In corporate finance, the objective of a finance manager is

to maximize the value of the firm.

When the stock is traded, the objective is to maximize the
stock price.
The Investment Decision

Maximize the value of the business (firm)

Invest in assets that earn a
return greater than the
minimum acceptable rate

The Financing Decision

Find the right mix of debt and
equity to fund your operations

The Dividend Decision

If you cannot find investments
that make your minimum
acceptable rate, return the
cash to owners of your
business
 Investment/Project Appraisal
• Investment appraisal is the process of
assessing a project's financial viability in a
structured way.
• In investment appraisal, we use cash flows
rather than earnings. You cannot spend
earnings.
• From financial perspective, 2 important
concepts related to investment appraisal are:
– Free Cash Flow (FCF) and
– Weighted Average Cost of Capital (WACC)
 Setting the table: What is an
investment/project?
● An investment/project can from big to small, money making to
cost saving:
○ Major strategic decisions to enter new areas of business or
new markets.
○ Acquisitions of other firms and projects
○ Decisions on new ventures within existing businesses or
markets.
● Put in broader terms, every choice made by a firm can be framed
as an investment.

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9
 Here are examples…
● New Paper Plant for Aracruz: Aracruz, as a paper company, is examining
whether to invest in a new paper plant in Brazil.
● An Online Store for Bookscape: Bookscape is evaluating whether it
should create an online store to sell books. While it is an extension of
their basis business, it will require different investments (and potentially
expose them to different types of risk).
● Acquisition of Sentient by Tata Chemicals: Sentient is a US firm that
manufactures chemicals for the food processing business. This cross-
border acquisition by Tata Chemicals will allow us to examine currency
and risk issues in such a transaction.

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 Measures of Return: Earnings versus Cash flows
Principles Governing Accounting Earnings Measurement
Accrual Concept:
Show revenues when products and services are sold or provided, not
when they are paid for.
Matching Principle:
All expenses of a particular accounting period must be matched with
the relevant income of that period, irrespective of the matter
whether they’re paid or received in cash.
If expenses are not properly recorded in the correct period, the net
income for a particular period may be either understated or
overstated.
Operating versus Capital Expenditures:
Only expenses associated with creating revenues in the current period
should be treated as operating expenses.
Expenses that create benefits over several periods are written off over
multiple periods as depreciation or amortization.
5
 Income Statement for the year ended June 30, 2017
Sales Revenue: 220
Cost of Goods Sold (COGS): 125

Gross Profit 95

Operating Expenses:
Salary expense 15
Utilities expense OPEX 15
Rent expense 15
Depreciation Partial CAPEX 18
Total Operating Expenses 63
Operating Profit/ Earnings Before Interest & Tax 32
Interest Payment Partial FINEX 12
Earnings Before Tax 20
Tax for the year @ 40% 8
Net income after tax 12
Proposed dividends 5
Retained earnings for the year 7
Measures of Return: Earnings versus Cash flows

● The income figure reported in the income statement might be

more or less than the cash balance during the period.
● Use cash flows rather than earnings. You cannot spend
earnings.
● Use “incremental” cash flows relating to the investment
decision.
● Use “time weighted” returns, i.e., value cash flows that occur
earlier more than cash flows that occur later.

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8
Measuring ROC for existing
investments..
 What is Free Cash Flow – FCF

• Free cash flow represents the cash a company generates after

meeting operational and capital expenditures of the business.

• Unlike earnings or net income, free cash flow is a measure of

profitability that excludes the non-cash expenses of the income
statement and includes expenditures on equipment and assets as
well as changes in working capital financing requirements.

• Free cash flow is the cash flow available to all the investors in a
company, including common stockholders, preferred
shareholders, and lenders.
 Definition and Significance of FCF
• The Free Cash Flow (FCF) is the cash generated by the
company after deducting operating and capital
expenditures from its operating cash flow.
• Free cash flow measures a company's ability to
generate cash.
• The presence of free cash flow indicates that a company
has cash to expand, develop new products, buy back
stock, pay dividends, or reduce its debt.
• High or rising free cash flow is often a sign of a healthy
company that is thriving in its current environment.
• Net present value of free cash flows coming from a
project tells the shareholders how much value that
project will add to the organization.
 3 Types of Expenditures
1. Capital Expenditure
2. Revenue/ Operating Expenditure
3. Financing Expenditure

WACC captures Financing Expenditure and the

concept of TVM
 FCF Calculation (Year 1)
Sales (Revenues from operations)
- COGS (Cost of goods sold-labor, material)
- SG&A (Selling, general administrative costs)
-Depreciation expense
EBIT (Earnings before interest and taxes or Operating
Profit)
- Taxes (Cash taxes)
NOPAT (Net Operating Profit After Taxes)
+ Depreciation expense
- CAPEX
- (Change in working capital)
FCF (Free cash flows)
 FCF Calculation (Subsequent Years)
Sales (Revenues from operations)
- COGS (Cost of goods sold-labor, material)
- SG&A (Selling, general administrative costs)
-Depreciation expense
EBIT (Earnings before interest and taxes or Operating
Profit)
- Taxes (Cash taxes)
NOPAT (Net Operating Profit After Taxes)
+ Depreciation expense
- Sustaining CAPEX (if any in that particular year)
- (Change in working capital)
FCF (Free cash flows)
 Breaking Down FCF (1)

• Some investors prefer FCF or FCF per share over earnings and
earnings per share as a measure of profitability. FCF accounts for
investments in property, plant, and equipment – which can be
uneven over time.

• Imagine a company has earnings before depreciation, amortization,

interest, and taxes (EBITDA) of $1,000,000 in a given year. Also
assume that this company has had no changes in working capital
(current assets – current liabilities) but they bought new equipment
worth $800,000 at the end of the year. The expense of the new
equipment will be spread out over time on the income statement,
which evens out the impact of the new equipment purchase on
earnings.
 Breaking Down FCF (2)
• However, because FCF accounts for new equipment purchase at
once, the company will report $200,000 FCF ($1,000,000 EBITDA -
$800,000 Equipment) on $1,000,000 of EBITDA that year.
• If we assume that everything else remains the same and there are no
further equipment purchases, EBITDA and FCF will be equal again the
next year.
• Interest payments are excluded from the generally accepted
definition of free cash flow. Investment bankers and analysts who
need to evaluate a company’s expected performance with different
capital structures will use variations of free cash flow like free cash
flow for the firm and free cash flow to equity, which are adjusted for
interest payments and borrowings.
 FCF in Company Analysis (1)
• Because FCF accounts for changes in working capital, it can provide
important insights into the value of a company and the health of its
fundamental trends.
• For example, a decrease in accounts payable (outflow) could mean
that vendors are requiring faster payment. A decrease in accounts
receivable (inflow) means the company is collecting from its clients
more quickly. An increase in inventory (outflow) could indicate a
building stockpile of unsold products.
• Including working capital in a measure of profitability provides an
insight that is missing from the income statement. For example,
assume that a company had made $50,000,000 per year in net
income each year for the last decade. On the surface, that seems
stable but what if FCF has been dropping over the last two years as
inventories were rising (outflow), customers started to delay
payments (outflow) and vendors began demanding faster payments
(outflow) from the firm?
 FCF in Company Analysis (2)
• In this situation, FCF would reveal a serious financial weakness that
wouldn’t have been apparent from an examination of the income
statement alone.

• FCF is also helpful as the starting place for potential shareholders

or lenders to evaluate how likely the company will be able to pay
their expected dividends or interest.

• If the company’s debt payments are deducted from FCF (Free Cash
Flow to the Firm), a lender would have a better idea for the quality
of cash flows available for additional borrowings. Similarly,
shareholders can use FCF to think about the expected stability of
future dividend payments.
 FCF Calculations (1)
• FCF can be calculated by starting with Cash Flows from
Operating Activities on the Statement of Cash Flows because
this number will have already adjusted earnings for interest
payments, non-cash expenses, and changes in working capital.
 FCF Calculations (2)
• The income statement and balance sheet can also be used to
calculate FCF.
 FCF Calculations (3)
• Other factors from the income statement, balance sheet and
statement of cash flows can be used to arrive at the same
calculation. For example, if EBIT was not given, an investor could
arrive at the correct calculation in the following way.
 FCF Calculations (4)
• While FCF is a useful tool, it is not subject to the same financial
disclosure requirements as other line items in the financial
statements.

• CAPEX can make the metric a little “lumpy,” However, FCF is a good
double-check on a company’s reported profitability. Although the
effort is worth it, not all investors have the background knowledge
or are willing to dedicate the time to calculate the number
manually.

• Fortunately, financial websites (like Investopedia) provides a

summary of FCF or a graph of FCF’s trend for most public
companies. However, the real challenge remains: what constitutes
good Free Cash Flow? Many companies with positive Free Cash
Flow will have miserable stock trends, and the opposite can also be
true.
 Trend Analysis of FCF (1)
• A concept we can borrow from technical analysts is to focus on
the trend of fundamental performance rather than the
absolute values of FCF, earnings, or revenue. If stock prices are
a function of the underlying fundamentals, then a positive FCF
trend should be correlated with positive stock price trends on
average.

• A common approach is to use the stability of FCF trends as a

measure of risk. If the trend of FCF is stable over the last four
to five years, then bullish trends in the stock are less likely to
be disrupted in the future. However, falling FCF trends,
especially FCF trends that are very different compared to
earnings and sales trends, indicate a higher likelihood of
negative price performance.
 Trend Analysis of FCF (2)
• This approach ignores the absolute value of FCF to
focus on the FCF trend. Consider the following example:

Factor 2013 2014 2015 2016 2017 2018

Sales $ 100 $ 105 $ 120 $ 126 $ 128 $ 130
EPS $ 1.00 $ 1.03 $ 1.15 $ 1.17 $ 1.19 $ 1.20
FCF/Share $ 0.85 $ 0.97 $ 1.07 $ 1.05 $ 0.80 $ 0.56
 Trend Analysis of FCF (2)
• This approach ignores the absolute value of FCF to
focus on the FCF and its relationship to price
performance. Consider the following example:
 Trend Analysis of FCF (3)
• Based on these trends, an investor would be on alert that
something may not be going well with the company, but
that the issues haven’t made it to the so-called “headline
numbers” – revenue and earnings per share (EPS). What
could cause these issues?

• A company could have diverging trends like these because

management is investing in property, plant, and equipment
to grow the business.

• In the previous example, an investor could detect that this is

the case by looking to see if CAPEX was becoming larger in
2016-2018. If FCF + CAPEX were still upwardly trending, this
scenario could be a good thing for the stock’s value.
 Stockpiling Inventory
• Between 2015 and 2016, Deckers Outdoor Corp
(DECK), famous for their UGG boots, grew sales by
a little more than 3%. However, inventory grew by
more than 26%, which caused FCF to fall that year
even though revenue was rising.

• Using this information, an investor may have

wanted to investigate whether DECK would be able
to resolve their inventory issues or if the UGG boot
was simply falling out of fashion, before making an
investment with the potential for extra risk.
 Credit Problems
• A change in working capital can be caused by inventory or a shift
in accounts payable and receivable. If a company’s sales are
struggling, then the company will extend more generous payment
terms to their clients, and as a result accounts receivable will rise,
which will have a negative impact on FCF.

• Alternatively, perhaps a company’s suppliers are not willing to

extend credit as generously and require faster payment. That will
reduce accounts payable, which will also have a negative impact
on FCF.
• In this situation, the divergence between the fundamental trends
was apparent in FCF but not immediately obvious by just
examining the income statement alone.
 Summary
• Free Cash Flow reconciles net income by
adjusting for non-cash expenses, changes in
working capital, and capital expenditures
(CAPEX). As a measure of profitability, it is more
uneven than net income but can reveal
problems in the fundamentals before they arise
on the income statement.
 Debt versus Equity

Fixed Claim Residual Claim

Tax Deductible Not Tax Deductible
High Priority in Financial Trouble Lowest Priority in Financial Trouble
Fixed Maturity Infinite
No Management Control Management Control

Debt
Hybrid Securities Equity
Bank Loan
Convertible Debt Venture Capital
Commercial Paper
Preferred Stock Common Stock
Corporate Bond
 Concept of WACC
The weighted average cost of capital (WACC) is the average return that the
company has to pay to its equity and debt investors. Another way of putting
this is that the WACC is the average return shareholders and debt holders
expect to receive from the company.
WACC equation without the impact of Tax (Tc ):
 WACC (Example)
United Transport Inc. has 3 million shares outstanding; the current market price per
share is $10. The company has also borrowed $10 million from its banks at a rate of
8%; this is the company’s cost of debt is rd.
The company thinks its shareholders want an annual return on their investment of
20%; this 20% return is the company’s cost of equity re . To compute United
Transport’s WACC we use the formula:
re= 20% ; rd= 8%
E= 3,000,000 shares each worth $ 10= $ 30,000,000
D= $ 10,000,000
 Concept of WACC
The equation of the WACC with tax impact is:
 Effect of Interest &Tax Rate on WACC
Calculation
• Debt financing has tax advantage. Interest on debt is
deducted from EBIT before charging tax payment. Thus debt
financing reduces tax.
• This tax advantage due to debt financing is reflected in
Weighted Average Cost of Capital (WACC):

• Here, this (1-Tc) is the portion by which cost of debt rd is

reduced. Thus debt financing reduces overall WACC.
• However, excessive amount of debt portion in the capital
exposes the company to financial risk i.e. bankruptcy risk.
 WACC (Situation 1)
United Transport Inc. has 3 million shares outstanding; the current market price per
share is $10. The company has also borrowed $10 million from its banks at a rate of
8%; this is the company’s cost of debt is rd. United Transport’s tax rate of Tc = 40%.
The company thinks its shareholders want an annual return on their investment of
20%; this 20% return is the company’s cost of equity rE . To compute United
Transport’s WACC we use the formula:
re= 20% ; rd= 8%
E= 3,000,000 shares each worth $ 10= $ 30,000,000
D= $ 10,000,000
Tc=40%
 WACC (Situation 2)
If the company takes loans from a bank to buy back some of
the common shares, then new capital structure stands as:
E= 2,000,000 shares each worth $ 10= $ 20,000,000
D= $ 10,000,000 +$ 10,000,000 = $ 20,000,000
re= 20%; rd= 8%; Tc=40%
Basic Investment Appraisal
Techniques:

Payback Period,
Discounted Payback Period,
NPV and IRR
 CAPITAL BUDGETING : PROBLEM 1
Hick Limited is considering investing in a new project, for which
the following information is available:
£ 000
Initial investment 450
Life of project 4 years
Estimated annual cash flows:
Year 1 150
Year 2 300
Year 3 100
Year 4 100
• Residual value 30
• Cost of capital or discount rate is 10%
 PROBLEM 1 (CONTINUED)
Required:
Evaluate the financial viability of the above project
using the following techniques:
I. Payback Period
II. Discounted Payback Period
III. Net Present Value
IV. Internal Rate of Return
Clearly state the assumptions made.
 SOLUTION 1
(i) Payback Period (PP)

Payback Period is the number of years

needed to recover initial cost (cash
outflows) of a project from its future
cash inflows. It does not consider time
value of money concept.
 Cash Flow Timeline

£ -450,000 150,000 300,000 100,000 100,000

+ 30,000

Year 0 1 2 3 4
 Payback Period
SOLUTION 1
(i) Payback Period
0 1 2

-450,000 150,000 300,000

Cumulative
150 K 450k
Inflows
Cash flow Cumulative
Investment= (450,000) (450,000)
Year 1 = 150,000 150,000
Year 2 = 300,000 450,000
Therefore payback period equals 2 years
 SOLUTION 1
(ii) Discounted Payback Period (DPP)

DPP is the number of years needed to

recover initial cost (cash outflows) of a
project from its future cash inflows. To
calculate it, we need consequentially add
the discounted value of each future cash
inflow as long as the initial cost is
recovered.
 SOLUTION 1 (CONTINUED)
(ii) Discounted Payback Period (DPBP)
Here, Cost of Capital = 10%
150 300 100 130
-450 (b) 1.14
1.1 1.12 1.13

(a)
136.36
247.93
75.131 (d)
88.71
136.36 K 385.29 K (c) 460.42 K
Total = 548.21

Cumulative DPBP = a + ( b - c ) / d
Inflows
= 2 + (450 – 385.29) / 75.131
= 2 + (65.71) / 75.131
= 2.87 Years
 Significance of Discounted Payback Period
• The discounted payback period (DPP) is the amount of time that
it takes (in years) for the initial cost of a project to equal to
discounted value of expected cash flows, or the time it takes to
reach to the break even point from an investment.
• While simple payback period ignores the time value of money
concept, discounted payback period takes the time value of
money into account by discounting each cash flow by the cost of
capital (or, WACC).
• Other things being equal, the shorter the payback period, the
earlier the initial investment will be recovered, and the greater
the liquidity of the project.
• If Project X has a discounted payback period of 5 years, that
means after 5 years, the discounted cash inflow will be enough
to recover the amount of discounted cash outflow.
 SOLUTION 1 (CONTINUED)
(iii) Net Present Value (NPV)

NPV is the present value of an

investment project’s net cash
inflows minus the project’s cash
outflows.
 SOLUTION 1 (CONTINUED)
(iii) Net Present Value (NPV)
Here, Cost of Capital = 10%
150 300 100 130
-450 1.1 1.12 1.13 1.14

136.36
247.93
75.131
88.71
Total = 548.21
NPV = Total Discounted Cash Inflows – Investment = 548,210 - 450,000 = 98,210
NPV = 98,210
 Significance of NPV
• NPV discounts each inflow and outflow to the
present, and then sums them to see how the
value of the inflows compares to the outflows.

• NPV > 0: The PV of the inflows is greater than

the PV of the outflows.
• NPV = 0: The PV of the inflows is equal to the
PV of the outflows.
• NPV < 0: The PV of the inflows is less than the
PV of the outflows.
 Significance of NPV (continued)
• Time value. It recognizes the time value of money
concept i.e. a $ received today is worth more
than a $ received tomorrow.
• Measure of true profitability. It uses all cash
flows occurring over the entire life of the project.
Hence, it is a measure of the project’s holistic
profitability.
• Shareholder value. The net present value (NPV)
method is always consistent with the objective of
the shareholder value maximization. This is the
greatest virtue of the method.
 SOLUTION 1 (CONTINUED)
(IV) IRR Calculation

IRR is the discount rate that equates the

present value of the future net cash flows
from an investment project with the
project’s initial cash outflow.
 SOLUTION 1 (CONTINUED)

-450

NPV = Total Discounted Cash Inflows –

Investment
=450,000 - 450,000
=0
 SOLUTION 1 (CONTINUED)
Now, at a discount rate of 25%
150 300 100 130
-450 1.25 1.252 1.253 1.254

120.00
192.00
51.20
53.25
Total = 416.45
NPV = Total Discounted Cash Inflows – Investment = 416,450-450,000 = -33,550
NPV = -33,550
 SOLUTION 1 (CONTINUED)
(IV) IRR Calculation
Using linear interpolation IRR can be estimated:
98,210−(−33,550) 98,210−0
= (At IRR, NPV=0)
0.25−0.1 𝑥−0.1
Rearranging gives,
98,210×0.15
x-0.1 =
98,210+33,550
Therefore, x = 0.11+0.1 = 21% approx.
IRR = 21%
 Significance of IRR
• IRR is the rate at which cash flows are discounted and such discounted cash flows are
equal to investment amount. This ensures that the project would at least cover the
amount of investment at a particular rate i.e. IRR.
• Mathematically, internal rate of return is a discount rate that makes the net present
value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely
on the same formula as NPV does.
• The higher a project's internal rate of return, the more desirable it is to undertake. In
theory, any project with an IRR greater than its cost of capital is a profitable one, and
thus it is in a company’s interest to undertake such projects.
• Assuming the costs of investment are equal among the various projects, the project
with the highest IRR would probably be considered the best and be undertaken first.
• Usually IRR and NPV calculation result in the same acceptance or rejection decision.
Any project with positive NPV would have IRR higher than its cost of capital.
• If a firm’s cost of capital is 10%, Project X has IRR of 12%, and Project Y has IRR of 15%,
the company should choose Project Y, if these projects are mutually exclusive. If not,
both of the projects should be chosen, as both would be profitable for the company
from financial perspective.
 CAPITAL BUDGETING : PROBLEM 2
A project requires an initial investment of £120,000 and is
expected to produce the following net cash inflows:

Year 1 £50,000
Year 2 £25,000
Year 3 £25,000
Year 4 £25,000
Year 5 £30,000

The discount rate is 8%

 PROBLEM 2 (CONTINUED)
Required:
Evaluate the financial viability of this project
using the following methods:
I. Payback
II. Discounted Payback Period
III. Net Present Value
IV. Internal Rate of Return
 Cash Flow Timeline

£ -120,000 50,000 25,000 25000 25,000 30,000

Year 0 1 2 3 4 5
 SOLUTION 2
(i) Payback Period (PP)
0 1 2 3 (a) 4 5

-120 K (b) 50 K 25 K 25 K 25 K(d) 30 K

50 K 75 K 100 K (c) 125k
Cumulative
Inflows

PP = a + ( b - c ) / d
=( 3+ (120,000- 100,000) /25,000)
=3.8 years
 SOLUTION 2 (CONTINUED)
(ii) Discounted Payback Period (DPBP)
Here, Cost of Capital = 8%
50 25 25 25 30
-120 (b) 1.08 1.082 1.083 1.084 1.085

(a)
46.30
21.43
19.85
18.38
20.42 (d) 136.36 K 385.29 K (c) 460.42 K
46.3 K 67.73 K 87.58K 105.96K(c) 126.38K
(Amounts are in thousands)
Cumulative
Inflows PBP = a + ( b - c ) / d
= 4 + (120 – 105.96) / 20.42
= 4 + (14.04) / 20.42
= 4.69 years
 SOLUTION 2 (CONTINUED)
(iii) NPV Calculation
Here, Cost of Capital = 8%
50 25 25 25 30
-120 1.08 1.082 1.083 1.084 1.085

46.30
21.43
19.85
18.38
20.42
Total = 126.38
(Amounts are in thousands)

NPV = 126,380 – 120,000 = 6,380

 SOLUTION 2 (CONTINUED)
(iii) NPV Calculation (At a 15% discount rate)
50 25 25 25 30
-120 1.15 1.152 1.153 1.154 1.155

43.48
18.90
16.44
14.29
14.92
Total = 107.93
(Amounts are in thousands)

NPV = 107,930 – 125,000 = -12,070

 SOLUTION 2 (CONTINUED)
IRR:

-120000

Year 0 1 2 3 4 5

NPV = Total Discounted Cash Inflows –Investment

=120,000 - 120,000
=0
 SOLUTION 2 (CONTINUED)
(IV) IRR Calculation
Using linear interpolation (or graphical method) IRR
cam be estimated:
6,380+12,070 6,380−0
= (At IRR, NPV=0)
0.15−0.08 𝑥−0.08
Rearranging gives,
6,380×0.07
x-0.08 =
6,380+12,070
Therefore, x = 0.024+0.08 = 10.4% approx.
IRR = 10.4%
 PROBLEM 3
Diamond Ltd
Diamond Ltd has £1m to invest and have identified the following
four projects:
Project Investment Outlay Net Present Value

A £400,000 +£100,000
B £600,000 +£125,000
C £300,000 +£90,000
D £250,000 +£40,000
Required
Assuming each project is divisible and the projects are not
mutually exclusive, in which projects should Diamond Ltd invest?
 SOLUTION 3
Diamond Ltd
Rank projects on basis of NPV per £ of investment
required
Investment
Project Net Present NPV per £ Ranking
Outlay Value (NPV)
A £400,000 +£100,000 £0,25 2

B £600,000 +£125,000 £0.208 3

C £300,000 +£90,000 £0.3 1

D £250,000 +£40,000 £0.16 4

 SOLUTION 3 (CONTINUED)
Allocate available funds accordingly

Project Funds used NPV

C £300,000 £90,000
A £400,000 £100,000
B £300,000 £62,500 (=½ 125,000)
(balance)

£1,000,000 £252,500