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Financial Management
Faculty: Gautam Negi
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Karma
Dharma
Moksha
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The Essence of Theory Lies in Practical
Application
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Objectives
Clarity on concepts
Ask questions reason..keep me on my toes.
Get attentive, interested and interactive
Peer learning
Stay disciplined and punctual
Love the subject.it will love you back
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There are no shortcuts in learning
We will create a glossary of 1000 financialwords in the next 3 months
Reference Books:
Prasanna Chandra
Van Horne
I M Pandey
Damodaran
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COURSE LAYOUT
INVESTMENT
FINANCING/WCMgmt
DIVIDEND VALUATION
Capex decisionsComplex decisionsCost of CapitalCash FlowRisk Analysis
Sources of Finance Capital Structure Deci Leveraging Inventory Mgmt Cash Mgmt
Dividend Relevance Dividend Irrelevance Value of firm
sential Tools:Time Value Of MoneyAnalysis Of Financial StatementsRisk Return Trade Off
Valuation concepts and Models(CAPM/APT)
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Contents
Introduction
Agency Costs
Time value of money
Valuation of Assets
Risk, Return, Portfolio
Beta Estimation
Financial Statements
FS Analysis
Capital Budgeting Decisions
Cost of Capital
Cash flow estimation
Risk Analysis in Capex
Operating and FinancialLeverage
Capital Structure
Introduction to Dividends
WC Management
Receivables Management
Inventory Management
Cash Management
WC finance
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Financial decisions can also be classified as
Long term
Short term
Functions of a Finance Manager Funds raising(Asset Mgmt-> Liability Mgmt-> Funds
Mgmt).
Funds Allocation
Profit Planning(Pricing/Cost/Volume Of Output)
Understanding the capital Markets
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The firm and its Objective..
Defining the Firm
Why a UNIQUE OBJECTIVE
Unique helps in harmony in decisioning Objective gives direction and must be SMART
Objective of the firm-> max value of
the firm-> Max Stock Price Managers are appointed by SHs. lenders can
protect themselves contractually
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Why Stock Price as the Objective
Most observable and updated constantly
Stock price reflects the long term effects ofthe firms decisions
Stockholders can liquidate and receive valuenow
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Agency Costs
MANAGERS
Shareholders
Society
Bondholders
FinancialMarkets
Firm positioned in an ideal world
Stockholders andManagers
Stockholders andBondholders
Firm and the Financial
Markets
Conflict betweenGroups
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Agency Costs between Groups
MANAGERS
Shareholders
Society
Bondholders
FinancialMarkets
Investing in badprojects
Overleveraging Overpaying on a
takeover Giving high dividends Resisting company
takeover
Overleveraging
Suppressing/delaying Info (eg.Satyam)
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Should stock price be taken as ameasure of Managerialperformance
Ability of the managers to suppress/delay info
Efficiency of the Capital Markets
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Ways to reduce Agency Costs
SHs and Managers
Disciplining the managers through an effectiveBoard/AGM
Making Managers think like SHs Threat of takeovers(Greenmail/Poison Pills/Golden
Parachute)
SHs and Bondholders
Bond Covenants(Affirmative/Negative)
Restricting investment policy/dividendpolicy/additional levarage.
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Ways to reduce Agency Costs
Firms and Financial Markets
Role of regulatory bodies(SEBI)
Making markets more efficient
Firms and Society
Corporate Citizen Behavior
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Other possible Objectives
Max of Profits
Window dressing/focus on the current only/ignorestime value of money
Max Market Share(Japan/China) Max Growth/Size/Revenues
Social Welfare Objectives..
conflict behind wealth maximization as an objective and Social welfare is the rhools have introduced Ethics in the curriculum
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Defense strategies against possibletakeover
Golden parachute
Greenmail
Poison Pills
Sell valuable portfolio(crown jewels)
Increase leverage Use up excess cash
Third party partnership with a break up fee.
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Introduction to FS
Suppliers of
funds:IndividualsCompanies
Govt
Demanders offunds:IndividualsCompanies
Govt
FinancialInstitutions
BanksInsurancecompanies
Mutual fundsProvident funds
Financial Markets
Funds
Funds
Deposits/shares
securiti
es
loans
Loancontract
securities
funds
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Time Value Of Money
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Time Value Of Money
Money has time valuewhy
Productivity
Why do you need to earn interest..
Presence of inflation
Preference to current consumption
How much return must you expect
Real rate
Inflation
The Fischers Effect
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Cont
Concept of compounding/discounting
Concept of SI/CI
FV of an amount being compounded Continuous compounding
Understanding the doubling rule
Rule of 72
.35+69/r
2=(1+r)n
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Time Value Formulae
PV of CF
FV of a CF
PV of an Annuity
FV of an Annuity
Finding Annuity given PV
Finding Annuity given FV
PV of a growing annuity
PV of a growing annuity to perpetuity
PV of a Perpetuity
Mathematically derive allthe formulae
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Uses of Time Value
In personal finance decisions
Amount to save annually
Annual deposit in sinking fund
Calculating annual growth
How long to wait
Determining periodic withdrawals
In Capex Decisions
NPV/IRR
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Teasers
A company currently has 1000 employees and thenumber is expected to grow at 20% perannum.How many employees will the companyhave 10 years from now.
ABC ltd had revenues of 100 lacs in 2000 whichincreased to 1000 lacs in 2010..What was thecompound growth rate in revenues.
Suppose you deposit Rs.50000/= per year in a fundwhich gives you an interest of 10%.What is the
value 20 years from now.
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Teasers
You want to buy a house after 5 years whenit is expected to cost 20 lacs. How muchshould you save annually if your savingsearn a compound return of 12%.
ABC ltd has an obligation to redeem Rs.500lacs bonds 6 years hence..how much shouldthe company deposit annually in a sinkingfund account wherein it earns 14% interest.
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Teasers
6. A finance company advertises that it will pay a lumpsum of Rs.8000 at the end of 6 years to investors whodeposit annually Rs.1000/= for 6 years..What interestrate is implicit in the offer?
7. You want to take up a trip to the moon which costsRs.10 lacs..You can save annually Rs.50,000 to fulfillyour desire..How long will you have to wait if yoursavings earn an interest of 12%.
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Teasers
9. Your father deposits Rs.3 lacs on retirementin a bank which pays 10% annual interest..howmuch can he withdraw annually for a period of10 years.
10. At the time of his retirement Mr.X is given achoice a) An annual pension of Rs.10000 for 15years b) a lump sum amount of Rs.50000todayAssuming an interest rate of 15%
which offer looks more attractive.
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Teasers
As a winner of the competition you can chooseone of the prizes:
Rs.5 lacs now
Rs.10 lacs at the end of 6 years
Rs.60000 a year forever
Rs.1 lac per year for 10 years
Rs.35,000 next year and rising thereafter by 5% peryear forever
If the interest rate is 10% which prize has thehighest PV.
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Teasers
You are 35 years old today and are considering your retirement needs. You expect to retire atage 65 and your actuarial table suggests that you will live to be 100you want to move toBahamas when you retire you estimate that it will cost you Rs.3, 00,000/= to make the moveon you 65th birthday and that your living expenses will be Rs.30000/= per year starting theend of 66th year and continuing through the end of year 100 after that
How much will you need to have saved by your retirement date to be able to afford this course of action
You already have Rs.50,000 in savings if you can invest money, tax free, at 8% a year, how much wouldyou need to save each year for the next 30 years to be able to afford this retirement plan
If you did not have any current savings and do not expect to be able to start saving money for the next 5yrs, how much would you have to set aside each yr after that to be able to afford this retirement plan
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Teasers
You are an investment advisor who has been approached by a client forhelp on his financial strategy.he has Rs.2, 50,000/= in savings in thebank..he is 55 years old and expects to work for 10 more years makingRs.1,00,000 per yearhe expects to make a return of 5% on his investmentfor the foreseeable future.
Once he retires 10 years from now, he would like to be able to withdraw Rs.80,000 ayear for the following 25 yearshis actuary tells him he will live to be 90 years
old..how much would he need in the bank 10 years from now to be able to do this.
How much of his income would he need to save each year for the next 10 years to beable to afford these planned withdrawals( Rs.80,000 a year after the tenth year)
Assume that the interest rate declines to 4% ,10 years from nowhow much, if any,would your client have to lower his annual withdrawal, assuming that he still plansto withdraw cash each year for the next 25 years.
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Teasers
A father is planning a savings program to put his daughter through college. His daughter is now 13years old. She plans to enroll at the University in 5 years and it should take her 4 years to complete hereducation. Currently the cost (for everythingfood, clothing, tuition, books) is Rs.12500 but a 5%annual inflation rate in these costs is forecasted. The daughter recently received Rs7500 from hergrandfather; this money which is invested in a bank account paying 8% interest compounded annuallywill be used to help meet the costs of the daughters education. The remaining costs will be met bymoney the father will deposit in the savings account. He will make 6 equal deposits to the account onedeposit in each year from now until his daughter starts college. These deposits will begin today and willalso earn 8 % interest compounded annually.
What will be the PV of the cost of 4 years of education at the time the daughter becomes 18? What will be the value of Rs.7500 that the daughter received from her grandfather when she starts college at age
18?
If the father is planning to make the first of 6 deposits today, how large must each deposit be for him to be able toput his daughter through college?
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Valuation.Bonds and
shares
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Concept of Valuation of assets
Assets
Real Assets
FinancialAssets(Bonds/Shares)
Concept of shares---> converting physical assets into financial instru
Principle of Valuation: Discounting all future CFs. Will depend on Certainty of CF Magnitude of CF Discounting Rate
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Cont
Concept of Value..
Book Value
Replacement value
Market Value
Going Concern Value
Liquidation Value
Present Value
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Understanding Bonds
What is a Bond(Par Value/Coupon/Maturity/Term)
Types of Bonds
Fixed Rate Bonds
Floating Rate Bonds
Call /Put Option Bonds
Zero Coupon Bonds
Secured/Unsecured Bonds
Perpetual Bonds
Convertible Bonds
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Cont
Interest rate on Bonds..
Coupon Rate
Current Yield
YTM: Bonds with Maturity/Perpetual ( PV= PV of Interest+ PV of
Maturity Value).
Relationship between Coupon Rate/YTM
Coupon Rate> Required Yield--> Bond Sells at Premium
Coupon Rate= Required Yield-- > Bond Sells at Par
Coupon Rate< Required Yield-- > Bond Sells at Discount
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Cont..
Valuation of Bonds
Bonds with Maturity
Perpetual Bonds
Deep Discount Bonds
Impact of changes in r on Bond Value
Valuation of Preference shares
Types of Preference Shares
Redeemable/non redeemable
Participative/non participative
Cumulative/ non Cumulative
Convertibles/non convertibles
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Cont
Bond Duration/Average Maturity
Volatility Of Bond
Impacted by Duration/Yield Valuation of bonds in the B/S
HTM
AFS AFT
Bond Rating Agencies..
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Cont
Valuation of Shares..
The Gordons Model
Assumptions:
The firm declares dividends
r > g
g is constant
Difficulty in valuation of shares.. Dividend declared is discretionary
Difficult to assess g
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Cont
Specific cases..
When the g is constant
When g is zero
When the firm pays no dividends Assume div is paid after n years
P/E Model
Relationship between Stock Price/Dividends
and Earnings g is a function of retained earnings and
ROE.
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Year BV EPS(10%)
DPS(40%)
RE(60%) EndingBV
1 100 10 4 6 106
2 106 10.6 4.24 6.36 112.36
3 112.36 11.24 4.49 6.74 119.10
4 119.1 11.91 4.76 7.15 126.25
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Risk & Return
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Introduction..
Concept of Return
On a single asset eg shares
Arithmetic Mean/Geometric Mean(CAGR)
Expected Return
Concept of Risk
Deviation from the average
Standard Deviation/Variance
S.D and Normal Distribution
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Understanding Portfolio..
What is a Portfolio
Return on a Portfolio
Rp=Rx * Wx + Ry*Wy Rp is a fn ( security returns/weights)
Risk in a Portfolio( why portfolio isless risky)
Economy Probabilit
y
Return
A(%)
Return
B(%)
Good .5 40 0
Bad .5 0 40
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Measuring for a two Asset case
The relationship
Influence of Covariance/Correlation
The relationship between Cov/Correlation Finding the min variance portfolio(=0)
Analysis:
=-1/0/1
Portfolio Risk for a n security case 1/n(Average Var) + (1-1/n)*(Av Covariance)
Impact of increasing n in the portfolio.
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Risk
Systematic
Unsystematic
R= SR+USR
No of Securities->
SR
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2 = 1/n (Av Var) + (1-1/n) (AvCovar)
USR SR-> cannot be diversified with n
Combining a risk free security and arisky security:Return Weights S.D
A 5% .5 0
B 15% .5 6
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Risk Return Models
CAPM
Establishes a relationship
Simple to understand
Used in estimating Kc and Valuation Models
Assumptions
Market Efficiency
Homogeneous expectations of risk and return Risk free rate
E(Ri) = Rf + i{ E(Rm) - Rf}
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Risk Return Models
Arbitrage Pricing Theory(APT)
What is Arbitrage(advantage of price differential)
The theory divides risk into twocomponents(predictable/unpredictable)
Predictable is Rf while Unpredictable can be firm specific(URs)/market specific(URm)
E(Ri) = Rf + (1F1+2F2+.nFn) + URs
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Teasers.
Share Beta InvestmentA .8 100000
B 1.25 100000
C 1 75000
D .6 125000
Given E(Rm) = 16% and Rf = 9% .what is the expected Return from thePortfolio.
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Beta Estimation..
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Revisiting the CAPM
Understanding the Betafor various values
Methods of Estimation
Direct Method..
The market modelregression on past data
Ri = + Rm ( Characteristic Line)
and are obtained by Normal Equations
The Normal Equations are Y = n + X
XY = n X + X2
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Beta Calculation by Excel
Year Stock Return Market Return
1 12 1
2 10 23
3 -10 -15
4 5 10
5 22 12
6 33 44
7 4 10
8 8 -10
9 -6 12
10 12 311 18 22
12 22 30
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Regression Statistics
Multiple R0.7307
8
R Square 0.53404Adjusted RSquare
0.487444
StandardError
8.63894
Observations 12
ANOVA
df SS MS FSignificanc
e F
Regression 1855.35
38855.35
3811.461
060.0069390
78
Residual 10746.31
2974.631
29
Total 11 1601.667
Coefficients SE t Stat P-value Lower 95%
Upper95%
Lower95.0%
Upper95.0%
Intercept4.5059
613.1164
821.4458
480.1788
22
-2.4379941
5511.44991
616
-2.437994
15511.44991
616
X Variable 10.5347
080.1579
443.3854
190.0069
390.1827857
670.886629
2750.182785
7670.886629
275
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Determinants of Beta Value(Covim /2m)
Nature of business( cyclicality of the business
leads to higher values of Beta). Operating leverage(use of FC)
Financial leverage (use of Debt)
Relation between Asset Beta and EquityBeta..
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Financial Statements
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What are financial statements
Indicates the financial position of a Firm
Perspective of Risk and Return
Answers the foll. Qs
How valuable are the Assets of the firm
How have these Assets been acquired
How profitable are these Assets
What is the Risk embedded in the Assets
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Financial Statements comprise
Balance Sheet
Income Statement
Statement of Changes in Financial Position Funds Flow Statement( WC )
Sources of WC( Liability(CL/SHE)
Uses of WC ( CA and FA)
Cash Flow Statement Cash flow from operating Activities
Cash Flow from Financing Activities
Cash Flow from Investing Activities
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Understanding the I/S
Income
Sales
Other income
Expenditure
Operating expenses
Depreciation
Interest Charges
EBT
Provision for Tax
PAT
P/L carried forward
Available for
Distribution Dividend
Tax on Dividend
Transfer to Reserves
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Understanding the B/S
Sources of Funds
Shareholders Equity
Share Premium
Reserves..
Long Term Debt
Total Capital Employed
Application of Funds
Fixed Assets
Gross Block
Accumulated Depn
Net FA
Investments
Minority(HTM/AFT/AFS)
Minority Active.
CA
Cash MS
Inventory
RM/WIP/FG
CL
Provisions..
Net CA(CA-CL)..
Net FA.
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Accounting profit Vs EconomicProfit
AP = Profit window dressing
Method of inventory valuation
Method of Depreciation
Goodwill valuation
Economic Profit = Net Cash Flow to firmand focuses on wealth creation
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The Funds Flow Statement
Current Assets
Cash/MS
Inventories
Debtors
Current Liabilities
Provisions
Creditors
Accounts PayableWC = CA -
CLThe funds flow statement depicts sources andapplications of WC. It is presented in 2 part:
sources and uses of WC Schedule of WC
There will be a WC only when there is a transaction between a current
account and aNon Current Account
Sources of WC cash flow from
operations Sale of non CA long term financing short term
Uses Of WC adjusted net loss from
operations purchase of Non CA repayment of Debt payment of Cash
Cash Flow statement Operating
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Cash Flow statementOperatingActivities
Cash from operating Activities
EBT..
Add Depreciation
Less Int Income received
Less Div Income
Less Gain on Asset Sale
Add loss on Asset Sale
Operating Profit before WCChanges
Adjustments for
CA( an in the value of a CA will imply
outflow of Cash, will imply inflow)
CL ( an in the value of a CL will implyinflow of cash, will imply outflow)
Cash generated fromOps..
Taxes Paid
CF from Operations..
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CF from Investing & Financing
CF from Investing Activities:
Sale of FA
Less purchase of FA
Sale of Investments
Purchase of Investments Interest recd from Investments
Dividend received
Net Cash used inInvesting
CF from financing Activities:
Dividends paid
Tax on Dividends
Interest paid on Debt Interest on short loans
Repayment of debt
Add New Debt
Add New Issue
Net Cash used in FinancingActivities
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Net Cash Flow to the firm
NCF= Cash Flow from OperatingActivities + Cash Flow from InvestingActivities
+ Cash Flow from Financing Activities
The Cash with the Firm Comprises: Cash on Hand Cash with Bank Cheques on hand
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Financial Statement
Analysis
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Analysis: Risk and Profitability
Users of financial analysis and their perspective ofanalysis.
Trade creditors-> liquidity position
Debt suppliers-> Solvency
Investors-> profitability
Management-> overall performance( risk/profitability)
Trade analysts/Academicians/Students/Researchers
Employees
Public
Government
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Financial Statement Analysis Comparative Analysis
Common Size Analysis
Trend Analysis CVP Analysis
Ratio Analysis
Liquidity Ratios
Leverage Ratios Turnover Ratios
Profitability Ratios
Valuation Ratios
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Liquidity Ratios: Current Ratio/Quick Ratio/Cash Ratio
Interval Measure->(CA-Inv) / Av daily Op Expenses
Leverage Ratios: Capital Structure
Total Debt/Capital Employed
Debt to Equity Ratio
Debt/ Capital Employed
Solvency
Interest coverage
Debt service coverage ratio
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Turnover Ratios(indicates the efficiency withwhich a firm utilizes its Assets/ the rate at whichAssets are being converted to Sales)
Inventory T/O
DIH(Days of Inventory Holding)
Debtors T/O
ACP(Average Collection Period)
Ageing Schedule of Debtors
NA Turnover Ratio
Total Assets Turnover Ratio
CA Turnover Ratio
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Profitability Ratios(Sales/Investment) Gross Profit Margin/ Net Profit Margin
ROCE/ROA/ROE
Valuation Ratios EPS
DPS
Dividend Yield
Earning Yield
P/E Ratio
MV to BV of Share
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Evaluating a firms Earning Power:
Du Pont Analysis
ROE= ROA(1+ D/E)
For No Debt Firm, ROE= ROA
ROE= NPM * Assets Turnover * Equity Multiplier
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Capital Budgeting
Decisions
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What is Capex.Allocationwhy
Features of Capex
Exchange of current funds for future benefits
Funds invested in long term assets
Objectives of Capex.Value
Types of Capex
Expansion/diversification/replacement/modernization/contingent
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Importance of Capex
Long term investment/large investments/highrisks/generally irreversible/strategicdecisions/complex
Steps involved in evaluation of investment
Determination of Cash flows
Estimation of required return/cost of capital
Application of decision rule
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Characteristics of a good decisionrule
Assist in wealth maximization
Must work well for both revenuegenerating and cost reduction projects
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Capex Evaluations
NPV IRR
Profitability Index
Payback Period
DiscountedPayback Period
ARR
DCF Criteria Non DCFCriteria
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NPV
It is the PV of all discounted CFs( I and O).
Steps(Determine CFs and r)
Decision Rule.accept/reject
Why is NPV important(. A firm has cash 1 lac) Features
It recognizes time value
Measures true profitability since it considers CFs
Value Additive.valuation of Corporate
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IRR
Measures yieldrate which equates current CFto all future CFs
Relationship between IRR/NPV
Stepscalculating CFs Decision ruleaccept (IRR> Cost of Capital)
Features
Popular since it uses %
It recognizes time value
Measures true profitability since it considers CFs
No value additivity
P fi bili I d
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Profitability Index
Ratio of PV of all CFs to InitialOutflow
Steps(measuring CFs and r)
Decision rule.PI > 1 Accept
P b k P i d
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Payback Period
Time required to recover initial investment
Steps ( determine CFs each year)
Decision rule..accept with shortest PB
Features
Simplicity/risk shield/focus on liquidity
Limitations
Ignores CF after PB period/ inconsistent with ourobjective of SH wealth maximization/not a measureof true profitability
Di t d PB i d
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Discounted PB period..
No. of years required to recover theinitial investment on a PV basis.
Uses discounted CFs in calculatingPBP.
ARR
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ARR..
Ratio of Average EBIT(1-t) to averageinvestment.
Decision rule..Accept(ARR> required return)
Features Uses accounting Data
Easy to understand and calculate
Demerits
Does not use CFs
Ignores time value of money
NPV/IRR
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NPV/IRR
Project C0 C1 C2 C3 NPV(9%)
IRR
A -1680 1400 700 400 301 23%
B -1680 140 840 1510 321 17%
NPV and IRR will give conflicting results in foll. Cases
project has a non conventional CF
Initial investments are differentProjects have different livesTiming of CFs is different.
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The Cost Of Capital
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Required return = cost of Capital
Concept of WACC (debt/equity/Preference)
Significance of Kc
Used in investment evaluation(NPV/IRR)
Designing debt policy
Performance appraisal of management/CFO
Opportunity Cost of Capital Cost of Capital
Historical cost / Marginal Cost
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Determining the WACC of Firm
Cost of Debt
Cost of Preference
Cost Of Equity
The cost of capital of the firm will bethe weighted average of thecomponent costs
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Cost of Debt
Debt issued at Par ( Kd = Coupon Rate)
Debt issued at Premium/Discount
After tax cost of debt = Kd(1-t)
Cost of Preference
Irredeemable (Div/Issue price)
Redeemable
enerally Kp > Kd since interest on Debt is Tax deductible
C t f E it
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Cost of Equity
Equity( external/retained earnings)
Is equity free of Cost
Methods of calculating Ke The dividend growth model
E/P ratio
CAPM
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Practical calculation of Ke
Dividend G Model
Ke = Div1/P + g
g can be calculated by ( retention ratio * ROE)or by EPS growth of the last 10 years.
CAPM
E(Ri) = Rf + i [ E(Rm) Rf ]
Beta can be found by regression.
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Determining CF for
Investment Analysis.
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CF vs Profit( FCF = EBIT(1-t) + Dep WC Capex)
FCF for Capex decisions and is the
cash available to lenders andshareholders.
Basic principles of CF estimation
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Basic principles of CF estimation
Separation principle( investment CF and financing CFare to be treated separately)
Incremental principle
CF from project = CF with implementation of project CF w/o
implementation of project Incidental effects be considered( cannibalization)
Ignore sunk costs
Include opportunity cost
Post Tax principle( consider tax impact) Consistency principle( CF must be consistent with
investor group).
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Risk Analysis in
Investment Decisions
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Every investment decision is based onforecasted CFs.
The forecasted CFs are influenced by
Economic factors
Industry factors
Company factors
Risk Measurement --> Variance
Reducing risk through the concept of ExpectedNCF( CFi x Pi) where i= 1,2n
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Conventional techniques of riskanalysis
Payback period
Risk adjusted discount rate(k = kf + kp )
Certainty equivalent (0< < 1). Choiceof is an indicator of the confidence
level of the CFs being realized asforecasted.
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Other methods of risk analysis Sensitivity analysis -> identifying variables that impact
revenues/ sales and thus CFs
DCF break even analysis
Scenario analysis
Simulation analysis
Decision tree analysis
1 2 3 4
S.P 15 15 15 15
V.C 6.5 6.5 6.5 6.5
If Project Cost = Rs.1000, V(15-6.5) x PVIFA(r,4yrs) = 1000
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Financial Leverage &
Operating Leverage
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Relationship between investmentdecision and financing decision
Defining capital structure( Capex ->
need to raise funds -> capitalstructure decision(D/E).purpose isKc and V
Defining FL
ROI > cost of debt
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Measuring FL Debt ratio( D/D+E)
Debt to Equity Ratio
Interest coverage = EBIT/ Interest Charges Analyzing impact of FL
ROI>Kd -> Increase in SH returns-> EPS/ROE
ROI< Kd -> Decrease in SH returns-> EPS/ROD
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How does FL impact EPS & ROE
Eg a project requires an investment of 5lacs. The return on investment expected
is 24% and the cost of debt is 15%.Which of these two alternatives shouldthe firm take.
Raise 5 lacs through equity( 50,000 x Rs.10)
Raise 2.5 lacs through equity (25,000 x Rs.10)and Rs. 2.5 lacs through debt.
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All equity 50% Debt
EBIT
Interest
EBT
Tax(50%)
PAT
No. of shares
EPS
ROE
ROI > Cost of debt
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All equity 50% Debt
EBIT 120000 120000
Interest 0 37500
EBT 120000 82500
Tax(50%) 60000 41250
PAT 60000 41250
No. of shares 50000 25000EPS 1.2 1.65
ROE 12% 16.5%
Return to investors 60000 78750
The gain from FL = Rs.18750.This is the interest tax shield enjoyed by the company since interest chargesare tax deductableThis is equivalent to ( Interest x Tax rate)
If ROI is 12% < Cost of debt,15%
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All equity 50% Debt
EBIT 60000 60000
Interest 0 37500
EBT 60000 22500
Tax(50%) 30000 11250
PAT 30000 11250
No. of shares 50000 25000EPS 0.6 0.45
ROE 6% 4.5%
Return to investors 30000 48750
The impact on EPS and ROE is negative.
Impact of FL on varying EBIT
N D bt I t t 5 l t f d bt
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No Debt Investment = 5 lacs, cost of debt=15%, ROI = -5%, 10%,
EBIT -25 50 75 120 160 300
Interest 0 0 0 0 0 0
EBT -25 50 75 120 160 300
PAT -12.5 25 37.5 60 80 150
#shares
50 50 50 50 50 50
EPS -.25 0.5 0.75 1.2 16 30
ROE -2.5% 5% 7.5% 12% 16% 30%
50% Debt
EBIT -25 50 75 120 160 300
Interest 37.5 37.5 37.5 37.5 37.5 37.5EBT -62.5 12.5 37.5 82.5 122.5 262.5
PAT -31.25 6.25 18.75 41.25 61.25 131.25
#shares
25 25 25 25 25 25
EPS -1.25 .25 .75 1.65 2.45 5.25
Impact of FL on varying EBIT
75% Debt
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75% Debt
EBIT -25 50 75 120 160 300
Interest 56.25 56.25 56.25 56.25 56.25 56.25
EBT -81.25 -6.25 18.75 63.75 103.75 243.75
PAT -40.62 -3.13 9.38 31.88 51.88 121.88
#shares
12.5 12.5 12.5 12.5 12.5 12.5
EPS -3.25 -2.5 .75 2.55 4.15 9.75ROE -32.5% -2.5% 7.5% 2.55% 41.5% 97.5%
Impact of FL on varying EBITInvestment = 5 lacs, cost of debt= 15%, ROI = -5%, 10%,
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No Debt
EBIT -25 50 75 120 160 300
EPS -.25 0.5 0.75 1.2 16 30ROE -2.5% 5% 7.5% 12% 16% 30%
50% Debt
EPS -1.25 .25 .75 1.65 2.45 5.25
ROE 12.5% 2.5% 7.5% 16.5% 24.5% 52.5%
75% Debt
EPS -3.25 -2.5 .75 2.55 4.15 9.75
ROE -32.5% -2.5% 7.5% 2.55% 41.5% 97.5%
S increases with increased EBIT for all financial plans
works both ways. It depresses EPS/ROE under unfavorable economic conditionincreases EPS/ROE under favorable conditions.
gher the FL , wider is the range in which the EPS fluctuates with varying EBIT.
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Relationship between EBIT,EPS
EPS = PAT/N = [(EBIT-Interest)x (1-t)] / N= (1-t)/N [ EBIT Interest ]
This can be rearranged as > -(1-t)/N xInterest + (1-t)/N x EBIT
This shows EPS is a linear function of EBIT
with EPS= a + b x EBIT From the above formula, EPS for varying
levels of EBIT can be worked out.
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Calculating the level of EBIT for whichEPS would be same under diff financialplans.
All equity firm, EPS1 = EBIT(1-t)/ N1 Debt firm , EPS2 = (EBIT- Interest) x (1-t) /
N2
The indifference point can be calculated byequating EPS1 and EPS2.
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Combining OL and FL
OL affects EBIT while FL affects PAT/EPS
DOL = % EBIT/ % Sales = Q(s-v)/Q(s-v)-F
DFL = % EPS/ % EBIT = Q(s-v)-F /Q(s-v)-F-Int
DCL = % EPS/ % Sales = Q(s-v)/ Q(s-v)-F-Int
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Capital Structure
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Meaning of Capital Structure
Advantages of Debt
Tax benefit( Tax rate x Interest)
Disciplining effect
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Disadvantages of Debt Expected bankruptcy
CF < Obligations
High SD of CFs
When a firm approaches bankruptcy there are twoassociated costs
Direct Costs ( borne by lender)
Indirect Costs( borne by firm)
Customers stop buying
Suppliers stop supplying Firm fails in raising fresh capital
The cost is high for durable products, products requiringregular maintence, high value goods.
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Disadvantages of debt
Loss of flexibility(Covenants:Affirmative/Negative)
Agency Costs
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Debt taken by a Company is influenced by High tax will encourage debt
Companies with low depreciation will prefer debt
Generally as taxes go up, the D/E of Companiesgoes up
Level of efficiency of Debt / Equity markets
Level of variability of a Cos CFs.
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Is there a relationship betweenCapital Structure and Value of a firm..
Traditional View(Net Income and NOI
Approach) Capital structure impacts value
Miller & Modigliani View
Capital Structure is irrelevant
Net Income approach
Ke and Kd are constant for a firm. The K0 of the firm
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Ke and Kd are constant for a firm. The K0 of the firmdeclines as debt is taken
Value of firm = V of Equity + V of Debt = NI/Ke +Interest/Kd
K0 = Ke (Ke-Kd)xD/Vas D increases ,the value ofK0 will decrease and will be minimum when D/V =1.
Value of firm = EBIT/K0 K0 is minimum at Debt100% and hence maximum value of firm is whenDebt is 100% of the structure.
Cost
D/
KeK0
Kd
Net Operating Income Approach
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Kd and K0 for the firm is constant.
As debt increases , Ke will increase Ke = K0 + (K0- Kd) x D/E.as D increases ,
Ke increases
K0 for the firm remains constant because thesubstitution of cheap debt is compensated bythe increase in cost of equity.
D/
E
Cost
Ke
K0
K
d
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MM Approach The value of a firm is independent of Capital
structure and only depends on earnings andrisk.
Assumptions of perfect capital markets , notransaction costs and no taxes.
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MM Proposition 1
> V1 = V2 = EBIT/K ( assuming K1= K2)
In MM view the way in which the firms arestructured only changes the way in which theearnings are distributed ( SH and Debt holders)
EBITK1
EBITK2
Levered Firm Unlevered Firm
Why should Proposition1work
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EBIT 150000 150000
Debt 500000 0
Kd 12%
Ke 16% 15%
Interest 60000
Equity Earnings 90000 150000
MV of Equity 562500 1000000
MV of Debt 500000 0
Value of Firm 1062500 1000000
Assume you own 10% shares of the levered firm. Your investment of
Rs.56250Gives you a return of Rs.9000 in the levered firm.
MM argue that if two firms have the same EBIT, their values must besame. If not thenThis will encourage arbitrage .
A rational investor will do the foll.
Sell 10% equity in L 56250
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Investor invests Rs.100000 in U (10%)
His old income was Rs.9000 . His new income is as below
The customer make an income of Rs.6250 keeping his earningsconstant.
The arbitrage will continue till the value of the firms equal.
Borrow 10% at rate 12% 50000
Total money 106250
Income from 10% stake inU
Rs.15000
Less interest on Rs.50,000@12%
Rs.6000
His net income Rs.9000
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MM proposition 2 Higher the financial risk greater will be
the required return of the investors and
higher will be the cost of equity. K0 = Ke( E/D+E) + Kd (D/D+E)
Ke = K0 + (K0 Kd) D/E
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The value of a firm increases with leverageand is theoretically max when D= 100%
Debt avoided on account of dangers of financialdistress.
The pecking order theory
Internal equity
Debt External equity
Enhancing firm value through DebtBook
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how will the Company value be impacted if ittakes a debt of Rs.75,000 @ 10% and buys backits shares from the market ? Assume tax rate of30%.
BookValue
Equity 1,50,000 Assets 1,50,000
Debt 0
TotalCapital
1,50,000 TotalAssets
1,50,000
MarketValue
Equity 8,00,000 Assets 8,00,000
Debt 0
TotalCapital
8,00,000 8,00,000
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Current tax structure: Corporate tax rate (30% + 3% education cess)
Personal taxes(10% - 30%)
Tax is 10% on Capital gains(investment
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Introduction to Dividend
Theory..
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What are dividends
Objective of the dividend policy..( balance between funds for growth
and distribution to SHs. Concept of Payout ratio/ retention
ratio/dividend yield
The dividend decision is impacted bythe investment decisions of a firm.
Impact of dividend payoutsHigh payout firm (80%)
Year Equity Earnings@2 Dividend RE
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Year Equity Earnings@20%
Dividend RE
1 100 20 16 42 104 20.8 16.64 4.16
3 108.16 21.63 17.31 4.32
10 142.33 28.47 22.77 5.69
15 173.17 34.63 27.71 6.92
20 210.68 42.14 33.71 8.43
Low payout firm (20%)
1 100 20 4 16
2 116 23.2 4.64 18.56
3 134.56 26.91 5.38 21.5310 380.30 76.06 15.21 60.85
15 798.75 159.75 31.95 127.80
20 1677.65 335.53 67.11 268.42Post 15th year low payout firm has a higher dividend.the growth for the
two firms has been
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Dividend theories Walters Model
Gordon Model
Walters Model:
P = PV of an infinite stream of dividends + PV of an infinitestream of Capital gains
P = Div/k + r(EPS-DPS)/k / k
Assumptions:
Constant r, k, EPS and DPS
100% payout or 100% retention
The firm has an infinite life
Demonstration of Walters Model
Consider three firms(growth firm/normal firm andd li i fi ) S 0
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declining firm).Assume EPS = Rs.10
Retain all earnings when r>k
Distribute all earnings when r
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Gordons ModelThe price of a share is the PV of an
infinite stream of dividends expected to
grow @ g
P=Div1 / k-g = EPS1( 1-b) / k r.b
Mathematically derive the formula..
Demonstration of Gordons Model
Consider three firms(growth firm/normal firm anddeclining firm) Assume EPS = Rs 10
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declining firm).Assume EPS = Rs.10
When r > k, keep low payout
When r < k, payout should be maximum
When r =k, the dividend decision has no impact on the value of the firm.
Assumptions in the model
Constant k and r. Both models have the same conclusions THE DIVIDEND DECISION OF A FIRM
HAS AN IMPACT ON ITS VALUE
Growthfirm(r=15%,k= 10%)
Normalfirm( r=10%,k=10%)
Decliningfirm( r=10%, k =15%)
Payout = 40%,b=0.6
P=400 P = 100 P = 77
Payout = 60%, b =0.4
P = 150 P = 100 P = 88
Payout = 90% ,b =0.1
P= 106 P = 100 P = 98
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Factors that influence the dividendpolicy of a firm
Current available investment
opportunities Stage of firm(introduction/growth/maturity/decline)
Thumb rule(r > k)
Expectation of the shareholders
Clientele effect( identifying the investors)
Constraints on paying dividends
Legal restrictions-> dividend to paid out of
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Legal restrictions > dividend to paid out ofprofits only
Liquidity constraints Borrowing capacity
Access to capital markets
Restriction in loan agreements Control
Forms of dividends
Cash Dividends
Bonus Shares
Shares Buyback
Bonus shares.. Eg a 2:1 bonus issue
Equity( 1 lac 10,00,
Equity( 1.5 15,00,000
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Bonus issue is only a recapitalization..(E/R)
Advantages of bonus:
It is an indication of higher future profits
Psychological value
Company conserves cash
Ideal for a company when in a financial crunch
Share price brought in the trading range
Equity( 1 lacshares @Rs10)
10,00,000
Reserves 20,00,000
Total NW 30,00,000
Equity( 1.5lac shares@ Rs10)
15,00,000
Reserves 15,00,000
Total NW 30,00,000
Share Splitreverse splitEquity( 1 lac 10,00,
Equity( 2 10,00,000
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Reasons for share split
Bring price of stock in trading range
Indication of companys higher earning infuture
Increased expected dividend to theshareholders
Equity( 1 lacshares @Rs10)
10,00,000
Reserves 10,00,000
Total NW 20,00,000
Equity( 2lac shares@ Rs 5)
10,00,000
Reserves 10,00,000
Total NW 20,00,000
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Shares buyback.. Rationalize capital structure
Pop up the share price
When company has idle cash
Manas Corp expects to earn Rs.66 lacs for the current yearand it plans to distribute 50% of this amount to itsshareholders. There are 11 lac outstanding shares and themarket price per share is Rs.30. The Co. believes that it canpay a cash dividend of Rs. 3 per share or buyback 1 lacshares at an offer price of Rs.33. what is the impact if theshares are brought at less than Rs.33 or greater thanRs.33.
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WC Management..
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Assets Management: Fixed Assets Management
CA Management
Concept of WC Gross WC
Net WC
Why is investment in CA required The concept of Operating Cycle
Operating cycle of a firm
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Order stock Cash FG Cash
Placed arrives Paid sold received
AP AR
Inventory period
Cash Cycle
Operating Cycle
perating Cycle is a function of Inventory period and AR.
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Factors influencing WC requirements.. Nature of business ( OC/retailers)
Seasonality of operations
Production policy
Market conditions
Conditions of supply/ supplier credit
Credit policy of Co
Operating efficiency
WC management is a trade off between liquidity andprofitability
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Cost of liquidity
Low returns, inventory wear off, carrying cost
Cost of illiquidity Unable to meet short term obligations
Borrowing at high cost ,production shortage
A B C
Sales 15,00.000 15,00,000 15,00,000
EBIT 1,50,000 1,50,000 1,50,000
FA 500000 500000 500000
CA 500000 400000 300000
TA 10,00,000 9,00,000 8,00,000ROI 15% 16.67% 18.75%
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Estimation of WC needs CA holding period cost
RM holding cost + WIP cost + FG holding cost +Debtors holding credit allowed
WC as a % of sales
WC as a % to fixed investment
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Receivables Management
and Factoring..
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How are receivables created-> CreditSales
Receivables involve an element of risk
It implies futurity
Measuring receivables
Net Credit Sales per day x Average collectionperiod
NCS is a function of sales
ACP is a function of the cos credit policy
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Why do companies grant credit
Competition
Buyers requirements
Companys bargaining power
Relationship with dealers
Marketing tool
Industry practice
the purpose of all is to enhance sales.
Receivables is a function of theCredit Policy
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Credit Policy Credit Standards
Credit Terms
Collection Effort
Goals of the credit policy Increasing sales
( Benefits > Costs)Increased Sales Bad Debt losses
Credit Administration and supervision
Collection Costs
Credit Standards and evaluation:
Individual:
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( Character/Capacity/Cash/Collatoral/Condition
) -> intention and the ability Company -> Financials and ratios
Evaluation and analysis of credit
Traditional approach
Numerical credit scoring
Discriminant analysisFactor
wt 5 4 3 2 1 Score
Past
p
.3
NPM .2
CR .1
D/E .4
CR
RO
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Credit Terms Rate of cash discount
Cash discount period
Net credit period
Eg. 2/10, net 30.
Monitoring receivables
ACP -> 360/ Debtors Turnover
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ACP 360/ Debtors Turnover
Ageing Schedule Collection Experience Matrix
O/Sdays
Amount
%
0-25 200000
20%
26-35
300000
30%
36-45
400000
40%
>45
100000
10%
Month
J F M A M
Sales 100 250 375 400 570Rec(%)
J 80%
F 60% 78%
M 20% 50% 90%
A 10% 40% 60%
M 10% 10% 70%
Factoring
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seller buyer
factor
1
4
2
3
56
7
1: buyer places order, 2: factor fixes buyer limit, 3: seller supplies goods to thBuyer , 4: seller raises invoice to the factor, 5: factor pays a portion upfront6: factor follows up with buyer for payment7: buyer makes the payment to the factor.
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Inventory Management
Types of inventory( RM/WIP/FG)
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Types of inventory( RM/WIP/FG)
Why hold inventory Transaction Motive
Precautionary Motive( D/S fluctuation)
Speculative Motive
Objectives of inventory management
Efficient and smooth production
Maintain optimum level
Costs associated with inventory management
Ordering cost Carrying cost
Inventory management seeks to answer
How much should be ordered ?
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At what level should the order be placed ?
How much to order->TC = ordering cost + Carrying Cost = (Annual
usage/Q ) x Per order cost + (Averageinventory) x carrying cost per unit
EOQ = Q = Sq root( 2UF/c)
When to order->
Reorder Point = Average Usage x Lead time
if safety stock is being maintained, its value isadded to the reorder point.
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Inventory control systems ABC Analysis
Just in Time
FSN ( fast moving, slow moving, nonmoving )
Computerized inventory controls.
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Cash Management
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Cash management concerns managing Cash flow into and out of the firm
Cash flow within the firm
Cash balances with the firm
Motives for holding cash
Transaction motive
Precautionary motive
Speculative motive
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Cash Management covers Cash planning
Managing the cash flows
Optimum level of cash Investing surplus cash
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Cash planning Forecasting
Short term: Receipts and disbursements
Long term: Cash flows generated through P/L
Managing the cash flows
Minimizing deviation between projectedand actual CFs. it includes
Accelerating cash collections
Controlling disbursements
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Speeding cash collections
Minimizing floats
Disbursement float: cheque issued and not debited
Collection float: cheques received and not credited
Net Float = Disbursement float + Collection float
Customer mails cheque co receives co deposits cheque cash available
Mailing time Processing Availability delay
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Maintaining Optimum Cash level
Under certainty: when the firm is able to
forecast cash needs with certainty
Baumols Model
Under uncertainty
The Miller Orr Model
Baumols Model
Total Cost = Holding Cost + Transaction
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Total Cost Holding Cost + Transaction
CostTC = (average cash balance) x k +
(Number of transactions) x cost pertransaction
TC = C/2 x k + (T/C) x Ct = sqroot( 2TCt/k)
C= starting cash balance, k = opportunity cost, T =
total cash requirement in the year, T/C = totalnumber of transactions, Ct = cost per transaction.
Cash
balance
tim
e
Miller Orr Model
UL
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3 limits are specified( upper limit, return point,
lower limit)
RP = 3 Sq root( 3b 2/4I) + LL
UL = 3RP 2LL
b= fixed cost per order for converting MS-> cash 2 = variance of daily changes in expected cash balance
I = interest rate (daily) earned on MS
cash
time
LL
R
P
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Investing surplus cash Factors considered: risk/return/liquidity
Types of short term investments
T Bills
Commercial Paper
Certificates of Deposit
Bank Deposits
Inter Corporate Deposits/ Call Money
Working Capital Finance
Trade Credit eas
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Trade Credit: easy
availability/flexibility( 3/15,net 45).implicitinterest rate
Deferred Income
Bank Finance OD, CC limit
Bills discounting
Letter of credit
WC loan
Commercial Paper.( conditions: NW > 5 Cr,Co. should be listed, CR > 1.33, Crisil rated .
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All The Best