304A- Financial Management & Decision Making

Unit- 1: Time value of Money

The simplest tools in finance are often the most powerful. Present
value is a concept that is intuitively appealing, simple to compute, and
has a wide range of applications. It is useful in decision making
ranging from simple personal decisions— buying a house, saving for
a child’s education, and estimating income in retirement—to more
complex corporate financial decisions—picking projects in which to
invest as well as the right financing mix for these projects.

1.1 Timelines and notations

Dealing with cash flows that are at different points in time is made
easier using a time line that shows both the timing and the amount of
each cash flow in a stream. Thus, a cash flow stream of $100 at the
end of each of the next 4 years can be depicted on a time line like the
one depicted below.

In the figure, 0 refers to right now. A cash flow that occurs at time 0
is therefore already in present value terms and does not need to be
adjusted for time value. A distinction must be made here between
a period of time and a point in time. The portion of the time line
between 0 and 1 refers to period 1, which, in this example, is the first
year.

The cash flow that occurs at the point in time 1 refers to the cash
flow that occurs at the end of period 1. The discount rate, which is

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10% in this example, is specified for each period on the time line and
may be different for each period. Note that in present value terms, a
cash flow that occurs at the end of period 1 is the equivalent of a cash
flow that occurs at the beginning of period 2.
Cash flows can be either positive or negative; positive cash flows are
called cash inflows and negative cash flows are called cash outflows.
For notational purposes, the following abbreviations are used:

Notation Stands for

PV Present value
FV Future value
Cash flow at the end of
Cft
period t
Annuity: Constant cash
A flows over several
periods
Discount Rate (also
k often abbreviated
as r or i)
g Expected growth rate
Number of periods over
n which cash flows are
received or paid

1.2 Future value of Single Amount

The value of a current single amount taken to a future date at a

specified interest rate is called the future value of a single amount.

In this case, "future value" means the amount to which

the investment will grow at a future date if interest is compounded.
The single amount refers to a lump sum invested at the beginning of
a period (e.g., year 1) and left intact for all periods.

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Explanation
To explain the concept of the future value of a single amount, let's
start with the table below.

In this table, we see what the future amount of $10,000 invested at

12% annual interest for three years would be, given a certain
compounding pattern. This is an example of determining the future
value of a single amount.

There were no additional investments or interest withdrawals. These

future value or compound interest calculations are important in
many personal and business financial decisions.

Formula for Accumulated Amount at Different

Compounded Rates

In this formula, the variables are defined as follows:

• p = Principal amount
• i = Interest rate
• n = Number of compounding periods

In the example of the amount of $10,000 compounded annually for 3

years at 12%, the $14,049.28 can be determined by the following
calculation:

= $10,000(1 + .12)3

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= $14,049.28

However, one of the simplest methods is to use tables that give the
future value of $1 at different interest rates and for different
periods.

Essentially, these tables interpret the above mathematical formula

for various interest rates and compounding periods for a principal
amount of $1.

Once the amount for $1 is known, it is easy to determine the amount

for any principal by multiplying the future amount for $1 by the
required principal amount. Many hand calculators also have function
keys that can be used to solve these types of problems.

1.3 Present Value of a Single Amount

What Is the Present Value of a Single Amount?
The value of a future promise to pay or receive a single amount at a
specified interest rate is called the present value of a single amount.

Present Value of a Single Amount: Explanation

Many times in business and life, we want to determine the value
today of receiving a specific single amount at some time in the
future.

For example, suppose you want to know the value today of receiving
$15,000 at the end of 5 years if a rate of return of 12% is earned.

Another way of asking this question is: What amount would you need
to invest today at 12% compounded annually in order to receive
$15,000 after 5 years?

Problems and questions like this are known as "present value of a

single amount problems." This is because we are interested in finding

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the present value, or the value today, of receiving a set sum in the
future.

Intuitively, we know that the present value will be less than the
future value.

For example, if you had the choice of receiving $12,000 today or in 2

years, you would take the $12,000 today.

This is because you can invest the $12,000 so that it will accumulate
to more than $12,000 at the end of 2 years.

Another way of looking at this is to say that because of the time

value of money, you would take an amount less than $12,000 if you
could receive it today, instead of $12,000 in 2years.

The amount you would be willing to accept depends on the interest

rate or the rate of return you receive.

Formula For Present Value of a Single Amount

The formula used to calculate the present value of a single amount
is:

In this formula, the following variables are defined as:

• PV = Present value of the amount

• FV = Future value of the amount (amount to be received

in future)

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 • i = Interest rate (in percentage terms)

• n = Number of periods after which the amount will be

received in future

Example
Suppose a company expects to receive $8,000 after 5 years.
Calculate the present value of this sum if the current market interest
rate is 12% and the interest is compounded annually.

Solution
The way to solve this is to apply the above present value formula. In
this example, the number of periods (n) is 5 and the interest rate (i)
is 12%. Therefore, the present value (PV) is calculated as follows:

PV = FV x 1 / (1+i)n

= 8,000 x 1 / (1+12%)5

= 8,000 x 1 / (1+0.12)5

= 8,000 x 1 / (1.12)5

= 8,000 x 1 / 1.7623

= 8,000 x 0.5674

= $4,540

According to these results, the amount of $8,000, which will be

received after 5 years, has a present value of $4,540.

This example shows that if the $4,540 is invested today at 12%

interest per year, compounded annually, it will grow to $8,000 after
5 years.

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In present value situations, the interest rate is often called the
discount rate. This is because we are discounting a future value back
to the present. Some individuals refer to present value problems as
"discounted present value problems."

One way to solve present value problems is to apply the general

formula we developed for the future value of a single amount
problems.

For example, returning to the previous example, assume that at the

end of 5 years, you aim to have $15,000. If you can earn 12% interest
compounded annually, how much do you need to invest today?

Using the general formula for the present value table, the answer is
$8,511.40. The working is as follows:

Accumulated amount = Factor x Principal

Principal = Accumulated amount / Factor

= $15,000 / 1.7623

= $8,511.40

This is equivalent to saying that at a 12% interest rate compounded

annually, it does not matter whether you receive $8,511.40 today or
$15,000 at the end of 5 years.

Based on this result, if someone offered you an investment at

a cost of $8,000 that would return $15,000 at the end of 5 years, you
would do well to take it if the minimum rate of return was 12%.

This is because at 12% the $15,000 is actually worth $8,511.45 today,

but you would need to make an outlay of only $8,000.

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1.4 Future value of Annuity

What Is the Future Value of an Annuity?

The future value of an annuity is the value of a group of recurring

payments at a certain date in the future, assuming a particular rate of
return, or discount rate.

The higher the discount rate, the greater the annuity's future value. As
long as all of the variables surrounding the annuity are known such as
payment amount, projected rate, and number of periods, it is possible
to calculate the future value of the annuity.

Understanding the Future Value of an Annuity

Because of the time value of money, money received or paid out

today is worth more than the same amount of money will be in the
future. That's because the money can be invested and allowed to grow
over time. By the same logic, a lump sum of $5,000 today is worth
more than a series of five $1,000 annuity payments spread out over
five years.

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KEY TAKEAWAYS
• The future value of an annuity is a way of calculating how much
money a series of payments will be worth at a certain point in
the future.
• By contrast, the present value of an annuity measures how much
money will be required to produce a series of future payments.
• In an ordinary annuity, payments are made at the end of each
agreed-upon period. In an annuity due, payments are made at the
beginning of each period.
• To calculate the future value of an annuity, you must know the
annuity payment amount, number of periods, and projected rate
of return.
• Because annuity due payments often entail having an additional
compounding period, the future value of an annuity due will
usually be higher than the future value of an annuity.

1.5 Present value of Annuity

What Is the Present Value of an Annuity?

The present value of an annuity is the current value of

future payments from an annuity, given a specified rate of return,
or discount rate. The higher the discount rate, the lower the present
value of the annuity.

Present value (PV) is an important calculation that relies on the

concept of the time value of money, whereby a dollar today is
relatively more "valuable" in terms of its purchasing power than a
dollar in the future.

Understanding the Present Value of an Annuity

An annuity is a financial product that provides a stream of payments
to an individual over a period of time, typically in the form of regular

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installments. Annuities can be either immediate or deferred,
depending on when the payments begin. Immediate annuities start
paying out right away, while deferred annuities have a delay before
payments begin.

Because of the time value of money, money received today is worth

more than the same amount of money in the future because it can be
invested in the meantime. By the same logic, $5,000 received today is
worth more than the same amount spread over five annual
installments of $1,000 each.

Present value is an important concept for annuities because it allows

individuals to compare the value of receiving a series of payments in
the future to the value of receiving a lump sum payment today. By
calculating the present value of an annuity, individuals can determine
whether it is more beneficial for them to receive a lump sum payment
or to receive an annuity spread out over a number of years. This can
be particularly important when making financial decisions, such as
whether to take a lump sum payment from a pension plan or to
receive a series of payments from an annuity. Present value
calculations can also be used to compare the relative value of different
annuity options, such as annuities with different payment amounts or
different payment schedules.

Formula and Calculation of the Present Value of an Annuity

The formula for the present value of an ordinary annuity, is below. An

ordinary annuity pays interest at the end of a particular period, rather
than at the beginning:1

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KEY TAKEAWAYS
• The present value of an annuity refers to how much money
would be needed today to fund a series of future annuity
payments.
• Because of the time value of money, a sum of money received
today is worth more than the same sum at a future date.
• You can use a present value calculation to determine whether
you'll receive more money by taking a lump sum now or an
annuity spread out over a number of years.

1.6 Present value of Perpetuity

What Does Perpetuity Mean in Finance?

A perpetuity is a security that pays for an infinite amount of time. In

finance, perpetuity is a constant stream of identical cash flows with no
end.

The concept of perpetuity is also used in several financial theories,

such as in the dividend discount model (DDM).

Understanding Perpetuity

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An annuity is a stream of cash flows. A perpetuity is a type of annuity
that lasts forever, into perpetuity. The stream of cash flows continues
for an infinite amount of time. In finance, a person uses the perpetuity
calculation in valuation methodologies to find the present value of a
company's cash flows when discounted back at a certain rate.

An example of a financial instrument with perpetual cash flows was

the British-issued bonds known as consols, which the Bank of
England phased out in 2015. By purchasing a consol from the British
government, the bondholder was entitled to receive annual interest
payments forever.

Although it may seem a bit illogical, an infinite series of cash flows

can have a finite present value. Because of the time value of money,
each payment is only a fraction of the last.

Specifically, the perpetuity formula determines the amount of cash

flows in the terminal year of operation. In valuation, a company is
said to be a going concern, meaning that it goes on forever. For this
reason, the terminal year is a perpetuity, and analysts use the
perpetuity formula to find its value.

How Does Perpetuity Work in a Security?

A perpetuity is a financial instrument that offers a stream of cash
flows in perpetuity—that is, without end. Before 2015, the U.K.
offered a government bond called a “consol” that was structured as a

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perpetuity, although these instruments have since been
discontinued.1 Unlike other bonds, perpetuities do not have a fixed
maturity date, but instead, continue paying interest indefinitely.

How Is a Perpetuity Valued?

At first glance, it may seem as though an instrument that offers an
infinite stream of cash flows would be almost infinitely valuable, but
this is not the case. Mathematically speaking, the value of a perpetuity
is finite, and its value can be determined by discounting its future cash
flows to the present using a specified discount rate. This procedure,
known as discounted cash flow (DCF) analysis, is also widely used to
value other types of securities, such as stocks, bonds, and real estate
investments.

What Is the Difference Between a Perpetuity and an Annuity?

A perpetuity and an annuity are similar instruments in that both offer
a fixed set of cash flows over time. However, the key difference
between them is that annuities have a predetermined end date, known
as the “maturity date,” whereas perpetuities are intended to last
forever. Importantly, both annuities and perpetuities can be valued
using DCF analysis.

KEY TAKEAWAYS
• A perpetuity, in finance, refers to a security that pays a never-
ending cash stream.
• It is essentially an annuity with no termination date.
• The present value of a perpetuity is determined by simply
dividing the amount of the regular cash flows by the discount
rate.
• A growing perpetuity includes a growth rate that increases the
cash flows received each period going forward.
• Perpetuities today are uncommon financial products, but the
concept of a perpetuity is nonetheless important in finance.

1.7 Intra-year Compounding and Discounting

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Time Value of Money says that the worth of a unit of money is going to be
changed in future. Put simply, the value of one rupee today will be
decreased in future. The whole concept is about the present value and
future value of money. There are two methods used for ascertaining the
worth of money at different points of time, namely, compounding and
discounting.

Compounding method is used to know the future value of present money.

Conversely, discounting is a way to compute the present value of future
money.

Compounding is helpful to know the future values, of the cash flow,

at the end of the particular period, at a definite rate. Contrary to this,
Discounting is used to determine the present value of the future cash
flow, at a certain interest rate. Here, in this article, we’ve described
the differences between compounding and discounting.
Comparison Chart
BASIS FOR
COMPOUNDING DISCOUNTING
COMPARISON
Meaning The method used to The method used to
determine the future value determine the present

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BASIS FOR
COMPOUNDING DISCOUNTING
COMPARISON
of present investment is value of future cash flows
known as Compounding. is known as Discounting.
Concept If we invest some money What should be the
today, what will be the amount we need to invest
amount we get at a future today, to get a specific
date. amount in future.
Use of Compound interest rate. Discount rate
Known Present Value Future Value
Factor Future Value Factor or Present Value Factor or
Compounding Factor Discounting Factor
Formula FV = PV (1 + r)^n PV = FV / (1 + r)^n

Intra-Year Compounding

Compounding interest more than once a year is called "intra-year

compounding". Interest may be compounded on a semi-annual,
quarterly, monthly, daily, or even continuous basis. When interest is
compounded more than once a year, this affects both future and
present-value calculations.

With intra-year compounding, the periodic interest rate, instead of

being the stated annual rate, becomes the stated annual rate divided by
the number of compounding periods per year. The number of periods,
instead of being the number of years, becomes the number of
compounding periods per year multiplied by the number of years.

As shown in the following table:

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With monthly compounding, for example, the stated annual interest
rate is divided by 12 to find the periodic (monthly) rate, and the
number of years is multiplied by 12 to determine the number of
(monthly) periods

UNIT-2: Risk and Return

2.1 Risk and return of single asset

What is Risk and Return?

Risk and return in financial management is the risk associated with a
certain investment and its returns. Usually, high-risk investments
yield better financial returns, and low-risk investments yield lower
returns. That is, the risk of a particular investment is directly related
to the returns earned from it.

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The risk and return analysis aim to help investors find the best
investments. Hence, investors use many methods to analyze and
evaluate the market, industry, and company. Diversification of the
portfolio, i.e., choosing an optimal mix of different investment
options, can reduce the risk and amplify returns.

Key Takeaways

• The concept of risk and return in finance is an analysis of the

likelihood of challenges involved in investing while measuring
the returns from the same investment.
• The underlying principle is that high-risk investments give
better returns to investors and vice-versa. Hence, the price of
the risk is reflected in the returns.
• Nevertheless, high-risk investments don’t always generate
higher revenue. That is precisely the ‘high risk’ involved in
investing. It’s a coin-tossing situation, and the investor should
be prepared for both scenarios – profit and loss.

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Risk and Return in Financial Management Explained

Risk and return in investing are perhaps the most crucial parameters
considered by investors while choosing an investment option.
Individuals who invest on a large scale analyze the risks involved in a
particular investment and the returns it can yield. Let’s take a step-
by-step approach to understand the concept.

First, let’s begin with risk. A risk can be defined as the uncertainty
related to the investment, market, or company. Investors want
profits, and the risks can potentially reduce the profits, sometimes
even making a loss for them.

Many types of risk are involved in investments – market-specific,

speculative, industrial, volatility, inflation, etc. However, studying the
market thoroughly can help investors make the right decisions. They
can analyze the trends and forecast the situation.

Now, let’s understand return on investment, or ROI. It can be

explained as the financial gains from investing in a certain
investment. Ideally, individuals prefer investments that give them
higher returns, like stocks of Google, Amazon, etc.

Relationship Between Risk and Return

The correlation between financial risk and return is fairly simple to

comprehend. The risk in choosing a certain investment is directly
proportional to the returns. Therefore, selecting a high-risk
investment can give higher profits, while a low-risk investment will
minimize the returns.

So, plotting a graph between the risk of investment and returns will
give a straight line passing through the center.

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2.2 Risk and return of portfolio
One of the ideal measures to reduce risk while
simultaneously maximizing revenue is by diversifying the investment
portfolio. Investors can choose multiple investments that offer
different returns accordingly.

There are different investment options:

stocks, bonds, commodities, mutual funds, etc. Stocks usually carry
high chance of failure but can give good returns. On the other hand,
government bonds can carry low to zero risk but offer low profits.

There are many benefits of diversifying an investment portfolio.

Investors can choose to invest in stocks with high risk and
compensate for the risk by investing in bonds. Bonds usually give
assured returns, although it is low. They can also invest in mutual
funds for a longer period with moderate risk.

Some financial experts even suggest investing in different industries

or markets. Because different sectors prosper and fall at different
times. For example, during the onset of the COVID-19 pandemic,

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many internet and e-commerce companies prospered, whereas
automobile companies didn’t do well. So, taking different investment
stands can help investors in the long run.

Examples
Here are a few examples of risk and return in investing.

Example #1
Consider the example of Jane, who has been investing for many
years. However, she wants to get maximum returns. She consults a
money manager, John, for this purpose. John advises her to diversify
her portfolio.

He suggests the following:

• Hold a FAANG stock.

• Invest in stocks ranging from $100 to $150 like Volkswagen or
Walmart.
• Invest in U.S. Treasury bonds.
• Invest in mutual funds.

This would help her to get better returns and offset losses if any.

Example #2
Let’s look at a recent example. Currently, most stock prices are
falling, especially in the United States. Many are convinced that an
economic recession accompanies this bear market. Therefore, many
people are in a hurry to sell off their shares when they can still make
profits, even if negligible.

However, the New York Times has published a new article that tells
investors not to sell their stocks in a bear market. Instead, they
should hold on to it. Even a cheap stock wouldn’t be a loss in the
long run. The theory behind this is that investors will be able to buy
low and sell high when the prices increase, which it eventually will.
But this will work out only for those ready to invest long-term.

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Also, it doesn’t mean buying and accumulating cheap stocks. Instead,
investors should analyze the market and the company. If they decide
to buy in a bear market, the stock should be promising in the long
run. And, like any investment, this too requires a lot of planning.

Portfolios Returns and Risks

A portfolio is the total collection of all investments held by an

individual or institution, including stocks, bonds, real
estate, options, futures, and alternative investments, such as gold
or limited partnerships.

Most portfolios are diversified to protect against the risk of single

securities or class of securities. Hence, portfolio analysis consists of
analyzing the portfolio as a whole rather than relying exclusively
on security analysis, which is the analysis of specific types of
securities. While the risk-return profile of a security depends mostly
on the security itself, the risk-return profile of a portfolio depends not
only on the component securities, but also on their mixture or
allocation, and on their degree of correlation.

As with securities, the objective of a portfolio may be for capital gains

or for income, or a mixture of both. A growth-oriented portfolio is a
collection of investments selected for their price appreciation
potential, while an income-oriented portfolio consists of investments
selected for their current income of dividends or interest.

The selection of investments will depend on one's tax bracket, need

for current income, and the ability to bear risk, but regardless of the
risk-return objectives of the investor, it is natural to want to minimize
risk for a given level of return. The efficient portfolio consists of
investments providing the greatest return for the risk, or —
alternatively stated — the least risk for a given return. To assemble an
efficient portfolio, one needs to know how to calculate the returns and
risks of a portfolio, and how to minimize risks through diversification.
Portfolio Returns

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Since the return of a portfolio is commensurate with the returns of its
individual assets, the return of a portfolio is the weighted average of
the returns of its component assets.

Portfolio Return Formula

Dollar Amount of
Asset k
n
Portfolio Return on
= ∑ ×
Return Asset k
k=1
Dollar Amount of
Portfolio
n = number of assets

The dollar amount of an asset divided by the dollar amount of the

portfolio is the weighted average of the asset and the sum of all
weighted averages = 100%.

Example: Calculating the Expected Return of a Portfolio of 2

Assets

Example Portfolio
Asset Weightings
Asset A 30%
Asset B 70%
Expected Returns
for each Asset
E(rA) 13.9%
E(rB) 9.7%

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The expected return of this portfolio is calculated thus:

Portfolio Expected Return = .3 × .139 + .7 × .097 = .109 = 10.9%

2.3 Measurements of market risk

What Is Market Risk?

Market risk is the possibility that an individual or other entity will
experience losses due to factors that affect the overall performance of
investments in the financial markets.

KEY TAKEAWAYS
• Market risk, or systematic risk, affects the performance of the
entire market simultaneously.
• Market risk cannot be eliminated through diversification.
• Specific risk, or unsystematic risk, involves the performance of
a particular security and can be mitigated through
diversification.
• Market risk may arise due to changes to interest rates, exchange
rates, geopolitical events, or recessions.

Understanding Market Risk

Market risk and specific risk (unsystematic) make up the two

major categories of investment risk. Market risk, also called
"systematic risk," cannot be eliminated through diversification,
though it can be hedged in other ways. Sources of market risk
include recessions, political turmoil, changes in interest rates,
natural disasters, and terrorist attacks. Systematic, or market
risk, tends to influence the entire market at the same time.

This can be contrasted with unsystematic risk, which is unique

to a specific company or industry. Also known as
“nonsystematic risk,” "specific risk," "diversifiable risk" or
"residual risk," in the context of an investment portfolio,
unsystematic risk can be reduced through diversification.

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Market risk exists because of price changes.1 The standard
deviation of changes in the prices of stocks, currencies, or
commodities is referred to as price volatility. Volatility is rated
in annualized terms and may be expressed as an absolute
number, such as $10, or a percentage of the initial value, such
as 10%.

Measuring Market Risk

To measure market risk, investors and analysts use the value-at-risk
(VaR) method. VaR modeling is a statistical risk management method
that quantifies a stock or portfolio's potential loss as well as the
probability of that potential loss occurring. While well-known and
widely utilized, the VaR method requires certain assumptions that
limit its precision.4 For example, it assumes that the makeup and
content of the portfolio being measured are unchanged over a
specified period. Though this may be acceptable for short-term
horizons, it may provide less accurate measurements for long-term
investments.

Beta is another relevant risk metric, as it measures the volatility or

market risk of a security or portfolio in comparison to the market as a
whole. It is used in the capital asset pricing model (CAPM) to
calculate the expected return of an asset.

What Are Some Types of Market Risk?

The most common types of market risk include interest rate risk,
equity risk, commodity risk, and currency risk. Interest rate risk
covers the volatility that may accompany interest rate fluctuations and
is most relevant to fixed-income investments. Equity risk is the risk
involved in the changing prices of stock investments, and commodity
risk covers the changing prices of commodities such as crude oil and
corn. Currency risk, or exchange-rate risk, arises from the change in
the price of one currency in relation to another. This may affect
investors holding assets in another country.

How Is Market Risk Measured?

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A widely used measure of market risk is the value-at-risk (VaR)
method. VaR modeling is a statistical risk management method that
quantifies a stock or portfolio's potential loss as well as the probability
of that potential loss occurring. While well-known, the VaR method
requires certain assumptions that limit its precision. Beta is another
relevant risk metric, as it measures the volatility or market risk of a
security or portfolio in comparison to the market as a whole. It is used
in the capital asset pricing model (CAPM) to calculate the expected
return of an asset.

2.4 Determinants of Beta

What is Beta in Finance?

The beta (β) of a stock or any other investment security is a

calculation of its volatility of returns in comparison to the entire
market. It is utilized as a calculation of risk and is an important part of
the Capital Asset Pricing Model (CAPM). A stock with a greater beta
has greater risk as well as greater expected returns.

The beta coefficient can be understood as follows −

• β = 1 − Beta exactly as volatile as the market
• β < 1 − Beta is less volatile than the market
• β > 1 − Beta is more volatile than the market
• β = 0 − Beta is uncorrelated to the market
• β < 0 − Beta is negatively correlated to the market

Examples of beta
• High β – A company with a β greater than 1 is more volatile
than the chosen market. For example, a high-risk electronic
company with a β of 1.65 would have returned 165% of what
the market has returned in a given period.
• Low β – A company with a β lower than 1 is less volatile than
the entire market. As an example, if an energy supplier company
with a β of 0.35, which would have returned only 35% of what
the market has returned in a given period.

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 • Negative β – A negative β company is negatively correlated to
the returns of the market. For example, a jewelry company with
a β of −0.3, which would have returned −3% when the market
was up 20%.

Three factors that affect Beta values

• Nature of the business. Usually, the earnings of a company

keep on fluctuating with time due to the business cycles. The
earning may go up in the growth phase in the business cycle,
while the earnings may go down when a firm is in the
contraction phase. Therefore, the company's earnings are related
to the conditions of business. In such circumstances, the
accounting betas usually correlate with the market beta, which is
based on share market returns and not the earnings.
• Financial leverage. Financial leverage is described as the debt
portion of the financial structure of a company. It shows how
much debt a company has taken to run the business. The more
the debt, the greater is the risk of the business organization. So,
growth in financial leverage increases the financial risk.
Therefore, this will increase the beta of a companies’ stock as
well.
• Operating leverage. Operating leverage is the change in
economic earnings before tax and interest. Having operating
leverage makes the companies be more volatile in terms of
management of assets. Firms with a higher operating lease are
risky; consequently, their stocks have a higher beta.

2.5 Relationship between risk and return

The Risk-Return Relationship

In general, higher investment returns can only be generated by

taking on higher investment risk. However, this does not hold in

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every single scenario. For example, by diversifying a portfolio of
investment assets, a comparable return can often be generated with
less risk than an undiversified investment portfolio. That being said,
there is a limit to the effectiveness of diversification as a portfolio
grows increasingly large.

The risk-return trade-off is a foundational investment principle.

There are many different types of investments and asset classes,
such as money market securities, bonds, public equities, private
equity, private debt, and real estate, to name but a few. All of these
asset classes come with varying levels of investment risk. Having
investments with different risk-return profiles helps meet the
different risk appetites of various investor groups.

Consider the above graph. Asset class #1, risk-free bonds, are issued
by governments and, in most cases, are considered “risk-free” since a
government can print money to pay off its debts. Because of this,
risk-free bonds are the safest asset and consequently have the
lowest investment return.

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Moving up the risk-return spectrum, we can see that each asset class
gets riskier. However, the potential investment return associated
with each asset class also increases.

Asset class #5 is private equity, which involves investments in private

companies that are not publicly traded on an exchange. These
investments are typically riskier than public equities and include
additional risks such as liquidity risk. However, because of these
additional risks, private equity also offers investors the highest
potential investment returns.

UNIT-3: Capital Structure and Firm’s Value

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3.1 Assumption and definition

What is Capital Structure

The most crucial component of starting a business is capital. It acts as
the foundation of the company. Debt and Equity are the two primary
types of capital sources for a business. Capital structure is defined as
the combination of equity and debt that is put into use by a company
in order to finance the overall operations of the company and for its
growth.
Types of Capital Structure
The meaning of Capital structure can be described as the
arrangement of capital by using different sources of long term funds
which consists of two broad types, equity and debt. The different
types of funds that are raised by a firm include preference shares,
equity shares, retained earnings, long-term loans etc. These funds
are raised for running the business.
Equity Capital
Equity capital is the money owned by the shareholders or owners. It
consists of two different types
a) Retained earnings: Retained earnings are part of the profit that
has been kept separately by the organisation and which will help in
strengthening the business.
b) Contributed Capital: Contributed capital is the amount of money
which the company owners have invested at the time of opening the
company or received from shareholders as a price for ownership of
the company.
Debt Capital
Debt capital is referred to as the borrowed money that is utilised in
business. There are different forms of debt capital.

1. Long Term Bonds: These types of bonds are considered the

safest of the debts as they have an extended repayment

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 period, and only interest needs to be repaid while the principal
needs to be paid at maturity.
2. Short Term Commercial Paper: This is a type of short term debt
instrument that is used by companies to raise capital for a short
period of time

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and
equity financing that helps in maximising the value of a company in
the market while at the same time minimises its cost of capital.
Capital structure varies across industries. For a company involved in
mining or petroleum and oil extraction, a high debt ratio is not
suitable, but some industries like insurance or banking have a high
amount of debt as part of their capital structure.
Financial Leverage
Financial leverage is defined as the proportion of debt that is part of
the total capital of the firm. It is also known as capital gearing. A firm
having a high level of debt is called a highly levered firm while a firm
having a lower ratio of debt is known as a low levered firm.
Importance of Capital Structure
Capital structure is vital for a firm as it determines the overall
stability of a firm. Here are some of the other factors that highlight
the importance of capital structure

1. A firm having a sound capital structure has a higher chance of

increasing the market price of the shares and securities that it
possesses. It will lead to a higher valuation in the market.
2. A good capital structure ensures that the available funds are
used effectively. It prevents over or under capitalisation.
3. It helps the company in increasing its profits in the form of
higher returns to stakeholders.
4. A proper capital structure helps in maximising shareholder’s
capital while minimising the overall cost of the capital.
5. A good capital structure provides firms with the flexibility of
increasing or decreasing the debt capital as per the situation.

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Factors Determining Capital Structure
Following are the factors that play an important role in determining
the capital structure:

1. Costs of capital: It is the cost that is incurred in raising capital

from different fund sources. A firm or a business should
generate sufficient revenue so that the cost of capital can be
met and growth can be financed.
2. Degree of Control: The equity shareholders have more rights in
a company than the preference shareholders or the debenture
shareholders. The capital structure of a firm will be determined
by the type of shareholders and the limit of their voting rights.
3. Trading on Equity: For a firm which uses more equity as a
source of finance to borrow new funds to increase returns.
Trading on equity is said to occur when the rate of return on
total capital is more than the rate of interest paid on
debentures or rate of interest on the new debt borrowed.
4. Government Policies: The capital structure is also impacted by
the rules and policies set by the government. Changes in
monetary and fiscal policies result in bringing about changes in
capital structure decisions.

Assumptions:
The relationship between the Capital Structure and the Cost of
Capital can better be understood if we assume:

(i) Two types of capital, viz., debt and equity, are employed;
(ii) Total assets of the firms must be presented;
(iii) Regularity of paying 100% dividends to the shareholders;
(iv) The operating incomes may not be expected to grow further;
(v) Business risk should be constant;
(vi) There will not be any income tax;
(vii) Investors should bear the same subjective probability
distribution relating to future operating income;

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(viii) The firm must enjoy a perpetual life.

3.2 Net income and net operating income approach

Difference between Operating Income and Net Income

Operating Income
Operating income is defined as the profit of a company after
deducting the operating expenses, which include the costs of running
its everyday operations. Operating income, which is also
synonymous with the operating profit, allows the analysts and the
investors to help see the company’s operating performance. These
expenses include general, administrative, selling, depreciation as
well as amortisation, along with the other operating expenses.

The operating income excludes several items like the investments in

other firms (also known as the non-operating income), interest
expenses and taxes. Also, the non-recurring items like the cash paid
in lieu of a lawsuit settlement are also not included in the operating
income. It is calculated by subtracting the operating expenses from
the gross profit of a company. The gross profit is defined as the total
revenue minus the costs of goods sold for an organisation. It is
extremely important to note that the operating income of a
company helps the stakeholders determine the gross earnings from
the operating and non-operating activities of a company.

Net Income
Net income is defined as the actual profits or earnings of a company.
The net income is also referred to as the bottom line as it sits at the
bottom of an income statement, and it is defined as the income that
remains after factoring in the total expenses, additional income
streams, debts and operating costs of running a company. The
bottom line is also known as the net income of a firm on the income
statement.

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The net income is calculated by the process of netting out several
items from operating income which include interest, depreciation,
taxes and other expenses. Sometimes the additional income streams
also end up in adding to the earnings like the interest on investments
or the proceeds from the sale of the assets of a firm.

In short, the net income of a firm is defined as the profit after all the
expenses get deducted from the revenues. The expenses include
general and administrative costs, interest on loans, income taxes and
other operating expenses such as utilities, rent, and payroll.

Difference between Operating Income and Net Income

It is important to understand that both operating income and net

income are extremely important to estimate the short term and long
term profitability of a firm. The stakeholders need to be aware of
these figures to gauge the direction of the company. There are some
major areas of difference between operating income and net
income, and we should focus on them below to get a better
understanding of the topic:

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Operating Income
Definition
Operating income is defined as
the company’s profit after
deducting the operating
expenses, which are the costs of
running its everyday operations.
Formula
The formula for operating
income is as follows:
Operating Income = Gross
Income – (COGS + Operating
Expenses + Depreciation and
Amortisation)
Significance
The operating income helps to
identify the proportion of
revenue that actually gets
transformed into profits. It helps
to calculate the total return on
capital employed.
Taxes
Taxes are not considered while
calculating the operating
income.
Components
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Net Income
Net income of a company is defined as
the income that remains after factoring in
all the debts, expenses, additional income
streams and the operating costs. It is also
known as its bottom line because it sits at
the bottom of the income statement.
The formula for operating income is as
follows:
Net Income = Operating Income +
(Investment Income – Interest Expense) +
(Extraordinary Income – Extraordinary
Expenses) – Taxes
The net income helps to identify the
actual earning potential for any business.
It is also used to calculate the ratios like
earnings per share, return on equity,
return on assets, etc.
Taxes are considered while calculating the
net income.
 The main components of The main components of net income can
operating income include also include the additional income like the
expenses like depreciation and sale of assets or interest income.
amortisation, selling expenses,
administrative expenses and
general expenses.

Conclusion
There are a number of points of difference between operating
income and net income. Both operating income and net income
display the income that is earned by a company. However, the two
represent distinctly separate ways of expressing an organisation’s
earnings. Both these metrics have their advantages, but they also
have different methods involved in the calculations. It is in the final
analysis of these two numbers that the investors will determine
where in the final process any company has started to earn a profit
or suffer a loss.

3.3 Traditional position

What Is the Traditional Theory of Capital Structure?

The traditional theory of capital structure states that when
the weighted average cost of capital (WACC) is minimized, and
the market value of assets is maximized, an optimal structure of
capital exists. This is achieved by utilizing a mix of both equity and
debt capital. This point occurs where the marginal cost of debt and
the marginal cost of equity are equated, and any other mix of debt
and equity financing where the two are not equated allows an
opportunity to increase firm value by increasing or decreasing the
firm’s leverage.

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KEY TAKEAWAYS
• The traditional theory of capital structure says that for any
company or investment there is an optimal mix of debt and
equity financing that minimizes the WACC and maximizes
value.
• Under this theory, the optimal capital structure occurs where
the marginal cost of debt is equal to the marginal cost of
equity.
• This theory depends on assumptions that imply that the cost of
either debt or equity financing vary with respect to the degree
of leverage.

Understanding the Traditional Theory of Capital Structure

The traditional theory of capital structure says that a firm's value
increases to a certain level of debt capital, after which it tends to
remain constant and eventually begins to decrease if there is too
much borrowing. This decrease in value after the debt tipping point
happens because of overleveraging. On the other hand, a company
with zero leverage will have a WACC equal to its cost of equity
financing and can reduce its WACC by adding debt up to the point
where the marginal cost of debt equals the marginal cost of equity
financing. In essence, the firm faces a trade-off between the value of
increased leverage against the increasing costs of debt as borrowing
costs rise to offset the increase value. Beyond this point, any
additional debt will cause the market value and to increase the cost
of capital. A blend of equity and debt financing can lead to a
firm's optimal capital structure.

The traditional theory of capital structure tells us that wealth is not

just created through investments in assets that yield a positive return
on investment; purchasing those assets with an optimal blend
of equity and debt is just as important. Several assumptions are at
work when this theory is employed, which together imply that the
cost of capital depends upon the degree of leverage. For example,

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there are only debt and equity financing available for the firm, the
firm pays all of its earnings as a dividend, the firm's total assets and
revenues are fixed and do not change, the firm's financing is fixed
and does not change, investors behave rationally, and there are no
taxes. Based on this list of assumptions, it is probably easy to see
why there are several critics.

The traditional theory can be contrasted with the Modigliani and

Miller (MM) theory, which argues that if financial markets are
efficient, then debt and equity finance will be essentially
interchangeable and that other forces will indicate the optimal
capital structure of a firm, such as corporate tax rates and tax
deductibility of interest payments.

3.4 Modigliani and Miller position

What Is the Modigliani-Miller Theorem (M&M)?

The Modigliani-Miller theorem (M&M) states that the market value
of a company is correctly calculated as the present value of its future
earnings and its underlying assets, and is independent of its capital
structure.
At its most basic level, the theorem argues that, with certain
assumptions in place, it is irrelevant whether a company finances its
growth by borrowing, by issuing stock shares, or by reinvesting its
profits.
Developed in the 1950s, the theory has had a significant impact on
corporate finance.

Understanding the Modigliani-Miller Theorem

Companies have only three ways to raise money to finance their
operations and fuel their growth and expansion. They can borrow
money by issuing bonds or obtaining loans; they can re-invest their
profits in their operations, or they can issue new stock shares to
investors.

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0 seconds of 1 minute, 32 secondsVolume 75%

Modigliani-Miller Theorem
The Modigliani-Miller theorem argues that the option or
combination of options that a company chooses has no effect on its
real market value.

Merton Miller, one of the two originators of the theorem, explains

the concept behind the theory with an analogy in his book, Financial
Innovations and Market Volatility:

"Think of the firm as a gigantic tub of whole milk. The farmer can sell
the whole milk as is. Or he can separate out the cream and sell it at a
considerably higher price than the whole milk would bring. (That's
the analog of a firm selling low-yield and hence high-priced debt
securities.) But, of course, what the farmer would have left would be
skim milk with low butterfat content and that would sell for much
less than whole milk. That corresponds to the levered equity. The M
and M proposition says that if there were no costs of separation
(and, of course, no government dairy-support programs), the cream
plus the skim milk would bring the same price as the whole milk."

History of the M&M Theory

Merton Miller and Franco Modigliani conceptualized and developed
this theorem, and published it in an article, "The Cost of Capital,
Corporation Finance and the Theory of Investment," which appeared
in the American Economic Review in the late 1950s.

At the time, both Modigliani and Miller were professors at the

Graduate School of Industrial Administration at Carnegie Mellon
University. Both were required to teach corporate finance to
business students but, unhappily, neither had any experience in
corporate finance. After reading the course materials that they were

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to use, the two professors found the information inconsistent and
the concepts flawed. So, they worked together to correct them.3
Later Additions

The result was the groundbreaking article published in the economic

journal. The information was eventually compiled and organized to
become the M&M theorem.

Early on, the two economists realized that their initial theorem left
out a number of relevant factors. It left out such matters as taxes
and financing costs, effectively arguing its point in the vacuum of a
"perfectly efficient market."

Later versions of their theorem addressed these issues, including

"Corporate Income Taxes and the Cost of Capital: A Correction,"
published in the 1960s.

KEY TAKEAWAYS
• The Modigliani-Miller theorem states that a company's capital
structure is not a factor in its value.
• Market value is determined by the present value of future
earnings, the theorem states.
• The theorem has been highly influential since it was introduced
in the 1950s.

3.5 EBIT-EPS Analysis

EBIT-EPS Analysis in Leverage:

EBIT-EPS analysis gives a scientific basis for comparison among

various financial plans and shows ways to maximize EPS. Hence EBIT-
EPS analysis may be defined as ‘a tool of financial planning that

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evaluates various alternatives of financing a project under varying
levels of EBIT and suggests the best alternative having highest EPS
and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EBT analysis is the method that studies the leverage, i.e.
comparing alternative methods of financing at different levels of
EBIT. Simply put, EBIT- EPS analysis examines the effect of financial
leverage on the EPS with varying levels of EBIT or under alternative
financial plans. It examines the effect of financial leverage on the
behavior of EPS under different financing alternatives and with
varying levels of EBIT. EBIT-EPS analysis is used for making the choice
of the combination and of the various sources. It helps select the
alternative that yields the highest EPS. We know that a firm can
finance its investment from various sources such as borrowed capital
or equity capital. The proportion of various sources may also be
different under various financial plans. In every financing plan the
firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial
leverage on the behavior of EPS under various financing plans with
varying levels of EBIT. It helps a firm in determining optimum
financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be

enumerated below:

Financial Planning:
Use of EBIT-EPS analysis is indispensable for determining sources of
funds. In case of financial planning the objective of the firm lies in
maximizing EPS. EBIT- EPS analysis evaluates the alternatives and
finds the level of EBIT that maximizes EPS.

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Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of
departments, product lines and markets. It identifies the EBIT earned
by these different departments, product lines and from various
markets, which helps financial planners rank them according to
profitability and also assess the risk associated with each.

Performance Evaluation:
This analysis is useful in comparative evaluation of performances of
various sources of funds. It evaluates whether a fund obtained from
a source is used in a project that produces a rate of return higher
than its cost.

Determining Optimum Mix: EBIT-EPS analysis is advantageous in

selecting the optimum mix of debt and equity. By emphasizing on the
relative value of EPS, this analysis determines the optimum mix of
debt and equity in the capital structure. It helps determine the
alternative that gives the highest value of EPS as the most profitable
financing plan or the most profitable level of EBIT as the case may
be.

Limitations of EBIT-EPS Analysis:

Finance managers are very much interested in knowing the

sensitivity of the earnings per share with the changes in EBIT; this is
clearly available with the help of EBIT-EPS analysis but this technique
also suffers from certain limitations, as described below

No Consideration for Risk: Leverage increases the level of risk, but

this technique ignores the risk factor. When a corporation, on its
borrowed capital, earns more than the interest it has to pay on debt,
any financial planning can be accepted irrespective of risk. But in
times of poor business the reverse of this situation arises—which
attracts high degree of risk. This aspect is not dealt in EBIT-EPS
analysis.

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Contradictory Results: It gives a contradictory result where under
different alternative financing plans new equity shares are not taken
into consideration. Even the comparison becomes difficult if the
number of alternatives increase and sometimes it also gives
erroneous result under such situation.

Over-capitalization: This analysis cannot determine the state of

over-capitalization of a firm. Beyond a certain point, additional
capital cannot be employed to produce a return in excess of the
payments that must be made for its use. But this aspect is ignored in
EBIT-EPS analysis.

3.6 ROI and ROE analysis

Return on investment (ROI) and return on equity (ROE) are two

essential indicators frequently used to determine success when
generating money from stock investments. Although they assess
different things, ROI and ROE are both significant. While ROE
calculates the percentage return on invested equity, ROI calculates
the percentage return on investment. In other words, ROE assesses
an investment's "efficiency," but ROI measures its "profitability."

ROI and ROE analysis may come up if you're trying to add real estate
to your investment portfolio. If you genuinely want to boost your
returns on your portfolio, these terms will allow you to assess the
strength of your investment. These performance measures are the
most frequently used to gauge how well your investment is doing.

What is Return on Equity (ROE)?

A metric of financial performance known as return on equity (ROE)
is obtained by dividing net income by shareholders' equity. ROE is
the return on net assets since shareholders' equity is determined by
subtracting a company's debt from its assets.

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ROE is regarded as a barometer of a company's profitability and how
well it produces profits. The management of a firm is more effective
at producing income and growth from its equity funding and the
higher the ROE.
• A company's net income ratio to its shareholders' equity is
known as return on equity (ROE).
• A company's profitability and the effectiveness of its revenue
generation are measured by its return on equity (ROE).
• A corporation is better at turning its equity funding into profits
the higher the ROE.
• Divide net income by shareholders' equity to get a return on
equity (ROE).
• Depending on the sector or industry in which the firm works,
ROEs will change.

Calculating Return on Equity (ROE)

Any corporation may compute its ROE in percentage form if its net
income or equity are also both positive figures. Before dividends to
common shareholders, dividends to preferred shareholders and
interest to lenders are considered when calculating net income.

The sum of a company's income, net costs, and taxes for a specific
period is known as net income. Equity added at the beginning of the
term is used to compute average shareholders' equity. The period's
start and finish should fall within the time frame in which net income
is generated.

The income statement includes net income for the most recent full
fiscal year, often known as the trailing 12 months, as a total of the
financial activities during that time. The balance sheet, a running
balance of all changes in a company's assets and liabilities over time,
is where investors may find their equity.

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Due to the discrepancy between the income statement and the
balance sheet, it is deemed best practice to compute ROE using
average equity over a period.

ROE

What Return on Equity Tells You?

The usual ROE for a stock's peers will determine whether an ROE is
considered excellent or terrible. For instance, utilities have many
assets and debts on their balance sheet but only a minor net
revenue. In the utility business, a typical ROE can be 10% or less. A
retail or technology company with lower balance sheet accounts
than net income may often have 18% or higher ROE values.

A decent rule of thumb is to aim for an ROE comparable to or slightly

higher than the industry average for companies doing the same type
of business. Assume, for instance, that TechCo, a corporation, has
consistently maintained an ROE of 18% for the previous five years,
higher than the 15% average of its rivals. Investors can conclude that
TechCo's management does a better job than average of generating
profits from the company's assets.

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Return on Equity

How do You Define ROI?

Return on investment, or ROI, is a straightforward notion that only
quantifies that proportion. Return on investment may be computed
by dividing the profit from an investment (in cash or shares) by the
initial investment.

Return on Investment

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Take a hypothetical Rs. 1,000 stock investment that yields a 10%
annual return. If you invested Rs. 1,000 and generated a profit of Rs.
100, your return on investment (ROI) would be 10%.

Return on investment (ROI) is widely used since it is simple to

compute and gives a clear picture of an investment's profitability.
Remember that return on investment is a relative number, however.
That is to say, all it can tell you is how well or poorly an investment
has done in relation to other investments.

Suppose, for the sake of argument, that you have two investments:
• Option A: Buying stock that increases in value by 10%
• Option B: A 20%-profitable stock investment
Even if the returns on both investments are 10%, Investment B is
obviously the better choice. This is why additional measures, such as
return on equity (ROE), are typically employed with ROI.

The Formula for Return on Investment

Formulas for determining a return on investment are as follows:
• Determine the company's net profit for the year. To
determine pretax profit, we must first deduct fixed and variable
overhead. After taxes are removed, this is the business's net
profit.
• Count the money it will take to make a profit. To start an
investment, a corporation must spend a certain amount.
Assuming the corporation put 20% down, or Rs. 80,000, on a
Rs. 400,000 property using a conventional business loan, the
investment cost is Rs. 80,000.
• Divide net ROI by investment cost. The return on investment
may be expressed as a decimal by dividing the two amounts.
The formula for converting this number to a percentage is as
follows: (number) x (100).

Difference between ROI and ROE

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ROI and ROE are two useful performance indicators that aid in
determining how strong or effective a business or investment is in
generating profits. Consequently, the return on investment formula
(ROI) is crucial for evaluating how successfully (or poorly) a firm
operates. What is ROI in business is a performance metric used to
evaluate a company's or investment's profitability by accounting for
earnings or losses concerning the investment's cost. On the other
hand, return on equity (ROE) is a financial term that measures a
company's profitability concerning its equity.

Purpose
Even though these phrases are essential, they cannot be used
interchangeably since they have different meanings. ROI aims to
describe the profit generated from a business choice or investment.
The goal of measuring an investment's profitability is determining
how well it will generate money for your company. This is why ROI
calculations are used. Rather than measuring the return on the
company's investment, ROE evaluates the shareholder investment
return. The goal of calculating ROE is to assess how much profit a
business makes concerning its shareholders' equity.

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Difference between ROI and ROE

Conclusion
The variables that affect a company's earnings are Return on Equity
and Return on Investment. They may be computed in a variety of
ways and have a significant influence in deciding how the industry
develops. They both have benefits and drawbacks. For a firm to
operate well, it has to have an income rate two times higher than its
debt. Otherwise, there is a greater risk of difficulties for the business.

3.7 Comparative analysis

Every business needs to prepare basic financial statements that

summarize its operating results and financial position for a particular
period. These statements primarily include income
statements, balance sheets, and cash flow statements.
Thus, the purpose of preparing these statements is to ascertain the
profitability and financial soundness of a business. But the detailed
information reflected in such statements alone is not sufficient to
reach meaningful managerial conclusions. Therefore,
detailed financial analysis and interpretation of these statements is
required using various tools and techniques.
This analysis helps to understand the relationship between various
components showcased in each of these statements. So, one of the
tools commonly used to undertake financial statement analysis is
creating comparative financial statements. Other techniques include:
• Common Size Statement Analysis
• Ratio Analysis
• Cash Flow Analysis
• Trend Analysis

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What Are Comparative Financial Statements?
Preparing Comparative Financial Statements is the most commonly
used technique for analyzing financial statements. This technique
determines the profitability and financial position of a business by
comparing financial statements for two or more time periods. Hence,
this technique is also termed as Horizontal Analysis. Typically, the
income statements and balance sheets are prepared in a
comparative form to undertake such an analysis.

Furthermore, there is a provision attached to comparing the financial

data showcased by such statements. This relates to making use of
the same accounting principles for preparing each of the
comparative statements. In case the same accounting principles are
not followed to prepare such statements, then the difference must
be disclosed in the footnote below.

Comparative Balance Sheet

A comparative balance sheet showcases:
• Assets and liabilities of business for the previous year as well as
the current year
• Changes (increase or decrease) in such assets and liabilities
over the year both in absolute and relative terms
Thus, a comparative balance sheet not only gives a picture of the
assets and liabilities in different accounting periods. It also reveals
the extent to which the assets and liabilities have changed during
such periods.
Furthermore, such a statement helps managers and business owners
to identify trends in the various performance indicators of the
underlying business.

What To Study While Analyzing A Comparative Balance Sheet?

A business owner or a financial manager should study the following
aspects of a comparative balance sheet:
1. Working Capital

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Working capital refers to the excess of current assets over current
liabilities.This helps a financial manager or a business owner to know
about the liquidity position of the business.
2. Changes in Long-Term Assets, Liabilities, and Capital
The next component that a financial manager or a business owner
needs to analyze is the change in the fixed assets, long-term
liabilities and capital of a business. This analysis helps each of the
stakeholders to understand the long-term financial position of a
business.
3. Profitability
Working capital refers to the excess of current assets over current
liabilities.This helps a financial manager or a business owner to know
about the liquidity position of the business.

Comparative Income Statement

A comparative income statement showcases the operational results
of the business for multiple accounting periods. It helps the business
owner to compare the results of business operations over different
periods of time. Furthermore, such a statement helps in a detailed
analysis of the changes in line-wise items of the income statement.

What To Study While Analyzing A Comparative Income Statement?

1. Comparing Sales With Cost of Goods Sold
Changes in the sales in the given accounting periods should be
compared with the changes in the cost of goods sold for the same
accounting periods.

2. Change in Operating Profits

Change in the operating profits should be analyzed.
3. The profitability of a Business
Understanding the overall profitability of a business concern taking
into consideration the changes in the net profit of the given
accounting periods.

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3.8 Guidelines for capital structure analysis

What is Capital Structure Analysis?

Capital structure analysis is a periodic evaluation of all

components of the debt and equity financing used by a business.
The intent of the analysis is to evaluate what combination of debt
and equity the business should have. This mix varies over time
based on the costs of debt and equity and the risks to which a
business is subjected. Capital structure analysis is usually confined
to short-term debt, leases, long-term debt, preferred stock, and
common stock.

When to Conduct a Capital Structure Analysis

The analysis may be on a regularly scheduled basis, or it could be

triggered by the upcoming maturity of a debt instrument, which
may need to be replaced or paid off. Alternatively, an analysis may
be required when there is a need to find funding for the
acquisition of a fixed asset or another business. It may also be
needed when a key investor demands to have the business buy
back shares or pay out a larger dividend. It may also be useful
when there is an expected change in the market interest rate.

Contents of a Capital Structure Analysis

When engaging in a capital structure analysis, consider the

following questions:

• How does the current or projected capital structure impact

any loan covenants, such as the debt to equity ratio? If the
effect is negative, it may not be possible to acquire any
additional debt, or existing debt may need to be paid down.
• Are there any expensive tranches of debt that can be paid
down? This involves a discussion of alternative uses for any

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 available cash, which could be more profitably employed
elsewhere.
• Are the uses for cash within the company's business
beginning to decline? If so, does it make more sense to
return cash to investors by buying back shares or issuing
more dividends?
• Are the company's financial circumstances so difficult that it
will be more difficult to obtain loans in the future? If so, does
it make sense to restructure operations to improve
profitability and thereby reopen this financing alternative?
• Does the investor relations officer want to establish a floor
for the company's stock price? This can be achieved by
engaging in an ongoing stock repurchase program that is
triggered whenever the stock price falls below a certain
amount.
• Does the company want to achieve a certain rating for its
bonds? If so, it may need to restructure its financing mix to
be more conservative, thereby improving the odds of
investors being repaid by the company for their purchases of
the company's bonds

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 Unit -8: Ratio Analysis

8.1 Profitability Ratios

What Are Profitability Ratios?

Profitability ratios are a class of financial metrics that are used to
assess a business's ability to generate earnings relative to its
revenue, operating costs, balance sheet assets, or shareholders'
equity over time, using data from a specific point in time.
Profitability ratios can be compared with efficiency ratios, which
consider how well a company uses its assets internally to generate
income (as opposed to after-cost profits).

KEY TAKEAWAYS
• Profitability ratios assess a company's ability to earn profits
from its sales or operations, balance sheet assets, or
shareholders' equity.
• Profitability ratios indicate how efficiently a company generates
profit and value for shareholders.
• Higher ratio results are often more favorable, but these ratios
provide much more information when compared to results of
similar companies, the company's own historical performance,
or the industry average.

What Do Profitability Ratios Tell You?

For most profitability ratios, having a higher value relative to a
competitor's ratio or relative to the same ratio from a previous
period indicates that the company is doing well. Profitability ratios
are most useful when compared to similar companies, the company's
own history, or average ratios for the company's industry.
Gross profit margin is one of the most widely used profitability or
margin ratios. Gross profit is the difference between revenue and the
costs of production—called cost of goods sold (COGS).
Some industries experience seasonality in their operations. For
example, retailers typically experience significantly higher revenues

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and earnings during the year-end holiday season. Thus, it would not
be useful to compare a retailer's fourth-quarter gross profit margin
with its first-quarter gross profit margin because they are not directly
comparable. Comparing a retailer's fourth-quarter profit margin with
its fourth-quarter profit margin from the previous year would be far
more informative.

Examples of Profitability Ratios

Profitability ratios are one of the most popular metrics used
in financial analysis, and they generally fall into two categories—
margin ratios and return ratios.

Margin ratios give insight, from several different angles, on a

company's ability to turn sales into a profit. Return ratios offer
several different ways to examine how well a company generates
a return for its shareholders.

Some common examples of profitability ratios are the various

measures of profit margin, return on assets (ROA), and return on
equity (ROE). Others include return on invested capital (ROIC)
and return on capital employed (ROCE).

Profit Margin
Different profit margins are used to measure a company's
profitability at various cost levels of inquiry, including gross margin,
operating margin, pretax margin, and net profit margin. The margins
shrink as layers of additional costs are taken into consideration—
such as the COGS, operating expenses, and taxes.

Gross margin measures how much a company makes after

accounting for COGS. Operating margin is the percentage of sales left
after covering COGS and operating expenses. The pretax
margin shows a company's profitability after further accounting for
non-operating expenses. The net profit margin is a company's ability
to generate earnings after all expenses and taxes.

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Return on Assets (ROA)
Profitability is assessed relative to costs and expenses and analyzed
in comparison to assets to see how effective a company is deploying
assets to generate sales and profits. The use of the term "return" in
the ROA measure customarily refers to net profit or net income—the
value of earnings from sales after all costs, expenses, and taxes. ROA
is net income divided by total assets.

The more assets a company has amassed, the more sales and
potential profits the company may generate. As economies of
scale help lower costs and improve margins, returns may grow at a
faster rate than assets, ultimately increasing ROA.

Return on Equity (ROE)

ROE is a key ratio for shareholders as it measures a company's ability
to earn a return on its equity investments. ROE, calculated as net
income divided by shareholders' equity, may increase without
additional equity investments. The ratio can rise due to higher net
income being generated from a larger asset base funded with debt.

EBITDA Margin
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and
Amortization. It represents the profitability of a company before
taking into account non-operating items like interest and taxes, as
well as non-cash items like depreciation and amortization. The
benefit of analyzing a company’s EBITDA margin is that it is easy to
compare it to other companies since it excludes expenses that may
be volatile or somewhat discretionary. The downside of EBTIDA
margin is that it can be very different from net profit and actual cash
flow generation, which are better indicators of company
performance. EBITDA is widely used in many valuation methods.

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8.2 Leverage Ratios

What Is a Leverage Ratio?

A leverage ratio is any one of several financial measurements that
look at how much capital comes in the form of debt (loans) or
assesses the ability of a company to meet its financial obligations.
The leverage ratio category is important because companies rely on
a mixture of equity and debt to finance their operations, and
knowing the amount of debt held by a company is useful in
evaluating whether it can pay off its debts as they come due. Several
common leverage ratios are discussed below.

KEY TAKEAWAYS
• A leverage ratio is any one of several financial measurements
that assesses the ability of a company to meet its financial
obligations.
• A leverage ratio may also be used to measure a company's mix
of operating expenses to get an idea of how changes in output
will affect operating income.
• Common leverage ratios include the debt-equity ratio, equity
multiplier, degree of financial leverage, and consumer leverage
ratio.
• Banks have regulatory oversight on the level of leverage they
can hold.

What Does a Leverage Ratio Tell You?

Too much debt can be dangerous for a company and its investors.
However, if a company's operations can generate a higher rate of
return than the interest rate on its loans, then the debt may help to
fuel growth. Uncontrolled debt levels can lead to credit downgrades
or worse. On the other hand, too few debts can also raise questions.
A reluctance or inability to borrow may be a sign that operating
margins are tight.

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There are several different ratios that may be categorized as a
leverage ratio, but the main factors considered are debt, equity,
assets, and interest expenses.
A leverage ratio may also be used to measure a company's mix of
operating expenses to get an idea of how changes in output will
affect operating income. Fixed and variable costs are the two types
of operating costs; depending on the company and the industry, the
mix will differ.
Finally, the consumer leverage ratio refers to the level of consumer
debt compared to disposable income and is used in economic
analysis and by policymakers.

Leverage Ratios for Evaluating Solvency and Capital Structure

Perhaps the most well known financial leverage ratio is the debt-to-
equity ratio.

The Debt-to-Equity (D/E) Ratio:

This is expressed as:

For example, United Parcel Service's long-term debt for the quarter
ending December 2019 was $21.8 billion. United Parcel Service's
total stockholders' equity for the ending December 2019 was $3.3
billion. The company's D/E for the quarter was 8.62. That is
considered high.

A high debt/equity ratio generally indicates that a company has been

aggressive in financing its growth with debt. This can result in volatile
earnings as a result of the additional interest expense. If the

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company's interest expense grows too high, it may increase the
company's chances of a default or bankruptcy.

Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an
investor; however, this yardstick can vary by industry. Businesses
that require large capital expenditures (CapEx), such as utility and
manufacturing companies, may need to secure more loans than
other companies. It's a good idea to measure a firm's leverage ratios
against past performance and with companies operating in the same
industry to better understand the data. Fedex has a D/E ratio of 1.78,
so there is cause for concern where UPS is concerned. However,
most analysts consider that UPS earns enough cash to cover its
debts.

The Equity Multiplier

The equity multiplier is similar, but replaces debt with assets in the
numerator:

The Debt-to-Capitalization Ratio

An indicator that measures the amount of debt in a company’s
capital structure is the debt-to-capitalization ratio, which measures a
company’s financial leverage. It is calculated as:

In this ratio, operating leases are capitalized and equity includes both
common and preferred shares. Instead of using long-term debt, an
analyst may decide to use total debt to measure the debt used in a
firm's capital structure. The formula, in this case, would include
minority interest and preferred shares in the denominator.

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8.3 Liquidity Ratios

What is a Liquidity Ratio?

A liquidity ratio is a type of financial ratio used to determine a
company’s ability to pay its short-term debt obligations. The metric
helps determine if a company can use its current, or liquid, assets to
cover its current liabilities.

Three liquidity ratios are commonly used – the current ratio, quick
ratio, and cash ratio. In each of the liquidity ratios, the current
liabilities amount is placed in the denominator of the equation, and
the liquid assets amount is placed in the numerator.

Given the structure of the ratio, with assets on top and liabilities on
the bottom, ratios above 1.0 are sought after. A ratio of 1 means that
a company can exactly pay off all its current liabilities with its current
assets. A ratio of less than 1 (e.g., 0.75) would imply that a company
is not able to satisfy its current liabilities.

A ratio greater than 1 (e.g., 2.0) would imply that a company is able
to satisfy its current bills. In fact, a ratio of 2.0 means that a company
can cover its current liabilities two times over. A ratio of 3.0 would
mean they could cover their current liabilities three times over, and
so forth.

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Summary
• A liquidity ratio is used to determine a company’s ability to pay
its short-term debt obligations.
• The three main liquidity ratios are the current ratio, quick ratio,
and cash ratio.
• When analyzing a company, investors and creditors want to see
a company with liquidity ratios above 1.0. A company with
healthy liquidity ratios is more likely to be approved for credit.

Types of Liquidity Ratios

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the simplest liquidity ratio to calculate and

interpret. Anyone can easily find the current assets and current
liabilities line items on a company’s balance sheet. Divide current
assets by current liabilities, and you will arrive at the current ratio.

2. Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable

Securities) / Current Liabilities

The quick ratio is a stricter test of liquidity than the current ratio.
Both are similar in the sense that current assets is the numerator,
and current liabilities is the denominator.

However, the quick ratio only considers certain current assets. It

considers more liquid assets such as cash, accounts receivables, and
marketable securities. It leaves out current assets such as inventory
and prepaid expenses because the two are less liquid. So, the quick
ratio is more of a true test of a company’s ability to cover its short-
term obligations.

3. Cash Ratio

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Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The cash ratio takes the test of liquidity even further. This ratio only
considers a company’s most liquid assets – cash and marketable
securities. They are the assets that are most readily available to a
company to pay short-term obligations.

In terms of how strict the tests of liquidity are, you can view the
current ratio, quick ratio, and cash ratio as easy, medium, and hard.

Importance of Liquidity Ratios

1. Determine the ability to cover short-term obligations

Liquidity ratios are important to investors and creditors to determine

if a company can cover their short-term obligations, and to what
degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t
ideal.

Creditors and investors like to see higher liquidity ratios, such as 2 or

3. The higher the ratio is, the more likely a company is able to pay its
short-term bills. A ratio of less than 1 means the company faces a
negative working capital and can be experiencing a liquidity crisis.

2. Determine creditworthiness

Creditors analyze liquidity ratios when deciding whether or not they

should extend credit to a company. They want to be sure that the
company they lend to has the ability to pay them back. Any hint of
financial instability may disqualify a company from obtaining loans.

3. Determine investment worthiness

For investors, they will analyze a company using liquidity ratios to

ensure that a company is financially healthy and worthy of their
investment. Working capital issues will put restraints on the rest of

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the business as well. A company needs to be able to pay its short-
term bills with some leeway.

Low liquidity ratios raise a red flag, but “the higher, the better” is
only true to a certain extent. At some point, investors will question
why a company’s liquidity ratios are so high. Yes, a company with a
liquidity ratio of 8.5 will be able to confidently pay its short-term
bills, but investors may deem such a ratio excessive. An abnormally
high ratio means the company holds a large amount of liquid assets.

For example, if a company’s cash ratio was 8.5, investors and

analysts may consider that too high. The company holds too
much cash on hand, which isn’t earning anything more than the
interest the bank offers to hold their cash. It can be argued that the
company should allocate the cash amount towards other initiatives
and investments that can achieve a higher return.

With liquidity ratios, there is a balance between a company being

able to safely cover its bills and improper capital allocation. Capital
should be allocated in the best way to increase the value of the firm
for shareholders.

8.4 Operating Ratios

What Is the Operating Ratio?

The operating ratio shows the efficiency of a company's

management by comparing the total operating expense (OPEX) of a
company to net sales. The operating ratio shows how efficient a
company's management is at keeping costs low while generating
revenue or sales. The smaller the ratio, the more efficient the
company is at generating revenue vs. total expenses.

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KEY TAKEAWAYS
• The operating ratio shows the efficiency of a company's
management by comparing the total operating expense of a
company to net sales.
• An operating ratio that is decreasing is viewed as a positive
sign, as it indicates that operating expenses are becoming an
increasingly smaller percentage of net sales.
• A limitation of the operating ratio is that it doesn't include
debt.

How the Operating Ratio Works

The calculation for the operating ratio is:

1. From a company's income statement take the total cost of

goods sold, which can also be called cost of sales.
2. Find total operating expenses, which should be farther down
the income statement.
3. Add total operating expenses and cost of goods sold or COGS
and plug the result into the numerator of the formula.
4. Divide the sum of operating expenses and COGS by the total
net sales.
5. Please note that some companies include the cost of goods
sold as part of operating expenses while other companies list
the two costs separately.

What Does the Operating Ratio Tell You?

Investment analysts have many ways of analyzing company
performance. Because it concentrates on core business activities,
one of the most popular ways to analyze performance is by

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evaluating the operating ratio. Along with return on
assets and return on equity, it is often used to measure a company's
operational efficiency. It is useful to track the operating ratio over a
period of time to identify trends in operational efficiency or
inefficiency.

An operating ratio that is going up is viewed as a negative sign, as

this indicates that operating expenses are increasing relative to sales
or revenue. Conversely, if the operating ratio is falling, expenses are
decreasing, or revenue is increasing, or some combination of both. A
company may need to implement cost controls for margin
improvement if its operating ratio increases over time.

Components of the Operating Ratio

Operating expenses are essentially all expenses except taxes and
interest payments. Also, companies will typically not include non-
operating expenses in the operating ratio.

Operating expenses are the costs associated with running the

business that is not directly tied to the production of the product or
service. Operating expenses include overhead expenses such as
sales, general, and administrative costs. An example of overhead
might be the expense of the corporate office for a company because
although necessary, it's not directly tied to production.

Operating expenses can include:

• Accounting and legal fees
• Bank charges
• Sales and marketing costs
• Non-capitalized research and development expenses
• Office supply costs
• Rent and utility expenses
• Repair and maintenance costs
• Salary and wage expenses

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Operating expenses can also include the cost of goods sold, which
are the expenses directly tied to the production of goods and
services. However, most companies separate operating expenses
from the cost of goods sold. Therefore, the two costs must be added
together to form the numerator in the operating ratio calculation.

Cost of goods sold can include the following:

• Direct material costs
• Direct labor
• Rent of the plant or production facility
• Benefits and wages for the production workers
• Repair costs of equipment

Revenue or net sales is the top line of the income statement and is
the amount of money a company generates before expenses are
taken out. Some companies list revenue as net sales because they
have returns of merchandise from customers whereby, they credit
the client back, which is deducted from revenue.

All of these line items are listed on the income statement.

Companies must clearly state which expenses are operational and
which are designated for other uses.

Limitations of the Operating Ratio

A limitation of the operating ratio is that it doesn't include debt.
Some companies take on a great deal of debt, meaning they are
committed to paying large interest payments, which are not included
in the operating expenses figure of the operating ratio. Two
companies can have the same operating ratio with vastly different
debt levels, so it is important to compare debt ratios before coming
to any conclusions.
As with any financial metric, the operating ratio should be monitored
over multiple reporting periods to determine if a trend is present.
Companies can sometimes cut costs in the short term, thus inflating

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their earnings temporarily. Investors must monitor costs to see if
they're increasing or decreasing over time while also comparing
those results to the performance of revenue and profit.
It's also important to compare the operating ratio with other firms in
the same industry. If a company has a higher operating ratio than its
peer average, it may indicate inefficiency and vice versa. Finally, as
with all ratios, it should be used as part of a full ratio analysis, rather
than in isolation.

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