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CORPORATE FINANCE

KUNAL MADAAN
NEHA BANSAL
NILESH DAKALIA
 TIME VALUE OF MONEY
Definition: The idea that money
available at the present time is worth
more than the same amount in the
future.
▰Reasons for this difference:
▻Presence of inflation
▻Preference of individual for current
consumption over future consumption
▻Investment opportunities
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 COMPOUNDING & DISCOUNTING
▰For example, assuming a 5% interest rate, $100 invested today will be worth $105
in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now
is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate
▰FV = PV * ( 1+ R)n
▻FV = Future Value
▻PV = Present Value
▻R = Interest Rate

• PV = FV/(1+R)^n
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You have won a cash prize! You have two payment options:
A - Receive $10,000 now or B - Receive $10,000 in three years. Which
option would you choose?

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 NET PRESENT VALUE

NPV
▰Net present value (NPV) is the
difference between the present value
of cash inflows and the present value
of cash outflows
Application of NPV
•The long-term investment decisions
of a firm
•Include expansion, replacement or
renewal of long-term assets

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 NPV – ACCEPTANCE RULE
▰The NPV rule states that all projects which have a positive net present value should be
accepted while those that are negative should be rejected

▰The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected

Accept the project when NPV is positive NPV > 0

Reject the project when NPV is negative NPV < 0
May accept the project when NPV is zero NPV = 0

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 CALCULATION OF NPV
 C1 C2 C3 Cn 
NPV      n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t

Assume that Project X costs Rs 2,500 now and is expected to generate

year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in
years 1 through 5. The opportunity cost of the capital may be assumed to
be 10 per cent
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 CALCULATION OF NPV
NPV is always calculated on After Tax Basis
NPV does not include sunk costs. We have to factor in opportunity costs
and factors such as Cannibalization

Initial Cash Outflow = { ( Fcinv + Wcinv) }

Cash Inflow = {EBIT(1-T) + DT}
Terminal Year Inflow = { Wcinv + Salvage – (Salvage- BV)T }
Main weakness of NPV is that it does not consider size of project while
evaluating projects.
Case 1 NPV = 100 Cost of Project = 100
Case 2 NPV = 25 Cost of Project = 10

PI(profitability Index) = 1 + NPV /Cost of Project 8

 INTERNAL RATE OF RETURN
Internal rate of return (IRR) is the discount rate often used in capital budgeting that makes
the net present value of all cash flows from a particular project equal to zero.
The higher a project's internal rate of return, the more desirable it is to undertake the
project
If IRR> Cost of capital, Accept the project
If IRR<Cost of capital, reject the project

▻After this hurdle rate is passed , usually a project with higher IRR is
considered beneficial
▻Think of IRR as the Growth Rate a project will provide YOY
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 INTERNAL RATE OF RETURN
▻A similar issue arises when using IRR to compare projects of different
lengths. For example, a project of a short duration may have a high IRR,
making it appear to be an excellent investment, but may also have a low
NPV. Conversely, a longer project may have a low IRR, earning returns
slowly and steadily, but may add a large amount of value to the company
over time
▻IRR may have multiple values and it may be difficult to decide on which
value to use
▻Whenever we get conflicting NPV and IRR always go with NPV because it
shows incremental wealth added to shareholders
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 INVESTMENT EVALUATION
Three steps are involved in the evaluation of an investment:
A. Estimation of cash flows

B. Estimation of the required rate of return (the

opportunity cost of capital)

C. Application of a decision rule for making the choice

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 COST OF CAPITAL
▰Cost of capital is the required return necessary to make a capital budgeting project, such as
building a new factory, worthwhile

▰Cost of capital includes the cost of debt and the cost of equity. A company uses debt,
common equity and preferred equity to fund new projects, typically in large sums

▰The returns provided by the next best alternative investment is called opportunity cost of
capital. This could serve as basis for cost of capital

▰Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value
and minimizes the firm's cost of capital

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 COST OF DEBT
Creditors have priority over shareholders in receiving interest and
repayment of capital

Debt securities include government bonds, corporate bonds, CDs,

municipal bonds, preferred stock, collateralized securities and zero-
coupon securities

In theory, debt financing generally offers the lowest cost of capital

due to its tax deductibility. However, it is rarely the optimal structure
since a company's risk generally increases as debt increases
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 CALCULATING COST OF DEBT
Because companies benefit from the tax deductions available on
interest paid, the net cost of the debt is actually the interest paid less
the tax savings resulting from the tax-deductible interest payment

After-tax cost of debt = Rd (1-t)

Note: Rd represents the cost to issue new debt, not the cost of the
firm's existing debt

t : Corporate Tax Rate

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 COST OF EQUITY
Equity capital is classified as
1) Internal: Profits that are not distributed but retained by the
firm in funding the growth, referred to as internal equity
2) External: Equity capital raised afresh to fund, called
external equity

A firm's cost of equity represents the compensation that the

market demands in exchange for owning the asset and
bearing the risk of ownership
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 Capital Asset Pricing Model
CAPM describes the relationship between risk and expected
return and that is used in the pricing of risky securities

Determinants of cost of equity under CAPM based approach

include three parameters
 the risk free rate, rf
 the market rate of return, rm and
 β, as measure of risk

re = rf + β * (rm – rf) 16
 BETA
Beta measures the amount that investors expect the stock price to change
for each additional percentage change in the market

High Beta implies volatile stock and high risk

A Stock Beta is represented graphically by the slope of the regression line of

the stock return against the market return

Systematic Risk: the market risk comprising factors affecting all assets
Unsystematic Risk: the unique risk emanating from factors affecting
individual asset. It can be eliminated by diversification
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 Weighted Average Cost of Capital
A firm's WACC is the overall required return on the firm as a whole and, as
such, it is often used internally by company directors to determine the
economic feasibility of expansionary opportunities and mergers.

WACC is a calculation of a firm's cost of capital in which each category of

capital is proportionately weighted

WACC is a composite figure reflecting cost of each component multiplied by

the weight of each component

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 WACC Calculation

WACC = E/(D+E) * Re + D/(D+E) * Rd * (1-t)

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
E/(D+E) = percentage of financing that is equity
D/(D+E) = percentage of financing that is debt
t = corporate tax rate 19
 CONCEPT OF FCFF & FCFE

FCFF - it is the cash flow available to all the firm’s providers of capital once the firm pays
all operating expenses (including taxes) and expenditures needed to support the firm’s
productive capacity. The providers of capital include common stockholders, bondholders,
preferred stockholders, and other claimholders.

 FCFF = NI + Interest(1-tax) + NCC –capex – working capital

expenditure

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 CONCEPT OF FCFF & FCFE

FCFE- is a metric of how much cash can be distributed to the equity shareholders of the
company as dividends or stock buybacks—after all expenses, reinvestments, and debt
repayments are taken care of.

FCFE = NI + NCC –capex – working capital expenditure + Net

Borrowings

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 IMPORTANT LINKS
TVM: http://www.investopedia.com/video/play/understanding-time-value-of-money/

NPV: http://www.investopedia.com/video/play/what-is-net-present-value/

CAPM: http://www.investopedia.com/video/play/capm

WACC: http://www.investopedia.com/video/play/what-is-wacc/

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THANK YOU!

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