Strategic financial management

1
Strategic Financial Management
By
Binoy john varghese

Strategic financial management refers to both,
financial implications or aspects of various
business strategies, and strategic management
of finance.
It is an approach to management that relates
financial techniques, tools and methodologies to
strategic decisions making to have a long-term
futuristic perspective of financial well being of the
firm to facilitate growth, sustenance and
competitive edge consistently.

An approach to management that applies
financial techniques to strategic decision
making.
Definition: “the application of financial
techniques to strategic decisions in order to
help achieve the decision-maker's
objectives”
Strategy: a carefully devised plan of action to
achieve a goal, or the art of developing or
carrying out such a plan

refers to both, financial implications or
aspects of various business
strategies, and strategic management
of finances.

Strategic Financial Decisions
Strategic Financial Management Deals with:
1. Investment decisions
 Long Term Investment Decisions
 Short Term Investment Decision
1. Financing Decisions
 Best means of financing- Debt Equity Ratio
1. Liquidity Decisions
 Organization maintain adequate cash reserves or
kind such that the operations run smoothly
1. Dividend Decisions
 Disbursement of Dividend to Share holder and
Retained Earnings
5. Profitability Decisions

Strategic Financial Management also Deals with:
1. Valuation of the firm
2. Strategic Risk Management
3. Strategic investments analysis and capital budgeting
4. Corporate restructuring and financial aspects
5. Strategic financial evaluation
6. Strategic capital restructuring
7. Strategic international financial management
8. Strategic financial engineering and architecture
9. Strategic market expansion planning
10.Strategic compensation planning
11.Strategic innovation expenditure
12.Other business challenges

Investment decisions
The investment decision relates to the selection of
assets in which funds will be invested by a firm. The
assets which can be acquired fall into two broad
groups: (a) long-term assets (Capital Budgeting) (b)
short-term or current assets (Working Capital
Management).
(a) Long Term Investment Decisions
Capital Budgeting Capital budgeting is probably the
most crucial financial decision of a firm. It relates to the
selection of an asset or investment proposal or course
of action whose benefits are likely to be available in
future over the lifetime of the project.
Capital Budgeting decisions
Use Pay Back period, NPV, IRR, etc. for evaluation

Investment Decisions
(b)Short Term Investment Decision
Working Capital Management : Working
capital management is concerned with the
management of current assets. It is an
important and integral part of financial
management as short-term survival is a
prerequisite for long-term success.
Fixed Part of working capital –managed from
long term funds
Fluctuating Part of Working Capital –managed
from short term funds

Financing Decisions
The second major decision involved in financial
management is the financing decision. The investment
decision is broadly concerned with the asset-mix or the
composition of the assets of a firm. The concern of the
financing decision is with the financing-mix or capital
structure or leverage. There are two aspects of the
financing decision.
First, the theory of capital structure which shows the
theoretical relationship between the employment of debt
and the return to the shareholders. The second aspect of
the financing decision is the determination of an
appropriate capital structure, given the facts of a particular
case. Thus, the financing decision covers two interrelated
aspects: (1) the capital structure theory, and (2) the capital
structure decision.

Dividend Decisions
Two alternatives are available in dealing with
the profits of a firm.
(1)They can be distributed to the shareholders
in the form of dividends or
(2)They can be retained in the business itself.
It depends on the dividend-pay out ratio, that
is, what proportion of net profits should be
paid out to the share holders.
It depends upon the preference of the
shareholders and investment
opportunities available within the firm

Profitability Management
The source of revenue has to be
pre-decided to obtain profits in
future.
It is closely related to investment
decisions as revenue generation
will be from operations,
investments and divestments.

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Working Capital Decision
Gross working capital (GWC)
GWC refers to the firm’s total investment in
current assets.
Current assets are the assets which can be
converted into cash within an accounting year
(or operating cycle) and include cash, short-
term securities, debtors, (accounts receivable
or book debts) bills receivable and stock
(inventory).

13
Concepts of Working Capital
Net working capital (NWC).
NWC refers to the difference between current
assets and current liabilities.
Current liabilities (CL) are those claims of
outsiders which are expected to mature for
payment within an accounting year and
include creditors (accounts payable), bills
payable, and outstanding expenses.
NWC can be positive or negative.
Positive NWC = CA > CL
Negative NWC = CA < CL

14
Concepts of Working Capital
GWC focuses on
– Optimization of current investment
– Financing of current assets
NWC focuses on
– Liquidity position of the firm
– Judicious mix of short-term and long-tern
financing

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Operating Cycle
Operating cycle is the time duration required
to convert sales, after the conversion of
resources into inventories, into cash. The
operating cycle of a manufacturing company
involves three phases:
– Acquisition of resources such as raw material, labour,
power and fuel etc.
– Manufacture of the product which includes conversion
of raw material into work-in-progress into finished goods.
– Sale of the product either for cash or on credit. Credit
sales create account receivable for collection.

Working Capital Management
Receivables Management
Investment in receivable
• volume of credit sales
• collection period
Credit policy
• credit standards
• credit terms
• collection efforts
Cash Management

Inventory Management
Stocks of manufactured products and
the material that make up the product.
Components:
• raw materials
• work-in-process
• finished goods
• stores and spares (supplies)

Cash Management
Cash management is concerned with the
managing of:
– cash flows into and out of the firm,
– cash flows within the firm, and
– cash balances held by the firm at a point of
time by financing deficit or investing
surplus cash

Functions of Financial Manager
1. Financial Forecasting and
Planning
2. Acquisition of funds
3. Investment of funds
4. Helping in Valuation Decisions
5. Maintain Proper Liquidity

Financial Policy
Criteria describing a corporation's choices
regarding its debt/equity mix, currencies of
denomination, maturity structure, method of
financing investment projects, and hedging
decisions with a goal of maximizing the
value of the firm to some set of
stockholders.
Hedging: A strategy designed to reduce investment risk
using call options, put options, short-selling, or futures
contracts. Its purpose is to reduce the volatility of a
portfolio by reducing the risk of loss.

Strategic planning
Strategic planning is an organization's
process of defining its strategy, or direction,
and making decisions on allocating its
resources to pursue this strategy, including
its capital and people.
Various business analysis techniques can be used in
strategic planning, including SWOT analysis (Strengths,
Weaknesses, Opportunities, and Threats ), PEST analysis
(Political, Economic, Social, and Technological), STEER
analysis (Socio-cultural, Technological, Economic,
Ecological, and Regulatory factors), and EPISTEL
(Environment, Political, Informatic, Social, Technological,
Economic and Legal).

Strategic planning
Strategic planning is the formal consideration of an
organization's future course.
All strategic planning deals with at least one of three key
questions:
"What do we do?"
"For whom do we do it?"
"How do we excel?"
In business strategic planning, some authors phrase the
third question as "How can we beat or avoid competition?".
(Bradford and Duncan, page 1). But this approach is more
about defeating competitors than about excelling.

Strategic planning
In many organizations, this is viewed as a process for
determining where an organization is going over the next
year or - more typically - 3 to 5 years (long term), although
some extend their vision to 20 years.
In order to determine where it is going, the organization needs
to know exactly where it stands, then determine where it wants
to go and how it will get there. The resulting document is called
the "strategic plan."
It is also true that strategic planning may be a tool for effectively
plotting the direction of a company; however, strategic planning itself
cannot foretell exactly how the market will evolve and what issues will
surface in the coming days in order to plan your organizational
strategy. Therefore, strategic innovation and tinkering with the
'strategic plan' have to be a cornerstone strategy for an organization to
survive the turbulent business climate.

Characteristics of Strategic planning
Successful Strategic planning constitutes
the following features. It should:
1. Exhibit impacts in daily routine
2. Facilitate dynamic, forward and backward thinking process
3. Counters repetitive patterns of mistakes, especially human
tendencies
4. Remain clear and simple
5. Ensure planning is complete only when it is properly
implemented
6. Designate a core planning team with a level of autonomy
7. Constitute collective leadership and involvement of key
stakeholders in decision making

Mission and Vision
Mission: Defines the fundamental purpose
of an organization or an enterprise,
succinctly describing why it exists and what
it does to achieve its Vision
A Vision statement outlines what the
organization wants to be, or how it wants
the world in which it operates to be. It
concentrates on the future. It is a source of
inspiration. It provides clear decision-
making criteria.

26
Finance Functions
Investment or Long Term Asset Mix
Decision
Financing or Capital Mix Decision
Dividend or Profit Allocation Decision
Liquidity or Short Term Asset Mix
Decision

Strategic Financial Planning
A Financial Plan is statement of what is to
be done in a future time.
Most decisions have long lead times,
which means they take a long time to
implement.
In an uncertain world, this requires that
decisions be made far in advance of their
implementation

It formulates the method by which financial
goals are to be achieved.
There are two dimensions:
1. A Time Frame
– Short run is probably anything less than a year.
– Long run is anything over that; usually taken to be a two-
year to five-year period.
2. A Level of Aggregation
– Each division and operational unit should have a plan.
– As the capital-budgeting analyses of each of the firm’s
divisions are added up, the firm aggregates these small
projects as a big project.

Scenario Analysis
Each division might be asked to prepare three
different plans for the near term future:
1. A Worst Case- This plan would require making the worst
possible assumptions about the companies products and
the state of the economy
2. A Normal Case- This plan would require making the most
likely assumptions about the company and the economy
3. A Best Case- Each divisions would be required to work out
a case based on optimistic assumptions. It could involve
new products and expansion.

Components of Financial Strategy
Start-Up Costs
A new business venture, even those started by existing
companies, has start-up costs. An existing manufacturer
looking to release a new line of product has costs that
may include new fabricating equipment, new packaging
and a marketing plan. Include your start-up costs in your
financial strategy.
Competitive Analysis
Your competition affects how you make money and how you spend
money. The products and marketing activities of your competition
should be included in your financial strategy. An analysis of how the
competition will affect revenue needs to be included in your
planning.

Ongoing Costs
These include labor, materials, equipment maintenance,
shipping and facilities costs, such as lease and utilities.
Break down your ongoing cost projections into monthly
numbers to include as part of your financial strategy.
Revenue
In order to create an effective financial strategy, you
need to forecast revenue over the length of the project. A
comprehensive revenue forecast is necessary when
determining how much will be available to pay your
ongoing costs, and how much will remain as profit.

Objectives and Goals
Goal: The Financial Goal of the firm
should be shareholder’s wealth
maximization, as reflected in the market
value of the firm’s share.
Firms’ primary objective is maximizing the
welfare of owners, but, in operational terms,
they focus on the satisfaction of its
customers through the production of goods
and services needed by them

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Objectives Of Financial Management
The term objective is used to in the sense of a
goal or decision criteria for the three decisions
involved in financial management
The goal of the financial manager is to maximise
the owners/shareholders wealth as reflected in
share prices rather than profit/EPS maximisation
because the latter ignores the timing of returns,
does not directly consider cash flows and
ignores risk.
As key determinants of share price, both return and risk
must be assessed by the financial manager when
evaluating decision alternatives. The EVA is a popular
measure to determine whether an investment positively
contributes to the owners wealth.

1-34
However, the wealth maximizing action of
the finance managers should be
consistent with the preservation of the
wealth of stakeholders, that is, groups
such as employees, customers, suppliers,
creditors, owners and others who have a
direct link to the firm.

35
Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
Financial Goals
• Profit maximization (profit after tax)
• Maximizing Earnings per Share
• Shareholder’s Wealth Maximization

36
Profit Maximization
Maximizing the Rupee Income of Firm
– Resources are efficiently utilized
– Appropriate measure of firm performance
– Serves interest of society also

37
Objections to Profit Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

38
Maximizing EPS
Ignores timing and risk of the expected
benefit
Market value is not a function of EPS. Hence
maximizing EPS will not result in highest
price for company's shares
Maximizing EPS implies that the firm should
make no dividend payment so long as
funds can be invested at positive rate of
return—such a policy may not always work

39
Shareholders’ Wealth
Maximization
Maximizes the net present value of a
course of action to shareholders.
Accounts for the timing and risk of the
expected benefits.
Benefits are measured in terms of cash
flows.
Fundamental objective—maximize the
market value of the firm’s shares.

40
Risk-return Trade-off
Risk and expected return move in tandem;
the greater the risk, the greater the
expected return.
Financial decisions of the firm are guided
by the risk-return trade-off.
The return and risk relationship:
Return = Risk-
free rate + Risk premium
Risk-free rate is a compensation for time
and risk premium for risk.

41
Managers Versus Shareholders’ Goals
A company has stakeholders such as employees, debt-
holders, consumers, suppliers, government and society.
Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of
managers’ role may compromise with the objective of SWM.
Managers may pursue their own personal goals at the cost
of shareholders, or may play safe and create satisfactory
wealth for shareholders than the maximum.
Managers may avoid taking high investment and financing
risks that may otherwise be needed to maximize
shareholders’ wealth. Such “satisfying” behaviour of
managers will frustrate the objective of SWM as a normative
guide.

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Financial Goals and Firm’s Mission
and Objectives
Firms’ primary objective is maximizing the welfare
of owners, but, in operational terms, they focus on
the satisfaction of its customers through the
production of goods and services needed by them
Firms state their vision, mission and values in broad terms
Wealth maximization is more appropriately a decision
criterion, rather than an objective or a goal.
Goals or objectives are missions or basic purposes of a
firm’s existence

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Financial Goals and Firm’s Mission and
Objectives
The shareholders’ wealth maximization is the
second-level criterion ensuring that the
decision meets the minimum standard of the
economic performance.
In the final decision-making, the judgement
of management plays the crucial role. The
wealth maximization criterion would simply
indicate whether an action is economically
viable or not.

What Will the Planning Process Accomplish?
Interactions
The plan must make explicit the linkages between
investment proposals and the firm’s financing choices.
Options
The plan provides an opportunity for the firm to weigh its
various options.
Feasibility- The different plans must fit into the overall
corporation objective of maximizing shareholder
wealth
Avoiding Surprises
One of the purpose of financial planning is to avoid surprise.

Strategic Planning
Strategic Planning relates to planning
in advance for a long period of time.
This facilitates predicting the future
and devising a course of action well
in advance.
It deals with future course of action
consistent with the business
environment changes.

Components of Strategic Planning
1. Vision- Organization visualizes what it would like to in
future
2. Mission- Deals with distinctive purpose which an
organization is striving for. It declares the main
concerns or priorities and principles of the business
firm.
3. Goals – They are concrete aims which enhance the
motivation of organization teams which prepare
themselves in specific aspects.
4. Objectives- intend to put forward in precise terms
what an organization wants to achieve, where it
wants to be in future, what are the tasks that needs
to be achieved in short spans of time.

Process of Strategic Planning
1.Visualizing ideal future
2.Identifying critical success factors
3.Analyzing the present status of the company both
internal and external
4.Identifying core areas and core competencies and
opportunities available in the environment
5.Focusing on core areas and devising strategy
accordingly
6.Designing of long-range plan
7.Implementing plans and transition management
8.Reviewing and redesigning and updating and checking
discrepancies
9.Achieving desired outcomes

Benefits of Strategic Planning
1. Development and articulation of the vision into
mission
2. Standardization and innovation in the dimensions get
included for the analysis for decision making
3. More acceptance throughout the organization and
from stakeholders
4. Results into a more tolerant, enduring and dynamic
organization
5. Opportunities in external environment can be tapped
6. Identifies competitive position and enables
competitive advantage through growth and sustenance

Benefits of Strategic Planning
7. Cross functional approach integrates the systems for
implementation
8. Flow of vision and its orientation to all levels and
departments in an organization
9. Well-directed inputs to reduce wastage are
encouraged
10. Facilities prioritization and utilization of resources
11.Empowerment leads to commitment and contribution
of ideas at all levels
12. The broad view of strategic level is transferred to
narrower levels of the organization

Financial Planning Model:
The Ingredients
1. Sales forecast
2. Pro forma statements
3. Asset requirements
4. Financial requirements
5. Plug
6. Economic assumptions

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1. Sales Forecast
 All financial plans require a sales
forecast.
 Perfect foreknowledge is impossible
since sales depend on the uncertain future
state of the economy.
 Businesses that specialize in
macroeconomic and industry projects can
be help in estimating sales.

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2. Pro Forma Statements
 The financial plan will have a forecast
balance sheet, a forecast income
statement, and a forecast sources-and-
uses-of-cash statement.
 These are called pro forma statements
or pro formas.

3-54
3. Asset Requirements
 The financial plan will describe
projected capital spending.
 In addition it will the discuss the
proposed uses of net working capital.

3-55
4. Financial Requirements
 The plan will include a section on
financing arrangements.
 Dividend policy and capital structure
policy should be addressed.
 If new funds are to be raised, the plan
should consider what kinds of securities
must be sold and what methods of
issuance are most appropriate.

3-56
5. Plug
 Compatibility across various growth targets will
usually require adjustment in a third variable.
 Suppose a financial planner assumes that
sales, costs, and net income will rise at g1. Further,
suppose that the planner desires assets and
liabilities to grow at a different rate, g2. These two
rates may be incompatible unless a third variable is
adjusted.
For example, compatibility may only be reached if
outstanding stock grows at a third rate, g3.
 Compatibility across various growth targets will
usually require adjustment in a third variable.
 Suppose a financial planner assumes that
sales, costs, and net income will rise at g1. Further,
suppose that the planner desires assets and
liabilities to grow at a different rate, g2. These two
rates may be incompatible unless a third variable is
adjusted.
For example, compatibility may only be reached if
outstanding stock grows at a third rate, g3.

3-57
6. Economic Assumptions
The plan must explicitly state the
economic environment in which the firm
expects to reside over the life of the
plan.
Interest rate forecasts are part of the
plan.
The plan must explicitly state the
economic environment in which the firm
expects to reside over the life of the
plan.
Interest rate forecasts are part of the
plan.

Matt H. Evans, matt@exinfm.com
Strategic Planning Model

9S Model of SFM
Nine S Model combines the quantitative and
qualitative skills of a strategist.
1.Sanctity
2.Selectivity
3.System
4.Strategic Cost Management
5.Sensitivity
6.Sustainability
7.Superiority
8.Structural Flexibility

9S Model of SFM
1. Sanctity refers to the ‘ethical economics’ of
business. This approach offers a long-term,
sustainable ‘brand-equity’ to the enterprise
which ultimately reduces every cost at every
stage of a product life cycle.
2. Selectivity refers to the most appropriate
business choices based on an enterprise's
core competence. SFM should concentrate on
building up a most flexible core competence
together with strategic cost mangement.

9S Model of SFM
3. System- emphasizes the need for a supportive
mechanism to make ‘SFM’ a continued success. It
refers to the technological, accounting, information
and operational systems of an enterprise.
4. Strategic Cost Management- is the micro-level
strategic analysis of various cost-structure and cost
implications. Some of costing methods are; Activity
Based Costing (or Objective Based Costing), Life
Cycle Costing, Notional Cost Benefit Analysis, Cost
analysis for establishing the validity of a certain
value-chain of an enterprise, etc.

9S Model of SFM
5.Sensitivity- It is to know the strategic use of
every piece of information. It convert
technical data into commercial data.
Sensitivity depends on the capacity to
transform ‘x’ information into ‘y’ in minimum
possible amount of cost and time.
6. Sustainability- of performance is a matter of
long-term strategic planning. Strategic plan
requires a very careful combination of ‘business
strategy ‘ and ‘business funding strategy’. It also
means ‘managing new competitors’ with extra
cost on sustenance’.

9S Model of SFM
7. Superiority- refers to the position of
‘Leadership’ that an enterprise must attain in the
market. SFM should aim at maintaining both
positions in the same market and little
paradoxical.
8. Structural Flexibility- It is the sum total of the
qualitative and quantitative adaptability and
adjustability of an organization. Sunk cost,
Committed cost, Engineered cost, Capacity
Costa, Burden costs and corrective cost could be
huge if structural flexibility is absent.

9S Model of SFM
9. Soul Searching- It is based on continuous
bench marking and requires a tremendous
amount of financial alertness, innovation and
total exposure to new variables and parameters.
It also refers to establishing new heights of
achievement and newer core-competences.
The 9 references of SFM ultimately aim for,
‘Wealth Maximization through the
accelerating Effect’.

Strategic planning
Strategic planning is an organization's
process of defining its strategy, or
direction, and making decisions on
allocating its resources to pursue this
strategy, including its capital and
people.

Strategic planning
Various business analysis techniques can be
used in strategic planning, including SWOT
analysis (Strengths, Weaknesses,
Opportunities, and Threats ), PEST analysis
(Political, Economic, Social, and
Technological), STEER analysis (Socio-
cultural, Technological, Economic,
Ecological, and Regulatory factors), and
EPISTEL (Environment, Political, Informatic,
Social, Technological, Economic and Legal).

Characteristics of Strategic planning
Successful Strategic planning constitutes the following
features. It should:
1. Exhibit impacts in daily routine
2. Facilitate dynamic, forward and backward thinking
process
3. Counters repetitive patterns of mistakes, especially
human tendencies
4. Remain clear and simple
5. Ensure planning is complete only when it is properly
implemented
6. Designate a core planning team with a level of
autonomy
7. Constitute collective leadership and involvement of key
stakeholders in decision making

Vision Goals
Components of
Strategic planning or
Strategic Intent
Mission Objectives

Vision
A Vision statement outlines what the
organization wants to be, or how it
wants the world in which it operates to
be. It concentrates on the future. It is a
source of inspiration. It provides clear
decision-making criteria.
Every organization visualizes what it would
like to be in future.
Vision describes a wishful long-term desire of
the company with out mentioning the steps or
plans to be used in order to set the target.

Mission
Mission: Defines the fundamental
purpose of an organization or an
enterprise, describing why it exists and
what it does to achieve its Vision.
Mission deals with a distinctive Purpose
which a organization is striving for. A
well defined mission statement declares
the main concerns or priorities and
principles of the business firm

Objectives
Objectives intend to put forward in
precise terms what an organization
wants to achieve where it wants to be in
future, what are the tasks that needs to
be achieved in short spans of time to
achieve the future objectives and goals.

Goals
Goals are the concrete aims or targets
which enhance the motivation of the
organizational teams which prepare
themselves in specific aspects.
Goals provide the benefit of breaking
down or fragmenting the broader
mission into more concert and clear
tasks that are understandable, and
responsibilities are allocated to
individuals and teams in the
organization.

Financial Objectives and
Goals
Goal: The Financial Goal of the firm
should be shareholder’s wealth
maximization, as reflected in the market
value of the firm’s share.
Firms’ primary objective is maximizing the
welfare of owners, but, in operational terms,
they focus on the satisfaction of its
customers through the production of goods
and services needed by them

1-77
The term objective is used to in the sense of a
goal or decision criteria for the three decisions
involved in financial management
The goal of the financial manager is to maximise
the owners/shareholders wealth as reflected in
share prices rather than profit/EPS maximisation
because the latter ignores the timing of returns,
does not directly consider cash flows and
ignores risk.
As key determinants of share price, both return and risk
must be assessed by the financial manager when
evaluating decision alternatives. The EVA is a popular
measure to determine whether an investment positively
contributes to the owners wealth.

1-78
However, the wealth maximizing action of
the finance managers should be
consistent with the preservation of the
wealth of stakeholders, that is, groups
such as employees, customers, suppliers,
creditors, owners and others who have a
direct link to the firm.

79
Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
Financial Goals
• Profit maximization (profit after tax)
• Maximizing Earnings per Share
• Shareholder’s Wealth Maximization

Start-Up Costs
A new business venture, even those started by existing
companies, has start-up costs. An existing manufacturer
looking to release a new line of product has costs that may
include new fabricating equipment, new packaging and a
marketing plan. Include your start-up costs in your financial
strategy.
Competitive Analysis
Your competition affects how you make money and how you
spend money. The products and marketing activities of your
competition should be included in your financial strategy. An
analysis of how the competition will affect revenue needs to
be included in your planning.

85
Objections to Profit Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

86
Maximizing EPS
Ignores timing and risk of the expected
benefit
Market value is not a function of EPS. Hence
maximizing EPS will not result in highest
price for company's shares
Maximizing EPS implies that the firm should
make no dividend payment so long as
funds can be invested at positive rate of
return—such a policy may not always work

87
Shareholders’ Wealth
Maximization
Maximizes the net present value of a
course of action to shareholders.
Accounts for the timing and risk of the
expected benefits.
Benefits are measured in terms of cash
flows.
Fundamental objective—maximize the
market value of the firm’s shares.

88
Risk-return Trade-off
Risk and expected return move in tandem;
the greater the risk, the greater the
expected return.
Financial decisions of the firm are guided
by the risk-return trade-off.
The return and risk relationship:
Return = Risk-
free rate + Risk premium
Risk-free rate is a compensation for time
and risk premium for risk.

89
Managers Versus Shareholders’ Goals
A company has stakeholders such as employees, debt-
holders, consumers, suppliers, government and society.
Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of
managers’ role may compromise with the objective of SWM.
Managers may pursue their own personal goals at the cost
of shareholders, or may play safe and create satisfactory
wealth for shareholders than the maximum.
Managers may avoid taking high investment and financing
risks that may otherwise be needed to maximize
shareholders’ wealth. Such “satisfying” behaviour of
managers will frustrate the objective of SWM as a normative
guide.

90
Financial Goals and Firm’s Mission
and Objectives
Firms’ primary objective is maximizing the welfare
of owners, but, in operational terms, they focus on
the satisfaction of its customers through the
production of goods and services needed by them
Firms state their vision, mission and values in broad terms
Wealth maximization is more appropriately a decision
criterion, rather than an objective or a goal.
Goals or objectives are missions or basic purposes of a
firm’s existence

91
Financial Goals and Firm’s Mission and
Objectives
The shareholders’ wealth maximization is the
second-level criterion ensuring that the
decision meets the minimum standard of the
economic performance.
In the final decision-making, the judgement
of management plays the crucial role. The
wealth maximization criterion would simply
indicate whether an action is economically
viable or not.

Costs and Benefits
Financial executives do financial cost benefit
analysis. IRR is a method of cost analysis in
certain cases and Economic Rate of Return
(ERR) should replace the IRR for adequate and
rational appraisal of the same project in both
the economy.
Indicative Cost –Benefit-Analysis may be
useful for highly subjective decisions or
judgments.
The indicative or relative significance of
various variables deciding the ultimate
outcome of the decision making process can
be used for approximate cost benefit analysis.

Costs and Benefits
Ongoing business processes require a
quick ‘incremental Cost-Benefit analysis’ for
quick conclusions.
As long as incremental profit exceeds
incremental costs, the project is worth
while.
Sustainable Net incremental Benefit is very
often a strategic decision. It also require a
lot of strategic analysis based on a long-
tem appraisal of the uncertainty involved.

Costs and Benefits
The long term project will have to be
assessed with an average Cost Benefit
Analysis (CBA) for the project’s life cycle.
CBA with strategic perspective is of vital
significance.
Multi-product or multi-locational enterprises
always makes use of CBA in totality.
LIFE CYCLE COASTING (LCC) is
commonly used of the ‘life-cycle strategy
formulations of a project.

LIFE CYCLE COASTING (LCC)
LCC involve the analysis of the following
cost:
1.Cost of Launching
2.Cost of early corrections
3.Cost of take of
4.Cost of consolidation
5.Cost of leadership
6.Cost of Sustainance
7.Cost of Revival
8. Cost of withdrawal from market

97
RISK AND UNCERTAINTY
There are two types of expectations
individuals may have about the future-
– Certainty, and
– uncertainty
Risk describes a situation where there is not just
one possible outcome, but an array of potential
returns. Also there are various probabilities for
each of the probable returns.
Risk refers to a set of unique outcomes for a given
event which can be assigned probabilities while
uncertainty refers to the outcomes of a given event
which are too unsecure to be assigned probabilities.

12 - 98
Risk and Uncertainty
Risk refers to the variability in the actual
returns vis-à-vis the estimated returns, in
terms of cash flows.
Risk is an integral part of investment
decision. The uncertainty related with the
returns from an investment brings risk
into an investment.
The possibility of variation of actual
return from the expected return is known
as risk.

12 - 99
Definition of Risk
Risk may be defined as “ the chance of
future loss that can be foreseen”
Risk is the potential for variability in
return.
Risk involved in capital budgeting can be
measured in absolute as well as relative
terms. The absolute measures of risk
include sensitivity analysis, simulation
and standard deviation. The coefficient
of variation is a relative measure of risk.

100
Nature of Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts.
In formal terms, the risk associated with an
investment may be defined as the variability
that is likely to occur in the future returns from
the investment.
Three broad categories of the events influencing
the investment forecasts:
– General economic conditions
– Industry factors
– Company factors

101
Types of Risk
Risk
1. Business Risk
a) Internal Business Risk
b) External Business Risk
2. Financial Risk
Unsystematic Risk
1. Interest Rate Risk
2. Market Risk
3. Purchasing Power Risk
4. Exchange Rate Risk
Systematic Risk

12 - 102
Types of Risk
It is classified into mainly two types.
1. Systematic Risk
2. Unsystematic Risk
Systematic Risk is the risk which is directly related
with overall movement in general market or
economy. This type of risk covers factors which are
external to a particular company and are
uncontrollable by the company.
Unsystematic Risk refers to variability in returns
caused by unique factors relating to that firm or
industry like management failure, labor strikes, and
shortage of raw material. There are two source of
unsystematic or unique risk –business risk and
financial risk.

12 - 103
Unsystematic Risk
1. Business Risk
2. Financial Risk
1. Business Risk is the variability in operating income due
operating conditions of the company. This can be divided
into two types
a. Internal Business Risk
Factors affecting Internal Business
Risk are:
Fluctuation in Sale
Research and development
Personnel management
Fixed cost
Single product
b. External Business Risk
Result of operating conditions
imposed on the firm circumstances
beyond its control.
Social and regulatory factors
Political Risk
Business cycle

12 - 104
Unsystematic Risk
2. Financial Risk
It refers to the variability in return due to
capital structure.
The use of debt with owned funds to increase the return of
shareholders is known as financial leverage.
If the earnings are low, it may lead to bankruptcy to equity
shareholders.
Financial risk considers the difference between EBIT and
EBT
Business risk causes the variation between revenue and
EBIT.
Financial risk can be avoided by management by reducing
borrowed funds

12 - 105
Risk refers to situation in which the
decision maker knows the possible
consequences of an investment decision
whereas Uncertainty involves a situation
about which the likelihood of possible
outcome is not known.
Risk is the consequence of making
wrong decision and due to this, the
decision that is made is uncertain.
The bigger the risk, the greater the
uncertainty.

12 - 106
Types of Uncertainty
Uncertainty can be classified into the following
categories.
1.Market Uncertainty- caused by factors which are
external to the economy.
2.Technical Uncertainty- caused by technical
factors like size of production or change in
technology
3.Competitive Uncertainty- due to action of
competitors
4.Technological Uncertainty- non availability of
technology
5.Political Uncertainty- Due to Unstable political
system

12 - 107
Source of Uncertainty
1.Information incomplete
2.Reliability of source of Information
3.Variability- Parameters which change over time
4.Linguistic imprecision- People using imprecise terms and
expression in communication
Causes or Reasons of Risk and Uncertainty
1. Nature of investment
2. Maturity period
3. Amount of investment
4. Bias in data and its
assessment
5. Misinterpretation of data
6. Non-availability of
managerial talents
7. Method of investment
8. Nature of Business
9. Terms of lending
10. Wrong timing of investment
11. Nature of calamities (disasters)
12. Wrong investment decision
13. Creditworthiness of issuer
14. Obsolescence
15. Salvage ability of
investment

12 - 108
Investment Decision Under
Types of Investment Decision
1.Certainty (No Risk)-The estimated returns are equal
to the actual return
2.Uncertainty- An uncertain situation in one when
probabilities of occurrence of a particular event are
not known. In the case of uncertainty, future loss
cannot be foreseen. So, it cannot be planned in
advance by management
3.Risk- A risky situation is one in which the
probabilities of a particular event’s occurrence are
known. In the case of risk, chance of future loss can
be foreseen due to past experiences.

12 - 109
TECHNIQUES OF INVESTMENT DECISIONS
Investment decision techniques refer to the
choice by several decision makers of possible
outcomes and probabilities of their
occurrence under risk and uncertainty.
An investment decision always involve a
trade-off between risk and return.
Assessing risk and incorporating the same in
the final decision is an integral part of
financial analysis.

12 - 110
TECHNIQUES OF INVESTMENT DECISIONS
The main techniques of decision making
under the conditions of risk and uncertainty:
1.Risk-adjusted discount rate
2.Certainty equivalent method or approach
3.Statistical Methods
a) Standard deviation method
b) Coefficient of variation method
c) Sensitivity analysis
d) Simulation method
e) Probability and expected value method
f) Decision Tree analysis

12 - 111
Risk Adjusted Discount Rate
In this approach a risk premium is added to
the risk free discount rate. Risk adjusted
discount rate is than used to calculate net
present value in the normal manner.
Drawbacks of risk-adjusted discount rate
method : Risk-adjusted discount rate
method relies on accurate assessment of
the riskiness of a project. Risk perception
and judgment are subjective and
susceptible to personal bias.

112
Risk-Adjusted Discount Rate
Risk-adjusted discount rate, will
allow for both time preference
and risk preference and will be a
sum of the risk-free rate and the
risk-premium rate reflecting the
investor’s attitude towards risk.
Under CAPM, the risk-premium
is the difference between the
market rate of return and the
risk-free rate multiplied by the
beta of the project.
=0
NCF
NPV =
(1 )
n
t
t
t k+
∑
f rk = k + k

12 - 113
Risk Adjusted Discount Rate (RADR)
A project is required to invest Rs. 1,10,000 and is expected to generate
cash flows after tax over its economic life of 5 years of Rs. 20,000, Rs.
30,000, Rs. 35000, Rs. 55,000 and Rs. 10,000. Risk free interest rate is 7%,
and risk premium 3%. Calculate NPV using RADR method.
RADR=Risk free rate + risk premium=7+3=10%
Years CFAT
Discount Factor
(10%) PV
1 20000 0.909 18181.82
2 30000 0.826 24793.39
3 35000 0.751 26296.02
4 55000 0.683 37565.74
5 10000 0.621 6209.21
Total Present Value of Cash Inflow 113046.18
110000.00
3046.18
Cash Out Flow
NPV

114
Evaluation of Risk-adjusted Discount Rate
The following are the advantages of risk-adjusted discount
rate method:
– It is simple and can be easily understood.
– It has a great deal of intuitive appeal for risk-averse businessman.
– It incorporates an attitude (risk-aversion) towards uncertainty.
This approach, however, suffers from the following
limitations:
– There is no easy way of deriving a risk-adjusted discount rate. As
discussed earlier, CAPM provides for a basis of calculating the
risk-adjusted discount rate. Its use has yet to pick up in practice.
– It does not make any risk adjustment in the numerator for the cash
flows that are forecast over the future years.
– It is based on the assumption that investors are risk-averse.
Though it is generally true, there exists a category of risk seekers
who do not demand premium for assuming risks; they are willing
to pay a premium to take risks.

115
Certainty Equivalent
Certainty-equivalent is a common procedure for dealing with
risk in capital budgeting to reduce the forecast the cash flows
to some conservative levels.
There is a certainty-equivalent cash flow for all projects.
Certainty-equivalent approach may be expressed as:
Where NCF= the forecasts of net cash flow with out risk-
adjustment
α= the risk adjustment factor or certainty equivalent coefficient
k- risk free rate assumed to be constant for all period
=0
NCF
NPV =
(1 )f
n
t t
t
t k
α
+
∑

116 Financial Management, Ninth
Edition © I M Pandey
Certainty-equivalent coefficient α assumes a value between 0
and 1
If the investor feels that only 80% of expected cash flow is
certain, the Certainty-equivalent coefficient will be .80
Certainty-equivalent coefficient can be determined as a
relationship between the certain cash flows and risky cash
flows. That is
If expected cash flow is 80,000 and certain cash flow is 60,000
the
Certainty-equivalent coefficient α= 60,000/80,000=0.75
*
NCF Certain net cash flow
=
NCF Risky net cash flow
t
t
t
α =

117
Reduce the forecasts of cash
flows to some conservative
levels.
The certainty—equivalent
coefficient assumes a value
between 0 and 1, and varies
inversely with risk.
Decision-maker subjectively or
objectively establishes the
coefficients.
The certainty—equivalent
coefficient can be determined as
a relationship between the
certain cash flows and the risky
cash flows.
=0
NCF
NPV =
(1 )f
n
t t
t
t k
α
+
∑
*
NCF Certain net cash flow
=
NCF Risky net cash flow
t
t
t
α =

118
Sky Way Ltd. is considering an investment proposal which
requires 20 lakhs. The expected cash inflow and certainty
coefficients are given below: Risk Free interest rate is 6%.
Determine NPV of proposal
Year Cash Inflow
Certainty
Coefficient
1 600000 0.90
2 300000 0.85
3 700000 0.80
4 800000 0.75
5 900000 0.65

119
Certainty Equivalent (NPV)
Sky Way Ltd. is considering an investment proposal which
requires 20 lakhs. The expected cash inflow and certainty
coefficients are given below: Risk Free interest rate is 6%.
Determine NPV of proposal
Year
Cash
Inflow
Certainty
Coefficient
Certain Cash
In Flow
Discount
Factor (6%)
Present
Value
1 600000 0.90 540000 0.94 509433.96
2 300000 0.85 255000 0.89 226949.09
3 700000 0.80 560000 0.84 470186.80
4 800000 0.75 600000 0.79 475256.20
5 900000 0.65 585000 0.75 437146.03
2118972.08
2000000.00
118972.08
Present Value of Cash Inflow
Present Value of Cash Outflow
Net Present Value

120
Certainty Equivalent (IRR)
A company is considering an investment proposal
whose cost is Rs. 10000 and its economic life is 4
years. Expected cash flow and certainty factor is given.
Determine IRR.
Year Cash Inflow
Certainty
Coefficient
1 6667 0.90
2 2500 0.80
3 2000 0.50
4 12500 0.40

121
Certainty Equivalent (IRR)
(10841-10000) 841
IRR=12+ ------------------- x 2= 12 + ----- x 2
(11274-10841) 432.92
=12+3.886=15.886%
Year Cash Inflow
Certainty
Coefficient
Certain
Cash In Flow
D.F
(10%) P V
D.F
(12%) P V
1 6667 0.90 6000 0.909 5454.82 0.893 5357.41
2 2500 0.80 2000 0.826 1652.89 0.797 1594.39
3 2000 0.50 1000 0.751 751.31 0.712 711.78
4 12500 0.40 5000 0.683 3415.07 0.636 3177.59
11274.09 10841.17Present Value of Cash Inflow

122
Evaluation of Certainty—Equivalent
This method suffers from many dangers in a
large enterprise:
– First, the forecaster, expecting the reduction that
will be made in his forecasts, may inflate them in
anticipation.
– Second, if forecasts have to pass through several
layers of management, the effect may be to greatly
exaggerate the original forecast or to make it ultra-
conservative.
– Third, by focusing explicit attention only on the
gloomy outcomes, chances are increased for
passing by some good investments.

123 Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
Risk-adjusted Discount Rate Vs. Certainty–
Equivalent
The certainty—equivalent approach recognises risk in
capital budgeting analysis by adjusting estimated cash
flows and employs risk-free rate to discount the
adjusted cash flows. On the other hand, the risk-
adjusted discount rate adjusts for risk by adjusting the
discount rate. It has been suggested that the certainty
—equivalent approach is theoretically a superior
technique.
The risk-adjusted discount rate approach will yield the
same result as the certainty—equivalent approach if
the risk-free rate is constant and the risk-adjusted
discount rate is the same for all future periods.

© Tata McGraw-Hill Publishing Company Limited, Financial Management
12 - 124
Statistical Methods
Statistical techniques are analytical tools for
handling risky investments. This enable the
decision-maker to make decisions under risk or
uncertainty.
The concept of probability is fundamental to the
use of the risk analysis techniques.
Probability may be described as a measure of
someone’s opinion about the likelihood that an
event will occur .
Most commonly used method is to use high,
low and best guess estimates

12 - 125
Measurement of Risk
Statistical Methods
a) Standard deviation method
b) Coefficient of variation method
c) Sensitivity analysis
d) Simulation method
e) Probability and expected value method
f) Decision Tree analysis

© Tata McGraw-Hill Publishing Company Limited, Financial Management 12 - 126
Measurement of Risk
Risk involved in capital budgeting can be
measured in absolute as well as relative terms.
The absolute measures of risk include
Sensitivity analysis,
Simulation, and
standard deviation.
The coefficient of variation is a relative measure
of risk.

Sensitivity Analysis
Sensitivity analysis provides information as to
how sensitive the various estimated project
parameters, namely selling price, cash flows, cost
of capital, unit sold, and project’s economic life
about estimation errors. Sensitivity analysis is
essentially a ‘what if’ analysis.
For example what if labor costs are 5% lower?
What if raw material double its price?, etc.
By carrying out a series of calculations it is
possible to build up a picture of the nature of
the risks facing the project and their impact on
project profitability.

Advantageous of Sensitivity analysis:
Information for decision making
To direct search – sensitivity analysis points to some
variables being more crucial than others
To make contingency plans –managers can make
contingency plans if the key parameters differ significantly
from the estimates
Drawbacks of Sensitivity analysis:
The absence of any formal assignment of probabilities
to the variations of the parameters is a potential
limitation of sensitivity analysis
Another criticism of sensitivity analysis is that each
variable is changed in isolation while all other factors
remain constant. In practice factors change
simultaneously

Sensitivity analysis provide information about
cash flows normally made under three
assumptions:
1) The most pessimistic – the worst
2) The most likely – the expected
3) The most optimistic- the best
the outcomes associated with the project

12 - 130
Example 1 From the under mentioned facts, compute the net present values
(NPVs) of the two projects for each of the possible cash flows, using
sensitivity analysis.
Particulars Project X Project Y
(’000) (’000)
Initial cash outlays (t = 0) Rs 40 Rs 40
Cash inflow estimates (t = 1 – 15)
Worst 6 0
Most-likely 8 8
Best 10 16
Required rate of return 0.10 0.10
Economic life (years) 15 15
Solution
The NPV of each project, assuming a 10 per cent required rate of return, can
be calculated for each of the possible cash flows. Table A-4 indicates that
the present value interest factor annuity (PVIFA) of Re 1 for 15 years at 10
per cent discount is 7.606. Multiplying each possible cash flow by Present
Value Interest Factor Annuity (PVIFA), we get, (Table 1):

© Tata McGraw-Hill Publishing Company Limited,
Financial Management 12 - 131
Table 1: Determination of NPV
Project X Project Y
Expected
cash inflows
PV NPV PV NPV
Worst
Most likely
Best
Rs 45,636
60,848
76,060
Rs 5,636
20,848
36,060
Nil
Rs 60, 848
1,21,696
(Rs 40,000)
20,848
81,696
Table 1 demonstrates that sensitivity analysis can produce some very useful
information about projects that appear equally desirable on the basis of the
most likely estimates of their cash flows. Project X is less risky than
Project Y. The actual selection of the project (assuming that the projects are
mutually exclusive) will depend on the decision maker’s attitude towards
risk. If the decision maker is conservative, he will select Project X as there
is no possibility of suffering losses. On the other hand, if he is willing to
take risks, he will choose Project Y as it has the possibility of paying a very
high return as compared to project X. Sensitivity analysis, in spite of being
crude, does provide the decision maker with more than one estimate of the
project’s outcome and, thus, an insight into the variability of the returns.

Assigning Probability
It has been shown above that sensitivity analysis provides more than one
estimate of the future return of a project. It is, therefore, superior to single-
figure forecast as it gives a more precise idea regarding the variability of the
returns. But it has a limitation in that it does not disclose the chances of
occurrence of these variations. To remedy this shortcoming of sensitivity
analysis so as to provide a more accurate forecast, the probability of the
occurring variations should also be given. Probability assignment to expected
cash flows, therefore, would provide a more precise measure of the variability
of cash flows. The concept of probability is helpful as it indicates the
percentage chance of occurrence of each possible cash flow.
For instance, if some expected cash flow has 0.6 probability of occurrence, it
means that the given cash flow is likely to be obtained in 6 out of 10 times (i.e.
60 per cent). Likewise, if a cash flow has a probability of 1, it is certain to
occur (as in the case of purchase–lease capital budgeting decision that is, the
chances of its occurrence are 100 per cent). With zero probability, the cash
flow estimate will never materialise. Thus, probability of obtaining particular
cash flow estimates would be between zero and one.

12 - 133
The procedure for assigning probabilities and determining the expected
value is illustrated in Table 2 by using the NPVs for projects X and Y of
Example 1.
TABLE 2 Calculation of Expected Values
Possible NPV Probability of the
NPV occurrence
NPV (×)
Probability
Project X
Rs 5,636 0.25 Rs 1,409
20,848 0.50 10,424
36,060 0.25 9,015
1.00 Expected NPV 20,848
Project Y
(40,000) 0.25 (10,000)
20,848 0.50 10,424
81,696 0.25 20,424
1.00 Expected NPV 20,848
The mechanism for calculating the expected monetary value and the NPV of
these estimates is further illustrated in Example 2.

Example 2
The following information is available regarding the expected cash flows generated,
and their probability for company X. What is the expected return on the project?
Assuming 10 per cent as the discount rate, find out the present values of the
expected monetary values.
Year 1 Year 2 Year 3
Cash flows Probability Cash flows Probability Cash flows Probability
Rs 3,000
6,000
8,000
0.25
0.50
0.25
Rs 3,000
6,000
8,000
0.50
0.25
0.25
Rs 3,000
6,000
8,000
0.25
0.25
0.50
Solution
TABLE 3 (i) Calculation of Expected Monetary Values
Cash
flows
Proba
bility
Monetar
y values
Cash
flows
Probab
ility
values
Monetar
y
Cash
flows
Proba
bility
values
Monet
ary
Rs 3,000
6,000
8,000
Total
0.25
0.50
0.25
Rs 750
3,000
2,000
5,750
Rs 3,000
6,000
8,000
0.50
0.25
0.25
Rs 1,500
1,500
2,000
5,000
Rs 3,000
6,000
8,000
0.25
0.25
0.50
Rs
750
1,500
4,000
6,250

(ii) Calculation of Present Values
Year 1 Rs 5,750 × 0.909 = Rs 5,226.75
Year 2 5,000 × 0.826 4,130.00
Year 3 6,250 × 0.751 4,693.75
Total 14,050.50

Sensitivity analysis
Sensitivity analysis can also be used to
ascertain how change in key variables (say,
sales volume, sales price, variable costs,
operating fixed costs, cost of capital and so
on) affect the expected outcome (measured
in terms of NPV) of the proposed
investment project.
For the purpose of analysis, only one
variable is considered, holding the effect of
other variables constant, at a point of time.

Example 6.1
Acmart plc has developed a new product line called Marts. The likely demand is
1,00,000 per year at a price of Rs. 1 for the 4 year period.
Cash Flows of Mart
Initial Investment Rs. 800,000
Cash Flow per unit Rs.
Sale Price 1.00
Costs
Labour
Material
Overhead
Cash Flow Per unit
0.20
0.40
0.10
0.70
0.30
Required rate of return is 15%
Solution
Annual Cash Flow =.30x1,00,000=Rs. 300,000
Present Value of annual cash flows=300,000xannuity factor for 4 years @ 15%
=300,000x2.855 =856,500 -
Initial Investment =800,000
Net Present Value =+56,500

What if the price is only 95 ps
Annual Cash flow= .25x1,00,000=Rs. 250,000
Present Value of annual cash flows=250,000x2.855 =713,750-
Net Present Value =-86,250
What if the price rose by 1%
What if the quantity demanded is 5% more
Present Value of annual cash flows=315,000x2.855 =899.325-
What if the quantity demanded is 10% less than expected
Annual Cash flow= .30x 90,000=Rs. 270,000
Net Present Value =-29,150

What if discount rate is 20% more than what is originally expected ( 15*1.2=18%)
Present Value of annual cash flows=300,000xannuity factor for 4 years @ 18%
=300,000x2.6901 =807,030 -
Net Present Value =+ 7,030
What if discount rate is 20% lower than what is originally expected ( 15*.8=13.5%)
Present Value of annual cash flows=300,000xannuity factor for 4 years @ 13.5%
=300,000x2.9438 =883,140 -
Net Present Value =+ 83,140

Break-Even NPV
The Break-Even point is where NPV is zero. If the NPV is
below zero the project is rejected, if it is above zero, it is
accepted

Scenario Analysis
With Sensitivity Analysis we change one variable at a time
and look at the result.
Managers are often interested in situation where a number
of factors change.
They are interested in worst-case and best-case scenario.
That is, what NPV will result if all the assumptions made
initially turned out to be too optimistic? And what would be
the result if, in the event, matters went extremely well on all
fronts.

Simulation
Simulation is a statistically based behavioral
approach used in capital budgeting to get a feel
for risk by applying predetermined probability
distributions and random numbers to estimate
risky outcomes.
A Simulation Model is akin (similar) to sensitivity analysis
as it attempts to answer ‘what if’ question.
Advantage of simulation is that it is more comprehensive.
Instead of showing impact on NPV for change in one key
variable, simulation enables the distribution of probable
values for change in all key variables.
Simulation requires sophisticated computing

143
Simulation Analysis
• The Monte Carlo simulation or simply the simulation
analysis considers the interactions among variables and
probabilities of the change in variables. It computes the
probability distribution of NPV. The simulation analysis
involves the following steps:
– First, you should identify variables that influence cash inflows and
outflows.
– Second, specify the formulae that relate variables.
– Third, indicate the probability distribution for each variable.
– Fourth, develop a computer programme that randomly selects one
value from the probability distribution of each variable and uses
these values to calculate the project’s NPV.

144
Techniques for Risk Analysis
• Statistical Techniques for Risk Analysis
–Probability
–Variance or Standard Deviation
–Coefficient of Variation
• Conventional Techniques of Risk Analysis
–Payback
–Risk-adjusted discount rate
–Certainty equivalent

© Tata McGraw-Hill Publishing Company Limited, Financial Management
12 - 145
Statistical Methods
Statistical techniques are analytical tools for
handling risky investments. This enable the
decision-maker to make decisions under risk or
uncertainty.
The concept of probability is fundamental to the
use of the risk analysis techniques.
Probability may be described as a measure of
someone’s opinion about the likelihood that an
event will occur .
Most commonly used method is to use high,
low and best guess estimates

Probability
• A typical forecast is single figure for a period. This is
referred to as “best estimate” or “most likely” forecast:
– Firstly, we do not know the chances of this
figure actually occurring, i.e., the uncertainty
surrounding this figure.
– Secondly, the meaning of best estimates or
most likely is not very clear. It is not known
whether it is mean, median or mode.
• For these reasons, a forecaster should not give just
one estimate, but a range of associated probability–a
probability distribution.
• Probability may be described as a measure of
someone’s opinion about the likelihood that an event
will occur.

Assigning Probability
• The probability estimate, which is based on a
very large number of observations, is known as
an objective probability.
• Such probability assignments that reflect the
state of belief of a person rather than the
objective evidence of a large number of trials
are called personal or subjective
probabilities.

148
Expected Net Present Value
• Once the probability
assignments have been
made to the future cash
flows the next step is to
find out the expected net
present value.
• Expected net present value
= Sum of present values of
expected net cash flows.
=0
ENPV =
(1 )
n
t
t
ENCF
k+
∑
ENCF = NCF ×t jt jtP

149
Variance or Standard Deviation
• Simply stated,
variance measures
the deviation about
expected cash flow
of each of the
possible cash flows.
• Standard deviation
is the square root of
variance.
• Absolute Measure
of Risk.
2 2
=1
(NCF) = (NCF – ENCF)
n
j j
j
Pσ ∑

Independent Cash Flows Over Time The mathematical
formulation to determine the expected values of the
probability distribution of NPV for any project is:
The above calculations of the standard deviation and the
NPV will produce significant volume of information for
evaluating the risk of the investment proposal. The
calculations are illustrated in Example 6.

12 - 151
Example 6
Suppose there is a project which involves initial cost of Rs 20,000 (cost
at t = 0). It is expected to generate net cash flows during the first 3
years with the probability as shown in Table 7.
TABLE 7 Expected Cash Flows
Probability Net cash
flows
flows
flows
0.10 Rs 6,000 0.10 Rs 4,000 0.10 Rs 2,000
0.25 8,000 0.25 6,000 0.25 4,000
0.30 10,000 0.30 8,000 0.30 6,000
0.25 12,000 0.25 10,000 0.25 8,000
0.10 14,000 0.10 12,000 0.10 10,000

12 - 152
Solution
Table 8 Calculation of Expected Values of Each Period
Time
period
Probability
(1)
Net cash flow
(2)
Expected value (1 × 2)
(3)
Year 1
Year 2
Year 3
0.10
0.25
0.30
0.25
0.10
0.10
0.25
0.30
0.25
0.10
0.10
0.25
0.30
0.25
0.10
Rs 6,000
8,000
10,000
12,000
14,000
4,000
6,000
8,000
10,000
12,000
2,000
4,000
6,000
8,000
10,000
Rs 600
2,000
3,000
3,000
1,400
= 10,000
400
1,500
2,400
2,500
1,200
= 8,000
200
1,000
1,800
2,000
1,000
= 6,000
(3) NPV = Rs 10,000 (0.909) + Rs 8,000 (0.826) + Rs 6,000 (0.751) – Rs
20,000 = Rs 204.

12 - 153
Solution
1 . Expected Values: For the calculation of standard deviation for
different periods, the expected values are to be calculated first. These
are calculated in Table 8.

154
Coefficient of Variation
Relative Measure of Risk
It is defined as the standard deviation of the
probability distribution divided by its
expected value:
Coefficient of Variation (CV)=
Standard deviation/Expected Value

155
Coefficient of Variation
• The coefficient of variation is a useful
measure of risk when we are comparing
the projects which have
– (i) same standard deviations but different expected
values, or
– (ii) different standard deviations but same
expected values, or
– (iii) different standard deviations and different
expected values.

156
Scenario Analysis
• One way to examine the risk of
investment is to analyse the impact of
alternative combinations of variables,
called scenarios, on the project’s NPV
(or IRR).
• The decision-maker can develop some
plausible scenarios for this purpose. For
instance, we can consider three
scenarios: pessimistic, optimistic and
expected.

Shortcomings
• The model becomes quite complex to
use.
• It does not indicate whether or not the
project should be accepted.
• Simulation analysis, like sensitivity or
scenario analysis, considers the risk of
any project in isolation of other projects.

158
Capital Asset Pricing Model
CAPM deals with how the assets or securities should be
priced in capital market. CAPM attempts to understand
the behavioural aspects of the capital markets. It is a
conservative but balanced approach.
It provides theoretical linear relationship between risk
return trade-offs of individual securities/assets to market
returns.
CAPM relates returns on individual stock and stock
market returns over a period of time.

Capital Asset Pricing Model
• Risky asset i:
• Its price is such that:
E(return) = Risk-free rate of return + Risk premium specific to asset i
= Rf + (Market price of risk)x(quantity of risk of asset i)
CAPM tells us 1) what is the price of risk?
2) what is the risk of asset i?

11-160
CAPITAL ASSET PRICING MODEL (CAPM)
APPROACH
The CAPM describes the relationship between the required rate of return or
the cost of equity capital and the non-diversifiable or relevant risk of the
firm as reflected in its index of non-diversifiable risk, that is, beta.
Symbolically,
Ke = Rf + b (Km – Rf ) (14)
Rf = Required rate of return on risk-free investment
b = Beta coefficient**, and
Km = Required rate of return on market portfolio, that is, the average
rate or
return on all assets
M = Excess in market return over risk-free rate,
J = Excess in security returns over risk-free rate,
MJ = Cross product of M and J and
N = Number of years
( )∑
∑
−
−
= 22
MNM
JMNMJ
b

Introduction
• 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.

Financial Management, Ninth Edition © I M Pandey
Motives and Benefits of Mergers and
Acquisitions
 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.

163Financial Management, Ninth Edition © I M Pandey
Benefits of Mergers and
Acquisitions
 The most common advantages of M&A
are:
 Accelerated Growth
 Enhanced Profitability
 Economies of scale
 Operating economies
 Synergy
 Diversification of Risk

Acquisitions
 Reduction in Tax Liability
 Financial Benefits
 Financing constraint
 Surplus cash
 Debt capacity
 Financing cost
 Increased Market Power

Costs of Mergers and
Acquisitions External growth could be expensive if the
company pays an excessive price for merger.
Price may be carefully determined and
negotiated so that merger enhances the value of
shareholders.

166
9-166
A Cost to Stockholders from Reduction in
Risk
In a firm with debt, the gains are likely to
be shared by both bondholders, and stock
holders. The benefit gained by bond
holders are on the expense of stock
holders.
The gains to the creditors are at the expense
of the shareholders if the total value of the firm
does not change.
An acquisition can create an appearance of
earnings growth, which may fool investors into
thinking that the firm is worth than it really is.

9-167
A Cost to Stockholders from
Reduction in Risk
 The Base Case
 If two all-equity firms merge, there is no transfer of
synergies to bondholders, but if…
 One Firm has Debt
 The value of the levered shareholder’s call option
falls.
 How Can Shareholders Reduce their Losses from
the Coinsurance Effect?
 Retire debt pre-merger.

AcquisitionsThe most common advantages of M&A are:
 Accelerated Growth
A company can achieve its growth objective by:
 Expanding its existing markets
 Entering into new markets
Mergers results into accelerated growth
 Enhanced Profitability
Combination of two or more companies may result in more
than the average profitability due to cost reduction and
efficient utilization of resources. This may happen
because of the following reasons:
 Economies of scale
 Operating economies
 Synergy

AcquisitionsEconomies of scale
Economics of scale arises when increase in the volume of production
leads to the decrease in cost of production per unit. Mergers may
help to expand volume of production without a corresponding
increase in fixed cost. It also helps in
 Optimum utilization of management resources and systems and
planning
 Budgeting
 Reporting and control
Operating economies
A combine firm may avoid or reduce overlapping functions and
facilities
It can consolidate functions such as manufacturing, marketing, R&D
and reduce operating costs
Vertical integration (backward integration or forward integration) leads
to better business operations- purchasing, manufacturing, and
marketing.

AcquisitionsSynergy
Synergy implies a situation where the combined firm is
more valuable than the sum of the individual combining
firms. Operating economics are one form of synergy
benefit. There is also
 enhanced managerial capabilities,
 Creativity,
 Innovativeness
 R&D and market coverage capacity

Acquisitions Diversification of Risk
Diversification implies growth through the combination
of firms in unrelated businesses. Such mergers are
called conglomerate mergers. Such mergers results in
reduction in non- systematic risks –company related
risks with out taking any efforts by the investors to
diversify their portfolio.
 Reduction in Tax –liability
A company is allowed to carry forward their accumulated
loss. The combined company can make use of this carry
forward facility of the loss of loss making company after
merger.

Acquisitions Financial Benefits
A merger may help in :
 Eliminating the financial constraint
 Deploying surplus cash
 Enhancing dept capacity
 Lowering the financial cost
 Increased Market Power
 A merger can increase the market share of the merged
firm that will improve the profitability
 The bargaining power vis-a-vis labour, suppliers, and
buyers is also increased
 Exploit technological advantage

Corporate Restructuring
Corporate restructuring implies activities related to
expansion/ contraction of a firm’s operations or
changes in its assets or financial or ownership
structure.
The most common forms of corporate restructuring are
mergers/amalgamations and acquisitions/takeovers,
financial restructuring, divestitures/demergers and
buyouts.

FORMS OF EXPANSION
 Internal Expansion
Gradual increase in the activities of the concern –
expand production capacity by adding m/c etc.
 External Expansion or Business Combinations
Two or more companies combine and expand their
business activities. The ownership and control of the
combining concerns may be undertaken by single
agency.

FORMS OF COMBINATIONS
Merger or Amalgamation
A merger is a combination of two or more
companies into one company. It may be in the
form of one or more companies being merged into
an existing company or a new company may be
formed to merge two or more existing companies.
 Absorption
A combination of two or more companies into an
existing company is known as absorption.
 Consolidation
A consolidation is a combination of two or
more companies into a new company.

Acquisition and Take-over
Acquiring company takes over the ownership of
one or more other companies and combine their
operations. The control over management of
another company can be acquired through either
a ‘friendly take-over’ or through ‘forced’ or
‘unwilling acquisition’.
Holding Companies
A holding company is a form of business
organization which is created for the purpose of
combining industrial units by owning a controlling
amount of their share capital.
FORMS OF COMBINATIONS ..

Acquisition
A transaction where one firm buys another firm
with the intent of more effectively using a core
competence by making the acquired firm a
subsidiary within its portfolio of businesses

Takeover vs. Acquisitions
Takeover – The term takeover is understood
to connote hostility. When an acquisition is a
‘forced’ or ‘unwilling’ acquisition, it is called a
takeover.
A 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.

Takeover vs. Acquisitions
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.

Types of Business
CombinationMerger or Amalgamation
– Merger or amalgamation may take two forms:
• Absorption is a combination of two or more
companies into an existing company.
• Consolidation is a combination of two or more
companies into a new company.
– 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.

Types of Business
CombinationForms of Merger:
–Horizontal merger - Combination of two
or more firms in similar type of
production, distribution, or area of
business
–Vertical merger - Combination of two or
more firms involved in different stages
of production or distribution.
–Conglomerate merger - Combination of
firms engaged in unrelated lines of
business activity.

Mergers and Takeovers
When two companies join to form one
new firm, it can be:
voluntary, also known as a ‘merger’
or
forced, when it is known
as a ‘takeover’

Merger
A transaction where two firms agree to integrate
their operations on a relatively coequal basis so
they have resources and capabilities that
together may create a stronger competitive
advantage
Merger activity is an example of ‘integration’
taking place within industries.

Mergers
While a merger is a combination of two or more firms
in which the resulting firm maintains the identity of one
of the firms only, an amalgamation involves the
combination of two or more firms to form a new firm. In
the case of merger/absorption, the firm that has been
acquired/absorbed is known as the target firm and the
firm that acquires is known as the acquiring firm. There
are three types of mergers:
1) Horizontal,
2) Vertical and
3) Conglomerate.

Horizontal merger is a merger when two or
more firms dealing in similar lines of activity
combine together.
Vertical merger is a merger that involves two
or more stages of production/distribution that
are usually separate.
Conglomerate merger is a merger in which
firms engaged in different unrelated activities
combine together.

Why Integrate?
Firms are sometimes keen to
merge when:
 they can make savings from being bigger
 this is known as gaining ‘economies
of scale’
 they can compete with larger firms
or eliminate competition
 they can spread production over
a larger range of products or services

Economics of Merger
The major economic advantages of a merger are:
1) Economies of scale,
2) Synergy,
3) Fast growth,
4) Tax benefits and
5) Diversification.
Synergy takes place as the combined value of the merged firm is
likely to be greater than the sum of individual business entities.
The combined value = value of acquiring firm, VA + value of target
firm, Vt + value of synergy, ΔVAT. (1)
In ascertaining the gains from the merger, costs associated with
acquisition should be taken into account. Therefore, the net gain
from the merger is equal to the difference between the value of
synergy and costs:
Net gain = ΔVAT – costs (2)

Economies of Scale
There are several types of economy
of scale:
 technical economies, when producing the good by
using expensive machinery intensively
 managerial economies,
by employing specialist managers
 financial economies, by borrowing
at lower rates of interest
 commercial economies,
by buying materials in bulk
 marketing economies, spreading the cost of
advertising
and promotion
 research and development economies, from
developing better products

Economies of Scale
There are sometimes problems
that can affect integrated firms. These are
known
as ‘diseconomies of scale’
 firms are too big
to operate effectively
 decisions take too long to make
 poor communication occurs

Mergers, Acquisition and Takeovers
The two terms - ‘mergers’ and ‘acquisition’
represent the ways by strategies used by
companies to buy, sell and recombine
businesses. In the present day when there exists
cut throat competition in every sphere, not all
mergers and acquisitions are consensual and
peaceful.
The concept of takeovers without consent have,
therefore been ideally termed “hostile takeovers”.
no consented.

Legal and Regulatory Framework for
Takeovers in India
The term “acquirer” means any person
who, directly or indirectly, acquires or
agrees to acquire control over the target
company, or acquires or agrees to acquire
control over the target company, either by
himself or with any person acting in
concert with the acquirer

Tender Offer and Hostile
Takeover
 A tender offer is a formal offer to purchase a
given number of a company’s shares at a
specific price.
 Tender offer can be used in two situations.
 First, the acquiring company may directly
approach the target company for its takeover. If
the target company does not agree, then the
acquiring company may directly approach the
shareholders by means of a tender offer.
 Second, the tender offer may be used without any
negotiations, and it may be tantamount to a
hostile takeover.

Permission for merger
Information to the stock exchange
Approval of board of directors
Application in the High Court
Shareholders’ and creditors’ meetings
Sanction by the High Court
Filing of the Court order
Transfer of assets and liabilities
Payment by cash or securities
Legal Procedures for merger

1. Permission for merger
Two or more companies can amalgamate only when
amalgamation is permitted under their memorandum of
association. Also, the acquiring company should have
the permission in its object clause to carry on the
business of the acquired company.
2. Information to the stock exchange
The acquiring and the acquired companies should inform
the stock exchanges where they are listed about the
merger
3. Approval of board of directors
The board of directors of the individual companies should
approve the draft proposal for amalgamation and
authorize the management of companies to further
persue the proposal.
Legal Procedures for merger

Legal Procedures for merger ..
4. Application in the High Court
An application for approving the draft amalgamation
proposal duly approved by the boards of directors of the
individual companies should be made to the high court.
High court would convene a meeting of the shareholders
and creditors to approve the amalgamation proposal.
5. Shareholders’ and creditors’ meetings
At least 75% of shareholders and creditors in separate
meeting, voting in person or by proxy, must accord their
approval to the scheme
6. Sanction by the High Court
After the approval of shareholders and the creditors, on
the petitions of the companies, the High court will pass
order sanctioning the amalgamation scheme after it is
satisfied that the scheme is fair and reasonable.

Legal Procedures for merger ..
7. Filing of the Court order
After the court order, its certified true copies will be filed
with the Registrar of companies.
8. Transfer of assets and liabilities
The assets and liabilities of the acquired company will be
transferred to the acquiring company in accordance
with the approved scheme, with effect from the specified
date
9. Payment by cash or securities
As per the proposal, the acquiring company will
exchange shares and debentures and/or pay cash for the
shares and debentures of the acquired company. These
securities will be listed on the stock exchange.

Accounting for Mergers and
Acquisitions
Pooling of Interests Method
 In the pooling of interests method of accounting, the
balance sheet items and the profit and loss items of the
merged firms are combined without recording the effects
of merger. This implies that asset, liabilities and other
items of the acquiring and the acquired firms are simply
added at the book values without making any
adjustments.
Purchase Method
 Under the purchase method, the assets and liabilities of
the acquiring firm after the acquisition of the target firm
may be stated at their exiting carrying amounts or at the
amounts adjusted for the purchase price paid to the
target company.

Takeovers in India
The term “acquirer” means any person who,
directly or indirectly, acquires or agrees to
acquire control over the target company,
either by himself or with any person acting in
concert with the acquirer.

The Takeover Code makes it difficult for the hostile
acquirer to just sneak up on the target company. It
forewarns the company about the advances of an
acquirer by mandating that the acquirer make a
public disclosure of his shareholding or voting rights
to the company if he acquires shares or voting
rights beyond a certain specified limit.
The Takeover Code also imposes a prohibition on the certain
actions of a target company during the offer period, such as
transferring of assets or entering into material contracts and
even prohibits the issue of any authorized but unissued
securities during the offer period. However, these actions
may be taken with approval from the general body of
shareholders.
Takeovers in India

Takeovers in India
The regulation provides for certain exceptions such as
the right of the company to issue shares carrying
voting rights upon conversion of debentures already
issued or upon exercise of option against warrants,
according to pre-determined terms of conversion or
exercise of option. It also allows the target company to
issue shares pursuant to public or rights issue in
respect of which the offer document has already been
filed with the Registrar of Companies or stock
exchanges, as the case may be.
Further the law does not permit the Board of Director, of the
target company to make such issues without the shareholders
approval either prior to the offer period or during the offer period
as it is specifically prohibited under Regulation 23.

Takeovers in India
The Takeover Code is required to be read with the
SEBI (Disclosure & Investor Protection) Guidelines,
which are the nodal regulations for the methods and
terms of issue of shares/warrants by a listed Indian
company.
Under the DIP guidelines, issuing shares at a
discount and warrants which convert to shares at a
discount is not possible as the minimum issue price
is determined with reference to the market price of
the shares on the date of issue or upon the date of
exercise of the option against the warrants.

Takeovers in India
Also, the FDI policy and the FEMA Regulations
have provisions which restrict non-residents from
acquiring listed shares of a company directly from
the open market in any sector, including sectors
falling under automatic route. There also exist
certain restrictions with respect to private acquisition
of shares by non-residents. This has practically
sealed any hostile takeover of any Indian company
by any non-resident

Reasons for strategic failures of
merger/acquisition
1. The strategy is misguided- Strategic plans which turned out
to be value destroying rather creating
2. Over optimism - Acquiring managers have to cope with
uncertainty about the future potential of their acquisition. It
is possible for them to be over optimistic about the market
economics, the competitive position and the operating
synergies available
3. Failure of Integration Management- One problem is the over-
rigid adherence to prepared integration plans. Usually the
plans require dynamic modification in the light of experience
and altered circumstances. The integration programme
may have been based on incomplete information and may
need post-merger adaptation to the new perception of
reality.

Reasons for strategic failures of
merger/acquisition
Most common causes of failure Most common causes of success
Target management attitudes
and cultural difference
Little of no post-acquisition
planning
Lack of knowledge of industry
or target
Poor management and poor
management practices in the
acquired company
Little or no experience of
acquisitions
Detailed post-acquisition
plans and speed of
implementation
A clear purpose for
making acquisitions
Good cultural fit
High degree of
management co-opertion
In-depth knowledge of the
acquiree and his industry

Reasons for failures of
merger/acquisition
There are several reasons merger or an acquisition failures. Some
of the prominent causes are summarized below:
 If a merger or acquisition is planned depending on the (bullish) conditions
prevailing in the stock market, it may be risky.
There are times when a merger or an acquisition may be effected for the
purpose of "seeking glory," rather than viewing it as a corporate strategy to
fulfill the needs of the company.
Regardless of the organizational goal, these top level executives are more
interested in satisfying their "executive ego."
Failure may also occur if a merger takes place as a defensive measure to
neutralize the adverse effects of globalization and a dynamic corporate
environment.
Failures may result if the two unifying companies embrace different
"corporate cultures.“
The primary issue to focus on is how realistic the goals of the prospective
merger are

207
Financing a Merger
Cash or exchange of shares or combination of
cash, shares and debt can finance a merger
or acquisition.
The means of financing may change the debt-
equity mix of the combined or acquired firm
after merger.

208
Financing a Merger
Cash Offer:
A cash offer is a straightforward means of financing a merger.
The share holders of the target company get cash for selling
their shares to the acquiring company.
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
of the acquiring company between its existing shareholders and
new shareholders (that is, shareholders of the acquired
company). The earnings and benefits would also be shared
between these two groups of shareholders. 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.

Swap Ratio
The ratio in which an acquiring company will offer its own
shares in exchange for the target company's shares during a
merger or acquisition. To calculate the swap ratio, companies
analyze financial ratios such as book value, earnings per
share, profits after tax and dividends paid, as well as other
factors, such as the reasons for the merger or acquisition.
For example, if a company offers a swap ratio of 1:1.5, it will provide one
share of its own company for every 1.5 shares of the company being
acquired.
This can also be applied as a debt/equity swap, when a company wants
investors to trade their bonds with the company being acquired for the
acquiring company's own shares.

Swap Ratio
Example: SFC would be offering 18.34 crore share for
25 crore outstanding shares of Excell, which means
0.734 share of SFC for one share of Excell or
Swap ratio of 0.734:1.

Share Exchange Ratio
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
Share price of the acquired firm
Share exchange ratio
Share price of the acquiring firm
b
a
P
P
= =

Swap Ratio
Example: If the share price of acquired firm is 24.00 and
that of acquiring firm is 96.00, the Share Exchange Ratio
(SER) is calculated as:
SER= 24.0/96.0 = 0.25
If the pre-merger number of shares of acquired firm is
4,000, then
Share price of the acquired firm
Share exchange ratio
Share price of the acquiring firm
b
a
P
P
= =
No. of shares exchanged SER Pre-merger number of shares of the acquired firm
( / ) 0.25 4,000 1,000b a bP P N
= ×
= = × =
PAT PATPost-merger combined PAT
Post-merger combined EPS =
Post-merger combined shares (SER)
a b
a bN N
+
=
+

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).
PAT PAT
PAT PAT
a b
w a b
c c
g g g= × + ×

Corporate restructuring is the process of
redesigning one or more aspects of a company. The
process of reorganizing a company may be
implemented due to a number of different factors,
such as positioning the company to be more
competitive, survive a currently adverse economic
climate, or poise the corporation to move in an
entirely new direction.
Restructuring a corporate entity is often a necessity
when the company has grown to the point that the
original structure can no longer efficiently manage the
output and general interests of the company.

For example, a corporate restructuring may call for
spinning off some departments into subsidiaries as a
means of creating a more effective management model
as well as taking advantage of tax breaks that would
allow the corporation to divert more revenue to the
production process.
In general, the idea of corporate restructuring is to allow
the company to continue functioning in some manner.

Financial Restructuring
Financial restructuring may take place in response to a
drop in sales, due to a sluggish economy or temporary
concerns about the economy in general.
When this happens, the corporation may need to
reorder finances as a means of keeping the company
operational through this rough time. Costs may be cut
by combining divisions or departments, reassigning
responsibilities and eliminating personnel, or scaling
back production at various facilities owned by the
company.
With this type of corporate restructuring, the focus is on
survival in a difficult market rather than on expanding
the company to meet growing consumer demand.

Distress Restructuring
Distress Restructuring is used to indicate the
corporate turnaround from severe financial distress
through methods such as Debt/Equity
Restructuring, Working Capital Management and
corporate Valuation.
Distress causes due to illiquidity due to poor
structuring or working capital at various levels (vix
work-in-progress, bills receivables etc.) of business.
Such companies must undertake restructuring
strategies (incentives for early payment, delaying in
payments to creditors etc.) and activities to come
out of this situation.

Financial Distress
Financial distress arises when a firm is not able
to meet its obligations (payment of interest and
principal) to debt-holders.
The firm’s continuous failure to make payments to
debt holders can ultimately lead to the insolvency of
the firm.
With higher business risk and higher debt, the
probability of financial distress become much
greater.
The degree of business risk of a firm depends on
the degree of operating leverage (the proportion of
fixed costs).

219
BUSINESS VALUTION
The term ‘valuation’ implies the estimated worth
of an asset or a security or a business. The
alternative approaches to value a firm/an asset
are:
 Book value,
 Market value,
 Intrinsic value,
 Liquidation value,
 Replacement value,
 Salvage value
 Value of Goodwill
 Fair value.

32 - 220
Book Value
The book value of an asset refers to the amount at
which an asset is shown in the balance sheet of a firm.
Generally, the sum is equal to the initial acquisition
cost of an asset less accumulated depreciation.
Accordingly, this mode of valuation of assets is as per
the going con-cern principle of accounting. In other
words, book value of an asset shown in balance does
not reflect its current sale value.
Book value of a business refers to total book value of
all valuable assets (excluding fictitious assets, such as
accumulated losses and deferred revenue
expenditures, like advertisement, preliminary
expenses, cost of issue of securities not written off)
less all external liabilities (including preference share
capital). It is also referred to as net worth.

Financial Management 25-221
Lease
Lease is a contractual arrangement under which
the owner of an asset (lessor) allows the use of
the asset to the user (lessee) for an agreed
period of time (lease period) in consideration for
the periodic payment (lease rent). At the end of
the lease period, the asset reverts back to the
owner, unless there is a provision for the
renewal of the lease contract.

© Tata McGraw-Hill Publishing Company Limited, Financial Management 25-222
Essential Elements
Parties to the Contract
There are essentially two parties to a contract of lease financing, namely,
the owner and the user, called the lessor and the lessee, respectively.
Lessor is the owner of the assets that are being leased.
Lessee is the receiver of the services of the assets under a lease contract.
Assets
The assets, property or equipment to be leased is the subject matter of a
lease financing contract. The asset may be an automobile, plant and
machinery, equipment, land and building, factory, a running business, an
aircraft and so on. The asset must, however, be of the lessee’s choice,
suitable for his business needs.
Ownership Separated from User
The essence of a lease financing contract is that during the lease tenure,
ownership of the asset vests with the lessor and its use is allowed to the
lessee. On the expiry of the lease tenure, the asset reverts to the lessor.

Term of Lease
The term of lease is the period for which the agreement of
lease remains in operation. Every lease should have a
definite period, otherwise it will be legally inoperative. The
lease period may sometimes stretch over the entire economic
life of the asset (i.e. financial lease) or a period shorter than
the useful life of the asset (i.e. operating lease). The lease
may be perpetual, that is, with an option at the end of lease
period to renew the lease for the further specific period.
Lease Rentals
The consideration that the lessee pays to the lessor for the
lease transaction is the lease rental. Lease rentals are
structured so as to compensate (in the form of depreciation)
the lessor for the investment made in the asset, and for
expenses like interest on the investment, repairs and
servicing charges borne by the lessor over the lease period.

Modes of Terminating the Lease :
At the end of the lease period, the lease is terminated and various
courses are possible, namely,.
a) The lease is renewed on a prepetual basis or for a definite
period, or
b) The asset reverts to the lessor, or
c) The asset reverts to the lessor and the lessor sells it to a
third party or
d) The lessor sells the asset to the lessee.
The parties may mutually agree to and choose any of the
aforesaid alternatives at the beginning of a lease term.

Classification
An equipment lease transaction can differ on the basis of
1) the extent to which the risks and rewards of ownership are
transferred,
2) number of parties to the transactions,
3) domiciles of the equipment manufacturer, the lessor, the lessee
and so on.
Risk, with reference to leasing, refers to the possibility of loss arising on
account of under-utilisation or technological obsolescence of the equipment,
while reward means the incremental net cash flows that are generated from
the usage of the equipment over its economic life and the realisation of the
anticipated residual value on expiry of the economic life. On the basis of
these variations, leasing can be classified into the following types:
Finance lease and Operating lease,
A. Sales and lease back and Direct lease,
B. Single investor lease and Leveraged lease and
C. Domestic lease and International lease.

(a) Finance Lease and Operating Lease
Finance Lease
According to the International Accounting
Standards (IAS-17), in a finance lease the lessor
transfers, substantially all the risks and rewards
incidental to the ownership of the asset to the
lessee, whether or not the title is eventually
transferred. It involves payment of rentals over
an obligatory non-cancellable lease period,
sufficient in total to amortise the capital outlay
of the lessor and leave some profit.

The IAS-17 stipulates that a substantial part of the ownership related risks and rewards
in leasing are transferred when
1) The ownership of the equipment is transferred to the
lessee by the end of the lease firm; or
2) The lessee has the option to purchase the asset at a price
that is expected to be sufficiently lower than the fair
market value at the date the option becomes exercisable
and if at the inception of the lease it is reasonably certain
that the option will be exercised; or
3) The lease term is for a major part of the useful life of the
asset; the title may not eventually be transferred. The
useful life of an asset refers to the minimum of its (i)
physical life in terms of the period for which it can
perform its function, (ii) technological life in the sense of
the period in which it does not become obsolete and (iii)
product market life defined as the period during which its
product enjoys a satisfactory market. The criterion/cut-off
point is that if the lease term exceeds 75 per cent of the
useful life of the equipment, it is a finance lease or

4. The present value of the minimum lease payment is
greater than, or substantially equal to, the fair
market value of the asset at the inception of the
lease (cost of equipment). The title may or may
not be eventually transferred.
The cut-off point is that the present value exceeds
90 per cent of the fair market value of the
equipment. The present value should be
computed by using a discount rate equal to the
rate implicit in the lease, in the case of the lessor,
and the incremental rate in the case of the lessee.

According to the Accounting Standard (AS)-19:
Risks include the possibility of losses from the idle
capacity or technological obsolescence and of variation
in return due to changing economic conditions. Rewards
may be represented by the expectation of profitable
operation over the economic life of the asset and of gain
from appreciation in the value of the residual value that
has been realised.
A lease is classified as a finance lease if it
transfers substantially all the risk and rewards
incidental to ownership. Title may or may not
eventually be transferred.

A finance lease is structured to include the following
features:
1)The lessee (the intending buyer) selects the equipment
according to his requirements, from its manufacturer or
distributor;
2)The lessee negotiates and settles with the manufacturer or
distributor, the price, the delivery schedule, installation,
terms of warranties, maintenance and payment and so on;
3)The lessor purchases the equipment either directly from
the manufacturer or distributor (under straight foward
leasing) or from the lessee, after the equipment is delivered
(under sale and lease back);
4)The lessor then leases out the equipment to the lessee. The
lessor retains the ownership while lessee is allowed to use
the equipment;
5)A finance lease may provide a right or option, to the lessee,
to purchase the equipment at a future date. However, this
practice is rarely found in India;

5. The lease period spreads over the expected economic
life of the asset. The lease is originally for a non-
cancellable period called the primary lease period during
which the lessor seeks to recover his investment
alongwith some profit. During this period, cancellation of
lease is possible only at a very heavy cost. Thereafter,
the lease is subject to renewal for the secondary lease
period, during which rentals are substantially low;
6. The lessee is entitled to exclusive and peaceful use of
the equipment during the entire lease period, provided he
pays the rentals and complies with the terms of the
lease;
7. As the equipment is chosen by the lessee, the
responsibility of its suitability, the risk of obsolescence
and the liability for repair, maintenance and insurance of
the equipment rest with the lessee.

Operating Lease
An operating lease is one that is not a finance
lease.
In a operating lease, the lessor does not transfer
all the risks and rewards incidental to the
ownership of the asset and the cost of the asset is
not fully amortised during the primary lease
period. The lessor provides services (other than
the financing of the purchase price) attached to
the leased asset, such as maintenance, repair and
technical advice.
For this reason, an operating lease is also called a
‘service lease’.

An operating lease is structured with the following features:
1) An operating lease is generally for a period significantly
shorter than the economic life of the leased asset. In
some cases, it may be even on an hourly, daily, weekly or
monthly basis. The lease is cancellable by either party
during the lease period.
2) Since the lease periods are shorter than the expected life
of the asset, the lease rentals are not sufficient to totally
amortise the cost of assets.
3) The lessor does not rely on the single lessee for recovery
of his investment. His ultimate interest is in the residual
value of the asset. The lessor bears the risk of
obsolescence, since the lessee is free to cancel the lease
at any time;
4) Operating leases normally include a maintenance clause
requiring the lessor to maintain the leased asset and
provide services such as insurance, support staff, fuel
and so on.

Examples of operating leases are:
a) Providing mobile cranes with operators;
b) Chartering of aircrafts and ships, including the
provision of crew, fuel and support services;
c) Hiring of computers with operators;
d) Hiring a taxi for a particular travel, which includes
service of the driver, provision for main-tenance, fuel,
immediate repairs and so on.

(b) Sale and Lease Back
Sale–Lease Back
Sale-lease back is a lease under which the
lessee sells an asset for cash to a prospective
lessor and then leases back the same asset,
making fixed periodic payments for its use.

Direct Lease
Direct lease is a lease under which a lessor
owns/acquires the assets that are leassed to a given
lessee. A direct lease can be of two types: bipartite and
tripartite lease.
Bipartite Lease
There are two parties in this lease transaction, namely,
1) the equipment supplier-cum-lessor and
2) the lessee. Such a lease is typically structured as an
operating lease with inbuilt facilities like upgradation
of the equipment (Upgrade lease), addition to the
original equipment configuration and so on.
Direct Lease

Tripartite Lease
Such a lease involves three different parties in the lease
agreement:
1) the equipment supplier,
2) the lessor and
3) the lessee. An innovative variant of the tripartite lease is the
sales-aid lease under which the equipment supplier arranges
for lease finance in various forms by:
 Providing reference about the customer to the leasing company;
 Negotiating the terms of the lease with the customer and
completing all the formalities on behalf of the leasing company;
 Writing the lease on his own account and discounting the lease
receivables with the designated leasing company. The effect is
that the leasing company owns the equipment and obtains an
assignment of the lease rental.

(c) Single Investor Lease and Leveraged
LeaseSingle Investor Lease
There are only two parties to this lease transaction: the lessor and
the lessee. The leasing company (lessor) funds the entire investment
by an appropriate mix of debt and equity funds. The debt raised by
the leasing company to finance the asset are without recourse to the
lessee, that is, in the case of default in servicing the debt by the
leasing company, the lender is not entitled to payment from the
lessee.
Leveraged Lease
There are three parties to the transaction: (i) the lessor (equity investor),
(ii) the lender and (iii) the lessee. In such a lease, the leasing company
(equity investor) buys the asset through substantial borrowing, with full
recourse to the lessee and any recourse to it. The lender (loan participant)
obtains an assignment of the lease and the rentals to be paid by the
lessee as well as first mortgage assets on the leased asset. The
transaction is routed through a trustee who looks after the interests of
the lender and lessor. On receipt of the rentals from the lessee, the
trustee remits the debt-service component of the rental to the loan
participant and the balance to the lessor.

To illustrate, assume the Hypothetical Ltd (HLL)
has structured a leveraged lease with an
investment cost of Rs 50 crore. The investment is
to be financed by equity from the company and
loan from the Hypothetical Bank Ltd (HBL) in the
ratio of 1:5. The interest on loan may be assumed
to be 20 per cent per annum, to be repaid in five
equated annual instalments. If the required rate
of return (gross yield) of the HLL is 24 per cent,
calculate (i) the equated annual instalment and
(ii) the annual lease rental.

(d) Domestic Lease and International
LeaseDomestic Lease
Domestic lease is a lease transaction if all parties to the agreement are
domiciled in the same country.
International Lease
International lease is a lease transaction if all parties to the agreement are
domiciled in different countries. This type of lease is further sub-classified
into (1) the import lease and (2) the cross-border lease.
Import Lease
In an import lease, the lessor and the lessee are domiciled in the same
country but the equipment supplier is located in a different country. The
lessor imports the asset and leases it to the lessee
Cross-Border Lease
When the lessor and the lessee are domiciled in different countries, the lease
is classified as cross-border lease. The domicile of the supplier is immaterial.

Significance
Advantage of Leasing: To the Lessee
Financing of Capital Goods
Lease financing enables the lessee to avail of finance for huge investments in
land, building, plant, machinery, heavy equipment, and so on, upto 100 per
cent, without requiring any immediate down payment.
Additional Sources of Finance
Leasing facilitates the acquisition of equipment, plant and machinery without
the necessary capital outlay and, thus, has a competitive advantage of
mobilising the scarce financial resources of a business enterprise. It
enhances the working capital position and makes available the internal
accruals for business operations.
Less Costly
Leasing as a method of financing is less costly than other alternatives
available.
Ownership Preserved
Leasing provides finance without diluting the ownership or control of the
promoters.

Flexibility in Structuring of Rentals
Some of the ways to structure lease rentals are illustrated below.
The following data relate to the Hypothetical Leasing Ltd:
(1) Investment outlay/cost, Rs 100 lakh
(2) Pre-tax required rate of return, 20 per cent per annum
(3) Primary lease period, 5 years
(4) Residual value (after primary period), Nil
(5) Assumptions regarding alternative rental structures:
(A) Equated/Level
(B) Stepped (15 per cent increase per annum),
(C) Ballooned (annual rental of Rs 10 lakh for years, 1–4),
(D) Deferred (deferment period of 2 years)
The annual lease rentals under the above four alternatives are computed below
Avoids Conditionalities
Lease finance is considered preferable to institutional finance as in the former
case there are no strings attached. Lease financing is beneficial since it is free
from restrictive covenants and conditionalities, such as representation on the
board, conversion of debt into equity, payment of dividend and so on, which
usually accompany institutional finance and term loans from banks.

(A) Equated Annual Lease Rental (Y):
Y = Y PVIFA [at 20 per cent for 5 years (20,5) = Rs 100 lakh×
= (Rs 100 lakh / 2.991) = Rs 33.43 lakh
(B) Stepped Lease Rental (assuming 15 per cent increase annually):
Y = Y PVIF (20,1) + (1.15)Y PVIF (20,2) + (1.15)× × 2
Y PVIF (20,3) +×
(1.5)3
Y PVIF (20,4) + (1.5)× 4
Y PVIF (20,5) = Rs 100 lakh×
= 8.33Y + 0.798Y (0.694 1.15Y) + 0.764Y (0.579 1.32Y) + 0.733Y× ×
(0.482 1.52Y) + 0.703Y (0.402 1.75Y)× ×
= (0.482 1.52 Y) + 0.703 (0.402 1.75 Y) = 3.833Y = Rs 100 lakh× ×
Y = Rs 26.10 lakh, where Y denotes the annual rental in year 1.
The lease rentals in different years over the lease term will be: Year 2,
Rs.30.02 lakh; Year 3, Rs 34.52 lakh; Year 4, Rs 39.70 lakh; an Year 5, Rs
45.65 lakh.

C) Ballooned Leased Rental (Rs 10 lakh for years 1–4):
Y = [10 × PVIFA (20,4) + Y × PVIF (20,5)] = Rs 100 lakh
Y = Rs 100 lakh – Rs 25.9 lakh
or Y = (Rs 74.10 lakh ÷ 0.402) = Rs 184.33 lakh, where Y
denotes
the ballooned payment in year 5.
(D) Deferred Lease Rental (deferment of 2 years):
Denoting Y as the equated annual rental to be charged between
years 3-5,
Y = Y × PVIF (20,3) + Y × PVIF (20,4) + Y × PVIF (20,5) =
Rs 100 lakh
1.463 Y = Rs 100 lakh
Y = Rs 68.35 lakh

Simplicity
A lease finance arrangement is simple to negotiate and free
from cumbersome procedures with faster and simple
documentation
Tax Benefits
By suitable structuring of lease rentals, a lot of tax advantage
can be derived
Obsolescence Risk is Averted
In a lease arrangement, the lessor, being the owner, bears the
risk of obsolescence and the lessee is always free to replace
the asset with the latest technology.

To the Lessor
Full Security The lessor’s interest is fully secured since he is always
the owner of the leased asset and can take repossession of the asset
if the lessee defaults.
Tax Benefit The greatest advantage of the lessor is the tax relief by
way of depreciation.
High Profitability The leasing business is highly profitable since the
rate of return is more than what the lessor pays on his borrowings.
Trading on Equity The lessor usually carrys out his operations with
greater financial leverage. That is, he has a very low equity capital and
use a substantial amount of borrowed funds and deposits. Thus, the
ultimate return on equity is very high.
High Growth Potential The leasing industry has a high growth
potential. Lease financing enables the lessees to acquire equipment
and machinery even during a period of depression, since they do not
have to invest any capital. Leasing, thus, maintains the economic
growth even during a recessionary period.

Limitations of Leasing
Restrictions on Use of Equipment A lease arrangement may impose
certain restrictions on use of the equipment, acquiring compulsory
insurance and so on.
Limitations of Financial Lease A financial lease may entail a higher
payout obligation if the equipment is not found to be useful and the
lessee opts for premature termination of the lease agreement.
Loss of Residual Value The lessee never becomes the owner of the
leased asset. Thus, he is deprived of the residual value of the asset
and is not even entitled to any improvements done by the lessee or
caused by inflation or otherwise, such as appreciation in value of
leasehold land.

Consequence of Default If the lessee defaults in complying with any
terms and conditions of the lease contract, the lessor may terminate
the lease and take over the possession of the leased asset.
Understatement of Lessee’s Asset Since the leased asset does not
form part of the lessee’s assets, there is an effective understatement
of his assets, which may sometimes lead to gross underestimation
of the lessee.
Double Sales Tax With the amendment of the sales tax law of
various States, a lease financing transaction may be charged sales
tax twice—once when the lessor purchases the equipment and again
when it is leased to the lessee.

Financial Evaluation of Leaseing
The process of financial appraisal in a lease
transaction generally involves three steps:
1) appraisal of the client, in terms of his financial
strength and credit worthiness;
2) evaluation of the security/collateral security
offered and
3) financial evaluation of the proposal. The most
critical part of a leasing transaction, both to the
lessor and the lessee, is the financial evaluation of
the proposal.

Lessee’s Perspective
Finance lease can be evaluated from the point of view of both the lessee and the
lessor. From the perspective of the lessee, leasing should be evaluated as a
financing alternative to borrow and buy. The decision-criterion requires
comparison of the present value (PV) of cash outflows after taxes under the
leasing option vis-á-vis borrowing-buy alternative. The alternative with the lower
PV should be selected.
The Net Advantage of Leasing (NAL) approach is the alternate approach to
evaluate finance lease. The benefits from leasing are compared with cost of
leasing.
The benefits from leasing are:
1) Investment cost of asset (saved),
2) Plus PV of tax shield on lease payment, discounted by kc and
3) Plus PV of tax shield on management fee, discounted by kc.
The cost of leasing are:
1) Present value of lease rentals, discounted by kd,
2) Plus management fee,
3) Plus PV of depreciation shield foregone, discounted by kc,
4) Plus PV of salvage value of asset, discounted by kc and
5) Plus PV of interest shield, discounted by kc.
In case NAL is positive (benefits > costs), leasing alternative is preferred.

Equationally NPV(L)/NAL
=Investment cost
Less: Present value of lease payments (discounted by Kd)
Plus: Present value of tax shield on lease payments (discounted by Kc)
Less: Management fee
Plus: Present value of tax shield on management fee (discounted by Kc)
Minus: Present value of depreciation (tax) shield (discounted by Kc)
Minus: Present value of (tax) shield on interest (discounted by Kc)
Minus: Present value of residual/salvage value (discounted by Kc)
where Kc = Post-tax marginal cost of capital
Kd = Pre-tax cost of long-term debt
If the NAL/NPV(L) is positive, the leasing alternative should be used, otherwise
the borrowing alternative would be preferable.

Example 1
XYZ Ltd is in the business of manufacturing steel utensils. The firm is
planning to diversify and add a new product line. The firm either can buy
the required machinery or get it on lease.
The machine can be purchased for Rs 15,00,000. It is expected to have a
useful life of 5 years with a salvage value of Rs 1,00,000 after the expiry of
5 years. The purchase can be financed by 20 per cent loan repayable in 5
equal annual instalments (inclusive of interest) becoming due at the end of
each year. Alternatively, the machine can be taken on year-end lease
rentals of Rs 4,50,000 for 5 years. Advise the company on the option it
should choose. For your exercise, you may assume the following:
(1) The machine will constitute a separate block for depreciation
purposes. The company follows written down value method of
depreciation, the rate of depreciation being 25 per cent.
(2) Tax rate is 35 per cent and cost of capital is 20 per cent.
(3) Lease rentals are to be paid at the end of the year.
(4) Maintenance expenses estimated at Rs 30,000 per year are to be borne
by the lessee.

PV of Cash Outflows Under Leasing Alternative
Year-end Lease rent after taxes [R(1 – t)]
[Rs 4,50,000 (1 – 0.35)]
PVIFA at 13%
[20% (1 –
0.35)]
Total PV
1–5 Rs 2,92,500 3.517 Rs 10,28,723
Borrowing/Buying Option:
Equivalent annual loan instalment = Rs 15,00,000/2.991 (PVIFA for 5 years at
20% i.e., 20,5) = Rs 5,01,505.

PV of Cash Outflows Under Buying Alternative
Year
-end
Loan
intsalment
Tax advantage on Net cash
outflows
col. 2 –(col. 3
+ 4)
PVIF at
13%
Total
PV
Interest
(I × 0.35)
Depreciation
(D × 0.35)
1 2 3 4 5 6 7
1 Rs 5,01,505 Rs 1,05,000 Rs 1,31,250 Rs 2,65,255 0.885 Rs 2,34,751
2 5,01,505 90,895 98,437 3,12,173 0.783 2,44,431
3 5,01,505 73,968 73,828 3,53,709 0.693 2,45,120
4 5,01,505 53,656 55,371 3,92,478 0.613 2,40,589
5 5,01,505 29,114 41,528 4,30,863 0.543 2,33,959
11,98,850
Less: PV of salvage value (Rs 1,00,000 × 0.543) 54,300
Less: PV of tax savings on short-term capital loss
(Rs 3,55,958 – Rs 1,00,000) × 0.35 = (Rs 89,585 × 0.543) 48,645 ________________
Total 10,95,905
Recommendation
The company is advised to go for leasing as the PV of cash outflows under the leasing
option is lower than under the buy/borrowing alternative.

Working notes
Schedule of Debt Payment
Year-
end
Loan
intsalment
Loan at the
beginning of
the year
Payments Loan outstanding at
the end of the year
(col. 3 – col. 5)
Interest
(col. 3 ×
0.20)
Principal
repayment
1 2 3 4 5 6
1 Rs 5,01,505 Rs 15,00,000 Rs 3,00,000 Rs 2,01,505 Rs 12,98,495
2 5,01,505 12,98,495 2,59,699 2,41,806 10,56,689
3 5,01,505 10,56,689 2,11,338 2,90,167 7,66,522
4 5,01,505 7,66,522 1,53,304 3,48,201 4,18,321
5 5,01,505 4,18,321 83,184* 4,18,321 —
*Difference between the loan instalment and loan outstanding.
Schedule of Depreciation
Year Depreciation Balance at the end of the year
1
2
3
4
5
Rs 15,00,000 × 0.25 = Rs 3,75,000
11,25,000 × 0.25 = 2,81,250
8,43,750 × 0.25 = 2,10,937
6,32,813 × 0.25 = 1,58,203
4,74,610 × 0.25 = 1,18,652
Rs 11,25,000
8,43,750
6,32,813
4,74,610
3,55,958

(Annual Lease Rentals)
Example 2
The following details relate to an investment proposal of the Hypothetical
Industries Ltd (HIL):
 Investment outlay, Rs 180 lakh
 Useful life, 3 years
 Net salvage value after 3 years, Rs 18 lakh
 Annual tax relevant rate of depreciation, 40 per cent
The HIL has two alternatives to choose from to finance the investment:
Alternative I:
Borrow and buy the equipment. The cost of capital of the HIL, 0.12; marginal
rate of tax, 0.35; cost of debt, 0.17 per annum.
Alternative II:
Lease the equipment from the Hypothetical Leasing Ltd on a three year full
payout basis @ Rs 444/Rs 1,000, payable annually in arrears (year-end). The
lease can be renewed for a further period of 3 years at a rental of Rs 18/Rs
1,000, payable annually in arrears.
Which alternative should the HIL choose? Why?

Decision Analysis (Rs lakh)
1.
2.
3.
4.
5.
6.
Investment outlay
Less: Present value of lease rentals (working note 1)
Plus: present value of tax shield on lease rentals (2)
Minus: present value of tax shield on depreciation (3)
Less: Present value of interest shield on displaced debt (4)
Less: Present value of net salvage value (5)
NAL/NPV(L)
Rs 180.00
176.61
67.19
41.01
18.29
12.81
(1.53)
Since the NAL is negative, the lease is not economically viable. The HIL
should opt for the alternative of borrowing and buying.
Working Notes
1. Present value of lease rentals: = Rs (180 lakh × 0.444) × PVIFA (17,3) = Rs
79.92 lakh × 2.210 = Rs 176.61 lakh
2. Present value of tax shield on lease rentals: = Rs (180 lakh × 0.444 × 0.35) ×
PVIFA (12,3) = Rs 27.972 lakh × 2.402 = Rs 67.19 lakh
3. Present value of tax shield on depreciation = [72 × PVIF (12,1) + 43.2 × PVIF
(12,2) + 25.92 × PVIF (12,3)] × 0.35 = [(72 × 0.893) + (43.2 × 0.797) + (25.92 ×
0.712)] × 0.35 = Rs 41.01 lakh

(Displaced) Debt (Present Value of Lease Rentals) Amortisation Schedule
(Rs lakh)
Year Loan outstanding Interest
content
(at 17%)
Capital content Instalment amount
at the beginning* (176.61 ÷ 2.210)
1 176.61 30.03 49.89 79.92
2 126.72 21.54 58.38 79.92
3 68.34 11.61 68.34 79.92
*Equal to the present value of lease rentals
5. Present value of net salvage value = 18 × PVIF (12,3) = 18 × 0.712 = Rs 12.81
lakh

(Monthly Lease Rentals)
Example 3
In Example 2, assume a lease rental of Rs 35/Rs 1,000 payable monthly, in
advance. Compute the NAL/NPV(L). Should the HIL opt for lease financing?
Solution
Decision Analysis (Rs lakh)
1.
2.
3.
4.
5.
6.
Investment outlay
Less: Present value of lease rentals (working note 1)
Plus: Present value of tax shield on lease rentals (2)
Less: Present value of tax shield on depreciation (3)
Less: Present value of interest shield on displaced debt (4)
Less: Present value of net salvage value (5)
NAL
Rs 180.00
182.10
63.56
41.01
13.12
12.81
(5.48)
As the NAL is negative, the lease is not financially advantageous and HIL
should not opt for it.

Debt Amortisation Schedule (Rs lakh)
Year Loan outstanding Interest content Capital content Instalment amount
[182.10 ÷ 2.409 (1.09
× 2.210)]
at the beginning*
1 181.10 24.15 51.45 75.60
2 130.65 15.39 60.21 75.60
3 70.44 5.16 70.44 75.60
*Equal to the present value of lease rentals
5. Present value of net salvage value: No change from annual payment basis
(Rs 12.81 lakh)
Working Notes
1. Present value of lease rentals: = Rs (180 × 0.035 × 12) × PVIFAm (17,3) =
75.6 × i/d(12) × PVIFA (I,3), where I = 0.17 = 75.6 × 1.09 (Table A-3) × 2.210
(Table A-2) = Rs 182.10 lakh
2. Present value of tax shield on lease payments: = Rs [(180 × 0.035 × 12) ×
PVIFA (12,3) × 0.35] = 75.6 × 2.402 × 0.35 = Rs 63.56 lakh
3. Present value of tax shield depreciation: No change from the annual
payment (Rs 41.01 lakh)

Break-Even Lease Rental
The break-even lease rental (BELR) is the rental at which the lessee
is indifferent to a choice between lease financing and
borrowing/buying. Alternatively, BELR has a NAL of zero. It reflects
the maximum level of rental that the lessee would be willing to pay.
If the BELR exceeds the actual lease rental, the lease proposal
would be accepted, otherwise it would be rejected. The
computation of the BELR is shown in example 4.

Example 4
For the HIL in Example 2, assume monthly lease payments in advance.
Compute the break-even monthly lease rental. Can the HIL accept a lease
quote of Rs 35/Rs 1,000 per month, payable in advance?
Solution
The monthly break-even lease rental (BL) can be obtained when NAL =
zero. Thus, [180 – (12 BL × 3.27 × 2.210) + (12 BL × 0.35 × 2.402) – 58.59 –
[(11.49 × 0.893) + (7.35 × 0.797) + (2.43 × 0.712)] × 0.35 BL – 12.81 = 0. BL =
Rs 2.78 lakh
Monthly lease rental payable by HIL = Rs 180 lakh × 0.035 = Rs 6.30 lakh
Since the BL is less than the actual rental to be paid, the lease proposal
cannot be accepted.
Working notes
Required Amortisation Schedule (Rs lakh)
Year Loan outstanding at
the beginning*
Interest content Capital
content
Instalment
amount
1 86.73 BL 24.51 BL 11.49 BL 12 BL
2 66.22 BL 28.65 BL 7.35 BL 12 BL
3 33.57 BL 33.57 BL 2.43 BL 12 BL

Lessor’s Viewpoint
For the lessor, lease decision is akin to a capital budgeting
decision. The leasing is viable when the PV of cash inflows after
taxes (CFAT) accruing to him exceeds the cost of asset. The CFAT
are discounted at the weighted average cost of capital.
The NAL approach can also be used by the lessor to assess the
financial viability of the lease decision. The NAL to a lessor =
Present value of lease payment plus (i) Present value of
management fee, (ii) Present value of depreciation tax shield, (iii)
Present value of net salvage value, (iv) Present value of tax shield
on initial direct costs, minus, (i) Initial investment, (ii) Present value
of tax on lease payments, (iii) Present value of tax on management
fee, and (iv) Present value of initial direct cost.
Example 5
For the firm in our Example 1, assume further that; (i) the lessor’s
weighted average cost of capital is 14 per cent. Is it financially
profitable for a leasing company to lease out the machine?

Determination of NPV of Cash Inflows
Particulars Years
1 (Rs) 2 (Rs) 3 (Rs) 4 (Rs) 5 (Rs)5 (Rs)
Lease rent
Less: Depreciation
Earnings before taxes
Less: Taxes (0.35)
Earnings after taxes
Cash inflows after
Taxes x PV factor at (0.14)
Total
4,50,000
3,75,000
75,000
26,250
48,750
4,23,750
0.877
3,71,629
4,50,000
2,81,250
1,68,750
59,062
1,09,688
3,90,938
0.769
3,00,631
4,50,000
2,10,937
2,93,063
83,672
1,55,391
3,66,328
0.675
2,47,271
4,50,000
1,58,203
2,91,797
1,02,129
1,89,668
3,47,872
0.592
2,05,940
4,50,000
1,18,652
3,31,348
1,15,972
2,15,376
3,34,028
0.519
1,73,361
Total PV (operations) 12,98,832
Add: PV of salvage value of machine (1,00,000 0.519)× 51,900
Add: PV of tax savings on short-term capital loss (Rs 89,585 0.519)× 46,495 ________________
Gross PV 13,97,227
Less: Cost of machine 15,00,000
NPV (1,02,773)
It is not financially profitable to let out the machine on lease by the leasing company, as NPV is negative.

Solution
(a) Break-even Lease Rental
Cost of machine
Less: PV of salvage value to be received at the end of 5 years
(Rs 1,00,000 × 0.519)
Less: PV of tax savings on short-term capital loss at the end of the 5th
year (Rs 89,585 × 0.519)
Less: PV of tax shield on depreciation: (Rs 3,75,000 × 0.35 × 0.877) +
(Rs 2,81,250 × 0.35 × 0.769) + (Rs 2,10,937 × 0.35 × 0.675) + (Rs 1,58,203 ×
0.35 × 0.592) + (Rs 1,18,562 × 0.35 × 0.519)
Required total PV of after tax lease rent
Divided by PVIFA for 5 years at 0.14
After tax lease rentals
Break-even lease rentals (Rs 3,22,352/(1 – 0.35)
Rs 15,00,000
51,900
46,495
2,94,955
11,06,650
÷ 3.433
3,22,357
4,95,933
Break-Even Lease Rental
From the viewpoint of a lessor, the break-even lease rental represents the minimum
(floor) lease rental that he can accept. The NAL/NPV(L) at this level of rental is zero. The
discount rate to compute the NAL is the marginal overall cost of funds to the lessor.
Example 6 For facts contained in Example 5, (a) determine the minimum lease rentals at
which the lessor would break-even. Also, prepare a verification table. Determine the
lease rentals if the lessor wants to earn an NPV of Rs 1 lakh.

Verification Table
Particulars Years
1 2 3 4 5
Lease rent Rs 4,95,933 Rs 4,95,933 Rs
4,95,933
Rs
4,95,933
Rs
4,95,933
Less: Depreciation 3,75,000 2,81,250 2,10,937 1,58,203 1,18,652
Earnings before
taxes 1,20,933 2,14,683 2,84,996 3,37,730 3,77,281
Less: Taxes (0.35) 42,327 75,139 99,749 1,18,206 1,32,049
Earnings after
taxes 78,606 1,39,544 1,85,247 2,19,524 2,45,232
CFAT (EAT +
Depreciation) 4,52,606 4,20,794 3,96,184 3,77,727 3,63,884
×PV factor at (0.14) 0.877 0.769 0.675 0.592 0.519
Total 3,97,812 3,23,591 2,67,424 2,23,614 1,88,856
PV of Lease rent 14,01,297
Add: PV of salvage value 51,900
Add: PV of tax savings on short- term
capital loss 46,495
Total PV 15,00,000

(b) Lease-Rentals to be Charged to Earn NPV of Rs 1,00,000
Required total PV of after-tax lease rentals (Rs 11,06,650 for
break-even + Rs 1,00,000) Rs 12,06,650
Divided by PVIFA for 5 years at 0.14 ÷ 3.433
After-tax lease rentals 3,51,486
Lease rentals to be charged [Rs 3,51,486/(1 – 0.35)] 5,40,740
Example 7
The under mentioned facts relate to a lease proposal before the Hypothetical
Leasing Ltd (HLL):
The initial cost of equipment to be leased out is Rs 300 lakh, on which 10 per
cent sales tax would be levied. At the end of the lease term, after 5 years, the
salvage value is estimated to be Rs 33 lakh. The other costs associated with
the lease proposal payable in advance (front-ended) are initial direct cost, Rs
3 lakh and management fee, Rs 5 lakh. The marginal cost of funds to the HIL
is 14 per cent while the marginal rate of tax is 35 per cent.
What is the break-even rental for HLL if the tax relevant rate of depreciation is
25 per cent?

Solution
Computation of Break-even Lease Rental (L)
Particulars Amount (Rs lakh)
1. Equipment cost (including ST) 3,30.000
2. Present value of lease rentals (working note 1) 3.433 L
3. Present value of tax on lease rentals (2) 1.202 L
4. Present value of tax shield on depreciation) 64.900
5. Present value of direct initial cost 3.000
6. Present value of management fee 5.000
7. Present value of tax shield on initial direct cost (4) 0.920
8. Present value of tax on management fee (5) 1.530
9. Present value of salvage value (6) 17.100
The break-even rental (L) can be derived from the equation:
3.433 L – 1.202 L + Rs 64.90 lakh – Rs 3 lakh + Rs 5 lakh + Rs 0.902 lakh – Rs 1.53
lakh + Rs 17.10 lakh – Rs 330 lakh = 0
L = Rs 123.30 lakh

Working Notes
1) Present value of lease rental = L [PVIFA (14,5)] = 3.433 L
2) Present value of tax on lease rental = 0.35 × L × PVIFA (14,5) = 1.202 L
3) Present value of tax shield on depreciation = [Rs 82.50 lakh × PVIF (14,1)
+ Rs 61.90 lakh × PVIF (14,2) + Rs 46.40 lakh × PVIF (14,3) + Rs 34.80
lakh × PVIF (14,4) + Rs 26.1 lakh × PVIF (14,5)] × 0.35 =
[(Rs 82.50 × 0.877) + (Rs 61.90 × 0.769) + (Rs 46.40 × 0.675) + (Rs 34.80 ×
0.592) + (Rs 26.1 × 0.519)] × 0.35 = Rs 64.90 lakh
4) Present value of tax shield on initial direct costs = Rs 3 lakh × 0.35 ×
PVIF (14,1) = Rs 0.92 lakh
5) Present value of tax shield on management fee = 0.35 × Rs 5 lakh × PVIF
(14,1) = Rs 1.53 lakh
6) Present value of salvage value = Rs 33 lakh × PVIF (14,5) = Rs 17.10 lakh

Example 8
The Hypothetical Leasing Ltd (HLL) has a lease proposal under
consideration. Its post-tax cost of funds is 14 per cent and it has to pay
central sales tax (CST) @ 10 per cent of the basic price of the capital
equipment on inter-state purchases. The marginal tax rate of the HLL is 35
per cent. The details of the proposed lease are given below:
 Primary lease period, 3 years
 Tax relevant depreciation, 40 per cent on written down basis (with other
assets in the block)
 Residual value, 8 per cent of the original cost.
(a) If the monthly lease rentals are collected in advance, what is the minimum
lease rental the HLL should charge for per Rs 1,000 for the lease?
(b) What is the minimum monthly lease rental for a lease proposal costing Rs
660 lakh (including CST at 10 per cent)?

Solution
(a) Minimum Monthly Rental per Rs 1,000
1 Investment cost Rs 1,000.00
2 Present value of lease rentals (working note 1) 29.93 L
3 Present value of tax shield on rentals (2) 9.75 L
4 Present value of tax shield on depreciation (3) 221.48
5 Present value of residumal value (4) 54.00
The break-even level of rental (L) can be derived from the equation (NAL = 0)
= Rs 1,000 + 29.93 L – 9.75 L + Rs 221.48 + Rs 54 = 0
L = Rs 35.90, that is, Rs 35.90/Rs 1,000/month
(b) Minimum monthly lease rental for the proposal costing Rs 660 lakh = Rs
660 lakh 0.03590 = Rs 23.69 lakh×
Working Notes
1. Present value of lease rentals = 12 L × PVIFAm (14,3) = 12L × 2.322 × 1.0743 =
29.93 L
2. Present value of tax shield on lease rentals = 12L × PVIFA (14,3) × 0.35 = 12 L ×
2.322 × 0.35 = 9.75 L
3. Present value of tax shield on depreciation = [Rs 400 × PVIF 914,1) + Rs 240 ×
PVIF (14,2) + Rs 144 × PVIF (14,3)] × 0.35 = (Rs 400 × 0.877) + (Rs 240 × 0.769) +
(Rs 144 × 0.675) = Rs 221.48
4. Present value of residual value = Rs 1,000 (0.08) × PVIF (14,3) = Rs 54.

Hire-Purchase Finance
Hire-purchase is an agreement relating to a transaction in which goods
are let on hire, the purchase price is to be paid in instalments and the
hirer is allowed the option to purchase the goods, paying all the
instalments. Though the option to purchase the goods is allowed in the
very beginning, it can be exercised only at the end of the agreement. It
implies ownership is transferred at the time of sale.
The ownership of the goods passes on to the purchaser simultaneously
with the payment of the initial/first instalment in instalment sale. The
hire-purchase also differs from the instalment sale in terms of the call
option and right of termination in the former but not in the latter.
Hire-purchase and leasing as modes of financing are different in several
respects such as ownership of the asset, its capitalisation, depreciation
charge, extent of financing, tax treatment, and accounting and reporting.
Hire-purchase contract, basically, requires two parties, namely, the
intending seller and the intending buyer. When such a sales is executed
through the involvement of finance companies, the hire-purchase
contracts involve three parties: the financier, the seller and the buyer.

Hire-purchase Vs Instalment Payment
In an instalment sale, the contract of sale is entered into, the goods
are delivered and the ownership is transferred to the buyer, but the
price of the goods is paid in specified instalments over a definite
period.
The first distinction between hire purchase and instalment purchase
is based on the call option (to purchase the goods at any time during
the term of the agreement) and the right of the hirer to terminate the
agreement at any time before the payment of the last instalment (right
of termination) in the former while in the latter the buyer is committed
to pay the full price. Secondly, in instalment sale the ownership in the
goods passes on to the purchaser simultaneously with the payment
of the initial/first instalment, whereas in hire purchase the ownership
is transferred to the hirer only when he exercises the option to
purchase/or on payment of the last instalment.

Lease Financing Vs Hire-purchase
Financing These two modes of financing differ in the following aspects:
Ownership The lessor (finance company) is the owner and the lessee
(user/manufacturer) is entitled to the economic use of the leased
asset/equipment only in case of lease financing. The ownership is never
transferred to the user (lessee). In contrast, the ownership of the asset
passes on to the user (hirer), in case of hire purchase finance, on payment of
the last instalment; before the payment of the last instalment, the ownership
of the asset vests in the finance company/intermediary (seller).
Depreciation The depreciation on the asset is charged in the books of the
lessor in case of leasing while the hirer is entitled to the depreciation shield
on assets hired by him.
Magnitude Both lease finance and hire-purchase are generally used to
acquire capital goods. However, the magnitude of funds involved in the
former is very large, for example, for the purchase of aircrafts, ships,
machinery, air conditioning plants and so on. The cost of acquisition in hire
purchase is relatively low, hence, automobiles, office equipments, generators
and so on are generally hire purchased.

Extent Leasing financing is invariably 100 per cent financing. It
requires no margin money or immediate cash down payment by the
lessee. In a hire-purchase transaction typically a margin equal to 20-
25 per cent of the cost of the equipment is required to be paid by the
hirer. Alternatively, the hirer has to invest an equivalent amount on
fixed deposits with the finance company, which is returned after the
payment of the last instalment.
Maintenance The cost of maintenance of a hired asset is to be borne,
typically, by the hirer himself. In case of finance lease only, the
maintenance of the leased asset is the responsibility of the lessee. It
is the lessor (seller) who has to bear the maintenance cost in an
operating lease.
Tax Benefits The hirer is allowed the depreciation claim and finance
charge and the seller may claim any interest on borrowed funds to
acquire the asset for tax purposes. In case of leasing, the lessor is
allowed to claim depreciation and the lessee is allowed to claim the
rentals and maintenance cost against taxable income.

Parties to a Hire-purchase Contract
There are two parties in a hire-purchase contract, namely, the
intending seller and the intending purchaser or the hirer. Nowadays,
however, hire-purchase contracts generally involve three parties,
namely, the seller, the financier and the hirer. With the
acknowledgement of the finance function as a separate business
activity and the substantial growth of finance companies in the
recent times, the sale element in a hire purchase contract has been
divorced from the finance element. A dealer now normally arranges a
hire purchase agreement through a finance company with the
customer. It is, therefore, a tripartite deal. A tripartite hire-purchase
contract is arranged with following modalities:

1) The dealer contracts a finance company to finance hire-purchase deals
submitted by him. For this purpose, they enter into a contract drawing out the
terms, warranties that the dealer gives with each transaction and so on.
2) The customer selects the goods and expresses his desire to acquire them on
hire purchase. The dealer arranges for a full set of documents to be completed
to make a hire-purchase agreement with a customer. The documents are
generally printed by the finance company.
3) The customer then makes a cash down payment on completing the proposal
form. The down payment is generally retained by the dealer as a payment on
account of the price to be paid to him by the finance company.
4) The dealer then sends the documents to the finance company requesting him
to purchase the goods and accept the hire purchase transactions.
5) The finance company, if it decides to accept the transactions, signs the
agreement and sends a copy to the hirer, along with the instructions as to the
payment of the instalments. The finance company also notifies the same to the
dealer and asks him to deliver the goods, if they are not already delivered.
6) The dealer delivers the goods to the hirer against acknowledgements and the
property in the goods passes on to the finance company.
7) The hirer makes payment of the hire instalment periodically.
8) On completion of the hire term, the hirer pays the last instalment and the
property in the goods passes on to him on issue of a completion certificate by
the finance company.

Taxation Aspects
The taxation aspects of hire-purchase
transactions can be divided into three parts:
1) Income tax,
2) Sales tax and
3) Interest tax

Income Tax
Hire-purchase, as a financing alternative, offers tax benefits both to the hire
vendor, (hire-purchase finance company) and the hire purchaser (user of the
asset).
Assessment of Hire-Purchaser (Hirer)
According to circular issued by the Central Board of Direct Taxes in 1943
and a number of court rulings, the hirer is entitled to (a) the tax shield on
depreciation, calculated with reference to the cash purchase price and (b)
the tax shield on the ‘consideration for hire’ (total charge for credit). In other
words, though the hirer is not the owner of the asset, he is entitled to claim
depreciation as a deduction on the entire purchase price. Similarly, he can
claim deduction on account of ‘consideration of hire’, that is, finance
charge.
Assessment of Owner (Hire Vendor)
The hire/hire charge/income received by the hire vendor is liable to tax under
the head profits and gains of business and profession, where hire-purchase
constitutes the business (mainstream activity) of the assessee, otherwise it
is taxed as income from other sources. The hire income from house
property is generally taxed as income from house property. Normal
deductions (except depreciation) are allowed while computing the taxable
income.

Tax Planning in Hire-Purchase
First, the net income (finance income less interest on borrowings by the hire
vendor) can be inflated at the rear end of the transaction and thereby defer
tax liability. The hirer can similarly postpone his tax liability by allocating a
finance charge on the basis of a actuarial/rate of return method that implies
a higher deduction in the early years.
Secondly, another possible area of tax planning is to use hire-purchase as a
bridge between the lessor and the lessee. In other words, instead of direct
lease an intermediate financier is introduced.
Suppose, X wants to lease an asset to Z. Instead of going for a direct lease,
they adopt a different strategy, wherein Y steps in as an intermediary. Y
takes the asset on hire-purchase from X and gives the same asset to Z on
lease. There is no prohibition of such arrangement, unless the hire-purchase
agreement prohibits the sub-lease.
Under this strategy, Y gets the dual advantage of depreciation and finance
charge against his income from lease rentals, thereby postponing his taxes.
This strategy can be very useful in case Y is a high tax paying entity. Y in
consideration for reduction in his tax liability will pass off some income to X
in the form of high hire charges and to Z by way of lease rentals. Even if the
intermediary Y derives no financial gains, substantial tax savings can be
reaped by distributing the income and tax benefits.

Sales Tax Aspect
The salient features of sales tax, pertaining to hire purchase transactions, after the
Constitution (Forty sixth Amendment) Act, 1982, are as detailed below
Hire-Purchase as Sale
Hire-purchase, though not sale in the true sense, is deemed to be sale. Such
transactions are per se liable to sales tax. The sales tax is payable once the goods
are de-livered by the owner (hire vendor) to the hirer (hire-purchaser), even if the
transaction does not fructify into a sale. There is no provision for the refund of
sales tax on an unpaid instalment. In other words, full tax is payable irrespective
of whether the owner gets the full price of the goods or not.
Delivery Vs Transfer of Property: Taxable Event
A hire-purchase deal is regarded as a sale immediately after the goods are
delivered and not on the transfer of the title to the goods. That is, the taxable event
is the delivery of the goods and not transfer of the title to the goods. For the
purpose of levying sales tax, a sale is deemed to take place only when the hirer
exercises the option to purchase.
Taxable Quantum
The quantum of sales tax is related to the sales price; it must be determined to be
the consideration for the transfer of the goods when the delivery of the goods
takes place. The consideration for the sale of the goods is the total amount that is
agreed to be paid before the transfer of the goods takes place in a hire-purchase
contract.

States Entitled to Impose Tax
When a hire-purchase transaction is entered in the state where the goods are lying,
the concerned state is entitled to impose sales tax.
Sales tax on hire-purchase is not levied if the state in which goods are delivered has
a single point levy system in respect of such goods and if the owner (finance
company) had purchased the goods within the same state. Moreover, sales tax is
not levied on hire-purchase transactions structured by finance companies if they
are not dealers in the type of goods given on hire.
The interstate hire-purchase deals attract central sales tax (CST). But in actual
practice, no hire-purchase transaction is likely to be subject to CST. Under the CST,
the taxable event is not the delivery but the transfer of goods.
Rate of Tax
The rates of tax on hire purchase deals vary from state to state. There is, as a matter
of fact, no uniformity even regarding the goods to be taxed. If the rates undergo a
change during the currency of a hire-purchase agreement, the rate in force on the
date of delivery of the goods to the hirer is applicable.
Interest Tax
The hire-purchase finance companies, like other credit/finance companies, have to
pay interest tax under the Interest Tax Act, 1974. According to this Act, interest tax
is payable on the deal amount of interest earned less bad debts in the previous year
@ 2 per cent. The tax is treated as a tax deductible expense for the purpose of
computing the taxable income under the Income Tax Act.

From the Point of View of the Hirer (Hire-Purchaser)
The tax treatment given to hire-purchase is exactly the opposite of that given
to lease financing. It may be recalled that in leasing financing, the lessor is
entitled to claim depreciation and other deductions associated with the
ownership of the equipment, including interest on the amount borrowed to
purchase the asset, while the lessee enjoys full deduction of lease rentals. In
sharp contrast, in a hire-purchase deal, the hirer is entitled to claim
depreciation and the deduction for the finance charge (interest) component of
the hire instalment. Thus, hire purchase and lease financing represent
alternative modes of acquisition of assets. The evaluation of hire purchase
transaction from the hirers’ angle, therefore, has to be done in relation to the
leasing alternative.
Decision Criterion
The decision criterion from the point of view of a hirer is the cost of hire-
purchase vis-à-vis the cost of leasing. If the cost of hire-purchase is less than
the cost of leasing, the hirer (purchaser) should prefer the hire purchase
alternative and vice versa.
Financial Evaluation

Cost of Leasing The cost of leasing (COL) consists of the following elements:
1) Lease management fee
2) Plus: Present value of lease payments discounted by Kd
3) Less: Present value of tax shield on lease payments, and lease
management fee discounted by Kc
4) Plus: Present value of interest tax shield on hire purchase discounted by
Kc
Cost of Hire-purchase The cost of hire-purchase to the hirer (CHP) consists
of the following:
1) Down payment
2) Plus: Service charges
3) Plus: Present value of hire purchase discounted by cost of debt (Kd)
4) Minus: Present value of depreciation tax shield discounted by cost of
capital (Kc)
5) Minus: Present value of the net salvage value discounted by cost of
capital (Kc)

Example 9
The Hypothetical Industries Ltd (HIL) has an investment plan amounting to
Rs 108 lakh. The tax relevant rate of depreciation of the HIL is 25 per cent, its
marginal cost of capital and marginal cost of debt are 16 per cent and 20 per
cent respectively and it is in 35 per cent tax bracket.
It is examining financing alternatives for its capital expenditure. A proposal
from the Hypothetical Finance Ltd (HFL), with the following salient features,
is under its active consideration:
Hire Purchase Plan: The (flat) rate of interest charged by the HFL is 16 per
cent. Repayment of the amount is to be made, in advance, in 36 equated
monthly instalments. The hirer/hire-purchaser is required to make a down
payment of 20 per cent.
Leasing Alternative: Lease rentals are payable @ Rs 28 ptpm, in advance.
The primary lease period can be assumed to be 5 years.
Assume that the SOYD method is used to allocate the total charge for credit
under the hire-purchase plan. The net salvage value of the equipment after 3
years can be assumed to be Rs 33 lakh.
Which alternative—leasing or hire-purchase—should the HIL use? Why?

Solution The choice will depend on the relative cost of hire purchase and leasing
Cost of Hire-Purchase (CHP) (Rs lakh)
1 Down payment (working note 1) Rs 21.60
2 Plus: Present value of monthly hire-purchase instalment (working
note 2) 99.19
3 Minus: present value of depreciation tax shield (working note 3) 20.44
4 Minus: present value of net salvage value 15.70
Total 84.65
Working Notes
1. Down payment = Rs 108 lakh × 0.20 = Rs 21.6 lakh
2. Monthly hire-purchase instalment = [Rs 86.4 lakh (Rs 108 lakh less 20 per cent
down payment) (Rs 86.4 lakh × 0.16 × 3 years)] ÷ 36 = Rs 3.552 lakh
Present value of monthly hire purchase instalment
= Rs 3.552 lakh × 12 × [I/d(12)
] × PVIFA (20,3) where I = 0.20
= (Rs 3.553 lakh × 12) × 1.105 × 2.106 = Rs 99.19 lakh
3. Present value of depreciation tax shield:
= [Rs 27 lakh × PVIF (16,1) + Rs 20.25 lakh × PVIF (16,2) + Rs 15.19
lakh× PVIF (16,3) + Rs 11.39 lakh × PVIF (16,4) + Rs 8.54 lakh × PVIF
(16,5)] × 0.35
= [(27 × 0.862) + (20.25 × 0.743) + (15.19 × 0.641) + (11.39 × 0.552) +
(8.54 × 0.476)] × 0.35 = Rs 20.44 lakh

Working Notes
1. Present value of lease payments:
= [Rs 108 lakh × 0.028 × 12) × [I/d(12)
] × PVIFA (20,5)], where I = 0.20
= Rs value of tax shield on lease payment = [Rs 108 lakh × 0.028 × 12 ×
PVIFA (16,5) × 35
= (Rs 36.29 lakh × 3.274)] × 0.35 = Rs 41.58 lakh
2. Present value of tax shield on charge for credit:
Total charge for credit = Rs 108 lakh × 0.80 × 0.16 × 3 = Rs 41.47 lakh
Cost of Leasing (COL) (Rs lakh)
1
2
3
Present value of lease payments (working note 1)
Minus present value of tax shield on lease payment (2)
Plus present value of tax shield on charge of credit (3)
Total
Rs 119.93
41.58
11.56
89.91
4.86
666
366
1...3536
1...1112
3
13.82
666
222
1...3536
13...2324
2
22.79
666
366
1...3536
25...3536
1
lakh)(RschargelAnnuafactorSOYDYear
MethodSODYCredit;forChargeTotalofAllocation
=
+++
+++
=
+++
+++
=
+++
+++

Net Present Value of Hire Purchase Plan [NPV (HPP)] The NPV (HPP)
consists of:
1) Present value of hire purchase instalments
2) Plus: Documentation and service fee
3) Plus: Present value of tax shield on initial direct cost
4) Minus: Loan amount
5) Minus: Initial cost
6) Minus: Present value of interest tax on the finance income
7) Minus: Present value of income tax on finance income (interest)
netted for interest tax
8) Minus: Present value of income tax on documentation and service fee
From the Viewpoint of Finance Company (Hire Vendor)
Hire-purchase and leasing represents two alternative investment decisions
of a finance company/financial intermediary/hire vendor. The decision
criterion, therefore, is based on a comparison of the net present values of
the two alternatives, namely, hire-purchase and lease financing. The
alternative with a higher net present value would be selected and the
alternative having a lower net present value would be rejected.

Present Value of Lease Plan [NPV (LP)] The NPV (LP) consists of the following
elements:
1) Present value of lease rentals
2) Add: Lease management fee
3) Add: Present value of tax shield on initial direct costs and depreciation
4) Add: Present value of net salvage value
5) Less: Initial investment
6) Less: Initial direct costs
7) Less: Present value of tax liability on lease rentals and lease
management fee
Example 10
For the HFL in Example 9, assume the following:
 Front-end (advance) cost of structuring the deal: 0.5 (half) per cent of the
amount financed
 Marginal cost of debt: 20 per cent
 Marginal cost of equity: 25 per cent
 Target long-term debt-equity ratio: 4:1
 Marginal tax rate: 35 per cent
 Residual value under lease plan: 10 per cent of the investment cost
Required Which plan—hire-purchase or lease—is financially more attractive to
the HFL? Why?

Solution
A (i) Net Present Value of Hire-Purchase Plan (Rs lakh)
1 Present value of monthly hire-purchase instalment (working note 1) 104.46
2 Plus present value of tax shield on initial direct costs (working note 2) 0.13
3 Less: Amount financed (Rs 108 lakh – Rs 21.60 lakh, down payment) 86.40
4 Less: Initial direct cost (0.5 per cent of Rs 86.4 lakh) 0.43
5 Less: Present value of interest tax on hire purchase-related income
(working note 3)
0.67
6 Less: Present value of income tax on net finance income (working note
4)
11.41
Total 5.68

Working Notes
Marginal cost of capital [0.80 × 0.20 × 0.65] + [0.20 × 0.25] = (0.104 + 0.05) =
15.4 per cent
1. Monthly hire-purchase instalment = [(Rs 86.4 lakh + (Rs 86.4 lakh × 0.16
× 3)] ÷ 36 = Rs 3.552 lakh
Present value of monthly hire-purchase instalments:
= Rs 3.552 lakh × PVIFAm (15.4,3)
= Rs 3.552 lakh × 12 × 2.265 × 1.082 = Rs 104.46 lakh
2. Present value of tax shield on initial direct cost:
Initial direct cost (0.5 per cent of Rs 86.4 lakh) = 0.432 lakh
Present value = Rs 0.432 lakh × 0.866 × 0.35 = Rs 0.13 lakh
3. Present value of interest tax on hire purchase related income:
Unexpired finance income (total charge for credit) at inception = Rs 86.4
lakh × 0.16 × 3 = Rs 41.47 lakh

Interest Tax and Income Tax on Annual Finance Income (Rs lakh)
Year Gross Finance
Income
Interest tax
(2%)
Net finance
income
Income tax
(0.35)
1 22.79 0.46 22.33 7.82
2 13.82 0.28 13.54 4.74
3 4.86 0.10 4.76 1.67
Present value = (Rs 0.46 lakh 0.866) + (Rs 0.28 lakh 0.751) + (Rs 0.10 lakh× × ×
0.648) = Rs 0.67 lakh
86.4lakh47.41Rs
666
78
1...3536
1...1112
3
82.13lakh47.41Rs
666
222
1...3536
13...2324
2
79.22lakh47.41Rs
666
366
1...3536
25...3536
1
lakh)(RschargeAnnualfactorSOYDYear
MethodSODYtheonBasedIncome,FinanceUnexpiredofAllocation
×=
+++
+++
×=
+++
+++
×=
+++
+++

4. Present value of income tax on net finance income:
= (Rs 7.82 lakh 0.866) + (Rs 7.74 lakh 0.751) + (Rs 1.67 lakh 0.648) = Rs× × ×
11.41 lakh
A (ii) Net Present Value of Leasing (Rs lakh)
1 Present value of lease rentals/receipts (working note 1) 130.08
2 Plus: Present value of depreciation tax shield (note 2) 20.62
3 Plus: Present value of tax shield on initial direct cost (note 3) 0.16
4 Plus: Present value of residual value (note 4) 5.21
5 Less: Initial investment 108.00
6 Less: Initial direct cost 0.54
7 Less: Present value of income tax on lease rentals (note 5) 42.09
Total 5.44

Working Notes
1. Present value of lease rentals = Rs 108 lakh × 0.028 × 12 × PVIFA (15.4, 5)
= Rs 108 lakh × 0.028 × 12 × 1.082 × 3.313 = Rs 130.08 lakh
2. Present value of depreciation tax shield = [Rs 27 lakh × PVIF (15.4,1) + Rs
20.25 lakh × PVIF
(15.4,2) + Rs 15.19 lakh × PVIF (15.4,3) + Rs 11.34 lakh × PVIF (15.4,4) + Rs
8.55 lakh
× PVIF (15.4,5)] × 0.35 = [Rs 27 lakh × 0.866) + (Rs 20.25 lakh × 0.751)
+ (Rs 15.19 lakh × 0.648) + (Rs 11.34 lakh × 0.562) + ( Rs 8.55 lakh × 0.482)]
= Rs 20.62 lakh
3. Present value of tax shield on initial direct cost:
= 0.54 lakh (0.5 per cent of Rs 108 lakh) × PVIF (15.4,1) × 0.35 = Rs 0.16 lakh
4. Present value of residual value = Rs 10.80 lakh (0.10 × Rs 108 lakh) × PVIF
(15.4,5) = Rs 5.21 lakh
5. Present value of income tax on lease rentals = Rs 108 lakh × 0.028 × 12 ×
PVIFA (15.4,5) × 0.35
= (Rs 36.29 lakh × 3.314) × 0.35 = Rs 42.09 lakh
As the present value of hire-purchase (Rs 5.68 lakh) exceeds the net present
value of leasing (Rs 5.44 lakh), the hire purchase plan is financially more
attractive to the HFL.

SOLVED PROBLEMS

SOLVED PROBLEM 1
ABC Machine Tool Company Ltd is considering the acquisition of a large
equipment to set up its factory in a backward region for Rs 12,00,000. The
equipment is expected to have an economic useful life of 8 years. The
equipment can be financed either with an 8-year term loan at 14 per cent
interest, repayable in equal instalments of Rs 2,58,676 per year, or by an
equivalent amount of lease rent per year. In both cases, payments are due at
the end of the year. The equipment is subject to the straight line method of
depreciation for tax purposes. Assuming no salvage value after the 8-year
useful life and 50 per cent tax rate, which of the financing alternatives should it
select?
Solution
PV of cash inflows under leasing alternative
Year end Lease payment after taxes
(L) (1 – 0.5)
PV factor
at 0.07 (Kd)
Total PV
1–8 Rs 1,29,338 5.971 Rs 7,72,277

Determination of interest and principal components of loan instalment
Year
end
Loan
instalment
Loan at
the beginning
of the year
Payment of Principal out-
standing at
the
end of the
year
(Col 3 – Col 5)
interest
(Col 3 ×
0.14)
principal
(Col 2 – Col 4)
1 2 3 4 5 6
1 Rs 2,58,676 Rs 12,00,000 Rs 1,68,000 Rs 90,676 Rs 11,09,324
2 2,58,676 11,09,324 1,55,305 1,03,371 10,05,953
3 2,58,676 10,05,953 1,40,833 1,17,843 8,88,110
4 2,58,676 8,88,110 1,24,335 1,34,341 7,53,769
5 2,58,676 7,53,769 1,05,528 1,53,148 6,00,621
6 2,58,676 6,00,621 84,087 1,74,589 4,26,032
7 2,58,676 4,26,032 59,644 1,99,032 2,27,000
8 2,58,676 2,27,000 31,676 2,27,000 —

PV of cash outflows under buying alternative
Year Loan
instalment
Tax advantage on Cash outflows
after taxes
[Col 2 – (Col 3
+ Col 4)]
PV
factor
at 0.07
Total
PV
interest
(I t)×
depreciatio
n
(D t)×
1 2 3 4 5 6 7
1 Rs 2,58,676 Rs 84,000 Rs 75,000 Rs 99,676 0.935 Rs 93,197
2 2,58,676 77,652 75,000 1,06,024 0.873 92,559
3 2,58,676 70,416 75,000 1,13,260 0.816 92,420
4 2,58,676 62,167 75,000 1,21,509 0.763 92,711
5 2,58,676 52,764 75,000 1,30,912 0.713 93,340
6 2,58,676 42,043 75,000 1,41,633 0.666 94,328
7 2,58,676 29,822 75,000 1,53,854 0.623 95,851
8 2,58,676 15,838 75,000 1,67,838 0.582 97,682
7,52,088
Recommendation The borrowing (buying) alternative of financing the purchase of the
large equipment should be selected.

SOLVED PROBLEM 2
For (Solved Problem 1) compute the net advantage of leasing (NAL) to the lessee
assuming (i) The company follows written down value method of depreciation, the
deprecation rate being 25 per cent; (ii) The corporate tax is 35 per cent; (iii) Post-tax
marginal cost of capital (Kc) is 12 per cent and (iv) The company has several assets in
the asset block of 25 per cent.
Solution
Computation of NAL to the lessee
Benefits from lease:
Cost of the equipment (investment saved) Rs 12,00,000
PV of tax shield on lease rentals (working note 2) 4,49,786
Total 16,49,786
Cost of lease:
PV of lease rental (1) 11,99,998
PV of tax shield foregone on depreciation (3) 2,72,333
PV of interest tax shield foregone on debt (4) 2,08,381
Total 16,80,712
NAL (30,926)
Recommendation The lease is not financially viable.

(3) PV of tax shield foregone on depreciation
Year Depreciation Tax shield PV factor (at 0.12) Total PV
1 Rs 3,00,000 Rs 1,05,000 0.893 Rs 93,765
2 2,25,000 78,750 0.797 62,764
3 1,68,750 59,062 0.712 42,052
4 1,26,562 44,297 0.636 28,173
5 94,922 33,223 0.567 18,837
6 71,191 24,917 0.507 12,633
7 53,393 18,688 0.452 8,447
8 40,045 14,016 0.404 5,662
2,72,333
Working Notes
(1) PV of lease rentals: Lease rentals PVIFA (14,8) = Rs 2,58,676 4.639 = Rs× ×
11,99,998.
(2)PV of tax shield on lease rentals: Lease rentals tax rate PVIFA (12,8) = Rs× ×
2,58,676 0.35 4.968 = Rs 4,49,786× ×

(4) PV of interest tax shield
Year Interest Tax shield PV factor (at 0.12) Total PV
1 Rs 1,68,000 Rs 58,800 0.893 Rs 52,508
2 1,55,305 54,357 0.797 43,322
3 1,40,833 49,292 0.712 35,096
4 1,24,335 43,517 0.636 27,677
5 1,05,528 36,935 0.567 20,942
6 84,087 29,430 0.507 14,921
7 59,644 20,875 0.452 9,436
8 31,676 11,087 0.404 4,479
2,08,381

SOLVED PROBLEM 3
For facts in Solveb Problem 2, determine the break even lease rentals (BELR) for the lessee.
Solution
Computation of BELR
Benefits from lease:
Cost of the equipment Rs 12,00,000
PV of tax shield on lease rentals (working note 2) 1.62365L
Cost of lease:
PV of lease rentals (note 1) 4.639L
PV of tax shield foregone on depreciation 2,72,333
PV of interest tax shield foregone on debt 2,08,381
BELR (L) = 4.639L + Rs 4,80,714 = 1.62365L + Rs 12,00,000
4.639L – 1.62365L = Rs 12,00,000 – Rs 4,80,714
L = Rs 7,19,286/3.01535 = Rs 2,38,541
Working Notes
(i) PV of lease rentals: L PVIFA (14,8) = 4.639 L = 4.639L× ×
(ii) PV of tax shield on lease rentals: L PVIFA (14,8) tax rate = 4.639L 0.35 = 1.62365L× × ×

SOLVED PROBLEM 4
HCL Ltd is considering acquiring an additional computer to supplement its time-
share computer services to its clients. It has two options:
(i) To purchase the computer for Rs 22,00,000.
(ii) To lease the computer for 3 years from a leasing company for Rs 5,00,000
annual lease rent plus 10 per cent of gross time-share service revenue. The
agreement also requires an additional payment of Rs 6,00,000 at the end of the
third year. Lease rent are payable at the year end, and the computer reverts to the
lessor after the contract period.
The company estimates that the computer under review now will be worth Rs 10
lakh at the end of the third year.
Forecast revenues are:
Year 1 Rs 22,50,000
2 25,00,000
3 27,50,000

Annual operating costs (excluding depreciation and lease rent of computer) are
estimated at Rs 9,00,000, with an additional Rs 1,00,000 for start-up and training
costs at the beginning of the first year.
HCL Ltd will borrow at 16 per cent interest to finance the acquisition of the
computer; repayments are to be made according to the following schedule.
Year-end Principal Interest Total
1 Rs 5,00,000 Rs 3,52,000 Rs 8,52,000
2 8,50,000 2,72,000 11,22,000
3 8,50,000 1,36,000 9,86,000
The company uses the straight line method to depreciate its assets and pays 50 per
cent tax on its income.
The management of HCL Ltd approaches you for advice. Which alternative would
you recommend? Why?

Solution
PV of cash outflows under leasing alternative
Y
e
a
r
Payment under lease contract Tax shield
@ 50% on
lease
payments
Net cash
outflows
PV
factor
(0.08)
Total
PV
Lease
rent
10% of
gross
revenue
Lumpsum
payment
1 Rs 5,00,000 Rs2,25,000 — Rs 3,62,500 Rs 3,62,500 0.926 Rs 3,35,675
2 5,00,000 2,50,000 — 3,75,000 3,75,000 0.857 3,21,375
3 5,00,000 2,75,000 Rs 6,00,000 6,87,500 6,87,500 0.794 5,45,875
12,02,925

PV of cash outflows under borrowing alternative
Year Loan
instalment
Tax advantage on Net cash
outflows
PV
factor
(0.08)
Total
PV(I 0.50)× (D 0.50)×
1 Rs 8,52,000 Rs 1,76,000 Rs 2,00,000 Rs 4,76,000 0.926 Rs 4,40,776
2 11,22,000 1,36,000 2,00,000 7,86,000 0.857 6,73,602
3 9,86,000 68,000 2,00,000 7,18,000 0.794 5,70,092
Salvage value (10,00,000) 0.794 (7,94,000)
8,90,470
Assumption The start-up and training costs are to be borne by the lessee even if the
computer is acquired on lease basis.
Recommendation The management is advised to buy the computer.

307
BUSINESS VALUTION
The term ‘valuation’ implies the estimated worth
of an asset or a security or a business. The
alternative approaches to value a firm/an asset
are:
 Book value,
 Market value,
 Intrinsic value,
 Liquidation value,
 Replacement value,
 Salvage value
 Value of Goodwill
 Fair value.

32 - 308
Book Value
The book value of an asset refers to the amount at
which an asset is shown in the balance sheet of a firm.
Generally, the sum is equal to the initial acquisition
cost of an asset less accumulated depreciation.
Accordingly, this mode of valuation of assets is as per
the going con-cern principle of accounting. In other
words, book value of an asset shown in balance does
not reflect its current sale value.
Book value of a business refers to total book value of
all valuable assets (excluding fictitious assets, such as
accumulated losses and deferred revenue
expenditures, like advertisement, preliminary
expenses, cost of issue of securities not written off)
less all external liabilities (including preference share
capital). It is also referred to as net worth.

Market Value
In contrast to book value, market value refers to the price at which an asset
can be sold in the market. The market value can be applied with respect to
tangible assets only; intangible assets (in isolation), more often than not,
do not have any sale value. Market value of a business refers to the
aggregate market value (as per stock market quotation) of all equity shares
outstanding. The market value is relevant to listed companies only.
Intrinsic/Economic Value
Intrinsic/Economic Value is the present value of incremental future cash
inflows using an appropriate discount rate.
Liquidation Value
As the name suggests, liquidation value represents the price at which each
individual asset can be sold if business operations are discontinued in the
wake of liquidation of the firm. In operational terms, the liquidation value of
a business is equal to the sum of (i) realisable value of assets and (ii) cash
and bank balances minus the payments required to discharge all external
liabilities. In general, among all measures of value, the liquidation value of
an asset/or business is likely to be the least.

Replacement Value
The replacement value is the cost of acquiring a new
asset of equal utility and usefulness. It is normally useful
in valuing tangible assets such as office equipment and
furniture and fixtures, which do not contribute towards
the revenue of the business firm.
Salvage Value
Salvage value represents realisable/scrap value on the
disposal of assets after the expiry of their economic
useful life. It may be employed to value assets such as
plant and machinery. Salvage value should be
considered net of removal costs.

Value of Goodwill
The valuation of goodwill is conceptually the most
difficult.
A business firm can be said to have ‘real’ goodwill
in case it earns a rate of return (ROR) on invested
funds higher than the ROR earned by similar firms
(with the same level of risk). In operational terms,
goodwill results when the firm earns excess
(‘super’) profits.

Fair Value
Fair value is the average of book value, market
value and intrinsic value.
The fair value is hybrid in nature and often is the
average of these three values.
In India, the concept of fair value has evolved from case
laws (and hence is more statutory in nature) and is
applicable to certain specific transactions, like payment to
minority shareholders. It may be noted that most of the
concepts related to value are ‘stock’ based in that they are
guided by the worth of assets at a point of time and not the
likely contribution they can make towards earnings/cash
flows of the business in the future.

Approaches/Methods of Valuation
There are four approaches to valuation of
business (with focus on equity share valuation):
1) Assets based,
2) Earnings based,
3) Market value based and
4) Fair value method.

Asset-Based Approach to Valuation
Assets-based method focuses on determining the value
of Net assets = (Total assets – Total external obligations)
(1)
Net assets per share can be obtained dividing total net
assets by the number of equity shares outstanding. It
indicates the net assets backing per equity share (also
known as net worth per share).
Net assets per share = Net assets / Number of equity
shares issued and outstanding (2)

For the purpose of valuing assets and liabilities, it will be useful for a finance
manager/valuer to accord special attention to the following points :
1. While valuing tangible assets, such as plant and machinery, he should consider
aspects related to technological obsolescence and capital improvements made in
the recent years. Depreciation adjustment may also be needed in case the
company is following unsound depreciation policy in this regard.
2. Is the valuation of goodwill satisfactory, given the amount of profits, capital
employed and average rate of return available on such businesses?
3. With respect to current assets, are additional provisions required for
“unrealisability” of debtors? Likewise, are adjustments required for “unsaleable”
stores and stock?
4. With respect to liabilities, there is a need for careful examination of ‘contingent
liabilities’, in particular when there is mention of them in the auditor’s report, with
a view to assess what portion of such liabilities may fructify. Similarly,
adjustments may be required on account of guarantees invoked, income tax,
sales tax and other tax liabilities that may arise.
Liquidation value is the final net asset value (if any) per share available
to the equity shareholder. The value is given as per Equation
Net assets per share = (Liquidation value of assets – Liquidation
expenses – Total external liabilities)/Number of equity shares issued and
outstanding. (3)

Example 1: Following is the balance sheet of Hypothetical Company Limited as on
March 31, current year.
Share capital
40,000 11% Preference shares of
Rs 100 each, fully paid-up
1,20,000 Equity shares of Rs 100
each, fully paid-up
Profit and loss account
10% Debentures
Trade creditors
Provision for income tax
40
120
23
20
71
8
282
Fixed assets
Less: Depreciation
Current assets:
Stocks
Debtors
Cash at bank
Preliminary expenses
Rs 150
30
100
50
10
120
160
2
____
282
Additional Information:
(i) A firm of professional valuers has provided the following market estimates of its
various assets: fixed assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45 lakh. All
other assets are to be taken at their balance sheet values.
(ii) The company is yet to declare and pay dividend on preference shares.
(iii) The valuers also estimate the current sale proceeds of the firm’s assets, in the
event of its liquidation: fixed assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40
lakh. Besides, the firm is to incur Rs 15 lakh as liquidation costs.
You are required to compute the net asset value per share as per book value,
market value and liquidation value bases.

Solution : Determination of Net Asset Value per Share (Rs lakh)
(i) Book value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities:
10% Debentures
Trade creditors
Provision for taxation
11% Preference share capital
Dividend on preference shares
(0.11 × Rs 40 lakh)
Net assets available for equity holders
Divided by the number of equity shares (in lakh)
Net assets value per share (Rs)
Rs 100
50
10
20
71
8
40
4.4
Rs 120
160
280
143.4
136.6
1.2
113.83

(ii) Market value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities (as per details given
above):
Net assets available for equityholders
Net assets value per equity share (Rs)
102
45
10
130
157
287
143.4
143.6
1.2
119.67

(iii) Liquidation value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities (listed above):
Less: Liquidation costs
Net assets available for equityholders
Divided by the number of equity shares (in
lakh)
Net assets value per equity share (in Rs)
90
40
10
105
140
245
143.4
15.0
86.6
1.2
72.17

©Tata McGraw-Hill PublishingCompanyLimited,Financial Management 32- 320
Earnings Based Approach to
ValuationEarnings based method relates the firm’s value to its
potential future earnings or cash flow generating capacity.
Accordingly, there are two major variants of this approach
(i) Earnings measure on accounting basis and (ii) earnings
measure on cash flow basis.
(i) Earnings measure on accounting basis
As per this method, the earnings approach of business valuation is
based on two major parameters, that is, the earnings of the firm and
the capatilisation rate applicable to such earnings (given the level of
risk) in the market. Earnings, in the context of this method, are the
normal expected annual profits. Normally to smoothen out the
fluctuations in earnings, the average of past earnings (say, of the last
three to five years) is computed.
Value of business (VB) = Future maintainable profits ÷ Relevant
capitalisation factor (4)

Example 2:
In the current year, a firm has reported a profit of Rs 65 lakh, after paying
taxes @ 35 per cent. On close examination, the analyst ascertains that the
current year’s income includes: (i) extraordinary income of Rs 10 lakh
and (ii) extraordinary loss of Rs 3 lakh. Apart from existing operations,
which are normal in nature and are likely to continue in the future, the
company expects to launch a new product in the coming year.
Revenue and cost estimates in respect of the new product are as follows:
(Rs lakh)
Sales
Material cost
Labour cost (additional)
Allocated fixed costs
Additional fixed costs
Rs 60
15
10
5
8
From the given information, compute the value of the business, given that
capitalisation rate applicable to such business in the market is 15 per
cent.

Solution : Valuation of Business (Rs lakh)
Profit before tax (Rs 65 lakh/(1 – 0.35)
Less: Extraordinary income (not likely to accrue in future)
Add: Extraordinary loss (non-recurring in nature)
Add: Incremental income expected from the launch of the new
product:
Sales
Less: Incremental costs:
Material costs
Labour costs
Fixed costs (additional)
Expected profits before taxes
Less: Taxes (0.35)
Future maintainable profits after taxes
Relevant capitalisation factor
Value of business (Rs 78 lakh/0.15)
Rs 15
10
8
60
33
Rs 100
(10)
3
27
120
42
78
0.15
520
Some useful insights into estimate of capitalisation rate can be made by
referring to the Price ear-nings (P/E) ratio. The reciprocal of the P/E ratio is
indicative of the capitalisation factor employed for the business by the
market. In Example 2, the P/E ratio is approximately 6.67 (1/0.15). The
product of future maintainable profits, after taxes, Rs 78 lakh and the P/E
multiple of 6.67 times, yield Rs 520 lakh. Given the fact that P/E ratio is a
widely used measure, it is elaborated below.

Price Earnings (P/E) Ratio
The P/E ratio (also known as the P/E multiple) is the method most
widely used by finance managers, investment analysts and equity
shareholders to arrive at the market price of an equity share. The
application of this method primarily requires the determination of
earnings per equity share (EPS). The EPS is computed as per Equation
EPS = Net earnings available to equity shareholders during the
period/Number of equity shares outstanding during the period. (5)
The EPS is to be multiplied by the P/E ratio to arrive at the market price
of equity share (MPS).
MPS= EPS × P/E ratio (6)
The P/E ratio may be derived given the MPS and EPS.
P/E ratio = MPS/EPS (7)(7)

Example 3
For facts in Example 2, determine the market price per equity share (based
on future earnings). Assuming:
(i) The company has 1,00,000 11% Preference shares of Rs 100 each,
fully paid-up.
(ii) The company has 4,00,000 Equity shares of Rs 100 each, fully paid- up.
(iii) P/E ratio is 8 times.
Solution
Determination of Market Price of Equity Share
Less: Preference dividends (1,00,000 × Rs 11)
Earnings available to equity-holders
Divided by number of equity shares
Earnings per share (Rs 67 lakh/4 lakh)
Multiplied by P/E ratio (times)
Market price per share (Rs 16.75 × 8)
Rs 78,00,000
11,00,000
67,00,000
4,00,000
16.75
8
134

Strategic financial management

To use the DCF approach, accounting earnings (as shown by the
firm’s income statement) are to be converted to cash flow figures as
shown in Format 1.
Format 1: Computation of Cash Flows
After tax operating earnings*
Plus: Depreciation
Plus: Other non-cash items (say, amortisation of non-tangible asset,
such as patents, trade marks, etc and loss on sale of long-
term assets)
* The interest costs are included as a part of the discount rate (K0).

Format 2 shows computation of operating free cash flows (OFCF)
for the purpose of valuation of a business.
Format 2: Determination of Operating Free Cash Flows (OFCFF)
After tax operating earnings*
Plus: Depreciation, amortisation and other non-cash items
Less: Investments in long-term assets
Less: Investments in operating net working capital**
Operating free cash flows (OFCFF)
*Exclusive of income from (i) marketable securities and non-
operating investments and (ii) extraordinary incomes or losses.
**Addition is to be made in the event of decrease of net working
capital.

Format 3: Determination of Free Cash Flows (FCFF)
Operating free cash flows (as per Format 2)
Plus: After tax non-operating income/cash flows*
Plus: Decrease (minus increase) in non-operating
Assets, say marketable securities
Free cash flows to Firm (FCFF)
* Non-operating income (1 – tax rate)
The free cash flow (FCFF) is the legitimate cash flow for the
purpose of business valuation in that it reflects the cash flows
generated by a company’s operations for all the providers (debt and
equity) of its ‘capital’. The FCFF is a more comprehensive term as it
includes cash flows due to after tax non-operating income as well
as adjustments for non-operating assets. Format 3 exhibits the
procedure of determining FCFF.

Approaches/Methods of Valuation
There are four approaches to valuation of
business (with focus on equity share valuation):
1) Assets based,
2) Earnings based,
3) Market value based and
4) Fair value method.

Asset-Based Approach to Valuation
Assets-based method focuses on determining the value
of Net assets = (Total assets – Total external obligations)
(1)
Net assets per share can be obtained dividing total net
assets by the number of equity shares outstanding. It
indicates the net assets backing per equity share (also
known as net worth per share).
Net assets per share = Net assets / Number of equity
shares issued and outstanding (2)

For the purpose of valuing assets and liabilities, it will be useful for a finance
manager/valuer to accord special attention to the following points :
1. While valuing tangible assets, such as plant and machinery, he should consider
aspects related to technological obsolescence and capital improvements made in
the recent years. Depreciation adjustment may also be needed in case the
company is following unsound depreciation policy in this regard.
2. Is the valuation of goodwill satisfactory, given the amount of profits, capital
employed and average rate of return available on such businesses?
3. With respect to current assets, are additional provisions required for
“unrealisability” of debtors? Likewise, are adjustments required for “unsaleable”
stores and stock?
4. With respect to liabilities, there is a need for careful examination of ‘contingent
liabilities’, in particular when there is mention of them in the auditor’s report, with
a view to assess what portion of such liabilities may fructify. Similarly,
adjustments may be required on account of guarantees invoked, income tax,
sales tax and other tax liabilities that may arise.
Liquidation value is the final net asset value (if any) per share available
to the equity shareholder. The value is given as per Equation
Net assets per share = (Liquidation value of assets – Liquidation
expenses – Total external liabilities)/Number of equity shares issued and
outstanding. (3)

Example 1: Following is the balance sheet of Hypothetical Company Limited as on
March 31, current year.
Share capital
40,000 11% Preference shares of
Rs 100 each, fully paid-up
1,20,000 Equity shares of Rs 100
each, fully paid-up
Profit and loss account
10% Debentures
Trade creditors
Provision for income tax
40
120
23
20
71
8
282
Fixed assets
Less: Depreciation
Current assets:
Stocks
Debtors
Cash at bank
Preliminary expenses
Rs 150
30
100
50
10
120
160
2
____
282
Additional Information:
(i) A firm of professional valuers has provided the following market estimates of its
various assets: fixed assets Rs 130 lakh, stocks Rs 102 lakh, debtors Rs 45 lakh. All
other assets are to be taken at their balance sheet values.
(ii) The company is yet to declare and pay dividend on preference shares.
(iii) The valuers also estimate the current sale proceeds of the firm’s assets, in the
event of its liquidation: fixed assets Rs 105 lakh, stock Rs 90 lakh, debtors Rs 40
lakh. Besides, the firm is to incur Rs 15 lakh as liquidation costs.
You are required to compute the net asset value per share as per book value,
market value and liquidation value bases.

Solution : Determination of Net Asset Value per Share (Rs lakh)
(i) Book value basis
Fixed assets (net)
Current assets:
Stock
Debtors
Cash and bank
Total assets
Less: External liabilities:
10% Debentures
Trade creditors
Provision for taxation
11% Preference share capital
Dividend on preference shares
(0.11 × Rs 40 lakh)
Net assets available for equity holders
Net assets value per share (Rs)
Rs 100
50
10
20
71
8
40
4.4
Rs 120
160
280
143.4
136.6
1.2
113.83

©Tata McGraw-Hill PublishingCompanyLimited,Financial Management 32- 340
Earnings Based Approach to
ValuationEarnings based method relates the firm’s value to its
potential future earnings or cash flow generating capacity.
Accordingly, there are two major variants of this approach
(i) Earnings measure on accounting basis and (ii) earnings
measure on cash flow basis.
(i) Earnings measure on accounting basis
As per this method, the earnings approach of business valuation is
based on two major parameters, that is, the earnings of the firm and
the capatilisation rate applicable to such earnings (given the level of
risk) in the market. Earnings, in the context of this method, are the
normal expected annual profits. Normally to smoothen out the
fluctuations in earnings, the average of past earnings (say, of the last
three to five years) is computed.
Value of business (VB) = Future maintainable profits ÷ Relevant
capitalisation factor (4)

Example 2:
In the current year, a firm has reported a profit of Rs 65 lakh, after paying
taxes @ 35 per cent. On close examination, the analyst ascertains that the
current year’s income includes: (i) extraordinary income of Rs 10 lakh
and (ii) extraordinary loss of Rs 3 lakh. Apart from existing operations,
which are normal in nature and are likely to continue in the future, the
company expects to launch a new product in the coming year.
Revenue and cost estimates in respect of the new product are as follows:
(Rs lakh)
Sales
Material cost
Labour cost (additional)
Allocated fixed costs
Additional fixed costs
Rs 60
15
10
5
8
From the given information, compute the value of the business, given that
capitalisation rate applicable to such business in the market is 15 per
cent.

Price Earnings (P/E) Ratio
The P/E ratio (also known as the P/E multiple) is the method most
widely used by finance managers, investment analysts and equity
shareholders to arrive at the market price of an equity share. The
application of this method primarily requires the determination of
earnings per equity share (EPS). The EPS is computed as per Equation
EPS = Net earnings available to equity shareholders during the
period/Number of equity shares outstanding during the period. (5)
The EPS is to be multiplied by the P/E ratio to arrive at the market price
of equity share (MPS).
MPS= EPS × P/E ratio (6)
The P/E ratio may be derived given the MPS and EPS.
P/E ratio = MPS/EPS (7)(7)

Example 3
For facts in Example 2, determine the market price per equity share (based
on future earnings). Assuming:
(i) The company has 1,00,000 11% Preference shares of Rs 100 each,
fully paid-up.
(ii) The company has 4,00,000 Equity shares of Rs 100 each, fully paid- up.
(iii) P/E ratio is 8 times.
Solution
Determination of Market Price of Equity Share
Less: Preference dividends (1,00,000 × Rs 11)
Earnings available to equity-holders
Divided by number of equity shares
Earnings per share (Rs 67 lakh/4 lakh)
Multiplied by P/E ratio (times)
Market price per share (Rs 16.75 × 8)
Rs 78,00,000
11,00,000
67,00,000
4,00,000
16.75
8
134

Venture Capital Financing
Theoretical Framework
Indian Venture Capital Scenario

Venture capital, as a fund-based financial service,
has emerged the world over to fill gaps in the
conventional financial mechanism, focusing on
new entrepreneurs, commercialisation of new
technologies and support to small/medium
enterprises in the manufacturing and the service
sectors.
Venture Capital

Over the years, the concept of venture capital has
undergone significant changes.
It is new technique of financing to inject long-
term capital into the small and medium sectors.
Venture Capital

Features of Venture Capital
• Equity Participation.
• Long-term Investments.
• Participation in Management.
Venture capitalist combines the
qualities of bankers, stock market
investors and entrepreneur in one.

Stages in Venture Financing
• Early Stage Financing
• Expansion Financing
• Acquisition/Buyout Financing

Venture Capital Investment
Process
• Deal Origination
• Screening
• Evaluation
• Deal Structuring
• Post-investment activity
• Exit

Methods of Venture Financing
• Equity
• Conditional Loan
• Income Note
• Other Financing Methods
1. Participating Debentures
2. Partially Convertible Debentures
3. Cumulative Convertible Preference Shares
4. Deferred Shares
5. Convertible Loan Stock
6. Special Ordinary Shares
7. Preferred Ordinary Shares

Features
The characteristics features of venture capital differentiate it
from other capital investments. It is basically equity finance
in relation to new listed companies and debt financing is only
supplementary to ensure running yield on the portfolio of the
venture capitalists/capital institution (VCIs). It is long-term
investment in growth-oriented small/medium firms.
There is a substantial degree of active involvement of VCIs
with the promoters of venture capital undertakings (VCUs) to
provide, through a hands-on approach, managerial skills
without interfering in the management.
The venture capital financing involves high risk-return
spectrum. It is not technology finance though technology
finance may form a sub-set of such financing. Its scope is
much wider.

Based on the above description of venture capital, some of the
distinguishing features of VC as against other capital investments can be
identified as:
 Venture capital is basically equity finance in relatively new companies
when it is too early to go to the capital market to raise funds. However,
such investment is not exclusively equity investment. It can also be made
in the form of loan finance/convertible debt to ensure a running yield on
the portfolio of venture capitalists. Nonetheless, the basic objective of
venture capital financing is to earn capital gain on equity investment at the
time of exist and debt financing is only supplementary.
 It is a long-term investment in growth-oriented small/medium firms. The
acquisition of outstanding shares from other shareholders cannot be
considered venture capital investment. It is new, long-term capital that is
injected to enable the business to grow rapidly.
 There is a substantial degree of active involvement of the venture capital
institutions with the promoters of the venture capital undertakings. It
means such finance also provides business skills to the investee firms
which is termed as ‘hands-on’ approach/management. However, venture
capitalists do not seek/acquire a majority/controlling interest in the
investees, though under special circumstances and for a limited period,
they might have a controlling interest. But the objective is to provide
business/managerial skill only and not interfere in management.

 Venture capital financing involves high risk-return spectrum. Some of
the ventures yield very high returns to more than compensate for heavy
losses on others which also may have had potential of profitable
returns. The returns in such financing are essentially through capital
gains at the time of exits from disinvestments in the capital market.
 Venture capital is not technology finance though technology finance
may form a sub-set of venture capital financing. The concept of venture
capital embraces much more than financing new, high technology-
oriented companies. It essentially involves the financing of small and
medium-sized firms through early stages of their development until they
are established and are able to raise finance from the conventional,
industrial finance market. The scope of venture capital activity is fairly
wide.
In brief, a venture capital institution is a financial intermediary between
investors looking for high potential returns and entrepreneurs who need
institutional capital as they are yet not ready/able to go to the public.
Venture capital institution (fund) is a financial intermediary between
investors looking for high potential returns and enterpreneurs who need
institutional capital as they are yet not ready to go to the public.
Contd.

Selection of Investment
The first step in the venture capital financing decision is the selection of
investment. The starting point of the evaluation process by the venture capital
institution (VCI) is the business plan of the venture capital undertaking (promoter).
The selection of the investment proposal includes, inter alia, stages of financing,
methods to evaluate deals and the financial instruments to structure a deal.
Stages of Financing
The selection of investment by a VCI is closely related to the stages and type of
investment. From analytical angle, the different stages of investments are
recognised and vary as regards the time-scale, risk perceptions and other related
characteristics of the investment decision process of the VCIs. The stages of
financing, as differentiated in the venture capital industry, broadly fall into two
categories: (a) early stage, and (b) later stage.
Early Stage Financing
This stage includes (i) seed capital/pre-start-up, (ii) start-up and (iii) second-round
financing.
Later Stage Financing
This stage of venture capital financing involves established businesses which
require additional financial support but cannot take recourse to public issues of
capital. It includes mezzanine/development capital, bridge/ expansion, buyouts and
turnarounds.

Early Stage Financing
Seed Capital
This stage is essentially an applied research phase where the
concepts and ideas of the promoters constitute the basis of a pre-
commercialisation research project usually expected to end in a
prototype which may or may not lead to a business launch.
Start up
Start up is a stage when product/service is commercialised for the
first time in association with venture capital institution.
Second Round Financing
This represents the stage at which the product has already been
launched in the market but the business has not yet become
profitable enough for public offering to attract new investors. The
promoter has invested his own funds but further infusion of funds by
the VCIs is necessary.

Later Stage Financing
Mezzanine/Development Capital
This is financing of established businesses which have overcome the
extremely high-risk early stage, have recorded profits for a few years but are
yet to reach a stage when they can go public and raise money from the
capital market/conventional sources.
Bridge/Expansion
This finance by VCIs involves low risk perception and a time-frame of one to
three years. Venture capital undertakings use such finance to expand
business by way of growth of their own productive asset or by the
acquisition of other firms/assets of other firms. In a way, it represents the
last round of financing before a planned exit.
Buyouts
These refer to the transfer of management control. They fall into two
categories:
Management Buyout Management buyouts are provisions of funds to enable
existing management/investors to acquire an existing product.
Management Buyins Management buyins are funds provided to enable an
outside group buy an ongoing venture/company.

Turnarounds
These are a sub-set of buyouts and involve buying the
control of a sick company. Two kinds of inputs are
required in a turnaround—namely, money and
management. The VCIs have to identify good management
and operations leadership. Such form of venture capital
financing involves medium to high risk and a time-frame
of three to five years. It is gaining widespread acceptance
and increasingly becoming the focus of attention of VCIs.

Financial Analysis
The venture investments are generally idea-based and
growth-based. Some of the valuation methods which
illustrate the approach that VCIs can adopt are:
1) Conventional venture capitalist valuation method,
2) The first Chicago method and
3) The revenue multiplier method.

(1) Conventional Venture Capitalist Valuation Method
Conventional method is a method of valuation of venture capital
undertakings which takes into account only the starting time of investment
and the exit time.
The sequence of steps in the valuation of the VCUs and the determination of
the percentage share ownership of the VCIs in the ICs are:
1) To compute the annual revenue at the time of liquidation of the
investments, the present annual revenue in the beginning is
compounded by an expected annual growth rate for the holding period,
say, seven years;
2) Compute the expected earnings level, that is equal to future earnings
level multiplied by after tax margin percentage at the time of liquidation;
3) Compute the future market valuation of the VCU, that is equal to
earnings levels multiplied by expected P/E ratio on the date of
liquidation;
4) Obtain the present value of the ICs, using a suitable discount factor; and
5) If the present value of the VCU is Rs 50 lakh and the entrepreneur wants
Rs 20 lakh as the venture capital from the VCIs, the minimum
percentage of ownership required is two-fifths (40 per cent).
The weakness of this method is that it ignores the stream of earnings
(losses) during the entire period and over-emphasises the one exit date.

(2) The First Chicago Method
The first chicago method is a method of valuation that considers the
entire earnings stream of the venture capital undertaking/investor
companies.
The steps involved in the valuation process are:
1) Three alternative scenarios, are perceived/considered, namely,
success, sideways survival and failure. Each one of these is
assigned a probability rating;
2) Using a discount rate, the discounted present value of the VCU is
computed. The discount rate is substantially higher to reflect risk
dimension.
3) The discounted present value is multiplied by the respective
probabilities. The expected present value of the VCU is equal to
the total of these in the three alternative scenarios.
4) Assuming expected present value of the VCU at Rs 5 crore and the
fund requirement from the VCIs as Rs 2.5 crore, the minimum
ownership required is 50 per cent (half).

(3) Revenue Multiplier Method
A revenue multiplier is a factor that can be used to estimate the value of a
VCU. By multiplying that factor the annual revenue of the company is
estimated by VCIs. Symbolically,
Where,
V = present value of the VCU
R = annual revenue level
r = expected annual rate of growth of revenue
n = expected number of years from the starting date to the exit date (holding
period)
a = expected after-tax profit margin percentage at the time of exit
P = expected price/earnings (P/E) ratio at exit time
d = appropriate discount rate for a venture investment at this stage
This method can be used in the case of early stage/start-up venture capital
investments when earnings, based on after-tax profits, may be low/negative
in early years but there may be revenue/sales income.
( ) ( )( )
( )n
d1
pa
n
r1
R
V
t
M
+
+==

Structuring the Deal/Financial Instruments
The structuring of the deal refers to the financial
instruments through which venture capital
investment is made. From the point of view of
nature, the financial instruments a VCI can
choose from, can be broadly divided into
Equity instruments
Debt instruments

Equity Instruments
1) Ordinary equity shares;
2) Non-voting equity shares which are entitled to a higher dividend but carry no
voting rights;
3) Deferred ordinary shares on which the ordinary share rights are deferred for a
specified period/until the happening of a certain event such as listing of shares
on the stock exchange or the sale of the company;
4) Preferred ordinary shares. In addition to the voting rights, such shares also
carry rights to a modest fixed dividend;
5) Equity warrants entitle investors in debentures/bonds to acquire ordinary
shares at a future date;
6) Preference shares;
7) Cumulative convertible preference shares which are converted into equity
shares after a specified time;
8) Participating preference shares which, in addition to the preference dividend,
are entitled to an extra dividend after the payment of dividend to the equity
shareholders;
9) Cumulative convertible participatory preferred ordinary shares combine the
benefit of preferred dividend and cumulative as well as participative features
and
10) Convertible cumulative redeemable preference shares have two elements,
namely, convertibility into equity at specified point of time and redeemability on
the expiry of a certain period.

Debt Instruments
To ensure that the entrepreneur retains managerial control and the VCI
receives a running yield during the early years when the equity portion is
unlikely to yield any return, debt instruments are also used by VCIs. They
include, in addition to conventional loans, income notes, non-convertible
debentures, partly convertible debentures, fully convertible debentures,
zero interest bonds, secured premium notes and deep discount bonds.
Condition Loan
Condition loan is a quasi-equity instrument without any pre-determined
repayment schedule or interest rate; the charge is a royalty on sales.
Conventional Loans
These are modified to the requirements of venture capital financing. They
carries lower interest initially which increases after commercial production
commences.
Income Notes
Income notes are instruments which carry a uniform low rate of interest
plus a royalty on sales.

Non-convertible Debentures (NCDs)
These carry a fixed/variable rate of interest, are redeemable at par/premium,
are secured, and can be cumulative/non-cumulative.
Partly Convertible Debentures (PCDs)
These have two components: (i) a convertible portion and (ii) a non-
convertible portion. The convertible portion is converted into equity shares at
par/premium. The non-convertible portion earns interest till redemption
generally at par.
Zero Interest/Coupon Bonds/Debentures
These can be either convertible or non-convertible with zero/no interest rate.
The non-convertible bonds are sold at a discount from their maturity value
while the convertible ones are converted into equity shares at a stipulated
price and time.
Secured Premium Notes
These are secured, redeemable at premium in lumpsum/instalments, have zero
interest and carry a warrant against which equity shares can be acquired. This
instrument is also useful for later stage financing.
Deep Discount Bonds
These are issued at a large discount to their maturity value. As a long-term
instrument, these are not suited to venture capital investment.

Investment Nurturing/Aftercare
The after-care stage of venture capital financing relates
to different styles of nurturing, its objectives and
techniques. The style of nurturing which refers to the
extent of participation by VCIs in the affairs of the
venture, falls into three broad categories: hands on,
hands off and hands holding. Some of the important
techniques to achieve the objectives are personal
discussion; plant visits, nominee directors, periodic
reports and commissioned studies.

Styles
Hands-on Nurturing
Hands-on nurturing is a continuous and constant involvement in the
operations of the investee company by the venture capital institution
which is institutionalized in the form of representation on the board
of directors.
Hand-off Nurturing
Hand-off nurturing is the passive role played by venture capital funds
in formulating strategies/policy matters.
Hands-holding Nurturing
This is mid-way between hands-on and hands-off styles. It is,
essentially, a reactive approach. Like the hands-on style, the VCI has
the right to have a nominee on the board of directors of the VCU, but
actively participates in the decision making process only on being
approached by the latter. If the VCU experiences any difficulty, the
VCI provides either in-house assistance or assistance from outside
experts.

Valuation of Portfolio
The venture capital portfolio has to be valued from time to
time to monitor and evaluate the performance of the venture
capital investment, that is, whether there has been an
appreciation in the value of the investment or otherwise. The
portfolio valuation approaches/techniques depend on the type
of investments, namely, equity and debt instruments. These, in
turn, depend on the stage of investment: seed, start-up, early
and later stages of the venture.
Equity Instruments
1) Cost Method
2) Market Value Based Methods
Debt Instruments
1) Convertible
2) Non-convertible
3) Leveraged

(1) Cost Method
According to this method, the value of equity holding is
computed/recorded at the historical cost of acquisition until it is
disposed of. Although simple, objective, and easy to under-stand, it
does not indicate a fair value of investment, does not reflect
management performance and may result in two values for equity
acquired at two different points in time. It does not provide a
satisfactory basis of valuation of venture capital investments.
(2) Market Value-based Methods
(1) Quoted Market Value Method
This is based on market quotations of securities. It is, therefore,
relevant only to organisations listed on stock exchanges.
(2) Fair Market Value Method
Fair value is the price to be agreed upon in an open and unrestricted
market between parties and equationally expressed as: a
representative level of earnings x appropriate capitalisation rate.

Stages of Investments
Unquoted Venture Investments
Unquoted venture investments are defined as investments in
immature companies, namely, seed, start-up and early stage,
until the companies stabilise and grow. They should generally
be valued at cost as their market value is not available.
Unquoted Development Investments
Unquoted development investments are investments in mature
companies with a profit record and where an exit can be
reasonably foreseen. They also do not have a market value.
Quoted Investments
Quoted investments in companies which have achieved a
possible exit by floatation of issues. They are valued at market
quotations.

Debt Instruments
(1) Convertible Debt
Debt instruments are generally valued at cost. But convertible
debts are converted into equity at a specified price and time.
They should, therefore, be valued in the case of VCIs on the
same basis as equity investments. There are two appropriate
methods for valuing them
(i) Market Value Method
This is appropriate for quoted convertible debt investments on
the basis of the same principles as are applicable to quoted
investments.
(ii) Fair Value Method
This is appropriate, as in the case of unquoted equity
investments, for unquoted convertible debt investments. As
pointed out earlier, the valuation according to this method is
based on the price agreed upon in an open and unrestricted
market.

(2) Non-convertible Debt
This debt supplied by VCIs can be of two types
(i) Fixed Interest Non-convertible Debt
This should be valued by relating the nominal yield of the investment
to an appropriate current yield which depends upon a number of
factors such as interest yield on the date of valuation, maturity date
of the issue, safety of the principal, debt-service coverage, stability
and growth of the earnings of the venture and so on.
(ii) Non-interest Non-convertible Debt
A factor of critical importance in this case is the solvency of the
venture. If it is doubtful, an appropriate discount rate may be used to
the value computed according to the method used for valuating fixed
interest non-convertible debt.
(3) Highly Leveraged Investments
These should, generally, be valued at cost.

Structural Aspects
The alternative forms in which VCIs can be structured
are:
1) Limited partnership,
2) Investment company,
3) Investment trust,
4) Offshore funds and
5) Small business investment company.

1) Limited Partnership
Normally, the partnership form of organisation/structure has
unlimited liability of partners. Limited partnership consists of two
types of partners: general and limited. The general partner, whose
liability is unlimited, invites other investors to become limited
partners in the partnership with limited liability and invest but do not
participate in the actual operations of the business. The main
functions of the general partners/service corporations are:
1) business identification and development,
2) investment appraisal and investigation of potential investment,
3) negotiation and closing of deals,
4) investment monitoring, advice and assistance to VCUs;
5) arrangement for sale of shares at the exit time and
6) other fund management functions.

Mode of Compensation
The general partner/service corporation as a fund manager is compensated
in two ways: (i) annual management fee, (ii) carried interest.
(i) Annual Management Fee
This covers the normal operating expenses such as salary and allowances
of employees, administrative expenses and all expenses related to the
selection of investments as well as disinvestments but excludes legal
expenses and professional fee related to investment portfolio which are
reimbursed separately.
(ii) Carried Interest
The most popular approach is that the general partner contributes one per
cent and the limited partners contribute 99 per cent of the capital of the
fund. The general partner normally receives one-fifth of the net gains as
carried interest while the remaining four-fifths is distributed among the
limited partners.
Evaluation
The benefit of limited partnership, as a form of structuring of VCIs, is its tax
treatment. The profit of limited partnership is taxed only at the level of the
partners. It is completely tax free if the partner is a tax free entity such as
pension funds.

(2) Investment Company
This is organised as a limited company. Although it is the simplest
structure for a VCI, a serious drawback is the double taxation of
income. Both the investment company and its shareholders are
liable to tax on their respective incomes.
(3) Investment Trust
This is a company and is, generally, not liable to tax on chargeable
gains/dividends but most of the other income of the trust is taxable.
(4) Offshore Investment Company
This is incorporated in a country other than the country in which the
offshore company makes an investment. Its tax liability depends on
the tax laws applicable to the resident status of the company.
Offshore Unit Trust
This resembles an offshore investment company in organisation but
enjoys tax concessions and has a very flexible structure.

Exit
The last stage in venture capital financing is the exit to realise the investment so
as to make a profit/minimise losses. The important aspect of the exit stage of
venture capital financing is the decision regarding the disinvestments/realisation
alternatives which are related to the type of investment, namely, equity/quasi-
equity and debt instruments.
Disinvestments of Equity/Quasi-Equity Investments
There are five disinvestment channels for realisation of such investments:
1) going public,
2) sale of shares to entrepreneurs/employees,
3) trade sales/sale to another company,
4) selling to a new investor and
5) liquidation/receivership.
The first four alternative routes are voluntary while the last one is involuntary.
(5) Small Business Investment Company
This provides an impetus to banks to participate in ventures in the form of equity
and long term debt. It can, however, invest only in small concerns. It is
prohibited from investing more than 20 per cent of its capital and reserves nor is
it allowed to acquire controlling interest in a single company. The loans must be
for more than five years. It has a very flexible structure of equity investments.

Going Public/Initial Public Offering/Flotation
The most common channel of disinvestment by a VCI is through
public issue of capital of the VCU, including its own holdings. The
merits of public issues are liquidity of investments through listing on
stock exchanges, higher price of securities compared to private
placement, better image and credibility with public, managers,
customers, financial institution and so on.
Sale of Shares to Entrepreneurs/Employees/Earnout
The shares/stakes of VCIs may be sold to the
entrepreneurs/companies themselves who are allowed to buy their
own equity.

Important Put-and-call Formulae
Book Value Method This is used in mature companies that have achieved a
healthy track record, that is they have achieved a reasonable degree of stability
in operations.
P/E Ratio This is the most common method for exercising the put and call
option. The price is equal to the earnings per share multiplied by the P/E ratio.
Percentage of Sales Method This is a modified P/E ratio. On the basis of the pre-
tax earnings/profit before tax as a percentage of sales for the industry, the
hypothetical/notional profit before tax for the investee company is determined as
also the earnings per share. The value of the shares is obtained by multiplying
the notional earnings per share with the industry P/E ratio. This method is
suitable in the early stages when profits are lower but the sales have reached a
reasonable level.
Multiple of Cash Flow Method In this, cash flow is used in place of the earnings
or sales. The cash flow is multiplied by the industry multiplier to arrive at the
value of the company/shares.
Independent Valuation This is valuation by outside experts on the basis of either
earnings potential method/price-earnings ratio method or the liquidation method.
On the assumption of liquidation a VCU, the net value is computed on the basis
of the net/relisable value of all the assets less the liabilities.
Agreed Price This is the price between the VCIs and the entrepreneur agree on
at the time of making the investment itself.

Trade Sales
Trade sales implies the sale of entire investee company to another
company/third party.
Sales to a New Investor/Takeout
Takeout is the sale of equity stake of venture capital institutions to a new
investor including another venture capital fund.
Liquidation
This is an involuntary exit forced on the VCI as a result of a totally failed
investment. The VCIs can use this exit method when the venture is not
performing well and has reached a stage beyond recovery due to stiff
competition, technology failure/obsolescence of technology, poor management
and so on.
Exit of Debt Instruments
Exit in case of debt component of venture capital financing, in contrast with
equity/quasi-equity component, has to normally follow the pre-determined
route. In case of a normal loan, the exit is possible only at the end of the period
of loan. If the loan agreement permits, whole or part can be converted into
equity prior to that. For conditional loans, exit, earlier than projected at the time
of initial investment, is possible on the basis of lumpsum repayment consistent
with the expectations of the VCI of the likely return on the loan.

Indian Venture Capital Scenario
The venture capital industry in India is of relatively recent origin. Before its
emergence, the DFIs had partially been playing the role of venture capitalists
by providing assistance for direct equity participation to ventures in the pre-
public stage and by selectively supporting new technologies. The concept of
venture capital was institutionalised/operationalised in November 1988 when
the CCI issued guidelines for setting up of VCFs for investing in unlisted
companies and to avail of a concessional facility of capital gains tax. These
guidelines, however, construed venture capital rather narrowly as a vehicle
for equity-oriented finance for technological upgradation and
commercialisation of technology promoted by relatively new entrepreneurs.
These were repealed on July 25, 1995.
Recognising the growing importance of venture capital, the Government
announced a policy for governing the establishment of domestic VCFs. They
were exempted from tax on income by way of dividends and long-term capital
gains from equity investment in the specified manner and in conformity with
stipulations in unlisted companies in the manufacturing sector, including
software units, but excluding other service industries. To augment the
availability of venture capital, guidelines were issued in September, 1995 for
overseas venture capital investments in the country. After empowerment to
register and regulate VCFs, SEBI issued VCF Regulations, 1996.

SEBI Venture Capital Funds (VCFs) Regulations, 1996
According to these regulations, a VCF means a fund established in the
form of a trust/company; including a body corporate, and registered with
SEBI which
1) has a dedicated pool of capital raised in a manner specified in the
regulations and
2) invests in accordance with these regulations.
A VCU means a domestic company
1) whose shares are not listed on a recognised stock exchange in India
and
2) which is engaged in the business of providing services/production
/manufacture of articles/things but does not include such
activities/sectors as are specified in the negative list by SEBI with
governmental approval—namely, non-banking financial companies
(NBFCs), gold financing, activities not permitted under the industrial
policy of the Government and any other activity which may be
specified by SEBI in consultation with the Government from time to
time.

Registration
All VCFs must be registered with SEBI and pay Rs 1,00,000 as application fee
and Rs 10,00,000 as registration fee for grant of certificate. The eligibility
criteria for registration is:
 The applicant should be either a (i) company under the Companies Act
or a (ii) trust under the Indian Trust Act, 19882, or under an Act of
Parliament or state legislature or a (iii) body corporate set up under the
law of the Central or state legislature;
 Its main objective, as contained in the memorandum of association in
case it is a company/instrument of the trust deed duly registered in the
form of a deed under the provisions of the Indian Registration Act, 1908,
in case of a trust, is to carry on the activity of a VCF and the body
corporate is permitted to carry on activities of a VCF;
 In the case of a company applicant, its memorandum and articles of
association prohibit invitation to public to subscribe to its securities;
 Its director/principal officer/employee/trustee/director of trustee
company/body corporate is not involved in any litigation connected with
the securities industry which may have an adverse bearing on its
business;

 Its director/principal officer/employee/trustee/director of trustee company/
body corporate has not at any time been convicted of any offence involving
moral turpitude/any economic offence.
 The applicant is a fit and proper person. The provisions of the SEBI Criteria
for Fit and Proper Person Regulations, 2004 would be applicable to all the
VCFS; and
 The applicant has not been refused registration or its registration not
suspended/cancelled by SEBI.
The applicant would have to furnish further information as the SEBI may require.
The certificate of registration from the SEBI is, inter alia, subject to the
following conditions:
1) The VCF has to abide by the provisions of the SEBI Act and SEBI VCF
regulations;
2) The VCF cannot carry on any other activity; and
3) It would immediately inform the SEBI in writing (a) if any information/
particulars submitted to it earlier are found to be false/misleading in any
material particular, or (b) there is any change in the material already
submitted.
An applicant, whose application has been rejected by SEBI, would not carry on
any activity as a VCF. In the interest of investors, SEBI can issue directions with
regard to transfer of records/documents/ securities/disposal of investments
relating to its activities as a VCF.

Investment Conditions and Restrictions
Minimum Investment in VCF
The VCFs are authorised to raise funds/money from (i) Indian, (ii) foreign and (iii)
non-resident Indians (NRIs) investors by way of issue of units, that is, beneficial
interest of the investors in the scheme/fund floated by trust or shares issued by a
company; including a body corporate. Excepting (a) employees/principal
director/directors of trustee company/trustee, (b) employees of fund manager/asset
management company, the minimum investment in a VCF by an investor must be Rs
5 lakh. Each scheme launched/fund set up by a VCF should have a firm commitment
from the investors for contribution of at least Rs 5 crore before the start of its
operation.
Restriction on Investment by VCF
The VCFs should, one, disclose the investment strategy at the time of their
registration. Two, they cannot invest more than 25 per cent corpus of the fund in one
VCU. Three, they are prohibited from investing in associate companies. An associate
company means a company which a director/trustee/sponsor/settler of the
VCF/asset management company holds individually/collectively equity shares in
excess of 15 per cent of the paid-up capital of the VCU.
The VCFs may invest in the securities of foreign companies subject to SEBI/RBI
conditions/guidelines. Moreover, at least 66.67 per cent of the investible funds (i.e.
corpus of the fund net of expenditure for administration and management of the
fund) of VCFs should be invested in unlisted equity shares/equity linked instruments
(i.e. convertible securities/share warrants/preference shares, debentures
compulsorily or optionally convertible into equity).

Prohibition on Listing
No VCF would be entitled to get its units listed on any recognised stock
exchange till the expiry of three years from the date of issuance of units by it.
General Obligations and Responsibilities
A VCF is not permitted to issue any document/advertisement inviting offers
from public for subscription/purchase of any of its units. It may receive
money from investment in the VCF through only private placement of its
units.
Placement Memorandum/Subscription Agreement
The VCF should (i) issue a placement memorandum containing details of the
terms/conditions or (ii) enter into contribution/subscription agreement with
the investors specifying the terms/conditions subject to which money is
proposed to be raised.

The contents of the placement memorandum/subscription agreement by a
VCF established as a trust are listed as follows:
a) Details of the trustees or trust company and the directors or chief
executives of the venture capital fund;
b) (i) Proposed corpus of the fund and the minimum amount to be raised for
the fund to be operational, (ii) Minimum amount to be raised for each
scheme and the provision of refund of money to investors in the event of
non-receipt of minimum amount;
c) Details of entitlements on the units of the VCF for which subscription is
being sought;
d) Tax implications that are likely to apply to investors;
e) Manner of subscription to the units of the VCF;
f) The period of maturity, if any, of the fund;
g) The manner, if any, in which the fund is to be wound up;
h) The manner in which the benefits accruing to investors in the units of the
trust are to be distributed;
i) The details of the fund manager or the asset management company, if
any, and of fees to be paid to such manager;
j) The details about the performance of the fund, if any, by the fund
manager;
k) Investment strategy of the fund; and
l) Any other information specified by SEBI.

Maintenance of Books/Records
The VCFs must maintain, for a period of eight years, books of
accounts/records/documents which give a true and fair picture of the state of
their affairs.
Winding-up
A VCF established as a company can be wound up in accordance with the
provision of the Companies Act. A scheme of the VCF set up as a trust would
be wound-up:
 when the period of the scheme mentioned in the placement memorandum
is over;
 if in the opinion of trustees/trustee company the scheme should be wound
up in the interest of the investors in the scheme;
 when 75 per cent of the investors in the scheme resolve in a meeting of the
unitholders;
 when SEBI directs in the interest of the investors.
A VCF set up as a body corporate would be wound up in accordance with the
provisions of the statute under which it is constituted.
The trustees/trustee company of the VCF set up as a trust or the Board of
Directors in case of a company/body corporate must inform SEBI/investors of
the circumstances leading to the winding up of the scheme.

Inspection and Investigation
SEBI may, suo moto, or upon receipt of information/complaint appoint
one/more person(s) as inspecting/investigating officer(s) to undertake
inspection/investigation of the books of accounts/records/documents relating
to a VCF for any of the following reasons:
 To ensure that the books of accounts, records and documents are being
maintained by it in the specified manner;
 To inspect or investigate into complaints received from investors, clients or
any other person, on any matter having a bearing on its activities;
 To ascertain whether it is complying with the provisions of the SEBI Act
and its regulations;
 To inspect or investigate suo moto into the affairs of a venture capital fund,
in the interest of the securities market/investors.

Obligations of VCFs
Every officer of the VCF, in respect of whom an inspection/investigation has been
ordered by SEBI and any other associate person who is in possession of relevant
information pertaining to its conduct/affairs, including fund manager/asset
management company, would be dutybound to
1) produce for the investigating/inspecting officer such books, accounts and other
documents as are in his custody/control and furnish him with the relevant
statements and information and
2) to give him all assistance and cooperation and
3) such information as required/sought by him.
On the basis of the inspection/investigation report, SEBI may call upon the VCF to
take such measures as it may deem fit in the interest of the securities market and
for due compliance with the provisions of the SEBI Act, and these regulations.
It may also issue to the VCF/trustees/directors such directions as it deems fit in the
interest of the securities market/investors, including directions in the nature of
1) requiring the VCF not to launch any new scheme/raise money from investors for
a particular period,
2) prohibiting the person concerned from disposing of any of the properties of the
fund/scheme acquired in violation of the VCF (these) regulations,
3) requiring him to dispose of the assets of the fund/scheme in a specified manner,
4) requiring him to refund any money/asset to the concerned investors along with
the requisite interest or otherwise collected under the scheme and
5) prohibiting him from operating in or from accessing the capital market for a
specified period.

Action in Case of Default
SEBI can suspend/cancel the registration of a VCF on the basis of the due
procedure.
Suspension of Registration
The certificate of registration granted to a VCF can be suspended by SEBI, in
addition to issuing of directions/measures specified above, in the following
circumstances:
a) Contravention of any of the provisions of the SEBI Act or these
regulations;
b) Failure to furnish any information relating to its activity as a VCF as
required by SEBI;
c) Furnishing to SEBI information which is false/misleading in any material
particular;
d) Non-submission of periodic returns/reports as required by SEBI;
e) Non-cooperation in any enquiry, inspection/investigation conducted by
SEBI;
f) Failure to resolve the complaints of investors/to give a satisfactory reply
to SEBI in this behalf.

Cancellation of Registration
The registration of a VCF can be cancelled by SEBI when it:
is guilty of fraud or is convicted of an offence involving moral turpitude;
has been guilty of repeated defaults which may result in suspension of the
registration;
contravenes any of the provisions of the SEBI Act or these regulations.
The order of suspension/cancellation of certificate of registration would be
published by SEBI in two newspapers. On and from the date of
suspension/cancellation, the VCF would cease to carry on any activity as a VCF
and would be subject to directions from concerning SEBI the transfer of
records, documents/securities that may be in its custody/control as it may
specify.
Action Against Intermediaries
SEBI may initiate action for suspension/cancellation of registration of an
intermediary (registered with it) who fails to exercise due diligence in the
performance of its functions or fails to comply with its obligations under these
regulations.
Any person aggrieved by an order of SEBI under these regulations may prefer
an appeal to the Securities Appellate Tribunal (SAT).

SEBI Foreign Venture Capital Investors (FVCIs) Regulations, 2000
A foreign venture capital investor (FVCI) is an investor incorporated and
established outside India which proposes to make investment in India and is
registered with SEBI under these regulations. While VCFs refer to funds
established in the form of a trust/company, including a body corporate, and
registered with SEBI Venture Capital Fund Regulations, 1996, which have a
dedicated pool of capital raised in the manner specified under the regulations
and invested in accordance with the regulations, a VCU is a domestic company
1) whose shares are not listed in a recognised stock exchange in India,
2) which is engaged in the business of providing services,
production/manufacture of articles/things but does not include such
activities/sectors as specified in the negative list by SEBI with Government
approval—namely NBFCs, gold financing, activities not permitted under
the industrial policy of the Government and any other activity which may
be specified from time to time. The main elements of FVCIs are described
below.

Registration
A FVCI should be registered with SEBI to carry on business in India. To seek
registration with SEBI, an applicant should apply in the prescribed form along with
an application fee of US $5,000. The eligibility criteria for registration of an applicant
include the following conditions:
1) its track record, professional competence, financial soundness, experience,
general reputation of fairness and integrity;
2) the RBI’s approval for investing in India;
3) it is an investment company/trust/partnership, pension/mutual/endowment
fund, charitable institution or any other entity incorporated outside India;
4) it is an asset/investment management company, investment manager or any
other investment vehicle incorporated outside India;
5) it is authorised to invest in VCFs/carry on activity as a VCF;
6) it is regulated by an appropriate foreign regulatory authority or is an income tax
payer or submits a certificate from its banker of its promoters’ track record
where it is neither a regulated entity nor an income tax payer;
7) it has not been refused a certificate by SEBI and
8) it is a fit and proper person. The provisions of SEBI Criteria for Fit and Proper
Person Regulation 2004 would be applicable to all FVCIs. The applicant may be
required by SEBI to furnish such further information as it may consider
necessary.

On being satisfied that the applicant is eligible and on receipt of the registration
fee of US $20,000, SEBI would grant it a certificate of registration subject, inter
alia, on the conditions that it would
a) abide by the SEBI Act and FVCIs regulation,
b) appoint a domestic custodian (i.e. a person registered under SEBI
Custodian of Securities Regulations, 1996) for custody of securities
c) enter into an arrangement with a designated bank (i.e. any bank in India
permitted by the RBI to act as a banker to the FVCI) for operating a special
non-resident rupee/foreign currency account, and
d) forthwith inform SEBI, in writing, if any information/particulars previously
submitted to it are found to be false/misleading in any material particular or
if there is any change in any information already submitted.

Investment Criteria
The investments by FVCIs should conform to the norms prescribed by SEBI.
First, they should disclose their investment strategy to SEBI. Second, they can
invest their total funds committed in one FVCI. Third, at least 66.67 per cent of
their investible funds (i.e. funds committed for investment in India net of
expenditure for administration and management of the fund) should be invested
in unlisted equity shares/equity-linked instruments, that is, convertible
securities/ share warrants, preference shares, debentures
compulsorily/optionally convertible into equity of VCUs.
General Obligations and Responsibilities The FVCIs have to maintain, for a
period of eight years, books of accounts/records/documents which would give
a true and fair picture of their affairs and intimate to SEBI the place where they
are being maintained.
On the basis of the inspection/investigation report, SEBI has the right to require
the FVCI to take such measures or issue such directions as it deems fit in the
interest of the capital market and investors, including directions in the nature of
a) requiring the disposal of the securities or investment in a specified
manner,
b) requiring not to further invest for a particular period and
c) prohibiting operation in the capital market in India for a specified period.

Inspection and Investigation The SEBI has the right to, suo moto, or upon
receipt of information/complaint, order an inspection/investigation in respect
of conduct and affairs of any FVCI by an officer to
1) ensure that the books/accounts/documents are being maintained in the
specified manner,
2) inspect/investigate into complaints from investors/clients/any other
person on any matter having a bearing on its activities,
3) ascertain whether the provisions of the SEBI Act and FVCIs regulations
are being complied with and
4) inspect/investigate, suo moto, into its affairs in the interest of the
securities market/investors.
He would also have the power
1) to examine on oath and record the statement of any person responsible
for or connected with the activities of the FVCI and
2) to get authenticated copies of documents/books/accounts of the FVCI
from any person having control/custody over them.

Procedure for Action in Case of Default
In addition to the issue of appropriate directions specified above, SEBI can also
suspend/cancel registration of the FVCI on the basis of the investigation report.
Suspension of Registration
The registration of a FVCI can be suspended by SEBI if it
1) contravenes any of the provisions of the SEBI Act or SEBI FVCI Regulations,
2) fails to furnish any information relating to its activities as required by SEBI,
3) furnish to it information which is false/misleading in any material particular,
4) does not submit periodic returns/reports as required by it and
5) does not cooperate in any enquiry/inspection conducted by it.
Cancellation of Registration
The SEBI may cancel the registration of a FVCI when he
1) is guilty of fraud/has been convicted of an offence involving moral turpitude,
2) has been guilty of repeated defaults of the nature resulting in suspension of
registration;
3) does not meet the eligibility criteria laid down in SEBI FVCIs Regulations and
4) contravenes any of the provisions of SEBI Act/these regulations.
The order of suspension/cancellation of registration may be published by SEBI
in two newspapers.

Strategic Financial Management Deals with:
1.Investment decisions
 Long Term Investment Decisions
 Short Term Investment Decision
1.Financing Decisions
 Best means of financing- Debt Equity Ratio
1.Liquidity Decisions
 Organization maintain adequate cash reserves or
kind such that the operations run smoothly
1.Dividend Decisions
 Disbursement of Dividend to Share holder and
Retained Earnings
5. Profitability Decisions

Financing Decisions
The second major decision involved in financial
management is the financing decision. The
investment decision is broadly concerned with
the asset-mix or the composition of the assets of
a firm. The concern of the financing decision is
with the financing-mix or capital structure or
leverage. There are two aspects of the financing
decision.
First, the theory of capital structure which shows the
theoretical relationship between the employment of debt
and the return to the shareholders. The second aspect of
the financing decision is the determination of an
appropriate capital structure, given the facts of a
particular case. Thus, the financing decision covers two
interrelated aspects: (1) the capital structure theory, and

© Tata McGraw-Hill Publishing Company
Limited, Financial Management
24-406
Hybrid Source Of Financing
A hybrid source of financing partakes
some features of equity shares and some
features of debt instruments.
The important hybrid instruments are:
Preference Shares,
Convertible Debentures/Bonds,
Warrants And Options.
The issue procedure for these instruments
is similar to the raising of equity shares.

24-407
HYBRID FINANCING/INSTRUMENTSHYBRID FINANCING/INSTRUMENTS
Preference Share Capital
Warrants
Convertible Debentures/Bonds
Options

24-408
Preference capital is a unique type of long-term financing in that it
combines some of the features of equity as well as debentures. As a
hybrid security/form of financing, it is similar to debenture insofar as:
1) it carries a fixed/stated rate of dividend,
2) it ranks higher than equity as a claimant to the income/assets,
3) it normally does not have voting rights and
4) it does not have a share in residual earnings/assets.
It also partakes some of the attributes of equity capital, namely
1) dividend on preference capital is paid out of divisible/after tax
profit, that is, it is not tax-deductible,
2) payment of preference dividend depends on the discretion of
management, that is, it is not an obligatory payment and non-
payment does not force insolvency/liquidation and
3) irredeemable type of preference shares have no fixed maturity
date.

24-409
Features/Attributes
Prior Claim on Income/Assets Preference capital has a prior
claim/preference over equity capital both on the income and assets
of the company. In other words, preference dividend must be paid
in full before payment of any dividend on the equity capital and in
the event of liquidation, the whole of preference capital must be
paid before anything is paid to the equity capital.
Cumulative Dividends Cumulative (dividend) Preference shares are
preference shares for which all unpaid dividends in arrears must be
paid along with the current dividend prior to the payment of
dividends to ordinary shareholders.
Redeemability Preference capital has a limited life/specified/fixed
maturity after which it must be retired. However, there are no
serious penalties for breach of redemption stipulation.
Straight Preference Shares Straight preference shares value/price
is the price at which a preference share would sell without the
redemption/call feature.

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Fixed Dividend Preference dividend is fixed and is expressed as a
percentage of par value. Yet, it is not a legal obligation and failure to
pay will not force bankruptcy. Preference capital is also called a fixed
income security.
Convertibility Conversion feature convertibility is a feature that
allows preference shareholders to change each share in a stated
number of ordinary shares.
Voting Rights Preference capital ordinarily does not carry voting
rights. It is, however, entitled to vote on every resolution if (i) the
preference dividend is in arrears for two years in respect of
cumulative preference shares or (ii) the preference dividend has not
been paid for a period of two/more consecutive preceding years or
for an aggregate period of three/more years in the preceding six
years ending with the expiry of the immediately preceding financial
year.
Participation Features Participation is a feature that provides for
dividend payments based on certain formula allowing preference
shareholders to participate with ordinary shareholders in the receipt
of dividends beyond a specified amount.

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Evaluation
Merits
The advantages for the investors are: (i) stable dividend, (ii) the
exemption to corporate investors on preference income to the
extent of dividend paid out. The issuing companies enjoy several
advantages, namely, (i) no legal obligation to pay preference
dividend and skipping of dividend without facing legal
action/bankruptcy, (ii) redemption can be delayed without
significant penalties, (iii) as a part of net worth, it improves the
credit-worthiness/ borrowing capacity and, (iv) no dilution of
control.
Demerits
The shareholders suffer serious disadvantages such as (a)
vulnerability to arbitrary managerial action as they cannot enforce
their right to dividend/right to payment in case of rede-mption, and
(b) modest dividend in the context of the associated risk. For the
company, the preference capital is an expensive source of finance
due to non-tax deductibility of preference dividend.

Debentures/Bonds/Notes
23412
Debenture/bond is a debt instrument
indicating that a company has
borrowed certain sum of money and
promises to repay it in future under
clearly defined terms.

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Convertible
Debentures/BondsConvertible Debentures Convertible debentures give the
holders the right (option) to change them into a stated
number of Equity Shares.
Conversion Ratio Conversion ratio is the ratio at which a
convertible debenture can be exchange for shares.
Conversion Price Conversion price is the per share price
that is effectively paid for the shares as the result of
exchange of a convertible debenture.
Conversion Time The conversion time refers to the period
from the date of allotment of convertible debentures after
which the option to convert can be exercised.

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Valuation
Compulsory Partly/Fully Convertible Debentures
Value (Vo) The holders of PCDs receive interest at a specified rate
over the term of the debenture plus equity share(s) on part
conversion and repayment of unconverted part of principal.
Symbolically,
where V0 = Value of the convertible debenture at the time of issue
It = Interest receivable at the end of period, t
n = Term of debentures
a = Equity shares on part conversion at the end of period, i
Pi = Expected pre-equity share price at the end of period, i
Fj = Instalment of principal payment at the end of period, j
kd = Required rate of return on debt
ke = Required rate of return on equity.

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Attributes
As a long-term source of borrowing, debentures have some
contrasting features compared to equities .
Trust Indenture When a debenture is sold to investing public, a
trustee is appointed through an indenture/trust deed.
Trust (bond) indenture is a complex and lengthy legal document
stating the conditions under which a bond has been issued.
Trustee is a bank/financial institution/insurance company/ firm of
attorneys that acts as the third party to a bond/debenture indenture
to ensure that the issue does not default on its contractual
responsibility to the bond/ debentureholders.
Interest The debentures carry a fixed (coupon) rate of interest, the
payment of which is legally binding/enforceable. The debenture
interest is tax-deductible and is payable annually/semi-
annually/quarterly.

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Maturity
It indicates the length of time for redemption of par value. A
company can choose the maturity period, though the redemption
period for non-convertible debentures is typically 7-10 years. The
redemption of debentures can be accomplished in either of two
ways:
(1) Debentures redemption reserve (sinking fund)
A DRR has to be created for the redemption of all debentures with a
maturity period exceeding 18 months equivalent to at least 50 per
cent of the amount of issue/redemption before commencement of
redemption.
(2) Call and put (buy-back) provision.
The call/buy-back provision provides an option to the issuing
company to redeem the debentures at a specified price before
maturity. The call price may be more than the par/face value by
usually 5 per cent, the difference being call premium. The put
option is a right to the debenture-holder to seek redemption at
specified time at predetermined prices.

Financial Management
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Security
Debentures are generally secured by a charge on the present and
future immovable assets of the company by way of an equitable
mortgage
Convertibility
Apart from pure non-convertible debentures (NCDs), debentures
can also be converted into equity shares at the option of the
debenture-holders. The conversion ratio and the period during
which conversion can be affected are specified at the time of the
issue of the debenture itself. The convertible debentures may be
fully convertible (FCDs) or partly convertible (PCDs). The FCDs
carry interest rates lower than the normal rate on NCDs; they may
even have a zero rate of interest. The PCDs have two parts:
1) Convertible part,
2) Non-convertible part.

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Credit Rating
To ensure timely payment of interest and redemption of
principal by a borrower, all debentures must be
compulsorily rated by one or more of the four credit
rating agencies, namely, Crisil, Icra, Care and FITCH
India.
Claim on Income and Assets
The payment of interest and repayment of principal is a
contractual obligation enforceable by law.
Failure/default would lead to bankruptcy of the
company. The claim of debenture-holders on income
and assets ranks pari passu with other secured debt
and higher than that of shareholders–preference as well
as equity.

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Evaluation
Advantages
The advantages for company are (i) lower cost due to lower
risk and tax-deductibility of interest payments, (ii) no dilution
of control as debentures do not carry voting rights. For the
investors, debentures offer stable return, have a fixed
maturity, are protected by the debenture trust deed and enjoy
preferential claim on the assets in relation to shareholders.
Disadvantages
The disadvantages for the company are the restrictive
covenants in the trust deed, legally enforceable contractual
obligations in respect of interest payments and repayments,
increased financial risk and the associated high cost of
equity. The debenture-holders have no voting rights and
debenture prices are vulnerable to change in interest rates.

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Innovative Debt Instruments
In order to improve the attractiveness of bonds/debentures,
some new features are added. As a result, a wide range of
innovative debt instruments have emerged in India in recent
years. Some of the important ones among these are discussed
below.
Zero Interest Bonds/Debentures (ZIB/D)
Also known as zero coupon bonds/debentures, ZIBs do not
carry any explicit/coupon rate of interest. They are sold at a
discount from their maturity value. The difference between the
face value of the bond and the acquisition cost is the
gain/return to the investors. The implicit rate of return/interest
on such bonds can be computed by Equation 1.
Acquisition price = Maturity (face) value/(1 + i)n
(1)
Where I = rate of interest
n = maturity period (years)

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Deep Discount Bond (DDB)
A deep discount bond is a form of ZIB. It is issued at
a deep/steep discount over its face value. It implies
that the interest (coupon) rate is far less than the
yield to maturity. The DDB appreciates to its face
value over the maturity period.
The DDBs are being issued by the public financial
institutions in India, namely, IDBI, SIDBI and so on.
Secured Premium Notes (SPNs)
The SPN is a secured debenture redeemable at a premium
over the face value/purchase price. The SPN is a tradeable
instrument. A typical example is the SPN issued by TISCO in
1992. Its salient features were

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Secured Premium Notes (SPNs)
Each SPN had a face value of Rs 300. No
interest would accrue during the first year after
allotment.
During years 4-7, principal will be repaid in
annual installment of Rs 75. In addition, Rs 75
will be paid each year as interest and
redemption premium.
A warrant was attached to the SPN entitling the
holder to acquire one equity share for cash by
payment of Rs 100.
The holder was given an option to sell back the
SPN at the par value of Rs 300.

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Optionally Convertible Debentures
The value of a Debenture depends upon three factors:
(1)Straight debenture value
(2)Conversion Value
(3)Option Value
Straight debenture value (SDV) equals the discounted value of the
receivable interest and principal repayment.

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Issue of Debt Instruments
A company offering convertible/non-convertible debt instruments
through an offer document should, in addition to the other relevant
provisions of these guidelines, comply with the following provisions.
Requirement of Credit Rating
A public or rights issue of all debt instruments (i.e. convertible as
well as non-convertible) can be made only if credit rating of a
minimum investment grade is obtained from at least two registered
credit rating agencies and disclosed in the offer document .
Requirement in Respect of Debenture Trustees
A company must appoint one/more debenture trustee(s) in
accordance with the provisions of the Companies Act before issuing
a prospectus/letter of offer to the pubic for subscription of its
debentures.

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Creation of Debenture Redemption Reserves (DRR) A company has
to create DRR as per the requirements of the Companies Act for
redemption of debentures in accordance with the provisions given
below:
If debentures are issued for project finance, the DRR can be created
up to the date of com-mercial production, either in equal instalments
or higher amounts if profits so permit. In the case of partly convertible
debentures, the DRR should be created with respect to the non-
convertible portion on the same lines as applicable for fully non-
convertible debenture issue. In the case of convertible issues by new
companies, the creation of DRR should commence from the year the
company earns profits for the remaining life of debentures.
Distribution of Dividends
In case of companies which have defaulted in payment of interest on
debentures or their redemption or in creation of security as per the
terms of the issue, distribution of dividend would require approval of
the debenture trustees and the lead institution, if any.
Redemption The issuer company should redeem the debentures as
per the offer document.

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Disclosure and Creation of Charge
The offer document should specifically state the assets on
which the security would be created as also the ranking of the
charge(s). In the case of second/residual charge or
subordinated obligation, the associated risks should also be
clearly stated.
Requirement of Letter of Option
Where the company desires to rollover the debentures issued
by it, it should file with the SEBI a copy of the notice of the
resolution to be sent to the debenture-holders through a
merchant bank prior to dispatching the same to the debenture-
holders. If a company desires to convert the debentures into
equity shares (according to the procedure discussed
subsequently), it should file with the SEBI a copy of the letter
of option to be sent to the debenture-holders through a
merchant bank prior to dispatching the same to the debenture-
holders.

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Rollover of Non-Convertible Portions of Partly Convertible Debentures
(PCDs)/Non-Convertible Debentures (NCDs) By Company Not Being in Default
The non-convertible portions of PCDs/NCDs issued by a listed company, the value
of which exceeds Rs 50 lakh, can be rolled over without change in the interest rate
subject to (i) Section 121 of the Companies Act and (ii) the following conditions, if
the company is not in default: (i) passing of a resolution by postal ballot, having
assent of at least 75 per cent of the debentures; (ii) redemption of debentures of
all the dissenting holders, (iii) obtaining at least two credit ratings of a minimum
investment grade within six months prior to the date of redemption and
communicating to the debenture-holders before rollover, (iv) execution of fresh
trust deed, and (v) creation of fresh security in respect of roll over debentures.
Rollover of NCDs/PCDs By a Listed Company Being in Default
The non-convertible portion of PCDs/NCDs by listed companies exceeding Rs 50
lakh can be rolled over without change in the interest rate subject to Section 121
of the Companies Act and the following conditions, namely, (a) a resolution by
postal ballot, having assent of at least 75 per cent of the debenture-holders,(b)
along with the notice for passing the resolution, send to the debenture-holders
auditor’s certificate on the cash flow of the company with comments on its
liquidity position, (c) redemption of debentures of all the dissenting debenture-
holders, and (d) decision of the debenture trustee about the creation of fresh
security and execution of fresh trust deed in respect debentures to be rolled over.

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Additional Disclosures in Respect of Debentures The offer
document should contain:
a) premium amount on conversion, time of conversion;
b) in case of PCDs/NCDs, redemption amount, period of maturity,
yield on redemption of the PCDs/NCDs;
c) full information relating to the terms of offer or purchase,
including the name(s) of the party offering to purchase, the
khokhas (non-convertible portion of PCDs);
d) the discount at which such an offer is made and the effective
price for the investor as a result of such discount;
e) the existing and future equity and long-term debt ratio;
f) servicing behaviour on existing debentures, payment of due
interest on due dates on term loans and debentures and
g) a no objection certificate from a financial institution or banker
for a second or pari passu charge being created in favour of
the trustees to the proposed debenture issues has been
obtained.

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Secondary Market for Corporate Debt Securities Any listed company making issue of
debt securities on a private placement basis and listed on a stock exchange should
comply with the following:
1) It should make full disclosures (initial and continuing) in the manner prescribed in
Schedule II of the Companies Act, 1956, SEBI (Disclosure and Investor Protection)
Guidelines, 2000 and the Listing Agreement with the exchanges.
2) The debt securities should carry a credit rating of not less than investment grade
from a credit rating agency registered with the SEBI.
3) The company should appoint a debenture trustee registered with the SEBI in respect
of the issure of debt securities.
4) The debt securities should be issued and traded in demat form.
5) The company should sign a separate listing agreement with the stock exchange in
respect of debt securities and comply with the conditions of listing.
6) All trades with the exception of spot transactions, in a listed debt security, should be
ex-ecuted only on the trading platform of a stock exchange.
7) The trading in privately placed debts should only take place between qualified QIBs
and high networth individuals (HNIs), in standard denomination of Rs 10 lakhs.
8) The requirement of Rule 19(2)(b) of the Securities Contract (Regulation) Rules, 1957
would not be applicable to listing of privately placed debt securities on exchanges,
provided all the above requirements are complied with.
9) If the intermediaries with the SEBI associate themselves with the issuance of private
placement of unlisted debt securities, they will be held accountable for such issues.

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Rating of Debt Instruments
Credit rating of debentures by a rating agency is mandatory. It
provides a simple system of gradation by which relative capacities
of borrowers to make timely payment of payment and repayment of
principal on a particular type of debt instrument can be noted. The
main elements of the rating methodology are
(1) Business risk analysis
(2) Financial risk analysis
(3) Management risk.
The rating agencies in India are CRISIL, ICRA, CARE and Fitch
India.

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Business Risk Analysis
The rating analysis begins with an assessment of the company’s
environment focusing on the strength of the industry prospects,
pattern of business cycles as well as the competitive factors affecting
the industry. The vulnerability of the industry to Government
controls/regulations is assessed. The main industry and business
factors assessed include:
Industry Risk Nature and basis of competition, key success factors,
demand and supply position, structure of industry, cyclical/seasonal
factors, government policies and so on.
Market Position of the Issuing Entity Within the Industry Market share,
competitive advantages, selling and distribution arrangements,
product and customer diversity and so on.
Operating Efficiency of the Borrowing Entity Locational advantages,
labour relationships, cost structure, technological advantages and
manufacturing efficiency as compared to competitors and so on.
Legal Position Terms of the issue document/prospectus, trustees and
their responsibilities, systems for timely payment and for protection
against fraud/forgery and so on.

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Financial Risk Analysis
After evaluating the issuer’s competitive position and operating
environment, the analysts proceed to analyse the financial strength of the
issuer. Financial risk is analysed largely through quantitative means,
particularly by using financial ratios. While the past financial performance
of the issuer is important, emphasis is placed on the ability of the issuer to
maintain/improve its future financial performance. The areas considered in
financial analysis include:
Accounting Quality Overstatement/understatement of profits, auditors
qualifications, method of income recognition, inventory valuation and
depreciation policies, off Balance sheet liabilities and so on.
Earnings Protection Sources of future earnings growth, profitability ratios,
earnings in relation to fixed income charges and so on.
Adequacy of Cash Flows In relation to debt and working capital needs,
stability of cash flows, capital spending flexibility, working capital
management and so on.
Financial Flexibility Alternative financing plans in times of stress, ability to
raise funds, asset deployment potential and so on.
Interest and Tax Sensitivity Exposure to interest rate changes, tax law
changes and hedging against interest rates and so on.

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Management Risk
A proper assessment of debt protection levels requires an
evaluation of the management philosophies and its strategies. The
analyst compares the company’s business strategies and financial
plans (over a period of time) to provide insights into a
management’s abilities with respect to forecasting and
implementing of plans. Specific areas reviewed include:
1) Track record of the management: planning and control
systems, depth of managerial talent, succession plans;
2) Evaluation of capacity to overcome adverse situations; and
3) Goals, philosophy and strategies.
Rating Symbols
Rating symbol is a symbolic expression of opinion of the rating
agency regarding the investment/credit quality/grade of the debt
instrument/obligation.

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EXHIBIT 1 CRISIL Rating Symbols
The rating of debentures is mandatory. CRISIL assigns alpha-based rating scale to
rupee-denominated debentures. It categorises them into three grades namely, high
investment, investment and speculations.
High Investment Grade includes:
AAA - (Triple A) Highest Security The debentures rated AAA are judged to offer the
highest safety against timely payment of interest and principal. Though the
circumstances providing this degree of safety are likely to change, such changes
as can be envisaged are most unlikely to affect adversely the fundamentally strong
position of such issues.
AA - (Double A) High Safety The debentures rated AA are judged to offer high
safety against timely payment of interest and principal. They differ in safety from
AAA issues only marginally.
Investment Grades are divided into:
A - Adequate Safety The debentures rated A are judged to offer adequate safety
against timely payment of interest and principal; however, changes in
circumstances can adversely affect such issues more than those in the higher
rated categories.
BBB - (Triple B) Moderate Safety The debentures rated BBB are judged to offer
sufficient safety to against timely payment of interest and principal for the present:
however, changing circumstances are more likely to lead to a weakened capacity
to pay interest and repay principal than for debentures in higher rated categories.

Financial Management23-435
Speculative Grades comprise:
BB - (Double B) Inadequate Safety The debentures rated BB are judged to carry
inadequate safety of the timely payment of interest and principal; while they are
less susceptible to default than other speculative grade debentures in the
immediate future, the uncertainties that the issuer faces could lead to inadequate
capacity to make interest and principal payments on time.
B - High Risk The debentures rated B are judged to have greater susceptibility to
default; while currently interest and principal payments are met; adverse business
or economic conditions would lead to a lack of ability or willingness to pay interest
or principal.
C - Substantial Risk The debentures rated C are judged to have factors present
that make them vulnerable to default; timely payment of interest and principal is
possible only if favourable circumstances continue.
D - Default The debentures rated D are in default and in arrears of interest or
principal payments or are expected to default on maturity. Such debentures are
extremely speculative and returns from these debentures may be realised only on
reorganisation or liquidation.
Note: (1) CRISIl may apply ‘+’ (plus) or ‘–’ (minus) signs for ratings from AA to C to
reflect comparative standing within the category. The contents within parenthesis
are a guide to the pronunciation of the rating symbols.
CONTD.

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EXHIBIT 2 ICRA Rating Symbols
ICRA symbols classify them into eight investment grades.
LAAA Highest Safety This indicates a fundamentally strong position. Risk
factors are negligible. There may be circumstances adversely affecting the
degree of safety but such circumstances, as may be visualised, are not likely
to affect the timely payment of principal and interest as per terms.
LAA+, LAA, LAA– High Safety Risk factors are modest and may vary slightly.
The protective factors are strong and the prospects of timely payment of
principal and interest as per the terms under adverse circumstances, as may
be visualised, differs from LAAA only marginally.
LA+, LA, LA– Adequate Safety Risk factors vary more and are greater during
economic stress. The protective factors are average and any adverse change
in circumstances, as may be visualised, may alter the fundamental strength
and affect the timely payment of principal and interest as per the terms.
LBBB+, LBBB, LBBB– Moderate Safety This indicates considerable variability
in risk factors. The protective factors are below average. Adverse changes in
the business/economic circumstances are likely to affect the timely payment
of principal and interest as per the terms.

LBB+, LBB, LBB- Adequate Safety The timely payment of interest and
principal are more likely to be affected by the present or prospective changes
in business/economic circumstances. The protective factors fluctuate in case
of economy/business conditions change.
LB+, LB, LB– Risk Prone Risk factors indicate that obligations may not be met
when due. The protective factors are narrow. Adverse changes in the
business/economic conditions could result in the inability/unwillingness to
service debts on time as per the terms.
LC+, LC, LC- Substantial Risk There are inherent elements of risk and timely
servicing of debts/obligations could be possible only in the case of continued
existence of favourable circumstances.
LD Default Extremely Speculative Indicates either already in default in
payment of interest and/or principal as per the terms or expected to default.
Recovery is likely only on liquidation or reorganisation.
CONTD.

Securitisation
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Securitisation is the process of pooling and
repackaging of homogeneous illiquid financial
assets, such as residential mortgage, into
marketable securities that can be sold to
investors.

23-439
Securitisation Process
1) Asset are originated through receivables, leases, housing loans or
any other form of debt by a company and funded on its balance
sheet. The company is normally referred to as the “originator”.
2) Once a suitably large portfolio of assets has been originated, the
assets are analysed as a portfolio and then sold or assigned to a
third party, which is normally a special purpose vehicle company
(‘SPV’) formed for the specific purpose of funding the assets. It
issues debt and purchases receivables from the originator.
3) The administration of the asset is then subcontracted back to the
originator by the SPV.
4) The SPV issues tradable securities to fund the purchase of assets.
5) The investors purchase the securities because they are satisfied
that the securities would be paid in full and on time from the cash
flows available in the asset pool.
6) The SPV agrees to pay any surpluses which, may arise during its
funding of the assets, back to the originator.
7) As cash flow arise on the assets, these are used by the SPV to
repay funds to the investors in the securities.

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Credit Enhancement
Credit enhancement are the various means that attempt to buffer
investors against losses on the asset collaterising their investment.
External Credit Enhancements
They include insurance, third party guarantee and letter of credit.
Insurance Full insurance is provided against losses on the assets.
This tantamounts to a 100 per cent guarantee of a transaction’s
principal and interest payments. The issuer of the insurance looks to
an initial premium or other support to cover credit losses.
Third-Party Guarantee This method involves a limited/full guarantee
by a third party to cover losses that may arise on the non-
performance of the collateral.
Letter of Credit For structures with credit ratings below the level
sought for the issue, a third party provides a letter of credit for a
nominal amount. This may provide either full or partial cover of the
issuer’s obligation.

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Internal Credit Enhancements Such form of credit enhancement comprise the
following:
Credit Trenching (Senior/Subordinate Structure) The SPV issues two (or
more) tranches of securities and establishes a predetermined priority in their
servicing, whereby first losses are borne by the holders of the subordinate
tranches (at times the originator itself). Apart from providing comfort to holders
of senior debt, credit tranching also permits targeting investors with specific
risk-return preferences.
Over-collateralisation The originator sets aside assets in excess of the
collateral required to be assigned to the SPV.
Cash Collateral This works in much the same way as the over-
collateralisation. But since the quality of cash is self-evidently higher and more
stable than the quality of assets yet to be turned into cash, the quantum of cash
required to meet the desired rating would be lower than asset over-collateral to
that extent.
Spread Account The difference between the yield on the assets and the yield
to the investors from the securities is called excess spread. In its simplest
form, a spread account traps the excess spread (net of all running costs of
securitisation) within the SPV up to a specified amount sufficient to satisfy a
given rating or credit equity requirement.
Triggered Amortisation This works only in structures that permit substitution
(for example, rapidly revolving assets such as credit cards)..

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Parties to a Securitisation Transaction
The parties to securitisation deal are (i) primary and (ii)
others. There are three primary parties to a securitisation
deal, namely, originators, special purpose vehicle (SPV) and
investors. The other parties involved are obligors, rating
agency, administrator/servicer, agent and trustee, and
structurer.
Originator is the entity on whose books the assets to be
securitised exist.
SPV (special purpose vehicle) is the entity which would
typically buy the assets to be securitised from the originator.
Investors The investors may be in the form of individuals or
institutional investors like FIs, mutual funds, provident funds,
pension funds, insurance companies and so on.

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Obligors are the borrowers of the original loan.
Rating Agency Since the investors take on the risk of the asset pool rather
than the originator, an external credit rating plays an important role. The rating
process would assess the strength of the cash flow and the mechanism
designed to ensure full and timely payment by the process of selection of
loans of appropriate credit quality, the extent of credit and liquidity support
provided and the strength of the legal framework.
Administrator or Servicer It collects the payment due from the obligor(s) and
passes it to the SPV, follows up with delinquent borrowers and pursues legal
remedies available against the defaulting borrowers. Since it receives the
instalments and pays it to the SPV, it is also called the Receiving and Paying
Agent (RPA).
Receiving and paying agent is one who collects the payment due from the
obligors and passes it on to the SPV.
Agent and Trustee It accepts the responsibility for overseeing that all the
parties to the securitisation deal perform in accordance with the securitisation
trust agreement. Basically, it is appointed to look after the interest of the
investors.
Structurer Normally, an investment banker is responsible as structurer for
bringing together the originator, the credit enhancer(s), the investors and
other partners to a securitisation deal. It also works with the originator and
helps in structuring deals.

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Asset Characteristics: The assets to be securities should have the
following characteristics
Cash Flow A principal part of the assets should be the right to
receive from the debtor(s) on certain dates, that is, the asset can be
analysed as a series of cash flows.
Security If the security available to collateralise the cash flows is
valuable, then this security can be realised by a SPV.
Distributed Risk Assets either have to have a distributed risk
characteristic or be backed by suitably-rated credit support.
Homogeneity Assets have to relatively homogenous, that is, there
should not be wide variations in documentation, product type or
origination methodology.
No Executory Clauses The contracts to be securitised must work
even if the originator goes bankrupt.
Independence From the Originator The ongoing performance of
the assets must be independent of the existence of the originator.
The securitisation process is depicted in Figure 1.

Obligor
Originator
Ancillary
service provider
Special purpose
vehicle
Investors
Rating agency
Structure
Consideration for
assets purchased
Credit rating of
securities
Subscription of securities
Issue of securitiesSales of assets
Interest and principal
Figure 1: Securitisation Process

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Instruments of Securitisation
Securitisation can be implemented by three kinds of instruments differing
mainly in their maturity characteristics. They are:
(1) Pass through certificates
Pass through certificate is a conduit for sale fo ownership in receivables
(mortgages).
(2) Pay through securities
The PTS structure overcomes the single maturity limitations of the pass
through certificates. Its structure permits the issuer to restructure
receivables flow to offer a range of investment maturities to the investors
associated with different yields and risks.
(3) Stripped securities
Under this instrument, securities are classifies as Interest only (IO) or
Principally only (PO) securities. The IO holders are paid back out of the
interest income only while the PO holders are paid out of principal
repayments only.

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Types of Securities
The securities fall into two groups:
Asset Backed Securities (ABS)
The investors rely on the performance of the assets that
collateralise the securities. They do not take an exposure either on
the previous owner of the assets (the originator), or the entity
issuing the securities (the SPV). Clearly, classifying securities as
‘asset-backed’ seeks to differentiate them from regular securities,
which are the liabilities of the entity issuing them. An example of
ABS is credit card receivables. Securitisation of credit card
receivables is an innovation that has found wide acceptance.
Mortgage Backed Securities (MBS)
The securities are backed by the mortgage loans, that is, loans
secured by specified real estate property, wherein the lender has
the right to sell the property, if the borrower defaults.

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FORMAT 1
Particulars Class A PTCs Class B PTCs
(a) Senior/subordinate
status
(b) Face value
(c) Pass through rate
(d) Tenure
(e) Schedule payment
pattern
(f) Subscribed to by
Senior
Rs 9,94,998
11.35% to 11.85% per
annum payable monthly
83 months
In 83 monthly payouts
comprising principal
and
interest
Investors
Subordinate
Rs 10,04,062.14
No fixed interest rate but
would receive all residual
cash flows from the pool
141 months
Redemption of principal
amount would begin only
after class A PTCs are
extinguished, except in
case of prepayments
HDFC (the originator)
Principal Terms of the PTCs
The NHB in its corporate capacity as also in its capacity as a sole trustee of the SPV
Trust would issue securities in the form of Class A and Class B PTCs. The Class B
PTCs are subordinated to Class A PTCs and act as a credit enhancement for Class
A PTC holders. Only Class A PTCs are available for subscription through the issue.
The Class B PTCs would be subscribed to by the HDFC itself (i.e. the originator).
Their features are listed in Format 1.

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Entering Into Memorandum of Agreement
The HDFC and the NHB entered into a Memorandum of Agreement on July 7, 2000,
to entitle the NHB to take necessary steps to securities the said housing loans,
including circulation of the Information Memorandum and collection of subscription
amount from investors.
Acquisition of the Housing Loans by the NHB
The NHB would acquire the amount of balance principal of the housing loans
outstanding as on the cut-off date, that is, May 31, 2000, along with the underlying
mortgages/other securities, under the deed of assignment.
Pool Selection Criteria
The loans in the pool comply with the following criteria:
 The loans were current at the time of selection,
 They have a minimum seasoning of 12 months,
 The pool consists of loans where the underlying property is situated in the states
of Gujarat, Karnataka, Maharashtra and Tamil Nadu,
 The borrowers in the pool are individuals,
 Maximum LTV (loan to value) ratio is 80 per cent,
 Instalment (EMI) to gross income ratio is less than 40 per cent,
 EMIs would not be outstanding for more than one month,
 Loan size is in the range of Rs 18,000 to Rs 10 lakh,
 Borrowers in the pool have only one loan contract with the HDFC,
 The HDFC has not obtained any refinance with respect to these loans.

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Pool Valuation and Consideration for the Assignment
The consideration for the pool would be the aggregate balance principal of the
housing loans being acquired, recorded as outstanding in the books of the
HDFC as on that cut-off date.
Registration of Deed of Assignment and Payment of Stamp Duty
The trust has been declared, the assets would cease to be reflected in the
books of the NHB. The entire process of buying the receivables pool along with
the underlying mortgage security and declaring the trust would be legally
completed on the same day. The housing loans acquired by the NHB would be
registered with the sub-registrar of a district in which one of the properties is
located, in accordance with the provisions of the Transfer of Property Act, 1882
and the Indian Registration Act, 1908. The NHB proposed to register the deed
of assignment in the State of Karnataka, where the stamp duty is 0.10 per cent
ad valorem, subject to an absolute limit of Rs one lakh.

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Declaration of Trust
After acquiring the housing loans, the NHB would make an express declaration
of trust in respect of the pool, by setting apart and transferring the housing
loans along with the underlying securities.
Issues of Pass Through Certificates
Once the housing loans have been declared as property held in trust, the NHB
in its corporate capacity as also trustee for the SPV Trust would issue Pass
Through Certificates (PTCs) to investors.
Credit Enhancements
The structure envisages the following credit enhancements for Class A PTCs:
(i) Subordinated Class B PTC pay-out,
(ii) Corporate guarantee from the HDFC, and
(iii) Excess spread.

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Other Details The other details of the securitisation transaction are as follows.
Recovery on Defaults and Enforcement of Mortgages
The HDFC would administer the housing loans given to the borrowers, in its capacity as
the S&P Agent. Administering of such loans would include follow-up for the recovery of
the EMIs from the borrowers in the event of delays.
The trustee (NHB) would empower the HDFC, under the provisions of the servicing and
paying agency agreement, to enforce the mortgage securities where required, and
institute and file suits and all other legal proceedings as may necessary, to recover the
dues from defaulting borrowers.
Treatment of Prepayments on the Loans
Borrowers are permitted to prepay their loans in full or in part, and may be charged a
prepayment penalty for the same. Such prepayments in the securitised receivables pool
are passed on entirely to the two classes of PTC-holders
In the event of prepayment in a given month, the amount is passed on entirely to the
Class A and Class B PTC-holders in proportion to their respective principal balances
outstanding as of the beginning of that month.
Treatment of Conversion of Loans
In case of conversion by the borrowers of a loan from fixed rate to floating rate or vice-
versa, or to a lower fixed rate, the loan would continue to remain in the receivables pool.
The profit/loss on account of change in the interest rate would accrue to/be borne by the
receivables pool and indirectly the Class PTC-holders. The conversion charge received
from borrowers who have exercised the option would accrue to the Class B PTC-holders.
Repayment of Loan by the Borrower
On the borrower having completed repayment in all respects on the loan, the S&P Agent
would intimate the trustee and return the documents relating to the mortgage debt to the
borrowers.

SOLVED PROBLEM

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Hindustan Copper Industries (HCI) manufactures copper pipe. It is contemplating
calling Rs 3 crore of 30-year, Rs 1,000 bonds (30,000 bonds) issued 5 years ago with
a coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,140 and
had initially collected proceeds of Rs 2.91 crore due to a discount of Rs 30 per
bond. The initial flotation cost was Rs 3,60,000. The HCI intends to sell Rs 3 crore of
12 per cent coupon interest rate, 25-year bonds to raise funds for retiring the old
bonds. It intends to sell the new bonds at their par value of Rs 1,000. The estimated
flotation costs are Rs 4,40,000. The HCI is in 35 per cent tax bracket and its after
cost of debt is 8 per cent. As the new bonds must first be sold and their proceeds
then used to retire the old bonds, the HCI expects a 2-month period of overlapping
interest during which interest must be paid on both the old and the new bonds.
Analyse the feasibility of the bond refunding by the HCI.
Solution
Decision analysis for bond refunding decision
Present value of annual cashflow savings (Refer working note 2):
Rs 3,81,460 × 10.675 (PVIF8,25) Rs 40,72,086
Less: Initial investment (Refer working note 1) 32,57,500
NPV 8,14,586
Decision The proposed refunding is recommended as it has a positive NPV.

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Working Notes
1. Initial investment:
(a) Call premium:
Before tax [(Rs 1,140 – Rs 1,000) × 30,000 bonds] Rs 42,00,000
Less: Tax (0.35 × Rs 42,00,000) 14,70,000
After tax cost of call premium Rs 27,30,000
(b) Flotation cost of new bond 4,40,000
(c) Overlapping interest:
Before tax (0.14 × 2/12/ × Rs 3 crore) 7,00,000
Less: Tax (0.35 × 7,00,000) 2,45,000 4,55,000
(d) Tax savings from unamortised discount on old bond
[25/30 × (Rs 3 crore – 2.91 crore) × 0.35] (2,62,500)
(e) Tax savings from unamortised flotation cost of old
bond (25/30 × Rs 3,60,000 × 0.35) (10,5,000)
32,57,500

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2. Annual cash flow savings
(a) Old bond
(i) Interest cost:
Before tax (0.14 × 3 crore) Rs
42,00,000
Less: Tax (0.35 × Rs 42,00,000) 14,70,000 27,30,00
0
(ii) Tax savings from amortisation of
discount [(Rs 9,00,000@
÷ 30) ×
0.35]
(10,500)
(iii) Tax savings from amortisation of
flotation cost [(Rs 3,60,000 ÷ 30) ×
0.40)
(4,200)
Annual after tax debt payment (a) 27,15,30
0
(b) New bond
(i) Interest cost:
Before tax (0.12 × 3 crore) 36,00,000
Less: Taxes (0.35 × Rs 36,00,000) 12,60,000
After tax interest cost 23,40,00
0
(ii) Tax savings from amortisation of
flotation cost [Rs 4,40,000 ÷ 25) ×
0.35
(6,160)

Derivatives: Managing
Financial Risk
Forward Contracts
Futures/Future Contracts
Options/Options Contracts

Derivative instruments include (a) a security derived from a
debt instrument, share, loan, risk instrument or contract for
differences or any other form of security and (b) a contract
that derives its value from the price/index of prices of
underlying securities.
The economic functions performed by the derivatives
markets are:
1) they help in the discovery of the future as well as current
prices,
2) they transfer risk to those who have an apetite for them,
3) the underlying cash markets witness high trading
volumes,
4) speculative trades shift to a more controlled
environment, and
5) they help increase savings and investment in the long
run.

The most common variants of
derivatives are
1) Forward,
2) Futures and
3) Options.

Forward Contract
A forward contract is an agreement to buy/sell an asset on a
specified date for a specified price. It is very useful in
hedging and speculations. A very serious limitation of
forward contracts is counterparty risk arising from possibility
of default of any one party to the transaction.
Future Contract
A future contract is an agreement between two parties to
buy/sell an asset at a certain time in future at a certain price.
It may be offset prior to maturity by entering into an equal but
opposite transaction. It eliminates counterparty risk and
offers more liquidity.
Future contracts have linear payoffs. It means that the losses
as well as the profit, for the buyer and the seller are
unlimited.

TABLE 1 Distinction Between Futures and Forwards
Futures Forwards
1. Traded on an organised stock
exchange
1. Over the Counter (OTC) in nature
2. Standardised contract terms,
hence, more liquid
2. Customised contract terms, hence,
less liquid
3. Requires margin payments 3. No margin payment
4. Follows daily settlement 4. Settlement happens at the end of
the period

Futures Terminology
Important terms associated with futures contracts are as follows:
Spot Price The price at which an instrument/asset trades in the spot market.
Future Price The price at which the futures contract trade in the future market.
Contract Cycle The period over which a contract trades. For instance, the
index futures contracts typically have one month, two months and three
months expiry cycles that expire on the last Thursday of the month. Thus, a
January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February.
On the Friday following the last Thursday, a new contract having three month
expiry is introduced for trading.
Expiry Date It is the date specified in the futures contract. This is the last day
on which the contract will be traded, at the end of which it will cease to exist.
Contract Size The amount of asset that has to be delivered under one contract.
For instance, the contract size of the NSE future market is 200 Nifties.
Basis Basis is defined as the futures price minus the spot price. There will be
a different basis for each delivery month for each contract. In a normal market,
basis will be positive. This reflects that futures prices normally exceed spot
prices.

Cost of Carry The relationship between futures prices and spot prices can be
summarised in terms of the cost of carry. This measures the storage cost plus
the interest that is paid to finance the asset, less the income earned on the
asset.
Initial Margin The amount that must be deposited in the margin account at the
time a futures contract is first entered into is the initial margin.
Marking to Market In the futures market, at the end of each trading day, the
margin account is adjusted to reflect the investor’s gain or loss depending
upon the futures closing price. This is called marking to market.
Maintenance Margin This is somewhat lower than the initial margin. This is set
to ensure that the balance in the margin account never becomes negative. If the
balance in the margin account falls below the maintenance margin, the investor
receives a margin call and is expected to top up the margin account to the
initial margin level before trading commences on the next day.
CONTD.

(2) Pricing Index Futures Given Expected Dividend Yield
F = S (1 + r – q)T
(3)
where F = futures price,
S = spot index value,
r = cost of financing,
q = expected dividend yield, and
T = holding period
Example 6 A two month futures contract trades on the NSE. The cost
of financing is 15 per cent and the dividend yield on Nifty is 2 per
cent annualised. The spot value of Nifty is Rs 1,200. What is the fair
value of the futures contract?
Solution
Fair value = Rs 1,200 (1 + 0.15 – 0.02) × 60.365 = Rs 1,224.35

Pricing Stock Futures
Stock futures is a future contract that gives its owner the right/obligation to
buy/sell the stocks (shares).
Pricing Stock Futures When No Dividend Expected
Example 7 SBI futures trade on NSE as one, two and three-month contracts.
Money can be borrowed at 15 per cent per annum. What will the price of a unit
of new two month futures contract on the SBI be if no dividends are expected
during the two month period, assuming spot price of the SBI is Rs 228?
Solution Futures price, F = Rs 228 × (1.15) × 60/365 = Rs 233.30
Pricing Stock Futures When Dividends Are Expected
Example 8 XL futures trade on NSE as one, two and three month contracts.
What will the price of a unit of new two-month futures contract on XL be if
dividends are expected during the two month period? Assume that XL will be
declaring a dividend of Rs 10 per share after 15 days of purchasing the
contract. The market price of XL may be assumed as Rs 140.
Solution To calculate the futures price, we need to reduce the cost-of-carry to
the extent of dividend received. The amount of dividend received is Rs 10. The
dividend is received 15 days later and, hence, compounded only for the
remainder of 45 days. Thus, the futures price, F = Rs 140 × (1.15) × 60/365 –
[10 × (1.15) × 45/365] = Rs 133.08.

Option
An option is a contract giving one party the right,
but not the obligation, to buy or sell a financial
instrument, commodity or some other underlying
asset at a given price, at or before a specified date
There are two basic types of options, call options and put
options.
Call Option A call option gives the holder the right but not
the obligation to buy an asset by a certain date for a certain
price.
Put Option A put option gives the holder the right but not
the obligation to sell an asset by a certain date for a certain
price.

Option : Concepts And Types
Options are a special type of financial contracts under
which the buyers of the options have the right to buy or
sell the shares/stocks but do not have obligation to do
so.
Some options are European while others are American.
American options are more flexible in nature in that they
can be exercised at any time upto the expiration date. In
contrast, European options can be exercised only on
the expiration date. In view of greater flexibility, most
exchange traded options are American.

Important Terms Associated with
Options
Buyer of an Option is the one, who by paying the option premium buys the
right to buy/sell securities but not the obligation to exercise his option on
the seller/writer of the option.
Writer of an Option is the one who receives the option premium and is
thereby obliged to sell/buy the securities if the buyer exercises the option on
him.
Option Price/Premium is the price that the option buyer pays to the option
seller. It is aptly referred to as the option premium.
Expiration Date is the date specified in the options contract by which the
option can be exercised. It is also known as the exercise date, the strike date
or the maturity date.
Strike Price The price specified in the options contract at which the buyer
can exercise his right to buy or sell the securities is known as the strike
price or the exercise price.
At-the-Money Option is an option that would lead to zero cash flow (no
profit no loss) to the holder if it were exercised immediately.
In-the-Money Option is an option that would lead to a positive cashflow to
the holder if it were exercised immediately.
Out-of-the-Money Option is an option that would lead to a negative
cashflow to the holder if it were exercised immediately.

TYPES
Options are essentially of two types
1) Call options
2) Put options

Call Option
Call option entities the holder the right but not the obligation to buy
securities.
An American call option is a contract that gives the holder the right but not
the obligation to buy (i.e., to call in) specified securities at a specified price on
or before a specified exercise date. For instance, if an investor buys one call
option (normally consisting of 100 shares) on Reliance, he has the right to
buy 100 equity shares of Reliance at a specified exercise price anytime
between today and a specified date by paying option premium. The fact that
the call holder is under no obligation to buy securities implies that he has
limited liability. In case the price of the equity shares of Reliance falls at
expiration date, he would prefer to walk away from the call contract.
In contrast, European options can be exercised only on the maturity date.
Since American options provide the owner an additional timing option (to
exercise early), they cannot be less valuable than equivalent European
options.
C1 = Max (S1 – E,0) (1)
Where Max implies the maximum value of S1 – E or Zero whichever is higher.

Example 1
Suppose the market price of equity share of Reliance on the expiration date is
Rs 140 and the exercise price is Rs 125. The value of call option is Rs 15 (Rs
140 – Rs 125). In case, the value of the share on expiration date turns out to
be Rs 120, the value of C1 would not be negative Rs 5 (Rs 120 – Rs 125); it
would be zero as the investor would not purchase shares at Rs 125 which is
available in the market and thereby incur a loss of Rs 5 per share.
The value of call option (for the facts contained in Example 1) is shown in Fig.
1. The price of share is plotted on X-axis and the call option value on Y-axis. It
may be noted that for market price of share less than exercise price, the value
of the option is zero; for S1 > E, the option has a positive value and increases
in a linear manner, rupee for rupee, with the increase in the share price. For
instance, when S1 goes up from Rs 140 to Rs 150 (by Rs 10), the value of call
option also increases by Rs 10 (from Rs 15 to Rs 25).

Option Terminology
Index Options These options have the index as the underlying. Some
options are European while others are American. American options can
be exercised at any time upto the expiration date. Most exchange
traded options are American. European options can be exercised only
on the expiration date itself. European options are easier to analyse
than American options, and properties of an American option are
frequently deduced from those of its European counterpart. Like index
futures contracts, index options contracts are also cash settled.
Stock Options Stock options are options on individual stocks. A
contract gives the holder the right to buy or sell shares at the specified
price.
Buyer of an Option The buyer of an option is the one who by paying
the option premium buys the right but not the obligation to exercise his
option on the seller/writer.
Writer of an Option The writer of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the
asset if the buyer exercises the option on him.

Option Price/Premium Option price is the price that the option buyer pays to the
option seller. It is also referred to as the option premium.
Expiration Date The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike Price The price specified in the options contract is known as the strike price
or the exercise price.
In-the-Money Option An in-the-money (ITM) option is an option that would lead to a
positive cashflow to the holder if it were exercised immediately. A call option on the
index is said to be in-the-money when the current index stands at a level higher
than the strike price (that is, spot price > strike price). If the index is much higher
than the strike price, the call is said to be deep ITM. In the case of a put, the put is
ITM if the index is below the strike price.
At-the-Money Option An at-the-money (ATM) option is an option that would lead to
zero cashflow if it were exercised immediately. An option on the index is at-the-
money when the current index equals the strike price (that is, spot price = strike
price).
CONTD.

Out-of-the-Money Option An out-of-the-money (OTM) option is an option that would
lead to a negative cashflow if it were exercised immediately. A call option on the
index is out-of-the-money when the current index stands at a level that is less than
the strike price (that is, spot price < strike price). If the index is much lower than the
strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if
the index is above the strike price.
Intrinsic Value of an Option The option premium can be broken down into two
components (i) intrinsic value and (ii) time value. The intrinsic value of a call is the
amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
Putting it another way, the intrinsic value of a call is Max[0,(St – K)] which means the
intrinsic value of a call is the greater of 0 or
(St – K). Similarly, the intrinsic value of a put is Max[0, K – St], that is, the greater of 0
or (K – St). K is the strike price and St is the spot price.
Time Value of an Option The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that
is OTM or ATM only has time value. Usually, the maximum time value exists when
the option is ATM. The longer the time to expiration, the greater is an option’s time
value, other things being equal. At expiration, an option would have no time value.
CONTD.

TABLE 2 Distinction Between Futures and Options
Futures Options
Exchange traded, with novation Same as futures
Exchange defines the product Same as futures
Price is zero, strike price moves Strike price is fixed, price moves
Price is zero Price is always positive
Linear payoff Non linear payoff
Both long and short at risk Only short at risk

Options Payoffs
A pay off for derivative contacts is the likely profit/loss that would accrue to
the market participant with change in the price of the underlying asset. The
optionality characteristic of options results in a non-linear pay off for options.
Non-linear pay-off implies the losses for the buyer of the options are limited
but profits are potentially unlimited; profits to the writer of the option are
limited to the option premium but losses are potentially unlimited.
Option premium is the price that the option buyer pays to the option seller.
Pay off Profile of Buyer of Asset: Long Asset In this basic position, an
investor buys the under-lying asset, the Nifty for instance, for 1,220 and sells
it at a future date at an unknown price, St. Once it is purchased, the investor
is aid to be “long” the asset. The investor would make profit if the index goes
up. If the index falls he would lose.
Pay off Profile for Seller of Asset: Short Asset In this basic position, an
investor shorts the und-erlying asset, the Nifty for instance, for 1,220 and
buys it back at a future date at an unknown price, St. Once it is sold, the
investor is said to be “short” the asset. The investor sold the index at 1,220. If
the index falls, he profits. If the index rises, he loses.

Pay off Profile for Buyer of Call Options: Long Call A call option gives the buyer
the right to pay the underlying asset at the strike price specified in the option. The
higher the spot price, the more profit he makes. If the spot price of the underlying
is less than the strike price, he lets his option expire unexercised. His loss in this
case is the premium he paid for buying the option.
Pay off Profile for Writer to Call Options: Short Call Call A call option gives the
buyer the right to buy the underlying asset at the strike price specified in the
option. The higher the spot price, the more is the loss he makes. If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets his
option expire unexercised and the writer gets to keep the premium.
Pay off Profile for Buyer of Put Options: Long Put Put A put option gives the
buyer the right to sell the underlying asset at the strike price specified in the
option. The lower the spot price, the more is the profit he makes. If the spot price
of the underlying is higher than the strike price, he lets his option expire
unexercised. His loss in the case is the premium he paid for buying the option.
Pay off Profile for Writer of Put Options: Short Put A put option gives the buyer
the right to sell the underlying asset at the strike price specified in the option. The
buyer’s profit is the seller’s loss. If upon expiration the spot price happens to be
below the strike price, the buyer will exercise the option on the writer. If upon
expiration the spot price of the underlying is more than the strike price, the buyer
gets his option expire unexercised and the writer gets to keep the premium.
An option gives the holder the right but not the obligation to do something.

 The Black-Scholes equation is done in continuous time. This
requires continuous compounding. The r that figures in this is
1n (1 + r). Example, if the interest rate per annum is 12 per cent,
you need to use 1n 1.12 or 0.1133, which is the continuously
compounded equivalent of 12 per cent per annum.
 N () is the cumulative normal distribution. N (d1) is called the delta
of the option, which is a measure of change in option price with
respect to change in the price of the underlying asset.
 σ a measure of volatility, is the annualised standard deviation of
continuously compounded returns on the underlying. When daily
sigma are given, they need to be converted into annualised sigma.

 On a average there are 250 trading days in a year.
 X is the exercise price, S the spot price and T the time to
expiration measured in years.
year.perdaystradingofNumber
duly
Sigma
annual
Sigma ×=

Pricing Index Options Under the assumption of the Black-Scholes
Options Pricing Model, index options should be valued in the same
way as ordinary options on common stock, the assumption being that
investors can purchase, without cost, the underlying stocks in the
exact amount necessary to replicate the index, that is, stocks are
infinitely divisible and the index follows a diffusion process such that
the continuously compounded returns distribution of the index is
normally distributed.
Example 9
A three-month call option on the Nifty with a strike of 1,180 is
available for trading. The Nifty stands at Rs 1,150, and it has a
volatility of 30 per cent per annum. The annual risk free rate is 12 per
cent. We can calculate the price of the 1,180 option using the Black-
Scholes option pricing formula. We take T = 0.25, S = 1,150, X = 1,180,
r =1n (1.12), and s = 0.3. Substituting these values in the formula, we
get the call price as Rs 70.15. The put price on an option with the
same strike works out to be Rs 67.19.

Pricing Stock Options Much of what was discussed about index options also
applies to stock options. The factors that affect option prices are listed below.
The Stock Price The payoff from a call option will be the amount by which the
stock prices exceeds the strike price. Call option, therefore, becomes more
valuable as the stock price increases and less valuable as the stock prices
decreases.
The Strike Price In the case of a call, as the strike price increases, the stock
price has to make a larger upward move for the option to go in-the-money.
Time to Expiration Both put and call American options become more valuable
as the time to expiration increases.
Volatility The volatility of a stock price is a measure of how uncertain we are
about future stock price movements. As volatility increases, the chance that
the stock will do very well or very poorly increases. The value of both calls
and puts, therefore, increases as volatility increases.
Risk Free Interest Rate The affect of the risk free interest rate is less clear
cut. It is found that the put option prices decline as the risk free rate
increases, whereas the prices of calls always increase as the risk free interest
rate increases.
Dividends Dividends have the effect of reducing the stock price on the ex-
dividend date. This has a negative affect on the value of call options and a
positive affect on the value of put options.

Application of Black-Scholes Option Pricing Formula to Stock
Options The Black-Scholes option pricing formula, with some
adjustment, can be used to price American calls and puts
options on stocks.
The first step is to value the option on the assumption that it
will be exercised on expiry. Thus, the present value of the
dividends is deducted from the stock price and the adjusted
value, Sd, is used in the Black-Scholes Model.
The second step is to assume that the option will be exercised
just before the ex-dividend date. The unadjusted stock price is
used. In addition, the time to expiry is shortened to be the
period up to the ex-dividend date. Following these adjustments,
the Black-Scholes model can be applied. The actual value of the
option will be the highest of the two valuations. Consider
Example 10.

24-483
Warrants
Warrant is an instrument that gives its holder the right to
purchase a certain number of shares at a specified price
over a certain period time.
Difference with Convertible Debentures
Warrants are akin to convertible debentures to the extent that
both give the holder the option/right to buy ordinary shares
but there are differences between the two. While the
debenture and conversion option are inseparable, a warrant
can be detached. Similarly, conversion option is tied to the
debenture but warrants can be offered independently also.
Warrant are typically exercisable for cash.

Features
Exercise Price It is the price at which the holder of a warrant is
entitled to acquire the ordinary shares of the firm. Generally, it is
set higher than the market price of the shares at the time of the
issue.
Exercise Ratio It reflects the number of shares that can be acquired
per warrant. Typically, the ratio is 1:1 which implies that one equity
share can be purchased for each warrant.
Expiry Date It means the date after which the option to buy shares
expires, that is, the life of the warrant. Usually, the life of warrants
is 5-10 years although theoretically perpetual warrants can also be
issued.

24-485
Types
Warrants can be
1) Detachable, and
2) Non-detachable.
A detachable warrant can be sold separately in the
sense that the holder can continue to retain the
instrument to which the warrant was tied and at the
same time sell it to take advantage of price increases.
Separate sale independent of the instrument is not
possible in case of non-detachable warrants. The
detachable warrants are listed independently for stock
exchange trading but non-detachable warrants are not.

24-486
Implied Price of an Attached Warrant
The implied price of a warrant is the price effectively
paid for each warrant attached to a bond. It can be
computed using Equation 4.
Implied price of all warrants = Price of bond with
warrants attached – Straight bond/debenture value
(4)
The straight debenture value can be computed using the
method to value convertible debentures.
The implied price of each warrant = Implied price of all
warrants / Number of warrants attached to each bond.

Value of Warrants
Like convertible bonds, a warrant has a (i) market value
and (ii) and a theoretical value. The difference between
them is known as the warrant premium.
Theoretical Value of Warrant (TVW)
The theoretical value of a warrant is the amount for
which the warrant can be expected to be sold in the
market. Symbolically, theoretical value of a warrant
(TVW)
= (P0 – E) × N (5)
Where,
Po = current market of a share
E = exercise price of the warrant
N = number of shares obtainable with one warrant.

HYBRID FINANCING/INSTRUMENTSHYBRID FINANCING/INSTRUMENTS
Warrants
Options
Solved Problems

A hybrid source of financing partakes some
features of equity shares and some features of
debt instruments. The important hybrid
instruments are: preference shares, convertible
debentures/bonds, warrants and options. The
issue procedure for these instruments is similar
to the raising of equity shares.

Preference capital is a unique type of long-term financing in that it
combines some of the features of equity as well as debentures. As a
hybrid security/form of financing, it is similar to debenture insofar as:
1) it carries a fixed/stated rate of dividend,
2) it ranks higher than equity as a claimant to the income/assets,
3) it normally does not have voting rights and
4) it does not have a share in residual earnings/assets.
It also partakes some of the attributes of equity capital, namely
1) dividend on preference capital is paid out of divisible/after tax
profit, that is, it is not tax-deductible,
2) payment of preference dividend depends on the discretion of
management, that is, it is not an obligatory payment and non-
payment does not force insolvency/liquidation and
3) irredeemable type of preference shares have no fixed maturity
date.

Features/Attributes
Prior Claim on Income/Assets Preference capital has a prior
claim/preference over equity capital both on the income and assets
of the company. In other words, preference dividend must be paid
in full before payment of any dividend on the equity capital and in
the event of liquidation, the whole of preference capital must be
paid before anything is paid to the equity capital.
Cumulative Dividends Cumulative (dividend) Preference shares are
preference shares for which all unpaid dividends in arrears must be
paid along with the current dividend prior to the payment of
dividends to ordinary shareholders.
Redeemability Preference capital has a limited life/specified/fixed
maturity after which it must be retired. However, there are no
serious penalties for breach of redemption stipulation.
Straight Preference Shares Straight preference shares value/price
is the price at which a preference share would sell without the
redemption/call feature.

Fixed Dividend Preference dividend is fixed and is expressed as a
percentage of par value. Yet, it is not a legal obligation and failure to
pay will not force bankruptcy. Preference capital is also called a fixed
income security.
Convertibility Conversion feature convertibility is a feature that
allows preference shareholders to change each share in a stated
number of ordinary shares.
Voting Rights Preference capital ordinarily does not carry voting
rights. It is, however, entitled to vote on every resolution if (i) the
preference dividend is in arrears for two years in respect of
cumulative preference shares or (ii) the preference dividend has not
been paid for a period of two/more consecutive preceding years or
for an aggregate period of three/more years in the preceding six
years ending with the expiry of the immediately preceding financial
year.
Participation Features Participation is a feature that provides for
dividend payments based on certain formula allowing preference
shareholders to participate with ordinary shareholders in the receipt
of dividends beyond a specified amount.

Evaluation
Merits
The advantages for the investors are: (i) stable dividend, (ii) the
exemption to corporate investors on preference income to the
extent of dividend paid out. The issuing companies enjoy several
advantages, namely, (i) no legal obligation to pay preference
dividend and skipping of dividend without facing legal
action/bankruptcy, (ii) redemption can be delayed without
significant penalties, (iii) as a part of net worth, it improves the
credit-worthiness/ borrowing capacity and, (iv) no dilution of
control.
Demerits
The shareholders suffer serious disadvantages such as (a)
vulnerability to arbitrary managerial action as they cannot enforce
their right to dividend/right to payment in case of rede-mption, and
(b) modest dividend in the context of the associated risk. For the
company, the preference capital is an expensive source of finance
due to non-tax deductibility of preference dividend.

Convertible Debentures Convertible debentures give the holders
the right (option) to change them into a stated number of shares.
Conversion Ratio Conversion ratio is the ratio at which a
convertible debenture can be exchange for shares.
Conversion Price Conversion price is the per share price that is
effectively paid for the shares as the result of exchange of a
convertible debenture.
Conversion Time The conversion time refers to the period from the
date of allotment of convertible debentures after which the option
to convert can be exercised.

Valuation
Compulsory Partly/Fully Convertible Debentures
Value (Vo) The holders of PCDs receive interest at a specified rate
over the term of the debenture plus equity share(s) on part
conversion and repayment of unconverted part of principal.
Symbolically,
where V0 = Value of the convertible debenture at the time of issue
It = Interest receivable at the end of period, t
n = Term of debentures
a = Equity shares on part conversion at the end of period, i
Pi = Expected pre-equity share price at the end of period, i
Fj = Instalment of principal payment at the end of period, j
kd = Required rate of return on debt
ke = Required rate of return on equity.
∑
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Value of Warrants
Like convertible bonds, a warrant has a (i) market value
and (ii) and a theoretical value. The difference between
them is known as the warrant premium.
Theoretical Value of Warrant (TVW)
The theoretical value of a warrant is the amount for
which the warrant can be expected to be sold in the
market. Symbolically, theoretical value of a warrant
(TVW)
= (P0 – E) × N (5)
Where,
Po = current market of a share
E = exercise price of the warrant
N = number of shares obtainable with one warrant.

Options
Options are not a source of financing like shares,
debentures, CDs and warrants. But they do stabilise
prices of shares by increasing trading activity in
them.
An option is an instrument that provides to its holders
an opportunity to purchase (call option)/sell (put
option) specified security/asset at a stated striking
price on/before a specified expiration date.
There are three basic forms of options:
1) Rights,
2) Warrants, and
3) Calls and puts.

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OPTION VALUATION
Option: Concept And Types
Option Payoffs
Call Option Boundaries
Factors Influencing Option Valuation
The Black-Scholes Option Pricing
Model
Solved Problems

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Option : Concepts And Types
Options are a special type of financial contracts under which
the buyers of the options have the right to buy or sell the
shares/stocks but do not have obligation to do so.
Some options are European while others are American.
American options are more flexible in nature in that they can
be exercised at any time upto the expiration date. In contrast,
European options can be exercised only on the expiration
date. In view of greater flexibility, most exchange traded
options are American.

© Tata McGraw-Hill Publishing Company Limited, Financial Management 27-
Important Terms Associated with
Options
Buyer of an Option is the one, who by paying the option premium buys the
right to buy/sell securities but not the obligation to exercise his option on
the seller/writer of the option.
Writer of an Option is the one who receives the option premium and is
thereby obliged to sell/buy the securities if the buyer exercises the option on
him.
Option Price/Premium is the price that the option buyer pays to the option
seller. It is aptly referred to as the option premium.
Expiration Date is the date specified in the options contract by which the
option can be exercised. It is also known as the exercise date, the strike date
or the maturity date.
Strike Price The price specified in the options contract at which the buyer
can exercise his right to buy or sell the securities is known as the strike
price or the exercise price.
At-the-Money Option is an option that would lead to zero cash flow (no
profit no loss) to the holder if it were exercised immediately.
In-the-Money Option is an option that would lead to a positive cashflow to
the holder if it were exercised immediately.
Out-of-the-Money Option is an option that would lead to a negative
cashflow to the holder if it were exercised immediately.

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Call Option
Call option entities the holder the right but not the obligation to buy
securities.
An American call option is a contract that gives the holder the right but not
the obligation to buy (i.e., to call in) specified securities at a specified price on
or before a specified exercise date. For instance, if an investor buys one call
option (normally consisting of 100 shares) on Reliance, he has the right to
buy 100 equity shares of Reliance at a specified exercise price anytime
between today and a specified date by paying option premium. The fact that
the call holder is under no obligation to buy securities implies that he has
limited liability. In case the price of the equity shares of Reliance falls at
expiration date, he would prefer to walk away from the call contract.
In contrast, European options can be exercised only on the maturity date.
Since American options provide the owner an additional timing option (to
exercise early), they cannot be less valuable than equivalent European
options.
C1 = Max (S1 – E,0) (1)
Where Max implies the maximum value of S1 – E or Zero whichever is higher.

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Example 1
Suppose the market price of equity share of Reliance on the expiration date is
Rs 140 and the exercise price is Rs 125. The value of call option is Rs 15 (Rs
140 – Rs 125). In case, the value of the share on expiration date turns out to
be Rs 120, the value of C1 would not be negative Rs 5 (Rs 120 – Rs 125); it
would be zero as the investor would not purchase shares at Rs 125 which is
available in the market and thereby incur a loss of Rs 5 per share.
The value of call option (for the facts contained in Example 1) is shown in Fig.
1. The price of share is plotted on X-axis and the call option value on Y-axis. It
may be noted that for market price of share less than exercise price, the value
of the option is zero; for S1 > E, the option has a positive value and increases
in a linear manner, rupee for rupee, with the increase in the share price. For
instance, when S1 goes up from Rs 140 to Rs 150 (by Rs 10), the value of call
option also increases by Rs 10 (from Rs 15 to Rs 25).

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Y
X
30
0
25
20
15
10
5
Value of
call option
(in Rs)
Price of share (in Rs)
Figure 1: Value of Call Option to Buyer
S1 ≤ E
S1 > E
(Profit potential area)
125 130 135 140 145 150

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Gain or Loss Assuming no transaction costs, the purchase of call option
primarily requires the payment of premium to the option writer. Assuming
premium (P) paid is Rs 5 per share, the gain (G) to the call-holder of Reliance
(assuming S1 = Rs 140) will be reduced by the amount of P as shown by
Equation 2.
G = Max (S1 – E, 0) – P = (Rs 140 – Rs 125) – Rs 5 = Rs 10 (2)
In case the value of the share is Rs 120, the loss to the call-holder would be
Rs 5 (equivalent to the amount of the premium paid). His loss will not increase
to Rs 10 (E – S1 = Rs 125 – Rs 120 = Rs 5 + Rs 5, premium paid) because the
call-holder is under no obligation to buy the share. He will obviously not buy
the share at Rs 125 whose market price is Rs 120.
Therefore, it can be generalised that the loss is equal to the premium paid
whenever S1 < E. When S1 > E, gain would be as shown by Equation 2. This is
illustrated in Fig. 2. It may be noted from the Figure that the call-holder suffers
a loss until the S1 rises to the point where it equals E + P. This point of
equality can be referred to as break-even point (BEP), given by Equation 3.
BEP = S1 – (E + P) = zero (3)

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Y
X
0
20
15
10
5
Gain (+)/Loss (-)
To call option
buyer (in Rs)
Figure 2: Gain/Loss to Call Option Buyer
S1 ≤ E + P
S1 > E + P
(Gain potential area)
125 130 135 140 145 150
-5
-10
Y
(E + P)
Premium paid (E)

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Beyond the BEP, the call-holder would gain with rise in share prices. In
contrast, the writer of the call option gains as long as the price of the share
(S1) on the date of maturity is less than the sum of exercise price and
premium received. Equation 4 indicates gain to the writer of the call option.
S1 > (E + P) subject to (S1 – E) < P (4)
Continuing with Example 1, the call option writer gains if the price of the
share on the date of expiration is less than Rs 130, that is Rs 125, E + Rs 5, P.
However, the maximum gain would be Rs 5 only (equivalent to the option
premium received) and this will accrue to him if S1 < E at the date of maturity.
The profit margin would be lower if S1 > E, but less than E + P.
Assume Reliance share’s market value is Rs 128. The call-holder gains by
exercising his right to buy Reliance share at Rs 125. The call option writer’s
profit margin would be reduced by Rs 3 as he would have to buy the share at
Rs 128 and sell at Rs 125; his profit margin would be Rs 2 (P, Rs 5 – Rs 3, S1 –
E).
Whereas the call writer’s profits are limited to Rs 5 per share, his losses can
rise sharply with increase in the market price of the share. Suppose Reliance
share’s market price jumps to Rs 200; his loss will be Rs 70 per share (S1 – E
+ P = Rs 200 – Rs 125 + Rs 5). Figure 3 shows the profit or loss position of the
call option writer.

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The call writer will be at the BEP when S1 = E + P. In Example 1, he would be at break-
even when share price is Rs 130 = Rs 125, E + Rs 5, P.
Y
X
-15
+5
0
-5
-10
Gain (+)/Loss (-)
To call option
writer (in Rs)
Figure 3: Gain/Loss to Call Option Writer
S1 ≤ E + P
S1 > E + P
(Potential loss area)
125 130 135 140 145 150
-20
Premium received

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Put Option
A put option is just the opposite of a call option. A put option gives
the holder the right but not the obligation to sell securities (i.e. to put
them) on or by a certain date at a fixed exercise price. In other words,
the seller/writer of the put option has the obligation to buy securities
in case the put owner decides to exercise his option. Since the put
option writer is at the receiving end, he receives the put premium (as
a compensation for risk assumed) from the put buyer.
The put option holder will exercise his right to sell the securities
should the price of the securities fall below the exercise price (E) at
the date of expiration. In case S1 > E, he will prefer to sell at a higher
price in the market than to sell to the put option writer. Consider
Example 2.

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Example 2
Suppose an investor wants the right to sell Reliance equity shares at Rs 135
after 2 months. He is to buy a 2-month put option with a Rs 135 exercise price.
In case the market price of Reliance share increases to Rs 150 (S1 > E), the put
option will expire worthless as it will be more profitable for an investor to sell
in the open market (at Rs 150) than to the put option writer (at Rs 135).
Assuming the market price of the share falls below the strike price, say to Rs
125, it will be profitable for the put option holder to excise his put option right
as it fetches him Rs 135 compared to Rs 125 he can otherwise obtain from the
market.
Equations 5A and 5B can be inferred from Example 2. The equation can serve
as a benchmark/guide when to avail put option and when not to avail it.
E > S1, avail put option (5A)
E < S1, do not avail put option (5B)
Like call options, put options cannot have negative value as the put option
owner will not sell securities at a lower price (compared to the higher price
available in the market) to the put option writer. Its value will be either zero as
per equation 6 (when he does not exercise his put option right) or higher
when E > S1. Accordingly,
Value of put option = Max (E – S1, 0) (6)

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The put option is illustrated in Figures 4 and 5. Figure 4
shows profit potential area from the perspective of put option
owner. He will exercise his right when the share price on the
date of expiration is less than the exercise price stipulated in
the put option contract; the bigger is the difference between
these two prices, the larger is the put option value to the
buyer. The curve has a negative slope.
At Rs 115 price of Reliance, value of put option is Rs 20 per
share; it declines to Rs 5 when share price increases to Rs
130. The value of put option is zero when the market price of
Reliance’s share is Rs 135 and more.

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Y
X
0
25
20
15
10
5
Value of
put option
(in Rs)
Figure 4: Value of Put Option to Buyer
S1 > E
(Profit potential
area)
110 115 120 125 130 135

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The financial impact of changes in market prices of shares on the put option writer is exactly the
opposite of what it is to the put option buyer. The gain of the put option buyer is the loss of the put
option seller. It is shown in Fig. 5. At S1 of Rs 130, the put option writer is at break-even; at prices
lower than Rs 130, he incurs loss and gains at price higher than Rs 130. His maximum gain is Rs 5
per share (equivalent to the premium received) at S1 = Rs 135 and above.
Y
-15
+5
-5
-10
Gain (+)/Loss (-)
to put option
writer (in Rs)
(BEP) (E)
Figure 5: Gain/Loss to Put Option Writer
(Potential loss area)
S1 ≤ E - P
-20
Y
X
0
110 115 120 125 130 135
Gain

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Option Payoffs
Call Option Payoffs
The call option owner’s loss is limited to the call option premium. The
profit he can earn is not so limited. In case the market price of the
share on the expiration date turns out to be substantially higher than
the exercise price, his total profit from the call option contract would
be substantial in relation to the investment (equivalent to the call
option premium paid up-front) he has made. Consider Example 3.
Put Option Payoffs
The put option owner/investor is benefited when the share price
prevailing on the date of maturity is less than the strike price at which
he has acquired the right to sell the shares to the put option writer.
This is illustrated in Example 4.

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Example 3: Call Option Payoffs
Suppose an investor buys 3-month 100 call option contracts (one call
contract consists of 100 equity shares) of Reliance with strike price
of Rs 125 and call option premium of Rs 5 per share. The one call
option contract involves cost/investment of Rs 500 (i.e., 100 equity
shares × Rs 5). Therefore, the total sum invested is Rs 50,000 (i.e. Rs
500 per contract × 100 contracts).
After 3 months, if the market price of Reliance turns out to be Rs 125
or less, the option is of no value and the investor loses Rs 50,000.
In case Reliance’s price moves up to more than Rs 125 on the date of
expiration of the contract, the investor would exercise his option as
the share price exceeds the exercise price. Assume Reliance has
risen to Rs 150 per share. The investor gains Rs 25 per share (i.e. Rs
150, S1 – Rs 125, E). His gross profit would be Rs 2,50,000 (i.e. Rs 25
per share × 100 contracts × 100 share per contract). His net profit will
be Rs 2,00,000 (Rs 2,50,000 – Rs 50,000 option premium paid). An
investment of Rs 50,000 would yield him a profit of
Rs 2,00,000.

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To illustrate further, suppose investor purchases the shares of Reliance with Rs
50,000 instead of buying call option. The total shares purchased (assuming
Reliance share was selling at Rs 125 on the date of call option contract) would
be 400 (i.e., Rs 50,000/Rs 125), yielding him profit of Rs 10,000 only (i.e. 400
shares × Rs 25 profit per share).
To put it differently, the option position brings magnifying financial impact.
This, in turn, is caused by large shares dealing possible under option. The
respective figures of shares dealt in option and purchase are 10,000 and 400 (25
times larger in option).
In case the Reliance price ends up below the exercise price (say, at Rs 115), the
loss to the call option investor would be Rs 50,000. In contrast, in the case of
purchase, his loss would be restricted to Rs 4,000 only (i.e. Rs 10 per share ×
400 shares). Therefore, the investor should also be conscious of comparatively
larger losses under option contract.
Example 4: Put Option Payoffs
Assume an investor buys 3-month 200 put option contracts (each contract
involving 100 shares) of Reliance with strike price of Rs 200 and put option
premium of Rs 8 per share. On the date of maturity, Reliance is selling at Rs
180.

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Solution
 The investor will obviously exercise his option of selling 20,000 shares
(200 contracts × 100) at strike price of Rs 200 as the market price is lower
at Rs 180.
 His gross profit will be Rs 4 lakh (i.e. 20,000 shares × Rs 20 profit per
share).
 His net profits will be Rs 2.4 lakh (i.e. Rs 4 lakh – put option premium of Rs
1,60,000 on 20,000 shares @ Rs 8 per share).
 Had he invested Rs 1.6 lakh in Reliance, his shares purchases would have
been Rs 1,60,000/Rs 200 = 800.
 Instead of earning profits, he would have, in fact, suffered a loss of Rs
16,000 (i.e. 800 shares × Rs 20 per share) in case of purchase of shares.
 In case the market price of Reliance ends up with a price higher than strike
price (say, Rs 210), the put option has zero value as the investor can sell
his shares in open market at a higher price.
 He would lose Rs 1.6 lakh put option premium.
 He would have gained Rs 8,000 by investing in shares (Rs 10 × 800 shares
owned).
 Thus, the risk-return trade-off in put option is of more severe nature than
in call option.

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Call Option Boundaries
Hitherto we have focussed on call option valuation on the date
of its maturity. What will be its value before maturity? To
explain the concept let us consider Example 3 where the option
is to buy Reliance shares at Rs 125. In case the ruling price on
the exercise date is less than Rs 125, the call option has zero
value; if the share price turns out to be higher than Rs 125, the
option would have worth equivalent to the price of the share
(S1) minus the exercise price (E). This position was depicted in
Fig. 1.

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Even before maturity, the price of the call option can never remain
below the heavy line in Fig. 6 (replicated from Fig. 1) as the value of
option can never be negative and its worth will be positive at least
equivalent to S0 – E when the price of the share (before maturity) is
higher than the exercise price. Otherwise, it will create/cause
arbitrage opportunity.
Continuing with our Example 3, suppose Reliance share is selling at
Rs 133 (with strike price of Rs 125 and call option premium of Rs 5).
Clearly, there are profit opportunities; the arbitrageur/investor can
buy the call for Rs 5 and immediately exercise it by buying shares at
Rs 125; his total cost/investment is Rs 130 per share; by immediately
selling it at Rs 133, he earns riskless profit of Rs 3 per share.
What holds true for the hypothetical investor will also be applicable
to other investors in the well-organised/efficient markets. As a result,
there will be more demand for call option (at Rs 5) till such time there
is an upward revision of the option price (in this case to Rs 8).
Therefore, to prevent arbitrage, the value of the call today (C0) must
be either greater than or equal to the difference of the share price
today (S0) and the exercise price. In equation terms:
C0 ≥ S0 – E (7)

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From the above, it can be deduced that the call options which have still some
time to run have their lower bound either zero or S0 – E, whichever is higher.
This has been depicted by point A in Figure 6.
Y
Value of call
option
Figure 6 : Upper and Lower Boundries of Call Option Value
X
E
B
C
A
Lower bound
C0 ≥ S0 -E
Upper bound
C0 ≤ S0

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The lower bound determines the intrinsic value of the call option. The intrinsic value
of a call is the amount the option is in the money (ITM), that is, the excess of share
price over exercise price; if it is out of the money (OTM), that is, the exercise price is
higher than share price; its intrinsic value is zero. On the other hand, the time value
of an option is the difference between the option premium and its intrinsic value.
The longer the time to expiration, the greater is an option’s time value, other things
being equal. At expiration, an option would have no time value.
The highest value of the call option (the upper bound) can never be more than the
price of the share itself (shown as point B in Figure 6). This value can be reached
only if the option has a very long time to expiration or is not likely to be exercised
until far into the future. In these situations, the present value of the strike price to be
paid in very distant future approaches zero. As a result, the value of the call option
approaches the value of the share. Thus, lines A and B in Figure 6 represent the
upper and lower boundaries.
However, in a realistic/practical situation, the call option price is likely to be in the
shaded region (between lines A and B). The upper bound is more a theoretical
possibility. This is so because if the share and the call option have the same price,
every one will rush to sell the call option and buy the share. In fact, it is more likely
to be an upward-sloping line (more close to the lower bound) shown by the dashed
curve, C. In other words, curve C represents typical call option values at varied
share prices, prior to maturity. The exact shape and position of the curve C depends
on a number of factors. These factors have been explained in the following Section.

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Factors Influencing Option
Valuation
1) Current share price
2) Exercise price
3) Risk-free rate
4) Time to expiration/maturity
5) Price volatility of share

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Example 5
Suppose an investor is interested in buying a call option to purchase Reliance
share to be exercised exactly after one year with exercise price of Rs 130; the
share’s current market price (S0) is Rs 125 and the risk-free rate available on T-
bills (Rf) is 7 per cent.
Assume further that the share price of Reliance will be either Rs 140 or at Rs
160 after one year. Since the exercise price is Rs 130, the call option will either
carry the value of Rs 10 (i.e. Rs 140 – Rs 130) or of Rs 30 (i.e. Rs 160 – Rs 130).
In both the situations, the call option will be in the money to the investor.
Let us assume further that the investor wants to have the same value of
investment/financial return (i) either from purchase of shares (ii) or from buying
a call option. In case of the latter alternative, the investor is required to invest
present value of the exercise price (Rs 130) in T-bills/risk-free securities to
exercise call option at year-end 1. The requisite sum is provided by Equation 8.
E/(1 + Rf )t
(8)
= Rs 130/(1 + 0.07)
= Rs 130 × 0.935 (PV of rupee one at year-end 1 discounted at 7 per cent as per
Table A – 1).
In both the situations the value of his investments (depending on the price of
share at year-end1) will be the same as shown in Table 1.

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Since both the alternatives have the same financial returns, they must a
priori have the same value today or it will cause arbitrage opportunity.
Since the current price of the share is Rs 125, the value of the call
option today (C0) is logically given by Equation 10.
S0 = C0 + E/(1 + Rf )t
(9)
C0 = S0 – E/(1 + Rf )t
(10)
= Rs 125 – (Rs 130/1.07) = Rs 125 – 121.55 = Rs 3.45
TABLE 1 Value of Investment at Year-end 1 (i) When Shares are Purchased and
(ii) When Call Options are Purchased in Conjunction with Treasury Bills.
Particulars Amount (year-end 1)
(a) When call value is Rs 10:
(i) Compounded value of Rs 121.55 invested at 7 per cent risk-
free rate [Rs 121.55 (1 + 0.07)]
(ii) Plus call value
(iii) Equal to market price of share
(b) When call value is Rs 30:
(i) Compounded value of Rs 121.55
(ii) Plus call value
(iii) Equal to market price of share
Rs 130
10
140
130
30
160

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The value of call option has to be Rs 3.45 as shown in verification
Table 2. The investment outlay under both the alternatives is the same.
TABLE 2 Value of Call Option
Particulars Amount
(A) Investment in shares Rs 125
(B) Investment in risk-free securities and call option
Risk-free securities/T-bills Rs 121.55
Plus: Call option premium 3.45 125

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Current Share Price
The current share price prevailing in the market has a positive impact on the
call value. In other words, the higher is the current market price (S0), the
higher is the value of the call option. Other things being equal, assume in
Example 5, the value of S0 is Rs 127 (instead of Rs 125), the value of call
option, C0 increases by Rs 2 [from Rs 3.45 to Rs 5.45 (i.e. Rs 127 – Rs 121.55)].
Exercise Price
The exercise price on the date of expiration has a negative influence on the
value of a call option, that is, the value of C0 is negatively related to E; the
higher the value of E, the lower is the value of C0 and vice-versa. Assuming
other factors constant and the value of E increases to Rs 132, the value of C0
decreases to Rs 1.68 (i.e. Rs 125 – Rs 123.42, PV of Rs 132 × 0.935).
Risk-Free Rate
Risk-free rate (interest rate) has a positive relationship with the value of call
option. The higher is the interest rate the higher is the C0. This is so because
the final payment for the purchase of shares is delayed till the time the option
is exercised at some future date. The higher is the Rf, the lower is the PV of
exercise price; since this price is to be subtracted from S0 as per Equation 10,
the value of call option increases.

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Time to Expiration/Maturity
It is very evident from the right part of Equation 10, [E/(1 + r)t] that the
higher is the value of t, the lower will be the present value of exercise price
(to be paid in future year, t). Since this amount is to be subtracted from S0,
to determine C0, it obviously implies the higher value of call option,
assuming other things remain constant. In Example 5, let us assume time
to expiration of 2 years instead of one year. The value of call option
enhances to Rs 11.51 (i.e. Rs 125 – Rs 113.49, PV of Rs 130 × 0.873, PV
factor for two years at 7 per cent rate of discount).
Example 6
For the facts in Example 5 assume that (i) the exercise price is Rs 145
instead of Rs 130 and (ii) current market price of the share is Rs 135 and
not Rs 125. Determine the value of call option.
In case, the share price of year-end 1 ends up at Rs 140, the value of call
option will be zero as S1 < E (Rs 140 < Rs 145). If the share price ends up at
Rs 160, the value of call option will be (Rs 160 – Rs 145) = Rs 15.
The basic approach of determining the value of the call option remains the
same, that is, the payoffs to the investor should be identical whether he
purchases shares or he goes for a combination of buying risk-free asset
and call option.

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To make the two alternatives comparable, (i) the investor will be
required to invest the present value of the lower price of the share
in a riskless asset and (ii) purchase the number of call options,
determined by Equation 11.
ΔS/ΔC (11)
Where ΔS = Difference in possible share prices
ΔC = Difference in call option values.
Accordingly,
(i) The investor will be required to invest Rs 130.90 (i.e. Rs 140 ×
0.935, PV factor at 7 per cent for one year).
(ii) The number of call options purchased is 4/3, that is, [(Rs 160 –
Rs 140) / (Rs 15 – zero)]
Thus, either buying 4/3 call options and investing Rs 130.90 in a
riskless security or making investment in shares fetch the identical
financial returns to the investor (Table 3)

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TABLE 3 Value of Investment at Year-end 1 (i) When Shares are
Purchased and (ii) when Call Options are Purchased in Conjunction
with Treasury Bills.
Particulars Amount (year-end 1)
(A) When call value is zero
(i) Compounded sum of Rs 130.90 (1 + 0.07 ) Rs 140
(ii) Plus call value 0
(iii) Equal to market price of share 140
(B) When call value is Rs 15
(i) Compounded sum of Rs 130.90 140
(ii) Plus call value (Rs 15 × 4/3) 20
(iii) Equal to market price of share 160

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TABLE 4 Value of Call Option
(A) Investment in shares Rs 135
(B) Investment in risk free security and call option:
Purchase of Treasury Bills Rs 130.90
Add: Call option premium (Rs 3.075 × 4/3) 4.10 135
Thus, with the same investment outlay/cost (of Rs 135) both the alternatives
yield the same value to the investor.
Since both the alternatives have exactly the same value in the future, they
should have the same value today; otherwise, difference in value gives rise to
arbitrage. The value of call option (C0) should be:
S0 = 4/3 C0 + (Rs 140/1 + Rf)
Rs 135 = 4/3 C0 + Rs 130.90
4/3 C0 = Rs 135 – Rs 130.90 = Rs 4.10
C0 = (Rs 4.10 ×3)/4 = Rs 3.075
Each call option is worth Rs 3.075. Table 4 contains its verification.

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Price Volatility of Shares
To make things more explicit, the value of C0 is determined with reference to
new set of possible market prices of the underlying share for the facts
contained in Example 6. The steps involved are as follows:
1) The investor is required to invest in risk free security/treasury bills
equivalent to the present value of the lower share price (Rs 130 in this
case); the amount of investment is Rs 121.55 (discount rate is 7 per cent).
In addition, he is to buy 1.6 call options (explained in step ii). In case, the
share price ends up at Rs 130, the call option has no value as the exercise
price is Rs 145.
2) In case the share price turns out to be Rs 170, the call option has worth of
(Rs 170 – Rs 145) Rs 25. The investor would get Rs 130 from his
investments in risk-free asset. He would fall short of Rs 40 to make his
portfolio worth of Rs 170 (equal to the share price). Since, one call is
worth of Rs 25, the required number of calls to be purchases is (Rs 40/Rs
25) 1.6.
3) Alternatively, the number of call options to be purchased to make it equal
to the price of a share can be determined by Equation 11.
[(Rs 170 – 130) = Rs 40] / [(Rs 25 – 0) = Rs 25] = 1.6

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Since the variance of the financial return associated with the security
has increased (in view of greater span of plausible price range, now of
Rs 130 and Rs 170 vis-à-vis Rs 140 and 160 earlier) the call value has
risen to Rs 8.4 as shown below.
Rs 135 = 1.6 C + Rs 130/(1 + 0.07)
1.6 C = Rs 135 – Rs 121.55 = Rs 13.45
C0 = Rs 13.45/1.6 = Rs 8.406
With increased volatility in share prices as reflected in the higher value
of variance, the value of C0 has more than doubled from Rs 3.075 to Rs
8.406.
Assigning Probabilities
Hitherto volatility in share prices has been explained without assigning any
probability. The induction of an element of probability would provide more
insight into the matter. Consider Example 7

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Example 7 An investor is considering call option on the two shares, X and Y.
Details are as follows:
Particulars Probability Share price Expected share price
Share X: 0.10 Rs 90 Rs 9
0.25 108 27
0.30 120 36
0.25 132 33
0.10 150 15
120
Share Y: 0.10 60 6
0.25 90 22.5
0.30 120 36
0.25 150 37.5
0.10 180 18.0
120.0

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The expected value of share price at the end of the period is the
same for both shares, X and Y: Rs 120. There is a much larger
dispersion of possible outcomes for share Y (the range being Rs 60
– Rs 180) vis-à-vis share X (the range of price variation is Rs 90 –
Rs 150).
Suppose the exercise prices of both the shares at year-end 1 is Rs
115. Will these shares (having the same expected value of Rs 120
and the exercise price of Rs 115) have the same call value? Since
the price volatility is comparatively more in share Y, its call option
value is higher at Rs 16.75 than that of share X of Rs 9.25 (Table 5).

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TABLE 5 Determination of Call Option Value
Particulars Expected
share price
Exercise
price
Call value Probability Expected
call value
Share X: Rs 90 Rs 115 Rs 0 0.10 Rs 0
108 115 0 0.25 0
120 115 5 0.30 1.50
132 115 17 0.25 4.25
150 115 35 0.10 3.50
9.25
Share Y: 60 115 0 0.10 0
90 115 0 0.25 0
120 115 5 0.30 1.50
150 115 35 0.25 8.75
180 115 65 0.10 6.50
16.75

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To conclude, the greater is the dispersion of the possible outcomes
for share prices, the greater is the call option value. Thus, there are
five factors which have a bearing on the value of call option*. Their
impact on the value of call option in terms of their positive or
negative relationship is shown in Exhibit 1.
EXHIBIT 1 Factors Affecting Call Value
Factor Impact
Current share price Positive (+)
Exercise price Negative (–)
Risk-free rate of return/Interest-rate Positive (+)
Time to expiration on the option Positive (+)
Variance/Price-volatility of share Positive (+)
Finally, the stock index options (say NIFTY Index) are valued in the
same way as options related to ordinary/equity shares. The market
lot size of stock index options for trading purposes in India is 200.

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The Black-Scholes Option
Pricing Model
The Black-Scholes option pricing model provides a precise formula
to determine the value of call as well as put options. Given certain
assumption, the BS formula requires input of five variables,
namely, spot price of the share, exercise price, short-term risk-free
interest rate (continuously compounded), time remaining for
expiration and standard deviation.
Out of these five variables, the first four are known to the market
participants. The fifth variable related to standard deviation can be
determined by referring to weekly observations of the share prices
in the immediate preceding year.
Given the availability of computer package or specifically
programmed calculators, the application of BS formula, in practice,
is straight forward and widely used by dealers for valuing options
on the options exchange.

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Example 8
Suppose an investor can purchase one-year call option of Reliance with an
exercise price of Rs 150; its current market price is also Rs 150. The interest
rate is 10 per cent. It is assumed that in a year’s time only two things are
possible. Its price may fall by 10 per cent to Rs 135 or increase by 20 per cent
to Rs 180. In case Reliance share price decreases to Rs 135, the call option will
be worthless and have zero value. However, if the price increases, the call
option will be worth (Rs 180 – Rs 150) Rs 30. The possible payoffs from the
call option are either zero or Rs 30. The payoffs from the levered investment in
shares must be identical to that of call option so that both the investments
have the same value.
To ascertain the number (or a fraction) of shares to be purchased, the amount
to be borrowed and other aspects, the following steps are suggested.
(i) The inverse of the ratio ΔS ÷ ΔC given by Equation 11Equation 11 referred to as hedge
ratio or option delta is useful here. Symbolically,
Option delta = (Spread of possible option prices, ΔC) / (Spread of possible
share prices, ΔS) (12)
= (Rs 30 – 0)/(Rs 180 – Rs 135) = Rs 30/Rs 45 = 2/3
(ii) The option delta of 2/3 implies that the investor will buy 2/3 of Reliance
share and borrow Rs 81.82. (explained in step iii).
(iii) Investor will borrow Rs 81.82 at 10 per cent; the modus-operandi of
determining Rs 82.82 is explained in Table 6.

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(iv) Since both alternatives yield identical payoffs, both investments today
must have the same value to avoid arbitrage (explained earlier).
C0 = Value of 2/3 of a share – Borrowings
= Rs 100 – Rs 81.82 = Rs 18.18.
The call option should sell at Rs 18.18. The net cost of buying the option
equivalent (Price of 2/3rd share, Rs 100 – Borrowings, Rs 81.82) is equal to the
value of call option.
TABLE 6 Payoffs With Purchase of 2/3 Share With Borrowings
Particulars Possible share price at year-end 1
Rs 135 Rs 180
2/3 market price of a share 90 120
Less: Payoffs (as under call option) 0 30
Repayment of loan along with interest 90 90
Borrowings at t = 0 [Rs 90/(1 + 0.1)] = Rs 81.82

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Assumptions
1) It considers only those options which can be exercised at their
maturity, that is, European options.
2) The market is efficient and there are no transaction costs and taxes.
Options and shares are infinitely divisible. Information is available to
all investors with no costs.
3) The risk-free rate or interest rate are known and constant during the
period of option contract. Investors can borrow as well as lend at this
rate.
4) No dividend is paid on the shares.
5) Share prices behave in a manner consistent with a random walk in
continuous time.
6) The probability distribution of financial returns on the share is normal.
7) The variance/standard deviation of the return is constant during the life
of the option contract and is known to market participants/investors.

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Given these assumptions, the Black-Scholes formulas for the prices
of European calls and puts on a non-dividend paying stock are:
( )
( )
tσ
t2σ
2
1
rS/EIn
or
tσ
1
d
2
d
tσ
t/22σrS/EIn
1
dwhere,
(14))
1
(–dSN–)
2
(–dNrt
eEP
(13))
2
N (drt
eE–)
1
(d
N
SC




−+
−=
++
−=
−=

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 The Black-Scholes equation is done in continuous time. This
requires continuous compounding. The r is short-term annual
interest rate compounded annually.
 N (d) is the cumulative normal distribution. N (d1) is called the
delta of the option, which is a measure of change in option
price with respect to change in the price of the underlying
asset.
 σ, a measure of volatility, is the annualised standard deviation
of continuously compounded returns on the underlying stock.
When daily sigma are given, they need to be converted into
annulaised sigma.
 .
On an average, there are 250 trading days in a year.
 E is the exercise price, S the spot price and t the time to
expiration measured in years.
 e is 2.71828, the base of natural logarithms and ln is natural
logarithm.
yearperdaystradingofNumbersigmaSigma dailyannual
×=

Application of BS Model
The solution of BS formula requires five variables.
Out of these 5 variables, the four variables, namely,
E, R, T and S are easily observable/known to market
participants. The only unknown variable is the
standard deviation of the share price; its value can
be determined by referring to weekly observations of
the share prices in the immediate preceding year;
this value of standard deviation can, then, be used
as a surrogate in the BS formula. The application of
BS formula is illustrated in Example 9.

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Example 9
From the following information available to a market participant,
determine the value of an European call option as per the BS
formula.
Spot price of the share = Rs 1,120
Exercise price of the call option = Rs 1,100
Short-term risk-free interest rate (continuously compounded) = 10
per cent per annum
Time remaining for expiration = 1 month
Volatility of the share/standard deviation = 0.2

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Solution
( ) ( )
( )( )
( )( )
1089.1
7]-ATableperAs11100[0.990
0.01-1100e
0.008-1100ert-
eE
0.46310.056568-0.5197
(0.28284)0.2-0.5197
0.080.2-0.5197
2
d
0.0565680.282840.2
0.080.126)-ATableper(as*0.019803
1
d
0.282840.2
0.080.020.16)-ATableper(as(1.02)In
0.080.2
0.08/2
2
0.20.100)(1,120/1,1In
tσ
t/22σrS/EIn
1
d
)
2
N(drt
eE)
1
SN(dC
=
=
==
=
=
=×
+
=
×
++
=
++
=
++
−−=















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C = 1120 N(0.5197) – 1089.1 N(0.4631)
= Values of N (0.5917) and N (0.4631) have been determined
with
reference to cumulative standardised normal probability
distribution Table A-8
= 1120 [N(0.51) + 0.97 (N(0.52) – N(0.51))]
= 1089.1 [N(0.46) + 0.31 (N(0.47) – N(0.46))]
= 1120 [0.6950 + 0.97 (0.6985 – 0.6950)] – 1089.1 [0.6772
+ 0.31
(0.6808 – 0.6772)]
= 1120 [0.6950 + 0.003395] – 1089.1 [0.6772 + 0.001116]
= 1120 [0.698395] – 1089.1 [0.678316]
= 782.20 – 738.75 = 43.45
Thus, the value of the call option is Rs 43.45.
From Example 9, it is evident that the application of the BS formula
is straight forward, given the availability of statistical tables,
computer package or specifically programmed calculators to
determine the required inputs. The model has immense theoretical
and practical significance to identify the over-valued and under-
valued options in the market.

SOLVED PROBLEMS

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SOLVED PROBLEM 1
An investor has purchased a 4-month call option on the equity share of Birla
company for Rs 5. It has a present market price per share of Rs 112, exercise
price of Rs 120. At the end of 4 months, the investor expects the price of share
to be in the following range of Rs 90 to 170 with varying probabilities.
Expected price Rs 100 Rs 110 Rs 125 Rs 150 Rs 170
Probability 0.10 0.25 0.30 0.25 0.10
From the above, you are required to answer the following:
1. What is the expected value of share price 4-months hence? What is the
value of call option at its expiration (C1) if the expected value of share price
prevails at the end of 4 months?
2. Determine the expected value of option price at maturity, assuming that the
call option is held to this time. Why does it differ from the option value
determined in part (i) ?
3. What is the theoretical value of the option, at the beginning of 4-month
period? Give comments on the market value of the call option in relation to
its theoretical value.

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Solution
(i) Expected value of share at the end of 4 months
Expected price Probability Expected value of share
price
Rs 100 0.10 Rs 10.00
110 0.25 27.50
125 0.30 37.50
150 0.25 37.50
170 0.10 17.00
Expected value of share price 129.50
C1 = S1 – E
Rs 129.50 – Rs 120 = Rs 9.5

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(ii) Expected value of call option
Expected
price
Exercise price Call value Probability Expected call
value
Rs 100 Rs 120 0 0.10 0
110 120 0 0.25 0
125 120 5 0.30 1.50
150 120 30 0.25 7.50
170 120 50 0.10 5.00
Expected call option value 14.00
Reason for difference: At share prices of less than Rs 120, the call option has
zero value (as the call option cannot have a negative value). This has
enhanced the expected call option value (i.e. Rs 14.00) vis-à-vis Rs 9.5 in part
(i). In part (i), calculation is based on negative call option values also as all the
share prices have been considered (from Rs 100 to 170).
(iii) Theoretical value of call option = Max. (S0 – E, 0) = (Rs 112 – Rs 120, 0) = 0.
However, the call option has a positive value of Rs 5. The reason is probability
distribution of possible share prices (higher than exercise price) is relatively
wide. This optimism of the market price of the share explains the positive call
option price.

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SOLVED PROBLEM 2
A stock is currently trading for Rs 28. The riskless interest rate is 6 per
cent per annum continuously compounded. Estimate the value of
European call option with a strike price of Rs 30 and a time of
expiration of 3 months. The standard deviation of the stock’s annual
return is 0.44. Apply BS model.
Solution
Spot price of the share (S) Rs 28
Exercise price of the call option (E) 30
Risk-free interest rate (r ) 0.06
Time remaining for expiration (t ) = 3 months = 3/12 (year) 0.25
Volatility of the stock (σ) 0.44

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29.406(0.9802)30
7)ATableperas0.9802(ee30
e30e30eEand
0.3559-d
0.25(0.44)-0.1359-tσ-dd
0.1359
0.22
0.03920.0691-
d
0.0691-(0.9333)ln
2.23352.3026-
2.30260.9700)1(
2.3026.9700)1(
2.3026(0.9333)Log(0.9333)ln
0.02-0.02-
0.015-)0.25(0.06rt-
2
12
1
10
==
==
==
=
==
−
+
=
=
+=
×+=
×=
×=
×
( )
( ) ( )( )
( ) ( )
( )0.50.44
0.250.09680.060.9333In
d
0.250.44
0.25/20.440.0628/30In
d
getweabovegivenninformatiothefromvaluesngSubstituti
tσ
t/2σrS/EIn
d
).(Epriceexercisetheofvaluepresentandd,dviz.,values,threeofncalculatiorequiresyessentialloptioncallofnComputatio
)(dNE-)(dNSCmodel.pricingoptionscholes-BlackusingbyobtainedbecanoptioncallEuropeanofvalueThe
1
2
1
2
1
rt-
e21
2
-rt
e1
++
=
++
=
++
=
=

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The equation of call option looks like C = 28 N (– 0.1359) – 29.406 N (– 0.3559)
The next step is to look up the values of a cumulative standardised normal
probability distribution at (– 0.1359) and (– 0.3559)
N (–0.1359) = N (–0.13) – 0.59 [N (–0.13) – N (–0.14)]
= 0.4483 – 0.59 [0.4483 – 0.4443]
= 0.4483 – 0.00236 = 0.4459
N (–0.3559) = N (–0.35) – 0.59 [N (–0.35) – N (–0.36)]
= 0.3632 – 0.59 [0.3632 – 0.3594]
= 0.3632 – 0.00224 = 0.3610
C = 28 (0.4459) – 29.406 (0.3610)
= 12.4852 – 10.6156 = Rs 1.87
Thus, the value of European call option is Rs 1.87.

Strategic financial management

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