or assumption is that the
rational investors in the maret place maintain diversified portfolios. >e discuss in the previous lecture
about calculating e!pected return on the portfolio and we mentioned that it is simply the weighted
average of return of each stoc in the portfolio. The formula
29+toc4 /ort,olio1# E5.ecte* Ret)rn E r/ J E 5A rA F 50 r0
29+toc4 /ort,olio Ri#4 Form)la
SdT g Y A2 [ A 2 SY02 [ 0 2 S 3 .YA Y0 [ A [ 0 A08
It is mentioned in the previous lecture that we can calculate the ris of larger portfolio using the
matri! approach
#atri! for ,alculating ;ortfolio =is1 ,ovariance Terms .<on-Diagonal 6o!es/ measures .2/
Magnit)*e o, mo"ement 7+tan*ar* De"iation8 and .3/ Clo#ene## o, mo"ement 7Correlation
Coe,,icient8 between any two stocs in the portfolio.
To compute the /ort,olio Variance for a 4-Stoc ;ortfolio, 0ust add up all the terms in every
bo!. To compute the ;ortfolio =is .Standard Deviation/, simply tae the S(uare =oot of the 9ariance.
8 ,opyright 9irtual :niversity of ;aistan OC
82S"oc% !or"folio Ris% Form#la 8 x 8 Ma"rix Approach
Stoc
A
Y
A
2
A
2
Y
A

Y
0 A

0 A0
Y
A

Y
C A

C AC
Stoc
6
Y
0

Y
A 0

A 0A
Y
0
2
0
2
Y
0

Y
C 0

C 0C
Stoc
,
Y
C

Y
A C

A CA
Y
C

Y
0 C

0 C0
Y
C
2
C
2

Ao) can e5ten* t&i# Matri5 A..roac& to calc)late t&e Ri#4 ,or a /ort,olio con#i#ting o, an(
n)mer o, #toc4#.
ATerms in 6o!es on Diagonal .Top @eft to 6ottom =ight/ are called PVARIANCEQ terms associated
with individual magnitude of ris for each stoc.
ATerms in all other .or <-<-DIAB-<A@/ 6o!es are called PCOVARIANCEQ terms which account
for affect of one stoc7s movement on another stoc7s movement. These represent the magnitude or size
of the movement between the two stocs. There are two parts for this covariance terms
A-ne of the two covariance terms for two stoc portfolios is YA Y0 [ A [ 0 A0>
6oth standard deviation and covariance are important to calculate the size of the movement of
both stoc A and 6. In other words, if covariance is large then a pair of stoc moves a lot and they also
move together. ,orrelation coefficient is the measure that how closely they move Standard deviation
tells us that how much they move.
>e have discussed in the previous lecture about the efficient portfolio map and the efficient
frontier. If we plot the ris and return for the portfolio whose correlation coefficient is negative then we
come up with a hoo shape curve and it tells us that it is possible to increase the return on portfolio ' at
same time reduce the ris which is ideal because the ob0ective is to ma!imize the return and to minimize
the ris. 6ut in conclusion of last lecture we said that there is a whole line with infinite number of points
that represents an efficient frontier and every single combination or mi! of the portfolio on this line
represents an efficient combination. 6ut this does not help us very much why because we do not now
which one of these mi! is the best. So, the first ting we are going to figure out is that what optimal mi!
of the portfolio is. The starting point to figure out this is to realize that if you have a portfolio of stocs
then every investor have access to another portfolio and that portfolio is the portfolio of T bills and we
are going to assume that every body have the option of investing in the T-6ills that give them the ris
free rate of return. "or ;aistan, we consider that figure to be 2DE.So% this is the starting point to figure
out that what is the optimal portfolio mi! is. The realization that if your portfolio is giving you the
return which is less then ris free rate of return then why would you investing in that portfolio and you
would choose to invest in T-bills. 6y using this understanding, let7s tae another loo on ris and return
portfolio frontier model and see that how we can use this fact to find the optimal portfolio mi! and we
tae loo at 4 stoc portfolio consisting of stoc A, 6 and , and added to that we will give ourselves the
option of investing in a T-bill portfolio wherever stocs are not providing sufficient return. So, if we
loo at the e efficient portfolio map you will see that /ort,olio ri#4 i# on @9 a5i# an* t&e .ort,olio
ret)rn on A9 a5i#>
8 ,opyright 9irtual :niversity of ;aistan OO
The efficient frontier for the 4 stoc portfolio is the overarching largest hoo shaped curve and
also remember that closed combination of the all the hoo shaped curves forms a parachute lie
shape and any one of the points inside that parachute is a possible mi! or combination of different
stocs that you can have in your portfolio. ?owever, the most efficient combinations lie on the
efficient frontier line and the ne!t logical step we are going to tae is to figure out what is the best
point on the efficient frontier. As it is mentioned that we will assume that we have access to T- bill
portfolio which offers a ris free rate of return of 2DE and that will be the starting point of our
capital maret line .,#@/.wherever this line if you e!tend from the 2D E point from y-a!is touches
the efficient frontier line and is tangent to it is the point for the )-ptimal ;ortfolio #i!.* This point
is shown as a large dot in the above figure. If you loo at the location of this large dot on the
efficient frontier you can see that it lies closer to the Stoc 6 and Stoc A. Therefore, there is larger
percentage of stoc A and 6 in this optimal portfolio mi!. Appro!imately, the optimal portfolio mi!
consist of IDE Stoc A, 4DE Stoc 6, and 3DE Stoc ,. It is important to remember that we have
the option of investing in the T-bill portfolio which offers a ris free rate of return
And the e!pected rate of return is 2DE.Therefore, if the returns on this portfolio decrease 2DE
then the investor will invest in the ris free T $bills portfolio. >hichever portfolio offers lowest
coefficient of variation is the better portfolio. The ,#@ represents different combinations that you
can pic in the ris free as well as stoc portfolio. Thus ,#@ represents combination of efficient
portfolio in the capital maret. It is the important point remembers that According to the ;ortfolio
Theory, +fficient ;ortfolios are "ully Diversified and they must lie on the ,#@ @ine. <ow, it is
also possible simply come up with the e(uation for the ,#@.
CML E2)ation$ r/J E rRF F L7rM 9 rRF8 ? [MN [/
rRFE ri#4 ,ree rate o, ret)rn
rM E e5.ecte* rate o, ret)rn ,or t&e mar4et o, all .o##ile #toc4
[M E ri#4 o, t&e mar4et
[/ E ri#4 o, #toc4 .ort,olio
The +!pected =eturn on an Investment in a ,ommon Share is not guaranteed or certain. The
;rice and Dividend can vary so we can guess what the ;ossible future =eturns .or -utcomes/ might
be and assign probabilities to each> :ncertainty about "uture +!pected =eturn on Investment gives
rise to ;robability Distribution of ;ossible -utcomes. This gives rise to a Spread of ;ossible "uture
=eturns which is a measure of the =is or :ncertainty or Standard Deviation. >e can apply this
8 ,opyright 9irtual :niversity of ;aistan 2DD
/ic4ing Mo#t E,,icient /ort,olio Ca.ital Mar4et
Line 7CML8 - T90ill /ort,olio
+toc4 C
Stoc 6
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3DE
C>HT
/ort,olio Ri#4
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Stoc A
H0T
3DE
4DE
2>GT
E,,icient Frontier
,or C9+toc4 /ort,olio
PT&e /arac&)teQ
;ortfolio with <egative
or Mero ,orrelation
,oefficient
O.timal /ort,olio Mi5
7G0TA< C0T 0< 20TC8 if
=is "ree T-6ill =-= T 2DE
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RF
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concept to the single stoc or a portfolio of a many stocs. >hen we tal about the e!pected return
on a single stoc then we are saying that it is the combination of the dividend gain yield and the
capital gain yield. >hen we tal about the e!pected return for the portfolio then we consider
e!pected return for each stoc in that portfolio and assign proportionate amount of weightage based
on the fraction of the investment in a particular stoc compare to the total value of the portfolio.
"urthermore, the individual ris of every investment affects the ris of every other investment in the
portfolioU The -verall ;ortfolio =is decreases as the number of investments increase up to the
point that the ,ompany Specific or :ni(ue =is has been totally eliminated i.e. About FD
uncorrelated stocs. In t&i# Range it i# .o##ile to Increa#e Ret)rn an* Re*)ce Ri#4] After that,
the ;ortfolio is assumed to be "ully Diversified and any additional investment will only contribute
to the #aret =is which can not be eliminated.
Mar4et Ri#4 - /ort,olio T&eor($
>e can measure that how maret ris varies from one stoc to another based on the 6eta7s. It is
mentioned that when you add newly stoc to the fully diversified portfolio then the only contribution
this new stoc is made to the ris of the e!isting portfolio is the maret ris because we are considering
that company7s uni(ue ris has entirely wiped out by diversification. If the correlation between different
stocs is negative or Mero then ris and return profile graph taes on a hoo shaped curve and this hoo
shaped curve is important to understand because it means that it is possible for certain combinations of
the portfolio to both reduce ris and increase return.
?owever, if the correlation coefficient is Sve then the ris return relationship is that of
continuous function which is continuously rising as return rises the ris also rises with it. It is the
fundamental concept in ris and return that the investor will not tae on any additional ris unless
they compensated by additional return. It is important to under stand that when we are taling about
efficient capital marets and taling about the capital maret line we are saying that efficient
portfolios in the maret all lie on the capital maret line. It means that if one investor is only
investing in the stoc A and the other has a diversified portfolio of FD stocs and now he is also
investing in Stoc A then the amount of ris for both investors will be different the investor who is
only investing in stoc A is taing on the #aret ris of the stoc as well as the company7s ris
whereas the other investor is only taing on the maret component ris for that stoc. Rational
In"e#tor# 3it& Di"er#i,ie* /ort,olio# e5.ect to e com.en#ate* ( e5tra ret)rn in e5c&ange ,or
ta4ing on E5tra Mar4et Ri#4>
8 ,opyright 9irtual :niversity of ;aistan 2D2
:oo4 +&a.e* C)r"e <egative ,orrelation ,oefficient
;ossible to Bet ?igher =eturn A<D @->+= =ISK
+toc4 A
7100T A8
+toc4 0
7100T 08
r
/
Z
/
3DE
2DE
IE 3DE 2IE OE
IDEA
CDEA
C0TA
C>HT
1GTA
/oint o, Minim)m Ri#4
22.IE
24E
2IE
/ort,olio Ri#4
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Rou can <-T e!pect to receive e!tra return .or compensation/ for taing on ,ompany-Specific
=is which =ational Investors have eliminatedU The +fficient #aret will only offer you a =eturn
.and a Share ;rice/ which is the bare minimum acceptable to =ational Diversified Investors. This is
the 6asis of the ,apital Asset ;ricing #odel .,A;#/.
0eta Conce.t - CA/M$
0eta$
It is a tendency of a Stoc to move with the #aret .or ;ortfolio of all Stocs in the Stoc
#aret/.it is the building bloc of ,A;#.
+toc4 Ri#4 "#> +toc4 0eta1
+toc4 Ri#4$
It is a statistical spread of possible returns .or 9olatility/ for that Stoc
+toc4 0eta$
It is a statistical spread of possible returns .or 9olatility/ for that Stoc relative to the
maret spread i.e. spread .or 9olatility/ of the fully diversified maret portfolio or inde!.
6eta ,oefficients of Individual Stocs are published in )6eta 6oos* by Stoc 6roerages ' =ating
Agencies
CA/M$ Ca.ital A##et /ricing Mo*el>
It is developed by ;rofessors Sharpe ' #arowitz. ?e won <obel ;rize in 2OOD
#aret =is is the only ris that is relevant to a =ational Investor with a Diversified ;ortfolio of
Investments. The ,ompany Specific .or :ni(ue/ =is is Diversified AwayU #aret =is is measured
in terms of the Standard Deviation .or 9olatility/ of the #aret ;ortfolio or Inde!. +very Stoc #aret
develops an Inde! comprising of a weighted average of the highest-volume shares in that maret. This
Inde! represents the relative strength of that Stoc +!change and is considered to be close to a Totally
Diversified ;ortfolio. In reality, no such ;ortfolio e!ists anywhere in the world. "or e!ample the
Karachi Stoc +!change has the KS+ 2DD Inde!.
=eturn, =is, and 6eta
Stoc A7s ;ossible
"uture =eturns
Stoc 67s ;ossible
"uture =eturns
Stoc A7s >eighted
Average =eturn or
+!pected #ean =eturn
Stoc 67s >eighted
Average =eturn or
+!pected #ean =eturn
Stoc A7s =is or
Standard Deviation
Stoc A7s =is or
Standard Deviation
>eightage of
Stoc A in
;ortfolio
>eightage of
Stoc 6 in
;ortfolio
,orrelation
between 3 Stocs
;ortfolio7s
E5.ecte* Ret)rn
;ortfolio =is
#aret =is
6eta
Lesson 24
+TOC= 0ETA< /ORTFOLIO 0ETA AND INTRODUCTION TO +ECURITA MAR=ET LINE
7+ML8
Learning O!ecti"e#$
topics.
+toc4 0eta
/ort,olio 0eta
Intro*)ction to +ML 7CA/M8
"irst, we would recap some of the concepts which we have studied in the previous lectures.
It is mentioned in the efficient capital marets the investors would tae on e!tra ris only if they are
compensated in the form of e!tra return. The maret only compensates the investor to the e!tent that he
will receive e!tra return for e!tra maret ris he taes on by investing in a new stoc. ?owever, the
maret will not pay the investor any e!tra return for taing on unnecessary ris in the form of
company7s own ris. Therefore, it is best for investors to act rationally and to maintain diversified
portfolios of many stocs and in this manner they can eliminate the company7s own ris and they can
mae investments in stocs at a lower re(uired rate of return. #aret portion of ris can be represented
through the Q6eta7 coefficient and it is the corner stone for ,apital Asset ;ricing #odel .,A#;/.
0eta$
It is a tendency of a Stoc to move with the #aret .or ;ortfolio of all Stocs in the Stoc
#aret/.it is the building bloc of ,A;#.
Total =is T Diversifiable =is S #aret =is
Total Stoc =eturn T Dividend Rield S ,apital Bain Rield
+toc4 Ri#4 V# +toc4 0eta1
+toc4 Ri#4$
It is a statistical spread of possible returns .or 9olatility/ for that Stoc
+toc4 0eta$
It is a statistical spread of possible returns .or 9olatility/ for that Stoc relative to the
maret spread i.e. spread .or 9olatility/ of the fully diversified maret portfolio or inde!.
6eta ,oefficients of Individual Stocs are published in )6eta 6oos* by Stoc 6roerages ' =ating
Agencies
MAR=ET$
It is the overall Stoc #aret. "or +!ample, Karachi Stoc +!change. KS+ 2DD Inde! represents 9alue
of );ortfolio* of ?ighest 9olume Stocs but <-T A@@ stocs. Therefore it is not fully perfect
diversified portfolio.
#aret carries =is. It moves up and down because of macroeconomic factors .inflation,
general interest rates/ and political changes. Therefore the maret has some e!pected rate of return
which changes with time because of this there is possibility of different outcomes. There are no fully
diversified portfolios in reality. The ,A#; based on the promise maret 6eta to be +(ual to S 2.D. >e
can then loo at the different beta and compare them with the marets.
Meaning o, 0eta ,or +&are A0C in =arac&i +toc4 E5c&ange 7=+E8$
A If Share A7s 6eta T S3.D then that Share is Twice as risy .or volatile/ as the KS+ #aret i.e. If
the KS+ 2DD Inde! moved up 2DE in 2 year, then based on historical data, the ;rice of Share 6
would move up 3DE in 2 year.
A If Share 67s 6eta T S2.D then that Share is +!actly as risy .or volatile/ as the KS+ #aret
A If Share ,7s 6eta T SD.I then that Share is only ?alf as risy .or volatile/ as the KS+ #aret
A If you could find a Share D with 6eta T -2.D then that share would be e!actly as volatile as the
KS+ #aret 6:T in the opposite way i.e. If the KS+ 2DD Inde! moved :; 2DE then the price
of the Share D would move D->< by 2DEU
A The 6eta of most Stocs ranges between S D.I and S 2.I
A The Average 6eta for All Stocs T 6eta of #aret T S 2.D Always>
-ur approach for calculating the beta will be straight forward. @et us assume that we analyze he
movements in KS+ inde! for period of three years and we also analyze the price movements for the
Stoc A in KS+ for the same period of time of three years. >e loo at the change in the price of the
stoc and compare it to the change in price in the maret for each one of the three years separately.
And then we plot those points on a graph where the e!pected return on the stoc on the y- a!is and
the e!pected return on the maret on !-a!is. >e are using the price of the stoc and value of the
inde! as representative measures for the e!pected return.
If you loo at the graph, we have plotted three years of data for the changes in the Karachi stoc
e!change 2DD maret inde! and the e!pected return on the stoc A. The e!pected return on A is on y-
a!is and it is represented by rAJ and the e!pected return on stoc in KS+ 2DD maret inde! is
represented by rMZ the YJ1 represented the e!pected part of the rate of return. In both cases the e!pected
returns have been benched mared against the ris free rate of return. That is because we pic the ris
free rate of return as the starting point for the changes in the e!pected return. Three points are shown on
the graph on for each year in the analysis and after plotting these points on the graph we can then do
what is nown as the linear regression of straight line which best fit through points. Rou have studied
this concept in the course of )Statistics and ;robability* .The slope of the line represents the beta
coefficient.
+lo.e E 0eta E ^ A ? ^ @ E T ^ rAJ ? T ^ rMJ
T A TRi#4 Relati"e to Mar4et T .rAJ 9 rRF8 ? 7rMJ 9 rRF8
6eta represents the ris of stoc relative to the return of the maret and in terms of ris free rate
of return we can define the 6eta as the e!pected rate of return for stoc A minus ris free rate of return
divided by the e!pected rate of return for the maret minus ris free rate of return. >e use historical
data of e!pected rate of return and we graphed it against changes in the overall maret inde!
Calc)lating /ort,olio 0eta 7CA/M8$
There are two ways of calculating portfolio beta
A Analyze ?istorical Data for ;ortfolio =eturns and #aret Inde! =eturns lie in the case of
Stoc 6eta, plot @east S(uares "it @ine, and compute ;ortfolio @ine Slope or 6eta directly.
A :se the ;ublished Data for In*i"i*)al +toc4 0eta# ,rom t&e P0eta 0oo4Q
;ortfolio beta can be calculated as the sample weighted average of the stoc beta7s in that portfolio.
/ort,olio 0eta E / E Y A A S Y0 6 S YC , Sd..
In the formula
iA represents the 6eta .or #aret =is/ of Stoc A.
Y
A
represents the >eight of Stoc .fractional value of investment in A to total
portfolio value/.The simple formula for calculating the portfolio beta is as follows.
;ortfolio 6eta .or #aret =is/ "ormula is a Simple >eighted Average unlie the portfolio ris formula
8 ,opyright 9irtual :niversity of ;aistan 2DF
Calc#la"ig S"oc% 9e"a +raphicall$
E5.ecte*
=eturn on
+toc4 A
.?istorical/ E
+!pected =eturn on =+E 100 Mar4et In*e5
.?istorical/ E
+lo.e E 0eta E A ? @ E
T r
A
J
?
T r
M
T
ATRi#4 Relati"e to Mar4et T
.r
A
J 9 r
RF
8
? 7r
M
J 9 r
RF
8
r
A
J 9 r
RF
r
M
J 9 r
RF
R-Intercept T
Al.&a T
Rear 2
Rear 4
Rear 3
7inear "egression or 7east (8uares %it through Experimental
Data Colle#ted for 5 9ears
Com.an( +.eci,ic Ri#4
3 3 3 3
A A 6 6 A 6 A 6
T Y SY S 3 .Y Y A6 / P
E5am.le$
A ,omplete 3-Stoc Investment ;ortfolio Data1
9alue E5. =eturn 7rJ8 Tot =is 0eta
Stoc A =s.4D 3DE 3DE 2>0
Stoc 6 =s.LD 2DE IE 0>G
Total 9alue T=s 2DD ,orrelation ,oefficient T S D.J
;ortfolio Mean E5.ecte* Ret)rn T 1CT T r/Z
;ortfolio Ri#4 .Total/ T R>GWT T / 7relati"e to r/J8
<ow we can calculate the portfolio beta which is measure of the maret portion of portfolio ris.
;ortfolio 0eta T Ya6a S Yb6b T .4D&2DD/ .3.D/ S .LD&2DD/ .D.I/ T D.J S D.4I
T F0>_G T / 7relati"e to Mar4et Ri#4 or Volatilit(8
It means that the ;ortfolio of A ' 6 is slightly less risy than the totally diversified KS+ 2DD
#aret ;ortfolio whose 6eta T S2.D
E,,ect o, Ne3 +toc4 In"e#tment on /ort,olio$
<ow we will see the case that what will happen to portfolio beta if we add another stoc to it.
+)..o#e< (o) a** a Cr* In"e#tment +toc4 C< to (o)r Ol* 29+toc4 /ort,olio>
9alue +!p =eturn .rZ/ 6eta
Stoc A =s.4D 3DE 3.D
Stoc 6 =s.4D 2DE D.I
Stoc , =s.FD 4DE 2.I
Total 9alue =s.2DD
C9+toc4 /ort,olio 0eta T i ; T Ya6a S Yb6b S Yc6c
T .4D&2DD/ .3.D/ S .4D&2DD/ .D.I/ S .FD&2DD/ .2.I/
T D.JSD.2ISD.J T 2.4I
The effect of adding a stoc with a 6eta higher than the ;ortfolio7s is that it increases the ;ortfolio7s
6eta or =is. In this case we also increase the beta by adding new stoc but the e!pected rate of return
also increases for the portfolio. So, the increase rate of return would compensate the increase in ris.
Re2)ire* Rate o, Ret)rn 7CA/M8
Re2)ire* ROR "#> E5.ecte* ROR
E5.ecte* ROR 7rJ8$
The #ost @iely .or #ean/ =-= e!pected in the future. It is calculated using %eig&te*
A"erage Form)la and ;robabilities .what we have been calculating so far/.It is basically the weighted
average or mean of the e!pected return of the individual investments in the portfolio.
Re2)ire* ROR 7r8$
It is the minimum return that investors re(uire from the stoc to invest in it. It
varies from individual to individual. It is based on
2/ ;erceived =is relative to the #aret and ;sychological =is ;rofile of each Investor and
3/ ?is personal -pportunity ,ost of ,apital preference.
>e have mentioned earlier that =-= or opportunity cost varies from person to person because
every individual have a different preference for ris taing. Some people have tendency to be gamblers
whereas other people put their money at national saving schemes. ?owever, the =-= can be lined
to the 6eta ris because based on the portfolio theory and ,A;# where we mentioned there is direct
relationship between ris and return.
Average =e(uired =-= for all rational investors in an +fficient #aret can be estimated using
the ,A;# Theory1 6eta and =is "ree =ate of =eturn.
Total =ate of =eturn .=-=/ for Single Stoc T Dividend Rield S ,apital Bain. B-=D-<7S
"-=#:@A "-= ,-##-< ST-,K ;=I,Ie can formulate the re(uired rate of return in terms of 6eta ris so how can we use beta coefficient to
calculate the re(uired rate of return for the average investor in the maret. The answer to it is the
8 ,opyright 9irtual :niversity of ;aistan 2DI
Security #aret line S#@. It is the part of ,A;# and it is the most critical part of ,A;#. S#@ is
straight line relationship that contains all possible combinations of efficient stocs in the maret. If the
combination of ris and return for any stoc does not lie on the S#@ then that stoc is not efficiently
priced. In other words, it means that for most of the investors in the maret there =-= for investment in
stoc A is directly proportional to 6eta ris for that stoc A. Rou will recall that we are not unfamiliar
with straight line relationship between ris and return when we are taling about the portfolio when we
calculate the portfolio ris with a Sve correlation coefficient we came up with a continuously increasing
relationship between portfolio ris and return. So that model is similar to S#@.
+ec)rit( Mar4et Line 7+ML8$
It is a Straight @ine #odel for 6eta =is and =e(uired =eturn. It is Similar to the =elationship for
the 3-Stoc ;ortfolio with
cD. 6eta =is is Directly ;roportional to =e(uired =eturn. The

Investors re(uire an e!tra =eturn which e!actly compensates them for the e!tra =is of the Stoc
relative to the #aret>
8 ,opyright 9irtual :niversity of ;aistan 2DJ
Ris% 's, Re"#r +raph 3Ris% Theor$7 6-(to#, Portfolio with
Positive Correlation Coeffi#ient
/
Ri#4
r
/
Z
/
o
r
t
,
o
l
i
o

R
e
t
)
r
n
IE OE 2IE 3DE
2DE
2IE
3DE
34E
3IE
23E
<on-+fficient ;ortfolio
Ris% 's, Re"#r +raph 3SML2 CA!M7 E%%ICIE'1
&A":E1( ;I1< %U779 DI$E"(I%IED PO"1%O7IO(
A'D E%%ICIE'179 P"ICED (1OC:(
/
Mar4et Ri#4
r
R
e
2
)
i
r
e
*

R
e
t
)
r
n
D.I 1>0
E M
3.D
2DE
2IE
3DE
3IE
2.I
FULLA DIVER+IFIED
/ORTFOLIO+ AND
EFFICIENTLA /RICED
+TOC=+ IN EFFICIENT
MAR=ET+ %ILL LIE ON
T:E +TRAIG:T +ML
LINE.
+ML Linear E2)ation ,or t&e Re2)ire* Ret)rn o, an( +toc4 A1
rA E rRF S .rM - rRF / i A .
In the above e(uation
rA E =eturn that Investors =e(uire from Investment in Stoc A.
rRF E =is "ree =ate of =eturn .ie. T-6ill =-=/.
rM E =eturn that Investors =e(uire from Investment in an Average Stoc .or the #aret ;ortfolio of All
Stocs where i # T S 2.D always/. i A T 6eta for Stoc A. .rM - rRF /
i A T =is ;remium or Additional =eturn in +!cess of =is "ree =-= to compensate the Investor for
the additional =is.
8 ,opyright 9irtual :niversity of ;aistan 2DL
Lesson 25
+TOC= 0ETA+ -RI+=< +ML- RETURN AND +TOC= /RICE+ IN EFFICIENT MAR=+
Learning O!ecti"e#$
topics.
+toc4 0eta# an* Ri#4
+ML - Re2)ire* Ret)rn# 7CA/M8
+toc4 /rice# in E,,icient Mar4et#
In the previous lecture, we have mentioned that the ris that is relevant in efficient marets where
the investors are sensible and rational is the maret ris. This is because rational investors maintain
many stocs and they maintain diversified portfolio which contain stocs from different sectors and they
manage to eliminate their diversifiable ris and the only ris they faced is the maret component of the
ris. ?owever, this maret component can not be eliminated and it will remain because marets do
fluctuate. "luctuation in the #aret Inde! .KS+ 2DD inde!/ is a measure of #aret =is. This
fluctuation is caused by macro economic and socio political factors. =ational Investors in +fficient
#arets eliminate the =andom ,ompany-Specific =is through ;ortfolio Diversification. So, in
+fficient #aret the only =is that remains is #aret =is. And so, the ;rice of +fficient Stocs is
based on #aret =is only. 6ut the ,A;# based on the fundamental principal that the rate of return for
the stoc is directly proportional to the ris premium and the ris premium dependent on maret ris
alone and not the total ris. 6efore going into details of S#@ we first go through the remaining topics
related to beta and its theoretical calculation based on standard deviation and covariance. >e have
mentioned that beta of the stocs have tendency of stoc to move with the maret. It is e!perimentally
possible to calculate beta of the stoc by monitoring the price or rate of return of the stoc and at the
same time monitoring the maret inde! in the same period of time ' comparing that how the changes in
the stoc maret price relate to the changes in the stoc maret inde!. If you plot them on the graph
where you have e!pected return for stoc on R- a!is and e!pected return from the stoc maret inde!
slope of the line from these points represent the beta
Stoc 6eta measures the =is of a Stoc =elative to the maret.
6eta Stoc A T T ^ rAJ ? T ^ rMJ T Slope of =egression @ine. =egression @ine uses
+!perimental Data.
The formula that relates beta of the stoc to the standard deviation is as follows
6eta Stoc A T ,ovariance of Stoc A with #aret & 9ariance of #aret
T h
A
h
#

AM ?
3
M
.,ovariance "ormula based on ;robability ' Statistical ;ortfolio Theory/ @ins Stoc 6eta
.#aret ;ortion of =is/ to Stoc Standard Deviation .Total Single Stoc =is/.
Simplified formula1
T h
A

AM ?
M E mar4et ri#4
T&eoretical 0eta E5am.le$
Suppose you have Analyzed the ?istorical Time Data for .2/ #ovements of the ;rice .or =eturn/ of
a Stoc A and .3/ #ovements in the 9alue of the Stoc Inde!.
Rou then Apply Simple ;robability "ormulas to compute the following Standard Deviations1
h
A
T 4DE .Stoc A7s Total =is or Standard Deviation/
h
#
T 3DE .Stoc #aret Inde! Standard Deviation or =is/

A#
T S D.C .,orrelation between Stoc A and the #aret Inde!/
,ompute the Theoretical 6eta of Stoc A1
Stoc A 6eta T 4DE .D.C/ & 3DE T 3FE & 3DE T 2.3
8 ,opyright 9irtual :niversity of ;aistan 2DC
The beta of 2.3 shows that stoc is relatively more risy then the maret and if the maret
moves up by 2DE this stoc will move up by 23E.
If all the points of the stoc lie on the straight line then stoc does not have any diversifiable ris. The
difference between the actual data point and the point which vertically lies above or below the point is
representative of the error which is representative of the company7s ris attached to any stoc.
<ow we can put together the two concepts which we studied up till now that is company7s
specific ris and the second concept of regression line and the distance between data line and actual
point of the company7s ris. <ow, we can come up with the total definition of total ris variances.
Total "ariance ri#4 ,orm)la$
Total =is of Stoc A in terms of 9ariance .T Std Dev 2/
Total =is T Mar4et Ri#4 S =andom Specific :ni(ue =is
3
A
T
3
A

3

#
S
3
A-+rror

Vi#)ali6ing t&e Variance Ri#4 Form)la on t&e Regre##ion Line
If a Stoc is ;art of a Totally Diversified ;ortfolio then its ,ompany =is T D. Therefore Total =is
T #aret =is. And the Stoc points will lie e!actly on the =egression line.
If a Stoc is a Single Investment then it carries ,ompany Specific or Diversifiable or =andom =is.
This means that its points will not lie on the =egression line. The e!tent to which the points are
scattered away is a measure of the 9ariance +rror Term .last term in the formula/
8 ,opyright 9irtual :niversity of ;aistan 2DO
Calc#la"ig S"oc% 9e"a +raphicall$
E5.ecte*
=eturn on
+toc4 A
.?istorical/ T
+!pected =eturn on =+E 100 Mar4et In*e5
.?istorical/ T
+lo.e E 0eta E A ? @ E
T r
A
J
?
T r
M
J T A
TRi#4 Relati"e to Mar4et T
.r
A
J 9 r
RF8
? 7r
M
J 9 r
RF
8
r
A
J 9 r
RF
r
M
J 9 r
RF
R-Intercept T
Al.&a T
Rear 2
Rear 4
Rear 3
Linear Regre##ion t&ro)g& Ann)al Data /oint# ,or C Aear#>
Com.an( +.eci,ic Ri#4
CALCULATION OF 0ETA
0A+ED ON E@/ERIMENTAL
DATA OR O0+ERVATION
Variance Ri#4# E5am.le$
If the #aret =is T 3DE and Stoc A7s 6eta T 2.I then what is the =elevant #aret =is
,omponent of Stoc AP
Stoc A7s #aret 9ariance T 6eta A
3
! #aret 9ariance T 2.I3 ! .3DE/ 3 T 3.3I ! FDDE T
ODDE .9ariance/
So the Stoc A7s #aret =is .in Standard Deviation terms/ T S(uare =oot of 9ariance T 4DE
T 6eta A h #
<ote that Total =is of Stoc A can be calculated directly by calculating the Standard Deviation of
the ;ossible "uture =eturns. That was the first =is "ormula we studied in =is Theory.
Suppose Total =is T 4IE. Then ,ompany Specific or Diversifiable or =andom =is of Stoc A T
Total =is - #aret =is T 4IE - 4DE T IE.
So CJE .T 4D&4I ! 2DD/ of Stoc A7s Total =is is #aret =is - (uite liely that Stoc A is ;art of
a well Diversified ;ortfolio or #utual "und.
+ec)rit( Mar4et Line 7+ML8 $
Straight @ine #odel is for 6eta =is and =e(uired =eturn. Similar to the =elationship for the 3-
Stoc ;ortfolio with =ocD 6eta =is is Directly ;roportional to =e(uired =eturn. The Investors re(uire
an e!tra =eturn which e!actly compensates them for the e!tra =is of the Stoc relative to the #aret.
S#@ @inear +(uation for the =e(uired =eturn of any Stoc A1
rA E rRF F 7rM 9 rRF 8 A
In the above formula
rA T =eturn that Investors =e(uire from Investment in Stoc A.
rRF T =is "ree =ate of =eturn .i.e. T-6ill =-=/.
rM T =eturn that Investors =e(uire from Investment in an Average Stoc .or the #aret
;ortfolio of All Stocs where i # T S 2.D always/.
i A T 6eta for Stoc A. .rM - rRF / i A T =is ;remium or Additional =eturn =e(uired in
+!cess of =is "ree =-= to compensate the Investor for the Additional #aret =is of the Stoc
Re2)ire* Rate o, Ret)rn<
Ri#4 /remi)m - Mar4et Ri#4$
S#@ #odel for +fficient #arets establishes a Straight @ine relationship .or Direct ;roportionality/
between a Stoc7s =e(uired =-= and its =is ;remium.
rA T rRF S .rM - rRF / A
A Stoc7s =is ;remium depends on its #aret =is ;ortion .and not the Total =is/
.ow Efficie"l$ !rice) is S"oc% A'
E5.ecte* =eturn
on +toc4 A
.?istorical/ T
+!pected =eturn on =+E 100 Mar4et In*e5 .?istorical/ T
r
A
J 9 r
RF
r
M
J 9 r
RF
=egression .6eta/ @ine for Stoc A
IF +TOC= A %ERE
EFFICIENT< ALL
/OINT+ %OULD LIE ON
A +TRAIG:T LINE AND
TOTAL RI+= E
MAR=ET RI+= ONLA
Error T
#easure of
,ompany
-Specific =is
of Stoc A
Error T
#easure of
,ompany
-Specific
=is of Stoc
A
In +fficient #arets, #aret ;rice of a Stoc is based on =e(uired =eturn which depends on
=is ;remium which depends on Stoc7s #aret =is ,omponent .and not the Total =is/.
+toc4 /rice# in E,,icient Mar4et#$
A Single Stoc Investor who owns <o Stocs and wants to buy a Share A will have to face
more =is .#aret =is S Specific =is/ than a =ational "ully Diversified Investor. The Single
Stoc Investor will want to buy the Stoc at a lower price to compensate him for the higher ris.
?owever, +fficient #arets do not price stocs based on Single Stoc Investors who want
compensation for taing on :nnecessary ,ompany-Specific =is which they should have
diversified away.
+fficient #arets price the Stocs based on their #aret =is ,omponent only. So, +fficient Stoc
;rices are based on =ational Investors holding Diversified ;ortfolios of many stocs.
+ML 9 N)merical E5am.le$
,alculate the =e(uired =ate of =eturn for Stoc A given the following data1
i A T 3.D .i.e. Stoc A is Twice as =isy as the #aret/
rM T 3DE pa .i.e. #aret =-= or =-= on a ;ortfolio consisting of All Stocs or =-= on
the )Average Stoc*/
rRF T 2DE pa .i.e. T-6ill =-=/
+ML E2)ation 7a##)me# E,,icient +toc4 /ricing< Ri#4< an* Ret)rn8
rA E rRF F 7rM 9 rRF 8 ` A >
E 2DE S .3DE - 2DE/ .3.D/ T 4DT
Inter.retation o, Re#)lt$
Investors re(uire a 4DE pa =eturn from Investment in Stoc A. This is higher than the
#aret =-= because the Stoc .6eta T 3.D/ is =isier than the #aret .6eta T 2.D always/.
If =e(uired =eturn .4DE/ is higher than +!pected =eturn .3DE/ it means that Stoc A is
:nliely to Achieve the Investors7 =e(uirement and Investors will <-T invest in Stoc A.
Sec#ri"$ Mar%e" Lie 3SML7 For Mar%e" of Efficie"
S"oc%s
Re2)ire*
Ret)rn 7rJ8
0eta Ri#4 7 8
M EF 1>0
r
M
E 20T
r
A
E C0T

A EF 2>0
r
RF
E 10T
=isy Stoc A7s
Total =is
/remi)m T
4D-2D T 3DE
#aret =is
/remi)m for
Avg Stoc T
2DE
+
e
c
)
r
i
t
(

M
a
r
4
e
t

L
i
n
e
r
A E
r
RF
F 7r
M
9 r
RF
8 5
A
y T c S m! where ! T and m T +lo.e E
.r
M
9 r
RF
8 ? 7 M 9 08 E .r
M
9 r
RF
8 ?1
Lesson 26
+ML GRA/: AND CA/ITAL A++ET /RICING MODEL
Learning O!ecti"e#$
topics.
+ML Gra.& - CA/M
>e will continue our discussion on ris. It is very important in our daily life .we are always
concerned with risy situation. There is ris that you can not watch this lecture due to the power failure.
>e have to now that how we can measure and control the ris in every day life. >e are going to see
that how we can use re(uired rate of return that we calculated by using the S#@ e(uation and use that
re(uired rate of return for the calculation we have been doing in the first two parts of this course. In first
part we did capital budgeting and <;9 calculations and in the <;9 formula the Qr7 we are using is the
re(uired rate of return not he e!pected rate of return. >e can use the value of re(uired return from S#@
e(uation in stoc or bond pricing. >e have studied that in the efficient marets the re(uired rate of
return is come from the maret return. There are two methods for the calculation of ris.
"irst approach the e!perimental cost base in this approach we use e!pected rate of return and maret
inde!. Then we plot these points on the graph and we 0oin them with a straight line called regression line
and slope of this line is called beta coefficient.
The second approach for its calculation is called theoretical beta of stoc1
6eta Stoc A T h
A
h
#

AM ?
3
M
T h
A

AM ?
M
+!tent to which Actual Stoc =eturn Data lies on =egression @ine
Total =is T #aret =is S =andom ,ompany Specific =is If the e!perimental data points
All lies e!actly on the regression line then this particular stoc has only maret ris.
T&eoretical Mar4et Ri#4 o, a +toc4$
Mar4et Ri#4 o, +toc4 A E ` A h M E h A
AM
+!tent to which Actual Stoc =eturn Data lies on =egression @ine
The third formula which we discussed is very important and cornerstone of the ,A;#.
+ec)rit( Mar4et Line 7+ML8 an* Re2)ire* Rate o, Ret)rn 7rA8$
I t allows us that the value which we have calculated for the beta and from that calculate
the re(uired rate of return of the stoc and then we use for stoc pricing. So, then the re(uired rate of
return for any stoc A is e(ual to
rA E rRF F 7rM 9 rRF 8 ` A >
In +fficient #arets, Stoc ;rice .and 9alue/ depends on =e(uired =eturn which depends on #aret
=is .not the Total =is/.
The re(uired rate of return in efficient marets depends upon the ris premium which depends only
upon the maret ris and not on the total ris. >e do not have to worry about company7s ris because
we assume that investors are rational and maintain diversified portfolio. <ow, let7s tae a loo at the
security maret line graphically .It is important to understand this graph and many things that it tells us.
The graph represents the S#@ in the efficient stoc maret. -n y $a!is we have re(uired rate of
return rZ for the stoc A for and ris free rate of return and on the !- a!is is beta ris which represents
the maret ris. S#@ is straight line and it tells us the relationship between the maret ris and the
re(uired return. it starts on the left hand side from ris free rate of return and it passes through a point
ion the middle which is the overall maret point. This point is located at the beta of S2.D and at the
re(uired return of 3DE.This means that the maret offers a rate of return which is higher then the ris
free rate of return. 6ecause the maret fluctuates it has a ris of 2.D and not D. if we e!tend the line it
passes through the point where the beta is S3.D and the re(uired return is 4DE.because this point lies on
the S#@ it means that stoc A has no company ris ' what is the ris premium P
=is premiumTrA-rRFT4DE-2DET3DE.
It is directly proportion to maret ris of stoc.
;lease note that slope of this line is T .rM-rRF/& .beta#-D/ T .rM-rRF/&2. This is the measure
tendency of the average investors in the maret to tae ris. If the S#@ line is steeper the investors will
not tae unnecessary ris. In other words they are ris aversive as the slope increase the avoidance for
the ris also increases in the maret as whole. It is very important to formulate the e(uation for S#@
Rou should be able understand the various points that lie on the S#@ line including the ris free rate of
return or T-6I@@ return as well as the maret point and you should also understand that the slope of
S#@ line isT.rM-rRF/&.beta#-D/T.rM-rRF/&2.6eta coefficient was the slope of the line for different graph
that graph shows the stoc rate of return on y-a!is and maret rate of return on !-a!is. 6ut over there
we are not taling about the re(uired rate of return we were taling about the e!pected rate of return so%
do not confuse these two different graphs. S#@ e!ist for only the efficient marets or perfect capital
marets. S#@ tells us in detail that rational investor will eliminate the company7s specific ris and the
total ris of the company will be e(ual to the maret ris of the company. S#@ line is an ideal case and
in efficient marets all the stocs lie on the S#@ line. If stoc is not on S#@ then according to maret
e(uilibrium it will come bac on S#@. If any stoc is not on S#@ then forces of maret e(uilibrium
will bring it on the security maret line. If ris and return combination of any stoc is above S#@ it
means that it is offering the higher rate of return as compare to efficient stoc. The people will rush to
buy such stoc when the demand will increase the return will decrease.
If any stoc is lying below the S#@ line the price will come down it will offer as much
potential as the efficient stoc offers. The supply for such stoc will increase and it will offer higher
return in form of capital gain. So, the maret forces will throw these points on the S#@. #arets are not
ris free .marets inde! fluctuate .The investors e!pect that maret return will be more than the average
e!pected return.
Sec#ri"$ Mar%e" Lie 3SML7 For Efficie" S"oc%s
Re2)ire*
Ret)rn 7rJ8
0eta Ri#4 7 8
M EF 1>0
r
M
E 20T
r
A
E C0T

A EF 2>0
r
RF
E 10T
=isy Stoc A7s
=is /remi)m T
4D-2D T 3D.
6ased on #aret
=is .not Total
=is/
#aret =is
/remi)m for
Avg Stoc T
2DE
+
e
c
)
r
i
t
(

M
a
r
4
e
t

L
i
n
e
r
A E
r
RF
F 7r
M
9 r
RF
8
A
>
y T c S m! where ! T and m T +lo.e E
.r
M
9 r
RF
8 ? 7 M 9 08 E .r
M
9 r
RF
8 ?1
RF E 0
+ven #arets and #aret =eturns "luctuate because of #acro Systematic "actors. So the "ully
Diversified #aret ;ortfolio consisting of all shares is <-T =is "ree. The #aret has a =is
;remium over the =is "ree =-=. This #aret =is ;remium represents 2DDE #aret =is and <o
,ompany-Specific or Diversifiable =is. +fficient Stoc combinations of =is ' =eturn in +fficient
#aret +(uilibrium must lie -< the S#@.
Any Stoc whose .=is, =eturn/ ;air lies A6-9+ T?+ S#@ is offering +!cessive =eturn .above the
#aret/. So, all rational investors will rush to 6uy it. The present ;rice would =ise and the =eturn .as
measured by ,apital Bain Rield T . ;n -;o/ & ;o/ would "all until it comes bac on S#@ Any Stoc
whose .=is, =eturn/ ;air lies 6+@-> T?+ S#@ is offering a =eturn that is lower than the #aret.
So, =ational Investors will rush to sell it. The Stoc ;rice would "all and the =eturn would =ise until it
comes bac on the S#@.
<ow , we will calculate the re(uired rate of return using B-=D-< "-=#:@A .so, we need to
calculate re(uired rate of return to understand the ris so, let7s use S#@ formula for re(uired rate of
return by plugging it into the B-=D-< "-=#:@ A. price valuation formula by B-=D-<1
Share A is being traded in the Karachi Stoc +!change .KS+/ at a #aret ;rice of =s 23. Rou need to
calculate the +!pected Theoretical "air ;rice of a Stoc A before you can decide whether to buy it or
not. Biven the following Data1
DIV1 E R# 2 .i.e. "orecasted Dividends in the upcoming year on a share of "ace 9alue T =s 2D/
g E 10T .a .i.e. "orecasted ,onstant Browth =ate in Dividends/
rRF E 10T .a .i.e. T-6ill =ate of =eturn or ;@S 6an Account =-=/
rM E 20T .a .i.e. The Karachi Stoc +!change7s historical average =-= based on the value of the
KS+ 2DD Inde!/
0eta o, +toc4 A E 2>0 .i.e. Stoc A has historically been twice as volatile or risy as the KS+ 2DD
Inde!/
:se the Bordon-S#@ +(uation to +stimate "air ;rice of Stoc A1
/oJ E DIV1 ? L 7rRF F 7rM 9 rRF 8 A 8 9 gN
T 3 & W2DE S .3DE - 2DE/ .3.D// - 2DEX
T 3 & W4DE - 2DEX T 3 & 3DE T =s 10
The =e(uired =ate of =eturn for Stoc A was calculated to be 4DE which is higher than the
#aret .3DE/. The #aret is offering a 2DE e!tra return as a =is ;remium because Stoc A .6eta T
3.D/ is twice as risy as the maret .6eta T 2.D/.
The "air ;rice of Stoc A .=s 2D/ is @+SS than the #aret ;rice .=s 23/ which means that the #aret
Speculators have -vervalued Stoc A and you should <-T buy it.
(e#urity &ar,et 7ine (SML (lope = "is, 1a,ing
Re2)ire*
Ret)rn 7rJ8
0eta Ri#4 7 8
M EF 1>0
r
M
E 20T

r
RF
E 10T
RF E 0
+tee. +lo.e +ML
Mo#t In"e#tor#
A"oi* In"e#tor#
Lo3 +lo.e +ML
Mo#t In"e#tor# in
t&i# Mar4et are
Gamler#
So, what does our answer meanP >e see that e!pected fair price of the share is =s.2D which is lower
than the maret price which is =s.23.eep in mind that price for the share is imperfect maret depends
upon the investor psychology , speculation and gambling that is taing place in the stoc maret .so,
when fair price is lower as in our e!ample and maret price is higher it means that the shares price or
stoc has been over valued and the rational investor will not purchase it .other thing to note is that we
calculated share premium and re(uired rate of return in our formula is 4DE.it is higher than the over all
maret ris .because it is twice risy as the maret beta ATS3.Dtherfore it is giving e!tra return to the
investors for the compensation.
N/V Calc)lation# - Ca.ital 0)*geting$
A..lication o, +ML 7CA/M8$
In the beginning of this course while studying capital budgeting and investment criteria we used
the <;9 and ;9 formulas for calculating re(uired rate of return and not for e!pected rate of return.
=e(uired rate of return is attached to the individual investors. we forecast our dividends and they are
not true cash flows so we discount them to the present .we calculate the standard deviation for over
all industry. N/V 7an* /V8 ,alculation which is the ?eart of Investment ,riteria and ,apital
6udgeting uses re(uired return .and <-T +!pected =-=/. This is why Share ;ricing also uses
=e(uired =ate of =eturn because Share ;rice was derived from the ;9 +(uation for Dividend ,ash
"lows.
>e can apply our ;robabilistic =is Analysis to +ntire ,ompanies or =eal ;ro0ects or Assets and
focus on the 9olatility or :ncertainty of their <et ,ash "lows. >e can compare that to the
9olatility of the ,ash "lows of the Industry that the ,ompany is a part of to come up with a 6eta
,oefficient for the Assets of a ,ompany as a whole. >e can then use the Asset 6eta to calculate
the -verall =e(uired =ate of =eturn for a ,ompany .i.e. All Assets - both +(uity and Debt/.
Ri#4 - Ret)rn 9 M)#t Con#i*er ot&$
In ;erfect #arets and +fficient #arets where =ational Investors have Diversified Away A@@
,ompany Specific =is, 9alue .and Stoc ;rice/ depends on =e(uired =eturn which depends on #aret
=is .and not Total =is/.In most =eal #arets where Investors are not fully Diversified, Total =is is
important. It can be calculated using the Sigma .Standard Deviation/ "ormulas, probabilities, and
+!pected =eturn. Total =is and e!pected =eturn must both be considered in ,omparing Investments.
#aret =is and re(uired return are related to one another in +fficient #arets according to the S#@
e(uation. =e(uired =eturn depends on the Individual Investor7s ;sychological =is ;rofile and
-pportunity ,ost of ,apital.
0eta#$
+toc4 0eta "#> Real A##et 0eta
-b0ective in "# is to ma!imize stoc holders7 .or -wners7/ >ealth
<egative Side +ffect - Treasury #anagers of @isted ,orporations in :SA and +urope spend too
much time manipulating Stoc ;rices.
=eal Assets have =isy =evenue ,ash "lows1
Asset 6eta T =evenue 6eta ! W2 S ;9 ."i!ed ,osts/&;9 .Assets/X
A Stoc7s 6eta or =is =elative to the #aret can change with time. If the ,ompany7s business
operations or environment change, its responsiveness to the #aret can alter i.e. if it buys another
business, implements a Total Vuality #anagement program, maes an ='D technological discovery,
taes on Debt, etc.
Note# on Mea#)ring Uncertaint(
+tan*ar* De"iation "#> 0eta
"or +!ample, -il Drilling ,ompanies1 possible to have ?igh Standard Deviations in "orecasted
+arnings and =eturns but @ow 6etas or Stoc ;rice volatility relative to #aret
Volatilit( "#> Ri#4$
Seasonal or macro volatility in +arnings does <-T necessarily signify =is 6:T ?igh Stoc
;rice volatility does signify =is.
Lesson 27
RI+= AND /ORTFOLIO T:EORA< CA/M< CRITICI+M OF CA/M AND A//LICATION OF
RI+= T:EORA
Learning O!ecti"e#$
Ri#4< /ort,olio T&eor(< CA/M
Critici#m# o, CA/M
A..lication# o, Ri#4 T&eor(
Today we will review some concepts about ris portfolio theory and capital asset pricing model.
There is saying in +nglish that fortune favours the brave.
+)mmar( o, +ingle +toc4 7+tan* Alone8 Ri#4 - Ret)rn$
The first thing that we studied was how to calculate the e!pected rate of return or ris for a
single stoc that is what we call stand alone investment. :ncertainty comes along as we are not what is
price of the stoc will be at any time in futureP 6ecause of this uncertainty there are possible outcomes
of such investment and we attach probability or their liely hood and we calculate a weighted average in
order to come up with e!pected rate of return on the investment.
+!pected =eturn "ormula .>eighted Average of #any ;ossible "uture -utcomes for =eturns of that
one Stoc/
X r V E b .. i ! r i/ .where p T probability of future outcome and r is the rate
of return from that outcome
So, if there are three possible outcomes attached with it the formula will be
XrVE/ArAF/0r0F/CrC
>here, pTpossible outcomes. There is a probablity distribution of such outcomes and this
distribution is the measure of the spread or range of possible values or uncertainty. if we a loo at the
graph of the normal distribution curve then the width of the curve is the measure of the ris or
uncertainty. >e measure ris mostly by standard deviation.
Stand Alone Total =is "ormula .Standard Deviation or Spread of Distribution of ;ossible "uture
=eturns/
Sigma T h T . b . r i - f r i c /2 p i // 0> G T .9ar/ 0> G
This formula which represents the total ris of a single stoc can be used for the portfolio of
stocs.
>e then spoe about the collection of many stocs. >hy do sensible people invest in many
stocs the logic is very simple that do not put all your eggs in one baset. The e!perimental studies have
shown that if some one has FD different stocs or investments which are not correlated to each other
then half of the ris can be eliminated. >hat ind of ris has been eliminatedP This is the company7s
specific ris that has been eliminated because of company7s random events in the life of the company.
So, the diversification or investment in increasing number of stocs reduces the overall or total ris and
even if you diversified in L uncorrelated stocs it is possible to reduce the large portion of the
company7s own ris .once you have nown the return of the individual stoc you have nown about the
portfolio stoc in collection of investments. +!pected rate of return for 4 stocs on a portfolio is1
+!pected ;ortfolio =eturn "ormula .>eighted Average of =eturns of Stocs in the ;ortfolio/
r
; Z
T r
A
!
A
S r
6
!
6
S r
,
!
,
S .for a 4-Stoc ;ortfolio/
;ortfolio =is "ormula
3 3 3 3
A 6 A 6 A 6 A6
p T Y S Y S 3 .Y Y / .3 Stocs/
If 3 stocs move in the same direction together then correlation coefficient is 2.D. if the e!actly
move in the opposite direction then the correlation coefficient -2.D and if there is no relation between the
movement of the stocs then the correlation coefficient is zero.
If #ore than 3 Stocs, then use =ISK #AT=IY
The portfolio theory told us there is direct relationship between ris and the return and as ris of the
investment goes up then return also increase .it is mentioned that if correlation co-efficient is less then
or e(ual to zero .$ve/ then the ris and return relationship between 3 stocs e!hibits shaped curve what
it tells us is that it is possible that when we added the 4
rd
stoc then it not only increase the overall return
but it also reduce the total ris of the portfolio and that is ideal . >e found the parachute curve for the
portfolio which consist of more then 3 stocs and this large hoo is the efficient frontier which
represents the most efficient combination of the different stocs in that portfolio. 6y adding stoc , we
came up with parachute curve and we also came up with curve that envelops both of these curves which
is nown as the efficient frontier. So, let7s see how can we derive ,#@ or the capital maret line and
the e(uation of ,#@ from this efficient maret curve .portfolio return is with y- a!is and ris along
with !-a!is we see the line from ris free rate of return which is assumed to be 2DE and is represented
by r
=" .

/arac&)te Gra.& and +fficient "rontier .?oo Shaped ,urve/ shows A@@ possible =is-=eturn
,ombinations for A@@ combinations of stocs in the ;ortfolio $ whether efficient or not.
CML +traig&t Line E2)ation .T-6ill ;ortfolio and -ptimal ;ortfolio #i! on +fficient "rontier ,urve/
connects r=" .=is-free or T-6ill return/ to the Tangent ;oint on the +fficient "rontier ,urve.
82S"oc% !or"folio Ris% Form#la 8 x 8 Ma"rix Approach
Stoc
A
Y
A
2
A
2
Y
A

Y
0 A

0 A0
Y
A

Y
C A

C AC
Stoc
6
Y
0

Y
A 0

A 0A
Y
0
2
0
2
Y
0

Y
C 0

C 0C
Stoc
,
Y
C

Y
A C

A CA
Y
C

Y
0 C

0 C0
Y
C
2
C
2

!ic%ig "he Mos" Efficie" !or"folio Capi"al
Mar%e" Lie 3CML7 & T29ill !or"folio
+toc4 C
Stoc 6
r
/
Z
/
10TE
3DE
C>HT Ri#4
/
o
r
t
,
o
l
i
o

R
e
t
)
r
n
Stoc A
H0T
3DE
4DE
2>GT
E,,icient Frontier
,or C9+toc4 /ort,olio
PT&e /arac&)teQ
;ortfolio with <egative
or Mero ,orrelation
,oefficient
C
a
.
i
t
a
l

M
a
r
4
e
t

L
i
n
e
r
RF
r
/
J E r
RF
F L 7r
M
9 r
RF
8 ? M N /
It represents all =is-=eturn ,ombinations for +fficient /ort,olio# in the ,apital #aret. >e
assume easy access to ris-free T-6ill ;ortfolio. ;ortfolio =is measured using Standard Deviation.
There is an optimal point of the line where
Stoc ATIDE
Stoc 6T4DE
Stoc ,T3DE
+)mmar( o, 0eta$
#aret =is and 6eta ,oefficient .,A;#/
Single Stoc 6eta .TSlope of 6est "it =egression @ine which passes through data points/
T ;ercent ,hange in Stoc =-= & ;ercent ,hange in #aret Inde! =-=
;ortfolio 6eta =is "ormula .>eighted Average "ormula/
Stoc 6eta "ormula in terms of Stoc Standard Deviation ' ,ovariance
T h
A
h
#

AM ?
3
M
T h
A

AM ?
M E mar4et ri#4
+ec)rit( Mar4et Line 7+ML8
+ML 7+ec)rit( Mar4et Line8 9 Corner#tone o, CA/M1
It represents all =is-=eturn ,ombinations for ALL E,,icient +toc4# in the ,apital #aret. Stoc
ris measured using 6eta. #aret ;rice of a Stoc is determined by =e(uired =eturn on Stoc which
depends on #aret =is .not Total =is/.Rou can not e!pect to receive e!tra return .or compensation/
for taing on ,ompany-Specific =is which =ational Investors have eliminatedU +fficient #aret
;rices are based on #aret =is -nly and <-T Total =is.
The +fficient #aret will only offer you a =eturn .and a Share ;rice/ which is the bare minimum acceptable
to rational diversified Investors.
Re2)ire* ROR vs +!pected =-=
S#@ @inear +(uation ' Braphical Interpretation
Critici#m# o, CA/M - Alternati"e#$
%ea4ne## in +ML$
A <ot All Investors are rich or well-informed enough to hold "ully Diversified ;ortfolios
therefore #aret =is .and 6etas/ is <-T the only relevant factor in estimating =e(uired
=eturn and Stoc ;rices. -ther +fficient #aret Assumptions.
A Ta!es and 6roerage ,osts that affect Investor7s analysis and estimation of =eturns have
been ignored
Sec#ri"$ Mar%e" Lie 3SML7 ALL Efficie" S"oc%s i
Efficie" Mar%e"s
Re2)ire*
Ret)rn 7rJ8
0eta Ri#4 7 8
M EF 1>0
r
M
E 20T
r
A
E C0T
A EF 2>0
r
RF
E 10T
=isy Stoc A7s
Total =is
/remi)m T
4D-2D T 3DE
#aret =is
/remi)m for
Avg Stoc T 2DE
+
e
c
)
r
i
t
(

M
a
r
4
e
t

L
i
n
e
r
A E
r
RF
F 7r
M
9 r
RF
8
A
>
%ea4ne## in CML$
<ot All Investors are influential enough to be able to 6orrow at the T-6ill =ate. Benerally the
6orrowing =ate is higher than the @ending =ate.
Fama - Frenc&$
,A;# ignores 3 important determinants of ?igher =e(uired =-= .2/ smaller firms and .3/
@ow #aret-to-6oo =atio.
Aritrage /ricing Mo*el1
Accounts for several factors that affect ris i.e. Ta!, inflation, oil price,...
Financial Management A..lication# o, Ri#49Ret)rn T&eor( 7CA/M8$
A /ractical Real A##et In"e#tment Deci#ion# an* Ca.ital 0)*geting
$ The most important N/V 7an* /V8 E2)ation# uses =+V:I=+D =-= .and <-T
+!pected =-=/
A Act)al +&are /ricing and Investment in Securities
$ Gor*on1# Form)la for Share ;ricing uses ;9 of Dividends which uses =+V:I=+D
=-=
Ri#4 - Ret)rn 9 M)#t Con#i*er ot&$
In this course we have studied the following concepts of financial management.
A "irst ;art of this ,ourse - 9aluation or ,alculating <;9 and ;9 which are measures of
=eturn. >e ignored =is and origins of =e(uired =-=.
A Second ;art of this ,ourse $ Application of ;9 ,oncept to 9aluation or ;ricing of 6onds
.Debt/ and Shares .+(uity/. Again we ignored =is and origins of =e(uired =-=.
A ;art 4 of the ,ourse Introduced =is and how it determines the =e(uired =eturn used in
<;9 and Share ;rice "ormulas.
A In ;erfect #arets, 9alue depends on =e(uired =eturn which depends on #aret =is .and
not Total =is/.
A 6:T, in =eal #arets which are Imperfect and Inefficient, Total =is is important. It can
be calculated using the Sigma .Standard Deviation/ "ormulas, probabilities, and +!pected
=eturn.
A Total =is and +!pected =eturn must 6-T? be considered in ,omparing Investments.
A #aret =is and =e(uired =eturn are =elated to one another
Common Li,e A..lication# o, Ri#4 an* Ret)rn T&eor($
,oncepts of =is ' =eturn Theory have >ide ;ractical Applications that re(uire a ,reative #ind.
+!pected 9alue or +!pected =-= or +!pected ;ayoff
Total =is or Standard Deviation .based on Spread or =ange of 6readth of ;ossible =-=
outcomes/ T :ni(ue S #aret =is
Systematic .or #aret or <o diversifiable/ =is .T 6eta A ! Sigma #/. Individual =is relative
to #aret or Industry.
A T&in4 O)t o, t&e 0o5$
Social ,ost-6enefit Analysis of ;ower ;lant1
+nvironmental and 9illage =elocation =is, :ncertain Savings
,ourt ,ase ;ayoff1 ,laims ' ;enalties
:ncertain lielihood of success and -pponent, :ncertain ;ayoff
@ielihood of >ar1 ,apability ' Intent .Bame Theory/
#agnitude of ,apability vs :ncertainty of Intent
Lesson 28
INTRODUCTION TO DE0T< EFFICIENT MAR=ET+ AND CO+T OF CA/ITAL
Learning O!ecti"e#$
Intro to Det< E,,icient Mar4et# - Co#t o, Ca.ital
In today7s lecture, we will start our discussion on capital structure and corporate financing. The first
thing which we study about the capital structure is the over view of the financial marets. >e have
mentioned that there are two main sources of capital raising i.e. debt and e(uity. There are various
financial marets where the money is available.
Ca.ital Mar4et#$
Stoc +!change .listed shares, unit trusts, T",/1
In the case of capital maret we have study the stoc e!change where the common or preferred
stocs of companies are traded. In these we have the supply or availability of the e(uity capital.
Mone( Mar4et# 7+&ort9term li2)i* *et mar4et/1
It is the maret for short term debt. and it includes the debt instruments lie term finance
certificates and bonds etc. ban loans ,leases from leasing company , mortgage agreements from house
building finance corporation insurance policy , credit cards and various other things .it also includes
ban deposits certificates and inter ban short term and over night borrowing and lending 6onds
Real A##et# Mar4et#$
The real asset maret where the real or tangible asset or physical asset change hand .for
e!ample, you have cotton e!change where raw bales of cotton change hands .computer hardware and
many other e!amples are available. "or e!ample, ,otton +!change, Bold #aret, Kapra #aret
;roperty .land, house, apartment, warehouse/ ,,omputer hardware, :sed ,ars, >heat, Sugar,
9egetables, etc.
Det an* E2)it( Mar4et#$
E2)it( Mar4et# an* In#tit)tion#
Stoc +!changes
;rivate ;lacements
;rivate +(uity Investments
9enture ,apital
Islamic "inance
Det Mar4et# an* In#tit)tion#
6ond #arets
#oney #arets ' ,all #arets
6an @oans ' ,ertificate of Deposits .,D7s/
;ro0ect "inancing
=unning "inance or >oring ,apital "inance
?ypothecation and ;ledge "inancing for Inventory ;urchase
6ridge "inancing
#ortgage "inancing
@ease "inancing
Insurance and ,redit ,ard
In previous lectures we have studied about the efficient marets.
E,,icient Mar4et#Q A##)m.tion$
>e assume that "inancial #arets are (uic and ;rices are =ight. There are @ots of =ational
Investors in every "inancial #aret. They are all well-informed and act (uicly on information related
to the companies7 operations, finances, ris and return. So ;rices of Securities .lie Stocs and 6onds/
ad0ust .e(uilibrate/ (uicly to new information. ;ricing by the #aret is +fficient and Accurate.
-bserved #aret ;rice is accurate reflection of "air ;rice .or Theoretical ;rice based on Investors7
<;9 calculations/.
All Stocs have -ptimal =is-=eturn ,ombinations, i.e. All Stocs lie right -< the S#@ @ineU
+ec)ritie#$
These are pieces of legal contractual paper that represent claim against assets
Direct Claim +ec)ritie#$
+toc4#$ it is e(uity paper representing ownership, shareholding. Appears on @iabilities side of
6alance Sheet
0on*#$ it is debt paper representing loan or borrowing.
$ %&en (o) are i##)ing 0on*# 7i>e> orro3ing mone(8 t&en t&e Val)e o, 0on*#
a..ear# )n*er Liailitie# #i*e 7a# Long Term Det8 o, 0alance +&eet>
$ I, (o) are In"e#ting 7or )(ing8 0on*# o, ot&er com.anie# t&en t&eir Val)e
a..ear# )n*er A##et# #i*e 7a# Mar4etale +ec)ritie#8 o, 0alance +&eet>
9alue of Direct ,laim Security is directly tied to the value of the underlying =eal Asset.
%&( Ta4e Det'
If you do <-T have enough money to meet your own or your family7s personal living
e!penses, then you approach a friend or a 6an for a ;ersonal @oan.
If you can <-T find friends, family, or investors who want to invest +(uity into your business
venture, then you approach an Individual @ender or 6an or @easing ,ompany for a 6usiness @oan. In
an +mergency or ,risis, the (uicest way to get money is generally to tae a @oan at a high interest rate.
,ountries that are short of money do this too.
Det "#> E2)it($
If the ,ompany raises money using Debt or 6onds, then it will have to pay a fi!ed amount of
interest .or mar-up/ regularly for a limited amount of time. -f course, failure to pay interest can
force company to close down.
If the ,ompany raises money using +(uity, then it is forced to bring in new shareholders who are
-wners ' can interfere in the management and will get a share of the net profits .or dividends/ for
as long as the company is in operation
Ca.ital +tr)ct)re$
#ost "irms eep a #i! of 6oth Debt and +(uity ,apital. In other words most "irms raise
money from both Stocholders .and Shareholders/ and 6ondholders .and 6ans/.
The #i!ture or ;roportion of Debt ,apital and +(uity ,apital are nown as the Ca.ital +tr)ct)re>
This "inancial ;olicy Decision is taen by the ,+-, ,"-, and 6oard of Directors
,apital Structure can ,hange >ith Time depending on "irm7s "inancing needs and strategy. Some
;ro0ects lie ;ower ;lants and ,ement are so ,apital Intensive and large that initially the sponsors need
Debt ,apital >hen a =unning 6usiness reaches maturity, some owners prefer to fi! the =atio of Debt to
+(uity at 3D&CD and only for =unning "inance. Some #uslim 6usinessmen use 2DDE +(uity ,apital
only .<o Debt/.
>here Do 6onds ' Stocs Appear on the
6alance SheetP
+toc4# - 0on*#
/)rc&a#e* a#
In"e#tment
O3n +toc4 I##)e* (
Com.an( to Rai#e Ca#&
O3n 0on*# I##)e* (
Com.an( to Rai#e Ca#&
Co#t o, Ca.ital$ "irms try to attract Debt and +(uity Investors to invest their ,apital .or money/. "irms
claim that they are SA"+ and ;=-"ITA6@+ investments. Therefore, "irms try to Bet Investment
,apital .or money/ at the @->+ST possible ,ost of ,apital.
=emember that whenever you 6orrow or =ent or 6uy anything .cycle, house, money/, it ,osts
Rou #oney in the form of a =ental, Interest or #ar-up, Installment, etc.
Stocholders .+(uity owners/ e!pect to receive Dividends
6ondholders .Debt ?olders and 6ans/ e!pect to receive Interest
Co#t o, Ca.ital - Re2)ire* ROR$
Re2)ire* ROR 7or O..ort)nit( Co#t8 T$
,A;# Theory .S#@ for +fficient #arets/ ' <;9
#inimum =-= re(uired attracting investor into buying a Security .i.e. Stoc or 6ond d/
-pportunity ,ost1 Investor Sacrifices the =-= available from the 3nd best investment.
Co#t o, Ca.ital T$
>eighted Average ,ost of ,apital .>A,,/
,ombined costs of all sources of financing used by "irm .i.e. Debt and +(uity/
>A,, is Similar to =e(uired =-= 6:T Taes into account some ;ractical "actors1
Ta5e#$ Interest ;ayments are ;&@ +!penses and <-T Ta!ed.
Tran#action co#t#$ 6roerage, :nderwriting, @egal, and "lotation ,osts incurred
when a "irm issues Stocs or 6ond Securities
%ACC
T%eig&te* A"erage Co#t o, Ca.ital
Assume that "irm marets 4 Types of "inancial ;roducts .or Securities or Instruments/ to attract
Investors7 ,apital>
6onds .Debt/1 ,ost T ,oupon Interest
,ommon Shares .+(uity/1 ,ost T 9ariable Dividend
;referred Shares .?ybrid +(uity/1 ,ost T "i!ed Dividend
The "irm Issues a Security or "inancial Instrument to the Investor and =eceives ,apital .or #oney/
in e!change. The "irm has to pay a PRental Co#tQ for using the Investors7 ,apital.
%ACC T E %eig&te* T Co#t o, Det F %eig&te* T Co#t o, Common E2)it( F %eig&te*
T Co#t o, /re,erre* E2)it( E r
D
5
D
F r
+
5
+
F r
;
5
;
%ACC m)#t ta4e Ta5e# - Tran#action Co#t# into acco)nt
Sec#ri"$ Mar%e" Lie 3SML7 For Mar%e"
of Efficie" S"oc%s
Re2)ire*
Ret)rn 7rJ8
0eta Ri#4 7 8
M EF 1>0
r
M
E 20T
r
A
E C0T

A EF 2>0
r
RF
E 10T
=isy Stoc A7s
Ri#4 /remi)m
T 4D-2D T 3DE
+
e
c
)
r
i
t
(

M
a
r
4
e
t

L
i
n
e
r
A
E r
RF
F 7r
M
9 r
RF
8
A
>

Stoc A lies
ON the S#@
@ine. E,,icient
=is-=eturn
,ombination
+)mmar( o, Form)la#$
Total ri#4T maret ris S company specific ris
3 3 3 3
+ +
N/V 0on* /ricing E2)ation$
6ond ;rice T ;9 T ,2& .2SrD/ S ,3 .2SrD/
3
S ,4 & .2SrD/
4
S d.. S ;A= & .2SrD/
4
Gor*on1# Form)la ,or +&are /ricing1
r
,+
T .DI9 2 & ;o/ S g T Dividend Rield S ,apital Bains Rield
+ML E2)ation 7CA/M T&eor(8
r T r
="
S 6eta .r
#
- r
="
/
Lesson 29
%EIG:TED AVERAGE CO+T OF CA/ITAL 7%ACC8
Learning O!ecti"e#$
%ACC 7%eig&te* A"erage Co#t o, Ca.ital8
In this lecture, we are going to tal about the very important component of capital structure which is
nown as weighted average cost of capital .>A,,/.In previous lecture, we have introduced some of the
broad concepts of capital structure. >e discuss about the company7s ways to raise capital. one of two
basic ways is the e(uity and the other is debt .The ob0ective of the company is to raise capital at the
lowest possible cost .0ust as when you go to the maret you try to buy things at the lowest possible cost.
Similarly, companies go looing for money in financial marets they try to raise funds at the lowest
possible cost. This means that when the company raises money in the stoc maret issues that it try to
sell its shares at the price at which it can earn ma!imum profit .Similarly, when a company go to the
money maret to tae loan it tries to get the loan at the lowest possible rate of interest .
>e mentioned that weighted average cost of capital concept is similar to concept of the re(uired
rate of return which we have discussed earlier lectures. It is also nown as opportunity cost and by
opportunity cost we mean )the rate of return that investors sacrifices by investing in the present
investment*. So, the rate of return that he can get from the second best of investment is the opportunity
cost or =-=. >e used the re(uired rate of return in our present value formula .>A,, is similar to the
re(uired rate of return .There is only slight difference between re(uired rate of return and
>A,,.>A,, only taes into account the practical aspects such as impact of ta!es and transaction
costs or flotation costs. .6y ta!es we mean income ta! or corporate ta! that the company needs to pay
to the govt. at the end of the year depending upon their net income and transaction associated with the
issuing selling and mareting of the financial securities lie stocs and bonds. >hen we tal about
>A,,, we generally include three possible types of capital.
%ACC E rD5D F rE5E F r/5/
>eighted E ,ost of 6ond .Debt/1
rD @D $
>here rD is the Average =ational Investors7 =e(uired =-= for investing in the 6ond, YD is the
>eight or "raction of Total ,apital value raised from 6onds T 6ond 9alue & Total ,apital
%eig&te* T Co#t o, Common E2)it($
rE @E $
>here rD is the Average =ational Investors7 =e(uired =-= for investing in ,ommon Share, YD
is >eight or "raction of Total ,apital raised from ,ommon +(uity. <ote that rE is <ot the >A,, and
<ot the =-+ .There r/ is the Average =ational Investors7 =e(uired =-= for investing in ;referred Share, @/
is >eight or "raction of Total ,apital raised from ;referred +(uity
%eig&te* Co#t o, Det T E rD @D
Re2)ire* ROR ,or Det
T&e ,ir#t term i# t&e rD 3&ic& i# t&e re2)ire* rate o, ret)rn an* t&e co#t o, *et can e inter.rete*
a# t&e re2)ire* rate o, ret)rn> Rou will recall that when we were taling about bond pricing that we
also spoe about the over all return on a bond and that is referred to as yield to maturity or RT#.
ATME intere#t (iel* Fca.ital gain (iel* and it is representative of over all cost of debt in the form of
bond.
Co#t o, Det Ca.ital E rD
;ractically speaing, 6onds are Issued .or sold/ in the #aret at a ;remium .above ;ar 9alue/ or
Discount .below ;ar 9alue/. And, the Issuance of 6onds has Transaction ,osts. These transaction
costs include @egal, Accounting, and #areting and Sales fees. 6oth these are factored into the #aret
;rice of the 6ond used in ;9 "ormula to calculate the ;re-Ta! ,ost of Debt ,apital T rDJ> So, rather
than using #aret ;rice of Debt, use the
<et proceeds T #aret ;rice $ Transaction ,osts
"inally, Debt becomes less ,ostly because Additional Interest creates a new form of Ta! Saving
or Ta! Shield.
After Ta! ,ost of Debt T rD T rDJ .2 - T,/
>here T, is the #arginal ,orporate Ta! =ate on the <et Income of the "irm
E5am.le$
,ompany A6, issues a 3 Rear 6ond of ;ar 9alue =s 2DDD and a ,oupon =ate of 2DE pa .and
annual coupon payments/. ,ompany A6, pays an Investment 6an =s ID per 6ond to structure and
maret the bond. They decide to sell the 6ond for =s OID .i.e. At a Discount/. At the end of the first
year, ,ompany A6,7s Income Statement shows the ,oupon Interest paid to 6ondholders as an e!pense.
Interest represents a Ta! Saving or Shield. 6ased on the <et Income and Industry Standard, the
#arginal ,orporate Ta! =ate is 4DE of <et Income. Assuming that the 3 Rear 6ond represents the
-<@R form of ,apital, calculate the After-Ta! >eighted Average ,ost of ,apital .%ACC/ E for
,ompany A6,.
+te. 11
,alculate =e(uired =-= using 6ond ;ricing or ;9 "ormula
/V E 2DD& .2SrZ/ S2DD& .2SrZ/
2
S2DDD& .2SrZ/
2
T 2DD& .2SrZ/ S 22DD& .2SrZ/
2

T Net /rocee*# E N/ E Mar4et /rice 9Tran#action Co#t#
T OID - ID T =s ODD
Solve the Vuadratic +(uation for ;re-Ta! =e(uired =-= T rZ
:sing the Vuadratic "ormula1 rJ E 1ST A<D r T - I E
T&i# 2)e#tion i# !)#t to re.re#ent t&e conce.t t&ro)g& an e5am.le> T&e "al)e# i>e> 1ST - 9GT are
a##)me* not e5actl( calc)late*>
+te. 21
,alculate After Ta! ,ost of Debt
rD E rDJ 7 1 9 TC 8 E D.2J . 2 - D.4D/ T D.2J .D.LD/ T 11 > 2 T
+te. C1
,alculate >eighted ,ost of ,apital .>A,,/
%ACC E rD @D> F r/ @/ F rE @E >
E rD @D S D S D
T 22.3 .2/ T 11>2 T
%eig&te* Co#t o, /re,erre* E2)it( E r/ @/
Re2)ire* ROR ,or /re,erre* E2)it(
The important thing to remember is that we calculated the price by using the ;erpetuity "ormula for
;erpetual Investment ' ,onstant Div
;9 T ;resent ;rice T ;oT DI92 & r.
So, r T DI92 & ;o. If you use the Actual -bserved #aret ;rice for ;o then r T =e(uired =-=.
Co#t o, /re,erre* E2)it( Ca.ital E r/
;ractically speaing, the process of @egally Structuring, ;rinting, and #areting ;referred Share
,ertificates costs money in the form of "lotation ,osts .including 6roerage and :nderwriting "ees/.
These ,osts are factored directly into the ;9 or -bserved #aret ;rice.
;9 T <et ;roceeds T #aret ;rice - "lotation ,osts
;referred Stoc Dividends are paid out from <et Income After ta!es. So they are not Ta! Deductible
.unlie 6ond Interest ;ayments/.
E5am.le$
,ompany A6, wants to issue a ;referred Stoc of "ace 9alue =s 2D. The 6oard of Directors has
agreed to fi! the Annual Dividend at =s 3 per share. The @awyer7s fee and Stoc 6roers7
,ommissions will cost =s 2 per share. The ;referred Share is floated at "ace 9alue. >hat is the ,ost of
,apital to ,ompany A6, for raising money through ;referred StocsP
:se /er.et)it( Form)la to ,ompute the Re2)ire* ROR
r T DI92& ;o T =s 3 & =s 2D T 20T
#inor ,hange in /er.et)it( Form)la to ,ompute the Co#t o, /re,erre* E2)it( Ca.ital
<et ;roceeds T <; T;rice-"lotation ,osts T2D-2T =s O
r T DI92& <; T =s 3 & =s O T 22T
Flotation Co#t# ADD TO CO+T o, Com.an( I##)ing t&e /re,erre* E2)it( Ca.ital
%eig&te* Co#t o, Common E2)it( E rE @E>
Re2)ire* ROR ,or Common E2)it( 7or +&are#8$ 2 A..roac&e#
Dividend Browth #odel1 Bordon "ormula .simplified ;9 "ormula/ for ;erpetual Investment '
,onstant Browth in Dividends
r T DI92 & ;o S g. If you use the Actual -bserved #aret ;rice for ;o then r T
=e(uired =-=. <ow 3 Approaches for proceeding to calculate ,ost of ,apital1
,A;# .S#@ +(uation/ Assuming +fficient #arets
r T rRF S 6eta .rM - rRF/. Advantage1 does not rely on Dividend "orecast
Co#t o, Common E2)it( Ca.ital E rE
#ost comple! cost of capital to calculate
=e(uired =-= on ,ommon +(uity <+IT?+= observable <-= certain unlie 6ond ,oupon Interest '
;referred Dividends both of which are fi!ed
+(uity ,apital can be raised in 3 >ays and =e(uired =-= and ,osts are different for each1 .2/
=etained +arnings and .3/ Issue of <ew ,ommon Stoc. Rou can use rE for <ew Stoc or =etained
+arnings .which is lower/.
,ommon Stoc Dividends are paid out from <et Income A"T+= TAY+S. So they are <-T Ta!
Deductible .unlie 6ond Interest ;ayments/>
E5am.le$
,ompany A6, wants to issue more ,ommon Stoc of "ace 9alue =s 2D. <e!t Rear the
Dividend is e!pected to be =s 3 per share assuming a Dividend Browth =ate of 2DE pa. The @awyer7s
fee and Stoc 6roers7 ,ommissions will cost =s 2 per share. Investors are confident about ,ompany
A6, so the ,ommon Share is floated at a #aret ;rice of =s 2J .i.e. ;remium of =s J/.
If the ,apital Structure of ,ompany A6, is entirely ,ommon +(uity, then what is the
,ompany7s >A,,P :se 3 Approaches and ,ompare the =esults
E5am.le 9 Co#t o, Common E2)it( Ca.ital
Di"i*en* Gro3t& Mo*el
Step 21 ,alculate =e(uired =-= for ,ommon Stoc using Bordon7s "ormula .;erpetual Investment
and ,onstant Browing Dividend/1
Approach I1 =etained +arnings Approach .use #aret ;rice/
r T .DI92&;o/ S g T 3&2J S D.2D TD.23I SD.2 TD.33I T 33.IE
Approach II1 <ew Stoc Issuance Approach
<et ;roceeds T "lotation ;rice - "lotation ,osts T 2J - 2 T 2I
r T.DI92&<;/ S g T 3&2I S D.2D T D.244 S D.2 TD.344 T 34.4E
,heaper for ,ompany A6, to =aise +(uity ,apital through =etained +arnings than to incur costs of
issuing <ew +(uity
;roblem1 >hich ,ost to ;icP
+!ample - ,ost of ,ommon +(uity ,apital
CA/M Mo*el 7+ML8 +fficient #aret
Biven some additional data1 T-6ill =-= T 2DE pa. #aret =-= T 3DE. 6eta for A6, ,ommon
Stoc T 2.3I
r E rRF F 0eta 7rM 9 rRF8 E 10T F 1>2G 720T910T8
E 10T F 12>GT E 22>GT
Same answer as =etained +arnings Approach in Dividends Browth #odel. Advantage1 Don7t need to
forecast dividends in ,A;# Approach.
,A;# matches Dividends #odel if <o "lotation & Transaction ,osts and #aret is +fficient
=e(uired =-= .or -pportunity ,ost/ E
CA/M T&eor( 7+ML ,or E,,icient Mar4et#8 - N/V
#inimum =-= re(uired to attract investor into buying a +ec)rit( .i.e. Stoc or 6ond d/
O..ort)nit( Co#t1 Investor Sacrifices the =-= available from the 3nd best investment.
,ost of ,apital E
>eighted Average ,ost of ,apital .%ACC/
,ombined costs of all sources of financing used by Firm .i.e. Debt and +(uity/
+imilar to Re2)ire* ROR 0UT Taes into account some ;ractical "actors1
TA@E+1
Interest ;ayments are ;&@ +!penses and <-T Ta!ed.
TRAN+ACTION CO+T+1
6roerage, :nderwriting, @egal, and "lotation ,osts incurred when a "irm
issues Stocs or 6ond Securities
+)mmar( o, Form)la#
Total ri#4T maret ris S company specific ris

3 3 3 3
+ +
<;9 6ond ;ricing +(uation1
6ond ;rice T ;9 T ,2& .2SrD/ S ,3 .2SrD/
2
F ,4 & .2SrD/
C
FU>> F /AR ? 71FrD8
C

Bordon7s "ormula for Share ;ricing1
rCE T .DI9 2 & ;o/ S g T Dividend Rield S ,apital Bains Rield
S#@ +(uation .,A;# Theory/
r E rRF F 0eta 7rM 9 rRF8
Lesson 30
0U+INE++ RI+= FACED 0A FIRM< O/ERATING LEVERAGE< 0REA= EVEN /OINT-
RETURN ON EDUITA
Learning O!ecti"e#$
0)#ine## Ri#4 ,ace* ( FIRM
O.erating Le"erage 7OL8
0rea4e"en /oint - ROE
In this lecture, we are going to continue our discussion on weighted average cost of capital and we
will begin our discussion on the concept of operating leverage. 6oth of these concepts are of the area
which we have stated in the previous lecture called capital structure.
In capital structure we decide what the distribution of debt and e(uity should be in the firm and it
is decided by the board of directors of the firm or company. The 0ob of deciding what amount of debt
and e(uity one has is difficult.
So, the first thing is to calculate the cost of capital. so, the company has the option that it may
either go into money maret or into the capital maret to raise money either through debt or through
e(uity . <ow, you might thin the e(uity the company might raise has no cost. >e all now that when a
company taes a loan it has to pay interest or mar up on it but often people thin when it raise fund
through e(uity in stoc e!change then there is no cost attached to it because they are not paying any
fi!ed rate of interest with regular intervals .but that is mistae because there is cost attached to it in form
of re(uired rate of return which your stoc holder e!pects to receive that and if company does not pay
that then the stoc holder will sell their shares and the price of the share will go down .Therefore it is
important to calculate the cost of e(uity.
<ow, let7s combine all the cost associated with the debt, preferred stoc and e(uity and
calculate the weighted average cost of capital .>A,,/ of company that raise capital in all three
possible ways.
E5am.le$
Suppose company A6, has e(ual amounts of debts, common stocs and preferred e(uity 2&4
each .in previous lecture, we calculated what the cost of debt was that was 22.3E then we calculated the
cost of preferred e(uity that was 2J.LE and we also calculated the cost of common e(uity which was
33.LE it was the most difficult part of the >A,, calculation now, it is easy because we are to apply the
Eof three different forms of capital.
%ACCE rD5DFrE5EFr/E.
T22.3 E. 2&4/ S2J.I E. 2&4/ S33.L E. 2&4/
T2J.OE
<ow, this is over all cost for a company .what does it meanP It means that it is the average cost
that company has to bear in order to use the capital of investors. The cost of debt or bond, preferred
e(uity and common stoc this is the average of all three securities cost.
It means that the company should invest in a pro0ect where the rate of return is higher than
2J.OE because it should be higher than the cost that it has to pay to the investors. @et7s see the graph of
weighted average cost of capital compared to the security maret line we discussed in capital asset
pricing model .,A;#/.
It is important to understand this graph because it combines the maret factors in the form of
S#@ as well as the company7s internal cost in the form of >A,,. It shows that what combinations of
the ris ' return for a particular company to invest in or not.
The graph is a combine presentation of ,A;# and >A,,.it shows the e!pected return against
the maret ris or beta. In graph, the upward sloping line is S#@ and it is the re(uirement for bond and
stocs in efficient marets where there are rational investors that are maintaining fully diversified
portfolio and where nowledge spread very (uicly through the marets. The ris and return
combinations of all securities should lie on S#@. The horizontal line is >A,, which is fi!ed at 2J.OE
we have 0ust calculated it .This represents re(uired rate of return. In other words, if the company invests
in any new pro0ect it should give a rate of return which is higher than 2J.OE you see that the only
feasible reason where that company made investment is the area which I have shown filled up with dots
and this is higher then the S#@ and >A,,. I have also made three crosses which represents that why
will not company invest in these areasP The first cross on right side Y2 is showing rate of return which
is higher than >A,, but lower than S#@ the company will not invest because it is not giving as much
rate of return as efficient maret is offering .The second cross !3 is lower than >A,, and S#@ and
cross three !4 is lower than >A,, but it is on the S#@ again the company will not invest in these two
pro0ects or regions.
It will invest only in dots regions on these two regions the cost is higher and the return is lower.
Det "# E2)it(
,rom Firm1# /oint o, Vie3
=emember, that it is mentioned that generally speaing companies want to eep the balance
both in form of debt and e(uity. >e have also mentioned that debt has a ris attached with it because
when we have to service the regular loan mar up or interest which will eat away your income and the
result will be net loss. you now that in income statement we deduct certain financial charges .it may be
due to many reasons because the company has to serve the debt .the other reason is that if the company
do not pay interest it may close down so, then why do companies tae debt P
I##)ing Det 7or Le"erage8
A*"antage# o, I##)ing Det$1
@imited fi!ed Interest payment - no share in profits
@imited @ife
Interest ;ayment is an +!pense i.e. Ta! Deductible
,an Improve .or Amplify/ the =eturn on +(uity .=-+/
Di#a*"antage#$
Debt adds to ,ompany-specific =is
If company doesn7t pay Interest, it can be closed down
I##)ing E2)it( 7generall( Common E2)it( or O3ner#&i.8
SML : ;ACC +raph
S12 >ine
)EETE&;A>
BA&FET
criterion'
FirmGs o#n
3)CC
)I;TE&;A>
criterion'
&eHuired
&O& r
CE
)2'
Beta &isI
r
&F
3 T-
Bill rate
JACC
(
8
9
F)S452 +647N &where
4++ of in8estment or
pro9ect is more than S12
and 3)CC(
I&& KJACC K SB>
I&& K SB>
I&& K JACC
A*"antage# of Issuing +(uity1
<ot re(uired to pay fi!ed regular Dividends
,apital Structure is a "irm7s #i! of Debt ' +(uity
Ri#4# Face* ( Firm$
Total Stand-Alone =is of a Stoc .from =is and ,A;# Theory/1
Stoc7s Total Stand Alone =is T Diversifiable S #aret
,ompany-specific =is1 :ni(ue, Diversifiable
#aret =is1 Systematic, <ot Diversifiable
Total +tan*9Alone Ri#4 o, a FIRM 7Ne38
"irm7s Total Stand Alone =is T 6usiness S "inancial
0)#ine## Ri#4$
It is defined as the =is of All Assets ' -perations .without debt/. Includes both
,ompany-Specific .and Diversifiable/ ' #aret =iss.
Financial Ri#4$
Additional =is faced by ,ommon Stocholders if "irm taes Debt. It is a pure debt-
related =is.
Financial Ri#4 .Investor7s ;oint of 9iew/1
Suppose firm A6, had a ,apital Structure of 2DDE ,ommon +(uity. Then the
#anagement and 6oard of Directors of firm A6, then decide to reduce half of the e(uity and
tae a loan .or Debt/ instead. This affects the distribution of ris ' return to the common
e(uity holders .or -wners/. In other words, the #anagement of firm A6, has added a new ind
of investor. The debt holder faces almost no ris because he is )guaranteed* the Interest
payment at all costs whether or not the firm is maing profit or whether or not the e(uity owners
are paid dividend. Debt holders eat away at the owners7 .or e(uity holders7/ money at almost
no ris. So, naturally, the ris faced by e(uity holders increases because same 6usiness =is is
now shouldered by fewer +(uity Shares. =is per Share Increases. Benerally Speaing,
Increasing Debt Shifts #ore =is :pon the Shareholders. Therefore re(uired =-= demanded
by the ,ommon +(uity ?older also increases .based on ,A;# Theory/.
Firm1# Total +tan* Alone Ri#4 .:ncertainty in =-A ' =-+/1
"irm7s Total Stand Alone =is measured by the :ncertainty or "luctuations in ;ossible outcomes
for "irm7s "uture overall =-=.
I, 0)#ine## &a# Det - E2)it( .i.e. levered firm/1
"irm7s -verall =-= T =-A T =eturn on Assets T =eturn to Investors & Assets T .<et
Income S Interest/ & Total Assets
<ote1 Total Assets T Total @iabilities T Debt S +(uity
I, 0)#ine## i# 100T E2)it( .or un-levered firm/
<o Debt and <o Interest.
"irm7s -verall =-= T <et Income & Total Assets. "or 2DDE +(uity "irm, Total Assets T
+(uity. So -verall =-= T <et Income & +(uity T =-+U
<ote1 <et Income is also called +arnings.
<ote1 =-+ does not e(ual r
+
.=e(uired =ate of =eturn/. =-+ is +!pected boo return on +(uity.
:sed in Stoc 9aluation "ormula to calculate )g* ' );9B-*
"luctuations in =-+ T )6asic 6usiness =is*
Rou should review "inancial Accounting =atios for better understanding of the above mentioned
concepts.
0a#ic 0)#ine## Ri#4 .<ot ,onsidering Debt/1
Ca)#e# o, :ig& P0a#ic 0)#ine## Ri#4Q or Uncertaint( or Volatilit( or PIn#tailit(Q or P+&oc4#Q
@arge changes in ,ustomers7 Demand .seasonality/
:nstable Selling ;rice .unstable marets and retailers/
:ncertainty in Input ,osts .raw material, labor, utilities/
Inability of #anagement to ,hange -perational Tactics and Strategy to #eet ,hanging
+nvironment
Ineffective ;rice Stabilization
;oor ;roduct ='D and ;lanning
?igh -perating @everage .-@/
#any other causes
O.erating Le"erage 7OL8$
Form)la E Fi5e* Co#t# ? Total Co#t#
,oncept1 ?igh -@ Increases =is1 ,ustomer Demand "alls but "i!ed ,osts remain high. So,
Small Decline in Sales ,an ,ause @arge Decline in =-+.
Fi5e* Co#t# Acro## Di,,erent In*)#trie#$
;lant, #achinery, +(uipment i.e. ;ower ;lant, ,ement, Steel, Te!tile Spinning
<ew ;roduct Development, ='D ,osts i.e. ;harma, Auto, IT
?ighly Specialized ' Silled >orers i.e. IT
-@ used in ,apital 6udgeting ' ,apital Structuring Decisions
O.erating Le"erage A..lication to Ca.ital 0)*geting
E5am.le$
,omparing 3 Types of Technologies for ,ement #anufacturing1
.2/ >et ;rocess and .3/ Dry ;rocess. Different Total ' "i!ed ,osts, Different -@.
Applications to ,apital 6udgeting
Different -@7s, Different 6reaeven ;oints, Different =iss,
Different =e(uired =-=7s
So, Different Discount =ates for 3 Technologies.
Affects ,omputation of <;9 Investment ,riterion
6reaeven ;oint1 Vuantity of Sales at which +6IT T D therefore =-+ T D.
+6IT T -p =evenue - -p ,osts T -p =evenue - 9ariable ,osts - "i!ed
,osts T ;V - 9V - ". >here ;T ;roduct ;rice .=s/, VT Vuantity or e
:nits Sold, 9T 9ariable ,ost .=s/, "T "i!ed ,ost .=s/. So I" +6IT T D
then ;V-9V-" T D so 6reaeven V T " & .; - 9/
O.erating Le"erage A..lication to Ca.ital +tr)ct)re
A..lication# to Ca.ital +tr)ct)re
*is#ali0ig Opera"ig Le'erage 3OL7 Impac" o 9rea%e'e
!oi" & Capi"al 9#)ge"ig
Total CO+T Line
Tec&nolog( A$
:ig&er OL
Total CO+T Line
Tec&nolog( 0
+ale# D)antit(
7a o, Unit#8
Re"en)e# -
Co#t# 7R).ee#8
+ale# REVENUE Line
Fi5e* Co#t# A
Fi5e* Co#t# 0
D
0
J
D
A
J
0rea4e"en A$ :ig&er>
More Ri#4(
Tec&nolog( A$ Larger
O/ERATING LO++
7Co#t V Re"en)e8>
More Ri#4(
+!ample of 3 Types of ,ement #anufacturing Technologies1 Different -@7s has 3
Impacts1
Different =iss so Different 6etas .,A;# Approach to ,ost of +(uity ,apital/,
Different >A,,7s for 3 Technologies. Affects ,hoice of ,apital #i! .or ,apital
Structure/
Different "i!ed ,osts, Different +6IT ' <I, Different =-+7s so Different
Dividend Browth =ates )g,* .Bordon-Dividends Approach to ,ost of +(uity
,apital/. So Different >A,,7s Affects ,hoice of ,apital #i!.
<ow, let7s tal in more detail about the operating leverage .in financial management the term leverage
refers to the little change in the amount of sales or (uantity of sale that will affect the over all earning of
the company .
O.erating le"erage 7OL8 EFI@ED CO+T+ ?TOTAL CO+T+
A company supposes has operating leverage of suppose IDE or D.I it is considered to a high leverage.
Benerally, it is more risy for a firm and the fi!ed cost does not change. So, the companies that has high
leverage are considered to be more risy .<ow, the companies have to hire the silled people and
technicians specially ,in the capital intensive industries .now, let7s tal about the operating leverage
.let7s tae the e!ample of cement industry there are two ways of technology if you want to set a cement
plant one is the old technology and the other is drying process new technology .these two types have
different costs .we have learnt that <;9 formula is best for investment decisions in which discount rate
r is used which is the re(uired rate of return .when -@ associated with a firm is higher then the ris also
becomes higher .we need to understand the impact of operating leverage both numerically ,and
graphically .please go over the concepts of >A,, and <;9.
"isualiLing Operating >everage )O>'
4mpact on +7 : Capital Structure
;echnolog* 51 >o#er O>1
>o# &isI & >o# &OE
;echnolog* )1 <igh 72-
<igh +is= : <igh +7>
<igher 3)CC
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&isI B
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!pected +7
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!pected +7
$ B+7C
5

Lesson 31
O/ERATING LEVERAGE< FINANCIAL LEVERAGE< ROE< 0REA= EVEN /OINT AND
0U+INE++ RI+=
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following topics1
O.erating Le"erage
Financial Le"erage
Conce.t# o, Ret)rn on E2)it(< 0rea49E"en /oint an* 0)#ine## Ri#4#
In this lecture we will continue our discussion of capital structure and specifically we will discuss
-perating @everage, "inancial @everage and the concepts related to =eturn on +(uity, 6rea-+ven
;oints and 6usiness =iss. In the last lecture we mentioned that total stand alone
ris faced by a firm
T 6usiness =is S "inancial =is
<ow, first we focus business ris then later we shall discuss financial ris.
0)#ine## Ri#4 7,rom O.eration# e5ce.t Det8$
6usiness ris stems from the operation and the assets of the firm. These may be caused by1
$ :ncertainty ' fluctuations in prices ' costs.
$ Specific business ' #aret ,auses.
$ ?igher operating leverage .-@ T "i!ed ,ost & Total ,ost/ that results in1
A ?igher breaeven point
A ?igher but risier e!pected return on e(uity .=-+/
A..lication o, O.erating Le"erage to Ca.ital 0)*geting$
-perating @everage is the impact of a small change in the sales on the returns on e(uity. In
other words small decline in sales can cause large decline in =-+ .when sales are below breaeven
point/. Its formula is
-perating @everage T "i!ed ,osts & Total ,osts
?igh operating leverage increases ris due to higher percentage of fi!ed costs. There are many
industries which are prone to high operating leverage. These are ,apital Intensive Industries .i.e. ;ower
;lant, ,ement, Steel, and Te!tile Spinning/, <ew ;roduct Development, and =esearch ' Development
?igh ,ost Industries .i.e. ;harma, Auto/ and industries that need ?ighly Specialized ' Silled >orers
.i.e. Information Technology, Software ?ouse, Semiconductor and #icroprocessor, #anufacturers/.
<ow let us have a loo at the sensitivity of =eturn on +(uity to changes in sales. =ecall from
the previous lectures, =-+ is a measure of overall return of a firm. In case of 2DDE e(uity firm the =-+
is the measure of the overall return and any changes or variation in =-+ is a measure of ris for that
firm.
"irst concept that comes within -perating @everage is 6rea-even. 6rea-even represents the
(uantity of sales at which operating revenues e!actly cover operating costs. In other words the
6reaeven ;oint is the point or (uantity of sales at which +arnings before Interest and Ta!es .+6IT/ T
D. <ow
+6IT T -perating =evenue - -perating ,osts
=ecall accounting concepts. -perating costs consists of fi!ed costs and variable costs. So
+6IT T -perating =evenue - 9ariable ,osts - "i!ed ,osts
T .;V/ $ .9V/ $ ",
where
;T ;roduct ;rice .=s./,
VT Vuantity or <umber of :nits Sold of product,
9T 9ariable ,ost of product per unit .=s./,
-perating =evenueT ;roduct ;rice multiplied by <umber of :nits Sold of product
9ariable ,ostsT 9ariable ,ost of product per unit multiplied by <umber of :nits Sold of product
"T "i!ed ,ost .=s/.
As at breaeven point +6IT T D
and we have 0ust seen +6IT T .;V/-.9V/-"
so +6ITT .;V/ $ .9V/ $ " T D.
"rom this by solving e(uation we can derive
V T " & .; - 9/.
This e(uation represents the minimum number of units the company must sell in order to cover its
operating costs. >e are discussing breaeven as changes in operating leverage will have an impact and
change in breaeven (uantity and also will have impact on the lielihood of the company maing great
losses. To understand the sensitivity and impact of small changes in sales on =-+, let us have loo at a
diagram1
4mpact on 5rea=e8en "oint : Capital 5udgeting
Total CO+T Line
Tec&nolog( A$
:ig&er OL
Total CO+T Line
Tec&nolog( 0
+ale# D)antit(
7a o, Unit#8
Re"en)e# -
Co#t# 7R).ee#8
+ale# REVENUE Line
Fi5e* Co#t# A
Fi5e* Co#t# 0
D
0
J
D
A
J
0rea4e"en A$ :ig&er>
More Ri#4(
Tec&nolog( A$ Larger
O/ERATING LO++
7Co#t V Re"en)e8>
More Ri#4(
?ere operating leverage has been graphed. -n the R-a!is we have the revenues and costs in
rupees and on Y-a!is the sales (uantity in number of units. @ine passing through the origin represents
sales revenue .;V/. Total cost line for two different technologies have also been drawn. Technology A
total cost is represented by a line which is higher up showing higher operating leverage and the
Technology 6 total cost line is lower with a high slope. Two important conse(uences to note from this
graph are1
19 "or Technology A fi!ed costs are high so it has higher operating leverage assuming lines shown on
the graph are representatives of total costs of technologies. Impact of technology A with high operating
leverage on +6IT is that technology A has larger operating loss as shown by the left hand side of the
graph. This loss is due to higher total cost than the sales revenue. A company with higher operational
leverage means it has higher E of fi!ed costs. >hether the company has high or low sales due to higher
E of fi!ed costs it has high riss of operational losses. That7s why companies, businesses, pro0ects and
technologies with higher operating leverages are perceived as more risy as they have more chances to
incur operating losses due to their unavoidable high fi!ed costs. ?igher operating leverage means
greater reduction in +6IT as shown in graph.
29 As operating leverage increases breaeven point also increases i.e. breaeven shifts to the right. In
other words, companies with high operating leverage re(uire more units to be sold to cover their
operating costs.
These are the two ways operating leverage affects the level of ris for a company. The above
discussion of impact of operating leverage on capital budgeting indicate operating leverage affects
+6IT. So, higher operating leverage means chances of falling =-+ drastically are higher. ?ence,
companies with higher operating leverage are more risy, their re(uired rate of return is higher, discount
rate in <;9 formula is higher and <;9 for these companies will be lower calculated for investment
decision.
O.erating Le"erage A..lication to Ca.ital +tr)ct)re$
-perating leverage also affects ,apital Structure. ,ompanies and technologies with high operating
leverage have higher riss that means they have
A ?igher 6etas .,A;# Approach to ,ost of +(uity ,apital/
A ?igher >eighted Average ,ost of ,apital
A Also higher average overall rate of return measured in terms of return on e(uity. This is possible
in case of sales of companies are higher than breaeven point. In this case companies with
higher operating leverages earn higher +6IT.
Therefore, overall impact of operating leverage must consider higher ris and higher return both
provided by companies with high operating leverage. ?ave a loo on the following graph to visualize
the effect of -perating @everage on ris and return of a particular technology1
;echnolog* 51 >o#er O>1
>o# &isI & >o# &OE
;echnolog* )1 <igh 72-
<igh +is= : <igh +7>
<igher 3)CC
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+eturn on @uit* & +7(A
&isI B
&isI A
!pected +7
$ B+7C
)
!pected +7
$ B+7C
5
-n the R-a!is we have the probability and on Y-a!is the =-+. There are two probability
distributions. -ne on the left side is tall sharp pea probability distribution that represents technology 6
with lower -perating @everage. It has lower ris and lower average =-+. -ther on the right side is
short and flatter that represents technology A with higher -@. It has high ris and higher average =-+.
It also has higher >A,, as it has higher re(uired rate of return. =ecall probability distribution and ris
theory discussion that riss can be visualized as width or range of probability distributions curves.
Shorter and flatter curve of A shows higher ris. Its average or mean =-+ to that of right of 6, shows
higher =-+ of A.
<ow we come to the other component of a firm ris i.e. financial ris.
Financial Ri#4$
A ,reated when "irm taes @oan or Debt or issues 6onds $ this is "inancial @everage
"@ T Debt & Total Assets
A Increase in =is faced by ,ommon Stoc ?olders .or +(uity ?olders or -wners/ when a "irm
taes on more Debt or "inancial @everage.
A Increase in debt shifts more ris on common stoc holders and ris per share increases.
A E5am.le$ Suppose a "irm A6, has Total Assets of =s.2DDD and is 2DDE +(uity based .i.e.
:n-levered/. There were 2D e(ual -wners and I of them want to leave. So the "irm taes a
6an @oan of =s.IDD .at 2DEpa #ar-up/ and pays bac the +(uity ,apital to the I -wners
who are leaving. <ow, half of the +(uity ,apital has been replaced with a @oan from a 6an
.i.e. Debt/. >hat impact does this have on =-+P
A Assuming 6usiness =is is unchanged, and then ris per share rises because +(uity is halved.
So, more =is is transferred to ,ommon Shareholders.
A Det In"e#tor# .i.e. @enders and 6ond ?olders/ face minimal ris because
.2/ Buaranteed =egular Interest Income and
.3/ 2st ,laim on Assets in event of 6anruptcy
Financial Le"erage 7Det8 Increa#e# ROE Ri#4$
"@ is the degree or e!tent to which a company7s total capital is composed of debt. So a company with
CDE debt is highly leveraged. @et us tae an e!ample of a company moving from 2DDE e(uity to IDE
e(uity and IDE debt to see Impact of "inancial @everage .@oan/ on 6alance Sheet.
Im.act o, Financial Le"erage 7Loan8 on 0alance +&eet
Un9Le"ere* Firm Le"ere* Firm
7100T E2)it(8 7G0T E2)it( 9 G0T Det8
A##et# Liailitie# A##et# Liailitie#
Det$ G00
E2)it($ 1000 E2)it($ G00
Total$ 1000 Total$ 1000 Total$ 100 Total$ 1000
Note$ Total A##et# E Total Liailitie# E Det F E2)it(
This table shows the capital structure of the firm under the conditions of leverage and no leverage.
:nder no leverage its AssetsT+(uityT2DDD. 6ut after leverage it has IDD as debt and IDD as e(uity. It
has converted IDD of e(uity into debt by taing loan.
A Increase in Debt increases chances of net loss if seasonal dip causes +6IT to fall below interest
payment.
A Increase in Debt increases uncertainty in =-+. =ange or Spread of ;ossible future values of
=-+ increases. =is faced by ,ommon Stoc ?olders Increases.
This can be illustrated by the following e!ample1
Im.act o, Financial Le"erage 7Loan8 on Income +tatement - ROE
Un9Le"ere* Le"ere*
7100T E2)it(8 7G0T E2)it(8
E5.ecte* E0IT C00 C00
Interest .2DE of IDD/ D ID
E0T 4DD 3ID
Ta! .4DE of +6IT/ OD LI
Net Income 7NI8 32D 2LI
+!pected =-+ .T<I&+(uity/ 32D&2DDDT 32E 2LI&IDDT4IE
Total Ret)rn 210 1WGFG0E22G
A Increase in Debt Improved or @everaged :p the =-+ to 4IE
A Increase in Debt also Increased the Total =eturn to Investors T <I S Interest. Increased from
=s.32D to 33I .2LISID/
A So, why not eep adding more DebtP 6ecause, Debt has increased the ris i.e. The Standard
Deviation or :ncertainty of =-+.
A Total Stand Alone =is of "irm T 6usiness =is S "inancial =is
$ Total Stand Alone =is T Standard Deviation of =-+ of @evered "irm
$ 6usiness =is T Standard Deviation of =-+ for :n-levered "irm
Financial Le"erage 7FL8 - O.erating Le"erage 7OL8$
+ffect of "inancial @everage ' -perating @everage on =-+ is Similar1
$ ?igh -perating @everage1 ?igh "i!ed ,osts so small changes in Vuantity Sold cause larger
changes in <et Income ' =-+
=isy if "irm7s Sales f 6reaeven ;oint 6:T
#ultiplies Increase in #ean =-+ when Sales c 6reaeven
$ ?igh "inancial @everage1 ?igh Debt ' Interest ;ayments so small changes in +6IT cause large
changes in <et Income ' =-+
=isy if "irm7s -verall =eturn is low and can not pay Interest on time but
#ultiplies Increase in #ean =-+ and Total =eturn .to +(uity ' Debt ?olders/ when
"irm7s -verall =eturn is ?igher than ,ost of Debt
The impact of leverage debt on =-+ can be visualized in a graph. "or this purpose we need to
consider the following table1
E0IT Intere#t E0T Ta5 Net Income ROE
7R#>G08 7C0T8 7ENI?E2)it(8
Un9Le"ere* JDD D JDD 2CD F3D F3E
Firm 3it& 4DD D 4DD OD 32D 32E
no *et or 100T ID D ID 2I 4I 4.IE
e2)it(
Le"ere* ,irm JDD ID IID 2JI 4CI LLE
3it& *et 4DD ID 3ID LI 2LI 4IE
ID ID D D D DE
Rou see for a levered firm range of =-+ is high from D to LLE for level of earnings from ID to
JDD. "or un levered firm this range is very short from 4.IE to F3E for same level of earnings. So for a
company whose sales are low un levered capital structure is safer than a levered one while for a
company with healthy sales growth, levered capital structure provides an opportunity of high =-+.
"isualiLing Financial >everage )F>'
LEVERED 7Det
- E2)it(8 Firm$
:ig&er +lo.e>
ROE more
#en#iti"e to
c&ange# in E0IT
UN9LEVERED
7100T E2)it(8
Firm> +a,er
Ca.ital +tr)ct)re
at Lo3 E0IT1#
E0IT 7R#8
ROE 7T8
32E T f=-+c
UL
4IE T f=-+c
L
C00
LLE
S00 G0
F3E
4.IE
DE
The impact of leverage debt on =-+ can also be shown in a graph based on probability distributions1
"isualiLing Impact of Financial >everage
on +7 : Capital Structure
Dn'2e8ered &100A @uit*(1
>o#er &OE and >o#er &isI+
2e8ered &De?t : @uit*(1
<igher +7 ?ut <igher
+is= also>
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&isI
&isI
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B+7C
2e8ered
$
/5A
!pected +7
B+7C
Dn'2e8ered
3 21A
-n the R-a!is we have the probability and on Y-a!is the =-+. There are two probability
distributions. -ne on the left side is tall sharp pea probability distribution that represents un levered
firm. It has lower ris and lower average =-+. -ther on the right side is short and flatter that represents
levered firm with higher -@. It has high ris and higher average =-+. =ecall probability distribution
and ris theory discussion that riss can be visualized as width or range of probability distributions
curves. >e shall discuss these graphs and financial leverage in detail in ne!t lecture.
Lesson 32
FINANCIAL LEVERAGE AND CA/ITAL +TRUCTURE
Learning O!ecti"e#$
topics1
Financial Le"erage
Ca.ital +tr)ct)re
"irst we recap some concepts of previous lectures.
>A,, E T r
D
Y
D
S r
+
Y
+
S r
;
Y
;
. .Debt, ,ommon +(uity, ;referred +(uity/
o >here )r* is A,T:A@ ,-ST which can be calculated from =+V:I=+D =-= after
accounting for Ta!es ' Transaction ,osts.
o +(uity ,apital1 If <ot +nough =etained +arnings then +(uity ,apital must be financed
by <ew Stoc Issuance which is more costly.
Total =is "aced by "I=#
T 6usiness =is S "inancial =is
?igher -perating @everage .-@ T "i!ed ,osts & Total ,osts/
o ?igher #ean =-+ >?+< "I=#7S SA@+S c 6=+AK+9+< ;-I<T
o ?igher "i!ed ,osts means ?igher 6reaeven ;oint and #ore ,hances of -perating
@oss. =is of @arge Drop in =eturn on +(uity .=-+/ so ?igher =is.
Financial Ri#4$
"rom the discussion of the previous lecture we can infer that
"inancial =is T Total Standalone =is $ 6usiness =is
"or e!ample, if
Total ris as measured by standard deviation of =-+ of levered firm T 4DE
and 6usiness ris as measured by standard deviation of =-+ of un-levered firm T 3DE
then "inancial =is T 4DE - 3DE T 2DE
"inancial =is is created when firms tae loan or debt. As companies tae more debt they are e!posed
to more financial ris.
Financial Le"erage 7FL8$
"inancial @everage shows the effect that small increase in +6IT can create much larger increase in =-+
of the firm.
"inancial @everage .E/ TDebt &Total Assets T Debt & Debt S +(uity
If firm has =s.2DDD of total assets and =s.IDD debt then it has IDE .TIDD&2DDD/ financial leverage. So
this firm has IDE leverage means IDE e(uity and IDE debt. ;ractically, firms increase financial
leverage by
$ Issuing <ew Debt .i.e. Taing <ew @oans and Increase Debt/
-=
$ =eplacing +(uity with <ew Debt . Increasing debt and increasing e(uity too/
Financial Le"erage Im.act on Ri#4 - Ret)rn o, Firm$
"inancial @everage .or Debt "inancing/ generally increases overall ris ' return of a firm. @et
us have a loo now on a table that shows how when a firm becomes levered it increases the variability
of =-+ and how it increases the mean =-+.
E,,ect o, Le"erage on ROE Volatilit( - Ri#4
E0IT Intere#t E0T Ta5 Net Income ROE
7R#>G08 7C0T8 7ENI?E2)it(8
Un9Le"ere* JDD D JDD 2CD F3D F3E
Firm 3it& 4DD D 4DD OD 32D 32E
no *et or 100T ID D ID 2I 4I 4.IE
e2)it(
Le"ere* ,irm JDD ID IID 2JI 4CI LLE
3it& *et 4DD ID 3ID LI 2LI 4IE
ID ID D D D DE
This table shows the effect on =-+ as earnings change from =s.ID to =s.JDD. This variation in
earnings can be due to maret forces or random events. This variation in sales revenue can lead to
change in +6IT and this is source of ris. This will lead to change in possible values of =-+. =esults of
the table for levered and un-levered firm indicate that leverage .or Debt/ increases the spread or range of
possible =-+ thereby increasing uncertainty and ris. "inancial @everage .or Debt "inancing/ generally
increases overall ris ' return of a firm due to the following reasons1
A Increases =eturn .#ean =-+/1
$ >hen +6IT &Total Assets c Interest ,ost then "inancial @everage is Bood. Small Increase
in +6IT can create much larger Increase in =-+. If
+6IT &Total Assets c Interest ,ost it means firm is generating profit by the use of its debt
resulting in increased =-+ as firm has positive cash flows.
$ If +(uity .and number of shares/ reduced then =eturn .<I/ per Share Increases. 6y reducing
its e(uity the firm will increase its percentage of debt in capital structure. As the earnings
are the same to be distributed among lesser number of shares due to reduced e(uity the
return will increase per share resulting in increased =-+.
These two effects can be visualized in the following graph1
9isualizing "inancial @everage ."@/
Im.act on ROE - Ca.ital +tr)ct)re
LEVERED 7Det
- E2)it(8 Firm$
:ig&er +lo.e>
ROE more
#en#iti"e to
c&ange# in E0IT
UN9LEVERED
7100T E2)it(8
Firm> +a,er
Ca.ital +tr)ct)re
at Lo3 E0IT1#
E0IT 7R#8
ROE 7T8
32E T f=-+c
UL
4IE T f=-+c
L
C00
LLE
S00 G0
F3E
4.IE
DE
This is the graphic representation of the above table of +ffect of @everage on =-+ 9olatility ' =is
for a levered and un levered firm. It indicates that leverage .or Debt/ increases the spread or range of
possible =-+ thereby increasing uncertainty and ris. =ange of possible values of =-+ have been
indicated by straight lines while level of ris by the probability distributions.
A Increases =is .Standard Deviation in =-+/1
$ "i!ed Interest Dues so ?igher ,hances of @osses, <o Dividends for Shareholders.
;ossibility of @arge Drop in =-+. ;ossibly Default. #ore =is Transferred to
Stocholders.
$ If +(uity .and number of shares/ reduced then =is per Share Increases.
This can also be visualized in the following graph1
8 ,opyright 9irtual :niversity of ;aistan 2FD
9isualizing Impact of "inancial @everage
on ROE - Ca.ital +tr)ct)re
Un9Le"ere* 7100T E2)it(81
@ower =-+ and @ower =is.
Le"ere* 7Det - E2)it(81
:ig&er ROE )t :ig&er Ri#4
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7
.
8
Ret)rn on E2)it( 7 ROE8T
=is
=is
Mean ROE
XROEV
Le"ere*
E
CGT
Mean ROE
XROEV
Un9Le"ere*
T 21T
Ca.ital +tr)ct)re T&eor($
"rom the discussion of "inancial leverage we now "inancial @everage ."@ T Debt & .Debt S
+(uity//
Increases -verall =eturn .#ean =-+/ when +6IT&Total Assets c Interest .or ,ost of Debt/
then @everage is Bood because small Increase in +6IT causes much @A=B+= Increase in
=-+.
Increases -verall =ISK .Standard Deviation of =-+/ of "I=#. @everage will always
#AB<I"R or A#;@I"R a small change in +6IT into a @A=B+= change in =-+.
A "undamental ;rinciple in =is-=eturn1 =ational Investors in +fficient #arets will only tae +!tra
=is if they are compensated by Sufficient +!tra =eturn.
A Should the #anagement of a "irm undertae "inancial @everageP If so, then how much Debt
should a "irm haveP
$ Answer provided by Ca.ital +tr)ct)re T&eor(.
Mo*igliani 9 Miller$
A "athers of ,orporate "inance
A ),ost of ,apital, ,orporate "inance and the Theory of Investment* =evolutionary Article
;ublished by ;rofessors #odigliani ' #iller in American +conomic =eview in Nune 2OIC.
>on <obel ;rize.
A P/)re M9MQ 7or Mo*igliani9Miller8 Mo*el 9 IDEAL CA+E$
There is no fi!ed ratio for debt in capital structure. Benerally it varies with each company7s needs
and re(uirements. ,apital structure theory tries to determine the most suitable ratio for a firm.
$ #a0or Assumptions1 <o Ta!es, <o 6anruptcy ,osts, +fficient #arets, +(ual
Information Available to All Investors
$ #a0or ,onclusions1
A ,apital Structure has no affect on value of a "I=#U ,apital Structure is
IrrelevantU
A It does <-T matter how a firm finances its operations, how much debt it has
because it has no bearing on a "irm7s -verall 9alue as calculated using <;9U
A ,orporate "inancing ' ,apital Structure Decisions have no bearing on
Investment .or ,apital 6udgeting/ Decisions.
A ,apital 6udgeting can be carried out without nowing the e!act ,apital
Structure of a "irm - you can assume 2DDE +(uity .:n-levered/ "irm.
Keep in view these conclusions of the theory are correct only under the ideal conditions as assumed by
#odigliani-#iller.
8 ,opyright 9irtual :niversity of ;aistan 2F2
Mo*i,ie* MM - %it& Ta5e#$
In order to apply it in the real world for its use, some other economists made some modifications. In
order to mae this theory applicable in the real world and to account for the effects of corporate and
personal ta!es on investment decision and on firm, the effect of ta!es was included in it.
A Mo*igliani9Miller 7%it& Cor.orate Ta58
$ In most countries, a "irm7s Interest ;ayments to 6ond ?olders are <-T Ta!ed. 6ut
Dividend ;ayments to +(uity ?olders are ta!ed.
$ 6ased on ,-=;-=AT+ TAY+S, "I=#S should prefer to raise ,apital using D+6T
"inancing rather than e(uity as there is saving associated with capital raised through
this source.
"rom firms point of view interest payments are source of ta! savings.
A Merton9Miller 7%it& /er#onal Ta58
$ In most countries, I<9+ST-=S .bondholders and shareholders/ pay a higher ;ersonal
Income Ta! on Interest Income from 6onds than on Dividend Income from +(uity .or
Stocs/.
$ 6ased on ;+=S-<A@ TAY+S, I<9+ST-=S should prefer to invest in ST-,KS .or
+(uity/.
Uncertain Concl)#ion1 Difficult to determine <et +ffect of ta!es on optimal capital structure. 6ut,
practically speaing, ,orporate Ta! +ffect is generally stronger so 6ased on Ta!es alone, "irms should
prefer Debt.
>e shall discuss other modifications in #odigliani $ #iller capital structure theory along with the one
discussed above in the ne!t lecture.
Lesson 33
MODIFICATION+ IN MILLAR MODIGLIANI CA/ITAL +TRUCTURE T:EORA
Learning O!ecti"e#$
After going through this lecture, you would be able to have an understanding of the following topic1
A Mo*i,ication# in Miller Mo*igliani Ca.ital +tr)ct)re T&eor(
Mo*i,ie* MM - %it& Ta5e#$
In order to apply it in the real world for its use, #iller-#odigliani and some other economists made
some modifications. In order to mae this theory applicable in the real world and to account for the
effects of corporate and personal ta!es on investment decision and on firm, the effect of ta!es was
included in it.
A Mo*igliani9Miller 7%it& Cor.orate Ta58
$ In most countries, a "irm7s Interest ;ayments to 6ond ?olders are <-T Ta!ed. 6ut
Dividend ;ayments to +(uity ?olders are ta!ed. This was conclusion after study of
different countries. #ost of the firms prefer debt rather than e(uity.
$ 6ased on ,-=;-=AT+ TAY+S, "I=#S should prefer to raise ,apital using D+6T
"inancing rather than e(uity as there is saving associated with capital raised through
this source.
"rom firms point of view interest payments are source of ta! savings.
A Mo*igliani 9Miller 7%it& /er#onal Ta58
$ In most countries, I<9+ST-=S .bondholders and shareholders/ pay a higher ;ersonal
Income Ta! on Interest Income from 6onds than on Dividend Income from +(uity .or
Stocs/.
$ 6ased on ;+=S-<A@ TAY+S, I<9+ST-=S should prefer to invest in ST-,KS .or
+(uity/.
Uncertain Concl)#ion1 Difficult to determine <et +ffect of ta!es on optimal capital structure. +ffects
of corporate ta!es and personal ta!es are contradictory. 6ut, practically speaing, ,orporate Ta! +ffect
is generally stronger so 6ased on Ta!es alone, "irms should prefer Debt.
Mo*i,ie* MM 9 %it& 0an4r).tc( Co#t$
The second ma0or change in ##-theory was to incorporate the effect of banruptcy costs. In the
real world companies face cash problems, their sales might drop, they face more competition, the
interest rate might go up, their debt servicing charges might go up, they start incurring losses, maing
operational cash outflows and this may lead the company to close down or go banrupt.
A 6anruptcy1 when a "irm is forced to close down because of continual @osses and <et ,ash
-utflows or Default on Interest ;ayments.
A 6anruptcy ,osts =eal #oney - ,ompanies Do <ot Die in ;eaceU There are costs associated
with banruptcy companies have to pay. "ees paid to @awyers and Accountants, possible
penalties and @egal ,laims by Suppliers, 6uyers, ' ;artner "irms, and @oss on Sale of Assets
because "irm is forced to (uicly @i(uidate its Assets and repay the Debt ?olders .such as
6ans/ first.
A +ven before banruptcy the T?=+AT or =:#-= of 6anruptcy can create problems for a
"irm. Suppliers refuse to supply raw materials and cancel Trade ,redit facilities. 6ans demand
higher Interest =ates. ,ustomers cancel ;urchase -rders so sales fall.
A If "irm is +Y,+SSI9+@R @+9+=AB+D .or has a @ot of Debt/ then there is a ?IB?+=
,hance of 6anruptcy.
A "or ,ertain Types of "irms, Debt is #ore @iely to ,ause 6anruptcy1
$ "irms with ?igh -perating @everage or high "i!ed ,osts
$ "irms with <on-@i(uid Assets that are difficult to sell (uicly for cash
$ "irms whose +6IT .or +arnings/ "luctuate a @ot
Tra*eo,, T&eor( o, Ca.ital +tr)ct)re %it& Ta5 - 0an4r).tc($
<ow let us discuss trade off theory. It mi!es a couple of changes in pure ##-theory by taing into
consideration both banruptcy costs and ta!es. >e will start with a firm of 2DDE e(uity capital and see
what happens when a firm starts taing debt and gradually increases the percentage of debt in its capital
structure. See the following graph to determine the effect of increasing leverage on the value of firm
measured by its stoc value to mae trade off theory concepts clear1
Tra*eo,, T&eor( Braph
@everage ' -ptimal ,apital Structure
+lig&tl( Le"erage* Firm1 Interest Ta!
Shield 6enefit. Total =eturn to Investors
=ises so Stoc 9alue =ises. Total Ret)rn
T <et Income .paid to Shareholders/ S
Interest .paid to Debt ?olders/
9alue of
"irm or
;rice of
Stoc
"inancial @everage T
Debt & Assets T
D&.DS+/
O/TIMAL Ca.ital
+tr)ct)re 9 MA@IMUM
VALUE - MINIMUM
%ACC
E5ce##i"el( Le"erage* Firm1
Threat of 6anruptcy has =eal
,osts. @ess Investor
,onfidence and @ower Share
;rice.
"irm =emains 2DDE
+(uity .:n-@evered/
Keep in mind< 9alue of "irm T ;rice of -ne Share ! <umber of Shares -utstanding
-n the R-a!is we have the 9alue of "irm or ;rice of Stoc and on Y-a!is the "inancial @everage T Debt
& Assets T Debt& .Debt S +(uity/ in percentage. In the graph 2.D shows 2DDE capital is from debt at that
point. ?orizontal line represents the case when a firm is 2DDE e(uity. It is un levered firm. ?ere firm
has no debt so its stoc value is not sensitive to financial leverage. <ow let us tae the case of the same
firm if it gradually adds debt to its capital structure.
A >hen 2DDE +(uity "irm adds a Small Amount of Debt, the 9alue of its Stoc Boes :p at first
because Total =eturn Increases.
Total =eturn
T <et Income .paid to +(uity ?olders/ S Interest .paid to Debt ?olders/.
The line therefore rises initially but then it reaches a ma!imum point which is the optimal
capital structure. At this point value of firm will be at its ma!imum. This is the best debt to
e(uity ratio for this firm at which >A,, will be at minimum. After this point firms7 debt gets
high and it starts facing high interest costs, chances of loosing creditors and buyers and threats
of banruptcy. Investors7 loose confidence on the share of the firm and the ,hances of
6anruptcy will offset the Initial 6enefit and the Stoc 9alue will "all.
A Decision regarding how much Debt .or "inancial @everage/ to tae is based on Tradeoff
between the Advantage of Debt ' Disadvantage of Debt.
$ Advantage of Debt over +(uity1 Interest ;ayments are <ot Ta!ed. Known as Interest
Ta! Saving or Ta! Shield or Ta! Shelter
$ Disadvantage of Too #uch Debt1 "irm becomes more =isy so @enders and 6ans
,harge ?igher Interest =ates and Breater ,hance of 6anruptcy
A Trade theory tells there is some optimal capital structure or there is some percentage of debt in
capital structure for a firm at a particular date. 6ut it does not give us the e!act figure for that. A
range for the -ptimal ,apital Structure or Debt&+(uity #i! can be calculated in theory. This is
where the "irm has #a!imum 9alue and #inimum >A,,. ;ractically speaing it varies
across industries and companies. -ptimal D&+ can range from 3D&CD to LD&4D and eeps
changing with time depending on the firm7s financial health and growth strategy.
+ignaling T&eor( o, Ca.ital +tr)ct)re9 An Im.ro"ement on Tra*eo,, T&eor($
This is another modification of the theory of #iller #odigliani ,apital Structure.
8 ,opyright 9irtual :niversity of ;aistan 2FF
A This theory taes into account the practical fact of the world that <-T all Investors have e(ual
amount of information. All investors are not rational. A "irm7s -wners ' #anagers .Insiders/
now more about it than -rdinary outside Investors.
A Signaling Theory1 )Insiders .#anagers ' -wners/ Know 6etter*
$ >hen "irm7s "uture genuinely loos Bood .i.e. ?igh forecasted ,ash "lows, +arnings,
<I, and =-+/ then #anagers will choose to raise financing through Debt .or 6onds or
@oan/ because they do not want to share the "inancial Bain with #ore Shareholders.
=ather They ;refer to Tae on Debt and pay a small interest to the Debt ?olders. There
is almost no ris of Default.
$ >hen "irm7s -utloo loos bad, then #anagers will choose to raise capital by Issuing
+(uity .or Stoc/ to be able to share the @iely @osses amongst more Shareholders
.-wners/. If they too Debt and couldn7t repay it, they might Default and be forced to
go 6anrupt.
So mangers are in a better position to decide about the firm.
+ignaling T&eor( Concl)#ion#$
A ;ractically speaing, "irms should maintain @+SS @everage than the -ptimal @evel from
Tradeoff Theory.
A "irms Should Save Some =eserve Debt "inancing ,apacity in case they find a Breat ;ro0ect or
Investment -pportunity. They should finance the ;ro0ect using Debt for 3 reasons1
$ they don7t have to share the "inancial Bains with more shareholders and
$ they give the =ight Signal to the #aret of Investors about the good health of their "irm
U
$ Debt "inancing brings "inancial Discipline and tighter cash control on some #anagers
that waste Shareholders7 money
A <ews of <ew +(uity "inancing Signals bad news1 It indicates shortfall in cash flows through
profit, Investors will sell stoc and #aret ;rice .;o/ of Stoc will fall. Therefore, =e(uired
=-= .r T DI9& .;o S g// will =ise and >A,, will Increase. <ow more difficult for ;ro0ects
and Investments to meet this "irm7s ,apital 6udgeting ,riterion by showing positive <;9 .T
Sum of ,ash "lows & .2Sr/
t
/.
8 ,opyright 9irtual :niversity of ;aistan 2FI
Lesson 34
A//LICATION OF MILLER MODIGLIANI AND OT:ER CA/ITAL +TRUCTURE
T:EORIE+
Learning O!ecti"e#$
Applicability of the #iller #odigliani ,apital Structure theory, #odified #iller #odigliani
,apital Structure Theory and other theories to the =eal >orld to see the Impact of Debt on "irm
9alue ' >A,, Braphs
E,,ect o, Le"erage on Co#t o, Det - Co#t o, E2)it($
>e need to now both of these effects to see the impact of leverage on >A,,>
A E,,ect o, Financial Le"erage 7or Det8 on Co#t o, Det 7rD8$
$ At low leverage, increase in leverage leads to slight increase in overall ris and return
of firm.
$ At higher leverage, there is ris of financial distress ' banruptcy. Therefore, bans
raise interest rate charges as now company has become more risy. ,ost of debt raises
faster and re(uired rate of return .=-=/ of firm7s debt holders .r
D
/ raises faster. So, as a
result of leverage financial ris of firm rises and its cost of debt also go up.
A E,,ect o, Financial Le"erage 7or Det8 on Co#t o, E2)it( 7rE8$
$ "irm7s total ris rises slowly at low leverage and
$ "irm7s total ris rises faster when leverage becomes e!cessive and ris of financial
distress arises. Also, firm7s stoc beta rises and firm7s stoc re(uired =-= .r
+
/ rises,
and cost of e(uity goes up. "rom the ,apital asset pricing model, we now whenever
the ris of the firm raises, its re(uired rate of return also rises and as a result cost of
stoc will also go up.
E,,ect o, Le"erage on %ACC$
A %ACC E rD5D F rE5E .assuming no ;referred +(uity/ where
!
D
T "raction of Debt
!
+
T "raction of +(uity
A E,,ect o, Det on %ACC C&ange# 3it& t&e t&eor( c&oice$
$ E,,ect )n*er /)re MM Vie3 7I*eal E,,icient Mar4et#8$ Its assumptions are <o
Ta!es and <o 6anruptcy ,osts so Debt increases =is 6:T is also cheaper than
+(uity. ,hange in Debt has no effect on >A,, and 9alue of the firm. >A,, curve is
flat.
$ E,,ect )n*er Tra*itionali#t Vie3 7Tra*eo,, T&eori#t#< Real Mar4et#8$ ,ombined
+ffect of Ta!es and "inancial Distress & 6anruptcy ,osts are a "lat :-Shaped >A,,
,urve with a #inimum ;oint which represents the -ptimal ,apital Structure .i.e. 6est
Debt =atio for the "irm/.
<ow we discuss these effects in detail. "irst we shall discuss +ffect of Debt on >A,, under
## ideal maret theory in detail and then later we will discuss it under traditional view.
E,,ect o, Det on %ACC )n*er MM i*eal mar4et t&eor($
9isualize the following graph eeping in view ideal #iller #odigliani ,apital Structure theory
conditions and assumptions of no ta!es and banruptcy costs and e(ual information available to all1
8 ,opyright 9irtual :niversity of ;aistan 2FJ
;ure ## Theory - Ideal #arets
>A,, Braph
%ACC E
r
D
5
D F
r
E
5
E
r
E
E Co#t o, E2)it(
E%ACCFD?E 7%ACC9r
D
8
r
D
E Co#t
o, Det
Co#t o,
Ca.ital
7T8
Det ? E2)it( E
D?E E 5
D
? 7 19 5
D
8
r
E
r
D
2DDE
+(uity
"irm
"inancial =is.
?igher =e(uired
=eturn on +(uity.
?igher r
E
-n the R-a!is we have cost of capital and on the Y-a!is Debt to e(uity ratio is proportional to
financial leverage. >A,, is constant shown by >A,, line starting from point r
+
on R-a!is and going
straight flat along Y-a!is. >e now %ACC E rD5D F rE5E. >hen Debt to e(uity ratio is zero at the
origin, the firm is un levered or 2DDE e(uity firm. As there is no debt the cost of e(uity of the firm is
e(ual to its >A,, at this point. The straight line >A,, curve shows there is no change in >A,,
even after debt under pure ## ideal marets. As the leverage increases, cost of debt and cost of e(uity
rises but >A,, remains unaffected.
MM Vie3 9 I*eal Mar4et# N)merical E5am.le$
<ow we do a numerical e!ample to calculate these impacts 0ust discussed above1
A A 2DDE +(uity "irm .or :n-levered/ has Total Assets of =s.2DDD. It has a weighted average
cost of capital for un levered firm .>A,,
:
/ of 32E and ,ost of debt for un levered firm . r
D,:
/
of 2DE. It then adds =s.FDD of Debt. "inancial =is increases ,ost of debt .r
D,@
/ of @evered
"irm to 24E. >hat is the @evered "irm7s cost of e(uity r
+,@
and >A,,
@
P
A A##)ming /)re MM Vie3 9 I*eal Mar4et#$ Total #aret 9alue of Assets of "irm .9/ is
:<,?A<B+D. 9alue of un levered firm T 9alue of levered firm. Also, >A,, remains
:<,?A<B+D by ,apital Structure and Debt.
A >A,,
:
T >A,,
@
T 32E
A <ow we come to the cost of e(uity of levered firm
r
+,@
T>A,, S Debt&+(uity .>A,,
@
- r
D,@
/
T 32E S FDD&JDD .32E - 24E/
T 3J.4E
r
+,@
T .>A,, - r
D
,
@
!
D
/& !
+

T .32E - 24E .FDD&2DDD// & .JDD&2DDD/
T 3J.4E
A ,ost of +(uity for @evered "irm
T r
+,@
T =is "ree Interest =ate S 6usiness =is ;remium S "inancial =is ;remium.
r
+,@
increases because re(uired =-= for stoc increased because of financial ris.
8 ,opyright 9irtual :niversity of ;aistan 2FL
This is the case of pure ## theory where there are no ta!es and banruptcy costs. 6ut in case of trade
off theory in reality initially value of the firm rises as there is interest ta! saving but with e!cessive
leverage, value of the firm starts declining as interest cost goes very high due to banruptcy ris. This
can be shown in the following graph1
Tra*eo,, T&eor( Braph $
@ined to Traditionalist Theory of
@everage ' -ptimal ,apital Structure
9alue of
"irm or
;rice of
Stoc
Debt & Assets T
D&.DS+/
O/TIMAL Ca.ital
+tr)ct)re 9 MA@IMUM
VALUE - MINIMUM
%ACC
;rice.
"irm =emains 2DDE
+(uity .:n-@evered/
?ere ma!imum value point of the firm is also the minimum point of >A,,. It is the best
capital structure for the firm to operate.
/)re MM I*eal Mar4et# E5am.le$
>e now the basic ob0ective of the firm is to ma!imize shareholder7s worth.
A +!ample1 Assuming ;ure ## Theory with Ideal +fficient #arets where Total #A=K+T
9A@:+ of Assets of "irm .9 TDebt S +(uity/ is :<,?A<B+D by the ,apital Structure .and
@everage/. Biven the following Data on @everage and ,ost of ,apital1
Det 7D8 Intere#t 7rD8 E2)it( Co#t o, E2)it(
7E E V9D8 7r E E 7%ACC9 rD 5D8? 5E8
=s.D .T9/ D =s.2DDD 32E .T>A,,/ :n-@evered
=s.3DD 2DE .r
="
/ =s.CDD .32E - 2DE .D.3//&D.C T 34.LIE
=s.4DD 22E =s.LDD .32E - 22E .D.4//&D.L T 3I.4E
=s.FDD 24E =s.JDD .32E - 24E .D.F//&D.J T 3J.4E
=s.IDD 2IE =s.3DD .32E - 2IE .D.C//&D.3 T FIE
As the level of debt increases from =s.D to =s.IDD the cost of e(uity rises from 32E to FIE.
,onsider the graph we discussed above again1
8 ,opyright 9irtual :niversity of ;aistan 2FC
;ure ## Theory - Ideal #arets
>A,, Braph
%ACC E
r
D
5
D F
r
E
5
E
r
E
E Co#t o, E2)it(
E%ACCFD?E 7%ACC9r
D
8
r
D
E Co#t
o, Det
Co#t o,
Ca.ital
7T8
Det ? E2)it( E
D?E E 5
D
? 7 19 5
D
8
r
E
r
D
2DDE
+(uity
"irm
"inancial =is.
?igher =e(uired
=eturn on +(uity.
?igher r
E
-n the R-a!is we have cost of capital and Y-a!is Debt to e(uity ratioT "inancial leverage. >hen
Debt to e(uity ratio is zero at the origin, the firm is un levered or 2DDE e(uity firm. As there is no debt
the cost of e(uity of the firm is e(ual to its >A,,. The straight line >A,, curve shows there is no
change in >A,, after debt under pure ## ideal marets. As firm taes more debt, the line slope at top
in the graph increases at an accelerating rate, this is due to very high debt that has raised banruptcy ris
of the firm.
A /rolem o, t&e t&eor($ In =eal #arets, Total #aret 9alue of "irm .9/ D-+S ,?A<B+ as
@everage Increases. >e have made above calculations very simply under ideal conditions.
So we have a traditional view to tae real effects into account. The following is the same graph with
traditional views. ?ere cost of e(uity for a levered firm rises very fast. Also cost of debt rises. Another
point to note is that >A,, line has become curve with a minimum point at its lowest. Initially it comes
down s it moves away from R-a!is and then after reaching its minimum it starts going up. The
minimum point is the best optimal point for firm to operate for it capital structure.
8 ,opyright 9irtual :niversity of ;aistan 2FO
Traditionalist Theory - =eal #arets
>A,, Braph
%ACC
L
E r
D
719Tc85
D F
r
E
5
E
r
E<L
E Co#t o, E2)it( E
%ACC
U
F 5
D
7%ACC
U
9r
D
8 719T
C
8
r
D
E Co#t o, Det
Co#t o,
Ca.ital
7T8
Det ? E2)it( E
D?E E 5
D
? 7 19 5
D
8
r
E
r
D
2DDE
+(uity
"irm
0an4r).tc( =is '
,osts. ?igher
=e(uired =eturn on
+(uity. Steeper =ise.
Interest Ta! Shield
Advantage
O.timal
Ca.ital
+tr)ct)re
Note$ 5
D
E D ? 7DFE8
Tra*itionali#t Vie3 E5am.le$
A >e are using same e!ample with some additional information to incorporate the effects of real
world1 A 2DDE +(uity "irm .or :n-levered/ had total assets of =s.2DDD. It had a >A,,
:
.>eighted average cost of capital of un levered firm/ of 32E. It then added =s.FDD at a cost of
debt r
D,@
.for @evered "irm/ of 24E. >hat is the @evered "irm7s r
+,@
and >A,,
@
.>eighted
average cost of capital of levered firm/P Biven Data for r
+
,
,orporate ta! rate of 4DE on +arnings before Ta!, and +6IT T =s.4DD.
A Traditionalist 9iew is based on ;ractical =eality. @everage provides interest ta! savings .or
shield/ but also increases financial ris. +!cessive leverage leads to banruptcy ris. Increases
in ris will change value of firm and >A,,.
A <ow r
+
is based on -bserved Data and +(uity 9alue .+/ is based on Simple Income Statement
"ormulas.
A Traditionalists "ormulas for +(uity1
+ T <et Income .<I/& ,ost of +(uity for levered firm .r
+,@
/
<ote that A,,
:
S !
D
.>A,,
:
- r
D
/ .2 - Tc/.
A Traditionalists "ormula for >A,,1
>A,,
@
T !
D
r
D
.2 - Tc/ S !
+
r
+
.
.2-Tc/ is the Ta! Discount "actor.
<ote1 9alue of firm T Debt S +(uity
!
D
T Debt &9alue T Debt& .Debt S +(uity/
!
D
S !
+
T 2
9 T #aret 9alue of "irm D T #aret 9alue of Debt
+ T #aret 9alue of +(uity
!
D
T "raction of Debt T A #easure of @everage
In the ne!t lecture we shall continue this discussion and do more e!amples to see the impact of
capital structure on value of firm.
8 ,opyright 9irtual :niversity of ;aistan 2ID
Lesson 35
NET INCOME AND TA@ +:IELD A//ROAC:E+ TO %ACC!
Learning O!ecti"e#$
Net Income - Ta5 +&iel* A..roac&e# to %ACC
In the last lecture we discussed the impact of debt on firm value under #iller #odigliani approach
in detail with numerical e!amples. >e also discussed the formulae to see the impact of debt on firm
value under traditionalist real maret concepts. <ow we continue the same discussion with the help of
an e!ample under traditionalist real maret views1
Tra*itionali#t# 9Real Mar4et# E5am.le$
The following e!ample will help to understand how we can calculate >A,, for a firm in the
real world1
A 2DDE +(uity "irm .or :n-levered/ has Total Assets of =s.2DDD. It has a >A,,
:
of 32E and
r
D,:
of 2DE. It then adds =s.FDD of Debt. "inancial =is increases r
D,@
of @evered "irm to 24E. >hat is
the @evered "irm7s r
+,@
and >A,,
@
P Ta! rate is 4DE.
Det
7Gi"en D8
rD7Intere#t8
7Gi"en8
rE
7Gi"en8
E0IT
7R#>8
NI
7R#>8
MV o, E2)it(
7EENI? rE8
Mar4et Val)e
o, Firm
7EDFE8
%ACC
7T8
=s.D .T9/ D 32E 4DD 32D =s.2DDD =s.2DDD 32E
=s.3DD 2DE .rRF/ 33E 4DD 2CO =s.CIO 2DIO 2O.2LE
=s.4DD 22E 34E 4DD 2CL =s.C24 2224 2C.CCE
=s.FDD 24E 3CE 4DD 2C4 =s.JI4 2DI4 3D.C3E
=s.IDD 2FE 44E 4DD 2LO =s.IF2 2DF2 32.CJE
"ollowing formula has been used to calculate the >A,,1
%ACCL E rD 5D 71 9 Tc8 F rE 5E>
>A,,
@
T 2DEZ .3DD&2DIO/ .2 $ 4DE/ S 33E Z .CIO&2DIO/.
T 2O.2LE
A Un le"ere* Ca#e$ DTD , rE T 32E T >A,,,
#aret value of +(uity T + T 9 T #aret value of "irm .due to no debt/ T =s2DDD
A Le"erage$ Debt .and @everage/ is gradually increasing from =s.3DD to =s.IDD. ,hange in
@everage ,hanges the "irm7s 9alue. >hen Debt T =s.FDD value of firm has Increased to
=s.2DI4 under traditionalist view whereas we assumed firm value fi!ed at =s.2DDD in ;ure ##
Ideal #aret +!ample. =ise in value of firm is due to interest savings.
A O.timal Ca.ital +tr)ct)re occurs at Debt of =s.4DD
.i.e. !
D
T D & 9 T =s.4DD & =s.2224 T D.3JOI/. So a "inancial @everage of 3J.OIE is the 6est
,apital Structure for this "irm. ?ere, >A,, T 2J.CE and value of the firm at its highest T
=s.2224.
A After this point value of firm starts falling and >A,, rising.
8 ,opyright 9irtual :niversity of ;aistan 2I2
Traditionalist 9iew - =eal #arets
>A,, Braph
%ACC
L
E r
D
719Tc85
D F
r
E
5
E
r
E<L
E Co#t o, E2)it( E
%ACC
U
F 5
D
7%ACC
U
9r
D
8 719T
C
8
r
D
E Co#t o, Det
Co#t o,
Ca.ital
7T8
Det ? E2)it( E
Mea#)re o, Le"erage
D?E E 5
D
? 7 19 5
D
8
r
E
r
D
2DDE
+(uity
"irm
0an4r).tc( =is '
,osts. ?igher
=e(uired =eturn on
Interest Ta! Shield
Advantage
O.timal Ca.ital
+tr)ct)re
Minim)m %ACC -
Ma5im)m Mar4et Val)e Note$ 5
D
E D ? 7DFE8
?ere cost of e(uity for a levered firm rises very fast. Also cost of debt rises. =ecall we have studied this
graph earlier in previous lectures. ?ere point to note is that >A,, line has become curve with a
minimum point at its lowest. Initially it comes down as it moves away from R-a!is and then after
reaching its minimum it starts going up. The minimum point at >A,, is the best optimal point for firm
to operate for it capital structure.
Tra*itionali#t# 9 Real Mar4et# E,,ect o, Le"erage on %ACC$
A Interest Ta! Savings Increase, ,ost of Interest or #ar-up Increases, and ,ost of +(uity
Increase. Depending on the =ate of Increase, they can affect computation of "irm7s #aret
9alue .9/ and >A,, in different ways - either maing them Increase or Decrease.
A +ffect of Increasing @everage .as measured by Debt&+(uity or !
D
T Debt&9alue/ on #A=K+T
9A@:+ of "irm .9/ is :ncertain. 6ased on ,ombination of +6IT, Ta! =ate, @everage, and
=elative ,osts of Debt ' +(uity.
A ;ractically speaing, Initially @everage adds Interest Ta! Savings 6enefit so 9alue .9/ rises but
after some point the ,ost associated with "inancial Distress and 6anruptcy =is maes the
9alue "all. #A=K+T 9A@:+ of "irm .9/ typically reaches a #AYI#:# 9A@:+ where
>A,, is #I<I#:#. This is the -ptimal ,apital Structure.
NI A..roac& ,or Calc)lating N)merical "al)e o, %ACC o, Le"ere* Firm E5am.le$
A Starting ;oint for ,alculating <umerical 9alue of >A,, suing A,,
:
of
:n-levered "irmP
A <et Income T +6IT - Interest - Ta!
T 2DD - D - D.4.2DD/
T =s.LD
A #aret 9alue of :n-levered +(uity T +u
T A,, u T r
+,:
T 3DE
$ If the "irm taes =s.2DD Debt at 2DE Interest or #ar-up then what is the >A,,@ of
@evered "irmP
A <et Income .<I/
T 2DD - 2D E. 2DD/ - Ta!
T 2DD - 2D - D.4.OD/
T =s.J4
A +(uity
T A,,@
T r
D,@
.2-Tc/ !
D
S r
+
,
@
!
+

T D.2.2-D.4/ .2DD&F2I/ S D.3.42I&F2I/
T 2J.OE
/oint to note i# t&at %ACCL i# lo3er t&an %ACCU>
A +e2)ence o, +te.#$
718 ,alculate A,,@
Ta5 +&iel* A..roac& 7or NOI A..roac&8 to Calc)lating %ACC o, Le"ere* Firm$
Ta! Shield T corporate ta! rate Z value of debt T Tc Z D
A =elationships between :n-@evered ,osts and @evered ,osts of ,apital
A Se(uence of Steps for <-I Approach for ,alculating <umerical 9alue of >A,, for @evered
"irm1
$ Step 21 Starting ;oint is #aret 9alue of @evered "irm
T 9@ T 9u S Tc D.
:nrealistic because 9@ should <-T eep increasing with Debt
$ Step 31 Tc ! D T Ta! Shield Advantage from Debt.
$ Step 41 #aret 9alue of +(uity T + T 9@ - D.
$ Step F1 ,alculate r
+,@
T A,,
@
T r
D,@
.2-Tc/ !
D
S r
+,@
!
+

$ <ote1 >A,,
@
T>A,,
:
.2-Tc/ !
D

A :se +ither <I Approach or Ta! Shield Approach depending on what Data has been given to
you.
Ot&er +&ort9c)t Form)la# - Lin4 et3een Ca.ital +tr)ct)re - 0eta#
A ,ost of +(uity .After Ta!/ +stimates and ST-,K 6+TAS
$ r
+,@
T >A,,
:
S !
D
.>A,,
: -
r
D
/ .2-Tc/
$ r
+,@
T r
+,:
S Debt&+(uity .r
+,:
-r
D
/ .2-Tc/
$ r
+,:
T r
="
S 6+TA
+
. r
#
- r
="
/
=ecall from ,A;# Theory
A >A,, .After Ta!/ +stimates A<D "I=# 6+TA
$ >A,,
@
T r
D,@
.2-Tc/!
D
S r
+,@
!
+
$ >A,,
@
T r
="
S 6+TA
>A,,,@
. r
#
- r
="
/
$ <ote1 -verall 6eta for the "irm
T 6+TA
>A,,,@
T 6eta
D
!
D
S 6eta
+
!
+

Lesson 36
MANAGEMENT OF CA/ITAL +TRUCTURE
Learning o!ecti"e#$
After going through optimal capital structure theories, modifications made in them, applicability
of theses theories, impact of debt on value of firm and >A,,, different principles to decide about
capital structure and different approaches to >A,, calculation now we study the management of
capital structure1
Tra*itionali#t T&eor( 9 E,,ect o, Ca.ital +tr)ct)re on Firm Val)e - +&are /rice$
A As 2DDE +(uity "irm Taes -n #ore and #ore Debt .or @everage/1
$ ,ost of ,apital decreases .cost of debt is cheaper than e(uity/, reaches a minimum
point, and then rises .e!cessive debt increases financial ris/.
$ Total #aret 9alue of "irm .9 T D S + T #aret 9alue of Debt S #aret 9alue of
+(uity/ first rises .because of Interest Ta! Shield savings/, then reaches a ma!imum
point .optimal capital structure/, and finally falls .because of e!cessive fall in <et
Income and +(uity value because of interest payments/.
$ Share ;rice .;oT Total 9alue & -riginal <umber of Shares -= +(uity value & <umber
of Shares -utstanding/ first rises, then reaches ma!imum .same point as ma!imum
9alue/, and finally falls. "ollows same shape as Total #aret 9alue of "irm. Share
;rice is a measure of "irm 9alue.
Tra*itionali#t T&eor( 9 E,,ect o, Ca.ital +tr)ct)re on Earning# an* Ri#4$
A As 2DDE +(uity "irm =eplaces #ore and #ore +(uity with Debt .or @everage/1
$ #ean .or +!pected/ +6IT assumed to be unchanged although e!cessive debt can cause
it to rise because of higher operational costs because of financial distress
$ #ean +6T will fall because interest payments rise
$ #ean <et Income .or +arnings/ generally falls continuously because interest payments
rise faster than any interest ta! savings.
$ #ean +arnings ;er Share .+;S T <et Income & <umber of Shares outstanding/
generally first rises if number of shares falls if +(uity is =eplaced with Debt, then
reaches ma!imum .different capital structure mi! from that which ma!imizes 9alue '
Share ;rice/ , and finally falls .because interest payments grow faster/. Similar shape to
Share ;rice ,urve but reaches #a!imum at a different Debt =atio and ,apital
Structure. "or -ptimizing ,apital Structure, we should focus on Share ;rice and not
+;S.
$ +arnings =is .9ariation or Standard Deviation/ Increases because of @everaging or
#agnifying effect of Debt. Debt increases "inancial Distress and =is of 6anruptcy.
And if "irm is financially unhealthy i.e. +6IT & Total Assets f ,ost of Debt then small
fall in +6IT can lead to large fall in =-+.
%ea4ne##e# o, Ca.ital +tr)ct)re Mat&ematical Mo*el#$
?ere are some of the rules of thumb or general principles financial managers eep in view while
deciding for capital structure of the company1
A "orecasting +rrors
$ ,hanges in ,ost of Debt and +(uity .or ,apitalization =ates/ are unpredictable when
Debt =atio is changing
$ ,hanges in +6IT are also difficult to correlate to changes in Debt or ,apital Structure
A Share ;rice and +;S calculation is very sensitive to minor errors in the estimates.
A "ocus on ,orporate "inance is on #aret 9alue .of +(uity, Debt, and Stocs/ 6:T #aret
9alue may not be so important for ;roprietorships and ;rivate @td ,ompanies where only a few
shareholders to whom the maret value assessed by investors in the maret is irrelevant.
A "undamentally, Stoc ;rices should be fundamentally driven by -perating Decisions and "ocus
on Improving +arnings and ,ash "lows $ and <-T by manipulating ,apital Structure. ,apital
Structure and ,orporate "inancing can be used to fine tune the value.
/ractical Ca.ital +tr)ct)re Management$
A "inancial Stability and ,onservatism vs. =eal-time ,apital Structure -ptimizationU Aim for
Target ,apital Structure
8 ,opyright 9irtual :niversity of ;aistan 2IF
A @ong =un 9iability vs. Short-term Stoc ;rice #a!imization
A "inancial =atio Targets
$ ,overage =atio i.e. TI+ .Times Interest +arned/
T +6IT & Interest. ?igher .over 3.D/ is better.
$ @ong Term Debt & Total ,apitalization =atio - about 4DE
$ ",, ."i!ed ,harge ,overage/ T .+6IT - @ease =ental/ & .Interest S @ease =ental S
Ad0usted Sining "und ;ayment/. Taes into account "i!ed "inancial ,harges other
than Interest
A #aintain =eserve 6orrowing ,apacity .recall Signaling Theory/ in case attractive ;ositive <;9
pro0ects are found ' also to give the right Signal to #aret
A #anagement ,ontrol
$ use Debt to avoid giving away voting rights and control 6:T ,reditors can tae control
if firm becomes insolvent or defaults
$ ,orporate =aiders can tae over a firm with large assets if debt is too low - using @6-
.@everaged 6uy -ut/. They convince shareholders to give them control in e!change for
higher share prices and +;S as a result of future leveraging.
A "irms with .2/ solid assets that can be mortgaged as security against a loan and .3/ stable sales
and -perating @everage can generally use debt more safely.
A =etained +arnings1 profitable firms have sizeable ,ash and =etained +arnings. These are ideal
sources of capital because <o transaction costs.
A ?igh Ta! 6racet "irms1 such firms have greater advantage in using debt because of large
Interest Ta! Shield Savings.
8 ,opyright 9irtual :niversity of ;aistan 2II
Lesson 37
DIVIDEND /AAOUT
Learning O!ecti"e#$
Di"i*en* /a(o)t
Dividend ;olicy is an important area connected to the capital structure in financial management as it
helps financial mangers to decide how much of the company7s profits should be distributed to the
shareholders or e(uity holders in the form of dividends.
Di"i*en* /olic( I##)e$
A Earning# an* /o#iti"e Ca#& Flo3# can e allocate* to t&e Follo3ing Ca#& O)t,lo3#$
$ 6uying assets lie machines, building etc. .,apital 6udgeting/
$ Investing in ;ro0ects lie ac(uiring new business.,apital 6udgeting/
$ ;aying Interest to Debt holders .i.e. 6ans, 6ondholders/ d 9alue holders who
receive a slice of the "irm7s value in form of Interest Income.
$ ;aying Dividends to Shareholders .i.e. ;ayout/ d 9alue holders who receive a slide of
the "irm7s value in form of Dividend income.
=emember bondholders and shareholders both are investors but debt holders are creditors to the
company while shareholders are owners of the company.
A Ma!or D)e#tion# in Di"i*en* /olic($
$ ?ow much to ;ayout to Shareholders in form of DividendP
A ;ayout =atio
T Annual Dividend Amount& <et Income
A<D
Dividend per Share
T Total Dividend Amount & -utstanding <umber of Shares
A There needs to be a tradeoff between Dividend Income ' ,apital Bains
=ecall Gor*on1# Form)la$
=e(uired =eturn on +(uity or ),ost of +(uity*
T r
,+
T Dividend Rield S ,apital Bains Rield
T .DI92&;o/ S g
Dividend Rield T "uture Dividend& ;resent ;rice
,apital Bains Rield T Dividend Browth =ate
$ ?ow to "inance the Dividend ;ayoutP
A ,ash or Stoc Dividend
A :se Internal =etained +arnings -= +!ternal "inancing .i.e. Debt or +(uity/
$ ?ow often to mae Dividend ;ayoutP
A Vuarterly, Annually, #onthlyd =andomP
$ Impact of Dividend ;olicy on "irm 9alue and Share ;riceP
A >hether or not ;aying -ut Dividend increases "irm 9alue or not depends on
many things including =eturn -n +(uity of "irm versus the =e(uired =ate -f
=eturn .r
+
/ of its shareholders
To answer this (uestion we need to consider some theories.
Di"i*en* T&eorie#$
A MM Irrele"ance 7Miller Mo*igliani8 T&eor($
It is an e!tension of #iller #odigliani theory of capital structure we studied earlier. Dividend
;ayout is basically irrelevant because the way you S;@IT cash flows within and amongst the
Shareholders and Debt holders has no affect on the Total 9alue of a "irm T Total debt S Total
+(uity. 9alue is determined by ?-> #:,? cash flows are generated by the woring assets
and the business ris of those assets. Also investors are not influenced by whether the dividend
is paid in dividend yield form or capital gains yield form. These conclusions were drawn under
same ideal assumptions as made in capital structure theory.
A 0ir* in t&e :an* 7Gor*on - Lintner8 T&eor($
8 ,opyright 9irtual :niversity of ;aistan 2IJ
This theory is more practical. Shareholder wealth .and "irm7s 9alue/ is ma!imized by a ?IB?
Dividend ;ayout because Investors thin that Dividend Income is more immediate, regular, and
less risy than ,apital Bains Income which is uncertain. So firm should pay as high dividend
payout as possible.
A Ta5 /re,erence T&eor($
Shareholder wealth is ma!imized .and cost of e(uity r
+
is minimized/ by @-> Dividend ;ayout
because #arginal Ta! =ate on Dividends is higher than on ,apital Bains. "irms should
accumulate high =etained +arnings that can then lead to Share ;rice Increase .,apital Bain/ or
Stoc =epurchase.
In real world we have to consider both above factors while deciding for dividend payout i.e.
time value of dividend income and ta! advantage of capital gains along with the following other factors1
Ot&er Factor# A,,ecting Di"i*en* /olic($
A +ignaling T&eor( 7Recall t&eor( 3e #t)*ie* earlier8$
$ In minds of Investors, change in Dividend ;ayout signals a change about management7s
forecast about future e!pected earnings. So increase in Dividend ;ayout is seen as
;ositive Signal that firm will have good earnings in future so Stoc ;rice rises. It has
real effects on the trading of shares of the company.
A Clientele E,,ect$
$ Investors buy stocs whose Dividend ;olicy they lie and sell the other ones. ,hange
in Dividend ;olicy can cause change in type of shareholders. Income Investors will
invest in ?igh Dividend Stocs. Browth Investors will invest in those stocs offering
larger ,apital Bains Rield. Income stocs are the shares of the companies who pay
regular fi!ed dividends lie large #ultinational corporations.
A Agenc( Co#t#$
$ Shareholders .owners/ incur agency costs to monitor and eep chec on managerial
spending and decisions. ?igh Dividend ;ayout forces firm to go to capital marets to
raise e!ternal capital. So, management is sub0ected to outside scrutiny which is an
e!ternal chec on management spending.
A Legal Re#triction#$
$ Det Contract#$ @oan Agreements and 6ond Indentures restrict Dividend ;ayout to
Shareholders if earnings or net woring capital is too low to pay interest. So companies
have to fulfill certain conditions and meet targeted ratios.
$ Im.airment o, Ca.ital R)le$ Dividends can <-T e!ceed =etained +arnings which
are shown on 6alance Sheet.
$ Ca#& Di"i*en*# can onl( e .ai* 3it& ca#&$ ,ash means cash. If cash balance .shown
on 6alance Sheet too/ is not enough then Sell assets, =aise +(uity, or Tae @oan d etc.
A Di"i*en* +tailit($
$ #ost firms aim for Steadily Increasing Dividend ;olicy but it is not easy and is a
challenge.
A +arnings, ,ash flows, ,apital Structure, and ,apital 6udgets fluctuate up and
down with time but Dividend ;ayouts should <-T change much $ nown as
)Sticy Dividend ;olicy*
A "inancial #anager acts as Stabilizer ,onverting fluctuating unpredictable
Incoming cash flows and Transforming them into steady and regular cash
outflows to shareholders .in form of Dividends/ and debt holders.
A Standpoint of Investors1 ;rovides low ris regular income for shareholders,
signals good future earnings, and growth compensates for Inflation. It eeps
running a source income regular to meet their day to day e!penses.
<ote1 Browth T g
T ;lough bac ! =-+
8 ,opyright 9irtual :niversity of ;aistan 2IL
T .2 $ Dividend ;ayout/ ! =-+.
A Standpoint of "irm1 ;ayout small but regular and increasing dividends. It helps
to eep reserve earnings to meet future capital e!penditure and investment
opportunities
A +tea*il( Gro3ing Di"i*en* /a(o)t Gi"e# /o#iti"e +ignal#$
$ "inancial Stability
$ @ess =is and :ncertainty
Re#i*)al Di"i*en* Mo*el
A Re#i*)al Di"i*en* Mo*el$ 6est ;ractical #odel for numerical calculations of optimal
Dividend ;olicy. Sets @ong-Term Target Dividend ;ayout =atio from which to bac-calculate
short-term Dividends.
A +te.# in Re#i*)al Di"i*en* Mo*el 7RDM8$
$ "orecast ,apital 6udget, +arnings, ,ash "lows .for ne!t I years/
A ,onservatism1 To be on safe side, underestimate the "ree ,ash "lows
$ Determine Target optimal ,apital Structure .or ;ractically Speaing, )=ange* for Debt
=atio/ and forecast re(uired +(uity .for ne!t I years/
$ :se =etained +arnings .internal capital/ to finance most of the re(uired +(uity because
=+ is less costly than e!ternal financing .higher transaction costs/. =etained earnings
cost less than loans to ac(uire finance.
$ @eftover or )=esidual* +arnings can be safely paid -ut as Dividends in @ong Term.
Then divide this into Small Ret =egular .may be (uarterly/ and Steadily Increasing
Dividend ;ayouts.
8 ,opyright 9irtual :niversity of ;aistan 2IC
Lesson 38
A//LICATION OF RE+IDUAL DIVIDEND MODEL
Learning O!ecti"e#$
topics1
A..lication o, Re#i*)al Di"i*en* Mo*el
In this lecture we shall continue our discussion of dividend policy.
Ca.ital 0)*geting< Ca.ital +tr)ct)re - Di"i*en* /olic($
A -nce the -ptimal ,apital 6udget and Target ,apital Structure have been estimated for I or
more years, we can then calculate the Dividend ;ayout based on =esidual .i.e. @eft over
+arnings/ Dividend #odel. This is important because it combines ,apital 6udgeting, ,apital
Structure, and Dividend ;olicy.
A +!ample1 "irm with +arnings T <I T=s.CD, Target Debt =atio T 3DE .T D&9/.
$ If ,apital +!penditure 6udget T =s.2DD then total value of firm7s financing needs is
=s.2DD. Debt T =s.3D. So, re(uire +(uity T =s.CD .2DD $ 3D/.
A ,an meet ,apital +!penditure 6udget e!actly provided that all of +arnings of
=s.CD are retained. =etained +arnings T =s.CD, ;lough bac T 2DDE .T .CD&CD/
!2DD/. So, Mero Dividend ;ayout.
A Dividend ;ayout would be zero. Assuming that "irm would prefer to use
=etained +arnings .internal capital is cheaper/ rather than e!ternal financing to
meet its ,apital 6udget -utlay.
$ If ,ap +! 6udget T =s.2ID then shortfall of =s.ID .T Total "inancing $ 6udget T 2DD $
2ID/. #eans "irm has to raise e!ternal financing. >hat ind and at what costP
A ,an <-T raise e!ternal Debt because Target ,apital Structure will change.
A #ust raise e!ternal +(uity. 6ut ,ost of +(uity will increase. =ecall that
Transaction and "lotation ,osts of +!ternal <ew Stoc Issuance is more than
-pportunity ,ost of :sing =etained +arnings.
A Again, assuming that Dividend ;ayout would be zero because "irm would want
to use entire +arnings as source of cheapest capital to meet ,apital +!penditure
6udget.
$ If ,apital +!penditure 6udget T =s.OD then surplus of =s.2D. >hat ,apital Structure
and Dividend ;ayoutP
A ,apital Structure1 Total 9alue of ,apital +!penditure 6udget T =s.OD. ,an
<-T use all =s.CD of +arning as +(uity because that would mean a Debt =atio
of 22E .T 2D&OD ! 2DD/ which is not our target. Target ,apital Structure is
3DE Debt. So, optimal case is to use =s.2C .T=s.OD ! D.3/ of Debt. So, +(uity
should be =s.L3 .T OD $ 2C/
A Dividend ;ayout1 =esidual +arnings can be used for Dividend ;ayout. So,
Dividend ;ayout T Total +arnings $ +(uity T CD $ L3 T =s.C. Dividend per
Share T Dividend & <umber of Shares -utstanding.
Di"i*en* /a(o)t /roce*)re$
A Declaration Date
$ 6oard announces Dividend amount and dates i.e. Nan 4Dth 3DD4. 6ased on
=ecommendation of ,+-, ,"-, and Treasurer
$ Declared dividend recorded as actual current liability on the 6alance Sheet and
=etained +arnings reduced by same amount.
$ If announced Dividend is higher than before, generally Stoc ;rice rises because
Investors tae this to be a ;ositive Signal about future earnings
A ?older-of-record Date
$ "irm records names of shareholders in the Stoc Transfer =egister i.e. "eb 3Cth 3DD4.
About 2 month after Declaration Date
A +!-Dividend Date .Important/
$ F Days before ?older-of-record Date. Deadline for new buyers to notify "irm so that
Dividend is paid to them and not the previous registered owners i.e. "eb 3Fth 3DD4
$ Share ;rice e!pected to D=-; by about the same amount as Dividend on this date.
8 ,opyright 9irtual :niversity of ;aistan 2IO
A ;ayment Date
$ "irm mails che(ues to registered shareholders i.e. #arch 2Ith, 3DD4. About 2 j
months after Declaration Date.
Ot&er Di"i*en* +c&eme#$
A Di"i*en* Rein"e#tment /lan# 7DRI/8
$ "irms give stocholders option to automatically reinvest cash dividends by buying more
of the same stoc
$ Advantage for "irm1 no transaction and flotation costs unlie new stoc issuance.
,heap way of raising e(uity.
$ Advantage for Investors1 no broerage fee paid to stoc broer
A +toc4 Re.)rc&a#e
$ "irms offer to repurchase stoc at a price above the maret price .this is a tricy
e!ercise/ in order to compensate shareholders when dividends are cut.
$ 9iewed as ;ositive Signal because shows confidence of management in buying bac
shares of their own firm
$ Advantage for Investors who want to sell shares1 lower marginal ta! on capital gains
than on dividend income
$ Advantage for remaining Shareholders1 number of shares outstanding falls so +;S rises
and Share ;rice rises.
A "undamental Share 9alue "ormula1
+&are /rice E /o E E/+ 5 7/?E8
$ Advantages for "irm1
A =educe the )Float* .e(uity or shares owned by outsiders/. =emoves e!cess
shareholders. Increases management control.
A ,an be used in combination with =esidual Dividend ;olicy to mae e!tra
payouts on rare occasions when earnings and free cash flows are in surplus
A ,an be used in combination with Debt Issuance .i.e. :sing money from a loan
to buy bac shares/ to mae very (uic and large changes in ,apital Structure.
,alled =+;@A,+#+<T
Di"i*en* +c&eme# ,or O.timi6ing +&are /rice$
A Stoc Dividends
$ :sed to control the share price if it rises too fast. 6rings share price down to within an
)-ptimal ;rice =ange* so that more investors can afford to trade in it and trading
volume rises. This is a commonly held belief.
$ ;ayment in the form of stoc to e!isting shareholders. ,an be declared fre(uently.
$ +!ample1 ,ompany offers 2DE stoc dividend to all shareholders. #eans that if you
own 2DD shares than company will give you 2D more shares free of cost. <umber of
shares increases but Total 9alue of "irm is unchanged.
A Stoc Splits
$ Also used to control share price if it rises too fast. <umber of shares outstanding
increase.
$ :sed to increase )"loat*
$ +!ample1 ,ompany with 2DDD shares outstanding to outside shareholders declares 3-
for-2 Stoc Split. #eans that the number of shares outstanding will increase to 3DDD
shares .i.e. 2DDE increase/. <umber of shares rises but "irm 9alue unchanged.
A Impact of Stoc Dividends ' Stoc Splits on +;S and ;rice
$ In both cases .Stoc Dividends and Stoc Splits/, +;S .+arnings ;+= S?A=+ T<I &
shares/ and Dividend ;+= S?A=+ fall because number of shares outstanding increases.
<ote1 "I=# 9A@:+ IS :<,?A<B+D $only the number of S@I,+S -" T?+
9A@:+ ;I+ .i.e. <umber of Shares/ have increases
$ ;rice rises immediately afterwards because investors tae them to be ;ositive Signals
about the ,ompany7s future
8 ,opyright 9irtual :niversity of ;aistan 2JD
$ 6:T if ,ompany does <-T declare higher earnings and dividends in near future, ;rice
will come bac down again.
+)mmar( o, +te.# in Di"i*en* /olic($
A "orecast ,apital +!penditure 6udget and Internal Sources of "unds .<e!t I Rears/.
$ 6e conservative1 6e on safe side -underestimate the "ree ,ash "lows
A Determine -ptimal ,apital Structure .or =ange for Debt =atio/
A :se =etained +arnings to finance most of the ,apital +!penditure
A ,alculate =esidual +arnings and Determine @ong-term Dividend ;ayout.
A 6ac-calculate the Short-term .Vuarterly/ Dividend ;ayout per Share. Set at S#A@@
,-<STA<T value which should grow slowly and never be lowered.
$ Stable Dividends signal financial stability and @ess =is
A "inancial #anager and ,+- submit recommendation to 6oard of Directors
A 6oard Announces Dividend and Dividend ,he(ues are mailed to =egistered Shareholders
8 ,opyright 9irtual :niversity of ;aistan 2J2
Lesson 39
;OR-IN+ CA!ITAL MANA+EMENT
Learning O!ecti"e#$
%or4ing Ca.ital Management
>oring ,apital #anagement is another important area of financial management.
A Financial Management Co)r#e
+arlier in the course we studied1
$ ,apital 6udgeting1 "ocuses on "i!ed Assets side of 6alance Sheet
$ ,apital Structure .' ,orporate "inancing/1 "ocuses @iabilities Side .@ong Term Debt
' +(uity/ of 6alance Sheet
<ow another important area is1
$ >oring ,apital #anagement1 "ocuses ,urrent Assets ' @iabilities of 6alance Sheet
in day-to-day operation
A Generall( %or4ing Ca.ital 7Gro##8 E C)rrent A##et#
$ ,urrent Assets T Inventory S Accounts =eceivables S ,ash S #aretable Securities S
d.The mentioned items are four ma0or items/
$ >oring ,apital is different from ),apital* .as used in ,apital 6udgeting/ which refers
to ,apital +!penditure in "i!ed Assets
$ Also it is different from ),apital* .as used in ,apital Structure/ which refers to
"inancing in the form of Debt or +(uity .@oans or share capital/
A Net %or4ing Ca.ital E C)rrent A##et# C)rrent Liailitie#
<et woring capital is slightly different from gross woring capital.
$ woring capital is different from <et >orth
T Assets $ @iabilities T +(uity
T Stoc S =etained +arnings
$ ,urrent @iabilities
T Accounts ;ayables S Accruals S Short Term @oans S d .as well as other minor
items/
A Im.ortant Mea#)re o, t&e +&ort9term Li2)i*it( o, a Firm
$ >oring capital is a measure of how easy it is for a firm to convert short-term assets
into )@i(uid* ,ash in order to meet the ,urrent -bligations by selling assets
$ Some ratios to measure li(uidity of firm are1
,urrent =atio T ,urrent Assets & ,urrent @iabilities
Acid Test or Vuic =atio T Vuic Assets & ,urrent @iabilities
A Vuic Assets T ,urrent Assets $ Inventory
A F)n*amental Tra*eo,, in %or4ing Ca.ital 7or C)rrent A##et#8
Decision in woring capital management is how much woring capital should be maintained by
a firm. It re(uires how much money needs to be invested in Inventory, Accounts =eceivables,
#aretable Securities and how much cash should be maintained.
$ Advantages of @arge ,urrent Assets1 less ris of shortages ' interruptions and less loss
of sales due to availability of funds for loan payments and purchases and inventory.
?igh @i(uidity so better ,=+DIT =ating.
$ Advantages of Small ,urrent Assets1 @ess investment in current assets means less
amount of money tied to the assets which are generating no return. So lower
-pportunity ,ost of ,apital.
$ "ind the -ptimum ,urrent Assets .woring capital/ At Any Biven Time and for a
Biven @evel of Sales ' Browth1
A "or this Alternative Investment ;olicies have been proposed and a good
business 0udgment is re(uired
%or4ing Ca.ital /olicie#$
A >hat is the -ptimum >oring ,apital .or ,urrent Assets/ for a "irm at any given time given in
level of Sales and Browth StrategyP This re(uirement fluctuates with time depending on sales
and seasons.
;ractically the following policies are used by the mangers to decide what is the best amount of
current assets or mi! of assets to be ept for the firm1
A PFat CatQ or Rela5e* /olic(
$ It re(uires @arge Amount of ,urrent Assets not to loose any sales i.e. when a customer
places order for a large amount, there is no shortage of inventory
$ -ccurs when ?igh sales driven by lot of credit facility to buyers
$ Bood ,redit =ating because ?igh @i(uidity and good ,urrent =atio
$ ,ase1 >all #art retail chain during <ew Rear and ,hristmas
A PLean - MeanQ or Re#tricte* /olic(
$ Small Amount of ,urrent Assets
$ It increases turnover and therefore ;rofits
A ,urrent Asset Turnover T Sales & ,urrent Assets. ?igher than 3D.
A @owers ,arrying ,osts of Inventory
$ "rees up cash and speeds up production .operational efficiency/
$ Small ,urrent Assets means @ower -pportunity ,ost of ,apital. "irms have raised
,apital from Investors .Debt ?olders and Shareholders/ which comes at a ,ost .the
>A,, includes Interest paid to Debt ?olders and Dividends paid to Shareholders/.
"irms must mobilize the capital in high-return investments in order to repay their
investors.
$ )Mero >oring ,apital ;olicy* .+!treme form of @ean ' #ean ;olicy/
It can not be D in reality but its ob0ective is to minimize.
A Napanese Nust in Time .NIT/ i.e. Toyota #otor ,o. It means the spare partsreach
0ust a few hours ago from the assembly time.
A Mo*erate /olic(
$ In between the "at ,at and @ean ' #ean ;olicies
Im.act o, 3or4ing ca.ital on Firm Val)e$
There is a lin between woring capital policy and our basic ob0ective of financial management of
ma!imizing shareholder7s wealth.
A EVA 7Economic Val)e A**e*8
$ +9A .in =upees/
T <et -perating Income discounted by the Ta! $ .>A,, ! Total ,apital/
T .<-I ! .2-Tc// - .>A,, E ! Tot ,apital/
In other words, +9A .in =upees/
T =evenues generated by firm $ ,ost of capital by firm
$ Total ,apital T #aret 9alue of Debt S #aret 9alue of +(uity
$ If >oring ,apital is reduced, then cash is freed up from the assets to which it was tied
up and can be used to reduce dependence on +!ternal "inancing .Debt and +(uity/.
Total +!ternal ,apital is reduced and >A,, is reduced. It raises +9A of the firm.
$ ?igher +9A means ?igher #aret 9alue of "irm .9/ and #a!imization of Shareholder
>ealth which is a fundamental ob0ective of "inancial #anagement.
A ROE 7Ret)rn on E2)it(8
$ Du;ont "ormula1
=-+
T ;rofit #argin ! Asset Turnover ! @everage "actor .or +(uity #ultiplier/
T .<et Income&Sales/ ! .Sales&Assets/ ! .Total Assets&+(uity/
T <et Income & +(uity
$ If >oring ,apital is reduced, then cash which is freed up can be used to reduce
re(uirement for +!ternal ,apital and Total @iabilities. 6y Total Assets reduced, Asset
Turnover =ises, and =-+ =ises
$ -b0ective is to eep =-+ ?igher than r
+
.=e(uired =eturn/ and this means eeping
capital mobilized and invested at all times to generate returns higher than >A,,
.which can not be done by simple cash holdings/.
Ca#& Management$
"irst we tal about first item of woring capital in balance sheet i.e. cash
A A*"antage# o, Ca#&
$ <eed cash for @i(uidity, Bood ,redit =ating, and #eet :ne!pected +!penses ' to Bet
Trade Discounts. )<eed ,ash to ;ay the 6ills.*
$ 6:T cash .and even ,urrent 6usiness Accounts in bans/ earns <- =+T:=< .i.e.
Interest or #arup/
A >hen Interest =ates are high, the -pportunity ,ost of holding cash rises.
$ 6usiness ,ompetition forces firms to sell on ,=+DIT but that leads to ;roblems in
=+,-9+=R of =eceivables .i.e. 6ad Debts and >rite-offs/.
A 0alance +&eet /er#.ecti"e
$ ),ash is King* and )-nly ,ash ,an ;ay the 6ills*
A Ca#& 0)*get 7Detaile* +&ort Term8
$ ;ro0ected ,ash Inflows and -utflows to estimate #onthly ,umulative <et cash Surplus
or Shortfall
A Tae into account ,redit ;urchases and ,redit Sales and +!pected ,ollection
.,ash =ecovery/ Time
A Shortfall tells you how much Short-term "inancing is re(uired
$ Importance of Timing of ,ollections and ;ayments and Target ,ash 6alance
Mont&l( Ca#& 0)*get
;an)ar( Fer)ar( Marc& A.ril
+ale# 7E5.ecte* Foreca#t# Y000 R#>8 7In,ormation8 2DD 3DD 4DD FDD
,ollections .QDDD =s./
,urrent month Sales .4DE/ 4D JD OD 23D
;revious month Sales .LDE/ LD 2FD 32D
TOTAL COLLECTION+ C0 1C0 2C0 CC0
;urchases =aw #aterial .QDDD =s./
W0T o, Ne5t Mont& +ale# 7In,ormation8 2FD 32D 3CD
-;ayments of purchases .paid ne!t month/ 2FD 32D 3CD
-ther +!penses .QDDD =s./
>ages 2D 2D 2D 2D
=ent 2D 2D 2D 2D
Ta!es 2D 2D 2D 2D
Interest ' Dividends D D D D
TOTAL /AAMENT+ C0 1W0 2H0 C10
<et ,ash for #onth D .D/ .2D/ 3D
-pening balance 0 0 7H08 7G08
C)m)lati"e Ca#& 7Clo#ing alance8 .FD/ .ID/ .4D/
Target ,ash 6alance 20 20 20 20
Net C)m)lati"e Ca#& 7208 7C08 7108
Note$ ,losing balance of previous month is opening balance of ne!t month i.e. closing balance of
"ebruary .FD/ is opening balance of #arch.
8 ,opyright 9irtual :niversity of ;aistan 2JF
The above is the cash budget for a firm for a period of four months with the most important
items. >e have forecasted the cash in the form of cash receipts from sales and in the form of cash
payments for e!penses. Shortfall or negative balance tells you how much Short-term "inancing is
re(uired to fill the gap.
Ca#& Management /olicie#$
A Intere#t9a#e* /olic( 7Minimi6e Ca#& &ol*ing# 3&en Intere#t rate# are :ig&8
$ >hen Interest =ates are high, the -pportunity ,ost of eeping capital in form of ,ash
.generating zero returns/ is higher.
$ Try to mae ,ollections (uicly and eep as much cash as possible in profit-earning
#aretable securities and Investments in ;ro0ects
A Ca#& Flo3 +(nc&roni6ation /olic(
$ :se )6illing ,ycles* to time the ,ash -utflows 0ust after the ,ash Inflows
$ +!ample1 Salaries paid on 4rd of +very #onth. +lectricity 6ill paid on the 2Cth of
+very #onth. Aim for ,ash ,ollections on the 2st and 2Ith of every month 0ust few
days before ,ash -utflows.
A +.ee* ). Ca#& Collection /olic(
$ 6usiness ,ompetition forces firms to Sell on ,=+DIT but that leads to ;roblems in
=+,-9+=R of =eceivables .i.e. 6ad Debts and >rite offs/.
$ ,ollection Staff, @etters, ,ollection Agency
$ :se Technology1 +lectronic >ire Transfer, Automatic Debit, ,redit ,ards
A Float /olic( 7=ee. Trac4 o, C&e2)e# Clearance8
$ Taes 2-3 days in ;aistan for che(ue to turn into cash in your account from the date of
deposit.
$ Aim to mae your own ,he(ue ,learing process (uicer .minimize your ,ollections
"loat/ than your Supplier7s. That way, you will encash che(ues before others can
encash yours.
$ So, you will have a ;ositive <et "loat in your 6an account. This cash can be used for
emergency e!penses.
8 ,opyright 9irtual :niversity of ;aistan 2JI
Lesson 40
CA+: MANAGEMENT AND %OR=ING CA/ITAL FINANCING
Learning O!ecti"e#$
Ca#& Management -
%or4ing Ca.ital Financing
Ca#& Di"i*en* /a(o)t Deci#ion$
A @in between Dividend ;olicy ' ,ash #anagement $ ,ash Dividends are paid out of ,ashU
A ,ash is an idle asset that do not generate any return for the company
A ?ow should firm decide to pay ,ash Dividend based on Its Impact on Share ;rice and "irm7s
9alueP
A Gor*on1# Form)la$
Dividend policy issue of the company can be seen through Bordon7s "ormula.
$ ;o .Share ;rice/ T DI92 & .r
+
$ g/
T +;S ! .DI92&+;S/ & .r
+
$ .;
b
! =-+//.
DI92 T "orecasted dividend in the ne!t year
r
+
T =e(uired rate of return on e(uity
g T Browth rate in dividends
;
b
T

;lough bac ratio
The two criteria that can help to decide about dividend are =-+ and r
+
.
A =-+ is financial accounting measure of the firm7s ability to internally generate a return. r
+
is the return that the firm7s shareholders =+V:I=+. "irms try to eep =-+ ?IB?+= than
r
+
.
A If =-+ f r
+
then firm is not generating enough return to meet shareholder re(uirements so it
is better to payout the dividend. @ower =-+ means company is not finding sufficient
pro0ects to generate enough return higher than rate of return on e(uity.
A If firm maes Dividend payout, in this case, share price ;o .and "irm 9alue/ will =IS+ as
dividend announcement has positive impact on company7s share price.
A If =-+ c r
+
then firm is better off to ;lough the =etained +arnings bac into the business
and investing in ;ositive <;9 ;ro0ects or the "irm7s core business. In this case, company
is generating higher return than the return shareholders re(uire, so the best use of internally
generated retained earnings is to use them as a cheap source of capital or financing.
A In this case of =-+ c r
+
if firm maes Dividend payout, share price .and "irm 9alue/ ;o
will "A@@. ?ere it maes sense for the company to eep cash and invest it in investments
as company is generating positive higher returns on its pro0ects rather than paying dividend.
A If =-+ T r
+
then dividend

payment has no impact on share price of the company.
In"entor( Management$
In the last lecture we studied woring capital and cash management in detail. <ow we discuss inventory
management, another part of woring capital.
A C T(.e# o, In"entorie#$ =aw #aterial, >or in ;rocess, "inished Boods
A I##)e# to Con#i*er in In"entor( Management$
$ Inventory is ac(uired 6+"-=+ sales so estimates must be accurate. +-V .+conomic -rder
Vuantity/ difficult to estimate otherwise1
A +&ort,all in Inventories1 interruptions in production and loss or sales orders
A +)r.l)# Inventories1 high carrying costs, wastage, and depreciation
$ ,ase of +id Time Sales1 :sing Short-term "inance or @oan to buy e!tra inventory can be =isy
because if you can7t sell it, you will be forced to sell at a Deep Discount. So sell at a loss. ,ash
tricling in 6:T =etained +arnings being wiped out. <ot enough cash to pay interest on the
loan. ;ossibly default and banruptcy.
$ Inventory ,osts1
8 ,opyright 9irtual :niversity of ;aistan 2JJ
A ,arrying ,osts .cost of capital, storage & warehouse rent, insurance premium, wastage/
as high as 3D $ 4D E of Inventory valueU
A Shipping ,osts1 Benerally @ess than IE of Inventory valueU
A ,ost of =unning Short @oss of sales, customers, and goodwill difficult to estimate.
A In"entor( Management /olicie#$
$ Tec&nolog( 0a#e*$ Dynamic Systems $ not only Static +-V Software for inventory but
Dynamic ,omputer Software that considers :sage Browth =ates. #=; .#aterial =esource
;lanning/ and +=; .+conomic =esource ;lanning/ Software.
$ ;IT1 Nust in Time. Developed by Toyota. Supplies arrive 0ust a few hours before they are
used. Inventory and >oring ,apital is minimized. Improves overall +fficiency.
$ O)t#o)rcing1 Instead of maing all the parts yourself, buy them from outside suppliers at a
lower cost and avoid any unionism issues. +!ample1 IT Divisions of @arge American
#<,7s outsource the writing of computer software to ;aistani software houses.
Acco)nt# Recei"ale# Management$
This is another area of woring capital. Accounts receivables are created out of credit sales.
A #ost firms would prefer to sell for ,ash 6:T ,ompetition forces them to sell on ,redit.
+!ample1 "abric trading in ;aistan where sellers offer 2 to 4 months credit .and even longer/.
A Acco)nt Recei"ale#
T ,redit Sales per day ! Average <umber of Days of ,redit
$ +!ample1
Account =eceivables
T=s.2DDDD & day ! 4D days
T=s.4DDDDD of fabric )Stuc in the maret* or )In =olling* at any given time.
A A&c =eceivables .other than ;rofit portion which appears in =etained +arnings/ need to be
"inanced somehow i.e. Short-term loan, trade credit, etc.
A A&c =eceivables T Daily Sales ! A,;
$ A,; T Average ,ollection ;eriod
T weighted average days of credit. ,an be obtained from Ageing Schedule ."inancial
Accounting/
$ +!ample1 "irm maes 4DE of sales on 4D day credit and LDE on JD day credit. So
A,;
T .D.4!4D/ S .D.L!JD/
T O S F3
T I2 Days
$ Try to #inimize Average ,ollection ;eriod and daily credit sales.
Cre*it /olic($
A Factor# con#i*ere* ,or cre*it$
$ ,redit Vuality Aspect1 ;roper Assessment of ,redit-worthiness of each credit customer
.,redit Vuality/
$ #inimize Time .,redit Duration or A,;/ and 9alue .,redit Biven/
$ ,reative ,redit Terms
A Incenti"i6e C)#tomer# to .a( ca#& an* to .a( 2)ic4l(
$ )Sell on I&2D.net 4D basis*. 4D basis #eans customer must pay full cash value within 4D
days. I&2D.net means IE discount for customers who pay within 2D days. So it is an
incentive for customer to pay cash (uicly.
A Im.o#e Carr(ing C&arge on Late /a(ment#
$ +!ample1 3E late payment ,harges if bill is not paid within 4D days. #eans 3FE penal
interest per yearU +!ample1 If customer does <-T pay =s.2DDDDD bill within 2 month,
then he will have to pay =s.3DDD e!tra for every month that he is lateU
%or4ing Ca.ital Financing /olicie#$
It involves the discussion regarding how firms should finance this woring capital.
A +ale# ,l)ct)ate 3it& Nat)re o, 0)#ine##< Time< +ea#on< +tate o, Econom($
8 ,opyright 9irtual :niversity of ;aistan 2JL
$ +conomic Browth or 6oom1 ?igh inventories and ,urrent Assets
$ +conomic =ecession1 @ow inventories and ,urrent Assets
A <ever drop to zero because always need minimal );ermanent ,urrent Assets.*
A Total A##et# E Fi5e* F /ermanent C)rrent F Tem.orar( C)rrent>
$ Total assets steadily grow with life of healthy company.
$ Temporary ,urrent Assets fluctuate with time. +!tra Spontaneous Inventory can be
financed by short-term debt financing or loan
A C /olicie# ,or %or4ing Ca.ital Financing 7a#e* on Mat)rit( Matc&ing /rinci.le8
$ Aggre##i"e
A #a!imum Short-term financing at low cost .but ris of non-renewal of loan/
A :se short-term financing for Temporary ,urrent Assets and even partly to buy
;ermanent ,urrent Inventory
$ Con#er"ati"e
A #a!imum @ong-term financing. Safe but higher interest costs.
A :se long-term financing for "i!ed Assets, entire ;ermanent Assets, and even
part of Temporary ,urrent Assets
$ Mo*erate
A 6alance of @ong and Short-term "inancing.
A @ong Term "inancing for "i!ed and ;ermanent ,urrent Assets. :se Short
Term "inancing for ;ermanent ,urrent Assets. :se Spontaneous ,urrent
@iability "inancing for Temporary ,urrent Assets
A A*"antage# o, +&ort Term Det or Loan
$ Speed of getting finance as they are short run
$ "le!ibility .not loced in/
$ @ower Interest =ates .generally :pward Sloping or <ormal Rield ,urve/
A Di#a*"antage o, +&ort Term Det is that cost of debt is uncertain and variable in long run.
<on-renewable.
Gra.&ical Vie3 o, Financing Mat)rit( Matc&ing /rinci.le Matc& t&e Mat)rit( o, Financing to
U#age o, A##et$
!raphical "ie# of Financing
Baturit Batching 0rinciple
Batch the Baturit of Financing to :sage of Asset
F4ED )SS;S F
Dsage 1ore than 1 Year
G"+1)NN;H CD++N; )SS;S
F Dsage 1ore than 1 Year
;1"7+)+Y CD++N; )SS;S F
Dsage 2ess than 1 Year
;ime &1onths(
#alue &+upees(
Spontaneous
Current
Liabilities &
Short Term
Financing
Short Term
Financing
& Long
Term
Financing
Long Term
Debt &
Equity
"irms generally pursue moderate policy of financing. 6asic logic behind this is #AT:=ITR
#AT,?I<B ;=I<,I;@+.
8 ,opyright 9irtual :niversity of ;aistan 2JC
Lesson 41
+:ORT TERM FINANCING< LONG TERM FINANCING AND LEA+E FINANCING
Learning O!ecti"e#$
topics1
Financing 7+&ort Term an* Long Term Financing8
Lea#e Financing
In this lecture we shall continue our discussion of woring capital financing and will discuss financing,
short and long term financing and lease financing.
%or4ing Ca.ital Financing$
A "inancial #anagers spend #ore than IDE of their time on >oring ,apital "inancing. This has
been observed in many companies. In other words, arrangement for funds to meet day-to-day
e!penses lie inventory, raw material supplies and miscellaneous e!penses has great significance.
A +o)rce# o, Financing
$ /ermanent Financing$
;ermanent "inancing comes in two forms1
A @ong-term @oans & 6onds $ Duration of this source is #ore Than 2 Rear. It has
@ow =is for "irm but has ?igh ,ost
A ,ommon +(uity & Stoc - );erpetual.* 6y definition. @ess =is for "irm but
?ighest ,ost.
=ecall here concepts of cost of debt and cost of e(uity we studied in capital structure to
decide which source of financing is better for firm and whyP.
$ Tem.orar( Financing$
Temporary financing also has two forms1
A Short-term @oan .An e!ample of woring capital financing/ $ Duration of this
source is @ess Than 2 Rear i.e. 4 months, J months, O months, etc. +asier to obtain
than @ong-term @oan as for long term loans many re(uirements lie financial
statements and guarantees need to be fulfilled. @ess costly than @ong-term @oan
due to lower interest rate generally. 6ut this interest costs is variable & uncertain as
you have to renew it each time and you are not sure whether you will get the same
lower interest rate as before. So #ore risy. <eeds to be rolled over fre(uently so it
is less li(uid.
A Spontaneous "inancing - ,urrent @iabilities lie Trade ,redit and Accrued Ta!es
.payable/ and >ages payable form its base. Arise )Spontaneously* from day-to-day
operations. It is in the form of money you have to pay but have not paid yet to your
suppliers. It is free loan or credit on which you do not have to pay any interest. As
you do not now the amount of money you will have and when, there is ?ighest
:ncertainty & =is. It has @east ,ost .can be freeU/. 6ut you cannot depend on it for
day-to-day e!penses as this all is 0ust your rough idea. Rou are not sure.
A Tra*eo,, et3een Li2)i*it( 7Ri#48 - /ro,itailit( 7Ret)rn8
$ ?igh ,urrent Assets means ?igh @i(uidity but @ow ;rofitability. This is due to more
money tied in current assets that have low profitability.
$ @ow ,urrent Assets means ?igh ;rofitability but ?igh =is. This is due to money tied
in fi!ed assets may not be available for payments as they come due.
$ ?igh @ong-term Debt means @ow =is of illi(uidity but ?igh ,ost of Debt in form of
interest.
$ ?igh ,urrent @iabilities .or short-term Spontaneous "inancing lie Trade Debt/ means
@ow ,ost but ?igh =is of illi(uidity.
8 ,opyright 9irtual :niversity of ;aistan 2JO
!raphical "ie# of Financing
Baturit Batching 0rinciple
Batch the Baturit of Financing to :sage of Asset
F4ED )SS;S F
Dsage 1ore than 1 Year
G"+1)NN;H CD++N; )SS;S
F Dsage 1ore than 1 Year
;1"7+)+Y CD++N; )SS;S F
Dsage 2ess than 1 Year
;ime &1onths(
#alue &+upees(
Spontaneous
Current
Liabilities &
Short Term
Financing
Short Term
Financing
& Long
Term
Financing
Long Term
Debt &
Equity
If a firm uses long term financing it has higher cost of financing comparatively due to high
interest cost of long term loans. Despite of this high cost you have low ris here due to surety of access
to money for a longer period. ,urrent liabilities as a source of financing are not reliable as you have no
surety whether you will have same amount of money available ne!t month for financing or less amount
of money or how much money. Also, if firm eeps continue this practice and do not pay its accounts
payable will raise so much after a period that it may go banrupt.
:o3 M)c& Li2)i*it( to =ee.'
A Keep enough @i(uidity to meet maturing short term obligations .i.e. Accounts ;ayable, Interest,
etc/ on time. ?ow much firm should eep of short term loans and how much of long term
loansP The decision is made eeping in view the following principles1
A :e*ging /rinci.le 7or /rinci.le o, +el,9Li2)i*ating Det or MATURITA MATC:ING8
$ #atch ,ash-flow characteristics of Asset being purchased with the maturity of the
Source of "inancing used to buy the asset.
A E5am.le$ Shoe Shop -wner can use ,urrent @iability to finance seasonal e!pansion in
inventory during +id Time. If he uses @ong-term financing, then e!cess & surplus & ID@+
@IV:IDITR BI9I & <- RI+@D 6:T ,-STI+= ;=-"ITS.
+id does not come each month. Shop owner needs e!tra money & inventory only for one month.
?e should tae short term loan. If he decides to tae long term loan he will have to pay for e!tra
interest cost unnecessarily.
A Another way of describing the hedging principle is ;ermanent Asset Investments should be
financed by ;ermanent "inancing. 6uy Temporary Assets through Temporary "inancing.
$ /ermanent A##et In"e#tment#$ "i!ed or #ovable or +9+< ,:==+<T assets .i.e.
Inventory/ that a firm plans to hold for c 2 Rear. The economic life of such assets can
be more or less.
$ Tem.orar( A##et#$ ,urrent Assets that will be li(uidated within 2 year. These are a
subset of current assets. "oe e!ample, inventory in use for less than 2 year.
A E5am.le$ :se @ong Term @oan to buy a long term asset. Studio owner should Do <-T use
short-term loan .f 2 Rear/ to buy a sophisticated professional Sony Digital ,amera costing
=s.2.I million which is e!pected to have an +conomic @ife of over I years and has a ;aybac
;eriod of 3 Rears. :se @ong Term @oan with #aturity over 3 Rears so that there is sufficient
time to repay interest from cash flows of asset .i.e. ,amera/.
8 ,opyright 9irtual :niversity of ;aistan 2LD
%or4ing Ca.ital Financing /olicie#$
Total Assets T "i!ed assets S ;ermanent ,urrent assets S Temporary ,urrent assets.
$ Total assets steadily grow with life of healthy company.
$ Temporary ,urrent fluctuates with time. +!tra spontaneous inventory can be financed
by short-term debt financing or loan
This will help us to understand which ind of policy should firm adopt according to the ind of
assets a firm have.
A C /olicie# o, %or4ing Ca.ital Financing 70a#e* on :e*ging /rinci.le o, Mat)rit(
Matc&ing8
$ Aggre##i"e
A #a!imum Short-term financing at low cost .but ris of non-renewal/
A :se short-term financing for Temporary ,urrent Assets and even partly to buy
;ermanent ,urrent Inventory
$ Con#er"ati"e
A #a!imum @ong-term financing. Safe but higher interest costs.
A :se long-term financing for "i!ed Assets, entire ;ermanent Assets, and even
part of Temporary ,urrent Assets
$ Mo*erate
A 6alance of @ong and Short-term "inancing. 6ased on #aturity #atching
;rinciple.
A @ong Term permanent "inancing for "i!ed assets lie land, building,
warehouse, machinery and ;ermanent ,urrent Assets only.
A Spontaneous financing or short term financing is used for short term portion of
current assets
Long9term Det Financing$
A %&at A,,ect# Financing Deci#ion# 7Factor# in,l)encing t&e c&oice o, long term ,inance (
manager#8
$ ,apital Structure1 match Actual ,apital Structure to -ptimum. )Sticy*, non-smooth,
never-ending process. It is not one day wor.
$ #aturity #atching .?edging ;rinciple/1 match maturity of debt to asset usage time
$ Interest =ates1 get long-term financing if long-term interest rates are low
$ "inancial ?ealth ' ,redit-worthiness1 get long-term financing while firm is still
healthy
A +&ort9term Det
$ 6an @oans1 #aturity period f 2 Rear. ,ollateral .security/ re(uired i.e. ;roperty,
inventory, or a&c receivables.
$ ,ommercial ;aper1 unsecured promissory note issued by large, strong firm
A Long9term Det Financing 7Mat)rit( Longer t&an 1 Aear8
The following are the forms of this loan1
$ 6an )Term @oans*1 c 2 Rear
$ 6onds1 Debentures vs. #ortgage vs. "loating =ate
$ Syndicated @oan1 for large loans, one lead ban heading team of other bans. Due to
large amount of loan one ban alone cannot tae the whole ris and liability.
$ ;ro0ect "inancing1 for large international infrastructural pro0ects i.e. +lectric power
plants, dams, development of highways. Broup of firms invest e(uity capital in a <ew
;ro0ect. 6an gives loan to <ew ;ro0ect. In return, ban is repaid from cash flows of
the <ew ;ro0ect. In fact, 6an gets the cash inflows first and then decides what to do
with themU <o other collateral or security is provided. So individual assets of each of
individual firms is free. So ban protects itself by eeping control of all the cash flows.
$ Securitization1 convert private debt contract into publicly traded financial instrument. A
large loan can be divided into smaller parts that are traded in the money marets.
8 ,opyright 9irtual :niversity of ;aistan 2L2
Lea#e Financing
A Lea#ing o, Fi5e* A##et# 7Financing o, Ca.ital E5.en*it)re in Fi5e* A##et#8
$ @easing ,ompany .@essor/ buys and owns the asset and leases it to the @essee
.6orrower/ who can use, operate, and control the asset. @essee pays @ease =ental to
@essor in return. @ifespan of lease can vary from few days to years.
$ @ie ,ollateralized @oan .where the leased asset is the collateral/. @ease ,ontract is
0ust as serious as a loan agreement. "ailure to pay lease rental is 0ust lie failure to pay
interest. ,an banrupt the @essee .6orrower/. @essor .@ender or @easing ,ompany/ can
seize the leased asset and, if the claim is larger, also demand up to 2 year lease rental.
$ -wnership vs. ,ontrol
$ 6etween 2D-4DE of fi!ed assets owned by @arge ,ompanies are leased i.e.
>arehouses, offices, e(uipment, machinery, computers, cars, furniture, airplanesU
A General A*"antage# ,rom Le##ee1# 70orro3er ? )#er8 /oint o, Vie3
It guides towards when lease financing should be used1
$ @ess risy than investing large amount of money in fi!ed assets in a new businesses that
suffer from ,yclicality i.e. Airplanes.
$ #ore suitable for hi-tech assets that become -bsolete (uicly lie software houses
$ >hen product demand is uncertain and hence e(uipment life is uncertain.
$ @ender has to share portion of operational ris and maintenance costs e.g. I6#
Lesson 42
LEA+E FINANCING AND TA/E+ OF LEA+E FINANCING
Learning O!ecti"e#$
topics1
Lea#e Financing$
T(.e# o, Lea#e Financing$
Lea#e Financing$
A Lea#ing o, Fi5e* A##et# 7Financing o, Ca.ital E5.en*it)re8
$ @easing ,ompany .@essor/ 6uys & -wns the Asset and the @essee .6orrower/ ,ontrols,
-perates, and :ses it. @essor receives a regular and fi!ed @ease =ental. @ifespan of
lease is limited .few months to several years/.
$ It is 0ust lie a ,ollateralized @oan .where the leased asset is the collateral/. @ease
,ontract is 0ust as serious as a loan agreement. "ailure to pay lease rental is 0ust lie
failure to pay interest. ,an banrupt the @essee .6orrower/. @essor .@ender or @easing
,ompany/ can seize the leased asset and, if the claim is larger, also demand up to 2 year
lease rental.
$ The two parties of lease agreement are1
A @essor .@easing ,ompany/
A @essee
$ -wnership vs. ,ontrol1
A -wnership of the asset is with leasing company
A ,ontrol is with lessee
$ In most of the countries 2D-4DE of fi!ed assets owned by ,ompanies are leased i.e.
>arehouses, offices, e(uipment, machinery, computers, cars, furniture, airplanesU
A General A*"antage# o, Lea#ing ,rom Le##ee1# 70orro3er ? )#er8 /oint o, Vie3
It guides towards when lease financing should be used1
$ @ess risy than investing own large amount of money in e!pensive fi!ed assets in a new
businesses that suffer from ,yclicality i.e. Airplanes
$ #ore suitable for hi-tech assets that become -bsolete (uicly.
$ >hen product demand and hence e(uipment life is uncertain.
$ @ender has to share portion of operational ris and maintenance costs
T(.e# o, Lea#ing Finance$
A 19 Financial Lea#e 7or Ca.ital Lea#e8
$ ;opular form of @easing in ;aistan
$ "inancial @ease is "ully Amortized1 @essor recovers 6-T? the full 9alue of Asset
.;rincipal amount/ A<D the ;rofit .in form of interest or mar-up/. 6-T? are built
into the @ease =ental amount collected by the @essor over the lifespan of the @ease.
=ecall A#-=TIMATI-< TA6@+ for 6an @oan where ;rincipal and Interest are
recovered in e(ual regular installments.
"ully Amortized @ease means the lessor recovers the principal amount plus interest amount.
$ "inancial @ease is <-T ,ancelable1 If @essee #:ST ,ancel or Terminate the @ease
;rematurely then pays heavy penalty to @essor.
$ +!ample of "inancial @ease1 Rou need to buy a ;entium I9 computer hardware system
complete with peripherals but you don7t have enough money. Rou go to computer
hardware store and negotiate the price for the system at =s.IDDDD. Rou then contact a
leasing company to buy the computer system and lease it to you in return for a monthly
rental of say, =s.IDDD per month. After one year, if you have paid all the lease rentals
on time, the @easing ,ompany will transfer the -wnership to you.
$ A*"antage o, Financial Lea#e ,or Le##ee$
A If factory needs to buy new machine urgently and does <-T have enough
finances.
A @eased Assets .and lease liabilities/ can sometimes be treated -"" T?+
6A@A<,+ S?++T IT+#S. Accounting Standards .i.e. "AS6 :SA/ in some
countries restrict this so generally speaing, @ease D-+S affect D+6T =ATI-
' ,apital Structure in similar way as @oan on 6alance Sheet.
A If ,ompany can <-T 0ustify an increase in Assets on the 6alance Sheet based
on historical earnings. ,apital e!penditure in @eased Asset can be )+!pensed*
out gradually.
A @ease =ental is a TAY-D+D:,TI6@+ +Y;+<S+ 0ust lie interest payments.
A As long as I== from leased e(uipment is higher than cost of lease financing.
A 29 O.erating Lea#e 7or +er"ice Lea#e8
$ -perating @ease offers "inancing A<D #AI<T+<A<,+1 often the @essor is the
Supplier & 9endor of the Asset i.e. I6#
$ -perating @ease is <-T ":@@R A#-=TIM+D A<D IS ,A<,+@@A6@+
A +!ample1 ,ar rental company .@essor/ charges you =s.2DDD per day for renting
out a new ?onda ,ivic with driver. Rou can lease the car for 3 days. Rou will
pay the @essor =s.3DDD. 6:T, the value of the car might be =s.2 million.
@essor does <-T e!pect you to pay that entire amount for using the car for 0ust
3 days. The car rental company will service and maintain the car in good
condition so it can rent it out to other people. This way, they can recover the
value of the car from 2DDD days of lease rent .T value & daily rental T 2,DDD,DDD
& 2DDD/UU This is the ;aybac ;eriod .without taing their maintenance costs
and profit margin/. Rou can ,ancel the lease and return the car after 2 day.
<ow you 0ust have to pay =s.2DDD.
$ -ther +!amples of -perating @ease1 I6# for ,omputer ?ardware, 6oeing for
Airplanes
6y not fully amortizing operating lease means the leasing company does not e!pect to recover the
whole amount or value of asset from you.
C9 +ale - Lea#e90ac4
$ Sale ' @ease-6ac is the #ost Interesting @easing Scheme $ creative e!tension of
"inancial @ease where the Seller of the asset is the :ser-lessee. :ser sells his asset to
@easing ,ompany in return for lump-sum cash and then repays the @easing ,ompany in
form of @ease =entals over a period of time to buy-bac the asset. It is considered to be
a creative way of mobilizing your asset to raise debt.
$ +!ample of Sale ' @ease-6ac1 Rou need =s.4DDDDD to start a business and all you
own is a car. >hat can you doP Bo to @easing ,ompany. As them to buy your car for
=s.4DDDDD and then lease it bac to you for 2 yearUUU This way, the @easing ,ompany
will tae ownership of the car and give you =s.4DDDDD cash to start your business.
,ompany has bought the car and you can start business from the cash you received.
Suppose you e!pect to earn =s.IDDDD per month from your business. Then you can
easily pay =s.4DDDD per month as lease rental and get your car bac in 2 year.
=emember company bought car from you for =s.4DDDDD but you will pay suppose
=s.4JDDDD bac to company at the end of period to have your car bac. =s.JDDDD is the
profit or interest or mar-up ,ompany is charging above the principal amount of
=s.4DDDDD.
Lea#e Anal(#e# - Calc)lation#$
A To 6uy or To @easeP $ That is the Vuestion. ?ere we are doing some numerical calculations
that can help us to decide whether it is better to leaseP
A Assume that the Decision to Ac(uire the Asset has already been made independently at the
,apital 6udgeting Stage .which comes first/.
A "irst value is <;9 .Similar to ,apital 6udgeting/ modified to <A@ for @easing Analysis
8 ,opyright 9irtual :niversity of ;aistan 2LF
$ <A@ T <et Advantage of @easing T ;9 .,ost of -wning Asset/ $ ;9 .,ost of
@easing/. If <A@ cD then @easing is 6etter than 6uying.
A Co#t o, O3ning A##et$ ,ost of -wning includes following ,ash "lows1 Initial
investment Io, yearly maintenance and service costs, yearly depreciation ta!
savings, replacement or the salvage value of the asset at the end of its life and
"inal net residual value .after any ta!/.
A Co#t o, Lea#ing includes following ,ash "lows1 Rearly @ease =entals, Rearly
Ta! Savings associated with @ease =entals
A Discount =ate )r*1 Benerate ,ash "low forecasts for life of asset. ,ash "lows
are (uite "IY+D A<D ,+=TAI< so use a @-> DIS,-:<T =AT+ T r T
mar-up rate on ban loan -= use =is "ree =ate of =eturn T r
="
T T-bill
Interest rate. If ,ompany is running in operation then use actual average cost of
Debt.
A IRR 7+imilar to Ca.ital 0)*geting8
$ Set the <A@ T D and solve for the Discount =ate )r* using Trial and +rror or Iteration.
This gives us the value of I==.
A #ost commonly used criterion $ I== E can simply be compared to mar-up E
on ban loans and also to the maret rate of interest and inflation rate.
A If I== f interest rate on loan then leasing is better than buying
Lea#e Anal(#i# 7%ACC8$
A >A,, .,apital Structuring ,riterion/
$ >A,, T r
D
!
D
S r
+
!
+
.where r
D
is A"T+=-TAY ,ost of Debt/. @ease I== E affects
the )r
D
* After Ta! ,ost of Debt. >A,, can be used as the Discount =ate )r* in <;9
calculations in ,apital 6udgeting.
$ ;ractically speaing, corporate financing and capital structure have feedbac effect on
capital budgeting decision. This means that capital budgeting raning of pro0ects may
have to be revised taing into account the cost of debt .or leasing/. The effect is minor
because pro0ects are selected based on strategic value and operational efficiency and not
0ust minor differences in <;9. -f course, feedbac effect goes entirely against mm
theory which is for ideal, efficient marets.
A @easing .and financing decisions in general/ can .very rarely/ have a
"++D6A,K +""+,T on ,apital 6udgeting Decisions. Suppose that you had
to choose one of 4 possible pro0ects and you piced ;ro0ect A based at the
,apital 6udgeting Stage .based on <;9/. #any wees later, you begin to
decide where to raise the money and ?-> T- "I<A<,+ ;ro0ect A. Rou
need to tae a ban loan at 2IE pa interest. Rou realize now that another
;ro0ect 6 .which had been re0ected at the ,apital 6udgeting Stage/ uses
e(uipment that can be @+AS+D at a lower cost .say 24E/. <ow, you had done
the ,apital 6udgeting e!ercise using your company7s >A,, as the discount
rate in the <;9 calculation. That >A,, used the company7s actual interest
cost on ban loans as the after-ta! cost of debt. 6ut, since ;ro0ect , can use the
cheaper @ease "inancing, you should =+-,A@,:@AT+ its <;9 using the
,ost of @ease .i.e. I==/ as the discount rate. This case is rare and the difference
of a few percentage points in the cost of debt should not change a fundamental
decision based on cash-flows, operational effectiveness, and overall strategic
advantage of investing in a pro0ect which are considered at the ,apital
6udgeting Stage.
8 ,opyright 9irtual :niversity of ;aistan 2LI
Lesson 43
MERGER+ AND ACDUI+ITION+
Learning O!ecti"e#$
Merger# - Ac2)i#ition# 7M-A8
Merger# - Ac2)i#ition# 7M-A8$
A The buying ' selling of entire firms or divisions of firms is a specialized art in finance.
A >hy firms #ergeP
$ Diversification1
A =educe =is and Stabilize +arnings, attain +conomies of Scale
A Achieve @ong Term Strategic Boals, Bain @arger #aret Share and Vuic
Browth in size,
$ Improving "inancials1 (uic way to improve the 6alance Sheet and ,ash "lows
$ "ind ,ash1 if another firm has large cash flows, cash reserves or li(uid assets
A ,herry ;icing1 It means when #aret 9alue of another similar firm is less
than cost of replacing your own assets it might be better to buy another firm
A Asset Stripping1 separate out the non-profitable and sell its assets individually
to generate cash and restore profitability
$ Agency ,ost1 Desire of #anagers for ;restige, ;ower, and Salary sometimes at e!pense
of Shareholders .-wners/
A >inning #anagement ,ontrol .e!ercise influence on 6oard/. #anager
Salaries =ise .larger firm, Agency ,osts/. "ear of @osing Nob if Taen -ver by
=ival "irm.
A ?ow do you pay for .or finance/ buying a "irmP
$ ,ash, Stoc or Shares, 6an 6orrowing or Debt .@6-7s/ or ,ombination
A )#erger* >hen 3 or more "irms combine to form 2 "irm.
A 6enefit of #erger Synergy1
3S3 T IU
It means value of a combined firm after merger is more than the firms7 value individually before
the merger
A 3 6road ,ategories of #ergers1
A ;ure "inancial #erger - -perations remain independent
A -perating #erger - -perations are Integrated ' ,hanged ' Synergies
+!pected
A F Specific Types of #ergers1
A ?orizontal #erger1 merger of 3 competitors - can lead to #onopoly
A 9ertical #erger1 merger of a supplier with a buyer
A ,o generic #erger1 merger of firms in same industry
A ,onglomerate #erger1 merger of firms in unrelated industries
A )Ac(uisition*1 #ost common form of #erger.
A >hen a "irm buys another "irm. This ac(uisition ,an be P:o#tileQ Rai* or )"riendly*
A The firm that ac(uires the other firm is nown as ac(uirer firm but the firm which is ac(uired is
nown as Target firm
A )Divestiture* T =everse #erger. 6enefit of +fficient =eallocation of =esources1
I - 2 T IU
It means by selling an inefficient or unproductive unit of the company you can have more value
as it saves costs
A )Sell off* - Sale .transfer -wnership/ of a Division of a "irm
A )Spin off* - transfer #anagement ,ontrol of a Division of a "irm
A )@i(uidation* - Sale of assets to pay off Shareholders
Merger I##)e# - Reg)lation#$
A Mono.ol( 7Concentration o, /o3er an* Mar4et +&are8
$ ?orizontal or 9ertical #erger of 3 giants.
8 ,opyright 9irtual :niversity of ;aistan 2LJ
$ @aws vary from country to country i.e. Anti-Trust @aws
A :o#tile Ac2)i#ition# 7or Ta4eo"er#8 ( Cor.orate Rai*er#
$ 3 6asic >ays of ?ostile Taeovers1
A ,anvassing general public shareholders for their ;ro!y 9otes
A @imited-time Share Tender -ffer by =aider at share price above the maret
,orporate raiders urge the shareholders to buy their shares.
$ :o3 Target Firm can Re#.on* to :o#tile Rai*
A /oi#on /ill $ Target "irm taes on e!cessive short-term debt to appear
unhealthy. 6ecause of high liabilities their balance sheet becomes unattractive.
A %&ite =nig&t $ a wealthy friendly investor who protects the Target "irm by
maing higher counter-tender offer against the corporate =aider.
A Fig&t 0ac41 Target "irm maes counter-tender offer to shareholders
A 0e Ac2)ire* .if =aider is offering much higher value than "irm is worth/
$ Target "irm need protection under law $ Shareholders might lose ownership and
+mployees might lose their 0obs.
Le"erage* 0)(9O)t# 7L0O1#8$
A #echanism of @everaged 6uy--uts .@6-7s/ using Debt "inancing1 Ac(uiring "irm borrows a
lot of money .from Debt Investors/ to buy the shares of another publicly traded Target "irm.
The ;ublic "irm thus becomes );rivatized* in the hands of fewer shareholders and it also means
less administrative costs. It then sells assets .Asset Stripping/ of the Target to mae immediate
interest payments. If "irm runs into difficulty, then can raise more money by selling its own
Nun 6onds. After =estructuring, ,ost ,utting, and Down-Sizing, the firm .now financially
stronger/ again goes ;ublic giving opportunity for its staeholders and deal-maers and
Investment 6an Advisers to recover their Investment and en cash ,apital Bains.
A /o##ile A*"antage# o, L0O$ Debt increases Ta! Shield Savings, @everage can improve
=-+, and forces cost cutting measures by #anagement
A #anagement 6uyouts ' )Boing ;rivate*1 A type of @6-. #anagement buys all or most of
publicly held shares of their own firm and effectively converts public firm into a privately held
one.
Merger# 9 Goo* or 0a*'
A Impact of #ergers on #aret, Shareholder, ' +mployees
$ Temporary Increase in Stoc ;rice because of competing Tender -ffers by 6uyer.
>rong signals distort maret prices.
$ Target "irms forced to tae Drastic #easures to defend themselves i.e. ;oison ;ills.
>aste of "irm7s resources and 9alue.
$ #ergers often followed by ,ost ,utting, Streamlining which can improve -perational
+fficiency ' Add Synergy. 6:T, Down-sizing of +mployees or Nob ,uts can lead to
serious social problem
N)merical Val)ation o, a Target Firm Merger Anal(#i# - Val)ation$
A 2 0a#ic A..roac&e# to Merger# Anal(#i# an* Val)ation
$ Discounted ,ash "lows .D,"/
$ #aret #ultiple Analysis .##A/
A Di#co)nte* Ca#& Flo3# 7DCF8 )#e# N/V$ %e )#e* in Ca.ital 0)*geting
o +stimate ;ost #erger ;erforma ."orecasted/ <et After-Ta! Incremental ,ash "lows
.,"7s/ of Target "irm for I Rrs or more. Account for ;ost $ #erger ,hange in
-perations impact on incremental ,ash "lows.
o :se -ld ;resent 9alue +(uation1
;9 T ,"2 & .2Sr/ S ,"3 & .2Sr/
3
S ,"4 & .2Sr/
4
S...
o Discount =ate .r/ or ,ost of ,apital for ;rospective Investors .i.e. Shareholders of the
Ac(uiring "irm i.e. r
+@
/ so focus on +(uity 9alue of Target "irm .not Total 9alue/
8 ,opyright 9irtual :niversity of ;aistan 2LL
:se ,A;# Theory & S#@ to estimate r
+
.=e(uired =eturn on +(uity for
Shareholders/ from 6eta .or =elative #aret =is/ of Target "irm. Then r
+,@
T
r
="
S .r
#
- r
="
/ ! 6eta
@
.
<ote that 6eta
@
T 6eta
:
W2 S .2-Tc/ .D&+/X
Tc T corporate ta! rate
D T Debt
+ T +(uity
N)merical Val)ation o, Target Firm Mar4et M)lti.le Anal(#i# 7MMA8$
A #aret #ultiple Analysis .##A/ Approach to #erger 9aluation is the most commonly used
because it is (uic ' easy. Appro!imate "ormulas and Ad-hoc =ules of Thumb that change
with different Industries and change with Time depending on #acroeconomic ,onditions in
country
A +!ample of #aret #ultiples used in ;aistan1
$ +stablished 6rand and "inancially ?ealthy Te!tile Spinning #ill1
"irm 9alue T 2D ! Annual <et Income .or +arnings/
The figure 2D comes from stoc maret reports analysis.
6ased on ,urrent Average ;&+ #ultiple for Te!tile Spinning Sector T Average #aret ;rice of
Share & Average +;S T 2D.D
$ "inancially Strong -perational Software ?ouse1
"irm 9alue T L ! Annual Sales
$ -perational #obile ;hone ,ompany1
"irm 9alue T =s.2DDDDD ! <umber of ,onnections
$ 9alue of ;roperty in ;aistan T 2D ! Annual =ental Income
Im.act o, Merger /rice on Val)e o, t&e Firm$
A Im.act o, Merger /rice on Val)e o, Ac2)iring Firm$
$ If <egotiated ;rice for Target "irm c "air ;rice .or D," 9alue +stimate/ for Target
"irm then Ac(uiring "irm7s Shareholders will @ose 9alue.
It is so as shareholders are paying more than the fair worth of the target company.
A Im.act o, Merger /rice on Val)e o, Target Firm$
$ If <egotiated ;rice per share of target firm c #aret ;rice of Target "irm7s share in
Stoc +!change then Target "irm7s Shareholders will Bain 9alue
Shareholders are being paid price much higher than firm worth.
8 ,opyright 9irtual :niversity of ;aistan 2LC
Lesson 44
INTERNATIONAL FINANCE 7MULTINATIONAL FINANCE8
Learning O!ecti"e#$
topics1
International Finance 7M)ltinational Finance8
In the lecture we shall cover three areas of International "inance1
#ultinational "inance
Impact of Blobalization and International "inance on different areas of financial management
lie capital budgeting, capital structure and ,apital asset pricing model
"oreign +!change ."&!/
"irst we discuss the first area of #ultinational "inance.
I##)e# o, International Finance$
A All Finance &a# ecome International
$ "inancial #arets .#oney and ,apital #arets/ of all countries are @ined by hi-speed
telecom satellite lins, computer, and Internet
$ 6utterfly +ffect $ )>hen <ew Ror Stoc +!change Sneezes, the Toyo Stoc
+!change catches a cold*. It e!plains the impact of capital marets that are lined all
over the world. As all the financial marets over the world are lined due to
international flow of money and international trade and transactions. So any change in
one part of the world has its affects on the other part of the world.
A All Firm# a,,ecte* ( International Factor#
$ +ven 2DDE Domestic "irm is affected by International "inance because it competes
with Importers and "oreign "ranchises substitutes and competing products whose prices
change with "oreign +!change =ate.
A 2 F)n*amental Flo3# Determine a Co)ntr(1# Foreign E5c&ange Rate
$ International "low or Trade of =eal ;hysical Boods1
Trade Surplus & Deficit T Imports - +!ports
$ International "low of ,apital or #oney $ 6alance of ;ayments .6-;/
T ,urrent Account S ,apital Account S "oreign +!change =eserves. C)rrent
Acco)nt includes Trade of Boods and Services.
Ca.ital Acco)nt measures ,apital coming in ."DI and ;ortfolio Investment/ and
Boing -ut.
$ Domestic #acroeconomic "actors affecting "oreign +!change1
2/ Inflation
3/ "iscal Deficit .if government e!penditures e!ceed their revenues through ta!es etc./
%&( *o M)ltinational# Do 0)#ine## Internationall('
$ To +!pand #aret Share1 :SA and +: are about k 2D Trillion +conomies +ach. And
each has about 4DD million people.
$ Bet ,loser to +nd :sers & ,onsumers i.e. Toyota of Napan in :SA
$ @ower ;roduction ,osts, Shipping ,osts, =aw #aterial ,osts i.e. 6ritish 6AT Tobacco
in <>";, :nion Te!as in 6adin
$ 6ypass Trade 6arriers and Import Tariffs i.e. ;aistanis set up te!tile units in Srilana,
:A+ and #e!ico to legally bypass :S Te!tile (uota for e!ports from ;aistan.
$ Diversify and =educe Sovereign .,ountry-Specific ;olitical/ =is
A ;ortfolio of Subsidiary ,ompanies, Divisions, ;ro0ects, Investments diversified
across different countries can reduce the Sovereign .or ,ountry-Specific
;olitical/ =is
A #anage "oreign +!change =ate +!posure. If your home currency is very wea
or Depreciating .because of Inflation, Deficits, ;olitical Turmoil etc. / then
invest abroad
A Tae advantage of @ower ,osts of Debt .interest rates/ in foreign countries or
lower Ta!es.
8 ,opyright 9irtual :niversity of ;aistan 2LO
Ma!or I##)e# Face* ( M)ltinational#$
$ "oreign +!change =is i.e. Turish @ira, =ussian =uble. ,aused by :ne!pectedly high
Inflation, Deficits, and ;olitical Turmoil etc.
$ Sovereign and ;olitical =is i.e. South Africa, Afghanistan, =wanda - ris of >ar, ,ivil
:nrest
$ Different @aws 6usiness ,ontract, ;roperty, ,ompanies, ,apital "low ' Different Ta!
=ates, Different Bovernment Involvement, and Different #aturity of "inancial #arets
A Saudi Arabia .=estricted property rights/
A :SA .strict #onopoly laws/ vs. 6ahamas .@enient @aws and Ta!/
A Napan .#ITI supports Napanese e!porters abroad/
$ Different ,ultures, ,ustomer Awareness about their rights and Vuality Standards,
,redit ,ultures, and 6usiness ;ractices and +thics
A Napanese Kereitsu .6an is 6usiness ;artner and Shareholder/ so in Napan large
companies lie Sony have large of debt in their capital.
A Korean ,haebols .,onglomerates with #onopoly power/
A Berman ,onsumer Standards
A 6usiness +thics i.e. <igeria vs. Singapore
A ,entral Asia .6arter economy and @ong ,redit ,ycle/
<ow we move to the second area of today discussion1
International Financial Management$
A International Di"er#i,ication
$ 6runo $ Solni1 These two persons analyzed I<T+=<ATI-<A@ ;ortfolio of 3D Stocs
has ?A@" as much ris as same portfolio containing stocs of 0ust 2 country.
A International CA/M Mo*el ,or Integrate* Gloal Mar4et
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- r
="
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$ r
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is the >-=@D #A=K+T =e(uired =ate of =eturn e!pected by all investors all
over the world
$ Assets are priced in @-,A@ .or S+B#+<T+D/ #A=K+TS so if an Investor can
diversify internationally, then he may attain =ISK-=+T:=< above the @ocal #aret
,apital #aret @ine.
$ Blobal +fficient "rontier .for Investment in >orld #arets/ offers higher =is-=eturn
combinations than @ocal Segmented #aret +fficient "rontier.
8 ,opyright 9irtual :niversity of ;aistan 2CD
Gloal In"e#ting Ma4e# t&e E,,icient Frontier an* t&e
CML 7Ca.ital Mar4et Line8 Ri#e U.
:ig&er Ret)rn ,or +ame Le"el o, Ri#4
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A International Cor.orate Financing
$ =aise capital in the country where you can get the best price and yield.
$ +uro e(uities +!ample AD=7s .American Depository receipts/1 <on-:S firms can be
listed and traded on the <ASDAV Stoc +!change in :SA. So ;aistani firms can
raise e(uity capital in America. "oreign firms can also be listed on @u!embourg stoc
e!change to raise +(uity capital in +uro currency.
$ +urobonds1 ,urrency of bond issue is different from the country of issue. +!ample1
;aistani company selling :Sk-denominated 6onds in @u!embourg can raise Debt
capital in +uro currency.
A International Ca.ital 0)*geting
;9 T ," 2 & .2Sr/ S ," 3 & .2Sr/
2
F ," 4 & .2Sr/
C
F U
$ ," or ,ash "lows in foreign countries need to be converted into the ?ome ,urrency of
the Investor .or country where ?ead -ffice is located/.
A Transfer ;ricing, =oyalties, and "oreign ,ountry7s Inflation affect forecast of
cash flows
A -pportunity ,ost of "oreign "unds 6loced because of =emittance =estriction
A Different ta!es in different countries. Ta! on =emitted Income.
$ Discount rate )r*
A Discount the foreign cash flows in the nominal foreign currency discount rate.
Then convert the ;9 in foreign currency to home currency.
A :se ?igh Discount =ate if ?igh @evel of ,ountry - specific ;olitical or
Sovereign =is
A Impact of ,oncessionary "inancing can affect choice of )r*
A International Acco)nting +tan*ar*#
$ ;rofit ' @oss Statement .or Income Statement/ $ ,onvert foreign e!penses and
revenues at the A9+=AB+ "&! =ate prevailing during the Accounting ;eriod.
$ 6alance Sheet $ "oreign "IY+D .<on-"inancial/ Asset values converted at
?IST-=I,A@ "&! =ate prevailing at the time of purchase. 6ut, "oreign "I<A<,IA@
Assets converted at A9+=AB+ "&! =ate prevailing during the Accounting ;eriod.
Foreign E5c&ange Rate$
8 ,opyright 9irtual :niversity of ;aistan 2C2
A ,urrencies, lie Boods, are bought and sold in marets. The price of a currency increases if the
financial, economic, and political health of that ,ountry becomes stronger. @ie price of cotton
from ;aistan which is different from ,hina and +gypt and changes with (uality and
Supply&Demand.
A ,urrencies or "&! are traded in International "&! #arets which is the largest "inancial #aret
of all with trading in Trillions of Dollars. 6ans, "irms, and Individuals can trade in 9irtual
+lectronic "&! #arets from their computer 3F-hours a day. "&! rates are changing every
secondU
A The Demand & Supply of "&! affect the 9alue of the ,urrency.
A 4 "&! #arets1
$ "&! Spot #aret 1 ),urrent* e!change rate for Delivery within 3 Days
$ "&! "orwards #aret1 #ae contract today for Delivery in future. "orward ;rice
Determined by Interest =ate Rield ,urve and Spot =ate. ,ontract size and delivery
date negotiated privately with bans.
$ "&! "utures #aret1 Derivative securities whose value is derived from "orward prices
and )#ar-to-maret* ris premium for meeting minimum balance in #argin Account
for trading. Tradable in +!changes because of Standardized contract size and fi!ed
future delivery dates.
$ "&! -ptions #aret1 Derivative securities. Spot -ption values derived from Spot "&!
=ate. "uture -ption values derived from "utures "&! =ate. -ptions .unlie "orwards
and "utures/ are not obligations. It is cheaper to buy an -ption to buy a house than to
buy the houseU Same for "&!. Also, you can decide not to buy and let the option e!pire.
A ,all -ption $ =ight to 6uy something at a fi!ed Strie ;rice for a limited time
in the future
A ;ut -ption $ =ight to Sell something at a fi!ed Strie ;rice for a limited time in
the future
A 9aluation or ;ricing of -ptions using famous 6@A,K ' S,?-@+S #-D+@
or simpler 6inomial #odel
Relation#&i. et3een Foreign E5c&ange Rate< Intere#t Rate - In,lation Rate$
A Spot "&! =ate of 3 ,ountries determined by ;rices of =eal Boods1
$ Relati"e /rice# o, +ame Goo* /)rc&a#ing /o3er /arit( T&eorem 7///8
A Spot price .=s. & :Sk/ T ;rice .;a/ & ;rice .:SA/
A +!ample1 :se ;rice of @evis Neans made in ;aistan and :SA to estimate the
theoretical Spot "&! =ate. ;rice of @evis ID2 is :SkID in :SA and =s.42DD in
;aistan so the +stimated Spot "&! =ate T S .=s. & :Sk/ T =s.42DD & :SkID T
=s.J3 & :Sk2. This is close to the actual Spot "&! rate in range of =s.ID-JD.
A <ominal Interest =ate determined by +!pected Inflation.
$ Relati"e E5.ecte* In,lation Rate# 7 g 8 Fi#c&er E,,ect
A .2S i
=s
./ & .2S i
:Sk
/ T .2S g
;a
/ & .2Sg
:SA
/
A "orward "&! =ate determined by Interest =ate Rield ,urve
$ Relati"e Intere#t Rate# 7 i 8 9 Intere#t Rate /arit( T&eorem 7IR/8
A " .=s. &:Sk/ & S .=s. &:Sk/
T .2S i
=S
/ & .2S i
:Sk
/
A +!ample1 :se 2 Rear +stimate of Interest =ates in ;aistan and :SA to
estimate the 2 Rear "orward "&! =ate. :sing Rield ,urves, you now that the
interest on 2 Rear #aturity in ;aistan is 2DE and in :SA 3E. Rou now that
the current .or Spot/ =ate is =s.JD&:Sk2. So, the 2 Rear "orward =ate
T " T S .=s. &:Sk/ .2S i =s./ & .2S i :Sk/
T .JD/ .2SD.2/ & .2SD.D3/
T =s.JF.L & :Sk2.
In other words, we have forecasted the "&! =ate after 2 Rear.
A 3 ,onventions for Vuotation of "&! =ates used by 6ans and "&! Dealers1
$ American1 :Sk & ",R i.e. :SkD.O & 2+uro .means )6id :Sk D.O & As 2 +uro*/
$ +uropean1 ",R & :Sk i.e. NR2DD & :Sk2, =s.JD & :Sk2.
$ Inverse =elationship1 +uropean T 2 & American. So, Napanese Ren .NR/ under
American ,onvention T 2 & 2DD T :SkD.D2 & 2NR. ,ommonly written as 2.DDD.
In ;aistan generally we follow +uropean convention.
A ;AI= of #aret ;rices for +very ,urrency in the "&! #aret
$ 6ID =ate T 6uying ;rice for ,urrency. +!ample1 6id =s.JD & :Sk2 #eans 6an
or #oney ,hanger will 6uy .or 6id/ one :Sk from you for =s.JD. This also means that
you .the ,ustomer/ are Selling Dollar to the 6an. 6id =s.JD & :Sk2 means 6id =sJD &
As :Sk2
$ ASK =ate T Selling ;rice for ,urrency. +!ample As =s.J2 & :Sk2 #eans 6an or
#oney ,hanger will Sell .or As/ one :Sk to you for =s.J2. This also means that you
.the ,ustomer/ are 6uying Dollar from the 6an. +!. If you are going to travel abroad
to :SA.
$ "undamental ;rinciple for "&! Traders and )#oney ,hangers*1 6uy @ow and Sell
?igh. So, ASK c 6ID =ate.
$ Standard Vuotation "ormat1 6id =ate & As =ate.
A +! 2. ):Sk JD&J2* means #oney ,hanger will 6uy 2 :Sk from you .the
customer/ for =s.JD 6:T they will Sell 2 :Sk to you for =s.J2. #eans a ;rofit
of =s.2 for every :Sk tradedU
A +!3. If you see only 2 Vuote i.e. ):Sk JD* then it generally refers to the 6id
Vuote i.e. 6id =sJD & :Sk2.
A ,ross =ates .Transitivity of "&! =ates/
$ +!ample with +ither 6id -= As =ates1 Suppose you want to convert your +uros into
:S Dollars in ;aistan and you need to estimate the +&:Sk "&! rate. #oney ,hangers
and 6ans in ;aistan show Spot "&! =ates in =upee-Terms1 =s.JD & 2:Sk and =s.II &
2+uro. Then Spot :Sk & +uro T . :Sk & =s. / ! . =s. & +uro/ T . 2:Sk & =s. JD/ !
. =sII & 2 +uro/ T :Sk D.O2JL & 2+uro
$ If you are given 6oth 6id and As =ates, then +stimate the ,ross =ate =A<B+.
A 6id +uro & As :Sk f . 6id +uro & As =s. / ! . 6id =s. & As :Sk/
A As +uro & 6id :Sk c .As +uro & 6id =s./ ! . As =s. & 6id :Sk/
Gloal In"e#tment#
Ma4e +ML 7,or E,,icient +toc4#8 Ri#e U.
?igher =eturn for Same @evel of =is
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Lesson 45
FINAL REVIE% OF ENTIRE COUR+E ON FINANCIAL MANAGEMENT>
O)tline o, G Ma!or Area# o, FM$
19 Intere#t Rate#
$ Com.o)n*ing .money grows with time/
Discrete Annual ."9T;9 .2Sr/
t
/ vs.
Discrete #ultiple & "ractional ."9 T ;9 .2S .r&m//
mn
/
)n* number of years,
)r* is the Discount =ate or -pportunity ,ost of ,apital or >A,, depending on your
perspective
)m* times a year interest is compounded
$ Di#co)nting 7or Re"er#e9Com.o)n*ing8
;9 T "9 & .2Sr/
t
$ Ann)it( an* /er.et)it(
"9 Annuity T ,," W.2Sr/
n
-2X & i. @imited time period.
;9 ;erpetuity T ,," & r.
$ Aiel* C)r"e# an* Term +tr)ct)re
A <ormal Rield ,urve is :pward Sloping. Interest =ates rise with maturity or life
of 6ond.
Geometric A"erage$
A .2 S 3Rr 6ond RT#/
T .2 S 2Rr 6ond RT# 2st year/ ! .2 S 2Rr 6ond RT# in 3nd Rear/.
A <ominal i T =eal i S Inflation S =is ;remiums .i.e. @i(uidity =is S #aturity =is
S Sovereign =is/
$ Financial +tatement# an* Ratio#
A 6alance Sheet, ;rofit and @oss Account .Income Statement/ and ,ash flow
statement
A Du;ont T ;rofit #argin ! Asset Turnover ! .Assets&+(uity/,
A #argin T <et Income&Sales
A Turnover T Sales & Assets
A Im.ortant ratio#$ =-A, =-+, +;S, ;&+, ;lough bac ;
b
, ,urrent ratio,
Debt&,apitalization, TI+
A =-A . T .<I S Interest/ & Total Assets/ and =-+ .T <I & +(uity/
A +;S .T <I & <o. of Shares -utstanding/ and ;&+ and ;lough bac .;b T g &
=-+ where )g* is Dividend growth rate E/
A ,urrent =atio .T,urrent Assets & ,urrent @iabilities/, Debt&,apitalization or
@everage =atio, TI+
8 ,opyright 9irtual :niversity of ;aistan 2CF
Copright1 B+ S+ Mumaun 5
FB 0erspective of Balance Sheet
O3n +toc4
I##)e* (
Com.an( to
Rai#e Ca#&
!raphical "ie# of
Simple* 6iscrete Compound* &
Continuous Interest - Important
CO;TI;:O:S COB0O:;6I;!
6ISC&ETE COB0O:;6I;!
SIB0>E I;TE&EST
Future "alue )F"'
in &upees
Time ).ears'
8 ,opyright 9irtual :niversity of ;aistan 2CI
.ield Curve for Bonds
Term Structure of Interest rates
)nnualiIed
4nterest +ate A
&5ond Yield(
;ime
&Years(
Now 1 Year 5 Years 10 Years
29 Ca.ital 0)*geting an* In"e#tment Deci#ion# to Ran4 /ro!ect# 9 Fi5e* a##et# +i*e o, 0alance
+&eet
$ O!ecti"e o, Financial Management$ #a!imization of Shareholders7 .-wners7/
>ealth. #a!imization of 9alue of "irm. #a!imization of 9alue of Shares of the "irm.
$ Ca#& Flo3# E ,"
T<et After Ta! Incremental ,ash "lows
T <-I S Depreciation S ,ost Savings $ +!tra Ta!es S Any Salvage 9alue
,ash "low Diagrams & Time @ine1 ,ash Inflows .:pward Arrows/
$ N/V or DCF .6est ,riterion/ $ ?ighest <;9 ;ro0ect is 6est.
<;9 uses Discount =ate
T =e(uired =-= or >A,, which can be changed for every year and varies depending
on the Investor7s =is ;rofile.
N/VE /V 9 Io
T -Io S ,"2& .2Sr/ S ,"3& .2Sr/
3
S ,"4& .2Sr/
4
S d,
"or comparison of pro0ects with :ne(ual @ives use A*!)#te* N/V
T <;9 ! +AA where +AA "actor T Wi ! .2Si/
n
& .2Si/
n
-2X
$ IRR 7T8 - ?igher I== is better. "i!ed throughout life of pro0ect,
If #ultiple I== then use .2S#I==/
n
T "9 Inflows & ;9 -utflows.
"9 T "uture 9alue and ;9 T ;resent 9alue
$ ,apital =ationing $ @imited 6udget, E 6udget :tilization

8 ,opyright 9irtual :niversity of ;aistan 2CJ
;0" $ I&& 6iagram
Com,ined :se of ;0" & I&&
to Compare 8 0roNects - Important
Discount
+ate A &r(
N"# &+s(
4++
"ro9ect )
4++
"ro9ect 5
"+7JC; ): 273+ 4++ 5D;
<46<+ N"# 5C)DS )C;D)2
GrH 4S #+Y 273>
"+7JC; 5: <46<+ 4++ 5D;
273+ N"#
)C;D)2
+e@uired
+eturn or
3)CC for
Investor
;0" A
;0" B
N"# F)#7+S "+7JC; )
S7 "+7JC; ) 4S 5;;+>
Non'Normal Cash Flo# 6iagram
1ultiple 4++ !ample
," 2 T S=s IDD
," 3 T -=s IDD
Io T - =s IDD
Rr D Rr 2 Rr 3
Sign ,hange e2
Sign ,hange e3
Note$ More t&an 1 +ign C&ange
in Direction o, Ca#& Flo3
Arro3# #)gge#t# M)lti.le IRR1#
&1K14++(
n
$ &F# Cash 4nflows( % &"# Cash 7utflows(
C9 +ec)ritie# Val)ation
$ Fair "#> Mar4et Val)e - ;9 "ormula gives "air .Intrinsic/9alue
$ #aret 9alue is determined by Investors in #aret and buying &selling of securities.
$ 0on* /ricing an* ATM - 6ond is @egal ;aper representing Debt
A :se ;9 "ormula to ,alculate 6ond ;rice1
;9 T ,"2 & .2Sr
D
/ S ,"3 & .2Sr
D
/
3
S d S ;A= value & .2Sr
D
/
n

A ,ash "lows T ," T ,oupon
T ,oupon =ate .E/ ! ;ar 9alue
A ,oupon =ate .fi!ed/ vs. Discount =ate .r
D
=e(uired =eturn for
6ond Investor/
A RT# T I== for 6ond. Set ;9 T D and solve for )r
D
* using Iteration.
A 6ond =atings of "I=#S by #oodys and S';.
8 ,opyright 9irtual :niversity of ;aistan 2CL
$ +&are /ricing an* Aiel*#$
Stoc is @egal ;aper representing -wnership
A #aret ;rice of Share T ;o T +;S ! ;&+
A Bordon7s "ormula is I#;-=TA<T1 r
+
T =e(uired =eturn on +(uity for
Shareholders
T .DI92 & ;o/ S g T Dividend Rield S ,apital Bains Rield.
<ote1 DI92 is e!pected future Dividend <+YT year. ;o is price T?IS year.
A +arnings Approach1 ;o T .+;S & r
+
/ S ;9B-.
$ ;9B- T <;92&.r
+
- g/ TW-Io S.,&r
+
/X & .r
+
-g/
$ Io T 9alue of =einvestment T ;
b
! +;S where ;
b
T ;lough bac T 2 -
;ayout T 2 - .DI9&+;S/
A Shareholders7 =e(uired =-= .T r
+
/ vs. =-+ .T <I & +(uity/
5ond Cash Flow Diagram
Savings Certificate Example
D 2 3 J
23
Time .#onths/
D 2 3 J
23
Time .#onths/
Co).on Ann)it( $
/ar Recei.t $
7at Mat)rit(8
7Mont&l(8
Comine*
Ca#& Flo3 Diagram
D 23
=s 2,DDD
=s 2DD,DDD
3 ,ash "low
Arrows at
SA#+ point in
time can be
added.
H9 Ri#4 an* Ret)rn
$ +ec)ritie#
A Single Stoc =is T Standard Deviation
$ +ingle +toc4 Ret)rn$ measured by Share ;rice or ,apital Bain or
=eturn .r
+
/
$ Single Stoc =is T Standard Deviation T S(. =oot of 9ariance in the
+!pected =eturn
$ Total =is
T Diversifiable .,ompany Specific/ =is S #aret =is
A /ort,olio T&eor( an* CML
$ ;ortfolio =eturn - >eighted Average "ormula
$ ;ortfolio =is1 =is #atri! , ,ovariance of each stoc with entire
#aret , ,orrelation ,oefficient
$ =is $ =eturn Braph1 ?oo-shaped ,urve, +fficient "rontier, T-6ill
;ortfolio and ,#@
$ ;ortfolio of Stocs =eturn1 >eighted Average "ormula.
3-Stoc ;ortfolio7s +!pected =eturn
T r
; Z
T !
A
r
A
S !
6
r
6
$ ;ortfolio =is1 #easured by Sigma ; .standard deviation/.
3 Stocs1
8 ,opyright 9irtual :niversity of ;aistan 2CC
; T Y
A
3
[
A

3
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6
3
[
6

3
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A
Y
6
[
A
[
6
b
A6
/.
$ =is #atri! , ,ovariance of each stoc with entire #aret , ,orrelation
,oefficient
$ =is $ =eturn Braph for ;ortfolio of Stocs
:oo49#&a.e* C)r"e$ possible to reduce ris and raise return
together
E,,icient Frontier shows all possible efficient portfolios
)=is "ree* T-6ill ;ortfolio is always available to all investors
CML connect# Ri#4 Free Ret)rn an* Tangent to E,,icient
Frontier
9-StocI 0ortfolio &isI Formula
&ISF BAT&IE
Stoc
A
Y
A
2
A
2
Y
A

Y
0 A

0 A0
Y
A

Y
C A

C AC
Stoc
6
Y
0

Y
A 0

A 0A
Y
0
2
0
2
Y
0

Y
C 0

C 0C
Stoc
,
Y
C

Y
A C

A CA
Y
C

Y
0 C

0 C0
Y
C
2
C
2
0ortfolio SiLe vs &isI !raph
/
;
o
r
t
f
o
l
i
o

=
i
s
<umber of Investments .Stocs/ in the ;ortfolio

W 20 H0
#
n
Mar4et or +(#tematic or <on-
Diversifiable or 0eta =is T
#inimum ;ossible ;ortfolio =is
Uni2)e or Di"er#i,iale or
+.eci,ic or <on-Systematic =is
T
o
t
a
l

R
i
#
4
Note$ About 100T o, t&e Di"er#i,iale Ri#4 .and G0T o, t&e Total
Ri#48 can e remo"e* ( Di"er#i,ication acro## H0 #toc4#. ;)#t W
care,)ll( c&o#en Un9Correlate* +toc4# mig&t e eno)g& to remo"e
C0T o, t&e Total Ri#4>
A ,A;# and S#@ -+fficient #arets, 6eta, <on-diversifiable #aret =is,
=is ;remium, =e(uired =-= on +(uity
.r
+
T r
="
S .r
#
$ r
="
/6eta/
A ,9 .,oefficient of 9ariation/ T =is & =eturn
8 ,opyright 9irtual :niversity of ;aistan 2CO
,riterion combines 6-T? =is and return in deciding which is the 6est Investment
.,apital 6udgeting/
"ortfolio fficient Frontier : C12 '
4mportant
+toc4 C
Stoc 6
r
/
Z
/
10TE
3DE
C>HT /ort,olio Ri#4
/
o
r
t
,
o
l
i
o

R
e
t
)
r
n
Stoc A
H0T
3DE
4DE
2>GT
E,,icient Frontier ,or
C9+toc4 /ort,olio
PT&e /arac&)teQ
;ortfolio with Negati"e
or Bero Correlation
Coe,,icient
C
a
.
i
t
a
l

M
a
r
4
e
t

L
i
n
e
r
RF
r
/
J E r
RF
F L 7r
M
9 r
RF
8 ? M N /
Securit BarIet >ine )S12'
A>> fficient StocIs in Efficient BarIets
Important
Re2)ire*
Ret)rn 7rJ8
0eta Ri#4 7 8
M EF 1>0
r
M
E 20T
r
A
E C0T
A EF 2>0
r
RF
E 10T
=isy Stoc A7s
Total =is
/remi)m T
4D-2D T 3DE
#aret =is
/remi)mfor
Avg Stoc T 2DE
+
e
c
)
r
i
t
(

M
a
r
4
e
t

L
i
n
e
r
A
E r
RF
F 7r
M
9 r
RF
8
A
> IM/ORTANT
8 ,opyright 9irtual :niversity of ;aistan 2OD
Com,ined &isI & &eturn
!raphical Comparison of
Investments
T90ill 01 @ow =is
' @ow =eturn
/ro!ect C1 ?igh
=is ' ?igh =eturn
/
r
o
i
l
i
t
(

7
.
8
Rate o, Ret)rn 7 r 8 T
=is 6
=is ,
+!p =eturn 6
+!p =eturn ,
$ Entire Firm
A =eturn - =-A T .<I S Interest/ & .DS+/ or =-+ T <I & +
A =is - Standard Deviation in =-+ .stand alone/, "I=# 6+TAS .maret =is/
A "irm7s -verall @evel of =is T 6usiness =is S "inancial =is
$ 6usiness =is caused by changes in price and cost of raw materials and
products and -perating @everage
$ 6usiness =is and -perating @everage
$ .-@ T "i!ed ,osts & Total ,ost/. -@ can be good if Sales c 6reaeven
;oint
$ "inancial =is, "inancial @everage1
$ "inancial =is caused by "inancial @everage or Debt
$ ."@ T Debt & Total Assets T D & .DS+//. "@ can be good if +6IT & Total
Assets c ,ost of Debt
0ro,a,ilit 6istri,ution
Ban 0ossi,ilities for Forecasted +eturns of
Single StocI $ :ncertaint & &isI
0
0>0G
0>1
0>1G
0>2
0>2G
0>C
0>CG
0>H
0>HG
920 10 H0
/
r
o
i
l
i
t
(

7
.
8
Rate o, Ret)rn A,ter 1 Aear X r V
)0ELL*
,urve
PE5.ecte* RORQ
or Mo#t Li4el(
or Mean ROR T
2DE
;ossible
-utcomes
G9 Ca.ital +tr)ct)re an* Cor.orate Financing 9 Long Term LIA0ILITIE+ +i*e o, 0alance +&eet
8 ,opyright 9irtual :niversity of ;aistan 2O2
Baturit Batching or Medging 0rinciple
of Financing $ Important
;emporar* Current )ssets
Fi!ed or "ermanent )ssets :
2ife % usage more than 1 Yr
Spontaneous Current
)ssets
Spontaneous
Financing ie>
)%c +ecei8a?les
Short ;erm
2oans
"ermanent Financing
ie> @uit* : 2ong ;erm
2oans % 5onds
;ime
#alue &+s(
5u* "ermanent Fi!ed )ssets with "ermanent Financing+ 41"7+;)N;
$ -b0ective1 To maintain best balance of Debt ' +(uity ,apital
$ ,ost vs. =e(uired =eturn- <et ;roceeds, After-Ta! ,ost of Debt , Source of +(uity
A ,ompute ,ost using <et ;roceeds1 <; T #aret ;rice .;o/ $ Issuance ,osts
A After-Ta! ,ost of Debt1 r
D
.2-Tc/
A Source of +(uity1 =etained +arnings cheaper than "resh Stoc Issuance in
Stoc #aret
$ >A,, .E/ - :se #A=K+T 9A@:+S of Debt and +(uity,
$ "I=#S T=R T- #I<I#IM+ T?+I= ,-ST -" ,A;ITA@
A >A,, T r
D
!
D
S r
+
!
+
. I#;-=TA<T "-=#:@A
$ r
D
and r
+
are ),osts* of Debt ' +(uity respectively. I<T+=+ST is the
cost paid by "irm to Investors who hold "irm7s Debt. DI9ID+<D is
cost paid by "irm to Investors who hold "irm7s +(uity.
$ !
D
and !
+
based on #A=K+T 9A@:+S of Debt and +(uity,
$ "irm 9alue T 9alue T Debt S +(uity
T Share ;rice ! <umber of Shares -utstanding
$ T3o 3a(# to com.)te$
A,,/
9@ is 9alue of @evered "irm. 9: is 9alue of :n levered "irm. Tc is ,orporate Ta! E. D is
Debt.
SB> $ JACC !raph
Important
S12 >ine
)EETE&;A>
BA&FET
criterion'
FirmGs o#n
3)CC
)I;TE&;A>
criterion'
&eHuired
&O& rCE )2'
Beta &isI
r&F 3 T-
Bill rate
JACC
(
8
9
F)S452 +647N &where
4++ of in8estment or pro9ect
is more than S12 and
3)CC(
I&& KJACC K SB>
I&& K SB>
I&& K JACC
4mpact on 5rea=e8en "oint : Capital 5udgeting
Total CO+T Line
Com.an( A$
:ig&er OL +o
:ig&er 0rea4e"en
Total CO+T Line
Com.an( 0
+ale# D)antit(
7a o, Unit#8
Re"en)e# -
Co#t# 7R).ee#8
+ale# REVENUE Line
Fi5e* Co#t# A
Fi5e* Co#t# 0
D
0
J
D
A
J
0rea4e"en A i# :ig&er>
A i# More Ri#4(> A#
long a# +ale# V
0rea4e"en< OL i# Goo*>
72 $ Fi!ed Cost %;otal Cost
"isualiLing Financial >everage )F>'
LEVERED 7Det
- E2)it(8 Firm$
:ig&er +lo.e>
ROE more
#en#iti"e to
c&ange# in E0IT
UN9LEVERED
7100T E2)it(8
Firm> +a,er
Ca.ital +tr)ct)re
at Lo3 E0IT1#
E0IT 7R#8
ROE 7T8
32E T f=-+c
UL
4IE T f=-+c
L
LLE
F3E
4.IE
DE
F2 4S 677D 4F 54; %
)SS;S C C7S; 7F
D5;>
;radeoff ;heor* !raph
>everage & Optimal Capital Structure
9alue of
"irm or
;rice of
Stoc
Debt & Assets T
D&.DS+/
O/TIMAL Ca.ital
+tr)ct)re 9 MA@IMUM
VALUE - MINIMUM
%ACC
;rice.
"irm =emains 2DDE
+(uity .:n-@evered/
$ Ca.ital +tr)ct)re T&eorie#$
$ Tradeoff Theory1 @ittle Debt reduces >A,,. ?igh Debt 6anruptcy =is
$ Signaling Theory1 =aising <ew Debt carries ;ositive signal to maret. "resh +(uity
carries <egative Signal
$ Agency Theory1 #anagers7 ;ersonal #otives clash with Shareholders7 .-wners7/
Interest
$ Ca.ital +tr)ct)re Mo*el#
$ Miller Mo*igliani
.>ithout Ta!es1 r
+
T >A,,
:
S .D&+ .>A,,
:
-r
+
/,
8 ,opyright 9irtual :niversity of ;aistan 2OF
0ure BB Theor - Ideal BarIets
JACC !raph - Important
%ACC E
r
D
5
D F
r
E
5
E
r
E
E Co#t o, E2)it(
E%ACCFD?E 7%ACC9r
D
8
r
D
E Co#t
o, Det
Co#t o,
Ca.ital
7T8
Det ? E2)it( E A
Mea#)re o, Le"erage E
D?E E 5
D
? 7 19 5
D
8
r
E
r
D
2DDE
+(uity
"irm
"inancial =is.
?igher =e(uired
=eturn on +(uity.
?igher r
E
#aret 9alue of "irm T 9 T +6IT & >A,,. As Debt Increases, =is Increases so r
D
and r
+
and
>A,, should increase. 6:T Debt is cheaper than e(uity .recall =is Theory/ so as Debt
Increases, >A,, should decreaseU <et +ffect is <o ,hange in >A,, and <o ,hange in
9alue. ,A;ITA@ 6:D+BTI<B is Independent of ,orporate "inance & ,apital Structure.
D+6T ?AS <- 6+A=<I<B -< A "I=#7S 9A@:+U
Traditionalist Theor - &eal BarIets
JACC !raph - Important
%ACC
L
E r
D
719Tc85
D F
r
E
5
E
r
E<L
E Co#t o, E2)it( E
%ACC
U
F 5
D
7%ACC
U
9r
D
8 719T
C
8
r
D
E Co#t o, Det
Co#t o,
Ca.ital
7T8
Det ? E2)it( E A
Mea#)re o,
Le"erage E D?E E 5
D
? 7 19 5
D
8
r
E
r
D
2DDE
+(uity
"irm
0an4r).tc( =is '
,osts. ?igher
=e(uired =eturn on
Interest Ta! Shield
Advantage
O.timal Ca.ital
+tr)ct)re E Minim)m
%ACC an*
Ma5im)m Val)e
Note$ 5
D
E D ? 7DFE8
$ Tra*itionali#t# Form)la# .>A,,
@
T r
D
.2-Tc/ !
D
S r
+
!
+
/
$ "I=#7S 9A@:+ T +6IT & ,-ST -" ,A;ITA@. #-=+ @+9+=AB+ .-= D+6T/
#+A<S #-=+ =ISK >?I,? #+A<S ?IB?+= ,-ST -" ,A;ITA@ A<D
T?+=+"-=+ @->+= 9A@:+
$ Traditionalist 9iew is based on ;ractical =eality. @everage provides Interest Ta!
Savings .or Shield/ but also Increases "inancial =is. +!cessive @everage leads to
6anruptcy =is. Increases in =is will ,hange 9alue of "irm and >A,,.
8 ,opyright 9irtual :niversity of ;aistan 2OI
$ ;ractical ,apital Structure #anagement- Target =atios i.e. TI+ of 3.I. TI+ and Debt &
,apitalization
$ Di"i*en* /olic( T&eorie# 9 MM< +ignaling< an* Agenc(<
$ DI92 T DI9o .2Sg/ , g T ;b ! =-+ , If =-+ f r
+
then better to give Dividends than to
=etain +arnings
$ ##1 Dividend ;olicy and Debt are Irrelevant to a "irm7s 9alue. >hat matters
is the ,ash "lows from :nderlying Assets and <-T how you divide or split up
the ,ash -utflows i.e. Dividends. I#;-=TA<T.
$ Signaling Theory1 Issuing <ew Debt .or taing new loan/ gives positive signal
to Investors. Issuing "resh Stoc & +(uity in Stoc #aret gives negative
signal.
$ Agency Theory1 #anagement7s ;ersonal #otives often clash with -wner &
Shareholders -b0ectives
$ Impact of Dividend Announcement and +!-Dividend Date on Share ;rice
$ Dividend ;ayout restricted by ,apital +!penditure =e(uirement, Target Debt =atio, and
restrictions placed by Debt ,ontracts
$ DI92 T "uture Dividend
$ If =-+ f r
+
then better to pay out Dividends rather than eep cash as =etained +arnings
because company is unable to generate an =-+ high enough to satisfy the
Shareholder7s =e(uired =eturn .r
+
/.
6lo?al 4n8esting 1a=es the fficient Frontier and
the C12 &Capital 1ar=et 2ine( +ise Dp
<igher +eturn for Same 2e8el of +is=
r
/
Z
/
Ri#4
/
o
r
t
,
o
l
i
o

R
e
t
)
r
n
E,,icient Frontier
7,or In"e#tment in
+ingle Co)ntr(8
C
M
L

7
,
o
r

+
i
n
g
l
e

C
o
)
n
t
r
(

I
n
"
e
#
t
m
e
n
t
#
8
r
RF
C
M
L

7
,
o
r

G
l
o
a
l
I
n
"
e
#
t
m
e
n
t
#
8
E,,icient Frontier 7,or
Gloal In"e#tment#8
O)tline o, H Minor Area# o, FM$
19 %or4ing Ca.ital an* +&ort Term Financing
$ ,urrent Assets #anagement1 ,ash, #aretable Securities, Inventory.
A ,urrent Assets necessary for safe li(uidity but earn no & little return on cash,
inventory
A "at ,at vs. @ean #ean , ,&" Synchronization and ,he(ues "loat ,
$ ,urrent @iabilities and Short Term "inancing1 Accounts ;ayable and Short Term
@oans. )Spontaneous* and unpredictable source of financing.
$ Types of "inancing
8 ,opyright 9irtual :niversity of ;aistan 2OJ
A ;ermanent .+(uity ' @ong Term @oan/ vs. Temporary .Short-Term @oan/
vs. Spontaneous "inancing .,urrent @iabilities/. I#;-=TA<T.
A ?edging ;rinciple or Self-@i(uidating Debt or #aturity #atching1 6uy
;ermanent Assets with ;ermanent "inancing. I#;-=TA<T.
29 Lea#e Financing
$ "inancing @ease, -perating @ease, Sale ' @ease 6ac
$ -wnership vs. ,ontrol
$ 9aluation of @ease "inance1 <A@ .modified <;9/ and I== .E/
C9 Merger# an* Ac2)i#ition# 7M-A8 an* Val)ation o, Firm#
$ #ergers, Ac(uisitions, @6-7s
$ #erger 9aluation using D," .<;9/ or ##A Short-cut "ormulas
$ Impact of #erger on Share ;rice and 9alue of "irm
H9 International Finance
$ Impact on #a0or Areas of "#1 ,apital Structure and ,orporate "inancing, "inancial
Accounting, ,apital 6udgeting
$ "oreign +!change ."&!/
A #arets1 Spot, "orward, "utures, -ptions
A =elationships1 ;;;, "ischer +ffect, I=;
A +uropean ,onvention ' ,ross =ates
----------------------------T?+ +<D----------------------
8 ,opyright 9irtual :niversity of ;aistan 2OL

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<umber of Investments .Stocs/ in the ;ortfolio

cD. 6eta =is is Directly ;roportional to =e(uired =eturn. The

<umber of Investments .Stocs/ in the ;ortfolio

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