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Corporate Finance: Introduction

What is corporate finance?

How CF is different from accounting?
How it is connected to the external financial and regulatory
markets?

© McGraw Hill, LLC

Now, let’s see how a firm looks like
from a financial perspective
We start with, how to value a
project, how to selects projects to
Assets invest in?

How to finance a
project, i.e., the How to
right mix of equity distribute CFs
Firm Value=FCF/r
and debt FV=Vd+Ve

Capital Debt cash flow (debt value) Cash

(Equity flows
and Debt) Equity cash flow (equity value)

1. Firm value is nothing but the sum of all the project values that a firm has
undertaken
2. We discuss how to make investments, financing and dividend decisions in a
manner which results in shareholders wealth maximisation.
3. All these decisions affect each other. For example, capital structuring decisions
affect the investment decisions

© McGraw Hill, LLC

Firm: From a financial perspective

Assets Liabilities Estimated future cash flows (going concern, i.e., perpetual cash flows)

0 0 1 2 3 4

100000 100000 35000 45000 50000 65000

Broadly:
Assets are Equity
invested and debt
in various
projects
Expected cash
flows

© McGraw Hill, LLC

JSW steel Balance sheet

Market value Equity: 2.02 Lakh

cr
Debt and other liabilities: 1.1
lakh cr
Total market value: 3.12 lakh cr
Total book value: 1.85 lakh cr

How 0.75 became 2.02?

© McGraw Hill, LLC

JSW steel Balance sheet

The value is created mainly

through investment
decisions

The value is destroyed if you

don’t make correct financing
decisions or working capital
decisions

© McGraw Hill, LLC

However,
This process of converting book value to market value is not
very smooth, it is affected by market imperfections

Information Asymmetry Financial development

Book Market
Value value

Agency problems Govt. Regulations

© McGraw Hill, LLC

What is value?
Suppose, you construct a building at a total cost of Rs.
5000000, and you want to sell it.
Four guys are interested in purchasing it
1. He and his family want to stay in that house. He can save
Rs.20000 on rent. (Bank rate is 10%)
2. He wants to run a PG in that house, he is expected to earn
at least Rs. 40000 per month
3. He wants to run a coaching institute in that building and
expects to earn a profit of about Rs. 750000 a year
How much do you sell for and what is the value created?

© McGraw Hill, LLC

Valuing the building
1. 240000/0.1=2400000
2. 480000/0.1=4800000
3. 750000/0.1=7500000
So you would sell for Rs.7500000
What is the value created?
Value created=7500000-5000000=2500000
What did we value here?
The building?
Or
The business?

© McGraw Hill, LLC

What we value is
Not the asset, but the business that the asset aids in.
Therefore,
What market values is the business. This is what market
capitalization reflects It simply reflects the
difference in their past
For example, check the following table investment decisions

Company TCS Infosys

Total assets 161,124 141,870

What
explains this
difference?
Market value 14,86,672 8,17,184

© McGraw Hill, LLC

Some details
1. Valuing a firm (firm value is the sum of all value of all
projects that a firm has taken up)
1. What are free cash
Project value=FCF/r Future
flows?
2. How to estimate them
cash flows from financial reports?
(FCF) 3. Forecasting FCFs
(Chp 6)

Project
valuation 1. What determines the
(Chp 5) discount rate?
2. The relationship
The between risk and
discount return
rate (r) 3. How to calculate it?
4. How financing
decisions affect r?
(Chp 10, 11 and 13)

© McGraw Hill, LLC

Some details: Financing decisions

Without
1. The MM theorems
taxes

1. The trade off between

the benefits and cost
of debt
With 2. The influence of
taxes information
Financing asymmetry and the
agency costs
decisions
3. Determining the
(Chp 16 and optimal capital
17) structure
How it affects
the investment
decisions (Chp
18)

© McGraw Hill, LLC

Some details: Dividend decisions

How it affects
firm value

Information
asymmetry, agency
problem and
Dividend dividends
decisions
(Chp 19)
Growth, tax, clientele
and other firm level
considerations in
dividend policy

© McGraw Hill, LLC

Some details: Dividend decisions

Operating and
cash cycles

Receivables
Working management
capital
management
(Chp 26 &
28)

Financing working
capital

© McGraw Hill, LLC

Some ground Rules
I expect punctuality and discipline in the classroom. Please do not disturb
others’ learning.
You can sleep, but do not disturb the class by talking to others (This
behaviour
Would be reflected in your class participation marks)
I will lock the classroom at exactly 9.15 AM/ 12.15 pm.
I usually come 5 min early, you can get your doubts from the previous
sessions cleared there or wait till the end of the session.
Assignments are compulsory and late submissions would never be
entertained.
Don’t miss classes. Classes are serially and chronologically correlated.
Laptop is compulsory (Don’t come to class if you are not bringing your
laptop). We would be using Excel extensively.
You can ask me questions anytime. But please raise your hand before
asking.
My slides are not a substitute for textbook readings
© McGraw Hill, LLC
Module 1

Capital budgeting/Investment decisions

© McGraw Hill, LLC

Before we start, you should know the
following terms
1. Book Vs Market balance sheet
2. Book value and market value
3. Profit Vs Cash flows
4. Firm cash flow, equity cash flow and debt cash flow
5. Expected return, required rate of return, the discount rate
6. Equity/Networth: Ordinary, preference, and Reserves
7. Debt: Bonds and debentures and Term loan (Bank debt)
8. The cost of capital, equity and debt
9. Earnings per share

© McGraw Hill, LLC

Now, let’s see how a firm looks like
from a financial perspective
We are here!!
Assets

Firm Value=FCF/r
FV=Vd+Ve

Capital Debt cash flow (debt value) Cash

(Equity flows
and Debt) Equity cash flow (equity value)

© McGraw Hill, LLC

Capital budgeting or investment
decisions
1. How to value projects: Different techniques of project
valuation, strengths and weakness of each of the
techniques
2. How to decide which projects to invest in?
3. How to resolve conflict between different techniques?
4. The relationship between project valuation and firm
valuation
5. Practical applications

© McGraw Hill, LLC

Overview
Capital Budgeting
• The process of evaluating and selecting long-term
investments that contribute to the firm’s goal of maximizing
owners’ wealth
• Capital Expenditure
• An outlay of funds by the firm that the firm expects to
produce benefits over a period of time greater than 1
year
• Operating Expenditure
• An outlay of funds by the firm resulting in benefits
received within 1 year

© McGraw Hill, LLC

Basic Terminology
Project: Any current investment which yield future cash flows
Current investment: Cash outflow
Future cash flows: Mostly Cash inflows
Required rate of return/discount rate: Min return you expect from your
investment. The project should give you at least this much return to
invest in it
Project return/Internal return: It is the actual return of the project
You would invest in the project only if project return is greater than the
required rate of return
Example: You are investing Rs.100000, which is borrowed from a bank
at 10%, in your friend’s business for one year. He has promised to pay
you Rs.120000 at the end of the year.
Required rate of return:10%
Project return:20%

© McGraw Hill, LLC

Techniques
Capital Budgeting Techniques
• To ensure that the investment projects a firm selects have
the best chance of increasing the value of the firm,
financial managers need tools to help them evaluate the
merits of individual projects and to rank competing
investments
• A number of techniques are available for performing such
analyses
• The best techniques take into account the time value of
money as well as the tradeoff between risk and return
• Project evaluation methods that fail to account for money’s
time value or for risk may not lead to shareholder value
maximization
© McGraw Hill, LLC
Techniques
The Net Present Value
The Internal Rate of Return
The Payback Period Method
The Discounted Payback Period Method
The Profitability Index

© McGraw Hill, LLC

Net present value (NPV)
 Value created is the present value of cash flow that is over
and above total investments you have made in the project
 Value created is calculated at the time of making investment
decisions (year 0)
 Relevant costs are: Upfront investment and the financing
cost of investment
 Example: Project X requires Rs.100000 investments which is
available at 10% cost. And it produces Rs.75000 for next
three years. Calculate the total value of the project and the
net value created.
 Total value of the project is= ƩFCF/(1+r)^n
 Net value created is = [ƩFCF/(1+r)^n]-Investments

© McGraw Hill, LLC

NPV: A capital budgeting technique that measures an
investment’s value by calculating the present value of its cash
inflows and outflows
Solution

Year 0 1 2 3

Cashflows -100000 75000 75000 75000

Total value ₹ 1,86,513.90 Present value

of these cash
Value created ₹ 86,513.90 flows

NPV

© McGraw Hill, LLC

NPV Adjustment for
capital
expenditure

Adjustment for
Financing
costs
Therefore,
NPV is the net value created
Decision Criteria
 If the NPV is greater than $0, accept the
project
 If the NPV is less than $0, reject the project
 The project with a greater NPV is preferred
Important: Note that NPV formulae assumes that the cash flows are reinvested at the
discount rate which is usually the cost of capital for the firm

© McGraw Hill, LLC

NPV in Excel

© McGraw Hill, LLC

NPV

© McGraw Hill, LLC

Applications
Mahindra ltd is planning to launch a new variant of Thar, i.e., Thar Roxx. The
estimated investment is about Rs. 1500 crore, which is available at 12%
cost. The sales can clock about 5000 per month. The average price at the
company level is Rs.12 lakhs, with a cash flow margin of about Rs. 50
thousand per car. This model is expected to be replaced by a new model in
about 15 years. Currently it has, 75.2 million shares outstanding (current
market price is Rs.442). If the firm finance this project using internal
resources,
1. Examine whether Mahindra should take this project up
2. If yes, find the expected increase in the share price
3. Construct book and market value balance sheets
Hint: First value the project and distribute it across the outstanding shares

© McGraw Hill, LLC

Value created
Year Cash flows

0 -1500 Total Value ₹ 2,043.26

1 300 NPV ₹ 543.26

2 300
3 300
4 300 Increase in share price 72.241934

5 300
6 300
7 300
8 300
9 300
10 300
11 300
12 300
13 300
14 300
15 300

© McGraw Hill, LLC

Market and book value balance sheet

Book value balance sheet

Assets Liabilities
Assets Equity
Debt
Total Assets Total liabilities
Market balance sheet
Assets Liabilities
Fixed assets Equity
Debt
Total Assets Total liabilities

© McGraw Hill, LLC

JSW steel Balance sheet

Market value of Equity: 2.02

Lakh crores
Book Value: 0.75 lakh cores

Where did this extra 1.27

come from?

This extra is sum of NPV of

all the projects that JSW
steel has taken up

© McGraw Hill, LLC

5.1 Why Use Net Present Value?
Accepting positive NPV projects benefits stockholders.
• NPV uses cash flows.
• NPV uses all the cash flows of the project.
• NPV discounts the cash flows properly.

© McGraw Hill, LLC

But,
Most of the investors have an issue with NPV.
NPV gives you return in absolute values, however, investors need it in
relative terms. The most basic question is
How much return do I make?
What is the project return?
How much return this project yields?
NPV technique can’t answer these questions.
Therefore,
In the next technique, we measure the actual return of the project in relative
terms,
And this is know as
Internal rate of return (IRR)

© McGraw Hill, LLC

Internal Rate of Return (IRR)
The discount rate that equates the NPV of an investment
opportunity with $0 (because the present value of cash inflows
equals the initial investment); it is the rate of return that the firm
will earn if it invests in the project and receives the given cash
inflows

© McGraw Hill, LLC

IRR: Example
Consider the following project:

The internal rate of return for this project is 19.44 percent.

$50 $100 $150

NPV 0  $200   
1  IRR  1  IRR  1  IRR 3
2

Important: IRR technique assumes that the future cash flows are reinvested
at project IRR
© McGraw Hill, LLC
IRR in excel…..

© McGraw Hill, LLC

© McGraw Hill, LLC
5.4 The Internal Rate of Return
IRR: the discount rate that sets NPV to zero
Minimum Acceptance Criteria:
• Accept if the IRR exceeds the required return.

Ranking Criteria:
• Select alternative with the highest IRR.

© McGraw Hill, LLC

Applications
Tony DiLorenzo is evaluating an investment opportunity. He
is comfortable with the investment’s level of risk. On the
basis of competing investment opportunities, he believes this
investment must earn a minimum compound annual after-tax
return of 9% to be acceptable. Tony’s initial investment would
be $7,500, and he expects to receive annual after-tax cash
flows of $500 per year in each of the first 4 years, followed by
$700 per year at the end of years 5 through 8. He plans to
sell the investment at the end of year 8 and net $9,000, after
taxes.

© McGraw Hill, LLC

Year Cash flow
0 −$7,500 (Initial investment)
1 500
2 500
3 500
4 500
5 700
6 700
7 700
8 9,700 ($700 + $9,000)

© McGraw Hill, LLC

The relationship between IRR and NPV
As discussed before, we have three important variables in
capital budgeting
1. Discount rate (DR)
2. Project return (IRR)
3. NPV
What is the relationship among these three?
4. If IRR<DR, then Negative NPV
5. If IRR=DR, then NPV=0
6. If IRR>Dr, the NPV is positive

© McGraw Hill, LLC

NPV Payoff Profile
If we graph NPV versus the discount rate, we can see the IR
R as the x-axis intercept.
0% $100.00
4% 73.88
8% 51.11
12% 31.13
16% 13.52
20% −2.08
24% −15.97
28% −28.38
32% −39.51
36% −49.54
40% −58.60
44% −66.82

© McGraw Hill, LLC

Conflicts between NPV and IRR

© McGraw Hill, LLC

Mutually Exclusive versus Independent
Independent projects: accepting or rejecting one project does
not affect the decision of the other projects.
• Must exceed a MINIMUM acceptance criteria.
Mutually exclusive projects: only ONE of several potential
projects can be chosen, e.g., acquiring an accounting
system.
• RANK all alternatives, and select the best one.

© McGraw Hill, LLC

Shortcomings of IRR common to all
projects

© McGraw Hill, LLC

Multiple IRRs
Consider this project

Which one
should we use?

© McGraw Hill, LLC

Modified IRR
Calculate the net present value of all cash outflows using the
borrowing rate.
Calculate the net future value of all cash inflows using the
investing rate.
Find the rate of return that equates these values.
Benefits: single answer and specific rates for borrowing and
reinvestment
Year CF PV FV Total
0 -200 ₹ -601.05 -801.052
1 200
2 800 ₹ 110.00 910
3 -800
MIRR 7%

© McGraw Hill, LLC

The Scale Problem
Would you rather make 100 percent or 50 percent on your
investments?
What if the 100 percent return is on a $1 investment, while
the 50 percent return is on a $1,000 investment?

IRR NPV

© McGraw Hill, LLC

The Timing Problem - I

© McGraw Hill, LLC

The Timing Problem - II

Access the text alternative for slide images

© McGraw Hill, LLC
Calculating the Crossover Rate
Incremental IRR: Compute the IRR for either Project A minus B or B
minus A
Year Project A Project B Project A-B Project B-A

0 −$10,000 −$10,000 $0 $0

1 10,000 1,000 9,000 −9,000,00

2 1,000 1,000 0 0

3 1,000 12,000 −11,000,00 11,000

Access the text alternative for slide images

© McGraw Hill, LLC
NPV versus IRR
NPV and IRR will generally give the same decision.
Exceptions:
Nonconventional cash flows—cash flow signs change more
than once.
Mutually exclusive projects.
• Initial investments are substantially different.
• Timing of cash flows is substantially different.

© McGraw Hill, LLC

Applications
Investment A B C D
Initial cost (₹ millions) 5 3 4 2

Expected life 10 yrs 10 yrs 10 yrs 10 yrs

NPV @ 15% (₹ ) 300,000 200,000 250,000 140,000
IRR 20% 25% 30% 35%

 If the company can raise large amounts of money at an annual cost of 15

percent, and if the investments are independent of one another, which should
it undertake?
 If the company can raise large amounts of money at an annual cost of 15
percent, and if the investments are mutually exclusive, which should it
undertake?
 Considering only these investments, if the company has a fixed capital
budget of ₹7 million, and if the investments are independent of one another,
which should it undertake?

© McGraw Hill, LLC

Other techniques

© McGraw Hill, LLC

5.2 The Payback Period Method
How long does it take the project to “pay back” its initial
investment?
Payback Period = number of years to recover initial costs
Minimum Acceptance Criteria:
• Set by management.

Ranking Criteria:
• Set by management.

© McGraw Hill, LLC

Calculate payback period for A and B

© McGraw Hill, LLC

The Payback Period Method
Disadvantages:
• Ignores the time value of money.
• Ignores cash flows after the payback period.
• Biased against long-term projects.
• Requires an arbitrary acceptance criteria.
• A project accepted based on the payback criteria may not
have a positive NPV.
Advantages:
• Easy to understand.
• Biased toward liquidity.

© McGraw Hill, LLC

5.3 The Discounted Payback Period
How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?
Decision rule: Accept the project if it pays back on a
discounted basis within the specified time.
By the time you have discounted the cash flows, you might
as well calculate the NPV.

© McGraw Hill, LLC

5.6 The Profitability Index

PV of cash flows subsequent to initial investment

PI 
Initial investment

Minimum Acceptance Criteria:

• Accept if PI > 1

Ranking Criteria:
• Select alternative with highest PI.

© McGraw Hill, LLC

The Profitability Index (PI)
Disadvantages:
• Problems with mutually exclusive investments.
Advantages:
• May be useful when available investment funds are limited.
• Easy to understand and communicate.
• Correct decision when evaluating independent projects.

© McGraw Hill, LLC

Figure 5.2 Survey Data on CFOs’ Use of
Investment Evaluation Techniques

© McGraw Hill, LLC

Summary—Discounted Cash Flow
Net present value
• Difference between market value and cost.
• Accept the project if the N PV is positive.
• Has no serious problems.
• Preferred decision criterion.

Internal rate of return

• Discount rate that makes N PV = 0.
• Take the project if the I RR is greater than the required return.
• Same decision as NPV with conventional cash flows.
• IRR is unreliable with nonconventional cash flows or mutually exclusive projects.

Profitability Index
• Benefit-cost ratio.
• Take investment if PI > 1.
• Cannot be used to rank mutually exclusive projects.
• May be used to rank projects in the presence of capital rationing.

© McGraw Hill, LLC

Summary—Payback Criteria
Payback period
• Length of time until initial investment is recovered.
• Take the project if it pays back in some specified period.
• Does not account for time value of money, and there is an
arbitrary cutoff period.
Discounted payback period
• Length of time until initial investment is recovered on a
discounted basis.
• Take the project if it pays back in some specified period.
• There is an arbitrary cutoff period.

© McGraw Hill, LLC

Practical applications of NPV

© McGraw Hill, LLC

Extra slides for further understanding

© McGraw Hill, LLC

Reinvestment assumption
A project requiring a $170,000 initial investment will provide
operating cash inflows of $52,000, $78,000, and $100,000 in
each of the next 3 years. The NPV of the project (at the
firm’s 10% cost of capital) is $16,867, and its IRR is 15%, so
clearly the project is acceptable.

© McGraw Hill, LLC

Now let’s see what happens if we assume that the firm reinvests
cash flows as they come in. Table 10.5 shows how much the firm
can earn by reinvesting each intermediate cash flow at either 10%
(the cost of capital) or 15% (the project’s IRR). If we assume that
the firm earns 10% on reinvested cash flows, the firm could
accumulate $248,720 in 3 years. Now suppose we discount that
value back to the present, using the 10% cost of capital. In doing so,
we are asking the question, what is the project worth today if it costs
$170,000 and the firm can reinvest cash flows at 10%? We have

© McGraw Hill, LLC

The project’s NPV calculated this way is $16,867, which
matches the number stated at the beginning of this example.
This confirms what we said earlier, namely, that the NPV
approach assumes that the firm reinvests cash flows at the
cost of capital. It is interesting that if the firm invests $170,000
today and 3 years later has accumulated $248,720, then its
average annual return over that period is 13.5%, not the 15%
figure obtained in the IRR calculation.

© McGraw Hill, LLC

Next, assume that the firm reinvests intermediate cash flows
at 15%. Table 10.5 shows that the firm can accumulate
$258,470 in 3 years by reinvesting cash flows as they arrive.
If undertaking this project costs $170,000 and the firm can
reinvest cash flows at 15%, what is the project worth today,
assuming a 10% cost of capital? Discounting $258,470 back
to the present, we obtain

© McGraw Hill, LLC

This time the NPV is larger than it was before, and that
difference is driven entirely by the 15% reinvestment rate
assumption. Table 10.6 summarizes the important lessons
from this example. The project’s NPV is $16,867, but if the
firm can reinvest cash flows only at the cost of capital, the
project effectively earns a 13.5% annual return. The project’s
IRR is 15%, but that assumes the firm can reinvest cash
flows at 15%. If the firm could do so, the project would be
even more valuable than the NPV calculation indicates.

© McGraw Hill, LLC

Reinvestment Rate Comparisons for a Project
Blank Reinvestment rate

Blank Blank Blank

10% 15%

Operating cash Number of years

Year inflows earning interest (t) Future value Future value
1 $ 52,000 2 $ 62,920 $ 68,770

2 78,000 1 85,800 89,700

3 100,000 0 100,000 100,000

Blank Blank Future value end of year $248,720 $258,470

NPV @ 10% = $16,867 Blank Blank Blank Blank

IRR = 15%

Note: Initial investment in this project is $170,000.

© McGraw Hill, LLC

Project Cash Flows after Reinvestment
Blank Reinvestment rate

Blank 10% 15%

Initial investment −$170,000 Blank
Year Operating cash inflows
1 $ 0 $ 0
2 0 0
3 248,720 258,470
NPV @ 10% $16,867 $24,192
IRR 13.5% 15.0%

© McGraw Hill, LLC

Example of Investment Rules – I
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is 10
percent.
Year Project A Project B
0 −$200 −$150
1 200 50
2 800 100
3 −800 150

© McGraw Hill, LLC

Example of Investment Rules - II

Project A Project B
C F0 −$200.00 −$150.00
PV0 of CF1−3 $241.92 $240.80
NPV = $41.92 $90.80
I RR = 0%, 100% 36.19%
PI = 1.2096 1.6053

© McGraw Hill, LLC

Example of Investment Rules - III
Payback Period:

Time Project A Project A Project B Project B

CF Cum. CF CF Cum. CF
0 −$200 −$200 −$150 −$150
1 200 0 50 −100
2 800 800 100 0
3 −800 0 150 150

Payback period for Project B = 2 years.

Payback period for Project A = 1 or 3 years?

© McGraw Hill, LLC

NPV and IRR Relationship

Discount rate NPV for A NPV for B

−10% −$87.52 $234.77
0% 0 150.00
20% 59.26 47.92
40% 59.48 −8.60
60% 42.19 −43.07
80% 20.85 −65.64
100% 0.00 −81.25
120% −18.93 −92.52

© McGraw Hill, LLC

NPV Profiles

Access the text alternative for slide images

© McGraw Hill, LLC
Quick Quiz
Consider an investment that costs $100,000 and has a cash
inflow of $25,000 every year for 5 years. The required return
is 9 percent, and payback cutoff is 4 years.
• What is the payback period?
• What is the discounted payback period?
• What is the NPV?
• What is the IRR?
• Should we accept the project?
What method should be the primary decision rule?
When is the IRR rule unreliable?

© McGraw Hill, LLC

Cash flow estimation / forecasting

© McGraw Hill, LLC

There are three important variables in
NPV
Calculating NPV is very easy if all the values are given to you,
however, the real life is not as kind as Prof.Nemiraja.
You have to estimate them, this is the real test in NPV analysis.
For this you need to understand the project and its features
thoroughly.
That is why, NPV sometimes called as an art of estimation.
NPV analysis involves estimating three variables
1. Estimate future cash flows:
2. Estimate discount rate.
3. Estimate initial costs.

© McGraw Hill, LLC

We are here!!

© McGraw Hill, LLC

The definition of Cash Flows: Basic cash flows
Cash flows matter—not accounting earnings.
Much of the work in evaluating a project lies in taking
accounting numbers and generating cash flows.
Basically, there are two types of cash flows
1. Cash flow from operations (Operating cash flows, OCF)
2. Cash flow from investments
 This includes after tax salvage value of your initial investments
 Change in working capital
 The liquidation value of working capital at the end of the project

Don’t be worried if any of these cash flows are negative!!!

© McGraw Hill, LLC

Project Cash Flows: Things to remember

Remember: we are interested in incremental CF only

Incremental Cash Flows
• The additional after-tax cash flows—outflows or inflows—
that will occur only if the investment is made
Then calculate Net Cash Flows
• The net (or the sum of) incremental after-tax cash flows
over a project’s life

© McGraw Hill, LLC

Incremental Cash Flows: Things to
remember
Sunk costs do not matter.
Opportunity costs matter.
Side effects like synergy and erosion matter.
Taxes matter: We want incremental after-tax cash flows.
Salvage value matters
Beware of allocated overhead costs.

© McGraw Hill, LLC 84

Calculating operating cash flows (OCF)

© McGraw Hill, LLC

Operating cash flows: There are four methods

1. Start with Cash Flow from Operations

• OCF = EBIT − Taxes + Depreciation.
2. Top-Down Approach
• OCF = Sales − Cash costs − Taxes.
• Do not subtract noncash deductions.
3. Bottom-Up Approach
• Works only when there is no interest expense.
• OCF = Net income + Depreciation.
4. Tax Shield Approach
• OCF = (Sales − Cash costs)(1 − TC) + Depreciation × TC.

© McGraw Hill, LLC 86

Example:
ITEMs Values
Sales 100000

Cash Exp/operating costs 50000

EBITDA 50000
Dep 20000
EBIT 30000
EBT 30000
Tax (30%) 9000
PAT 21000

© McGraw Hill, LLC

Basic method: EBIT-Taxes+Dep
(30000-9000+20000=41000)

Top down: Sales-cash costs-taxes

(100000-50000-9000=41000)

Tax shield approach: (Sales − Cash costs)(1 − TC) + Depreciation × TC.

(100000-50000)*(1-0.3)+(20000*0.3)=41000)

Bottom-Up Approach: Net income + Depreciation.

(21000+20000=41000)

© McGraw Hill, LLC

Calculating Investment cash flows

© McGraw Hill, LLC

Investment cash flows
1. Recognize Net Capital Spending in the initial year
• Do not forget salvage value of the old machine (after tax, of
course).
2. Adjust for changes in Net Working Capital
• Adjust for changes in net working capital every year (Usually,
this represents investment in working capital and hence a
cash outflow, it could be cash inflow as well)
• When the project winds down, investments in working capital
is liquidated and the amount is recovered, hence, it
represents a cash inflow in the terminal year
• I,e., at the end of the project the amount invested in working
capital one year prior to the terminal year is recovered
(positive cash flow).
© McGraw Hill, LLC 90
Net capital spending in the initial year
You are trying to replace an old machine with a book value of
Rs.50000 with a new machine which cost Rs. 500000. The old
machine could be sold in the market for about Rs.100000. If
the tax rate is 30%, what is the investment required?
Start with calculating cash inflow from selling the old machine.
The salvage value is Rs.100000, however, the book value is
Rs. 50000. So, the profit is Rs.50000. On this profit, you have
to pay 30% tax
Tax=(100000-50000)(0.3)=15000
Cash inflow from selling old machine=Selling price-tax:
100000-15000=85000
Initial invt required= Price of new machine- cash inflow from
selling old machine: 500000-85000=415000

© McGraw Hill, LLC

Think….
What happens if you sell your old machine for less than book
value?
Book value: 100000
Salvage Value: 50000
Tax: 30%
Calculate the total cash flow generated.

© McGraw Hill, LLC

Investment in net working capital
Working capital: Capital required to run day to day operations
like inventories, cash, credit sales (receivables) and so on.
These are part of current assets (Gross working capital)
We are interested in the financing part of working capital only
i.e., How much do we have to invest in working capital (it
represents a cash outflow)
A part of the working capital is financed by current liabilities
Therefore,
Current assets-Current liabilities represents the actual
capital invested by the firms in day to day operations, hence it
is called
Net working capital (CA-CL)

© McGraw Hill, LLC

Two things to remember about NWC
1. NWC is closely linked to sales. It is usually expressed in
terms of sales
Ex: 10% of the sales
2. Since, it fallows many cycles in a given year, you just
have to calculate additional investment required in NWC
for each year. When project ends, the entire investments
in NWC is recovered.
Terminal year:
Annual investment in NWC:
Cash inflow
Cash outflow

Year 0 1 2 3 4
Sales 10000 15000 18000 25000
Total Invt in NWC 1000 1500 1800 2500
Change in NWC -1000 -500 -300
Amount recovered 1800
© McGraw Hill, LLC
How do we treat Interest Expense?
For now, it is enough to assume that the firm’s level of debt
(and, hence, interest expense) is independent of the project at
hand.
Your MBA Value: Rs. 5 crs

Your father’s money

Bank’s money

Total value: 5 Crs Total value: 5 Crs

You get: 5 Crs You get: 4 Crs
Bank: 1 Cr

For now, let us assume that the way you finance would simply change the distribution
of the cash flows between owners and creditors, but will not affect the total value!!!

Later chapters will deal with the impact the amount of debt a
firm has in its capital structure has on firm value.
© McGraw Hill, LLC 95
Forecasting a Project's Cash Flow 3

Treat Inflation Consistently.

• Consistently handle inflation.
• Nominal interest rates discount nominal cash flows.
• Real interest rates discount real cash flows.
• Results are the same.

© McGraw Hill, LLC 96

6.2 The Baldwin Company – I
Costs of test marketing : $250,000
Current market value of proposed factory site (which we
own): $150,000
Cost of bowling ball machine: $100,000 (depreciated
according to 5-year SL/WDV (20%)
Salvage Value: 38000
Increase in net working capital: $10,000
Production (in units) by year during 5-year life of the
machine: 5,000, 8,000, 12,000, 10,000, 6,000

© McGraw Hill, LLC 97

The Baldwin Company – II
Price during first year is $20; price increases 2 percent per
year thereafter.
Production costs during first year are $10 per unit and
increase 10 percent per year thereafter.
Annual inflation rate: 5 percent
Working Capital: initial $10,000 changes with sales
Cost of capital: 10%

© McGraw Hill, LLC 98

How to go about solving this!
What you have to find here?
NPV
To get NPV what do you need?
Cash flows and discount rate (which is already given)
How to calculate CFs?
1. First calculate investment cash flows: You need initial
investment, change in NWC and after tax salvage value
of the assets to calculate this
2. Second, calculate operation cash flows: You need Sales,
costs and tax to calculate this
3. Add them up

© McGraw Hill, LLC

Investment cash flows
($ thousands) (All cash flows occur at the end of the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:

(1) Bowling ball machine −$100.00 30

(4) Opportunity cost (warehouse) −150.00 150.00

(5) Net working capital (end of 10.00 10.00 16.32 24.97 21.22
year)
(6) Change in net working capital −10.00 −6.32 −8.65 3.75 21.22

(7) Total cash flow of investment −260.00 −6.32 −8.65 3.75 201.22
[(1) + (4) + (6)]

© McGraw Hill, LLC 100

Operating cash flows

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89
(9) Operating costs −50.00 −88.00 −145.20 −133.10 −87.85
(10) Depreciation (SL) -20 -20 -20 -20 -20
(11) Income before 30 55.2 84.5 59.24 22.04
taxes [(8) – (9) – (10)]
(12) Tax (21%) -6.3 -11.6 -17.75 -12.45 -4.63
(13) Net Income 23.7 43.6 66.75 46.79 17.41

© McGraw Hill, LLC 101

The Baldwin Company – V

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89

Recall that production (in units) by year during the 5-year life
of the machine is 5,000, 8,000, 12,000, 10,000, and 6,000 for
each year, respectively.
Price during the first year is $20 and increases 2 percent per
year thereafter.

Sales revenue in Year 2 8,000 $20 1.021  8,000 $20.40 $163,200.

© McGraw Hill, LLC 102

The Baldwin Company - VI

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89
(9) Operating costs −50.00 −88.00 −145.20 −133.10 −87.85

Again, production (in units) by year during 5-year life of the

machine is 5,000, 8,000, 12,000, 10,000, and 6,000 for each
year, respectively.
Production costs during the first year (per unit) are $10, and
they increase 10 percent per year thereafter.

Production costs in Year 2 8,000 $10 1.101  $88,000.

© McGraw Hill, LLC 103

Depreciation Calculation

Year 0 1 2 3 4 5
Dep Method : SL
Asset Value 100 80 60 40 20 0
Dep 20 20 20 20 20
Dep Method: WDM (20%)
Asset Value 100 80 64 51.2 40.96 32.768
Dep 20 16 12.8 10.24 8.192

© McGraw Hill, LLC

Incremental Cash Flows for the Baldwin
Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(1) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89

(2) Operating costs −50.00 −$88.00 −145.20 −133.10 −87.85

(3) Taxes -6.3 -11.6 -17.75 -12.45 -4.63

(4) OCF (1) - (2) -
(3)
(5) Total CF of −$260.00
Investment
(6) IATCF [(4) + (5)] −$260.00

© McGraw Hill, LLC 105

Some interesting application of NPV analysis

 Investment timing decisions

 Choosing a projects when projects have unequal lives
 Cost-Cutting Proposals
 Setting the Bid Price
 Investments of Unequal Lives
 The choice between long or short life equipment
 When to replace a old machine

© McGraw Hill, LLC 106

The Investment Timing Decision 1

Some projects are more valuable if undertaken in the future.

Example
You own a large tract of inaccessible timber. To harvest it, you have
to invest a substantial amount in access roads and other facilities.
The longer you wait, the higher the investment required. On the
other hand, lumber prices may rise as you wait, and the trees will
keep growing, although at a gradually decreasing rate. Given the
following data and a 10% discount
Year of
rate,Year
Year of
when
of
should Year
Year of
youof harvest?
Harvest 0 Harvest 1 Harvest 2 Harvest 3 Harvest 4
Year of
Harvest 5

Net future value ($ thousands) 50 64.4 77.5 89.4 100 109.4

Discount net values back to present.

© McGraw Hill, LLC 107

The Investment Timing Decision 2

Year of Year of Year of Year of Year of Year of

Harvest 0 Harvest 1 Harvest 2 Harvest 3 Harvest 4 Harvest 5

NPV($ thousands) 50 58.5 64.0 67.2 68.3 67.9

Year of Year of Year of Year of Year of Year of

Harvest 0 Harvest 1 Harvest 2 Harvest 3 Harvest 4 Harvest 5
Net future value ($ thousands) 50 64.4 77.5 89.4 100 109.4

Change in value from previous year (%) +28.8 +20.3 +15.4 +11.9 +9.4

Answer:
Year 4

Growth rate < Discount rate

© McGraw Hill, LLC 108

Projects with unequal lives
Example
Given the following Costs from operating two machines and
a 6% cost of capital, which machine do you choose?

Costs ($ thousands)
Year: 0 1 2 3 PV at 6%
Machine A 15 5 5 5 $28.37
Machine B 10 6 6 — 21.00

© McGraw Hill, LLC 109

To address unequal lives….

Equivalent Annual Cash Flow : The cash flow per period with
the same present value as the actual cash flow as the
project.
I,e., annuity cash flows which have the same present value
as the actual project cash flows

present value of cash flows

Equivalent annual cost (annuity) 
annuity factor

© McGraw Hill, LLC 110

Equivalent Annual Cash Flows 2

Example
Given the following Costs from operating two machines and
a 6% cost of capital, which machine has the lower equivalent
annual cost?
Machine A Costs ($ thousands)

Year: 0 1 2 3 PV at 6%
Machine A 15 5 5 5 28.37
Equivalent annual cost 10.61 10.61 10.61 28.37

Machine B Costs ($ thousands)

Year: 0 1 2 PV at 6%
Annual
Machine B 10 6 6 21.00 Avg.
Equivalent annual cost 11.45 11.45 21.00 cost

Answer: Machine A (10.61 < 11.45)

© McGraw Hill, LLC 111

NPV analysis applied to Cost-Cutting
Proposals
Things to consider…………..
Cost savings will increase pre-tax income
• But, we have to pay taxes on this amount.

Depreciation will reduce our tax liability

Does the present value of the cash flows associated with the
cost savings exceed the cost?
• If yes, then proceed.

© McGraw Hill, LLC 112

Cost-cutting proposals
Our institute is considering going for ERP system which costs
about Rs. 10 crores. This system will save about Rs.1.2 crores
per year in time, material and labor costs for the institute (Net
savings). Expenditure on this system could be depreciated
over 15 year period using the straight-line method. This
system will have to be replaced by another a more modern
system after 15 years. Assume that the institute is falling into
30% tax slab and its cost of capital is 10%. Should it go for this
system?
Years 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Invt -10
Savings 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20 1.20
Dep 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67
EBIT 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53 0.53
Tax 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16
OCF 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04 1.04
PV ₹ 7.91
NPV ₹ -2.09

© McGraw Hill, LLC

Calculating the bid price
ABC needs someone to supply it with 145000 cartons of
machine screws per year to support its manufacturing needs
over the next five years, and you have decided to bod on the
contract. It will cost about 2.1 million to install the equipment
necessary to start production, you will depreciate this over
project life in straight line method. The salvage value would be
150000. Fixed costs are 650000 per year and variable cost is
9.45 per carton. Initial requirement in working capital is
325000. tax rate=21% and cost of capital is 11%. What is your
bid price?

© McGraw Hill, LLC

How to think about this
What do you want to find?
The quote which makes that project profitable at 11%
That is, NPV of this project at 11% should be at least equal to
zero
You need investment and operating cash flows to calculate
NPV
Years 0 1 2 3 4 5
Operating CF OCF OCF OCF OCF OCF
Investment CV ICF ICF ICF ICF ICF ICF
Total CF TCF TCF TCF TCF TCF TCF
NPV=PV of TCF-Initial investment

So, let us calculate these things

© McGraw Hill, LLC

To calculate OCF, we need Sales which is nothing but the
minimum bid price which makes the project profitable at 11%
To calculate sales, we can use
OCF= Net come + Dep and
Net Income=(Sales-costs-Dep)(1-Tc)
By using these two relationships, we can solve the question
Let’s do it!

© McGraw Hill, LLC

Solution
Years 0 1 2 3 4 5

Investment -2.1 0.1185

Total costs 2.02025 2.02025 2.02025 2.02025 2.02025

Dep 0.42 0.42 0.42 0.42 0.42

WC -0.325 0.325

Years 0 1 2 3 4 5
OCF OCF OCF OCF OCF OCF
Invest -2.1 0.1185
NWC -0.325 0.325
Cash flow -2.425 OCF OCF OCF OCF OCF+0.4435
PV of 0.4435 0.263196
-2.1618 OCF ₹ 0.58

OCF=Net income+ Dep NI=(Sales-costs-dep)(1-Tc)

0.58=NI+0.42 0.16=(Sales-0.02025-0.42)(1-0.21)
NI=0.16 Sales=0.643
Per Carton=0.643/0.145=4.44

© McGraw Hill, LLC

Setting the Bid Price
Find the sales price that makes NPV = 0
Step 1: Use known changes in NWC and capital to estimate
“preliminary” NPV
Step 2: Determine what yearly OCF is needed to make
NPV = 0
Step 3: Determine what NI is required to generate the OCF
• OCF = NI + Depreciation.
Step 4: Identify what sales (and price) are necessary to
create the required NI
• NI = (Sales − Costs − Depreciation)*(1 − T)

© McGraw Hill, LLC 118

Interesting application by MG motors,
India
• Recently MG motors launched Windsor EV with two
purchase options
1. BaaS (Battery as a Service): Purchase the vehicle at Rs.10
lakh and have the battery on rent for 3.5 /KM (Min monthly
usage is 1500 Kms). On road price in most of the cities
would be around Rs.10.5 lakh
2. Outright purchase of the vehicle along with the battery at
Rs. 13.5 (14.00) lakhs
You want to purchase this vehicle, your monthly KMs-1500,
cost of charging Rs. 1/KM
Which option should you chose?

© McGraw Hill, LLC

Investments of Unequal Lives – I
There are times when application of the NPV rule can lead to
the wrong decision. Consider a factory that must have an air
cleaner that is mandated by law. There are two choices:
• The “Cadillac cleaner” costs $4,000 today, has annual
operating costs of $100, and lasts 10 years.
• The “Cheapskate cleaner” costs $1,000 today, has annual
operating costs of $500, and lasts 5 years.

Assuming a 10 percent discount rate, which one should we

choose?

© McGraw Hill, LLC 120

Equivalent Annual Cost (EAC)
The EAC is the value of the level payment annuity that has
the same PV as our original set of cash flows.
• For example, the EAC for the Cadillac air cleaner is
$750.98.
• The EAC for the Cheapskate air cleaner is $763.80, thus
we should reject it.

© McGraw Hill, LLC 121

Investments of Unequal Lives - III
This overlooks the fact that the Cadillac cleaner lasts twice
as long.
When we incorporate the difference in lives, the Cadillac
cleaner is actually cheaper (that is, has a higher NPV).

© McGraw Hill, LLC 122

• Risk, Return and CAPM

© McGraw Hill, LLC

Return
What you get for your investment
Always expressed in percent relative to initial investment
made
By default it is expressed on annual or per annum basis,
unless mentioned specifically
Return could be negative

© McGraw Hill, LLC

Return
Ex Ante Returns
• Return calculations may be done ‘before-the-fact,’ in
which case, assumptions, especially about the probability
distribution of the possible returns, must be made about
the future

Ex Post Returns
• Return calculations done ‘after-the-fact,’ in order to
analyze what rate of return was earned.
• Also called as historical returns

© McGraw Hill, LLC

Measuring return
Total returns can be decomposed into the two forms of income that
equity investors may receive, dividends and capital gains (loss).

 D1 
kc     g  Income / Dividend Yield   Capital Gain (or loss) Yield 
 P0 

WHEREAS

Fixed-income investors (bond investors for example) can expect to

earn interest income as well as (depending on the movement of
interest rates) either capital gains or capital losses.

© McGraw Hill, LLC

Measuring return
• Income yield is the return earned in the form of a periodic
cash flow received by investors.
• The income yield return is calculated by the periodic cash
flow divided by the purchase price.

CF1
[8-1] Income yield 
P0

Where CF1 = the expected cash flow to be received

P0 = the purchase price

© McGraw Hill, LLC

Measuring return
An investor receives the following dollar returns a stock
investment of $25 in one years:
▪ $1.00 of dividends
▪ Share price rise of $2.00

The capital gain (or loss) return component of total return is calculated:
ending price – minus beginning price, divided by beginning price

P1  P0 $27 - $25
Capital gain (loss) return   .08 8%
P0 $25

© McGraw Hill, LLC

Measuring return

Total return Income yield  Capital gain (or loss) yield

CF1  P1  P0

[8-3] P0
 CF   P  P 
 1    1 0 
 P0   P0 
 $1.00   $27  $25 
    0.04  0.08 0.12 12%
 $25   $25 

© McGraw Hill, LLC

Hopding period return and yield
• What is the return earned by a stock if you purchase it at
Rs.250 and sell it at Rs.380 after 3 years?
• 15% for three years: this return is for the entire holding
period, therefore, it is called HPR
• What is the average return per annum, i.e., Holding
period yield (HPY)?

© McGraw Hill, LLC

Measuring Average Returns
Ex Post Returns

Measurement of historical rates of return that have been

earned on a security or a class of securities allows us to
identify trends or tendencies that may be useful in
predicting the future.
There are two different types of ex post mean or average
returns used:
• Arithmetic average
• Geometric mean

© McGraw Hill, LLC

Measuring average return

r i
Arithmetic Average (AM)  i 1
n

1
Geometric Mean (GM)  [( 1  r1 )( 1  r2 )( 1  r3 )...( 1  rn )] -1
n

© McGraw Hill, LLC

Example:

Years Tata motors Mahindra

1 0.1 0.18
2 0.08 -0.1
3 0.15 0.15
4 0.16 0.08
5 -0.05 0.12
6 0.14 0.16
AM
GM

© McGraw Hill, LLC

Measuring average return
If all returns (values) are identical the geometric mean =
arithmetic average.

If the return values are volatile the geometric mean <

arithmetic average

The greater the volatility of returns, the greater the

difference between geometric mean and arithmetic
average.

© McGraw Hill, LLC

Measuring Expected (Ex Ante)
Returns

While past returns might be interesting, investor’s are most

concerned with future returns.
Sometimes, historical average returns will not be realized in
the future.
Developing an independent estimate of ex ante returns
usually involves use of forecasting discrete scenarios with
outcomes and probabilities of occurrence.

© McGraw Hill, LLC

Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns

The general formula

n
Expected Return (ER)  (ri Prob i )
i 1

Where:
ER = the expected return on an investment
Ri = the estimated return in scenario i
Probi = the probability of state i occurring

© McGraw Hill, LLC

Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns

Example:
This is type of forecast data that are required to
make an ex ante estimate of expected return.

Possible
Returns on
Probability of Stock A in that
State of the Economy Occurrence State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%

© McGraw Hill, LLC

Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns

Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.

(1) (2) (3) (4)=(2)×(1)

Possible Weighted
Returns on Possible
Probability of Stock A in that Returns on
State of the Economy Occurrence State the Stock
Economic Expansion 25.0% 30% 7.50%
Normal Economy 50.0% 12% 6.00%
Recession 25.0% -25% -6.25%
Expected Return on the Stock = 7.25%

© McGraw Hill, LLC

Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns

Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.

n
Expected Return (ER)  (ri Prob i )
i 1

(r1 Prob1 )  (r2 Prob 2 )  (r3 Prob 3 )

(30% 0.25)  (12% 0.5)  (-25% 0.25)
7.25%

© McGraw Hill, LLC

Interpreting the expected return

(1) (2) (3) (4)=(2)×(1)

Possible W e ighte d
Re turns on Possible
Proba bility of Stock A in tha t Re turns on
Sta te of the Econom y Occurre nce Sta te the Stock
Ec onomic Ex pans ion 25.0% 30% 7.50%
Normal Ec onomy 50.0% 12% 6.00%
Recess ion 25.0% -25% -6.25%
Ex pe cte d Re turn on the Stock = 7.25%

You are purchasing this stock and want to hold it for a

year, what would be your return?

This is the long term average return expected

Imp Assumption:
Future returns follow the same distribution

If you hold this security for many years, the

expected average return would be 7.5%

© McGraw Hill, LLC

Risk

© McGraw Hill, LLC

We are done with
this component of
NPV

Let’s understand
how to estimate
the discount rate

Before knowing how to estimate the discount rate, you should know what it
represents, i.e., what determines it.

© McGraw Hill, LLC

The discount rate
Any idea what determines the discount rate?
The most important concept in finance is that
“the discount rate is determined by the riskiness of the
cash flow that you discount”
The discount rate (r) and CF are very
much connected. The riskiness of CF
would determine r

Therefore, the most important challenge in finance is to develop a model that connects
CF riskiness with the discount rate.
This is what we do now!!!

© McGraw Hill, LLC

But,

Before developing a model that connects CF risk with the

discount rate,
We need to understand
What risk is and how to measure it.
So,
Let’s understand the concept of risk!

© McGraw Hill, LLC

Firm: From a financial perspective

Assets Liabilities Estimated future cash flows (going concern, i.e., perpetual cash flows)

0 0 1 2 3 4

100000 100000 35000 45000 50000 65000

Broadly:
Assets are Equity
invested and debt
in various
projects
Expected cash
flows

© McGraw Hill, LLC

Firm: From the risk perspective

Assets Liabilities Estimated future cash flows (going concern, i.e., perpetual cash flows)

0 0 1 2 3 4
-10000 -10000
15000 15000 The same CF variation

20000 20000
Expected cash
100000 100000 35000 45000 50000 65000 flows
Broadly:
Assets are Equity 45000 CF
35000
Variation
invested and debt
in various 50000 50000 The same CF variation
projects
60000 60000

© McGraw Hill, LLC

Stock returns mimic this CF variation
How do we know what CF/return from this
distribution would be realized in a given year?
Possible CF Stock returns
-10000 -3% We can’t!!! It depends on macro and firm specific
events that are going to happen in that given year
15000 2%
20000 4.5% Stock Return Variation (Volatility): On
35000 7% this particular year, the stock could yield
any one of these returns depending on
45000 9.5% the realized CF
50000 12%
60000 15%
The same CF variation leads to across year variation in stock returns

Year 1 2 3 4 5 6 7
Realized CF -10000 15000 20000 35000 45000 50000 60000
Stock returns -3% 2.50% 4% 7% 9% 11.50% 15%

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Firm: From the risk perspective

Assets Liabilities Estimated future cash flows (going concern, i.e., perpetual cash flows)

0 0 1 2 3 4

This is risk free cash flow

100000 100000 35000 45000 50000 65000

Broadly:
Assets are Equity
invested and debt
in various
projects
No dispersion of
expected CF

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Which one do you invest in?

Firms Nemiraja Ltd Some Unknown Ltd

-10 3
High chance of
making loss -5 7

This is risk 10 10
Both have
At the same time, 20 14 the same
high chance of exp return
making greater profit
35 16

Mean 10 10

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Differences in Levels of Risk
Illustrated

Outcomes that produce harm The wider the range of probable

outcomes the greater the risk of the
Probability
investment.
B A is a much riskier investment than B

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock

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Coca-cola Vs Google: Which is riskier?

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So, what is risk? And how do we measure it?
In simple terms, risk is the dispersion of values.
And this dispersion of values is measured mainly through
standard deviation (SD).
The higher is the SD the greater is the dispersion, i.e., risk.
With a greater SD, you have a greater degree of uncertainty
regarding what would be your actual return in the future. This is
risk for you.
Firms Nemiraja Ltd Some Unknown Ltd
-10 3
-5 7 I am very risky!
10 10 Be careful!!!
20 14
35 16
Mean 10 10
SD 18.37 5.24

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Risk
• In Finance, risk is all about the probability of making
lesser than expected returns
• That is, dispersion around the expected return is
important and that is “risk” in finance
• Important question,
• Then why would investors invest in risky securities?
Or how can you make investors to invest in risky
securities?
• Remember,
• By definition, if you have a greater probability of making
loss, the probability of making a greater profit should also
be high

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Risk and uncertainty

Possible
Returns on
Probability of Stock A in that
State of the Economy Occurrence State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%

• Risk: All possible outcomes and the probability distribution of

such outcomes are known
• Uncertainty: All possible outcomes and hence the probability
distribution is unknown

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Individual assignment

Calculate its risk

Possible
Returns on
Probability of Stock A in that
State of the Economy Occurrence State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%

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Some assumptions
1. Return or cash flows follow some probability distribution
We assumed the Normal distribution so far
But,
You can use other probability distributions as well
2. We assume that investors are rational and
Risk neutral
Risk taking
Risk averse

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Risk Neutral

Stock Exp Ret SD Which one do you invest in?

A 10 2
B 15 25

If you are risk neutral, then you are indifferent about the risk of these two stocks.
You make your decisions based only on the expected return

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Risk taking

Stock Exp Ret SD Which one do you invest in if

you are risk taking?
A 10 2
B 5 25

If you are risk taking, then you would chose B.

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Who are risk averse?
Let’s have some fun
Cricket betting
Weakest cricket team:
Strongest cricket team:
Winning probability for the weakest team is 1%
If the bet is 1:1 for the weakest team, then, would you bet on the weakest
team?
What if the bet ratio is 1:5?
What if the bet ratio is 1:10?
What if the bet ratio is 1:100?
What if the bet ratio is 1:100000?
All of you are risk averse!!

© McGraw Hill, LLC

Risk averse
Risk averse mean you don’t like risk, but, you would start
liking risk if there is enough return attached to the winning
probability, however small the probability is!!!
I,e., individuals start accepting risk when there is enough
reward for it
This is a very important assumption in finance! All finance
models are built with this assumption and hence applicable
to risk averse individuals only.

© McGraw Hill, LLC

What is the relationship between risk
and return?
Do you know why risk and return are positively related?
Because,
Investors are risk-averse
Ok, if investors are risk-averse and risk and return are positively
related, then answer the following question
Suppose, Nemiraja is taking 10 units of risk and Samskruti is
taking 15 units. How much extra return should Samskruti get?
So,
We need to develop a model to connect risk and return: This is
what we started with on the slide;126.

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Now, let’s get back to our original task:
Slide 126
To develop a model that links risk with return, i.e.,
To establish a functional form of relationship, we use the
modern portfolio theory.

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Modern Portfolio theory
• This is based on the assumption that a rational and risk
averse investor always tries to maximize returns and at the
same time tries to minimize his risk exposure.
• This is call mean-variance approach
• If you have Rs.100 to invest in and have two securities in
your opportunity set, which one do you invest in?

Nemiraja Some other

Expected Return 15 10

SD 8 5

• The basic intuition is that from the risk perspective, it is

always better to invest in multiple securities than in a
security
© McGraw Hill, LLC
Portfolios

A portfolio is a collection of different securities such as stocks and

bonds, that are combined and considered a single asset

The risk-return characteristics of the portfolio is demonstrably different

than the characteristics of the assets that make up that portfolio,
especially with regard to risk.

Combining different securities into portfolios is done to achieve

diversification.

© McGraw Hill, LLC

MPT: The intuition
• What is the intuition behind MPT?
• The negative event happening in one security is specific to
that security and it doesn’t affect the return of the other
security
• A negative return in once security is off set by a positive
return in the other security
• In the portfolio approach, you try to diversify the sources of
risk, i.e., from one source to many sources.
• The probability that all the securities experiencing a
negative shock simultaneously is very low, as they are
independent of each other
• And hence, your overall risk exposure is diversified.

© McGraw Hill, LLC

MPT

• This co-movement of return of the securities, preferably in

the negative direction, leads to reduced risk exposure
• We measure this co-movement by correlation/Covariance,
therefore,
• Correlation is the most important determinant of
portfolio effectiveness

© McGraw Hill, LLC

Objective of diversification
To minimize risk exposure
But,
What happens to return in the process of risk reduction?
The answer is,
There would be some reduction in returns too
However,
The degree of risk reduction is much greater than the
degree of return sacrifice…..i.e.,
The overall ratio of return/risk is maximized

© McGraw Hill, LLC

Mathematics of MPT

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Expected Return of a Portfolio
Modern Portfolio Theory

The Expected Return on a Portfolio is simply the weighted average of

the returns of the individual assets that make up the portfolio:

n
ER p  ( wi ERi )
i 1

The portfolio weight of a particular security is the percentage of the

portfolio’s total value that is invested In that security.

Security Exp Ret Amount Invested

A 14 2000

B 6 7000

© McGraw Hill, LLC

Expected Return of a Portfolio
Example

Portfolio value = $2,000 + $5,000 = $7,000

rA = 14%, rB = 6%,
wA = weight of security A = $2,000 / $7,000 = 28.6%
wB = weight of security B = $5,000 / $7,000 = (1-28.6%)= 71.4%

n
ER p  ( wi ERi ) (.286 14%)  (.714 6% )
i 1

4.004%  4.284% 8.288%

© McGraw Hill, LLC

Range of Returns in a Two Asset Portfolio

In a two asset portfolio, simply by changing the weight of the

constituent assets, different portfolio returns can be achieved.

Because the expected return on the portfolio is a simple weighted

average of the individual returns of the assets, you can achieve
portfolio returns bounded by the highest and the lowest individual asset
returns.

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Range of Returns in a Two Asset Portfolio

Example 1:

Assume ERA = 8% and ERB = 10%

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Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and
B

10.50

10.00 ERB= 10%

Expected Return %

9.50

9.00

8.50

8.00
ERA=8%
7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

Portfolio Weight

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Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and
B

A portfolio manager can select the relative weights of the two

assets in the portfolio to get a desired return between 8%
(100% invested in A) and 10% (100% invested in B)
10.50

10.00 ERB= 10%

Expected Return %

9.50

9.00

8.50

8.00
ERA=8%
7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

Portfolio Weight

© McGraw Hill, LLC

Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and
B

10.50

ERB= 10%
10.00
Expected Return %

9.50 The potential returns of

the portfolio are
9.00 bounded by the highest
and lowest returns of
the individual assets
8.50 that make up the
portfolio.
8.00

ERA=8%
7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

Portfolio Weight

© McGraw Hill, LLC

Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and
B

10.50

ERB= 10%
10.00
Expected Return %

9.50

9.00
The expected return on
8.50 the portfolio if 100% is
invested in Asset A is
8%.
8.00
ER p wA ERA  wB ERB (1.0)(8%)  (0)(10%) 8%
7.50 ERA=8%

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

Portfolio Weight

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Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and
B
8 - 4 FIGURE

10.50 The expected return on

the portfolio if 100% is
invested in Asset B is ERB= 10%
10.00 10%.
Expected Return %

9.50

9.00

ER
8.50

8.00
ER p wA ERA  wB ERB (0)(8%)  (1.0)(10%) 10%

7.50 ERA=8%

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

Portfolio Weight

© McGraw Hill, LLC

Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and
B
8 - 4 FIGURE

10.50 The expected return on

the portfolio if 50% is
invested in Asset A and ERB= 10%
10.00 50% in B is 9%.
Expected Return %

9.50

ER p wA ERA  wB ERB

9.00
(0.5)(8%)  (0.5)(10%)

ER
8.50
4%  5% 9%
8.00

7.50 ERA=8%

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

Portfolio Weight

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Risk in Portfolios

Risk, Return and Portfolio Theory

© McGraw Hill, LLC

Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Covariance

[8-11]  p  ( wA ) 2 ( A ) 2  ( wB ) 2 ( B ) 2  2( wA )( wB )(COVA, B )

Risk of Asset A Risk of Asset B Factor to take into

adjusted for weight adjusted for weight account comovement
in the portfolio in the portfolio of returns. This factor
can be negative.

© McGraw Hill, LLC

Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Correlation Coefficient

[8-15]  p  ( wA ) 2 ( A ) 2  ( wB ) 2 ( B ) 2  2( wA )( wB )(  A, B )( A )( B )

Factor that takes into

account the degree of
comovement of returns.
It can have a negative
value if correlation is
negative.

© McGraw Hill, LLC

Calculate portfolio SD

Security Exp Ret Amount Invested SD

A 5 7000 15

B 14 7000 40
Correlation -0.5

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Grouping Individual Assets into Portfolios

The riskiness of a portfolio that is made of different risky assets is a

function of three different factors:
• the riskiness of the individual assets that make up the portfolio
• the relative weights of the assets in the portfolio
• the degree of comovement of returns of the assets making up the
portfolio
The standard deviation of a two-asset portfolio may be measured using
the Markowitz model:

 p   w   w  2 w A wB  A, B A B
2
A
2
A
2
B
2
B

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Risk of a Three-Asset Portfolio

The data requirements for a three-asset portfolio grows

dramatically if we are using Markowitz Portfolio selection formulae.

We need 3 (three) correlation coefficients between A and B; A and

C; and B and C.
A
ρa,b ρa,c
B C
ρb,c

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB  A, B A B  2wB wC  B ,C B C  2wA wC  A,C A C

© McGraw Hill, LLC

Risk of a Four-asset Portfolio

The data requirements for a four-asset portfolio grows dramatically

if we are using Markowitz Portfolio selection formulae.

We need 6 correlation coefficients between A and B; A and C; A

and D; B and C; C and D; and B and D.

A
ρa,b ρa,d
ρa,c
B D
ρb,d
ρb,c ρc,d
C

© McGraw Hill, LLC

Correlation

The degree to which the returns of two stocks co-move

is measured by the correlation coefficient (ρ).
The correlation coefficient (ρ) between the returns on
two securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation
-1 is perfect negative correlation

COVAB
 AB  COVAB  AB  A B
 A B

Covariance and Correlation Coefficient

Solving for covariance given the correlation coefficient and

standard deviation of the two assets:

COVAB  AB  A B

Importance of Correlation

Correlation is important because it affects the degree to

which diversification can be achieved using various
assets.
Theoretically, if two assets returns are perfectly
positively correlated, it is possible to build a riskless
portfolio with a return that is greater than the risk-free
rate.

Affect of Perfectly Negatively Correlated Returns
Elimination of Portfolio Risk

Returns
If returns of A and B are
%
20% perfectly negatively correlated,
a two-asset portfolio made up of
equal parts of Stock A and B
would be riskless. There would
15% be no variability
of the portfolios returns over
time.

10%

Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2

Example of Perfectly Positively Correlated Returns
No Diversification of Portfolio Risk

Returns
If returns of A and B are
%
20% perfectly positively correlated, a
two-asset portfolio made up of
equal parts of Stock A and B
would be risky. There would be
15% no diversification (reduction of
portfolio risk).

10%
Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2

Affect of Perfectly Negatively Correlated Returns
Numerical Example

Weight of Asset A = 50.0%

Weight of Asset B = 50.0%
n
Expected ER p  ( wi ERi ) (.5 5%)  (.5 15% )
i 1
Return on Return on Return on the 2.5%  7.5% 10%
Year Asset A Asset B Portfolio
xx07 5.0% 15.0% 10.0%
xx08 10.0% 10.0% 10.0%
xx09 15.0% 5.0% 10.0%
n
ER p  ( wi ERi ) (.5 15%)  (.5 5% )
i 1

7.5%  2.5% 10%

Perfectly Negatively
Correlated Returns
over time

Zero Risk Portfolio

We can calculate the portfolio that removes all risk.

When ρ = -1, then

[8-15]  p  ( wA ) 2 ( A ) 2  ( wB ) 2 ( B ) 2  2( wA )( wB )(  A, B )( A )( B )

Becomes:

[8-16]  p w A  (1  w) B

Diversification Potential

The potential of an asset to diversify a portfolio is dependent upon the

degree of co-movement of returns of the asset with those other
assets that make up the portfolio.
In a simple, two-asset case, if the returns of the two assets are
perfectly negatively correlated it is possible (depending on the
relative weighting) to eliminate all portfolio risk.
This is demonstrated through the following series of spreadsheets, and
then summarized in graph format.