Professional Documents
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Financial Management: Faculty: Gautam Negi
Financial Management: Faculty: Gautam Negi
Karma Dharma
Moksha
Objectives
Clarity on concepts Ask questions reason..keep me on my toes. Get attentive, interested and interactive Peer learning Stay disciplined and punctual Love the subject.it will love you back
There are no shortcuts in learning We will create a glossary of 1000 financial words in the next 3 months Reference Books:
Prasanna Chandra Van Horne I M Pandey Damodaran
COURSE LAYOUT
INVESTMENT
FINANCING/WC Mgmt
Sources of Finance Capital Structure Deci Leveraging Inventory Mgmt Cash Mgmt
DIVIDEND
VALUATION
Capex decisions Complex decisions Cost of Capital Cash Flow Risk Analysis
Value of firm
Essential Tools: Time Value Of Money Analysis Of Financial Statements Risk Return Trade Off Valuation concepts and Models(CAPM/APT)
Contents
Introduction Agency Costs Time value of money Valuation of Assets Risk, Return, Portfolio Beta Estimation Financial Statements FS Analysis Capital Budgeting Decisions Cost of Capital Cash flow estimation Risk Analysis in Capex Operating and Financial Leverage Capital Structure Introduction to Dividends WC Management Receivables Management Inventory Management Cash Management WC finance
Objective of the firm-> max value of the firm-> Max Stock Price
Managers are appointed by SHs. lenders can protect themselves contractually
Agency Costs
Shareholders
Bondholders
MANAGERS
Society
Financial Markets
Stockholders and Managers Stockholders and Bondholders Firm and the Financial Markets Firm and the Society
Bondholders
MANAGERS
Society
Financial Markets
Suppressing/delaying Info (eg.Satyam)
Introduction to FS
Funds Deposits/ shares Suppliers of funds: Individuals Companies Govt Financial Institutions Banks Insurance companies Mutual funds Provident funds loan s
Loan contract
Cont
Concept of compounding/discounting Concept of SI/CI FV of an amount being compounded Continuous compounding Understanding the doubling rule
Rule of 72 .35+69/r 2=(1+r)n
In Capex Decisions
NPV/IRR
Teasers
A company currently has 1000 employees and the number is expected to grow at 20% per annum.How many employees will the company have 10 years from now. ABC ltd had revenues of 100 lacs in 2000 which increased to 1000 lacs in 2010..What was the compound growth rate in revenues. Suppose you deposit Rs.50000/= per year in a fund which gives you an interest of 10%.What is the value 20 years from now.
Teasers
You want to buy a house after 5 years when it is expected to cost 20 lacs. How much should you save annually if your savings earn a compound return of 12%. ABC ltd has an obligation to redeem Rs.500 lacs bonds 6 years hence..how much should the company deposit annually in a sinking fund account wherein it earns 14% interest.
Teasers
6. A finance company advertises that it will pay a lump sum of Rs.8000 at the end of 6 years to investors who deposit annually Rs.1000/= for 6 years..What interest rate is implicit in the offer? 7. You want to take up a trip to the moon which costs Rs.10 lacs..You can save annually Rs.50,000 to fulfill your desire..How long will you have to wait if your savings earn an interest of 12%.
Teasers
9. Your father deposits Rs.3 lacs on retirement in a bank which pays 10% annual interest..how much can he withdraw annually for a period of 10 years. 10. At the time of his retirement Mr.X is given a choice a) An annual pension of Rs.10000 for 15 years b) a lump sum amount of Rs.50000 todayAssuming an interest rate of 15% which offer looks more attractive.
Teasers
As a winner of the competition you can choose one of the prizes:
Rs.5 lacs now Rs.10 lacs at the end of 6 years Rs.60000 a year forever Rs.1 lac per year for 10 years Rs.35,000 next year and rising thereafter by 5% per year forever
If the interest rate is 10% which prize has the highest PV.
Teasers
You are 35 years old today and are considering your retirement needs. You expect to retire at age 65 and your actuarial table suggests that you will live to be 100you want to move to Bahamas when you retire you estimate that it will cost you Rs.3, 00,000/= to make the move on you 65th birthday and that your living expenses will be Rs.30000/= per year starting the end of 66th year and continuing through the end of year 100 after that
How much will you need to have saved by your retirement date to be able to afford this course of action You already have Rs.50,000 in savings if you can invest money, tax free, at 8% a year, how much would you need to save each year for the next 30 years to be able to afford this retirement plan If you did not have any current savings and do not expect to be able to start saving money for the next 5 yrs, how much would you have to set aside each yr after that to be able to afford this retirement plan
Teasers
You are an investment advisor who has been approached by a client for help on his financial strategy.he has Rs.2, 50,000/= in savings in the bank..he is 55 years old and expects to work for 10 more years making Rs.1,00,000 per yearhe expects to make a return of 5% on his investment for the foreseeable future.
Once he retires 10 years from now, he would like to be able to withdraw Rs.80,000 a year for the following 25 yearshis actuary tells him he will live to be 90 years old..how much would he need in the bank 10 years from now to be able to do this. How much of his income would he need to save each year for the next 10 years to be able to afford these planned withdrawals( Rs.80,000 a year after the tenth year) Assume that the interest rate declines to 4% ,10 years from nowhow much, if any, would your client have to lower his annual withdrawal, assuming that he still plans to withdraw cash each year for the next 25 years.
Teasers
A father is planning a savings program to put his daughter through college. His daughter is now 13 years old. She plans to enroll at the University in 5 years and it should take her 4 years to complete her education. Currently the cost (for everythingfood, clothing, tuition, books) is Rs.12500 but a 5% annual inflation rate in these costs is forecasted. The daughter recently received Rs7500 from her grandfather; this money which is invested in a bank account paying 8% interest compounded annually will be used to help meet the costs of the daughters education. The remaining costs will be met by money the father will deposit in the savings account. He will make 6 equal deposits to the account one deposit in each year from now until his daughter starts college. These deposits will begin today and will also earn 8 % interest compounded annually.
What will be the PV of the cost of 4 years of education at the time the daughter becomes 18? What will be the value of Rs.7500 that the daughter received from her grandfather when she starts college at age 18? If the father is planning to make the first of 6 deposits today, how large must each deposit be for him to be able to put his daughter through college?
Assets
Financial Assets(Bonds/Shares)
Concept of shares---> converting physical assets into financial instruments
Principle of Valuation: Discounting all future CFs. Will depend on Certainty of CF Magnitude of CF Discounting Rate
Cont
Concept of Value..
Book Value Replacement value Market Value Going Concern Value Liquidation Value Present Value
Understanding Bonds
What is a Bond(Par Value/Coupon/Maturity/Term) Types of Bonds
Fixed Rate Bonds Floating Rate Bonds Call /Put Option Bonds Zero Coupon Bonds Secured/Unsecured Bonds Perpetual Bonds Convertible Bonds
Cont
Interest rate on Bonds..
Coupon Rate Current Yield YTM: Bonds with Maturity/Perpetual ( PV= PV of Interest+ PV of Maturity Value).
Cont..
Valuation of Bonds
Bonds with Maturity Perpetual Bonds Deep Discount Bonds
Impact of changes in r on Bond Value Valuation of Preference shares Types of Preference Shares
Redeemable/non redeemable Participative/non participative Cumulative/ non Cumulative Convertibles/non convertibles
Cont
Bond Duration/Average Maturity Volatility Of Bond
Impacted by Duration/Yield
Cont
Valuation of Shares..
The Gordons Model Assumptions:
The firm declares dividends r>g g is constant
Cont
Specific cases..
When the g is constant When g is zero When the firm pays no dividends
Assume div is paid after n years P/E Model
Relationship between Stock Price/Dividends and Earnings g is a function of retained earnings and ROE.
Year 1
BV 100
EPS(10%) 10
DPS(40%) 4
RE(60%) 6
Ending BV 106
2
3 4
106
112.36 119.1
10.6
11.24 11.91
4.24
4.49 4.76
6.36
6.74 7.15
112.36
119.10 126.25
Introduction..
Concept of Return
On a single asset eg shares Arithmetic Mean/Geometric Mean(CAGR) Expected Return
Concept of Risk
Deviation from the average Standard Deviation/Variance
Understanding Portfolio..
What is a Portfolio Return on a Portfolio
Rp=Rx * Wx + Ry*Wy Rp is a fn ( security returns/weights)
Risk
Systematic Unsystematic R= SR+USR
SR
No of Securities->
A B
5% 15%
.5 .5
0 6
Assumptions
Market Efficiency Homogeneous expectations of risk and return Risk free rate
E(Ri) = Rf + i{ E(Rm) - Rf}
Teasers.
Share A B C D Beta .8 1.25 1 .6 Investment 100000 100000 75000 125000
Given E(Rm) = 16% and Rf = 9% .what is the expected Return from the Portfolio.
Beta Estimation..
Revisiting the CAPM Understanding the Betafor various values Methods of Estimation
Direct Method.. The market modelregression on past data
Ri = + Rm ( Characteristic Line) and are obtained by Normal Equations The Normal Equations are Y = n + X XY = n X + X2
2
3
10
-10
23
-15
4
5 6 7 8 9 10 11 12
5
22 33 4 8 -6 12 18 22
10
12 44 10 -10 12 3 22 30
Regression Statistics Multiple R 0.73078 R Square 0.53404 Adjusted R Square 0.487444 Standard Error 8.63894 Observations ANOVA df Regression Residual Total SS MS F Significance F 1 855.3538 855.3538 11.46106 0.006939078 10 746.3129 74.63129 11 1601.667 Coefficien ts Intercept X Variable 1 12
SE
t Stat
P-value
Lower 95%
4.505961 3.116482 1.445848 0.178822 -2.437994155 11.44991616 -2.437994155 11.44991616 0.534708 0.157944 3.385419 0.006939 0.182785767 0.886629275 0.182785767 0.886629275
Financial Statements
Expenditure
Operating expenses Depreciation Interest Charges
Investments
Minority(HTM/AFT/AFS) Minority Active.
Long Term Debt Total Capital Employed Application of Funds Fixed Assets
Gross Block Accumulated Depn Net FA
CA
Cash MS Inventory
RM/WIP/FG
CL
Provisions..
Economic Profit = Net Cash Flow to firm and focuses on wealth creation
Current Liabilities
Provisions Creditors Accounts Payable
WC = CA - CL
The funds flow statement depicts sources and applications of WC. It is presented in 2 part: sources and uses of WC Schedule of WC
There will be a WC only when there is a transaction between a current account and a Non Current Account Sources of WC cash flow from operations Sale of non CA long term financing short term borrowing Uses Of WC adjusted net loss from operations purchase of Non CA repayment of Debt payment of Cash Dividend
Adjustments for
CA( an in the value of a CA will imply outflow of Cash, will imply inflow) CL ( an in the value of a CL will imply inflow of cash, will imply outflow)
The Cash with the Firm Comprises: Cash on Hand Cash with Bank Cheques on hand
Analysis: Risk and Profitability Users of financial analysis and their perspective of analysis.
Trade creditors-> liquidity position Debt suppliers-> Solvency Investors-> profitability Management-> overall performance( risk/profitability) Trade analysts/Academicians/Students/Researchers Employees Public Government
Liquidity Ratios:
Current Ratio/Quick Ratio/Cash Ratio Interval Measure->(CA-Inv) / Av daily Op Expenses
Leverage Ratios:
Capital Structure
Total Debt/Capital Employed Debt to Equity Ratio Debt/ Capital Employed
Solvency
Interest coverage Debt service coverage ratio
Turnover Ratios(indicates the efficiency with which a firm utilizes its Assets/ the rate at which Assets are being converted to Sales)
Inventory T/O DIH(Days of Inventory Holding) Debtors T/O ACP(Average Collection Period) Ageing Schedule of Debtors NA Turnover Ratio Total Assets Turnover Ratio CA Turnover Ratio
Profitability Ratios(Sales/Investment)
Gross Profit Margin/ Net Profit Margin ROCE/ROA/ROE
Valuation Ratios
EPS DPS Dividend Yield Earning Yield P/E Ratio MV to BV of Share
Importance of Capex
Long term investment/large investments/high risks/generally irreversible/strategic decisions/complex
Capex Evaluations
DCF Criteria Non DCF Criteria
NPV
It is the PV of all discounted CFs( I and O). Steps(Determine CFs and r) Decision Rule.accept/reject Why is NPV important(. A firm has cash 1 lac) Features
It recognizes time value Measures true profitability since it considers CFs Value Additive.valuation of Corporate
IRR
Measures yieldrate which equates current CF to all future CFs Relationship between IRR/NPV Stepscalculating CFs Decision ruleaccept (IRR> Cost of Capital) Features
Popular since it uses % It recognizes time value Measures true profitability since it considers CFs No value additivity
Profitability Index
Ratio of PV of all CFs to Initial Outflow Steps(measuring CFs and r) Decision rule.PI > 1 Accept
Payback Period
Time required to recover initial investment Steps ( determine CFs each year) Decision rule..accept with shortest PB Features
Simplicity/risk shield/focus on liquidity Ignores CF after PB period/ inconsistent with our objective of SH wealth maximization/not a measure of true profitability
Limitations
Discounted PB period..
No. of years required to recover the initial investment on a PV basis. Uses discounted CFs in calculating PBP.
ARR..
Ratio of Average EBIT(1-t) to average investment. Decision rule..Accept(ARR> required return) Features
Uses accounting Data Easy to understand and calculate Demerits
Does not use CFs Ignores time value of money
NPV/IRR
Project A B C0 -1680 -1680 C1 1400 140 C2 700 840 C3 400 1510 NPV(9%) 301 321 IRR 23% 17%
The cost of capital of the firm will be the weighted average of the component costs
Cost of Debt
Debt issued at Par ( Kd = Coupon Rate) Debt issued at Premium/Discount After tax cost of debt = Kd(1-t)
Cost of Preference
Irredeemable (Div/Issue price) Redeemable
Generally Kp > Kd since interest on Debt is Tax deductible
Cost of Equity
Equity( external/retained earnings) Is equity free of Cost Methods of calculating Ke
The dividend growth model E/P ratio CAPM
Practical calculation of Ke
Dividend G Model
Ke = Div1/P + g g can be calculated by ( retention ratio * ROE) or by EPS growth of the last 10 years.
CAPM
E(Ri) = Rf + i [ E(Rm) Rf ] Beta can be found by regression.
CF vs Profit( FCF = EBIT(1-t) + Dep WC Capex) FCF for Capex decisions and is the cash available to lenders and shareholders.
Post Tax principle( consider tax impact) Consistency principle( CF must be consistent with investor group).
Every investment decision is based on forecasted CFs. The forecasted CFs are influenced by
Economic factors Industry factors Company factors
Risk Measurement --> Variance Reducing risk through the concept of Expected NCF( CFi x Pi) where i= 1,2n
S.P
V.C
15
6.5
15
6.5
15
6.5
15
6.5
Relationship between investment decision and financing decision Defining capital structure( Capex -> need to raise funds -> capital structure decision(D/E).purpose is Kc and V Defining FL
ROI > cost of debt
Measuring FL
Debt ratio( D/D+E) Debt to Equity Ratio Interest coverage = EBIT/ Interest Charges
Analyzing impact of FL
ROI>Kd -> Increase in SH returns-> EPS/ROE ROI< Kd -> Decrease in SH returns-> EPS/ROD
All equity EBIT Interest EBT Tax(50%) PAT No. of shares EPS ROE
50% Debt
EBT
Tax(50%) PAT No. of shares
120000
60000 60000 50000
82500
41250 41250 25000
EPS
ROE Return to investors
1.2
12% 60000
1.65
16.5% 78750
The gain from FL = Rs.18750. This is the interest tax shield enjoyed by the company since interest charges are tax deductable This is equivalent to ( Interest x Tax rate)
EBT
Tax(50%) PAT No. of shares
60000
30000 30000 50000
22500
11250 11250 25000
EPS
ROE Return to investors
0.6
6% 30000
0.45
4.5% 48750
ROE
50% Debt EPS ROE
-2.5%
-1.25 12.5% -3.25 -32.5%
5%
.25 2.5% -2.5 -2.5%
7.5%
.75 7.5% .75 7.5%
12%
1.65 16.5% 2.55 2.55%
16%
2.45 24.5% 4.15 41.5%
30%
5.25 52.5% 9.75 97.5%
75% Debt
EPS ROE
EPS increases with increased EBIT for all financial plans FL works both ways. It depresses EPS/ROE under unfavorable economic conditions and and increases EPS/ROE under favorable conditions. Higher the FL , wider is the range in which the EPS fluctuates with varying EBIT.
Calculating the level of EBIT for which EPS would be same under diff financial plans.
All equity firm, EPS1 = EBIT(1-t)/ N1 Debt firm , EPS2 = (EBIT- Interest) x (1-t) / N2 The indifference point can be calculated by equating EPS1 and EPS2.
Combining OL and FL
OL affects EBIT while FL affects PAT/EPS DOL = % EBIT/ % Sales = Q(s-v)/ Q(s-v)-F DFL = % EPS/ % EBIT = Q(s-v)-F / Q(s-v)-F-Int DCL = % EPS/ % Sales = Q(s-v)/ Q(s-v)-F-Int
Capital Structure
Disadvantages of Debt
Expected bankruptcy
CF < Obligations High SD of CFs
Disadvantages of debt
Loss of flexibility(Covenants: Affirmative/Negative) Agency Costs
Ke
D/E
K0
Kd D/E
MM Approach
The value of a firm is independent of Capital structure and only depends on earnings and risk. Assumptions of perfect capital markets , no transaction costs and no taxes.
MM Proposition 1
EBIT K1 EBIT K2
> V1 = V2 = EBIT/K ( assuming K1= K2) In MM view the way in which the firms are structured only changes the way in which the earnings are distributed ( SH and Debt holders)
Why should Proposition1 work Levered Firm EBIT Debt Kd Ke Interest Equity Earnings MV of Equity MV of Debt Value of Firm 150000 500000 12% 16% 60000 90000 562500 500000 1062500 150000 1000000 0 1000000 15% Unlevered Firm 150000 0
Assume you own 10% shares of the levered firm. Your investment of Rs.56250 Gives you a return of Rs.9000 in the levered firm. MM argue that if two firms have the same EBIT, their values must be same. If not then This will encourage arbitrage .
Investor invests Rs.100000 in U (10%) His old income was Rs.9000 . His new income is as below
Income from 10% stake in U
Less interest on Rs.50,000 @12% His net income
Rs.15000
Rs.6000 Rs.9000
The customer make an income of Rs.6250 keeping his earnings constant. The arbitrage will continue till the value of the firms equal.
MM proposition 2
Higher the financial risk greater will be the required return of the investors and higher will be the cost of equity. K0 = Ke( E/D+E) + Kd (D/D+E)
Ke = K0 + (K0 Kd) D/E
The value of a firm increases with leverage and is theoretically max when D= 100%
Debt avoided on account of dangers of financial distress.
Total Capital
Market Value Equity Debt
1,50,000
8,00,000 0
Total Assets
Assets
1,50,000
8,00,000
Total Capital
8,00,000
8,00,000
how will the Company value be impacted if it takes a debt of Rs.75,000 @ 10% and buys back its shares from the market ? Assume tax rate of 30%.
What are dividends Objective of the dividend policy..( balance between funds for growth and distribution to SHs. Concept of Payout ratio/ retention ratio/dividend yield The dividend decision is impacted by the investment decisions of a firm.
3
10 15 20 1 2 3
108.16
142.33 173.17 210.68 100 116 134.56
21.63
28.47 34.63 42.14 20 23.2 26.91
17.31
22.77 27.71 33.71 4 4.64 5.38
4.32
5.69 6.92 8.43 16 18.56 21.53
10
15 20
380.30
798.75 1677.65
76.06
159.75 335.53
15.21
31.95 67.11
60.85
127.80 268.42
Post 15th year low payout firm has a higher dividend.the growth for the two firms has been Different( ROE x Retention ratio)
Dividend theories
Walters Model Gordon Model
Walters Model:
P = PV of an infinite stream of dividends + PV of an infinite stream of Capital gains P = Div/k + r(EPS-DPS)/k / k Assumptions:
Constant r, k, EPS and DPS 100% payout or 100% retention The firm has an infinite life
Payout =100%
P =100
P = 100
P = 100
Retain all earnings when r>k Distribute all earnings when r<k When r =k, the dividend decision has no impact on the value of the firm. Assumptions in the model Constant k and r.
Gordons Model
The price of a share is the PV of an infinite stream of dividends expected to grow @ g P=Div1 / k-g = EPS1( 1-b) / k r.b
Mathematically derive the formula..
When r > k, keep low payout When r < k, payout should be maximum When r =k, the dividend decision has no impact on the value of the firm. Assumptions in the model Constant k and r. Both models have the same conclusions THE DIVIDEND DECISION OF A FIRM HAS AN IMPACT ON ITS VALUE
Forms of dividends
Cash Dividends Bonus Shares Shares Buyback
Shares buyback..
Rationalize capital structure Pop up the share price When company has idle cash
Manas Corp expects to earn Rs.66 lacs for the current year and it plans to distribute 50% of this amount to its shareholders. There are 11 lac outstanding shares and the market price per share is Rs.30. The Co. believes that it can pay a cash dividend of Rs. 3 per share or buyback 1 lac shares at an offer price of Rs.33. what is the impact if the shares are brought at less than Rs.33 or greater than Rs.33.
WC Management..
Assets Management:
Fixed Assets Management CA Management
Concept of WC
Gross WC Net WC
Cost of liquidity
Low returns, inventory wear off, carrying cost
Cost of illiquidity
Unable to meet short term obligations Borrowing at high cost ,production shortage
Estimation of WC needs
CA holding period cost
RM holding cost + WIP cost + FG holding cost + Debtors holding credit allowed
Measuring receivables
Net Credit Sales per day x Average collection period NCS is a function of sales ACP is a function of the cos credit policy
Increased Sales
ROE
Credit Terms
Rate of cash discount Cash discount period Net credit period
Monitoring receivables
ACP -> 360/ Debtors Turnover Ageing Schedule Collection Experience Matrix
O/S days 0-25 Amount 200000 % Sales 20% 30% 40% 10% Rec(%) J F M A M Month J 100 80% 60% 20% 78% 50% 10% 90% 40% 10% 60% 10% 70% F 250 M 375 A 400 M 570
Factoring
1 seller 3 buyer
4 2
5 6 7 factor
1: buyer places order, 2: factor fixes buyer limit, 3: seller supplies goods to the Buyer , 4: seller raises invoice to the factor, 5: factor pays a portion upfront 6: factor follows up with buyer for payment 7: buyer makes the payment to the factor.
Inventory Management
When to order->
Reorder Point = Average Usage x Lead time if safety stock is being maintained, its value is added to the reorder point.
Cash Management
Cash planning
Forecasting
Short term: Receipts and disbursements Long term: Cash flows generated through P/L
Mailing time
Processing
Availability delay
Minimizing floats
Disbursement float: cheque issued and not debited Collection float: cheques received and not credited Net Float = Disbursement float + Collection float
Under uncertainty
The Miller Orr Model
Baumols Model
Total Cost = Holding Cost + Transaction Cost TC = (average cash balance) x k + (Number of transactions) x cost per transaction TC = C/2 x k + (T/C) x Ct = sq root( 2TCt/k)
C= starting cash balance, k = opportunity cost, T = total cash requirement in the year, T/C = total number of transactions, Ct = cost per transaction.
Cash balance
time
3 limits are specified( upper limit, return point, lower limit) RP = 3 Sq root( 3b 2/4I) + LL UL = 3RP 2LL
b= fixed cost per order for converting MS-> cash 2 = variance of daily changes in expected cash balance I = interest rate (daily) earned on MS
Commercial Paper.( conditions: NW > 5 Cr, Co. should be listed, CR > 1.33, Crisil rated .