Capital Budgeting

Capital Budgeting Process

Planning the Monitoring

Generating Analyzing
Capital and Post
Ideas Proposals
Budget Auditing
 Types of Capital
Budgeting
Projects

Replacement Expansion New Products

Projects Projects and Services
Important concepts in Capital Budgeting
Decisions
Incremental Cash Flow is relevant
Timing of Cash Flow is important
Sunk Costs are ignored
Opportunity Cost are considered
Impact of Cannibalization
Financing costs are ignored
Cash Flow pattern (Conventional vs. Non-Conventional)
Challenging Situations
 Mutually Exclusive Projects
 Project Sequencing
 Capital Rationing
Investment Decision Criteria
Net Present Value
Internal Rate of Return
Profitability Index
Payback Period
Discounted Payback Period
Average Accounting Rate of Return
 Cash Flow Projections
1. Initial Outlay (For a new investment) = FCInv + NWCInv
Where,
FCInv: Investment in new fixed capital
NWCInv: Investment in net working capital
Initial Outlay (For a replacement project) = FCInv + NWCInv – Sal0 + T(Sal0 – B0)
Where,
Sal0: Cash Proceeds/Salvage Value from sale of old fixed capital
T: Tax rate
B0: Book value of old fixed capital
 Cash Flow Projections
2. Annual after-tax operating cash flow:
CF = (S-C-D)(1-T) + D, or
CF = (S-C)(1-T) + TD
Where,
S: Sales
C: Cash Operating Expenses
D: Depreciation Charge
3. Terminal year after-tax non-operating cash flow:
TNOCF = SalT+ NWCInv - T(SalT – BT)
Where,
SalT : Cash Proceeds/Salvage Value from sale of fixed capital on termination date
BT : Book value of fixed capital on termination date
Case I
A firm incurs investment outlay of $200,000 on fixed capital items. This
includes $25,000 for non depreciable land and $175,000 for equipment
that will be depreciated straight-line to zero over five years. The project
requires $50,000 of current assets but generated $20,000 in current
liabilities. Each year, sales will be $220,000 and cash operating
expenses will be $90,000. The firm is subject to a tax rate of 40%. At the
end of 5 years, the company will sell off all the fixed capital assets for
$50,000. This investment has a required rate of return of 10%. Use NPV
to evaluate this proposal.
Case II
A firm is considering the replacement of old equipment with new equipment that has more capacity and is less
costly to operate. The characteristics of old and new equipment are given below:
Old Equipment New Equipment
Current Book Value: $400,000
Current Market Value: $600,000 Acquisition Cost: $1,000,000
Remaining life: 10 years Life: 10 years
Annual Sales: $300,000 Annual Sales: $450,000
Cash Operating Expenses: $120,000 Cash Operating Expenses: $150,000
Annual Depreciation: $40,000 Annual Depreciation: $100,000
Accounting Salvage Value: $0 Accounting Salvage Value: $0
Expected Salvage Value: $100,000 Expected Salvage Value: $200,000
If the new equipment replaces the old equipment, an additional investment of $80,000 in net working capital
will be required. The firm is subject to tax rate of 30%. Use NPV criteria to evaluate the proposal if the required
rate of return is 8%.
Capital Budgeting Methods
I: Net Present Value (NPV); PV (Inflows)- PV (Outflows)
II: Internal Rate of Return (IRR);

Where;
r= IRR
Ct = Cash flows in year ‘t’
C0 = Cash flows in year ‘0’
It is Solved using interpolation between 2 discount rates, which give a positive and negative value of NPV;
r= l + a (h-l)/(a-b)
Where;
l is the lower discount rate with positive NPV (a)
h is the higher discount rate with negative NPV (b)
 Question: A Project costs $16000 and is expected to generate cash inflows of $8000, $7000 and $6000 at the end of each
year for the next 3 years. Find the project’s IRR. Is the investment profitable if investors’ required return is 20%?
III: Profitability Index (Benefit/Cost Ratio) (PI); PV (Inflows)/Initial Cash Outlay
 Question: The initial cash outlay of a project is $100,000 and it can generate cash inflow of $40,000, $30,000, $50,000 and
$20,000 in year 1 through 4. Compute its NPV and PI at 10% discount rate.
IV: Payback Period (PB); Number of years required to recover the original cash invested in the project
 In case of equal cash inflows; PB= Initial Investment/Annual Cash Inflow
 In case of unequal cash inflows; add up cash inflows until the total is equal to initial cash outlay
 Question: A project requires an outlay of $50,000 and yields annual cash inflow of $12,500 for 7 years. Find its payback
period.
 Question: A project requires a cash outlay of $20,000 and generates cash inflows of $8,000, $7,000, $4,000 and $3,000
during the next 4 years. Find its payback period.
V: Discounted Payback Period; Number of periods taken to recover the investment outlay on present value basis
VI: Accounting Rate of Return (ARR); Average Income/Average Investment
Where;
Average Income= Earnings after taxes without adjustment for interest (Net Operating profit after tax) (EBIT(1-t))
 Question: A project costs $40,000. Its stream of EBDIT during the first 5 years is expected to be $10,000, $12,000, $14,000,
$16,000 and $20,000. Calculate the project’s ARR assuming a 50% tax rate and depreciation on straight-line basis.
Comparison of NPV and IRR
NPV Profile
14,000
12,000
10,000
8,000
6,000
NPV

4,000
2,000
0
-2,0000% 5% 10% 15% 16% 20% 25%
-4,000
-6,000
Discount Rate

Problem in the following situations;

1. Lending vs Borrowing type of projects
2. Non-Conventional projects with multiple sign changes
3. Mutually Exclusive Projects
Ranking Mutually Exclusive Projects (NPV
vs IRR)
I: Differing timing of Cash Flows (Higher Cash Flows earlier or later)
Projects C0 C1 C2 C3 NPV (@ 9%) IRR
A -1680 1400 700 140 301 23%
B (Better) -1680 140 840 1510 321 17%

Incremental IRR
Project C0 C1 C2 C3 NPV (@ 9%) IRR
B-A 0 -1260 140 1370 20 10%

Project B is better than A in spite of lower IRR, because it offers all that
project A offers and the opportunity to make additional investment @10%
II: Different Scale of Investment
Projects C0 C1 NPV (@ 10%) IRR
A -1000 1800 636.36 80%
B (Better) -100,000 150,000 36,363 50%

III: Different Life Spans of Projects

Projects C0 C1 C2 C3 C4 C5 NPV (@ IRR
10%)

A -10,000 12,000 - - - - 908 20%

B (Better) -10,000 - - - - 20,120 2,495 15%

Prefer the NPV rule as it is always consistent with the Wealth

Maximisation Principle. This is also supported by Incremental IRR analysis
Reinvestment Rate Assumption and Modified IRR (MIRR)
 Conflict in these 2 evaluation techniques arises due to difference in reinvestment rate assumption.
 IRR(NPV) assumes that cash flows generated during lifetime of the project are reinvested at IRR(opportunity cost of
capital)
 It is more realistic to use opportunity cost of capital as the reinvestment rate
 Using the above mentioned assumption we can compute MIRR
MIRR; (TV/PVC) 1/n - 1
Where;
TV: Terminal value of all cash inflows at opportunity cost of capital
PVC: Present Value of all cash outflows at opportunity cost of capital

 Question: Compute MIRR of an investment with the following cash flows if the opportunity cost of capital is 15%;

C0 C1 C2 C3 C4 C5 C6
-120 -80 20 60 80 100 120
Comparison of NPV and PI
They can lead to conflicting solutions in case of mutually exclusive
projects
Project A Project B Project A-B
PV (Cash Inflows) 100,000 50,000 50,000
Initial Outlay 50,000 20,000 30,000
NPV 50,000 30,000 20,000
PI 2 2.5 1.67 (Incremental PI>1)

Project A is better
Prefer NPV rule except in situations of Capital Rationing
Complex Investment Decisions
I: Mutually exclusive projects with different lives
II: Investment timing and duration
III: Investment decisions under Capital Rationing
• External Capital Rationing: Occurs due to imperfection in capital
markets. It may be due to deficiency in market information or rigid
attitude of investors that may hamper the free flow of capital
• Internal Capital Rationing: Refers to self imposed restrictions by the
management
I: Mutually Exclusive projects with different lives
Question: A firm is considering investment in project X or Y. X and Y require an initial outlay of
$24,000 and $44,000 respectively. They give net cash inflows of $14,000 each year for the next 3
years and $16,000 each year for the next 5 years respectively. Which project should the firm
prefer if the required return of investors is 15%?
Solution: NPVX = $7,962
NPVY = $9,632
Here, NPV of X and Y is realised within 3 years and 5 years respectively. It would be inappropriate
to use the NPV rule as it has a bias for longer life.
To evaluate such situations, we can use;
1. Replacement Chain Analysis (Assumes that the firm replaces these projects at the end of life of
each project till we arrive at equal periods of time. Then a comparison of NPVs is made)
2. Annual Equivalent Value (AEV) (Comparison is made by annualising NPVs over respective lives
of the project)
 Replacement Chain Analysis
C0 C1 C2 C3 C4 C5 C6 C7 C8 C9 C10 C11 C12 C13 C14 C15 NPV
(in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000) (in ‘000)

X -24 14 14 14 14 14 14 14 14 14 14 14 14 14 14 14 20,408
(Better) -24 -24 -24 -24
Y -44 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16,832
-44 -44

Annual Equivalent Value Method (AEV)

AEVX = 7962/PVAF(15%,3) = $3488
AEVy = 9632/PVAF (15%,5) = $2873
Question: A company is evaluating 2 mutually exclusive projects. Project X
will cost $10,000 now and generate cash flows of $5,000 each year for 4
years. Project Y will cost $2500 now and generate cash flows of $3000 each
year for 3 years. Which project will you select assuming 10% opportunity cost
of capital?
II: Investment Timing and Duration
• Some projects may be more valuable if taken in future
• In certain situations, unprofitable projects may yield positive NPVs if
they are accepted later on
• Project should be undertaken at the time when NPV is maximum
Situation C0 C1 C2 C3 NPV (@10%)
I -100 150 36.35
II -120 180 39.6
(Best Alternative)
III -140 205 38.32
III: Capital Rationing/Financial
Exclusiveness
Question: A firm can invest in the following projects A,B,C subject to a budget constraint of
$50,000. What are its appropriate investment options if investors’ required return in 10%?

C0 C1 C2 C3 NPV PI
(in ‘000) (in ‘000) (in ‘000) (in ‘000)
(Ranking)
A -50 30 25 20 12.94 1.26 (III)
B -25 10 20 10 8.12 1.32 (I)
C -25 10 15 15 7.75 1.31 (II)

Solution: Prefer PI
A: NPV = 12.94
B+C: NPV = 15.87
Limitations of PI:
1. Multi-period Constraint
Eg; In the previous case, the firm also had an option to invest in project
D in year 1. It has additional budget of $50,000 in year 1.

C0 C1 C2 C3 NPV PI
(in ‘000) (in ‘000) (in ‘000) (in ‘000)
(Ranking)
A -50 30 25 20 12.94 1.26 (III)
B -25 10 20 10 8.12 1.32 (I)
C -25 10 15 15 7.75 1.31 (II)
D ----- -80 60 40 6.88 1.09 (IV)
Alternate Combinations:
B+C+D: Not possible due to limited funds
A+D: Possible; NPV = 19.82 (Best Option; here low PI projects are
better)
B+C: Possible; NPV = 15.87
2. Situations in which projects are indivisible
Eg; Consider the following projects available with a firm which is subject to a budget constraint of $1,000,000
Outlay NPV PI (Ranking)
A 500,000 110,000 1.22 (I)
B 150,000 -7500 0.95 (VI)
C 350,000 70,000 1.20 (II)
D 450,000 81,000 1.18 (IV)
E 200,000 38,000 1.19 (III)
F 400,000 20,000 1.05 (V)

 If projects are divisible, PI gives the correct decision;

A+C+0.75E: Outlay=$1,000,000 NPV=$208,500
 If projects are indivisible, PI does not give the correct decision;
As per PI (A+C): Outlay= $850,000 NPV=$180,000
Better combination (C+D+E): Outlay: $1,000,000 NPV= $189,000
 Question: A firm has the following investment options, but only $90,000 are available for investment. Which projects
would it undertake?
Project A B C D E F
NPV 5000 5000 10000 15000 15000 3000
Investment 10000 5000 90000 60000 75000 15000
Linear Programming Approach to Capital
Rationing
Max. XA (12.94) + XB(8.12) + Xc (7.75) + XD (6.88)
Sub.to;
50XA + 25XB + 25XC + 0XD ≤ 50
-30XA - 10XB - 10XC + 80XD ≤ 50
0 ≤ XA ≤ 1
0 ≤ XB ≤ 1
0 ≤ XC ≤ 1
0 ≤ XD ≤ 1
Where, XA, XB , XC , XD are fraction of funds invested in projects A,B,C,D
respectively
Solution: XA = 0, XB = 1, XC = 1, XD = 0.875; NPV=21.89
Capital Structure:
Theory and Policy
Relation between Capital Structure and Firm
Value
We have examined that EPS increases with financial leverage only
under favourable conditions
Thus, it cannot be stated definitely whether or not the firm’s value will
increase with leverage
The objective of a firm should be directed towards maximisation of the
firm’s value
If capital structure decision can affect a firm’s value, then it would like
to have a capital structure which maximises its market value
However, there are conflicting theories on relationship between capital
structure and firm value
Net Income (NI) Approach
(Relevance of Capital Structure)
A relationship between capital structure and firm’s value exists, as a
change in the financing mix leads to a change in WACC
It works on the assumption that kd<ke; i.e. if a firm increases the use
of cheaper debt, it can provide magnified returns to shareholders
With more use of debt in the capital structure, ko will reduce and
value of the firm will increase
Value of Equity (E) = NI/ke; Value of Debt (D) = Interest/kd; Value of
the firm (V) = E+D or V=EBIT/ko
Question: A firm has an expected EBIT of $200,000. It has issued
Equity share capital with ke @10% and 6% debt of $500,000. Find out
value of the firm and WACC. Re-estimate the firm’s value and WACC if
the amount of debt increases to $700,000. Make your computations
applying the NI approach.
Solution:
Part A Part B
EBIT 2,00,000 EBIT 2,00,000

(Interest=6% of 500000) -30,000 (Interest=6% of 700000) -42,000

PBT 1,70,000 PBT 1,58,000

Value of Equity (E)=170000/0.1 1700000 Value of Equity (E)=170000/0.1 1580000

Value of Debt (D) 500000 Value of Debt (D) 700000

Value of the firm (D+E) 2200000 Value of the firm (D+E) 2280000

WACC=EBIT/V 9% WACC=EBIT/V 8.77%

Here ke remains the same, but ko falls

Net Operating Income (NOI) Approach
(Irrelevance of Capital Structure)
The market value of the firm depends upon the NOI (EBIT)
For a given value of EBIT, the value of the firm remains the same
The financing mix is irrelevant and does not affect the firm’s value
It works on the assumption that ko is constant, as it depends on the
business risk which is assumed to be constant
The increased use of debt leads to increase in risk of shareholders.
Thus, ke increases and offsets the benefits of employing cheaper debt
Value of the firm (V) = EBIT/ko
Value of equity (E) = V-D
Question: A firm has an EBIT of $200,000 and belongs to a risk class
of 10%. Estimate the ke if it employs 6% debt to the extent to 30% or
40% of the total capital fund of $1,000,000. Make your computations
applying the NOI approach.
Solution:
Computation with 30% Debt Computation with 40% Debt

EBIT 2,00,000 2,00,000

ko 10% 10%

V 20,00,000 20,00,000

D 300000 400000

E (V-D) 17,00,000 16,00,000

NI (EBIT-I) 182000 176000

ke 10.71% 11.00%

Here ko remains the same, but ke rises

Traditional Approach
(Compromise between the earlier approaches)
The relation between capital structure and firm value can be viewed in 3 stages;
 Increasing Value: With increase in debt, ke remains constant or only slightly increases
initially. This doesn’t offset the advantage of low cost debt. Thus, ko decreases with increase
in leverage
 Optimum Value: Once the firm has reached certain degree of leverage, then increase in
leverage has a negligible impact on WACC. This is because k e starts rising due to added
financial risk, and increase in ke just offsets the advantage of low cost debt. Within that range
or at that specific point, ko will be minimum and value will be maximum
 Declining Value: Beyond the acceptable limit of leverage, the value of firm decreases with
leverage . Equity holders perceive more risk and ke increases to offset the advantage of low
kd. Thus, ko increases and value of the firm reduces
This theory is criticised as there is no justification for the assumption that perception of risk
is different at different levels of leverage
However, optimum capital structure can be supported on account of tax deductibility of
interest and other market imperfections
Modigliani and Miller (MM) Hypothesis
(Irrelevance of Capital Structure)
Proposition I
Two firms (levered and unlevered) that have identical assets, operate in
the same industry, face similar competitive conditions and business risk
will have the same WACC and value
Their market value is independent of the debt-equity mix
Same value exists due to arbitrage
This works on the assumption that capital markets are perfect (investors
can buy and sell securities without transaction costs and can borrow
unlimited amount without restrictions), firms operate under
homogeneous risk class, there are no taxes and the payout ratio is 100%
Arbitrage Process
Eg; Two firms L and U are identical in all respects, except that L Co. has 10% debt of $3,000,000. Both have an EBIT of $1,000,000 and an equity
capitalisation rate of 20%. On the basis of this information, value of levered and unlevered firm will be $6,500,000 and $5,000,000 respectively.
An arbitrage process would ensure that this inequality doesn’t persist for long. Investors would sell their stake in levered company and buy
stake in unlevered company, till they have equal values
L Co. (figures in $) U Co. (figures in $)
EBIT 1,000,000 1,000,000
(INTEREST) (300,000) -
PBT 700,000 1,000,000
ke 0.2 0.2
E 3,500,000 5,000,000
D 3,000,000 -
V 6,500,000 5,000,000
ko (EBIT/V) 15.38% 20%

 Suppose an investor holds 10% equity of L Co., his ownership is $350,000. He gets 10% of PBT (i.e. $70,000)
 He sells his stake in L Co., gets $350,000 and borrows 10% of debt value ($300,000); thereby creating personal leverage
 Out of $650,000 he invests 10% in U Co. ($500,000)
 His net return is $70,000, i.e. $100,000 (10%*$1,000,000) less $30,000 (interest on debt). Additionally, he has remaining un-invested
amount of $150,000
 This process continues till market values of both firms are the same
MM Hypothesis
(Proposition II)
This provides justification for the levered company’s cost of capital
remaining the same
ke increases to offset the advantage of debt (ke of the levered firm
should be higher than ke of the unlevered firm)
This can be explained with the following equation:
ko = ke(E/V) + kd(D/V)
ke = ko + [(D/E)*(ko-kd)] (The second term in this equation represents
the financial risk premium)
Criticism of MM Theory
The theory would not hold true in presence of taxes and transaction costs
The assumption that firms and individuals can borrow and lend at the
same rate, does not hold in practice. In practice, firms have a higher
credit standing and can borrow at lower rates
Homemade (Personal) Leverage and Corporate Leverage are not
substitutable. If the levered firm goes bankrupt, investors loose to the
extent of their investment. But if investors create personal leverage and
invest in unlevered firm, with bankruptcy of the unlevered firm he will
loose shares of the unlevered company and would also be liable to return
the amount of his personal loan
MM Theory
(With Corporate Taxes)
Incorporating taxation into our analysis will result in the irrelevance of capital structure breaking down
To illustrate, consider an infinitely lived, levered firm. Assume that it earns cash flow X t in period t, the following funds are paid to the investors in
the firm:
Ct = rdD + (1-tc)(Xt-rdD) = (1-tc)(Xt) + tcrdD
where rdD is the interest paid every period, tc is corporate tax rate
The first term of the equation is the payment made by an unlevered firm with cash flow X t in period t. Hence, discounting this stream of funds at
an appropriate rate yields a present value of V U
The second term is the gain made by the levered firm in saving on its corporate tax through using debt in the capital structure. This is known as
the tax shield advantage of debt.
The cash flows arising on account of interest tax shield are less risky than the firm’s operating income that is subject to business risk. Interest tax
shield depends upon the corporate tax rate and the firm’s ability to earn enough profit to cover the interest payments. The corporate tax rates
do not change very frequently and the levered firm is assumed to earn at least equal to the interest payable otherwise it would not like to
borrow. Thus, the cash inflows from interest tax shield can be considered less risky, and they should be discounted at a lower discount rate. It will
be reasonable to assume that the risk of interest tax shield is the same as that of interest payments generating them. Thus, they are discounted
at the required return by debt holders
Market value of the firm can be estimated using the following equation:
VL = VU + tcD
According to the above equation, firms must choose leverage as large as possible. However, firms with higher levels of debt in their capital
structure incur greater costs of financial distress
MM Theory
(With Corporate and Personal Taxes)
 If debt holders are subject to personal tax td, the amount of interest received by them will be rdD(1- td)
 If equity holders are subject to personal tax t e, the amount of income received by them will be (Xt-rdD)(1-tc)(1-te)
 Hence, the total amount paid by the firm is:
= (Xt-rdD)(1-tc)(1-te) + rdD(1- td)
= Xt(1-tc)(1-te) + rdD [(1- td)-(1-te)(1-tc)]
 First term in the above equation represents cash flows accruing to equity holders of an unlevered firm (with identical cash
flows to the levered firm). Hence, discounting this stream of funds at an appropriate rate yields a present value of V U
 The second term should be discounted at the post personal tax return on debt; r d(1- td)
 The value of the firm can be written as;
VL=VU+D[1- {(1-tc)(1-te)}/(1-td)]……………………..(1)
 This implies that if (1-tc)(1-te) > (1-td); tax advantage is negative and the optimal capital structure choice is all equity
 If the preceding inequality is reversed, the tax advantage is positive and optimum capital structure involves issuing as
much debt as possible
Miller’s Equilibrium
On reconsidering the MM hypothesis with corporate and personal taxes, we derive the
Miller’s equilibrium in a setting where investors differ in their tax rates on personal
income
The Miller’s equilibrium is obtained by stating that demand for debt must be equal to
supply for debt in equilibrium
Let us denote the required return by debtholders and equity holders as r d and re
respectively; and corporate tax rate, personal tax rate on debt income and equity income
as tc, td and te respectively
Firms are willing to issue debt if;
rd (1-tc) < re…………………………(2)
Investors are willing to hold debt if;
rd (1-td) > re (1-te)………………..(3)
To understand Miller’s equilibrium, let us assume that the pre tax return on debt, rd, offered by firms
is equal to the pre tax return on equity, re.
In this case, firms are willing to issue debt which tax exempt investors are willing to buy as both
inequalities in equation (2) and (3) are satisfied
Firms have incentive to increase leverage and will continue to replace equity with debt by increasing
the return rd they offer to attract investors with higher personal income tax rates until; rd =
[re(1-te)]/(1-td) = re/(1-tc)
If the rate of return offered on debt is lower than re/(1-tc), firms still have incentive to issue more
debt as, at this point, it is still profitable to issue debt to investors with marginally higher personal
income tax rates
In contrast, if the rate of return offered on debt is higher then re/(1-tc), firms would be better off
issuing equity than debt
Thus, in equilibrium there is no advantage for firms to issue debt as the equilibrium rate of return
offered to debt holders is such that firms are indifferent between issuing debt and equity. In
equation (1), VL = VU, as (1-tc) (1-te) = (1-td)
The after tax Miller’s theory hence implies that there is an equilibrium aggregate amount of debt
outstanding in the economy which is determined by relative corporate and personal tax rates
However, the amount of debt issued by any particular firm is a matter of indifference
Trade-off Theory of Capital Structure
Financial managers often think of the firm’s debt-equity decision as the
trade-off between interest tax shields and the costs of financial distress
Financial distress refers to a situation when the firm is unable to meet its
financial obligations. Continuous failure to do so may lead to bankruptcy. For
a given level of operating risk, chances of financial distress increase with
increasing leverage; and it may increase with increasing business risk
The trade-off theory recognises that target debt ratios may vary from firm to
firm. Companies with safe, tangible assets and plenty of taxable income to
shield ought to have higher target ratios. Whereas, unprofitable companies
with risky, intangible assets ought to rely primarily on equity financing
Costs of Financial Distress
Direct Costs: Legal costs of bankruptcy proceedings, sale of assets at distressed prices
Indirect Costs: Can arise amongst financially distressed firms that are close to bankruptcy. It can
affect actions of various stakeholders in the following manner;
1. Employees: They are demoralised and worried about the future of the company. Efficient
employees may start to leave the organisation and productivity may decline
2. Customers: They doubt the product and service quality of the firm, leading to reduction in demand
3. Suppliers: They would discontinue or curtail credit
4. Managers: They expropriate the firm’s resources and take decisions with the short term view. They
may focus on cost cutting, leading to reduction in quality. To avoid risk, they may pass profitable
opportunities and take sub-optimal decisions
5. Investors: They are not willing to supply capital to the firm
6. Shareholders: They start behaving differently and may prefer sub-optimal projects with
low/negative NPV
Agency Problems and Agency Costs
Agency problems arise due to conflict of interest between Debt-Holders, Shareholders and Managers
Agency costs refer to the difference between value of a hypothetical firm that is perfect and value of
an actual firm
Agency problems due to conflict between shareholders and managers: Managers may not undertake
risky proposals (thereby forego profits) to protect their jobs and may transfer shareholder’s wealth
by higher perks
Agency problems due to conflict between shareholders and debtholders: It leads to the following
distortions in investment strategies;
I. Debt Overhang Problem
II. Short-sighted Investment Problem
III. Asset Substitution Problem
IV. Reluctance to Liquidate Problem
Agency problems may lead to departures from MM I
I. Debt Overhang (Underinvestment Problem)
Firms with large levels of outstanding debt may pass up positive NPV
projects as it may not favour equity holders. Such firms see a reduction in
corporate value.
Eg; A firm invests $10,000 by Equity in time T0. This investment pays off
$20,000 in T1. The firm receives cash flows at T0, which reflects its past
investment decisions. These cash flows are uncertain and depend on the
economic situation. They may be equal to $50,000, $80,000 and $130,000
with a probability of 0.25,0.5 and 0.25 respectively. Also, the firm issued a
debt with face value of $100,000 in the past, which is to be repaid in T1.
Find the NPV of this project. In the given situation, will the firm accept
this project? Assume discount rate = 0.
Solution;
State 1 2 3
Probability 0.25 0.5 0.25
T0 (Cash Inflows) 50,000 80,000 130,000
T0 (Cost) 10,000 10,000 10,000
T1 (Cash Inflows) 20,000 20,000 20,000
NPV: $20,000-$10,000 = $10,000
Pay off to Debtholders in T1:
In state 1; $70,000
In state 2; $100,000
In state 3; $100,000
Pay off to Equity holders in T1:
In state 1 & 2: 0
In state 3; $20,000-$10,000 = $10,000
Expected pay off;(0.25 * $20,000) – $10,000 = $-5000
Since managers work in favour of equity holders, they reject this positive NPV project, as cash flows
are accruing to debt holders whereas equity holders bear the cost
II. Short-sighted Investment Problem
 Highly levered firms prefer projects that pay off quickly. These firms may accept projects with lower NPV and forego
projects with a longer life and higher NPV. They have a myopic view on investment decisions
 Eg; A firm has debt obligations of $100 million and $40 million due in year 1 and 2 respectively. It is considering 2 mutually
exclusive projects; A & B. Project A is a short term project which is expected to give $50 million in year 1. Project B is a long
term project which is expected to give $20 million and $40 million in year 1 and 2 respectively. Cash flows from existing
assets are expected to be $50 million in year 1 and $60 million (favourable state, probability=0.5) or $10 million
(unfavourable state, probability=0.5) in year 2. Which project should the firm select? Assume discount rate = 0.
Debt Due Existing cash flows Cash flows from Cash flows from
project A project B
Year 1 $100 million $50 million $50 million $20 million
Year 2 $40 million $60 million 0 $40 million
(Favourable State)
$10 million
(Unfavourable
State)
NPV $50 million $60 million
 Solution;
Pay off to Debtholders:
Project A;
Year 1: $100 million
Year 2: $(40 million + 10 million)/2= $25 million
Project B;
Year 1: $100 million ( They receive $70 million. Thus, the firm issues sub-ordinate debt worth $30 million and pays it off in year 2)
Year 2: Existing debt holders= $40 million, New debt holders= $(50+10)/2 million = $30 million
(Total debt = $90 million; sub-ordinate debt holders demand $50 million to recover their investment of $30 million)
{(0.5*x)+(0.5*10)=30}
Pay off to Equity Holders:
Project A;
Year 1: 0
Year 2: $ 20 million in favourable state
Expected payoff = $10 million
Project B;
Year 1: 0
Year 2: $10 million in favourable state
Expected payoff = $5 million

Since managers work in favour of equity holders, they favour project A in spite of lower NPV
III. Asset Substitution Problem
 Debt provides incentive for firms to take risk. Highly levered firms may substitute risker investment projects for less risky ones
 Eg; A firm has to choose between two mutually exclusive projects costing $70 million each. Out of this $40 million is raised using debt and
$30 million using equity. Their payoffs in favourable and unfavourable states are given below:
Project Unfavourable State Favourable State Expected Value NPV Risk (S.D.)
(Prob.= 0.5) (Prob. = 0.5)
A $50 million $100 million $75 million $5 million $ 25 million

B $25 million $115 million $70 million $0 $45 million

Which project should the firm select? Assume discount rate=0.

 Solution;
Pay off to Debt Holders
Project A: $40 million
Project B: $25 million in unfavourable state and $40 million in favourable state (Expected payoff = $32.5)
Pay off to Equity Holders
Project A: $10 million in unfavourable state and $60 million in favourable state (Expected value = $35 million)
Project B: $75 million in favourable state (Expected value = $37.5 million)
Since managers work in favour of equity holders, they select project B, which has lower NPV and higher risk. Debt holders would realise this
and demand $55 (25*0.5 + x*0.5 = 40; x=55) to compensate for their loss in case project B is taken. Now payoff to Equity holders will be $30
million in case project B is accepted and $22.5 million in case project A is accepted. This is even lower than the payoff of project A in the
earlier situation. If they were committed to acceptance of project A, debtholders wouldn’t have raised interest
IV. Reluctance to Liquidate Problem
Financially distressed firms may not always undergo liquidation. They may reorganise and continue to operate if
their going concern value is higher than liquidation value. But in certain situations firms may continue operations
even if liquidation value is higher than going concern value. This may happen because managers don’t want to loose
their jobs and shareholders may not get anything on liquidation.
Eg; A firm has $500 million debt obligation. If it liquidates immediately, it will receive $480 million. If it continues to
operate, its going concern value is $600 million in favourable situation (Probability = 0.5) and $200 million in poor
conditions. Should the firm liquidate?
Solution;
Pay off to Debt Holders:
On Liquidation: $480 million
On Continuation: ($500 million + $200 million)/2 = $350 million
Pay off to Equity Holders:
On Liquidation: 0
On Continuation: $100 million/2 = $50 million
Equity holders and managers would want the firm to continue its operations
Agency Cost of Free Cash Flows
(Overinvestment Problem)
Although debt may generate agency costs, Jensen (1986) argues that debt may also
reduce agency costs of free cash flows
Managers of firms with substantial free cash flow (i.e. cash flow in excess of that
required to fund all profitable projects) are tempted to invest it at below cost of
capital or waste it on organisation inefficiencies rather than return the cash to
shareholders through payment of dividends or repurchase of shares
They have incentives to engage in empire building by growing their firms beyond their
optimal size
Presence of debt in the firm’s capital structure may alleviate agency costs of free cash
flows by decreasing the cash flow available for spending at the discretion of managers
Firm Value and Asymmetric Information
Presence of information asymmetries between corporate insiders and
outsiders may also lead to departures from MM I
The role played by asymmetric information is emphasised by;
1. Ross (1977) Signalling Argument for Debt
(Explains how debt can be used to signal firm quality)
2. Myers & Majluf (1984) Pecking Order Theory
(Explains the information revealed by security issues and preference
order for meeting firms’ financing needs)
Ross Signalling argument for Debt
In an environment of information asymmetry, where firm quality is not observable to outsiders, firms use debt to
signal their quality to investors
Assume that firms differ according to their future cash flow prospects, where high quality firms expect large future
cash flows, whereas low quality firms expect cash flows to be small
Managers of high quality firms have an incentive to attempt to signal their quality to the market, as in the absence
of signals the market can’t distinguish between high and low quality firms and will value them identically
One way the management can signal is through debt policy. High quality firms choose large leverage ratios and
vice-versa
The market can observe leverage and hence value firms accordingly (assigning firm values increasing in leverage)
Leverage is a credible signal as it is assumed that firm managers are averse to bankruptcy. High levels of debt
imply a higher probability of bankruptcy, and only managers of high quality firms are willing to expose themselves
to this probability
Empirical work supports this argument. Masulis (1983) demonstrates that firms which swap debt for equity
experience positive stock returns. The stock price reactions imply that leverage increasing transactions are good
news.
Myers-Majluf Pecking Order theory
This study generates departures from MM I through information asymmetry by
concentrating on the information revealed by security issues
Assume that firms differ in quality and managers of any firm are better informed about
the firm’s quality. Also, managers act in interest of firm’s existing equity holders
Only managers know whether the equity of their firm is over or under priced, and this
creates an opportunity for them to exploit the market in order for existing shareholders
to profit
In this setting, managers may raise equity for 2 reasons;
1. They may wish to invest in positive NPV investment, which would result in an increase
in the value of the firm’s equity
2. They may wish to issue overpriced equity, which would result in transfer of wealth
from new to old equity holders
Given rational expectations, the financial market recognises both incentives to raise equity
Managers of low quality firms raise equity because it is overvalued and managers of high quality firms
with undervalued equity abstain from raising equity
Hence, the presence of information asymmetry between managers and equity holders leads to
distortions in investments
Issue decisions affect prices as they reveal information on firm quality. Managers are more likely to issue
equity when their firm’s assets are overvalued as opposed to undervalued
On an average, equity issues thus lead to stock price drops
Generalising the above, we can fit securities into an order of preference
Firms prefer to finance their investments with retained earnings rather than external sources. They adapt
dividend policies to reflect their investment needs. If external finance is needed, they issue straight debt,
followed by convertible bonds and equity is issued as the last resort
Debt is cheaper than the costs of internal and external equity due to interest deductibility
Internal equity cheaper and easier to use than external equity as personal taxes might have to be paid by
shareholders on distributed earnings and no transaction costs are incurred when earnings are retained
Donaldson (1961) was the first to describe firms’ preferences for internal funds over external funds, and
firms’ preferences for issuing debt over issuing equity. Myers and Majluf (1984) explain these preferences
in a theoretical model that deals with capital structure decisions of firms with external financing needs
Determinants of Capital Structure
Size:
• Size is cited as a considerable determinant of the capital structure for several reasons. Warner (1977) and
Altman (1984) report that larger firms have lower bankruptcy cost. Thus, according to trade-off theory, larger
firms are more likely to issue more debt. Besides, larger firms are highly diversified, have larger economies of
scale, their cash flows are less volatile and they can easily access capital markets. Considering all, they are
more tolerant to higher leverage ratio, which means that there should be a positive linkage between size and
debt ratio.
• On the other hand, it is argued that larger firms have less asymmetric information because they tend to
provide more information to the market (Fama & Jensen, 1983; Rajan & Zingales, 1995). In this sense, large
firms should borrow less because they can issue informationally sensitive securities like equity without giving
a bad signal. Thus, pecking order theory predicts that as size increases leverage ratio decreases.
• The results of empirical studies are conflicting. While most studies find positive linkage (Booth et al., 2001;
Bauer, 2004; Deesomsak et al., 2004; Eriotis et al., 2007; Jong et al., 2008; Marsh, 1982; Rajan & Zingales;
1995; Serrasqueiro & Rogao, 2009; Zou & Xiao, 2006), some studies find negative relationship (Chen, 2004).
Wald, 1999 reports that the relationship between size and leverage is positive for firms in USA, UK, and Japan;
negative for firms in Germany and French.
Profitability:
• Two important capital structure theories; trade-off theory and pecking order theory, predict
different direction of relationship between leverage and profitability
• According to classical trade-off theory, profitability should be positively related with the
leverage since the firms with higher profit should borrow more to shelter their income. Besides,
according to Jensen (1986) debt is a discipline mechanism that prevents wasteful investment. In
this regard, higher the profitability or free cash flow that a firm generates, higher leverage ratio it
should attain. Therefore, agency-based theories also relate profitability positively with the
leverage
• On the other hand, pecking-order theory predicts that firms first use internal financing and then
move to debt and finally they issue new equity when necessary. Therefore, pecking order theory
suggests that there is a negative relationship between debt and profitability which is a source of
internal funds
• The empirical studies mostly find a negative linkage between profitability and leverage as
pecking order theory predicts (Bauer, 2004; Booth et al., 2001; Chen, 2004; Friend & Lang, 1998;
Huang & Song, 2006; Jong et al., 2008; Kester, 1986; Rajan & Zingales, 1995; Serrasqueiro &
Rogao, 2009; Titman & Wessels, 1988; Tong & Green, 2005; Toy et al., 1974; Wald, 1999;
Wiwattanakantang, 1999; Zou & Xiao, 2006)
Tangibility:
• It is assumed, from the theoretical point of view, that tangible assets can be used as collateral.
Therefore higher tangibility lowers the risk of a creditor and increases the value of the assets in the case
of bankruptcy. Thus a positive relation between tangibility and leverage is predicted. Several empirical
studies confirm this suggestion, such as Rajan & Zingales, 1995;Friend & Lang, 1988 and Titman &
Wessels, 1988.
Growth Opportunities:
• According to Myers (1977), firms with high future growth opportunities should use more equity
financing, because a higher leveraged company is more likely to pass up profitable investment
opportunities. Therefore, from agency theory perspective, growth and leverage should be inversely
related
• However, pecking-order theory predicts that growth is positively related with the leverage because only
internal financing may not be adequate for high growth firms
• Empirical studies report conflicting results for the relationship between growth and leverage. While
some studies find negative relationship as agency related theories predict (Booth et al., 2001;
Deesomsak et al., 2004; Eriotis et al., 2007; Wald, 1999; Zou & Xiao, 2006), certain studies report a
positive relationship and confirm pecking order theory (Frank & Goyal, 2009; Kester, 1986). Titman &
Wessels (1988) report that relationship between growth and leverage is inconclusive because the
directions of the relationship changes as the proxy of growth changes
Tax:
• According to the trade-off theory, a company with a higher tax rate should use more
debt and therefore should have higher leverage, because it has more income to shield
from taxes. However, certain empirical studies do not support this argument. (See,
Fama and French, 1998; MacKie-Mason, 1990)
Non-Debt Tax Shield:
• Firms also have non debt tax shields such as depreciation, carry forward losses, etc.
• DeAngelo & Masulis (1980) argue that that non-debt tax shields are the substitutes of
the tax shields on debt financing. Therefore, a firm having higher non-debt tax shield
is expected to use lower leverage in comparison with a firm having lower non-debt tax
shield. The empirical evidence generally confirms this hypothetical inverse relationship
between leverage and non-debt tax shields (MacKie-Mason, 1990; Wald, 1999).
• On the other hand, Bradley et al. (1984) find a positive relationship between leverage
and non-debt tax shield. Companies with higher depreciation would tend to have
higher fixed assets, which serve as collateral for debt
Volatility:
• High volatility in earnings can be indicative of financial distress. As volatility increases,
the firm is more likely to fail in fulfilling its contractual claims as they come due.
Therefore, the financial theories hypothesize an inverse relationship between volatility
in earnings and leverage ratio. Several studies support this negative relationship (Booth
et al., 2001; Bradley et al., 1984; Fama & French, 2002; Jong et al., 2008).
Liquidity:
• According to trade-off theory, firms with higher liquidity should borrow more debt
because they are able to fulfil their obligations on time. Moreover, Jensen (1986) argues
that leverage prevents the agency problems especially for firms having high liquidity but
low growth rate.
• On the other hand, pecking order theory predicts a negative relationship between
liquidity and leverage because firms with higher liquidity should use its internally
generated cash rather than borrowing debt.
• Empirical studies usually support pecking-order theory and report that liquidity and
leverage are inversely related (Deesomsak et al., 2004; Mazur, 2007; Viviani, 2008)
Cost of Capital
Cost of Capital and its significance
 The opportunity cost of capital (or cost of capital) for a project is the discount rate for discounting its cash flows
 The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its
cash flows
 Since investment projects undertaken by a firm may differ in risk, each one of them will have its own unique cost of capital
 The firm’s cost of capital represents the aggregate of investment projects undertaken by it. It is the overall, or average, required rate of
return on the aggregate of investment projects
 Cost of capital is used for evaluating investment decisions and determining the optimum capital structure
 Investors require different rates of return on various securities due to risk differences
 Viewed from all investors’ point of view, the firm’s cost of capital is the rate of return required by them for supplying capital for financing the
firm’s investment projects by purchasing various securities
 Rate of return required by all investors will be an overall rate of return (weighted rate of return). Thus, the firm’s cost of capital is the
average of the opportunity costs (or required rates of return)
 Following is the generalised formula for determining cost of capital:
I0 = C1/(1+k) + C2/(1+k)2 +…….+ Cn/(1+k)n
Where;
I0 is the capital supplied by investors in period 0 (net cash inflow to the firm)
Cn are returns expected by investors in period n (cash outflows to the firm)
k is the required rate of return (cost of capital)
Specific/Component Cost of Capital
 Cost of Debt;
 The before tax cost of debt is the required return by lenders
• Debt Issued and redeemed at Par or Irredeemable Debt:

kd = i= Int./B0

Where,

kd is the before tax cost of debt

i is the coupon rate of interest

B0 is the issue price of the bond

• Debt Issued at Discount or Premium:
n
B0 = ∑ Intt + Bn
t=1 (1+kd)t (1+kd)n
Where,

Bn is the repayment of debt on maturity

It can be approximated using the following formula:

kd= [Int + (Bn-Bo)/n]/ [(Bn + B0)/2]

 The after tax cost of debt = kd (1-t)

Where t is the corporate tax rate

Cost of Preference Capital;
• Irredeemable Preference Shares:
kp = PDIV/P0
Where,
kp is the cost of preference share
PDIV is the expected preference dividend
P0 is the issue price of the preference share
• Redeemable Preference Shares:
Where,
n
P0 = ∑ PDIVt + Pn
t=1 (1+kp)t (1+kp)n

Pn is the redemption value

(The approximation formula mentioned for estimating cost of debt can also be used here)
Cost of Internal Equity (Retained Earnings)
• With constant growth in dividends: ke = (D1/P0)+g
Where,
ke is cost of equity
D1 is DPS expected in the next period
P0 is market price of the share
g is growth rate in dividends (ROE times retention ratio, ROE*b)
• With zero growth in dividends: ke = D/P0 = E/P0
Where E is EPS
Cost of External Equity is estimated using the same formulae with issue price
substituting the market price
Cost of Equity can also be estimated using CAPM [ke = rf + ß(rm-rf)]
Adjustments for Floatation Costs
Adjust floatation costs in Cost of Capital:
The previously mentioned equation can be re-written as;
I0 (1-f) = C1/(1+k) + C2/(1+k)2 +…….+ Cn/(1+k)n
where, f is the percentage floatation cost
Adjust floatation costs in cash flows:
The above mentioned procedure is criticised as floatation costs are
not annual, but only one time cost. Thus, an alternate way of
treatment would be to add them in the initial cost of the project
Question: A company issued irredeemable bonds 10 years ago at face vale of $100 per bond with a coupon rate of
14%. Compute the cost of such bonds if the current market price of these bonds is $125 per bond. Assume the
corporate tax rate as 30%.
Question: A company has issued perpetual bonds with face value of $2000 each, carrying a coupon rate of 12% P.A.
The company has incurred a floatation cost of 4% of issue price. Compute the cost of debt for these bonds,
assuming a corporate tax rate of 30%.
Question: A company issues 10% irredeemable preference shares with a face value and issue price of $100 and $95
per share respectively. What is the cost of preference share?
Question: A company has issued a fresh loan of $5,000,000 from a bank at an interest rate of 15% P.A. The company
has paid a fee to the merchant banker for this purpose @ 2% of the loan amount. The loan is to be repaid after 5
years. Compute the cost of debt assuming a corporate tax rate of 30%
Question: A firm is currently earning $100,000 and its share is selling at a market price of $80. The firm has 10,000
shares outstanding and has no debt. The earnings of the firm are expected to remain stable , and it has a pay-out
ratio of 100%. What is the cost of equity? In another situation, the firm’s pay-out ratio is assumed to be 60% and
that it earns 15% rate of return on its investment opportunities, then what would be the firm’s cost of equity?
Question: The share of a company is currently selling for $100. It wants to finance its capital expenditure of $100
million either by retaining earnings or by selling new shares. If the company sells new shares, the issue price will be
$95. The DPS next year is $4.75 and is expected to grow at 6%. Compute the cost of internal and external equity.
Weighted Average Cost of Capital (WACC)/
Overall Cost of Capital
Different sources of capital are related to each other;
• The firm’s decision to use debt in a given period reduces its future debt capacity as well as increases risk of
shareholders. The shareholders will require a higher rate of return to compensate for the increased risk
• Similarly, the firm’s decision to use equity capital would enlarge its potential for borrowings in the future
Over the long run, firms are expected to maintain a balance between debt and equity
The mix of debt and equity is called the firm’s capital structure
Because of the connection between the sources of capital and the firm’s desire to have a target capital
structure in the long run, the cost of capital should be used in the composite, overall sense
WACC is the weighted cost of various sources of capital in proportions of debt and equity used
We can estimate the WACC of the firm as well as the project
Historical Cost that was incurred in the past in raising capital is not relevant in financial decision making
The relevant cost in investment decisions is the future cost or marginal cost. It is the new or incremental
cost that the firm incurs if it were to raise capital now, or in the near future
Computing WACC
 WACC is calculated using the following formula:
ko = kd (1-t)*wd + ke*we
Where wd and we are weights of debt and equity respectively. They
represent the percentage of debt and equity in the firm’s capital.
wd = D/D+E, we = E/D+E
(Weights can be determined on the basis of Book or Market Value)
 Question: A firm has the following book value and market value of capital structure:
Sources of Finance Amount in $ Amount in $
(Book Value) (Market Value)
Equity Capital 600,000 900,000
Preference Capital 100,000 100,000
Debt 300,000 300,000

Compute its WACC with weights based on book value and market value.
Cost of equity, preference shares and debt is 18%, 11% and 8% respectively
Divisional and Project Cost of Capital
• Firm’s risk is composed of Operating and Financial Risk. Operating risk arises due to
uncertainty of cash flows of the firm’s investments. Financial risk arises on account of the use
of debt for financing investments
• Firm’s cost of capital reflects the return required on its securities commensurate with the
perceived average risk
• Thus, it would be inappropriate to use this for evaluating individual decisions or investment
projects with different degrees of risk
• However, it may work well in case of companies that have a single line of business or where
different businesses are highly correlated
• For diversified businesses or projects it is essential to estimate the required rate of return for
each division or project. This is done using the pure-play technique
• Alternately, the firm may adjust the WACC of firm or division upwards or downwards using a
risk adjustment factor (R ); Adjusted WACC = WACC +/- R
The Pure-Play Technique
 It uses Beta of comparable firms or pure-play firms (i.e. firms in the same industry or business) as a proxy for
the beta of the division or the project. It involves the following steps:
1. Identify comparable firms
2. Estimate equity betas (levered beta) for comparable firms
3. Estimate asset betas (unlevered beta) for comparable firms
ßa = ßd (D/V) + ße (E/V)
Assuming ßd = 0, ßa = ße (E/V) = ße [1-(D/V)]
4. Calculate the division’s asset beta (by taking average of ßa of comparable firms)
5. Using asset beta, estimate the division’s levered beta
ße = ßa/ 1-(D/V)
6. Calculate cost of equity for the division using the levered beta [k e = rf+ ße(rm-rf)]
7. Calculate the overall cost of capital for the division ko = [kd*(1-t)*(D/V)] + [ke*(E/V)]
 Question: A company (X Ltd.) wants to diversify into garments business and make a new division. It has
found a comparable garments company of approximately same characteristics as the proposed division. It
has ße = 1.35 and debt ratio of 0.8. The corporate tax rate is 40%. X Ltd. will have a debt ratio of 50% for the
proposed business. Find the cost of equity for the new division with risk-free rate and market premium of 5%
Capital structure Planning
Important Issues in Capital Structure
Planning
The following questions need to be addressed:
• How should the investment project be financed?
• How does financing affect shareholders’ risk, return and value?
• Does there exist an optimum financing mix in terms of maximum
value to the firm’s shareholders?
• Can the optimum financing mix be determined in practice for a
company?
• What factors in practice should a company consider in designing its
financial policy?
Leverage Analysis
• It refers to analysis of relation between 2 interrelated variables
• It analyses the responsiveness of one financial variable to another
• Firms’ profits are affected by Operating Leverage and Financial
Leverage
• Operating Leverage affects a firm’s operating profits/net operating
income (EBIT) whereas Financial Leverage affects PAT or EPS
Operating and Financial Risk
Operating Risk:
• It can be defined as the variability of EBIT (Return on Assets)
• The internal and external environment in which a firm operates, determines the variability
of EBIT
• The variability of EBIT is comprised of variability of sales and variability of expenses
Financial Risk:
• It refers to variability in EPS
• It is associated with usage of debt in capital structure
• Firms exposed to same degree of operating risk can differ with respect to financial risk
when they finance their assets differently
Riskiness of EBIT and EPS is measured using standard deviation and coefficient of
variation
Degree of Operating Leverage (DOL)
Can be computed as;
= % Change in EBIT / % Change in Sales
= Contribution/EBIT
= 1+(Fixed Cost/EBIT)
The presence of fixed cost leads to Operating Leverage
DOL is 1 in absence of any fixed cost
Introduction of Fixed Cost magnifies operating profits at higher levels of operations
DOL is Positive (Negative) when the firm is operating above (below) the Breakeven level
Break Even Level: Level of Sales just sufficient to cover its variable and fixed costs
Degree of Financial Leverage (DFL)
Can be computed as;
= % Change in EPS / % Change in EBIT
= EBIT/PBT
= 1+(Interest/PBT)
= EBIT (1-t)/PBT (1-t)-PD; in presence of Preference Dividends (PD)
The presence of fixed financial charge leads to Financial Leverage
DFL is 1 in absence of any fixed financial charge
DFL is Positive (Negative) when the firm is operating at a level above (below) the Financial Break Even level
Financial Break Even Level: Level of EBIT just sufficient to cover fixed financial
charges. At this level, EPS=0.
EBIT= Int.
or
EBIT= Int. + PD/(1-t)
Measures of Financial Leverage
Debt Ratio: D/D+E
This measures the debt to total capital, and can range between 0-1
Debt-Equity Ratio: D/E
This is used more popularly in practice. Its value can range from 0 to any large number
The above 2 ratios can be expressed either in terms of book values or market values. However,
using market value is theoretically more appropriate as it reflects the current attitude of investors
Interest Coverage Ratio: EBIT/Interest
This indicates the capacity of the company to meet fixed financial charges with
Net Operating Income (EBIT)
The use of fixed-charges sources of funds along with owners’ equity in the capital structure, is
described as financial leverage or gearing or trading on equity
Degree of Combined Leverage (DCL)
• DOL and DFL are combined to see the impact of total leverage on EPS
Can be computed as;
= % Change in EPS / % Change in Sales
= Contribution/PBT
Question: A firm has sales of Rs.1,000,000; Contribution margin of 30% and fixed costs of Rs.
150,000. It has debt of Rs. 800,000 at 10% interest rate. What are the operating, financial and
combined leverages? If the firm wants to double its EBIT, how much rise in sales would be needed on
a percentage basis?
Question: A firm has Sales of Rs. 8,000 million. Variable Costs are 70% of sales and it incurs fixed cost
of Rs. 450 million. It pays interest of Rs. 1,000 million on debt and is subject to tax rate of 30%.
Calculate different types of leverage. Estimate the percentage change in EPS if sales increase by 5%?
Question: A firm has interest liability of Rs. 20,000 and preference dividend of Rs. 36,000. Given the
tax rate of 30%, find out the financial break even level.
EBIT-EPS Analysis
With leverage analysis, we analysed the relation between change in sales level and EPS
Under EBIT-EPS analysis, we analyse the impact of different patterns of financing on EPS
With a particular level of EBIT, we analyse the level of return available to shareholders under different
conditions of financing
Question: A company expects an EBIT of Rs.150,000 P.A. on an investment of Rs. 500,000. It has 4 options to
raise required funds:
1. Issue Equity (Shares of Rs. 100 each)
2. Raise 50% funds by Equity and 50% funds by 12% Preference Shares
3. Raise 50% funds by Equity, 25% by 12% Preference Shares and 25% by
10% Debt
4. Raise 25% funds by Equity, 25% by 12% Preference Shares and 50% by
10% Debt
Analyse the impact of different financial plans on EPS, assuming that the firm is subject to tax rate
of 50%
Plans 1 2 3 4

Equity Share Capital 500,000 250,000 250,000 125,000

Preference Capital - 250,000 125,000 125,000

Debt - - 125,000 250,000

Total Funds 500,000 500,000 500,000 500,000

EBIT 150,000 150,000 150,000 150,000

(Interest) - - (12,500) (25,000)

PBT 150,000 150,000 137,500 125,000

(Tax) (75,000) (75,000) (68,750) (62,500)

PAT 75,000 75,000 68,750 62,500

(Preference Dividend) - (30,000) (15,000) (15,000)

Profit available for Equity 75,000 45,000 53,750 47,500

Share Holders)
No. of outstanding shares 5,000 2,500 2,500 1,250
(Of Rs. 100 each)
EPS 15 18 21.5 38 (Maximum)
Favourable and Unfavourable Financial Leverage
 Financial Leverage is a twin-edged sword, and is favourable only when Return on Investment (ROI) > Cost of Debt
 In the previous example, ROI was 30% (150,000/500,000). If ROI is 18%, then EBIT = 500,000*18% (90,000)
 Its impact on the previous example is shown in the following table;

Plans 1 2 3 4
EBIT 90,000 90,000 90,000 90,000

(Interest) - - (12,500) (25,000)

PBT 90,000 90,000 77,500 65,000
(Tax) (45,000) (45,000) (38,750) (32,500)
PAT 45,000 45,000 38,750 32,500
(Preference Dividend) - (30,000) (15,000) (15,000)
Profit available for Equity 45,000 15,000 23,750 17,500
Share Holders)
No. of outstanding shares 5,000 2,500 2,500 1,250
(Of Rs. 100 each)
EPS 9 6 (Firm is earning 9% post 9.5 (Firm is earning 9% 14 (Maximum)
tax but paying 12% to post tax but paying 5% post (Firm is earning 9% post
Preference shareholders) tax to Debt Holders) tax but paying 12% and 5%
post tax to Preference
Shareholders and Debt
Holders respectively)
EBIT-EPS Analysis
(With Varying Patterns of EBIT)
Question: There are 3 firms A,B,C that are alike in all respects except for leverage.
The ROI earned by them depends on economic conditions. In normal conditions,
they earn 8%, and it may fluctuate to +/- 3% in good and bad conditions
respectively. Analyse the impact of varying financing patterns of these firms on
EPS, assuming the firm is subject to a tax rate of 50%. The following table
describes their capital structure;
Firms A B C
Equity Share Capital 200,000 100,000 50,000
(Shares of Rs. 100
each)
6% Debt - 100,000 150,000
Total 200,000 200,000 200,000
Analysis for Firm A
(With no Financial Leverage)
Economic Conditions Bad Normal Good
Total Assets 200,000 200,000 200,000
EBIT (Total Assets * ROI) 200,000 * 5% = 10,000 200,000 * 8% = 16,000 200,000 * 11% = 22,000
Interest - - -
PBT 10,000 16,000 22,000
Tax (5,000) (8,000) (11,000)
PAT 5,000 8,000 11,000
Number of shares 2,000 2,000 2,000
outstanding
EPS 2.5 4 5.5

There is no magnifying effect of increase in EBIT on EPS.

% change in EPS (+/-37.5%) is the same as % change in EBIT (+/-37.5%)
Analysis for Firm B
(With 50% Debt)
Economic Conditions Bad Normal Good
Total Assets 200,000 200,000 200,000
EBIT (Total Assets * ROI) 200,000 * 5% = 10,000 200,000 * 8% = 16,000 200,000 * 11% = 22,000
Interest (6,000) (6,000) (6,000)
PBT 4,000 10,000 16,000
Tax (2,000) (5,000) (8,000)
PAT 2,000 5,000 8,000
Number of shares 1,000 1,000 1,000
outstanding
EPS 2 5 8

There is a magnifying effect of increase in EBIT on EPS.

% change in EPS (+/-60%) is more than % change in EBIT (+/-37.5%)
Analysis for Firm C
(With 75% Debt)
Economic Conditions Bad Normal Good
Total Assets 200,000 200,000 200,000
EBIT (Total Assets * ROI) 200,000 * 5% = 10,000 200,000 * 8% = 16,000 200,000 * 11% = 22,000
Interest (9,000) (9,000) (9,000)
PBT 1,000 7,000 13,000
Tax (500) (3,500) (6,500)
PAT 500 3,500 6,500
Number of shares 500 500 500
outstanding
EPS 1 7 13

There is a magnifying effect of increase in EBIT on EPS.

% change in EPS (+/-85.7%) is more than % change in EBIT (+/-37.5%)
Indifference Point/Level
It refers to the level of EBIT at which the EPS remains constant, irrespective of
different financial plans
At this level, the firm is indifferent amongst different financing patterns
Indifference level of EBIT is computed using the following formula;
[ (EBIT-Interest1)(1-t)-PD1]/N1 = [ (EBIT-Interest2)(1-t)-PD2]/N2
Where; N1 and N2 are no. of outstanding shares under different
financing plans
(The above equation is a generalised formula where the firm is
comparing 2 alternate plans with different levels of debt and
preference capital)
Question: A company has an existing capital structure of 1,000,000
equity shares of Rs. 10 each. It is subject to a tax rate of 50% and
plans to raise additional capital of Rs.10,000,000 for a project. Its
evaluating 2 alternative financial plans:
A: Issue 1,000,000 equity shares of Rs. 10 each
B: Issue Rs. 10,000,000 debt carrying 14% interest rate
Compute the indifference point
Solution: EBIT = Rs. 2,800,000
Indifference Level
1.5

1
EPS

0.5

0
1000000 2000000 2800000 3000000 4000000
-0.5
EBIT

Plan A Plan B
Mergers and Acquisitions
Merger vs Acquisition
The terms ‘mergers’ and ‘acquisitions’ are often used interchangeably, although in actuality, they
hold different meanings
When one company takes over another entity, and establishes itself as the new owner, the
purchase is called an acquisition.
From a legal point of view, the target company ceases to exist, the buyer absorbs the business,
and the buyer's stock continues to be traded, while the target company’s stock ceases to trade.
On the other hand, a merger describes two firms of approximately the same size, who join forces
to move forward as a single new entity, rather than remain separately owned and operated.
This action is known as a ‘merger of equals’. Both companies' stocks are surrendered and new
company’s stock is issued in its place.
In case we do not observe a ‘merger of equals’, the two parties involved in the deal are referred
to as Bidder (the buying firm which initiates the offer) and Target firm (the acquired firm which
receives the offer)
Types of Mergers & Acquisitions (M&A)
Strategic M&A:
• Such transactions yield value through taking advantage of operating
synergies. Two firms prove to be more profitable combined than separate
• It can further be divided into Horizontal and Vertical mergers
• Horizontal merger takes place between 2 firms in the same line of business
• Vertical merger involves companies at different stages of production. The
buyer expands back towards the source of raw material or forward in the
direction of the consumer
Conglomerate M&A: Involve companies in unrelated lines of business to
gain benefits of diversification
Financial M&A:
• Such transactions do not involve any operating synergies, instead they
give benefits of synergy in financing activities
• The bidder believes that target firm’s management is not working
efficiently, and it takes over the firm to take advantage of corporate
inefficiencies. This is referred to as a Disciplinary takeover
• They are often structured as Leveraged Buyouts (LBOs), where significant
amount of borrowed money is used to meet the cost of acquisition
• By structuring the transaction as an LBO, the responsibility to pay interest
and repay debt, forces the management to perform better which results
in increased productivity. It also gives benefits of interest tax shields
Motives of Mergers
To achieve Operating Synergies:
• Benefits of economies of scale in case of horizontal mergers. Also, a merger between competitors results in
a less competitive market
• Vertical mergers can eliminate various coordination and bargaining problems
To achieve Financial Synergies:
• These are associated with tax advantages of debt that can be achieved in LBOs and Conglomerate
mergers . Since diversification reduces the risk of bankruptcy, the firm can increase the amount of debt in
the firm’s optimal capital structure and lower the firm’s cost of capital
Management incentive issues: Disciplinary takeovers may be intended to correct non value maximising
policies. Such takeovers are usually structured as LBOs or MBOs (Management Buyouts are transactions
where a company’s management team purchases the assets and operations of the business they manage)
Tax Motivations: When one of the two merged companies had past losses, and firms are combined; then
losses of unprofitable firms become valuable tax shields for the profitable firm
Surplus Funds: Firms generating substantial amounts of free cash flows that lack profitable investment
opportunities can purchase other companies’ shares
Disadvantages of Mergers
Reduction of Value:
• Combining two firms can destroy value, if managers of the combined
firm transfer resources between the firms and don’t do away with a
losing business in operation
• Also, at times the top management may be reluctant to cut jobs
Reduction of information contained in stock prices:
• Mergers can reduce the information contained in stock prices. When
two firms combine, there is one less publicly traded stock.
Valuing M&A

Since additional value is created by combining firms, the acquiring firm offers a premium
over the target company’s stock price to purchase the firm
P.V. (Acquisition) = P.V. (Firm) + P.V. (Synergies)
 Eg; Co.B is currently selling for $22 per share and has 1 million outstanding shares. Co.A
is considering the acquisition of Co.B. It believes that by combining sales force, it can
generate savings of $500,000 P.A. They expect the savings to be permanent and certain.
If the discount rate is 10%, how much is the worth of Co.B to Co.A?
 Solution:
P.V.(Savings) = 500,000/0.1 = $5,000,000 = $5 per share
P.V. (Co.B) = 22+5= $27
(However, in practice the target firm’s stock price may reflect the probability that the firm
may be taken over at a premium. Adjustments should be made accordingly)
Methods of Financing M&As
• M&As can be financed by purchasing the target company with cash or by offering the target
shareholders its own stock in exchange for the target’s stock
• In case the compensation is made using stock, the offer is expressed in terms of exchange
ratio (swap ratio), which is defined as the number of shares the acquiring firm is willing to
give in exchange for one share of the target firm. Eg; an exchange ratio of 0.5 means that the
acquiring firm is willing to give half a share for every share of the target firm
• The commonly used bases for establishing the exchange ratio are book value per share,
earnings per share, market price per share, dividend discounted value per share and
discounted cash flow value per share
 Eg; A Ltd. (acquiring firm) wants to acquire B Ltd. (target firm). M.P. of A Ltd. and B Ltd. is $21
and $14 respectively. The exchange ratio is calculated as M.P (target co.)/M.P. (acquiring
company); 14/21 = 2:3. This means that for every 3 shares in B Ltd., 2 shares of A Ltd. will be
offered
 Eg; A Ltd. (acquiring firm) wants to acquire B Ltd. (target firm). EPS of A Ltd. and B Ltd. is $5
and $2 respectively. The exchange ratio is calculated as EPS (target co.)/EPS (acquiring
company); 2:5. This means that for every 5 shares in B Ltd., 2 shares of A Ltd. will be offered
Factors affecting financing methods
Tax Implications: Target company’s shareholders generally prefer
stock offer, as then they would not need to pay capital gains tax on
shares. Also, if they need cash, they can obtain it by selling shares.
Capital Structure Implications: If firms are over leveraged, they may
want to finance the M&A using stock compensation. If firms are
under leveraged, they may want to finance the transaction with debt
Asymmetric Information Effects: When the management believes
that shares of their firms are under priced, they are less likely to
finance the M&A with stock as they would have to offer more number
of shares as compensation and vice versa.
Costs and Benefits of Merger
 Assume Co.A is acquiring Co.B. In this case we need to find out the NPV of this decision to A and
B. Co.A is making a capital investment decision, whereas Co.B is making a capital disinvestment
decision
 In case the merger is executed with cash compensation;
Benefits of the Merger: PVAB – (PVA + PVB)
Cost of the Merger (For Co.A): Cash – PVB
NPVA = Benefit – Cost = PVAB – PVA – Cash
NPVB = Cost to A = Cash – PVB
 In case the merger is executed with stock compensation;
Benefits of the Merger: PVAB – (PVA + PVB)
Cost of the Merger (For Co.A): αPVAB – PVB
(where α is the proportion of combined share capital held by shareholders of Co.B)
NPVA = Benefit – Cost = PVAB – PVA – αPVAB
Question: Firm A and B have a value of $20 million and $5 million
respectively. If the two firms merge, cost savings with a present value
of $5 million would occur. Firm A proposes to offer $6 million cash
compensation to acquire firm B. Calculate the NPV of the merger for
both the firms.
Solution:
Benefit of the merger=$5 million
Cost to A = Cash – PVB = $6 million - $5 million = $1 million
NPV (A) = $5 million - $1 million = $4 million
NPV (B) = Cost to A = $1million
 Question: Firm A plans to acquire firm B. The relevant financial details of the two firms, prior to merger announcement are:
Firm A Firm B
Market price per share $50 $20
Number of shares 1,000,000 500,000
outstanding
Market Value of the firm $50,000,000 $10,000,000

The merger is expected to bring gains which have a present value of $10 million. Firm A offers 250,000 shares in exchange of 500,000 shares
to shareholders of firm B. Calculate the NPV of the merger for both the firms.
 Solution:
Benefit of the merger=$10 million
Cost to A = αPVAB – PVB
α = 250,000/(250,000+1,000,000)=0.2
Thus, Cost to A = 0.2($70,000,000)-$10,000,000= $4,000,000
Note: PVAB = $50 mill. + $10 mill. + $10 mill. = $70 mill.
NPV (A) = $10 million - $4 million = $6 million
NPV (B) = Cost to A = $4 million
Question: Consider two firms X and Y, that compete in the same
product market. Corporation X currently has 1 million shares
outstanding, each with value of $2. Firm Y has 500,000 shares on offer
and share price of $10. Firm Y is contemplating takeover of
corporation X, as it knows that corporation X is being run inefficiently.
Firm Y estimates that, if it takes corporation X over, it could increase
firm X’s net cash flow by $300,000 per year. Assume that these firms
are infinitely lived. The relevant cost of capital for firm X is 10%. Find
the payoffs of firm X and Y in the following situations:
1. Firm Y agrees to purchase every share in firm X at a price of $3 per
share
2. Firm Y offers 1 share to shareholders of firm X for every 4 shares
they hold
Also find the share price of the merged enterprise.
Solution:
Co.Y Co.X
No. of outstanding shares 500,000 1,000,000
M.P per share 10 2
M.V. of the firm 5,000,000 2,000,000

(1) Benefit of the merger = 300,000/0.1 = $3,000,000

Cost to Y (acquiring co.)= Cash – PVX = (3*1,000,000)-(2,000,000)
= $ 1,000,000
NPVY = $3,000,000-$1,000,000 = $2,000,000
NPVX (Cost to Y) = $1,000,000
(2) Benefit of the merger=$3,000,000
Here, exchange ratio is 1:4, i.e. shareholders of X get 1 share of Y for every 4 shares they hold.
Since Co.X has 1,000,000 shares outstanding, shareholders of X will now have 250,000 shares in
the merged entity (1,000,000/4).
α= 250,000/(500,000+250,000)=0.33
Cost to Y (acquiring co.)= αPVXY – PVX = (0.33*10,000,000)-(2,000,000)
= $ 1,333,333
(Note: Value of the combined firm is PVX ($2 mill.) + PVY ($5 mill.)+ PVgain ($3 mill.) = $10 mill.
NPVY = $3,000,000-$1,333,333 = $1,666,667
NPVX (Cost to Y) = $1,333,333
 Market Price of the merged enterprise = PVXY/total no. of outstanding shares
= $10,000,000/(250,000 + 500,000) = $13.33 per share
Risk Analysis in
Capital Budgeting
Nature and estimation of Risk
Risk exists because of the inability of the decision maker to make
perfect forecasts
Broad categories of events influencing investment forecasts:
• General Economic Conditions
• Industry Factors
• Company Factors
Risk is defined as the variability that is likely to occur in future returns
Most common measures for estimating risk: Standard Deviation and
Coefficient of Variation
Expected NPV
n
ENPV = ∑ ENCFt / (1+k)t
t=0

Where,
ENPV: Expected NPV
ENCF: Expected Net Cash Flow
K: Discount Rate
ENCFt = NCFjt * Pjt
NCFjt and Pjt : Net Cash Flow and Probability for jth event in period t
Risk (Using Standard Deviation and Coefficient of Variation)

n
σt = √∑ (NCFjt – ENCFt)2 Pjt
t=1

n
σProject = √∑ (σt * PVFt)2
t=1

The above formula assumes independence of cash flows over time

C.V. = Standard Deviation/Expected Value

Question: The following are possible net cash flows of Projects X and
Y and their associated probabilities. Both projects involve initial
investment of $5000, have life of 1 year and have a discount rate of
10%. Calculate the expected NPV for each project. Which project is
preferable?
Possible Event Project X Project Y

Cash Inflows Probability Cash Inflows Probability

A 4,000 0.1 12,000 0.1

B 5,000 0.2 10,000 0.15

C 6,000 0.4 8,000 0.5

D 7,000 0.2 6,000 0.15

E 8,000 0.1 4,000 0.1

Question: The cost of a project is $1,600,000. The following data
presents details about distribution of cash flows. Find the expected
NPV and risk associated with the project, if the cost of capital is 10%.
Year I Year II

Cash Inflows Probability Cash Inflows Probability

500,000 0.1 1,000,000 0.3

700,000 0.4 1,405,000 0.2

800,000 0.3 1,500,000 0.5

1,000,000 0.2 ------- -------

Conventional Techniques of Risk Analysis
Payback Period
Risk-Adjusted Discount Rate
Certainty Equivalent Method

Analysts can make conservative forecasts including shorter payback

period or higher discount rate for discounting cash flows
Risk-Adjusted Discount Rate (RADR)
RADR = Risk free rate + Risk Premium
(Can be estimated using CAPM)
This approach accounts for risk by varying the discount rate
depending on the degree of risk of investment projects
A higher rate will be used for riskier projects and vice versa.
Some projects may be accepted when no allowance for risk is granted
but may become unacceptable if a risk premium is added to the
discount rate.
Certainty Equivalent Method
n
NPV = ∑ αt * NCFt /(1+kf)t
t=0
Where;
NCFt : Forecast of Net Cash Flow without Risk Adjustment
αt : Risk Adjustment Factor or Certainty Equivalent Coefficient, assumes a value between 0 and 1, and varies inversely with
risk
kf : Risk free rate assumed to be constant for all periods

αt * NCFt /(1+kf)t = NCFt /(1+k)t

αt = (1+kf)t/(1+k)t

αt is a decreasing function of time. i.e. Risk is an increasing function of time

 A project involves an outlay of $100,000. Its expected cash inflows at the end of year 1 are $40,000. Thereafter it decreases
by $2000 every year. The certainty equivalent factor is αt = 1-0.05t. Calculate the NPV of the project if it has economic life
of 6 years and the risk free rate is 10% P.A.
Non-Conventional Techniques of Risk
Analysis
Sensitivity Analysis
DCF Break-Even Analysis
Scenario Analysis
Simulation Analysis
Sensitivity Analysis/What-If Analysis
In evaluation of an investment, we work with forecasted cash flows which are a
function of various variables such as sales volume, unit selling price, variable
costs, etc.
The reliability of NPV depends on the reliability of forecasts of underlying
variables.
To work out how much difference does it make to forecasted NPV(IRR) with
changing variables, we change the value of underlying variables; one at a time
keeping other variables constant
We evaluate its impact on NPV(IRR) under 3 situations;
Pessimistic, Optimistic and Expected
The greater the change in NPV(IRR), the more critical is the underlying variable
 Question: A co. is considering the installation of a plant costing $10,000 to increase its processing capacity.
Compute the NPV assuming 12% discount rate and taking into consideration the following information:
Variables Value
Investment 10,000
Sales Volume 1,000
Unit Selling Price 15
Unit Variable cost 6.75
Annual Fixed Costs 4,000
Depreciation (WDV) 25%
Corporate Tax Rate 35%
Discount Rate 12%

Using sensitivity analysis, compute NPV under the following assumptions:

Variable Pessimistic Expected Optimistic
Volume 750 1000 1250
Unit Selling Price 12.75 15 16.5
Unit Variable Cost 7.425 6.75 6.075
Annual Fixed Cost 4800 4000 3200
NPV under different assumptions
Variable Pessimistic Expected Optimistic

Volume -1146 4972 11,090

Unit Selling Price -1702 4972 9422

Unit Variable Cost 2970 4972 6975

Annual Fixed Cost 2599 4972 7346

DCF Break Even (Financial Break
Even)Analysis
It is a variation of Sensitivity Analysis
It answers the question ‘How much lower can the sales volume become before the project
becomes unprofitable?’
We attempt to find that level of sales/volume of sales at which NPV is 0

Question: Calculate the financial break even point of the following project with an initial
investment of $30,000 and following inflows for the next 5 years:
Sales: $42,000
Variable Costs: $28,000
Fixed Costs: $3,000
Depreciation: $2,000
Assume tax rate of 50% and discount rate of 10%
Scenario Analysis
Takes into consideration the inter-relation of variables unlike
sensitivity analysis
To analyse risk if an investment we analyse the impact of alternate
combinations (scenarios) on the project’s NPV or IRR
(Eg; The sales volume can be increased by reducing selling price and
increasing advertising costs)
NPV (IRR) is evaluated under 3 possible scenarios; Pessimistic,
Optimistic and Expected
 Question: A co. is considering the installation of a plant costing $10,000 to increase its processing capacity.
Compute the NPV assuming 12% discount rate and taking into consideration the following information:
Variables Value
Investment 10,000
Sales Volume 1,000
Unit Selling Price 15
Unit Variable cost 6.75
Annual Fixed Costs 4,000
Depreciation (WDV) 25%
Corporate Tax Rate 35%
Discount Rate 12%

Using scenario analysis, compute NPV under the following assumptions:

Variable Base Pessimistic Expected Optimistic
Volume 1000 750 1250 1250
Unit Selling Price 15 12.75 13.5 16.5
Unit Variable Cost 6.75 7.43 7.10 6.75
Annual Fixed Cost 4000 4800 4400 3200
Simulation Analysis
This takes into consideration the interaction amongst variables and
probabilities of change in variables.
Expected NPV and risk of a project is computed using the following
steps:
• The analyst needs to identify the variables that influence cash inflows
and outflows and specify the formulae that relate them
• Then, the probability distribution for each variable needs to be
indicated. Using this, multiple values of NPV are computed and a
probability distribution of NPV is generated
• Lastly, the expected value and variation in NPV is computed
Decision Trees
(For Sequential Investment Decisions)
So far we have considered current investments in isolation of
subsequent decisions
In practice, present investment decision may depend upon future
events, and the alternatives of a whole sequence of decisions in future
may be affected by the present decision as well as future events
In such situations, sequence of decisions has to be evaluated over time
Decision Tree Approach is used in analysing and evaluating sequential
investments
Decision Tree is a graphic display of relationship between a present
decision and future events, future decisions and their consequences
Steps in Decision Tree Approach
Define the investment proposal
Identify decision alternatives:
Eg; A company is thinking of building a new plant. It may construct a
large/medium/small size plant. Each alternative will have different
consequences. It may consider expansion at a later stage
Draw a decision tree: It is graphed indicating Decision Points (represented by
squares) and Chance Events (represented by circles). Other relevant data such
as projected cash flows, probability distributions, etc. is located on the
decision tree branches
Analyse data: The data is evaluated using Backward Induction or Rolling Back
method, and the best alternative is selected
Case I
Water Purity Ltd. has developed a scientifically more effective water filter than the ones currently available in
the market. One option before the company is to start production on a large scale by installing a large plant
costing Rs. 50 Lakh. Alternatively, it can initially install a small plant at a cash outlay of Rs. 10 Lakh and then
decide to expand the capacity after a year at a cost of Rs. 45 Lakh if the initial demand is high. There is a 50-50
chance that the initial demand will be high or low. If it is high, then there is a 70% chance that the demand in
subsequent years will be high. If it turns out to be low, it is expected to remain low in subsequent years also.
The large plant is likely to generate net cash flow of Rs. 10 Lakh in year 1 if demand is high and Rs. 7 Lakh if
demand is low. With a high initial demand, net cash flows are expected to be Rs. 16 Lakh in perpetuity if the
subsequent demand is high and Rs. 10 Lakh if the subsequent demand is low. The subsequent demand will
remain low if the initial demand is low and the expected cash flow in perpetuity will be Rs. 7 Lakh.
The small plant is estimated to yield net cash flows of Rs. 4 Lakh in year 1 if demand is high and Rs. 2 Lakh if
demand is low. If the initial demand is high, the company will expand its capacity and it is expected to generate
net cash flows of Rs. 20 Lakh in perpetuity if the subsequent demand is high and Rs. 8 Lakh if the subsequent
demand is low. If the initial demand is low, the subsequent demand will be low, and the expected net cash flow
is Rs. 2 Lakh in perpetuity.
What is the best alternative for Water Purity Ltd., assuming that it has an opportunity cost of capital of 20%?
Case II
Supreme Engineering Ltd. has developed a new product which has a 10 year expected life. A
market study conducted by the company has revealed that a domestic as well as an export
market exists for the product. It is also indicated that a small plant will suffice to cater to the
domestic demand. However, a large plant will have to be build if export demand also has to be
met. The exact magnitude of the export market is not known. The company has the option of
building a small plant today, and then, after 3 years decide to expand. The company may decide
to expand if the initial demand consisting of both domestic and export is high. Further the
company has 2 options vis-à-vis its decision to expand: the small plant could be expanded to a
large size or a small size. The market study indicates that the chance that the initial demand will
be high and low is 0.6 and 0.4 respectively. Given a high initial demand, there is 0.8 probability
that demand will be high in the subsequent years, and 0.2 probability of demand being low. With
low initial demand, there is 0.2 and 0.8 probability of demand being high and low respectively in
subsequent years. The company uses 10% discount rate for evaluating its proposals. Evaluate this
investment proposal. Which is the best alternative given the following cash flows:
Plant Size Cash Initial (1-3 Years) Subsequent (4-10 Years)
Outlay
Demand Probability NCF Demand Probability NCF
Large 50 Lk High 0.6 10 Lk High 0.8 12 Lk
Low 0.2 10 Lk
Low 0.4 8 Lk High 0.2 8 Lk
Low 0.8 6 Lk
Small 20 Lk High 0.6 4 Lk High 0.8 4 Lk
Low 0.2 3 Lk
Low 0.4 3 Lk High 0.2 3 Lk
Low 0.8 2 Lk
Expansion to Large 30 Lk High 0.8 13 Lk
size
(after 3 years)
Low 0.2 9 Lk

Expansion to Small 10 Lk High 0.8 7 Lk

size
(after 3 years)
Low 0.2 5 Lk
Corporate Governance
Introduction
Corporate Governance can be defined as the system of internal controls and
procedures by which companies are managed. It provides a framework that
defines the rights, roles and responsibilities of various groups within an
organisation.
It is an arrangement of checks, balances and incentives a company needs in
order to minimize and manage the conflicting interests between insiders and
external stakeholders
A corporate governance system is likely to be influenced by several stakeholder
groups such as Shareholders, Creditors, Managers and Employees, Board of
Directors, Customers, Suppliers, Governments and Regulators. Conflicting
interests between these groups may lead to Principal-Agent problems
Importance of Corporate Governance
Weak corporate governance is a common thread found in many corporate failures
Lack of proper oversight by the board of directors, inadequate protection for minority
shareholders, and incentives at companies that promote excessive risk taking can be
problematic for a company
Poor corporate governance practices have resulted in scandals and bankruptcies over the past
years
In response to these failures, regulations have been introduced to promote stronger
governance practices and protect financial markets and investors
Academicians, Policy makers and Investment community believe in the importance of good
corporate governance practices
Apart from governance, investors have also become attentive to environmental and social
issues related to a company’s operations. Collectively, these areas are often referred to as ESG
(Environmental, Social and Governance)
Impact of Corporate Governance on Stock
Valuation (Empirical Evidence)
 Corporate Governance is believed to have a significant impact on stock valuation. Empirical evidence
reports positive as well as negative relation between them
 Coombes and Watson (2000) did a survey of 200 institutional investors across the United States of
America, Europe, Latin America and Asia. They found that, investors would pay more for shares of good
governed companies
 Bauer and Guenster (2003) show that investors perceive a higher value for well-governed firms
incorporated in member states of the European Monetary Union (EMU). The result of this study is
compatible with the findings of (Gompers, Ishii et al. (2001), Drobetz, Schillhofer et al. (2004) who work
on American and German markets respectively
 Shen, Shu, and Chen (2006) work on Taiwan’s market. According to them, setting a good corporate
governance policy will lead to a lot of benefits to different levels of management and helps the
organization to avoid management level corruption and helps in enhancing the firm values,
shareholders’ value creation and reducing the investment and financial risks. Therefore a good, sound
and healthy corporate governance policy is a very important criterion while investing in a company
Black & Khanna (2007) did an event study on change in share price of the
companies with respect to regulations passed by the regulatory bodies in India.
They found that the May 1999 announcement by Indian securities regulators of
plans to adopt Clause 49 was accompanied by increase in share prices
Aman and Nguyen (2008) report that a portfolio of Japanese firms with poor
governance has significantly higher returns and risk than a portfolio of well
governed firms
Carvalhal and Nobili (2011) find an abnormal governance return of 10% per year in
the Brazilian market from buying poor governance firms and selling good ones
Kouwenberg, Salomons, Thontirawong (2012) work on Asian markets and find that
a portfolio of poorly governed firms has a higher market beta, higher expected
return and higher realized return, compared to a good governance portfolio
Mohamed and Elewa (2016) work on Egyptian firms and suggest that firms should
improve their corporate governance practices, as it has a significant effect on
firms’ value
Real Options
Real Options
These are capital budgeting options that allow managers to make decisions in future that alter the value of
capital budgeting investment decisions made today
Instead of making all capital budgeting decisions now, managers can wait and make additional decisions at
future dates when these future decisions are contingent upon future economic events or information
Real options are those strategic elements in investments that help creating flexibility of operations, or that have
the potential of generating profitable opportunities, in future, for the firm
Real options are like financial options dealing with real assets instead of financial assets. However, they may not
always be confined to real assets. Their application may be extended to assets that have a value to the owner
such as Patents and Brands
The corporation should exercise a real option only if it is value-enhancing
Financial options are contingent on the underlying asset, whereas real options are contingent on future events
Some capital investments have embedded options. Managers must recognize and value these options, and
exercise them when it is advantageous to do so
Some large investment projects may involve complex options. There may be options on options, or options may
be interdependent or mutually exclusive
Types of Real Options
 Sizing Options;
1. Growth/Expansion Option: If the company can make additional investments when future financial results are strong
2. Abandonment Option: If after investing, the company can abandon the project when the financial results are disappointing. Managers
should exercise this option, if at some future date the cash flow from abandoning a project exceeds the present value of cash flows from
continuing the project.
 Timing Options;
Instead of investing now, the company can delay investing. Delaying an investment and basing the decision on hopefully improved information
that you might have in future, could help improve NPV of the projects selected
 Flexibility Options;
Once an investment is made, other operational flexibilities may be available besides abandonment or expansion. The firm may have following
flexibility options;
1. Price-Setting Option: If demand exceeds the production capacity, the management may exercise price-setting option. It could benefit by
increasing the prices instead of increasing production.
2. Production-Flexibility Option: When a demand-supply mismatch occurs, the company can profit from working overtime. This type of option
also includes the possibility of using different inputs or producing different outputs.
 Fundamental Options;
In all the above cases, there are options embedded in the project that can raise its value. In other cases, the whole investment is essentially an
option. Eg; The value of an oil well or refinery investment is contingent upon the price of the oil. If oil prices are high, it would be profitable to
drill. Here, the payoffs from the investment are contingent on the underlying asset, just like financial options
Valuing Real Options
An investment with real options consists of 2 values:
Value of cash flows from the project’s asset +
Value of any future opportunity (option) arising from holding the asset
Long position in call option: When firm has the right to expand or right to enter a
new venture in future, at a given price. The cost of expansion would be the
exercise price
Long position in put option: When firm has the right to abandon or right to
liquidate in future at a given price
Short position in call/put option: Managerial commitments to disinvest (short
call) or invest (short put) contingent upon the action of another party
The option pricing theory provides a framework for valuing these strategic
investments
Black-Scholes Formula for Option Valuation
Co = So N(d1)-Xe-rf*tN(d2)
Po = Xe-rf*t [1-N(d2)]- So [1-N(d1)]
Where;
Co/Po: Current value of Call/Put Option
So: Current market value of the underlying asset
X: Exercise Price
E: 2.7183; exponential constant
rf: risk-free rate of interest
t: time to expiration
N(d1)/N(d2): Cumulative normal probability density function
d1= [ln(So/X) + (rf+σ2/2)t]/σ√t
d2= d1-σ√t
Where;
ln: natural logarithm
σ : standard deviation in the underlying asset’s return
Black-Scholes Formula for Option Valuation
(With Dividend Yield)
Co = So e-y*t N(d1)-Xe-rf*tN(d2)
Po = Xe-rf*t [1-N(d2)]- So e-y*t [1-N(d1)]
d1= [ln(So/X) + (rf-y+σ2/2)t]/σ√t
d2= d1-σ√t
Where;
y=dividend yield
Option to Expand
Sometimes firms invest in projects because these investments allow them either to make further
investments or to enter other markets in the future
In such cases, the initial projects are viewed as options allowing the firm to invest in other projects
Thus, the firm should be willing to pay a price for such options
A firm may accept a negative net present value on the initial project because of the possibility of high
positive net present values on future projects
The option to expand can be evaluated at the time the initial project is analysed
Assume that this initial project will give the firm the right to expand and invest in a new project in the
future
Assessed today, the firm takes into consideration expected present value of the cash flows from investing
in the future project and the total investment needed for this project
The firm has a fixed time horizon, at the end of which it has to make the final decision on whether or not
to make the future investment
The firm cannot move forward on this future investment if it does not take the initial project.
Inputs to value the option to expand
- There are two projects usually that drive this option;
• The first project generally has a negative net present value and is recognized as a poor investment, even by the firm
investing in it
• The second project is the potential to expand that comes with the first project. It is this project that represents the
underlying asset for the option. The inputs have to be defined accordingly;
 Value of the underlying asset: The present value of the cash flows that a firm would generate if it were to invest in the
second project (the expansion option) is the value of the underlying asset – S in the option pricing model
 Variance: If there is uncertainty about the expansion potential, the present value is likely to be volatile and change over
time as circumstances change. The variance in this present value is used to value the expansion option. Since projects are
not traded, this variance is estimated from simulations or by using the variance in values of publicly traded firms in the
same business. Following steps define the simulation analysis:
o Define probability distributions for each of the key inputs that underlie the cash flows
o In each simulation, draw one outcome from each distribution and estimate the present value of the cash flows based
upon these draws
o After repeated simulations, a distribution of present values is derived.
o The mean of this distribution should be the expected value of the project and the standard deviation of the
distribution can be used as the variance in the value to value options on the project
Inputs to value the option to expand
Strike Price: The cost that is incurred on expansion, is the equivalent of the strike
price
Cost of Waiting: There may be a cost of waiting, once the expansion option
becomes viable. This may take the form of cash flows that will be lost on the
expansion project if it is not taken or a cost imposed on the firm until it makes its
final decision. For instance, the firm may have to pay a fee every year until it
makes its final decision
Life of the option: It is fairly difficult to define, since there is usually no externally
imposed exercise period. When valuing the option to expand, the life of the
option remains an internal constraint imposed by the firm on itself. For instance,
a firm that invests on a small scale might impose a constraint that it either will
expand within 5 years or pull out of the market.
Case I
Magic Foods Ltd. specializes in ready-to-make South Indian dishes. It is evaluating the idea of
introducing a breakfast cereal. There is a lot of uncertainty about the demand for breakfast cereal
since most Indians like traditional breakfast. However, there are indications that many Indians have
started going for breakfast cereals. Magic Foods Ltd. anticipates the demand for such cereals to go
up. To judge the customer reaction, it will initially introduce the cereal in Delhi and Mumbai. The
estimated cost of this introduction is Rs. 30 Million and the present value of estimated cash inflows
is Rs. 21 Million. This has a negative NPV, however, the management anticipates that if the company
does not introduce the cereal, the competitors will do so in future. Introducing the cereal now will
give the company the first mover’s advantage, and if the demand picks up, it will have the option to
scale up production in future. The firm can consider the decision to expand within 5 years and cost
of expansion to the company is estimated as Rs. 50 Million. The present value of cash flows over the
anticipated life of the project is expected to be Rs. 45 Million. The demand for breakfast cereal is
highly uncertain, and the investment can turn out to be highly beneficial to the company if the
market picks up. The expansion project has a standard deviation of 30%. Evaluate this proposal if
the risk-free rate of return is 8%. Estimate the value of Magic Foods Ltd.
Case II
Rediff.com is an internet portal serving the Indian sub-continent. Last year, firm had only a few million in
revenues, but had tremendous growth potential as a portal and electronic marketplace. Using a discounted
cash flow model, Rediff.com is valued at $474 million, based upon its expected cash flows in the internet portal
business. You are evaluating a decision to buy Rediff.com. Assume that in buying Rediff.com, you are in fact
buying an option to expand in the online market in India. This market is a small one now, but could potentially
be much larger in five or ten years. In more specific terms, assume that Rediff.com has the option to enter the
internet retailing business in India in the future. The cost of entering this business is expected to be $1 billion
and, based on current expectations, the present value of the cash flows that would be generated by entering
this business is only $500 million. Based upon current expectations of the growth in the Indian e-commerce
business, this investment clearly does not make sense, but there is substantial uncertainty about future growth
in online retailing in India and the overall performance of the Indian economy. If the economy booms and the
online market grows faster than expected over the next 5 years, Rediff.com might be able to create value from
entering this market. The standard deviation in the present value of the expected cash flows (which is currently
$500 million) is assumed to be 50%.
Estimate the value of the option to expand into internet retailing business if 5 year T-Bond rate is 5.8%. Also
estimate the value of Rediff.com.
Option to Abandon
When investing in new projects, firms worry about the risk that the
investment will not pay off and that actual cash flows will not
measure up to expectations
Having the option to abandon a project that does not pay off can be
valuable, especially on projects with a significant potential for losses
Thus, it is important to examine the value of the option to abandon
and its determinants
The option pricing approach provides a general way of estimating and
building in the value of abandonment
Payoff on Option to Abandon
Assume that V is the remaining value on a project if it continues to the end of its life and L is
the liquidation or abandonment value for the same project
If the project has a remaining life of n years, the value of continuing the project can be
compared to the liquidation (abandonment) value
If the value from continuing is higher, the project should be continued; if the value of
abandonment is higher, the holder of the abandonment option could consider abandoning
the project
The abandonment option takes on characteristics of put option
The payoffs can be written as;
Payoff from owning an abandonment option:
0 if V > L
L-V if V ≤ L
Case I
Lear Aircraft is interested in building a small passenger plane and it approaches Airbus with
a proposal for a joint venture. Each firm will invest $500 million in the joint venture and
produce the planes. The investment is expected to have a 30-year life. Airbus works
through a traditional investment analysis and concludes that their share of the present
value of the expected cash flows would be only $480 million. The net present value of the
project would therefore be negative and Airbus would not want to be part of this joint
venture. On rejection of the joint venture, Lear approaches Airbus with a sweetener,
offering to buy out Airbus’s 50% share of the joint venture after 5 years for $400 million.
This is less than what Airbus will invest initially but it puts a floor on their losses and thus
gives Airbus an abandonment option. To estimate the variance, assume that Airbus employs
a Monte Carlo simulation on the project analysis and estimates a standard deviation in
project value of 25%. Since the project is a finite life project, the present value will decline
over time, because there will be fewer years of cash flows left. Estimate the value of this
option using 5% risk free rate.
Case II
The Govt. of Uttaranchal has asked Jaisurya Hydraulic Power Co. (JHPC)
to build a hydropower generation plant near Joshimath. The plant will
cost $2000 million. The project will have a life of 25 years. The present
value of project’s cash flows are expected to be $1850 million. Since
this project has a negative NPV, JHPC is not interested in building the
plant. As an incentive to the company, the Uttaranchal Govt. agrees
that the company will have the option to sell the plant to the Govt. at
$1800 million at the end of 10 years. What is the value of this option if
the project is estimated to have a standard deviation of 30%? Assume
the risk free rate is 8%.
Option to Delay
An option that is embedded in many projects, is the option to wait and take the
project in a later period
A firm might want to do this if the present value of the cash flows on the project
are volatile and can change over time
A project with a negative net present value today may have a positive net
present value in the future
Furthermore, a firm may gain by waiting on a project even after a project has a
positive net present value, because the option has a time premium that exceeds
the cash flows that can be generated in the next period by accepting the project
This option is most valuable in projects where a firm has the exclusive right to
invest in a project and becomes less valuable as the barriers to entry decline
Option to Delay
There are three cases where the option to delay can make a difference while
valuing a firm;
1. The first is undeveloped land in the hands of real estate investor or
company. The choice of when to develop rests in the hands of the owner
and presumably development will occur when real estate values increase
2. The second is a firm that owns a patent. Since a patent provides a firm
with the exclusive rights to produce the patented product or service, it can
and should be valued as an option
3. The third is a natural resource company that has undeveloped reserves
that it can choose to develop at a time of its choosing – presumably when
the price of the resource is high
Payoff on the Option to Delay
Assume that a project requires an initial up-front investment of X and that the present value of expected cash
inflows from investing in the project, computed today, is V.
The net present value of this project is the difference between the two;
NPV = V - X
Now assume that the firm has exclusive rights to this project for the next n years and that the present value of the
cash inflows may change over that time, because of changes in either the cash flows or the discount rate
Thus, the project may have a negative net present value right now, but it may still be a good project if the firm
waits.
Defining V again as the present value of the cash flows, the firm’s decision rule on this project can be summarized
as follows;
If V > X Invest in the project: Project has positive net present value
V < X Do not invest in the project: Project has negative net present value
If the firm does not invest in the project over its life, it incurs no additional cash flows, though it will lose what it
invested to get exclusive rights to the project
Payoff on this Option is similar to payoffs from a Call Option
Inputs for Valuing the Option to Delay
Value of the underlying asset: Present Value of Expected Cash Flows
Variance in the value of the asset: It can be estimated using the following ways;
1. If the firm has invested in similar projects in the past, the variance in the cash flows from those projects can be used
as an estimate
2. Simulation Analysis can be used
3. The average variance in the value of firms involved in the same business (as the project being considered) can be used
• The value of the option is largely derived from the variance in cash flows
• The higher the variance, the higher the value of the project delay option
• Thus, the value of an option to invest in a project in a stable business will be less than the value of one in an
environment where technology, competition and markets are all changing rapidly
Exercise Price of the Option: The option to delay a project is exercised when the firm owning the rights to the project
decides to invest in it. The cost of making this initial investment is the exercise price of the option. The underlying
assumption is that this cost remains constant (in present value dollars) and that any uncertainty associated with the
investment is reflected in the present value of cash flows on the product
Expiration of the Option: The project delay option expires when the rights to the project lapse
Inputs for Valuing the Option to Delay
Cost of Delay (Similar to dividend yield in case of stock option):
• There is a cost in delaying investing in a project, once the net present value turns positive
• If you wait an additional period, you may gain if the variance pushes value higher but you
also lose one period of protection against competition.
• You have to consider this cost when analysing the option and there are two ways of
estimating it;
1. If the cash flows are evenly distributed over time and the life of the patent is n years,
the annual cost of delay is 1/n. Each year of delay translates into one less year of value
generating cash flows
2. If cash flows are uneven, the cost of delay is calculated as:
(Present value in next period-Present value now)/Present value now
Case I
Biogen is a bio-technology firm with a patent on a drug called Avonex, which has received FDA
approval for use in treating multiple sclerosis. You have to value the patent using the following
estimates;
• An internal analysis of the financial viability of the drug today, based upon the potential
market and the price that the firm can expect to charge for the drug, yields a present value of
cash flows of $3.422 billion, prior to considering the initial development cost.
• The initial cost of developing the drug for commercial use is estimated to be $2.875 billion
• The firm has the patent on the drug for the next 17 years and the current long-term treasury
bond rate is 6.7%.
• The average variance in firm value for publicly traded bio-technology firms is 0.224
Assume that the potential for excess returns exists only during the patent life and that
competition will eliminate excess returns beyond that period. Thus, any delay in introducing
the drug, once it becomes viable, will cost the firm one year of patent protected returns
Valuing a firm with patents
The value of a firm that derives its value primarily from commercial products that
emerge from its patents can be written as a function of following three variables;
• The cash flows it derives from patents that it has already converted into
commercial products (estimated using traditional cash flow models)
• The value of the patents that it already possesses that have not been commercially
developed (estimated using option pricing models)
• The expected value of any patents that the firm can be expected to generate in
future periods from new patents that it might obtain as a result of its research
(based upon perceptions of a firm’s research capabilities)
Value of Firm = Value of commercial products + Value of existing patents + (Value of
New patents that will be obtained in the future – Cost of obtaining these patents)
Case I (Part II)

In the previous case, you are required to value Biogen as a firm. The following additional
information is available;
• Biogen had two commercial products (a drug to treat Hepatitis B and Cancer) at the time of
this valuation that it had licensed to other pharmaceutical firms. The license fees on these
products were expected to generate $50 million in after-tax cash flows each year for the
next 12 years. To value these cash flows, which were guaranteed contractually, the cost of
debt of 7% of the licensing firms was used.
• Biogen continued to fund research into new products, spending about $120 million on R&D
in the next year. These R&D expenses were expected to grow 20% a year for the next 10
years and 5% thereafter. While it was difficult to forecast the specific patents that would
emerge from this research, it was assumed that every dollar invested in research would
create $1.25 in value in patents (valued using the option pricing model described above) for
the next 10 years and break even after that (i.e., generate $1 in patent value for every $1
invested in R&D). There was a significant amount of risk associated with this component
and the cost of capital was estimated to be 15%.
Time Value of Money
Reasons behind time preference for money:
• Uncertainty about future cash receipts
• Consumption preferences
• Investment options
It is important to understand time value of money for comparison of
cash flows
Discount rate: It is the opportunity cost of investments with
comparable risk
Multi-period /Non Annual Compounding
Nominal Interest Rate: Interest rate is specified on annual basis
Effective Interest Rate: The actual annualised rate when compounding is done more than once a year
(1+re) = (1+r/m)m
Where;
r: nominal interest rate
re: effective interest rate
m: number of compounding periods in a year
Eg; Value of $100 compounded semi-annually at 10% P.A. is $110.25. Here r e is 10.25% P.A. which is higher than r
Continuous Compounding: FV=X(e)rn
Where;
e: mathematical constant that is the base of the natural logarithm (2.7183)
r: rate of interest
n: number of years
Questions
1. A deposit of $10,000 is made in a bank for 1 year. The bank offers 2 options;
A. Receive interest @ 12% P.A. compounded monthly
B. Receive interest @ 12.25% P.A. compounded half yearly
Which option should be preferred?
2. A company is borrowing $2,000,000 from a bank for expansion of its business.
The banks gives it two options:
C. Return the money in 5 equal annual instalments @ 10% P.A.
D. Return the money in equal half yearly instalments over a period of 5 years @
9.8% P.A.
Which option should be preferred?
Annuity
Future Value of Annuity (Amount ‘X’ deposited at the end of each year for 4 years):
F4 = X(1+r)3 + X(1+r)2 + X(1+r)1 + X
FVAF= ((1+r)4-1)/r
FV (V4) = X (FVAF4,r%)
Present Value of Annuity (Amount ‘X’ received at the end of each year for 4 years):
PV= X/(1+r)1 + X/(1+r)2 + X/(1+r)3 + X/(1+r)4
PVAF= 1/r – 1/r(1+r)4
PV(V0)= X (PVAF4,r%)
Present Value of Perpetuity (Amount ‘X’ received at the end of each year forever):
PV(V0)= X/r
Annuity Due
Future Value of Annuity Due (Amount ‘X’ deposited at the beginning of each year
for 4 years):
F4 = X(1+r)4 + X(1+r)3 + X(1+r)2 + X(1+r)1
FV (V4) = X (FVAF4,r%) (1+r)
Present Value of Annuity Due (Amount ‘X’ received at the beginning of each year
for 4 years):
PV= X + X/(1+r)1 + X/(1+r)2 + X/(1+r)3
PV(V0)= X (PVAF4,r%) (1+r)
Questions
1. You are awarded a scholarship and 2 options are available:
A. Receive $1100 now
B. Receive $100 P.M. at the end of each next 12 months
Which option would you prefer if the interest rate in market is 12% P.A.
2. A deposit is made in year 0 in an account that will earn 8% compounded annually. It is desired to withdraw
$5000 three years from now and $7000 six years from now. What should be the size of the deposit?
3. An investor is considering the purchase of a bond that pays 8% P.A. on its face value of $1000. It will mature
in 20 years. What is the maximum purchase price that should be paid for this bond if the investor requires 10%
return?
4. An investor deposits a sum of $100,000 in a bank account on which interest is credited at 10% P.A. How
much can be withdrawn annually for a period of 15 years?
5. A company is selling a debenture which will provide annual interest payment of $1200 for indefinite number
of years. Should it be purchased if its being quoted in the market for $10,500 and the required rate of return is
12%.
6. The cost of a new automobile is $10,000. If the interest rate is 5%, how
much would you have to set aside now to provide this sum in 5 years?
7. A retired couple gave $1 million to buy a lottery ticket and won $194
million. However, this sum was to be paid in 25 equal instalments. If the
first instalment was received immediately and the interest rate is 9%, how
much was the prize worth?
8. After working on an office building for 3 years, you are about to sell it for
$420,000. But someone offers to rent it for 8 years for a fixed annual rental
of $8,000. At the end of this period, you would be able to sell the building.
Your real estate advisor estimates that prices of office buildings will
increase by 3% P.A. Would you prefer to sell it now or wait for 8 years, if the
discount rate is 5%? If you plan to wait for 8 years, will you accept the offer
of $8,000 rent P.A. or would you negotiate for a higher amount?