Finance and Economics Compendium FINANCE AND ECONOMICS COMPENDIUM Table of Contents PART I: ACCOUNTING AND FINANCE ............................................................................................................ 6 FINANCIAL REPORTING ............................................................................................................................... 6 BASICS OF ACCOUNTING ......................................................................................................................... 6 BOOKKEEPING ......................................................................................................................... 6 FINANCIAL REPORTING .............................................................................................................. 6 ACCOUNTING PRINCIPLES .......................................................................................................... 6 TYPES OF ACCOUNTS ................................................................................................................ 7 GOLDEN RULES OF ACCOUNTING ................................................................................................. 7 ACCOUNTING EQUATION ........................................................................................................... 7 THE 3 FINANCIAL STATEMENTS .................................................................................................................... 8 INCOME STATEMENT ............................................................................................................................... 8 ELEMENTS OF INCOME STATEMENT .............................................................................................. 8 DEPRECIATION AND AMORTISATION ............................................................................................. 8 COMPREHENSIVE INCOME .......................................................................................................... 9 COMMON SIZE INCOME STATEMENT ............................................................................................ 9 FORMAT OF INCOME STATEMENT ................................................................................................. 9 BALANCE SHEET ................................................................................................................................... 10 ELEMENTS OF BALANCE SHEET .................................................................................................. 10 COMMON SIZE BALANCE SHEET ................................................................................................ 10 FORMAT OF BALANCE SHEET .................................................................................................... 10 CASH FLOW STATEMENT ....................................................................................................................... 11 ELEMENTS OF CASH FLOW STATEMENT ....................................................................................... 11 FREE CASH FLOW TO THE FIRM ................................................................................................. 12 FREE CASH FLOW TO EQUITY .................................................................................................... 12 FINANCIAL ANALYSIS TECHNIQUES ............................................................................................................. 13 RATIO ANALYSIS ................................................................................................................................... 13 LIQUIDITY RATIOS ................................................................................................................... 13 SOLVENCY RATIOS .................................................................................................................. 15 ACTIVITY RATIOS .................................................................................................................... 17 PROFITABILITY RATIOS ............................................................................................................. 18 VALUATION RATIOS ................................................................................................................. 20 GRAPHICAL ANALYSIS ............................................................................................................................ 23 2 FINANCE AND ECONOMICS COMPENDIUM REGRESSION ANALYSIS .......................................................................................................................... 23 DUPONT ANALYSIS: .............................................................................................................................. 23 CORPORATE FINANCE ................................................................................................................................ 24 ROLE OF CORPORATE FINANCE .............................................................................................................. 24 CAPITAL BUDGETING ............................................................................................................................. 24 INTRODUCTION ...................................................................................................................... 24 KEY PRINCIPLES OF CAPITAL BUDGETING ...................................................................................... 24 THE CAPITAL BUDGETING PROCESS ............................................................................................ 24 A FEW CONCEPTS TO KEEP IN MIND ...................................................................................................... 25 SUNK COST ........................................................................................................................... 25 OPPORTUNITY COST ............................................................................................................... 25 DISCOUNT RATE/ TIME VALUE OF MONEY .................................................................................. 26 CANNIBALISATION .................................................................................................................. 26 DECISION CRITERION .............................................................................................................. 27 COST OF CAPITAL ................................................................................................................................. 30 INTRODUCTION ...................................................................................................................... 30 OPTIMAL CAPITAL BUDGET ...................................................................................................... 31 COST OF DEBT....................................................................................................................... 31 COST OF PREFERRED STOCK ..................................................................................................... 32 COST OF EQUITY .................................................................................................................... 32 DIVIDENDS .......................................................................................................................................... 33 DIVIDEND POLICY ................................................................................................................... 33 THEORIES OF DIVIDEND POLICY ................................................................................................ 33 SIGNALLING HYPOTHESIS ......................................................................................................... 33 CLIENTELE EFFECT .................................................................................................................. 34 RESIDUAL DIVIDEND MODEL .................................................................................................... 34 STOCK REPURCHASES ............................................................................................................................ 34 REASONS FOR REPURCHASES .................................................................................................... 34 ADVANTAGES O F REPURCHASES ................................................................................................ 34 DISADVANTAGES OF REPURCHASES ............................................................................................ 34 STOCK DIVIDENDS VS . STOCK SPLITS ........................................................................................... 35 REASONS FOR STOCK DIVIDENDS OR STOCK SPLIT ........................................................................ 35 CONCLUSION ......................................................................................................................... 35 MERGERS AND ACQUISITIONS .................................................................................................................... 36 INTRODUCTION .................................................................................................................................... 36 WHY MERGERS AND ACQUISITIONS TAKE PLACE ? ...................................................................................... 36 3 FINANCE AND ECONOMICS COMPENDIUM FORMS OF ACQUISITIONS ..................................................................................................................... 37 METHODS OF PAYMENT ........................................................................................................................ 38 METHODS OF VALUATION ....................................................................................................................... 38 VALUATION TECHNIQUES ........................................................................................................................... 39 VALUATION TECHNIQUES ....................................................................................................................... 39 COMPARABLE COMPANIES ANALYSIS .......................................................................................... 39 PRECEDENT TRANSACTION ANALYSIS .......................................................................................... 44 DISCOUNTED CASH FLOW METHOD ........................................................................................... 46 DIVIDEND DISCOUNT MODEL ................................................................................................... 52 CAPITAL MARKETS .................................................................................................................................... 53 PRIMARY AND SECONDARY MARKETS ..................................................................................................... 53 1. PRIMARY MARKET .............................................................................................................. 53 2. SECONDARY MARKET .......................................................................................................... 53 DERIVATIVES ............................................................................................................................................ 55 BASIC TERMS ....................................................................................................................................... 55 FIXED INCOME & BONDS .......................................................................................................................... 57 ELEMENTS OF FIXED I NCOME SECURITIES ................................................................................................ 57 ISSUERS OF BONDS ................................................................................................................. 57 BOND MATURITY ................................................................................................................... 57 PAR VALUE ........................................................................................................................... 57 COUPON PAYMENTS ............................................................................................................... 57 BOND INDENTURE .................................................................................................................. 57 CASH FLOW OF FIXED INCOME SECURITIES ................................................................................... 58 FIXED INCOME V ALUATION .................................................................................................................... 59 BOND PRICING ...................................................................................................................... 59 CALCULATING VALUE OF A BOND ............................................................................................... 60 FULL (DIRTY) AND FLAT (CLEAN) PRICE OF A BOND ....................................................................... 60 ASSET BACKED SECURITIES .................................................................................................................... 60 SECURITIZATION ..................................................................................................................... 61 TRANCHES ............................................................................................................................ 61 CREDIT ANALYSIS .................................................................................................................................. 61 CREDIT RISK .......................................................................................................................... 61 SENIORITY RANKING OF BONDS ................................................................................................. 61 CREDIT RATINGS .................................................................................................................... 62 4 C’S OF CREDIT ANALYSIS: ...................................................................................................... 62 CREDIT ENHANCEMENT TECHNIQUES .......................................................................................... 62 4 FINANCE AND ECONOMICS COMPENDIUM PRIVATE EQUITY AND VENTURE CAPITAL ..................................................................................................... 63 Private Equity .................................................................................................................................... 63 Venture Capital.................................................................................................................................. 63 PART II: ECONOMICS ............................................................................................................................ 63 INTRODUCTION ........................................................................................................................................ 63 WHAT IS ECONOMICS? ............................................................................................................ 63 MAJOR THEORIES IN ECONOMICS .............................................................................................. 63 MICRO ECONOMICS .................................................................................................................................. 64 BASIC CONCEPTS .................................................................................................................................. 64 TYPES OF MARKET STRUCTURES ................................................................................................ 64 MACRO ECONOMICS................................................................................................................................. 66 AGGREGATE DEMAND ............................................................................................................. 66 NATIONAL INCOME ................................................................................................................. 66 CONCEPTS OF NATIONAL INCOME .............................................................................................. 66 PROBLEM OF DOUBLE COUNTING .............................................................................................. 67 METHODS TO CALCULATE NATIONAL INCOME ............................................................................... 67 INFLATION ............................................................................................................................ 67 DEFLATION ........................................................................................................................... 68 DISINFLATION ........................................................................................................................ 68 STAGFLATION ........................................................................................................................ 68 CONSUMER PRICE INDEX ......................................................................................................... 68 FISCAL AND MONETARY POLICY ................................................................................................. 68 FDI & FIIS: ........................................................................................................................... 70 STOCK PITCH ............................................................................................................................................ 71 5 FINANCE AND ECONOMICS COMPENDIUM PART I: ACCOUNTING AND FINANCE FINANCIAL REPORTING BASICS OF ACCOUNTING BOOKKEEPING Bookkeeping is a process of recording and organizing all the business transactions that have occurred in the course of the business. Bookkeeping is an integral part of accounting and largely focuses on recording day-to-day financial transaction of the business. FINANCIAL REPORTING Refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing & presenting financial statements. ACCOUNTING PRINCIPLES Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial data. In the United States, the Financial Accounting Standards Board (FASB) issues generally accepted accounting principles (GAAP). Internationally, the International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). Some of the most fundamental accounting principles include the following: 1. Accrual Principle: It is a concept in accounting that mandates the recording of transactions in the time period in which they occur regardless of when the actual cash flows for the transaction are received. 2. Consistency Principle: According to this principle, when an organisation adopts a specific accounting method of reporting or documentation, then it should stay consistent with the method. The aim of this basic accounting principle is to make financial statements comparable across industries and companies. 3. Conservatism Principle: According to this principle, one should recognize expenses and liabilities at the early stages even if there is uncertainty about the outcome. However, the principle recognizes revenues and assets when there is an assurance of its receival. 4. Economic Entity Principle: This is a concept of accounting that requires businesses to be treated as a separate financial and legal entity. This means that the recorded activities of the business entity must be kept separate from the recorded activities of the owner and other entities. 5. Matching Principle: The matching principle is a concept in accounting that states that companies must report their expenses and revenues simultaneously. The revenues and expenses are matched on income statements for a specific time period. 6. Materiality Principle: As per the materiality principle, any item that may impact the decisionmaking process of an investor must be recorded. 6 FINANCE AND ECONOMICS COMPENDIUM 7. Full Disclosure Principle: As per the principle, each piece of information should be included in the financial statement of an entity. This is necessary since it might affect the reader’s perspective of understanding the statement. 8. Going Concern Principle: According to this accounting principle, a company will complete its recent plans, meet its financial obligations and use its existing assets. This process of continuing operations indefinitely must go on until the company has any evidence on the contrary. 9. Reliability Principle: This principle ensures that every transaction, business activity, event, etc is reliable when presented in the financial statement. Information should be associated with objective evidence and it can be checked, reviewed, and verified. 10. Revenue Recognition Principle: The revenue recognition principle states that you should only record revenue when it has been earned, not when the related cash is collected. TYPES OF ACCOUNTS Nominal Account: A nominal account is a normal ledger account that records all income, expenses, profits, and losses for a business. Real Account: A real account is a normal ledger account that can record all the assets and liabilities. It has both - actual and intangible assets. Tangible assets include furniture, land, buildings, machinery, and so on. Intangible assets, on the other hand, such as goodwill, copyright, patents, and so on. Personal Account: A personal account is a general ledger account that pertains to individuals. It can be natural persons - such as humans, or artificial persons, like corporations, firms, associations, and so on. GOLDEN RULES OF ACCOUNTING 1. Credit all income & gains and debit all expenses & losses – Nominal Account 2. Debit what comes in, credit what goes out – Real Account 3. Credit the giver and Debit the Receiver – Personal Account ACCOUNTING EQUATION The basic accounting equation reflects the basic relationship between assets, liabilities and equity. An entity’s assets are purchased using either debt (liabilities) or investment (equity). The basic equation of accounting is: Assets = Liabilities + Equity 7 FINANCE AND ECONOMICS COMPENDIUM THE 3 FINANCIAL STATEMENTS INCOME STATEMENT Income Statement reports the revenues and expenses of the firm over a period of time. It is also known as statement of earnings or profit & loss statement (P&L). Revenue – Expenses = Net Income ELEMENTS OF INCOME STATEMENT 1. Revenues are amounts reported from sale of goods and services in the normal course of business. 2. Expenses are amounts incurred to generate revenue and include cost of goods sold, operating expenses, interest and taxes. 3. Gross Profit is the amount that remains after direct cost of production are subtracted from revenue. 4. Operating Profit is the amount that remains after deducting operating expenses, such as selling, general & administrative expenses, from gross profit. EBIT (Earnings before interest and tax) is also used as a proxy for operating profit. 5. Net profit/Net Income is the amount that remains after interest and income taxes are deducted from operating profit. Revenue is often referred to as “Top Line” & Net Profit is referred to as “Bottom Line” DEPRECIATION AND AMORTISATION Depreciation is the allocation of the cost of a long-lived asset over the life of the asset. Long-lived assets are expected to provide benefits over an asset’s life, hence the cost of these are capitalised on the balance sheet (created as an asset), instead of being expensed in the current period. Over the course of the estimated life, this asset’s value is reduced by the amount of depreciation which is reported in the income statement as an expense every year. There are two methods of calculating depreciation: 1. Straight Line Depreciation: This method recognizes an equal amount of depreciation expense each year. ππΏ π·ππππππππ‘πππ ππ₯ππππ π = πΆππ π‘ − π ππ πππ’ππ ππππ’π ππ πππ’π ππππ 2. Accelerated Depreciation: It speeds up depreciation recognition in a way to recognize more depreciation in the initial years of the asset’s life. Amortisation is the allocation of the cost of an intangible asset over the life of the asset. These include patents, copyrights, trademarks etc. 8 FINANCE AND ECONOMICS COMPENDIUM Intangible assets with indefinite lives, e.g. goodwill, are not amortised but are tested for impairment at least annually. COMPREHENSIVE INCOME Net income is equal to revenue minus expenses. Comprehensive income is more complex and is the sum of net income and other comprehensive income (OCI), which includes income such as foreign currency translation gains/losses, adjustments for minimum pension liability, unrealized gains/losses from cash flow hedging activities and from available-for-sale securities. COMMON SIZE INCOME STATEMENT A Common Size Income Statement expresses each item on the income statement as a percentage of revenue. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis. FORMAT OF INCOME STATEMENT ABC Company Income Statement For the years ending Dec 31, 2021 and Dec 31, 2022 Revenue Sales Revenue Interest Revenue Other Revenue Total Revenues Expenses Cost of goods sold Selling, General & Administrative Expenses (SG&A) Depreciation R&D Expenses Interest Expense Total Expenses Net Income before taxes Income Tax Expense Income from continuing operations Income from discontinued operations, net of tax Extraordinary items Net Income 2022 2021 576 30 45 651 487 27 30 544 167 98 27 12 7 311 340 102 238 98 10 346 169 99 26 10 6 310 234 70.2 163.8 60 6 229.8 9 FINANCE AND ECONOMICS COMPENDIUM BALANCE SHEET ELEMENTS OF BALANCE SHEET The Balance sheet, or the statement of financial position, reports the firm’s financial position at a particular point in time. The Balance sheet consists of 3 elements: 1. Assets are the resources controlled by the firm 2. Liabilities are amounts owed by the firm to others, such as lenders and creditors 3. Equity is the residual interest in the net assets that remains after deducting liabilities from assets The proportions of liabilities and equity used in financing a company are known as the company’s capital structure. Balance Sheet can be used to assess a company’s liquidity, solvency and ability to make distributions to shareholders. COMMON SIZE BALANCE SHEET A Common Size Balance Sheet expresses each item on the income statement as a percentage of total assets. This allows for comparison over time (time-series analysis) and across firms (cross-sectional analysis. FORMAT OF BALANCE SHEET [Company Name] Balance Sheet [USD $ millions] 2022 2021 Cash --- --- Accounts Receivable --- --- Prepaid expenses --- --- Inventory --- --- Total current assets --- --- I. Assets 1. Current Assets: 2. Non-Current Assets Fixed Assets --- --- Tangible Assets --- --- Intangible Assets --- --- Capital Work in progress --- --- Non-Current investments --- --- Deferred Tax Assets --- --- --- --- --- --- Total Assets II. Liabilities 1. Current liabilities: 10 FINANCE AND ECONOMICS COMPENDIUM Accounts Payable --- --- Accrued expenses --- --- Unearned revenue --- --- Total current liabilities --- --- Long-term debt --- --- Other long-term liabilities --- --- Total Liabilities --- --- Shareholder's Equity --- --- Equity Capital --- --- Retained Earnings --- --- Shareholder's Equity --- --- Total Liabilities & Shareholder's Equity --- --- 2. Non-Current Liabilities CASH FLOW STATEMENT The cash flow statement (CFS), is a financial statement that summarizes the movement of cash and cash equivalents that come in and go out of a company. The CFS measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. ELEMENTS OF CASH F LOW STATEMENT Cash From Operating Activities: The operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company’s products or services. Cash From Investing Activities: Investing activities include any sources and uses of cash from a company’s investments. This includes inflows and outflows of cash resulting from acquisition and disposal of long term assets. Cash From Financing Activities: Cash from financing activities includes inflows and outflows resulting from transactions affecting a firm’s capital structure. Inflows include principal amount of debt issues, proceeds from issuing stocks, whereas outflows include payment of debt, payments to reacquire stock etc. Note: 1. Under U.S. GAAP, dividends and interests received are operating cash flow and dividend paid are financing cash flow whereas interest paid is operating cash flow. 2. Under IFRS, interests and dividends received may be classified as either operating or investing whereas interest and dividend paid may be classified as either operating or financing activities. Hence, IFRS allows for more flexibility. 3. There are two ways of presenting cash flow statements – Direct & indirect methods. The difference in the 2 methods lies only in presentation of CFO. 11 FINANCE AND ECONOMICS COMPENDIUM 4. Under direct method, each item in the accrual based income statement is converted into cash receipts or payments. Under the indirect method, net income is converted into CFO by making adjustments for transactions that affect net income but are not cash transactions. FREE CASH FLOW TO THE FIRM FCFF is the cash available to all investors, both equity owners and debt holders. It is calculated as: πΉπΆπΉπΉ = πππ‘ πΌπππππ + ππππΆππ β πβπππππ (π·ππππππππ‘πππ) + πΌππ‘ππππ π‘(1 − πππ₯ π ππ‘π) − πππ‘ πΆπ΄ππΈπ − πππππππ πππππ‘ππ πΌππ£ππ π‘ππππ‘ OR πΉπΆπΉπΉ = πΆπΉπ + πΌππ‘ππππ π‘(1 − π‘ππ₯ πππ‘π) − πππ‘ πΆπ΄ππΈπ FREE CASH FLOW TO EQUITY FCFE is the cash available for distribution to common shareholders. It is calculated as: πΉπΆπΉπΈ = πΆπΉπ − πππ‘ πΆπ΄ππΈπ + πππ‘ ππππππ€ππππ 12 FINANCE AND ECONOMICS COMPENDIUM FINANCIAL ANALYSIS TECHNIQUES There are various tools and techniques that facilitate financial analysis. These include ratio analysis, common size analysis, graphical analysis and regression analysis. We discuss ratio analysis in detail as follows: RATIO ANALYSIS A few basic things: • • One ratio cannot be used for the analysis of the whole company and several of them have to be looked at simultaneously to form the whole picture The ratios vary vastly across different industries. Also, for the purpose of financial analysis, ratios cannot be looked at in isolation, therefore they must be compared to the ratios of their peer companies (cross sectional analysis) as well as against its ratios in the previous years (time series analysis) to get a fair idea about the company’s performance There are majorly five different types of ratios. They are as follows: 1. Liquidity ratios: These ratios provide information about the ability of the company to meet its short-term obligations. 2. Solvency ratios: Solvency ratios provide information about a company’s ability to meet its long-term obligations. They also provide an information about the leverage of the company. Therefore, these ratios are also referred to as the debt ratios (Leverage refers to the use of borrowed money by a company to fund its operations) 3. Activity ratios: These ratios give indication of how efficiently is a company using it assets like inventory and fixed assets. These ratios are also referred to as turnover ratios. 4. Profitability ratios: These ratios provide information on how well a company generates profits from its sales, assets, capital etc. 5. Valuation ratios: Valuation ratios are generally used to estimate the attractiveness of a potential or an existing investment and get an idea of the company’s valuation in comparison to its peer companies. LIQUIDITY RATIOS Liquidity has to do with a firm's assets and liabilities. In particular, liquidity looks at whether or not a firm can pay its current liabilities with its current assets. Following are the list of liquidity ratios – 1. Current Ratio The current ratio shows how many times over the firm can pay its current debt obligations from its current assets. In general, current assets refers to those assets which will be utilized and hence generate cash in 1 year and current liabilities refers to those liabilities that need to be paid within 1 year that is cash will be utilized. So, this ratio means how much current assets a firm has to meet its current liabilities. πΆπ’πππππ‘ π΄π π ππ‘π Current Ratio = πΆπ’πππππ‘ πΏπππππππ‘πππ 13 FINANCE AND ECONOMICS COMPENDIUM Remarks - A current ratio of less than 1 indicates that the company may have problems meeting its short-term obligations so a current ratio of more than 1 around 1.5-2.5 is safe. However, too high current ratio is also not desirable because that would mean company is not using its current assets efficiently – For instance, current ratio for Apple was recently around 10 or 12 because they amassed a hoard of cash. But investors get impatient, saying, “We didn’t buy your stock to let you tie up our money. Give it back to us.” And then they are in a position of paying dividends. 2. Quick ratio or acid test ratio The quick ratio is a more stringent test of liquidity than is the current ratio. It looks at how well the company can meet its short-term debt obligations without having to sell any of its inventory to do so. Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations without having to rely on selling inventory. Also, prepaid expenses are something which are already been paid and hence, are not included. Acid Test or Quick Ratio = πΆπ’πππππ‘ π΄π π ππ‘π – πΌππ£πππ‘πππ¦ – πππππππ πΈπ₯ππππ ππ πΆπ’πππππ‘ πΏπππππππ‘πππ Ratio of 1:1 is held to be the ideal quick ratio indicating that the business has in its possession enough assets which may be immediately liquidated for paying off the current liabilities. If it is less than 1, the low quick ratio will not allow the company to pay off its current liabilities outstanding in the short term entirely. However, if the ratio is higher than 1, the company retains such liquid assets to discharge its current liabilities immediately. 3. Cash ratio The cash ratio is a further more stringent measure of the liquidity as compared to the current ratio and the quick ratio. It measures the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities. It only looks at the most liquid shortterm assets of the company, which are those that can be most easily be used to pay off current obligations. It ignores inventory, prepaid expenses and receivables as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities. Between quick ratio and cash ratio, the difference is that account receivables is not present in cash ratio unlike quick ratio. Cash Ratio = πΆππ β + πΆππ β πΈππ’ππ£πππππ‘π πΆπ’πππππ‘ πΏπππππππ‘πππ Remarks - A cash ratio of 1.00 and above means that the business will be able to pay all its current liabilities in immediate short term. Therefore, creditors usually prefer high cash ratio. But businesses usually do not plan to keep their cash and cash equivalent at level with their current liabilities because they can use a portion of idle cash to generate profits. This means that a normal value of cash ratio is somewhere below 1.00. Also, it is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities. The reason being that it's often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns. 14 FINANCE AND ECONOMICS COMPENDIUM SOLVENCY RATIOS These ratios aim to highlight the amount of debt taken by a firm. In most cases, a high amount of debt is not generally preferable, as higher debt means higher obligations to pay interest payments, thus a higher financial risk. However, a higher debt is not always bad as long as the company is using that debt to expand or optimize its business operations or make long term investment which will generate revenue or reduce cost – for instance purchase/replace equipment or buy land or buy plant. In general, debt means long term borrowings and other non-current liabilities (not including provisions). The following are types of debt ratios: 1. Debt to Assets ratio This is the simplest ratio to measure the amount of debt. It means what percentage of assets are being funded by debt. Debt Ratio = πππ‘ππ π·πππ‘ πππ‘ππ π΄π π ππ‘π Generally, large well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble. A ratio greater than 1 shows that a considerable portion of the assets is funded by debt. In other words, the company has more liabilities than assets. A high ratio also indicates that a company may be putting itself at risk of defaulting on its loans if interest rates were to rise suddenly. A ratio below 0.5, meanwhile, indicates that a greater portion of a company's assets is funded by equity. This often gives a company more flexibility, as companies can increase, decrease, pause, or cancel future dividend plans to shareholders. 2. Debt to Equity Ratio It is another way of representing the capital structure of the firm. This is a measurement of how much lenders, creditors and obligors have committed to the company versus what the shareholders have committed. πππ‘ππ π·πππ‘ Debt to Equity = πβπππβπππππ’π πΈππ’ππ‘π¦ In general, if your debt-to-equity ratio is too high, it’s a signal that your company may be in financial distress and unable to pay your debtors. But if it’s too low, it’s a sign that your company is over-relying on equity to finance your business, which can be costly and inefficient. Remarks - The debt-to-equity ratio can be misleading at times. An example is when the equity of a business contains a large proportion of preferred stock. In this case a dividend may be mandated in the terms of the stock agreement. This in turn impacts the amount of available cash flow to pay debt. Then the preferred stock has the characteristics of debt, rather than equity. The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0. 15 FINANCE AND ECONOMICS COMPENDIUM 3. Financial Leverage This is another way of type of debt ratio. It means how much assets is funded by equity. Lower the leverage, the more is equity-funded asset. πππ‘ππ π΄π π ππ‘π Financial Leverage= πππ‘ππ πΈππ’ππ‘π¦ This is also known as Equity Multiplier. So, if the ratio is high, it means less equity has been used to fund total assets. Business companies with high leverage are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. 4. Interest Coverage Ratio More the debt, higher will be the interest expense. That means the company has to have higher EBIT to cover it. πΈπ΅πΌπ(1−π‘ππ₯ πππ‘π) ICR = πΌππ‘ππππ π‘ πΈπ₯ππππ π This ratio shows how the ability of the company to meet its interest payments from its operating income. The higher the ratio, the better position a company is in, to meet its interest obligations. Using tax Rate in the numerator is optional as taking tax into account is a more conservative approach – since tax will anyways be deducted from the total income, so we remove the tax component before calculating ICR. However, it is not necessary to remove tax but we have to consistent with the formula. In most cases, the above formula is preferred. The formula for ICR without taking the Tax rate into consideration is as follows: πΈπ΅πΌπ ICR = πΌππ‘ππππ π‘ πΈπ₯ππππ π Remarks: As a general rule of thumb, investors should not own a stock or bond that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. For a company, in a situation where its sales decline and the there is a subsequent decrease in its net income, a high interest obligation can be a cause of concern. An excessive decrease in the net income would result in a sudden, and equally excessive, decline in the interest coverage ratio, which should send up red flags for any conservative investor. 16 FINANCE AND ECONOMICS COMPENDIUM ACTIVITY RATIOS These usually imply how effectively you transform something that the business has to something that the business generates from it (for example: sales from assets), or a balance sheet item to a corresponding Profit and Loss item that the balance sheet item is ultimately used for. Usually, the Balance sheet items are the average of the opening and closing values for the period for which the Profit and Loss is being considered. 1. Asset Turnover Ratio (ATR) In general the purpose of all the assets is to generate sales for the business. Net Sales Asset Turnover = Average Total Assets A high ATR ratio is usually preferred for a company. It means that the company is more efficiently generating sales from the assets that it owns. However, an ideal ratio would differ from industry to industry. NOTE: This ratio has further application in the DuPont Analysis. 2. Inventory turnover ratio A business usually has inventories so that they can be consumed to be sold off as the final product. The formula for Inventory turnover ratios is as follows: Cost of Goods Sold Inventory Turnover = Average Inventory Sometimes, when COGS is not given, Net Sales can also be taken in place of it. This can be interpreted as the number of times the average inventory has to be restocked for all the production in the year. 365 Hence, Days Inventory Outstanding(DIO) = πΌππ£πππ‘πππ¦ ππ’ππππ£ππ π ππ‘ππ This can be interpreted as the number of days it takes from buying the raw material to selling the produced goods. Thus, a lower DIO indicates inventory efficiency of the company and is desirable. However, an ideal number of days would differ from industry to industry. 3. Receivables turnover ratio Receivables are usually owed by the customers to the business, and are a part of the sales by the company. Net Credit Sales Receivables Turnover ratio = Average Accounts Receivables This ratio can be interpreted as how efficiently does a company collects receivables from the credit that it has extended to its customers. This is mostly used in the form of Days Sales Outstanding. 365 Days Sales Outstanding (DSO) = π πππππ£πππππ ππ’ππππ£ππ π ππ‘ππ This is the number of days a company takes to collect revenue after a sale has been made. Due to the high importance of cash in running a business, it’s best for the company to collect 17 FINANCE AND ECONOMICS COMPENDIUM outstanding receivables as quickly as possible and reinvest in the business, and thus a low DSO is desirable and a high DSO could lead to cash flow problems for the company. However, it is to be noted that that a very low DSO is also not considered very good, as it might indicate that the company has a very strict credit policy and thus it might lose out on potential sales opportunities. 4. Trade Payables turnover ratio Payables are usually to the suppliers of the business to purchase the raw material and other things. Net Credit Purchases Payables Turnover = Average Trade Payables This is mostly used in the form of Days Payables Outstanding. 365 Days Payables Outstanding (DPO) = πππ¦πππππ ππ’ππππ£ππ π ππ‘ππ This is the number of days the company on an average takes to pay its suppliers. A high DPO could imply that the suppliers have trust in the company are willing to give it supplies on credit. Another way to look at it could be that the company is having trouble paying its suppliers and is taking very long. 5. Cash Conversion Cycle (CCC) Usually, a company acquires inventory on credit, which results in accounts payable. A company can also sell products on credit, which results in accounts receivable. Cash, therefore, is not involved until the company pays the accounts payable and collects the accounts receivable. So, the cash conversion cycle measures the time between the outlay of cash and the cash recovery and measures the number of days each net input dollar is tied up in the production and sales process before it is converted into cash. Its formula is given by CCC = DIO + DSO – DPO CCC is not looked usually at a standalone basis and it is seen as a pattern over the years or with respect to its competitors, along with other ratios. But typically, a lower CCC is considered healthier for a company and a higher CCC could indicate cash flow problems. A negative cash flow basically means that the company has higher powers to dictate terms. This could be due to the large size of the company in the market or the company could be the only monopoly player. Taking a large FMCG as example, (ITC) can have a negative cash flow since it can demand a higher credit period from its suppliers and in turn give lower credit to the customers. Also, some industries like the e-commerce This is also known as the Operating Cycle. PROFITABILITY RATIOS 1. Profit Margins Margins are the profit metric used as a percentage of the total sales. 18 FINANCE AND ECONOMICS COMPENDIUM Margin = ππππππ‘ πππ‘πππ πππ‘ππ πππππ The Profit metric used could be Gross Profit, EBITDA, EBIT, PBT or PAT, and the margin is called the metric followed by the word “Margin”, for example: Gross Profit Margin = πΊπππ π ππππππ‘ πππ‘ π ππππ πππ‘ ππππππ‘ Net Profit Margin = πππ‘ π ππππ Comparing the margins for competitors could give an idea of the relative performance of companies and the differences in margins for a company are used to analyse how much money is spent at what stage of the business. 2. Return on Assets (ROA) Return on assets is an indicator of how profitable a company relative to its total assets. ROA = πΈπ΅πΌπ∗(1−π‘ππ₯) π΄π£πππππ πππ‘ππ π΄π π ππ‘π Therefore, a higher ROA is generally considered good for a company. Sometimes, just EBIT is used in the numerator. It is useful especially when the income tax rate changes over time, when the funding structure changes or when comparing entities with different financing structure. EBIT*(1-t) in the numerator is useful when comparing enterprises with different share of liabilities in the financial structure. Thus, ROA is a measure of how efficiently the company manages its assets. Generally, a high Return on assets ratio is considered to be good for a company. 3. Return on Capital Employed (ROCE) ROCE = πΈπ΅πΌπ∗(1−π‘ππ₯) π΄π£πππππ πΆππππ‘ππ ππππππ¦ππ Where Capital Employed = Total Assets – Current Liabilities Capital Employed may also be seen Equity + Non-Current Liability or as the total money the company has raised through financing. Similar to ROA, a high ratio for ROCE also, is generally considered better. Although both ROA and ROCE convey similar information, ROCE is from the liability perspective as to how much return a company gives per the amount of capital raised, whereas ROA is from the asset perspective as to how well the company is using its assets. 4. Return on Invested Capital (ROIC) ROIC = πΈπ΅πΌπ∗(1−π‘ππ₯) πΌππ£ππ π‘ππ πΆππππ‘ππ 19 FINANCE AND ECONOMICS COMPENDIUM Where, Invested Capital is Capital Employed – Cash and Cash equivalents. This is a further refinement of ROCE since the cash although is needed to buy assets needed to generate profits, but in itself, sitting with the company as reserves, it isn’t generating any revenue or profit for the company, thus makes sense to be removed from the Employed Capital. NOTE: NOPAT (Net operating profit after tax) is usually used for ROA, ROCE and ROIC calculations to account for tax payable directly on the operating profit. But even here, interest expense is not reduced because the denominator contains assets financed from both debt and equity and thus portion of the income contributed towards debt holders (i.e., interest) should not be removed. NOPAT = EBIT*(1-tax) OR Net Income + Interest*(1-tax) 5. Return on Equity (ROE) ROE = πππ‘ πΌπππππ π΄π£πππππ π βπππβππππππ πΈππ’ππ‘π¦ ROE is a metric of how profitable it is to invest in the equity of a company. Net income, instead of EBIT is used in the numerator for ROE, because Net Income is the value that is given back to the shareholders through dividends paid or the increase in shareholder’s equity through retained earnings. The interest and tax paid is removed from EBIT to arrive at Net income for the ROE calculation. This is done as the interest payment and the taxes belongs to the lender and the government respectively. It is to be noted that two companies with the exactly same assets and performance may have very different ROE if they have different capital structures. This can be better understood from a DuPont analysis. Thus, it can be deduced that a company’s ROE can be driven by either high profit margins or the efficient use of its assets (asset turnover) or it can simply be the effect of high amount of debts and low equity of a company (leverage ratio). Based on an understanding of where the ROE is coming from, an analyst must make his judgements accordingly. VALUATION RATIOS 1. EPS Earnings per share (EPS) refers to the amount of net income that each shareholder is entitled to. πππ‘ ππππππ‘ EPS = ππ ππ ππ’π‘π π‘ππππππ π βππππ NOTE: Unlike several of the Market Ratios, EPS is independent of the market price of the share and not to be confused with the dividends paid. 2. Dividend Payout Ratio and Retention Ratio The net income generated by a company can be utilized for 2 purposes. To pay cash rewards to the shareholders or to invest back and grow the business. The portions of the Net Income given to these 2 purposes are the Dividend Payout Ratio and Retention Ratio respectively. 20 FINANCE AND ECONOMICS COMPENDIUM π·ππ£πππππ Dividend Payout Ratio = πππ‘ πΌπππππ Retention Ratio = πππ‘ πΌπππππ – πππ‘ππ π·ππ£ππππππ ππππ πππ‘ πΌπππππ Note: Total Dividends Paid = Dividend given per share * #Shares, but given the financials of the company, you can calculate the Total Dividends Paid by checking what part of the net income has not been added to the retained earnings, i.e., Net Income – (Increase in the Retained Earnings from opening to closing) 3. Price to Earnings Ratio Often called the PE ratio, its formula is as its name suggests P/E Ratio = ππππππ‘ πππππ πππ π βπππ πΈππ The EPS taken is usually for the past year or TTM (Trailing Twelve Months) This ratio is the price you pay in order to earn a dollar of earnings from the total earnings of the company. A high PE ratio means that you have to pay more to earn every dollar of the company’s earnings and thus it might indicate that the company is overvalued and similarly a low PE ratio might indicate that a company is undervalued. So, normally you’d prefer a lower PE. Different industries have very different ranges of PE ratios and even within an industry, the capital structure adversely changes the PE ratio. Note: For a better understanding of how Capital Structure changes the PE ratio watch: https://www.khanacademy.org/economics-finance-domain/core-finance/stock-andbonds/valuation-and-investing/v/p-e-conundrum 4. PEG Ratio Price/Earnings-to-growth ratio considers the estimated growth of the company of the company. The earnings in PE ratio are historical, but for PEG ratio, we consider the future estimates of earnings for the coming year, thus the denominator is estimated EPS or TTM EPS * growth estimate. πβπππ πππππ PEG Multiple = πΈππ ∗ πππππππ‘ππ πΈπππππππ πΊπππ€π‘β This could give a better picture to compare 2 shares for investing purposes. When the PEG exceeds one, this tells you that the market expects more growth than estimates predict, or that increased demand for a stock has caused it to be overvalued. A ratio result of less than one says that either analysts have set their consensus estimates too low, or that market has underestimated the stock’s growth prospects and value. 5. Price/Book Value Ratio The Book Value of the equity is its value that is mentioned on the liabilities side in the Balance Sheet, which can also be calculated as the difference of the total assets and the liabilities. The 21 FINANCE AND ECONOMICS COMPENDIUM Price part denotes what the market values this equity as. It can be calculated using the following formula: ππππππ‘ πΆππππ‘ππππ§ππ‘πππ πβπππ πππππ P/B ratio = π΅πππ ππππ’π ππ πΈππ’ππ‘π¦ Or π΅πππ ππππ’π πππ π βπππ Where, Market Capitalization = Share Price * Shares outstanding P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market prices. A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal. 6. EV/EBITDA One major drawback of the PE ratio is its dependence on the capital structure of the firm, for which EV/EBITDA is a better measure. Here, note that EBITDA is used in the denominator instead of EBIT as the depreciation method adopted by different companies could be different. Although, EBIT is a better proxy for operating profits but we are not interested in operating profits rather, we are more interested in a proxy for cash flows. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a widely used measure of core corporate profitability. EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income. Being a market valuation ratio, the asset value corresponding to the operating profit has to be based on what the market evaluates the company’s operating assets value to be. Thus Enterprise Value is defined as the market value of operating assets. Enterprise Value = Market Value of Equity + Market Value of Liabilities – Cash Reserves = Market Capitalization + Total Liabilities – Cash OR Enterprise Value = Market Capitalization + Preferred Stock + Outstanding Debt + Minority Interest – Cash and Cash Equivalents Cash is excluded from the enterprise value as cash is received back by the acquirer. So, it reduces the net payment made for the acquisition. Thus, the ratio is given by EV/EBITDA = πΈππ‘ππππππ π ππππ’π πΈπ΅πΌππ·π΄ The main advantage of this ratio over PE ratio is its inherent incorporation of the capital structure. 7. Dividend Yield A financial ratio that indicates how much a company pays out in dividends each year relative to its share price. It is somewhat a measure of bang for your buck. 22 FINANCE AND ECONOMICS COMPENDIUM Dividend Yield (%) = (π·ππ£πππππ ππππ’ππ‘ πππ π βπππ ∗100) ππππππ‘ πππππ ππ π βπππ Yields for a current year are often estimated using the previous year’s dividend yield or by taking the latest quarterly yield, multiplying by 4 (adjusting for seasonality) and dividing by the current share price 8. Other Industry Specific Ratios Various other ratios are used for specific industries for example Price/Sales for retail industry or EV/tonne for the cement industry. GRAPHICAL ANALYSIS Graphs can be used to visually represent performance comparisons over time. Bar graphs, line graphs etc. are commonly used to present and predict financial data. REGRESSION ANALYSIS This can be used to study relationships between variables. The regression results are often used for forecasting. DUPONT ANALYSIS: The DuPont analysis is used to analyse return on equity (ROE). It breaks down ROE into a function of different ratios to see the impact of leverage, profit margins and turnover on shareholder returns. The approach is as follows: π ππΈ = πππ‘ πΌπππππ π΄π£πππππ πΈππ’ππ‘π¦ Step 1: Multiplying ROE by (revenue/revenue) and rearranging: π ππΈ = πππ‘ πΌπππππ π ππ£πππ’π π π ππ£πππ’π π΄π£πππππ πΈππ’ππ‘π¦ Step 2: The first item in above equation is profit margin and second is equity turnover. ROE can be rewritten as: π ππΈ = (πππ‘ ππππππ‘ ππππππ) π(πΈππ’ππ‘π¦ ππ’ππππ£ππ) Step 3: The above can be expanded further by multiplying and dividing by assets: π ππΈ = πππ‘ πΌπππππ π ππ£πππ’π π΄π£πππππ πππ‘ππ π΄π π ππ‘π π π π ππ£πππ’π π΄π£πππππ πππ‘ππ π΄π π ππ‘π πΈππ’ππ‘π¦ Step 4: The above can be rearranged as: π ππΈ = (πππ‘ ππππππ‘ ππππππ) π(π΄π π ππ‘ ππ’ππππ£ππ) π (πΏππ£πππππ π ππ‘ππ) This is called the original DuPont equation. Conclusion: The DuPont method is a way to decompose ROE and see what changes are driving the change in ROE. If ROE is low, it must be because: the company has poor profit margin or company has poor asset turnover or the firm has too little leverage. 23 FINANCE AND ECONOMICS COMPENDIUM CORPORATE FINANCE ROLE OF CORPORATE FINANCE The objective of Corporate Finance is to create shareholder value. It has 4 primary functions: 1. Planning for funds: This involves deciding on the Capital structure of the firm. 2. Raising funds: The quantum and type of funds (debt/equity, etc.) is decided. This fund is raised at a certain cost known as Weighted Average Cost of Capital (WACC). 3. Management of funds: This involves Capital Budgeting (long-term planning) and Working capital management (Short-term planning). 4. Distribution of funds: This involves planning for dividends. It is important for a firm to decide whether to reinvest the reserves & surplus or pay dividends. CAPITAL BUDGETING INTRODUCTION The capital budgeting process is the process of identifying and evaluating capital projects, i.e., projects where the cash flow to the firm will be received over a period longer than a year. Capital budgeting usually involves the calculation of each project’s future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and other factors. KEY PRINCIPLES OF CAPITAL BUDGETING 1. Decisions are based on cash flows, not accounting income (Incremental cash flows are to be considered, not sunk costs). 2. Cash flows are based on opportunity costs. 3. The timing of cash flows is important. 4. Cash flows are analysed on an after-tax basis. 5. Financing costs are reflected in the project’s required rate of return. THE CAPITAL BUDGETING P ROCESS We will try to understand this process while using an example. Suppose a firm XYZ & Co. has enough funds and now has decided to invest in Capital projects. The process it will follow is: 1. Generating Ideas- Generation of investment ideas can be from anywhere. All levels of the organization- from the top to the bottom, from departments to functional areas- can contribute by generating fresh investment ideas. Ideas can also be generated from outside the company. In our example, the firm can increase its existing production capacity, expand its product line by setting up an additional factory, invest in some other business, etc. 2. Analyzing Individual Proposals- In the next step XYZ & Co. would gather adequate, reliable information in order to first forecast future cash flows from each proposed project and then evaluate their profitability. In this stage, the non-profitable proposals are screened away and the remaining are moved on to next stage. 3. Planning the Capital Budget- Next, the profitable proposals are organized after taking into account two key considerations: • The match between the proposal and the company’s overall strategic objectives 24 FINANCE AND ECONOMICS COMPENDIUM • The duration and timing of the project. Since companies have various financial and other resource constraints, the proposals usually have to be scheduled on a priority-basis. Suppose XYZ & Co. identifies two potential profitable investments as investing in a different business and expanding its existing production facility. The option of investing in a different business is forecasted to generate a better profitability, but the money would be locked in for a long period and one of the company’s goals is to become a market leader in its existing market. In such a situation, the option of expanding its existing production facility would be ranked highest and undertaken first. 4. Monitoring and Post-auditing- Post-auditing capital projects are as important as selecting and implementing them. Firstly, it serves to monitor the analysis and forecasts that the capital budgeting process is based on. Overly optimistic forecasts can be detected and such systematic errors rectified. Secondly, the negative deviation between actual performance and expectations can be corrected by taking adequate measures, wherever possible, which in turn improves business operations. Lastly, sound ideas for future investments may be evolved during post-auditing current investments. A FEW CONCEPTS TO KEEP IN MIND SUNK COST A sunk cost is one that has already been incurred. It is a past and irreversible outflow. Because sunk costs are bygones and cannot be changed, they cannot be affected by the future decisions, and so they should be ignored in decision-making. Example: Lockheed had already spent $1 billion on the development of the TriStar airplane. In order to continue its development, the company sought a federal guarantee to back a new bank loan for it. On the one hand, those in favour of the project argued that it would be extremely imprudent on the part of the company to abandon a project on which such huge capital expenditures had already been made. On the other hand, some of Lockheed’s critics countered that it would be equally foolish to continue with such a project that did not offer a satisfactory return on that $1 billion. Both groups were guilty of the sunk-cost fallacy; the $1 billion was irrecoverable and, therefore, irrelevant. (Brealey). The decision should be solely based upon the future cash flows. Principle: Today’s decisions should be based on current and future cash flows and should not be affected by prior or sunk costs. OPPORTUNITY COST It is the cost of any activity measured in terms of the best alternative forgone. It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices. In capital budgeting, the opportunity cost of capital or the discount rate is the expected rate of return that is foregone by investing in the project chosen rather than investing in the next-best alternative. Examples: Suppose that a company already owns a building that could be used for a new project instead of buying a new building. If the company’s managers decide to use this building, the company would not incur the cash outlay of $12 million that would be required to buy a new building. Would this 25 FINANCE AND ECONOMICS COMPENDIUM mean that the $12 million expenditure should be excluded from the analysis, which would obviously raise the expected NPV? The answer is that we should exclude the cash flows related to the new building, but we should include the opportunity cost associated with the new building as a cash cost. For instance, if the building had a market value of $14 million, then the company would be giving up $14 million if it uses the building for the project. Therefore, the $14 million that would be foregone as an opportunity cost should be charged to the project. • • If an old machine is replaced with a new one, what is the opportunity cost? The opportunity cost here is the cash flows that the old machine would generate. If $20 million is invested, what is the opportunity cost? The $20 million itself is the opportunity cost here since it could have been invested elsewhere. DISCOUNT RATE/ TIME VALUE OF MONEY Discount rate is the interest rate used to calculate the present value of future cash flows. It essentially flows from the concept of ‘time value of money’, which says that, other things being equal, due to its potential earning power, a given sum of money has higher worth now than it would be in future. The discount rate takes into account the time value of money and the risk or uncertainty associated with future cash flows. The discount rate applicable to a capital project depends on many factors such as the riskiness of the project, the weighted average cost of capital of a firm, etc. The formula for present value and future value, when discount rate is “r” and number of periods is “n” is as follows: ππ = πΉπ’π‘π’ππ πΆππ β πΉπππ€ (1 + π)π πΉπ = ππππ πππ‘ πΆππ β πΉπππ€ (1 + π)π EXAMPLE: For e.g., An instrument which returns Rs. 100 each at end of next two years would have a present value of 173.55 when the discount rate is 10%. CANNIBALISATION Cannibalization takes place when an investment results in one part of a company taking away customers and sales from another part. An externality is defined as the effect that an investment has on other things besides the investment itself and cannibalization is one such externality. The lost cash flows due to cannibalization should be charged to the new project. 26 FINANCE AND ECONOMICS COMPENDIUM However, it often turns out that if the company would not have produced the new product, some other company would have and hence, the old cash flows would have been lost anyway. In this case, no charge should be assessed against the new project. All this makes determining the cannibalization effect difficult, because it requires estimates of changes in sales and costs, and also of the timing when those changes will occur. Example: Apple’s introduction of the iPod Nano caused some people who were planning to purchase a regular iPod to switch to a Nano. The Nano project generates positive cash flows, but it also reduces some of the company’s current cash flows. This is a manifestation of the cannibalization effect because the new business eats into the company’s existing business. Principle: Cannibalization can be important, so its potential effects should be considered and any significant lost cash flows due to it should be charged to the new project. DECISION C RITERION 1. NET PRESENT VALUE (NPV) The NPV is the sum of present values of all expected incremental cash flows if a project is undertaken. The discount rate used is the firm’s cost of capital, it is calculated based on the next best alternative use of the money. For a normal project with an initial cash outflow, flowed by a series of cash inflows (after tax), the NPV is given by: Where, r = discount rate n = time For independent projects, the NPV decision rule is to accept projects with positive NPVs and to reject projects with negative NPVs. Simple Example Year 0 1 2 3 4 Project A (INR) -2000 1000 800 600 200 Project B (INR) -2000 200 600 800 1200 The Table shows the expected net after-tax cash flows of two projects, A and B. Discount Rate (Required rate of Return) = 10% NPV of A 1000 800 600 200 -2000 + 1.11 + 1.12 + 1.13 + 1.14 = INR 157.64 27 FINANCE AND ECONOMICS COMPENDIUM NPV of B 200 600 800 + 2 + 3 1.11 1.1 1.1 -2000 + 1200 1.14 + = INR 98.36 Both projects A and B have positive NPVs, so both can be accepted. But, if only one project is to be chosen and if other factors are kept constant, then Project A should be chosen because it has a positive NPV. Advantage of the NPV Method: It is a direct measure of the expected increase in the value of the firm/project. Disadvantage of the NPV Method: The project size is not measured. For example, an NPV of INR 100 for a project costing INR 10,000 is good, but the same NPV of INR 100 is not so good for a project costing INR 10,000,000. 2. INTERNAL RATE OF RETURN (IRR) The IRR is the discount rate which makes the present values of a project’s estimated cash inflows equal to the present value of the project’s estimated cash outflow. It is the discount rate at which the NPV of a project is equal to 0. If IRR > the required rate of return, accept the project If IRR < the required rate of return, reject the project Continuing with the above example used for NPV:1000 800 600 200 Project A: 0 = -2000 +(1+πΌπ π )1 + (1+πΌπ π )2 + (1+πΌπ π )3 + (1+πΌπ π )4 = INR 157.64 π 200 π 600 π 800 π 1200 Project B: 0 = -2000 +(1+πΌπ π )1 + (1+πΌπ π )2 + (1+πΌπ π )3 + (1+πΌπ π )4 π π π π Using trial-and-error methods, financial calculators or Excel, the IRR for Project A = 14.49% and the IRR for Project B = 11.79%. Both can be accepted as the IRRs for both projects > 10%. Advantage of the IRR Method: It measures profitability as a percentage, showing the return in each Rupee invested. One can comment on how much below the IRR the actual project return could fall (in percentage terms) before the project becomes economically unfeasible. Disadvantages of the IRR Method: The possibility of producing rankings of projects which may differ from the NPV rankings (either due to cash flow timing differences or due to differences in project size) and the possibility of Multiple IRRs for the same project or no IRR. 28 FINANCE AND ECONOMICS COMPENDIUM 3. PAYBACK PERIOD (PBP) The Payback Period is the number of years it takes to recover the initial cost of an investment. Continuing with the same example:Year 0 1 2 3 4 Project A (INR) Net Cash Cumulative Net Cash Flow Flow -2000 -2000 1000 -1000 800 -200 600 400 200 600 Project B (INR) Net Cash Cumulative Net Cash Flow Flow -2000 -2000 200 -1800 600 -1200 800 -400 1200 800 Payback Period = Full years until recovery + (Unrecovered Cost at the beginning of last year/Cash flow during last year) Payback Period (Project A) = 2 + (200/600) = 2.33 years Payback Period (Project B) = 3 + (400/1200) = 3.33 years Since the Payback Method does not take into account the time value of money and cash flow Beyond the payback period, project decisions cannot be based solely on this method. However, this method is a good measure of project liquidity. The drawbacks of the payback period are apparent. Since the cash flows are not discounted at the project’s required rate of return, the payback period ignores the time value of money and the risk of the project. Additionally, the payback period ignores cash flows after the payback period is reached. Thus this method provides a good measure of payback and not of profitability. But its simplicity and easy calculation make it useful as an indicator of project liquidity. Thus a project with a two-year payback may be more liquid than a project with a longer payback. 4. DISCOUNTED PAYBACK PERIOD (DPBP) This method uses the present values of the projects’ estimated cash flows. It must be greater than the Payback Period without discounting. Continuing with the same example:- Year Net Cash Flow 0 1 2 3 4 -2000 1000 800 600 200 Project A ( INR) Cumulative Discounted Discounted Net Cash Net Cash Flow Flow -2000 -2000 909 -1091 661 -430 451 21 137 158 Net Cash Flow -2000 200 600 800 1200 Project B ( INR) Cumulative Cumulative Discounted Discounted Net Cash Net Cash Flow Flow -2000 -2000 182 -1818 496 -1322 601 -721 820 98 29 FINANCE AND ECONOMICS COMPENDIUM Discounted Payback Period (Project A) = 2 + (429/451) = 2.95 years Discounted Payback Period (Project B) = 3 + (721/820) = 3.88 years This method addresses the concern of discounting cash flows at the project’s required rate of return, but it still does not consider cash flows beyond the discounted payback period. 5. PROFITABILITY INDEX (PI) This is the Present Value of a project’s future cash flows divided by the initial cash outlay. It is closely related to the NPV. PI = (PV of future cash flows/Initial Investment) = 1 + (NPV/Initial Investment) If PI > 1.0, accept the project, else, if PI < 1.0, reject the project. COST OF CAPITAL INTRODUCTION A firm must decide on how to raise capital for its various projects, to funds its business and for growth, dividing it among common equity, debt and preferred stock. The optimum mix which produces the minimum overall cost of capital will maximize the value of the firm. Debt, preferred stock and common equity are referred to as the capital components of the firm. The cost of each of these components is called the component cost if capital. ππ :Cost of Debt – The rate at which the firm can issue new debt. It can also be considered as the yield to maturity on existing debt (pre-tax component). ππ (1 – t): After-tax cost of Debt. “t” is the firm’s marginal tax-rate ππ : Cost of preferred Stock. WACC: Weighted Average Cost of Capital – It is the cost of financing the firm’s assets. WACC is the average of the costs of the above sources of financing, each of which is weighted by its respective use in the given situation. WACC = (ππ ) [ππ (1 – t)] + (ππ) (ππ ) + (ππ ) (ππ ) Where, ππ = percentage of debt in the capital structure, ππ = percentage of preferred stock in the capital structure, ππ = percentage of equity in the capital structure Simple Example Suppose Company A’s target capital structure is as follows: wd = 0.45, wp = 0.05, we = 0.50. Before-tax cost of debt = 8%, cost of equity = 12%, cost of preferred stock = 8.4%, marginal tax rate = 40% 30 FINANCE AND ECONOMICS COMPENDIUM WACC = (ππ ) [ππ (1 – t)] + (ππ) (ππ ) + (ππ ) (ππ ) WACC = (0.45) (0.08) (1 – 0.40) + (0.05) (0.084) + (0.50) (0.12) = 0.0858 = 8.58% The weights in the calculation of WACC should be based on the firm’s target capital structure (The proportions the firm aims to achieve over time). The assumption here is that the firm would stick to the same capital structure throughout the life of the project. OPTIMAL CAPITAL BUDGET In the figure below, the intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount of the optimal capital budget. The firm should undertake projects, whose IRRs are greater than the cost of funds as this will maximize the value created. It is useful to view graphically how WACC alters as leverage changes. The classic figure below shows how WACC is high at low levels of leverage (debt), it reaches an ‘optimum’ at the idealized WACC before rising quickly into the territory where financial distress (risk of bankruptcy) becomes a major factor. COST OF DEBT The after-tax cost of debt is the interest rate at which firms can issue new debt net of the tax savings from the tax deductibility of interest. After-tax cost of debt = Interest Rate – Tax savings = ππ – ππ (t) = ππ (1 – t) 31 FINANCE AND ECONOMICS COMPENDIUM COST OF PREFERRED STOCK If a company has preferred stock in its capital structure, the cost of preferred stock (ππ ) is: ππ = π·ππππππππ π«ππππ πππ π (π«ππ) π΄πππππ π·ππππ ππ π·ππππππππ πΊππππ (π·) COST OF EQUITY The cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Two methods have been discussed below to calculate the Cost of Equity: the Capital Asset Pricing Model (CAPM) and the Dividend Discount Model. 1. Capital Asset Pricing Model (CAPM) The most commonly accepted method for calculating cost of equity comes from the Capital Asset Pricing Model (CAPM): The cost of equity is expressed formulaically below:ππ or ππ = ππ + (ππ – ππ ) * β Where, ππ or ππ = the cost of equity or the required rate of return on equity, ππ = the risk free rate- the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries ππ = expected return on the market portfolio, (ππ – ππ ) = the equity market risk premium- It represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the riskfree rate. β = beta coefficient = systematic risk of the firm- This measures how much a company's share price reacts against the market as a whole. A beta of 1 indicates that the company moves in line with the market. If the beta is in excess of 1, the share is exaggerating the market's movements; less than 1 means the share is more stable. Occasionally, a company may have a negative beta, which means the share price moves in the opposite direction to the broader market. 2. Dividend Discount Model Approach If dividends are expected to grow at a constant rate, g, then the current value of the company’s stock is given by this model. π·π = π«π /(ππ – g) Where, π·π = the current value of the company’s stock, π«π = next year’s dividend, ππ = required rate of return on equity or cost of equity, 32 FINANCE AND ECONOMICS COMPENDIUM g = the firm’s expected constant growth rate (g = (Retention Rate)(Return on Equity ROE)). Rearrange the terms to solve for ππ WACC Example Question: Monetrix Inc. (a listed firm) is considering a project in the Financial Education business. It has a D/E ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of 14%. The equity beta is 0.966. The risk-free rate is 5% and the expected return on the market portfolio is 12%. Calculate the appropriate WACC to evaluate the project. Solution Project Cost of Equity = 5% + 0.966(12% - 5%) = 11.762% Cost of Debt = 14%, Cost of Preferred Stock = 0%, Weight of preferred stock = 0 As D/E = 2, ππ = 2/3, ππ = 1/3 Therefore, WACC = 1/3(11.762%) + 2/3(14%) (1 – 0.40) = 9.52% DIVIDENDS A dividend is a pro rata distribution to shareholders that is declared by the company’s board of directors and may or may not require approval by shareholders. DIVIDEND POLICY The decision to pay out earnings versus retaining and reinvesting them. Dividend policy issues include: • • • • High or low dividend payout? Stable or irregular dividends? How frequently to pay dividends? Announce the dividend policy? THEORIES OF DIVIDEND POLICY The 3 theories of dividend policy: 1. Dividend irrelevance: Investors don’t care about dividend payout. 2. Bird-in-the-hand: Investors prefer a high payout. 3. Tax preference: Investors prefer a low payout. SIGNALLING HYPOTHESIS Investors view dividend increases as signals of management’s view of the future. Since managers hate to cut dividends, they won’t raise dividends unless they think the raise is sustainable. However, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends. 33 FINANCE AND ECONOMICS COMPENDIUM CLIENTELE EFFECT 1. Different groups of investors, or clienteles, prefer different dividend policies. 2. Firm’s past dividend policy determines its current clientele of investors. 3. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies. RESIDUAL DIVIDEND MODEL 1. Find the retained earnings needed for the capital budget. 2. Pay out any leftover earnings (the residual) as dividends only if more earnings are available than are needed to support the optimal capital budget. 3. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC. Dividends = Net Income – (Target equity ratio * Total capital budget) Simple Example: Capital budget = $800,000 Target capital structure = 40% debt, 60% equity Forecasted net income = $600,000 How much of the forecasted net income should be paid out as dividends? • • • Calculate portion of capital budget to be funded by equity Of the $800,000 capital budget, 60% ie. $480,000 will be equity financed Calculate the excess or need for equity capital? There will be $600,000 - $480,000 = $120,000 left over to be paid as dividends. Calculate the dividend payout ratio (DIV/PAT)? q$120,000 / $600,000 = 0.2 or 20% STOCK REPURCHASES A repurchase of stock is a distribution in the form of the company buying back its stock from shareholders. REASONS F OR REPURCHASES 1. As an alternative to distributing cash as dividends. 2. To dispose of one-time cash from an asset sale. 3. To make a large capital structure change. ADVANTAGES OF REPURCHASES 1. 2. 3. 4. Stockholders can tender (sell) or not. Helps avoid setting a high dividend that cannot be maintained. Income received is capital gains rather than higher-taxed dividends (sometimes). Stockholders may take as a positive signal-management thinks stock is undervalued. DISADVANTAGES OF REPURCHASES 1. May be viewed as a negative signal (firm has poor investment opportunities). 34 FINANCE AND ECONOMICS COMPENDIUM 2. IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. 3. Selling stockholders may not be well informed, hence be treated unfairly. 4. Firm may have to bid up price to complete purchase, thus paying too much for its own stock. STOCK DIVIDENDS VS. STOCK SPLITS Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If stock dividend is 10%, shareholders get 10 shares for each 100 shares owned. Stock split: Firm increases the number of shares outstanding, say 2:1. Shareholders get extra shares in the ratio of stock split. Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.” Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged. But splits/stock dividends may get us to an “optimal price range.” REASONS F OR STOCK DIVIDENDS OR STOCK SPLIT There’s a widespread belief that the optimal price range for stocks is $20 to $80. Stock splits can be used to keep the price in this optimal range. Stock splits generally occur when management is confident, so are interpreted as positive signals. On average, stocks tend to outperform the market in the year following a split. CONCLUSION 1. Share repurchases have a positive effect on share prices. 2. Dividend initiations have a positive effect on share prices. 3. Dividend increases have a positive effect on share prices. Interesting Read: The Pizza Theory of Business Valuation 35 FINANCE AND ECONOMICS COMPENDIUM MERGERS AND ACQUISITIONS INTRODUCTION The term mergers and acquisitions (M&A) refers to the consolidation of companies or their major business assets through financial transactions between companies. A company may purchase and absorb another company outright, merge with it to create a new company, acquire some or all of its major assets, make a tender offer for its stock, or stage a hostile takeover. All are M&A activities. Acquisitions: When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition. Example: Abbott India acquiring the domestic formulations business of Piramal Healthcare solutions. Mergers: Two firms, of approximately the same size, that join forces to move forward as a single new entity, rather than remain separately owned and operated. Reverse Mergers: Similar to a merger but the bigger company ceases to exist as it acquires the smaller company’s name. Usually done when the smaller company has a more well-known brand name. Example: ICICI Bank reverse merger back in 2001. Consolidations: A consolidation is similar to a merger except that both companies lose their previous legal existence and form a new legal entity. Example: The Indian telecom tower sector has seen a wave of consolidations this past year as smaller players look to exit the market owing to lack of scale and efficiency. WHY MERGERS AND ACQUISITIONS TAKE PLACE ? There are several reasons why companies enter into M&A activity. The prominent ones include: 1. Growth Companies wanting to grow into bigger companies or enter into new avenues are most likely to enter into M&A. It is typically faster for companies to acquire companies to grow themselves, rather than invest money and resources in developing from within (organic growth). It’s always less risky to acquire an established player rather than enter an unfamiliar market on one’s own. Example: Indian Generic Pharma companies have become the target of many inbound M&A deals as the foreign players look to protect their bottom line in wake of their drugs going off patent. They increasingly see India as a potential market where they could leverage their sales and distribution skills to expand their market share. 2. Synergies Synergies occur when the combined company is worth more than the sum of the parts. Synergy is a theoretical term and usually denotes enhanced revenues by means of cross selling or reduced costs via economies of scale. Companies often end up paying huge amounts for targets if they feel it can provide benefits in the long run. For example, Sanofi when it first made a bid for Genzyme back in July 2010, its offer price was $69 - a 38% premium over Genzyme’s share price of $50. 3. Increase Market Power M&A that is done from the sole point of increasing market power is called Horizontal Mergers. In it companies acquire firms in the same market. It is most likely to attract the ire of the regulator as such mergers are looked as stifling competition. 36 FINANCE AND ECONOMICS COMPENDIUM 4. Unlock Hidden Value When an acquirer feels that the target company is underperforming for the moment, and it feels it has the capability to unlock its potential. Companies engage M&A from this perspective if they feel they can acquire the company for less than the Break Up value or the value obtained from dividing the company and selling its assets. 5. Diversification Companies enter into fields that are not at all related to their current field of activity to diversify and shore up revenues in bad times. Diversification is sometimes viewed negatively by investors because it doesn’t add to shareholder value as they are free to diversify their stock holdings themselves. Example: BHP Billiton, a world leader in mining made a bid for Canadian Potash manufacturer, Potash. The deal could not be consummated because of concerns from the Canadian government. 6. Acquiring unique capabilities and resources When companies feel they can no longer internally create cost effective capabilities needed to grow, they engage in M&A, to acquire the desired capability. Companies believe they can get resources for less than Replacement Value. Example: Low cost drug manufacturing and technical expertise of most Indian Pharma companies have generated substantial foreign interest. HOW ARE MERGERS AND ACQUISITIONS STRUCTURED ? Mergers can be structured in a number of different ways, based on the relationship between the two companies involved in the deal: 1. Horizontal merger: Two companies that are in direct competition and share the same product lines and markets. 2. Vertical merger: A customer and company or a supplier and company. Think of an ice cream maker merging with a cone supplier. 3. Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company. 4. Market-extension merger: Two companies that sell the same products in different markets. 5. Product-extension merger: Two companies selling different but related products in the same market. 6. Conglomeration: Two companies that have no common business areas. FORMS OF ACQUISITIONS There are two basic forms of mergers and acquisitions (M&A): 1. Stock purchase In a stock purchase, the acquirer pays the target firm’s shareholders cash and/or shares in exchange for shares of the target company. Here, the target’s shareholders receive compensation and not the target. There are certain aspects to be considered in a stock purchase: • The acquirer absorbs all the assets and liabilities of the target – even those that are not on the balance sheet. 37 FINANCE AND ECONOMICS COMPENDIUM • To receive the compensation by the acquirer, the target’s shareholders must approve the transaction through a majority vote, which can be a long process. • Shareholders bear the tax liability as they receive the compensation directly. 2. Asset Purchase In an asset purchase, the acquirer purchases the target’s assets and pays the target directly. There are certain aspects to be considered in an asset purchase, such as: • Since the acquirer purchases only the assets, it will avoid assuming any of the target’s liabilities. • As the payment is made directly to the target, generally, no shareholder approval is required unless the assets are significant (e.g., greater than 50% of the company). • The compensation received is taxed at the corporate level as capital gains by the target. METHODS OF PAYMENT There are two methods of payment – stock and cash. However, in many instances, M&A transactions use a combination of the two, which is called a mixed offering. 1. Stock In a stock offering, the acquirer issues new shares that are paid to the target’s shareholders. The number of shares received is based on an exchange ratio, which is finalized in advance due to stock price fluctuations. 2. Cash In a cash offer, the acquirer simply pays cash in return for the target’s shares. METHODS OF VALUATION A very important part of any M&A is valuation of a firm. When you go to buy a second-hand car, you try to estimate its value using factors like age, miles driven, price of similar second-hand cars etc. and then based on this estimate you negotiate a price with the dealer. Similarly, when you set out to acquire a firm, you need to figure out its value and it is based on that estimate that you quote a price at which you’ll purchase that firm. There are several methods for valuation and depending on the industry different methods are the gold- standard when it comes to valuing companies. In this section we will look at some of the most common methods, discuss what is right and wrong about them and in which sector they are used the most. 1. Discounted cash flow approach: The discounted cash flow approach to a business valuation compares the potential future value of the business with its present-day cash flow perspective. If a business is projected to be worth a hefty sum in a given period — say, five years from now — an appraiser will work backward from the future valuation to determine its present-day worth. This estimate then becomes the company valuation now, even though the potential future income is hypothetical. 2. Replacement Cost: This method is used to value the firm by totalling the cost incurred in replacing the assets of the firm today with similar assets. This method reflects current price conditions and is quite effective in valuing firms during periods of high inflation. The replacement cost value is usually higher than the book value because depreciation is not taken into account. Total Replacement cost minus Liabilities equals the value of the business. 38 FINANCE AND ECONOMICS COMPENDIUM Depreciated Replacement cost method of valuation, however, takes into account the depreciation of the asset to be replaced. But this method is not without its share of disadvantages – replacement cost is the cost of replacing assets today, but usually managers don’t expect the old designs/assets to continue in the future. Besides being subjective, it is also problematic to value intangible assets. 3. Market Priced Based: The market price of the firm is simply the sum of market values of firm’s debt and equity. Market value of equity can be obtained by multiplying share price with the number of shares whilst the market value of debt can be calculated by using present value of estimated debt cash flows. In some cases, book value of debt (from balance sheet) is used as a proxy for market value of debt. As the market prices reflect what is known, this method is a logical place to start valuation if the shares are actively traded in the market and the market is efficient i.e., the prices reflect all public information available about the firm. It is therefore a useful metric for merger negotiations. 4. Book Value Based: Book value of a firm is derived from the books of accounting. It is a simple method for valuing firms with audited financial reports. An advantage is that it reflects the principle of conservatism as accounting relies on the same principle. The failings of this method include inability to value intangible assets (such as brand value, employee skills etc.), based on past market information. Also, Book value is a backward-looking figure, whereas valuation needs to be forward looking. VALUATION TECHNIQUES VALUATION TECHNIQUES There are two primary methods of valuation of any company 1. Relative Valuation A. Comparable Companies Analysis B. Precedent Transaction Analysis 2. Absolute / Intrinsic Valuation A. Discounted Cash Flow Method B. Dividend Discount Model COMPARABLE COMPANIES A NALYSIS Comparable companies’ analysis (a.k.a. comps analysis) is based on the idea that because similar organizations share essential business and financial traits, performance drivers, and risks, they offer a highly relevant benchmark for evaluating a particular target. Steps for comps analysis: Select the universe of comparable companies Locate the necessary financial information Spread key Statistics, ratios and trading multiples Benchmark the Comparable companies Determine valuation Step 1: Select the universe of comparable companies 39 FINANCE AND ECONOMICS COMPENDIUM The core of comps analysis involves selecting a universe of comparable companies for the target. To identify companies with similar business and financial characteristics, it is first necessary to gain a sound understanding of the target. For studying the targets that are public companies, annual and quarterly annual report filings, equity and fixed income research reports, press releases, transcripts of earnings call, investor presentations and corporate websites provide key business and financial information. Private companies present a greater challenge as the banker is forced to rely upon sources such as corporate websites, sector research reports, news runs, and trade journals for basic company data. A framework for studying the target and selecting comparable companies is shown in the below list. It is not an exhaustive list. Step 2: Locate the necessary financial information Step 3: Spread key statistics, ratios & trading multiples Computation of the following: • • • • Size - Market Valuation: equity value and enterprise value; and Key Financial Data: Sales, gross profit, EBITDA, EBIT, and net income Profitability: Gross profit margin, EBITDA margin, EBIT margin, and Net income margins Growth Profile: Historical and estimated Diluted EPS growth rates Return on investment: o Return on invested Capital (ROIC) 40 FINANCE AND ECONOMICS COMPENDIUM • o Return on Equity (ROE) o Return on Asset (ROA) o Dividend yield Credit Profile: Leverage ratio, Debt-to-total capitalization ratio, Interest Coverage Ratios, and credit ratings (Kindly refer Financial ratios section for the formulas of above ratios) Size: Enterprise Value and Equity Value Enterprise value (“total enterprise value” or “firm value”) is the sum of all ownership interests in a company and claims on its assets from both debt and equity holders. Theoretically, enterprise value is considered independent of capital structure, meaning that changes in a company’s capital structure do not affect its enterprise value. For example, in scenario 1, the company choses to issue debt whereas in scenario 2, the company choses to issue equity shares. It is to be noted that, the enterprise value in both the scenarios remain same at the end. Scenario I: Issuance of Debt ($ in Million) Actuals Particulars Adjustments 2022 Equity Value 650 (+) Total Debt 150 100 (+) Preferred Stock 45 (+) Noncontrolling Interest 15 (-) Cash and Cash Equivalents -50 -100 Enterprise Value 810 0 Expected 2023 650 250 45 15 -150 810 Scenario II: : Issuance of Equity ($ in Million) Actuals Expected Particulars Adjustments 2022 2023 Equity Value 650 100 750 (+) Total Debt 150 150 (+) Preferred Stock 45 45 (+) Noncontrolling Interest 15 15 (-) Cash and Cash Equivalents -50 -100 -150 Enterprise Value 810 0 810 41 FINANCE AND ECONOMICS COMPENDIUM Supplemental Financial Concepts and Calculations 1. Calculation of Last Twelve Months (LTM) Financial Data Listed companies are required to report their financial performance on a quarterly basis, including a full-year report filed at the end of the fiscal year. Therefore, in order to measure financial performance for the most recent annual or LTM period, the company’s financial results for the previous four quarters are summed. 2. Adjustments for Non-Recurring Items To assess a company’s financial performance on a “normalized” basis, it is standard practice to adjust reported financial data for non-recurring items. These adjustments involve the addback or elimination of one-time charges and gains, respectively, to create a more indicative view of ongoing company performance. Typical charges include those incurred for restructuring events (e.g., store/plant closings and headcount reduction), losses on asset sales, changes in accounting principles, inventory write-offs, goodwill impairment, extinguishment of debt, and losses from litigation settlements, among others. Typical benefits include gains from asset sales, favorable litigation settlements, and tax adjustments, among others. Calculation of Key Trading Multiples 42 FINANCE AND ECONOMICS COMPENDIUM Step 4: Benchmark comparable companies • Benchmark financial statistics and key ratios: It is done for the target and its comparables in order to establish relative positioning, with a focus on identifying the closest or “best” comparables and noting potential outliers. • Benchmark the trading multiples: Analysis and comparison of the trading multiples for the peer group, placing particular emphasis on the best comparables is done. Next, the means, medians, highs, and lows for the range of multiples are calculated and displayed, providing a preliminary reference point for establishing the target’s valuation range. Step 5: Determine Valuation • • • • Depending on the sector, point in the business cycle, and comfort with consensus estimates, the comparable companies may be trading on the basis of LTM, one-year forward, or even two-year forward financials A range across the multiples is determined in any of the following ways: o Mean and median values o +/- 10% on the median values o High/Low range of 2-3 closest comparable The selected multiple range is then applied to the target’s appropriate financial statistics to derive an implied valuation range. To arrive at the implied share price, equity value is divided by the no of shares O/S. In case it is Enterprise Value multiple, reverse formulae is applied to get to the equity value Comparable companies’ analysis example What is the value of a company in the that posts annual sales of $340 million, EBITDA of $175 million, and earnings of $80 million (let's call it ABC Co.). Companies might be valued with sales multiples, earnings multiples or EBITDA multiples. These numbers can be found in research reports distributed by different research departments inside investment banks or brokerage firms. The numbers used for EBITDA or earnings might be figured for the 12 months trailing (the previous 12 months), the last fiscal year, 12 months projected, or the next fiscal year projected. Let's assume that there are four companies similar to ABC. An investment bank would perform a comparison to determine relevant multiples: Company Amount in $M Value (Market Cap) Sales EBITDA Earnings DEF Co. 1000 320 145 65 GHI Co. 600 210 140 60 JKL Co. 700 350 200 90 MNO Co. 350 350 240 80 43 FINANCE AND ECONOMICS COMPENDIUM Company Sales Multiples EBITDA Multiples Price-to Earnings Multiple (Market Cap/Sales) (Market Cap/EBITDA) (Market Cap/Earnings) DEF Co. 3.1 6.9 15.4 GHI Co. 2.9 4.3 10.0 JKL Co. 2.0 3.5 7.8 MNO Co. 1.0 1.5 4.4 Average 2.2 4.0 9.4 Particulars ABC Values Valuation Average ($M) ($M) Sales Multiple 340 2.2 763.5 EBITDA Multiple 175 4.0 706.2 Earnings Multiple 80 9.4 750.7 Range of Valuation $706M-$750M So using the multiples method, we can estimate the value of ABC Co. between $706 and $750 million PRECEDENT TRANSACTION ANALYSIS Precedent transactions analysis, like comparable companies analysis, employs a multiples-based approach to derive an implied valuation range for a given company, division, business, or collection of assets (“target”). It is premised on multiples paid for comparable companies in prior M&A transactions. It looks at the premium that acquiring companies are willing to pay for a similar company and apply that to the target company. Steps: Step 1: Selecting the comparable acquisitions Some of the key points to be considered are: • • • • • • Time of Acquisition (Consider recent deals only) & Market condition Reason of Acquisition (Motivation) Percentage stake sold (Keep the deal size like the one the value is applied to) Type of buyer: Financial or strategic Type of takeover: Hostile or friendly Purchase Consideration: Stock, cash, or hybrid Once comparable acquisitions are selected, the next steps are similar to ones carried for trading comparables. Also, these are shown on target’s reported LTM financials. 44 FINANCE AND ECONOMICS COMPENDIUM Step 2: Locate the Necessary Deal-Related and Financial Information For M&A deals involving both public and private companies, this step focuses on gathering financial and deal-related data. Because of the SEC's mandated disclosure requirements, it is typically simpler to find pertinent information on comparable purchases for transactions involving public companies. Public acquirers, on the other hand, may occasionally suppress this information for competitive reasons and only divulge what is legally or statutorily needed to be disclosed. It can be difficult and occasionally impossible to obtain complete (or any) financial information necessary for calculating the transaction multiples in M&A deals involving private enterprises. Step 3: Spread Key Statistics, Ratios, and Transaction Multiples Once the banker has located the relevant deal-related and financial information, they can proceed to spread each selected transaction. This process involves inputting the key transaction data, such as the purchase price, form of consideration, and target financial statistics, into an input page. The relevant multiples for each transaction are then calculated, based on key multiples used for precedent transactions and comparable companies, such as enterprise value-to-EBITDA and equity value-to-net income. The main difference between multiples for precedent transactions and those for comparable companies is that precedent transaction multiples often reflect a premium paid by the acquirer for control and potential synergies. Additionally, precedent transaction multiples are usually calculated based on actual last twelve months (LTM) financial statistics available at the time of deal announcement. Step 4: Benchmark the Comparable Acquisitions Similar to trading comparables, the following stage of analysis involves a detailed examination of the chosen comparable acquisitions to determine the ones most pertinent for valuing the target. During the benchmarking analysis, the banker assesses the key financial statistics and ratios of the acquired companies, with a focus on those that are most comparable to the target. Other pertinent aspects of the deals and market dynamics are also scrutinized. Each precedent transaction is meticulously evaluated during the final curation of the universe, with the most appropriate comparable transactions identified and any significant outliers removed. Finally, an experienced sector banker is consulted to help determine the final universe. Step 5: Determine Valuation Previous transactions provide a basis for determining the implied value range of a target, by using the multiples of comparable acquisitions. The banker typically uses the mean and median multiples from the selected acquisitions universe to establish a preliminary valuation range for the target, with the high and low ends serving as reference points. This initial analysis paves the way for a more detailed examination, where the banker uses the multiples from the most relevant transactions to anchor the final valuation range. Often, the focus is on two or three transactions that closely resemble the target. Once the chosen multiples range is established, the endpoints are multiplied by the target’s relevant financial statistics for the last twelve months to produce an implied valuation range. As with trading comparables, the target’s implied valuation range is then subjected to a sanity check and compared to the results from other valuation methodologies. Key Pros and Cons of Relative Valuation Pros 45 FINANCE AND ECONOMICS COMPENDIUM • • • • Market-based – Information available for the public i.e. market information is used to derive a valuation for the target, which reflects the market’s risk and growth expectations, as well as overall sentiment Relativity – easily measurable and comparable versus other companies Quick and convenient – valuation can be determined based on a few easy-to-calculate inputs Current – valuation is based on prevailing market data, which can be updated on a daily (or intraday) basis Cons • • • Market-based – When there is irrational optimism or pessimism in the market, a value that is entirely reliant on the market may be biased. Absence of relevant comparable – If the target is in a specialised industry, finding "pure play" comparables may be challenging or perhaps impossible, making the valuation by trading comps less relevant. Company-specific issues – The target is valued based on other companies' valuations, which might not account for the target's unique strengths, limitations, prospects, and risk. DISCOUNTED CASH F LOW METHOD The present value of Free Cash Flow to the Firm with the hurdle rate being the cost of capital for the firm (WACC)called the Discounted Cash Flow Model. It is usually computed as discounted value of Free Cash Flows till valuation horizon, plus present value of the forecasted value of business at the time horizon. Formula: Steps: 46 FINANCE AND ECONOMICS COMPENDIUM Step 1: Study the Target and Determine Key Performance Drivers It is essential to have a thorough understanding of the target's business strategy, financial profile, value proposition for consumers, end markets, competitors, and significant risks in order to build a framework for valuation. The banker must be able to develop or verify a reasonable set of financial predictions, along with hypotheses for the target's terminal value and weighted average cost of capital (WACC). In order to create (or support) a credible set of FCF estimates, it is necessary to identify the major factors influencing a company's performance, particularly sales growth, profitability, and FCF projection. These factors may be internal (such as opening new facilities or stores, developing new products, obtaining new client contracts, and enhancing operational and/or working capital efficiency) or external (such as acquisitions, end market trends, consumer buying patterns, macroeconomic factors, or even legislative or regulatory changes). Step 2: Project Free Cash Flow The cash flow available to all the security holders of the organization including equity and debt holders alike is called Free Cash Flow. Cash flow available to equity holders is called Free Cash Flow to Equity (FCFE) and it takes into consideration repayment of debt as well as new debt capital raised by the firm. A measure of company’s profitability (net cash generated) after taking into consideration its expenses, taxes and investments is called Free Cash Flow to the Firm (FCFF) Free Cash Flow Calculation Earnings Before Interest and Taxes Less: Taxes (at the Marginal Tax Rate) Earnings Before Interest After Taxes Plus: Depreciation & Amortization Less: Capital Expenditures Less: Increase/(Decrease) in Net Working Capital Free Cash Flow The following parameters should be considered for Projecting Free Cash Flow • • • • • • • Historical Performance Projection Period Length Projection of Sales, EBITDA, and EBIT Tax Projections Depreciation & Amortization Projections Capital Expenditures Projections Change in Net Working Capital Projections 47 FINANCE AND ECONOMICS COMPENDIUM Step 3: Calculation of Weighted Average Cost of Capital WACC is a broadly accepted standard for use as the discount rate to calculate the present value of a company’s projected FCF and terminal value. It represents the weighted average of the required return on the invested capital (customarily debt and equity) in each company. As debt and equity components have different risk profiles and tax ramifications, WACC is dependent on a company’s “target” capital structure. WACC can also be thought of as an opportunity cost of capital or what an investor would expect to earn in an alternative investment with a similar risk profile. Debt After tax Cost of Debt × % of Debt in the Capital Structure + Equity Cost of Equity × % of Equity in the Capital Structure + Cost of Debt (rd) Cost of debt (rD) is the rate of interest that has to be paid on the debt capital issued by the firm. Usually, it depends on the leverage ratio (D/E) of the firm and the default risk. If the D/E ratio increases, then the probability that creditors will not get fully reimbursed if the firm is dissolved increases which leads to a rise in cost of debt. Thus, the cost of debt can be modelled as a risk free rate plus a risk premium which incorporates the risk of default. Since cost of debt is composed of interest paid, it is fairly easy to calculate. Cost of Equity (Re) Cost of Equity (rE) is the rate of return demanded by the investors. It is effectively the opportunity cost of investing in the firm for equity holders. Since, creditors have the first claim on the assets of the company; cost of equity is greater than the cost of debt. Estimation of cost of equity presents considerably more challenge compared to the cost of debt. For estimating rE we can use the Capital Asset Pricing Model (CAPM). According to CAPM, 48 FINANCE AND ECONOMICS COMPENDIUM Where rf is the risk free rate of return, rm is the expected rate of return on market portfolio and beta is the measure of market risk on the stock i.e how sensitive it is to movements in market. Since, cost of equity is greater than cost of debt, one may wonder if it is possible to reduce overall WACC by taking more and more debt. The answer ofcourse is that it cannot be done and the reason comes from Modigliani Miller theorem. With increase in leverage, the cost of equity rises (since with rising debt, the risk for equity holders increases). Exactly how much does the cost of equity increase can be calculated as follows: The firm’s asset Beta can be written as Now, when D/E ratio changes, since ra does not depend on financing decision of the firm (MM), βa remains unchanged. Thus, for the original D/E ratio and using original βE, calculate the βa. This is called unlevering the β. Equity for new leverage ratio can then be calculated as This process is called relevering the β. Once we have the new equity β, we can calculate the new cost of equity (using CAPM) and then calculate the new WACC. Step 4: Determine Terminal Value The terminal value typically accounts for a substantial portion of the target’s value in a DCF It is important that the target’s financial data in the final year of the projection period i.e. “terminal year” represents a steady state or normalized level of financial performance, as opposed to a cyclical high or low There are two methods to calculate the terminal value: • • Exit Multiple Method Perpetual Growth Method 49 FINANCE AND ECONOMICS COMPENDIUM where, g = perpetuity growth rate i.e. ROE*Retention Ratio FCF = Unlevered Free cash flow n = terminal year of the projection period r = WACC “g” can be also computed using the Implied Perpetuity Growth Rate Formula Step 5: Calculate Present Value and determine valuation Calculating present value centres on the notion that a dollar today is worth more than a dollar tomorrow, a concept known as the time value of money. 50 FINANCE AND ECONOMICS COMPENDIUM Calculation of Enterprise Value : Deriving implying Equity Value Conducting Sensitivity Analysis The valuation can be significantly impacted by any of the many assumptions included in the DCF. As a result, rather than being evaluated as a single value, the DCF output is seen as a valuation range dependent on a number of important input assumptions. The exercise of deriving a valuation range by varying key inputs is called sensitivity analysis. Sensitivity analysis provides evidence that valuation is both a science and an art. The most frequently sensitive inputs in a DCF are important valuation factors like WACC, exit multiple, and perpetual growth rate. Key Pros and Cons of DCF Valuation Pros • • • Cash flow-based – The DCF Valuation reflects value of projected FCF, which represents a more fundamental approach to valuation than using multiples-based methodologies Market independent – The DCF Valuation is more insulated from market ups and downs Self-sufficient – This valuation does not rely entirely upon truly comparable companies or transactions, which may or may not exist, to frame valuation; a DCF is particularly important when there are limited or no “pure play” public comparables to the company being valued 51 FINANCE AND ECONOMICS COMPENDIUM Cons • • • Dependence on financial projections – Accurate forecasting of financial performance is challenging, especially as the projection period lengthens Sensitivity to assumptions – relatively small changes in key assumptions, such as growth rates, margins, WACC, or exit multiple, can produce meaningfully different valuation ranges Terminal value – the present value of the terminal value can represent as much as three-quarters or more of the DCF valuation, which decreases the relevance of the projection period’s annual FCF DIVIDEND DISCOUNT MODEL According to this method, valuing a firm, would be to calculate the value of equity and then add the value of debt. We shall use the price of the share to calculate the value of Equity. Price of any project/investment is equal to the discounted cash flows in future years. For an equity investor (who does not sell his share) the cash flows from equity investment are the dividends and thus the value of share is the discounted present value of all the future dividends. This is known as dividend discount model. Under this model, if DIV1 is the dividend paid out at the end of the first year, r is the discount rate and g is the growth rate of dividends, then current price i.e. P0 is given by The dividends grow because the firms do not pay out all the earnings as dividends. Some of the earnings are reinvested into the business and earn incremental income leading to growth in dividends. The ratio of earnings paid out as dividends is called the Payout ratio = DIV/EPS (where EPS is the earning per share). Thus, 1 – Payout ratio represents the fraction of income reinvested in the business. This is called plowback rate or retention rate. A major assumption that we have made in the above discussion is that all these ratios remain constant which is rarely the case in real life scenarios. For stocks with variable growth rates we find dividends for each year separately and then sum the discounted value to get the price of stock. The process is like that in DCF. 52 FINANCE AND ECONOMICS COMPENDIUM CAPITAL MARKETS PRIMARY AND SECONDARY MARKETS 1. PRIMARY MARKET It is a market that issues new securities on an exchange. It is used by Companies, governments and other groups obtain financing through debt or equity based securities. The primary markets are where investors can get first crack at a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. Primary markets are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors. IPO–It is the first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market. Prospectus- A formal legal document, which is required by and filed with the SEBI that provides details about an investment offering for sale to the public. A prospectus should contain the facts that an investor needs to make an informed investment decision. Book Building- SEBI guidelines defines Book Building as "a process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built-up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memoranda or offer document". Book Building is basically a process used in Initial Public Offer (IPO) for efficient price discovery. It is a mechanism where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date. 2. SECONDARY MARKET This is the market wherein the trading of securities is done. Secondary market consists of both equity as well as debt markets. Securities issued by a company for the first time are offered to the public in the primary market. Once the IPO is done and the stock is listed, they are traded in the secondary market. The main difference between the two is that in the primary market, an investor gets securities directly from the company through IPOs, while in the secondary market, one purchases securities from other investors willing to sell the same. Equity shares, bonds, preference shares, treasury bills, debentures, etc. are some of the key products available in a secondary market. SEBI is the regulator of the same. For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring 53 FINANCE AND ECONOMICS COMPENDIUM and control conduit—by facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions. 2.1 Stock Exchange The stock exchanges in India, under the overall supervision of the regulatory authority, the Securities and Exchange Board of India (SEBI), provide a trading platform, where buyers and sellers can meet to transact in securities. There are 6 stock exchange and 3 commodity derivative exchange recognized by SEBI in India, majority of the trading activity happens through BSE and NSE. The trading platform provided by BSE and NSE is an electronic one and there is no need for buyers and sellers to meet at a physical location to trade. They can trade through the computerized trading screens available with the BSE/NSE trading members or the internet based trading facility provided by the trading members of BSE/NSE Demutualization of stock exchanges Demutualization refers to the legal structure of an exchange whereby the ownership, the management and the trading rights at the exchange are segregated from one another. Difference between a demutualised exchange and mutual exchange In a mutual exchange, the three functions of ownership, management and trading are concentrated into a single Group. Here, the broker members of the exchange are both the owners and the traders on the exchange and they further manage the exchange as well. This at times can lead to conflict of interest in decision making. A demutualised exchange, on the other hand, has all these three functions clearly segregated, i.e. the ownership, management and trading are in separate hands. 2.2 Product Details Following are the main financial products/instruments dealt in the secondary market: Equity : The ownership interest in a company of holders of its common and preferred stock.The various kinds of equity shares are as follows: a) Equity Shares : An equity share, commonly referred to as ordinary share also represents the form of fractional ownership in which a shareholder, as a fractionalowner, undertakes the maximum entrepreneurial risk associated with a business venture. The holders of such shares are members of the company and have votingrights. b) Rights Issue / Rights Shares: The issue of new securities to existing shareholders ata ratio to those already held. c) Bonus Shares: Shares issued by the companies to their shareholders free of cost by capitalization of accumulated reserves from the profits earned in the earlier years d) Preferred Stock / Preference shares: Owners of these kinds of shares are entitledto a fixed dividend or dividend calculated at a fixed rate to be paid regularly beforedividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of 54 FINANCE AND ECONOMICS COMPENDIUM the company’s creditors, bondholders / debentureholders. e) Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remains unpaid. All arrears of preference dividend have to be paidout before paying dividend on equity shares. f) Cumulative Convertible Preference Shares: A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital of the company. g) Participating Preference Share: The right of certain preference shareholders to participate in profits after a specified fixed dividend contracted for is paid. Participation right is linked with the quantum of dividend paid on the equity shares over and above a particular specified level Fixed Income : Fixed-Income securities are debt instruments that pay a fixed amount of interest, in the form of coupon payments, to investors. The interest payments are commonly distributed semi-annually, and the principal is returned to the investor at maturity. Bonds are the most common form of fixed-income securities. Other forms of fixed income securities are: a) Government securities (G-Secs): These are sovereign (credit risk-free) coupon bearing instruments which are issued by the Reserve Bank of India on behalf of Government of India, in lieu of the Central Government's market borrowing programme. These securities have a fixed coupon that is paid on specific dates on half-yearly basis. These securities are available in wide range of maturity dates b) Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to the holder. The buyer of these bonds receives only one payment, at the maturity of the bond c) Convertible Bond: A bond giving the investor the option to convert the bond into equity at a fixed conversion price. d) Commercial Paper: A short term promise to repay a fixed amount that is placed onthe market either directly or through a specialized intermediary. It is usually issued by companies with a high credit standing in the form of a promissory note redeemableat par to the holder on maturity and therefore, doesn’t require any guarantee. Commercial paper is a money market instrument issued normally for tenure of 90 days. e) Treasury Bills: Short-term (91 days, 182 days, 364 days) bearer discount security issuedby the Government as a means of financing its cash requirements. DERIVATIVES BASIC TERMS 1. Option: The right but not the obligation to buy (sell) some underlying cash instrument at a specific rate on a particular expiration date. 55 FINANCE AND ECONOMICS COMPENDIUM 2. Premium: The cost associated with a derivative contract, referring to the combination of intrinsic value and time value. 3. Put Option: A put option is a financial contract giving the owner the right but not the obligation to sell a particular amount of the underlying financial instrument at a pre-set price. 4. Spot: The price in the cash market for delivery using the standard market convention. 5. Strike Price: The price at which the holder of a derivative contract exercises his right. 6. In-The-Money Spot: An option with positive intrinsic value with respect to the current market spot rate. 7. In-The-Money-Forward: An option with positive intrinsic value with respect to the current market forward rate. 8. American Style Option: A type of option that can be exercised at any time unlike the European Style option which can only be exercised at expiry 9. At-the-Market: A kind of financial transaction where the order to buy or sell is executed at the current market price. 10. At-the-Money Spot: An option whose strike price is equal to the current market price in the cash spot market. 11. At-the-Money Forward: An option whose strike price is equal to the current market price in the forward market. 12. Call Option: It is a financial contract that gives the owner the right but not the obligation to buy a specific amount of the underlying financial instrument at a particular price with a specific date of maturity. 13. Commodity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of is a commodity index. 14. Currency Swap: A currency swap involves the exchange of an interest in one currency for the same in another currency. 15. Delta: The change in the financial instrument’s price to changes in the price of the underlying cash index. 16. Equity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of which is an equity index. 17. European Style Option: An option that can be exercised only at expiry as opposed to an American Style option 18. Forward Contracts: An over-the-counter obligation to buy or sell a financial instrument that is settled privately between the two counterparties. 19. Futures Contracts: An exchange-traded obligation to buy or sell a financial instrument. 20. Gamma: The degree of curvature in the financial contract’s price curve to its underlying price. 21. Hedge: A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. 22. Theta: The sensitivity of a derivative product’s value to changes in the date, all other factors staying the same. 56 FINANCE AND ECONOMICS COMPENDIUM FIXED INCOME & BONDS ELEMENTS OF FIXED INCOME SECURITIES BONDS: A bond is a fixed-income investment that represents a loan made by an investor to a borrower, usually corporate or governmental. ISSUERS OF BONDS Following types of entities issue bonds to borrow money: • • • • Corporations Sovereign national governments - e.g. U.S. Treasury Bonds Non-sovereign governments – e.g. State of New York Supranational entities – e.g. IMF, World Bank BOND MATURITY • • • • Term to maturity/Tenor – time remaining until maturity Perpetual bonds – No maturity date Money Market Securities – Bond with maturity of one year or less Capital Market Securities – Bond with maturity of more than one year PAR VALUE Par value is the principal amount that will be repaid at maturity. It is also called face value, maturity value, redemption value or principal value of a bond. If bond is selling for more than its par value, its termed as a premium bond and if it is selling for less than its par value, it’s a discount bond. COUPON PAYMENTS Coupon rate is the annual percentage of the bond’s par value that will be paid to bond holders as interest. 1. Plain Vanilla/Conventional bond: Bond with fixed coupon rate. E.g.: A 10 year, $1000 par value bond paying 5% would pay $50 annually or $25 semi-annually. 2. Zero Coupon/Pure discount bond: These bonds pay no interest prior to maturity. These are sold at a discount and redeemed at par value, the difference is termed as interest for the bond holder. BOND INDENTURE A bond indenture is a legal document or contract between the bond issuer and the bondholder that records the obligations of the bond issuer and benefits owed to the bondholder. Provisions in the bond indenture are known as covenants. 57 FINANCE AND ECONOMICS COMPENDIUM Covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business. Covenants are of two types: 1. Affirmative Bond Covenants : An affirmative or positive covenant is a clause in a bond that requires the issuer (i.e., borrower) to perform specific actions. Examples of affirmative covenants include requirements to maintain adequate levels of insurance, requirements to furnish audited financial statements to the lender, compliance with applicable laws, and maintenance of proper accounting books and credit rating, if applicable. 2. Negative Bond Covenants: Negative, or restrictive, bond covenants are put in place to make issuers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that an issuing firm must maintain as of the date of the financial statements. CASH FLOW OF FIXED INCOME SECURITIES 1. Bullet Structure: A bullet bond is a debt investment whose entire principal value is paid in one lump sum on its maturity date and pays periodic interest payments over the life of the bond. When the final payment includes a lump sum along with the period’s interest payment, it is referred to as a balloon payment. 2. Amortizing Loan: An amortizing loan is a type of loan that requires monthly payments, with a portion of the payments each going towards the principal and interest payments. An amortizing loan is organized in a way that it completely pays off the outstanding loan balance over a period of time. BOND C OLLATERAL Collateral: Assets pledged to support a bond issue are referred to as collateral. 1. Unsecured bonds represent claim to overall assets of the issuer, not any specific asset. 2. Secured bonds are backed by a claim to specific assets of the company. RELATIONSHIP BETWEEN BOND PRICES AND INTEREST RATES All else being equal, if new bonds are issued with a higher interest rate than those currently on the market, the price of existing bonds will decline as demand for those bonds falls. Equally, if new bonds are issued with a lower interest rate than bonds currently on the market, the price of existing bonds will increase in line with demand. If prevailing interest rates are higher than when the existing bonds were issued, the prices on those existing bonds will generally fall. That's because new bonds are likely to be issued with higher coupon rates as interest rates increase, making the old or outstanding bonds generally less attractive unless they can be purchased at a lower price. So, higher interest rates mean lower prices for existing bonds. 58 FINANCE AND ECONOMICS COMPENDIUM If interest rates decline, however, prices of existing bonds usually increase, which means an investor can sometimes sell a bond for more than the purchase price, since other investors are willing to pay a premium for a bond with a higher interest payment, also known as a coupon. FIXED INCOME VALUATION BOND PRICING Yield to maturity (YTM): YTM is the market discount rate used to discount a bond’s cash flows. If we know the bond’s YTM, we can calculate its value (market price) and vice versa. The relationship between price and yield is as follows: • • • When the bond’s yield decreases, the present value of the bond’s payment, i.e. its market value, increases When the bond’s yield increases, the present value of the bond’s payment, i.e. its market value, decreases If bond’s coupon/interest rate is greater than its YTM, its price will be at premium and if the bond’s coupon is less than YTM, its price will be at discount to par value. Figure: Market Yield vs. Bond Value 59 FINANCE AND ECONOMICS COMPENDIUM CALCULATING VALUE OF A BOND Bond value is calculated by finding the sum of present value of the future cash flows from the bond, i.e. the coupon payments and par value, discounted at the YTM rate. π ∑ π‘=1 πΆππ’ππππ‘ πππ ππππ’ππ + π‘ (1 + πππ) (1 + πππ)π Consider a bond having a coupon of 10% and 3 years remaining to maturity. The face value/par value of the bond is Rs.1000. The bond gives has a yield to maturity of 12.5%. Then the value of the bond may be calculated as: Cash Flow in Year 1: 10% of 1000 = Rs 100. PV of cash flow = 100/ (1.125) = Rs.88.88 Cash Flow in Year 2: Rs.100. PV of cash flow = 100/ (1.125) ^2 = Rs.79.01 Cash Flow in Year 3: Rs.1100 (as the principal of Rs.1000 is also paid back). PV of cash flow = Rs.1100/ (1.125) ^3 = Rs.772.65 Bond Value = 88.88+79.01+772.65 = Rs. 940.46 As the YTM is greater than the coupon rate the bond is trading at a discount i.e. the price of the bond is less than its par value. If YTM is lesser than coupon rate then the bond will trade at a premium i.e the current value will be greater than the par value. FULL (DIRTY) AND F LAT (C LEAN) PRICE OF A BOND Usually, bond price is calculated on coupon payment dates but for most bond trades, the settlement date will fall between coupon dates, complicating the calculation of the bond value using the above formula. In these cases, value of bond between coupon dates is calculated as the full price of the bond. The Full Price is as follows: πΉπ’ππ πππππ = (ππ ππ π‘βπ ππππ ππ πππ π‘ πππ’πππ πππ‘π ππππππ π ππ‘π‘ππππππ‘) π (1 + πππ )π‘/π # ππ πππ’πππ πππππππ πππ π¦πππ This price factors in the accrued interest in between the 2 payment dates and is termed as dirty price of the bond. πΉπππ‘ πππππ = πΉπ’ππ πππππ − π΄ππππ’ππ πΌππ‘ππππ π‘ ASSET BACKED SECURITIES 60 FINANCE AND ECONOMICS COMPENDIUM SECURITIZATION Securitization is a financial practice in which assets, such as mortgages, car loans, or credit card debts, are pooled together and sold as securities to investors. The cash flows generated from the underlying assets are then used to pay the investors. The process of securitization involves several steps. First, a financial institution or lender pools together a group of similar assets, such as a group of mortgages, and creates a special purpose vehicle (SPV) to hold them. The SPV then issues bonds or other securities backed by the cash flows generated by the underlying assets. Securitization is used by financial institutions to manage their balance sheets and free up capital for new lending. It is also used by investors to gain exposure to different types of assets and diversify their portfolios. TRANCHES In securitization, tranches refer to the different classes or levels of securities created from a pool of assets, such as mortgages or loans. Each tranche has different risk and return characteristics and is designed to appeal to different types of investors. The process of creating tranches involves dividing the pool of assets into segments based on their risk profile. The assets with the highest credit quality and lowest risk are placed in the highest-rated tranche, while the assets with lower credit quality and higher risk are placed in lower-rated tranches. Investors can choose to invest in a particular tranche based on their risk appetite and return expectations. Generally, higher-rated tranches offer lower returns but are less risky, while lower-rated tranches offer higher returns but are more risky. CREDIT ANALYSIS CREDIT RISK Credit risk refers to the risk that a borrower may default on their financial obligations, such as failing to repay a loan or meet their interest payments. The main components of credit risk include: 1. Default Risk: The probability that the borrower will default on their financial obligations within a specified time frame. 2. Loss Severity: The amount of loss that the lender or investor is likely to incur if the borrower defaults. 3. Expected Loss: (Default risk) x (Loss severity) SENIORITY RANKING OF BONDS A bond’s priority of claims to the issuer’s assets and cash flows us referred to as seniority ranking. Each category of debt from the same issuer is ranked according to a priority of claims in case of default. Secured Debt has a higher priority of claims than unsecured debt and can be further distinguished as first lien secured, senior secured or junior secured debt. Unsecured debt can be divided into senior, junior and subordinated grades. 61 FINANCE AND ECONOMICS COMPENDIUM CREDIT RATINGS Issuer credit ratings are called corporate family ratings whereas issue-specific ratings are called corporate credit ratings. Bonds with high credit rating (Baa3/BBB- and above) are considered investment grade bonds and those with ratings Ba1/BB+ or lower are considered non-investment grade or junk bonds. 4 C’S OF C REDIT ANALYSIS: The 4 C's of credit analysis are: 1. Character: This refers to the borrower's creditworthiness and integrity, including their credit history, reputation, and overall reliability. 2. Capacity: This refers to the borrower's ability to repay the loan based on their income, expenses, and other financial obligations. Lenders will often look at a borrower's debt-toincome ratio to assess their capacity to repay the loan. 3. Collateral: This refers to assets that the borrower can offer as security for the loan, such as real estate or other valuable possessions. Lenders may require collateral as a way to mitigate the risk of lending money to the borrower. 4. Covenants: Covenants are the terms and conditions of the bond issue. Overly restrictive covenants may reduce the issuer’s ability to pay. CREDIT ENHANCEMENT TECHNIQUES Credit enhancement techniques are methods used to improve the credit quality of a security or bond. Here are some common credit enhancement techniques: 1. Collateralization: This involves securing the loan or bond with collateral, which serves as a form of security for the lender or investor. The collateral can be cash, assets, or other securities. 2. Guarantees: Guarantees are promises made by a third party to repay the loan or bond in case the borrower defaults. This could be a corporate parent, government agency, or other entity with strong creditworthiness. 3. Letters of credit: A letter of credit is a document issued by a bank, guaranteeing that the borrower will repay the loan. The letter of credit serves as a form of security for the lender or investor. 4. Insurance: Insurance policies can be purchased to cover the risk of default on a loan or bond. This could be mortgage insurance, bond insurance, or other types of insurance. 5. Overcollateralization: This involves securing the loan or bond with more collateral than the amount of the loan or bond. This provides additional security for the lender or investor. 6. Seniority: This refers to the order in which investors will be repaid if the borrower defaults. Senior debt holders are paid first, followed by junior debt holders. 7. Restrictive covenants: These are conditions placed on the borrower, such as limitations on how much debt the borrower can incur or requirements to maintain certain financial ratios. These conditions help ensure that the borrower maintains strong credit quality. 62 FINANCE AND ECONOMICS COMPENDIUM PRIVATE EQUITY AND VENTURE CAPITAL Private Equity The definition of a private equity (PE) firm is an investment management organisation that raises capital from a group of investors. High net worth individuals or institutional investors, such as sovereign wealth funds, pension funds, etc., make up these investors. These funds are used by a PE to buy stock in running businesses. However, private equity firms do invest in publicly traded companies. This type of investment is known as private investment in public equity (PIPE). Venture Capital Startup businesses with growth potential require a specific sum of financing. Wealthy investors choose to put their money into these types of companies with the goal of long-term growth. The investors are referred to as venture capitalists, and this capital is known as venture capital. Such investments carry risk due to their lack of liquidity, but if used wisely, they can yield spectacular profits. The expansion of the business affects the venture capitalists' returns. Given that their money is on the line, venture capitalists have the ability to influence important corporate choices. PART II: ECONOMICS INTRODUCTION WHAT IS ECONOMICS ? Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices on allocating resources to satisfy their wants and needs, trying to determine how these groups should organize and coordinate efforts to achieve maximum output. Economics can be classified in two ways: 1. Macroeconomics: It is a branch of economics that studies how an overall economy—the market systems that operate on a large scale—behaves. Macroeconomics studies economy-wide phenomena such as inflation, price levels, rate of economic growth, national income, gross domestic product (GDP), and changes in unemployment. 2. Microeconomics: It is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. It describes the pricing of products and money, causes of different prices to different people, how can provide benefit to producers, consumers, and others, and how individuals best coordinate and cooperate. MAJOR THEORIES IN E CONOMICS 1. Classical Economics: It asserts that the power of the market system, if left alone, will ensure full employment of economic resources. 63 FINANCE AND ECONOMICS COMPENDIUM 2. Keynesian Economics: It is an economic theory of total spending in the economy and its effects on output and inflation. 3. Marxist Economics: It is the study of the laws of motion of capitalist society, allowing us to understand why capitalism perpetually goes into crisis. 4. Neoclassical Economics: Neoclassical economics is attributed with integrating the original classical cost of production theory with utility in a bid to explain commodity and factor prices and the allocation of resources using marginal analysis. 5. Rational Expectation: It asserts that people collect relevant information about the economy and behave rationally—that is, they weigh costs and benefits of actions and decisions. 6. Monetarism: Like rational expectations theory, monetarism represents a modern form of classical theory that believes in laissez-faire and in the flexibility of wages and prices. 7. Institutionalism: Institutional economics focuses mainly on how institutions evolve and change and how these changes affect economic systems, economic performance, or outcomes. MICRO ECONOMICS BASIC C ONCEPTS Microeconomics is the branch of economics that studies how individuals and firms make decisions about the allocation of scarce resources. Here are some of the basics of microeconomics: Scarcity: Resources are limited, but our wants and needs are unlimited. This creates a condition of scarcity, which requires individuals and firms to make choices about what to produce, how to produce it, and for whom to produce it. Opportunity Cost: When individuals and firms make a choice, they incur an opportunity cost. Opportunity cost is the value of the next best alternative that is forgone as a result of the decision. Demand and Supply: The demand curve represents the willingness and ability of consumers to buy a product at different prices, while the supply curve represents the willingness and ability of firms to produce a product at different prices. Equilibrium: The market equilibrium is the point at which the quantity demanded equals the quantity supplied, resulting in an efficient allocation of resources. Market Structures: There are four types of market structures: perfect competition, monopolistic competition, oligopoly, and monopoly. Each structure has different characteristics and can affect market outcomes. TYPES OF MARKET STRUCTURES Perfect competition Perfect competition is a market structure in which there are many small firms producing identical products, and there are no barriers to entry or exit from the market. The key characteristics of perfect competition include: 1. Large Number of Small Firms: There are many small firms operating in the market, and no single firm has a dominant market share. 64 FINANCE AND ECONOMICS COMPENDIUM 2. Homogeneous Products: All firms produce identical products that are perfect substitutes for each other. 3. Price Takers: Each firm is a price taker, meaning that they must accept the market price for their product and cannot influence it. 4. Free Entry and Exit: Firms can enter or exit the market freely without facing any barriers or costs. 5. Perfect Information: Consumers and firms have perfect information about prices, quality, and availability of products in the market. 6. Profit Maximization: Firms in perfect competition aim to maximize their profits by producing at the level where marginal cost equals marginal revenue. Oligopoly Oligopoly is a market structure in which a small number of firms dominate the market for a particular product or service. The key characteristics of an oligopoly include: 1. Few Firms: There are only a small number of firms that dominate the market. This gives these firms significant market power to influence prices and output. 2. Interdependence: The actions of one firm affect the profits of the other firms in the industry. Therefore, each firm must take into account the possible reactions of its competitors when making decisions about pricing and output. 3. Barriers to Entry: Oligopolies often have high barriers to entry, such as high start-up costs or government regulations, which make it difficult for new firms to enter the market. 4. Product Differentiation: Firms in an oligopoly may differentiate their products through branding, advertising, or other means to gain a competitive advantage. 5. Non-Price Competition: Firms in an oligopoly may engage in non-price competition, such as product innovation or marketing campaigns, to attract customers and increase market share. Oligopolies can lead to higher prices and reduced output compared to a perfectly competitive market. They can also lead to collusion among firms to restrict output and raise prices, which is illegal in many countries. Government intervention, such as antitrust regulations, may be necessary to promote competition and protect consumers. Monopolistic Competition Monopolistic competition is a type of market structure in which many firms compete against each other, but each firm has some degree of market power due to product differentiation. This means that each firm produces a differentiated product that is not identical to those produced by its competitors, and therefore, it has some control over the price it charges. Overall, monopolistic competition is characterized by a large number of firms, differentiated products, some degree of market power, and relatively easy entry and exit for firms. Monopoly Characteristics associated with a monopoly market make the single seller the market controller as well as the price maker. He enjoys the power of setting the price for his goods. In a monopoly market, factors like government license, ownership of resources, copyright and patent and high starting cost make an entity a single seller of goods. All these factors restrict the entry of other sellers in the market. Monopolies also possess some information that is not known to other sellers. 65 FINANCE AND ECONOMICS COMPENDIUM MACRO ECONOMICS AGGREGATE DEMAND The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. AD = C + I + G + (X-M) C = Consumers' expenditures on goods and services I = Investment spending by companies on capital goods G = Government expenditures on publicly provided goods and services X = Exports of goods and services M = Imports of goods and services. NATIONAL INCOME National income means the value of goods and services produced by a country during a financial year. Thus, it is the net result of all economic activities of any country during a period of one year and is valued in terms of money. CONCEPTS OF NATIONAL INCOME Gross Domestic Product It is the monetary value of all the finished goods and services produced within a country's borders in a specific time period. GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a country's standard of living. Critics of using GDP as an economic measure say the statistic does not take into account the underground economy - transactions that, for whatever reason, are not reported to the government. Gross National Product It is an economic statistic that includes GDP, plus any income earned by residents from overseas investments, minus income earned within the domestic economy by overseas residents. GNP is a measure of a country's economic performance, or what its citizens produced (i.e. goods and services) and whether they produced these items within its borders. Net Domestic Product Net domestic product (NDP) is an annual measure of the economic output of a nation that is adjusted to account for depreciation and is calculated by subtracting depreciation from the gross domestic product (GDP). It accounts for capital that has been consumed over the year in the form of housing, vehicle, or machinery deterioration. Net National Product Net national product (NNP) is the monetary value of finished goods and services produced by a country's citizens, overseas and domestically, in a given period. It is the equivalent of gross national product (GNP) minus the amount of GNP required to purchase new goods to maintain existing stock, otherwise known as depreciation. GDPFC = GDPMP – Net Indirect Taxes (Indirect Taxes – Subsidies) NDPFC = GDPFC – Depreciation 66 FINANCE AND ECONOMICS COMPENDIUM NNPFC (National Income) = NDPFC + Net Factor Income from Abroad PROBLEM OF D OUBLE C OUNTING According to output method (an alternative method to value added method) of calculating national income, value of only final goods and services produced by all the production units of a country during a year should be counted. But in actual practice, while taking value of final goods, value of intermediate goods also gets included because every producer treats the commodity he sells as final product irrespective of whether it is used as intermediate or final good. In this way certain items are counted more than once resulting in over-estimation of national product to the extent of the value of intermediate goods included. This is called the problem of double counting which means counting value of the same commodity more than once. There are two alternative ways of avoiding double counting: 1. Final Product approach 2. Value Added approach METHODS TO CALCULATE NATIONAL INCOME 1. Production Method: In this method, national income is measured as a flow of goods and services. We calculate money value of all final goods and services produced in an economy during a year. Formula: πΊππ΄ππ = ππππ’π ππ ππ’π‘ππ’π‘ − πΌππ‘ππππππππ‘π πΆπππ π’πππ‘πππ Taking the sum of GVAMP (Gross Value Added at Market Price) of all the industrial sectors of the economy will give NDPMP (Net Domestic Product). 2. Income Method: Under this method, national income is measured as a flow of factor incomes. There are generally four factors of production labour, capital, land and entrepreneurship. Labour gets wages and salaries, capital gets interest, land gets rent and entrepreneurship gets profit as their remuneration. Formula: ππ·πππ = πΆππππππ ππ‘πππ ππ πΈπππππ¦ππ π + π πππ‘ & π ππ¦πππ‘π¦ + πΌππ‘ππππ π‘ + ππππππ‘ + πππ₯ππ πΌπππππ 3. Expenditure Method: The expenditure estimate is based on the value of total expenditure on goods and services, excluding intermediate goods and services, produced in the domestic economy during a given period. Thus expenditure approach reflects the value of spending by corporations, consumers, overseas purchasers and government on goods and services. The primary data for this measure come from expenditure surveys of households and businesses, as well as from data on government expenditure. GDP as examined using the Expenditure Approach is reported as the sum of four components. The formula for determining GDP is: C + I + G + (X - M) = GDP INFLATION Inflation refers to the sustained increase in the general price level of goods and services over a period of time. It is often measured as the percentage change in the Consumer Price Index (CPI), which is a 67 FINANCE AND ECONOMICS COMPENDIUM basket of goods and services purchased by households. Inflation means that the purchasing power of money decreases over time, and it can affect different groups of people and institutions differently. There are several causes of inflation, including: 1. Increase in demand: When there is an increase in demand for goods and services, it can lead to a shortage of supply, resulting in higher prices. 2. Increase in production costs: When the cost of producing goods and services increases, such as wages or raw materials, producers may pass on these costs to consumers through higher prices. 3. Increase in money supply: When there is too much money in circulation, it can lead to an increase in demand for goods and services, leading to higher prices. DEFLATION Deflation refers to a sustained decrease in the general price level of goods and services over a period of time. It is the opposite of inflation, and it means that the purchasing power of money increases over time. Deflation can occur due to a variety of factors, including a decrease in demand, an increase in supply, or a decrease in the money supply. DISINFLATION Disinflation refers to a decrease in the rate of inflation, which means that prices are rising at a slower rate than before. In other words, disinflation is a situation where the overall level of prices is still increasing, but at a slower pace than before. STAGFLATION Stagflation is an economic condition characterized by stagnant economic growth, high unemployment, and high inflation occurring simultaneously. This is a rare and undesirable economic phenomenon that is difficult to address with traditional economic policies because measures to address one issue may exacerbate the other. CONSUMER PRICE INDEX CPI uses a "basket of goods" approach that aims to compare a consistent base of products from year to year, focusing on products that are bought and used by consumers on a daily basis. The CPI measures price change from the perspective of the retail buyer. It is the real index for the common people. It reflects the actual inflation that is borne by the individual. CPI is designed to measure changes over time in the level of retail prices of selected goods and services on which consumers of a defined group spend their incomes. FISCAL AND MONETARY POLICY The government exerts its control over the nation‘s economy using two distinct set of policies. One is the monetary policy (the central bank manages this on behalf of the government) and secondly the 68 FINANCE AND ECONOMICS COMPENDIUM fiscal policy. Fiscal policy is the use of government expenditure and revenue collection through taxation to influence the economic activity. With the help of monetary policy, the Reserve Bank of India (RBI) attempts to stabilize the economy by controlling interest rates and spending. Monetary policy consists of various policy rates and reserve ratios. Fiscal Policy It is a set of tools at the Government’s disposal to maintain growth, inflation and employment rate at desired levels. This is ensured through spending on the relevant sectors. Essentially, fiscal policy boils down to government expenditures and revenues that can be understood by the following terms: Receipts: These are the sources of income for the government. These can be further classified as follows: 1. Revenue receipts: The income which creates neither a liability nor reduces the assets of the government (disinvestment or sale). Taxes and interest on investments, transfer of interest by RBI are prime examples of this. 2. Capital receipts: The income generated by raising debt or by depleting assets (disinvestment). Raising money through bonds and disinvestment are prime examples of this. Expenditure: This is how the government spends/invests the money in order to meet the growth, inflation and employment rates. 1. Revenue expenditure: The expenditure which does not create an asset but is incurred to run the operations. Salary payments, pensions and interest servicing on the previous debts are prime examples 2. Capital Expenditure: The expenditure which results in creation of assets, be it through acquisition of assets or investments or payback of existing debts (principal payments). Land acquisition, investment in companies and paying off debt obligations are a few examples Expansionary Fiscal Policy When the economy is in recession, government wants to increase Aggregate Demand (AD) • Tax cut: increases consumers disposable income • Increases Aggregate Demand as long as consumers don’t increase savings or spending on imports • Increase in government spending: directly shifts the Aggregate Demand curve Contractionary Fiscal Policy When economy is suffering from inflation, government wants to decrease Aggregate Demand • Tax increase: decreases disposable income of consumers • Aggregate Demand curve shifts left, both inflation and GDP decrease • Decrease in government spending: directly shifts the Aggregate Demand curve left Monetary Policy Monetary policy refers to the use of monetary tools by the central bank to influence the supply of money, interest rates, and credit conditions in an economy to achieve its policy objectives. The primary objective of monetary policy is to maintain price stability while also supporting economic growth and employment. 69 FINANCE AND ECONOMICS COMPENDIUM Some of the commonly used monetary policy tools are: 1. Bank rates: Central banks use interest rates to influence the borrowing and lending activities of banks and other financial institutions. Higher interest rates increase the cost of borrowing, which reduces consumer and business spending, while lower interest rates increase borrowing and spending, which can stimulate economic growth. 2. Repo Rate: Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds in the short term. 3. Reverse Repo Rate: The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected. 4. Reserve requirements: Central banks can also require banks to hold a certain percentage of their deposits as reserves, which limits the amount of money that banks can lend, thereby influencing the money supply in the economy. 5. Open market operations: This involves the buying and selling of government securities by the central bank to influence the money supply in the economy. If the central bank buys securities, it increases the money supply, while selling securities reduces the money supply. Apart from the above-mentioned quantitative measures, RBI adopts qualitative measures as well to meet its objectives. 1. Moral Suasion: The bankers are vocally communicated to head the in the direction that RBI wants the scheduled banks to. This may be through press releases or direct meetings with the heads of the banks but not by issuing hard and fast rules. 2. Rationing of credit: Banks may be encouraged to lend credit to certain sectors and be discouraged to lending to certain sectors. Priority sector lending requirement is one such measure. 3. Margin requirements: Certain sectors and class of individuals may be required to put up higher margins for their loans as, thereby encouraging credit availability to certain sectors and discouraging it to others. 4. Direct Action: A few banks may be put under the direct control of RBI with restrictions on customer withdrawals, credit disbursement, branch expansion and hiring. PMC bank is a prime example of this. FDI & FIIS: 1. FDI stands for Foreign Direct Investment and refers to the investment made by a foreign entity in a business or a physical asset in a foreign country. This investment is usually long-term and involves the acquisition of a controlling stake in a business or the establishment of a new business. FDI is often associated with the transfer of technology, management expertise, and job creation in the host country. 2. FII stands for Foreign Institutional Investment and refers to the investment made by foreign institutions, such as pension funds, mutual funds, and hedge funds, in the financial markets of a foreign country. FII is usually short-term and involves the purchase of securities such as 70 FINANCE AND ECONOMICS COMPENDIUM stocks and bonds. FIIs are interested in earning a return on their investment and can withdraw their investments quickly if they anticipate a change in market conditions. STOCK PITCH A sample stock pitch is attached below for your reference. 71 Avenue Supermart Ltd. Rating: HOLD TP : INR 3,377 Paused, but poised to resume… Team A-cube MI Capital 20P183 Aditya Diwan 20P184 Aditya Manjeshwar 20P194 Anurag Bagaria 20P210 Mahima Gupta 20P206 Ishani Vijay
