Corporate Finance

1. EMBA - 2020
Executive Education
18EPG201 Corporate Finance
CA A G Krishnan
9886217080 agk_1954@yahoo.com
Unit 1
Corporate finance is primarily concerned with maximizing shareholder
value through long and short-term financial planning and the
implementation of various strategies.
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Faculty introduction
• A G Krishnan , qualified Chartered Accountant(1981), Cost Accountant(1981)
and Company Secretary (1990)
• Diploma in Information Systems Audit (2005) – just to showcase that age is no
bar for learning
• In industry for more than 35 years First 25 years in service and later part in
practice as a practicing Chartered Accountant
• Companies worked include Kirloskar Toyoda Textile Machinery Limited and
MTR Foods Limited as the CFO and Company Secretary
• As a practicing Chartered Accountant, a mixed profile as Statutory Auditor
(including Hubli Electricity Supply Company Limited and HAL (overhaul
division), Concurrent auditor for bank branches, internal auditor, tax advisor
and consultant(direct and indirect taxes), management consultant, teaching as
Visiting Faculty
• Independent director for 3 years in an OTC listed company .
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Learning outcomes
• Understand the role of the Corporate Finance Manager and the concept of profit
vs. wealth maximization in an organization.
• Understand the concept of present value, future value, amortization schedule,
effective and nominal rate of interest, multi period of compounding, sinking fund
factor. Explain the methods of calculating present & future value and use of
discounting & compounding techniques with the help of problems & cases
• Understand the concept and calculation of cost of capital of a business and
calculate the cost of debt capital, preference share capital & equity share capital.
Calculate the weighted average cost of capital and discuss its usefulness.
Understand the factors affecting the capital structure of the firm, the concept of
financial, operating & combined leverage & its impact on shareholders return &
risk.
• The learner will understand the factors that determining a company’s dividend
policy and forms of dividends and the conceptual understanding of buy back of
shares.
• Understand the different elements of working capital concept, operating & cash
conversion cycle, and estimation of working capital. The student should have
conceptual understanding of credit, cash & Inventory management.
Understanding working capital receivables, inventory & cash management.
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Executive Education
Unit 1 Syllabus
• Overview of Corporate Finance:
• Scope of finance
• Objective of corporation
• Finance function.
• Financial Manager’s role
• Agency Problem
• Financial goal: Profit Maximization vs. Wealth Maximization.
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Importance of Corporate Finance
• Page 9 of book by Prof Paramasivan
• Financial planning
• Acquisition of funds
• Proper use of funds
• Financial Decision
• Improve profitability
• Increase the value of the firm
• Promoting savings
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Scope of Corporate Finance
• Page 4 of book by Prof Paramasivan
• Financial management and economics – Financial economics
• Financial Management and accounting
• Financial Management and mathematics. Lot of tools available now –
Econometrics
• Financial Management and production management
• Financial Management and marketing
• Financial Management and HR
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Objective Function
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
 Firms can always focus on a different objective function.
Examples would include

maximizing earnings

maximizing revenues

maximizing firm size

maximizing market share

maximizing EVA

 The key thing to remember is that these are intermediate objective
functions.

To the degree that they are correlated with the long term health and value of the company,
they work well.

To the degree that they do not, the firm can end up with a disaster

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What is corporate finance?

 Every decision that a business makes has financial implications, and any
decision which affects the finances of a business is a corporate finance
decision.

 Defined broadly, everything that a business does fits under the rubric of
corporate finance.
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Corporate finance is focused…
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It is the focus on maximizing the value of the business that
gives corporate finance its focus. As a result of this singular
objective, we can Choose the “right” investment decision
rule to use, given a menu of such rules.
 Determine the “right” mix of debt and equity for a
specific business
 Examine the “right” amount of cash that should be
returned to the owners of a business and the “right”
amount to hold back as a cash balance.
This certitude does come at a cost. To the extent that you
accept the objective of maximizing firm value, everything in
corporate finance makes complete sense. If you do not,
nothing will.
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Principles don’t change – First principles not to be ignored
• A publicly traded firm, with its greater access to capital markets and more
diversified investor base, may have much lower costs of debt and equity
than a private business, but they both should look for the financing mix
that minimizes their costs of capital.
• A firm in an emerging markets may face greater uncertainty, when
assessing new investments, than a firm in a developed market, but both
firms should invest only if they believe they can generate higher returns on
their investments than they face as their respective (and very different)
hurdle rates.
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What can go wrong?
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TheInvestmentDecision
Investinassetsthatearnareturn
greaterthantheminimumacceptable
hurdlerate
TheFinancingDecision
Findtherightkindofdebtforyour
firmandtherightmixofdebtand
equitytofundyour operations
TheDividendDecision
If youcannotfindinvestmentsthatmake
yourminimumacceptablerate,returnthe
cashtoownersofyourbusiness
HurdleRate
4.Define&MeasureRisk
5.TheRiskfreeRate
6.EquityRiskPremiums
7. CountryRiskPremiums
8.RegressionBetas
9.BetaFundamentals
10. Bottom-upBetas
11. The"Right"Beta
12. Debt:Measure&Cost
13. FinancingWeights
InvestmentReturn
14. EarningsandCashflows
15. TimeWeightingCashflows
16. LooseEnds
FinancingMix
17. TheTradeoff
18.CostofCapitalApproach
19. CostofCapital:Followup
20.CostofCapital:Wr
a
pup
21.AlternativeApproaches
22.Movingtotheoptimal
FinancingType
23.TheRightFinancing
DividendPolicy
24.Trends&Measures
25.Thetradeoff
26.Assessment
27.Action&Followup
28.TheEndGame
Valuation
29.Firststeps
30.Cashflows
31. Growth
32.TerminalValue
33.Tovaluepershare
34.Thevalueofcontrol
35.RelativeValuation
SetUpandObjective
1:Whatiscorporatefinance
2:TheObjective:UtopiaandLetDown
3:TheObjective:RealityandReaction
36.ClosingThoughts

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What we studied in Trimester 1
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Cash flow statement as part of audited accounts
A CASH FLOW FROM OPERATING ACTIVITIES
Net Profit Before Tax
Adjustments for:
Depreciation -
Preliminary Expenses w/off -
Deferred Revenue Expenditure -
(Profit)/loss on sale of Assets -
Interest & Finance Charges -
Interest on FD -
Dividend Income -
Operating Profit before Working Capital Changes
Adjustments for:
Decrease/(Increase) in Receivables -
Decrease/(Increase) in Inventories -
Increase/(Decrease) in Payables -
Cash generated from operations
Income Tax paid
Net Cash flow from Operating activities
B CASH FLOW FROM INVESTING ACTIVITIES
Purchase of Fixed Assets -
Mutual Fund -
Sale of Fixed Assets -
Increase in Advances & others -
Interest on FD -
Dividend Income -
Net Cash used in Investing activities
C CASH FLOW FROM FINANCING ACTIVITIES
Proceeds from Long term Borrowings -
Interest paid -
Net Cash used in financing activities
Net increase in cash & Cash Equivalents (A+B+C)
Cash and Cash equivalents as at 01.04…..
Cash and Cash equivalents as at 31.03……
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Three areas of Corporate Finance - Investing ,
Financing and Operating
• 1. What long-term investments should you take on? That is, what lines of
business will you be in and what sorts of buildings, machinery and
equipment will you need? CAPITAL BUDGETING
• Greenfield projects or ongoing projects(acquisition , amalgamation, etc)
• Horizontal expansion
• Vertical expansion
• Forward Integration
• Backward Integration
• Make or buy
• Short term to long term on a flexible basis
• Capacity build up and capacity optimization between the two opposite scenarios
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Three areas of Corporate Finance - Investing ,
Financing and Operating
• 2. Where will you get the long-term financing to pay for your investment? Will
you retain the profits which you make, will you bring in other owners or will you
borrow the money? CAPITAL STRUCTURE
• Promoter Contribution or distributed shareholding
• Plough back of profits based on realistic cashflows
• Term Loans or debentures
• Deep discount bonds or normal bonds
• Debt Equity Ratio
• Financial Leverage
• Business Valuation for equity infusion
• Vision and Mission
• Exit route for external promoters.
• Income tax, SEBI, Companies Act, RBI , etc compliances
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Capital Structure
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Theories of capital structure
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• All theories have basic assumptions.
• Net Income Approach Value = Market Value of Equity + Market Value of Debt
• Net Income Approach = Cost of capital = EBIT / (MVE+MVD)
• Net Operating Income Approach = WACC remains constant. As proportion of debt
increases, shareholder risk perception increases which neutralises the lower cost of
debt
• Traditional approach : Chart the WACC in different scenarios of debt and equity
proportion and choose the one which optimises the cost of capital
• Modigliani Miller two postulations one without considering tax effects and one
considering the tax effects
• Without taxes – same as Net operating Income approach
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Modigliani – Miller Model……
• According to the M-M approach, the value of an unlevered firm (Which does
not use debt ) can be calculated as follows.
• Value of unlevered firm, Vu = EBIT/ Ke (1-T)
Where EBIT = Earnings Before Interest an Taxes
T = Tax rate Ke = Cost of equity
VL = Vu = (T x D)
Value of levered firm = Value of unlevered firm = (Tax rate x Debt)

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Three areas of Corporate Finance - Investing ,
Financing and Operating
• 3. How will you manage your everyday financial activities such as
collecting from customers and paying suppliers? WORKING CAPITAL
MANAGEMENT
• Working Capital cycle
• Working capital from own funds or borrowed funds
• Borrowed funds from banks or from suppliers
• Fund based or non fund based
• Collection methods to be applied to expedite collections
• Payment to vendors on timely basis
• Non postponement of statutory payments.
• Each item of working capital / within this each sub item / within this each sub sub
item, etc
• Effective financial controls and checks and balances to smoothen operations
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Accounting and Finance
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• The main difference between them is that those who work
in finance typically focus on planning and directing
the financial transactions for an organization, while those who work
in accounting focus on recording and reporting on those transactions
• Both roles are equally important . But the above explanation makes sense.

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Finance manager’s roles and responsibilities
• Collecting, interpreting and reviewing financial information
• Predicting future financial trends
• Reporting to management and stakeholders, and providing advice how the
company and future business decisions might be impacted
• Producing financial reports related to budgets, account payables, account
receivables, expenses etc.
• Developing long-term business plans based on these reports
• Reviewing, monitoring and managing budgets
• Developing strategies that work to minimise financial risk
• Analysing market trends and competitors
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Finance functions – another look
• Raising Finance
• Capital Markets
• Financial due diligence
• Dispute and advisory regulations
• Financial modelling
• Valuations and Intellectual Property
• Strategy and exit planning
• MBO’s and MBI’s
• Mergers & Acquisitions
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Financial analysis and analytics
Evaluating whether the company’s current assets and investments are the
best use of the company’s excess working capital, by looking at return on
investment (ROI) and comparisons with other ways the company might
utilize its cash flow (e.g., other possible investments, increased stock
dividends, etc
Gauging the company’s overall financial health, primarily by using key
financial ratios such as the debt to equity ratio, current ratio, and interest
coverage ratio
Determining which of the company’s products or product lines generate
the largest portion of its net profit
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Financial analysis and analytics
Identifying which products have the highest profit margin (and which
have the lowest) – This is a separate inquiry from the one listed above, as
product(s) that carry the highest profit margin may not necessarily be
those that generate the greatest amount of total profit – A simple example:
Product A may carry a higher profit margin than Product B, but the
company may sell substantially more units of Product B
Examining and evaluating the cost-efficiency of each department of the
company, in light of what percentage of the company’s financial resources
each department consumes
Working with individual departments to prepare budgets and consolidate
them into one overall corporate budget
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Financial analysis and analytics
• Preparing internal reports for executive leadership and supporting their
decision making
• Creating, updating, and maintaining financial models and detailed forecasts of
the company’s future operations
• Comparing historical results against budgets and forecasts, and performing
variance analysis to explain differences in performance and make improvements
going forward
• Considering opportunities for the company to expand or grow. Mapping out
growth plans, including capital expenditures and investments. Generating three-
to five-year financial forecasts
• In the end, a company’s financial analysts are expected to provide upper
management with analysis and advice regarding how to most effectively utilize
the company’s financial resources to increase profitability and grow the
company at an optimal rate, while avoiding putting the company at serious
financial risk.
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Key aspects in corporate finance
• The key aspects
• characteristics of the finance function in high-growth businesses
• events in the lifetime of the business that prompted the founder/directors
to build in additional financial capability
• the symbiosis between a company’s high growth and its finance function
• how business planning works in a high-growth environment and the role
of the finance team in this
• the particular skill sets and support required for senior management and
the finance function in responding to and managing growth, and
• the challenges presented by both obstacles to growth and ‘growing pains’
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Personal traits required for a finance manager
• An analytical mind
• Negotiation skills and the ability to develop strong working relationships
• Commercial and business awareness
• Good communication skills – both written and verbal
• A keen eye for detail and desire to probe further into data
• Ability to stick to time constraints
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Introduction to the subject
• .
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Let us see what the course curriculum says
• The subject raises the awareness of the role, purpose, and centrality of the
finance function in effective corporate governance
• Corporate Governance
• Principles and tenets
• Internal Monitoring mechanisms
• External Monitoring by reporting and compliance
• Conflict of interest
• Related party transactions
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Corporate Governance
• .
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Corporate Governance
• Almost all corporate governance provisions affect either the threat of
removal or compensation. Some provisions are internal to a firm and are
under its control.
• These internal provisions and features can be divided into five areas: (1)
monitoring and discipline by the board of directors; (2) charter provisions
and bylaws that affect the likelihood of hostile takeovers; (3)
compensation plans; (4) capital structure choices; and (5) accounting
control systems.
In addition to the corporate governance provisions that are under a firm’s
control, there are also environmental factors outside of a firm’s control, such
as the regulatory environment, block ownership patterns, competition in
the product markets, the media, and litigation
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Corporate Governance in Indian Context
• Listed companies and big ticket companies
• Other companies
• Audit Committee, Remuneration Committee, etc
• Independent Director mandatory
• Under Listing agreement certificate by CEO and CFO on internal controls,
compliances, etc
• Auditor Report on Corporate Governance
• Directors Report to give related party transactions
• Shareholding pattern and threshold limits for entry and exit
• SEBI ,RBI and other agencies with control mechanism by compliance
reporting . Competition Commission of India,etc.
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Curriculum content – continued
• Corporate Finance builds upon the concepts from the core finance
subjects,
• objective of finance
• profit v/s wealth maximization
• time value of money
• financial markets & institutions
• measuring risk and return
• cost of capital
• capital budgeting decision
• optimal capital structure
• long-term and short-term sources of fund
• working capital management decision
• capital market.
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Overview of Corporate Finance
• The basic types of financial management decisions and the role of the
financial manager
The financial implications of the different forms of business organization
 The goal of financial management
 The conflicts of interest that can arise between managers and owners
 The role of financial institutions in the financial markets
The importance of financial markets in the financial management of the
firm
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Three main limbs of Corporate Finance
• 1. What long-term investments should you take on? That is, what lines of
business will you be in and what sorts of buildings, machinery and
equipment will you need? CAPITAL BUDGETING
• 2. Where will you get the long-term financing to pay for your investment?
Will you retain the profits which you make, will you bring in other owners
or will you borrow the money? CAPITAL STRUCTURE
• 3. How will you manage your everyday financial activities such as
collecting from customers and paying suppliers? WORKING CAPITAL
MANAGEMENT
These are not the only questions by any means, but they are among the
most important. Corporate finance, broadly speaking, is the study of ways to
answer these three questions
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Various considerations that corporates have to go through
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Another way to look at Corporate Finance
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Each of the points given below has a long list of Things to do
• (1) innovativeness,
• (2) quality of management,
• (3) long-term investment value,
• (4) social responsibility,
• (5) employee talent,
• (6) quality of products and services,
• (7) financial soundness,
• (8) use of corporate assets, and
• (9) effectiveness in doing business globally
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The Key Attributes of Successful Companies
• First, successful companies have skilled people at all levels inside the
company, including leaders, managers, and a capable workforce.
• Second, successful companies have strong relationships with groups outside
the company. For example, successful companies develop win–win
relationships with suppliers and excel in customer relationship
management.
• Third, successful companies have enough funding to execute their plans and
support their operations. Most companies need cash to purchase land,
buildings, equipment, and materials
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Some key terms we will be using
• Equity
• Preference
• Convertible securities
• Non convertible securities
• Long term rupee loans
• Long term FC loans
• Lease finance
• Deep Discount Bonds
• Derivatives
• Innovative financial instruments
• Cost Benefit analysis
• Taxation as a major constituent
• Short term and long term cash flows
• Government regulations and controls
– Government through RBI, SEBI,
MCA, etc.
• Other regulations – Competition
Commission, Environment clearances,
etc.
• Positives like Single Window
Clearance, Preferential Treatment,
Government subsidies, etc.
• Cost, Control, Risk, etc.
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Financial goal: Profit Maximization vs. Wealth Maximization.
• The essential difference between the maximization of profits and the
maximization of wealth is that the profits focus is on short-term earnings,
while the wealth focus is on increasing the overall value of the business
entity over time. These differences are substantial, as noted below:
• Planning duration. Under profit maximization, the immediate increase of
profits is paramount, so management may elect not to pay
for discretionary expenses, such as advertising, research, and
maintenance. Under wealth maximization, management always pays for
the discretionary expenditures.
• Risk management. Under profit maximization, management minimizes
expenditures, so it is less likely to pay for hedges that could reduce the
organization's risk profile. A wealth-focused company would work on risk
mitigation, so its risk of loss is reduced.
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Financial goal: Profit Maximization vs. Wealth Maximization.
• Pricing strategy. When management wants to maximize profits, it prices
products as high as possible in order to increase margins. A wealth-oriented
company could do the reverse, electing to reduce prices in order to build market
share over the long term.
• Capacity planning. A profit-oriented business will spend just enough on its
productive capacity to handle the existing sales level and perhaps the short-term
sales forecast. A wealth-oriented business will spend more heavily on
capacity in order to meet its long-term sales projections.
• It should be apparent from the preceding discussion that profit maximization is
a strictly short-term approach to managing a business, which could be damaging
over the long term. Wealth maximization focuses attention on the long term,
requiring a larger investment and lower short-term profits, but with a long-term
payoff that increases the value of the business.
• Profit maximization is the primary objective of the concern because of profit act
as the measure of efficiency. On the other hand, wealth maximization aim at
increasing the value of the stakeholders. There is always a conflict regarding
which one is more important between the two
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Agency Problem and Conflict of Interest
• managers acting in their own best interests, rather than in the best
interests of the owners
• Similar between holding company and subsidiary company
• Managers are hired as agents to act on behalf of the owners.
• Agency problems can be addressed by a company’s corporate
governance, which is the set of rules that control a company’s behavior
towards its directors, managers, employees, shareholders, creditors,
customers, competitors, and community
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1981 to 2017 Ambuja Cements Limited
1981Private Limited Company Incorporation
Manufacture of Cement
Many international tie ups for world class manufacturing
1985
Share capital increased with participation by government companies, Non resident , etc
Doubling production capacitiy
1990Second cement plant
1991
Lot of financing plans put on the anvil non convertible and convertible securities
1992Bulk movement through ships designed and built
1998Foray into international tie ups with Sri Lanka
2000Strategic tie up with major competitor
2001FCCBs floated by company
2009Knowledge Centre set up
201125 years completion and achieves water positive status
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Cases in Corporate Finance
• Capital Structure:
• Pilgrim's Pride (2003)
• Intel (1991)
• Marriott's Spin-Off (1992)
• Host Marriott (1998)
• Excessive Use of Debt:
• LTCM (1998)
• Dividend Policy — Share
Repurchase:
• Salomon: Share Repurchase (1997)
• Microsoft (2003–2004)
• Berkshire Hathaway, Inc.
• Florida Power & Light Company (FPL)
(1994)
• DIRECTV (2011)
• Apple (2014)
• Restructuring
• "Chain Saw" AL and Sunbeam (1995–
1998)
• GE (2007)
• Sun Company, Inc. (1995)
• AutoNation (2006)
• Kerr–McGee and Icahn (2005)
• GE (2014)
• Pfizer–Zoetis (2013
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Cases in Corporate Finance
• Mergers: Raids: Use of Debt:
• Hoffman–Sterling–Kodak (1986)
• OCF (1986)
• Bendix–Marietta–Allied (1982)
• E–II Holding Inc. (1987)
• LBO of RJR Nabisco (1988)
• RJR Nabisco (1993)
• RJR–KKR–Borden (1994)
• Hilton–ITT–Starwood (1997)
• Anheuser–Busch–InBev (2008)
• Merck–Shering Plough (2009)
• The Acquisition of by P&G (2005)
• P&G and the Gillette Company (2005)
• Use of Exotics:
• Time Warner (1989–1991)
• Income Deposit Security (IDS) (2004)
• ZYPs (1999) Bank Austria
• The Walt Disney Company (SPN) (1995)
• Media One Group (1998)
• Computer Associates: A Synthetic
Convertible
• Leveraged Buyouts:
• Philips Petroleum, Mesa and Icahn
(1985)
• Marrietta Corporation (1994–1996)
• The Managerial Buyout of United States
Can Company (2000)
• Metromedia (1984)
• Hertz (2006)
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Cases in Corporate Finance
• Non-Conventional Corporations:
• Fortress Investment Group (2007)
• The Blackstone Group
• TIFD vs USA (Nov 2004) GECC
• Buy vs Lease:
• DIMAR Company: A Lease or Buy
Case(2006)
• Sale-Lease of 399 Park Avenue
(2002)
• An International Element:
• Guandong International Trust (1993)
• Marlin Water Trust (1998)
• Sanofi-Synthelabo and Aventis
(2004)
• Merger Water Trust (1998)
• SAFRA Republic: Debenture (1997)
• Shinsei Bank (Japan 2000–2004)
https://www.worldscientific.com/worldsc
ibooks/10.1142/9550
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Pilgrim's Pride completes corporate reorganization
• Pilgrim's Pride Corporation on December 28 announced that the company and six of its
subsidiaries have emerged from Chapter 11 bankruptcy protection after a 13-month
restructuring.
• In connection with its emergence, the company has entered into a $1.75 billion exit
credit facility with Co Bank, ACB, as Administrative Agent and Collateral Agent; Co
Bank, Bank of Montreal and Rabobank International, as Joint Syndication Agents; Co
Bank, Rabo bank, Bank of Montreal, Barclays Capital, Morgan Stanley Senior Funding
Inc., and ING Capital LLC, as Joint Lead Arrangers and Joint Book runners; and Barclays
Bank PLC, Morgan Stanley Senior Funding Inc., and ING Capital LLC, as Joint
Documentation Agents. The exit credit facility is secured by substantially all of the
company's assets. Under the terms of the company's plan of reorganization, all
creditors of the company and its debtor subsidiaries holding allowed claims will be
paid in full as soon as practicable. In the case of bondholders, payment will be made
either through reinstatement of the bonds or in accordance with the holder's previous
election of a cash-out option.
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Pilgrim's Pride completes corporate reorganization
• Under the terms of the confirmed plan, all of the shares of the company's common stock outstanding
immediately prior to the effective date of the plan were cancelled and converted on a one-for-one basis into
the right to receive new shares of the reorganized company. The reorganized company issued 64 percent of
its common stock to JBS USA Holdings, Inc. in exchange for $800 million in cash. The remaining 36 percent of
the common stock of the reorganized company was issued to stockholders existing immediately prior to the
effective date. Proceeds from the sale of the common stock of reorganized Pilgrim's Pride to JBS are being
used to fund cash distributions to unsecured creditors.
• The reorganized company's common stock will begin trading on December 29 on the New York Stock
Exchange under the symbol "PPC."
• "Pilgrim's Pride today begins a new chapter as a market-driven company clearly focused on delivering the
highest levels of service, selection and value to our customers as efficiently as possible," said Don Jackson,
president and chief executive officer. "Over the past 13 months, we have made significant improvements
across our organization aimed at positioning Pilgrim's Pride to respond quickly to the needs of the market.
Those changes have touched every aspect of our business, from supply chain and operations to sales and
marketing. Thanks to the commitment and support of our 41,000 employees and 4,500 growers, Pilgrim's
Pride today is a stronger, leaner company with a growing customer base, improved capital structure and a
culture built on results and accountability. We are very excited about the strategic opportunities available
with JBS as our majority shareholder and we look forward to generating sustained, profitable growth in the
future.“
• Pilgrim's Pride Corporation employs approximately 41,000 people and operates chicken processing plants and
prepared-foods facilities in 12 states, Puerto Rico and Mexico
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Florida Power & Light Company (FPL) (1994) Strike while
the iron is hot
• Recommendation: Dividend Policy
• It is our recommendation that FPL reduce its pay out ratio to 60% because
such a ratio would place them at the lower end of the range of that of their
peer companies,
better positioning FPL for future performance and growth in a recently der
egulated industry. Additionally, reducing the pay out ratio reduces taxes
for their shareholders.
• Buy back shares subsequent to dividend cut.
• In order to counteract negative market reaction to dividend cut.
• Make firm less of a target for acquisition
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Merck–Shering Plough (2009)
• Merck & Co. is buying Schering-Plough Corp., hoping a combined company will have more firepower to compete in a
drug industry that faces slumping sales, tough generic competition and intense pricing pressures.
• Merck also hopes to expand its presence in emerging markets and bolster its pipeline of potential new medicines.
• Merck and Schering-Plough had a combined $47 billion in revenue in 2008, nearly as much at Pfizer Inc., which
posted $48.42 billion..
• The combined company will be “well-positioned for sustainable growth through scientific innovation” and have a
strong, diversified product portfolio, he said.
• “We’ll double Merck medicines in (late-stage development) to 18,” he added. Several Schering-Plough products won’t
face generic competition for several years.
• Both companies and many of their rivals are eliminating thousands of jobs and restructuring operations to further
cuts costs.
• Across the pharmaceutical industry, companies face slumping sales as the blockbuster drugs of the 1990s lose
patent protection, complicated by a dearth of major new drugs coming on the market.
• The transaction is to be structured as a reverse merger. As a result, Schering-Plough will be the surviving
corporation but will take the name Merck. The new company will be based at Merck’s sprawling headquarters in
Whitehouse Station, N.J., but the “substantial majority” of employees of Kenilworth, N.J.-based Schering-Plough will
remain with the combined company, according to the announcement
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Questions which can come from Unit 1 (Generally carry forward questions can also be there ie
what you studied in Trimester 1) 5 marks questions
• What are the three areas of corporate finance?
• Explain the three core functions of Corporate Finance briefly
• Write any two roles by the finance manager
• What is agency problem?
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Questions which can come from Unit 1 (Generally carry forward questions can also be there ie
what you studied in Trimester 1) 10 marks questions
• Write a note comparing Profit Maximization and Wealth Maximization
• What are the typical components of financial statement? What are the
financial statement analysis techniques? Explain each one of them
• What is Corporate Finance? What are the salient features? What is the
importance of corporate finance
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Questions which can come from Unit 1 (Generally carry forward questions can also be there ie
what you studied in Trimester 1) 15 marks questions
• Numericals
• You will be given Statement of Profit and/or Balance Sheet. You may asked
to prepare any one of
• Common Size P&L Account with your observations
• Common Size balance sheet with your observations
• Trend Analysis
• Ratio analysis (You have to calculate ratios with some explanations )
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EPGDM Corporate Finance
CA A G Krishnan

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Syllabus Unit 1 and Unit 2
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Session
1
Overview of Corporate Finance:
Scope of finance, Objective of corporation, Finance function.
Financial Manager’s role, Agency Problem, Financial goal: Profit Maximization
vs. Wealth Maximization.
Session
2
Time Value of Money:
Time lines, Future value – Single & Annuity, Present value – Single & Annuity,
Simple & Compound interest, Payment perpetuities, Growing Annuities, Semi-
annual & other compounding period, Amortized loans
Session
3
Cost of Capital:
Concept of opportunity cost of capital, Methods of calculating cost of capital –
Cost of debt, Preference & Equity capital, CAPM model, Determination of
Weighted Average Cost of Capital (WACC).

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Introduction
• Corporate Finance is on Investing , Financing and Operating
• Past financials are analysed for future projections
• But there are ever so many variables which make the decision making very
difficult.
• Investing is getting discussed first, because without initial investment ,
there is no starting the business. But before the business is commenced,
lot of planning needs to be factored.
• In this decision making, the time value of money plays a very critical role
and is the first topic to be discussed .
• We will restrict our thinking to the Indian scenario because of the complex
calculations involved.
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Introduction
 Thetimevalueofmoney(TVM)istheideathatmoneyavailable at
thepresenttimeisworthmorethanthesameamountinthe future
duetoitspotentialearningcapacity.Thiscoreprinciple offinance
holdsthat,providedmoneycanearninterest,any amountofmoney
isworthmorethesoonerit is received.
 TimeValueofMoney(TVM)isanimportantconceptin financial
management.Itcanbeusedtocompareinvestment alternatives
andtosolveproblemsinvolvingloans,leases, savings.

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Examples of Time Value of Money
• Saving Account
• Interest increases the amount with time
• Loan
• Payment amount
• Retirement Annuity
• Pays out constant amount per month
• Pays out an amount that increases with inflation per month

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Some Nomenclature
• F= Future value
• P=Present value
• i= interest rate for interest period
• r=nominal interest rate (%/yr)
• ny= no. of years
• n= no. of interest periods

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Interest
• Simple interest
• F=(1+n*i)P
• Compound Interest
• F=(1+i)nP
• Allows present or future value to be determined
• Can be inverted to give present value associated with a discount factor
• Nominal Interest (simple interest when period is not 1 yr)
• r =i*m
• m= periods per year
• Effective Interest Rate (compound interest when period is not 1 yr)
• ieff= (1+r/m)m-1
• Continuous Compounding
• ieff==exp(r) - 1

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Random thoughts
• Risk and Return
• Cashflow management and effect
• Present Value and Future value
• Practical applications
• Alternative avenues for investment and comparison of various alternatives
• There are many avenues for investment . We are not going to discuss the
entire spectrum but related to the syllabus and corporate finance.
• Like for example investment in real estate. Here there is no time value of
money in the strict sense , but the appreciation is the real return.
• But time value of money is very critical in corporate finance. All decision
making hinge on this basic premise.
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Random thoughts
• There is a flooding of Initial Public Offerings in the market , the latest being
Zomato
• All the present generation IPO’s are issued at a premium value. Why is it so?
• The business valuation considers future cashflows, but discounts them to arrive
at present value. This becomes the basis for Public Offerings, Mergers&
Acquisitons, etc.
• There are many many models. For example I am helping a start up Sports App
company. The investor’s representative brought another model for business
valuation. But the underlying time value of money did not change.
• A company issues long maturity debentures. It starts dividend redemption
reserve. The final payment accumulated over a period. Here time value of
money applies to the yearly outgo and the final redemption.
• It will spell disaster if the time value of money is not considered in the scheme of
things.
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Random thoughts
• No doubt cash flow is a very critical aspect. The cashflow on the face of it
may not show the time value effect very explicitly. But then let us not get
confused. We are seeing the financial performance from many angles.
• Understand each concept on standalone basis first and then try to
correlate one to the other.
• When we take a loan to set up a business , there is a repayment sitting at
the end of the tunnel. The cash flow has to support both the interest
payment and the principal repayment .
• There is an initial investment and future business inflows and the terminal
value have to justify this initial investment. Time value of money is one of
the concepts in this effort.
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What Does Time Value of Money Mean?
• The concept that money available today is worth more than the same
amount of money in the future
• This preference rests on the Time value of money.
• Thus, a money received today is worth more than a money received
tomorrow, why?

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• This is because that
• a money received today can be invested to
earn interest
• Due to money's potential to grow in value
over time.
• Because of this potential, money that's
available in the present is considered more
valuable than the same amount in the future

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Reason for time value of money
Therearecertainreasonwhichdeterminethatmoneyhastime value
1. RiskandUncertainty–Asweknowfutureis nevercertain andwecan’t
determinestheriskinvolvedinfuturebecause outflowofcashis inourhandas
paymentwhereasthereis no certaintyforfuturecash inflows.
2. Inflation-Inaninflationary economy,themoneyreceived today,hasmore
purchasingpowerthanthemoneytobe receivedinfuture.Inotherwords,arupee
todayrepresentsa greaterrealpurchasingpowerthanarupeein future.
3. Consumption-Individualsgenerallyprefercurrent consumptiontofuture
consumption.
4. Investmentopportunities-Aninvestorcanprofitablyuse thereceivedmoney
todaytogethigherreturntomorrowor afteracertainperiodof time.
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Importance of Time Value of Money
1. InInvestmentDecisions- Smallbusinessesoftenhave limitedresourcestoinvestin
businessoperations,activities andexpansion.Oneofthefactorswehavetolookatishowto
invest,isthetimevalueofmoney.
2. InCapitalBudgetingDecisions-Whenabusiness choosestoinvestmoneyinaproject
-suchasanexpansion, astrategicacquisitionorjustthepurchaseofanewpieceof
equipment--itmaybeyearsbeforethatprojectbegins producingapositivecashflow.The
businessneedstoknow whetherthosefuturecashflowsareworththeupfront investment.
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Time Value of Money
77
 Future value
 Value of Rs 10000 invested today at 10 % after 3 years
 Present value
 Today’s value of Rs. 10000 to be received after 3 years
 Annuities
 Annual payment for a future value
 Present value of annuity to be received over 10 years
 Rates of return
 Today’s value and future value are available . Rate of return for starting from
today’s value and arriving at the future in the time frame
 Amortization
 Repayment of loan in instalments which include a portion of principal and a
portion of interest . EMI Equated Monthly Instalments

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Time Value of Money Real-Life Examples
We can use the time value of money in everyday money decisions. Take, for example, the
following situations:
Scenario 1: Congratulations! You’ve finally won the lottery! The lottery commission is
giving you a choice of how you would like to be paid. You can either receive $1000 per week
for life or an immediate lump sum settlement of $1.5 million. What would be the best option?
There is no straightforward answer to this situation. Your answer would depend on a few
factors that are specific to your life situation, such as:
• Your age, and your life expectancy. If your life expectancy is short, you may not get
the full value of your winnings at $1000 per week.
• What current investment opportunities are available to you. Taking the lump sum but
having nothing to invest it in may not be worthwhile.
• The stability of the organization making the payments. Will the lottery commission be
around “for life”?
Once you come up with the discount rate you can use the calculators to help in calculating
what is the better payout for you.

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Scenario 2: You are receiving a payout which is worth $100
today. This same payout, if taken later, will be worth $110 then. When
making your decision, consider the following:
•Where is the interest coming from?
•Where can you invest that $100 today and how much would it be a
year from now?
TMV Calculators to help you decide:

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Scenario 3: You’re going to get an extra $1,000 on your tax
refund. There are many things you can do with that money, but
you’ve narrowed it down to two choices. Should you invest the
$1000 for the next 20 years or use it to pay down your mortgage
today? When you make your decision, you should think about:
•Your current and future mortgage rates.
•The investment opportunities for this money.
Potentially you can decide to invest this money into a stable
bond. You can this calculator to decide how much this annuity is
worth it to you.

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Significance of Time Value of Money
It is mostly used concept in Finance world; based on this, decisions are made
to maximize return on investments. It helps shareholders to invest their fund
wisely. Its concept contributes to this aspect to much extent
Investment Decision is decision to make investment of funds for long term
purpose. TVM help us to identify long term cash flow statements which will
occur at different point of time. So, if investor have two projects to invest its
money in, those two projects can be compared with this technique even if
their cash flow statement time period doesn’t matches with each other by
providing present value of their future cash flow. Its concept is mostly used in
equity or debt securities investment by using valuation models while doing
investments.

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Applications of Time Value of Money in Real Life Problems Asset Replacement Problem A Manager has to
find out accumulated sum of money in future date to replace it with existing assets. Example: ABC Ltd has
Rs. 100,000 of Debentures (5%). Company want set up a replacement of existing assets after 10 years. This
replacement asset earns 8% per year. Required investment will be as follows: Outcome: So ABC Ltd should
invest Rs. 46,319.35 now to get Rs. 100,000 as replacement at 10 years.
Investment Problem (Rate of Return) Manage wants to calculate implicit rate of return over an investment.
Example: Company offering to pay Rs. 201,475 at the end of 10 years with deposit of Rs. 15,000 p.a. How
much implicate rate of return ABC ltd is offering to its customers? Outcome: Company is offering 5.3% of
annual return.
Loan Repayment Problem A manager pay loan in fixed period of time through equal installments. Example:
ABC Ltd has a loan of Rs. 100,000 from a Bank at a rate of 9% p.a. Company want to pay back money in 10
equal installments. Outcome: So company should pay Rs. 23,674 annual to redeem loan in next 10 years.
Profit Problem (Growth Rate of Return) Manager wants to calculate compounded growth rate over an
investment in specified period of time. Example: ABC Ltd. wants to calculate compounded growth rate over
its profit and company is getting annual profit % as follows. Outcome: Company has achieved 10.66% of
rate of return p.a. to achieve its target of profit Rs. 75 lacs

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Valuation Problem TVM help us to solve problem of valuation for
investment in equity, bonds, debentures, fixed deposits, recurring
deposits etc.
TVM is a very vibrant concept in finance world. It helps us to
calculate approximate future value of current investment or
present value of future returns. It helps us to in making decision
where to invest and which not to consider. There are various real
life problems which can be solved through this technique. So
recommendation is to always consider this technique before
making any investment in any financial instrument like equity,
debts, bonds, insurance and various other instruments.

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Quilici FamilyComposed of Greg (father), Debra (mother), and 5 year old son Brady.Greg is a partner in the family owned commercial
painting business.Debra is a housewife.
Money Matters Greg earns $85,000 a year.
Greg is an alumnus of Stanford University (Tuition = $20,000 per year)Debra graduated from University of North Carolina at Chapel Hill
(Tuition = $2,500 per year)The couple wants to send Brady to either school when he turns 18, with a slight preference towards Stanford.
Tuition is expected to increase at an annual rate of 5%Living expenses are estimated to be $6000 per year for both schools (expecting to
grow 3% per year)The couple can deposit their money into a growth oriented mutual fund at Neuberger and Berman Management, Inc.
(historically earning 12% per annum)
Questions
How much will the tuition and living expenses be per year when Brady is ready to attend? Give an answer for each university .Once Brady
starts college what will his total expenses be in each of his four years? Again, give an answer for each university. How much money will
Greg and Debra have to deposit per month to allow Brady to attend Stanford University? How much money will have to be deposited per
month to allow Brady to attend the University of North Carolina? (Consider the cost of all four years.)
What if the Quilicis feel the Neuberger & Berman mutual fund will only yield 10 per cent? How much will have to be deposited per month in
order for Brady to attend each college? What is the relationship between the amount that must be deposited monthly by the parents and the
future increases in both tuition and living expenses?

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Financing Decision is decision to make to
optimize capital structure of the organization.
Raising fund for equity, debt or from any other
source. TVM helps in this decision by
comparing cost to company through usage of
effective rate of interest of each source of
finance. And then present value of costs of two
alternatives is compared against each other to
decide on appropriate source of financing.
Operational Decision: This concept is also used
in evaluating creditor cycle and debtors’ cycle
in managing cash collection under current
assets management.

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Time lines
• Show the timing of cash flows.
• Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the first
period (year, month, etc.) or the beginning of
the second period.
CF0 CF1 CF3
CF2
0 1 2 3
i%

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Drawing time lines:
$100 lump sum due in 2 years;
3-year $100 ordinary annuity
100 100
100
0 1 2 3
i%
3 year $100 ordinary annuity
100
0 1 2
i%
$100 lump sum due in 2 years

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Drawing time lines:
Uneven cash flow stream; CF0 = -$50,
CF1 = $100, CF2 = $75, and CF3 = $50
100 50
75
0 1 2 3
i%
-50
Uneven cash flow stream

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What is the future value (FV) of an initial $100 after 3
years, if I/YR = 10%?
• Finding the FV of a cash flow or series of cash
flows when compound interest is applied is
called compounding.
• FV can be solved by using the arithmetic,
financial calculator, and spreadsheet methods.
FV = ?
0 1 2 3
10%
100

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Solving for FV:
The arithmetic method
• After 1 year:
• FV1 = PV ( 1 + i ) = $100 (1.10)
= $110.00
• After 2 years:
• FV2 = PV ( 1 + i )2 = $100 (1.10)2
=$121.00
• After 3 years:
• FV3 = PV ( 1 + i )3 = $100 (1.10)3
=$133.10
• After n years (general case):
• FVn = PV ( 1 + i )n

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PV = ? 100
What is the present value (PV) of $100 due in 3 years, if
I/YR = 10%?
• Finding the PV of a cash flow or series of cash
flows when compound interest is applied is
called discounting (the reverse of
compounding).
• The PV shows the value of cash flows in terms
of today’s purchasing power.
0 1 2 3
10%

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Solving for PV:
The arithmetic method
• Solve the general FV equation for PV:
• PV = FVn / ( 1 + i )n
• PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

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The Power of Compound Interest
A 20-year-old student wants to start saving for retirement. She plans to
save $3 a day. Every day, she puts $3 in her drawer. At the end of the year,
she invests the accumulated savings ($1,095) in an online stock account.
The stock account has an expected annual return of 12%.
How much money will she have when she is 65 years old?
Principal = 1095
Compounding period = 65-20 = 45 years
Rate of Interest =12 %
Every year she invests 1095 . Therefore we should have a formula for this
The formula is Annuity x [(1+ Interest)^N /interest) – (1/ Interest)]
We should have a scientific calculator or exponential enabled mobile

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Explanation
• You want to buy a house in 2023. But you have to start saving from now
onwards. How do you optimise your periodic savings with the proposed
down the line investment ? This is the Future Value of current saving /
current investment.
• This is the basic example. This has many layers of analysis and
interpretation.

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Techniques of Time Value of Money
• Therearetwotechniquesforadjustingtimevalueofmoney.They are:
1.Compounding Techniques/Future Value Techniques Theprocessofcalculatingfuture
valuesofcashflows.Inthis concept,theinterestearnedontheinitialprincipal amountbecomes
apartoftheprincipalattheendofthecompounding period.
2. Discounting/Present Value Techniques Theprocessofcalculatingpresentvaluesofcash
flows
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Methods of calculating future value
 Compounding. - Itistheprocessoffindingthefuturevalues ofcashflowsbyapplying the
conceptof compoundinterest.
 Compound interest. - Itistheinterestthatisreceivedonthe originalamount(principal)as
wellasonanyinterestearned butnotwithdrawnduringearlier periods.
 Simple interest. - Itistheinterestthatiscalculatedonlyon theoriginalamount(principal),
andthus,nocompoundingof interesttakesplace.
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• A dollar in hand today is worth more than a dollar to be received in the future
because, if you had it now, you could invest it, earn interest, and end up with
more than a dollar in the future. The process of going to future values (FVs)
from present values (PVs) is called compounding.
• Managers should strive to make their firms more valuable and that the value of a
firm is determined by the size, timing, and risk of its free cash flows (FCF).
• Free cash flows are the cash flows available for distribution to all of a firm’s
investors (stockholders and creditors) and that the weighted average cost of
capital is the average rate of return required by all of the firm’s investors.
• That formula takes future cash flows and adjusts them to show how much those
future risky cash flows are worth today. That formula is based on time value of
money concepts

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• One Payment per Period.
• Many calculators “come out of the box” assuming that 12 payments are
made per year, i.e., they assume monthly payments.
.
• End Mode.
• With most contracts, payments are made at the end of each period.
However, some contracts call for payments at the beginning of each period.
You can switch between “End Mode” and “Begin Mode,” depending on the
problem

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• Finding present values is called discounting, and as noted above, it is the
reverse of compounding—if you know the PV, you can compound to find
the FV, while if you know the FV, you can discount to find the PV.
• We know PV, FV, and N, and we want to find I. For example, suppose we
know that a given security has a cost of $100 and that it will return $150
after 10 years. Thus, we know PV, FV, and N, and we want to find the rate of
return we will earn if we buy the security.
• We sometimes need to know how long it will take to accumulate a sum of
money, given our beginning funds and the rate we will earn on those funds.
For example, suppose we now have $500,000 and the interest rate is 4.5%.
How long will it take to grow to $1 million

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• However, many assets provide a series of cash inflows over time, and many
obligations like auto loans, student loans, and mortgages require a series of
payments. If the payments are equal and are made at fixed intervals, then the
series is an annuity. For example, $100 paid at the end of each of the next 3
years is a 3-year annuity.
• If payments occur at the end of each period, then we have an ordinary (or
deferred) annuity. Payments on mortgages, car loans, and student loans are
examples of ordinary annuities. If the payments are made at the beginning of
each period, then we have an annuity due. Rental payments for an apartment,
life insurance premiums, and lottery payoffs are examples of annuities due.
Ordinary annuities are more common in finance, so when we use the term
“annuity” in this book, assume that the payments occur at the ends of the
periods unless otherwise noted.

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Annuity
• Series of Single payments, A, made at fixed time periods
• Examples – Installment Loans
• Student Loan Repayment
• Mortgage Loan
• Car Loan
• Retirement – old system
• Assumes periodic Compound Interest and payment at end of first period
• discrete uniform-series compound-amount factor
• F=A[(1+i)n-1]/i
• Present Worth of Annuity
• P=F/(1+i)n

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.

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.
.

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• An amortized loan is one that is paid off in equal payments over a
specified period. An amortization schedule shows how much of each
payment constitutes interest, how much is used to reduce the principal,
and the unpaid balance at each point in time.

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Formulas
110

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Formulas
111

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Formulas
112

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• Assume that 1 year from now, you will deposit $1,000 into a savings
account that pays 8%.
• a. If the bank compounds interest annually, how much will you have in
your account 4 years from now?
• b. What would your balance 4 years from now be if the bank used
quarterly compounding rather than annual compounding?
• c. Suppose you deposited the $1,000 in 4 payments of $250 each at Year
1, Year 2, Year 3, and Year 4. How much would you have in your account
at Year 4, based on 8% annual compounding?
• d. Suppose you deposited 4 equal payments in your account at Year 1,
Year 2, Year 3, and Year 4. Assuming an 8% interest rate, how large
would each of your payments have to be for you to obtain the same
ending balance as you calculated in part a?
.

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• Future Value of a single payment
• If you deposit $10,000 in a bank account that pays 10% interest
annually, how much will be in your account after 5 years
• 16105.10
• Present Value of a single payment
• What is the present value of a security that will pay $5,000 in 20 years if
securities of equal risk pay 7% annually
• 1292.10
• Interest rate of a single payment
• Your parents will retire in 18 years. They currently have $250,000, and
they think they will need $1,000,000 at retirement. What annual
interest rate must they earn to reach their goal, assuming they don’t
save any additional funds?
• 8.01

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• Number of periods of a single payment
• /
• 11.01 Years
• No of periods for an annuity
• You have $42,180.53 in a brokerage account, and you plan to
deposit an additional $5,000 at the end of every future year until
your account totals $250,000. You expect to earn 12% annually on
the account. How many years will it take to reach your goal?
• 11 Years

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• Future payment : Annuity versus Annuity Due
• What is the future value of a 7%, 5-year ordinary annuity that pays
$300 each year? If this were an annuity due, what would its future
value be?
• FVAS 1725.22 FVAS due 1845.99
• Present and Future Value of an uneven cashflow stream
• An investment will pay $100 at the end of each of the next 3 years,
$200 at the end of Year 4, $300 at the end of Year 5, and $500 at
the end of Year 6. If other investments of equal risk earn 8%
annually, what is its present value? Its future value?
• PV 923.98 FV 1466.24

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• Annuity Payment and EAR
• You want to buy a car, and a local bank will lend you $20,000. The
loan would be fully amortized over 5 years (60 months), and the
nominal interest rate would be 12%, with interest paid monthly.
What would be the monthly loan payment? What would be the
loan’s EAR?
• PMT (EMI) 444.89 EAR 12.6825%

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Present and Future Values of Single Cash Flows for Different Periods
• Find the following values, using the equations, and then work the
problems using a financial calculator to check your answers. Disregard
rounding differences. (Hint: If you are using a financial calculator, you
can enter the known values and then press the appropriate key to find
the unknown variable. Then, without clearing the TVM register, you can
“override” the variable that changes by simply entering a new value for
it and then pressing the key for the unknown variable to obtain the
second answer. This procedure can be used in parts b and d, and in
many other situations, to see how changes in input variables affect the
output variable.)
• a. An initial $500 compounded for 1 year at 6%.
• b. An initial $500 compounded for 2 years at 6%.
• c. The present value of $500 due in 1 year at a discount rate of 6%.
• d. The present value of $500 due in 2 years at a discount rate of 6%.
• 530, 561.80, 471.70, 445

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Present and Future Values of Single Cash Flows for Different Interest Rates Periods
• Use equations and a financial calculator to find the following
values..
• a. An initial $500 compounded for 10 years at 6%..
• b. An initial $500 compounded for 10 years at 12%.
• c. The present value of $500 due in 10 years at a 6% discount rate.
• d. The present value of $500 due in 10 years at a 12% discount
rate.
• 895.42 , 1552.92 , 279.20 , 160.99

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Time for Lumpsum to double
• To the closest year, how long will it take $200 to double if it is
deposited and earns the following rates
• a. 7%.
• b. 10%.
• c. 18%.
• d. 100%.
• 10.24 years , 7 years, 4 years, 1 year

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Effective rate of Interest
• Find the interest rates, or rates of return, on each of the following:
• a. You borrow $700 and promise to pay back $749 at the end of 1 year.
• b. You lend $700 and receive a promise to be paid $749 at the end of 1 year.
• c. You borrow $85,000 and promise to pay back $201,229 at the end of 10
years.
• d. You borrow $9,000 and promise to make payments of $2,684.80 per
year for 5 years.

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Determine Present Value
• Each Purchases
• Each Sale of Salvage Equipment
• All Annual Payments to for Maintenance
• Add them up
• Purchases are negative
• Sales are positive

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Pump A Pump B
Installed Cost 20,000.00
$ 25,000.00
$
Yearly maintenance 4,000.00
$ 3,000.00
$
Service Life (yr) 2 3
Salvage Value 500.00
$ 1,500.00
$
Interest Rate 6.8% 6.8%
Life of Plant (yr) 6 6
Calculation of Present value of future purchases (-) and sales (+) of salvage equipment
1st Pump (20,000.00)
$ (25,000.00)
$ Purchase Price is present value
Annual Maintenance (19,184.45)
$ (14,388.34)
$ Present Value of Annuity for Annual Maintenance
2nd Pump - Salvage (17,095.91)
$ (19,290.97)
$ Present value of future purchase
3rd Pump - Salvage (14,988.20)
$ Present value of future purchase
Slavage value 336.93
$ 1,010.80
$ Present value of future sale
Total Present Value (70,931.63)
$ (57,668.51)
$

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Unit 3 Cost of Capital
CA A G KRISHNAN
9886217080
Agk_1954@yahoo.com
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Cost of Capital:
• Concept of opportunity cost of capital,
• Methods of calculating cost of capital –
• Cost of debt,
• Preference
• Equity capital
• CAPM model
• Determination of Weighted Average Cost of Capital (WACC
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Theories of capital structure
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Economic Value Add
• Economic value added (EVA) is a measure of a company's financial
performance based on the residual wealth calculated by deducting its cost
of capital from its operating profit, adjusted for taxes on a cash basis. EVA
can also be referred to as economic profit, as it attempts to capture the
true economic profit of a company. This measure was devised by
management consulting firm Stern Value Management, originally
incorporated as Stern Stewart & Co.
• Economic value added (EVA), also known as economic profit, aims to
calculate the true economic profit of a company.
• EVA is used to measure the value a company generates from funds
invested in it.
• However, EVA relies heavily on invested capital and is best used for asset-
rich companies, where companies with intangible assets, such as
technology businesses, may not be good candidates.
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Calculation of EVA
128
Book value Cost
Weighted cost
proportion * cost
Debentures 30000 2.25% 675
Tax benefit is there.
Therefore (1-t) has to be
applied
Equity share 45000 14% 6300
retained earnings 15000 13% 1950
Preference share capital 10000 10% 1000
100000 9925 9.925%WACC
Market Value Cost
Weighte
d cost
proporti
on * cost
Debentures 30000 2.25% 675
Equity share 67500 14% 9450
retained earnings 22500 13% 2925
Preference share capital 10000 10% 1000
130000 14050 10.81%

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Explanation on how values are arrived at
In the book value case , the values or the split up between equity and retained earnings is separately
available
In the market value case, the total market value is divided in same proportion as equity capital and retained
earnings. In this case it is 3 :1
Economic Value Add
The value added by the company . Ie it has earnings and it has cost of capital to earn that income
Book Value based EVA
NOPAT 25000
Net Operating Profit after
taxes
Cost of earning this 9925100000 capital deployed at 9.93 %
EVA 15075
Market value based EVA
NOPAT 25000
Net Operating Profit after
taxes
Cost of earning this 14053130000 capital deployed at 10.81 %
EVA 10947
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• Examples of Opportunity Cost
• Someone gives up going to see a movie to study for a test in order to get a good grade. The opportunity
cost is the cost of the movie and the enjoyment of seeing it.
• At the ice cream parlor, you have to choose between rocky road and strawberry. When you choose rocky
road, the opportunity cost is the enjoyment of the strawberry.
• A player attends baseball training to be a better player instead of taking a vacation. The opportunity cost
was the vacation.
• Jill decides to take the bus to work instead of driving. It takes her 60 minutes to get there on the
bus and driving would have been 40, so her opportunity cost is 20 minutes.
• This semester you can only have one elective and you want both basket-weaving and choir. You choose
basket weaving and the opportunity cost is the enjoyment and value you would have received from choir.
• The opportunity cost of taking a vacation instead of spending the money on a new car is not getting a
new car.
• When the government spends $15 billion on interest for the national debt, the opportunity cost is
the programs the money might have been spent on, like education or healthcare.
• If you decide not to go to work, the opportunity cost is the lost wages.
• For a farmer choosing to plant corn, the opportunity cost would be any other crop he may have planted,
like wheat or sorghum.
• Tony buys a pizza and with that same amount of money he could have bought a drink and a hot dog. The
opportunity cost is the drink and hot dog.
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• You decide to spend $80 on some great shoes and do not pay your electric bill. The opportunity
cost is having the electricity turned off, having to pay an activation fee and late charges. You might
also have food in the fridge that gets ruined and that would add to the total cost.
• As a consultant, you get $75 an hour. Instead of working one night, you go to a concert that costs $25 and
lasts two hours. The opportunity cost of the concert is $150 for two hours of work.
• David decides to quit working and got to school to get further training. The opportunity cost of this
decision is the lost wages for a year.
• Caroline has $15,000 worth of stock she can sell now for $20,000. She wanted to wait two months
because the stock was expected to increase. She decides to sell now. The opportunity cost would
be determined in two months and would be the difference between the $20,000 and the price she
would have gotten if she sold the stock then.
• Jorge really wants to eat at a new restaurant and can only afford it if he does not order a dessert. The
opportunity cost is the dessert.
• A business owns its building. If the company moves, the building could be rented to someone else. The
opportunity cost of staying there is the amount of rent the company would get.
• When Tobias graduated high school, he decided to go to college. The opportunity cost of going to college
is the wages he gave up working full time for the number of years he was in college.
• Mario has a side business in addition to his regular job. If he decides to spend more time on his side
business, the opportunity cost is the wages he lost from his regular job.
• Mr. Brown makes $400 an hour as an attorney and is considering paying someone $1000 to paint
his house. If he decides to do it himself, it will take four hours. His opportunity cost for doing it
himself is the lost wages for four hours, or $1600.
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Opportunity Cost of Capital
• Opportunity costs represent the potential benefits an individual, investor,
or business misses out on when choosing one alternative over another. The
idea of opportunity costs is a major concept in economics.
• Because by definition they are unseen, opportunity costs can be easily
overlooked if one is not careful. Understanding the potential missed
opportunities foregone by choosing one investment over another allows
for better decision-making.
• While financial reports do not show opportunity costs, business owners
often use the concept to make educated decisions when they have multiple
options before them. Bottlenecks, for instance, are often a result of
opportunity costs.
• To properly evaluate opportunity costs, the costs and benefits of every
option available must be considered and weighed against the others.
• Opportunity Cost = FO−CO
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• Application of Opportunity Cost
• For example, assume a firm discovered oil in one of its lands. A land
surveyor determines that the land can be sold at a price of $40 billion. A
consultant determines that extracting the oil will generate an operating
revenue of $80 billion in present value terms if the firm is willing to invest
$30 billion today.
• The accounting profit would be to invest the $30 billion to receive $80
billion, hence leading to an accounting profit of $50 billion. However, the
economic profit for choosing to extract will be $10 billion because the
opportunity cost of not selling the land will be $40 billion.
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• Other Costs in Decision-Making: Incremental Costs
• A firm may choose to sell a product in its current state or process it further in hopes of generating
additional revenue. For example, crude oil can be sold at $40.73 per barrel. Kerosene, a product of
refining crude, would sell for $55.47 per kilolitre. While the price of kerosene is more attractive than
crude, the firm must determine its profitability by considering the incremental costs required to refine
crude oil into kerosene.
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• Other Costs in Decision-Making: Sunk Cost
• A sunk cost is a cost that has occurred and cannot be changed by present
or future decisions. As such, it is important that this cost is ignored in the
decision-making process.
• For instance, assume that the firm described above has invested $30
billion to start its operations. However, a fall in demand for oil products
has led to a foreseeable revenue of $50 billion. As such, the profit from this
project will lead to a net value of $20 billion. Alternatively, the firm can still
sell the land for $40 billion.
• The decision in this situation would be to continue production as the $50
billion in expected revenue is still greater than the $40 billion received
from selling the land. The $30 billion initial investment has already been
made and will not be altered in either choice.
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Risk and opportunity cost
• In economics, risk describes the possibility that an investment's actual and
projected returns are different and that the investor loses some or all of
the principal.
• Opportunity cost concerns the possibility that the returns of a chosen
investment are lower than the returns of a forgone investment.
• The key difference is that risk compares the actual performance of an
investment against the projected performance of the same investment,
while opportunity cost compares the actual performance of an investment
against the actual performance of a different investment.
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Case study on cost of capital - findings
• The study has analyzed there is significant relationship between cost of capital
and the efficiency, profitability, dividend policy, growing capacity relationship of
Telecommunication industry in India; some of the important ratios were used to
measure the financial performance of these companies. Based on the above
analysis the significant negative relationship is found between two variables
other than growth and cost of capital.
• The overall cost of capital is affected by the designing of capital structure of
Indian industries. Therefore, maintenance of optimum level of capital structure
irrespective of nature of industries is mandatory for a firm. Hence, the corporate
executive should give due attention for attaining optimum level of capital
structure for sustainable growth of the firm.
• The optimum level of capital structure depends on nature of each industry. The
change of cost of capital affects the company’s profitability position. Again the
lower cost of capital positively affects the profitability position of the companies.
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Why cost of capital is critical
• The cost of capital aids businesses and investors in evaluating all
investment opportunities. It does so by turning future cash flows
into present value by keeping it discounted.
• The cost of capital can also aid in making key company budget calls that
use company financial sources as capital.
• In a cost of opportunity scenario, the cost of capital can be used to evaluate
the progress of ongoing projects and investments by matching up the
progress of those investments against the cost of capital.
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How cost of capital works
• Implicit cost. This represents the opportunity cost cited above, i.e., the
cost of an investment opportunity considered, but ultimately not taken.
There is no bottom-line reduction in revenues - it's implied. But under the
cost of capital model, it can be factored into opportunity costs not earned.
• Explicit cost. The explicit cost of capital is the cost that companies can
actually use to make capital investments, payable back to investors in the
form of a stronger stock price or bigger dividend payouts to shareholders.
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• Kimi Ford, a portfolio manager for NorthPoint Group, is looking for value
opportunities. Specifically, Nike has caught Ford’s attention in its recent
drop in share price, and she would like to know as to whether this would
be a good company to add to the NorthPoint Large-Cap Fund, which Ms.
Ford manages. After finding significantly conflicting conclusions from
reputable analyst reports across the board, Ford decides her own
independent research and forecasting will clear the air. Through a
sensitivity analysis of a discounted cash flow forecast, Ms. Ford feels Nike
would be a value opportunity at discount rates below 11.17%. Ford
decides to delegate the task of calculating Nike’s weighted average cost of
capital to Joanna Cohen, her assistant
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• What is the WACC and why is it important to estimate a firm’s cost of
capital? WACC, or weighted average cost of capital, is a calculation of a
company’s cost of financing proportionate to its degree of leverage. It is
important to estimate a firm’s cost of capital as it serves as a type of
benchmark when deciding where it would be most effective or worthwhile
to deploy a company’s capital
• Use of book values instead of market values in calculation. Using a market
value approach will more accurately reflect the most current opportunity
cost to the company
• We should approach cost of debt by calculating the yield to maturity of
Nike’s outstanding corporate bonds.
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Cost of capital examples
• Cost of Capital for Investing
• In investing, the cost of capital is the variation between an investment that you
make and one that you could have made - but didn't.
• Consider a stock market trader or real estate investor that invests $10,000 into a
particular opportunity. The opportunity cost is the difference between any profit
actually earned, and the profit that could have been earned. Let's say the
investor earned a 5% profit on the actual investment (Opportunity "A") but could
have earned 10% on the investment opportunity not chosen (Opportunity "B".)
The difference between the profit earned on Opportunity "A" and Opportunity
"B" (5%) is the actual cost of capital.
• Cost of Capital for Business
• In business, the goal with the cost of capital is to improve on the rate of return
that might have been generated by steering the amount of money into a separate
investment, and with the same amount of risk.
• After all, companies count on the cost of capital to be the return rate it earns on
business-related investment projects, in order to maximize opportunities to
attract investors, and to stay profitable and competitive in its marketplace.
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Key things to know about cost of capital
• Figuring out the cost of capital generally relies on two key criteria - a lender's
required rate of return and a borrower's weighted average cost of capital.
• Two key themes in calculating the cost of capital are recognizing the time value
of money and knowing how to discount cash flows and returns into present
value.
• Investors looking for a better grip on the cost of capital should focus on the
opportunity cost of alternative investments, stemming from that investment's
risk level and the investment's estimated return.
• In formulating the total cost of equity and the cost of debt, companies need to
calculate a weighted average cost of capital (WACC), combing all company
financing sources into the calculation.
• In general, the definition of cost of capital is two-fold: For businesses, it's the
cost of an organization's debt and equity funds. For investors, the cost of capital
is the required rate of return on a particular investment.
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Case study
• Decisions regarding the mix of debt and equity used to finance operations are
quite important
• The owner-managers have an incentive to choose risky projects, which is
consistent with an option’s value rising with the risk of the underlying asset.
• Potential lenders recognize this situation, so they build covenants into loan
agreements that restrict managers from making excessively risky investments.
• a firm might choose to issue convertible debt which gives bondholders the
option to convert their debt into stock if the value of the company turns out to be
higher than expected.
• In exchange for this option, bondholders charge a lower interest rate than for
nonconvertible debt. Because owner-managers must share the wealth with
convertible-bond holders, they have a smaller incentive to gamble with high-risk
projects.
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• Both the degree of risk in the projects it undertakes and the types of funds
it raises are under the company’s control, and both have a profound effect
on its cost of capital
• When a company evaluates potential projects , it must determine whether
the return on the capital it must invest in the project will exceed the cost
of that capital.
• On acquisitons, the company must estimate the expected return on
capital, and the cost of that capital, for each of these acquisitions, and then
make the investment only if the expected return is greater than the cost.
• We estimate that it has a 17.7% return on capital, well above its 8%
estimated cost of capital. With such a large differential, it’s no wonder GE
has created a great deal of value for its investors
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Cost of capital – why it is important
• Importance to Capital Budgeting Decision
• Importance to Structure Decision
• Importance to Evolution of Financial Performance
• Importance to Other Financial Decisions
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Cost of capital
• Most important business decisions require capital, including decisions to
develop new products, build factories and distribution centers, install
information technology, expand internationally, and acquire other
companies.
• For each of these decisions, a company must estimate the total investment
that is required and decide whether the expected rate of return exceeds
the cost of the capital
• The cost of capital is also a key factor in choosing the mixture of debt and
equity used to finance the firm and in decisions to lease rather than buy
assets.
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• Market Value Add
• Market Value of Stock less Money supplied by shareholders
• Opportunity cost : Rate of return you will earn on an alternate investment
of similar risk if you don’t invest in the security under consideration
• Capital Asset Pricing Model The firm should earn on its reinvested
earnings at least as much as its shareholders could earn on alternate
investments of equivalent risk.
• CAPM = Risk free rate. Market risk premium. Beta coefficient
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Cost of debt
• The component cost of debt is the after-tax cost of new debt. It is found
by multiplying the cost of new debt by (1 _ T), where T is the firm’s
marginal tax rate: rd(1 - T).
• Example : The loan Interest rate 12% Income tax rate 30%
• Cost of debt = L x (1-t) = 12 x 70% = 8.40 %
• But income tax structure in India is subject to two factors
• This formula may not apply in a loss scenario even through carry forward of loss is
there
• Cashflow may not support this presumption. But usually cost of debt is on this basis
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Cost of debt
• Variations within debt
• both fixed- and floating-rate debt, straight and convertible debt, and debt with
and without sinking funds, and each form has a somewhat different cost.
• New or marginal debt against historical or embedded rate
• Suppose a company has outstanding bonds with a 9% annual coupon rate, 22
years remaining until maturity, and a face value of $1,000. The bonds make
semiannual coupon payments and currently are trading in the market at a price
of $835.42. We can find the yield to maturity using a financial calculator with
these inputs: N 44, PV 835.42, PMT 45, and FV 1,000. Solving for the rate, we
find I/YR 5.500%. This is a semiannual periodic rate, so the nominal annual rate
is 11.00%. This is consistent with the investment bankers’ estimated rate, so
11% is a reasonable estimate for rd
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Cost of debt
• Flotation cost adjustments should be made for debt if the flotation costs are
relatively large. Reduce the bond’s issue price by the flotation expenses, reduce
the bond’s cash flows to reflect taxes, and then solve for the after-tax yield to
maturity.
• Example
• Bond issue price = 100
• Floation cost 5
• Cash inflow (denominator) 95
• Rate of Interest 12
• Tax percentage 30 %
• Cost of debt = (1-tax rate)/(issue price-floatation)
• 9% / 95 = 9.47 %. This should be applied
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• A company issues Rs. 20,00,000, 10% redeemable debentures at a
discount of 5%. The costs of floatation amount to Rs. 50,000. The
debentures are redeemable after 8 years. Calculate before tax and after tax.
Cost of debt assuring a tax rate of 55%.
• 2000000 actual realization 1900000 less floation cost 50000 = 1850000
• Cost of capital = 200000+(150000/8) / 0.5(2000000+1850000)
• Pre tax cost of debt =218750 / 1925000 = 11.36 %
• Post tax cost of debt = 11.36 % x (1-55%) = 5.11 %
• It is the rate of return which the lenders expect. The debt carries a certain
rate of interest
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Cost of preferential Shares
• Preference Shares have a fixed pre determined rate of dividend. We have
to adjust floation cost to the cost. There is no tax benefit as it is
appropriation of profits and not an expense item. In India we have to add
the dividend tax the company pays to the cost of preference shares. So
long as it is non convertible , no other considerations need to be applied.
• Exampe
• 12 % Preference Share Capital
• Floation Cost 5 %
• Cost of preference shares = 12 % /(100-5) = 12.632 %
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Cost of preference capital
• Redeemable and Irredeemable preference capital
• Redeemable = Dividend / Net proceeds
• Irredeemable = Dividend plus amortization of discount and floation cost
• XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs.
2 per share. Calculate cost of preference share capital if these shares are issued
(a) at par, (b) at a premium of 10% and (c) of a debentures of 6%.
• Issued at a premium : you get more than face value
• Redeemable at a premium : you pay ,more than face value
• Par = 8/98 = 8.16 %
• Premium = 8/108 = 7.40 %
• With a discount of 6 % = 160000 /(2000000-120000-40000)
• = 8.69 %
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Cost of preference capital
• ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable
after 8 years at a premium of 10%. The cost of issue is Rs. 2 per share.
Calculate the cost of preference share capital
• = 160000+ ((2200000-1960000)/8) / 0.5 x(2200000+1960000)
• = 9.13 %
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Cost of retained earnings
• Cost of retained earnings is the same as the cost of an equivalent fully
subscripted issue of additional shares, which is measured by the cost of
equity capital
• K =K (1 – t) (1 – b)
• t = tax on individual and b = brokerage incurred
• A firm’s Ke (return available to shareholders) is 10%, the average tax rate
of shareholders is 30% and it is expected that 2% is brokerage cost that
shareholders will have to pay while investing their dividends in alternative
securities. What is the cost of retained earnings?
• 10 % * 70 % * 98 % = 6.86 %
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Cost of Equity
• The cost of common equity, rs, is also called the cost of common stock. It is
the rate of return required by the firm’s stockholders, and it can be estimated by
three methods:
• (1) the CAPM approach
• (2) the dividend-yield-plus growth- rate, or DCF, approac
• (3) the bond-yield-plus-risk-premium approach
• We should consider the effects of leveraging in this equation. The slightly
advantageous starting point gets vitiated when the leveraging increases
and the risk bearing of the equity shareholders will be sorely tested
wanting them to change their earlier positive stance.
• The firm should earn on its reinvested earnings at least as much as its stockholders
themselves could earn on alternative investments of equivalent risk.
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Cost of Equity
• Dividend price (D/P) approach
• The cost of equity capital will be that rate of expected dividend which will maintain
the present market price of equity shares
• Dividend price plus growth (D/P + g) approach
• The cost of equity is calculated on the basis of the expected dividend rate per share
plus growth in dividend. It can be measured with the help of the following formula:
• Earning price (E/P) approach
• Cost of equity determines the market price of the shares. It is based on the future
earning prospects of the equity. The formula for calculating the cost of equity
according to this approach is as follows
• Realized yield approach.
• Under this method, cost of equity is calculated on the basis of return actually
realized by the investor in a company on their equity capital.
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• A company issues 10,000 equity shares of Rs. 100 each at a premium of
10%. The company has been paying 25% dividend to equity shareholders
for the past five years and expects to maintain the same in the future also.
Compute the cost of equity capital. Will it make any difference if the
market price of equity share is Rs. 175?
• Cost of Capital = Dividend / Share issue price x 100
• = (25/110) x 100 = 22.72 %
• Cost of capital if the market price is 175 = (25/175)x 100
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Dividend growth model
• A company plans to issue 10000 new shares of Rs. 100 each at a par. The
floatation costs are expected to be 4% of the share price. The company
pays a dividend of Rs. 12 per share initially and growth in dividends is
expected to be 5%. Compute the cost of new issue of equity shares.
• = 12/(100-4) + 5% = 17.50%
• If the current market price of an equity share is Rs. 120. Calculate the cost
of existing equity share capital
• =12 /120+ 5% = 15 %
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167. EMBA - 2020
Executive Education
Earning price approach
• A firm is considering an expenditure of Rs. 75 lakhs for expanding its
operations. The relevant information is as follows :
• Number of existing equity shares =10 lakhs
• Market value of existing share =Rs.100
• Net earnings =Rs.100 lakhs
• Compute the cost of existing equity share capital and of new equity capital
assuming that new shares will be issued at a price of Rs. 92 per share and
the costs of new issue will be Rs. 2 per share.
• = 1. 10/100 = 10 % 2. 10/90 = 11.11%
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168. EMBA - 2020
Executive Education
Realized yield approach
• Ke = PVf × D
• Realized yield is the actual return earned during the holding period for an
investment. It may include dividends, interest payments,
• KE = [{(D-P)/p} – 1] * 100
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169. EMBA - 2020
Executive Education
Capital Asset Pricing Model (CAPM)
• To use the CAPM approach,
• (1) estimate the firm’s beta,
• (2) multiply this beta by the market risk premium to determine the firm’s
risk premium, and
• (3) add the firm’s risk premium to the risk-free rate to obtain the cost of
common stock: rs = rRF + (RPM)bi
• Risk Free Rate >> Market Risk Premium >> Beta (Mark Risk versus Firm
Risk)
• The best proxy for the risk-free rate is the yield on long-term T-bonds
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170. EMBA - 2020
Executive Education
CAPM
• To estimate the cost of common stock using the Capital Asset Pricing
Model (CAPM) as discussed in Chapter 6, we proceed as follows:
• Step 1. Estimate the risk-free rate, rRF.
• Step 2. Estimate the current expected market risk premium, RPM, which is
the expected market return minus the risk-free rate.
• Step 3. Estimate the stock’s beta coefficient, bi, and use it as an index of
the stock’s risk. The i signifies the ith company’s beta.
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171. EMBA - 2020
Executive Education
Risk free rate
• Common stocks are long-term securities, and although a particular
stockholder may not have a long investment horizon, most stockholders do
invest on a long-term basis. Therefore, it is reasonable to think that stock
returns embody long-term inflation expectations similar to those reflected
in bonds rather than the short-term expectations in bills.
• 2. Treasury bill rates are more volatile than are Treasury bond rates and,
most experts agree, more volatile than rs.
• 3. In theory, the CAPM is supposed to measure the expected return over a
particular holding period. When it is used to estimate the cost of equity for
a project, the theoretically correct holding period is the life of the project.
Since many projects have long lives, the holding period for the CAPM also
should be long. Therefore, the rate on a long-term T-bond is a logical
choice for the risk-free rate.
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172. EMBA - 2020
Executive Education
Market risk premium
• Historical risk premium
• Forward looking premium
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173. EMBA - 2020
Executive Education
4
 Since financial resources are finite, there is a hurdle that projects have
to cross before being deemed acceptable.
This hurdle will be higher for riskier projects than for safer
projects.
 A simple representation of the hurdle rate is as follows: Hurdle
rate = Riskless Rate + Risk Premium
 The two basic questions that every risk and return model in
finance tries to answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?
Benchmarking for cost of capital

174. EMBA - 2020
Executive Education
What is Risk?
5
Risk, in traditional terms, is viewed as a ‘negative’.
Webster’s dictionary, for instance, defines risk as “exposing
to danger or hazard”. The Chinese symbols for risk,
reproduced below, give a much better description of risk:
危机
The first symbol is the symbol for “danger”, while the second
is the symbol for “opportunity”, making risk a mix of danger
and opportunity. You cannot have one, without the other.
Risk is therefore neither good nor bad. It is just a fact of life.
The question that businesses have to address is therefore not
whether to avoid risk but how best to incorporate it into their
decision making.

175. EMBA - 2020
Executive Education
The Equity Risk Premium
3
The risk premium is the premium that investors demand for
investing in an average risk investment, relative to the riskfree
rate.
As a general proposition, this premium should be
 greater than zero
 increase with the risk aversion of the investors in that
market
 increase with the riskiness of the “average” risk
investment

176. EMBA - 2020
Executive Education
• Yield to Maturity (YTM) – otherwise referred to as redemption or
book yield – is the speculative rate of return or interest rate of a fixed-rate
security, such as a bond. The YTM is based on the belief or understanding
that an investor purchases the security at the current market price and
holds it until the security has matured (reached its full value), and that all
interest and coupon payments are made in a timely fashion.
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