Finance primer
MESA School of Business
Shashi Bhushan
16th November 2023
1
Course Objectives
• Supposed to be a foundational finance course
• Designed to provide students with an initial grasp of financial concepts and statements, enabling them
to understand the prevalent business models in the Indian startup ecosystem.
• While core courses in finance, accounts, and economics are yet to be scheduled, this primer course
serves as a bridge, offering students essential insights into the financial dynamics within startup
environments.
Short, quick, fast paced, Q&A driven, practical and hands-on with real life examples
Page 2
Learning Outcomes
At the end of this course, the students are expected to:
• Gain a foundation in fundamental financial concepts and statements, specifically tailored to the dynamics of the Indian startup
ecosystem.
• Prepare for advanced financial studies by seamlessly bridging the gap with insights into startup financial dynamics before core
courses in finance, accounts, and economics.
• Understand the strategic role of finance managers in startups, equipping oneself to contribute effectively to the financial
strategies of emerging ventures.
• Acquire practical skills in analyzing Profit and Loss (P/L) statements, enabling the interpretation and preliminary analysis of
financial data crucial for startup evaluation.
• Classify costs, distinguish between fixed and variable elements, and identify critical revenue drivers within startup contexts.
• Master key financial metrics such as CAC, LTV, and Churn Rate, gaining the ability to assess and interpret startup performance
for effective decision-making.
• Gain a basic understanding of tool of capital budgeting and valuation methods for start-ups.
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Course Structure
• Module 1: Introduction to start-up finance
• Module 2: Profit & loss statement and its analysis
• Module 3: Cost behavior
• Module 4: Break-even analysis
• Module 5: Cash flow statement & its analysis
• Module 6: Financial metrics and performance indicators
• Module 7: Fundamentals of corporate finance
• Module 8: Introduction to valuation methods
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Module 1: Introduction to start-up finance
Page 5
Main Stages of Start-up Development
There’s no exact or universal classification of startup phases.
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India’s start-up landscape
Page 7
Start-up financial landscape
"Funding winter" is a
term used in the startup
and venture capital world
to describe an extended
period of reduced capital
inflows to startups
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Naming convention for financing rounds
• Even though startups rarely
follow a standardized capital
raising progression, there are
venture financing instruments
that are tailored to meet the
needs of a startup's investors
and founders at each of these
stages of development.
• While a model startup may raise
five successive rounds of
financing labeled Series Seed,
Series A, Series B, Series C, and
Series D, startups often label
their financing rounds differently
if they are concerned about the
signal the name of their latest
round sends to the market.
• The naming conventions for
startup financing rounds are
fluid in reality.
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Business models and financials
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ORGANIZATIONAL GOALS
Maintain cash for short-term
obligations
Quick Decision Making
Cash Flow Managers
•
•
•
•
Quick Decision Maker
•
•
Secure initial funding
Establish basic financial
systems
Arrange for liquidity
Negotiation with suppliers
Speed up collections
Vendor managed inventory
Entrepreneurship and risktaking
Rapid decision-making and
innovation
Fund raiser & Story Teller
•
•
•
Business Model Review
Financial Modeling
Networking & pitching to
investors
System Design
•
•
•
Excel / tally based accounting
Macro code automation
Excel based analytics
EVOLVING ROLE OF THE FINANCE
Role of a finance manager in start-ups
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Key terms / concepts
Page 12
Module 2: Profit & loss statement & its
analysis
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Types of financial statements
Sl. No.
1.
2.
Statement
Purpose
Use
Income Statement (or P&L
statement or Statement of
earnings or Statement of
Operations)
Provide information about the financial
performance of the company in a specified 
period. It contains all the revenues and 
expenses of the organization.
Balance Sheet
It is the statement of financial position of 
business as on a particular date; shows 
balances of assets, liabilities and equity 
on a date

3.
Cash Flow
4.
Statement of changes
shareholders’ equity
Summarizes the cash flowing into / out of 
the organization over a period of time

in Displays the changes in equity of the 
company over a period of time
To assess the profitability and growth of the company
To identify the sources of revenue and costs
To assess sources and uses of funds
To assess growth rates in them
To assess what company owns and who has claims on
them
To assess the sources and uses of cash (further split
across three heads of operations, investing & financing)
To assess the liquidity position
Helps to understand company’s requirement of financing,
ability to pay interest, dividends or incur capital
expenditure
To analyse all the transactions between the company and
its owners / shareholders / investors
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Components of profit & loss statement
Sl.
No.
•
•
•
•
•
Net Sales (or revenue) – Cost of Sales (or Cost of Goods Sold)
= Gross Profit (or Gross Margin)
Gross Profit – Operating Expenses = Net Operating Profit
Net Operating Profit + Other Income – Other Expenses = Net Profit
Before Taxes
Net Profit Before Taxes – Income Taxes = Net Profit (or Loss)
Accrual basis: All revenues (whether received in cash or not) and
expenses (whether paid in cash or not) are recorded on accrual
basis
Component /
Classification
Explanation
1.
Primary source of Income; total income / revenue / sales
Sales / Gross from ordinary course of business. Sales is same as
Sales / Net Sales Income OR Turnover. Net sales = Gross sales – returns –
allowances – duties and taxes.
2.
Cost of Goods
Sold / Cost of
Sales / Cost of
Services
3.
Gross Margin
4.
Operating
Expenses
5.
Other non-operating income (gain on sale of assets /
Other income /
investments) or expenses (loss due to currency
expenses
fluctuations, interest expenses).
6.
Taxes / provision
Tax liabilities arising in relation to the income reported.
for taxes
7.
Excess of revenues over expenses. Represents an
economic benefit to the firm by way of inflows or
Profit / PAT / Net increase in assets or decrease in liabilities except
Income
contribution by equity participants. Other gains and
losses are included in Net income. These may or may not
result from ordinary business activity.
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Direct costs (recall your learnings from Part 1) related to
the products and / or services offered by the company.
This will include direct material, direct labour and (fixed
and variable) factory overheads.
Net Sales - Cost of Goods Sold / Cost of Sales / Cost of
Services.
All other costs and expenses incurred to earn the
revenue but that are not included on cost of goods sold.
Components of profit & loss statement (Cont’d…)
Non Cash Expenses
Note: US listed companies
include depreciation in the
COGS,
while
Indian
companies
report
it
separately below EBITDA
Revenue
Wages
material
Cost of Goods Sold
Overhead
Depreciation
Gross Profit
Salary
Sales
SG&A
Marketing
EBITA
Amortization
Operating Profit (EBIT)
Interest
Profit before tax
Income Tax
Deferred
Taxes
Net income
Production
Employees
Suppliers
Employees/
Suppliers
Non-Cash
Support Staff
Sales
Advertising Non-Cash
Debt
Investors
Govt.
Non-Cash
Taxes
Net
Income
Equity
Investors
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Revenue drivers
• Variables whose mathematical operations
will result into revenue.
• First level: Revenue, R = Price, P x Quantity,
Q
• Second level: P and Q will have their own set
of drivers
• Case of Airlines?
• Case of Banks
Refer to Note 2 for estimating the revenue drivers from various industries
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Revenue drivers (Cont’d…)
Page 18
Revenue drivers (Cont’d…)
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Revenue drivers (Cont’d…)
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Cost drivers
• Variable costs: Cost which varies in direct proportion to the activity level within a relevant range.
Example: direct material cost, direct labour cost, direct variable O/H, direct selling & admin cost.
Variable costs / unit of output remain constant in relevant range.
• Fixed costs: Cost which remains constant irrespective of the activity level within a relevant range.
Relevant Range is the range of activity level within which variable cost/unit and fixed cost remain
same.
• Fixed costs can be discretionary fixed costs, say for example: advertising, administrative expenses,
salaries or committed costs such as facility related costs, say for example rent & insurance and
depreciation.
• There is no impact on total fixed costs due to movement in activity level however management may
change some costs such as advertising spending, management salaries etc. Fixed costs / unit are
inversely related to the activity level. Increase in activity level reduces fixed cost / unit and decrease in
activity level increases fixed cost / unit.
• In practise, there is hardly any costs that remain constant with activity levels of the company. In the
long run, every cost changes with the activity level. A cost may remain fixed in a short run or relevant
range (as long as activity level is range bound) but it can’t remain fixed throughout over the life of the
firm or significant changes in the activity level (activity level moves outside the relevant range). In the
long run, every cost will behave as a variable cost.
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Interpretation & preliminary analysis of P&L Statement
Ratio analysis is used to describe relationships between different variables used in financial statements. It is
extensively used to make comparison between different companies and between different time periods.
Profitability Ratios
• Indicator of how well the company generates operating profits and net profits from its sales.
• Examples: net, gross, and operating profit margins, pretax margin.
Examine the P&L
statement of
Amazon, Swiggy
& Nykaa
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Module 3: Cost behavior
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Costs behaviour
• Total revenues and variable costs will increase with increase in output and vice versa (Linear and proportionate
relationship)
• Total fixed costs will remain constant with increase / decrease in output (fixed relationship)
• Total costs will increase with increase in output and vice versa.
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Cost Drivers
Direct costs are associated with
the production cycle, while
indirect costs keep the production
cycle operating. The cost of
materials is an example of a
direct cost, while utilities are an
example of an indirect cost.
Direct costs are used purely in
the production of a product.
Indirect costs are those used
specifically to keep a business
running.
Direct manufacturing costs can also
affect profitability. Higher prices for
materials as well as other expenses
related directly to the
manufacturing or production of a
part can drive up costs.
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Module 4: Break-even analysis
Page 26
Contribution margin & break-even analysis
• Contribution margin is defined as revenue in excess
of variable costs. Total contribution margin =
revenue – variable costs.
• Hence, contribution margin / unit = revenue / unit –
variable cost / unit
• A Breakeven Point (BEP) is the production level at
which total revenue is equal to total cost (variable +
fixed) hence operating income at BEP is nil.
• At BEP: Total Revenue – Total variable cost – total
fixed cost = 0
• If a firm manufactures above or below its BEP level,
it will have operating profit or loss respectively.
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Break-even analysis
Excel based Numerical Examples…….
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Start-up contribution margins: CM1, CM2 & CM3
Multiple definitions of CM1, CM2 and CM3 are floating in
the market as these are not accounting terms from the
field of corporate finance, but rather metrics from the
field of startups and venture. These terms CM1, CM2, CM3
are not frequently encountered outside the startup
world.
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Understanding CM1, CM2 & CM3
CM1 (Contribution Margin 1):
• Is what’s left after the cost of the goods has been accounted for.
• Calculated as = Product and Shipping revenue minus cost of goods sold (COGS).
• This is an indicator of your core product margin.
• You can make CM1 higher by increasing prices; increasing shipping fees; reducing discounts; purchasing the
goods for less; or changing the mix of products purchased into higher margin products.
CM2 (Contribution Margin 2):
• Is what’s left after all costs associated with fulfilling the order have been accounted for (think of it as all costs
except marketing).
• Improving CM2 with the same CM1 is about more efficiency/savings in warehousing, shipping, packaging,
customer service and card processing costs.
CM3 (Contribution Margin 3):
• The aim is to optimise your CM3 – the money left to pay salaries, office costs etc.
• Whatever is left after your overheads is your profit.
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Understanding CM1, CM2 & CM3 (Cont’d…)
•
As a business scales, all costs and revenue grow.
•
However, if a business is to become profitable,
revenue should grow the fastest, followed by
variable costs, and then fixed costs slowest of all.
•
The widening gap between revenue and variable
costs leads to an increasing CM2, which eventually
covers all fixed costs, making the business
profitable. This is why CM2 matters.
•
A positive CM2 assures us that the business has
the potential to be profitable in the future.
Excel based Numerical Examples…….
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Module 5: Cash flow statement & its
analysis
Page 32
Components of cash flow statement
Sl.
No.
Component /
Explanation
Classification
1.
Cash flows arising out of transactions that involve the
firm’s primary activities. This includes the main route by
which any company intends to make profits. It includes the
Cash
flow
day to day business functions of a company. Examples:
from
Collection from Debtors / Cash Sales, Proceeds from sale
operating
of trading securities, Tax refund, Payment to suppliers,
activities
Payment for other expenses, Taxes paid. Excludes noncash items such as depreciation, amortization, impairment,
deferred payments etc.
2.
Cash flows arising out of activities associated with the
Cash
flow
acquisition and disposal of long term assets. Examples of
from
inflows: Sale of PPE, Sale of investments other than trading
investing
securities; Example of outflows: Purchase of PPE,
activities
Acquisition of investment other than trading securities etc.
3.
Cash flows arising out of activities related to obtaining or
Cash
flow repaying capital to be used in the business. Examples of
Inflows: Issuance of shares, Receipt of loan from financer,
from
financing
Issue of debentures; Example of outflows: Payment for
debentures, Buy back of stocks, Loan repayment, Dividend
activities
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paid to shareholders etc.
Components of cash flow statement (Cont’d…)
Cash Inflow
• From Operating Activities
• Decrease in inventory(sale)
• Decrease in a/c receivable
• Increase in a/c payable
• Increase in bills payable
• From Investing Activities
Cash Outflow
 To Operating Activities
• Increase in a/c receivable
• Increase in inventory
• Decrease in a/c payable
• Decrease in bills payable
• Disposal of property, plant, equipment
• Taxes paid
• Disposal of intangibles
• Interest paid
• Receipt of interest
• Receipt of dividends
• From Financing Activities
• Issue of equity
• Borrow debt
 To Investing Activities
• Purchase of fixed assets, intangibles
• Acquire business
 To Financing Activities
• Repay debt
Excel based Numerical Example to explain accrual versus cash flow
• Buyback equity, Pay dividend
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Cash burn rate and runway
Burn Rate
•
Indicates how fast the startup is spending money.
•
Helps calculate cash runway and decide if you want to cut costs
or invest a little more in processes like marketing or hiring new
talent.
•
Makes you aware of leakages or anything else that might
indicate your business is spending money on unimportant
expenses.
•
To calculate monthly burn rate, take the total amount of money
at the beginning of the month and just subtract the total amount
of money at the end of the month.
Cash Runway
•
How long the money is going to last
•
Decide if you need to improve your fundraising efforts, cut some
expenses or come up with a better sales strategy.
•
To calculate your cash runway, divide cash balance by monthly
burn rate.
•
Track sales pipeline alongside cash runway to have a better
picture of company’s cash flow.
Excel based Numerical Examples…….
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Module 6: Financial metrics and
performance indicators
Page 36
Financial metrics and performance indicators
1. Customer Acquisition Cost (CAC)
•
Basically, the cost of acquiring a new customer
•
One of the most important growth metrics for an early and growing startup company since customers are the ones generating
revenue.
•
To calculate CAC, pick a specific time period, like a quarter, and then divide the cost of marketing and sales by the number of
customers gained during that period.
•
A lower CAC is better
•
Perfectly normal to have a high CAC at first when you’re trying to get noticed by your target customers, the challenge here is to
lower your CAC so it becomes profitable.
•
Unless you launched a new product or service that required a whole new campaign, the rising CAC is a crystal sign of danger
and that you won’t be able to keep the ship above water for long.
2. Retention Rate (RR)
•
% of customer retained over a time period
•
Retention rate = 1 – churn rate; Churn rate = % of customers deserted you
•
important to nurture the customers you already have, otherwise they’ll eventually feel abandoned and not cared for and will
probably take their business elsewhere.
•
Think about your CAC, think about how much it is costing you to acquire a new customer to later neglect them just to spend
more money on getting a new customer. Doesn’t sound profitable, right?
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Financial metrics and performance indicators (Cont’d…)
3. Customer Lifetime (CLV, or LTV for “lifetime value”)
•
Helps you predict future value and measure long-term business
success
•
Tells you how much profit your company can expect from a typical
client over the course of the relationship.
•
More to the point, CLV helps you estimate how much you should
invest in order to retain a customer.
4. Viral Coefficient
•
Measures your organic growth.
•
When trying to launch your product, you’re probably going to share it
with friends and close acquaintances, if they like it, they’re going to
share it and invite others.
•
To calculate your Viral Coefficient you need to have your initial
amount of customers (before starting sharing it), the number of
invites sent to potential customers, and the percentage of acquired
customers through those invites. This rate over several cycles is
your Viral Coefficient.
•
Allows you to see if your product has a positive response and
therefore if it’s eventually going to be profitable.
Doesn’t take into account the time value of money
Takes into account
the time value of
money but
assumes infinite
lifespan
The best way to calculate CLV is to forecast the value
period wise over the lifespan and discount the same
at the cost of capital.
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Financial metrics and performance indicators (Cont’d…)
5. Return on Advertising Spend (ROAS)
•
They say the best advertising is word of mouth, and though that might be true and it’s also free, it’s very hard to get people to
talk about your product.
•
If you’re a startup, you surely need to have an advertising budget to move your product and take it to the right audience,
expecting a fair return of it.
•
ROAS calculates such a return, just divide the value of sales that came from your advertising spending over a period of time.
6. Monthly Recurring Revenue
•
Basically, this is a measurement of how much revenue your customers generate in one month, either new users or monthly
active users.
•
MRR is one of the major startup metrics to keep an eye on. It will help you understand your company’s growth, the market, and
even predict future revenue (considering your Customer Acquisition Costs and Churn rates are on point).
Excel based Numerical Examples…….
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Module 7: Fundamentals of Corporate
Finance
Page 40
A. The capital budgeting & understand its relevance
B. Types of capital budgeting projects
• The process for making long term investment decisions
• To evaluate the viability of capital expenditure decision
• Planning expenditures for investments on which the
returns are expected to occur over a period of more
than 1 year
1. Expansion
projects
2. New
product
development
• Examples: Acquisition or disposal of long-term assets
and the financing ramifications of such decisions
• Investment is large and directly impacts company’s
operation & growth over multiple years
• Follows a particular process and is subjected to various
tools of rigorous analysis
Sl.
Projects
Description
1.
Independent
If the cash flows of one are not
affected by the acceptance of the other.
Hence, multiple projects can be
selected.
2.
Mutually
Exclusive
Acceptance of one automatically leads
to rejection of other projects
Types of capital
budgeting projects
6.
Acquisitions
&
investments
5. Mandatory
projects
3.
Replacement
projects
4. Entry into
a new
geography
Page 41
C. Steps in capital budgeting process
1. Identification of
requirement/oppo
rtunity
2. Preliminary
Search & proposal
diligence
• Assessment of the type
of capital expenditure
project required in line
with a company’s goals
and objectives
• Preliminary research
and exploration of all the
options and alternatives
available around the
capital investment theme
• Ideas and suggestion can
emanate from any
department or
managerial level in the
organization
• Proposal diligence by
each department in the
entity’s value chain to
pass only value accretive
projects to the next
stage
• Crucial most important
step in the process and
also leads to the
initiation of the capital
budgeting process
3. Evaluation &
Assessment
• Quantitative and
qualitative analysis of
available information
• Quantitative - Estimating
initial capital outlay,
subsequent years’ cash
flows, the net working
capital requirements, the
salvage value
• Qualitative: Nonfinancial
measures such as
customer expectation
and satisfaction, need for
training, government
requirements, tech
evolution etc.
4. Selection &
Financing
• Selection on the basis of
financial analysis (NPV,
IRR or payback period)
and nonfinancial
considerations.
• Risk and return profile of
all the projects
compared
5. Implementation
& monitoring
• This is the final stage in
which the project is
implemented and
monitored over time to
ensure project develops
as per schedule.
• Projects passing the
internal benchmarks
(qualifying criteria) of the
company are selected
• Once the projects are
shortlisted, Management
starts exploring funding
avenues for the project.
Source of funding can be
internal accruals, debt or
equity.
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A. The concept of Time Value of Money (TVM)
B. The hurdle rate
• Money has the ability to grow. Hence, the money available
now is worth more than the same amount in the future, (A
$ today is more valuable than a $ tomorrow)
• A future cash flow therefore needs to be discounted to get
its present worth
• The discount rate (also called hurdle rate) is the minimum
acceptable rate of return (MARR) on a capital investment
project
• A reflection of time value of money, inflation premium and
risk premium
• A compensation desired by an investor for investing into a
project
Present value of a future cash flow is that value of cash required today that will grow to the future value if invested
at MARR. Hence, present value of a cash flow (CFt) in period t (years) from now at a hurdle rate of k is given by
𝑷𝑽 𝑪𝑭𝒕 =
𝑪𝑭𝒕
1+𝒌
𝒕
Page 43
C. Capital Budgeting Tools (NPV)
Net Present Value (NPV) Method
Hurdle rate (the discount rate)
• Discounts all the future cash flows of the firm with the hurdle
rate to obtain their present values.
• The discount rate used here can be interpreted as:
• The present values of all the future cash inflows are
aggregated and netted against the present values of all the
future cash outflows to obtain NPV.
𝑵𝑷𝑽 = 𝑷𝑽 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔 − 𝑷𝑽 (𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔)
• In case, the project involves just one cash outflow in t = 0 and
cash inflows in subsequent year (normal or conventional
project) then,
•
•
•
Minimum return required by the firm from a capital investment
A return which is available to the company had it invested the funds
in an alternative with same risk profile
Desired rate of return, hurdle rate, threshold rate, opportunity cost
of capital
• Should be appropriate to the risk of the project & reflect
all the three factors behind time value of money:
inflation, uncertainty and opportunity costs.
• Is not directly observable, is subjective and varies from
investor to investor.
• Two commonly used surrogates for discount rate are:
𝑵𝑷𝑽 = 𝑷𝑽 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔 − 𝑷𝑽 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔
•
𝒏
=
𝒕
•
𝟏
𝑪𝑭𝒕
− 𝑪𝑭𝟎
𝟏+𝒌 𝒕
Minimum rate of return: based on firm’s strategic objectives, industry
averages and common investment opportunities.
Weighted average cost of capital: weighted average cost of funding
instruments used by the company for financing the project.
A project’s NPV is the present value of the project’s future expected cash flows minus the proposal’s initial cash
outflow. Standard functions in Microsoft Excel (NPV, XNPV) uses periodic cash flows and discount rate for
calculations.
Page 44
C. Capital Budgeting Tools (IRR)
• IRR is the annualized effective compounded rate or return that can be earned on the capital invested.
• IRR is that discount rate at which NPV of a project (capital investment) is zero. It’s that discount rate
which makes the sum of present value of all the future cash inflows same as that of all the future cash
outflows.
• Mathematically, IRR is solution to k from the equation below:
𝑵𝑷𝑽 = 𝑷𝑽 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔 − 𝑷𝑽 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔
𝒏
=
𝒕
• Alternatively,
𝒏
𝒕
𝟏
𝟏
𝑪𝑭𝒕
− 𝑪𝑭𝟎 = 𝟎
𝟏+𝒌 𝒕
𝑪𝑭𝒕
− 𝑪𝑭𝟎 = 𝟎
𝟏 + 𝑰𝑹𝑹 𝒕
IRR is that hurdle rate that makes the NPV of an investment zero. Standard functions in Microsoft Excel (IRR, XIRR)
Page 45
uses periodic cash flows for calculations.
C. Capital Budgeting Tools (Payback period)
Payback Period Method
• (Simple) Payback period is the time period taken to recover the initial cost of an investment.
• Future net cash inflows are compared with the net initial investment to determine the time it will take to recoup
the net initial investment, without taking the time value of money into consideration.
• In case of uniform cash flows
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒂𝒏𝒏𝒖𝒂𝒍 𝒏𝒆𝒕 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘
• In case of uneven cash flows:
𝑼𝒏𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒆𝒅 𝒄𝒐𝒔𝒕 𝒂𝒕 𝒕𝒉𝒆 𝒚𝒆𝒂𝒓 𝒃𝒆𝒈𝒊𝒏𝒏𝒊𝒏𝒈
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 = 𝒀𝒆𝒂𝒓𝒔 𝒖𝒏𝒕𝒊𝒍 𝒇𝒖𝒍𝒍 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚 +
𝑪𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘 𝒅𝒖𝒓𝒊𝒏𝒈 𝒕𝒉𝒆 𝒚𝒆𝒂𝒓
Discounted Payback Period Method
• Addresses payback period’s limitation of ignoring time value of money.
• Uses the present value of cash flows instead of undiscounted cash flows to calculate the payback period.
• Each year’s cash flow is discounted using an appropriate discount rate, and then those discounted cash flows are
used to calculate the payback period.
Mathematically, payback period is the time when cumulative cash flows of the project turns zero.
Page 46
C. Capital Budgeting Tools (Profitability Index)
• Profitability Index determines the ratio of the PV of net future cash flows (both inflows and outflows) to
the amount of the initial investment.
• All future cash flows are in the numerator and all initial cash flows are in the denominator.
• 𝑷𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑰𝒏𝒅𝒆𝒙 𝑷𝑰 =
𝑷𝑽 𝒐𝒇 𝒏𝒆𝒕 𝒇𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔
𝑵𝒆𝒕 𝒊𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
• In case of a conventional (or normal) project:
𝑷𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑰𝒏𝒅𝒆𝒙 𝑷𝑰 =
∑𝒏𝒕
𝑪𝑭𝒕
𝟏+𝒌
𝑪𝑭𝟎
𝟏
𝒕
=
𝑵𝑷𝑽 + 𝑪𝑭𝟎
𝑵𝑷𝑽
=𝟏+
𝑪𝑭𝟎
𝑪𝑭𝟎
Profitability index thus measures the return in present value per unit of money currently invested in a project.
Page 47
D. Decision Criteria
Under NPV Method
Sl. No. Criteria
Decision
Under IRR Method
Sl. No. Criteria
Decision
1.
If NPV > 0 Accept the project
1.
If IRR > RRR
Accept the project
2.
If NPV < 0 Reject the project
2.
If IRR < RRR
Reject the project
3.
If NPV = 0 Indifferent
3.
If IRR = RRR
Indifferent
Under Payback Period Method
• The generic decision criterion is shorter the payback period,
better the project is.
• Widely used in industries where the lifecycle of the project is
very short.
• Also used when investor is more interested in capital
preservation rather than earning interest.
Under Profitability Index (PI) Method
• If PI > 1.0, accept the project
• If PI < 1.0, reject the project
• Amongst many projects, select the project with highest PI
first and in descending order subsequently
• If projects are independent: Accept all the projects which satisfy the decision criteria
• If projects are mutually exclusive: Accept the project with highest NPV (or IRR) or lowest payback period.
• If there is a capital rationing (limited capital available), size of the project can render it ineligible for selection even if it meets the
NPV or IRR or any other investment decision criteria.
Page 48
E. Relative advantages and disadvantages of NPV and IRR
methods
• NPV is an absolute value unlike IRR, which is a %. For some decision makers, IRR is easier to visualize and interpret than NPV.
• For conventional projects, the NPV and IRR will agree on whether to invest or not to invest.
• NPV and IRR may give conflicting results if there is difference in project size, cash flow pattern, project life or cost of capital over
the project term.
• Generally, NPV is preferred for evaluating capital budgeting projects. It is consistent with the objective of maximizing
shareholder’s wealth. Shareholder’s wealth is the NPV of the firm’s future cash flows at its weighted average cost of capital.
• NPV values of individual projects can be added together to estimate the effect of accepting some possible combination of
projects.
• Since IRR is a %, multiple projects can’t be added or averaged to evaluate combination of projects.
• Both the methods have heavy reliance on the hurdle rate. Any error in estimating the benchmark rate can lead to a wrong
selection of projects by both the methods.
• NPV is appropriate in cases where required rate of return for a project varies over the project tenure since discounting can be
done at different required rates. In case of IRR, comparison of project IRR will be difficult with multiple required rate of return.
• A project will have as many IRRs as many times its cash flow changes its sign. So in a project with a mix of positive and negative
cash flows during the tenure of the project, there will be multiple IRRs. However, in most of the cases, it has been seen that just
one of them will be a reasonable value while all others will be quite unreasonable or even negative. See example below.
• An IRR ignores the size of the project completely.
• The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when
allocating capital.
Page 49
E. Relative advantages and disadvantages of the payback
and discounted payback methods
Sl. No. Parameter
1.
Advantages
Payback period method
Discounted payback period method

Simple & easy to understand & calculate


Useful for a quick, preliminary screening when
there are many proposals

Useful when expected cash flows in later years of

the project are uncertain

2.
Disadvantages
Useful tool for project evaluation where risk of

technological obsolescence exist

Ignores time value of money

Ignores post payback period cash flows

Ignores the cost of capital,

Does not give weight to profitability

Bias towards short term projects irrespective of
profitability

Concept easy to understand but calculation may
be tedious as every years cash flow needs to be
discounted separately even in case of annuity
or constant cash flows
Overcomes the Payback Method’s weakness of
not accounting for the time value of money
Other benefits of payback period method
Still fails to account for cash flows after the
payback period
Page 50
Integrated Use Case
EV Corporation is contemplating upon its fleet replacement. It
intends to replace the fleet of conventional vehicles with electric
vehicles. There will be an initial outlay of $ 15 mn towards
purchase of the new electric vehicles and another $ 2 mn
towards their transportation, certification and installation of
tracking devices. The firm would have to commit an incremental
$ 4 mn of working capital. The new fleet is expected to generate
$ 6 mn of annual cash savings for 5 years and is expected to
have a salvage value of $ 1 mn. The existing fleet that would be
sold to make room for the project. A scrap dealer has agreed to
buy it for $ 1 mn. EV Corporation undertake capital projects only
if they generate a pre tax return in excess of 12%. It prefers a
capital project with payback period of 3 years or less. (Ignore
taxes).
Tasks in hand
1.
As a first step, identify the relevant cash
flows year-wise and plot it on timeline.
2.
Find the net cash flows year-wise.
3.
Find the NPV, IRR and Payback period.
4.
Present your recommendations to EV
Corporation.
Solution and workings will be demonstrated in
the Microsoft Excel file
Page 51
Module 8: Introduction to valuation methods
Page 52
Drivers of a start-up valuation
Intellectual Property
Business & Revenue Model
•
•
•
•
•
•
Solve a recurring, real & significant problem
Ease of replication
Risk factors
03
Building bocks of sustainable differentiator
Proprietary technology
Patents, trademarks, copyrights
04
Current Stage
Ability to do what it takes
•
•
•
•
Founders background
Mission, Vision & values
Execution team
Motivation, passion, skin in the game
Potential to grow & scale up
•
•
•
•
Disruptive idea
Unique & sustainable advantage
Product market fit
Size of market disruption
02
•
•
•
•
05
Drivers of
Valuation
01
06
Journey so far
Stage of funding
Risk reward profile
Path to profitability
Technology Integration
•
•
•
•
Potential to leverage AI, ML
Streamline processes
Improve communication & collaboration
Increase efficiency and reduce costs
Page 53
Questions asked by investors
Competition
TAM
Model
•
Current size, future growth
•
Is the space crowded?
•
Recurring revenues?
•
Macro trends, timing
•
Any differentiator?
•
Value proposition?
•
Customer intent
•
Entry barriers
•
Length of sales cycle
Traction
Product
•
Market fit?
•
Growth
•
Scalable?
•
Customer attention
•
Moat, if any?
•
Customer retention
Financials
•
Previous rounds, prior
valuations
•
Burn / future dilution
Page 54
Principles and Methodologies
Challenges in
valuation
•
Limited or no historical
Principles
followed
•
financial data
Valuation
methods
Analyze the growth
•
Fixed Range
potential
•
Cost Approach
•
Uncertain forecasts
•
Assess the market factors
•
Scorecard Valuation
•
Limited operations
•
Evaluate the qualitative
•
VC Method
•
Proof of concept has not
factors
•
Discounted cash flow
Search for stability in
•
Market or comparable
been developed yet
•
Lack of objective data
•
uncertainty
transaction multiples
The list is infinite, and the analysts will often use a combination of the methods
Page 55
Principles and Methodologies
Page 56
Fixed Ranges Method
Incubators propose a ‘take or leave’ investment, which is based on the fixed ranges
of capital offered in exchange for a share of equity
The Berkus Approach
Up to
$ 0.5
million
Up to
$ 0.5
million
Up to
$ 0.5
million
Up to
$ 0.5
million
Up to
$ 0.5
million
Values a startup based on a detailed assessment of five key success factors for a theoretical maximum
pre-money valuation of $ 2.5 million
Sound Idea
(Basic Value)
Prototype
(Reducing
technology risk)
Quality
Management
Team (Reducing
execution risk)
Strategic
Relationships
(Reducing market
risks)
Product Rollout
or Sales
(Reducing
production risk)Page 57
Risk Factors Summation Approach
STEP 1: FIND THE
AVERAGE INDUSTRY
PRE-MONEY
VALUATION
Risk Factors
STEP 2: CONSIDER
12 RISK FACTORS
CORRELTED WITH
THE START UP & ITS
INDUSTRY
Ratings
Addition/Subtraction
Management Risk
+2
$ 500,000
Stage of the Business
-1
$ (250,000)
Legislation/Political Risk
+1
$ 250,000
Manufacturing Risk (or Supply Chain Risk)
0
$-
Sales and Marketing Risk
+1
$ 250,000
Funding/Capital Raising Risk
0
$-
Competition Risk
-2
$ (500,000)
Technology Risk
-1
$ (250,000)
Litigation Risk
0
$-
International Risk
0
$-
Reputation Risk
0
$-
Exit Value Risk
+1
$ 250,000
-
$ 250,000
Sum
STEP 3: CASTIGATE
ALL THE RISK
FACTORS
STEP 4: ADD THE
PRE-MONEY
VALUATION
• Finally, add the average industry pre-money
valuation to the adjustments.
• The pre-money valuation of the target startup
= Average industry pre-money valuation [+]
Adjustment
= $ 2,500,000 [+] $ 250,000)
= $ 2,750,000
= $ 2.75 million
Page 58
The Cost Approach
The cost approach sets the idea that an investor is willing to cover the costs that have
already been incurred to get the target entity to its current stage
•
•
•
•
•
Calculates all expenditures linked to the
from-scratch development of products
or services to arrive at a startup
valuation
Set up cost
Recruitment, salaries,
Product implementation
Inventory
Office rent………
• Excludes intangible assets such as
brand value, team quality, and the
overall potential for future growth
• Usually generates lower startup
valuations
• Underestimates the venture's worth,
especially for companies developing
innovative solutions
Page 59
The Scorecard Valuation Method
The investors have a list of criteria based on which the target entity and its peers are
evaluated
Multiply the total
score by your
baseline valuation
(1.24 x $ 10 million =
$ 12.4 million)
Page 60
The Venture Capital (VC) Method of Valuation
The value of the target entity is estimated as the value after a few years (the so called
‘exit-value’). That value is then discounted to the present value using a discount rate.
The VC Method is all
about projecting a future
state and then working
backwards to derive the
current
pre
money
valuation
Page 61
The Discounted Cash Flow (DCF) Method of Valuation
The DCF method is used for companies where cash flows can be reasonably estimated
1. The DCF approach estimates the value of
the target entity based on its expected future
free cash flows
2. The cash flows are discounted to
the present value using an appropriate
discount rate
Typical discount rate ranges as per stage
Source: PwC Deals insights: How to value a start-up business
Page 62
The Market or Comparable Transactions Multiple Method
of Valuation
The potential investors could consider either the current market price of publicly traded
peer companies or the previous comparable transactions with disclosed multiples
Often used multiples: enterprise value-to-revenue (EV/R), enterprise value-to-EBITDA
(EV/EBITDA), enterprise value-to-EBIT (EV/EBIT), and enterprise value-to-free cash
flows (EV/FCF)
Page 63
Thank You
Page 64