Lecture 3 1564800138457

BITS Pilani
Hyderabad Campus
MBA ZG521
Financial Management
Lecture 3 & 4
Short-term solvency or Liquidity ratios
Intended to provide information about firm’s liquidity - the firm’s

ability to pay bills over the short run without undue stress
 Current Ratio
 Quick (or acid test) Ratio
 Cash Ratio
BA ZG521 / FIN ZG521 / MBA ZG521 /

8/3/2019 POM ZG513, FINANCIAL 2
MANAGEMENT BITS Pilani, Hyderabad Campus
Long-term solvency or Financial
leverage ratios
Intended to provide information about firm’s long run ability to meet

financial obligations
 Debt to Asset & Debt to Equity Ratio & Equity multiplier

 Times Interest earned
 Cash coverage ratio

Asset Management or Turnover
measures
Intended to provide information about firm’s efficiency with which

it uses its assets
 Inventory turnover
 Receivables turnover
 Total Assets turnover

Profitability ratios
Intended to measure how efficiently the firm manages its operations.
 Profit Margin
 EBITDA Margin
 Return on Assets (or ROA)
 Return on Equity (or ROE)

Market value ratios
Intended to measure the market values
 Price to Earnings ratio

 EV/EBITDA ratio

DuPont analysis

Question 1 contd. from
Lecture 2
You are an intern with an Investment Banking firm.
You have been given the task to assess the private
company ABC Corp. You have been provided the
Balance Sheet for the last three years’ ending and Profit
& Loss statement for last three periods. The cash flow
statement is not available. You have to assess the co.
based on its’ cash flow.
In addition to cash flow statement, you also wanted to get
an idea of profit margins, y-o-y sales growth rates ,etc.
Refer to excel Lecture 2_Problem1

Question 2 – Application of
Horizontal & Vertical analysis
Prospective Analysis
You are an intern with an Investment Banking firm.

You have been given the task to project the Balance sheet
and Profit & Loss statement of co. ABC in order to value
the company. Given Profit & Loss and Balance sheet for
the Years 2017-2019. Project the P&L and Balance sheet
for 2020 using the most recent assumptions
Refer to excel Lecture 2_Problem2

Net Present Value (The Investment
decision)
The Net Present Value (NPV) of an investment is the present value of
the expected cash flows, less the initial investment.
Accept Investments that have positive NPV
NPV = -C0 + PV of expected Cash Flows

Where C0 is the initial investment incurred (mostly the Capital
expenditure incurred at t=0)

Present Value concept
Present Value (PV)
The current value of a future sum of money or stream of cash

flows discounted by an appropriate interest rate *or the hurdle
rate*
The hurdle rate is the minimum acceptable rate of return on a

capital investment project given its risk and it is the opportunity
cost of forgoing other projects of similar risk.
* Opportunity cost of capital/ cost of capital / required rate of

return / discount rate/ Hurdle rate
Compound and Simple Interest
What is the difference between Compound interest and Simple
interest?

Present Value Formula - General
Timeline for the Cash Flows:
Discount rate : r per period and Discount Factort = 1/(1+r)t . Assumption : r

is stated annual rate discounted annually

Problem no. 1
Given:
PV of Cash Flow streams = $7300
Discount factor = 8% discounted annually
To find : Missing CF at time t = 2
Year CF
1 1500
2?
3 2700
4 2900
Answer : $1908.44
8/3/2019 14
BITS Pilani, Hyderabad Campus
Future Value or Terminal Value
concept
Future Value (FV or TV) : The value of an asset or cash at a specified

date in the future that is equivalent in value to a specified sum today.
FVt = C0(1+r)t
Where
C0 = Cash to be invested at date 0
r : is the interest rate per period
t: No. of periods over which cash is invested
8/3/2019 15
BITS Pilani, Hyderabad Campus
Compounding periods – more than
once a year (m periods)
The general formula for FV at the end of year t where interest is paid m
times a year and the interest amount is reinvested every period is
FVt = C0(1+r/m)mt
Where
C0 = Cash to be invested at date 0
r : is Stated annual interest rate (or APR) compounded m times a year
t: No. of years over which cash is invested
Now m can be = 2 (semi-annual compounding) ;

4 (quarterly compounding) ; 12 (monthly compounding) ; 52 (weekly
compounding) or infinity (continuous compounding)
When m tends to infinity , the term (1+r/m)mt approaches ert

FVt = C0ert where e isBA2.71828
ZG521 / FINwith
ZG521continuous
/ MBA ZG521 / compounding
Compounding periods – more than
once a year (m periods) contd. (Problem A)
Which one would you prefer?
a) An investment paying interest of 10% compounded annually

b) An investment paying interest of 10% compounded semi-annually
c) An investment paying interest of 10% compounded monthly
d) An investment paying interest of 10% compounded continuously
Assume: You would like to invest INR 1 for a year.
Answer : d

Compounding periods – more than once a
year (m periods)
Present Value (PV) = Ct/(1+r/m)mt
With r being stated annual interest rate compounded m times in a year
T is no. of years
Present Value (PV)= Cte-rt

Where r is stated annual interest rate continuously compounded
Ct is the CF at the end of tth year

Effective Annual Rate (EAR),
Effective Annual Yield (EAY) or Effective
Interest Rate
r
EAR  [(1  )^ m]  1
m
Where r is the stated annual interest rate or Annual Percentage Rate (APR)
compounded m times in year
•EAR is a way of restating the APR so that it takes into account the effects
of compounding
•APR should always be stated with periods of compounding otherwise

APR has no meaning

EAR and APR example
Given : APR (Annual Percentage rate) or SAIR (Stated Annual

Interest rate) is equal to 10% compounded monthly
What is the equivalent EAR (Effective annual rate)?
EAR =[ (1+10%/12)^12] -1 = 10.471%
An APR of 10% compounded monthly is equivalent to

An EAR of 10.471% which is again equivalent to
An APR of 10.471% compounded annually

Example of Payday loans
CI Co. allows you to write a post-dated cheque for 115 INR dated 14 days
in the future for which they give you 100 INR today.
What is the APR and EAR of this arrangement?
FV = PV (1+r) where r is the interest rate for 14 days
115 = 100 (1+r)

r = 15%
APR = 15% *365/14 = 391.07%
EAR = (1+Quoted rate/m)m-1

Where m is no. of periods in a year = 365/14
EAR = (1+391.07%/(365/14))365/14 - 1 = 3723.66%
APR is calculated as interest rates per period multiplied by no. of
periods in a year
Conventions to refer time
Date Date Date Date

0Few follow the exact
1 2 treat CFs being
time rule as they 3 received on exact
dates and there is a gap of one period (say a year) between any two
dates. Date 0 is the present time
End of End of Year 1 End of End of Year

Year 0 = Year 2 3
Now Most follow the end of year rule (or an end of a period rule). Under this
convention a beginning of year 0 has already passed and is not referred
to. Beginning of Year 1 is End of Year 0 and so on....
Perpetuity
A constant stream of cash flow forever .
PV of Perpetuity = C/r where r is not equal to zero
Where C is the Cash flow received one period hence and every year, r is
the appropriate discount rate.
Sum of Geometric Series (Finite)
Sum of Geometric Series (Infinite)

As n goes to infinity, the absolute value of r must be less than one for the series to converge. The sum then becomes

Problem 2 on Perpetuity
Given an interest rate of 6.1% per year, what is the value at date t = 7
of a perpetual stream of $2,500 annual payments that begin at date t =
15?
C C C..........
PV
T =7 T =9 .......... T =14 T =15 T =16 ..........
PV at (t = 14 ) = C/r = 2500/0.061 = $40983.61
PV (t = 7) = PV (at t =14)/(1+r)7 = $40983.61/(1.061)7 = $27077.121

Growing Perpetuity
A constant stream of cash flow forever growing at a rate of growth g%.
C is the Cash flow received one period hence, r is the appropriate discount
rate, g is the rate of growth per period expressed as a percentage
C
PV 
rg
Where r > g

Problem 3 on Growing Perpetuity
Mark has been working on an advanced technology in laser eye
surgery. His technology will be available in the near term. He
anticipates his first annual CF from technology to be 175,000$ received
two years from today. Subsequent annual CF will grow at 3.5% in
perpetuity. What is the PV of the technology if the discount rate is
10%.
C C(1+g) C(1+g)2 .........................................................
T =0 T =1 T =2 T =3 T =4 ....................................................
PV at t =1 C/(r-g) $2692307.692
PV at t= 0 PV (T=1)/(1+r)
8/3/2019
BA ZG521 /$2447552.448
FIN ZG521 / MBA ZG521 /
POM ZG513, FINANCIAL 26
Problem on Growing Perpetuity
Barett Pharma is considering a drug project that costs $2.5 million
today and is expected to generate end of year (Year 1 onwards) annual
cash flow of $227000, growing at 5% forever. At what discount rate
would Barett be indifferent between accepting or rejecting the project.
C C(1+g) C(1+g)2 .........................................................
T =0 T =1 T =2 T =3 ....................................................
Answer 14.08%

Annuity
An annuity is a level stream of regular payments that lasts for a fixed
number of periods.
PV of Annuity for T years =
r is the appropriate discount rate.

Where C is the Cash flow received one period hence and for T years,

Problem 4 on Annuity
You want to borrow $65000 from your local bank to buy a new
sailboat. You can afford to make monthly payments of $1320, but no
more. Assuming monthly compounding, what is the highest APR you
can afford on a 60 month loan?
0 1 60
–$65,000 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320
PV of an annuity = 65000
Find r which will be a monthly rate. Use goal seek in excel
r = 0.6721% which is a monthly rate
APR = r *12 = 8.065% BAcompounded monthly
ZG521 / FIN ZG521 / MBA ZG521 /
Problem 5 on Annuity
You are saving for the college education of your two children. They are two years apart
in age; one will begin college 15 years from today and other will begin 17 years from
today. You estimate the college expenses to be $45000 per year per child. Given r = 7.5%
annual. College expenses are paid at the beginning of each school year. How much
money must you deposit in an account each year to fund your children’s education?
Your deposits begin one year from today. You will make last deposit till end of 15th year.
Assume four years of college.
0 1 14 15 16 17 18 19
…
$45,000 $45,000 $45,000 $45,000
$45,000 $45,000 $45,000 $45,000
C C C C
Assume : Today is end of year 0. We assume that college starts at the end of year 15
(Child 1) and end of year 17 (Child 2).
Find the PV of an annuity (expenses of first child’s education) at t=13 and then at t=0
Find the PV of an annuity (expenses of second child’s education) at t=15 and then at t=0
Equate the sum of the above two to PV of deposits and find C
Answer : C = $12439.336 BA ZG521 / FIN ZG521 / MBA ZG521 /
Growing Annuity
A growing annuity is a level stream of regular growing payments that lasts
for a fixed number of periods.
PV of growing Annuity =
Where C is the Cash flow received one period hence and for t years, r is
the appropriate discount rate , g is the rate of growth per period expressed
as %

Problem 6 on Growing Annuity
You have received a job offer from an investment bank (analyst
profile). Given r = 9% annual
T= 25 years
Growth in basic salary = 3.5% each year
You will get a Joining Bonus amount = $10000 at t=0
Bonus amount every year = 10% of his basic salary every year
Your Base salary = $55000 receiving at t=1
To find : PV of the offer
Find the PV of growing annuity for base salary

Find PV of growing annuity for bonus
Find PV of offer = PV of base salary + bonus + bonus(paid today)
Answer : $808533.55

All Formulas
PV of a perpetuity = C/r
PV of a growing perpetuity = C/(r-g)
PV of an Annuity = C/r [1-1/(1+r)t]
PV of a Growing Annuity = (C/r-g) [1-((1+g)/(1+r))t]

Annuity due
Annuity due requires payments to be made at the beginning of each period
with the first payment due immediately

Problem 7 on Annuity due
You want to lease a set of golf clubs from Pings Ltd. The lease contract
is in the form of 24 equal monthly payments at a 10.4% stated annual
interest rate compounded monthly. Because the clubs cost $2300 retail,
Pings Ltd. want the PV of lease payments to equal $2300. Suppose that
your first payment is due immediately. What will your monthly lease
payments be?
0 1 23 24
…
–$2,300
C C C C C C C C C
Find the PV of annuity at t= 0 and then add the payment (today) and
equate it to 2300
Answer : $105.64
Loan amortization
Loan amount $5000 for 5 years at 9% annual interest. Borrower is required
to make a single fixed payment each period. What is the single fixed
amount the borrower should make every year and how will the
amortization schedule look like?
5000 = PV of annuity at 9% and C payment every year

So calculate C
C = $1285.46

Problem 8 on Loan payments
You need a 30 year fixed rate mortgage to buy a new home for
$250,000. Your mortgage bank will lend you the money at a 5.3% APR
for 360 month loan. However, you can only afford monthly payments
of $950, so you offer to pay off any remaining loan balance at the end
of the loan in the form of a single balloon payment. How large will this
balloon payment have to be for you to keep your monthly payments at
$950?
r monthly = 5.3%/12
C = $950
Calculate PV of annuity
Find the difference between Loan amount and PV of annuity
This will give you the PV of amount to be repaid
Calculate the Future Value and that is the single balloon payment to be
made. Answer : $385664.73

Lecture 3 1564800138457

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BITS Pilani

Intended to provide information about firm’s liquidity - the firm’s

BA ZG521 / FIN ZG521 / MBA ZG521 /

Intended to provide information about firm’s long run ability to meet

 Debt to Asset & Debt to Equity Ratio & Equity multiplier

BA ZG521 / FIN ZG521 / MBA ZG521 /

Intended to provide information about firm’s efficiency with which

BA ZG521 / FIN ZG521 / MBA ZG521 /

Intended to measure how efficiently the firm manages its operations.

BA ZG521 / FIN ZG521 / MBA ZG521 /

Intended to measure the market values

 Price to Earnings ratio

BA ZG521 / FIN ZG521 / MBA ZG521 /

BA ZG521 / FIN ZG521 / MBA ZG521 /

Refer to excel Lecture 2_Problem1

BA ZG521 / FIN ZG521 / MBA ZG521 /

You are an intern with an Investment Banking firm.

BA ZG521 / FIN ZG521 / MBA ZG521 /

Accept Investments that have positive NPV

NPV = -C0 + PV of expected Cash Flows

BA ZG521 / FIN ZG521 / MBA ZG521 /

Present Value (PV)

The current value of a future sum of money or stream of cash

The hurdle rate is the minimum acceptable rate of return on a

* Opportunity cost of capital/ cost of capital / required rate of

BA ZG521 / FIN ZG521 / MBA ZG521 /

Discount rate : r per period and Discount Factort = 1/(1+r)t . Assumption : r

BA ZG521 / FIN ZG521 / MBA ZG521 /

To find : Missing CF at time t = 2

Future Value (FV or TV) : The value of an asset or cash at a specified

Now m can be = 2 (semi-annual compounding) ;

When m tends to infinity , the term (1+r/m)mt approaches ert

a) An investment paying interest of 10% compounded annually

Assume: You would like to invest INR 1 for a year.

BA ZG521 / FIN ZG521 / MBA ZG521 /

Present Value (PV)= Cte-rt

BA ZG521 / FIN ZG521 / MBA ZG521 /

•APR should always be stated with periods of compounding otherwise

BA ZG521 / FIN ZG521 / MBA ZG521 /

Given : APR (Annual Percentage rate) or SAIR (Stated Annual

What is the equivalent EAR (Effective annual rate)?

EAR =[ (1+10%/12)^12] -1 = 10.471%

An APR of 10% compounded monthly is equivalent to

BA ZG521 / FIN ZG521 / MBA ZG521 /

115 = 100 (1+r)

APR = 15% *365/14 = 391.07%

EAR = (1+Quoted rate/m)m-1

Date Date Date Date

End of End of Year 1 End of End of Year

PV of Perpetuity = C/r where r is not equal to zero

Sum of Geometric Series (Infinite)

BA ZG521 / FIN ZG521 / MBA ZG521 /

T =7 T =9 .......... T =14 T =15 T =16 ..........

PV at (t = 14 ) = C/r = 2500/0.061 = $40983.61

PV (t = 7) = PV (at t =14)/(1+r)7 = $40983.61/(1.061)7 = $27077.121

A constant stream of cash flow forever growing at a rate of growth g%.

BA ZG521 / FIN ZG521 / MBA ZG521 /

C C(1+g) C(1+g)2 .........................................................

C C(1+g) C(1+g)2 .........................................................

BA ZG521 / FIN ZG521 / MBA ZG521 /

PV of Annuity for T years =

r is the appropriate discount rate.