FM Combined Slides Till Midsem

Financial Management
Prof. Niranjan Swain

BITS Pilani
Course Objectives
To understand how business is managing its

various activities to create, sustain and maximize
it’s value (Intrinsic Value) in order to maximize its
shareholders’ value in the long run. Why not
profit maximization?
2 BITS Pilani, Deemed to be University under Section 3, UGC Act

FM Application in organizations.
Module-from 1 to 5:
The concepts and theories discussed from module 1 to 5 will be in the
context of broadly five organizations.
1. The first one is a large multinational company in entertainment
sector from developed economy (Disney, USA).
2. The second one is a large multinational company in mining / metal
sector from developing economy (Vale, Brazil). These two companies
will allow us to look at what do they share common and what they
might do different.

How to Achieve Course Objectives ?
3. The third one is a part of family group of companies – a public

limited manufacturing company in a developing economy (Tata
Motors, India).
The objective is to examine the special features that a

manufacturing company faces and what it means for an individual
investor to be a part of much larger family group whose interest
might be different from interest of Tata Motors.

4. Fourth company is from most influential economy and is a

dominant search engine in an emerging economy (Baidu, China).
We will analyze what it shares with the rest of the world and how
corporate governance can be an issue.

5. The fifth one is a regulated financial services company in a

developed economy (One leading Bank, Germany) and will analyze
how constraints put on company can influence corporate finance
decision.

Understanding various concepts / theories and

applying these in an organization’s context
through Experiential Learning Assignments
(ELA).

Module-1: Financial Statement Analysis and
Interpretation – (Self Study)
Learning:
Analyze and interpret financial accounting numbers based on GAAP from
financial decision making perspectives; understand how goal of an organization
is aligned with its financial performance and external environment;
understand the difference between business risk and financial risk; appreciate
importance of break-even analysis of analytical settings; distinguish among the
financial concepts of operating leverage, financial leverage, and combined
leverage; calculate the firm's degree of operating leverage, financial leverage,
and combined leverage; and explain why a firm with a high business risk
exposure might logically choose to employ a low degree of financial leverage in
its financial structure.

Self Reading Assignment

Module-2: Introduction and significance of Financial
Management
Learning:
Relationship between traditional balance sheet and financial
balance sheet; Describe what the subject of financial management
is about; Interface between Finance and Other Functions; Interface
between goal of the firm, responsibility of finance manager and
financial system; Themes of Financial Management; and Business
objectives (Share Price Maximization versus Business Value
Maximization); Level of significance of financial management
decisions; and small shareholders’ wealth protection.

Module-3: Risk & Return: (Hurdle Rate - WACC)
Learnings:
Hurdle Rate: Define & Measure Risk and Return; Risk Free Rate –
Define and Identify; Equity Risk Premium (ERP) – Static Equity Risk
Premium vs. Dynamic Equity Risk Premium (Forward Looking);
Country Risk Premium; Measuring Regression Beta
(Market/Systematic Risk); Limitations of regression beta, Measuring
Beta of five organizations, Determinants of Beta; cost of equity
share capital, cost of preference share capital and cost of debt
capital; and Measure WACC

Module-4:Time Value of Money
Learnings:
Understand the mechanics of compounding: how money grows over time
when it is invested; determine the future or present value of a sum
when there are non-annual compounding periods; understand the
relationship between compounding (future value) and bringing money
back to the present (present value); define an ordinary annuity and
calculate its compound or future value; differentiate between an
ordinary annuity and an annuity due, and determine the future and
present value of an annuity due; calculate the annual percentage yield
or effective annual rate of interest.

Module-5: Capital Budgeting (Value Creation –
Financial Feasibility Study of Capex)
Learnings:
Introduction - Types and importance of capital expenditure
(Project) decisions on business sustainability; Capital expenditure
processes and principles; Investment criteria; Cash flow
projections; Project analysis and evaluation - non-discounted and
discounted cash flow methods; and Measuring and analyzing risk of
capital expenditure decisions.

Module-6: Working Capital Management -How
much an organization needs for its smooth day-
to-day operation ?
Learnings:
Introduction and Objective of Working Capital Management: Static and Dynamic view
of Working Capital; Factors Affecting Composition of Working Capital; and Working
Capital Estimation;
Financing Current Assets: Behavior and pattern of financing, Spontaneous sources of
financing (Trade credit), Short-term bank finance, CPs and Factoring; Management of
Current Assets: Inventories - Role of Inventories in Working Capital, Cost of carrying
inventories, Inventories planning and management techniques; Receivables – Purpose
and cost of maintaining receivables; and Impact of credit policy and process of credit
evaluation, Monitoring Receivables; and
Management of Cash: Difference between profits and cash, and factors affecting cash
management and Internal Treasury Controls.

Module-7: Capital Structure – How much Debt
as opposed to Equity an organization can carry?
Learning Objectives:
Proposition I (Without Taxes: Capital Structure Irrelevance) and Proposition – II
(Without Taxes: Higher Financial Leverage Raises the Cost of equity), With
Taxes, the Cost of Capital, and Value of the Company; Cost of Financial
Distress; Agency Costs; Costs of Asymmetric Information; The Optimal Capital
Structure According to the Static Trade-off Theory; and Practical Issues in
Capital Structure Policy (Determinants of capital strcture).

Module-8: Dividend Policy – How much an
organization can distribute as Dividend vs.
Retain to Create & Sustain Future Value?
Learning Objectives:
Dividend Policy and Company Value- Theory - Dividend Policy Does not
Matter, Dividend Policy Matters – The Bird in the Hand Argument, The Tax
Argument and Other Theoretical Issues; Factors Affecting Dividend Policy –
Investment Opportunities, Expected Volatility of Future Earnings, Financial
Flexibility, Tax Considerations, Floatation Costs, Contractual and Legal
Restrictions; and Payout Policies – Types of Dividend Policies, Dividend
versus other ways and means of rewarding shareholders.

Experiential Learning Assignment (ELA)
(Learning by Doing)
All Experiential Learning Assignments will be applied in selected

organization by the student. Student can select his/her own
organization or continue with the same organization(s) selected in
FOFA course or select new organization. However, in any case,
organization(s) must be listed in stock exchange and having active
stock trading, and must have five years published financial statements.
There are two types of Experiential Learning Assignments viz.

Evaluative and Practice

Experiential Learning Assignment-
Learning by Doing
Q:1/ How to select organization for the experiential learning components
(Assignments)?
Ans: Select any organization or continue with the same organization

selected for FOFA course or select a new organization. However, in any
case, organization must be listed in stock exchange and having active stock
trading, and must have five years published financial statements.
Q:2/Is it an individual assignment or group assignment?

Ans: All assignments are individual assignment (not more than 4 students in
a group).
Q:3/What is the focus or learning from assignment?

Ans: Application of concepts / theories discussed in the sessions. For
learning objectives, refer to the respective module mentioned in course
handout.

Experiential Learning (Learning by Doing – Assignment)
Q:4/What submission can include?

Ans: One consolidated word file containing all four evaluative
assignments with appropriate heading for each assignment
topic and one data zipped file supporting each assignment.
Q:5/When to submit and where?

Ans: Refer to the evaluation component

Evaluation Component:

Introduction to Financial Management?
Every decision that a business makes has financial implication, and
any decision which affects the finance of a business is a financial
decision.
FM deals with any decisions that involves money and everything else
you have done or will be doing is in service of Financial management.

Introduction to Financial Management
There are MDPs and books on Finance for Non-Finance Executive but
not Marketing for Non-Marketing Executives, Production for Non-
Production Executives, and so on. Why?
The common thread running through all the decisions taken by the
various managers is money and there is hardly any manager working
in any organization to whom money does not matter. To illustrate
this point, let us consider the following instances.

 The R&D manager has to justify the money spent on research by

coming up with new products and processes which would help to
reduce costs and increase revenue.
 If the R&D department is like a bottomless pit only swallowing

more and more money but not giving any positive results in return,
then the management would have no choice but to close it.
 No commercial entity runs a R&D department to conduct

infructuous basic research.

 Materials manager should be aware that inventory of different

items in stores is nothing but money in the shape of inventory –
Trade-off between Liquidity-Profitability

Interface Between Finance and Other Functions
Marketing-Finance Interface
 The Marketing Manager should have a clear understanding of the

impact of the credit extended to the customers on the profits of the
company.
 Similarly, he should weigh the benefits of keeping a large inventory of
finished goods in anticipation of sales against the costs of maintaining
that inventory.
 Other key decisions of the Marketing Manager which have financial
implications are pricing, product promotion and advertisement, choice
of product mix and distribution policy.

Production-Finance Interface
 In any manufacturing firm, the Production Manager controls a
major part of the investment in the form of equipment,
materials and men.
 He should so organize his department that the equipments under

his control are used most productively, the inventory of work-in-
process or unfinished goods and stores and spares is optimized
and the idle time and work stoppages are minimized.

Production-Finance Interface
 If the production manager can achieve this, he would be holding
the cost of the output under control and thereby help in
maximizing profits.
 He has to make decisions regarding make or buy, buy or lease,

etc. for which he has to evaluate the financial implications
before arriving at a decision.

Top Management-Finance Interface:
 The top management is interested in ensuring that the business’s

long-term goals are met, finds it convenient to use the financial
statements as a means for keeping itself informed of the overall
effectiveness of the organization.
 Strategic planning and management control are two important

functions of the top management. Finance function provides the
basic inputs needed to undertake these activities.

Top Management-Finance Interface:

 With the recent liberalization of the Indian economy, abolition of
the office of the Controller of Capital Issues who used to fix issue
prices beforehand and efforts of the Indian economy towards
globalization, finance managers are presently facing some new
challenges as indicated below:
 Treasury Operations, Foreign Exchange, Financial Structuring,
Maintaining Share Prices, Ensuring Management Control, etc.

Objectives of our 40 sessions
Enable you to understand

the theories and apply in
To give big picture of
real world situations, the
Financial Management so
techniques that have been
developed in Financial that you can understand
how things fit together
Management / corporate
finance
To make you to
realize that financial
management is fun.

Outcomes of Financial Accounting and their differences
Statement of Income & Gain and Statement of Sources & Application
Expenses & Losses. of Fund.
Shows Financial Performance Shows Financial Position on a
during a period - FY. particular date since inception
Traditional
Profit & Accounting B/S
Loss (P/L) Balance
Sheet (B/S)
FF
The Traditional Accounting Balance Sheet
– Backward Looking
Application of Funds Sources of Funds

Financial Balance Sheet-
Forward Looking
the business
Two ways you can fund
Mysterious

Three basic Decisions that governs the
business to maximize its objective(s)
Maximize the Value of the Business (Firm)

Business Objectives
Objective:
Objective: Share Objective: Business
Shareholders Wealth
Price Maximization Value Maximization
Maximization
FM deals with Decisions:

1. Investment
2. Financing
3. Rewarding (Dividend)

Theme derived from 3 decisions
Theme -1 : “Common Sense”
If you can generate fund at 8% get it, do not go for 9%,

and do not invest in project that can generate less than
8%.
It means - use your common sense, do not depend on
only formulas, models – when model gives some answer
in which you are not comfortable with then use your
common sense.

Theme -2 : “Focused”
Only objective is to Maximize Value of the business– single
objective which has some advantages and disadvantages also.
Single objective has led to
Choose the “right”

investment decision
rule to use, given a
menu of such rules
Determine the “right”
mix of debt and equity Examine the “right”
for a specific business amount of cash that should
be returned to the owners
of a business and “right”
amount to hold back as a
cash balance

Theme – 3: Focus changes across the life cycle
Business go through life cycle like human being goes through

– born, growth, mature and decline.
Application of extent of financial management decision

depends on business life cycle. To what extent financial
management decision makes sense to business depends on
business’s life cycle / where does business stand in its life
cycle.

FM Decisions depend on
Business Life Cycle

Level of application of 3 FM Decisions
irrespective of nature / size of business
Con Ed’s (Consolidated Edison) Financial Balance
Assets Sheet Liabilities
Old Matured
$15 billion Investment $7 billion Company (180 years,
Debt
already made. supplier of energy: –
Investment yet to electricity & gas)
$3 billion be made. Equity $11 billion
Linkedin’s Financial Balance Sheet

Assets Liabilities
$0.25 billion Investment $0 billion
Debt
already made.
New Growth
Investment yet to company
$13.35 billion be made. Equity $13.6 billion

Theme – 4: Universal
Every business, small or large, public or private, developed or

emerging market, has to make investment, financing and
dividend decisions.
The objective in business finance (Financial Management)

for all of these businesses remains the same: Maximizing
Value

While the constraints and challenges that businesses face can vary
dramatically across businesses, but the first theme / principle do
not change.
A publicly limited company, with its grater access to capital

markets and more diversified investor base, may have much lower
costs of debt and equity than a private business, but they both
should look for the financing mix that minimizes their cost of
capital.

A business in an emerging markets may face greater
uncertainty, when a assessing new investments, than a
business in a developed market, but both the businesses
should invest only if they believe they can generate higher
returns on their investments than they face as their
respective (and very different) hurdle rates.

There are some investors / analysts / managers who convince
themselves that the first theme / principle does not apply to
them because of their superior education, standing or past
successes, and then proceed to put into place strategies or
schemes that violate first principle

Theme – 5: PAY for violation of principles
Sooner or later, these strategies will blow up and

create huge costs.
Almost every corporate disaster or bubble has its

origins in a violation of first theme / principle,

Financial Management will be
Applied to ……..
Will enable you to examine
Disney & Vale: Will allow
how the owner of the small
you to look at what do private business faces exactly
they share common and the same decisions that large
what they might do public traded business faces.
different
Will enable you
to understand
how constraints
put on company
can influence
corporate
Will enable you to finance
examine the special tribal
decision.
that a manufacturing
company faces and what
it means to be a part of
much larger family group Will enable you to examine what it
whose interest might be shares with the rest of the world and
different from interest of
how corporate governance can be an
the company
issue.
Financial Management deals with Business
Decisions …….Activities
Inv. Funds Flow
CG
Financial Investment Decisions
Assets- Risk &
Return Maxim
Financial Risk (DFL)
ize
Busine
Investment ss
WC Value
Operating Risk (DOL)

Physical Assets
(capex).
Output Dividend
TVM Rewarding
Operating CFs
Decisions
Financing Decisions
RE Fin. Funds Flow
Loan
Equity BITSPilani, Pilani Campus
Financial Management or
Corporate Finance
Vs.
Business Analysis & Valuation
Internal – How do I run External – Should I

the business? invest in this stock /
company?
53

BITS Pilani
Big Picture of Financial Management

Financial Balance Sheet-
Forward Looking
the business
Two ways you can fund
Mysterious
Maximize value of firm - existing and growth assets

The Classical Objective – Maximizing
Shareholders Wealth (MVA & TSR)
Assumption:
Stockholders have
complete power of
management.
Assumption: Lenders even

if they do not protect their
interest will not be riffed
off.
BITS Pilani, Deemed to be University under Section 3, UGC Act

What can go Wrong?
Small investor neither attend meeting nor surrender their proxies

which is economically not viable proposition considering cost of
attending annual board meeting holding may be 100 shares.
The worst is the small investors do not surrender their proxies and
hence it results in giving chance to manager to exercise voting
power of small investor in absentia which could be as high as 40 to
50%.
Therefore, it is very difficult to get vote against manager for their

wrong decisions in annual board meeting

What can go Wrong?
Small shareholders
neither cast their
votes
(uneconomical) nor
surrender their
voting rights
Lenders do
not protect
their
interest

Sahara India Pariwar Ltd. – Worst Board

Disney Board Members during 1997

Disney Board during 1997 – Worst Board
1) Too many number (17). Study show more than 9 to 10 is

unproductive.
2) Relationship with Disney- Either works for Disney or used
to work for Disney earlier worked in Disney.
3) Chairman of Board is CEO of Disney
4) Relationship with Board Chairman – CEO Chairman grand
daughter studies in school and his son studies in
Georgetown University.
Therefore, board is like a rubber stamp of Chairman works for
shareholders. Board works for managers than shareholders.

As an investor what you should look for
…… Who runs /who owns your company
Where the power of an organization lies? (Who are the top stockholders in your firm?,
What are the potential conflicts of interest that you see emerging from this stockholding
structure?
Government
Outside stockholders: Inside stockholders:
1. % of stock hold
1. Size of holding
2. Active or Passive
Control of 2. Voting & Non-
3. Short or Long the firm Voting shares
term? 3. Control structure
Employees
Lenders
Manager:
1. Length of tenure
2. Link to insiders

Top 17 stockholders of Disney in 2003
Out of 17,
16 are
institutional
and pension
fund investors
(They
walkaway
than fight).
No scope for
small
investors.

Voting vs. No-Voting Shares and
Golden Shares - Vale
Vale had eleven members on its board of Directors. Ten of

whom were nominated by Valespar and Board was chaired by
Don Conrado of CEO of Valespar
Top stockholders of Tata Motors in 2013
Expect
decision
taken by Tata
Motors could
be in the best
interest of
the Group
not small
investors

Legal Rights and Corporate Structure: Baidu
The Board: The company has six director, one of
whom is Robin Li, who is the founder / CEO of
Baidu.
Mr. Li also owns a majority stake of class B

shares, which have ten times voting rights of
Class A, granting him effective control of the
company.

Legal Rights and Corporate Structure: Baidu
Buying shares of Baidu is essentially buying
shares of shell.
The Legal system: Baidu’s operating counterpart

in China is structured as a Variable Interest
Entity (VIE), and it is unclear how much legal
power the shareholders in the shell company
have to enforce changes at the VIE

Top stockholders of Disney in 2009
Steve Jobs
had 60%
share in
Pickshare and
when Disney
took over
Pickshare,
Steve Jobs
became
largest
shareholders

BITS Pilani
Discussion
Defining and Measuring Risk &
Return
BITS Pilani
Big Picture of Financial Management

Hurdle Rate - The notion of a Benchmark
Hurdle Rate is the Minimum Rate which will make an

investment BEP (No profit no loss)
 Financial resources are limited, there is a hurdle rate that

projects / investments have to cross before being deemed
acceptable.
 This hurdle rate will be higher for riskier projects than for
safer projects.

Hurdle Rate - The notion of a Benchmark
A simple representation of the hurdle rate is as follows:
Hurdle Rate = Risk free Rate + Risk Premium
The two basic questions that every risk and return model in
finance tries to answer are:
1. How do you measure risk?

2. How do you translate this risk measure into a risk
premium?

MEASURING THE RATE OF RETURN
It is the income from the security in the form of cash flows and the
difference in price of the security between the beginning and end of
the holding period expressed as a percentage of the purchase price of
the security at the beginning of the holding period.

A stock’s rate of return
Rates of return are usually stated at an annual percentage rate to

allow comparison of returns between securities.

A stock’s rate of return
What are the two components of return from shares? The first
component “Dt” is the income in cash from dividends and the
second component is the price change (appreciation and
depreciation).
Example:
If a share of ACC is purchased for Rs.3,580 on February 3 of last year,
and sold for Rs.3,800 on February 4 of this year and the company
paid a dividend of Rs.35 for the year, calculate the rate of return?

Rate of Return of a Bond (Debenture)
In the case of bonds, instead of dividends, the investor is entitled

to payments of interest annually or semi-annually, based on the
coupon rate. The investor also benefits if there is an appreciation
in the price of the bond.
Example:
If a 14%, Rs.1,000 ICICI debenture was purchased for Rs.1,350 and
the price of this security rises to Rs.1,500 by the end of an year.
Rate of return for this debenture would be….

Probabilities and Rates of Return
What are probabilities?

A probability is a number that describes the chances of
an event taking place. Probabilities range from 0 to 1.
 A probability can never be larger than 1 (In other
words maximum probability of an event taking place is
100%).
 The sum total of probabilities must be equal to 1.
 A probability can never be a negative number.

If an outcome is certain to occur, it is assigned a probability of 1,
while impossible outcomes are assigned a probability of 0.
How does probability affect the rate of return?
In a world of uncertainty, the expected return may or may not
materialize.
In such a situation, the expected rate of return for any asset is the
weighted average rate of return using the probability of each rate of
return as the weight.
The expected rate of return “k” is calculated by summing the
products of the rates of return and their respective probabilities.
This can be mathematically stated as follows:

Example:

What is Risk?
Risk, in traditional terms, is viewed as a “negative”. Webster’s

dictionary, for instance, defines risk as “exposing to danger or
hazard”.
The Chinese symbols for risk is
Symbol is combination of danger and opportunity

What is Risk?
Risk is therefore neither good nor bad. It is just a fact of life.
The question that businesses have to address is therefore
not whether to avoid risk but how best to incorporate it into
their decision making.
How much opportunities we need to compensate the

given risk?

Risk
Risk and return go hand in hand in investments and finance. One
cannot talk about returns without talking about risk, because,
investment decisions always involve a trade-off between risk and
return.
Risk can be defined as the chance that the actual outcome from an
investment will differ from the expected outcome.
This means that, the more variable the possible outcomes that can
occur (i.e., the broader the range of possible outcomes), the
greater the risk.

RISK AND EXPECTED RATE OF RETURN
The width of a probability distribution of rates of return is a measure

of risk.
The wider the probability distribution, the greater is the risk or
greater the variability of return the greater is the variance. This
variance can be appraised visually.
Take a look at the probability distribution of Alpha company in
comparison with the probability distributions of the rates of return
of two other companies Beta and Gamma.

Beta Alpha
Low Risk
Company expected return Company
of return is 8%
Gamma
Company
High Risk expected return of

return is 20%

Of the three companies:-
Gamma company seems to be the riskiest because its probability
distribution is the widest and Beta company is the least risky because
its probability distribution is the narrowest.
If we look more closely, we also see that the expected return of Gamma
company is the highest at 20% while that of Beta company is at 8%.
This substantiates the fact that an investor cannot expect greater

returns without being willing to assume greater risks.

SOURCES OF RISK
Interest Rate Risk: Interest rate risk is the variability in a security’s
return resulting from changes in the level of interest rates. Other things
being equal, security prices move inversely to interest rates. This risk
affects bondholders more directly than equity investors.
Market Risk: Market risk refers to the variability of returns due to

fluctuations in the securities market. All securities are exposed to
market risk but equity shares get the most affected. This risk includes a
wide range of factors exogenous to securities themselves like
depressions, wars, politics, etc.

Inflation Risk: With rise in inflation there is reduction of purchasing power, hence
this is also referred to as purchasing power risk and affects all securities. This risk
is also directly related to interest rate risk, as interest rates go up with inflation
(Irving Fisher’s Equation vs. Liquidity Approach).
Business Risk: This refers to the risk of doing business in a particular industry or
environment and it gets transferred to the investors who invest in the business or
company.
Financial Risk: Financial risk arises when companies resort to financial leverage
or the use of debt financing. The more the company resorts to debt financing, the
greater is the financial risk.
Liquidity Risk:
This risk is associated with the secondary market in which the
particular security is traded. A security which can be bought or sold
quickly without significant price concession is considered liquid. The
greater the uncertainty about the time element and the price
concession, the greater the liquidity risk. Securities which have ready
markets like treasury bills have lesser liquidity risk.

Measurement of Total Risk
Risk is associated with the dispersion in the likely

outcomes. Dispersion refers to variability. If an asset’s
return has no variability, it has no risk. An investor
analyzing a series of returns on an investment over a
period of years needs to know something about the
variability of its returns or in other words the asset’s
total risk.

Measurement of Total Risk
There are different ways to measure variability of

returns. The range of the returns, i.e. the difference
between the highest possible rate of return and the
lowest possible rate of return is one measure, but the
range is based on only two extreme values.

The variance of an asset’s rate of return can be found as the
sum of the squared deviation of each possible rate of return
from the expected rate of return multiplied by the probability
that the rate of return occurs.

A third and most popular way of measuring variability of
returns is standard deviation. The standard deviation is
simply the square root of the variance of the rates of
return explained above.

Calculating the Standard Deviation
Let us calculate the for Alpha Company’s rates of return.

PORTFOLIOS AND RISK
What is a portfolio?
An investment portfolio refers to the group of assets that
is owned by an investor. It is possible to construct a
portfolio in such a way that the total risk of the portfolio
is less than the sum of the risk of the individual assets
taken together.

PORTFOLIOS AND RISK
Generally, investing in a single security is riskier than

investing in a portfolio, because the returns to the investor
are based on the future of a single asset. Hence, in order to
reduce risk, investors hold a diversified portfolio which might
contain equity capital, bonds, real estate, savings accounts,
bullion, collectibles and various other assets.

In other words, the investor does not put all his eggs into one basket.
How does diversification reduce risk? Let us take a look at a very simple
illustration.
Let us assume you put your money equally into the stocks of two
companies Banlight Limited, a manufacturer of sunglasses and Varsha
Limited, a manufacturer of rain coats. If the monsoons are above
average in a particular year, the earnings of Varsha Limited would be
up leading to an increase in its share price and returns to
shareholders. On the other hand, the earnings of Banlight would be on
the decline, leading to a corresponding decline in the share prices and
investor’s returns. If there is a prolonged summer the situation would
be just the opposite.

While the return on each individual stock might vary quite a
bit depending on the weather, the return on your portfolio
(50% Banlight and 50% Varsha stocks) could be quite stable
because the decline in one will be offset by the increase in
the other. In fact, at least in theory, the offsetting could
eliminate your risk entirely.

The next slides will explain you the returns on the two stocks
on the assumption that rainy, normal and sunny weather are
equally likely events (1/3 probability each).
Let us calculate the expected return and standard deviation

of the two stocks individually and of the portfolio of 50%
Banlight and 50% Varsha stocks.

Note that the portfolio earns 10% no matter what the weather is.
Hence through diversification, two risky stocks have been combined to
make a riskless portfolio as is evidenced by the standard deviation of
the portfolio.

While the above hypothetical example served us in
understanding the benefits of diversification, in practice
one rarely finds stocks which can perfectly offset each
other. The returns on Banlight and Varsha are said to be
perfectly negatively correlated since they always move
in opposite directions in exactly the same manner.

On the other hand, two stocks which go up or down
together in the same manner are said to be perfectly
positively correlated.
Both these types of correlation rarely happen in
practice. In general, all stocks have some degree of
positive correlation because certain variables like
economic factors, political climate, etc. tend to affect
all stocks.

We need not have stocks which are perfectly negatively
correlated in a portfolio in order to achieve the benefit
of risk reduction through diversification.
As long as the assets in a portfolio are not perfectly

positively correlated, diversification does result in risk
reduction.

The risk reduction effects of diversification are important both
to financial managers and investors. The finance managers’
attempt is to maximize the market value, which is what the
investors are interested in.

Diversifiable and Non-diversifiable Risk
The fact that returns on stocks do not move in perfect
tandem means that risk can be reduced by
diversification. But the fact that there is some positive
correlation means that in practice risk can never be
reduced to zero. So, there is a limit on the amount of
risk that can be reduced through diversification. This can
be traced to two major reasons.

DEGREE OF CORRELATION
The amount of risk reduction depends on the degree of
positive correlation between stocks. The lower the
degree of positive correlation, the greater is the amount
of risk reduction that is possible.

THE NUMBER OF STOCKS IN THE PORTFOLIO
The amount of risk reduction achieved by diversification
also depends on the number of stocks in the portfolio. As
the number of stocks increases, the diversifying effect of
each additional stock diminishes as shown in the figure
below:

As the figure indicates, the major benefits of
diversification are obtained with the first 10 to 12 stocks,
provided they are drawn from industries that are not
closely related. Additions to the portfolio beyond this
point continue to reduce total risk but the benefits are
diminishing.

From the figure it is also apparent that it is the diversifiable
risk that is being reduced unlike the non-diversifiable risk
which remains constant whatever your portfolio is.

What are diversifiable and non-
diversifiable risks?
The risk of any individual stock can be separated into two

components: (1) non-diversifiable and (2) diversifiable risk.
Non-diversifiable risk is that part of total risk (from various

sources like interest rate risk, inflation risk, financial risk,
etc.) that is related to the general economy or the stock
market as a whole and hence cannot be eliminated by
diversification. Non-diversifiable risk is also referred to as
market risk or systematic risk.

Diversifiable risk on the other hand, is that part of total risk
that is specific to the company or industry and hence can be
eliminated by diversification. Diversifiable risk is also called
unsystematic risk or specific risk.
Let us take a look at some of the factors that give rise to
diversifiable and non-diversifiable risk.

NON-DIVERSIFIABLE OR MARKET RISK FACTORS
 Major changes in tax rates

 War & other calamities
 An increase or decrease in inflation rates
 A change in economic policy
 Industrial recession
 An increase in international oil prices, etc.

Diversifiable or Specific Risk Factors
 Company strike
 Bankruptcy of a major supplier
 Death of a key company officer
 Unexpected entry of new competitor into the market
etc.

Risk of Stocks in a Portfolio
How do we measure the risk of stocks in a portfolio?

We can think of a portfolio’s standard deviation as a good
indicator of its risk to the extent that if addition of a stock to
the portfolio increases the portfolio’s standard deviation, the
stock adds risk to the portfolio.
But the risk that a stock adds to a portfolio will depend not only
on the stock’s total risk, its standard deviation, but on how that
risk breaks down into diversifiable and non-diversifiable risk.

If an investor holds only one stock, there is no question of
diversification, and his risk is therefore, the standard
deviation of the stock. For a diversified investor, the risk of a
stock is only that portion of the total risk that cannot be
diversified away or its non-diversifiable risk.

How does one measure non-diversifiable
or market risk?
It is generally measured by Beta coefficient. Beta measures the
relative risk associated with any individual portfolio as
measured in relation to the risk of the market portfolio.
The market portfolio represents the most diversified portfolio of
risky assets an investor could buy since it includes all risky
assets. This relative risk can be expressed as: (β)

Thus, the beta coefficient is a measure of the non-diversifiable
or systematic risk of an asset relative to that of the market
portfolio.
a) A beta of 1.0 indicates an asset of average risk.
b) A beta coefficient greater than 1.0 indicates above-average
risk – stocks whose returns tend to be more risky than the
market.
c) Stocks with beta coefficients less than 1.0 are of below
average risk i.e., less riskier than the market portfolio.

An important point to note here is that in the case of the
market portfolio, all the possible diversification has been done
– thus the risk of the market portfolio is non-diversifiable which
an investor cannot avoid.
Similarly, as long as the asset’s returns are not perfectly

positively correlated with returns from other assets, there will
be some way to diversify away its unsystematic risk. As a result
beta depends only on non-diversifiable risks.

The beta of a portfolio is nothing but the weighted average of
the betas of the securities that constitute the portfolio, the
weights being the proportions of investments in the respective
securities.
For example, if the beta of a security A is 1.5 and that of
security B is 0.9 and 60% and 40% of our portfolio is invested in
the 2 securities respectively, the beta of our portfolio will be
1.26*
*[1.5 x 0.6 + 0.9 x 0.4].

Measurement of Beta
The systematic relationship between the return on the security
or a portfolio and the return on the market can be described
using a simple linear regression, identifying the return on a
security or portfolio as the dependent variable kj and the
return on market portfolio as the independent variable km, in
the single-index model or market model developed by William
Sharpe. This can be expressed as:

The beta parameter in the model represents the slope of
the above regression relationship and it measures the
responsiveness of the security or portfolio to the general
market and indicates how extensively the return of the
portfolio or security will vary with changes in the market
return.
The beta coefficient of a security is defined as the ratio of
the security’s covariance of return with the market to the
variance of the market.

The alpha parameter is the intercept of the fitted line
and indicates what the return of the security or portfolio will
be when the market return is zero.
For example, a security with an of + 2 percent would earn
2 percent even when the market return was zero and would
earn an additional 2 percent at all levels of market return. The
converse is true if a security has of –2 percent.

The positive thus represents a sort of bonus return and would
be a highly desirable aspect of a portfolio or security while a
negative represents a penalty to the investor.
The third term ej is the unexpected return resulting from
influences not identified by the model. Frequently referred
to as random or residual return, it may take on any value but
is generally found to average out to zero.

Example:

This can be calculated as follows:

What do these figures of Bi (Beta) and Alpha imply?
When we say that the security has a Beta of 1.54 we mean

that if the return on the market portfolio rises by 10%, the
return on the security ‘j’ will rise by 15.4%. An Alpha of
4.6% implies that the security earns 4.6% over and above
the market rate of return.

THE CAPITAL ASSET PRICING MODEL (CAPM)
The CAPM developed by William F Sharpe, John Lintner

and Jan Mossin is one of the major developments in
financial theory. The CAPM establishes a linear
relationship between the required rate of return of a
security and its systematic or undiversifiable risk or
beta.

Assumptions
The CAPM is based on a list of critical assumptions, some of which are as
follows:
 Investors are risk-averse and use the expected rate of return and standard
deviation of return as appropriate measures of risk and return for their
portfolio. In other words, the greater the perceived risk of a portfolio, the
higher return a risk-averse investor expects to compensate the risk.
 Investors make their investment decisions based on a single-period horizon
i.e., the next immediate time period.
 Transaction costs in financial markets are low enough to ignore and assets
can be bought and sold in any unit desired. The investor is limited only by
his wealth and the price of the asset.
 Taxes do not affect the choice of buying assets.
 All individuals assume that they can buy assets at the going market price
and they all agree on the nature of the return and risk associated with each
investment.

The assumptions listed above are somewhat limiting but the
CAPM enables us to be much more precise about how trade-
offs between risk and return are determined in financial
markets.

What do investors require (expect) when they invest?
 First of all, investors can earn a riskless rate of return by

investing in riskless assets like treasury bills.
 This risk-free rate of return is designated Rf and the

minimum return expected by the investors.
 In addition to this, because investors are risk-averse, they

will expect a risk premium to compensate them for the
additional risk assumed in investing in a risky asset.

Required Rate of Return = Risk-free rate + Equity Risk
premium.
The CAPM provides an explicit measure of the risk premium.

It is the product of the Beta for a particular security j and the
market risk premium km – Rf

This beta coefficient is the non-diversifiable risk of the
asset relative to the risk of the market. If the risk of
the asset is greater than the market risk, i.e. exceeds
1.0, the investor assigns a higher risk premium to asset
j than to the market.

For example, suppose a fertilizer company had a Beta of
1.5, that its required rate of return on the market (km)
was 15 percent per year and that its risk free interest
rate (Rf) was 6 percent per annum.

The above calculations show that the required rate of
return on this stock would be 19.5% – the sum of 6
percent risk-free return and a 13.5 percent risk
premium.
This 19.5 percent is larger than the 15 percent required
return on the market because the fertilizer stock is
riskier than the market.

The expected return as we know is computed
as below:

While estimating the expected return a year hence, in
the absence of historic data on returns and
probabilities, the following formula which is derived
from the basic formula given above may be used.

Investors will be tempted to sell security Y because it offers less
than the required rate of return.
This increase in the supply of Y will drive down its price and
correspondingly increase the return until security is once again in
equilibrium.

Risk Free Rate
In order to get hurdle rate we need to get a Risk Free Rate which is
central point of finance and which is becoming very complex now
than before 5 to 10 years.
Understanding how can we arrive at an best appropriate Risk Free
Rate of Return

Risk Free Rate & Time Horizon
On a risk free asset, the actual return is always equal to the
expected return. For an investment to be risk free, i.e., to have an
actual return be equal to the expected return, two conditions have
to be met:
There has to be no default risk, which generally implies that the

security has to be issued by the government. Note, however, that
not all governments can be viewed as default free.
There can be no uncertainty about reinvestment rates, which

implies that it is a zero coupon security with the same maturity as
the cash flow being analyzed.

Risk Free Rate & Time Horizon
Theoretically, this translates into using different risk free rates for
each cash flow – the 1 year zero coupon rate for the cash flow in
year 1, the 2-year zero coupon rate for the cash flow in year 2 …..

The Bottom Line on Risk Free Rate
Using a long term government rate (even on a coupon bond) as
the risk free rate on all of the cash flows in a long term
analysis will yield a close approximation of the true value.
For short term analysis, it is entirely appropriate to use a short

term government security rate as the risk free rate.

What is Euro Risk Free Rate

What if there is no Default Free Entity
If the government is perceived to have default risk, the government

bond rate will have a default spread component in it and not be risk
free. There are three choices we have, when this is the case:
Adjust the local currency government borrowing rate for default risk
to get a risk free local currency rate.
 In November 2013, the Indian Government rupees bond rate was

8.82%. The local currency rating from Moody’s was Baa3 and the
default spread for a Baa3 rated country bond was 2.25%.
 Therefore, risk free rate in rupee = 8.82% - 2.25% = 6.57%

Do the analysis in an alternate currency, where getting the

risk free rate is easier. With Vale (Brazilian Company) in
2013, we could choose to do the analysis in US dollars
(rather than estimate a risk free rate in in R$). The risk
free rate is then the US treasure bond rate.

Do your analysis in real terms, in which case the risk free

rate has to be a real risk free rate. The inflation-indexed
treasury rate is a measure of a real risk free rate.

Estimating Default Spread for a country in 2013

Estimating Default Spread for a country in 2013

Estimating Equity Risk Premium:
Market Premium

What is Equity Risk Premium?
The risk premium is the premium that
investors demand for investing in an
average risk investment, relative to the
risk free rate.
ERP is dynamic / forward looking

– depends on level of risk aversion, change
in market price of security,

How can we arrive at ERP?
1. Survey investors on their desired risk
premiums and use the average premium from
these surveys.
2. Assume that the actual premium delivered

over long time periods is equal to the expected
premium i.e. , use historical data.
3. Estimate the implied premium in today’s asset

prices.

Equity Risk Premium (ERP )
ERP is based on HOPES (reaction to past) not

Expected Rate of Return and discontinued
Expected Return = Rf + ERP

= Rf + Bi ( Expected Market
Return – Risk Free Rate)

Historical Risk Premium: USA in
January 2014
Stock Return over T-Bills & T-Bonds

In November 2013, Historical Risk Premium for the US
was 4.20% (Geometric average, stock over T-Bonds.)

Using the default spread on the sovereign bond or
based upon the sovereign rating and adding that
spread to the mature market premium (4.20% for
the US) Why do we take US ERP?
Ans: Has long history of equity market
November 2013
This default spread can be considered as risk free rate of

return from US investor’s perspective.

India’s Sovereign CDS Spread (Country risk) = 4.20%.
Assuming CDS Spread of USA is 1.15,
India’s Sovereign CDS Spread ( Net of USA) = 3.05%

Beyond the bond default spread ?
Equities are riskier than bond
While default risk spreads and equity risk premiums are
highly correlated, one would expect equity spreads to be
higher than debt spreads. One approach to scaling up the
premium is to look at the relative volatility of equities to
bonds and to scale up the default spread to reflect this.
Standard deviation of equity index return and standard

deviation of government bond return

Beyond the bond default spread ?
Equities are riskier than bond
USA ERP in 2013
Country
Risk
Premium

Implied ERP (Forward Looking ERP)
Implied Equity Risk Premium (1/1/2014) =

8.04 % - 2.55% = 5.49%

BITS Pilani
Discussion
Time Value of Money
(TVM)
BITS Pilani, WILPD

Time Value of Money (TVM)
How do we understand time value of Money (TVM)?

• Purchasing Power of Money
• Inflation
• Interest Rate
• Nominal Interest Rate and Real Interest Rates
Why Should we Study the time Value of Money (TVM)? What is the importance
of Time Value of Money (TVM) in Finance?
• Most of the financial decisions involve costs & benefits that are spread out
over time.
• Time Value of money allows comparison of cash flows from different periods
BITS Pilani, WILPD

Time Value of Money (TVM) : Motivation
Risk and Uncertainty
• Future is always uncertain and risky. Outflow of cash is in our control as

payments are made by us.
• There is no certainty for future cash inflows. Cash inflows is dependent

on our creditor, banks etc
• As an individual or firm is not certain about future cash receipts, it

prefers receiving cash now.
BITS Pilani, WILPD

Inflation
• In an inflationary economy, the money received today, has more

purchasing power than the money to be received in future
• In other words, a rupee today represents a greater real purchasing

power than a rupee a year later.
BITS Pilani, WILPD

Consumption
• Individuals generally prefer current consumption to future consumption
Investment opportunities
• An investor can profitability employ a rupee received today, to give him

a higher value to be received tomorrow or after a certain period
BITS Pilani, WILPD

Time Value of Money (Purchasing Power -
Inflation) and Interest Rate.
Nominal or Market Interest Rate is the Combination of.

BITS Pilani, WILPD
How Do You Take Care of TVM ?
BITS Pilani, WILPD
Compounding Vs. Discounting
6/8/2024 8 BITS Pilani, WILPD

Time Value of Money (TVM) : Types of Interest
Simple Interest (SI)

• Interest is paid (earned) on only the original amount, or principal borrowed.
Compound Interest(CI)
• Interest is paid (earned) on any previous interest earned, as well as on the principal borrowed.
• Formula: SI = P0(i)(n)
SI: Simple Interest
P0:Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
Example: Assume that you deposit Rs.1,000 in an account earning 7% simple interest for 2
years. What is the accumulated interest at the end of the 2nd year?
SI = P0(i)(n) = Rs.1,000(.07)(2) = Rs.140

BITS Pilani, WILPD
Time Value of Money (TVM) : Future Value and
Present Value
Simple Interest (FV)
• What is the Future Value (FV) of the deposit ?
FV = P0 + SI
= Rs.1,000 + Rs.140
= Rs.1,140
• What is Future Value ?
Is the value at some future time of a present amount of money, or a series of
payments, evaluated at a given interest rate.
Q: What is the Present Value (PV) of the previous problem ?

Present Value is simply the originally deposited. That is the value today! Rs.1,000 you
• Present Value is the current value of a future amount of money, or a series of

payments, evaluated at a given interest rate.
BITS Pilani, WILPD

General Future Value Formula
FV1 = P0(1+i)1 FV2 = P0(1+i)2
General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
FVn = Future Value of the initial

flow n years hence.
P0 = Initial cash flow n = Life of investment
i = Annual Interest Rate.

BITS Pilani, WILPD
Why Compound Interest ?
Future Value of a Single Rs.1,000 Deposit
20000
10% Simple
15000 Interest
Future Value (Rs. )
7% Compound
10000
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year

Future Value Example
X wants to know how large his Rs.10,000 deposit will

become at a compound interest rate of 10% for 5
years.
0 1 2 3 4 5
10%
Rs.10,000
FV5

Future Value Example Solution
Calculation based on general formula:

FVn = P0 (1+i)n
FV5 = Rs. 10,000 (1+.10)5
= Rs. 16,105.10
Calculation based on Table :
FV5 = Rs. 10,000 (FVIF10%, 5)
= Rs. 10,000 (1.611)
= Rs. 16,110 [Due to Rounding]

Present Value Example
X wants to know how large of a deposit to make

so that the money will grow to Rs.10,000 in 5
years at a discount rate of 10%.
0 1 2 3 4 5
10%
Rs.10,000
PV0

Present Value Example Solution
Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0 = Rs.10,000 / (1+ 0.10)5
= Rs.6,209.21
Calculation based on Table :

PV0 = Rs.10,000 (PVIF10%, 5)
= Rs.10,000 (.621)
= Rs. 6,210.00
Increased Frequency of Compounding
Suppose you bought a scheme where compounding is done more

frequently.
For example, assume you deposit Rs. 10,000 in bank which offers 10%
interest per annum compounded semi-annually which means that
interest is paid every six months.
Beginning amount = Rs.10,000
BITS Pilani, WILPD

Increased Frequency of Compounding
Beginning amount = Rs.10,000

Interest @10% p.a for first 6 months: 10,000 * (0.1/2)
Rs. 500
Interest @10% p.a for second 6 months:10,500 * (0.1/2)

Rs.525
Amount at the end of the Rs. 11,025

year:
BITS Pilani, WILPD
Frequency of Compounding
General Formula:
FVn = PV0(1 + [i/m])m n
n:Number of Years
m:Compounding Periods per Year
i:Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
Accounting and Finance for Bankers Slide 26

24October2022
BITS Pilani, WILPD

Impact of Frequency
You have Rs.1,000 to invest for 2 Years at an annual interest
rate of 12%.
Annual FV2 = 1,000 (1+ [.12/1])(1) (2)

= 1,254.40
Semi FV2 = 1,000(1+ [.12/2])(2) (2)

= 1,262.48
BITS Pilani, WILPD

Impact of Frequency
Qtrly FV2 = 1,000 (1+ [.12 / 4])(4) (2)
= 1,266.77
Monthly FV2 = 1,000(1+ [.12 /12]) (12) (2)
= 1,269.73
Daily FV2 = 1,000 (1+[.12 / 365 ]) (365) (2)
= 1,271.20
BITS Pilani, WILPD

Semi Annual Compounding
BITS Pilani, WILPD

Quarterly Compounding
BITS Pilani, WILPD

Comparison
BITS Pilani, WILPD

Which loan is cheaper?
• Is a loan with a 14% annual interest with monthly

compounding cheaper than a loan with a 14.75% interest
rate with annual compounding?
• How does it compare to a loan with a 14.5% with semi-

annual compounding?

To compare the rates we need to express them in a single, consistent

format.
In this case, effective annual rate is the most appropriate.
• 14.75% with annual compounding 14.75%

• 14% with monthly compounding = ( 1 + .14/12 )^12 -1 = 14.93%
• 14.5% with Semi Annual compounding = ( 1 + .145/2 )^2 -1 = 15.03%
Therefore the 14% stated rate loan is not cheaper than the 14.75%
stated rate loan, although it is cheaper than the 14.5% loan

SI No Compounding Period Effective Rate
1 Annual 12.00%
2 Semi-annual 12.36%
3 Quarterly 12.551%
4 Monthly 12.683%
5 Daily 12.747%
6 Hourly 12.75%
7 Per Second 12.749685%
8 Continuous 12.749685%
Suppose Interest rate is 12% and compounded annually.
When compounding becomes continuous, the effective interest rate is expressed as

follows:
Effective interest rate = e^r -1 = [(2.71828)^.12] – 1 = 1.127-1 = 12.7
where e (2.71828) is the base of natural logarithm, and r is the stated interest rate
Double Your Money!!!
Quick! How long does it take to double

Rs. 5,000 at a compound rate of 12% per
year (approx.)?
We will use the “Rule-of-72”.

The “Rule-of-72”
Quick! How long does it take to

double Rs. 5,000 at a compound
rate of 12% per year (approx.)?
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
6/8/2024 36
BITS Pilani, WILPD
Rule of 69
However, an accurate way of

calculating doubling period is the
“rule of 69”
= 0.35 + (69/Interest Rate)
BITS Pilani, WILPD

Present Value of an Ordinary Annuity
Ordinary Annuity wherein payments or receipts occur at the end of each

period where as in Annuity Due payments or receipts occur at the beginning of
each period.
Therefore, an annuity due will always be greater than an otherwise equivalent
ordinary annuity because interest will compound for an additional period.
• Ordinary Annuity = Equal Annual Series of Cash Flows
• Example: How much could you borrow if you could afford annual
payments of Rs. 2,000 (which includes both principal and interest) at
the end of each year for three years at 10% interest?

Present Value of an Ordinary Annuity
Using PVIFA Tables
PVA = 2,000(PVIFA,10%,3)
= 2000 * 2.487
= Rs. 4,973.70

Example of an Ordinary Annuity -- PVA
End of Year
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Rs.934.58
Rs.873.44
Rs.816.30
PVA3 = Rs.1,000/(1.07)1 +
Rs.1,000/(1.07)2 +
Rs.2,624.32 = PVA3
Rs.1,000/(1.07)3
= Rs.934.58 + Rs.873.44 +Rs.816.30
= Rs.2,624.32
Future Value of an Annuity Due
• Annuity = Equal Annual Series of Cash Flows
• Example: How much will your deposits grow to if you

deposit Rs. 100 at the beginning of each year at 5%
interest for three years.

Future Value of an Annuity Due
Using the FVIFA Tables
FVA = 100(FVIFA,5%,3)(1+k) = Rs. 330.96
FVA = 100*(3.152)*(1.05) = Rs. 330.96

Valuation Using Table
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
FVAn = Rs. (FVIFAi%,n)
FVA3 = Rs.1,000 (FVIFA7%,3)
= Rs.1,000 * (3.215)
= Rs.3,215
Future Value of an Ordinary Annuity
Annuity = Equal Annual Series of Cash Flows

Example: How much will your deposits grow to if
you deposit Rs. 100 at the end of each year at
5% interest for three years.

Future Value of an Ordinary Annuity
FVA = 100(FVIFA,5%,3) = Rs. 315.25

Example of an FV of an Ordinary Annuity – (FVA)
End of Year
0 1 2 3
7%
Rs. 1,000 Rs.1,000 Rs.1,000
Rs.1,070
Rs.1,145
Rs. 3,215 = FVA3

FVA3 = Rs. 1,000(1.07)3 + Rs.1,000
(1.07)2 + Rs.1,000(1.07)1 = Rs.1,145 +
Rs.1,070 +Rs.1,000 = Rs.3,215
Steps to Amortizing a Loan
Step 1 : Calculate the payment per period.

Step 2: Determine the interest in Period t.
( Loan Balance at t-1) x (i% / m)
Step 3: Compute principal payment in Period t.
( Payment - Interest from Step 2)
Step 4: Determine ending balance in Period t.

(Balance - principal payment from Step 3)
Start again at Step 2 and repeat.
BITS Pilani, WILPD

Amortizing a Loan Example 01
You borrowed Rs.10,000 at an annual

interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.
EYI = Equal Yearly Instalment
Step 1: Payment
PV0 = R (PVIFA i%, n )
Rs. 10,000 = R (PVIFA 12%, 5 )
Rs.10,000 = R (3.605)
R = Rs.10,000 / 3.605 = Rs. 2,774
Amortizing a Loan Example 01 2774 – 1200= 1574
(12% * 10,000)
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000 10000-1574
1 $2,774 $1,200 $1,574 8,426
8426-1763
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
12% * 8426 4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000
2774 – 1011=1763
[Last Payment Slightly Higher Due to Rounding]
6/8/2024 49
BITS Pilani, WILPD
You borrow Rs. 30,00,000 at 9 % compound annual interest rate for 10

years.
A. What is the annual payment that will completely amortize the loan over
four years?
B. Of each equal payment, what is the amount of interest and what is the
amount of loan principal?

Present Value of an Ordinary Annuity.
30,00,000 = EYI * (1- ((1/1.09)^10) / (0.09)

General Formula
(1/1.09)^10 = 0.422
1-0.422 = 0.577
0.577/.09 = 6.417
EYI = 30,00,000 / 6.417 = Rs.467508
PV = Present Value, In this example, RS.30,00,000
P = Equal Instalment (You need to calculate)
r = Interest Rate (in this example it is 9%)
n = Time period (in this example it is 10 years

B.
Principal
End of the Instalment Annual Principal Amount
Year Payment Interest Payment Owing at
Year End
0 100000
1 34320 14000 20320 79680
2 34320 11160 23160 56520
3 34320 7910 26410 30110
4 34320 4210 30110 0
Total 137280 37280 100000

Lease Management Question
On 01/04/2021, you got a premium car (Mercedes Benz) on a lease of Rs.20,000 (as lease rental)
per month for 6 years from M/s Ashok Leyland Finance Ltd. You have paid lease rental for one year
ending 31/03/2022 and from 01/04/2022 onwards you have been facing financial difficulties in
meeting lease rental commitments. Therefore, you approached the leasing company to revise the
terms of lease with an assumption that you will not able to pay instalments for next one year up to
31/03/2023. However, you want to keep the total repayment period same (2027) as before. The
leasing company agreed to waive next 12 instalments (2022-23) by increasing the amount to Rs.
27,500 per month for the remaining period (4 years). If your opportunity cost of capital is 12%,
should you accept the revised payment terms from the leasing company? Justify. Also find to what
revised lease rents you could to remain indifferent.

Solution
Number of instalments remaining are 60. With 12% cost the discount rate per month is 1%.
To evaluate the better lease terms, we compare the NPVs of the two alternative lease plans.
Existing Terms:
Period of annuity = 60 Months
Required Rate of Return = 1%
Present value of annuity for 60 months at 1% = PVIFA(1%,60)
= 44.955
Monthly lease payment = 20,000
Present value of existing lease payments = 44.955 *20,000
= 8,99,100
Revised Terms:
Present value of annuity for 48 months at 1% = PVIFA(1%,48)
= 37.974
Monthly lease payment = 27500
Present Value of lease after 12 Months = 37.974*27,500
= 10,44,285
Solution
Present value of Rs. 1 after 12 months at 1% = PVIF(1%,12)
= 0.8874
Present value of revised lease payments = 0.8874*10,44,285
= 9,26,699
Since the present value of lease payments under the revised terms is higher you should not
accept the proposal of the leasing company. The maximum amount under the revised terms
of lease should be such that the Net Present value (NPV) is equal to the NPV of the lease
rents under the existing schedule.
If we consider the revised value of rent to be ‘R’

The present value of these rentals under the revised plan is = 37.974*0.8874*R
The present value of existing lease payments = Rs. 8,99,100
Solve for R by equating the above 37.974*0.8874*R = 8,99,100
We get R = 26681.0076415
So we should not accept for any lease payment more than 26,681

Estimation of Project’s
Cash Flow
1.Initial Cash Flow Mostly Outflows

2.Operating Cash Flow Inflows or Outflows
3.Terminal Cash Flow Mostly Inflows
Principles Governing Accounting
Earning Management
Principles Governing Accounting
Earning Management
To get from accounting earnings to cash flows:
Financial Appraisal
Cash Flow Estimation – Expansion and Replacement

Project
Cash Flows Relating to Equity
Cash Flows Relating to Long-term Funds
Cash Flows Relating to Total Funds

Cash Flow: Expansion Project
Naveen Enterprises is considering a capital project about which

the following information is available:
The investment outlay on the project will be Rs.100 million.
This consists of Rs.80 million on plant and machinery and Rs 20
million on net working capital. The entire outlay will be
incurred at the beginning of the project.
The project will be financed with Rs 45 million of equity
capital, Rs 5 million of preference capital, and Rs 50 million
of debt capital. Preference capital will carry a dividend rate
of 15 percent; debt capital will carry an interest rate of 15
percent.
The life of the project is expected to be 5 years. At the end

of 5 years, fixed assets will fetch a net salvage value of Rs
30 million whereas net working capital will be liquidated at
its book value.
The project is expected to increase the revenues of the firm
by Rs.120 million per year. The increase in costs on account
of the project is expected to be Rs 80 million per year (This
includes all items of cost other than depreciation, interest,
and tax). The effective tax rate will be 30 percent.
Plant and machinery will be depreciated at the rate of 25
percent per year as per the written down value method.
Hence, the depreciation charges will be:
First year: Rs 20.00 million
Second year: Rs 15.00 million
Third year : Rs 11.25 million
Fourth year: Rs 8.44 million
Fifth year: Rs 6.33 million
Tax Rate = 30% * PBT = .30*20 = 6
PAT + Depreciation 17.50+15.00 50+23.57+6.33

= 14+20
Project Evaluation (Financial Feasibility):
Approaches
Non-Discounted cash flows and discounted cash flows.
Why: Discounted Cash Flows?
Ans: Long term investment subject to the impact of Time Value of
Money on both cash outflows and cash inflows
Why cash flows not profit?
Ans: (1) Chances of getting negative cash flow is lesser than profit
and (2) Profit is a vague – (Which profit? - Accounting profit, Cash
Profit or economic profit, Profit both from operation and income
from other sources
Project Evaluation Approaches
Non-Discounted Cash flow
1) Payback Period (PBP)
2) Accounting Rate of Return (Not covered)
Discounted Cash flows
1) Net Present Value (NPV)
2) Internal Rate of Return (IRR)
3) Modified Internal Rate of Return (MIRR – Not covered)
4) Profitability Index (PI)
Proposed Project Data
Your company is evaluating a new project and you have
estimated after-tax cash flows (PAT + Non-Cash
Expenses ie. Depreciation & Amortization) of the
project which will be $10,000, $12,000, $15,000,
$10,000, and $7,000 respectively for each of the Years
1 through 5. The initial cash outlay / out flows /
investment will be $40,000.
Independent Project
For this project, assume that it is independent of any

other potential projects that you may undertake.
Independent -- A project whose acceptance (or

rejection) does not prevent the acceptance of other
projects under consideration.
The reverse in exclusive project

Non-Discounted Evaluation Methods
Payback Period
0 1 2 3 4 5
- 40 K 10 K 12 K 15 K 10 K 7K
PBP is the period of time required for the cumulative

expected cash flows from an investment project to
equal the initial cash outflow.
What is PBP : Time taken to get back investment made.

Payback Period
0 1 2 3 (a) 4 5
-40 K (-b) 10 K 12 K 15 K 10 K (d) 7K

10 K 22 K 37 K(c) 47 K 54 K
Cumulative
Inflows (PAT +
Non-Cash
Expenses)
PBP = a + ( b - c ) / d = 3 + (40 - 37) / 10
= 3 + (3) / 10= 3.3 Years
PBP Acceptance Criterion
Suppose your company has set a maximum PBP of

3.5 Years for projects of this type.
Should this project be accepted ?
Yes! Because you will receive back the initial cash

outlay in less than 3.5 Years. [3.3 Years < 3.5
Year Max.]
PBP Strengths Weaknesses
Strengths: Weaknesses:
– Easy to use and – Does not account
understand for TVM
– Can be used as a – Does not consider cash flows
measure of beyond the PBP
liquidity (speed of – Cutoff period is subjective
getting money back)
– Easier to forecast
– ST than LT flows
What is your PBP in this program?

Discounted Pay Back Period (DPBP)
Your company’s has determined that the

appropriate discount rate (k) for this project is
13% (Cost of capital).
$10,000 $12,000 $15,000
DPBP = + + +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000 - $40,000

+
(1.13)4 (1.13)5 (1.13)0
Discounted Payback Period (DPBP)
DPBP = - $40,000 + $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $7,000(PVIF13%,5)
DPB= - $40,000 - $10,000(.885) + $12,000(.783) + $15,000(.693) +

$10,000(.613) + $7,000(.543)
DPBP= - $40,000 + $8,850 + $9,396 + $10,395 + $6,130 + $3,801 =

- $1,428
Therefore, DPBP will be more than 5 Years. Hence, this project

will not be accepted
Suppose cash inflow at the end of 6th year is $2800, then

DPBP = $1428 / $2800 = 5 years and more than 6 months (More
than 5.6 years)
PV = FV / (1+K)^n
Discounted Evaluation Methods
Net Present Value (NPV) is the sum of present value of all

cash flows (cash inflows and cash out flows.
Net Present Value (NPV)

NPV is the sum of present value of all cash flows (cash
inflows and cash out flows.
CF1 CF2 CFn

NPV = + + - Cf0/(1+k)^0
(1+k)1 (1+k)2 (1+k) n
CF1= Cash Inflow at the end of year 1

CF2= Cash Inflow at the end of year 2
ICO = Investment Cash Outflows
K = Cost of capital ( K of the company versus of the project)
Your company’s has determined that the
appropriate discount rate (k) for this project is
13% (Cost of Capital).
$10,000 $12,000 $15,000
NPV = + + +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000 - $40,000

+
(1.13)4 (1.13)5 (1.13)0
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
Your management has determined that the required

rate is 13% for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means that the project is

reducing shareholder wealth. [Reject as NPV < 0 ]
What does +ve / -ve NPV imply ?

Net Present Value (NPV) –
Strength and Weakness
– Cash flows – May not include
assumed to be managerial
reinvested at the options embedded in
hurdle rate. the project.
– Accounts for TVM.
– Considers all
cash flows.
Net Present Value Profile
$000s Sum of CF’s Plot NPV for each
15 discount rate.
Net Present Value
10
5 IRR
NPV@13%
0
-4
0 3 6 9 12 15
Discount Rate (%)
Profitability Index (PI)
PI is the ratio of the present value of a project’s future

net cash flows to the project’s initial cash outflow.
CF1 CF2 CFn

PI = + + . . . +n ICO
(1+k)1 (1+k)2 (1+k)
<< OR >>
PI = 1 + [ NPV / ICO ]
Profitability Index (PI) Acceptance Criteria
PI = $38,572 / $40,000 = .9643
No! The PI is less than 1.00. This means that the

project is not profitable. [Reject as PI < 1.00 ]
Profitability Index (PI) –
Strengths and Weaknesses
– Same as NPV – Same as NPV
– Allows – Provides only relative
comparison of profitability
different scale – Potential Ranking
projects Problems
Internal Rate of Return
IRR is the discount rate that equates the present value

of the future net cash flows from an investment
project with the project’s initial cash outflow.
CF1 CF2 CFn

ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n
Internal Rate of Return (IRR)
$10,000 $12,000
$40,000 = + +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000

+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the discounted cash
flows to equal $40,000.
Internal Rate of Return (IRR) – Solution – Try at 10%
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
Internal Rate of Return (IRR) – Solution – Try at 15%
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841[Rate is too high!!]
Internal Rate of Return (IRR) - Interpolate
.10 $41,444
.05 X IRR $40,000 $1,444 $4,603
.15 $36,841
X $1,444
.05 $4,603
=
.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841
X $1,444
.05 $4,603
=
.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841
($1,444)(0.05)
$4,603
X= X = .0157
IRR = .10 + .0157 = .1157 or 11.57%

Internal Rate of Return (IRR) - Acceptance
The management of Basket Wonders has determined

that the hurdle rate is 13% for projects of this type.
No! Because your company will receive 11.57% (IRR)

for each dollar invested in this project at a cost of
13%. [IRR < Hurdle Rate]
Internal Rate of Return – Strengths and Weakness
– Accounts for – Assumes all cash
TVM flows reinvested at
– Considers all the IRR
cash flows – Difficulties with
– Less project rankings and
Subjectivity Multiple IRRs
Evaluation Summary
Basket Wonders Independent Project
Method Project Comparison Decision

PBP 3.3 3.5 Accept
IRR 11.57% 13% Reject
NPV -$1,428 $0 Reject
PI .96 1.00 Reject
Example:2-
India Pharma Ltd. is engaged in the
manufacture of pharmaceuticals. The
company was established in 1991 and has
registered a steady growth in sales since
then. Presently the company manufactures
16 products and has an annual turnover of
Rs 2200 million. The company is
considering the manufacture of a new
antibiotic preparation, K-cin, for which the
following information has been gathered
K-cin is expected to have a product life
cycle of five years and thereafter it
would be withdrawn from the market.
The sales from this preparation are
expected to be as follows:
Year Sales ( Rs in million)
1 100
2 150
3 200
4 150
5 100
The capital equipment required for
manufacturing K-cin is Rs 100 million
and it will be depreciated at the rate of
25 percent per year as per the WDV
method for tax purposes. The
expected net salvage value after five
years is Rs 20 million.
The working capital requirement for

the project is expected to be 20
percent of sales.
At the end of 5 years, working
capital is expected to be
liquidated at par, barring an
estimated loss of Rs 5 million on
account of bad debt. The bad debt
loss will be a tax- deductible
expense.
The accountant of the firm has provided
the following cost estimates for K-cin:
Raw material cost : 30 percent of sales
Variable labour cost : 20 percent of sales
Fixed annual operating and maintenance
cost : Rs 5 million
Overhead allocation (excluding
depreciation, maintenance, and interest):
10 percent of sales
The manufacture of K-cin would also
require some of the common facilities of
the firm. The use of these facilities would
call for reduction in the production of
other pharmaceutical preparations of the
firm. This would entail a reduction of Rs
15 million of contribution margin.
The tax rate applicable to the firm is 40
percent.
Ojus Enterprises is determining the cash
flow for a project involving replacement
of an old machine by a new machine. The
old machine bought a few years ago has a
book value of Rs 400,000 and it can be
sold to realize a post tax salvage value of
Rs 500,000.
It has a remaining life of five
years after which its net salvage
value is expected to be Rs.160,000.
It is being depreciated annually at
a rate of 25 percent under the
written down value method. The
working capital required for the
old machine is Rs 400,000.
The new machine costs Rs
1,600,000. It is expected to fetch a
net salvage of Rs 800,000 after 5
years when it will no longer be
required. The depreciation rate
applicable to it is 25 percent under
the written down value method.
The net working capital required
for the new machine is Rs 500,000.
The new machine is expected to
bring a saving of Rs 300,000
annually in manufacturing costs
(other than depreciation). The tax
rate applicable to the firm is 40
percent.
Selecting the Best
Project
1
What is Capital Budgeting ?
The process of identifying,

analyzing, and selecting investment
projects whose returns (cash flows)
are expected to extend beyond one
year.
Importance of Project / Capex
Being in focus is fine, But how do you

continue to GROW ?
The Biggest Issue faced by Global Companies

is ... The fate of Fortune 500 Companies
Why Project (Capex)?

Ans: Growth
Project or Capex with ROI > Cost of Capital

creates Growth or Risk Adjusted Cost of
capital
John S Clarkeson, President & CEO BCG
Growth
Create Shareholders Stakeholders

Competi
Social
Value Value
tiveness Maximization Welfare
maximization
4 4
Why Capital Budgeting?
Needs to Sustain and Grow with Limited

Resources with inherent Risk.
Capital Budgeting: Optimal uses of resources
5
Classification of Investment
Project Proposals
New Products or expansion of existing products.
Replacement of existing equipment or buildings.
Research and development.

Exploration.
Other (e.g., safety or pollution related).
6 6
Overview
Major steps in the identification, selection and
management of capital investments include:
• assessment of environment;
•recognition and identification of opportunities
• analysis of alternatives;
7
• selection of the “best” course of action;
• capital investment;
• management of projects to ensure success;
•reassessment of the project and management
during project life;
• conducting a post-audit to identify lessons
learned.
8
9
•Temporal Spread
Temporal Spread : Long gestation period creates problem in estimating

discount rates and establishing equivalences
10 10
11 11
12
Thank You
13

FM Combined Slides Till Midsem

Uploaded by

Copyright:

Available Formats

You might also like

FM Combined Slides Till Midsem

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FM Combined Slides Till Midsem

Uploaded by

Copyright:

Available Formats

Financial Management

Prof. Niranjan Swain

To understand how business is managing its

2 BITS Pilani, Deemed to be University under Section 3, UGC Act

3 BITS Pilani, Deemed to be University under Section 3, UGC Act

3. The third one is a part of family group of companies – a public

The objective is to examine the special features that a

4 BITS Pilani, Deemed to be University under Section 3, UGC Act

4. Fourth company is from most influential economy and is a

5 BITS Pilani, Deemed to be University under Section 3, UGC Act

5. The fifth one is a regulated financial services company in a

6 BITS Pilani, Deemed to be University under Section 3, UGC Act

Understanding various concepts / theories and

7 BITS Pilani, Deemed to be University under Section 3, UGC Act

8 BITS Pilani, Deemed to be University under Section 3, UGC Act

9 BITS Pilani, Deemed to be University under Section 3, UGC Act

10 BITS Pilani, Deemed to be University under Section 3, UGC Act

12 BITS Pilani, Deemed to be University under Section 3, UGC Act

14 BITS Pilani, Deemed to be University under Section 3, UGC Act

15 BITS Pilani, Deemed to be University under Section 3, UGC Act

16 BITS Pilani, Deemed to be University under Section 3, UGC Act

18 BITS Pilani, Deemed to be University under Section 3, UGC Act

20 BITS Pilani, Deemed to be University under Section 3, UGC Act

All Experiential Learning Assignments will be applied in selected

There are two types of Experiential Learning Assignments viz.

22 BITS Pilani, Deemed to be University under Section 3, UGC Act

Ans: Select any organization or continue with the same organization

Q:2/Is it an individual assignment or group assignment?

Q:3/What is the focus or learning from assignment?

23 BITS Pilani, Deemed to be University under Section 3, UGC Act

Q:4/What submission can include?

Q:5/When to submit and where?

24 BITS Pilani, Deemed to be University under Section 3, UGC Act

25 BITS Pilani, Deemed to be University under Section 3, UGC Act

26 BITS Pilani, Deemed to be University under Section 3, UGC Act

27 BITS Pilani, Deemed to be University under Section 3, UGC Act

 The R&D manager has to justify the money spent on research by

 If the R&D department is like a bottomless pit only swallowing

 No commercial entity runs a R&D department to conduct

28 BITS Pilani, Deemed to be University under Section 3, UGC Act

 Materials manager should be aware that inventory of different

29 BITS Pilani, Deemed to be University under Section 3, UGC Act

 The Marketing Manager should have a clear understanding of the

30 BITS Pilani, Deemed to be University under Section 3, UGC Act

 He should so organize his department that the equipments under

31 BITS Pilani, Deemed to be University under Section 3, UGC Act

 He has to make decisions regarding make or buy, buy or lease,

32 BITS Pilani, Deemed to be University under Section 3, UGC Act

Top Management-Finance Interface:

 The top management is interested in ensuring that the business’s

 Strategic planning and management control are two important

33 BITS Pilani, Deemed to be University under Section 3, UGC Act

Top Management-Finance Interface:

34 BITS Pilani, Deemed to be University under Section 3, UGC Act

Enable you to understand

35 BITS Pilani, Deemed to be University under Section 3, UGC Act

Application of Funds Sources of Funds

37 BITS Pilani, Deemed to be University under Section 3, UGC Act

38 BITS Pilani, Deemed to be University under Section 3, UGC Act