Beta Primer Basics Module IBD

8/13/2019 Beta Primer Basics Module IBD

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BETA PRIMER [INVESTMENT BANKING BASICS MODULE]

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COST OF EQUITY ............................................................................................................................ 17

INTEREST TAX SHIELD .................................................................................................................... 18

VALUATION ....................................................................................................................................... 18

DCF: ............................................................................................................................................... 18

DDM: ............................................................................................................................................. 18

FINANCING ........................................................................................................................................ 19

THE PECKING ORDER THEORY OF FINANCE .................................................................................. 19

DEBT: TRANCHES AND SENIORITY ................................................................................................ 20

EQUITY: TRANCHES AND SENIORITY ............................................................................................. 21

IPO –INITIAL PUBLIC OFFERING .................................................................................................... 21

FPO- FOLLOW-ON PUBLIC OFFER .................................................................................................. 22

SEO-SEASONED EQUITY OFFERING ............................................................................................... 22

RIGHTS ISSUE ................................................................................................................................ 22

QIP- QUALIFIED INSTITUTIONAL PLACEMENT .............................................................................. 23

AUCTIONS ..................................................................................................................................... 23

PAYOUT ............................................................................................................................................. 23

STOCK SPLITS ................................................................................................................................. 23

BONUS SHARE ............................................................................................................................... 24

STOCK REPURCHASES .................................................................................................................... 24

DIVIDEND (PAYOUT POLICY) ......................................................................................................... 24




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INTRODUCTION

Andy, Kindly add suitable intro

CAPITAL BUDGETING

Capital budgeting entails making decisions to invest present funds in long-term projects in order to earn

future returns.

IMPORTANCE OF CAPITAL BUDGETING

Firstly, capital budgeting has immense significance for corporations. Capital projects make up a

considerable portion of the long-term assets on the balance sheet of companies. The outlays on

these projects can be so big that the future of corporations may be decided by capital budgeting

decisions. Reversal of capital decisions cannot be done at a low cost, hence mistakes in the selection

of capital projects can be very costly.

Secondly, many other corporate decisions also have scope for the application of capital budgeting

principles, as adopted for the specific case. Examples of such areas of application are investments inworking capital, mergers and acquisitions, leasing and bond refunding.

Thirdly, the valuation principles in capital budgeting are quite similar to those used in portfolio

management and security analysis. Thus, the diverse use of capital budgeting methods extends to

these areas also.

Fourthly, the focus of capital budgeting is on ultimately maximizing shareholder value. Thus, correct

capital budgeting decisions have payoffs for a number of stakeholders in the company.

THE CAPITAL BUDGETING PROCESS

Step One: Generating Ideas- Generation of investment ideas can be from anywhere. All levels of the

organization- from the top to the bottom, from departments to functional areas- can contribute bygenerating fresh investment ideas. Ideas can also be generated from outside the company.

Step Two: Analyzing Individual Proposals- The next step involves gathering adequate, reliable

information in order to first forecast future cash flows from each proposed project and then the

profitability of the project is evaluated.

Step Three: Planning the Capital Budget- Next, the profitable proposals are organized after taking

into account two key considerations:

o The match between the proposal and the company’s overall strategic objectives,

o The projects’ timing.

Since companies have various financial and other resource constraints, the proposals usually have to

be scheduled on a priority-basis.

Step Four: Monitoring and Post-auditing- Post-auditing capital projects are as important as selecting

and implementing them. Firstly, it serves to monitor the analysis and forecasts that the capital

budgeting process is based on. Overly optimistic forecasts can be detected and such systematic

errors rectified. Secondly, the negative deviation between actual performance and expectations can

be corrected by taking adequate measures, wherever possible, which in turn improves business

operations. Lastly, sound ideas for future investments may be evolved during post-auditing current

investments.




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BASIC PRINCIPLES OF CAPITAL BUDGETING

1. Cash flows are the basis for decisions. Accounting concepts, such as net income, are not the basis

for decisions.

2. Timing of cash flows is crucial.

3.

Cash flows are based on opportunity costs. Here we consider what the incremental cash flows aredue to the investment, as compared to the cash flows without the investment.

4. Cash flows are adjusted for tax payments, i.e. after-tax cash flows are taken.

5. Financing costs are not accounted for. Even though financing for a project may be done by raising

debt and equity capital, these costs are ignored. Instead, the operating cash flows are focused on

and the costs of debt (and other capital) are reflected in the discount rate.

6. Cash flows are recorded only when they actually occur and not when work is undertaken or a

liability is incurred.

A FEW BASIC CONCEPTS IN CAPITAL BUDGETING

SUNK COST

A sunk cost is one that has already been incurred. It is a past and irreversible outflow. Because sunk costs are

bygones and cannot be changed, they cannot be affected by the decision to accept or reject the project, and

so they should be ignored.

EXAMPLE: Lockheed had already spent $1 billion on the development of the TriStar airplane. In order to

continue its development, the company sought a federal guarantee to back a new bank loan for it. On the

one hand, those in favour of the project argued that it would be extremely imprudent on the part of the

company to abandon a project on which such huge capital expenditures had already been made. On the

other hand, some of Lockheed’s critics countered that it would be equally foolish to continue with such a

project that did not offer a satisfactory return on that $1 billion. Both groups were guilty of the sunk-cost

fallacy; the $1 billion was irrecoverable and, therefore, irrelevant. (Brealey)

PRINCIPLE: Today’s decisions should be based on current and future cash flows and should not

be affected by prior or sunk costs.

OPPORTUNITY COST

An opportunity cost is the worth of the next-best alternative that has been forgone in order to pursue the

current course of action. In capital budgeting, the opportunity cost of capital or the discount rate is theexpected rate of return that is foregone by investing in the project chosen rather than investing in the next-

best alternative.

EXAMPLES:

Suppose that a company already owns a building that could be used for a new project instead of

buying a new building. If the company’s managers decide to use this building, the company would

not incur the cash outlay of $12 million that would be required to buy a new building. Would this

mean that the $12 million expenditure should be excluded from the analysis, which would obviously

raise the expected NPV? The answer is that we should exclude the cash flows related to the new

building, but we should include the opportunity cost associated with the new building as a cash cost.




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For instance, if the building had a market value of $14 million, then the company would be giving up

$14 million if it uses the building for the project. Therefore, the $14 million that would be foregone

as an opportunity cost should be charged to the project.

If an old machine is replaced with a new one, what is the opportunity cost? The opportunity cost

here is the cash flows that the old machine would generate.

If $20 million is invested, what is the opportunity cost? The $20 million itself is the opportunity costhere since it could have been invested elsewhere.

PRINCIPLE: The opportunity cost of capital for an investment project is the expected rate of

return demanded by investors in common stocks or other securities subject to comparable risks as the project.

CANNIBALIZATION

Cannibalization takes place when an investment results in one part of a company taking away customers and

sales from another part. An externality is defined as the effect that an investment has on other things

besides the investment itself and cannibalization is one such externality. The lost cash flows due to

cannibalization should be charged to the new project. However, it often turns out that if the company would

not have produced the new product, some other company would have and hence, the old cash flows would

have been lost anyway. In this case, no charge should be assessed against the new project. All this makes

determining the cannibalization effect difficult, because it requires estimates of changes in sales and costs,

and also of the timing when those changes will occur.

EXAMPLE: Apple’s introduction of the iPod nano caused some people who were planning to purchase a

regular iPod to switch to a nano. The nano project generates positive cash flows, but it also reduces some of

the company’s current cash flows. This is a manifestation of the cannibalization effect because the new

business eats into the company’s existing business.

PRINCIPLE: Cannibalization can be important, so its potential effects should be considered and

any significant lost cash flows due to it should be charged to the new project.

INCREMENTAL CASH FLOWS

“An incremental cash flow is a cash flow that is the result of a specific decision made: the cash flow with a

decision minus the cash flow without that decision. If opportunity costs are correctly assessed, theincremental cash flows provide a sound basis for capital budgeting.” (Corporate Finance and Portfolio

Management) Most managers naturally hesitate to throw good money after bad. For instance, they are

reluctant to invest more money in a losing division. But occasionally turnaround opportunities can be

encountered in which the incremental NPV on investment in a losing division is strongly positive

EXAMPLE: Suppose that a railroad bridge is in urgent need of repair. With the bridge the railroad can

continue to operate; without the bridge it cannot. In this case, the payoff from the repair work consists of all

the benefits of operating the railroad. The incremental NPV of such an investment may be enormous.




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PRINCIPLE: The value of a project depends on all the additional/incremental cash flows that

follow from project acceptance and hence, incremental cash flows provide a sound basis for capital

budgeting.

PROJECT VALUATION METHODS:

The most comprehensive and often used measures of whether a project is profitable or unprofitable are the

net present value (NPV) and internal rate of return (IRR).

NET PRESENT VALUE (NPV)

For a project with a single initial investment outlay, the net present value (NPV) is the present value of

the future after-tax cash flows discounted at the relevant discount rate minus the investment outlay, or

where

Ct = the net cash receipt at the end of year t

Io = the initial investment outlay

r = the discount rate/the required minimum rate of return on the investment

n = the project/investment's duration in years.

EXAMPLE: Suppose a company is considering an investment of $70 million in a capital project that will

return after-tax cash flows of $20 million per year for the next three years plus another $30 million in

year 4. The required rate of return is 10 percent.

Here, the NPV would be

NPV= 20/1.1 + 20/1.1^2 +20/1.1^3 + 30/1.1^4 – 70

= 70.2274 – 70 = $0.2274 million.

Thus the investor’s wealth is expected to increase by a net of $0.2274 million. This indicates the decision

rule for NPV:

Invest if NPV > 0

Do not invest if NPV < 0

Positive NPV investments increase investor wealth whereas negative NPV investments decrease it. Many

investments have cash outflows that occur not only at time zero, but also at future dates. In this case, all

cash outflows are taken as negative and discounted at the required rate of return just as in the case of

positive cash inflows at different points of time.




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INTERNAL RATE OF RETURN (1RR)

For a project with one initial investment outlay, the IRR is the discount rate that makes the present value

of the expected incremental after-tax cash inflows equal to the investment outlay. In other words, it is

that discount rate that will cause the net present value of a project to be equal to zero or

Where

CF = the cash flow generated in the specific period (the last period being ‘n’)

r = the IRR

In the above example given for NPV, the IRR is the discount rate that solves the following equation:

-70 + 20/(1+IRR) + 20/(1+IRR)^2 + 20/(1+IRR)^3 + 30/(1+IRR)^4 =0

Algebraically, this equation would be very difficult to solve. Normally, trial and error method is resorted

to, systematically plugging various discount rates until one, the IRR, satisfies the equation. But financial

calculators and spreadsheet software have routines that calculate IRR easily, so the trial and error

method can be avoided. The IRR is 10.14 percent here.

The decision rule for the IRR is to invest if the IRR exceeds the required rate of return for a project:

Invest if IRR > r

Do not invest if IRR < r

In the above example, since the IRR of 10.14 percent exceeds the project’s required rate of return of 10

percent, the company should invest.

COMPARISON BETWEEN NPV AND IRR

NPV is a theoretically sound method that provides a direct measure of the expected increase in firm

value. Its main drawback is that it does not take the size of the project into consideration.

IRR provides information about “how much below the IRR (estimated return) the actual project

return could fall, in percentage terms, before the project becomes uneconomic (has a negative NPV)”

(Corporate Finance, Portfolio Management, and Equity Investments). Thus, the IRR reflects the

margin of safety that the NPV does not.

Project Ranking conflicts- In the case of two mutually exclusive projects, the decision rules for NPV

and IRR, as applied, might give conflicting decisions. For instance, for two mutually exclusive projects

A and B, project A might have a larger NPV than Project B whereas Project B has a higher IRR than

Project A. Differing patterns of future cash flows and dissimilar project sizes are some of the causes

of this situation. The thumb rule here is to always choose the project based on NPV.

Multiple IRR Problem- For projects with cash outflows not only at time zero, but also at other points

during its life or at the end of its life (projects with unconventional cash flows), there may be more

than one IRR.




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No IRR Problem- For projects with unconventional cash flows, it is possible that mathematically no

IRR exists at times. The lack of an IRR does not mean that the project is unprofitable; in fact, the

project may actually be a good investment.

PAYBACK PERIOD

The payback period is the number of years required to recover the initial investment in a project. This

period is sometimes referred to as" the time that it takes for an investment to pay for itself." The basic

premise of the payback method is that the more quickly the cost of an investment can be recovered, the

more desirable is the investment.

EXAMPLE:

Year Investment Cash Inflow

1 $4,000 $1,000

2 0

3 2,000

4 2,000 1,000

5 500

6 3,000

7 2,000

8 2,000

What is the payback period on this investment? The answer is 5.5 years, but to obtain this figure it is

necessary to track the unrecovered investment year by year. The steps involved in this process are shown

below:




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Year Beginning

Unrecovered

Investment

Investment Cash Inflow Ending

Unrecovered

Investment

(1) + (2) - (3)

1 $ 0 $4,000 $1,000 $3,000

2 3,000 0 3,000

3 3,000 2,000 1,000

4 1,000 2,000 1,000 2,000

5 2,000 500 1,500

6 1,500 3,000 0

7 0 2,000 0

8 0 2,000 0

By the middle of the sixth year, sufficient cash inflows will have been realized to recover the entire

investment of $6,000 ($4,000 + $2,000). (Accounting for Management)

The drawbacks of the payback period are apparent. Since the cash flows are not discounted at the project’s

required rate of return, the payback period ignores the time value of money and the risk of the project.

Additionally, the payback period ignores cash flows after the payback period is reached. Thus this method

provides a good measure of payback and not of profitability. But its simplicity and easy calculation make ituseful as an indicator of project liquidity. Thus a project with a two-year payback may be more liquid than a

project with a longer payback.

The discounted payback period partially addresses the shortcomings in the payback period method. It takes

the cumulative discounted cash flows from the project into consideration while calculating the number of

years it takes to recover the original investment. Thus, it takes the time value of money and risk of the

project into account, but this method also ignores the cash flows that occur after the discounted payback

period is reached. For a project with negative NPV, there will not be any discounted payback period since it

never recovers its original investment. The discounted payback period must be greater than the payback

period without discounting.

PROFITABILITY INDEX

The profitability index (PI) is the present value of a project’s future cash flows divided by the initial cash

outlay. It can be expressed as

PI = PV of future cash flows/ Initial investment = 1 + ( NPV/ Initial investment)

Thus, it can be seen that PI is closely related to NPV. The PI is the ratio of the PV of future cash flows to the

initial investment, whereas the NPV is the difference between the PV of future cash flows and the initial

investment. Whenever the NPV is positive, the PI will be greater than 1; conversely, whenever the NPV is

negative, the PI will be less than 1. (Corporate Finance and Portfolio Management)




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WHY MERGERS & ACQUISITIONS?

There are several reasons why companies enter into M&A activity. The prominent ones include:

1. Growth

Companies wanting to grow into bigger companies or enter into new avenues are most likely to

enter into M&A. It is typically faster for companies to acquire companies to grow themselves,

rather than invest money and resources in developing from within (organic growth). It’s always

less risky to acquire an established player rather than enter an unfamiliar market on one’s own.

Example: Indian Generic Pharma companies have become the target of many inbound M&A

deals as the foreign players look to protect their bottom line in wake of their drugs going off

patent. They increasingly see India as a potential market where they could leverage their sales

and distribution skills to expand their market share.

2. Synergies

Synergies occur when the combined company is worth more than the sum of the parts. Synergy

is a theoretical term and usually denotes enhanced revenues by means of cross selling or

reduced costs via economies of scale. Companies often end up paying huge amounts for targets

if they feel it can provide benefits in the long run. For example, Sanofi when it first made a bid

for Genzyme back in July 2010, its offer price was $69 - a 38% premium over Genzyme’s share

price of $50.

3. Increase Market Power

M&A that is done from the sole point of increasing market power is called Horizontal Mergers. In

it companies acquire firms in the same market. It is most likely to attract the ire of the regulator

as such mergers are looked as stifling competition.

4. Unlock Hidden Value

When an acquirer feels that the target company is underperforming for the moment, and it feels

it has the capability to unlock its potential. Companies engage M&A from this perspective if they

feel they can acquire the company for less than the Break Up value or the value obtained from

dividing the company and selling its assets.

5. Diversification

Companies enter into fields that are not at all related to their current field of activity to diversify

and shore up revenues in bad times. Diversification is sometimes viewed negatively by investors

because it doesn’t add to shareholder value as they are free to diversify their stock holdings

themselves. Example: BHP Biliton, a world leader in mining made a bid for Canadian Potash

manufacturer, Potash. The deal could not be consummated because of concerns from the

Canadian government.

6. Acquiring unique capabilities and resources

When companies feel they can no longer internally create cost effective capabilities needed to

grow, they engage in M&A, to acquire the desired capability. Companies believe they can get

resources for less than Replacement Value. Example: Low cost drug manufacturing and technical

expertise of most Indian Pharma companies have generated substantial foreign interest.




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M&A DEFINITIONS

o Mergers: When one (smaller) company is absorbed by another (bigger) company and the

smaller company ceases to exist.

o Acquisitions: When one defined segment of a company, assets of or the entire company isacquired by another it is termed an acquisition. Example: Abbott India acquiring the

domestic formulations business of Piramal Healthcare solutions.

o Reverse Mergers: Similar to a merger but the bigger company ceases to exist as it acquires

the smaller company’s name. Usually done when the smaller company has a more well-

known brand name. Example: ICICI Bank reverse merger back in 2001.

o Consolidations: A consolidation is similar to a merger except that both companies lose their

previous legal existence and form a new legal entity. Example: The Indian telecom tower

sector has seen a wave of consolidations this past year as smaller players look to exit the

market owing to lack of scale and efficiency.

METHODS OF VALUATION

There are several methods for valuation and depending on the industry different methods are the

gold-standard when it comes to valuing companies. In this section we will look at some of the most

common methods, discuss what is right or wrong about them and in which sector are they used the

most.

REPLACEMENT COST

This is method is used to value the firm by totaling the cost incurred in replacing the assets of the

firm today. This method reflects current conditions and is quite effect in valuing firms during periods

of high inflation.

But this method is not without its share of disadvantages – replacement cost is the cost of replacing

assets today, but usually managers don’t expect the old designs/assets to continue in the future.

Besides being subjective, it is also problematic to value intangible assets. Another question to be

asked before using this method is, what is being replaced and by what?

MARKET PRICE

The market value of the firm is simply the sum of market values of debt and equity. Market value of

equity can be obtained by multiplying share price with the number of shares whilst the market value

of debt can be calculated by using present value of estimated debt cash flows. In some cases bookvalue of debt (from balance sheet) is used as a proxy for market value of debt

As the market prices reflect what is known, this method is a logical place to start valuation if the

shares are actively traded in the market and the market is efficient i.e. the prices reflect all public

information available about the firm. It is therefore a useful metric for merger negotiations.

BOOK VALUE

Book value of a firm is derived from the books of accounting. It is a simple method for valuing firms

with audited financial reports. An advantage is that it reflects the principle of conservatism as

accounting relies on the same principle. The failings of this method include inability to value

intangible assets, based on past market information. Also, Book value is a backward looking figure,

whereas valuation needs to be forward looking.




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CASH FLOW BASED

There are different cash flows that can be used to calculate the value of the firm. Free cash flow to

firm (FCFF) and free cash flow to equity (FCFE) are two most common methods. Cash flow based

methods are excellent for valuation because they can be used for valuing a firm from a control

perspective which DCF doesn’t allow.

MULTIPLES BASED

Trading VS Transactional Multiples

o Both are examples of Relative Valuation in which valuation of a firm is compared with other

similar firms in the peer group. Such a valuation implies that like companies should have a

similar valuation.

o Trading Multiples of peer firms relies on the trading price of the firm scrip and valuation

multiples of the peer group to obtain a valuation for the firm.

o Transactional Multiples relies on transactions of similar firms in the market to obtain the

valuation of the desired firm. It requires data – actual prices and multiples, for acquisition of

“similar” firms in the market. Data can often be hard to get as most acquisitions are done in

private. Secondly, it is hard to describe “similar” firms. Thirdly, data should not be very old,

as market conditions change.

Financial

o Here we will see both price and enterprise multiples.

o P/E

Price-to-earnings ratio is the most common financial multiple and measures what

price an investor pays for 1$ of earnings.

The numerator is the price of the firm scrip, and the denominator is the Earnings per

share (EPS).

P/E can be trailing, based on the preceding 12 months or 4 quarters, or forwardlooking, based on the estimated 12 month or 4 quarter forward earnings.

Advantages

Ideally one would like to compare like-for-like. The Price in the numerator is

the market price and Earnings are what are used to pay out dividends to

shareholders

Disadvantages

EPS can be negative or zero, and in such cases P/E doesn’t make sense

EPS can be distorted by managers which affects the comparability among

peer companies

o P/BV

Ratio of price per share to book value per share. It reflects investment made by common shareholders in the company.

Advantages

Book Value is positive unlike EPS which can be negative or zero.

Book Value is more stable than earnings

Book Value is primarily beneficial for companies that are no longer expected

to be a going concern, in other words are expected to be liquidated.

Disadvantages

P/B may be misleading when the level of assets employed are different

Intangible assets are not included. Many-a-time acquisitions are done to

acquire the “human capital” which BV omits.




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Book Value reflects the historical cost of asset acquisitions. Hence P/B

doesn’t reflect the present scenario very well.

o EV/EBITDA

This is the most common enterprise multiple.

EBITDA is a measure of pre-interest, pre-tax operating cash flow to both debt and

equity holders; hence it makes sense to use Enterprise Value and not Price in thenumerator. EBITDA is frequently positive.

Enterprise Value (EV) is calculated as sum of market values of common equity, debt,

preferred stock minus the cash and short term investments. Short term investments

are subtracted as the acquirer must buyout both equity and debt holders and then

receives cash.

Advantages

EV/EBITDA is better than P/E when the levels of financial leverage differ

EBITDA includes depreciation and amortization while EPS is post both. Hence

for capital intensive business (subject to depreciation) EV/EBITDA is much

better.

o EV/S Enterprise Value-to-Sales is a better alternative to Price-to-Sales ratio because not all

sales are attributed to the equity investors. Also in a debt financed company, P/S is

not meaningful.

Non-Financial

Besides the set of financial ratios discussed above there are certain industry-specific ratios that are

non-financial in nature and are useful places to start valuation. Ideally one would want to use non-

financial ratios to triangulate the valuation rather than using it as a primary measure.

o Retail Companies Same stores sales

Sales per square meter

o Service Sectors

Revenues per employee

Net income per employee

o Hotel/ Hospitals

Average daily rate

Occupancy rate

o Financial Firms

Current Account Savings Account

Net Interest Margins

Monetary reserves

MEASURING CASH FLOWS

In an earlier section, we talked about the various methods of valuation and which is the methods to be

applied where. In this section we will start from the cash flow methods. A firm in its daily operations will

generate cash and we will use the cash so generated to value the firm.

FCFF/FCFE, DIVIDEND, RESIDUAL INCOME

Cash flow, as the name suggests, concerns the inflows and outflows of cash (liquidity) in a business. While

cash flows do not always convey much information about the profitability of the firm, they are of prime

importance as they indicate the ability of firm to finance its operating capital needs and the requirements of




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debt. For a growing firm, cash flows are usually negative because of high investment demands but they

become positive as the business matures.

Free cash Flow is the surplus cash available to the firm after making all its expenditures including investments

both in assets as well as working capital.

Free Cash Flow = EBIT*(1-t) + Depreciation/Amortization – Changes in Working Capital –

Investment in fixed assets

This cash flow is also called the Free cash flow to the Firm and is available to all the security holders of the

organization including equity and debt holders alike. Since debt holders also have a claim on the cash flow

described above, we can further find out cash flow available to equity holders called Free Cash Flow to

Equity (FCFE). FCFE additionally takes into consideration repayment of debt as well as new debt capital

raised by the firm. It is given by:

FCFE = FCFF + New debt – Debt Repayment – Preferred Dividends- Interest*(1-t)

Example: Following are the details for a firm: Net Income = $2,176 Million, Capital Expenditures = $494

Million, Depreciation = $ 480 Million, Change in Non-Cash Working Capital = $ 35 Million.

FCFE = 2176 + 480 – 494 – 35

FCFE = $2127 million

(Source: Damodaran)

Now, that we know what is the surplus cash available to the equity holders, the question arises as to what

does firm do with this cash? There are two options for the firm, either to invest further in the business or topay out the cash to equity holders in the form of dividends. Dividend is basically the portion of earnings of

the firm paid out to equity holders. In this context we define payout ratio with the ratio of earnings of the

firm distributed to equity holders

Payout ratio = Dividend per share / Earnings per share

Example: Consider a firm that has EPS of $2.5 and pays out $0.5 as dividend Then payout ratio = 0.5/2.5 = 0.2

The dividends are of particular interests to shareholders since that is the only way they get paid back for the

equity capital invested in the firm (except liquidation). Thus, dividends are instrumental in finding the valueof equity shares of a firm as we will see later.

So far, we have discussed about the cash flows available to firm and the equity holders. If, however, we

wanted get a better idea of the kind of returns shareholders are getting, we use another measure called

residual value or Economic Value Added (EVA)

EVA = income earned – cost of capital * capital employed

The advantage of using EVA is that it does not just look at the earnings of the firm but also takes into

consideration the returns on capital required or the cost of the capital. If a firm/division has a positive




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income but negative EVA, it means that the profits earned are not enough to cover the cost of capital and

thus the capital can be better employed elsewhere.

Example: Consider a firm which made an income of $130 million and employed capital of $1000 million.

Furthermore, the cost of capital is 10%. Then EVA = 130 - .1*1000 = $30 million

(Source: BMA)

DISCOUNT RATE

In the previous section we saw different measures for earnings and cash flows for the firm as well as the

equity holders. While defining EVA, we came across the concept of cost of capital. Now we shall examine this

in detail. For this, first let us define the expected return on assets, ra

Expected return on assets = r a = Expected income/market value of all securities

Here, securities include both the debt and the equity. Now, given that debt holders want a return of rD and

equity holders rE, and that the total market value of the firm is V which is equal to market value of debt D

and market value of capital E; question arises as to what is the overall expected rate of return from the firm

and does it affect on the leverage ratio (D/E)? If it does, then what is the optimal D/E ratio which maximizes

the value of the firm?

MODIGLIANI MILLER THEOREMS

Modigliani and Miller said that under the assumptions of perfect and frictionless markets, no transaction

costs, no default risk, no taxation, both firms and investors can borrow at the same rd interest rate; the value

of a firm is same regardless of its financing decision i.e. firm value is independent of D/E ratio. This is the first

proposition of Modigliani Miller Theorem. The MM theorem further states that:

a. Proposition2: The expected rate of return on equities of a levered firm increases linearly

with the debt/equity ratio.

b. Proposition3: The firm’s dividend policy does not affect its value, it only changes the mix of

debt and equity.

c. Proposition4: For new investment to be feasible, the marginal cost of new capital should

equal the average one.

Example: Consider a firm A, that is unleverd and firm B which has a Debt-equity ratio of 1. Let V denote the

value of firm, D denote debt, E the equity, P denote profit, and r d be the interest on debt. Suppose there are

100 shares of A each of price 1Re and firm B has 50 shares at price 1Re and the other 50 comes from debt.

Now if one buys 10% of shares for company A then his reutrn on investment would be .1*P. Compared to

this if one purchases the same fraction of debt AND equity from firm B his returns would be – 0.1*(P-

interest) + 0.1*interest = 0.1*P which is the same as in previous case. Thus in a perfect market both firms

would be valued equally as long as investers can lend (or borrow) money on same terms as the firm.

What implication does Modigliani Miller theorem have for the Expected return on assets ra? Since a firm’s

borrowing decision does not affect its total market value, it does not affect the expected return on firm’s

assets ra. The expected return thus, is simply a weighted average of expected returns on individual holdings.

Expected return on assets,

Where, D is the market value of the Debt, E is the market value of the Equity, and rD and rE are the cost of

debt and equity respectively.




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WEIGHTED AVERAGE COST OF CAPITAL

In the absence of taxes, this is also the Weighted Average Cost of Capital (WACC). With the presence of tax,

however, the interest paid by the firm on its debt is tax deductible and thus the after tax cost of debt

becomes rD*(1-T) and thus for the firm, the weighted average cost of capital comes out to be

WACC =

Where, D is the market value of the Debt, E is the market value of the Equity, T is the Tax rate and r D and rE

are the cost of debt and equity respectively.

Example: Consider a firm for which cost of debt = 8%, cost of equity = 15%, tax rate = 35% & D/E =

9.According the formula, WACC = 0.08*(1-0.35)(0.9)+0.15*0.1 = 0.62 = 6.2%

In order to gain a better understanding of WACC, let us explore each of the terms further.

COST OF DEBT

Cost of debt (rD) is the rate of interest that has to be paid on the debt capital issued by the firm. Usually, itdepends on the leverage ratio (D/E) of the firm and the default risk. If the D/E ratio increases, then the

probability that creditors will not get fully reimbursed if the firm is dissolved increases which leads to a rise in

cost of debt. Thus, the cost of debt can be modeled as a risk free rate plus a risk premium which incorporates

the risk of default. Since cost of debt is composed of interest paid, it is fairly easy to calculate.

COST OF EQUITY

Cost of Equity (rE) is the rate of return demanded by the investors. It is effectively the opportunity cost of

investing in the firm for equity holders. Since, creditors have the first claim on the assets of the company;

cost of equity is greater than the cost of debt. Estimation of cost of equity presents considerably more

challenge compared to the cost of debt. For estimating rE we can use the Capital Asset Pricing Model (CAPM).

According to CAPM,

Expected return on stock = r f + β(r m – r f )

Where rf is the risk free rate of return, rm is the expected rate of return on market portfolio and beta is the

measure of market risk on the stock i.e how sensitive it is to movements in market.

Since, cost of equity is greater than cost of debt, one may wonder if it is possible to reduce overall WACC by

taking more and more debt. The answer ofcourse is that it cannot be done and the reason comes from

Modigliani Miller theorem. With increase in leverage, the cost of equity rises (since with rising debt, the risk

for equity holders increases). Exactly how much does the cost of equity increase can be calculated as follows:

The firm’s asset Beta can be written as

β a = βD *(D/D+E) + βE *(E/D+E)

Now, when D/E ratio changes, since ra does not depend on financing decision of the firm (MM), β a remains

unchanged. Thus, for the original D/E ratio and using original βE, calculate the βa. This is called unlevering the

β.

Equity for new leverage ratio can then be calculated as




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This process is called relevering the β. Once we have the new equity β, we can calculate the new cost of

equity (using CAPM) and then calculate the new WACC.

INTEREST TAX SHIELD

If the return on debt is rD and the market value of debt is D then:

Interest Payment I = r D*D

This interest is tax deductible, which leads to following implications. If interest were not tax deductible we

would have had to pay entire I from EBIT *(1-T) and thus out net income would have been, net income = EBIT

(1-T) – I

Now, due to the tax laws, we can play interest from EBIT and they pay taxes, therefore

Net income = (EBIT – I)*(1-T) = EBIT(1-T) – I + I*T

The difference between of I*T is called the interest tax shield. It arises because interest paid on debt is tax

deductible. Furthermore,

PV(tax shield) = T*I/r D = T*D

Thus, the effective payment becomes rD*D – T*D = (rD-T)*D and hence, we see that effective cost of debt

become rD*(1-T) as was mentioned earlier.

Now, that we have a deeper understanding of each of the components of WACC, let us see what exactly does

WACC signify. WACC essentially is the hurdle rate or the discount rate for the firm. It is the rate of return the

firm must be able to achieve to justify investment of capital. WACC can also be used as a discount rate for

any new projects that the form might take, but only if the D/E ratio for the new project is same as firm D/E

and project is as risky as firm’s other assets are on an average.

VALUATION

DCF:

So far, we have seen ways to measure the cash flows and income of a firm and what is the cost of capital that

it incurs on the capital employed for generating the income. Now, we know that NPV of any project is the

present value of cash flows. Thus, NPV of a firm can be calculated as the present value Free cash Flow to the

Firm with the hurdle rate being the cost of capital for the firm (WACC). This model of valuing a firm is called

the Discounted Cash Flow Model. The value of a business is usually computed as discounted value of Free

Cash Flows till valuation horizon, plus present value of the forecasted value of business at the time horizon.

Thus, the present value of a firm is given by

Where FCFi represents Free cash flow to firm in period i, and H is the horizon. PVH is the expected value of

firm after period H, the horizon chosen for valuation.

Valuation horizons are used because it would be impractical and error prone to try and calculate cash flows

till infinity. PVH is effectively an estimate of discounted cash flows from year H+1 onwards. It can be

calculated in many ways, some of which are constant growth method, based on P/E ratio etc.

DDM:

Another method for valuing a firm would be to calculate the value of equity and then add the value of debt.

To calculate the value of Equity, we need the price of a share. Let us see how it can be calculated. We know

that price of any project/investment is equal to the discounted cash flows in future years. For an equity




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investor (who does not sell his share) the cash flows from equity investment are the dividends and thus the

value of share is the discounted present value of all the future dividends. This is known as the dividend

discount model. Under this model, if DIV1 is the dividend paid out at the end of first term, r is the hurdle rate

and g is the rate of growth of dividends, then current price

P0 = DIV 1 /(r-g)

And why do the dividends grow? Because the firms do not pay out all of the earnings as dividends. Some of

the earnings are reinvested into the business and earn incremental income leading to growth in dividends as

well. Recall, that the ratio of earnings paid out as dividends is called the payout ratio = DIV/EPS (where EPS is

earnings per share).

Thus, 1- DIV/EPS represents the fraction of income reinvested in the business. This is called the plowback

ratio. The ploughed back capital would earn a return equal to the Return on Equity earned by the company

and thus if the payout ratio stays constant, the income and hence the dividend would grow at g = plowback

ratio * ROE.

A major assumption that we have made in the above discussion is that all these ratios remain constant which

is rarely the case in real life scenarios. For stocks with variable growth rates we find dividends for each year

separately and then sum the discounted value to get the price of stock. The process is similar to that in DCF.

Where DIVi represents dividend in i

th

period and PH is the expected price of stock at the end of period H.Usually H is chosen to be the time when the firm’s growth is expected to stabilise.

Example: Consider a firm that has an EPS of Rs. 10 and a payout ratio of 0.5. Furthermore, the ROE is 15%,

and discount rate is 10%Then, g = 0.5*0.15 = 0.075;P = Price of share = 10*0.5/(.1-0.075) = Rs. 200

FINANCING

THE PECKING ORDER THEORY OF FINANCE

As per the Pecking Order Theory of Finance, a firm prefers to utilize internal sources of funding i.e. retained

earnings over external sources of funding. Further, in the latter case, a firm would prefer to issue debt over

equity. The theory is based on the idea that information asymmetry between a firm’s managers and

shareholders and transaction costs incurred in raising funds from external sources influence the firm’s choice

of capital structure.

Consider a firm which needs funds for a project. It can raise debt or equity or use internal accruals. If the

firm’s prospects are more positive as compared to its current market valuation, it would prefer to issue debt

rather than issuing equity as it is undervalued. On the contrary, another firm which has poorer prospects vis-

à-vis its current market valuation would prefer to issue equity over debt to avoid worsening its financial

position.

However, there is information asymmetry between investors who are external to the firm and the managers

who run the business. Consequently, investors tend to draw inferences from the actions of the managers.

Rational investors would conclude that an equity issuing firm has an overvalued share price and debt issuing

firms have an undervalued one. Hence, the share price of an equity issuing firm would fall. To avoid this fate,




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the manager of the firm with poorer prospects would issue debt as well. Therefore, while raising external

financing a firm irrespective of its prospects would prefer issuing debt to issuing equity. However, both

managers would prefer internal accruals over external sources of financing as it doesn’t incur any transaction

costs & carries no signaling risks.

A conclusion of this theory is that, the more profitable the firm the higher its reliance on internal accruals

and lesser its recourse to debt. On the contrary, a less profitable firm will issue more debt as its internalaccruals would be inadequate to meet its capital requirements. Therefore, within an industry there will be

inverse relation between the profitability and debt-equity ratio of companies.

DEBT: TRANCHES AND SENIORITY

A debt is an obligation to repay money.

Debt can be secured or unsecured. Secured debt is collateralized with assets which are pledged by the

borrower to provide protection to the creditor. In case of default, the creditor can sell the collateral to

recover the outstanding dues. On the contrary, unsecured debt has no underlying collateral and hence

carries more risk for the creditor. Due to this, for the same borrower, secured debt is cheaper than

unsecured debt.

Debt is also classified as senior or subordinated. Senior debt is the debt that gets priority in repayment in

case of a default. It is ranked higher in the corporate debt hierarchy as compared to junior or subordinated

debt. Due to its junior status and unsecured nature, subordinated debt is riskier and carries a higher interest

rate.

A subordinated debt is typically issued to the promoters of the company as external creditors would demand

a risk premium for holding unsecured debt.

Mezzanine debt is debt that has the characteristics of both debt and equity. It has equity characteristics in

the form of embedded equity based options and is ranked lowest in the debt hierarchy just above preferred

stock. Mezzanine debt is issued to finance acquisitions and is issued quickly without thorough due diligence.

Consequently, it carries a very high rate of interest.

Seniority in the capital structure:

Priority Instrument

1 Debt

a Senior Secured

Debt

b Senior Unsecured

Debtc Subordinated

Debt

d Mezzanine Debt

2 Preferred Stock

3 Ordinary Shares




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EQUITY: TRANCHES AND SENIORITY

There are two main types of equity: preferred stock and common stock.Preferred stocks or preference shares are senior to common stocks as they have preference over common

stocks in dividend payouts arising from liquidation or distribution of earnings. A preferred stock usually

carries no voting rights and may have no fixed maturity. If a preference share has no fixed maturity, it is a

called a perpetual preference share. Due to their fixed dividend, a preference share usually holds less

possibility for appreciation as compared to a common stock.

Depending on whether the dividend payable on a preferred stock is deferrable or not they are classified as

cumulative and non-cumulative. Depending on whether a prefer stock is callable or not they are classified as

redeemable or irredeemable preference shares. If the preferred stock is convertible into equity, it is called a

convertible preferred stock.

Unlike common stocks preferred stocks have no voting rights.

Common stocks

Common stocks or ordinary shares are the least secured claims in the capital structure of a company. They

are ranked lower to all types of debt and preferred stock and form the residual claim on a company’s assets

during liquidation. Consequently, equity holders are the last to be paid off during distribution of profits.

Common stocks usually carry voting rights. These rights enable shareholders to vote at meetings, nominate

directors and decide the corporate policy of the company. However, unlike preferred stock, there is no fixed

dividend payable to common stock holders which makes their returns volatile. A major attraction of common

stocks is the potential for capital appreciation which they offer. Common stocks are perpetual in nature and

extinguish only on liquidation of the company.

IPO –INITIAL PUBLIC OFFERING

When a company offers its shares for subscription to the public for the first time, the offering is called an

Initial Public Offering. An IPO could be dilutive or non-dilutive or a mix of the two. In a dilutive offering, fresh

shares are issued to new subscribers which dilute the EPS and shareholding for the existing shareholders. In

non-dilutive offering existing shareholders sell some or all of their shares as part of the offering thereby

keeping total number of shares & EPS constant.

An IPO involves taking a private company public. Reasons for undertaking an IPO include lower cost of

capital, greater liquidity for shareholders, opening up newer sources of funding, greater prestige related to

being a public company, raising funds without reducing control (loss of Board seats).

An IPO is undertaken through underwriters who form a syndicate to sell the issue to the public. The

underwriters also buy the non-subscribed portion of shares in case actual subscription is below expectations.The pricing of an IPO is a contentious issue for both the company and investors. An underpriced issue could

lead to oversubscription but will also imply that the company has left too much money on the table. An

overpriced issue would lead to under subscription and could lead to losses on listing to investors which is

also not desirable.

Some of the recent oversubscribed IPOs include Coal India, MOIL, Punjab & Sind Bank Ltd. The IPO of A2Z

Maintenance was under-subscribed 0.33 times.




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Steps in IPO process

FPO- FOLLOW-ON PUBLIC OFFER

Any public issue of shares by a company subsequent to an IPO is called a follow-on public offer (FPO).

NTPC and NMDC came out with FPOs recently.

SEO-SEASONED EQUITY OFFERING

A Seasoned Equity Offering is a FPO by an established company whose shares have substantial liquidity and

trading volume in the secondary markets

A seasoned equity offering could be either dilutive or non-dilutive.

RIGHTS ISSUE

A rights issue is an invitation to the existing shareholders to buy more shares of the company. The number of

shares offered in a rights issue is in a fixed proportion to their current holdings. The rights are similar to a call

option as they vest in the rights owner the right to buy a specified number of shares at a pre-specified price

on a stated maturity date. The rights holder can exercise the rights, allow them to lapse or sell them to other

investors. The intrinsic value of the rights helps to compensate the shareholder for the subsequent dilution.

However, if the rights are ‘Non-renounceable’ they will not be tradable.

Appointment ofI-bankers &Registrars

Submission ofDraft OfferProspectus

SEBI ApprovesDraft OfferProspectus

SubmitProspectus to

Stock Exchange

Distribution of

RHP & Forms toInvestors

Issue open forSubscription

Price Fixedbased on bids

Processing ofApplications by

Registrar

Actual Listing

Step 1




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Rights issues are usually preferred by companies with weak balance sheets when they are unable to borrow

money. The rights issue was also preferred as a source of funding during the credit crisis when external

funding sources dried up. However, rights issues are also made by companies with strong balance sheets to

meet capital expenditure plans and to fund acquisitions.

SBI is planning a Rs 20,000 crore rights issue to bolster its capital ratios. Industrial & Commercial Bank of

China Ltd recently concluded a $1.68bn rights issue.

QIP- QUALIFIED INSTITUTIONAL PLACEMENT

A QIP is a means of raising capital in which a listed company issues securities directly to Qualified

Institutional Buyers (QIB). QIBs are sophisticated investors who due to their expertise and financial strength

need less protection from issuers as compared to retail investors. The securities issued under a QIP can be

equity shares or any other securities convertible to equity shares except warrants.

QIPs involve few procedural & regulatory requirements and hence are a quicker mode of raising capital as

compared to other options. Indian companies were found to prefer foreign markets for fund raising due to

their less complicated requirements. To prevent excessive dependence on foreign capital, QIPs were

introduced in India. During the credit crisis, cash strapped Indian companies issued a number of QIPs to

repair their debt laden balance sheets.

Adani Enterprises (Rs 4,000 crore) and Tata Motors (Rs 3,350 crore) are some of the recently concluded QIPs.

AUCTIONS

Dutch Auction:

A Dutch auction is a type of auction in which the auctioneer lowers the asking price till a bid is obtained. In

case of a securities offering, a Dutch auction is used by the issuer to achieve a lower interest rate in case of

bonds and a higher share price in case of equities. The issuer invites bids from investors within a pre-

specified price range. Once the total bids at every price point are listed, the share price is lowered from the

higher end of the price range till the desired amount of subscription is obtained. The price at which this

happens is called the cutoff price. In case of bonds the bids are listed in ascending order as per the interest

rate demanded. The interest rate is increased from the lowest interest rate onwards till the issue is fullysubscribed. The price/ interest rate so fixed is applicable to all bidders whose bids have been accepted. In

case the total eligible subscription exceeds the number of shares/ bonds offered, the allocation can be made

on a pro rata basis. In case the subscription is inadequate the offer can be scrapped.

French Auction:

In a French auction, the issuer sets a minimum reserve price below which no subscriber can bid. Once the

bids have been received, the issuer and the securities regulator check the bids and decide a minimum and

maximum price range for eligible bids. All bids above the maximum price range are disqualified. Allocation is

made to bidders within the price range on a pro-rata basis.

Unlike the book-building route in which the upper level of the price band is also fixed, a French auction has

no upper price cap which leads to better price discovery.The French auction was used during the NTPC and REC FPOs.

PAYOUT

In this section we will discuss what choices the firms have while paying its shareholders.

STOCK SPLITS

A stock split increases the number of shares held by investors by reducing the face value of existing shares.

Consequently, though the number of shares increases, the proportional ownership of each shareholder in

the company remains constant. Also as the market capitalization remains the same, the share price falls in

inverse proportion to the stock split ratio.




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For e.g. a 2:1 stock split of a share with face value 10 and market price 100 will create 2 shares with face

value 5 each and market price 50 respectively.

Companies undertake stock splits to improve the liquidity of their shares by making them more affordable.

Hence, stock splits are undertaken by companies whose shares have risen to high levels. Usually, the post-

split fall in the share price increases demand for the shares driving up the stock price.

The stock of LIC Housing Finance recently underwent a 5:1 stock split.A reverse split is a form of stock split in which companies increase their currently low share prices by

reducing the number of shares issued. This is done by ‘reverse splitting’ or ‘merging’ shares thereby

increasing face value as well as market value of the share. Reverse-splitting is undertaken by companies to

gain a respectable share price or to mitigate the risk of delisting due to currently low stock price.

BONUS SHARE

When a company gives free additional shares to its shareholders, it is called a bonus share. In a bonus issue,

the shares are awarded in fixed ratio per existing share thereby maintaining the same proportional

shareholding as before. Unlike a stock split, post bonus issue the face value per share remains constant.

However, other per share metrics such as EPS and book value per share fall proportionately.

The accounting effect of a bonus issue is to convert reserves and surplus into paid up share capital.

The Board of Directors of ONGC Ltd has recently announced a 1:1 bonus issue.

STOCK REPURCHASES

In a stock repurchase a company buys back its own shares from shareholders in exchange for cash . The

bought back shares are either extinguished or held in a treasury account for resale after the share price

appreciates.

The various modes of share repurchase include:

1. Open market repurchase: In this mode of repurchase, the company may either notify its intention to

repurchase or post-facto declare the amount of shares repurchased.

2. Fixed Price tender: In this, the company specifies the single price at which it will repurchase shares

along with disclosures about maximum number of shares sought, duration of tender offer etc.3. Dutch auction: Shareholders are invited to offer their shares within a pre-specified price range. The

offer price is fixed at that price at which the offers tendered cumulatively satisfy the firm’s buy -back

requirement. All offers at and below this price are accepted and paid the offer price. If the number of

shares tendered exceeds the buy-back requirement, shares may be bought on a pro rata basis.

The various reasons for undertaking share repurchase are to:

1. Pay excess cash to investors by buying out their shareholding.

2. Benefit from depressed share prices by buying shares for treasury portfolio

3. Signal undervaluation by repurchasing shares at a premium to market price

4.

Improve the EPS by reducing number of shares outstanding.5. Share repurchases are a more tax efficient way of payout in certain jurisdictions with double taxation

of dividends.

Lakshmi Machine Works Ltd has recently announced a share buyback plan. Hindustan Unilever Ltd has an

outstanding buy-back offer under which it will buy shares till a specified date for a maximum price of Rs 280

per share.

DIVIDEND (PAYOUT POLICY)

Dividends are distributions of earnings to shareholders. Dividends are usually in cash or shares but can be in

the form of assets such as products or services. We will look at cash dividends. Cash dividends are necessarily

paid out of the retained earnings of a company and cannot be paid from the paid up share capital.




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Dividends are perceived by the market as signaling mechanisms which indicate the health of the business. A

cut in the dividend could be perceived to reflect deterioration in business fundamentals and consequently

punished with mass selling of shares. Consequently, company executives are reluctant to change the

dividend unless and even borrow to meet dividend expectations. Also, managers avoid making dividend

increases which they may be to reverse later. Consequently, dividend increases usually lag sustainable

growth in profits. Also executives prefer to distribute transitory earnings or cash hoards through sharerepurchases rather than dividends.




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