1.

Assets:
Asset is an economic resource, something valuable that you own as an individual or
a business entity. In simple words, something that adds money value, it might be in the
form of a tangible(physical) or intangible(not seen or touched) asset.
e.g. The house and the car you own are your personal assets. As a business owner, the
land & building, the furniture, machinery, laptops, cash etc. that you have are your
tangible business assets. The goodwill, patents, trademark etc. are few intangible
assets of any business or company.
The assets that you own basically count towards your net worth. They can be easily
sold to generate money in case need arises in future. Business assets are a crucial part
of a Company’s Balance Sheet.

2. Liabilities:
Liability simply refers to what you owe to somebody. In the race of starting or growing
your business, you tend to create debts or bank loans etc. The same needs to be paid
back along with interest as applicable. The liabilities can be short term or current
liabilities(to be met immediately or after a short while) like creditor’s dues or long term
like term loans(that are spread over a particular tenure). These short term or long
term debts that you need to repay back add to your liabilities. e.g. Your credit card bill
or EMI for your home loan is your personal liability that you have to bear every month.
Similarly, the secured loans or unsecured loans taken on behalf of your firm or company
count towards your business liabilities.
3. Financial Statements:
Financial statements are a great tool for business owners, investors and individuals to
learn and review the past and prevailing financial condition of any firm or company.
Think it like a quick snapshot that shall help you know about the financial situation of
any company.
Profit & Loss Account or Income Statement:
As the name itself suggests, this financial statement summarises the profitability
situation of an entity. Profit & Loss Account or P&L Account displays the income
earned and related expenses incurred during a particular period. The net of income
and expenses amounts to the profit/loss of a business during a set time period.
Generally a quarterly or annual P&L statement is analysed. If you wish to check whether
a company is actually profitable, then P&L shall help you get the requisite answer.

Balance Sheet:
A summary of the financial position of the company on a specific point of time. Assets,
liabilities and owner’s equity are an indispensable part of a balance sheet. “What a
Company owns” i.e. its Total assets and ” What a company owes” i.e. its current as
well as long term liabilities plus the share capital form an important component of this
financial statement.
Simply put, a balance comprises of following components:

 Assets
 Liabilities
  Owner’s Equity
4. Capital:
Capital is an essential pre-requisite that is required to run any business or company.
The partners or directors can introduce initial capital. But, looking at the growing needs
of any business, you may require additional funds or money to be invested by outside
parties to further manage your business. May it be working capital needs i.e. the funds
needed for routine activities of any business organisation or various other business
demands, Capital plays a pivotal role.
So, whether you wish to start a company, procure goods, purchase business assets,
pay wages or salaries to staff, incur other business expenses etc. you require money for
that.

When a business requires funds to expand and grow, this can be done in 2 ways
through: Equity or Debt. A company can acquire funds through “Equity” i.e. by giving
ownership of its shares. We call this as Share Capital that refers to the sum raised
by a Company by issuing its shares.
The second way is by applying for loans from banking or Non Banking Financial
Corporations(NBFC). This component is known as “Debt”.

5. Cash Flow Statement:

A statement that depicts the money that has entered your business plus the money that
exited during a specific period of time. How much cash/money has been
generated? How much of money has been actually used in various business
activities? These queries can be answered looking at this financial statement.
Hence, in Financial accounting, Cash flow statement comprises of cash generated and
used in operating activities, investing activities and financing activities.
To summarise, the Cash flow statement helps to know the cash inflow and cash
outflow and reconcile the cash position of a company. This statement proves quite
handy for investors.
6. Compound Interest:
Compound interest is a really powerful concept that every newbie must know in order to
learn to multiply his earnings in the long run.
When you earn interest on your amount invested as principal plus on the interest
earned amount also, your returns are going to compound or grow at a geometric rate
over the years.
Compound Interest = Interest on ( Principal+ Accumulated Interest)
This concept plays a crucial role in your retirement planning. The earlier you start
planning your savings and investment, the better accumulated funds you shall have on
your retirement.

What is Investing in Shares or Stocks? Individual Point of view

We generally hear about investing in shares or stocks. But, as a newbie investor, you
might wish to know what this actually means. So, from an individual point of view when
we hear Investing in shares this refers to shares of a company.
A share of ownership that you shall get in a company whether private limited or public
limited company. To simplify, we can say, as an investor, when you buy shares of a
company, you become its shareholder. Now, if that company performs well and its
share price rises, the investment that you had made in it shall automatically increase. In
layman terms, you shall earn profits.
But, if due to some internal or external factors, the company performs badly and share
price of a company falls, your returns reduce. You shall bear losses. Share market is
highly volatile and huge risk is involved in share trading and investing. So, be cautious
and act wisely while investing your hard earned money.

What is Capital Budgeting?

Capital budgeting is a process of evaluating investments and huge expenses in order to
obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vs replace decision. Ideally, an organization would like
to invest in all profitable projects but due to the limitation on the availability of capital an
organization has to choose between different projects/investments.
Capital budgeting as a concept affects our daily lives. Let’s look at an example-

Your mobile phone has stopped working! Now, you have two choices: Either buy a new
one or get the same mobile repaired. Here, you may conclude that the costs of
repairing the mobile increases the life of the phone. However, there could be a
possibility that the cost to buy a new cell phone would be lesser than its repair costs.
So, you decide to replace your cell phone and you proceed to look at different phones
that fit your budget!

What are the objectives of Capital budgeting?

Capital expenditures are huge and have a long-term effect. Therefore, while performing
a capital budgeting analysis an organization must keep the following objectives in mind:

1. Selecting profitable projects

An organization comes across various profitable projects frequently. But due to capital
restrictions, an organization needs to select the right mix of profitable projects that will
increase its shareholders’ wealth.

2. Capital expenditure control

Selecting the most profitable investment is the main objective of capital budgeting.
However, controlling capital costs is also an important objective. Forecasting capital
expenditure requirements and budgeting for it, and ensuring no investment
opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another
important objective of capital budgeting. Finding the balance between the cost of
borrowing and returns on investment is an important goal of Capital Budgeting.

Capital Budgeting Process

The process of capital budgeting is as follows:
1. Identifying investment opportunities
An organization needs to first identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to
purchasing a new asset. For example, a company finds two new products that they can
add to their product line.

2. Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate
its options for investment. That is to say, once it is decided that new product/products
should be added to the product line, the next step would be deciding on how to acquire
these products. There might be multiple ways of acquiring them. Some of these
products could be:

 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or
 Purchased from the market

3. Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an
organization needs to decide the most profitable investment and select it. While
selecting a particular project an organization may have to use the technique of capital
rationing to rank the projects as per returns and select the best option available.
In our example, the company here has to decide what is more profitable for them.
Manufacturing or purchasing one or both of the products or scrapping the idea of
acquiring both.

4. Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund the
project it needs to identify the sources of funds and allocate it accordingly.
The sources of these funds could be reserves, investments, loans or any other available
channel.

5. Performance Review
The last step in the process of capital budgeting is reviewing the investment. Initially,
the organization had selected a particular investment for a predicted return. So now,
they will compare the investments expected performance to the actual performance.
In our example, when the screening for the most profitable investment happened, an
expected return would have been worked out. Once the investment is made, the
products are released in the market, the profits earned from its sales should be
compared to the set expected returns. This will help in the performance review.
CAPITAL BUDGETING TECHNIQUES / METHODS
There are different methods adopted for capital budgeting. The traditional methods or
non discount methods include: Payback period and Accounting rate of return method.
The discounted cash flow method includes the NPV method, profitability index method
and IRR.

 Payback period method:

As the name suggests, this method refers to the period in which the proposal will
generate cash to recover the initial investment made. It purely emphasizes on the cash
inflows, economic life of the project and the investment made in the project, with no
consideration to time value of money. Through this method selection of a proposal is
based on the earning capacity of the project. With simple calculations, selection or
rejection of the project can be done, with results that will help gauge the risks involved.
However, as the method is based on thumb rule, it does not consider the importance of
time value of money and so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow

Example
Project Project
A B
Cost 1,00,000 1,00,000
Expected future cash
flow
Year 1 50,000 1,00,000
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Payback period of project B is shorter than A, but project A provides higher
returns. Hence, project A is superior to B.

Need Guidance? Ask from Experts!

 Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The
rate of return is expressed as a percentage of the earnings of the investment in a
particular project. It works on the criteria that any project having ARR higher than the
minimum rate established by the management will be considered and those below the
predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better
means of comparison. It also ensures compensation of expected profitability of projects
through the concept of net earnings. However, this method also ignores time value of
money and doesn’t consider the length of life of the projects. Also it is not consistent
with the firm’s objective of maximizing the market value of shares.
ARR= Average income/Average Investment

 Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the
life of an asset. These are then discounted through a discounting factor. The discounted
cash inflows and outflows are then compared. This technique takes into account the
interest factor and the return after the payback period.

 Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In
this technique the cash inflow that is expected at different periods of time is discounted
at a particular rate. The present values of the cash inflow are compared to the original
investment. If the difference between them is positive (+) then it is accepted or
otherwise rejected. This method considers the time value of money and is consistent
with the objective of maximizing profits for the owners. However, understanding the
concept of cost of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made in the
initial year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of
the investment proposal and n is the expected life of the proposal. It should be noted
that the cost of capital, K, is assumed to be known, otherwise the net present, value
cannot be known.
 NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs

 Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The
discounted cash inflow is equal to the discounted cash outflow. This method also
considers time value of money. It tries to arrive to a rate of interest at which funds
invested in the project could be repaid out of the cash inflows. However, computation of
IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.
It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IR < k = reject

 Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to
the initial cash outflow of the investment. It may be gross or net, net being simply gross
minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as
follows.
PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term
investments which involve more financial risks. That is why proper planning through
capital budgeting is needed.
2) Huge investments and irreversible ones: As the investments are huge but the
funds are limited, proper planning through capital expenditure is a pre-requisite. Also,
the capital investment decisions are irreversible in nature, i.e. once a permanent asset
is purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to evaluate
different projects in terms of their viability to be taken up for investments
 It helps in exposing the risk and uncertainty of different projects
 It helps in keeping a check on over or under investments
 The management is provided with an effective control on cost of capital
expenditure projects
 Ultimately the fate of a business is decided on how optimally the available
resources are used

Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three steps: recording the
investment’s cost, projecting the investment’s cash flows and comparing the projected
earnings with inflation rates and the time value of the investment.
For example, equipment that costs $15,000 and generates a $5,000 annual return
would appear to "pay back" on the investment in 3 years. However, if economists
expect inflation to rise 30 percent annually, then the estimated return value at the end of
the first year ($20,000) is actually worth $15,385 when you account for inflation
($20,000 divided by 1.3 equals $15,385). The investment generates only $385 in real
value after the first year.
Definition of WACC

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of
capital across all sources, including common shares, preferred shares, and debt. The
cost of each type of capital is weighted by its percentage of total capital and they are
added together. This guide will provide a detailed breakdown of what WACC is, why it is
used, how to calculate it, and will provide several examples.

WACC is used in financial modeling as the discount rate to calculate the net present
value of a business.

What is the WACC Formula?

As shown below, the WACC formula is:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
An extended version of the WACC formula is shown below, which includes the cost of
Preferred Stock (for companies that have it).

The purpose of WACC is to determine the cost of each part of the company’s capital
structure based on the proportion of equity, debt, and preferred stock it has. Each
component has a cost to the company. The company pays a fixed rate of interest on its
debt and a fixed yield on its preferred stock. Even though a firm does not pay a fixed
rate of return on common equity, it does often pay dividends in the form of cash to
equity holders.

The weighted average cost of capital is an integral part of a DCF valuation model and
hence it is an important concept to understand for finance professionals, especially
for investment banking and corporate development roles. This article will go through
each component of the WACC calculation.

WACC Part 1 – Cost of Equity

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which
equates rates of return to volatility (risk vs reward). Below is the formula for the cost of
equity:

Re = Rf + β × (Rm − Rf)

Where:

Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)
β = equity beta (levered)
Rm = annual return of the market

The cost of equity is an implied cost or an opportunity cost of capital. It is the rate of
return shareholders require, in theory, in order to compensate them for the risk of
investing in the stock. The Beta is a measure of a stock’s volatility of returns relative to
the overall market (such as the S&P 500). It can be calculated by downloading
historical return data from Bloomberg or using the WACC and BETA functions.

Risk-free Rate

The risk-free rate is the return that can be earned by investing in a riskless security,
e.g., U.S. Treasury bonds. Typically, the yield of the 10-year U.S. Treasury is used for
the risk-free rate.

Equity Risk Premium (ERP)

Equity Risk Premium (ERP) is defined as the extra yield that can be earned over the
risk-free rate by investing in the stock market. One simple way to estimate ERP is to
subtract the risk-free return from the market return. This information will normally be
enough for most basic financial analysis. However, in reality, estimating ERP can be a
much more detailed task. Generally, banks take ERP from a publication called
Ibbotson’s.

Levered Beta

Beta refers to the volatility or riskiness of a stock relative to all other stocks in the
market. There are a couple of ways to estimate the beta of a stock. The first and
simplest way is to calculate the company’s historical beta (using regression analysis) or
just pick up the company’s regression beta from Bloomberg. The second and more
thorough approach is to make a new estimate for beta using public company
comparables. To use this approach, the beta of comparable companies is taken from
Bloomberg and the unlevered beta for each company is calculated.

Unlevered Beta = Levered Beta / ((1 + (1 – Tax Rate) * (Debt / Equity))

Levered beta includes both business risk and the risk that comes from taking on debt.
However, since different firms have different capital structures, unlevered beta (asset
beta) is calculated to remove additional risk from debt in order to view pure business
risk. The average of the unlevered betas is then calculated and re-levered based on the
capital structure of the company that is being valued.

Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))

In most cases, the firm’s current capital structure is used when beta is re-levered.
However, if there is information that the firm’s capital structure might change in the
future, then beta would be re-levered using the firm’s target capital structure.

After calculating the risk-free rate, equity risk premium, and levered beta, the cost of
equity = risk-free rate + equity risk premium * levered beta.
WACC Part 2 – Cost of Debt and Preferred Stock

Determining the cost of debt and preferred stock is probably the easiest part of the
WACC calculation. The cost of debt is the yield to maturity on the firm’s debt and
similarly, the cost of preferred stock is the yield on the company’s preferred stock.
Simply multiply the cost of debt and yield on preferred stock with the proportion of debt
and preferred stock in a company’s capital structure, respectively.

Since interest payments are tax-deductible, the cost of debt needs to be multiplied by (1
– tax rate), which is referred to as the value of the tax shield. This is not done for
preferred stock because preferred dividends are paid with after-tax profits.

Take the weighted average current yield to maturity of all outstanding debt then multiply
it one minus the tax rate and you have the after-tax cost of debt to be used in
the WACC formula.
What Is a Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an
investment based on its future cash flows. DCF analysis attempts to figure out the value
of a company today, based on projections of how much money it will generate in
the future.

DCF analysis finds the present value of expected future cash flows using a discount
rate. A present value estimate is then used to evaluate a potential investment. If the
value calculated through DCF is higher than the current cost of the investment, the
opportunity should be considered

What is the Discounted Cash Flow DCF Formula?

The discounted cash flow (DCF) formula is equal to the sum of the cash flow in each
period divided by one plus the discount rate (WACC) raised to the power of the period
number.

Here is the DCF formula:

Where:

CF = Cash Flow in the Period

r = the interest rate or discount rate

n = the period number

Analyzing the Components of the Formula

1. Cash Flow (CF)

Cash Flow (CF) represents the free cash payments an investor receives in a given
period for owning a given security (bonds, shares, etc.)

When building a financial model of a company, the CF is typically what’s known

as unlevered free cash flow. When valuing a bond, the CF would be interest and or
principal payments.
2. Discount Rate (r)

For business valuation purposes, the discount rate is typically a firm’s Weighted
Average Cost of Capital (WACC). Investors use WACC because it represents the
required rate of return that investors expect from investing in the company.

For a bond, the discount rate would be equal to the interest rate on the security.

3. Period Number (n)

Each cash flow is associated with a time period. Common time periods are years,
quarters or months. The time periods may be equal, or they may be different. If they’re
different, they’re expressed as a decimal.

What is the DCF Formula Used For?

The DCF formula is used to determine the value of a business or a security. It

represents the value an investor would be willing to pay for an investment, given a
required rate of return on their investment (the discount rate).

Examples of Uses for the DCF Formula:

 To value an entire business

 To value a project or investment within a company
 To value a bond
 To value shares in a company
 To value an income producing property
 To value the benefit of a cost-saving initiative at a company
 To value anything that produces (or has an impact on) cash flow

What is the Dividend Discount Model?

The Dividend Discount Model (DDM) is a quantitative method of valuing a company’s

stock price based on the assumption that the current fair price of a stock equals the sum
of all of the company’s future dividends discounted back to their present value.
Breaking Down the Dividend Discount Model

The dividend discount model was developed under the assumption that the intrinsic
value of a stock reflects the present value of all future cash flows generated by a
security. At the same time, dividends are essentially the positive cash flows generated
by a company and distributed to the shareholders.

Generally, the dividend discount model provides an easy way to calculate a fair stock
price from a mathematical perspective with minimum input variables required. However,
the model relies on several assumptions that cannot be easily forecasted.

Depending on the variation of the dividend discount model, an analyst requires

forecasting future dividend payments, the growth of dividend payments, and the cost of
equity capital. Forecasting all the variables precisely is almost impossible. Thus, in
many cases, the theoretical fair stock price is far from reality.

Formula for the Dividend Discount Model

The dividend discount model can take several variations depending on the stated
assumptions. The variations include the following:

1. Gordon Growth Model

The Gordon Growth Model (GGM) is one of the most commonly used variations of
the dividend discount model. The model is called after American economist Myron J.
Gordon, who proposed the variation.

The GGM is based on the assumptions that the stream of future dividends will grow at
some constant rate in future for an infinite time. Mathematically, the model is expressed
in the following way:
Where:

 V0 – the current fair value of a stock

 D1 – the dividend payment in one period from now
 r – the estimated cost of equity capital (usually calculated using CAPM)
 g – the constant growth rate of the company’s dividends for an infinite time

2. One-period Dividend Discount Model

The one-period discount dividend model is used much less frequently than the Gordon
Growth model. The former is applied when an investor wants to determine the intrinsic
price of a stock that he or she will sell in one period from now. The one-period dividend
discount model uses the following equation:

Where:

 V0 – the current fair value of a stock

 D1 – the dividend payment in one period from now
 P1 – the stock price in one period from now
 r – the estimated cost of equity capital

3. Multi-period Dividend Discount Model

The multi-period dividend discount model is an extension of the one-period dividend
discount model wherein an investor expects to hold a stock for the multiple periods. The
main challenge of the multi-period model variation is that forecasting dividend payments
for different periods is required. The model’s mathematical formula is below: