Advanced Corporate Finance.pdf

Advanced Corporate Finance (30221)
Welcome in Lecture Series for
Advanced Corporate Finance
by
Dr Santosh Kumar
Feb. 2023 (Term – III)
Email:santosh.kumar1@jaipuria.ac.in

The principles and
the methods to
control Supply
and demand of
money.
Financial Management is
an area
of financial decision-
making, harmonizing
individual motives and
enterprise goals, by
Weston and Brigham
Advance Corporate
Finance : Application of
different decisions at
one place , coming from
different purposes
(Investment/Finance/div
idend)
Introduction of Course
Advance Finance : An Overview

On successful completion of the course you should be able to:
CLO1: Compute the market value of equity, market value of debt and market value of firm.
CLO2: Analyze and manage financial risk in business decisions.
CLO3: Analyze corporate restructuring decisions.
Text book : Brigham, Eugene F. and Ehrhardt, Michael C., Cengage Learning (New Delhi), 14th Edition.
Pandey, I. M., Financial Management, Pearson,12e

Topic/ Module Contents/ Concepts
Module I: Valuation of Equity, Debt and Firm Introduction to discounted cash flow and relative valuation that can be used to value
equity, debt and firm.
Module II: Risk Analysis in Capital Budgeting Applying Sensitivity analysis, scenario analysis to analyze risk in capital budgeting
decisions.
Selecting appropriate discount rate considering risk of a project.
Selection of projects in capital rationing situations
Module III: Managing Risk using Derivative
Instruments
Managing risk using derivative instruments like future, options and swaps.
Module IV: Managing Foreign Exchange Risk Understanding of direct and indirect quotes, cross rate.
Determination of exchange rates
Managing foreign exchange risk using futures and options
Module V: Corporate Restructuring Decisions Rationale of Merger
Analyze merger decisions considering minimum and maximum exchange ratio,
synergy, Demerger Analysis

Sl. Assessment Item Description Weightage (%) CLO
01 Quizzes There shall be four quizzes, uniformly distributed over the term. The
quizzes will be designed in such a way so as to evaluate students on
two parameters: Knowledge and Application.
20 CLO1, CLO2, CLO3
02 Role Play/Group
Assignment
It will be on group (group of 5-6 students) basis. Role play will
involve application of course content in the context of Indian
companies. Role play will be in the form of board meeting where
members of the board arrive at different kinds of risk management
decisions.
20 CLO2
03 Individual Project It will be an individual project which will involve application of
valuation models to value equity of Indian companies.
20 CLO1
04 End-term
examination
It will be based on entire syllabus. The question paper will be
designed in such a way so as to evaluate students on three
parameters: Knowledge; Application and Higher Order Skills.
40 CLO1, CLO2, CLO3

Let’s start our life as Finance Manager

As financial manager of Organics, Inc., you have recently concurred with a general
management decision to enter into the plastics business. Much to your surprise, the price of
the firm's common stock subsequently declined from $40 per share to $30 per share. You are
anxious to determine how the market perceives the relevant risk of the firm and you have
determined that the following changes in the financial markets have occurred since Organics
entered into the plastics business:
(a) The real rate of interest has been constant at 2% but the inflation premium has increased
from 4% to 6%;
(b) The expected growth rate has been re-evaluated and a 10.5% rate is now considered to be
more realistic than the previous 5% rate;
(c) The risk aversion attitude of the market has shifted somewhat so that the market risk
premium is now 3% instead of 2%. (Km-Krf is now 3%)
Given that the current dividend, D0, is $1.90 per share, determine the change in beta for your
firm.
Recall from Corporate Finance

Module 1 with 4 Sessions
 Understanding of Valuation aspect and need of
valuation
 Valuation of Equity: concept and different approaches
 Valuation of Debt : concept and different approaches
 Valuation of Firm : concept and different approaches.
Session Outcome For Module 1

Valuation : Concept and Understanding
• An estimation of the worth of something, especially one carried out by a
professional valuer.
• In finance, valuation is the process of determining the present value of an
asset. In a business context, it is often the hypothetical price that a third party
would pay for a given asset.
• Valuation is a quantitative process of determining the fair value of an asset
or a firm
Valuation can be primarily categorized into two main types: Absolute
Value and Relative Value .
• Book Value and Replacement value
• Liquidation value and Going Concern Value
• Market value

Valuation : Concept and Understanding
• Valuation of securities/Firm is a quantitative process of knowing the intrinsic or fair
value.
Market price ( Current Market Price CMP): The market price per share of stock, or
the "share price," is the most recent price that a stock has traded for. It's a function
of market forces, occurring when the price a buyer is willing to pay for a stock meets
the price a seller is willing to accept for a stock.
Case 1: Underpriced share
• CMP < intrinsic value of share
• Actual return of share > Expected return as per intrinsic value concept
Case 2: overpriced share
• CMP > intrinsic value of share
• Actual return of share < Expected return as per intrinsic value concept
Case 2: Fair-priced share
• CMP = intrinsic value of share
• Actual return of share =Expected return as per intrinsic value concept

Need Of Valuation
• For taking investment decision
• For Pledging of security for loan
•For IPO ,FPO and Right issue
• For merger ,acquisition or any type of restructuring
•For Buy back
•For Calculation of Wealth tax , Gift tax , transfer Tax etc

Techniques of Fundamental Equity Valuation
Dividend discount Models
• Single year Holding
• Multiple Year Holding
• Zero growth model
• Constant growth model
• Two Stage mode
• H-Model
Techniques of
Fundamental
Equity
Valuation
Balance Sheet Techniques
• Book Value
• Liquidation value
• Replacement Cost
Discounted Cash Flow
Techniques
• Dividend discount model
• Free cash flow model
Relative Valuation
Techniques
• Price earnings ratio
• Price-book value ratio
• Price-sales ratio

Q .The cash flows associated with common stock are more difficult to estimate
than those related to bonds because stock has a residual claim against the
company versus a contractual obligation for a bond.
True /False
Q. Companies can issue different classes of common stock. Which of the
following statements concerning stock classes is CORRECT?
a. All common stocks, regardless of class, must have the same voting rights
b. All firms have several classes of common stock
c. All common stock, regardless of class, must pay the same dividend.
d Some class or classes of common stock are entitled to more votes per share
than other classes
e All common stocks fall into one of three classes: A, B, and C

Key words of Discounted Future Free Cash Flow (Dividend)
Method
•Discounting
•Discounting rate
•Cash flow
•Time period
•Dividend Vs Free cash Flow
Regular income(dividend)
One time income(Capital Gain)

Q. How to estimate Share price from the concept of Free cash flow for equity :
Case of B&B Corporation the data are given in Million
Q. A company has a current value of operations of $800 million. The company has $100
million in short-term investments. If the company has $400 million in debt and has 10
million shares outstanding, what is the price per share?
Constant free cash flow (FCF) =$10
Weighted average cost of capital (WACC) =10%
Short-term investments =$2
Debt =$28
Preferred stock =$4
Number of shares of common stock =5

Value of
Operations
=
FCF
1 + WACC
+
FCF
1 + WACC
+ ⋯ +
FCF
1 + WACC
Value of
Stock
=
D
1 + r
+
D
1 + r
+ ⋯ +
D
1 + r
Free cash flow
(FCF)
Weighted average
cost of capital
(WACC)
Firm’s debt/equity mix
Cost of debt
Cost of equity: The required
return on stock
Dividends (D)
Corporate Valuation and Stock Valuation

• Single year Holding
• Multiple Year Holding
P0 = Intrinsic value of share
D1 = Dividend of first year
P = Expected Price at end of period (Selling price)
K= Expected rate of return
N = Years of holding

Q. The Company dividend appears to grow smoothly at a constant rate of 5.5% from the
current level of $ 3.8 per share. Analysts forecast that next year’s price of the share will be $
58 . Investors require 14% return on this class of stock.
a. What would be the fair of price ?
b. What would be your recommendation for the share if the current CMP is $ 58 ?
c. Do you change your recommendation for an investor with 10% as the expectation of
return from the investment.?
Q. Northern Gas is expected to pay a $2.80 annual dividend on its common stock next year.
This dividend increases at an average rate of 3.8 percent per next three year. The stock is
expected to sell for $26.91 a share at the end of third year. What should be the market
price at expected return of 12% per year?
Q. Nynet, Inc., paid a dividend of $4.18 last year. The company's management does not
expect to increase its dividend in the foreseeable future. If the required rate of return is
18.5 percent, what is the current value of the stock?

• Zero growth model : Dividend remain constant
• Constant growth model : Gordon Model of Share valuation : in case of
dividend grow with constant growth rate for infinite time
𝟎
𝟏 𝟎
D0 = Dividend of current year
g= annual growth rate of Dividend

• Earnings and dividends of most companies grow over time, at least, because of their
retention policies.
• Let exercise a mini Situation to understand this argument :
• Day 1- Book Value =100 , ROE (IRR)= 10%, Retention = 60%
𝟐 𝟏
𝟏
If a totally equity financed firm retains a constant proportion of its annual earnings (b) and
reinvests it at its internal rate of return, which is its return on equity (ROE), then it can be
shown that the dividends will grow at a constant rate equal to the product of retention ratio
and return on equity; that is:
Q. An all-equity-financed firm plans to grow at an annual rate of at least 28%.
Its return on equity is 43%. What is the maximum possible dividend payout
rate the firm can maintain without resorting to additional equity issues?

Q. The Company has paid a dividend of $ 0.51 per share in current year and expected to
increase dividend by 10% . Analysts forecast that next year’s price of the share will be $
45.50. CMP of the share is $43.13 and Investors require 6.8% return on this class of stock.
a. What would be the dividend yield?
b. What would be the capital gain rate?
c. Will you invest in the share [ comment before making any calculation]
*Dividend Yield and Capital gain rate
Q. The Company has paid a dividend of $ 0.5 per share in current year and expected to
increase dividend by 6% thereafter. Make a recommendation sheet based on expected
return for investors if the CMP of share is $ 50.

Q . Ewald Company’s current stock price is $36, and its last dividend was $2.40. In view of
Ewald’s strong financial position and its consequent low risk, its required rate of return is only
12%. If dividends are expected to grow at a constant rate, g, in the future, and if return is
expected to remain at 12%, what is Ewald’s expected stock price 5 years from now?
Q. A stock is trading at $80 per share. The stock is expected to have a year-end dividend of $4
per share (D1 $4), which is expected to grow at some constant rate g throughout time. The
stock’s required rate of return is 14%. If you are an analyst who believes in efficient markets,
what is your forecast of g?
Q. A company recently issued a dividend of $3. The expected growth rate is 10%, and you
expect the rate to fall to a stable growth rate of 2% over the next twelve years. If the required
rate of return is 11%, what would the value of a share in the hypothetical company be under
the H-model?

• Two Stage model : a model based on two -stage of cash flows, where the
first stage may have an unequal amount of dividend and the second stage is
usually have a constant dividend growth rate for infinite period.
𝑷𝟎 =
𝑫𝒊
(𝟏 + 𝑲)𝒊
𝒏
𝒊 𝟏
+
𝑫𝒏 ∗ (𝟏 + 𝒈)
𝒌 − 𝒈 ∗ (𝟏 + 𝑲)𝒏
D = Dividend at different years
g= annual growth rate of Dividend
n = time at constant growth rate

• H model of Share valuation : in case of dividend grow with abnormal rate
and normalize to constant growth rate for infinite time
D0 = Dividend of current year
ga and gn = Growth rate of dividend at aggressive
and normalize rate respectively
H= half time required to reduce growth rate to
normal =n/2

• FCF discounting method of Share valuation : Generally used by PE , Venture
Capital Fund in case of early stage companies.
E1, E2, En =Income of year
b1, b2, bn = Share in Income towards debt commitment.
K1, K2, Kn = Expected rate of return of Capital
T= tax rate

Q. Snyder Computer Chips Inc. is experiencing a period of rapid growth. Earnings and
dividends are expected to grow at a rate of 15% during the next 2 years, at 13% in the third
year, and at a constant rate of 6% thereafter. Snyder’s last dividend was $1.15, and the required
rate of return on the stock is 12%.
a. Calculate the value of the stock today.
b. Calculate the dividend yield for Years 1, 2, and 3
Q. You buy a share of The Synergy Corporation stock for $21.40. You expect it to pay
dividends of $1.07; $1.1449, and $1.2250 in Years 1, 2, and 3, respectively, and you expect to
sell it at a price of $26.22 at the end of 3 years.
a. Calculate the growth rate in dividends.
b. Assuming that the calculated growth rate is expected to continue, you can add the dividend
yield to the expected growth rate to get the expected total rate of return. What is this stock’s
expected total rate of return?

Relative Valuation models
A relative valuation model is a valuation method that compares a
company's value to that of its competitors or industry peers to
assess the firm's financial worth. Relative valuation models are
an alternative to absolute value models, which try to determine a
company's intrinsic worth with reference to another company or
industry average. Relative valuation models help for determining
whether a company's stock is a good buy.
Some popular Relative Valuation Models are:
• P/E ratio
• Price to book value (PBV) Ratio
• Price to Enterprise value (PEV) Ratio
• Price To Sales Ratio (PSR Ratios)

Q. Your employer, a mid-sized human resources management company, is considering
expansion into related fields, including the acquisition of Temp Force Company, an
employment agency that supplies word processor operators and computer programmers to
businesses with temporary heavy workloads. Your employer is also considering the
purchase of Biggerstaff & McDonald (B&M), a privately held company owned by two
friends, each with 5 million shares of stock. B&M currently has free cash flow of $24
million, which is expected to grow at a constant rate of 5%. B&M’s financial statements
report short-term investments of $100 million, debt of $200 million, and preferred stock of
$50 million. B&M’s weighted average cost of capital (WACC) is 11%. Answer the following
questions.
a) What is its estimated value of operations?
b) What is its estimated total corporate value?
c) What is its estimated intrinsic value of equity?
Find the value of firm and intrinsic value of each share
FCF0 = $24 million
WACC = 11%
FCF is expected to grow at a constant rate of g = 5%

Earnings Multiplier Approach
P0 = m E1
Determinants of m (P / E)
From concept of constant growth dividend model , 𝑷𝟎 =
𝑫𝟏
𝑲 𝒈
Dividend will calculated as : Earning –Retained profit
𝑷𝟎 =
𝑬𝟏(𝟏 − 𝒃)
𝑲 − 𝑹𝑶𝑬 ∗ 𝒃
b = Plough back ratio ( retained profit ratio)
𝑷𝟎
𝑬𝟏
=
𝟏 − 𝒃
𝒌 − 𝑹𝑶𝑬 ∗ 𝒃

Price to book value (PBV) Ratio
The PBV ratio has always drawn the attention of investors. During the 1990s Fama
and others suggested that the PBV ratio explained to a significant extent the returns
from stocks.
𝑷𝟎 =
Market price per share at time t
Book value per share at time t
𝑫𝟏
𝑲 𝒈
𝑫𝟏 = 𝑬𝟏 ∗ 𝟏 − 𝒃 = 𝑬𝟎 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈 = 𝑩𝑽𝟎 ∗ 𝑹𝑶𝑬 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈
𝑷𝟎 =
𝑩𝑽𝟎 ∗ 𝑹𝑶𝑬 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈
𝑲 − 𝒈
PBV ratio,
𝑷𝟎
𝑩𝑽𝟎
=
𝑹𝑶𝑬 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈
𝑲 − 𝒈

Price to sales ratio (PSR)
The PSR ratio has always drawn the attention of investors in recent years.
Portfolios of low PSR stocks tend to outperform portfolios of high PSR stocks. The
Net Profit Margin(NPM) is key driver of PSR.
𝑷𝟎 =
Market price per share
Annual sales
𝑫𝟏
𝑲 𝒈
𝑫𝟏 = 𝑬𝟏 ∗ 𝟏 − 𝒃 = 𝑬𝟎 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈 = 𝑺𝟎 ∗ 𝑵𝑷𝑴 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈
𝑷𝟎 =
𝑺𝟎 ∗ 𝑵𝑷𝑴 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈
𝑲 − 𝒈
PS ratio,
𝑷𝟎
𝑺𝟎
=
𝑵𝑷𝑴 ∗ 𝟏 − 𝒃 ∗ 𝟏 + 𝒈
𝑲 − 𝒈

Net Assets Value (NAV) Method
Value of Share = Net Assets of Company / Total No. of Shares.

Multiplier Approach Method
• The easiest and the most used method of valuation
• Ratio multiplying method .
Value of share = Current Earning * (Price/ Earning ratio)
P/E= 8.2+1.5 growth rate in earning+6.7 payout ratio -0.2 variability of earning
By whitebek and Kisor

a. The free cash flow valuation model discounts free cash flows by the required return on equity.
b. The free cash flow valuation model can be used to find the value of a division.
c. An important step in applying the free cash flow valuation model is forecasting the firm's pro
forma financial statements.
d. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the
horizon, or terminal, value.
e. The free cash flow valuation model can be used both for companies that pay dividends and those
that do not pay dividends.
Which of the following statements is NOT CORRECT?

Concept Of Bond (Debentures-Fixed Income securities)

• Fixed Rate Bonds
• Floating Rate Bonds
• Inverse Floater Bonds
• Zero Interest Rate Bonds
• Indexed Bond (Inflation Linked
Bonds)-TIPS
• Convertible Bond
• Non-convertible Bond
• Callable Bond
• Puttable Bond
Types Of Bond ( Point of Valuation)
• Perpetual Bonds
• Subordinated Bonds
• Bearer Bonds
• War Bonds
• Serial Bonds
• Climate Bonds
• International Bonds [ Foreign
Bond, Eurobonds, Global Bonds]

Value of Bond
• Bond pricing can be viewed as a three-step process.
Step 1: obtain the cash flows the bondholder is entitled to.
Step 2: obtain the discount rates for the maturities corresponding to
the cash flow dates. [ Current Yield, YTM, YTC]
Step 3: obtain the bond price as the discounted value of the cash
flows.
𝑷𝒓𝒊𝒄𝒆 𝒐𝒇 𝑩𝒐𝒏𝒅 = 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 [𝑪𝒐𝒖𝒑𝒐𝒏 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘𝒔 + 𝒕𝒆𝒓𝒎𝒊𝒂𝒏𝒍 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘]

Value of Bond
Case 1: With fixed maturity and fixed coupon rate
Case 2: With Zero coupon rate
Case 3: With infinite maturity ( perpetuity)
Case 4: With Amortization bond
𝒊
𝒊

Q1.
Q2. Suppose the government is proposing to sell a 5-year bond of ₹ 1,000 at 8
per cent rate of interest per annum. The bond amount will be amortised
(repaid) equally over its life. If an investor has a minimum required rate of
return of 7 per cent, what is the bond’s present value for him?

Q3.
Q4. The Brightways company has a perpetual bond that pays ₹ 140 interest annually.
The current yield on this type of bond is 13% in 2020
a) At what price will it sell?
b) If the required yield rises to 15% in 2021 ,what will be the new price?
C) What is the total return from the investment ?
• https://www.youtube.com/watch?v=UVBatBqKrYU

• The Term Structure Of Interest Rates
The term structure of interest rates, or spot rate curve, or yield curve, at a certain time t
defines the relation between the level of interest rates and their time to maturity T −t.
The discount curve at a certain time t defines instead the relation between the discount
factors Z(t, T) and their time to maturity T − t.
The three key types of yield curves include normal, inverted, and flat.
• The term spread, or slope, is the difference between long-term interest rates (e.g. 10-year
rate) and the short-term interest rates (e.g. 3-month rate).
Typically, in the normal market, the term spread is positive.: Like discount factors, the term
spread depends on numerous variables, such as expected future inflation, expected future
growth of the economy, agents’ attitudes toward risk, and so on.
Understanding of Interest Rate

Q. Which of the following statements is CORRECT?
a. Most sinking funds require the issuer to provide funds to a trustee, who saves the money
so that it will be available to pay off bondholders when the bonds mature.
b. A sinking fund provision makes a bond more risky to investors at the time of issuance.
c. Sinking fund provisions never require companies to retire their debt; they only establish
"targets" for the company to reduce its debt over time.
d. If interest rates have increased since a company issued bonds with a sinking fund, the
company is less likely to retire the bonds by buying them back in the open market, as
opposed to calling them in at the sinking fund call price.
e. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is
most likely to occur if interest rates decline after the bond has been issued.

Q. Hillard purchase in a 7% coupon bond issued for 10 years for yield of 9%
and sold the same after 2 years at yield of 7% for such type of bond. Find the
total return for Hillard in the investment.

Yields of Bond
• Bond yield is the amount of return an investor will realize on a bond.
Format 1: Current yield : the annual return on the dollar amount paid for a
bond, regardless of its maturity.
Format 2: Yield to Maturity (YTM) : YTM is the internal rate of return required for
the present value of all the future cash flows of the bond (face value and
coupon). if the investor holds the bond until maturity.
Format 3: Yield to Maturity (YTC) : YTC is the internal rate of return required for
the present value of all the future cash flows of the bond (Call value and
coupon). if the investor holds the bond until call.
• YTC/YTM will be calculated as trial and error method.

YTM as trial and error Method [ linear
interpolation method]
• STEP 1: Check if the bond price is lower than the face value. If yes, YTM must
be higher than the coupon rate. If no, YTM is lower than the coupon rate.
• STEP 2: Keeping the result from Step 1 in view, set a low ‘Y’ value [YL ]such
that the present value of bond cash flows [VL ]is higher than the bond price.
• STEP 3: Set a high ‘Y’ value [VH ]such that the present value of bond cash
flows [VH ]is lower than the bond-price.
• STEP 4: Use the following equation to solve for yield to maturity ‘YTM’:

Approximated YTM
• The primary importance of yield to maturity is the fact that it enables
investors to draw comparisons between different securities and the returns
they can expect from each. It is critical for determining which securities to
add to their portfolios.

Q1. A bond currently sells for $850. It has an eight-year maturity, an annual
coupon of $80, and a par value of $1,000. What is its yield to maturity? What
is its current yield?
Q2. A bond currently sells for $1,250. It pays a $55 Semiannual coupon and
has a 20-year maturity, but it can be called in 5 years at $1,110. What are its
YTM and its YTC? Is it likely to be called if interest rates don't change?
Q3. A company had issue a Pure discount bond of ₹ 1,000 face value for ₹ 520
today for a period of 6 years. Find the YTM for investors.

Q4.A 6 year 10%, ₹ 1,000 bond selling at price of ₹ 1025 that pays interest annually is
callable in 3 years at premium of 5%.
a) Find YTC
b) Fid YTM
c) Decision to exercise the call based on the above calculation.
Q 5. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of
$1,000 is currently selling for $1,135.90, producing a yield to maturity (YTM) of 8
percent. However, the bond can be called after 5 years for a price of $1,050.
1. What is the bond's yield to call (YTC)?
2. If you bought this bond, do you think you would be more likely to earn the YTM or
the YTC? Why?

Q. An investor has two bonds in his portfolio. Each bond matures in 4 years,
has a face value of $1,000, and has a yield to maturity equal to 9.6%. One
bond, Bond C, pays an annual coupon of 10%; the other bond, Bond Z, is a zero
coupon bond. Assuming that the yield to maturity of each bond remains at
9.6% over the next 4 years, what will be the price of each of the bonds at the
following time periods? Fill in the following table:
Q. A bond trader purchased each of the following bonds at a yield to maturity
of 8%. Immediately after she purchased the bonds, interest rates fell to 7%.
What is the percentage change in the price of each bond after the decline in
interest rates? Fill in the following table:

Bond Values and Changes in Interest Rates
• The value of the bond declines
as the market interest rate
(discount rate) increases.
• The value of a 10-year, 12 per
cent ₹ 1,000 bond for the market
interest rates ranging from 0 per
cent to 30 per cent is shown in
the figure.

Bond Maturity and Changes in Interest Rates
• The intensity of interest rate risk
would be higher on bonds with long
maturities than bonds with short
maturities.
• The differential value response to
interest rates changes between short
and long-term bonds will always be
true. Thus, two bonds of same
quality (in terms of the risk of
default) would have different
exposure to interest rate risk.
Bond Value at Different Interest Rates

 Understanding of Valuation to measure risk of a
project.
 Valuation the impact of change in different factors
(price, variable cost, risk, quantity and fixed cost) on
capital budgeting decisions.
 Analyze risk in capital budgeting decisions under
different scenario (Base, Worst and Best).
 Analyze capital budgeting decisions under the
condition of capital rationing (scarcity of capital).
 Analyze risk in capital budgeting decisions in
simulation random perspective
(Measurement of Risk in Capital Budgeting Decisions.)

MACRS Depreciation is the tax depreciation system that is currently employed in the United States. The MACRS, which
stands for Modified Accelerated Cost Recovery System, was originally known as the ACRS (Accelerated Cost Recovery
System) before it was rebranded to its current form after the enactment of the Tax Reform Act in 1986.

The Key Terms for Capital budgeting Risk Analysis
Relevant cash flow : Net Operating Profit After Taxes (NOPAT)+ Depreciation
Incremental Cash flows: Firm’s cash flows with project- Firm’s cash flows without project
Timing of cash flows
Sunk cost
Externalities : [ Negative within the firm, Positive within the firm and Environmental externalities]
Treatment of Working capital investment
Treatment of salvage value

Salvage value treatment : Example: If Sold After 3
Years for $25 ($ thousands)
• Original basis = $240.
• After 3 years, basis = $17.8 remaining.
• Sales price = $25.
• Gain or loss = $25 – $17.8 = $7.2.
• Tax on sale (@25%)= 0.25($7.2) = $1.80.
• Cash flow = Sales price – taxes
• Cash flow = $25 – $1.80 = $23.2.

What does “risk” mean in capital budgeting?
• Uncertainty about a project’s future profitability.
• Measured by σNPV, σIRR, beta.
• Will taking on the project increase the firm’s and stockholders’ risk?
• We Can sometimes use historical data, but generally cannot.
• So risk analysis in capital budgeting is usually based on subjective judgments.
Types of risk in CB
• Stand-alone risk
• Corporate risk
• Market (or beta) risk

How is each type of risk used?
• Market risk is theoretically best in most situations.
• However, creditors, customers, suppliers, and employees are more affected by
corporate risk.
• Therefore, corporate risk is also relevant.
• Stand-alone risk is easiest to measure, more intuitive.
• Core projects are highly correlated with other assets, so stand-alone risk
generally reflects corporate risk.
• If the project is highly correlated with the economy, stand-alone risk also
reflects market risk.

Methods of Risk Assessment
• Sensitivity Analysis
• Scenario Analysis
• Simulation Analysis
Sensitivity Analysis: Shows how changes in a variable affect the outcome , such
as unit sales affect NPV or IRR. Each variable is fixed except one. Change this
one variable to see the effect on NPV or IRR
• Gives an idea of stand-alone risk.
• Identifies dangerous variables.
• Gives some breakeven information.

Sensitivity Analysis: NPV for Input Deviations
from Base Case
Dev.
From Base
NPV: Unit
Cost Dev.
NPV: Unit
Sales Dev.
NPV:
Salvage Dev.
-30% $136,927 -$9,363 $58,751
-15% $99,760 $26,615 $60,672
0% $62,593 $62,593 $62,593
15% $25,426 $98,571 $64,514
30% -$11,742 $134,548 $66,435

Sensitivity Graph: NPV for Input Deviations
from Base Case
Cost per unit Units Sold
Salvage
-$20,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
-30% -15% 0% 15% 30%
NPV
Deviations of Inputs from Base Case

Scenario Analysis
• Examines several possible situations, usually worst case, most likely case, and
best case.
• Provides a range of possible outcomes
• Only considers a few possible out-comes.
• Assumes that inputs are perfectly correlated—all “bad” values occur together
and all “good” values occur together.
• Focuses on stand-alone risk, although subjective adjustments can be made.

Steps in Scenario Analysis
1. Calculate Capital Budgeting output for base case.
2. Create a 3 scenarios (at least) Worst , Base and best
3. Calculate the cash flows from the 3 scenarios‘.
4. Calculate Capital Budgeting output for all scenarios.
5. Find the probable Capital Budgeting output
6. Find the Standard deviation for Capital Budgeting output
7. Find the CV for Capital Budgeting output

Best scenario: 1,200 units @ $240
Worst scenario: 800 units @ $160
Scenario Prob.
Unit
Sales Unit Price NPV
Best Case 25% 1,200 $240 $227,595
Base Case 50% 1,000 $200 $62,593
Worst Case 25% 800 $160 -$63,399
Expected NPV = $72,345
Standard Deviation = 103,343
Coefficient of Var. = Std Dev / Exp. NPV = 1.43

Simulation Analysis
• A computerized version of scenario analysis that uses continuous probability
distributions.
• Computer selects values for each variable based on given probability distributions.
• NPV and IRR are calculated.
• Process is repeated many times (1,000 or more).
• End result: Probability distribution of NPV and IRR based on sample of simulated
values.
• Generally shown graphically.
Advantage
• Reflects the probability distributions of each input.
• Shows range of NPVs, the expected NPV, σNPV, and CVNPV.
• Gives an intuitive graph of the risk situation.

Steps in Simulation Analysis (Excel)
• Identifying the Inputs for decision making
• Run Scenario at least for 3 condition
• Find the deviation in Inputs value as per Scenario
• Generate a random Variable in Normal distribution environment
• Simulate the identified input with random variable ( create a simulated Inputs)
• Develop a capital budgeting model with new simulated input
• Record the result of simulated output
• Create Summary Statistics for Simulated Input Variables
• Validate output of simulation ( Graphical approach)

You must analyze a potential new product --- a caulking compound that Korry Materials’ R&D people developed for use in the
residential construction industry. Korry’s marketing manager thinks they can sell 115,000 tubes per year at a price of $3.25
each for 3 years, after which the product will be obsolete. The required equipment would cost $125,000, plus another $25,000
for shipping and installation. Current assets (receivables and inventories) would increase by $35,000, while current liabilities
(accounts payables and accruals) would rise by $15,000. Variable costs would be 60 percent of sales revenue, fixed costs
(exclusive of depreciation) would be $70,000 per year, and the fixed assets would be depreciated under MACRS with a 3-year
life. When production ceases after 3 years, the equipment should have a market value of $15,000. Korry’s tax rate is 40
percent, and it uses a 10 percent WACC for average risk projects.
The R&D costs for the new product were $30,000, and those costs were incurred and expensed for tax purposes last year. If
Korry Materials accepts the new project it will result in an annual loss of revenues on an existing product of $5,000.
Find
a) the required year 0 investment,
b) the annual after-tax operating cash flows,
c) the terminal year cash flow.
d) Assuming the project is of average risk, would you recommend accepting the project with help of the capital budgeting
techniques ( NPV, IRR, MIRR , PI , PB , DPB)
e) Calculate Break even cost of capital

Chance, Inc. is considering a project with an initial cost of $0.8 million. The
project will not produce any cash flows for the first two years. Starting in year
3, the project will produce sales revenue of $625,000 a year for four years,
with a variable cost of 20% of sales and a fixed cost of $15000 each year. The
equipment will have a market value of $0.1 M. Follow the straight-line
method of deprecation for book value zero at the end, the prevailing tax rate
is 35%. Calculate the feasibility of the project at 10%, 15% and 20% as a
discount rates.

 Understanding of Foreign Exchange Market –
Exchange Rate Quotations
 Understand how the exchange rates are determined in
foreign exchange markets.
 Management of foreign exchange risk – By use of
currency derivatives.
(Managing Foreign Exchange Risk)

Multinational Financial Management
• A multinational corporation is one that operates in two or more countries.
• At one time, most multinationals produced and sold in just a few countries.
• Today, many multinationals have world-wide production and sales.
Major Factors Distinguishing Multinational from Domestic Financial Management
• Currency differences
• Language differences
• Cultural differences
• Economic systems
• Legal systems
• Taxation
• Government intervention
• Political risk
• Terrorism and crime

Value = + + ···+
FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Intrinsic Value in a Global Context
Currency
exchange
rates
Culture
Regulatory
systems
Global financial markets Political risk

Foreign Exchange market (ForEx, FX or Currency
Market)
• The foreign exchange (forex) market is the largest financial market in the
world and is made up of banks, commercial companies, central banks,
investment management firms, hedge funds, retail forex brokers, and
investors.
• For trade in currencies and contract of currencies.
• Average daily transaction is $ 6.6 trillion (including Spot and derivatives) as
per data of BIS-2019.
• 24*7 operation
• No physical presence

Exchange rate
• An exchange rate is the value of one nation's currency versus the currency of
another nation or economic zone.
• Any Foreign exchange market quotation always uses the abbreviation of the
currency under question. There are standard currency keys or currency codes
that have been created by International Standards Organization (ISO).
• The key is made up of 3 alphabets. The first two alphabets of the key denote the
country to which the currency belongs whereas the third alphabet of the key is
the first alphabet of the currency.
• A quote has two currencies: The left-hand currency and the right-hand currency.
A quote of LEFT/RIGHT is for the value of the LEFT currency expressed in units of
the RIGHT currency.
1US$ = IN₹ 71.45 or US$/IN₹= 71.45

Notation
IMPORTANT NOTE
• The “/” in the quote for EUR/USD does not mean “per” or “divided by.”
This is a source of great confusion for students! It actually means the
opposite!
• The quote EUR/USD = 1.25 means 1 euro is equal to 1.25 dollars or $1.25.
• To express this using “per” you would say the rate is “1.25 dollars per
euro.”
• To avoid confusion, we will avoid using the “/” to mean “per” with
currency names and instead, spell out “per” when appropriate.

Exchange Rate Quotation
Presentation of value of one nation's currency in term of another nation currency .
• Direct quotation and Indirect quotation. Direct quotation is when the one unit of
foreign currency is expressed in terms of domestic currency.
1US$ = IN₹ 71.45 or US$/IN₹= 71.45
• Indirect quotation is when one unit of domestic currency us expressed in terms of
foreign currency
1IN₹ = US$ 0.0139 or IN₹/ US$ = 0.0139
Bid and Ask quotation: (also known as bid and offer)- refers to a two-way
price quotation, the Bid price indicates the dealer is willing to pay for a currency,
while the ask price is the rate at which a dealer will sell the same currency.
EUR/US$ =1.2342/47

Exchange Rate Quotation
• Ask Price of currency > Bid Price of currency.
• Cross Exchange rate : The cross rate refers to the exchange rate between two
currencies, each of which has an exchange rate quote against a common
currency. Example: In the case of the GBP/CHF.
The bid prices are as follows: GBP/USD=1.5700,
USD/CHF=0.9300.
GBP/CHF=GBP/USD* USD/CHF= 1.5700*0.9300=1.4601

Currency Appreciation and Depreciation
• To determine whether currency X has appreciated or depreciated against
currency Y:
• Write the exchange rate as the number of units of Y per unit of X.
• Comparing the old rate with the new rate shows how much more (or less) of
currency Y that X can purchase.
• The percentage that X appreciates against Y is not the same as the
percentage that Y depreciates against X.

BY Dr. Santosh Kumar
Q1. Calculate Indirect quote for the following currency
(a) €1 = US$ 0.8420
(b) £1 = US$ 1.4565
(c) NZ$1 = US$ 0.4250
Q2. Given
(a) Calculate the cross rate for pounds in yen terms.
(b) Calculate the cross rate for Australian dollars in yen terms
( C ) Calculate the cross rate for pounds in Australian dollar terms.

Q3. Calculate the realized profit or loss as an amount in dollars when C$
8,540,000 are purchased at a rate of C$1 = $1.4870 and sold at a rate of
C$1 = $1.4675.
Q4. Given a) US$/INR = 71.4723/27
b) £/INR = 80.3423/35
Calculate Spread and Spread rate for the above currency exchange.

Exchange Rate System
Exchange rate system into eight categories:
• Exchange arrangement with no separate legal tender(37 countries has adopted
this)
• Currency Board Agreement (fixed rate) (8 countries)
• Conventional fixed peg arrangement: currencies with a band variation not
exceeding ± 1% . (32 countries)
• Pegged Exchange Rates Within Horizontal Bands : (8 countries)
• Crawling Peg (6 countries)
• Crawling bands (9 countries)
• Managed float : (35 countries)
• Independently floating (48 countries including India, US)

Spot Exchange Rate and Forward Exchange Rate
• Spot exchange rate is Current market price of currency
• Forward Rate: expected price of currency
• Forward Premium: the excess of the forward rate over the spot rate.
• Forward Discount: expected future price for a currency is less than the
spot price.
Forward Premium / Discount= *

Q . Calculate Forward Premium and Discount for given situations as
1 GBP/INR
a) Find Forward premium/Discount for Bid Price for all forward rate
separately
b) Find Forward premium/Discount for Ask Price for all forward rate
separately
Spot Rate => INR 78.0001 / INR 78.2254
1 month forward rate => INR 78.4256 / INR 78.5200
3 months forward rate => INR 77.8952 / INR 77.9999
6 months forward rate => INR 78.8925 / INR 78.9925

Q. Bank A quotes NZ$1 = US$0.4220/ 0.4225
Bank B quotes NZ$1 = US$0.4226/ 0.4231
What arbitrage opportunity exists? How much profit could be made by
performing this arbitrage on a principal amount of NZ$10,000,000?.
Q . Suppose Bank One gives the following quotes:
SJPY/USD = 100 JPY/USD
USD/GBP = 1.60 USD/GBP
SJPY/GBP = 140 JPY/GBP
Find arbitrage opportunity in cross trade.

Factor of Exchange rate determination
• The concept of determination
mainly applicable in a floating
exchange rate is a regime where
the currency price of a nation is set
by the forex market based on supply
and demand relative to other
currencies.
• The major factor of floating rate
determination is Demand and supply
of currency in market . The
exchange rate will at equilibrium
point of demand and supply.

Major factors :
• Balance of Payments(Country’s Current Account )
• Inflation Rates ( Purchasing Power Parity theory)
• Interest rate (Interest Rate Theory)
• Government Debt
• Government intervention
• Political Stability & Performance
• Recession ( economic condition)
• Speculation

Purchasing Power Parity theory(PPP-Inflation rate)
• This theory states that the exchange rate between currencies of two
countries should be equal to the ratio of the countries’ price levels.
• The basic idea of PPP originated with scholars at the University of
Salamanca, the oldest University in Spain, in the 16th century.
• Gustav Cassel, a Swedish economist, who formulated PPP in its modern
form and popularized it in the 1920s.
• The basis for PPP is the "law of one price". In the absence of
transportation and other transaction costs, competitive markets will
equalize the price of an identical good in two countries when the prices
are expressed in the same currency.

Assumptions of PPP
• There exist perfect market conditions
• Absence of transportation costs from one market to another (country to
another)
• Free trade across the international market
• No barriers or controls over international trade like tariffs, taxes,
incentives, promotions etc.
• No country is strong enough to influence the exchange rate
Date USA US$/CHF Switzerland
01-01-2019 A basket cost $100 2
Same basket cost
CHF 200
31-12-2019 A basket cost $108 1.9074
Same basket cost
CHF 206
On January 1,
S (USD/CHF) = 2.00 = PCHF /P US = 200/100
On December 31,
S (USD/CHF) = 1.9074 = PCHF /P US = 206/108

Forms of PPP
• Absolute PPP Theory: In the olden days (1700 -1970) gold formed the basis
for determination of the exchange rate because it commanded good demand
all over the world
St = Pt / Pt*
• Relative PPP Theory :It comprises of a basket of commodities in which gold
is only a commodity.
• Inflation influences exchange rates
• Two countries India and China. Inflation rate in India is 10% and that of China
is 0%; then the INR will depreciate when compared to Chinese Yuan.

Q . The united state and Switzerland are running annual inflation rate of
5% and 3% respectively. The current spot exchange rate is SFr 1= $ 0.75.
Find out the forward expected rate.
a) After six months
b) After 1 year
c) After 2 years , if PPP stand true.
d) Find out the arbitrage opportunity, If forward rate after 2 years is SFr
1= $ 0.85.
Q . The current spot exchange rate is CHF 1= $ 0.75. The expected
forward exchange rate is CHF 1= $ 0.80 after one year. The united state is
having annual inflation rate of 4%. Find out the inflation rate in
Switzerland if PPP stand true.
Q. rNom, 6-month T-bills = 7%; rNom of similar default-free 6-month
Japanese bonds = 5.5%; Spot exchange rate, S0: 1 Yen = $0.009; 6-month
forward exchange rate = ft = ?

Interest-Rate Parity theory(IRP)
• This theory states that the exchange rate between currencies of two
countries should be equal to the ratio of the countries’ interest rate level.
• Interest rate parity connects interest rate, spot exchange, and foreign
exchange rates
• It is also known as the asset approach to exchange rate determination.
• IRP theory holds that the forward exchange rate should be equal to the
spot currency exchange rate times the interest rate of the home country,
divided by the interest rate of the foreign country.
• The basis for IRP is the "law of no arbitrage". Interest rate parity refers to
a condition of equality between the rates of return on comparable assets
between two countries.

Forms of IRP
• Covered Interest Rate Parity (CIRP): The exchange rate forward
premiums (discounts) nullify the interest rate differentials between two
sovereigns. In other words, covered interest rate theory says that the
difference between interest rates in two countries is nullified by the
spot/forward currency premiums so that the investors could not earn an
arbitrage profit.
• Uncovered Interest Rate Parity (UIP): The expected appreciation (or
depreciation) of a particular currency is nullified by lower (or higher)
interest.
• If domestic interest rate is below foreign interest rates, the foreign
currency must trade at a forward discount. This is applicable for
prevention of foreign currency arbitrage.

Calculations in IRP
Interest Rate differential ,
If , not equal to , there is an arbitrage opportunity which will
leads to disequilibrium in economy.

A Japanese company wants to calculate the one-year forward JPY/USD rate.
With spot yen selling at 150 JPY/USD and the JPY annual interest rate equal to
7% and the USD annual interest rate equal to 9%. Find forward rate
a) In six months period
b) In one year period
c) In 1.5 years period
Q. Suppose you are given the following data,
St = 150 JPY/USD, RJPY,1-yr = 7%, RUSD,1-yr = 9%
and Ft,1-yr = 140 JPY/USD.
Find out interest differential and arbitrage opportunity if any.
Q. Spot rate = 1 yen = $0.0086; ft = 1 yen = $0.0086; rNom of 90-day Japanese
risk-free securities = 4.6%; rNom of 90-day U. S. risk-free securities = ?

Q. The annual interest rate is 5 percent in the United States and 8 percent
in the U.K., and that the spot exchange rate is $1.80/£ and the forward
exchange rate, with one-year maturity, is $1.78/£. Establish a arbitrage
opportunity with borrowing up to $1,000,000.
Q. The annual interest rate is 9 percent in India and 5 percent in the USA,
and that the spot exchange rate is $70.80/INR and the forward exchange
rate, with one-year maturity, is $74.30/INR. Establish a arbitrage
opportunity with borrowing up to $1,000,000.

Q. Today's spot exchange rate: 1 euro = $1.25.
US interest rate (home interest rate) is 7%.
EU interest rate (foreign interest rate) is 10%.
a) If the IRP (Interest rate parity) holds, what should the forward exchange
rate be today?
b) Assume that today, you invest $500 in the EU market for one year and
at the same time, enter a currency forward contract to sell euro in a year
at the forward rate from part a). If today's spot exchange rate is: 1
euro=$1.32 instead of $1.25, show how much profits or losses you make
next year.
 
 
$
1
1
t
e
t t t
r
F S
r




Q17.13. Chapman Inc.'s Mexican subsidiary, V. Gomez Corporation, is expected
to pay to Chapman 30 pesos in dividends in 1 year after all foreign and US taxes
have been subtracted. The exchange rate in 1 year is expected to be 0.10 dollars
per peso. After this, the peso is expected to depreciate against the dollar at a
rate of 4% a year forever due to the different inflation rates in the US and
Mexico. The peso-denominated dividend is expected to grow at a rate of 8% a
year indefinitely. Chapman owns 10 million shares of V. Gomez. What is the
intrinsic value of the company’s equity in dollars, assuming V. Gomez's cost of
equity is 13%?
[$32.1888, Growth rate= 3.68%, K=13%]

Q. 17.14. The South Korean multinational manufacturing firm, Nam Sung Industries, is
debating whether to invest in a 2-year project in the United States. The projects expected
dollar cash flows consist of an initial investment of $1 million with cash inflows of $700,000 in
Year 1 and $600,000 in Year 2. The risk-adjusted cost of capital for this project is 13%. The
current exchange rate is 1,050 won per U.S dollar. Risk free interest rates in the United States
and S. Korea are:
U.S. 1-year 4.0% 2-year 4.25%
S. Korea 1-year 3.0% 2-year 3.25%
a. If this project were instead undertaken by a similar U.S. based company with the same risk-
adjusted cost of capital, what would be the net present value and rate of return generated by
this project?
b. What is the expected forward exchange rate 1 year from now and 2 years from now? (hint:
take the perspective of the Korean company when identifying home and foreign currencies
and direct quotes of exchange rates.)
c. If Nam Sung undertakes the project, what is the net present value and rate of return of the
project for Nam Sung?

17.14. a. a.If a U.S. based company undertakes the project, the rate of return for the project is a simple calculation,
as is the net present value.
NPV = −$1,000,000 + $700,000/1.13 + $600,000/(1.13)2 = $89,357.
Rate of return: Enter into your financial calculator or Excel cash flow register CF0 = −1,000,000, CF1 = 700,000, CF2 = 600,000
and calculate IRR = 20.0%
b.

 Understanding of Derivative Market
 Understanding of operation and types of derivative
market
 Management of risk – By use of derivatives.
(Managing Risk With Financial Derivatives)
https://www.nseindia.com/
https://www.mcxindia.com/#
https://www.sebi.gov.in/stock-exchanges.html

• The Securities Contracts (Regulation) Act 1956 defines ‘derivative’ as under:
Derivative’ is a financial contract which derives its value from the prices, or index of prices of
underlying securities, includes a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
• A derivative is a financial instrument whose return is derived from the return on another
instrument.
• The widely used definition of derivative is that they derive their performance from
underlying assets. However, this definition could apply to exchange-traded funds (ETFs) or
even mutual funds. A better distinction would be to say derivatives usually transform the
performance of the underlying asset.
Derivative

Derivative
Example Underlying-Assets
Stock option, such as option on the stock of Nortel
Networks
A stock, such as the stock of Nortel Networks
Stock index option, such as an option on the S&P
100 index
A portfolio of stocks, such as the portfolio of
stocks comprising the S&P 100 index
Treasury bill futures contract A Treasury bill
Foreign currency forward contract A foreign currency
Gold futures contract Gold
Futures option on gold A gold futures contract
Weather derivative Snowfall at a specified site

• It is a contract:
• Derives value from underlying asset:
• Specified obligation:
• Performed in Future
• Reference Direct or exchange traded:
• Related to notional amount:
• Delivery of underlying asset not involved:.
• May be used as deferred delivery:
• Secondary market instruments:
• Exposure to risk:
• Off Balance sheet item:
Features of Derivative

• Risk Control tools:
• Prediction of future prices:
• Enhance liquidity:
• Assist investors for higher return:
• Integration of price structure:
• Catalyze growth of financial markets:
• Brings perfection in market: ( Market Efficiency)
Uses of Derivative

A. On the basis of Underlying Asset.
Commodity Derivatives –
• Metal commodity derivatives
• Crude oil Commodity derivatives
• Agri commodity derivatives
Financial Derivatives-
• Index derivatives –e.g., F& O on Nifty , Bond Index derivatives.
• Equity derivatives
• Currency derivatives- Currency Option, Currency Future, Currency Swap etc.
• Interest rate derivatives-
• Bond derivatives contract
• Asset backed derivatives
Types of Derivative

B. On the basis of Trading /Market Place.
Over the Counter (OTC) or Non-exchange traded derivatives-
• Forward derivative contracts
• Swap Derivatives Contracts
Exchange Traded Derivatives (ET)-
• Future derivatives contract.
• Option Derivatives contract.
Types of Derivative

C. On the basis of Commitment/ Claim.
Forward Commitment Contract: is a legally binding obligation to engage in a certain transaction in
the spot market at a future date at terms agreed upon today. Forward commitment can be made in
any form of derivative trading market , (OTC or ET).
• Forward derivative contract
• Future derivatives contract
• Swap derivatives contract
Contingent Claim Contract: in which the outcome is determined by outcome of underlying or
condition of some event occurring.
• Options derivatives contract.
• Credit derivatives contract.
• Asset backed derivatives contract
Types of Derivative

Derivative Markets Structure
• Derivative Markets
• Over-the-counter and exchange traded
• Trading in derivatives in 2020 was over $15.5 trillions on at least 78 derivatives
exchanges, according to BIS-OTC derivative data.
• Derivatives trade all over the world
• Volume on the Indian exchange grew to about 6 billion derivative contracts in 2019,
surpassing CME’s 4.83 billion, according to FIA’s website.

• OTC or Over the counter market is a decentralized market for unlisted
securities, not having a specific physical location, rather the firms/persons
involved in trading directly negotiate over a communication network such as
telephone lines, emails, computer terminals, etc. Trading Over the counter is
also called off-exchange trading, because of the absence of a formal
exchange.
• It is a dealer’s market, The dealers making the market for a certain securities
quote the price at which they are going to pay for the stock called as the bid
price and the rate at which they are going to sell the stock is called ask price.
Here, the bid-ask spread implies the amount left in-between the bid and
asked prices indicating the markup of the dealer.

BASIS FOR COMPARISON OTC (OVER THE COUNTER) EXCHANGE
Operation Decentralized , driven by dealers . Centralized , regulated market,
Market maker Dealer Exchange itself
Investors Small companies, Banks , Well established companies
Physical Location No Yes
Trading Time 24×7 Exchange hours
Underlying Assets Unlisted Stocks Listed Stocks
Transparency Low Comparatively high
Nature of Contracts Customized Standardized

Derivative Market Instruments [Forward Derivative]
• Forward derivative contract: A forward contract is a customized contract
between two entities, where settlement takes place on a specific date in
the future at
today’s pre-agreed price.
• FD is an agreement between the counter parties to buy or sell a
specified quantity of an asset at a specified price, with delivery at a
specified time(future) and place. These contracts are not standardized,
each one is usually customized to its owner’s specifications.
• If the price of the asset increases after inception of the contract, the buyer
benefits while the seller losses out.

Derivative Market Instruments [Forward Derivative]
Example :
• An Indian car manufacturer buys auto parts from a Japanese car maker with
payment of one million yen due in 60
days. The importer in India is short of yen and suppose present price of yen is
Rs. 68. Over the next 60 days, yen may rise/fall to any price.
• The importer can hedge this exchange risk by negotiating a 60 days forward
contract with a bank at a price of Rs. 70. According to forward contract, in 60
days the bank will give the importer one million yen and importer will give the
banks 70 million rupees to bank.

Future Derivative
• A futures contract is an agreement between two parties, a buyer and
a seller, to exchange an asset at a later date for a price agreed to in
advance, when the contract is first entered into at any organized stock
exchange.
• Future contract is a special case of standardized Forward contract
• The delivery call this price the futures price.
• Trades on a futures exchange.

Future Derivative
• A futures contract can be either “bought” or “sold.” [long position and
Short Position]
• Party commits to buy or sell the underlying asset or security at the specified
price and date.
• No money changes hands up front, except for the posting of initial margin.
• The fact that the futures price is negotiated now but delivery and payment
are delayed until the settlement date creates an opportunity cost for the
seller in receiving payment.
• As a result, the negotiated price for future delivery of the asset differs from
the current cash price by an amount that reflects the cost of waiting to get
paid.

Future Derivative
Example : Agreement to:
• Buy 100 oz. of gold @ US$1300/oz. in December
• Sell £62,500 @ 1.4500 US$/£ in March
• Sell 1,000 bbl. of oil @ US$50/bbl. in April

Future Price Convention
• Futures quotes are available from exchanges and several online sources
• The asset underlying the futures contract, the contract size, and the way
the price is quoted
•

Some Popular Types[Future Derivative]
• Interest rate futures: Interest bearing instruments like T-bills, bonds, debentures, euro
dollar deposits and municipal bonds, notional gilt-contracts, short term deposit futures
and treasury note futures.
• Stock index futures: Stock market indices. For example in US, Dow Jones Industrial
Average, Standard and poor's 500 New York Stock Exchange Index. Other futures of this type
include Japanese Nikkei index, TOPIX etc.
• Foreign currency futures: Trade in foreign currency generating used by exporters,
importers, bankers, FIs and large companies.
• Bond index futures: Trade in Bond indices i.e. indices of bond prices. Municipal Bond Index
futures based on Municipal Bonds are traded on CBOT (Chicago Board of Trade).
• Cost of living index future: Trade in inflation measured by CPI and WPI etc. These can
be used to hedge against unanticipated inflationary pressure
• Equity Future :
• Cryptocurrency Future

Feature of Future
• Exchange traded (No Counter-party risk).
• standardized contracts:
• Long and short positions:
• Strike price:
• Notional Value of contract:
• Trade on margin:
• Settled daily:
• Total long position= Total short Position ( in a contract)

Trading in Future contract
Margin :
• A margin is cash or marketable securities deposited by an
investor with his or her broker
• The balance in the margin account is adjusted to reflect daily
settlement
• Margins minimize the possibility of a loss through a default
on a contract

Trading in Future contract
Margin Cash Flow- (Mark to Mrket-MTM)
• A trader has to bring the balance in the margin account up to the
initial margin when it falls below the maintenance margin level
• A member of the exchange clearing house only has an initial
margin and is required to bring the balance in its account up to
that level every day.
• These daily margin cash flows are referred to as variation margin
• Mark-to-market (MTM) is a method of valuing positions and
determining profit and loss which is used in statement reporting
purposes.
• A member is also required to contribute to a default fund

Day Price
Change in
Value
Gain/Loss
Cumulativ
e
Gain/Loss
Account
Balance
1 6 12,000
2 6.15 0.15 300 300 12,300
3 6.12 -0.03 -60 240 12,240
4 6.07 -0.05 -100 140 12,140
5 6.09 0.02 40 180 12,180
6 6.1 0.01 20 200 12,200
A farmer growing apples
is in anticipation of the
prices of the commodity
to rise. The farmer
considers taking a long
position in 20 apple
contracts on Dec- 21 of
100 bushels each with
margin price of $6 for
each bushels.
Prepare MTM transaction
in the farmer’s account as
per change in price

Call Option
• Call option is an option which grants the buyer (holder) the right to buy
an underlying asset at a specific date from the writer (seller) a particular
quantity of underlying asset on a specified price within a specified
expiration/maturity date.
• An investor goes long European call option of lot 100 shares for 4
months with premium of $5/share :
K=$100 for with a strike
Case 1:
Case 1:
Case 3:

Call Option
• Payoff from call Option : ( 𝑻 − K, 0) −Premium)

Put Option
• Put option is an option which grants the buyer (holder) the right to sell
an underlying asset at a specific date from the writer (seller) a particular
quantity of underlying asset on a specified price within a specified
expiration/maturity date.
• An investor goes long European put option of lot 100 shares for 4
months with premium of $7/share :
K=$70 for with a strike
Case 1: 70
Case 1:
Case 3:

Put Option
• Payoff from call Option : 𝑻) −Premium)

Position in Option
• There are two sides to every option contract. On one side is the
investor who has taken the long position (i.e., has bought the
option). On the other side is the investor who has taken a short
position (i.e., has sold or written the option) .
• There are four types of option positions:
1. A long position in a call option
2. A long position in a put option
3. A short position in a call option
4. A short position in a put option.

Swap Derivative
• Swaps are private agreements between two parties to exchange cash flows
in the future according to a prearranged cash flow formula.
• A swap is an agreement to exchange cash flows at specified future times
according to certain specified rules.
• A swap is a derivative contract through which two parties exchange the series
of cash flows or future liabilities from two different financial instruments.
• The birth of the over-the-counter swap market can be traced to a currency
swap negotiated between IBM and the World Bank in 1981. The World Bank
had borrowings denominated in US dollars while IBM had borrowings
denominated in German deutsche marks and Swiss francs.
• The statistics produced by the Bank for International Settlements show that
about 58.5% of all over-the-counter derivatives are interest rate swaps and a
further 4% are currency swaps.

Swap Derivative (features)
• OTC Derivatives
• At least two parties
• Planned cash flows: defines the dates when the cash flows are to be paid
and the way in which they are to be calculated .
• Cash flow associated in not known

Types of Swap Contract
• Currency Swaps: Counterparties exchange the principal amount and
interest payments denominated in different currencies. These contracts
swaps are often used to hedge another investment position against
currency exchange rate fluctuations.
• Commodity Swaps: Commodity swaps are common among
individuals or companies that use raw materials to produce goods or
finished products. Profit from a finished product may suffer if commodity
prices vary, as output prices may not change in sync with commodity
prices. A commodity swap allows receipt of payment linked to the
commodity price against a fixed rate.

Types of Swap Contract
• Interest rate Swaps: Counterparties agree to exchange one stream
of future interest payments for another, based on a predetermined
notional principal amount. Generally, interest rate swaps involve the
exchange of a fixed interest rate for a floating interest rate.
• Credit default swap (CDS):A CDS provides insurance from the
default of a debt instrument. The buyer of a swap transfers to the
seller the premium payments. In case the asset defaults, the seller
will reimburse the buyer the face value of the defaulted asset, while
the asset will be transferred from the buyer to the seller. Credit
default swaps became somewhat notorious due to their impact on
the 2008 Global Financial Crisis.

An Example of a “Plain Vanilla” Interest Rate Swap
• swap initiated on March 5, 2019, between Microsoft and
Intel. We suppose Microsoft agrees to pay Intel an interest rate of 3% per
annum on a principal of $100 million, and in return Intel agrees to pay
Microsoft the 6-month LIBOR rate on the same principal.
• Microsoft is the fixed-rate payer; Intel is the floating rate payer.
An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 3%
per annum every 6 months for 3 years on a notional principal of $100 million
• Next slide illustrates cash flows that could occur (Day count conventions are
not considered)
Intel Microsoft
3.0%
LIBOR

Cash Flows to Microsoft
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash FlowCash FlowCash Flow
Mar. 8, 2016 2.2%
Sept. 8, 2016 2.8% +1.10 –1.50 –0.40
Mar. 8, 2017 3.3% +1.40 –1.50 –0.10
Sept. 8, 2017 3.5% +1.65 –1.50 +0.15
Mar. 8, 2018 3.6% +1.75 –1.50 +0.25
Sept. 8, 2018 3.9% +1.80 –1.50 +0.30
Mar. 8, 2019 3.4% +1.95 –1.50 +0.45

Cash Flows to Intel
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash FlowCash FlowCash Flow
Mar. 8, 2016 2.2%
Sept. 8, 2016 2.8% -1.10 +1.50 +0.40
Mar. 8, 2017 3.3% -1.40 +1.50 +0.10
Sept. 8, 2017 3.5% -1.65 +1.50 -0.15
Mar. 8, 2018 3.6% -1.75 +1.50 -0.25
Sept. 8, 2018 3.9% -1.80 +1.50 -0.30
Mar. 8, 2019 3.4% -1.95 +1.50 -0.45

 Understanding of the rationale behind mergers and
acquisitions.
 Understanding of analyze demerger decisions (Spin off,
split up and divestiture)
(Corporate Restructuring Decisions)

Corporate Restructuring
• Corporate restructuring refers to the changes in ownership, business mix,
assets mix and alliances with a view to enhance the shareholder value.
• Hence, corporate restructuring may involve ownership restructuring,
business restructuring and assets restructuring.
• Corporate restructuring includes mergers and acquisitions (M&As),
amalgamation, takeovers, spin-offs, leveraged buy-outs, buyback of shares,
capital reorganisation etc.
• M&As are the most popular means of corporate restructuring or business
combinations

• Acquisition may be defined as an act of acquiring effective control over
assets or management of a company by another company without any
combination of businesses or companies.
• A substantial acquisition occurs when an acquiring firm acquires substantial
quantity of shares or voting rights of the target company.
• Takeover – The term takeover is understood to connote hostility. When an
acquisition is a ‘forced’ or ‘unwilling’ acquisition, it is called a takeover. [
Friendly takeover]
• Demerger Means transfer and vesting of an undertaking of a company into
another company.
• Reconstruction means re-organization of share capital in any manner; varying
the rights of shareholders and/or creditors.
TYPES OF Restructuring

TYPES OF Restructuring
• Arrangement All modes of reorganizing the share capital, including
interference with preferential and other special rights attached to shares
• Holding company is a company that holds more than half of the nominal value
of the equity capital of another company, called a subsidiary company, or
controls the composition of its Board of Directors. Both holding and subsidiary
companies retain their separate legal entities and maintain their separate
books of accounts.
• Reverse merger In a reverse merger, the private company buys the majority
shares of the public company and becomes a public limited company.

Corporate Restructuring (Business Combination)
• Merger
• Merger may take two forms:
• Absorption
• Consolidation
• In merger, there is complete amalgamation of the assets and liabilities as
well as shareholders’ interests and businesses of the merging companies.
• There is yet another mode of merger. Here one company may purchase
another company without giving proportionate ownership to the
shareholders of the acquired company or without continuing the business
of the acquired company.

Merger (Business Combination)
• Forms of Merger
• Horizontal merger
• Vertical merger
• Conglomerate merger
• Mergers and Acquisition are intended to:
• Limit competition.
• Utilise under-utilised market power.
• Overcome the problem of slow growth and profitability in one’s own industry.
• Achieve diversification.
• Gain economies of scale and increase income with proportionately less investment.
• Establish a transnational bridgehead without excessive start-up costs to gain access to
a foreign market.

MOTIVES OF M&A
• Utilise under-utilised resources–human and physical and managerial skills.
• Displace existing management.
• Circumvent government regulations.
• Reap speculative gains attendant upon new security issue or change in P/E ratio.
• Create an image of aggressiveness and strategic opportunism, empire building and to
amass vast economic powers of the company.
• The most common advantages of M&A are:
• Accelerated Growth
• Enhanced Profitability
• Economies of scale
• Operating economies
• Synergy
• Diversification of Risk
• Reduction in Tax Liability
• Financial Benefits
• Financing constraint
• Surplus cash
• Debt capacity
• Financing cost
• Increased Market Power

MERGERS AND ACQUISITION IN INDIA
EXAMPLES OF LARGE DEALS
Tata Steel-Corus, $12.2 billion: On 30 January 2007, Tata
Steel purchased a 100% stake in the Corus Group at 608
pence per share in an all-cash deal, cumulatively valued at
$12.2 billion. The deal is the largest Indian takeover of a
foreign company till date and made Tata Steel the world’s fifth-
largest steel group.
HCL Technologies Limited-IBM, $1.8 billion: In 2018,
under the all-cash deal, HCL proposed 1.475 billion dollars of
its own cash and borrowed 300 million dollars to finance the
transaction”.

VALUE CREATION THROUGH M&A
• Merger will create an economic advantage (EA) when the combined present
value of the merged firms is greater than the sum of their individual present
values as separate entities.
Net economic advantage = Economic advantage – Cost of merger/acquisition
NEA [ ( )] – (cash paid )
PQ P Q Q
V V V V
   
In order to apply DCF technique, the following information is required:
Estimating Free Cash Flows
Revenues and expenses
Capex and depreciation:
Working capital changes
Estimating the Cost of Capital
Terminal Value
The Best DCF method of the purpose – AVP ( Adjusted Present Value)

FINANCING A MERGER
• Cash Offer:
• A cash offer is a straightforward means of financing a merger. It does not cause any dilution in
the earnings per share and the ownership of the existing shareholders of the acquiring
company.
• Share Exchange:
• A share exchange offer will result into the sharing of ownership, earnings and benefits of the
acquiring company between its existing shareholders and new shareholders (that is,
shareholders of the acquired company).
• The precise extent of net benefits that accrue to each group depends on the exchange ratio in
terms of the market prices of the shares of the acquiring and the acquired companies.

MERGER NEGOTIATIONS: SIGNIFICANCE OF P/E RATIO AND EPS
ANALYSIS
• The mergers and acquisitions decisions are also evaluated in terms of EPS, P/E ratio, book
value etc.
• Share Exchange Ratio
• The share exchange ratio (SER) would be as follows:
• The exchange ratio in terms of the market value of shares will keep the position of the
shareholders in value terms unchanged after the merger since their proportionate wealth
would remain at the pre-merger level.
Share price of the acquired firm
Share exchange ratio
Share price of the acquiring firm
b
a
P
P
 

ANALYSIS
• Post-merger weighted P/E ratio:
• (Pre-merger P/E ratio of the acquiring firm)  (Acquiring firm’s pre-merger earnings  Post-
merger combined earnings) + (Pre-merger P/E ratio of the acquired firm)  (Acquired firm’s
pre-merger earnings  Post-merger combined earnings)
PAT PAT
Post-merger combined PAT
Post-merger combined EPS =
Post-merger combined shares (SER)
a b
a b
N N



P/E (P/E ) (PAT / PAT ) (P/E ) (PAT / PAT )
w a a c b b c
  

ANALYSIS
Earnings Growth
• The formula for weighted growth in EPS can be expressed as follows:
• Weighted Growth in EPS = Acquiring firm’s growth × (Acquiring firm’s pre-
merger PAT/combined firm’s PAT) + Acquired firm’s growth × (Acquired firm’s
pre-merger PAT/combined firm’s PAT).
P A T P A T
P A T P A T
a b
w a b
c c
g g g
   

FACTORS INFLUENCING THE EARNINGS GROWTH
• The price–earnings ratios of the acquiring and the acquired companies.
• The ratio of share exchanged by the acquiring company for one share of the
acquired company.
• The pre-merger earnings growth rates of acquiring and the acquired
companies.
• The level of profit after tax of the merging companies.
• The weighted average of the earnings growth rates of the merging companies.

Adjusted Present Value (APV)
• Adjusted Present Value (APV) is used for the valuation of projects and
companies. It takes the net present value (NPV), plus the present value
of debt financing costs, which include interest tax shields, costs of debt
issuance, costs of financial distress, financial subsidies, etc.
• So why do we use Adjusted Present Value instead of NPV in evaluating
projects with debt financing?

Tom Gilbert, founder and chairman of the board of Gilbert Enterprises, could not believe his eyes as he read the quote about his firm stock
price in The Economic Times newspaper. The stock had closed at ₹35, down ₹5 for the week. He called his Vice President of Finance, Jane
Arnold, and they agreed to meet on Saturday at 9:00 a.m. for breakfast to discuss the current situation of capital structure, capital cost and
future growth by acquiring a new firm. When Jane arrived, they reviewed the stock's performance for the last few months. Gilbert
Enterprises works for construction projects and EXIM business. The Company buy products from the USA and sells in India and other Asian
countries.
Gilbert Enterprises had the industry's most advanced just-in-time (JIT) inventory management system. For that reason, Arnold believed the
firm would enjoy supernormal growth beyond industry standards for the next three years. His best estimate was that a 15 per cent growth
rate during that period was entirely reasonable. After that time span, a more normal growth rate of 6 per cent was expected. Current
dividends (D0) were 1.20 per share, and he decided to use a discount or required rate of return of 10 per cent. He discussed this approach
with his partners. While they generally agreed, they suggested that he also consider a more traditional approach of comparing the firm's
price-earnings ratio to other firms in the industry.
Gilbert Enterprises is thinking of acquiring Timber enterprises, a company trading in similar products, to grow their business with an
expected cost of ₹20 Million. Arnold favours issuing a 7% debenture of face value ₹1000 for 10 years to pay for the deal. The expected
return in the market from such debentures is 9%.
The Company's financial report shows a bill payment of $100,000 after 3 months to his supplier, so Arnold is worried about the depreciating
value of the Indian currency. The spot exchange rate is $/₹=73.25, and the inflation rate is 2% and 8% in USA and India, respectively.
• Jane Arnold was your classmate during your MBA program, so he approached you as an Investment banker to get help on some financial
decisions with the following highlights.
• Help Tom Gilbert to find the intrinsic value of their stocks.
• Help Tom Gilbert find the debenture number to be issued in the market to fund the expected acquisition.
• Help Tom Gilbert to find the net US$ bill amount in IN₹ at the time of payment if PPP stands true.
• Help them about the benefits and losses of the acquisition of a company

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