Finance

1. What is finance?

A branch of economics concerned with resource allocation as well as resource

management, acquisition and investment. It is the commercial activity of providing
funds and capital.

2. What is capital budgeting?

Capital budgeting (or investment appraisal) is the planning process used to

determine whether a firm's long term investments such as new machinery,
replacement machinery, new plants, new products, and research development
projects are worth pursuing.

3. Which method is btr?

Below-Target-Risk (BTR) - The expected value of unfavorable deviations of a

random variable from a specified target level.

4. How do u arrive at the free cash flows?

To arrive at free cash flow, take net cash flow from operating activities and subtract dividends
and purchases of plant assets and add in sales of plant and equipment assets.

5. What is accrued cash flows?

An accounting method that measures the performance and position of a company

by recognizing economic events regardless of when cash transactions occur. The
general idea is that economic events are recognized by matching revenues to
expenses (the matching principle) at the time in which the transaction occurs
rather than when payment is made (or received). This method allows the current
cash inflows/outflows to be combined with future expected cash inflows/outflows
to give a more accurate picture of a company's current financial condition.

6. Why is depreciation added back?

Because we begin preparing the statement of cash flows using the net income
figure taken from the income statement, we need to adjust the net income figure
so that it is not reduced by Depreciation Expense. To do this, we add back the
amount of the Depreciation Expense.
7. What if there is a mismatch between npv & irr? How do u select?

Conflicts between NPV and IRR can arise in numerous circumstances: different lives,
different sizes, different risk factors, or different timing of cash flows. The underlying
cause of the conflict resides in the assumption of cash flow reinvestment. The process of
discounting and time value of money is predicated on interest compounding and
discounting (defined in Chapter 2) is predicated on what discount rate is chosen. In IRR
calculation, the implied interest rate of reinvestment of cash flows is IRR itself. In NPV
calculation, it is the discount rate. Which of the two methods is correct depends on the
choice of what is a more realistic rate of reinvestment of cash flows: IRR or discount rate.
Most often the reinvestment opportunities that a company has are those that can earn its
weighted average cost of capital, because it is what its projects earn on average. Relying
on an assumption of weight average cost of capital as the reinvestment opportunity is
also more conservative. Thus, NPV is most often the safest basis for decision.

But that may not be always the case. For instance, choosing projects that have positive
NPV implies that they earn a higher return than risk adjusted cost of capital. This implies
that we expect opportunities for reinvestment of cash flows at higher rates. Higher rates
of return can also be required when future inflation is anticipated. To investigate the
impact of cash flow reinvestment opportunity, advanced textbooks in financial
management recommend calculating an adjusted NPV and an adjusted IRR. These are
obtained by first calculating a terminal value which is the future value of cash flows
compounded at the opportunity rate of reinvestment. Then the terminal value is
discounted to the present using the weighted average cost of capital.

Key differences between the most popular methods, the NPV (Net Present Value) Method
and IRR (Internal Rate of Return) Method, include:

• NPV is calculated in terms of currency while IRR is expressed in terms of the

percentage return a firm expects the capital project to return;

• Academic evidence suggests that the NPV Method is preferred over other methods
since it calculates additional wealth and the IRR Method does not;

• The IRR Method cannot be used to evaluate projects where there are changing cash
Flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be
required in the case of land reclamation by a mining firm);

• However, the IRR Method does have one significant advantage -- managers tend to
better understand the concept of returns stated in percentages and find it easy to
compare to the required cost of capital; and, finally,
• While both the NPV Method and the IRR Method are both DCF models and can even
reach similar conclusions about a single project, the use of the IRR Method can lead to
the belief that a smaller project with a shorter life and earlier cash inflows, is preferable
to a larger project that will generate more cash.

• Applying NPV using different discount rates will result in different recommendations.
The IRR method always gives the same recommendation.

8. Can npv be negative?

If the NPV of a prospective project is positive, it should be accepted. However, if

NPV is negative, the project should probably be rejected because cash flows will
also be negative. If NPV is less than 0, which is to say, negative, the project should
not be immediately rejected. Sometimes companies have to execute an NPV-
negative project if not executing it creates even more value destruction.

9. What are assets?

In financial accounting, assets are economic resources owned by business

or company. Anything tangible or intangible that one possesses, usually
considered as applicable to the payment of one's debts is considered an asset.
Simplistically stated, assets are things of value that can be readily converted into
cash (although cash itself is also considered an asset).

10. What is capital?

Assets available for use in the production of further assets.

11. Why assets are equal to liabilities?

One of the most important things to understand about the balance sheet is that it must always
balance. Total assets will always equal total liabilities plus total equity. Thus, if a company's
assets increase from one period to the next, you know for sure that the company's liabilities and
equity increased by the same amount.

12. Is debt a part of capital?

Debt capital is funds supplied by lenders that are part of a firm's capital structure.
Debt capital usually refers to long-term capital, specifically bonds, rather than short-term
 loans to be paid off within one year. If the short-term debt is continually rolled over,
however, it can be considered relatively permanent and thus debt capital.

13. What is net worth of a firm?

Net worth is total assets minus its total liabilities. Put another way, net worth represents
the owners' interest in company assets, as opposed to liabilities, which represents
creditors' interest. If a firm has little net worth, its assets are mostly financed by debt, and
it will have trouble paying its bills in hard times. (A company can have negative net worth
-- liabilities exceed assets -- although bankruptcy is probably near.). But a high net worth
company with few liabilities may be squandering opportunities by refusing to take out
loans.

14. What are the different ratios? Explain each.

ACCOUNTING RATIOS

Industry
To test Name of Ratio Formula Parties interested
norm
Liquidity and i) Current Ratio Current Assets Short-term creditors, 2:1
Solvency Current Liabilities investors, money
lenders & like parties
ii) Liquid/Quick/ Current assets - Stock - -do- 1:1
Acid Test Ratio Prepaid Expenses
Current Liabilities - Bank
Overdraft - Prereceived
Income
iii) Absolute Liquid Cash + Marketable securities -do- 1:1
Ratio Quick Liabilities
iv) Proprietary Proprietor's Fund -do- 60% to
Ratio Total Assets 75%
[Proprietor's funds = Equity
Capital + Preference Capital +
Reserves and Surplus +
Accumulated funds - Debit
balances of P & L A/c and
Miscellaneous Expenses]
Capitalisation i) Debt Debt -do- 2:1
Equity Ratio Equity
[Debt = Long/Short-term
loans, debentures, bills, etc,
Equity = Proprietor's funds]
ii) Capital Gearing Fixed cost funds -do- 2:1
Ratio Funds not carrying fixed cost
 [Fixed cost funds = Preference
share capital, Debentures,
Loans from banks, financial
institutions, other unsecured
loans].
[Funds not carrying fixed cost
= Equity share capital +
undistributed profit - P & L
A/c (Dr. Bal.) - Misc.
expenses].
Profitability and i) Gross Profit Gross Profit x 100 Shareholders, Long- 20% to
management Ratio Net sales term Creditors, 30%
efficiency Government

ii) Net Profit Ratio Net Profit x 100 -do- 5% to

Net sales 10%
[Net profit may be either
Operating Net profit, Profit
before tax or Profit after tax].
iii) Return on Net profit x 100 -do- �
Capital Capital employed
Employed [Capital employed = Fixed
(ROCE) Assets + Current Assets -
Current Liabilities].
iv) Return on Profit after tax -do- �
Proprietors Proprietor's funds
fund
v) Return on Profit after tax less pref. -do- �
Capital Dividend x 100
Equity Share Capital
vi) Earnings per Profit after tax less pref. -do- �
share [EPS] Dividend
Total No. of Equity Shares
vii) Dividend per Total Dividend paid to Shareholders, �
share [DPS] ordinary shareholders Investors
Number of ordinary shares
Management i) Stock Turnover Cost of goods sold Management 5 to 6
efficiency Average Stock times
ii) Debtors Debtors + Bills receivable x Management 45 to 60
Turnover Ratio 365 days
Net Credit sales
iii) Debtor's Credit sales Management 60 to 90
Turnover Rate Avg. Debtors + Bills receivable days
iv) Creditor's Creditors + Bills payable x -do-
Turnover Ratio 365
Credit purchases
v) Creditor's Credit purchases
 Turnover Rate Average Creditors
vi) Operating Ratio Operating Costs x 100
Net sales
[Operating Cost = Cost of
goods sold + Operating
expenses (viz. Administrative,
selling & finance expenses)]
Number of times Preference Net profit (after Interest & Tax Preference
preference shareholders' but before equity dividend) shareholders
dividends covered coverage ratio Preference Dividend
by net profit
Number of times Equity Net profit (after interest, tax & Equity shareholders
equity dividends shareholder's Pref. Dividend)
covered by net coverage ratio Equity Dividend
profit
Number of times Interest coverage Net profit (before Interest & Debentureholders,
fixed interest ratio Tax) (PBIT) Loan creditors
covered by net Fixed interests & charges
profit
Relationship Total coverage Net profit (before Interest & Shareholders,
between net profit ratio Tax) (PBIT) investors, creditors,
and total fixed Total fixed charges lenders
charges
The idle capacity Fixed expenses to Fixed expenses Management
in the total cost ratio Total cost shareholders
Organisation
Material Material Material consumption Management
consumption to consumption to Sales
sales sales ratio
Wages to sales Wages to sales Wages Management
ratio Sales
The future market Price earning ratio Market price of a share (MPS) Investors, speculators
price of a share Earnings per share (EPS)

15. Explain the P&L Account? The diff stages of a P&L a/c and what do u obtain?

The profit and loss account (P & L), called the income statement in the US, shows the profit or loss a
company has made over a period of time. The ratios investors look at most often, such as
the PE andyield, are calculated using numbers from the P & L.

Profits are ‘spent’ in three ways.

1) Retained for future investment and growth.

2) Returned to owners eg a ‘dividend’.
3) Paid as tax.
Parts of the Profit and Loss Account: The Profit & Loss Account aims to monitor profit. It has three parts.

1) The Trading Account.

This records the money in (revenue) and out (costs) of the business as a result of the business’ ‘trading’ ie
buying and selling. This might be buying raw materials and selling finished goods; it might be buying
goods wholesale and selling them retail. The figure at the end of this section is theGross Profit.

2) The Profit and Loss Account proper

This starts with the Gross Profit and adds to it any further costs and revenues, including overheads. These
further costs and revenues are from any other activities not directly related to trading. An example is
income received from investments.

3) The Appropriation Account. This shows how the profit is ‘appropriated’ or divided between the three
uses mentioned above.

16. Wat is debt service coverage ratio?

The debt service coverage ratio (DSCR), is the ratio of cash available for debt
servicing to interest, principal and lease payments. It is a popular benchmark used in
the measurement of an entity's (person or corporation) ability to produce enough
cash to cover its debt (including lease) payments. The higher this ratio is, the easier it
is to obtain a loan.

DSCR = Annual Net Income + Amortization/Depreciation + other non-cash and discretionary

items (such as non-contractual management bonuses) / Principal Repayment + Interest
payments + Lease payments

17. What is cost of capital?

The cost of capital is the cost of a company's funds (both debt and equity), or, from an
investor's point of view "the expected return on a portfolio of all the company's existing
securities”. It is used to evaluate new projects of a company as it is the minimum return
that investors expect for providing capital to the company, thus setting a benchmark that
a new project has to meet.
18. What is CAPM? Explain the different elements.

A model that describes the relationship between risk and expected return and that is used in the
pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time
value of money and risk. The time value of money is represented by the risk-free (Rf)
rate in the formula and compensates the investors for placing money in any investment
over a period of time. The other half of the formula represents risk and calculates the
amount of compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) that compares the returns of the asset to the
market over a period of time and to the market premium (Rm-Rf).

19. What is the different M&A valuation techniques?

There are many legitimate ways to value companies. The most common method is to look at
comparable companies in an industry, but deal makers employ a variety of other methods and
tools when assessing a target company. Here are just a few of them:
1. Comparative Ratios - The following are two examples of the many comparative metrics on
which acquiring companies may base their offers:
 Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring
company makes an offer that is a multiple of the earnings of the target company.
Looking at the P/E for all the stocks within the same industry group will give the
acquiring company good guidance for what the target's P/E multiple should be.
 Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company
makes an offer as a multiple of the revenues, again, while being aware of the price-
to-sales ratio of other companies in the industry.
2. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the
target company. For simplicity's sake, suppose the value of a company is simply the sum
of all its equipment and staffing costs. The acquiring company can literally order the
target to sell at that price, or it will create a competitor for the same cost. Naturally, it
takes a long time to assemble good management, acquire property and get the right
equipment. This method of establishing a price certainly wouldn't make much sense in a
service industry where the key assets - people and ideas - are hard to value and develop.
3. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis
determines a company's current value according to its estimated future cash flows.
Forecasted free cash flows (net income + depreciation/amortization - capital expenditures
- change in working capital) are discounted to a present value using the
company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right,
but few tools can rival this valuation method.
Synergy: The Premium for Potential Success
For the most part, acquiring companies nearly always pay a substantial premium on the stock
market value of the companies they buy. The justification for doing so nearly always boils down
to the notion of synergy; a merger benefits shareholders when a company's post-merger share
price increases by the value of potential synergy.

Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by
not selling. That means buyers will need to pay a premium if they hope to acquire the company,
regardless of what pre-merger valuation tells them. For sellers, that premium represents their
company's future prospects. For buyers, the premium represents part of the post-merger
synergy they expect can be achieved. The following equation offers a good way to think about
synergy and how to determine whether a deal makes sense. The equation solves for the
minimum required synergy:

In other words, the success of a merger is measured by whether the value of the buyer is
enhanced by the action. However, the practical constraints of mergers, which we discuss in part
five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised
by deal makers might just fall short.

What to Look For

It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the
acquiring company. To find mergers that have a chance of success, investors should start by
looking for some of these simple criteria:
 A reasonable purchase price - A premium of, say, 10% above the market price seems
within the bounds of level-headedness. A premium of 50%, on the other hand, requires
synergy of stellar proportions for the deal to make sense. Stay away from companies that
participate in such contests.
 Cash transactions - Companies that pay in cash tend to be more careful when calculating
bids and valuations come closer to target. When stock is used as the currency for
acquisition, discipline can go by the wayside.
 Sensible appetite – An acquiring company should be targeting a company that is smaller
and in businesses that the acquiring company knows intimately. Synergy is hard to create
from companies in disparate business areas. Sadly, companies have a bad habit of biting
off more than they can chew in mergers.

20. Why do firms go for M&A apart from synergy?

The reasons to merge or acquire are varied. These range from acquiring
market share and restructuring corporate structure to meeting global
competition. It also involves issues related to business concerns such as
competition, efficiency, marketing, product, resource, and tax issues. They
 can also occur because of some very personal reasons such as retirement
and family concerns.

However, major reasons are explained below:

Cost Efficiency and the Long-Range Average Cost Curve

Due to technology and market conditions, firms may benefit on a cost basis from being a
certain size. Clearly, one way to grow is to combine with other small firms until the firm
is optimally sized. Generally, the assumption is that larger firms are more cost-effective
than are smaller firms (i.e., that larger firms exhibit economies of scale when compared
to smaller firms). This is often the stated motive for mergers in the financial services
industry.

Eliminate Competition

One important reason that companies combine is to eliminate competition. Acquiring a

competitor is an excellent way to improve a firm's position in the marketplace. It
reduces competition, and allows the acquiring firm to use the target's resources and
expertise.

Corporate Greed

Some people say that mergers and acquisitions occur because the greedy corporations
want to acquire everything. As far as economic theory is concerned, the primary
objective of a firm is to maximize profits, and thereby maximize shareholder wealth.

21. Whats the difference btwn merger, acquisition, takeover?

Merger is a financial tool that is used for enhancing long-term profitability by expanding
their operations. Mergers occur when the merging companies have their mutual consent.
Acquisitions or takeovers occur between the bidding and the target company. There may
be either hostile or friendly takeovers. Reverse takeover occurs when the target firm is
larger than the bidding firm. In the course of acquisitions the bidder may purchase the
share or the assets of the target company. In simple words, a merger is a combination of
two companies to form a new company, while an acquisition is the purchase of one
company by another in which no new company is formed.

Takeover: A corporate action where an acquiring company makes a bid for an acquiree. If
the target company is publicly traded, the acquiring company will make an offer for the
outstanding shares.
22. What are the accounting requirements for M&A?

New standards effective at the beginning of 2009 will impact the accounting for mergers and acquisitions.

FAIR VALUE ACCOUNTING

The focus of the new standards is on the use of fair value accounting. In other words, all assets acquired
and liabilities assumed in an acquisition are to be measured at their fair values on the date of acquisition
(called the acquisition method). By contrast, the former standards, although they applied fair value
accounting, focused more on an accumulation of costs related to the acquisition (called the purchase
method).

TRANSACTION COSTS

M&A transaction costs typically include payments to investment bankers, attorneys, accountants,
appraisers and other advisors. Previously, these costs were capitalized as part of the overall purchase price
for an acquisition. Under the new standards, these costs will be expensed as incurred, because they are
considered incremental costs to the transaction and not a component of the fair value of the business
acquired. Therefore, earnings in the period prior to the acquisition will be negatively impacted.

RESTRUCTURING COSTS

Under the new standards, costs to restructure the operations of an acquired company can be recognized as
part of the acquisition accounting only if certain conditions are met - that is, the acquirer's restructuring
plan must be in place at the date of the acquisition. The cost of these restructurings will be charged to
earnings in the post-acquisition period. Previously, these costs were recorded as a liability at the time of
the acquisition, resulting in higher goodwill.

EARN-OUTS

Previously, earn-outs were considered part of the acquisition cost. Under the new standards, earn-outs
and other contingent consideration are to be recorded at fair value at the date of the acquisition,
regardless of the likelihood of payment. Subsequent changes in the fair value of most contingent
consideration will be recorded in earnings. However, if the contingent condition is classified as equity, it
would not be adjusted for changes in fair value in subsequent periods.

IN-PROCESS R&D

In-process research and development will continue to be measured at fair value on the acquisition date.
However, these assets will no longer be written off as a one-time expense immediately after the
acquisition. Instead, IPR&D will be capitalized and recorded as an indefinite-lived intangible asset, subject
to impairment until completion. Abandoned projects will be written off as an expense.

ACQUISITION DATES

The acquisition date is the closing date of the transaction. If equity securities are issued as all or a part of
the purchase price, these will be measured on the closing date, rather than the announcement date.
Therefore, changes in the value of the acquirer's stock after the announcement date and before closing will
have an impact on the amount of the purchase price for accounting purposes.

ADJUSTMENTS

As was the case before, companies will have a one-year period of time to recognize adjustments to the
provisional values that are recorded. However, the new standards require that prior-period statements be
revised to record any material adjustments of the estimated provisional amounts recorded at the
acquisition date. This will likely increase the due diligence efforts to provide more accurate estimates, thus
reducing the likelihood of having to revise prior-period statements.

FAIR GAME

In summary, fair value accounting is pervasive throughout the new standard. The resulting changes,
although they may not at first blush appear to be dramatic, are indeed significant.

23. What are derivatives, options, forwards, futures, swaps, FRA’s, swaptions?

A derivative is a financial instrument that is derived from some other asset, index, event, value or
condition (known as the underlying asset).

Option is an instrument that conveys the right, but not the obligation, to engage in a future
transaction on some underlying security, or in a futures contract.

A forward contract or simply a forward is an agreement between two parties to buy or sell an asset
at a certain future time for a certain price agreed today.

A futures contract is a standardized contract to buy or sell a specified commodity of standardized

quality at a certain date in the future and at a market-determined price (the futures price). The
contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks,
bonds, rights or warrants. They are still securities, however, though they are a type of derivative
contract.

A swap is a derivative in which two counterparties exchange certain benefits of one party's financial
instrument for those of the other party's financial instrument.

A forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate,
and receives a floating interest rate equal to a reference rate (the underlying rate). The payments
are calculated over a notional amount over a certain period, and netted, i.e. only the differential is
paid. It is paid on the effective date. The reference rate is fixed one or two days before the effective
date, dependent on the market convention for the particular currency. FRAs are over-the counter
derivatives. A swap is a combination of FRAs.

A swaption is an option granting its owner the right but not the obligation to enter into an
underlying swap. Although options can be traded on a variety of swaps, the term "swaption"
typically refers to options on interest rate swaps.
24. Draw long call, long put, short call & short put?

Payoff of a Long Put Position

The payoff of a long put equals any intrinsic value of

the option at expiration less the premium paid for
the option.

A long put strategy breaks even if the underlier falls by an amount equal to the option
premium. If the underlier falls further than that, the position will be profitable. The
payoff diagram for a short call is illustrated below:

Payoff of a Short Call Position

The payoff of a short call equals the option premium

received for the option less any intrinsic value of the
option at expiration.

This strategy will lose money if the underlier appreciates by an amount greater than the
option premium.

Long call

Pay-off diagram below represents the effective pay-off of a long call position of an option at the time of the expiry
date. It looks at the option from the point of view of buyer.
If a trader believes the share of a company is on the rise, he can purchase a call option without buying the share.
Assume he bought a call option (strike price is $5 and premium is 50 cent). The break even point for this trade is
$5.50. If at expiry date, the underlying share is trading at a point between $5 and $5.50, he will be able to recover
portion of the premium by exercising the option. If the share is above $5.50 at this time, there will be a linear
relationship between the share price and the profit. If the share price has moved up to $6 by the option expiry date,
the profit on the option will be $0.50 (the different between the exercise price, which is $5, and the current share
price, less the option premium, which is $0.50)

Short put

Pay-off diagram below shows the effective pay-off of a short put position of an option at the time of the expiry date. It
looks at the option from the point of view of seller.

In this example, the seller will receive full premium if the share price is at or above $5 strike price. However if the
share price drops, there is a linear relationship between the index and the loss made on this position. The break even
point is $4.50, where the profit is equal to the loss incurred.
25. What are the different option strategies?

There is a wide variety of different option strategies, each with their own advantages and disadvantages.
Below is a list of the different things you can do with options.

1. Buying short term options. This can be beneficial if you believe that a stock is going to make a big move
anytime soon. This strategy is not for the long term but seeks to take advantage of sudden swings.

2. Buying Leaps. Unlike short term options the leap is said to take advantage if the longer term prospective
on a stock. Because a leap is normally one to two years out you would have a long term perspective with
the power of leverage on your side as well.

3. Selling short term options. This strategy tries to capture an income from the market by Selling out of the
money options and collecting the premium. As long as the stock does not go past the strike price of the
option the option would expire worthless and you would walk away with the premium.

4. Selling covered calls. This is similar to selling short term options. There are only two major differences.
The first one is that you are limited to selling call. The second is you buy the stock first so that if the stock
goes above your strike price and you have to sell you do not have to buy the stock at a higher price and
sell it at a lower price. You already have the stock so you will just sell the stock you already own.

5. Forming a diagonal spread. This is similar to the covered call strategy. The only difference is that you
buy the leap or the right to buy a stock at a given price and sell short term calls. If you get called out you
can buy the stock with the leap and sell it.

26. Who discovered derivatives?

The history of derivatives is surprisingly longer than what most people think. Some texts even find the
existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative
contracts can even be found in incidents that date back to the ages before Jesus Christ.

However, the advent of modern day derivative contracts is attributed to the need for farmers to protect
themselves from any decline in the price of their crops due to delayed monsoon, or overproduction.

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These
were evidently standardised contracts, which made them much like today's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848
where forward contracts on various commodities were standardised around 1865. From then on, futures
contracts have remained more or less in the same form, as we know them today.
27. What is the DU PONT formula?

DuPont analysis (also known as the DuPont identity, DuPont Model or the DuPont method) is an
expression which breaks ROE (Return on Equity) into three parts.

Basic formula
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net
profit/Sales)*(Sales/Assets)*(Assets/Equity)

 Operating efficiency (measured by profit margin)

 Asset use efficiency (measured by asset turnover)
 Financial leverage (measured by equity multiplier)

ROE analysis
The Du Pont identity breaks down Return on Equity (that is, the return to equity that investors have
contributed to the firm) into three distinct elements. This analysis enables the analyst to understand the
source of superior (or inferior) return by comparison with companies in similar industries (or between
industries). The Du Pont identity, however, is less useful for some industries, such as investment banking,
that do not use certain concepts or for which the concepts are less meaningful. Variations may be used in
certain industries, as long as they also respect the underlying structure of the Du Pont identity.

Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by definition
true.

28. What is the black schole’s formula?

The Black Scholes formula is used for obtaining the price of European put and call options. It is obtained by
solving the Black–Scholes PDE - see derivation below.

Using this formula, the value of a call option in terms of the Black–Scholes parameters is:

The price of a put option is:

For both, as above:

 N(•) is the cumulative distribution function of the standard normal distribution

 T - t is the time to maturity
 S is the spot price of the underlying asset
 K is the strike price
  r is the risk free rate (annual rate, expressed in terms of continuous compounding)
 σ is the volatility in the log-returns of the underlying

Interpretation
N(d1) and N(d2) are the probabilities of the option expiring in-the-money under the
equivalent exponential martingale probability measure (numéraire = stock) and the
equivalent martingale probability measure (numéraire = risk free asset), respectively.
The equivalent martingale probability measure is also called the risk-neutral
probability measure. Note that both of these are probabilities in a measure
theoretic sense, and neither of these is the true probability of expiring in-the-money
under the real probability measure.

29. What are the different types of risks?

Systematic Risk or market risk

Unsystematic Risk - Stock or company specific risk
Credit or Default Risk - can they pay the interest on the load or the dividend on that stock
Country Risk - Measure of politcial and economic stability
Foreign Exchange Risk - will your money depreciate when you buy an asset in another country?
Interest Rate Risk - will the central bank raise interest rates
Political Risk - Politcal stability of a country
Execution risk - the time between when you see your price and when the trade actually goes to the
market.

30. What is the M&M theory?

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern
thinking on capital structure. The basic theorem states that, under a certain market price process
(the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information,
and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not
matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the
firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital
structure irrelevance principle.

31. What is the DCF method?

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow
(DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted
average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment.
If the value arrived at through DCF analysis is higher than the current cost of the investment, the
opportunity may be a good one.
32. What is the traditional theory of capital structure?

The theory that an optimal capital structure exists, where the WACC is minimized
and market value is maximized.

33. What are the different dividend policy theory?

There are three theories:

 Dividends are irrelevant: Investors don’t care about payout.
 Bird in the hand: Investors prefer a high payout.
 Tax preference: Investors prefer a low payout, hence growth.

Dividend Irrelevance Theory

 Investors are indifferent between dividends and retention-generated capital gains. If they
want cash, they can sell stock. If they don’t want cash, they can use dividends to buy
stock.
 Modigliani-Miller support irrelevance.
 Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not
be true. Need empirical test.

Bird-in-the-Hand Theory
 Investors think dividends are less risky than potential future capital gains, hence they like
dividends.
 If so, investors would value high payout firms more highly, i.e., a high payout would result
in a high P0.

Tax Preference Theory

 Retained earnings lead to long-term capital gains, which are taxed at lower rates than
dividends. Capital gains taxes are also deferred.
 This could cause investors to prefer firms with low payouts, i.e., a high payout results in
a low P0.

Miller and Modigliani Model

Miller and Modigliani have propounded the MM hypothesis to explain the irrelevance of a
firm's dividend policy. This model which was based on a few assumptions sidelined the
importance of the dividend policy and its effects thereof on the share price of the firm. According
to the model, it is only the firms' investment policy that will have an impact on the share value of
the firm and hence should be given more importance.

Critical Assumptions
This model is based on the following assumptions
1. The first assumption is the existence of a perfect market in which all investors are rational. In
perfect market condition there is easy access to information and the flotation and the transaction
costs do not exist. The securities are infinitely divisible and hence no single investor is big
enough to influence the share price.
2. Secondly, it is assumed that there are no taxes, implying that there are no differential tax rates
for the dividend income and the capital gains.
3. The third assumption is a constant investment policy of the firm, which will not change the
risk complexion not the rate of return even in cases where the investments are funded by the
retained earnings.
4. Finally, it was also assumed that the investors are able to forecast the future earnings, the
dividends and the share value of the firm with certainty.

Dividend Growth Model is; 'A stock valuation model that deals with dividends and their growth,
discounted to today'.

This model assumes that the basis of the valuation of stock is:

 The Current Dividend

 Growth of the Dividend

 Required Rate of Return

The formula for the Dividend Growth Model is:

Value = (Current Dividend * (1 + Dividend Growth)) / (Required Return - Dividend Growth)

34. What is working capital?

A measure of both a company's efficiency and its short-term financial health. The working capital
ratio is calculated as:

Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable to meet its short-
term liabilities with its current assets (cash, accounts receivable and inventory). Also known as
"net working capital", or the "working capital ratio".

35. How do decide what is the risk taking capacity of the company to decide what
is the optimal combination of debt & equity?

Investments into companies usually require both debt and equity. The optimal
ratio needs to be carefully determined for each individual situation. It is
unlikely that this ratio will consist of 100% equity. If the long-term prospects
are so poor that a company can never make sufficient profits to benefit from
leverage then the opportunity is probably not worth pursuing. Conversely,
relying on 100% debt financing often places a heavy cash drain on companies
and leads to sub-optimal growth.

Debt and equity financing should not be seen as substitutes for each other.
Instead, they are very different in nature and complement each other. Debt
needs to be repaid in cash. Equity needs to be rewarded with long-term
profits. Depending on individual circumstances and opportunities the trick for
each investment is to find the best mix of both.

36. What are the different capital structure theories?

 Net Income Approach: The net income approach makes the simplest
assumptions, that neither creditors nor investors increase their required rates of
return as a company takes on debt. The cost of capital declines as higher-cost
equity is replaced with lower-cost debt. This approach concludes that the optimal
financing mix is all debt.

 Net Operating Income Approach: The net operating income approach assumes
that creditors do not increase their required rate of return as a company takes on
debt, but investors do. Further, the rate at which investors increase their required
rate of return as the financing mix is shifted toward debt exactly offsets the
weighting away from the more expensive equity and toward the cheaper debt. The
result is that the cost of capital remains constant regardless of the financing mix.
This approach concludes that there is no optimal financing mix any mix is as good
as any other.

 Traditional Approach: The traditional approach assumes that both creditors and
investors increase their required rates of return as a company takes on debt. At first
this increase is small, and the weighting toward lower-cost debt pushes the cost of
capital down. Eventually, the rate at which creditors and investors increase their
required rates of return accelerates and dominates the weighting toward debt,
pushing the cost of capital back upward. The result is that the cost of capital
declines with debt and reaches a minimum point before rising again. This approach
concludes that there is a optimal financing mix consisting of some debt and some
equity.

 Modigliani-Miler Approach: The Modigliani-Miller theorem forms the basis for

modern thinking on capital structure. The basic theorem states that, under a certain
market price process, in the absence of taxes, bankruptcy costs, and asymmetric
information, and in an efficient market, the value of a firm is unaffected by how that
firm is financed. It does not matter if the firm's capital is raised by issuing stock or
selling debt. It does not matter what the firm's dividend policy is. Therefore, the
 Modigliani-Miller theorem is also often called the capital structure irrelevance
principle.

37. What is PPP? (public pvt partnership)

We can define a PP partnership as a contract between a public sector ‘Institution’ and a private
party, in which the latter assumes substantial financial, technical and operational risks in the
design, financing, building and operation of an infrastructure project. It is thus an alternative
method of procurement for the public sector, involving a medium to long term relationship
between the public and private sector in which private sector capital and management is
mobilised to plan, implement and operate an infrastructure project. It involves sharing and
transferring of risks and rewards between the public sector and the private partner.

38. What is infrastructure financing?

Infrastructure is the physical underpinning of a country that support activities and transportation,
such as roads, railways, electrical systems, and so on. In contemporary jargon, the basic abilities and
structure of a company.

Financing Options
 Government sole financing – implementation, operation and maintenance.
 This is faced with the following issues:
o Cost efficiency
o Equity consideration
o Allocational efficiency
o Fiscal prudence
o Future residence enjoy the facilities at no cost
o Inefficiency on management/poor maintenance
Hence other financing options are being adopted worldwide.
Other Financing Options
 Debt
 Equity Financing Options
o BOT
o B & LB
o PPP
o Bonds
Benefits of other Financing Options
 The projects generate direct and indirect employment opportunities
 Government don’t have to wait for availability of funds to embark of
developmental projects
 White elephant projects are eliminated – projects are backed by economic
jurisdiction
 Cases of abandoned projects eliminated
 Government can initiate expensive projects quickly and share the burden
with future users
 Infrastructure can be used to drive economic growth instead of vice versa.