If you consider a mfg company or a trading company or software or non-banks, non-NBFCs

Balance Sheet
Liabilities
Assets
Source of Funds
Application of Funds
Financing Side
Operating Side
Most of finance work is here
Where do we get funding from
If we can get from multiple sources,
which is the best mix o funding

Do you really need so much

Do we really need this project, if yes,
why, please justify

1. Owners
2. Lenders
3, Vendors

Owners / Shareholders
Promoters
Institutions that are willing to subscribe to equity
Domestic
Foreign
Various kind of foreign investors
Hedge funds
Exchange traded funds
Regular fund managers
Emerging market funds
India focussed funds
Start up, just above start ups
Angel funding
Venture capital

Private equity
Owner gives you cash and expects capital appreciation
If he invests Rs 100, he expects Rs 1,000 (you need not pay him, but if the market values
holding at Rs 1,000, he is thrilled)
Dividends, if at all you pay, are petty cash - the purpose of investment is not dividend, it
appreciation
Lenders
Banks, Financial Institutions, NBFCs
Foreign Institutions
Retail Public
Term Loans
Working capital facilities
Packing Credit
Pre Shipment Credit
Post Shipment Credit
Buyers Credit
Bill Discounting
Bonds
Fixed Deposits
Preference Shares
Unsecured Loans
Lending means the lender gives you cash and expects two sets of cash flows from you
a. Interest
b. Return of principal

Own Sources of Funding

Your own hard work and profits generated from hard work - retained earnings - long and p
You have some businesses that aren't doing well, or are doing well, but you need funds ve
you sell them off and get cash
Sometimes, you could argue that these businesses are not my core competence and so I h
to divest

Vendors
How are vendors sources of funds
They provide you with products and services without asking you to pay right away
This is the most common source for working capital (short term business management)
Next session - I want Groups 1 to 7 to be ready to present to us the following
Size of the debt market in the world, with some composition break up
Bonds
Banks, Institutions
Government assistance
IMF, WB
Multi lateral institutions
Groups 8 to 14/15 as the case may be
Overview of equity markets
How large are they
Who are the big investors
Who are the small ones
What is this emerging market animal, how large, how trendy
Who are these hedge funds, other funds
Talk for ten min, questions for 2/3 min

What is packing credit

Packing credit, pre-shipment, post-shipment - these are all Indian banks facilities to expo
bring in dollars
Rupee loans are expensive - 10 to 15%
Dollar loans are cheap - 4 to 7%
But dollar loans carry a sword - exchange volatility - if Rs 65 becomes Rs 68, you are kille
But if you are an exporter, you have a natural hedge - your inflows will also be strengthen
Pre-shipment - from the date of getting your order to the date of shipment
Post-shipment - your asset has converted from Inventories into Receivables
Time value of money
If you give me Rs 100 today and I return back Rs 100 in the year 2020, that is not fair

1 Interest
2 Inflation - sub-set of Interest
3 Risk
4 Opportunity Cost

Inflation is a sub-set of Interest

Interest rates in India are 10 to 15% bcoz inflation is India is 6 to 8%
Interest rates in Nigeria are 35 to 55% bcoz inflation in Nigeria is 18 to 28%
Interest rates in Japan are 0.25% to 0.75% bcoz inflation in Japan is deflation many a time
In economics, they say
Nominal Rate of Interest = Real Rate of Interest + Inflation

In finance, we generally ignore inflation, bcoz we consider Nominal Interest rates that alr
inflation

Risk is a sub-set of Interest

When SBI lends to ICICI, they may be happy with 8% interest - overnite markets, call mon
SBI lending to Reliance - 8.50%
SBI lending to Siddharth - 12.50%
SBI lending to lawyers - 15.50%
A higher rate of interest is nothing but compensation for risk
Credit rating happens all the time even for SME
If your credit rating falls a notch, your interest rate rises by 0.50%
Opportunity Cost
There are primarily two sources of funding (and investment) are debt and equity
Interest applies to the debt side of the story (inflation and risk are accompaniments)
What about equity investing
You will demand compensation for (a) inflation, (b) risk, (c ) return
This retun is not as simple as an interest rate (or a real interest rate)
It is something more complicated

Compounding

Discounting
Compounding
You place a Fixed Deposit in SBI for Rs 10 lakhs at 9.50% interest for a 5 year tenor
This is a cumulative deposit
What will you get after 5 years

Year

r=
1+r=

Open Bal Interest Cl Bal

1
10.00
0.95
10.95
2
10.95
1.04
11.99
3
11.99
1.14
13.13
4
13.13
1.25
14.38
5
14.38
1.37
15.74

9.50%

9.50%
109.50%

If you multiply by (1+r), then workings become easier

Year

Open Bal
0
10.00
1
10.95
2
11.99
3
13.13
4
14.38
5
15.74

Future Value = Present Value x (1+r)^n

10.00 109.50%
5

Compounding is moving from the present to the f

In compounding, we multiply by (1+r)

Future value, Present value

The Future value of Rs 10 lakhs (after 5 years, at
is Rs 15.74 lakhs
Conversely, one could say
The Present value of Rs 15.74 lakhs (after 5 years
is Rs 10.00 lakhs

15.74

We know this, we are okay with this, but we find the more detailed table better

If Dena Bank were to offer you 9.45% compounded every half year, would you go for it
Simple annual quoted rate =
r=
4.725% per half year
Number of half years (n) =
10.00 104.725%

9.45% compounded half year

104.725%
10
10

15.87

A half year rate of 4.725% results in a yield of how much per annum
If this were compouned annually, what would that have come to
104.725%

2 109.673%

9.673% Equivalent annual rate

You are comparing 9.50% SBI (annual compounding) with 9.673% Dena (annualized compou
Way back in the late 1980s, we had a roaring public deposits market
Public placing deposits with corporates
SBI used to offer 9%, Tata Motors 11%, Tata Steel 11%, Hind Lever 11%, Pfizer 11%
Brokerage houses used to also pay a kick back of 0.50% per annum
There was an industry called leasing industry (now it has joined the dinosaurs)
Between 1988 and 1993, there were 1400 IPOs from this sector alone

Harshad Mehta announced publicly that he will make the shareholders of Mazda Leasing p
Leasing companies started offering 16%, 17%, 18%, 19% interest
They collected crores of rupees in public deposits
Some of them felt that paying this much interest is good enough, principal need not be re
RBI said we will have a cap on the interest rate - 14% cap
X Leasing - said - we will pay 14% compounded annually
Y Leasing - said - we will pay 14% compounded half yearly
Z Leasing - said - we will pay 14% compounded quarterly

Nth Leasing - said - we will pay 14% compounded daily

5 minutes next session

In the world of derivative mathematics, we use continuous compounding (every second)

-banks, non-NBFCs

the market values his

is not dividend, it is capital

lows from you

rnings - long and painful

you need funds very badly - so

petence and so I have decided

right away
s management)

ollowing

s facilities to exporters who

s 68, you are killed

also be strengthened

hat is not fair

lation many a times

erest rates that already include

markets, call money markets

nd equity
ompaniments)

year tenor

e present to the future

(after 5 years, at 9.50%)

akhs (after 5 years, at 9.50%)

le better

ld you go for it

annual rate

annualized compounding)

Pfizer 11%

of Mazda Leasing pay wealth tax

pal need not be returned

g (every second)

Market Cap
If you want to buy the whole of TCS, how much should you have in your pocket
Only Rs 500,000 crores, thats enuf

Why should L&T exist

To increase Market Cap
You, as a shareholder invested Rs 10 in 1977 and today it is worth Rs 10 crores - great com
Any decision that is taken, should be subjected to a simple question
Will this increase market cap

1980s - Business India - Top 500 companies - Total Assets as per the Balance Sheet - Telco,
Century Textiles
Late 1980s, Early 1990s - Top 500 companies - Listed on the basis of Turnover
Mid 1990s, Late 1990s - Business Today - Top 500 companies - Ranked on the basis of Mark
an Infosys burst on the scene
Terms like value, value creation, valuation are vague - this is crisp
What is the objective of e-commerce companies
To create market cap
Can this market cap be created (or having created, be sustained) with losses in the P&L
Huge question, no clear answers
This question has been asked since 1905 and most of the time, the answer has been no
But while the music is playing, humanity refuses to listen to this answer NO

How many companies were set up to mfg cars in 1900, 1901, 1902, 1903, 1904, 1905 in th

Market Cap to GDP Ratio

Developed countries, this ratio is high
India has been around 80% to 125% over the last 15 years

Most analysts believe that if this ratio is at the lower end, then there is scope for an upm

Free Float
Shares held by promoters are excluded here
Free float is the component of shareholding that is trade-able in the market
So if market cap is Rs 1,000 cr and 40% is held by promoters, then Rs 600 cr is free float

Hedge Funds
Hedge funds are funds that invested in various instruments, countries, products with alm
limits, no regulations on them
They seek only those customers who are (a) wealthy (b) take responsibility for investing i
areas
I might buy, I might sell what I dont have (short sell), do whatever

Hedging has nothing to do with hedge funds, they only share some common alphabets
Modi has nothing to do with Moodys
Hedging is supposed to be a noble activity seeking to minimize risk
Hedge funds are aggressive entities, nothing noble about them - they are ruthless capital

How can an index represent a whole market

The index is very carefully structured, such that if the market falls by 5%, the index will a
around that level
If the index does not represent the larger market, then its gets changed
Suddenly one day, NIIT might move out and HPCL might come in
How can Sensex be 27,000 and Nifty be only 8,300
How can Amitabh Bachhan be 73 years old and Abhishek only 43 years old
Answer - they were born in different years and other factors
Index is not an absolute number, it is a relative number

One fine day in 1978, some wise people thought, lets start with 100 as the base (Sensex)
Another fine day in 1994, some other wise people thought, lets start with 1000 as the bas
The correlation tends to be 99.98 or so

A company is listed on an exchange BSE, NSE

It can be listed on both
Can it be part of the two indices
Yes
But the company has no role in the index constitution
If you are Reliance, they want you there
There is a text book which most people say ranks as the best in the world in Finance
Please read the respective chapters and reach out to me for any questions
DISCOUNTING
Your friend wants a loan
He can repay you Rs 15 lakhs after 5 years
You want to earn 12%
How much should you lend him today
Year

Cls Bal
5
4
3
2
1

Year

15.00
13.39
11.96
10.68
9.53

Interest Op Bal
1.61
13.39
1.43
11.96
1.28
10.68
1.14
9.53
1.02
8.51

15.00
13.39
11.96
10.68
9.53

Op Bal
13.39
11.96
10.68
9.53
8.51

Cls Bal
5
4
3
2
1
15.00

112%

5.00

12%
r is the rate of interest
1+r is determined
You divide by (1+r) to discou

Rs 8.51 lakhs is the present

Rs 15.00 lakhs is the future

8.51

Moving from present to futu

Moving back from future to

Example
Your friend can return Rs 3 lakhs per annum at the end of years 4, 5, 6, 7, 8
How much should you lend him today

We determine Present Value Factor

This is a simple tool to help us handle multiple cash flows
What is the present value of one rupee that might be coming to you after x years
Year

PV Factor
0
1.000
1
0.893 If you gave him 0.893 today and he returned back on rupee,
2
0.797
3
0.712
4
0.636
5
0.567
6
0.507
7
0.452
8
0.404

Year

Nominal
CashFlows
0
1
2
3
4
5
6
7
8

Year

3.00
3.00
3.00
3.00
3.00

Open Bal

PV Factor Discounted
CashFlows
1.000
0.893
0.797
0.712
0.636
1.91
0.567
1.70
0.507
1.52
0.452
1.36
0.404
1.21
7.70

Interest Repaym
Accrual
7.70

0.92

If you lend him Rs 7.70 lakh

returns back Rs 3.00 lakhs p
you would have earned 12%

Closing
Balance
-

8.62

2
3
4
5
6
7
8

Example
Premium
Tenor
Sum Assured

8.62
9.66
10.81
9.11
7.21
5.07
2.68

1.03
1.16
1.30
1.09
0.86
0.61
0.32

3.00
3.00
3.00
3.00
3.00

9.66
10.81
9.11
7.21
5.07
2.68
-

36000
15 years
1500000

What is the rate of return on this policy

In math terms, we call this as solving for 'r'
This solution is an iterative solution
Let the r be

Year

11.98% I know it is not 10%, but I am desperate

111.98%

Nominal
PV Factor Discounted
CashFlows
CashFlows
036,000
1.000 36,000
136,000
0.893 32,150
236,000
0.798 28,711
336,000
0.712 25,640
436,000
0.636 22,898
536,000
0.568 20,449
636,000
0.507 18,261
736,000
0.453 16,308
836,000
0.405 14,564
936,000
0.361 13,006
10 36,000
0.323 11,615
11 36,000
0.288 10,373
12 36,000
0.257 9,263

Nominal cash flows are drive

estimates and come from do
Not from finance (knowledg

13 14 15

36,000
36,000
1,500,000

0.230 0.205 0.183

-

8,273
7,388
274,898
0

Excel has a ready function called IRR (Internal Rate of Return) for such situations where y
11.98%

e in your pocket

rth Rs 10 crores - great company

the Balance Sheet - Telco, Tisco, Mafatlal,

sis of Turnover
anked on the basis of Market Cap - suddenly

d) with losses in the P&L

the answer has been no

is answer NO

902, 1903, 1904, 1905 in the US

n there is scope for an upmove

n the market
hen Rs 600 cr is free float

untries, products with almost no

esponsibility for investing in high risk

me common alphabets

- they are ruthless capitalists

falls by 5%, the index will also tend to fall

changed

3 years old

h 100 as the base (Sensex)

start with 1000 as the base (Nifty)

n the world in Finance

ny questions

112%
is the rate of interest
+r is determined
ou divide by (1+r) to discount your cash flows

s 8.51 lakhs is the present value

s 15.00 lakhs is the future value

oving from present to future is 'compounding'

oving back from future to present is 'discounting'

s 4, 5, 6, 7, 8

o you after x years

e returned back on rupee, you would have earned 12%

you lend him Rs 7.70 lakhs today and he

eturns back Rs 3.00 lakhs per annum as above,
ou would have earned 12% in this transaction

I am desperate

ominal cash flows are driven by facts, business

stimates and come from domain experts
ot from finance (knowledge, concepts)

for such situations where you solve for 'r'

Simple personal life examples

You want a certain sum of money at a future date - Rs 25 lakhs in 5 years
You can save Rs xx per annum - Rs 3 lakhs
What is the required rate of return for you to achieve your objective
Year

CashFlows
03.00
13.00
23.00
33.00
43.00
5
25.00

17.54%

Example
I want to retire at 30
Post 30, I propose to live upto 80
Every year I want Rs 5 lakhs (from 31 to 80)
Yield on investments is 8% (lets assume)
How much should I save from age 23 to 30, so that this can be managed (per annum numb
Year

Op Bal
23
24 25 26 27 28 29 30 31 32 33 34 35 36 -

6.21
12.92
20.16
27.98
36.43
45.56
55.41
66.05
65.94
65.81
65.68
65.53
65.37

CashFlow
-

5.75
5.75
5.75
5.75
5.75
5.75
5.75
5.75
5.00
5.00
5.00
5.00
5.00
5.00

IntInc
-

0.46
0.96
1.49
2.07
2.70
3.37
4.10
4.89
4.88
4.88
4.87
4.85
4.84
4.83

Cl Bal
6.21
- 12.92
- 20.16
- 27.98
- 36.43
- 45.56
- 55.41
- 66.05
- 65.94
- 65.81
- 65.68
- 65.53
- 65.37
- 65.20

8.00%
###

37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72

65.20
65.02
64.82
64.61
64.38
64.13
63.86
63.57
63.25
62.91
62.54
62.15
61.72
61.26
60.76
60.22
59.64
59.01
58.33
57.59
56.80
55.94
55.02
54.02
52.94
51.78
50.52
49.16
47.70
46.11
44.40
42.55
40.56
38.40
36.07
33.56

5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00

4.82
4.80
4.79
4.77
4.75
4.73
4.71
4.69
4.66
4.63
4.60
4.57
4.54
4.50
4.46
4.42
4.37
4.32
4.27
4.21
4.14
4.08
4.00
3.92
3.84
3.74
3.64
3.53
3.42
3.29
3.15
3.00
2.84
2.67
2.49
2.28

65.02
64.82
64.61
64.38
64.13
63.86
63.57
63.25
62.91
62.54
62.15
61.72
61.26
60.76
60.22
59.64
59.01
58.33
57.59
56.80
55.94
55.02
54.02
52.94
51.78
50.52
49.16
47.70
46.11
44.40
42.55
40.56
38.40
36.07
33.56
30.85

73 74 75 76 77 78 79 80 -

30.85
27.91
24.75
21.33
17.63
13.64
9.33
4.68

5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00

2.07
1.83
1.58
1.31
1.01
0.69
0.35
0.03

27.91
24.75
21.33
17.63
13.64
9.33
4.68
0.35

Insurance Policy Example

You assume you are buying an endowment policy, 20 year tenor, Rs 1 cr cover from LIC rig
On the other hand, you can also buy a term assurance policy from Pru I or SBI Life - 20 ye
Which one is better - quantified answer
LIC Premium Endowment
SBI Premium Term

230,000 Rs per annum

6,813 Rs per annum
223,187
483,000

PPF
Year

EndowCF
Invest
FutValuePPF
0230,000
223,187
3,652,798
1230,000
223,187
3,176,346
2230,000
223,187
2,762,040
3230,000
223,187
2,401,774
4230,000
223,187
2,088,499
5230,000
223,187
1,816,086
6230,000
223,187
1,579,206
7230,000
223,187
1,373,222
8230,000
223,187
1,194,106
9230,000
223,187
1,038,353
10 230,000
223,187
902,916
11 230,000
223,187
785,144

15.00%
115.00%
20
19
18
17
16
15
14
13
12
11
10
9

6.93%

12 230,000
13 230,000
14 230,000
15 230,000
16 230,000
17 230,000
18 230,000
19 230,000
20 10,000,000

223,187
223,187
223,187
223,187
223,187
223,187
223,187
223,187

682,734
593,682
516,245
448,909
390,355
339,440
295,165
256,665
26,293,687
16,293,687

8
7
6
5
4
3
2
1

Capital Expenditure Evaluation

In businss situations we dont know the future cash flows
Personal savings and returns can be volatile, but not as much
There is judgement involved, we dont know what we will earn
This lack of predictability adds a few layers of complexity
But the underlying concepts remain the same
We distinguish capital expenditure (Bal Sheet) from revenue expenditure (P&L)
In capex we spend first, then time passes and we hopefully generate returns
Time value of money becomes critical

We set up a factory (which takes two minutes in our class room life) and we spend Rs 10 c
We will earn Rs 2 cr, Rs 3 cr, Rs 4 cr, Rs 4 cr, Rs 4 cr and then sell it off for Rs 5 cr at the e
Is this a good idea
How would corporates typically evaluate this idea
1 Payback period
2 IRR
3 MIRR
4 Net Present Value NPV
5 Discounted Payback Period

More popular
More popular
More popular

6 Profitability Index
Year

CashFlows
010.00
1
2.00
2
3.00
3
4.00
4
4.00
5
9.00
12.00

CumuCF
PV Factor
DCF
CumuDCF
10.00
1.000 - 10.00 10.00
8.00
0.877
1.75 8.25
5.00
0.769
2.31 5.94
1.00
0.675
2.70 3.24
3.00
0.592
2.37 0.87
12.00
0.519
4.67
3.81
NPV
3.81

Payback
How long does it take to get your money back
Without getting into discounting, compounding, interest
Could be understand as 3.25 years
0.25
Payback is widely used
SME entities have a strict rule - anything more than 3 years is a NO
Anything more than 2 years is slightly suspicious
18 months, looks nice
12 months, lets discuss
Longer payback means higher risk
Larger corporates have many many projects
Tata Motors would have 825 projects per annum
90% of them cost less Rs 10 crores
Who initiates them
Mid level managers
Here again, 4 years - NO
18 months, lets see
12 months, okay wow
IRR
25.60%
Good, bad, okay, excellent, wow, hopeless, too little, uninteresting ?
The IRR has a basic mathematical problem (to call it a flaw may be too harsh)

That problem might make the IRR unreliable - 25 is not 25 - it just looks like 25
The IRR assumes that all intermediate cash flows can be reinvested at the IRR rate
It requires brilliance on a daily basis
Which is not easy
High IRRs may not be practically achieveable
Most of the time, the incremental cash flows are reinvested in some treasury instruments

Reasonable IRRs are reliable - In India, an IRR of 12 to 17% is considered reasonable in the
may have 1,000 projects available at any point in time and surpluses from other projects
in new projects
Bill Gates saw this problem that humanity is facing with the IRR
He created MIRR - Modified IRR
MIRR asks for a borrowing rate and a reinvestment rate
Borrowing rate
12%
Reinvestment rate
6%
MIRR
18.97%

The MIRR has its own problems, but it probably makes the higher IRR a little more realisti
This problem of the IRR is also called REINVESTMENT RISK

NPV
Net means net of inflows and outflows
What does Rs 3.81 positive mean
A positive NPV means your return is higher than your cost of capital, so project is prima f
A negative NPV means your return is lower than your cost of capital, so project is prima f
not even earning 14%)

After 5 years, what would be your cash in hand, assuming the projects runs exactly as you
3.81
14%
114%
5
7.33
Year

CashFlows Interest
010.00
1
2.00
2
3.00

Repayment
1.40
1.32

Cl Bal
10.00
0.60
9.40
1.68
7.72

3
4
5

4.00
4.00
9.00

1.08
0.67
0.21

2.92
3.33
8.79 -

4.80
1.47
7.33

Discounted Payback Period

The cash flow of the 5th year (Rs 9.00 cr) comprises of Operating Cash Flow of Rs 4 cr and
When will sale of factory happen ? Last day
Your discounted payback workings would be based on which number ? 4, 5, 9 ? Only Rs 4 c
4.00
0.519
2.08 This is the DCF of the operating cash flow compon
We need how much
0.87
How long will this take
0.42
12
5.02
365
153 Discounted Payback Perio

Profitability Index
In the normal course of life, the IRR and the NPV will give you the same signals (red, gree
There is no conflict
But when you two or more mutually exclusive projects, then there could be conflict
Project Rs cr
Cost
NPV
IRR
Which is better
Profitability Index =

B
100
53
18%

C
150
87
17%

181
88
12%

PV of Inflows
PV of Outflows

PV of Inflows
153
237
Prof Index
1.53
1.58
Ranking
2
1
For every one rupee that I spend today, how much am I getting back

269
1.49
3

ged (per annum number)

0.35

46.00
250.00

cr cover from LIC right now

u I or SBI Life - 20 years, Rs 1 cr

LIC will pay you Rs 1 cr plus a loyalty bonus

which is approx 70/1000 on an average
5.5%
20
110%
1.00
1.10
2.10

IRR on Endowment

ture (P&L)
returns

and we spend Rs 10 crs on it

ff for Rs 5 cr at the end of the 5th year

oo harsh)

Cost of Capital - as
1+r=

14%
114%

oks like 25
at the IRR rate

treasury instruments which yield 6%, 7%

red reasonable in the sense that, a corporate

from other projects could be fruitfully utilized

R a little more realistic

so project is prima facie interesting

so project is prima facie uninteresting (you are

ts runs exactly as you forecasted

The NPV assumes that all borrowings cost

you the 14% rate and all surpluses can be

reinvested at the same 14% rate

sh Flow of Rs 4 cr and Sale of Factory of Rs 5 cr

? 4, 5, 9 ? Only Rs 4 cr
ing cash flow component of the 5th year

ounted Payback Period is 4 years, 153 days

me signals (red, green)

ould be conflict

Application of the principles of compounding, discounting in the bond market

Bond - Face Value
100 PredefinedOn the day on which the bond was issued, the mar
Issue Price
100 Predefinedof interest was indeed 9%, so they issued at 9%
Redemption Price
100 PredefinedBut today, the rate is 8% - if the company were to
Tenor (Years)
5 Predefinedsuch a bond today, they would be able to price at 8
Coupon
9% PredefinedInterest rates have dropped since the time of issue
Frequency
1 Predefined
Market rate of Interes
8% This comes from external data
108%
Annual Interest Coup
9
Semi Annual Interest
4.50
If the yield is given, the price of the bond can be determined
If the price is given, the yield on the bond can be determined
Year

CashFlow PV Factor DCF

0
1.000
Policy = Factory = Bond
1
9
0.926
8.33
2
9
0.857
7.72
3
9
0.794
7.14
4
9
0.735
6.62
5
109
0.681
74.18
103.99 We derived the price from the given yield

If say 8% is the market yield, but coupons are paid out on semi-annual basis, then what happ

Half Year CashFlow PV Factor DCF

0
1.000
1
4.50
0.962
4.33
8%
2
4.50
0.926
4.17
2
3
4.50
0.891
4.01
3.925%
4%
4
4.50
0.857
3.86 103.925%
104%
5
4.50
0.825
3.71 108.00%
108.16% I want this number to
6
4.50
0.794
3.57
What is my semi-annu
7
4.50
0.764
3.44
8
4.50
0.735
3.31
A semi-annual 3.925% translates into an
9
4.50
0.707
3.18
yield
10
104.50
0.680
71.11
104.68
Exercises
One
A bond was issued at Rs 100, 10% coupon annual, 7 years ago. Total tenor was 11 years
Its price is Rs 102. What is the YTM

Two
A bond was issued a year ago for Rs 100, 11% coupon semi annual, its tenor was 12 years
and its price today is Rs 105. What is its YTM
Three for practice
You invest in the bond in exercise two above. Post maturity you invest in another bond where
the coupon is 10% for 10 years. All interim coupons that you earn are invested at 6%.
The final corpus after the second bond matures is then invested at 9% in a Govt fund
You will withdraw Rs xx from this fund every year for the next 15 years (to meet your
living expenses). How much is this Rs xx that you can withdraw
Equity Valuation
In equity there are no fixed coupons, there is no redemption date
End game is not clear, annual cash flows are also unclear
But we will estimate
Company X earned Rs 12 per share last year. Its earnings will grow at 15% for the next
3 years, at 20% for another 3 years and then settle down at 8% thereafter
Investors here seek a return of 14% on their investment
What should be the value of this share
Year

Earnings PV Factor DCF

0
12.00
1.000
1
13.80
0.877
12.11
2
15.87
0.769
12.21
3
18.25
0.675
12.32
4
21.90
0.592
12.97
5
26.28
0.519
13.65
6
31.54
0.456
14.37
TerminalVal 567.66
0.456
258.62
336.24

Growth
15%
20%
8%

115%
120%
108%

14%

114%

77.62
258.62
336.24

7
34.06
0.400
Terminal Value will be (34.06 / r - g)
r=
14%
g=
8%
r-g=
6%
Terminal Value is
567.66 This value is determined at the end of year 6

Years 1 to 6 are called as EXPLICIT FORECAST PERIODExplicit Forecast Valuation

Years 7 to Infinity are called as TERMINAL PERIODS

Terminal Valuation

What is the value of an infinite series of cash flows that are constant
Suppose you go to SBI and place a deposit of Rs 100
SBI says we will pay 8% forever on this deposit, but dont ask for the principal back
100 = 8 + 8 + 8 + 8 +
Zero growth annuity
Year
Annuity PV
0
1
8.00
2
8.00
3
8.00
4
8.00
5
8.00
6
8.00
7
8.00
8
8.00
9
8.00
10
8.00
11
8.00
12
8.00
13
8.00
14
8.00
15
8.00
16
8.00
17
8.00
18
8.00
19
8.00
20
8.00
21
8.00
22
8.00
23
8.00
24
8.00
25
8.00
26
8.00
27
8.00
28
8.00
29
8.00
30
8.00
31
8.00
32
8.00
33
8.00
34
8.00
35
8.00

FactorDCF
1.000
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215
0.199
0.184
0.170
0.158
0.146
0.135
0.125
0.116
0.107
0.099
0.092
0.085
0.079
0.073
0.068

Years
7.41
6.86
6.35
5.88
5.44
5.04
4.67
4.32
4.00
3.71
3.43
3.18
2.94
2.72
2.52
2.34
2.16
2.00
1.85
1.72
1.59
1.47
1.36
1.26
1.17
1.08
1.00
0.93
0.86
0.80
0.74
0.68
0.63
0.58
0.54

123
###
187
###
64 0.00768624127

8%
108%

Mathematically, this formula becomes

The present value of a perpetual zero growth annu
the annual coupon divided by the discounting rate
(Rs 8.00 / 8%) = Rs 100

36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80

8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00

0.063
0.058
0.054
0.050
0.046
0.043
0.039
0.037
0.034
0.031
0.029
0.027
0.025
0.023
0.021
0.020
0.018
0.017
0.016
0.015
0.013
0.012
0.012
0.011
0.010
0.009
0.008
0.008
0.007
0.007
0.006
0.006
0.005
0.005
0.005
0.004
0.004
0.004
0.003
0.003
0.003
0.003
0.002
0.002
0.002

0.50
0.46
0.43
0.40
0.37
0.34
0.32
0.29
0.27
0.25
0.23
0.21
0.20
0.18
0.17
0.16
0.15
0.14
0.13
0.12
0.11
0.10
0.09
0.09
0.08
0.07
0.07
0.06
0.06
0.05
0.05
0.05
0.04
0.04
0.04
0.03
0.03
0.03
0.03
0.02
0.02
0.02
0.02
0.02
0.02

81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125

8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00

0.002
0.002
0.002
0.002
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

0.02
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170

8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00

0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

171
172
173
174
175
176
177
178
179
180
181
182
183
184
185
186
187

8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00
8.00

0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Growing annuity
Year
Annuity PV FactorDCF
0
1.000
1
8.00
0.926
2
8.24
0.857
3
8.49
0.794
4
8.74
0.735
5
9.00
0.681
6
9.27
0.630
7
9.55
0.583
8
9.84
0.540
9
10.13
0.500
10
10.44
0.463
11
10.75
0.429
12
11.07
0.397
13
11.41
0.368
14
11.75
0.340
15
12.10
0.315
16
12.46
0.292
17
12.84
0.270
18
13.22
0.250
19
13.62
0.232
20
14.03
0.215
21
14.45
0.199

0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

3% Growth
Years
123
187
64

159.53
159.98
0.45

8%
108%

7.41
7.06
6.74
6.43 Mathematically, this formula becomes
6.13 The present value of a growing annuity is the first
5.84 divided by (r-g)
5.57
5.32
8.00
5.07
8%
3%
5%
4.83
4.61
160.00
4.40
4.19
4.00
3.81
3.64
3.47
3.31
3.16
3.01
2.87

22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66

14.88
15.33
15.79
16.26
16.75
17.25
17.77
18.30
18.85
19.42
20.00
20.60
21.22
21.86
22.51
23.19
23.88
24.60
25.34
26.10
26.88
27.69
28.52
29.37
30.25
31.16
32.10
33.06
34.05
35.07
36.12
37.21
38.32
39.47
40.66
41.88
43.13
44.43
45.76
47.13
48.55
50.00
51.50
53.05
54.64

0.184
0.170
0.158
0.146
0.135
0.125
0.116
0.107
0.099
0.092
0.085
0.079
0.073
0.068
0.063
0.058
0.054
0.050
0.046
0.043
0.039
0.037
0.034
0.031
0.029
0.027
0.025
0.023
0.021
0.020
0.018
0.017
0.016
0.015
0.013
0.012
0.012
0.011
0.010
0.009
0.008
0.008
0.007
0.007
0.006

2.74
2.61
2.49
2.37
2.26
2.16
2.06
1.96
1.87
1.79
1.70
1.63
1.55
1.48
1.41
1.34
1.28
1.22
1.17
1.11
1.06
1.01
0.96
0.92
0.88
0.84
0.80
0.76
0.73
0.69
0.66
0.63
0.60
0.57
0.55
0.52
0.50
0.47
0.45
0.43
0.41
0.39
0.37
0.36
0.34

67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111

56.28
57.97
59.71
61.50
63.34
65.24
67.20
69.22
71.29
73.43
75.63
77.90
80.24
82.65
85.13
87.68
90.31
93.02
95.81
98.69
101.65
104.70
107.84
111.07
114.40
117.84
121.37
125.01
128.76
132.63
136.60
140.70
144.92
149.27
153.75
158.36
163.11
168.01
173.05
178.24
183.58
189.09
194.76
200.61
206.63

0.006
0.005
0.005
0.005
0.004
0.004
0.004
0.003
0.003
0.003
0.003
0.002
0.002
0.002
0.002
0.002
0.002
0.002
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.001
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

0.32
0.31
0.29
0.28
0.27
0.26
0.24
0.23
0.22
0.21
0.20
0.19
0.18
0.18
0.17
0.16
0.15
0.14
0.14
0.13
0.13
0.12
0.11
0.11
0.10
0.10
0.09
0.09
0.09
0.08
0.08
0.07
0.07
0.07
0.06
0.06
0.06
0.06
0.05
0.05
0.05
0.05
0.04
0.04
0.04

112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156

212.82
219.21
225.79
232.56
239.54
246.72
254.12
261.75
269.60
277.69
286.02
294.60
303.44
312.54
321.92
331.57
341.52
351.77
362.32
373.19
384.38
395.92
407.79
420.03
432.63
445.61
458.98
472.75
486.93
501.54
516.58
532.08
548.04
564.48
581.42
598.86
616.83
635.33
654.39
674.02
694.24
715.07
736.52
758.62
781.38

0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

0.04
0.04
0.03
0.03
0.03
0.03
0.03
0.03
0.03
0.03
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.02
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.01
0.00

157
158
159
160
161
162
163
164
165
166
167
168
169
170
171
172
173
174
175
176
177
178
179
180
181
182
183
184
185
186
187

804.82
828.96
853.83
879.45
905.83
933.00
960.99
989.82
1,019.52
1,050.10
1,081.61
1,114.05
1,147.48
1,181.90
1,217.36
1,253.88
1,291.49
1,330.24
1,370.15
1,411.25
1,453.59
1,497.20
1,542.11
1,588.38
1,636.03
1,685.11
1,735.66
1,787.73
1,841.36
1,896.60
1,953.50

0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

The company's earnings from Year 7 to Year 700 are worth Rs 258 today
These are worth Rs 567 at the end of Year 6 from today
258
14%
114%
6
566
Company Share Value = Earnings from Y1 to Y6 plus Earnings from Y7 to Yinfinity
77.62
258.62
336.24

Rate of discounting

Lets imagine you are evaluating a company's project

The company wants to build a new plant
They want to know at what rate they should discount their cash flows
We assumed 14% in the last example, but why 14%, how 14%

Companies are funded by (a) debt and (b) equity

Debt is provided by lenders, who want a rate of interest and they want principal back
Equity is provided by investors, who want the share price to go up up up and they are okay w
Capital = Debt + Equity
Cost of funding (rate of discounting) comes from (a) cost of debt and (b) cost of equity
Cost of Debt
If you were to borrow today, at what rate would the world give you funding
The interest that you pay is a tax deductible expense - the interest reduces your profi, which
If you pay interest at 10% and your tax rate is 30%, effectively you have borrowed at 7%

You borrowed from HDFC for you home at 10%

The interest that you pay is tax deductible
If your salary income is Rs 10 lakhs and this interest is Rs 1.50 lakhs, your taxable income is o
If your rate of tax is 30%, then you have saved 30% on Rs 1.50 lakhs, that is Rs 45,000
You paid HDFC
You saved tax
Your effective cost of interest

30%
70%

150000
45000
105000

10%
3%
7.00%

If you have issued a bond with a coupon of 9%, but the current YTM (yield, interest) is 8% and
what is your cost of debt ?
We should consider the current market rates (and not your historical costs)
Current market rate (yield, YTM)
8.00%
Tax benefit
30%
2.40%
Post tax cost of debt
70%
5.60%
I have one loan from the bond market, where the YTM is 8%
I have another loan from SBI, where historically I have paid 12%
But now SBI is ready to give me fresh loans at 11.50%
What is my SBI cost of debt

11.50%

30%

3.45%

8.05%

Pref Shares
Pref Shares are like bonds in terms of features, but the dividend I pay here is not tax deductib
I have issued Pref Shares of Rs 100 face value, they are quoted in the market at Rs 102
Dividend is 8%, balance tenor is 6 years

What is the effective cost of these Pref Shares

Year

CashFlow
0
-102
1
8
2
8
3
8
4
8
5
8
6
108

7.57% No tax benefit

7.57% So cost of debt of this instrument is

Equity Shares
What is the cost of equity shares
Many people think cost is zero, bcoz we are not obligated to pay anything to the equity holde
There is no apparent / legal cost, but there are shareholders expectations, which become you
at least that much - that becomes your cost of equity
How much do shareholders expect you to earn
CAPM - Prof William Sharpe of Stanford
The shareholders will first of all seek a risk free return based on their economy
So, in India, we have a G Sec market, which is risk free (Govt bond market)
Long term yield (10 year, 20 year) is aroun
8.21%

Equity Risk Premium (the incremental return that an investor seeks bcoz he is taking addition
This ERP is modeled based on history
Historically, what has the equity market generated and what has the bond market generated
Suppose the equity market has generated 7% more
That means, investors are happy to earn 7% extra
7%
17%
10%

7.25%
16%
9%

6.80%
13%
6%

7.50%
12%
5%

8.10%
15%
7% Average
7.27%
This is an arithmetical average, which is

107.00% 107.25% 106.80% 107.50% 108.10%

117.00% 116.00% 113.00% 112.00% 115.00%
100
100

107
117

115
136

123
153

132
172

142
198
139%
6.76%
This is a geometric mean, which is corre

But this 6.76% is for the market as a whole (had I invested in the Sensex, Nifty, India), I would

with a return of

14.97%

But you are asking me to invest in your company

How risky is your company viv-s-vis the Sensex
Suppose your company is
1.32 times more risky than Sensex
This is computed based on market price movements (volatility of the share price)
The investor will ask for more compensation
Relative risk is called Beta
Cost of Equity = Risk Free Rate + (ERP x Relative Risk)
8.21%
6.76%
1.32
8.92%
17.13%
Usually, these kind of calculations are done by long term investors
Long term investors generally consider beta determined over the long term

Debt
Equity

5.60%
17.13%

We determine the average cost, which is called WEIGHTED AVERAGE COST OF CAPITAL (WACC
This average cost is based on market valuations of debt and market valuations of equity
Rs cr
Suppose your debt is only bonds
Bond issue price is Rs 100, market price is Rs 104
Total bonds issued at issue price are Rs 400 crores
What is the market value of these bonds
416
Value of your equity based on current price

1,025
1,441.00

Cost

WACC

5.60%

23.30

17.13%
13.80%

175.62
198.92

Any discounting that I do for my future cash flows, will be at 13.80%

In other words, the world expects me to earn 13.80% on every rupee of capital that I utilize fr

bond market
was issued, the market rate
hey issued at 9%
e company were to issue
be able to price at 8%
ce the time of issue

8%
- 103.99
9.00
9.00
9.00
9.00
109.00

given yield

sis, then what happens

ant this number to be 108%

hat is my semi-annual discounting rate

% translates into an 8% annual

r was 11 years

nor was 12 years

nother bond where

ested at 6%.
a Govt fund
meet your

% for the next

Estimated
Estimated
Estimated
Investors expectations of returns

77.62

ipal back

al zero growth annuity is

he discounting rate

103%

annuity is the first year coupon

58 today

rom Y7 to Yinfinity

ncipal back
nd they are okay with some risk of losses

ost of equity

s your profi, which reduces your tax

borrowed at 7%

taxable income is only Rs 8.50 lakhs

t is Rs 45,000

, interest) is 8% and tax rate is 30%,

e is not tax deductible (no tax benefit)

ket at Rs 102

to the equity holder

which become you bar - you have to earn

he is taking additional risk)

d market generated

al average, which is wrong

mean, which is correct

Nifty, India), I would have been happy

T OF CAPITAL (WACC)
tions of equity

apital that I utilize from the world

Should we express all this on annualized basis or semi-annual basis

What is human convention
Age - 7948 very correct, but these people dont understand - not convention
Interest world over is expressed as an annual rate
When we say interest is 10%, we mean two things (unless otherwise stated)
a. This is 10% per annum
b. This is compounded annually
Pre tax cost of these bonds (annualized)
Pre tax cost of these bonds (semi-annual)
Price of the Bond
3.584%
103.584%
107.30%
7.30%
Annualized IRR
Tax Ben
2.77%
Post Tax
4.52%

IRR

38%

Could be read 4.45% to 4.59%

95.60
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375

14.66%
7.08%
Coupon
FaceVal

7.11%
3.54%
6.75%
3.375%
100.00
3.375

3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
3.375
103.375

Cost of Equity
Cost of Equity = Risk Free Rate + (Equity Risk Premium x Beta)
Risk Free Rate
A good representative of risk free rates are Govt bonds of those countries
5.74% 20 year yield
4.88% 5 year yield
20 years makes a lot sense

We need a good long term rate (not a short term rate)

Serious equity investing is a long term activity
What is long term - this has no answer
5 years, 10 years, 20 years, 100 years - depends on who you are, how deep your pocket is
philosophy of investing, what is the data availability
In India, 20 year yields are not available
The most liquid one is 10 year in India

I would argue that we use a reasonably long term rate - if the 20 year rate in the US is liq
assume it is, in the absence of info to the contrary), then a 20 year rate is fine
But if it were India, I would rather use a 10 year rate
Equity Risk Premium
This is incremental return that investors in shares have earned over investors in bonds
Over the long term, such incremental returns make investors satisfied
Geometric mean is superior to arithmetic mean in such matters
5.90%
If an investor were to invest in Dow Jones Index, he would be reasonably satisfied with a
11.64%

Beta
This tries to bring out the fact that Nike is not Dow Jones (relative risk)
5 year beta is
0.80 One would be reasonably okay with this beta, unless you
inputs that this beta is likely to get disrupted in the comi
If the company is planning huge debt issues, or is plannin
high risk businesses, then beta of the past may be errone
Beta for the future cannot be seen, measured - it can only be estimated
To the extent we are using current beta (based on history), we are carrying a limitation
Cost of Equity =

5.74%
10.46%

Cost
Debt
Equity

5.90%

Wrong Mix WACC

4.52%
27%
1.22%
10.46%
73%
7.64%
8.86%

0.80

Warren Buffet says you g

quite a lot for a cheery c

What is the WACC

Cost

Right Mix

WACC

MktValues

Debt
Equity

4.52%
10.46%

10.2%
89.8%

0.46%
9.39%
9.86%

1,296
11,427
12,723

Book values considered for debt, in the absence of information on market values
Debt market values (where traded and liquid) does not tend to move too far from book va
Further, most debt is not trade-able, hence subsitution of book values is fairly common

Book - Chapters 1, 2, 5, 6, 7, 9, 10
Specific examples as per mail for homework

Work to do
1 What exactly is beta and how is it calculated
2 What is the effective cost of borrowing in a foreign currency - simple examples
inputs
WHAT IS THE FRAMEWORK FOR MEASURING IRR, NPV, PAYBACK
Is it profit
If profit, is it PAT, PBT, EBIT, EBIDTA, Core EBIDTA
If not PAT, then what else
Do the numbers come from P&L or Balance Sheet or Cash Flow Statement or an amalgam

Our old example

We set up a factory (which takes two minutes in our class room life) and we spend Rs 10 c
We will earn Rs 2 cr, Rs 3 cr, Rs 4 cr, Rs 4 cr, Rs 4 cr and then sell it off for Rs 5 cr at the e
Is this a good idea
What are these Rs 2 cr, Rs 3 cr numbers - what exactly are they

Answer - these numbers are a form of Cash Flow (but a rather peculiar form)
They are determined in a certain way, which is uncommon otherwise (these numbers may

in a P&L or a Balance Sheet or a Cash Flow Statement)

We assume that capital is being provided by a combination of two communities (lender an

The Liab side of the Balance Sheet is the Funding Side
The Asset side of the Bal Sheet is the Operating Side (these guys use up all the cash)

The Operating chaps should not interfere in funding decisions (and hopefully the other wa

You, as an engineer, have estimated that it will cost Rs 10 cr fo this factory

Now your job is set up that factory
My job is to provide you Rs 10 cr
You dont worry how I am generating these funds (how much debt, how much equity, bon
JPY Notes)
I will not bother you with which machine, what capacity, which manufacturer, which tech
There is a Chinese wall - at least in concept
It is possible that your factory in in Pune and your office is in BKC
All the nuances of the WACC is known only within BKC
Pune guys are told, please earn minimum 17% and dont ask why
Real P&L
Sales Revenue
Operating Costs
EBIDTA
Depn
EBIT
Interest
PBT
Tax
30%
PAT

1,000.00
600.00
400.00
150.00
250.00
55.00
195.00
58.50
136.50

Capex Evaluation - a corrupted form of cash flow

Sales Revenue
1,000.00
Operating Costs
600.00
EBIDTA
400.00
Depn
150.00
EBIT
250.00
Tax on EBIT
30%
75.00 Hypothetical
EBIT x (1-t)
175.00
Add back Depreciation
150.00
Capex
80.00
Changes in working capital
40.00
Final number
205.00 This series of numbers for Year 1, Year 2, will
determining my payback period, NPV, IRR, etc

Cost of borrowing in a foreign currency

Usually firms hedge their forex borrowings (at least the conservative ones do)
You borrow USD 10 mill at Rs 62
If the rates goes to Rs 72, you are finished
You buy a forward contract for a one year tenor at say Rs 66.50
Which means, you will get dollars at Rs 66.50 after one year (frozen rate)
So are prepared to pay Rs 4.50 extra - this is your cost of interest
66.5
62

107.26%

7.26% Hedging cost

3.00% Interest
10.26% Total cost

If rupee borrowings would have cost you 11%, then you have saved 0.74% and also not got

Dec 15,16 we are all afraid of USD interest increases and rupee would most likely depreci
unless you have dollar revenues in your life
Right now, the premium is approx

32
12
384
66.61

35 paise per month

12
420
66.61

5.76%

6.31%

7.33%
3.56%

7.28%
3.58%

7.20%

annual
paid semi-annual, semi-annual coupon

deep your pocket is, what is your

r rate in the US is liquid (and you can

ate is fine
5.74%

nvestors in bonds

ably satisfied with a return of

his beta, unless you have specific

isrupted in the coming years
issues, or is planning to get into
past may be erroneous

rrying a limitation

ren Buffet says you generally pay

e a lot for a cheery consensus

10.19%
89.81%

arket values
too far from book values, in any case
s is fairly common

y - simple examples - using market

ment or an amalgam of all of these

and we spend Rs 10 crs on it

f for Rs 5 cr at the end of the 5th year

(these numbers may never be found

mmunities (lender and investors)

up all the cash)

pefully the other way round also)

w much equity, bonds, SBI loans,

facturer, which technology

Year 1, Year 2, will help in

period, NPV, IRR, etc

ones do)

74% and also not got hit by dollar volatility

d most likely depreciate - leaving a USD Loan open is rather hazardous,

e per month

1 Corporate examples for capital expenditure evaluation

2 Little bit of risk, sensitivity
3 Some more stuff about beta (which is essentially risk again)
4 Little bit about bonds
Incremental working capital
What is working capital
Current assets minus Current liabilities
Most of the time, is it positive or negative
Positive (CA > CL)
Does it take away cash or generate cash
It will take away cash, primarily it represents outflows
Your working capital last year was Rs 125 cr - March 31, 2015
Next year, it is estimated to increase to Rs 180 cr - March 31, 2016
What is the meaning of this projection
Please run around the world and arrange for Rs 55 cr
You need to fund it, it is a negative cash flow in this year (it is a period of time number)
What can kill a project
1 Low profitability
2 Heavy capex, not commesurate with returns
3 Inefficient management of working capital
The cash flow template beautifully brings out all these potential dangers
In a new project, all number are incremental by default, so its easy
But many projects are replacement projects or extension projects
Here, clarity of thought is important
Cash flow thinking does not come naturally to human beings
Most of us are wedded to history, you have an anchor point
You bought SBI share at 275

Now it is 255
You are not happy with the results and you are not keen on the share right now
Most of us, will tell ourselves - let it reach 275 and I will sell it off
This is an anchor point
You believe that selling at 255 is a loss - this is all psychology
REPLACING AIRCONDITIONING SYSTEM AT THE CAMPUS
What are the costs that we incur currently - repairs (frequency, quantum)
Book value of the aircontioners (original cost less depn till date)
Original cost
100
Depn till date
35
Power costs - current
50
Regular maintenance - current
25
Warranty if any
Salvage value of the current systems - today
10
Salvage after ten years
1
New system
Purchase cost
Power cost
Repairs
Maintenance
Risk - more risk
Warranty
Salvage value of the new system

300
38
10
5

Relevant numbers for capital expenditure evaluation

Year
0
Old System
Cost of the new AC
0
Salvage realizn of the old one
0
0
Instal the New System
Cos the new system
-300
Sell the old system
10
-290

12
15
15
42
15

-290
8%

42

42

42

What would have been the cash flows had we continued with the current system
What are the cash flows now that we shift to the new system - we are not evaluating this
What are the incremtental cash flows - this is being evaluated

PHUKET BEACH HOTEL CASE DISCUSSION

of time number)

20

10

100

58

15

42

nt system
not evaluating this

42

42

42

42

42

56

Risk, sensitivity - how do we handle in capex decisions

All numbers about the future are merely estimates
They could go wrong, bcoz the actuals may not turn out the way you thought
They could be over-estimated or under-estimated to begin with
People build buffers all the time

You are committing to a decision, millions of dollars based on some projections - mere es
What is they are wrong, would have decided otherwise
Instead of one possible projection, we try and present many (over a range of inputs)
11.45 lakhs
10 to 13 lakhs
Whether there is a big diff between 10 and 13, make or break
Year

Outfllow Inflow
Net
0 - 100.00
- 100.00
1
20.00
20.00
2
24.00
24.00
3
28.80
28.80
4
34.56
34.56
5
41.47
41.47
13.1%

20%

120%

If the inputs change, how much will the IRR change - I might have tolerance limits
Data Table in Excel wonderful sensitity
13.1%
-70
-80
-90
-100
-110
-120
-130

13%
10.00
12.50
15.00
17.50
20.00
22.50
25.00

10%

15%

27.50

Discounting frequency
Corporate situations we are happy with annual discounting, as a convention
Market situations we may get into daily discounting, or minute to minute discounting dep
investment and the nature of the discounting (annual is also fine for long term investing

If a corporate has surpluses, the ability to reinvest in the short term at the WACC rate is l

Bonds
Fixed income markets are terribly complex markets (complex in a mathematical sense)
Whatever we have done on bonds, is KG class stuff
We did not discuss spot rates or zero rates, forward rates, boot-strapping, fitting a curve,
We approached bonds from the point of view of seeing the application of discounting and
Coupon rate
Yield to Maturity YTM
Current Yield
Yield to Call
Yield to Put

Face value
Coupon
Balance Tenor
Frequency
Price today
Year

Current Yield = Coupon / CMP

9
98
9.18%

YTM

100
9%
5
1
98

CashFlow
0
-98
1
9
2
9
3
9
4
9
5
109
9.521%

Call Option
In general, it is a right to buy
In bond markets, the corporation that has issued these bonds can call the bonds back - th
They tell you that it is a 10 year bond, but they can call back in 7 years (if they choose to

If in the above case, the corporation has a call after 2 years, then the yield on the instrum
as under
Year

CashFlow
0
-98
1
9
2
109
10.155% Yield to Call

Put Option
Right to sell
In bond markets, this a right that the b
the corporation to buy back
If you had this right, say after 3 years,
Year

CashFlow
0
-98
1
9
2
9
3
109
9.801%

Hamada Equation
Levered Beta = Unlevered Beta x (1 + (1-t)(d/e))
This equation is reasonably respected by humanity (not a physics equation, merely a popu
If you have leverage, you are increasing your risk
That incremental risk will show up in your beta
For any serious analysis involving beta, we need to separate the leverage impact on beta

This equation is applied for projecting betas for situations that we cant observe today (w
equity of Rs 2,000 cr), used for new companies that dont have betas, used for understan
structure
Capital structure example
How much debt and how much equity is ideal for me
What should be our objective (to define what is a good capital structure)

We should get the beta close to 1.000 or lower

Lower the better ?

Depends
Risk appetite - those with high appetites can borrow tons of funds ? For them, a
How much cash we have - those who lots of cash - what should they do ? - they
funds to buy back equity ? Why do all this ? What is the objective ?
Objective - to have as a low a WACC as you can get to

0%

99%
Mix

Cost of Debt
Tax Rate
Post Tax Cost of Debt
Cost of Equity

30%

WACC

11.00%
3.30%
7.70%
16.00%

1%
99%

0.08% All this is wrong, t

15.84%
15.92%
15.92%
12.68%
7.78%

As you increase your debt, you will find that are very few people willing to lend
Even those few people suddenly start asking you to pay higher and higher and higher inte
As you borrow more, equity holders will find that the investment is getting too risky
What will they do
Their expectations will rise, so beta will rise, cost of equity will rise
Our capital structure is say 50:50

2.50%
1.00%
0.25%
t=
d=
e=
d/e =

30.00%
50.00%
50.00%
1.00

Risk free rate

8.00%
ERP
7.50%
Market Beta, Observed Beta, Levered Beta
What will happen to this Beta if I change the capital structu
Levered Beta = Unlevered Beta x (1 + (1-t)(d/e))
1.31

UnLevBeta =

Debt

UnLevB x

1
1
1.70

70.00%
0.70

0.77

Cost of Post tax Equity

d/e
Levered Cost of WACC
Debt
CostofDe
Beta
Equity
10% 11.00% 7.700%
90%
0.11
0.83
14%
13.58%
20% 11.25% 7.875%
80%
0.25
0.91
15%
13.41%
30% 11.50% 8.050%
70%
0.43
1.00
16%
13.27%
40% 11.75% 8.225%
60%
0.67
1.13
16%
13.18%
50% 12.00% 8.400%
50%
1.00
1.31
18%
13.11%
60% 12.25% 8.575%
40%
1.50
1.58
20%
13.08%
70% 13.25% 9.275%
30%
2.33
2.03
23%
13.46%
80% 13.50% 9.450%
20%
4.00
2.93
30%
13.55%
90% 16.00% 11.200%
10%
9.00
5.63
50%
15.10%
99% 18.50% 12.950%
1%
99.00
54.17
414%
16.96%

You are a new company

You are an unlisted company
You are a family managed company
What is your beta
Dont know
What is your cost of equity
Dont know
What is your WACC
Dont know

How to know
You take listed companies in your secto
Mkt Betas Unlevered
Betas
A
0.99
0.71
B
1.05
0.78
C
1.16
0.85
D
1.28
0.93
C
1.43
1.08

Not a good average

Average
1.18
0.87
If ABCDE had zero debt, what would th
What is the sector unlevered beta
If I had been zero debt, my unlevered
close to this number of
I bring in my debt into the equation
Suppose my debt is
My equity will be

Levered Beta = Unlevered Beta x 2.3

0.87
2.30
2.001
Hypothetically, if I were listed, my bet
2.001

1 What if my size is not comparable with others in the industry

Others are Rs 5,000 cr plus
My turnover is Rs 400 cr ?
2 What is there is no sector like mine ?
I make garments for elephants

ections - mere estimates

ge of inputs)

nce limits

20%

25%

e discounting depending on the size of the

ng term investing)

he WACC rate is low

ematical sense)

g, fitting a curve, ZCYC

f discounting and compounding concepts to bonds

9
years
Annual

e bonds back - they can prepone the redemption

(if they choose to)

eld on the instrument well be computed

a right that the bond-holder has - he can force

ay after 3 years, the Yield to Put can be determined

on, merely a popular equation)

e impact on beta

observe today (what will happen if I issue

sed for understanding what is a good capital

unds ? For them, a high debt structure is good ?

d they do ? - they should borrow, use these

Debt in your capital structure

l this is wrong, this is math

1:99
40:66
99:1

r and higher interest rates

ng too risky

1.31
he capital structure

1.00

nies in your sector

nlevered

bt, what would their betas have been

evered beta
0.87
t, my unlevered beta would have been
0.87

o the equation
65%
35%
1.86
1.30
2.30

70.00%

ered Beta x 2.3

re listed, my beta would be around