FM Midterm

Financial Management
INDIAN INSTITUTE OF MANAGEMENT ROHTAK

Class structure
• Follow the class timings – be present present
• Case – come prepared
• Call/mail – Try not to WhatsApp
• If it is a collective request – approach via CR
• My room number is 13 – D
• Phone number – 8076920291
• Email address – [email protected]
• Consultancy hours – Tuesday– 2:00 PM to 3:00 PM
Why to study corporate finance?
• It is in curriculum, I have no choice….
• I plan to be in corporate strategy. I should know the financial aspects
of strategy
• I want to be an investment banker. I want to understand corporate
finance to value firms
• I am going to start my own venture, I should know how to manage
finances of a business. As a CEO, I should know my finance
• Profitability analysis is an important part of my marketing job, I
should learn it formally
• Critical for both professional and personal decisions
• Placements
• Integral part of other non finance areas
• Management…..funds
• Marketing…..price
• Operations management….working capital
• Accounting….how financial manager will use it
• There is financial implication of every activity, be it marketing, strategic or manpower
• Most key personal decisions require financial knowledge/understanding
Example: buying a house or car, planning for retirement, children’s education, etc.
Pre requisite of the course
• Basics of accounting – you should understand the financial accounting
– understand how to read the financial statements – which I believe
you are thorough to some extent now.
• Basics of statistics –
• Basics of data handling –

What is corporate finance
• Every decision that a business makes has financial implications, and any decision
which affects the finances of a business is a corporate finance decision.
• Defined broadly, everything that a business does fits under the rubric of corporate
finance.
https://theprint.in/economy/modi-meets-foreign-investors-today-as-india-looks-to-attract-
investments-for-infrastructure/537134/
Major financial decisions
• Investments - Capital Budgeting
• Financing – Capital Structure
• Working Capital
• Dividend - Dividend or interest payment, Reinvestment

Financial management decisions
1. Capital Budgeting or Investment decision-Capital budgeting relates to the selection of an asset
whose benefits would be available over the project's life. Capital Budgeting refers to the process of
generating, evaluating, selecting and following up of capital expenditures alternatives
2. Capital-structure or Financing decision-Financing decision relates to the choice of the proportion

of debt and equity sources of financing. The firm’s capital structure is considered optimum when the
market value of shares is maximized.
3. Profit allocation or Dividend decision-Deciding on dividend-payout ratio. It would depend on the

future investment and expansion plans of the firms
4. Working capital or Liquidity decision-Working capital management is concerned with the

management of current assets-Receivables, cash & inventory. Investment in current assets affects the
firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the
firm against the risk of illiquidity
Roles and responsibility of financial manager
• Investment Planning- efficient allocation of funds
• Investor Communication
• Financial Structure-debt equity mix
• Treasury Operations- obtaining, maintaining, and servicing the
organization's loans, lines of credit, hedging operations, and other capital
raising activities.
• Profit Planning
• Management Control- a process that helps to achieve organizational goals
• Foreign exchange management
• Understanding Capital Markets
The first principles of corporate finance & the
tie to value
Maximize the value of the business (firm)
The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business
The hurdle rate The return should How much How you choose
should reflect the The optimal The right kind
reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities
Agency relationships
• An agency relationship exists whenever a principal hires an agent to
act on his or her behalf.
• An agency problem results when the agent makes decisions that are
not in the best interest of principals
Agency relationships
• Agency problem is the likelihood that managers may place personal
goals ahead of corporate goal
• The cost borne by the shareholders to prevent or minimize agency
problems is known as agency costs
Stockholder-Manager Conflicts
• Managers are naturally inclined to act in their own best interests

(which are not always the same as the interest of stockholders).
• But the following factors affect managerial behavior:
• Managerial compensation packages
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover
Stockholder-Debtholder Conflicts
• Stockholders are more likely to prefer riskier projects, because they
receive more of the upside if the project succeeds. By contrast,
bondholders receive fixed payments and are more interested in
limiting risk.
• Bondholders are particularly concerned about the use of additional
debt.
• Bondholders attempt to protect themselves by including covenants
in bond agreements that limit the use of additional debt and
constrain managers’ actions.
Balancing Shareholder Interests and Society
Interests
• The primary financial goal of management is shareholder wealth
maximization, which translates to maximizing stock price.
• Value of any asset is present value of cash flow stream to owners.
• Most significant decisions are evaluated in terms of their financial
consequences.
• Stock prices change over time as conditions change and as
investors obtain new information about a company’s prospects.
• Managers recognize that being socially responsible is not inconsistent
with maximizing shareholder value.
The Objective in Decision Making
• In traditional corporate finance, the objective in decision making is to
maximize the value of the firm.
• A narrower objective is to maximize stockholder wealth. When the stock is
traded and markets are viewed to be efficient, the objective is to maximize
the stock price.
Maximize equity Maximize market
Maximize value estimate of equity
firm value
value
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets
Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
Stock Prices and Intrinsic Value
• In equilibrium, a stock’s price should equal its “true” or intrinsic

value.
• Intrinsic value is a long-run concept.
• To the extent that investor perceptions are incorrect, a stock’s price
in the short run may deviate from its intrinsic value.
• Ideally, managers should avoid actions that reduce intrinsic value,
even if those decisions increase the stock price in the short run.
Determinants of Intrinsic Values and Stock Prices
Managerial Actions, the Economic

Environment, Taxes, and the Political Climate
“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk
Stock’s Stock’s
Intrinsic Value Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
The Classical Objective Function
STOCKHOLDERS
Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting
Lend Money No Social Costs

BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value
FINANCIAL MARKETS
Why do we need these assumptions?
• Since, in many large firms, there is a separation of ownership from management,
managers have to be fearful of losing their jobs and go out and maximize stockholder
wealth. If they do not have this fear, they will focus on their own interests.
• If bondholders are not protected, stockholders can steal from them and make
themselves better off, even as they make the firm less valuable.
• If markets are not efficient, maximizing stock prices may not have anything to do
with maximizing stockholder wealth or firm value.
• If substantial social costs are created, maximizing stock prices may create large side
costs for society (of which stockholders are members).
• Note that corporate finance, done right, is not about stealing from other groups
(bondholders, other stockholders or society) but about making the firm more productive
and valuable.
What can go wrong?
STOCKHOLDERS
Managers put
Have little control their interests
over managers above stockholders
Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information
FINANCIAL MARKETS
What can go wrong?
• Stockholders have little or no control over managers. Managers, consequently, put
their interests above stockholder interests.
• Bondholders who do not protect themselves find stockholders expropriating their
wealth.
• Information conveyed to markets is noisy, biases and sometimes misleading. Markets
do not do a very good job of assimilating this information and market price changes
have little to do with true value.
• Firms in the process of maximizing stockholder wealth create large social costs.
• In this environment, stockholder wealth maximization is not a good objective function.
Business ethics
• ‘Moral Behaviour” or “Code of Conduct”
• Business Ethics: A company’s attitude and conduct toward its
employees, customers, community, and stockholders
• Dealing with money….Other’s money
• https://en.wikipedia.org/wiki/List_of_scandals_in_India
Corporate governance
• The “set of rules’ that a firm follows when conducting business
• In India, internal financial controls assumed importance after the
Satyam scandal in 2009
• The Companies Act, 2013 (“Act”) took a major step in raising the bar on
corporate governance in India with the introduction of Internal Financial
Controls (“IFC”).
• https://www2.deloitte.com/in/en/pages/risk/articles/governance-101.html
• Good corporate governance generates higher returns to stockholders
Goals/objectives of organization
• An objective specifies what a decision maker is trying to accomplish and by so doing provides measures that can
be used to choose between alternatives. So why do we need an objective, and if we do need one, why cannot we
have several?
• The managers of the firm, rather than the owners (stockholders), make the decisions about where to invest or how
to raise funds for an investment.
• If an objective is not chosen, there is no systematic way to make the decisions that every business will be
confronted with at some point in time.
• For instance, without an objective, how can Qualcomm managers decide whether the investment in Jio is a good
investment? There would be a menu of approaches for picking projects, ranging from reasonable ones like
maximizing return on investment to obscure ones like maximizing the size of the firm, and no statements could be
made about their relative value.
• Consequently, three managers looking at the same investment may come to three separate conclusions.
Goals/objectives of organization
• Should be aligned with the mission of the Corporation

• Primary goal:
• Revenue maximization
• Cost minimization
• Profit maximization
• Stockholder wealth maximization (value maximization) —Translate to
Shareholder wealth maximization - translates to maximizing stock price.
Profit maximization and value maximization
• Profit maximization –
• Ambiguity……short-term or long-term, before tax or after tax, ROI or ROA or ROCE or
Return on shareholders equity………………..
• Timing of benefits TIME A (Rs. In lakh) B (Rs. In lakh)
Period I 50 -
Period II 100 100
Period III 50 100
Total 200 200
• Certainty of the benefits/Riskiness
State of Economy A (Profit in Rs. Crore) B (Profit in Rs. Crore)
Recession 9 0
Normal 10 10
Boom 11 20
Total 30 30
Profit Maximization-
Profit maximization implies that a firm either produces maximum output for a given
amount of input, or uses minimum input for producing a given output. The underlying
logic of profit maximization is economic efficiency.
• Leads to Efficient allocation of resources
• Profit is considered as the most appropriate measure of a firm’s performance
But the precise meaning of the profit maximization objective is unclear. The definition of
the term profit is ambiguous. Does it mean short or long-term profit? Does it refer to
profit before or after tax? Total profits or profit per share?
✓The profit maximization objective ignores time value of money

• Wealth Maximization/Value Maximization-
• Shareholders wealth maximization (SWM) is considered as appropriate
decision criterion for financial management decisions
• The timing and risk of expected benefits is taken into consideration
• Wealth maximization means maximizing the net present value (NPV) of a
course of action to its shareholders
• This concept focuses on all the stakeholders
• It also can be based on economic value added (EVA)[NOPAT-
WACC*Capital]
• The ultimate goal is to maximize market capitalization
Value Maximization
It is dependent on (everything kept equal)-
The value of a firm is the present value of its expected cash flows,
discounted back at a rate that reflects both the riskiness of the
projects of the firm and the financing mix used to finance them.
• The cash flow the firm is expected to provide in the future

• Timing of those cash flows
• Certainty of those cash flows (risk associated with them)
• The ultimate goal is to maximize market capitalization
Stock Prices and Intrinsic Value
• In equilibrium, a stock’s price should equal its “true” or intrinsic

value.
• Intrinsic value is a long-run concept.
• To the extent that investor perceptions are incorrect, a stock’s price
in the short run may deviate from its intrinsic value.
• Ideally, managers should avoid actions that reduce intrinsic value,
even if those decisions increase the stock price in the short run.
Determinants of Intrinsic Values and Stock Prices
Managerial Actions, the Economic

Environment, Taxes, and the Political Climate
“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk
Stock’s Stock’s
Intrinsic Value Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
While managers have to cater to all the stakeholders (such as consumers, employees,
suppliers etc.), they need to pay particular attention to the owners of the corporation i.e.
shareholders.
If managers fail to pursue shareholder wealth maximization, they will lose the support
of investors and lenders. The business may cease to exist and ultimately, the managers
will lose their jobs!
Finance Within the Organization
Board of Directors
Chief Executive Officer (CEO)
Chief Operating Officer (COO) Chief Financial Officer (CFO)
Marketing, Production, Human Accounting, Treasury, Credit,

Resources, and Other Operating Legal, Capital Budgeting, and
Departments Investor Relations
Forms of Business Organization
• Proprietorships and • Corporation
Partnerships • Advantages
• Advantages • Unlimited life
• Ease of formation • Easy transfer of ownership
• Subject to few regulations • Limited liability
• No corporate income taxes • Ease of raising capital
• Disadvantages • Disadvantages
• Difficult to raise capital • Double taxation
• Unlimited liability • Cost of setup and report filing
• Limited life
• Often set up through LLCs/LLPs.
Time value of money
Introduction
• Most financial decisions, such as the purchase of assets or procurement of
funds, affect the firm's cash flows in different time periods.
• For example, if a fixed asset is purchased, it will require an immediate cash

outlay and will generate cash inflows during many future periods.
• Similarly, if the firm borrows funds from a bank or from any other source , it
receives cash now and commits an obligation to pay cash for interest and
repay principle in future periods.
• The firm may also raise funds by issuing equity shares.
• The firm's cash balance will increase at the times shares are issued, but, as the
firm pays dividends in future, the outflow of cash will occur.
Introduction
• Sound decision making requires that the cash flows, which are firm is
expected to receive or give up over a period of time, should be logically
comparable.
• In fact, the absolute cash flows, which differ in timing and risk, are not
directly comparable.
• Cash flows become logically comparable when they are appropriately adjusted
for their differences in timing and risk.
• The recognition of the time value of money and risk is extremely vital in
financial decision-making .
Time Value of Money (TVM)
• If an individual behaves rationally, he or she would not value the opportunity
to receive a specific amount of money now, equally with the opportunity to
have the same amount at some future date.
• Most individuals value the opportunity to receive money now higher than
waiting for one or more periods to receive the same amount.
• Time preference for money or time value of money (TVM) is an individual's

preference for possession of a given amount of money now, rather than the
same amount at some future time.
• Three reasons may be attributed to the individuals time preference for

money: risk, preference for consumption, and investment opportunities.
Required Rate of Return
• The required rate of return may also be called the opportunity
cost of capital of comparable risk.
• It is called so because the investor could invest his money in assets

or securities of equivalent risk.
• Compounding – the process of calculating future values of cash

flows.
• Discounting – the process of calculating present values of cash

flows.
Future Value
• Compound interest is the interest that is received on the original
amount (principal) as well as on any interest earned but not
withdrawn during earlier periods.
• Compounding is the process of finding the future values of

cashflows by applying the concept of compound interest.
• Simple interest is the interest that is calculated only on the original

amount (principal), and thus, no compounding of interest takes
place.
Future Value of a Single Cash Flow
𝐅𝐧 = 𝐏 (𝟏 + 𝐢 )𝐧 ……………………………………. (1)
where,
F is the future value or compound value
P is the present value
i represent the interest rate per period
n is the number of periods before pay-off
• The term (1 + i )n is the compound value factor (CVF) of a lump sum of Re 1, and it always
has a value greater than 1 for positive i, indicating that CVF increases as i and n increases.
• The compound value can be computed for any lump sum amount at i rate of interest for n
number of years, using the given equation (1).
Future Value of a Single Cash Flow
Question: Suppose your father gave you Rs. 100 on your eighteenth birthday. You deposited
this amount in a bank at 10 per cent rate of interest for one year. How much future sum
would you receive after one year?
Answer: As per the formula of compounding of the cash flows:
𝐅𝐧 = 𝐏 (𝟏 + 𝐢 )𝐧
The future value is :

F= 𝟏𝟎𝟎 (𝟏 + 𝟎. 𝟏𝟎 )𝟏
F = Rs. 110
Future Value of a Lump Sum
Question: Suppose that Rs. 1000 are placed in the savings account of a bank at 5 percent interest rate. How
much shall it grow at the end of three years?
Answer: 𝐅𝟏 = 𝟏, 𝟎𝟎𝟎 + 𝟏, 𝟎𝟎𝟎 × 𝟓 % As per the formula of compounding

𝐅𝟏 = 1,000 + 50 of the cash flows:
𝐅𝟏 = Rs. 1,050
𝐅𝐧 = 𝐏 (𝟏 + 𝐢 )𝐧
𝐅𝟐 = 𝟏, 𝟎𝟓𝟎 + 𝟏, 𝟎𝟓𝟎 × 𝟓 %
𝐅𝟐 = 1,050 + 52.50 F= 1000 (1 + 0.05 )3
𝐅𝟐 = Rs. 1,102.50 F = 1000 (1.05 × 1.05 × 1.05)
F = Rs. 1,157.60
𝐅𝟑 = 𝟏, 𝟏𝟎𝟐. 𝟓𝟎 + 𝟏, 𝟏𝟎𝟐. 𝟓𝟎 × 𝟓 %
𝐅𝟑 = 1,050 + 55.10
𝐅𝟑 = Rs. 1,157.60
Question: If you deposited Rs. 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-year time
deposit, how much would the deposit grow at the end of ten years?
Answer: FV = 55,650 × 𝑪𝑽𝑭𝟏𝟎,𝟎.𝟏𝟓

FV = 55,650 × 4.046 = Rs. 2,25,159.90
Future Value of an Annuity
• Annuity is a fixed payment (or receipt) each year for a specified number of years.
• If you rent a flat and promise to make a series of payments over an agreed period, you
have created an annuity.
• The equal-instalment loans from the housing financing companies or employers are
common example of annuities.
(𝟏+𝐢 )𝐧 − 1
• 𝐅𝐧 = A [ ]
𝑖
Question: Suppose Rs. 100 are deposited at the end of each of the next three years at 10 per
cent interest rate. What will be the compound value of the annuity ?
Answer: Rs. 331

Sinking Fund
• Sinking fund is a fund, which is created out of fixed payments each period to accumulate to a
future sum after a specified period.
• For example, companies generally create sinking funds to retire bods (debentures) on maturity.
• Suppose we want to accumulate Rs. 21,875 at the end of four years from now. How much should
we deposit each year at an interest rate of 6 per cent so that it grows to 21,875 at the end of
fourth year?
𝑖
A = 𝐅𝐧
(𝟏+𝐢 )𝐧 − 1
0.06
A = 21,875 ×
(𝟏+𝟎.𝟎𝟔 )𝟒 − 1
A = Rs. 5,000
• The sinking fund factor is useful in determining the annual amount to be put in a fund to repay
bonds or debentures at the end of a specified period.
Present Value of a Single Cash Flow
• Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of
equivalent value to the decision maker.
• Discounting is the process of determining present values of a series of future cash flows.
• The compound interest rate used for discounting cash flows is also called the discount rate.
1
P = 𝐅𝐧
(𝟏+𝐢 )𝐧
• The term in the parentheses is the discount factor or present value factor (PVF), and it is always
less than 1.0 for positive i, indicating that a future amount has a smaller present value.
Question: Suppose an investor wants to find out the present value of Rs. 50,000 to be received after
15 years. The interest rate is 9 percent.
Answer: PV = 50,000 × PVF15,0.09

PV = 50,000 × 0.275 = Rs. 13,750
Present Value of an Annuity
(𝟏+𝐢 )𝐧 − 1
P=A
𝑖(𝟏+𝐢 )𝐧
where,
P is the present value of an annuity
A is the annuity amount
i represent the interest rate per period
n is the number of periods before pay-off
Question: Suppose that a person receives an annuity of Rs. 5,000 for four years. If the rate of interest is 10 per cent, the present
value of Rs. 5,000 annuity is:
(𝟏+𝟎.𝟏𝟎 )𝟒 − 1
Answer: P = 5,000
𝟎.𝟏𝟎(𝟏+𝟎.𝟏𝟎 )𝟒
P = 5,000 (3.170)
P = Rs. 15,850
Capital Recovery
• If we make an investment today for a given period of time at a specified rate of interest, we may
like to know the annual income.
• Capital recovery is the annuity of an investment made today, for a specified period of time, at a
given rate of interest.
𝐢(𝟏+𝐢 )𝐧
A=P
(𝟏+𝐢 )𝐧 −1
where,
the term within the brackets may be referred to as the capital recovery factor
Question: Suppose you plan to invest Rs. 10,000 today for a period of 4 years. If your interest rate is 10 percent, how much
income per year should you receive to recover your investment?
𝟎.𝟏𝟎(𝟏+𝟎.𝟏𝟎 )𝟒
Answer: A = 10,000
(𝟏+𝟎.𝟏𝟎 )𝟒 −𝟏
P = 10,000 (0.3155)
P = Rs. 3,155
Loan Amortization
• Capital recovery factor helps in the preparation of a loan amortization schedule or loan
repayment schedule.
(𝟏+𝐢 )𝐧 − 1
P=A
𝑖(𝟏+𝐢 )𝐧
where,
the term within the brackets may be referred to as the capital recovery factor
Question: Suppose you have borrowed a 3-year loan of Rs. 10,000 at 9 per cent from your employer to buy a motorcycle. If
your employer requires three equal end-of-year repayments, then the annual instalment will be?
Answer: 10,000 = A × PVF𝐴3,0.09

10,000 = A × 2.531
A = Rs. 3,951
By paying Rs. 3,951 each year for three years, you shall completely pay off your loan with 9 per cent interest. This can be
observed from the loan amortization schedule given in the next slide:
Loan Amortization Schedule
Question: Suppose you have borrowed a 3-year loan of Rs. 10,000 at 9 per cent from your employer to buy a motorcycle. If
your employer requires three equal end-of-year repayments, then the annual instalment will be?
Answer: 10,000 = A × PVF𝐴3,0.09

10,000 = A × 2.531
A = Rs. 3,951
End of year Payment Interest Principal Repayment Outstanding Balance
0 10,000
1 3,951 900 3,051 6,949
2 3,951 625 3,326 3,623
3 3,951 326 3,625* 0
Present Value of a Perpetuity
• Perpetuity is an annuity that occurs indefinitely.

• For instance, irredeemable preference shares (i.e., preference shares without a maturity), the
company is expected to pay preference dividend perpetually.
Perpetuity
Present value of a perpetuity =
Interest rate
A
P=
i
• To take an example, let us assume that an investor expects a perpetual sum of Rs. 500 annually
from his investment. What is the present value of this perpetuity if interest rate is 10 per cent?
500
Answer: P=
0.10
P = Rs. 5,000
Present Value of Uneven Cashflows
Question: Consider that an investor has an opportunity of receiving Rs. 1,000, Rs. 1,500, Rs. 800, Rs.
1,100 and Rs. 400 respectively at the end of one through five years. Find out the present value of this
stream of uneven cash flows, if the investor’s required interest rate is 8 per cent.
𝟏,𝟎𝟎𝟎 𝟏,𝟓𝟎𝟎 𝟖𝟎𝟎 𝟏,𝟏𝟎𝟎 𝟒𝟎𝟎

Answer: Present value = + + + +
(𝟏.𝟎𝟖) (𝟏.𝟎𝟖)𝟐 (𝟏.𝟎𝟖)𝟑 (𝟏.𝟎𝟖)𝟒 (𝟏.𝟎𝟖)𝟓
PV = Rs. 3,927.60
OR
PV = 1,000× PVF1,0.08 + 1,500 × PVF2,0.08 + 800 × PVF3,0.08 + 1,100 × PVF4,0.08+ 400 × PVF5,0.08
PV = Rs. 3,927.60
Present Value of a Growing Annuity
Question: A company paid a dividend of Rs. 60 last year. The dividend stream commencing from year
one is expected to grow at 10 per cent per annum for 15 years and then end. If the discount rate is 21
per cent, what is the present value of the expected series?
𝑨 𝟏+𝐠 𝑛
Answer: P= 1 −ቆ
𝒊−𝒈 𝟏+𝒊
𝟔𝟔 𝟏.𝟏𝟎 15
P= 1 − ቆ
𝟎.𝟐𝟏−𝟎.𝟏𝟎 𝟏.𝟐𝟏
P = 600 × ( 1- 0.90915 )
P = 600 × 0.7606
P = Rs. 456.36
Present Value of Growing Perpetuities
𝑨
P=
𝒊−𝒈
Question: Suppose dividends of Rs. 66 after one year are expected to grow at 10 per cent indefinitely.
The discount rate is 21 per cent. What is the present value of a constantly growing perpetuity:
Answer:
𝟔𝟔
P=
𝟎.𝟐𝟏−𝟎.𝟏𝟎
𝟔𝟔
P=
𝟎.𝟏𝟏
P = Rs. 600
Question: XYZ bank pays 12 percent and compounds interest quarterly. If Rs. 1,000 is deposited
initially, how much shall it grow at the end of 5 years ?
n*m
𝑖
Answer: F = P 1 +
𝑚
0.12 5 * 4
F = 1,000 1 +
4
F = 1,806
Terms used in financial mathematics
• PV Present value
• FV Future value
• Pmt Payment/annuity/cash inflow/cash outflow
• i Interest rate/discount rate/required rate
• N/Nper Number of periods
• Bgn Beginning of the period
• End End of the period
• Type 1 for beginning of the period and 0 for end of the period (Excel)
Financial Management-2
Introduction to Time Value of Money
• Money has time value. A rupee today is more valuable than it will be a year hence or two years hence. This is
because of the following factors.
• If a person is saving money, he is sacrificing his present needs for the future; therefore he should be
compensated for this.
• In an inflationary period, money today represents more purchasing power than money tomorrow. In the
example above, Rs. 20,000 per month, which is sufficient for a person to meet his living costs today is
not sufficient after 30 years because of the effect of inflation. He needs Rs. 86,438 after 30 years to maintain
the same standard of living if we assume the average rate of inflation to be 5% per annum.
• The person who will ultimately use the money saved will use it for productive purposes and therefore, the
person who is sacrificing his present should be compensated in the form of returns.
• When a person is giving his money to be used by another person, he is also taking the risk associated with
it, i.e. default risk and the need to compensate in the form of interest or return.
• In order to compare two investment alternatives in which cash inflow is occurring at different intervals, there
has to be a single tool for comparison, and that is present value or PV
Terms used in financial mathematics
• PV Present value
• FV Future value
• Pmt Payment/annuity/cash inflow/cash outflow
• i Interest rate/discount rate/required rate
• N/Nper Number of periods
• Bgn Beginning of the period
• End End of the period
• Type 1 for beginning of the period and 0 for end of the period (Excel)
Formula
1.CALCULATION OF FUTURE VALUE FOR A
ONE-TIME INVESTMENT I.E. A SINGLE
INVESTMENT
• FV = PV (1+R) ^Nper
• FV = Future value
• PV = Present value
• R = Rate of return
• Nper= Number of periods (number of times compounded)
Annuity
• An annuity is a series of payments of the same amount at regular
intervals, over a specified period of time. The word annuity has been
used to describe monthly, quarterly, semi-annual and annual payments
which are of equal amounts
• Payment of EMI on a housing loan
• Interest from Government of India bonds (semi-annual)
• Quarterly interest from Senior Citizen Saving Scheme
• Rent or lease amount on a house
Ordinary Annuity or Investment/Payment at the
End of the Period
• Suppose a person invests a certain amount of money at the end of
every month after meeting all the monthly expenses. If the 1st
installment is at the end of January (31st January), he will lose the
benefit of interest for the month of January and will start getting
interest on his investment from 1st February
• if a person pays the installment of a loan amount at the end of every
month, he will have to pay more because the lender will charge him a
higher EMI as he will lose one month’s interest on this amount.
Annuity due or Investment/Payment at the
Beginning of the Period
• Suppose a person has made a budget of his monthly expenses and he
invests a certain amount at the beginning of every month. If the 1st
installment is paid at the beginning of January (1st January), he will
start getting interest from this date itself, instead of from 1st February
as in the previous example.
• He will get one month’s extra interest. The same is true for quarterly,
semi-annual and annual investments. If we see the other side, i.e. if we
make the payment of loan amount at the beginning of the period, we
will have to pay a lesser EMI than if we pay at the end of the month.
Deferred Annuity
• Suppose a person aged 40 has invested a lump sum amount today and
after 20 years when he retires, he will start getting a certain amount
every month in the form of pension; this is a case of deferred annuity
as the payment of regular pension has been deferred for 20 years.
• The amount invested will earn interest for 20 years and after that it
will start paying a monthly annuity in the form of a pension. Here
again, payment of annuity can be at the beginning of the period or at
the end of the period.
Annuity in Perpetuity
• Suppose a person wishes that the payment of annuity should continue
forever: he should invest a sufficient amount of money so that the
interest income from this is enough to pay the amount of annuity. This
is called annuity in perpetuity.
• If a person wishes to have an annual annuity of Rs. 1,20,000 and the
rate of interest is 10% p.a., he should invest Rs. 12,00,000 so that he
will continue to get Rs. 1,20,000 every year. To compute annuity in
perpetuity, the required amount of annuity will be divided by the rate
of interest. In this case it will be: 120000/0.10 = Rs. 12,00,000
Growing Annuity
• Growing annuity means that the amount of annual investment will keep
increasing. Every individual gets an increase in his income/salary each year
and if he saves a percentage of this every year then his annual investment
will also increase.
• We can calculate the future value of a growing annuity either with the help
of a formula or with the help of an Excel sheet.
• FV of a growing annuity = Pmt {(1+ i) ^n – (1+ g) ^n}/{(1+i) – (1 + g)}
• Pmt = 1st installment
• i = Rate of return on investments
• g = Growth rate of income
• n = Number of years of investment
Future Value of Annuity
• Future value is the accumulated amount which a person will get after a
certain number of years.
• Rakesh invests Rs. 20,000 every year at the end of every year at the rate of
12% p.a. How much money will be accumulated in his account after 10
years?
• Go to fx select the category: financial and select FV and feed the values
• Type 1 for beginning of the period and 0 for the end of the period
• Rate 12% or 0.12
• Nper 10
• Pmt –20000
• Type 0
• Formula result = 350974.70
• That is future value or the accumulated amount.
Formula
Problem
• In the previous question, if Rakesh decides to invest Rs. 20,000 at the
beginning of every year for 10 years @12% per annum, how much
will be accumulated in his account?
• Rate 12% or 0.12
• Nper 10
• Pmt –20000
• Type 1
• Formula result = FV = 393091.66
Problem 2
• Rahul is 20 years old and has just joined a bank as relationship manager. He
happened to meet a certified financial planner who advised him to start
investing systematically and explained to him the power of compounding.
Rahul was impressed with the advice given and started saving Rs. 1,800
every month at the beginning of the month. The rate of return expected on
his investment is 15% p.a. How much will be accumulated in his account
after 40 years?
• –1800 pmt
• Bgn
• 480 n
• 1.25 i
• Comp FV = 56526759.82. (5.65 Cr)
HOW TO COMPUTE REQUIRED
MONTHLY/ANNUAL
SAVING (PMT)
• When we know our financial goal of accumulating a certain amount
during a certain period, we have to compute Pmt, i.e. the amount of
regular savings to be made to reach that goal.
• In Excel, go to fx, select the category: Financial, select PMT and feed
the
values as follows:
Rate —%
Nper ——
FV ——
Type 0 or 1(1 for beg and 0 for end)
Problem 3
• Shashi needs Rs. 12,00,000 for her daughter’s marriage which will take
place after 12 years. She wishes to save money at the end of every month in
a systematic investment plan which will generate 14% return per annum.
What amount should she save every month to meet this goal after 12 years?
• In Excel
• Rate 14%/12
• Nper 12 × 12
• FV 1200000
• Type 0
• Formula Result = –3245.52
Problem 4
• Richa is 14 years old and she is very intelligent and good in studies.
She plans to pursue an engineering degree course from Australia. For
this the amount required is Rs. 8,00,000 in today’s terms which will
increase @ 6% p.a. and the amount is required after 5 years. How
much per quarter should her father start saving from now on if the rate
of return on investment is expected to be 9% p.a.?
Solution
• Step 1
• –800000 PV
• 6i
• 5n
• Comp FV =1070580.46
• Step 2
• We have to compute quarterly PMT required to be saved for 20 quarters
• @ 2.25% per quarter.
• 1070580.46 FV
• 20 n
• 2.25 i
• Comp Pmt = 42975.31
Present Value of Annuity
Problem 5
• Vishal has taken a loan of Rs. 25,00,000 from his employer for
purchase of a flat @ 10% p.a. for a period of 20 years. Compute the
amount of Equated Monthly Installment (EMI) amount?
• Loan amount is always assumed to be PV and a – sign will always
be put before PV.
• –25,00,000 PV
• 240 n
• 0.833 i
• Comp Pmt = 24125.54
Problem 6
• Mr. Prashant is thinking of buying a residential house partly with the
help of a loan amount and partly with his own savings. He has 20 lakh
of financial assets out of which some assets may be sold off to pay the
upfront amount. He can pay maximum EMI of Rs. 12,000 p.m. He has
identified a house for Rs. 25 lakh. He is 33 years old and the loan will
be repaid in 25 years. Rate of interest on loan is 9% p.a. Compute the
maximum amount of loan he can take from the housing finance
company and what amount of savings he will have to withdraw to
meet his commitment of buying a house?
Solution
• In this case we have to compute the maximum loan amount, i.e. PV
which will be paid back in 25 years @ 9% p.a. convertible monthly
with an EMI of Rs. 12,000 p.m.
• Go to fx, select the category: Financial, select PV and press ok
• Rate 9%/12
• Nper 25 × 12
• Pmt 12000
• Type 0
• Formula result = Rs. 14,29,939.46
Present Value
• How much should be saved by a person today to get Rs. 20,000 per
annum at the end of every year for 5 years if the rate of return
expected is 8% p.a.?
• 20000 Pmt
•5n
•8i
• Comp PV = –79854.20
Problem
• Sudhir wishes to accumulate Rs. 45,00,000 for his retirement which is
expected after 19 years. He wishes to invest semi-annually into a
diversified equity fund with a growth option. Assuming a return of 8%
per semi-annual, how much amount per semi-annual should Sudhir
invest in order to meet his goal of having Rs. 45 lakh?
• 4500000 FV
38 n
8i
Comp Pmt = –20425.21
COMPUTATION OF RATE AND NUMBER
OF PERIODS
• A person wishes to accumulate Rs. 28,00,000 to meet various goals
which will arrive after 12 years. He can save Rs. 10,000 p.m. What
rate should the investments generate to meet his goals which need to
be fulfilled after 12 years?
• We will compute the value of i in this way:
• –10000 Pmt
• 144 n
• 2800000 FV
• Comp i = 0.848 monthly or 10.18% annually.
Problem
• Anilesh met a financial planner while travelling from Delhi to
Mumbai. After introductions they started discussing their job profiles.
Anilesh is a businessman and runs his business smoothly but lacks
knowledge about investments. The financial planner explained to him
how proper investment of money is different from saving money.
Anilesh can save Rs. 25,000 p.m. for 13 years. He wishes to
accumulate Rs. 1 crore. What rate of return should the investments
provide to meet this?
Solution
• Use the function rate
• –25000 pmt
• 156 n
• 10000000 FV
• Comp i = 1.07456 monthly or 12.895 annually
• To compute the annual rate, the monthly rate will be multiplied by 12
to get the annualized return.
How to compute the number of periods (n)?
• Mr. Uday invests Rs. 2,500 at the beginning of every month into two
systematic investment plans for higher education of his two sons at an
annual rate of 12% p.a. convertible monthly. His elder son requires Rs.
15,00,000 and the younger son requires Rs. 17,00,000. Compute the
number of years required to make this happen?
Solution
• For elder son
• Go to fx, select the category: Financial, select Nper and press ok
• Rate 12%/12 or 0.01
• Pmt –2500
• FV 1500000
• Type 1
• Formula result =194.70 months or 16.22 years.
• For younger son
• Rate 12%/12 or 0.01
• Pmt –2500
• FV 1700000
• Type 1
• Formula result = 205.56 months or 17.13 years
Problem
• A person took a loan of Rs. 3,00,000 and it is to be paid in 6 annual
installments with a coupon rate of 12% p.a. Compute the amount of
equated annual installments?
• –3,00,000 PV
•6n
• 12 i
• Compute Pmt = -72967
Problem
• An income stream provides Rs. 2,000 for the first 3 years and Rs.
3,000 for the next 3 years. If interest rate is 14% per annum, how
much money should be taken in lieu of the above payments or
compute the present value of the income stream?
• Present value of income stream for 1st 3 years:
• 2000 Pmt
•3n
• 14 i
• Compute PV = –4643.26 (1)
Solution
• Step 2
• Present value of income stream for the next 3 years:
• 3000 Pmt
• 3n
• 14 i
• Compute PV = –6964.89
• 6964.89 FV
• 3n
• 14 i
• Compute PV = –4701.10 (2)
• Present value of the two income streams = (1) + (2) = 9344.36
• In this case, the income stream in the 2nd phase of 3 years has to be brought at today’s terms, i.e.
present value at the beginning of the investment
Problem
• Seema is 22 years old and saves Rs. 1, 00,000 every year at the end of
every year into a deposit which pays 8% p.a. She will save for 15
years and after that she wishes to use this money partly to finance her
trip to Germany which costs Rs. 1,20,000 in today’s terms and partly
to finance the purchase of a house. Inflation is assumed to be 4% for a
15 year period. Calculate the amount which can be used to finance the
purchase of a house after 15 years?
Solution
• First, we have to compute how much will be accumulated in 15
• years.
• –100000 Pmt
•8i
• 15 n
• Compute FV = Rs. 27,15,211 (1)
• The second step is to compute the amount of money required by
Seema after 15 years, to visit Germany. In terms of today, the amount
required is Rs. 1,20,000 which will increase with the rate of inflation.
• –120000 PV
• 15 n
•4i
• Compute FV = Rs. 2,16,113 (2)
• In the third step, we have to compute how much will remain for
financing the house purchase after meeting the expenses for the trip
abroad. (1) – (2) = 2715211 – 216113 = Rs. 24,99,098 or nearly Rs. 25
lakh
Problem
• Mr. Shah has identified a house that he wishes to purchase for Rs. 30
lakh. He is 35 years old and wishes to pay back the loan in 20 years
through monthly installments (in due). He approached a housing
finance company who has agreed to finance up to 80% of the cost of
the house. The rate of interest is 9% p.a. convertible monthly
Solution
• The first step is to calculate the amount of loan that the housing
finance company will give 80% of Rs. 30,00,000 is Rs. 24,00,000.
• –2400000 PV
• 9%/12 (0.75) i
• 20 × 12 (240) n
• Compute Pmt = 21593.42
• Bgn –Annuity Due
• Compute Pmt = 21432.67
Deferred Annuity
Lata wishes to invest a lump sum for her future security. She is 40 years old and
her health does not allow her to work till the age of 60 but the pension from her
employer will start only after she has attained 60 years of age. She is single and
wishes to retire after 10 years. Her employer will not give her a pension for a
period of 10 years, i.e. from 50 to 60 years of age. She wishes to save a lump
sum amount now which will enable her to get an yearly annuity of Rs. 2,50,000
at the end of every year, with the first payment occurring at the end of the 11th
year from now. She is expecting a return of 12% on her investments. How much
should she invest now? How to Compute the Present Value of a Deferred Annuity?
Solution
• We have to find the present value of the annuity for 10 years
• 250000 Pmt
• 12 i
• 10 n
• Comp PV = –1412555.75 (at year 10)
• Step 2: To compute the PV of this amount at year 1 as we have to invest the
money today
• 1412555.75 FV
• 12 i
• 10 n
• Comp PV= –454805.15
• The amount will grow for 10 years and it will start paying out at the end of the
11th year.
Growing Annuity
• a graduated/growing annuity is one in which the cash flows are not all
the same, instead they are growing at a constant rate.
• we can make the PV function do the work for us by altering the
interest rate that we use
• here are two opposing rates : The growth rate and the discount rate.
• The growth rate makes the cash flows larger, but the discount rate
makes them smaller. Therefore, the "net" interest rate that we will use
must be a combination of these two rates.
Time Lines
• Show the timing of cash flows.
• Tick marks occur at the end of periods, so Time 0
is today; Time 1 is the end of the first period
(year, month, etc.) or the beginning of the second
period.
0 1 2 3
I%
CF0 CF1 CF2 CF3
5-103
Drawing Time Lines
$100 lump sum due in 2 years

0 1 2
I%
100
3-year $100 ordinary annuity
0 1 2 3
I%
100 100 100
5-104
INTRO FUTURE VALUE PRESENT VALUE I&N ANNUITIES RATES/RETURN AMORTIZATION
Drawing Time Lines
Uneven cash flow stream
0 1 2 3
I%
-50 100 75 50
5-105
What is the future value (FV) of an
initial $100 after 3 years, if I/YR =

4%?
• Finding the FV of a cash flow or series of cash
flows is called compounding.
• FV can be solved by using the step-by-step,
financial calculator, and spreadsheet methods.
0 1 2 3
4%
100 FV = ?
5-106
Solving for FV:
The Step-by-Step and Formula

Methods
• After 1 year:
FV1 = PV(1 + I) = $100(1.04) = $104.00
• After 2 years:
FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
• After 3 years:
FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
• After N years (general case):

FVN = PV(1 + I)N
5-107
Solving for FV:

Calculator and Excel Methods
• Solves the general FV equation.
• Requires 4 inputs into calculator, and will solve
for the fifth. (Set to P/YR = 1 and END mode.)
INPUTS 3 4 -100 0
N I/YR PV PMT FV
OUTPUT 112.49
Excel: =FV(rate,nper,pmt,pv,type)
5-108
Present Value
• What is the present value (PV) of $100 due in
3 years, if I/YR = 4%?
• Finding the PV of a cash flow or series of cash flows is
called discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.
0 1 2 3
4%
PV = ? 100
5-109
Solving for PV:

The Formula Method
• Solve the general FV equation for PV:
PV = FVN /(1 + I)N
PV = FV3 /(1 + I)3

= $100/(1.04)3
= $88.90
5-110
Solving for PV:

Calculator and Excel Methods
• Solves the general FV equation for PV.
• Exactly like solving for FV, except we have
different input information and are solving for a
different variable.
INPUTS 3 4 0 100
N I/YR PV PMT FV
OUTPUT -88.90
Excel: =PV(rate,nper,pmt,fv,type)
5-111
Solving for I: What annual interest
rate would cause $100 to grow to

$119.10 in 3 years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 3 -100 0 119.10
N I/YR PV PMT FV
OUTPUT 6
Excel: =RATE(nper,pmt,pv,fv,type,guess)
5-112
Solving for N: If sales grow at 10%
per year, how long before sales

double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 10 -1 0 2
N I/YR PV PMT FV
OUTPUT 7.3
EXCEL: =NPER(rate,pmt,pv,fv,type)
5-113
What is the difference between an

ordinary annuity and an annuity due?
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT
Annuity Due
0 1 2 3
I%
PMT PMT PMT
5-114
Solving for FV:
3-Year Ordinary Annuity of $100 at

4%
• $100 payments occur at the end of each period,
but there is no PV.
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 312.16
Here type = 0.
5-115
Solving for PV:

3-year Ordinary Annuity of $100 at 4%
• $100 payments still occur at the end of each
period, but now there is no FV.
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -277.51
Here type = 0.
5-116
Solving for FV:

3-Year Annuity Due of $100 at 4%
• Now, $100 payments occur at the beginning of each period.
FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
• Alternatively, set calculator to “BEGIN” mode and solve for the FV of
the annuity due:
BEGIN
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 324.65
Here type = 1.
5-117
Solving for PV:

3-Year Annuity Due of $100 at 4%
• Again, $100 payments occur at the beginning of each period.
PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
• Alternatively, set calculator to “BEGIN” mode and solve for the PV of
the annuity due:
BEGIN
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -288.61
Here type = 1.
5-118
What is the present value of a 5-year

$100 ordinary annuity at 4%?
• Be sure your financial calculator is set back to
END mode and solve for PV:
• N = 5, I/YR = 4, PMT = -100, FV = 0.
• PV = $445.18.
5-119
What if it were a 10-year annuity? A

25-year annuity? A perpetuity?
• 10-year annuity
• N = 10, I/YR = 4, PMT = -100, FV = 0; solve for PV =
$811.09.
• 25-year annuity
• N = 25, I/YR = 4, PMT = -100, FV = 0; solve for PV =
$1,562.21.
• Perpetuity
• PV = PMT/I = $100/0.04 = $2,500.
5-120
The Power of Compound Interest

A 20-year-old student wants to save $5 a day for
her retirement. Every day she places $5 in a
drawer. At the end of the year, she invests the
accumulated savings ($1,825) in a brokerage
account with an expected annual return of 8%.
How much money will she have when she is 65

years old?
5-121
Solving for FV: If she begins saving
today, how much will she have when

she is 65?
• If she sticks to her plan, she will have $705,373
when she is 65.
INPUTS 45 8 0 -1825
N I/YR PV PMT FV
OUTPUT 705,373
Excel: =FV(.08,45,-1825,0,0)
5-122
Solving for FV: If you don’t start
saving until you are 40 years old, how

much will you have at 65?
• If a 40-year-old investor begins saving today, and
sticks to the plan, he or she will have $133,418 at
age 65. This is $571,954 less than if starting at
age 20.
• Lesson: It pays to start saving early.
INPUTS 25 8 0 -1825
N I/YR PV PMT FV
OUTPUT 133,418
Excel: =FV(.8,25,-1825,0,0)
5-123
Solving for PMT: How much must the
40-year old deposit annually to catch

the 20-year old?
• To find the required annual contribution, enter the
number of years until retirement and the final goal
of $705,372.75, and solve for PMT.
INPUTS 25 8 0 705373
N I/YR PV PMT FV
OUTPUT -9,648.64
Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)
5-124
What is the PV of this uneven cash

flow stream?
0 1 2 3 4
4%
100 300 300 -50

96.15
277.37
266.70
-42.74
597.48 = PV
5-125
Solving for PV:

Uneven Cash Flow Stream
• Input cash flows in the calculator’s “CFLO”
register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
• Enter I/YR = 4, press NPV button to get NPV =
$597.48. (Here NPV = PV.)
5-126
Will the FV of a lump sum be larger or
smaller if compounded more often, holding

the stated I% constant?
• LARGER, as the more frequently compounding
occurs, interest is earned on interest more often.
0 1 2 3
10%
100 112.49
Annually: FV3 = $100(1.04)3 = $112.49
0 1 2 3
0 1 2 3 4 5 6
5%
100 112.62
Semiannually: FV6 = $100(1.02)6 = $112.62
5-127
Classification of Interest Rates

• Nominal rate (INOM): also called the quoted or
stated rate. An annual rate that ignores
compounding effects.
• INOM is stated in contracts. Periods must also be given,
e.g. 4% quarterly or 4% daily interest.
• Periodic rate (IPER): amount of interest charged
each period, e.g. monthly or quarterly.
• IPER = INOM/M, where M is the number of
compounding periods per year. M = 4 for quarterly
and M = 12 for monthly compounding.
5-128
Classification of Interest Rates

• Effective (or equivalent) annual rate (EAR =
EFF%): the annual rate of interest actually being
earned, considering compounding.
• EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
• Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
• Should be indifferent between receiving 4.04% annual
interest and receiving 4% interest, compounded
semiannually.
5-129
Why is it important to consider
effective rates
of return?
• Investments with different compounding intervals
provide different effective returns.
• To compare investments with different
compounding intervals, you must look at their
effective returns (EFF% or EAR).
5-130
Why is it important to consider
effective rates
of return?
• See how the effective return varies between
investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 4.00%
EARSEMIANNUALLY 4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%
5-131
When is each rate used?

• INOM: Written into contracts, quoted by banks and
brokers. Not used in calculations or shown on
time lines.
• IPER: Used in calculations and shown on time
lines. If M = 1, INOM = IPER = EAR.
• EAR: Used to compare returns on investments
with different payments per year. Used in
calculations when annuity payments don’t match
compounding periods.
5-132
What is the FV of $100 after 3 years
under 10%
semiannual compounding? Quarterly
compounding? MN
 I 
FVN = PV1 + NOM 
 M 
23
 0.04 
FV3S = $1001 + 
 2 
FV3S = $100(1.02) 6 = $112.62
FV3Q = $100(1.01)12 = $112.68
5-133
Can the effective rate ever be equal to

the nominal rate?
• Yes, but only if annual compounding is used, i.e.,
if M = 1.
• If M > 1, EFF% will always be greater than the
nominal rate.
5-134
What’s the FV of a 3-year $100 annuity, if
the quoted interest rate is 4%,

compounded semiannually?
• Payments occur annually, but compounding
occurs every 6 months.
• Cannot use normal annuity valuation techniques.
0 1 2 3 4 5 6
2%
100 100 100
5-135
Method 1:
Compound Each Cash Flow
0 1 2 3 4 5 6
2%
100 100 100

104.04
108.24
312.28
FV3 = $100(1.02)4 + $100(1.02)2 + $100

FV3 = $312.28
5-136
Method 2:
Financial Calculator or Excel
• Find the EAR and treat as an annuity.
• EAR = (1 + 0.04/2)2 – 1 = 4.04%.
INPUTS 3 4.04 0 -100

N I/YR PV PMT FV
OUTPUT 312.28
Excel: =FV(.0404,3,-100,0,0)
5-137
Find the PV of This 3-Year Ordinary

Annuity
• Could solve by discounting each cash flow, or…
• Use the EAR and treat as an annuity to solve for
PV.
INPUTS 3 4.04 100 0

N I/YR PV PMT FV
OUTPUT -277.30
Excel: =PV(.0404,3,100,0,0)
5-138
Loan Amortization
• Amortization tables are widely used for home
mortgages, auto loans, business loans, retirement
plans, etc.
• Financial calculators and spreadsheets are great
for setting up amortization tables.
EXAMPLE: Construct an amortization schedule

for a $1,000, 4% annual rate loan with 3 equal
payments.
5-139
Step 1:
Find the Required Annual Payment
• All input information is already given, just
remember that the FV = 0 because the reason for
amortizing the loan and making payments is to
retire the loan.
INPUTS 3 4 -1000 0
N I/YR PV PMT FV
OUTPUT 360.35
Excel: =PMT(.04,3,-1000,0,0)
5-140
Step 2:
Find the Interest Paid in Year 1
• The borrower will owe interest upon the initial
balance at the end of the first year. Interest to be
paid in the first year can be found by multiplying
the beginning balance by the interest rate.
INTt = Beg balt(I)

INT1 = $1,000(0.04) = $40
5-141
Step 3:
Find the Principal Repaid in Year 1
• If a payment of $360.35 was made at the end of
the first year and $40 was paid toward interest, the
remaining value must represent the amount of
principal repaid.
PRIN = PMT – INT

= $360.35 – $40 = $320.35
5-142
Step 4:
Find the Ending Balance after Year 1
• To find the balance at the end of the period,
subtract the amount paid toward principal from
the beginning balance.
END BAL = BEG BAL – PRIN

= $1,000 – $320.35
= $679.65
5-143
Constructing an Amortization Table:

Repeat Steps 1-4 Until End of Loan
YEAR BEG BAL PMT INT PRIN END BAL
1 $1,000 $ 360 $40 $ 320 $680
2 680 360 27 333 347
3 347 360 14 347 0
TOTAL – $1,081 $81 $1,000 –
• Interest paid declines with each payment as the

balance declines. What are the tax implications of
this?
5-144
Challenge yourself
• PV of annuity is $3,955.17
• Annual rate of return is 6%
• Annual payments are as follows:
• Years 1 – 10 = $200.00
• Years 11 – 20 = unknown
• Years 21 – 30 = $500.00
• How do you solve for Years 11 – 20 payment using Excel?
Time value of money
Finding the interest rate
• The U.S. Treasury offers to sell you a bond for $585.43. No payments
will be made until the bond matures 10 years from now, at which time
it will be redeemed for $1000. What interest rate would you earn if
you bought this bond for $585.43? What rate would you earn if you
could buy the bond for $550? For $600?
Finding the interest rate
• Microsoft earned $0.97 per share in 2003. Ten years later in 2013 it
earned $2.65. What was the growth in Microsoft’s earnings per share
(EPS) over the 10-year period? If EPS in 2013 had been $2.10 rather
than $2.65, what would the growth rate have been?
Finding the number of years
• How long would it take $1000 to double if it was invested in a bank
that paid 6% per year? How long would it take if the rate was 10%?
Finding the number of years
• Microsoft’s 2013 earnings per share were $2.65, and its growth rate
during the prior 10 years was 10.57% per year. If that growth rate was
maintained, how long would it take for Microsoft’s EPS to double?
Ordinary annuities and annuities due
• If the payments are made at the beginning of each year, the annuity is
an annuity due.
• If the payments are made at the end of year each, the annuity is an
ordinary (or deferred) annuity.
Calculate annuity due
• AB Limited is creating a sinking fund to redeem its preference capital
of Rs. 5 lakh issued on 6 April 2009 and maturing on 6 April 2020.
The first annual payment will be made on 6 April 2009. The company
will make equal annual payments and expects that the fund will earn
12% per year. How much will be the amount of sinking fund payment?
• A * (CVFAn,i)*(1+i) = 500000
• A * 24.133 * 1.12 = 500000
• A = 500000/27.029
• A = 18498.65
Case 1 – Required annuity payments
• Andrew is 50 years old and will retire in 10 years. He expects to live for 25 years
after he retires, until he is 85. He wants a fixed retirement income that has the
same purchasing power at the time he retires as $40,000 has today. (The real value
of his retirement income will decline annually after he retires.) His retirement
income begin the day he retires, 10 years from today, at which time he will receive
24 additional annual payments. Annual inflation is expected to be 5%. He
currently has $100,000 saved, and he expects to earn 8% annually on his savings.
How much must he save during each of the next years (end-of-year deposits) to
meet his retirement goal?
1. Will save for 10 years, then receive payments for 25 years. How much must he deposit at the end of each of the
next 10 years?
2. Wants payments of $40,000 per year in today’s dollars for first payment only. Real income will decline. Inflation will be
5%. Find FV
3. He now has $100,000 in an account that pays 8%, annual compounding. We need to find the FV of the $100,000
after 10 years. Enter N = 10, I/YR = 8, PV = -100000, PMT = 0, and solve for FV = $215,892.50.
4. He wants to withdraw, or have payments of, $65,155.79 per year for 25 years, with the first payment made at the
beginning of the first retirement year. So, we have a 25-year annuity due with PMT = 65,155.79, at an interest rate
of 8%. Set the calculator to “BEG” mode, then enter N = 25, I/YR = 8, PMT = 65155.79, FV = 0, and solve for PV =
$751,165.35. This amount must be on hand to make the 25 payments.
5. Since the original $100,000, which grows to $215,892.50, will be available, we must save enough to accumulate
$751,165.35 - $215,892.50 = $535,272.85.
6. The $535,272.85 is the FV of a 10-year ordinary annuity. The payments will be deposited in the bank and earn 8%
interest. Therefore, set the calculator to “END” mode and enter N = 10, I/YR = 8, PV = 0, FV = 535272.85, and solve
for PMT = $36,949.61  $36,950.
Case 2 – Required annuity payments
• Andrew is now planning a savings program to put his daughter through college.
She is 13, plans to enrol at the university in 5 years, and should graduate 4 years
later. Currently, the annual cost (for everything – food, clothing, tuition, books,
transportation, and so forth) is $15,000, but these costs are expected to increase by
5% annually. The college requires total payment at the start of the year. She now
has $7,500 in a college savings account that pays 6% annually. Her father will
make six equal annual deposits into her account, the first deposit today and the
sixth on the day she starts college. How large must each of the six payments be?
1. Determine the annual cost of college. The current cost is $15,000 per year, but that is escalating at a 5% inflation
rate.
College Current Years Inflation Cash

Year Cost from Now AdjustmentRequired
1 $15,000 5 (1.05)5 $19,144.22
2 15,000 6 (1.05)6 20,101.43
3 15,000 7 (1.05)7 21,106.51
4 15,000 8 (1.05)8 22,161.83
2. How much must be accumulated by age 18 to provide these payments at ages 18 through 21 if the funds are invested
in an account paying 6%, compounded annually? CF0 = 19144, CF1 = 20101, CF2 = 21107, CF3 = 22162, and I/YR =
6. Solve for NPV
3. The daughter has $7,500 now (age 13) to help achieve that goal. Five years hence, that $7,500, when invested at
6%, will be worth $10,037: $7,500(1.06)5 = $10,036.69
4. The father needs to accumulate –> NPV (calculated in step 2) – 10037.
5. Calculate PMT of step 4

Non annual compounding
• You plan to make five deposits of $1,000 each, one every 6 months,
with the first payment being made in 6 months. You will then make no
more deposits. If the bank pays 4% nominal interest annually,
compounded semi-annually, how much will be in your account after 3
years?
0 1 2 3 4 5 6 6-mos.
0 1 2 3 Years
2%
| | | | | | |
1,000 1,000 1,000 1,000 1,000 FVA = ?
Since the first payment is made 6 months from today, we have a 5-period ordinary annuity.
The applicable interest rate is 4%/2 = 2%. First, we find the FVA of the ordinary annuity in
period 5 by entering the following data in the financial calculator: N = 5, I/YR = 4/2 = 2,
PV = 0, and PMT = -1000. We find FVA5 = $5,204.04. Now, we must compound this
amount for 1 semiannual period at 2%.
$5,204.04(1.02) = $5,308.12.
Non annual compounding
• One year from today you must make a payment of $10,000. To prepare for this
payment, you plan to make two equal quarterly deposits ( at the end of Quarters 1
and 2) in a bank that pays 4% nominal interest compounded quarterly. How large
must each of the two payments be?
Here’s the time line:
0 1 2 3 4 Qtrs
1%
| | | | |
PMT = ? PMT = ? FV = 10,000
Required value
= $9,802.96
of annuity
Step 1: Discount the $10,000 back 2 quarters to find the required value of the 2-period
annuity at the end of Quarter 2, so that its FV at the end of the 4th quarter is
$10,000.
Using a financial calculator enter N = 2, I/YR = 1, PMT = 0, FV = 10000, and solve

for PV = $9,802.96.
Step 2: Now you can determine the required payment of the 2-period annuity with a FV of
$9,802.96.
Net Present value of cash flow stream
• A rookie quarterback is negotiating his first NFL contract. His opportunity cost is 10%.
He has been offered three possible 4-year contracts. Payments are guaranteed, and they
would be made at the end of each year. Terms of each contract are as follows:
Year 1 Year 2 Year 3 Year 4
• Contract 1: $3,000,000 $3,000,000 $3,000,000 $3,000,000
• Contract 2: $2,000,000 $3,000,000 $4,000,000 $5,000,000
• Contract 3: $7,000,000 $1,000,000 $1,000,000 $1,000,000
• As his adviser, which contract would you recommend that he accept?

$3,000,000 $3,000,000 $3,000,000 $3,000,000
Contract 1: PV = + + +
1.10 (1.10) 2 (1.10) 3 (1.10) 4
= $2,727,272.73 + $2,479,338.84 + $2,253,944.40 + $2,049,040.37
= $9,509,596.34.
$2,000,000 $3,000,000 $4,000,000 $5,000,000

1.10 (1.10) 2
(1.10) 3
(1.10) 4
= $1,818,181.82 + $2,479,338.84 + $3,005,259.20 + $3,415,067.28
= $10,717,847.14.
$7,000,000 $1,000,000 $1,000,000 $1,000,000

1.10 (1.10) 2 (1.10) 3 (1.10) 4
= $6,363,636.36 + $826,446.28 + $751,314.80 + $683,013.46
= $8,624,410.90.
Case 3 – Shyam Lal
Valuation of bonds
Different debt categories have different
characteristics
• Having different maturity structure, covenants, access, security etc.
• Bank Debt (And other private debt sources) – Relational debt source
• Bonds (And other public debt sources)– Transactional debt source
• Intercorporate loans – Easier access for a group affiliated firm
• India has a much different debt market. Firms are exposed to different debt types in their debt
structure.
Values of bank loans and corporate bonds
across countries. In $ Billion.
United States South Korea China India
End of year Banks Bonds Banks Bonds Banks Bonds Banks Bonds
31-03-2013 2068 17074 739 854 7902 3101 496 238
31-03-2014 2211 17483 786 942 8922 3439 497 245
31-03-2015 2398 18022 787 945 10133 4263 505 281
31-03-2016 2645 18339 791 965 11271 5575 499 305
31-03-2017 2832 18694 839 984 11252 6269 536 371
31-03-2018 2966 19459 936 1082 13365 7602 561 422
Source: CRISIL report on Indian Debt Market (2018)

Introduction to Bond
❑ A bond is a long-term debt instrument or security.
❑ Bonds issued by the government do not have any risk of default. The
government will always honour obligations on its bonds.
❑ Bonds of the public sector companies in India are generally secured, but
they are not free from the risk of default.
❑ The private sector companies also issue bonds, which are also called
debentures in India. A company in India can issue secured or unsecured
debentures.
❑ In the case of a bond or debenture, the rate of interest is generally fixed and
known to investors.
❑ The principal of a redeemable bond or bond with a maturity is payable after
a specified period, called maturity period.
How RBI defines bond..
• What is bond?
A bond is a debt instrument in which an investor loans money to an entity (typically corporate or
government) which borrows the funds for a defined period of time at a variable or fixed interest
rate. Bonds are used by companies, municipalities, states and sovereign governments to raise
money to finance a variety of projects and activities. Owners of bonds are debt holders, or
creditors, of the issuer.
• What is a G-Sec?
A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or
the State Governments. It acknowledges the Government’s debt obligation. Such securities are
short term (usually called treasury bills, with original maturities of less than one year) or long
term (usually called Government bonds or dated securities with original maturity of one year or
more). In India, the Central Government issues both, treasury bills and bonds or dated securities
while the State Governments issue only bonds or dated securities, which are called the State
Development Loans (SDLs). G-Secs carry practically no risk of default and, hence, are called
risk-free gilt-edged instruments.
• What are T-bills?
Treasury bills or T-bills, which are money market instruments, are short term debt instruments
issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182
day and 364 day. Treasury bills are zero coupon securities and pay no interest. Instead, they are
issued at a discount and redeemed at the face value at maturity. For example, a 91 day
Treasury bill of ₹100/- (face value) may be issued at say ₹ 98.20, that is, at a discount of say,
₹1.80 and would be redeemed at the face value of ₹100/-. The return to the investors is the
difference between the maturity value or the face value (that is ₹100) and the issue price.
• What are Cash Management Bills?

In 2010, Government of India, in consultation with RBI introduced a new short-term instrument,
known as Cash Management Bills (CMBs), to meet the temporary mismatches in the cash flow
of the Government of India. The CMBs have the generic character of T-bills but are issued for
maturities less than 91 days.
https://m.rbi.org.in/scripts/FAQView.aspx?Id=79#1
Features of a Bond
The main features of a bond or debenture are discussed below.
Face value: Face value is called par value. A bond (debenture) is generally issued at a par
value of Rs 100 or Rs 1,000, and interest is paid on face value.
Interest rate: Interest rate is fixed and known to bondholders (debenture-holders). Interest
paid on a bond/debenture is tax deductible. The interest rate is also called coupon rate.
Coupons are detachable certificates of interest.
Maturity: A bond (debenture) is generally issued for a specified period of time. It is repaid
on maturity.
Redemption value: The value that a bondholder (debenture-holder) will get on maturity is
called in redemption, or maturity, value. A bond (debenture) may be redeemed at par or at a
premium (more than par value) or at a discount (less than par value).
Market value: A bond (debenture) may be traded in a stock exchange. The price at which it
is currently sold or bought is called the market value of the bond (debenture), Market value
may be different from par value or redemption value.
Classification of Bonds
Classification of
bonds
Bonds with Pure discount

Perpetual bonds
maturity bonds
A) Bond with maturity

✓The government and companies mostly issue bonds that specify the interest rate (coupon)
and the maturity period.
✓The present value of a bond (debenture) is the discounted value of its cash flows; that is,
the annual interest payments plus bond's terminal, or maturity value.
✓The discount rate is the interest rate that investors could earn on bonds with similar
characteristics.
✓By comparing the present value of a bond with its current market value, it can be
determined whether the bond is overvalued or undervalued.
Question (Value of bond with maturity)
Suppose an investor is considering the purchase of a five year, Rs 1,000 par value bond,
bearing a nominal rate of interest of 7 per cent per annum. The investor's required rate of
return is 8 per cent. What should he be willing to pay now to purchase the bond if it matures
at par?
Answer: The investor will receive cash Rs 70 as interest each year for 5 years and Rs 1,000
on maturity (i.e., at the end of the fifth year). We can thus determine the present value of the
bond (B) as follows:
70 70 70 70 70 1000
𝐵0 = + + + + +
(1.08)1 (1.08)2 (1.08)3 (1.08)4 (1.08)5 (1.08)5
𝑩𝟎 = 960.51
OR NOTE: This implies that Rs. 1,000
𝐵0 = (70 × 3.993) + (1000 × 0.681) bond is worth Rs. 960.51today if the
required rate of return is 8 per cent.
𝐵0 = 279.51 + 681 The investor would not be willing to
pay more than Rs. 960.51 for bond
today.
𝑩𝟎 = Rs. 960.51
Classification of
bonds

Perpetual bonds
maturity bonds
B) Pure discount bonds

✓Pure discount bonds do not carry an explicit rate of interest.
✓They provide for the payment of a lump sum amount at a future date in exchange for the
current price of the bonds.
✓The difference between the face value of the bond and its purchase price gives the return or
YTM to the investor.
B) Pure Discount Bonds
For example,
❖ A company may issue a pure discount bond of Rs 1,000 face value for Rs 520 today for a period of
five years.
❖ Thus, the debenture has
(a) purchase price of Rs 520,
(b) maturity value (equal to the face value) of Rs 1,000 and
(c) maturity period of five years.
The rate of interest can be calculated as follows:
1000
520 = (1+𝑖)5
1000
(1 + 𝑖)5 =
520
(1 + 𝑖)5 = 1.9231
i = (1.9231)(1/5) -1
i = 0.14 or 14 %
B) Pure Discount Bonds
▪ Pure discount bonds are also called deep-discount bonds or zero-interest bonds or zero-
coupon bonds.
▪ Industrial Development Bank of India (IDBI) was the first to issue a deep-discount bond in
India in January 1992.
▪ The bond of a face value of Rs 100,000 was sold for Rs 2,700 with a maturity period of 25
years.
▪ If an investor held the IDBI deep-discount bond for 25 years, she would earn an implicit
interest rate of: 1,00,000
2700 =
(1+𝑖)25
i = 15.54 %
▪ IDBI again issued a deep-discount bond in 1998 at a price of Rs 12,750, to be redeemed
after 30 years at the face value of Rs 500,000.
▪ The implicit interest rate for this bond works out to be 13 per cent.
Classification of
bonds

Perpetual bonds
maturity bonds
C) Perpetual bonds
✓Perpetual bonds, also called consols, have an indefinite life and therefore, have no maturity
value.
✓In case of the perpetual bonds, as there is no maturity, or terminal value, the value of the
bonds would simply be the discounted value of the infinite stream of interest flows.
C) PERPETUAL BONDS
Question: Suppose that a 10 per cent, Rs 1,000 bond will pay Rs 100 annual interest into
perpetuity? What would be its value of the bond if the market yield or interest rate were 15
per cent?
Answer: The value of the bond is determined as follows:
𝐼𝑁𝑇
𝐵0 =
𝐾𝑑
100
𝐵0 =
0.15
𝑩𝟎 = Rs. 667
• If the market yield is 10 per cent, the value of the bond will be Rs 1,000 and if it is 20 per
cent the value will be Rs 500.
• Thus, the value of the bond will decrease as the interest rate increases and vice-versa.
Yield to maturity
• CAGR
• IRR
Yield to maturity
The market price of a Rs. 1,000 par value bond, carrying a coupon rate of 9
per cent and maturing after 8 years, is Rs.800. What rate of return would
an investor earn if he buys this bond and holds it till its maturity?
• The procedure for linear interpolation is as follows:
(a) Find the difference between the present values for the two rates, which in this
case is Rs.39.5 (Rs.808 – Rs.768.5).
(b) Find the difference between the present value corresponding to the lower rate
(Rs.808 at 13 per cent) and the target value (Rs.800), which in this case is Rs.8.0.
(c) Divide the outcome of (b) with the outcome of (a), which is 8.0/39.5 or 0.2. Add
this fraction to the lower rate, i.e. 13 per cent. This gives the YTM of 13.2 per cent.
An approximation to YTM
• If you are not inclined to follow the trial-and-error approach described above,
you can employ the following formula to find the approximate YTM on a bond:
Example
• The price per bond of Zion Limited is Rs.90. The bond has a par value of Rs.100,a coupon rate of
14 per cent, and a maturity period of 6 years. What is the yield to maturity? Using the
approximate formula the yield to maturity on the bond of Zion works out to:
Problem 1
Solution
Coupon rate = 6%, which remains unchanged. The coupon payments are fixed at $60 per year.
When the market yield increases, the bond price will fall. The cash flows are discounted at a higher rate.
At a lower price, the bond’s yield to maturity will be higher. The higher yield to maturity for the bond is
commensurate with the higher yields available in the rest of the bond market.
Current yield = coupon rate/bond price
As coupon rate remains the same and the bond price decreases, the current yield increases.
Problem 2,3 and 4
Solutions
2.When the bond is selling at a discount, $970 in this case, the yield to maturity is
greater than 8%. We know that if the yield to maturity were 8%, the bond would sell at
par. At a price below par, the yield to maturity exceeds the coupon rate.
Current yield = coupon payment/bond price = $80/$970
Therefore, current yield is also greater than 8%.
3. Coupon payment = 0.08 *$1,000 = $80; Current yield = $80/bond price = 0.06
Therefore: bond price = $80/0.06 = $1333.33
4..Coupon rate = $80/$1,000 = 0.080 = 8.0%

Current yield = $80/$950 = 0.0842 = 8.42%
Yield to maturity = 9.00% [n = 6; PV = -950; FV = 1000; PMT = 80]
Problem 5,6
Solution
5.Current yield = coupon/price = $80/$1,100 = 0.0727 = 7.27%
YTM = [PV = ()1150, FV = 1000, n = 10, PMT = 80, compute i]
6.When the bond is selling at face value, its yield to maturity equals its
coupon rate. This firm’s bonds are selling at a yield to maturity of
9.25%. So the coupon rate on the new bonds must be 9.25% if they are
to sell at face value.
Problem 7
Solution
Bond 1
year 1: PMT = 80, FV = 1000, i = 10%, n = 10; compute PV0 = 877.11
year 2: PMT = 80, FV = 1000, i = 10%, n = 9; compute PV1 = 884.82
$80 + ($884.82 − $877.11)
Rate of return = = 0.100 = 10.0%
$877.11
Bond 2
year 1: PMT = 120, FV = 1000, i = 10%, n = 10; compute PV0 = $1,122.89
year 2: PMT = 120, FV = 1000, i = 10%, n = 9; compute PV1 = $1,115.18
$120 + ($1,115.18 − $1,122.89)
Rate of Return = = 0.100 = 10.0%
$1,122.89
Both bonds provide the same rate of return.
Problem 8 and 9
Solutions
• With a par value of $1,000 and a coupon rate of 8%, the bondholder receives $80
per year.
• Price = [$80 *annuity factor(7%, 9 years)] + ($1,000/1.079 ) = $1,065.15
• If the yield to maturity is 6%, the bond will sell for $1,136.03
Using a financial calculator, enter: n = 30, FV = 1000, PMT = 80.

• Enter PV = -900, compute i = yield to maturity = 8.971%
• Enter PV = -1,000, compute i = yield to maturity = 8.000%
• Enter PV = -1,100, compute i = yield to maturity = 7.180%
Valuation of shares
Valuation of Preference Shares
• Owners of shares are called shareholders, and capital contributed by them is called share
capital.
➢ Preference shares have preference over ordinary shares in terms of payment of dividend
and repayment of capital if the company is wound up. They may be issued with or without
a maturity period.
➢ Redeemable preference shares are shares with maturity.
➢ Irredeemable preference shares are shares without any maturity.
➢ The holders of preference shares get dividends at a fixed rate.
➢ With regard to dividends, preference shares may be issued with or without cumulative
features.
➢ In the case of cumulative preference shares unpaid dividends accumulate and are
payable in the future.
➢ Dividends in arrears do not accumulate in the case of non-cumulative preference shares.
Value of a Preference Share
Question: Suppose an investor is considering the purchase of a 12-year, 10 per cent Rs 100
par value preference share. The redemption value of the preference share on maturity is Rs
120. The investor's required rate of return is 10.5 per cent. What should she be willing to pay
for the share now?
Answer: The investor would expect to receive Rs 10 as preference dividend each year for 12
years and Rs 120 on maturity (i.e., at the end of 12 years). We can use the present value
annuity factor to value the constant stream of preference dividends and the present value
factor to value the redemption payment.
Value of preference share = Present value of dividends + Present value of maturity value
10 10 10 10 10 120
𝑃0 = + + + + …..…….+ +
(1.105)1 (1.105)2 (1.105)3 (1.105) 4 (1.105)12 (1.105)12
𝑷𝟎 = Rs. 101.30
Note: The present value of Rs 101.30 is composite of the present value of dividends, Rs 65.06 and the present
value of the redemption value, Rs 36.24. The Rs 100 preference share is worth Rs 101.3 today at 10.5 per cent
required rate of return. The investor would be better off by purchasing the share for Rs 100 today.
Value of a Irredeemable Preference Share
Question: Consider that a company has issued Rs. 100 irredeemable preference shares on
which it pays a dividend of Rs. 9. Assume that this type of preference share is currently
yielding a dividend of 11 percent. What is the value of the preference share?
Answer: The preference dividend of Rs. 9 is a perpetuity. Therefore, the present value of the
preference share is:
𝑃𝐷𝐼𝑉
𝑃0 =
𝐾𝑝
9
𝑃0 =
0.11
𝑃0 = Rs. 81.82
EQUITY VALUATION
Why?
• The two major financial claims are debt (or bonds) and equity. So, the financial manager must understand
how to value these claims.
• Knowing how to value securities (bonds and equity shares, in the main) is as important for investors as it is
for managers.
• Current and prospective investors (shareholders, bondholders, and others) must understand how to value
securities.
• Such knowledge is helpful to them in deciding whether they should buy or sell securities at the prices
prevailing in the market place.
@ https://efinancemanagement.com/investment-decisions/equity-valuation-methods
DDM (Dividend Discount Model)
• According to the dividend discount model (DDM), the value of an
equity share is equal to the present value of dividends expected from
its ownership plus the present value of the sale price expected when
the equity share is sold.
• If the value obtained from the DDM is higher than the current trading
price of shares, then the stock is undervalued and qualifies for a buy,
and vice versa.
Assumptions
(i) dividends are paid annually
(ii)the first dividend is received one year after the equity share is
bought.
Single-period Valuation Model
• The investor expects to hold the equity share for one year. The price of the equity
share will be:
𝐷1 𝑃1
𝑃𝑜 = +
(1 + 𝑟) (1 + 𝑟)
Where,
𝑃𝑜 𝑖𝑠 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒
𝐷1 is the dividend expected a year hence
𝑃1 𝑖𝑠 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑎 𝑦𝑒𝑎𝑟 ℎ𝑒𝑛𝑐𝑒 and
r is the rate of return required on the equity share

XYZ equity share is expected to provide a dividend of Rs. 2 and
fetch a price of Rs.18 a year hence. What price would it sell
for now if investors required rate of return is 12%?
The current price will be
𝐷1 𝑃1
𝑃𝑜 = +
(1 + 𝑟) (1 + 𝑟)
2 18
𝑃𝑜 = +
(1 + .12) (1 + .12)
2 18
𝑃𝑜 = +
(1.12) (1.12)
𝑃𝑜 = 𝑅𝑠. 17.86
What happens if the price of the equity share is expected to grow at a
rate of g percent annually? If the current price, P0, becomes P0(1 + g) a
year hence, we get:
𝐷1 𝑃𝑜 (1 + 𝑔)
𝑃𝑜 = +
(1 + 𝑟) (1 + 𝑟)
By simplifying this
𝐷1
𝑃𝑜 =
(𝑟 − 𝑔 )
g is expected growth rate of the equity share

The expected dividend per share on the equity share of R Ltd is Rs.2.
The dividend per share of R Ltd has grown over the past five years at
the rate of 5%. This growth rate will continue in future. The market
price of the equity share of R Ltd too is expected to grow at the same
rate. What is a fair estimate of the intrinsic value of the equity share of
the company if the required rate is 15%?
𝐷1
𝑃𝑜 =
(𝑟 − 𝑔 )
2
𝑃𝑜 =
(.15 − .05 )
𝑃𝑜 = 𝑅𝑠. 20
Expected Rate of Return is equal to:
𝐷1
r= + g
P𝑜
The expected dividend per share of V ltd is Rs.5. The dividend is
expected to grow at the rate of 6% per year. If the price per share now
is Rs.50, what is the expected rate of return?
𝐷1
r= + g
P𝑜
5
r= + 0.06
50
= 16%
Multi-period valuation model
Since equity shares have no maturity period, they may be expected to
bring a dividend stream of infinite duration. Hence the value of an
equity share may be put as:
Po = D1/ (1+r) + D2/ (1+r) ^2 + D3/ (1+r) ^3 + …… Dn/ (1+r) ^n
Po = Price of the equity share
D1 = expected dividend 1 year from now
D2 = expected dividend 2 years from now
Dn = expected dividend n years from now.
r = expected rate of return
The assumptions about the pattern of dividend growth are:
1. The dividend per share remains constant forever, implying that the growth rate
is nil (zero growth model)
2. The dividend per share grows at a constant rate per year forever (the constant
growth model)
3. The dividend per share grows at a constant rate for a finite period, followed by a
constant normal rate of growth forever thereafter (two-stage model)
4. The dividend per share, currently growing at an above-normal rate, experiences
a gradually declining rate of growth for a while. Thereafter, it grows at a
constant normal rate (the H model)
The dividend per share remains constant forever,
implying that the growth rate is nil (zero growth model)
𝐷
𝑃𝑜 =
𝑟
The intrinsic value of Alkyl amine is Rs. 450 and the company pays a
dividend of Rs. 30. What is the cost of equity?
The intrinsic value of SBI share is Rs. 100 and the cost of equity is 10%.
What is the expected dividend?
Constant Growth Model/GORDON MODEL
𝐷1
𝑃𝑜 =
𝑟−𝑔
R ltd is expected to grow at the rate of 6% per annum. The dividend
expected on R’s equity share a year hence is Rs.2. What price will you
put on it if your required rate of return for this share is 14%?
𝐷1
𝑃𝑜 =
𝑟−𝑔
2
𝑃𝑜 =
0.14 − 0.06
𝑃𝑜 = 𝑅𝑠. 25
A share of common stock has just paid a dividend of $3.00. If the expected
long-run growth rate for this stock is 12 percent, and if investors require a
17 percent rate of return, what is the price of the stock?
A share of common stock has just paid a dividend of $3.00. If the expected
long-run growth rate for this stock is 12 percent, and if investors require a
17 percent rate of return, what is the price of the stock?
𝐷1
𝑃𝑜 =
𝑟−𝑔
3 (1 + 0.12)
𝑃𝑜 =
0.17 − 0.12
3 (1.12)
𝑃𝑜 =
0.05
3.36
𝑃𝑜 =
0.05
= 67.2
Two-stage growth model
• The simplest extension of the constant growth model assumes that the
extraordinary growth (good or bad) will continue for a finite number
of years and thereafter the normal growth rate will prevail indefinitely.
• Assuming that the dividends move in line with the growth rate, the
price of the equity share will be:
n
1 + 𝑔1
1− D1 1 + 𝑔1 n−1 1 + 𝑔2 1
1+𝑟
𝑃𝑜 = D1 +
r − 𝑔1 r − 𝑔2 ൫1 + 𝑟)𝑛
The current dividend on an equity share of Vertigo Ltd is Rs.2. Vertigo is expected
to enjoy an above normal growth rate of 20% for a period of 6 years. Thereafter,
the growth rate will fall and stabilize at 10%. Equity investors require a return of
15%. What is the intrinsic value of the equity share of Vertigo?
n
1 + 𝑔1
1− D1 1 + 𝑔1 n−1 1 + 𝑔2 1
1+𝑟
𝑃𝑜 = D1 +
r − 𝑔1 r − 𝑔2 ൫1 + 𝑟)𝑛
𝐷0 = 2
D1=𝑫𝟎 (𝟏 + 𝒈𝟏 )
𝑔1=20 % 𝑔2=10 %
n = 6 years = 2(1+.20)
r/Ke = 15% D1=Rs.2.40

n
1 + 𝑔1
1− D1 1 + 𝑔1 n−1 1 + 𝑔2 1
1+𝑟
𝑃𝑜 = D1 +
r − 𝑔1 r − 𝑔2 ൫1 + 𝑟)𝑛
1.20 6
1− 2.40 1.20 5 1.10 1
1.15
𝑃𝑜 = 2.40 +
.15 − .20 .15 − .10 ൫1.15)6
1 − 1.291 2.40 2.488 1.10

𝑃𝑜 = 2.40 + 0.432
−0.05 .05
= 13.96 +56.80
= Rs.70.76
The growth drivers of stock valuation are
1. Plough back ratio
2. Return on equity (ROE)
Your company has net income of $1, 600 for the year. You paid out
$400 in dividends to your stockholders. What is the dividend payout
ratio? What is the plowback ratio?
• Dividend Payout Ratio = Dividend/Net Income
• Dividend Payout Ratio = Dividend/Net Income = 400/1600 = .25
• Plowback ratio = 1- Dividend payout ratio = 1-0.25 = 0.75
Omega Ltd has an equity (net worth) base of 100 at the beginning of
year 1. It earns a return on equity of 20%. It pays out 40% of its equity
earnings and ploughs back 60% of its equity earnings. Its financials for
a 3 year period are shown in table below.
Year 1 Year 2 Year 3

Beginning equity 100
Return on equity 20% 20% 20%
Equity earnings
Dividend payout 0.4 0.4 0.4
ratio
Dividends
Ploughback ratio 0.6 0.6 0.6
Retained earnings
Year 1 Year 2 Year 3
Beginning equity 100 112 125.44
Return on equity 20% 20% 20%
Equity earnings 20 22.4 25.1
Dividend payout ratio 0.4 0.4 0.4
Dividends 8 8.96 10.04
Ploughback ratio 0.6 0.6 0.6
Retained earnings 12 13.44 15.06
At what rate the dividend is growing?

12 %
ROE * Ploughback ratio
0.20 * 0.6 = 0.12

Impact of growth of price, returns and P/E ratio
Consider three cases of growth rates:
Low growth firm Normal growth firm and Supernormal growth firm
with 5% , 10 %, and 15% respective growth rate. The expected earnings
per share and dividend per share of each of the three firms for the
following year are Rs.3.00 and Rs.2.00 respectively.
Investor’s required total return from equity investments is 20%. Given
the above information, calculate the stock price, dividend yield, capital
gains yield, and P/E ratio for the three cases.
Price Dividend yield Capital gains Price earnings
yield ratio (P/E)
𝐷1 𝐷1
𝑃𝑜 = 𝑷𝟎
𝑟−𝑔 𝑃𝑜 (𝑃1 − 𝑃0 )
𝑬
𝑃0
Low growth
firm
Normal
growth firm
Supernormal
growth firm
Price Dividend yield Capital gains Price earnings
yield ratio (P/E)
𝐷1 𝐷1
𝑃𝑜 = 𝑷𝟎
𝑟−𝑔 𝑃𝑜 (𝑃1 − 𝑃0 )
𝑬
𝑃0
Low growth 2.00 15% 5% 4.44
𝑃𝑜 =
firm .20 − 0.5
=Rs.13.33
Normal 2.00 10% 10% 6.67
𝑃𝑜 =
growth firm .20 − 0.1
=Rs.20
Supernormal 2.00 5% 15% 13.33
𝑃𝑜 =
growth firm .20 − 0.15
=Rs. 40
Price Dividend yield Capital gains yield Price earnings
ratio (P/E)
𝐷1 𝐷1 (𝑃1 − 𝑃0 )
𝑃𝑜 = 𝑷𝟎
𝑟−𝑔 𝑃𝑜 𝑃0
𝑬
Low growth firm 𝟐. 𝟎𝟎 15% 5% 4.44

𝐏𝐨 =
. 𝟐𝟎 − 𝟎. 𝟓
=Rs.13.33
Normal growth 𝟐. 𝟎𝟎 10% 10% 6.67
𝐏𝐨 =
firm . 𝟐𝟎 − 𝟎. 𝟏
=Rs.20
Supernormal 𝟐. 𝟎𝟎 5% 15% 13.33
𝐏𝐨 =
growth firm . 𝟐𝟎 − 𝟎. 𝟏𝟓
=Rs. 40
Inference
As the expected growth in dividend, increases, other things remaining constant, the expected
return depends more on capital gains yield and less on the dividend yield.
As the expected growth rate in dividend increases, other things remaining constant, the P/E ratio
increases.
• High dividend yield and low P/E ratio imply limited growth prospects.
• Low dividend yield and high P/E ratio imply considerable growth
prospects.
The P/E ratio or earnings multiplier approach is estimated as follows:
𝑃0 = 𝐸1 ∗ 𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑅𝑎𝑡𝑖𝑜
Where
𝑃0 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒
𝐸1 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Intel Corp (INTC) (P/E) Analysis
Current EPS $1.35
5 -year average P/E ratio 30.4
EPS growth rate 16. 5%

Expected stk price = ?
Expected stk price = historical P/E ratio * projected EPS stock price
Expected stock price = 30.4 ($1.35*1.165) = $47. 8116
Price/Earnings (P/E) Multiples/Ratio
Valuation_ Preference Stock
• Preference stock generally pays regular, fixed dividends.
• Preference dividends are not increased when the profits of the rise, nor are they
lowered or suspended unless the firm faces financial difficulties.
• These stocks may be perpetual or redeemable.
• While the former has no maturity period, the latter is expected to be redeemed
after its limited life.
• Preference stock in India is typically redeemable.
𝑡
𝐷 𝑀
𝑃𝑜 = ෍ 𝑡
+
(1 + 𝑟𝑝 ) (1 + 𝑟𝑝 )𝑛
𝑡=1
Where,
𝑃𝑜 𝑖𝑠 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠𝑡𝑜𝑐𝑘
𝐷 is the annual dividend
𝑛 𝑖𝑠 𝑡ℎ𝑒 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠𝑡𝑜𝑐𝑘
𝑟𝑝 is the required rate of return on the preference stock
M is the maturity value
Or
𝑃𝑜 = 𝐷 ∗ 𝑃𝑉𝐼𝐹𝐴𝑝,𝑛 + 𝑀 ∗ 𝑃𝑉𝐼𝐹𝑝,𝑛
To compute the value of a preference stock, consider an 8 year, 10 percent preference stock with a par value of
Rs.1000/-. The required return on this preference stock is 9 percent.
𝑃𝑜 = 100 ∗ 𝑃𝑉𝐼𝐹𝐴9%,8𝑦𝑟𝑠 + 1000 ∗ 𝑃𝑉𝐼𝐹9%,8𝑦𝑟𝑠
= 100*5.535 + 1000*0.502
=Rs.1055.5
Risk and return
Case – Beta Management Company
What is investment risk?
• Two types of investment risk
– Stand-alone risk
– Portfolio risk
• Investment risk is related to the probability of earning a low or
negative actual return.
• The greater the chance of lower than expected, or negative returns, the
riskier the investment.
Failure to Diversify
• If an investor chooses to hold a one-stock portfolio (doesn’t diversify),
would the investor be compensated for the extra risk they bear?
– NO!
– Stand-alone risk is not important to a well-diversified investor.
– Rational, risk-averse investors are concerned with σp, which is based upon
market risk.
– There can be only one price (the market return) for a given security.
– No compensation should be earned for holding unnecessary, diversifiable risk.
Coefficient of Variation (CV)
• A standardized measure of dispersion about the expected value, that
shows the risk per unit of return.
Standard deviation 
CV = =
Expected return r̂
Portfolio risk and return
• Any single security held in isolation is very risky
• But in reality, no rational investor invests all his or her money in a
single security
• They invest in many securities i.e., they hold a portfolio of securities
• Therefore, portfolio risk and return is important
Diversification
• A stock by itself is risky, it may go up or down
• But if you hold many stocks i.e. a portfolio – effect of a stock going
down will be offset by some other stock going up
• As the saying goes “ Wise men do not put all eggs in one basket”
Risk and Rates of Return
• Risk and Diversification
• Risk of a company's stock can be separated into two parts:
• Firm Specific Risk - Risk due to factors within the firm
• Market related Risk - Risk due to overall market conditions
• Diversification: If investors hold stock of many companies, the firm specific
risk will be canceled out: Investors diversify portfolio.
• Even if hold many stocks, cannot eliminate the market related risk
Market related risk is also called non-diversifiable

risk or systematic risk
Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk
• Market risk: portion of a security’s stand-alone risk that cannot be

eliminated through diversification. Measured by beta.
• Diversifiable risk: portion of a security’s stand-alone risk that can be
eliminated through proper diversification.
Different Types of Risk
• Market risk / Systemic Risks
• Interest rate
• Inflation
• Liquidity
• Exchange rate
• Political
256
Different Types of Risk
• Unsystemic Risks
• Business
• Financial
257
Total Risk
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of total
risk
• For well diversified portfolios, unsystematic risk is
very small
• Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk
258
Systematic Risk Principle
• There is a reward for bearing risk
• There is not a reward for bearing risk unnecessarily
• The expected return on a risky asset depends only on that asset’s
systematic risk since unsystematic risk can be diversified away
259
Diversifiable or Unsystematic Risk
• Risk factors that are unique to a stock also known as unique risk and
company-specific risk
• Includes such things as labor strikes, part shortages, etc.
• This risk that can be eliminated by combining stocks into a portfolio
• If we hold only one stock, or stocks in the same industry, then we are
exposing ourselves to risk that we could diversify away
• Unsystematic risk is also known as specific risk, diversifiable risk,
idiosyncratic risk or residual risk.
260
The Principle of Diversification
• Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns
• This reduction in risk arises because worse than expected returns from
one security are offset by better than expected returns from another
• However, there is a minimum level of risk that cannot be diversified
away and that is the systematic risk
261
Probability Distributions
• A listing of all possible outcomes, and the probability of each
occurrence.
• Can be shown graphically.
Firm X
Firm Y
Rate of
-70 0 15 100 Return (%)
Expected Rate of Return

Portfolio Expected Returns
• The expected return of a portfolio is weighted average of the expected
returns on the stocks which comprise the portfolio
• You can also find the expected return by finding the portfolio return in
each possible state and computing the expected value as we did with
individual securities
263
Portfolio Return
• A Ltd.’s share gives a expected return of 20% and B Ltd.’s share gives
32% expected return. Mr. Daniel invested 25% in A Ltd. shares and
75% of B Ltd. shares. What would be the expected return of the
portfolio?
• Portfolio Return = 0.25 (20) + 0.75 (32) = 29%
Expected return on Portfolio of two stocks A and B
Return on Return on
State Probability Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
3 20% 20% -10%
Expected return on Stock A = 0.20x5%+0.30x10%+0.30X15%+0.20x20% = 12.5%
Expected return on Stock B = 0.20x50%+0.30x30%+0.30x10%+0.20x-10% = 20%
Expected return on Portfolio consisting of 50% Stock A and 50% Stock B = 0.50x12.5%+0.50x20% = 16.25%
Expected return on Portfolio consisting of 75% Stock A and 25% Stock B = 0.75x12.5%+0.25x20% = 14.38%
PROBLEM
• STOCKS L AND M HAVE YIELDED THE
FOLLOWING RETURNS FOR THE PAST TWO
YEARS.
YEARS RETURN RETURN
L M
1995 12 14
1996 18 12
A)WHAT IS THE EXPECTED RETURN ON

PORTFOLIO MADE UP OF 60 PERCENT OF L
AND 40 PERCENT OF M?
Solution:
A) Rp = N∑t=1X1R1
• Avg. RETURN OF STOCK L=(12+18)/2=15
AND
• M=(14+12)/2=13.
• X1=0.6; X2=0.4
• RP=0.6X15+(O.4X13)=14.2
Correlation
• Correlation is a statistical measure of the relationship between any two series of numbers.
• If two series move in the same direction, they are positively correlated.
• If the series move in opposite directions, they are negatively correlated.
• The degree of correlation is measured by the correlation coefficient, which ranges from1 for perfectly
positively correlated series to -1 for perfectly negatively correlated series.
• The perfectly positively correlated series move exactly together; the perfectly negatively correlated series
move in exactly opposite directions.
r12 = Covariance of X1X2
σ1 σ2
𝑵 (𝑹𝟏−𝑹𝟏)(𝑹𝟐−𝑹𝟐)
Cov of X1 X2 =σ𝒊=𝟏
𝑵−𝟏
INTRO STAND-ALONE RISK PORTFOLIO RISK RISK & RETURN: CAPM/SML
Returns Distribution for Two Perfectly Negatively

Correlated Stocks (ρ = -1.0)
8-270
Partial Correlation, ρ = +0.35
8-271
Illustrating Diversification Effects of a

Stock Portfolio
8-272
Portfolio risk formula
Example
• You are considering two securities, Stock X and Stock Y, for
investment. The following table shows your expectation of their
expected return and standard deviation:
Asset E(R) Standard Deviation

X 12% 6%
Y 8% 4%
Portfolio is constructed with 50% of funds invested in X and 50% of funds invested
in Y. Correlation coefficient between returns on both stock is expected to be 0.6
Calculate the risk and return of the portfolio
• Return = 0.5*12+0.5*8 =10%
• Risk
𝜎 2 = (0.5^2)*(.06)^2+(0.5)^2*(.04)^2+2*0.5*0.5*(0.60)*0.06*0.04
= 0.0009+0.0004+0.00072 = 0.00202
𝜎 = 0.0449 = 4.49%
• Measuring a stock’s Systematic or Market Risk
• Systematic risk is the risk of the overall market. To measure the stock’s
systematic risk we need to compare individual stock returns to the overall
market returns.
• Measuring Market Risk
• Market risk is the risk of the overall market. To measure the market risk we
need to compare individual stock returns to the overall market returns.
• A proxy for the market is usually used: An index of stocks such as the Nifty or
Sensex
• Market risk is the risk of the overall market, so to measure need to compare
individual stock returns to the overall market returns.
• A proxy for the market is usually used: An index of stocks such as the S&P
500
• Market risk measures how individual stock returns are affected by this market
• Market Risk is measured by Beta
• Interpreting Beta
• Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
• Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
• Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average
Beta
• Measures a stock’s market risk, and shows a stock’s volatility relative
to the market.
• Indicates how risky a stock is if the stock is held in a well-diversified
portfolio.
The Concept of Beta
• Beta Coefficient, :
• A measure of the extent to which the returns on a given
stock move with the stock market.
•  = 0.5: Stock is only half as volatile, or risky, as the
average stock.
•  = 1.0: Stock has the same risk as the average risk.
•  = 2.0: Stock is twice as risky as the average stock.
• Most stocks have betas in the range of 0.5 to 1.5.
Can the beta of a security be negative?
• Yes, if the correlation between Stock i and the market is negative (i.e.,
ρi,m < 0).
• If the correlation is negative, the regression line would slope
downward, and the beta would be negative.
• However, a negative beta is highly unlikely.
Calculating Betas
• Well-diversified investors are primarily concerned with how a stock is
expected to move relative to the market in the future.
• Without a crystal ball to predict the future, analysts are forced to rely
on historical data. A typical approach to estimate beta is to run a
regression of the security’s past returns against the past returns of the
market.
• The slope of the regression line is defined as the beta coefficient for
the security.
What is the market risk premium?
• Additional return over the risk-free rate needed to compensate
investors for assuming an average amount of risk.
• Its size depends on the perceived risk of the stock market and
investors’ degree of risk aversion.
• Varies from year to year, but most estimates suggest that it ranges
between 4% and 8% per year.
Capital Asset Pricing Model (CAPM)
• Model linking risk and required returns. CAPM suggests that there is
a Security Market Line (SML) that states that a stock’s required return
equals the risk-free return plus a risk premium that reflects the stock’s
risk after diversification.
ri = rRF + (rM – rRF)bi
• Primary conclusion: The relevant riskiness of a stock is its

contribution to the riskiness of a well-diversified portfolio.
There are 3 assets- Defensive, Moderate and Aggressive- with Beta
value of 0.5, 1.0 and 1.5, respectively. The risk free rate is assumed to
be 5% and the market return is expected to be 15%. The expected return
of 3 securities will be?
Beta 0.5 1 1.5

Rf 5%
Rm 15%
Rx 10% 15% 20%
Assume the beta of Tanla Solution Company is 1.25, the risk-free rate is 5%, and the market risk premium is
7%. Calculate the expected return for Tanla Solution Company ?
The risk-free rate is 3 percent and that the market risk premium is 7 percent. If a stock has a required rate
of return of 14.25 percent, what is its beta?
Security Market Line (SML):
• The line that shows the relationship between risk as measured by beta
and the required rate of return for individual securities.
• Risk-free rate is the minimum rate of return that is expected on
investment with zero risks by the investor, which, in general, is
the government bonds
• It is the hypothetical rate of return, in practice, it does not exist
because every investment has a certain amount of risk.
Security Market Line
• It displays the expected rate of return of an individual security as a
function of systematic, non-diversifiable risk.
• The security market line (SML) is a visual representation of the capital
asset pricing model or CAPM. It shows the relationship between the
expected return of a security and its risk measured by its beta
coefficient.
• In other words, the SML displays the expected return for any given
beta or reflects the risk associated with any given expected return.
SECURITY MARKET LINE
The security market line (SML) is a visual representation of the capital asset pricing model or CAPM. It shows
the relationship between the expected return of a security and its risk measured by its beta coefficient. In
other words, the SML displays the expected return for any given beta or reflects the risk associated with any
given expected return.
Beta
140
110
80
140
110
80
Practice questions and cases
• Expected return = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) +
(0.2)(25%) + (0.1)(60%) = 11.40%.
• variance = (-50% – 11.40%)2(0.1) + (-5% – 11.40%)2(0.2) +

(16% – 11.40%)2(0.4) + (25% – 11.40%)2(0.2) + (60% –
11.40%)2(0.1) = 712.44;
• Standard deviation = 26.69%.
• CV = = 2.34.
Investment Beta
35,000 0.8
40,000 1.4
Total $75,000
beta = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12.

1. rRF = 6%; rM = 13%; b = 0.7; r = ?
r = rRF + (rM – rRF)b

= 6% + (13% – 6%)0.7
= 10.9%.
2. rRF = 5%; RPM = 6%; rM = ?

rM = 5% + (6%)1 = 11%.
r when b = 1.2 = ?
r = 5% + 6%(1.2) = 12.2%.
3. a.
r = 11%; rRF = 7%; RPM = 4%.
r = rRF + (rM – rRF)b
11%= 7% + 4%b
4% = 4%b
b = 1.
b. rRF = 7%; RPM = 6%; b = 1

R = rRF + (rM – rRF)b
= 7% + (6%)1
= 13%.
1. In equilibrium:
rJ = r̂J = 12.5%.
rJ = rRF + (rM – rRF)b

12.5% = 4.5% + (10.5% – 4.5%)b
b = 1.33.
2. We know that bR = 1.50, bS = 0.75, rM = 13%, rRF = 7%.
ri = rRF + (rM – rRF)bi = 7% + (13% – 7%)bi.
rR = 7% + 6%(1.50) = 16.0%
rS = 7% + 6%(0.75) = 11.5
4.5%
3. An index fund will have a beta of 1.0. If rM is 12.0% (given in the problem) and the risk-free rate is
5%, you can calculate the market risk premium (RPM) calculated as rM – rRF as follows:
r = rRF + (RPM)b
12.0% = 5% + (RPM)1.0
7.0% = RPM.
Now, you can use the RPM, the rRF, and the two stocks’ betas to calculate their required returns.
Bradford:
rB = rRF + (RPM)b
= 5% + (7.0%)1.45
= 5% + 10.15%
= 15.15%.
Farley:
rF = rRF + (RPM)b
= 5% + (7.0%)0.85
= 5% + 5.95%
= 10.95%.
The difference in their required returns is:

15.15% – 10.95% = 4.2%.
4. rRF = r* + IP = 2.5% + 3.5% = 6%.
r = 6% + (6.5%)1.7 = 17.05%.
a. = 0.1(-28%) + 0.2(0%) + 0.4(12%) + 0.2(30%) + 0.1(50%) = 13%.
rRF = 6%. (given)
Therefore, the SML equation is:

ri = rRF + (rM – rRF)bi = 6% + (13% – 6%)bi = 6% + (7%)bi.
b. First, determine the fund’s beta, bF. The weights are the percentage of funds invested in each stock:
A = $160/$500 = 0.32.
B = $120/$500 = 0.24.
C = $80/$500 = 0.16.
D = $80/$500 = 0.16.
E = $60/$500 = 0.12.
bF = 0.32(0.5) + 0.24(1.2) + 0.16(1.8) + 0.16(1.0) + 0.12(1.6)

= 0.16 + 0.288 + 0.288 + 0.16 + 0.192 = 1.088.
Next, use bF = 1.088 in the SML determined in Part a:

= 6% + (13% – 6%)1.088 = 6% + 7.616% = 13.616%.
c. rN = Required rate of return on new stock = 6% + (7%)1.5 = 16.5%.
An expected return of 15% on the new stock is below the 16.5% required rate of
return on an investment with a risk of b = 1.5. Since rN = 16.5% > = 15%, the new
stock should not be purchased. The expected rate of return that would make the fund
indifferent to purchasing the stock is 16.5%.
Case – Merrill Finch Inc. (Textbook case)
• Page 299 – 8-23
Hypothetical Investment Alternatives
Economy Prob. T-Bills HT Coll USR MP

Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%
Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0%
Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%
Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0%
Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%
8-312
Why is the T-bill return independent of the economy? Do

T-bills promise a completely risk-free return?
• T-bills will return the promised 5.5%, regardless

of the economy.
• No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely
to occur over such a short period of time.
• T-bills are also risky in terms of reinvestment risk.
• T-bills are risk-free in the default sense of the
word.
8-313
How do the returns of High Tech and Collections

behave in relation to the market?
• High Tech: Moves with the economy, and has a

positive correlation. This is typical.
• Collections: Is countercyclical with the economy,
and has a negative correlation. This is unusual.
8-314
Calculating the Expected Return
r̂ = Expected rate of return
N
r̂ =  Piri
i =1
r̂ = (0.1)(-27%) + (0.2)(-7%) + (0.4)(15%)

+ (0.2)(30%) + (0.1)(45%)
= 12.4%
8-315
Summary of Expected Returns

Expected Return
High Tech 12.4%
Market 10.5%
US Rubber 9.8%
T-bills 5.5%
Collections 1.0%
High Tech has the highest expected return, and appears

to be the best investment alternative, but is it really?
Have we failed to account for risk?
8-316
Calculating Standard Deviation
 = Standard deviation
 = Variance =  2
N
=  (r − r̂ )2 Pi
i =1
8-317
Standard Deviation for Each

Investment
N
=  (r − r̂ )2 Pi
i =1
1/ 2
 (5.5 − 5.5)2 (0.1) + (5.5 − 5.5)2 (0.2) 
 T -bills = (5.5 − 5.5)2 (0.4) + (5.5 − 5.5)2 (0.2)
 
 + (5.5 − 5.5) (0.1)
2

 T -bills = 0.0%
σHT = 20% σColl = 13.2%
σM = 15.2% σUSR = 18.8%

8-318
Comparing Standard Deviations
Prob.
T-bills
USR
HT
0 5.5 9.8 12.4 Rate of Return (%)
8-319
Comments on Standard Deviation
as a
Measure of Risk
• Standard deviation (σi) measures total, or stand-
alone, risk.
• The larger σi is, the lower the probability that
actual returns will be close to expected returns.
• Larger σi is associated with a wider probability
distribution of returns.
8-320
Comparing Risk and Return

Security Expected Return, r̂ Risk, s
T-bills 5.5% 0.0%
High Tech 12.4 20.0
Collections* 1.0 13.2
US Rubber* 9.8 18.8
Market 10.5 15.2
*Seems out of place.
8-321
Coefficient of Variation (CV)

• A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
Standard deviation 
CV = =
Expected return r̂
8-322
Illustrating the CV as a Measure of

Relative Risk
Prob.
A B
0 Rate of Return (%)
σA = σB , but A is riskier because of a larger

probability of losses. In other words, the same
amount of risk (as measured by σ) for smaller
returns.
8-323
Risk Rankings by Coefficient of

Variation
CV
T-bills 0.0
High Tech 1.6
Collections 13.2
US Rubber 1.9
Market 1.4
• Collections has the highest degree of risk per unit of return.

• High Tech, despite having the highest standard deviation of
returns, has a relatively average CV.
8-324
Investor Attitude Towards Risk

• Risk aversion: assumes investors dislike risk and
require higher rates of return to encourage them to
hold riskier securities.
• Risk premium: the difference between the return
on a risky asset and a riskless asset, which serves
as compensation for investors to hold riskier
securities.
8-325
Portfolio Construction: Risk and

Return
• Assume a two-stock portfolio is created with $50,000
invested in both High Tech and Collections.
• A portfolio’s expected return is a weighted average of
the returns of the portfolio’s component assets.
• Standard deviation is a little more tricky and requires
that a new probability distribution for the portfolio
returns be constructed.
8-326
Calculating Portfolio Expected Return
r̂p is a weighted average :
N
r̂p =  w ir̂i
i =1
r̂p = 0.5(12.4%) + 0.5(1.0%) = 6.7%
8-327
Calculating Portfolio Standard

Deviation and CV
1
 0.10 (0.0 - 6.7) 2 2
 
+ 0.20 (3.0 - 6.7) 
2
 
 p = + 0.40 (7.5 - 6.7) 2  = 3 .4 %
+ 0.20 (9.5 - 6.7) 2 
 
+ 0.10 (12.0 - 6.7) 
2
3 .4 %
CVp = = 0.51
6 .7 %
8-328
Comments on Portfolio Risk Measures
• σp = 3.4% is much lower than the σi of either

stock (σHT = 20.0%; σColl = 13.2%).
• σp = 3.4% is lower than the weighted average of
High Tech and Collections’ σ (16.6%).
• Therefore, the portfolio provides the average
return of component stocks, but lower than the
average risk.
• Why? Negative correlation between stocks.
8-329
General Comments About Risk

• σ  35% for an average stock.
• Most stocks are positively (though not perfectly)
correlated with the market (i.e., ρ between 0 and
1).
• Combining stocks in a portfolio generally lowers
risk.
8-330
Cost of capital and optimal
capital structure
Case – Midland Energy Resources, Inc.: Cost
of Capital
• Why is there a need to estimate WACC?
• What does WACC represents?
• What should discount rate reflect?
• Should our analysis focus on before-tax or after-tax capital costs?
• Should our analysis focus on historical (embedded) costs or new (marginal) costs?
• How are weights determined?
• Use accounting numbers or market value (book vs. market weights)?
• Use actual numbers or target capital structure?
Capital
Capital
Preferred Common
Debt
Stock Equity
New
Notes Long-Term Retained
Payable Debt Common
Earnings
Stock
Components of cost of capital
Cost of Capital
Cost of
Cost of Equity Cost of Retained earnings
Cost of Debt Preference
Capital and external equity
Capital
Cost of
debentures
Cost of term
loans
Cost of Capital
• Rate of return that the suppliers of capital require as compensation for
their contribution of capital
• The rate of return the firm expects to earn from its investments in
order to increase the value of the firm in the market place
• Minimum required rate of return

Calculating the Weighted Average Cost
of Capital
WACC = wdrd(1 – T) + wprp + wcrs
• The w’s refer to the firm’s capital structure

weights.
• The r’s refer to the cost of each component.
Cost of Debentures
• Discount rate which equates the net proceeds from the issue of
debentures to the expected cash outflows in the form of interest and
principal repayments.
𝒏 𝑰(𝟏−𝒕) 𝑭 k d = Post tax cost of debenture capial

•𝑷 = σ𝒕=𝟏 + I= Annual interest payment per debenture capital
(𝟏+𝒌𝒅 )𝒕 (𝟏+ 𝒌𝒅 )𝒏
t = Corporate tax rate
F = Redemption price per debenture
𝑭−𝑷 P = Net amount realized per debenture and
𝑰 𝟏−𝒕 + 𝒏
• 𝒌𝒅 = 𝑭+𝑷
n = Maturity period
𝒏
Question
Ajax Ltd. has recently made an issue of non-convertible debentures for
Rs. 400 lakh. The terms of the issue are as follows: each debenture has a
face value of Rs. 100 and carries a rate of interest of 14 %. The interest
is payable annually and the debenture is redeemable at a premium of 5
percent after 10 years.
If Ajay Ltd. realises Rs. 97 per debentures and the corporate tax rate is
50 percent, what is the cost of debentures to the company?
• Given,
I = Rs. 14
Find out 𝑘𝑑 !
T= 0.50
P= Rs. 97
n=10 years
F=Rs. 105
Cost of Term Loans
• Interest rate
I= Interest rate
𝒌𝒕 = 𝑰 𝟏 − 𝒕 t = Corporate tax rate
F = Redemption price per debenture
P = Net amount realized per debenture and
n = Maturity period
Cost of Preference Capital
• Discount rate which equates the proceeds from preference capital issue
to the payments associated with the same i.e. dividend payment and
principal payments
𝑭−𝑷
𝑫+ 𝒏 k p = cost of preference capital
𝒌𝒑 =
𝑭+𝑷 D = preference dividend per share
𝟐 payable annually
F = redemption price
P = net amount realized per share and
• Can also use - kp = Dp/Pp n = maturity period
= $10/$111.10
= 9%
Question
• The terms of the preference share issue made by Color-Dye-Chem are
as follows: Each preference share has a face value of Rs. 100 and
carries a dividend rate of 14 percent payable annually. The share is
redeemable after 12 years at par. If the net amount realized per share is
Rs. 95, what is the cost of the preference capital?
• D= 14, F= 100, P = 95, and n=12

Cost of Equity Capital
• According to dividend forecast approach, the intrinsic value of an
equity stock is equal to the sum of the present values of the dividends
associated with it. i.e.,
D1
Pe =
ke−𝒈
D1
Ke = + 𝑔
Pe
Three Ways to Determine the Cost of
Common Equity, rs
• CAPM: rs = rRF + (rM – rRF)b
• DCF: rs = (D1/P0) + g
• Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
Find the Cost of Common Equity
Using the CAPM Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
rs = rRF + (rM – rRF)b

= 7.0% + (6.0%)1.2 = 14.2%
Find the Cost of Common Equity Using the
DCF Approach
D0 = $4.19, P0 = $50, and g = 5%.
D1 = D0(1 + g)
= $4.19(1 + 0.05)
= $4.3995
rs = (D1/P0) + g
= ($4.3995/$50) + 0.05
= 13.8%
Can DCF methodology be applied
if growth is not constant?
• Yes, nonconstant growth stocks are expected to

attain constant growth at some point, generally in
5 to 10 years.
• May be complicated to calculate.
Bond-Yield-Plus-Risk-Premium Approach
rd = 10% and RP = 4%.
• This RP is not the same as the CAPM RPM.

• This method produces a ballpark estimate of rs,
and can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
What is a reasonable final estimate of rs?
Method Estimate
CAPM 14.2%
DCF 13.8
rd + RP 14.0
Range = 13.8%-14.2%, might use midpoint of

range, 14%.
Why is the cost of retained earnings cheaper than the
cost of issuing new common stock?
• When a company issues new common stock they

also have to pay flotation costs to the underwriter.
• Issuing new common stock may send a negative
signal to the capital markets, which may depress
the stock price.
Question
• The market price per share of Mobile Glycols Ltd. is Rs. 125. The
dividend expected per share a year hence is Rs. 12 and the DPS is
expected to grow at a constant rate of 8 percent per annum. What Is
the cost of equity capital to the company?
Cost of retained earnings and cost of external
equity
• Earnings of a firm can be reinvested or paid as dividend
• If firm retained part of earnings for future growth of the firm, the
shareholder will demand compensation from the firm for using that
money
• Thus, cost of retained earnings is expected return from the firm’s
common stock
• Thus, Kr = Ke
Why is there a cost for retained earnings?
• Earnings can be reinvested or paid out as dividends.
• Investors could buy other securities, earn a return.
• If earnings are retained, there is an opportunity cost (the return that
stockholders could earn on alternative investments of equal risk).
• Investors could buy similar stocks and earn rs.
• Firm could repurchase its own stock and earn rs.
• Under dividend capitalization model, the following formula can be used
for calculating the cost of external equity :
D1 K’e = Cost of external equity

K’e = +𝑔 D1 = Dividend expected at the end of year 1
P0(1−f) P0 = Current market price per share
g = Constant growth rate applicable to dividends
f = Floatation costs as a percentage of the current
market price
• For all other approaches,

Ke = rate of return required by the equity investors
K’e = cost of external equity
f = Floatation costs as a percentage of the current
Ke market price
K’e =
(1−f)
Question
• Gamma Asbestos Ltd. has got Rs. 100 lakh of retained earnings and
Rs. 100 lakh of external equity through a fresh issue, in its capital
structure. The equity investors expect a rate of return of 18%. The cost
of issuing external equity is 5%. The cost of retained earnings and the
cost of external equity can be determined as follows:
• Cost of retained earnings:

Kr=Ke
Ke
K’e =
(1−f)
a. rd(1 – T) = 0.10(1 – 0.3) = 7%.
rp = $5/$49 = 10.2%.
rs = $3.50/$36 + 6% = 15.72%.
b. WACC: After-Tax Weighted
Component Weight  Cost = Cost
Debt 0.15 7.00% 1.05%
Preferred stock 0.10 10.20 1.02
Common stock 0.75 15.72 11.79
WACC= 13.86%
c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.
rs = D1/P0 + g
= $2(1.07)/$24.75 + 7%
= 8.65% + 7% = 15.65%.
WACC = wd(rd)(1 – T) + wc(rs); wc = 1 – wd.
13.95% = wd(11%)(1 – 0.35) + (1 – wd)(15.65%)

0.1395 = 0.0715wd + 0.1565 – 0.1565wd
-0.017 = -0.085wd
wd = 0.20 = 20%.
• If the investment requires $5.9 million, that means it requires $3.54 million (60%)
of common equity and $2.36 million (40%) of debt. In this scenario, the firm
would exhaust its $2 million of retained earnings and be forced to raise new stock
at a cost of 15%. Needing $2.36 million in debt, the firm could get by raising debt
at only 10%. Therefore, its weighted average cost of capital is: WACC =
0.4(10%)(1 – 0.4) + 0.6(15%) = 11.4%.
Capital Structure Theories
Theories of Capital Structure
• Net Income Theory
• Net Operating Income Theory
• Traditional Approach
• Modigliani and Miller (MM Approach)
• Trade-off Theory
• Packing Order Theory
• Signalling
Net income theory
• The approach was given by David Durand
• According to this approach, capital structure decision is relevant to the valuation
of the firm
• In other words, a change in the capital structure will lead to a corresponding
change in the overall cost of capital as well as the total value of the firm
• If D then, Cost of capital If D then, Cost of capital

Market value of share Market value of share
Value of the firm Value of the firm
Net income theory
• According to the NI Approach, the financial leverage is, an important
variable to the capital structure of a firm. With a judicious mixture of
debt and equity, a firm can evolve an optimum capital structure which
will be the one at which value of the firm is the highest and the overall
cost of capital is the lowest. At that structure, the market price per
share would be maximum
Net income theory
• Assumptions:
1. There are no corporate taxes
2. Cost of debt is less than cost of equity
3. Use of debt, does not change the risk perception of the investors.
That, the financial risk perception of the investors does not change
with the introduction of debt or change in leverage. Thus, due to
change in leverage, there is no change in either the cost of debt or
the cost of equity
Example
• A company’s expected annual net operating income (EBIT) is Rs
50,000. The company has Rs 2,00,000, 10% debentures. The equity
capitalisation rate (ke) of the company is 12.5 per cent.
Base case Increase in Debt Decrease in Debt
EBIT – Rs. 50000 EBIT – Rs. 50000 EBIT – Rs. 50000

B – Rs. 200000 B – Rs. 300000 B – Rs. 100000
I or Kd – 10% I or Kd – 10% I or Kd– 10%
Ke= 12.5% Ke= 12.5% Ke= 12.5%
Calculate NI = EBIT – Interest Calculate NI = EBIT – Interest Calculate NI = EBIT – Interest
Calculate S – MV of Shares = NI/Ke Calculate S – MV of Shares = NI/Ke Calculate S – MV of Shares = NI/Ke
Calculate V = S + B Calculate V = S + B Calculate V = S + B
Ko = EBIT/V Ko = EBIT/V Ko = EBIT/V

Net Income Approach (NI)
We can graph the relationship between the various factors (ke, ki, k0) with the
degree of leverage
Net Operating Income Theory
• As per this approach, the WACC and the total value of a company are independent of the capital
structure decision or financial leverage of a company
• Benefits that a firm derives by infusion of debt is negated by the simultaneous increase in the
required rate of return by the equity shareholders
• As per this approach, the market value is dependent on the operating income and the associated
business risk of the firm.
• Both these factors cannot be impacted by the financial leverage.
• Financial leverage can only impact the share of income earned by debt holders and equity holders
but cannot impact the operating incomes of the firm.
• Therefore, change in debt to equity ratio cannot make any change in the value of the firm.
Net operating income theory
Assumptions:
1. There are only two sources of financing – debt and equity
2. Value of equity is calculated by deducting the value of debt from total value of
the firm
3. Value of firm is EBIT/Ko
4. WACC remains constant and with an increase in debt, the cost of equity
increases
5. Dividend payout ratio is 1
6. There are no taxes and no retained earnings
Example
• Operating income Rs 50,000; cost of debt, 10 per cent; and
outstanding debt, Rs 2,00,000. If the overall capitalisation rate (overall
cost of capital) is 12.5 per cent, what would be the total value of the
firm and the equity-capitalisation rate?
Base case Increase in Debt Decrease in Debt
EBIT – Rs. 50000 EBIT – Rs. 50000 EBIT – Rs. 50000

B – Rs. 200000 B – Rs. 300000 B – Rs. 100000
I or Kd– 10% I or Kd – 10% I or Kd – 10%
Ko = 12.5% Ko = 12.5% Ko = 12.5%
Ke, V= ? Ke, V = ? Ke, V = ?
Assuming WACC (Ko) remains Assuming WACC (Ko) remains Assuming WACC (Ko) remains
constant constant constant
V = EBIT/Ko V = EBIT/Ko V = EBIT/Ko
S=V–B S=V–B S=V–B
Ke = (EBIT – Interest)/S Ke = (EBIT – Interest)/S Ke = (EBIT – Interest)/S

Net Operating Income Approach (NOI)
degree of leverage
Traditional/ Intermediate Approach
Traditional approach has emerged as a compromise to the extreme proposition taken by NI and
NOI approach.
The main propositions of the traditional approach are:

• The cost of equity capital, Ke, remains more or less constant or rises only gradually up to a
certain degree of leverage and rises sharply thereafter.
• The cost of debt capital, Ki, remains more or less constant up to a certain degree of leverage but
rises thereafter at an increasing rate.
• The average cost of capital, Ko, as a consequence of the above behavior of Ke and Ki,
(i) decreases up to a certain point;
(ii) remains more or less unchanged for moderate increases in leverage thereafter; and
(iii) rises beyond a certain point.
• Thus there is a optimal capital structure when weighted average cost of capital is minimum and
the value of the firm is maximum.
Traditional Approach
degree of leverage
Readings
• Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the
theory of investment. The American economic review, 48(3), 261-297
• Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior,
agency costs and ownership structure. Journal of financial economics, 3(4), 305-360.
• Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when
firms have information that investors do not have. Journal of financial economics, 13(2),
187-221.
• Rajan, R. G., & Zingales, L. (1995). What do we know about capital structure? Some
evidence from international data. The journal of Finance, 50(5), 1421-1460.
• Denis, D. J., & Osobov, I. (2008). Why do firms pay dividends? International evidence on
the determinants of dividend policy. Journal of Financial economics, 89(1), 62-82.
Modigliani and Miller (1958, 1963)
• Modigliani and Miller developed two approaches of Capital Structure:
1. Modigliani and Miller : Without taxes (1958)
2. Modigliani and Miller : With taxes (1963)
3. Modigliani and Miller (1958) :

➢Similar to NOI Approach
➢Capital Structure Irrelevant Approach
Modigliani and Miller
In their celebrated 1958 paper, Modigliani and Miller (MM, hereafter) have restated and amplified the net
operating income position in terms of three basic propositions.
Assumption of the Approach
• Capital markets are perfect. Information is freely available and transactions are costless;
• Investors are rational. Investors are well-informed and choose a combination of risk and return that is
most advantageous to them.
• Investors have homogeneous expectations.
• Firms can be grouped into ‘equivalent risk classes’ on the basis of their business risk.
• There is no corporate income tax.

Basic Propositions
• Based on the above assumptions, MM derived the following three propositions.
• Proposition I : The total market value of a firm is equal to its expected operating income divided by the discount rate
appropriate to its risk class. It is independent of the degree of leverage.
• In other words, the total value of a firm must be constant irrespective of the degree of leverage (debt-equity ratio). Similarly,
the cost of capital as well as the market price of shares must be the same regardless of the financing-mix.
Vj = Sj + Bj = Oj/ko
where Vj = total market value of firm j
Sj = market value of the equity of firm j
Bj = market value of the debt of firm j
Oj = expected operating income of firm j
ko = discount rate applicable to the risk class to which the fi rm j belongs.
Example: Two companies X & Y have identical assets, Operating in same industry, same segment, and have equal market share.
• Proposition II: The expected yield on equity, ke, is equal to ko plus a premium. This premium is equal to the debt–
equity ratio times the difference between ko and the yield on debt, ki. In symbols
ke = ko + (ko – ki) B/S
For a zero-debt company, the second component of the above equation is zero. As the company starts using debt, the ke
increases and the equity-investor is to be compensated for it. The higher the employment of debt in financing
company’s assets, the higher is the financial risk as well as the financial risk premium.
• Proposition III: The cutoff rate for investment decision making for a firm in a given risk class is not affected by the
manner in which the investment is financed. (This proposition states the implication of the earlier propositions for
investment decision-making. It emphasizes the point that investment and financing decisions are independent
because the average cost of capital is not affected by the financing decision.)
Arbitrage Mechanism and Home Made leverage
• According to MM, if two firms, say X and Y, are in the same risk class and have the same expected operating income,
they will have the same value in the market place, irrespective of differences in their capital structure. If their values
diverge, investors will resort to arbitraging.
• The term ‘arbitrage’ refers to an act of buying an asset/security in one market (at lower prices) and selling it in
another (at higher price). As a result, equilibrium is restored in the market price of a security in different markets.
• The MM Approach illustrates the arbitrage process with reference to valuation in terms of two firms which are
exactly similar in all respects except leverage so that one of them has debt in its capital structure while the other
does not.
• Such homogeneous firms are, according to Modigliani and Miller, perfect substitutes.
Example
• Assume there are two firms, L and U, which are identical in all
respects except that firm L has 10 per cent, Rs 5,00,000 debentures.
The earnings before interest and taxes (EBIT) of both the firms are
equal, that is, Rs 1,00,000. The equity-capitalisation rate (ke) of firm L
is higher (16 per cent) than that of firm U (12.5 per cent).
L U
Net Operating Income (EBIT)
Less : Interest (I)
Earnings available to equityholders (NI)
Ke
Mkt value of equity (S) = NI/Ke
Mkt value of debt (B)
Value of firm (V) = S+B
Overall cost of capital : Ko = EBIT/V
Debt-equity ratio : B/S
Arbitrage process
• In the example, the value of the levered firm is higher than that of the unlevered firm. Such a
situation cannot persist because equity investors would do well to sell their equity
investment in firm and invest in the equity of firm X with personal leverage.
• Suppose, Mr. X holds 10% of outstanding shares in L firm. His holding is equal to Rs. 31250 and
his share of earnings (that belong to equity shareholders) will be Rs. 5000
• Now, he will sell his holdings in L and invest in U. Since firm U has no debt in its capital structure,
the financial risk to Mr. X would be less than in firm L
• To reach the level of financial risk of firm L, he will borrow additional funds equal to his
proportionate share in the levered firm’s debt on his personal account. That is, he will substitute
personal leverage (or home-made leverage) for corporate leverage
• In other words, instead of the firm using debt, Mr. X will borrow money
Limitation of MM Approach (Tax Advantage)
• The most crucial element in the MM Approach is the arbitrage process which forms the behavioural
foundation of, and provides operational justification to, the MM hypothesis.
• The arbitrage process, in turn, is based on the crucial assumption of perfect substitutability of
personal/home-made leverage with corporate leverage.
• In practice how personal leverage may differ from the corporate leverage?
• Risk perception
• Convenience
• Cost
• Taxes
• The leverage irrelevance theorem of MM is valid if the perfect market assumptions underlying their
analysis are satisfied. However, in the face of imperfections characterizing the real world capital markets,
the capital structure of a firm may affect its valuation. Presence of taxes is a major imperfection in the
real world.
• When taxes are applicable to corporate income, debt financing is advantageous. Why? While dividends
and retained earnings are not deductible for tax purposes, interest on debt is a tax-deductible expense. As
a result, the total income available for both stockholders and debtholders is greater when debt capital is
used.
Limitation of MM Approach (Distress/ Bankruptcy cost )
• MM agree that the value of the firm will increase and cost of capital will decline with leverage, if corporate
taxes are introduced in the exercise. Since interest on debt is tax-deductible, the effective cost of
borrowing is less than the contractual rate of interest. Debt, thus, provides a benefit to the firm because of
the tax-deductibility of interest payments. Therefore, a levered firm would have greater market value
than an unlevered firm. Hence, it implies that the value of a levered firm will be
Value of levered firm = Value of unlevered firm + Gain from leverage
VL = VU + tcB
• In addition to taxation, which is the most important imperfection, there are several other imperfections
which have a bearing on the optimal capital structure. One of the most important such cost is bankruptcy
or financial distress cost
• In a perfect capital market, there are no costs associated with bankruptcy. If a firm becomes bankrupt its
assets can be sold at their economic values and there are no legal and administrative expenses. In the real
world, however, there are considerable costs associated with bankruptcy.
Limitation of MM Approach
• Assets, when disposed under distress conditions, generally sell at a significant discount below
their economic values. Further, the legal and administrative costs associated with bankruptcy
proceedings are quite high. Finally, an impending bankruptcy entails significant costs in the
form of sharply impaired operational efficiency.
• Other things being equal, the probability of bankruptcy is higher for a levered firm than for an
unlevered firm. It seems that the probability of bankruptcy increases at an increasing rate as
the debt-equity ratio increases beyond a certain threshold level. Thus investors of levered firm
expect a higher rate of return for firms with higher bankruptcy rate.
Real world Corporate Financing Behaviour
Trade off Theory
• Use of debt as a means of corporate finance have led to the genesis of the trade-off theory on capital structure.
• It trades off the advantage of debt financing (interest tax shields) against the costs of financial distress (consisting of
higher interest rates and bankruptcy costs).
• In Case I, Ko remains constant under perfect market
conditions. Advantage of cheaper debt source is
nullified by the higher equity capitalization rate
• In case II, recognises the tax benefit of debt sources
and hence, in this case Ko is decreasing with
increasing leverage ratio
• In case III, the presence of bankruptcy cost due to
excessive debt is recognised. As a result beyond
point D the tax advantage is negated by the higher
bankruptcy cost.
• At the point of ‘D’ the company has an optimal
structure.
• Its conclusion that debt should be used within safe
limits converges with the trade-off theory.
Pecking Order Theory
• There is an alternative theory which explains why profitable firms (example: SBI Life Insurance, HUL,
ICICI Pru Life Insurance, ITC, Ambuja Cements) use little debt. According to this theory, there is a pecking
order of financing which goes as follows:
• Retained Earnings (internal finance) (What is RE?)
• Debt Finance
• Equity Funding (External Finance)
• A firm first taps retained earnings. Its primary attraction is that it comes out of profits and not much effort
is required to get it. Further, the capital market ordinarily does not view the use of retained earnings
negatively.
• When the financing needs of the firm exceed its retained earnings, it seeks debt finance. As there is very
little scope for debt to be mispriced, a debt issue does not ordinarily cause concern to investors. Also, a
debt issue prevents dilution of control.
• External equity appears to be the last choice. A great deal of effort may be required in obtaining external
equity. More important, while retained earnings is not regarded by the capital market as a negative signal,
external equity is often perceived as ‘bad news’. Investors generally believe that a firm issues external
equity when it considers its stock overpriced in relation to its future prospects.
Signalling theory
Debt signaling is a financial theory that correlates a stock's future performance with any
current announcements made regarding its debt.
Announcements made about a company taking debt are typically seen as positive news as
it can signal the company is creditworthy and is raising capital for the purposes of growth.

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Financial Management

INDIAN INSTITUTE OF MANAGEMENT ROHTAK

• Basics of data handling –

• Financing – Capital Structure

• Dividend - Dividend or interest payment, Reinvestment

2. Capital-structure or Financing decision-Financing decision relates to the choice of the proportion

3. Profit allocation or Dividend decision-Deciding on dividend-payout ratio. It would depend on the

4. Working capital or Liquidity decision-Working capital management is concerned with the

The Investment Decision The Financing Decision The Dividend Decision

• Managers are naturally inclined to act in their own best interests

• In equilibrium, a stock’s price should equal its “true” or intrinsic

Managerial Actions, the Economic

“True” Investor “True” “Perceived” Investor “Perceived”

Hire & fire Maximize

Lend Money No Social Costs

Lend Money Significant Social Costs

• Should be aligned with the mission of the Corporation

✓The profit maximization objective ignores time value of money

• The cash flow the firm is expected to provide in the future

• In equilibrium, a stock’s price should equal its “true” or intrinsic

Managerial Actions, the Economic

“True” Investor “True” “Perceived” Investor “Perceived”

Chief Executive Officer (CEO)

Chief Operating Officer (COO) Chief Financial Officer (CFO)

Marketing, Production, Human Accounting, Treasury, Credit,

• For example, if a fixed asset is purchased, it will require an immediate cash

• The firm may also raise funds by issuing equity shares.

• Time preference for money or time value of money (TVM) is an individual's

• Three reasons may be attributed to the individuals time preference for

• It is called so because the investor could invest his money in assets

• Compounding – the process of calculating future values of cash

• Discounting – the process of calculating present values of cash

• Compounding is the process of finding the future values of

• Simple interest is the interest that is calculated only on the original

Answer: As per the formula of compounding of the cash flows:

The future value is :

Answer: 𝐅𝟏 = 𝟏, 𝟎𝟎𝟎 + 𝟏, 𝟎𝟎𝟎 × 𝟓 % As per the formula of compounding

Answer: FV = 55,650 × 𝑪𝑽𝑭𝟏𝟎,𝟎.𝟏𝟓

Answer: Rs. 331

Answer: PV = 50,000 × PVF15,0.09

Answer: 10,000 = A × PVF𝐴3,0.09

Answer: 10,000 = A × PVF𝐴3,0.09

End of year Payment Interest Principal Repayment Outstanding Balance

• Perpetuity is an annuity that occurs indefinitely.

𝟏,𝟎𝟎𝟎 𝟏,𝟓𝟎𝟎 𝟖𝟎𝟎 𝟏,𝟏𝟎𝟎 𝟒𝟎𝟎

CF0 CF1 CF2 CF3

$100 lump sum due in 2 years

3-year $100 ordinary annuity

100 100 100

Drawing Time Lines

Uneven cash flow stream

initial $100 after 3 years, if I/YR =

The Step-by-Step and Formula

• After N years (general case):

Solving for FV:

Solving for PV:

PV = FV3 /(1 + I)3

Solving for PV:

rate would cause $100 to grow to

per year, how long before sales