24-07-2023

CORPORATE FINANCE
Prof Amit Puniyani

COURSE OUTLINE
Session Topics

1-2 Module 1: Introduction to corporate finance and Indian financial system

•
3-4 Module 2: Time value of money

5-7 Module 3: Bond & stock valuation

8 Quiz 1 & Module 4 (starting)

9-11 Module 4: Risk & return

12-13 Module 5: Relevant cash flows

14-17 Module 6: Capital budgeting techniques – PBP, DPBP, NPV, IRR, PI

18 Quiz 2 & Module 6 (Ending)

19-20 Module 7: Cost of capital

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 24-07-2023

COURSE OUTLINE
Session Topics

1-2 Module 1: Introduction to corporate finance and Indian financial system

•
3-4 Module 2: Time value of money

5-7 Module 3: Bond & stock valuation

8 Quiz 1 & Module 4 (starting)

9-11 Module 4: Risk & return

12-13 Module 5: Relevant cash flows

14-17 Module 6: Capital budgeting techniques – PBP, DPBP, NPV, IRR, PI

18 Quiz 2 & Module 6 (Ending)

19-20 Module 7: Cost of capital

TIME VALUE OF MONEY

Suppose a firm has an opportunity to spend $15,000 today on some investment that will produce $17,000
spread out over the next five years as follows:

Time Payoff
Year 1 $3,000
Year 2 $5,000
–$15,000 $3,000 $5,000 $4,000 $3,000 $2,000
Year 3 $4,000
0 1 2 3 4 5
Year 4 $3,000 End of Year

Year 5 $2,000

A time line depicts the cash flows associated with a given investment. It is a horizontal line on which
zero time appears at the leftmost end and future periods are marked from left to right.

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FUTURE VALUE AND PRESENT VALUE

FUTURE VALUE AND PRESENT VALUE

PV -849.219

Time Payoff PV FV

0 -15000 -15000 -21038.3

1 3000 2803.738 3932.388

2 5000 4367.194 6125.215

3 4000 3265.192 4579.6

4 3000 2288.686 3210

5 2000 1425.972 2000

FV -1191.07

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FUTURE VALUE
Future value is the value at a given future date of an amount placed on deposit today and earning interest
at a specified rate. The future value depends on the rate of interest earned and the length of time the
money is left on deposit. Here we explore the future value of a single amount.

For example, if you deposit Rs. 100,000 today into an account that pays 6 percent annual interest, how
much would you have in the account in 10 years? You could use Excel or a calculator.

Time FV
1 1,00,000+6%(1,00,000) = 1,06,000
2 1,06,000+6% (1,06,000) = 1,12,360
3 1,12,360+6%(1,12,360)=1,19,101
10 1,79,084.77

FUTURE VALUE
Future value formula: Compound interest

FVn = P * (1 + r)n

P = Principal
r = Interest rate
n = periods

Time Formula FV
1 100,000 1 + 0.06 1,06,000.00
3 100,000 1 + 0.06 1,19,101.60
5 100,000 1 + 0.06 1,33,822.56
10 100,000 1 + 0.06 1,79,084.77

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FUTURE VALUE
 An investment pays 12%. We invest ₹1000000. How long would it take to double ? Using the
compound interest formula, after n years we would get:

10,00,000 1.12

n FV factor
1 1.12
2 1.2544
3 1.404928
4 1.573519
5 1.762342
6 1.973823
7 2.210681

FUTURE VALUE
 In 1980, an Indian govt. employee is evaluating an investment proposition. He has Rs 100,000. He
could either invest it in an FD that pays 9%, and which he can break, or in an instrument that pays
11% where his money is locked for 30 years. Assuming he plans to pass the investment over to his
next generation, how much difference would it make ?

n FV of 1 @ 9% FV of 1@ 11%
1 1.09 1.11
3 1.295029 1.367631
5 1.53862395 1.685058
10 2.36736367 2.839421
20 5.60441077 8.062312
25 8.62308066 13.58546
30 13.2676785 22.8923
Rs 13,26,760 Rs 22,89,230

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A BIRD IN HAND
Suppose you have the option of receiving ₹1 lakh in the future, say in 2 years vs. ₹80,000 now, what
would you prefer ?

To compare, we could compute the future value of ₹80,000. If ₹80,000 had to be invested somewhere for
two years, would the amount be larger than ₹1 lakh then.

Using a ’risk free’ rate of 6%, ₹80,000 would become

𝐹𝑉 = 𝑐 1 + 𝑟 = 80,000 1 + 0.06 = 89,988

in two years which is less than ₹100,000. Therefore, it is better to wait. (Assuming no risk in the payment
of ₹100,000 in two years).

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A BIRD IN HAND
Suppose you have the option of receiving ₹1 lakh in the future, say in 2 years vs. ₹80,000 now, what
would you prefer ?

Alternatively, we could compute the discounted value of the ₹1 lakh using the treasury rate or the risk-
free rate to answer whether it would be more or less than ₹80,000.

Using a risk free rate of 6%, we would obtain the present value of the future payment as:

100,000
𝑃𝑉 = = 88,999
1 + 0.06
, which is larger than ₹80,000.

Therefore, the decision to wait on the payment is better.

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INVESTMENT DECISION
A company can invest funds in a long term asset for ₹35 lakh and generate an additional profit of ₹8 lakh
after 3 years. Is this a good investment proposition ?

Assuming, the interest rate is 8%, we could generate 43 lakh of outflow with how much investment ?

PV of 43 lakh = = 34.13 lakh

.

Conclusion: The company could invest 34.13 lakh in an 8% yielding instrument for 3 years instead.

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SAVING FOR COLLEGE

A businessman wishes to send his children to a good medical school when they are the right
age which is in 5 years. He is uncertain about his business and must keep the money aside
for this purpose. Assuming that medicine education could cost ₹30 lakh, how much should
he stave off now. Assume an interest rate of 6% and not counting inflation.

PV of 30 lakh = = 22.42 𝑙𝑎𝑘ℎ

.

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ANNUITIES
 How much would you pay for 10 years to receive a guaranteed ₹3 lakh at the end of each of
the next 20 years after that?

 How much will you have at the end of 5 years if your employer withholds and invests ₹100,000
of your bonus at the end of each of the next 5 years, guaranteeing you an 8.5 percent annual rate
of return?

 An annuity is a stream of equal periodic cash flows, over a specified time period. These cash
flows are usually annual but can occur at other intervals, such as monthly rent or car payments.
The cash flows in an annuity can be inflows (the ₹30,000 received at the end of each of the next
20 years) or outflows (the ₹100,000 invested at the end of each of the next 5 years).

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ANNUITIES
 There are two basic types of annuities. For an ordinary annuity, the cash flow occurs at the end
of each period. For an annuity due, the cash flow occurs at the beginning of each period.

Comparison of ordinary annuity vs annuity

TABLE
due

Annual cash flows

Year Annuity A (ordinary) Annuity B (annuity due)
0 ₹ 0 ₹1,000
1 1,000 1,000
2 1,000 1,000
3 1,000 1,000
4 1,000 1,000
5 1,000 0

 Note that the amount of each annuity totals ₹5,000. The two annuities differ only in the timing of
their cash flows: The cash flows are received sooner with the annuity due than with the ordinary
annuity.

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ANNUITIES
 FV

𝑐
𝐹𝑉 = 𝑐 1+𝑟 = 1+𝑟 −1
𝑟

 PV

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

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ANNUITIES
 Solving in Excel using functions PV and FV is possible.

 Alternatively, use a discount factor column

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EMPLOYEE PROVIDENT FUND

 Suppose your employer deposits ₹1 lakh at the end of each year for 5 years in an account that
pays 8.5%, how much would you have at the end of the 5 years ?

Amount Deposited
Year
(in lakh)

1 ₹ 1.00
2 ₹ 1.00
3 ₹ 1.00
4 ₹ 1.00
5 ₹ 1.00

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EMPLOYEE PROVIDENT FUND

 Suppose your employer deposits ₹1 lakh at the end of each year for 5 years in an account that
pays 8.5%, how much would you have at the end of the 5 years ?

Amount
Discount
Year Deposited (in
Factor
lakh)
1 ₹ 1.00 1 + 0.085
2 ₹ 1.00 1 + 0.085
3 ₹ 1.00 1 + 0.085
4 ₹ 1.00 1 + 0.085
5 ₹ 1.00 1

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EMPLOYEE PROVIDENT FUND

 Suppose your employer deposits ₹1 lakh at the end of each year for 5 years in an account that
pays 8.5%, how much would you have at the end of the 5 years ?

Amount
Discount Future Value (at
Year Deposited (in
Factor maturity in lakh)
lakh)
1 ₹ 1.00 1 + 0.085 ₹ 1.39
2 ₹ 1.00 1 + 0.085 ₹ 1.28
3 ₹ 1.00 1 + 0.085 ₹ 1.18
4 ₹ 1.00 1 + 0.085 ₹ 1.09
5 ₹ 1.00 1 ₹ 1.00
₹5.93

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PENSION PLAN
 Suppose you invest x rupees in an account for 10 years at an interest rate of 6%, how much is x if
it pays ₹3 lakh a year for the 20 years following that ?

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ANNUITIES
 FV

𝑐
𝐹𝑉 = 𝑐 1+𝑟 = 1+𝑟 −1
𝑟

 PV

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

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HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

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HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

( %/ )
Inverting, 𝑐 = = % =₹29,977.53
( )

25

HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

Inverting, 𝑐 = = ₹29,977.53

 Using Excel

-PMT(0.06/12, 360, 5000000)

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HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

Inverting, 𝑐 = = ₹29,977.53

 Using Excel

-PMT(0.06/12, 360, 5000000) = 29,977.53

27

AUTO LOAN EMI

 A borrower loans out ₹5 lakh to purchase a vehicle. What should be his monthly EMI if the
tenure of the loan is 3 years and annual interest rate at which the loan is offered is 12% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

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AUTO LOAN EMI

 A borrower loans out ₹5 lakh to purchase a vehicle. What should be his monthly EMI if the
tenure of the loan is 3 years and annual interest rate at which the loan is offered is 12% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

Inverting, 𝑐 = = 16,607

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PENSION PLAN
 Suppose you invest x rupees in an account for 10 years at an interest rate of 6%, how much is x if
it pays ₹3 lakh a year for the 20 years following that ?

 Step 1: What should be the FV at 10 years such that at an interest rate of r=6%, it would pay
c=₹3 lakh every year for 20 years:

𝑐 𝑐 1
= 1− = 34.41 𝑙𝑎𝑘ℎ
1+𝑟 𝑟 1+𝑟

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PENSION PLAN
 Suppose you invest x rupees in an account for 10 years at an interest rate of 6%, how much is x if
it pays ₹3 lakh a year for the 20 years following that ?

 Step 1: What should be the FV at 10 years such that at an interest rate of r=6%, it would pay
c=₹3 lakh every year for 20 years:

𝑐 𝑐 1
= 1− = 34.41 𝑙𝑎𝑘ℎ
1+𝑟 𝑟 1+𝑟

 Step 2: What should be x, such that the future value of 10 annual payments of x is 34.41 lakh:

1+𝑟 − (1 + 𝑟) 34.41
𝑥 1+𝑟 =𝑥 = 13.97𝑥 ⇒ 𝑥 = = 2.46 𝑙𝑎𝑘ℎ
𝑟 13.97

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PERPETUITY

 A perpetuity is a series of payments until eternity

 PV formula for a perpetuity

1 𝑐
𝑃𝑉 = 𝑐 =
1+𝑟 𝑟

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PERPETUAL GOVERNMENT PENSION

A government office is computing reserves required to sustain a life long pension of ₹50k pm for its
employees. How much lump sum money would need to be reserved per employee to pay this amount
? Assume an interest rate of 6%.

PV = = 10,000𝑘 = 1 𝑐𝑟
%

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TERMS OF SEPARATION
A wealthy businessman is divorcing his movie star wife with whom he has one child. How much
money should he stave off from his profits to pay his wife a fixed alimony of ₹5 lakh per month for
life ? Assume that he can invest in an instrument that pays 8%.

PV = = 750 𝑙𝑎𝑘ℎ = 7.5 𝑐𝑟

%

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MIXED STREAMS
 A mixed stream is a series of payments which are not necessarily equal. Formulas for FV and PV
are as below:

𝐹𝑉 = 𝑐 1+𝑟

𝑐
𝑃𝑉 =
1+𝑟

35

MIXED STREAMS
 A company has the below projected cash flows. Using a 6% discounting rate, compute the PV. Is
it profitable ?

Time Cash flow

1 -₹ 2,000.00
2 ₹ 800.00
3 ₹ 500.00
4 -₹ 400.00
5 ₹ 300.00
6 ₹ 200.00

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MIXED STREAMS
 A company has the below projected cash flows. Using a 6% discounting rate, compute the PV. Is
it profitable ?

Discounted
Time Cash flow Discount factor
cashflow
1 -₹ 2,000.00 0.943 -₹ 1,886.79
2 ₹ 800.00 0.890 ₹ 712.00
3 ₹ 500.00 0.840 ₹ 419.81
4 -₹ 400.00 0.792 -₹ 316.84
5 ₹ 300.00 0.747 ₹ 224.18
6 ₹ 200.00 0.705 ₹ 140.99
Net flow -₹ 706.65

37

MIXED STREAMS EXERCISE

 A company has the below projected cash flows. Using an 8% discounting rate, compute the PV.

Time Cash flow

1 ₹ 1,000.00
2 -₹ 300.00
3 ₹ 200.00
4 -₹ 400.00
5 ₹ 300.00

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LOAN AMORTIZATION
The term loan amortization refers to the determination of equal periodic loan payments. These
payments provide a lender with a specified interest return and repay the loan principal over a
specified period. The loan amortization process involves finding the future payments, over the term
of the loan, whose present value at the loan interest rate equals the amount of initial principal
borrowed. Lenders use a loan amortization schedule to determine these payment amounts and the
allocation of each payment to interest and principal. In the case of home mortgages, these tables are
used to find the equal monthly payments necessary to amortize, or pay off, the mortgage at a
specified interest rate over a 15- to 30-year period.

39

HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

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HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

( %/ )
Inverting, 𝑐 = = % =₹29,977.53
( )

41

HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

Inverting, 𝑐 = = ₹29,977.53

 Using Excel

-PMT(0.06/12, 360, 5000000)

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HOME LOAN EMI

 A borrower loans out ₹50 lakh to purchase a home. What should be his monthly EMI if the tenure
of the loan is 30 years and annual interest rate is 6% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

Inverting, 𝑐 = = ₹29,977.53

 Using Excel

-PMT(0.06/12, 360, 5000000) = 29,977.53

43

AUTO LOAN EMI

 A borrower loans out ₹5 lakh to purchase a vehicle. What should be his monthly EMI if the
tenure of the loan is 3 years and annual interest rate at which the loan is offered is 12% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

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AUTO LOAN EMI

 A borrower loans out ₹5 lakh to purchase a vehicle. What should be his monthly EMI if the
tenure of the loan is 3 years and annual interest rate at which the loan is offered is 12% ?

1 𝑐 1
𝑃𝑉 = 𝑐 = 1−
1+𝑟 𝑟 1+𝑟

Inverting, 𝑐 = = 16,607

45

INTEREST RATE CALCULATION

 Borrowing rates are often not risk free because borrowers can be prone to credit default. How
does one determine the rate of interest ?

 Jay is paying back a ₹50 lakh home loan via an EMI of ₹35,000 for a 20 year period. What is the
interest rate used to compute the EMI ?

 Use the Excel RATE Function:

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INTEREST RATE CALCULATION

 Borrowing rates are often not risk free because borrowers can be prone to credit default. How
does one determine the rate of interest ?

 Jay is paying back a ₹50 lakh home loan via an EMI of ₹35,000 for a 20 year period. What is the
interest rate used to compute the EMI ?

 Use the Excel RATE Function:

RATE(240,35000,-5000000)*12

47

INTEREST RATE CALCULATION

 Borrowing rates are often not risk free because borrowers can be prone to credit default. How
does one determine the rate of interest ?

 Jay is paying back a ₹50 lakh home loan via an EMI of ₹35,000 for a 20 year period. What is the
interest rate used to compute the EMI ?

 Use the Excel RATE Function:

RATE(240,35000,-5000000)*12 = 5.71%

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CORPORATE FINANCE
Prof Amit Puniyani

49

COURSE OUTLINE
Session Topics

1-2 Module 1: Introduction to corporate finance and Indian financial system

•
3-4 Module 2: Time value of money

5-7 Module 3: Bond & stock valuation

8 Quiz 1 & Module 4 (starting)

9-11 Module 4: Risk & return

12-13 Module 5: Relevant cash flows

14-17 Module 6: Capital budgeting techniques – PBP, DPBP, NPV, IRR, PI

18 Quiz 2 & Module 6 (Ending)

19-20 Module 7: Cost of capital

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COURSE OUTLINE
Session Topics

1-2 Module 1: Introduction to corporate finance and Indian financial system

•
3-4 Module 2: Time value of money

5-7 Module 3: Bond & stock valuation

8 Quiz 1 & Module 4 (starting)

9-11 Module 4: Risk & return

12-13 Module 5: Relevant cash flows

14-17 Module 6: Capital budgeting techniques – PBP, DPBP, NPV, IRR, PI

18 Quiz 2 & Module 6 (Ending)

19-20 Module 7: Cost of capital

51

BOND VALUATION

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BOND VALUATION
 What is a bond ? A bond is a fixed income instrument providing a series of cash-flows in return
for a fixed ‘notional’

 The series of cash flows is an annuity plus a final payment at the end, the cash flows excluding
the final payment are called coupons. The final payment is the face value.

 A zero coupon bond is a simple bond in which there is a fixed payoff at maturity only. There are
no coupons. For example the ZC bond pays 100 rupees after 1 year which is its maturity.

 If the cashflows are known and the interest rate is known, then we could find the price of the
bond easily, except what interest rate should be used ?

53

BOND VALUATION

 Bond prices/rates are determined by market forces. Of course this is for

bonds traded in the secondary markets. A bond may have been issued at
a certain rate but it could be exchanged at a different rate based on the
market.
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BOND VALUATION
 Real rate of interest (R) is theoretically the equilibrium rate of interest resulting from
the market dynamics

 Nominal rate of interest or actual rate of interest is the real rate plus a spread
representing inflation and risk

𝑟 =𝑅+𝑠 +𝑠

 Bonds are traded in a market typically highly liquid. Hence, the inflation premium
and the risk premium are both implied from market prices. For example a bond may
be trading at 7% while the treasury rate is 5% (Real rate). In this case, the inflation
spread and the risk spread would together add up to 2%.

55

YIELD CURVE

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BOND VALUATION
 Say, a zero coupon bond has a face value of Rs 1000 and was issued in the primary
market at a price of Rs 950 or equivalently an approximately 5.2% effective rate of
interest.

 This very bond in a few days could become worth Rs 960. What does this mean in
terms of interest rates ? To find out substitute in the equation:

1000
960 =
(1 + 𝑟)

𝑟= =4.1%

57

YIELD TO MATURITY (YTM)

 The YTM or simply yield refers to the actual rate of interest. It is the interest rate that
needs to be substituted in the PV equation to make the PV=Market Price.

𝑐
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 =
1+𝑦

 The important point is that it is not the price that is computed from yield but
yield that is implied from market price.

 This is different from the current yield which is simply (assuming const. c)

𝑐
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
𝑃𝑟𝑖𝑐𝑒

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YIELD TO MATURITY (YTM)

 The YTM represents the actual return on the bond investment. To compare the return
of a bond with another bond or any other instrument, we must compute the YTM or
simply ‘yield’.

 Please note that, unless the bond is a perpetual bond, the return is not ,
but the yield.

 In the case of perpetual bond though, YTM =

59

YIELD TO MATURITY (YTM)

 Suppose a bond trading at Rs 950 in the secondary market pays annual coupons of Rs
50 for 6 years and a final payoff of Rs 1000, what is the YTM ?

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YIELD TO MATURITY (YTM)

 Suppose a bond trading at Rs 950 in the secondary market pays annual coupons of Rs
50 for 6 years and a final payoff at year 7 of Rs 1000, what is the YTM ?

 Use Excel solver to obtain the value of y that makes the below equation true:

950= ∑ +

61

YIELD TO MATURITY (YTM)

 Suppose a bond trading at Rs 950 in the secondary market pays annual coupons of Rs
50 for 6 years and a final payoff at year 7 of Rs 1000, what is the YTM ?

 Use Excel solver to obtain the value of y that makes the below equation true:

Market 𝑃𝑟𝑖𝑐𝑒 − ∑ − =0

 y = 5.263%

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APPROXIMATION FOR YIELD TO MATURITY

An approximation to the YTM can be derived as follows:

𝑭𝑽 − 𝑷𝑽
𝒄+
𝒚= 𝒏
𝑭𝑽 + 𝑷𝑽
𝟐

, where
FV = Face Value of the bond and
PV = Present market value of the bond

63

YIELD TO MATURITY (YTM)

 Elliot Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate
and a $1,000 par value, pay interest annually, and have 18 years to maturity.
 Calculate the bonds’ yield to maturity (YTM).

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YIELD TO MATURITY (YTM)

 Elliot Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate
and a $1,000 par value, pay interest annually, and have 18 years to maturity.
 Calculate the bonds’ yield to maturity (YTM).

 Excel solver gives 9.257%

( )/
 Formula gives: = 9.45%
( )/

65

TERMINOLOGY
 The par value is the value of the bond at the time of issue.

 If the bond sells at a higher cost, it is said to be selling at a premium

 If it sells at a lower price, it is said to be selling at a discount

 The ‘notional’ or ‘face value’ of a bond is the cashflow received in the final
installment.

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YIELD CURVE: TERM STRUCTURE OF INTEREST RATES

 The yields at different maturities graphed as a function of the maturity form the yield
curve or term structure of interest rates.

 Yields tend to be different at different maturities because of market expectations of

crisis or growth.

67

YIELD CURVE: TERM STRUCTURE OF INTEREST RATES

 When the market expects crises, yield curves invert. This is because investors are
willing to keep their money in bonds for longer maturities

 When the market expects growth, yield curves are monotonic increasing. This is a
‘normal’ state. This implies that bond investors expect to be paid more interest for
loaning out money for longer periods.

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CORPORATE BONDS
 Corporates are more risky borrowers so the bonds they float are sold at higher interest
rates, or effectively lower prices compared to government treasuries

 Corporates are periodically rated and their borrowing rates are correlated with these
ratings.

 Corporate bonds can have other deal sweetners such as callability, convertibility.

69

CORPORATE BONDS LISTINGS ON NSE

WEIGHTED LAST WEIGHTED
ISIN DESCRIPTOR AVERAGE PRICE TRADE AVERAGE
PRICE YIELD(YTM) (%)
INE477K07018 GREEN INFRA WIND ENERGY LIMITED SR-I 9.65 101.0645 101.0645 9.5672
LOA 04AG23 FVRS985000

INE062A08249 STATE BANK OF INDIA SR I 7.74 BD PERPETUAL 99.9828 100.2600 4.7100

FVRS10LAC

INE094A08085 HINDUSTAN PETROLEUM CORPORATION LIMITED 100.2129 100.2129 8.5000

SR IV 4.79 NCD 23OT23 FVRS10LAC

INE020B08DF6 REC LIMITED SR 203B 5.85 BD 20DC25 FVRS10LAC 99.9960 99.9800 4.5650

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STOCK VALUATION

71

COMMON STOCK VALUATION

 Assume that a single share of a certain company is expected to earn an annual
dividend 𝐷 in year i and the discounting rate for the stock is 𝑟 . This could be the
dividend paid or the amount earned and re-invested into the firm. Then the
discounted value of the stock is:

𝐷
𝑃 =
1+𝑟

 If we assume the dividends to not grow with time, ‘zero growth model’, then
𝐷 = 𝐷 , and we obtain:
1 𝐷
𝑃 =𝐷 =
1+𝑟 𝑟

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COMMON STOCK VALUATION: CONSTANT GROWTH

(GORDON GROWTH MODEL)
 Assume that the dividends grow at a constant rate g every year or equivalently by
a factor (1+g), then the price would be:

𝑃 = ∑ =

73

COMMON STOCK VALUATION: VARIABLE GROWTH

 Can be done using cash flow discounting from scratch. No closed form formula.

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COMMON STOCK VALUATION

You are evaluating the potential purchase of a small business currently generating
$42,500 of after-tax cash flow (D0 = $42,500). On the basis of a review of similar-
risk investment opportunities, you must earn an 18% rate of return on the proposed
purchase. Because you are relatively uncertain about future cash flows, you decide
to estimate the firm’s value using several possible assumptions about the growth
rate of cash flows.
 What is the firm’s value if cash flows are expected to grow at an annual rate of
0% from now to infinity?
 What is the firm’s value if cash flows are expected to grow at a constant annual
rate of 7% from now to infinity?
 What is the firm’s value if cash flows are expected to grow at an annual rate of
12% for the first 2 years, followed by a constant annual rate of 7% from year 3
to infinity?

75

COMMON STOCK VALUATION

 What is the firm’s value if cash flows are expected to grow at an annual rate of
0% from now to infinity?

𝐷 42,500
𝑃 = = = $236,111
𝑟 18%

 What is the firm’s value if cash flows are expected to grow at a constant annual
rate of 7% from now to infinity?

𝐷 42,500
𝑃 = = = $386,363
𝑟 − 𝑔 18% − 7%

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COMMON STOCK VALUATION

 What is the firm’s value if cash flows are expected to grow at an annual rate of
12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to
infinity ?

42,500(1.12) 42,500 1.12 386,363𝑋 1.12

𝑃 = + + = $426,698
(1.18) 1.18 1.18

77

PREFERRED STOCK VALUATION

 Jones Design wishes to estimate the value of its outstanding preferred stock. The
preferred issue pays an annual dividend of $6.40 per share. Similar-risk preferred
stocks are currently earning a 9.3% annual rate of return. What is the market
value of the outstanding preferred stock?

𝐷 6.4
𝑃 = = = 68.8172
𝑟 9.3%

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RISK AND RETURN

79

COURSE OUTLINE
Session Topics

1-2 Module 1: Introduction to corporate finance and Indian financial system

•
3-4 Module 2: Time value of money

5-7 Module 3: Bond & stock valuation

8 Quiz 1 & Module 4 (starting)

9-11 Module 4: Risk & return

12-13 Module 5: Relevant cash flows

14-17 Module 6: Capital budgeting techniques – PBP, DPBP, NPV, IRR, PI

18 Quiz 2 & Module 6 (Ending)

19-20 Module 7: Cost of capital

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COURSE OUTLINE
Session Topics

1-2 Module 1: Introduction to corporate finance and Indian financial system

•
3-4 Module 2: Time value of money

5-7 Module 3: Bond & stock valuation

8 Quiz 1 & Module 4 (starting)

9-11 Module 4: Risk & return

12-13 Module 5: Relevant cash flows

14-17 Module 6: Capital budgeting techniques – PBP, DPBP, NPV, IRR, PI

18 Quiz 2 & Module 6 (Ending)

19-20 Module 7: Cost of capital

81

RISK AND RETURN FUNDAMENTALS

 Portfolio – group of assets.
 Risk – variability in cash flows or gains
 Return – total gain or loss on an investment over period of
time (cash distributions plus change in value).

Ct + Pt – Pt-1 r t– rate of return (actual, expected, or

rt =
Pt-1 required) during period t
Ct – cash flow received from asset investment
Pt – value of asset at t (time)
Pt-1 – value of asset t-1

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SOURCES OF RISK

Firm-Specific Risks
 Business risk – possibility that the company will not be able
to cover its operating costs.
 Financial Risk - possibility that the company will not be able to
meet financial obligations.

Investor-Specific Risks
 Interest rate risk – chance that interest rates will unfavorably
affect value of an investment.
 Liquidity risk- possibility that an investment cannot be
easily converted into cash without loss of capital and/or
income.
 Market risk – chance that market value of an investment will drop
due to market fluctuations such as increased bearishness.

83

SOURCES OF RISK (CONTINUED)

Firm and Shareholder Risks

 Event risk – possibility of an unforeseen event affecting the

value of the firm or an investment.
 Exchange rate risk – chance of change in currency exchange
rate, unfavorably affecting the value of an investment.
 Purchasing power risk - chance that the cash flow from an
investment or firms value will be adversely affected due to
inflation or deflation.
 Tax risk – possibility of changes in tax laws that could adversely
affect the value of the firm or an investment.

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Risk preference – attitude of people towards risks.

 Risk-averse
Someone who avoids risk and requires more return for increased risk.

 Risk-indifferent
Someone whose attitude (required or expected return) towards risk does
not change as risk increases.

 Risk-seeking
Someone whose required return decreases as risk increases.

85

RISK OF A SINGLE ASSET

Scenario analysis – a way to assess risk using several outcomes. Common

method is to use worst, expected, and best outcomes.
Example:

Scenario Analysis: Asset A Asset B

Initial Investment $ 100, 000 $100,000

Annual rate of return

Pessimistic (worst) 10% 6%
Most Likely (expected) 16% 14%
Optimistic (best) 19% 20%
Range 9% 14%

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RISK OF A SINGLE ASSET

(CONTINUED)

87

RISK OF A SINGLE ASSET

(CONTINUED)

• Standard deviation (σr) is used as a statistical indicator of an asset's

risk. It measures dispersion around expected value of return. Usually,
higher the standard deviation, the greater the risk.

• Expected value of return is the anticipated mean return on an asset.

• Coefficient of Variation(CV) used to determine volatility of an

investment. Higher CV indicates greater risk and therefore – higher
return.

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RISK OF A SINGLE ASSET (EXAMPLE)

Expected Values of returns for Assets 1 and 2

Possible Probability (P) Returns (R) Weighted value
Outcomes (PxR)
Asset 1
Pessimistic 0.15 11% 1.65%
Expected 0.55 13% 7.15%
Optimistic 0.30 15% 4.5%
Total 13.3%
Asset 2
Pessimistic 0.15 5% 0.75%
Expected 0.55 10% 5.5%
Optimistic 0.30 17% 5.1%
Total 11.35

89

RISK OF A SINGLE ASSET (EXAMPLE)

Standard Deviation for the returns of assets 1 and 2

j rj 𝑟¯ rj - 𝑟¯ (rj - 𝑟¯)2 Prj (rj - 𝑟¯)2 x Prj
(outcome) (return) (expectad value (probability of
of return) occurrence)

Asset 1
1 11% 13% -2% 4% 0.15 0.6%
2 13% 13% 0% 0% 0.55 0%
3 15% 13% 2% 4% 0.30 1.2%
Asset 2
1 5% 10% -5% 25% 0.15 3.75%
2 10% 10% 0% 0% 0.55 0%
3 17% 10% 7% 49% 0.30 14.7%

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RISK OF A SINGLE ASSET (EXAMPLE)

Expected Return, Standard deviation, and Coefficient of variation

Statistics Asset 1 Asset 2
Expected Return (R) 13.3% 11.35%

Standard deviation (S) 8% 6%

Coefficient of variation (R/S) 1.6 1.9

91

RISK OF A PORTFOLIO

In reality any new investment is not evaluated independently

of other assets, but as a part of a portfolio.

Maximizes return
for a given level
of risk
Efficient Portfolio
or

Minimizes risk for

a given level of
return

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RISK OF A PORTFOLIO

In reality any new investment is not evaluated independently

of other assets, but as a part of a portfolio.

Also, for most industries, there are competitors/parallels

such that as a portfolio their individual risks would mostly
cancel out without affecting the average return. This is an
assumption that could be made.

93

RISK OF A PORTFOLIO
(CONTINUED)

 Correlation - measures a relationship between two financial variables.

 Positively correlated – series move in the same direction (Example 1).

 Negatively correlated – series move in opposite directions (Example 2).

 Correlation coefficient – degree of correlation, ranges from +1 to -1.

Example 1. Example 2.
A

B B
Time

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RISK OF A PORTFOLIO
(CONTINUED)

 Diversification – combining assets that have negative or low

positive correlation to reduce overall risk of a portfolio.
 Uncorrelated assets - assets that have no interaction between
their returns.
 Correlation coefficient of uncorrelated assets is close to zero.

Asset A Asset B Portfolio of Assets Aand B

Return

Return

Return
Time Time Time

95

DIVERSIFICATION
Suppose the standard deviation riskof a stock S is σ and its average expected return is r .

Suppose a similar stock S has zero correlation with this stock but has std dev σ and return r .

S +S r +r σ +𝜎
Then the resulting average portfolio has return and standard deviation .
2 2 2

If σ and σ were very close to each other and the standard deviations

σ ≈ 𝜎 , then the resulting average portfolio has return

≈ r and risk or standard deviation of returns

σ
≈
2

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DIVERSIFICATION

For N such stocks which have minimal correlation due to idiosyncratic risks emanating from operational

S + S + S + ⋯S
sources, the return of the average portfolio would be
N
≈ r and risk or std. dev of returns

which can be negligible for large values of N.

Thus the return remains the same but the risk becomes much smaller. As N is very large risk
becomes negligible.

Thus firm specific risks can be reduced by diversification i.e. by combining as a portfolio
equities.

97

THE CAPITAL ASSET PRICING MODEL (CAPM)

 The Capital Asset Pricing Model – describes the link between

risk and expected return.

 Total security risk = Nondiversifiable risk + Diversifiable risk

 Diversifiable risk (unsystematic) – company- or industry-specific

risk, such as a strike or a lawsuit that could negatively affect price
of company’s stock. It can be eliminated through diversification.

 Non-diversifiable risk (systematic risk) – related to market

factors that affect whole industry. It cannot be eliminated
through diversification.

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THE CAPITAL ASSET PRICING MODEL (CAPM)

 Non-diversifiable risk is assumed to be the risk to the entire

market, thus if the regression equation

 𝑟 =𝛼 +𝛽 𝑟 +𝜖

holds, the non-diversifiable risk or the market linked risk is

 𝜎 =𝛽𝜎 ,

,where 𝜎 is the undiversifiable risk of the security S.

99

THE CAPITAL ASSET PRICING MODEL (CAPM)

 The market price of risk or the extra return required per unit of
risk is the same for all assets. Thus, if 𝑟 is the risk free rate,

𝑟 = 𝑟 + 𝜆𝜎 Market Price of risk

𝑟 = 𝑟 + 𝜆𝜎

 Here 𝜎 is the non-diversifiable risk. Combining the above two

equations along with

𝜎 =𝛽𝜎

gives us a formula for the expected stock return. This is known as

CAPM:
 𝑟 = 𝑟 + 𝛽 (𝑟 − 𝑟 )

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THE CAPITAL ASSET PRICING MODEL (CAPM) (CONTINUED)

 Market beta is considered to be 1.0

 Betas for assets can be positive or negative. Majority of betas are in the
range of 0.5 and 2.0
 Stock with a beta of 2.0 indicates that it is twice as responsive as a
market.
 Stock with a beta of 0.5 is half as responsive as market.
 Portfolio betas are interpreted just like beta for a single asset, but
considering the proportion of the total dollar value of every security.
 Generally, the higher the beta, the higher the required return, the lower
the beta, the lower the required return.

101

THE CAPITAL ASSET PRICING MODEL (CAPM) (CONTINUED)

Beta of a portfolio:
𝛽 = 𝑤𝛽

wj – proportion of j-th asset (in $

value) as a part of the whole
portfolio
𝛽 –beta of j-th asset

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THE CAPITAL ASSET PRICING MODEL (CAPM) (CONTINUED)

 Graphically CAPM is represented as Security Market Line (SML).
 It represents amount of required return for each level of nondiversifiable
risk.
Required Return, r (%)

SML
11 Security Market Line

0
1 2
Nondiversifiable Risk, b

103

THE CAPITAL ASSET PRICING MODEL (CAPM) (CONTINUED)

Position and slope of Security Market Line are affected by:
 Risk aversion
 Inflationary expectations

13 In graph to the left we can

see that 3% increase in
Required Return, r (%)

SML infationary expections

11
causes SML to shift upward,
8 which leads to 3% increase
in required return.
5

0
1 2
Change in inflationary expectations will result in corresponding change in the
returns of the assets.

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THE CAPITAL ASSET PRICING MODEL (CAPM) (CONTINUED)

 The slope of Security Market Line represents the degree of risk aversion. The
steeper the slope of SML, the greater the risk premium in the market, which
also means the greater the degree of risk aversion. Risk premiums increase
with increasing risk avoidance. 13

SML
11

8
New market risk
premium
5

Initial market risk

premium

105

NOTES ON CAPM.
UNDERLYING ASSUMPTIONS AND
LIMITATIONS.
 CAPM model relies on historic data. Betas are calculated using past
performance, therefore, they may or may not actually predict future returns.
 CAPM assumes efficient capital market, with many small investors (all rational
and risk-averse) have the same information and expectations, there are no
limitations on investments, with no taxes or transaction costs.
 It also assumes that all investors are fully diversified. However, in practice
that may not always be true.
 Although CAPM assumes all investors having the same time horizon, in
practice, however, all investors have different time horizons.
 Despite some of its drawbacks, CAPM is still an important framework used to
evaluate risk and return.

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