MS-42(JAN 2017)

Q1) What is cost of Capital? How is it calculated for different sources of Capital? How is
average weighted cost of Capital measured?

Ans) What is 'Cost Of Capital'

The cost of funds used for financing a business. Cost of capital depends on the mode of
financing used – it refers to the cost of equity if the business is financed solely through
equity, or to the cost of debt if it is financed solely through debt. Many companies use a
combination of debt and equity to finance their businesses, and for such companies, their
overall cost of capital is derived from a weighted average of all capital sources, widely
known as the weighted average cost of capital (WACC). Since the cost of capital represents
a hurdle rate that a company must overcome before it can generate value, it is extensively
used in the capital budgeting process to determine whether the company should proceed
with a project.

BREAKING DOWN 'Cost Of Capital'

The cost of various capital sources varies from company to company, and depends on
factors such as its operating history, profitability, credit worthiness, etc. In general, newer
enterprises with limited operating histories will have higher costs of capital than established
companies with a solid track record, since lenders and investors will demand a higher risk
premiumfor the former.

Every company has to chart out its game plan for financing the business at an early stage.
The cost of capital thus becomes a critical factor in deciding which financing track to follow
– debt, equity or a combination of the two. Early-stage companies seldom have sizable
assets to pledge as collateralfor debt financing, so equity financing becomes the default
mode of funding for most of them.

The cost of debt is merely the interest rate paid by the company on such debt. However,
since interest expense is tax-deductible, the after-tax cost of debt is calculated as: Yield to
maturity of debt x (1 - T he e T is the o pa ’s marginal tax rate.

The cost of equity is more complicated, since the rate of return demanded by equity
investors is not as clearly defined as it is by lenders. Theoretically, the cost of equity is
approximated by the Capital Asset Pricing Model (CAPM) = Risk-free rate +
Co pa ’s Beta x Risk Premium).

The fi ’s o e all ost of apital is ased o the eighted a e age of these osts. Fo
example, consider an enterprise with a capital structure consisting of 70% equity and 30%
debt; its cost of equity is 10% and after-tax cost of debt is 7%. Therefore, its WACC would be
(0.7 x 10%) + (0.3 x 7%) = 9.1%. This is the cost of capital that would be used to discount
future cash flows from potential projects and other opportunities to estimate their Net
Present Value (NPV) and ability to generate value.

1
Companies strive to attain the optimal financing mix, based on the cost of capital for various
funding sources. Debt financing has the advantage of being more tax-efficient than equity
financing, since interest expenses are tax-deductible and dividends on common shares have
to be paid with after-tax dollars. However, too much debt can result in dangerously
high leverage, resulting in higher interest rates sought by lenders to offset the higher default
risk.

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which
each category of capital is proportionately weighted.

All sources of capital, including common stock, preferred stock, bonds and any other long-
term debt, a e i luded i a WACC al ulatio . A fi ’s WACC i eases as the beta and rate
of return on equity increase, as an increase in WACC denotes a decrease in valuation and an
increase in risk.

To calculate WACC, multiply the cost of each capital component by its proportional weight
and take the sum of the results. The method for calculating WACC can be expressed in the
following formula:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total a ket alue of the fi ’s fi a ing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Explanation of Formula Elements

Cost of equity (Re) can be a bit tricky to calculate, since share capital does not technically
have an explicit value. When companies pay debt, the amount they pay has a
predetermined associated interest rate that debt depends on size and duration of the debt,
though the value is relatively fixed. On the other hand, unlike debt, equity has no concrete
price that the company must pay. Yet, that doesn't mean there is no cost of equity.
Since shareholders will expect to receive a certain return on their investment in a company,
the equity holders' required rate of return is a cost from the company's perspective, since if
the company fails to deliver this expected return, shareholders will simply sell off their
shares, which leads to a decrease in share price and in the o pa ’s alue. The ost of
equity, then, is essentially the amount that a company must spend in order to maintain a
share price that will satisfy its investors.

Calculating cost of debt (Rd), on the other hand, is a relatively straightforward process. To
determine the cost of debt, use the market rate that a company is currently paying on its

2
debt. If the company is paying a rate other than the market rate, you can estimate an
appropriate market rate and substitute it in your calculations instead.

There are tax deductions a aila le o i te est paid, hi h is ofte to o pa ies’ e efit.
Be ause of this, the et ost of o pa ies’ de t is the a ou t of i te est the a e pa i g,
minus the amount they have saved in taxes as a result of their tax-deductible interest
payments. This is why the after-tax cost of debt is Rd (1 - corporate tax rate).

BREAKING DOWN 'Weighted Average Cost Of Capital - WACC'

In a broad sense, a company finances its assets either through debt or with equity. WACC is
the average of the costs of these types of financing, each of which is weighted by its
proportionate use in a given situation. By taking a weighted average in this way, we can
determine how much interest a company owes for each dollar it finances.

De t a d e uit a e the t o o po e ts that o stitute a o pa ’s apital fu di g.

Lenders and equity holders will expect to receive certain returns on the funds or capital they
have provided. Since cost of capital is the return that equity owners (or shareholders) and
debt holders will expect, so WACC indicates the return that both kinds
of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC
is a i esto ’s opportunity cost of taking on the risk of investing money in a company.

A firm's WACC is the overall required return for a firm. Because of this,
company directors will often use WACC internally in order to make decisions, like
determining the economic feasibility of mergersand other expansionary opportunities.
WACC is the discount rate that should be used for cash flowswith risk that is similar to that
of the overall firm.

To help understand WACC, try to think of a company as a pool of money. Money enters the
pool from two separate sources: debt and equity. Proceeds earned through business
operations are not considered a third source because, after a company pays off debt, the
company retains any leftover money that is not returned to shareholders (in the form
of dividends) on behalf of those shareholders.

Suppose that lenders requires a 10% return on the money they have lent to a firm, and
suppose that shareholders require a minimum of a 20% return on their investments in order
to etai thei holdi gs i the fi . O a e age, the , p oje ts fu ded f o the o pa ’s
pool of money will have to return 15% to satisfy debt and equity holders. The 15% is the
WACC. If the only money in the pool as $5 i de t holde s’ o t i utio s a d $5 i
sha eholde s’ i est e ts, a d the o pa i ested $ i a p oje t, to eet the
le de s’ a d sha eholde s’ etu e pe tatio s, the p oje t ould eed to ge e ate etu s
of $5 each year for the le de s a d $ a ea fo the o pa ’s sha eholde s. This ould
require a total return of $15 a year, or a 15% WACC.

Uses of Weighted Average Cost of Capital (WACC)

Securities analysts frequently use WACC when assessing the value of investments and when
determining which ones to pursue. For example, in discounted cash flow analysis, one may
apply WACC as the discount rate for future cash flows in order to derive a business's net

3
present value. WACC may also be used as a hurdle rate against which to
gauge ROIC performance. WACC is also essential in order to perform economic value added
(EVA) calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth
pursuing. Put simply, WACC is the minimum acceptable rate of return at which a
company yields etu s fo its i esto s. To dete i e a i esto ’s pe so al etu s o a
i est e t i a o pa , si pl su t a t the WACC f o the o pa ’s etu s
percentage. For example, suppose that a company yields returns of 20% and has a WACC of
11%. This means the company is yielding 9% returns on every dollar the company invests. In
other words, for each dollar spent, the company is creating nine cents of value. On the other
hand, if the company's return is less than WACC, the company is losing value. If a company
has returns of 11% and a WACC of 17%, the company is losing six cents for every dollar
spent, indicating that potential investors would be best off putting their money elsewhere.

WACC can serve as a useful reality check for investors; however, the average investor would
rarely go to the trouble of calculating WACC because it is a complicated measure that
requires a lot of detailed company information. Nonetheless, being able to calculate WACC
can help investors understand WACC and its significance when they see it in brokerage
analysts' reports.

Q2) Discuss the various components of project planning. Explain the application o f work
breakdown structure in monitoring and controlling a project.

Ans) thinking about projects and project execution, the competition in this world has
become so huge and intense that organizations hardly want to take any risks that might
place their projects within the zone of penalty and negative implications during any phase
of the project/program. Having said that, because of the accumulative bunch of free
project tools and process knowledge available out there today, organizations also take the
necessary corrective actions upfront to ensure that all of their programs/projects are fully
compliant from a process, quality cost, time, scope and schedule perspective that are
much compulsory to meet the delivery demands of the Client/Customer in this
progressively challenging project galaxy across the globe. Of the factors mentioned above,
let’s take S ope . S ope is the ore eed for all proje ts – this is the real thing that needs
to be understood and implemented for the project. As we all know very well, there are
several circumstances across the orb wherein projects have failed or have went into losses
for the simple reason of the scope either not being correctly understood or not being
orre tly i ple e ted o oth. S ope is the o e ti g fa tor for the rest of the proje t
parameters of cost, time, resources, etc. and hence getting to understand scope, breaking
it into smaller pieces, creating simpler scope tasks, and confirming the associated project

4
 deliverables is the key for any project. This article describes one of the most important
tools – the WBS (Work Breakdown Structure) for understanding and decomposing project
scope and also the various advantages/successes that a project team could derive if a WBS
is well-prepared and used through the duration of the project.

What Is A Work Breakdown Structure?

Simply put, a work breakdown structure is a hierarchical decomposition of the

scope/work that needs to be estimated and executed during the course of the project in
order to accomplish the project objectives and deliverables.
Though it sounds so simple, a WBS has enormous strength and influence to convert complex
requirements/scope into small and easier pieces for project estimation, planning and
execution. A WBS:

 Gives Clarity on the project needs in terms of deliverables and success criteria – it highlights
the hat of the project
 Organizes the project scope, puts a defined decomposing structure around it
 Gives more simplicity and break-up of the activity to be performed using its each
hierarchical decomposed level
 Successively subdivides the scope into manageable components in terms of size, duration,
and responsibility
 Is a structured diagram portraying the hierarchical listing of overall project requirements
into increasing levels of detail
 Aids in assigning responsibilities, resource allocation, and monitoring and controlling the
project
 Is an important instrument for reviewing the decomposed scope (with defined deliverables)
with the project stakeholders. It also gives a meaningful pictorial view of the scope and
deliverables of the project.

How To Create A WBS And What’s Its I po ta e?

Step1: List Out The Highest Level Requirements / Scope Deliverables
It’s o e of the ost o o p a ti es that the fi st s ope state e t o the s ope of o k
that a project team receives might contain information in a mix-up format and hence it
cannot be taken as-is and used for project estimation and implementation. The project team
needs to discuss the scope with the Customer/ Customer analysts/system users to
understand the need of the scope mentioned and also the main
objectives/ e ui e e ts/deli e a les that a e e pe ted out of the p oje t. It’s i pli it that
these requirement clarifications and discussions with the Customer teams are required
throughout the course of the project as and when required from an estimating perspective.
Place these objectives/requirements/deliverables at the first level of hierarchy in the WBS
diagram (See Figure 1). This step gives a defined starting point to the project estimation
process by converting a scope document into a first set of high level requirements. One of
the points to keep in mind is that developing a hierarchical diagram is only for ease of

5
understanding and quicker understanding of the scope decomposition. The broken-up
components can be listed and numbered in any format and in any tool (Word, Excel, MPP,
etc...) and can be tracked in various ways. It is not the format that matters but the
connection and linkage between the parent and the child scope items that make the WBS
structure one of the most prominent and useful tools for the process of project estimation.

Figure 1: High Level Requirements

Step2: Break-Up Each High Level Requirement Into Major Deliverable Categories
Once the high level requirements are available as defined in Step 1 above, for each of the
high level requirements, teams should then take-up each of them one by one and start
diggi g i to the e t le el su a ies of hat’s the p odu t o hat a e the p odu ts that
need to be created/changed/implemented for meeting the requirement. It will quite be
possible that for a given high level requirements changes might need to be made to four
different systems/components each of which could be implemented independently. As part
of this step, team should keep asking itself – hat eeds to e do e to a hie e this
requirement? One needs to be sure that the next level break-up being created should relate
to products/activities that need to be defined further (See Figure 2).

Figure 2: High Level Requirements Broken-up into Sub-Categories

6
Step3: Break-Up Each Major Deliverable Into Single Or Multiple Measurable Activities
The next step is to take each deliverable/system change identified in Step2 and create
defined activities or work-product(s) for each of them with the information related to the
associated effort required for each of the activities together the level of risk and complexity
for each of them. One thing that needs to be remembered is that as we go down the WBS
structure, the activities should get refined till they reach a reasonable and measurable
activit . No the uestio is hat’s the ule fo a easu a le a ti it ? . I ould sa the e
is no such confirmed rule and it would mostly depend on the type, size and complexity of
the project, organization process and also the level of break-up that the WBS is being built
with. Normally, an activity with duration of 40 hours or up to the max of 80 hours is
considered as a measurable activity as these durations are reasonable enough for a project
lead or a project manager to monitor. The measurable activities thus created are sometimes
termed as work packages and one of the principles of a WBS is that the requirements need
to be continuously decomposed till we arrive at a final list of work packages that could be
monitored. It is very well possible that each major deliverable that we started off in this step
might have more work packages and in some cases, it might be needed to decompose the
current deliverable into more sub-levels until a defined work package is arrived at. In that
case, the WBS structure will go into deeper sub-levels which is ok since the goal of carrying
out the WBS exercise is to ensure that each requirement is successfully drilled down to its
respective final deliverable/work package (See Figure 3).

Figure 3: Major Deliverables broken down into measureable activities/work-packages

7
Step4: Review Work Packages For Completeness Of Scope Coverage
The final step in this process is to ensure that the correct numbering is applied to each of
the levels and that each requirement is efficiently drilled down to is respective deliverable
mapping all the intermediate WBS components. Each component within each level of a WBS
is u e ed as a d he it’s eated. I this step, the WBS o po e ts a e e ie ed f o
top to bottom to ensure that the top level requirement has its hierarchical deliverable
numbers for each of the levels clearly listed and also ensure that none of the high level
requirements or the intermediate deliverable is missed in the process. This step also
ensures that the implementation of listed components or completion of listed actions will
indeed lead to the anticipated results. This final listing of WBS numbering also gives a good
idea for the project managers when they are creating the project schedule as the WBS gives
detailed information on the predecessor and the successor activities of the each
component.

Is WBS Required For Every Project?

I ould sa es - But not necessarily as a mandatory requirement. It merely depends on
the project needs, the organization process and the type, size and complexity of the project.
Having said that, even if we use the WBS process as a standard procedure within the project
or not, it is imperative that the principles of WBS are always used by anybody estimating for
an important project. Otherwise, ho ould the a i e at the esti ates? If it’s ee
t ial a d e o , the, ha es of p oje t failu e a e e t e el high. I othe ases, it’s just that
the standard process is not explicitly followed, but the implementation team would
definitely have arrived at an estimate by implicitly making certain decisions based on the
goals of the project that need to be achieved, project risks, expertise, past experience, the
o ga izatio ’s p o ess o plia e a d the p oje t o st ai ts. As e tio ed efo e, WBS is
just an instrument or a tool to decompose a large or a hypothetical scope into a set of
definable, structured and measurable activities or tasks that are associated to the respective
project deliverables. To add, since a WBS gives an idea of the effort required for each of the
work packages together with the associated risk and complexity information, it could also
be used as an apparatus to prioritize requirements or deliverables based on the effort
required, risk associated, number of unknowns and complexity involved. Hence, a WBS is
sometimes used as a connecting point between the Sales/Marketing and implementation
teams as it aids them in making scope decisions quickly and with more precision thereby
reducing the risk of losing some functionality in the system/product that would otherwise
have been more beneficial to the system/product/organization.

Dos A d Do ’ts
Team Building Activity: The process of creating a WBS should be considered as a team
building activity. For projects of normal size, a WBS cannot be created by one team
member. It needs various team members to take-up each high level requirement within the
given scope, discuss about it with others in the team and then each lead team members
need to come-up with the activity/work-package break-up details related to that specific
requirement. Likewise, the activity details are arrived at the other lead team members and
the project team consolidates all the deliverables information received and collates back to
a fully blown WBS which can then further be sued for the next steps of project planning and
scheduling.

8
Q3) What are major global sources of financing? Distinguish between Foreign Direct
Investment and Portfolio Investment.

Ans) 1. They make profit by selling a product for more than it costs to produce. This is the
most basic source of funds for any company and hopefully the method that brings in the
most money.

2. Like individuals, companies can borrow money. This can be done privately through bank
loans, or it can be done publicly through a debt issue. The drawback of borrowing money is
the interest that must be paid to the lender.

3. A company can generate money by selling part of itself in the form of shares to investors,
which is known as equity funding. The benefit of this is that investors do not require interest
payments like bondholders do. The drawback is that further profits are divided among
all shareholders.

In an ideal world, a company would bring in all of its cash simply by selling goods and
services for a profit. But, as the old saying goes, "you have to spend money to make
money," and just about every company has to raise funds at some point to develop products
and expand into new markets.

When evaluating companies, it is most important to look at the balance of the major
sources of funding. For example, too much debt can get a company into trouble. On the
other hand, a company might be missing growth prospects if it doesn't use money that it
can borrow.

Definition of FDI

Foreign Direct Investment (FDI) implies an investment made with an intent of obtaining an
ownership stake in an enterprise domiciled in a country by an enterprise situated in some
other country. The investment may result in the transfers of funds, resources, technical
know-how, strategies, etc. There are several ways, of making FDI i.e. creating a joint venture
or through merger and acquisition or by establishing a subsidiary company.

The investor company has a substantial amount of influence and control over the investee
company. Moreover, if the investor company obtains 10% or more ownership of equity
shares, then voting rights are granted along with the participation in the management.

Definition of FPI

Foreign Portfolio Investment (FPI), refers to the investment made in the financial assets of
an enterprise, based in one country by the foreign investors. Such an investment is made
with the purpose of getting short term financial gain and not for obtaining significant control
over managerial operations of the enterprise.

9
 The investment is made in the securities of the company, i.e. stock, bonds, etc. for which
the overseas investors deposit mo e i the host ou t ’s a k a ou t a d pu hase
securities. Usually, FPI investors go for securities that are highly liquid.

Key Differences Between FDI and FPI

The difference between FDI and FPI can be drawn clearly on the following grounds:

1. The investment made by the international investors to obtain a substantial interest in the
enterprise located in a different country is a Foreign Direct Investment or FDI. The
investment made in passive holdings like stocks, bonds, etc. of the enterprise of a foreign
country by overseas investors is known as a Foreign Portfolio Investment (FPI).
2. FDI investors play an active role in the management of the investee company whereas FPI
investors play a passive role, in the foreign company.
3. As the FDI investors gain both ownership and management right through investment, the
level of control is relatively high. Conversely, in FPI the degree of control is less as the
investors obtain only ownership right.
4. FDI investors have a substantial and long-term interest in the firm which is not in the case of
FPI.
5. FDI projects are managed with great efficiency. On the other hand, FPI projects are less
efficiently managed.
6. FDI investors invest in financial and non-financial assets like resources, technical know-how
along with securities. As opposed to FPI, where investors invest in financial assets only.
7. It is not easy for FDI investors to sell out the stake acquired. Unlike FPI, where the
investment is made in financial assets which are liquid, they can be easily sold.

Conclusion

Entry and exit of FDI are very difficult, while this is not so with FPI. An investor can easily
make the foreign portfolio investment. FDI and FPI are two methods through which foreign
capital can be brought into the economy. Such an investment has both positive and negative
aspects, as the inflow of funds improves the position of balance of payment while the
outflow of funds in the form of dividends, royalty, import, etc. will result in the reduction of
balance of payment.

Q4) What are the major factors that are taken into consideration for determining the
di ide d poli of a o pa ? Co pa e Walte ’s Model ith Go do ’s Model a d e a i e
their rationality

10
Ans) Factors Affecting Dividend Policy Of A Firm
A firm's dividend policy is influenced by the large numbers of factors. Some factors affect
the amount of dividend and some factors affect types of dividend. The following are the
some major factors which influence the dividend policy of the firm.

1. Legal requirements

There is no legal compulsion on the part of a company to distribute dividend. However,

there certain conditions imposed by law regarding the way dividend is distributed. Basically
there are three rules relating to dividend payments. They are the net profit rule, the capital
impairment rule and insolvency rule.

2. Firm's liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained
earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need

A firm uses several forms of debt financing to meet its investment needs. These debt must
be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying
debt, the dividend payment capacity reduces.

4. Expected rate of return

If a firm has relatively higher expected rate of return on the new investment, the firm
prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning

If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than
a firm with relatively fluctuating earnings.

6. Desire of control

When the needs for additional financing arise, the management of the firm may not prefer
to issue additional common stock because of the fear of dilution in control on management.
Therefore, a firm prefers to retain more earnings to satisfy additional financing need which
reduces dividend payment capacity.

7. Access to the capital market

11
If a firm has easy access to capital markets in raising additional financing, it does not require
more retained earnings. So a firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation

For a closely held company, stockholders prefer relatively lower cash dividend because of
higher tax to be paid on dividend income. The stockholders in higher personal tax bracket
prefer capital gain rather than dividend gains.

On the relationship between dividend and the value of the firm different theories have been
advanced.

They are as follows:

1. Walter’s odel

. Go do ’s odel

1. Walter’s model:

Professor James E. Walterargues that the choice of dividend policies almost always affects
the value of the enterprise. His model shows clearly the importance of the relationship

et ee the fi ’s i te al rate of return (r) and its cost of capital (k) in determining the
dividend policy that will maximise the wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is
not issued;

. The fi ’s i te al ate of etu , a d its ost of apital k a e o sta t;

3. All earnings are either distributed as dividend or reinvested internally immediately.

4. Beginning earnings and dividends never change. The values of the earnings pershare (E),
and the divided per share (D) may be changed in the model to determine results, but any
given values of E and D are assumed to remain constant forever in determining a given
value.

12
5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K

ADVERTISEMENTS:

The above equation clearly reveals that the market price per share is the sum of the
present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism:

Walte ’s odel is uite useful to sho the effe ts of di ide d poli o a all e uit fi
under different assumptions about the rate of return. However, the simplified nature of the

odel a lead to o lusio s hi h a e et t ue i ge e al, though t ue fo Walte ’s

model.

The criticisms on the model are as follows:

. Walte ’s odel of sha e valuation mixes dividend policy with investment policy of the
firm. The model assumes that the investment opportunities of the firm are financed by
retained earnings only and no external financing debt or equity is used for the purpose
when such a situatio e ists eithe the fi ’s i est e t o its di ide d poli o oth ill

be sub-optimum. The wealth of the owners will maximise only when this optimum
investment in made.

. Walte ’s odel is ased o the assu ptio that is o sta t. I fa t de eases as more
investment occurs. This reflects the assumption that the most profitable investments are
made first and then the poorer investments are made.

13
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimise the wealth of the owners.

. A fi ’s ost of apital o dis ou t ate, K, does ot e ai o sta t; it ha ges di e tl

ith the fi ’s isk. Thus, the p ese t alue of the fi ’s i o e o es i e sel ith the
cost of capital. By assuming that the discount rate, K is o sta t, Walte ’s odel a st a ts
from the effect of risk on the value of the firm.

2. Gordo ’s Model:

One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.

Assumptions:
Go do ’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.

14
A o di g to Go do ’s di ide d apitalisatio odel, the a ket alue of a sha e P is
equal to the present value of an infinite stream of dividends to be received by the share.
Thus:

The above equation explicitly shows the relationship of current earnings (E,), dividend
policy, (b), internal profitability (r) and the all-e uit fi ’s ost of apital k , i the

determination of the value of the share (P0).

Q5) What is financial engineering? Briefly discuss the financial engineering process that you
will follow while developing new products or solutions

Ans) What is 'Financial Engineering'

Financial engineering is the use of mathematical techniques to solve financial problems.
Financial engineering uses tools and knowledge from the fields of computer science,
statistics, economics and applied mathematics to address current financial issues as well as
to devise new and innovative financial products. Financial engineering is sometimes referred
to as quantitative analysis and is used by regular commercial banks, investment banks,
insurance agencies and hedge funds.

Product development, also called new product management, is a series of steps that
includes the conceptualization, design, development and marketing of newly created or
newly rebranded goods or services. The objective of product development is to cultivate,
maintain and increase a company's market share by satisfying a consumer demand. Not
every product will appeal to every customer or client base, so defining the target market
for a product is a critical component that must take place early in the product
development process. Quantitative market research should be conducted at all phases of
the design process, including before the product or service is conceived, while the product
is being designed and after the product has been launched.
Product development frameworks

Although product development is creative, the discipline requires a systematic approach to

guide the processes that are required to get a new product to market. Organizations such as
the Product Development and Management Association (PDMA) and the Product
Development Institute (PDI) provide guidance about selecting the best development

15
framework for a new product or service. A framework helps structure the actual product
development.

Some frameworks, like the fuzzy front end (FFE) approach, define what steps should be
followed, but leave it up to the team to decide which order makes most sense for the
specific product that is being developed. The five elements of FFE product development are:

Identification of design criteria -- involves brainstorming possible new products. Once

an idea has been identified as a prospective product, a more formal product
development strategy can be applied.

Idea analysis -- involves a closer evaluation of the product concept. Market research
and concept studies are undertaken to determine if the idea is feasible or within a
relevant business context to the company or to the consumer.

Concept genesis -- involves turning an identified product opportunity into a tangible

concept.

Prototyping -- involves creating a rapid prototype for a product concept that has been
determined to have business relevance and value. Prototyping in this front-end context
means a "quick-and-dirty" model is created, rather than the refined product model that
will be tested and marketed later on.

Product development -- involves ensuring the concept has passed muster and has been
determined to make business sense and have business value.

Other frameworks, like design thinking, have iterative steps that are designed to be
followed in a particular order to promote creativity and collaboration. The five components
of design thinking are:

Empathize -- Learn more about the problem from multiple perspectives.

Define -- Identify the scope and true nature of the problem.

Ideate -- Brainstorm solutions to the problem.

16
 Prototype -- Weed out unworkable or impractical solutions.

Test -- Solicit feedback.

This composite new product development (NPD) framework for manufactured goods has
eight important components:

Idea generation is the continuous and systematic quest for new product opportunities,
including updating or changing an existing product.

Idea screening takes the less attractive, infeasible and unwanted product ideas out of
the running. Unsuitable ideas should be determined through objective consideration.

Concept development and testing is vital. The internal, objective analysis of step two is
replaced by customer opinion in this stage. The idea, or product concept at this point,
must be tested on a true customer base. The testers' reactions can then be leveraged
to adjust and further develop the concept according to the feedback.

Market strategy/business analysis is comprised of four P's, which are product, price,
promotion and placement.

Product: The service or good that's been designed to satisfy the demand of a target
audience.

Price: Pricing decisions affect everything; profit margins, supply and demand, and
market strategy.

Promotion: The goals of promotion are to present the product to the target
audience, increasing demand by doing so, and to illustrate the value of the
product. Promotion includes advertisements, public relations and marketing
campaigns.

Placement: The transaction may not occur on the web, but in today's digital
economy, the customer is generally engaged and converted on the internet.
Whether the product will be provided in bricks-and-mortar or clicks-and-

17
 mortarshops, or available through an omnichannel approach, the optimal channel,
or channels, for placement must be determined if the targeted potential customers
are to become actual customers.

Feasibility analysis/study yields information that is critical to the product's success. It

entails organizing private groups that will test a beta version, or prototype, of the
product, then evaluate the experience in a test panel. This feedback communicates the
target market's level of interest and desired product features, as well as determines
whether the product in development has the potential to be profitable, attainable and
viable for the company, while satisfying a real demand from the target market.

Product technical design/Product development integrates the results of the feasibility

analyses and feedback from beta tests from stage five into the product. This stage
consists of turning that prototype or concept into a workable market offering; ironing
out the technicalities of the product; and alerting and organizing the departments
involved with the product launch, such as research and development, finance,
marketing, production or operations.

Test marketing, or market testing, differs from concept or beta testing in that the
prototype product and whole proposed marketing plan, not individual segments, are
evaluated. The goal of this stage is to validate the entire concept -- from marketing
angle and message to packaging to advertising to distribution. By testing the entire
package before launch, the company can vet the reception of the product before a full
go-to-market investment is made.

Market entry/commercialization is the stage in which the product is introduced to the

target market. All the data obtained throughout the previous seven stages of this
approach are used to produce, market and distribute the final product to and through
the appropriate channels.

18