FINANCIAL ACCOUNTING AND FINANCIAL ANALYSIS

PGWPM BATCH TWO

RAGHU IYER
AUGUST 2011

As you move higher in management, the language changes

Tons, kms, people Operating language
RoE, EV, EVA, OPM, FA Turnover ??

Your purpose is the same - to make money

Language of money becomes important

Without money, the best ideas fail

Wright Brothers - aeroplane - without money, they would be unheard and we would be
bullock carts
James Watt - engine

It is easy - but any new language takes a little bit of effort and a little bit of time
Raw material - time, little commercial sense

1 Financial accounting
Accounting means recording of transactions (financial events)
Balance Sheet
Profit & Loss Account
Cash Flow Statement

2 Financial analysis
Reading the statements and understanding the import
Is the company healthy
Is the company profitable
Is the company making its owners happy
What is the level of risk

3 Financial decision making

Should I set up this new factory
Should I spend so much on this advertising campaign
Should I upgrade my machines
Spend first and wait for returns (takes time)
 4 Valuation of companies, projects

5 Financial markets
Stock market, derivatives market, commodities market

Finance is a life time journey

If we build the right awareness, basic understanding and curiosity, then you go ahead a
Many non-finance people understand finance better than finance people

Most CEOs understand finance better than CFOs

I am v v sure that the decision to make Nanos was Ratan Tata's decision and not Tata M

FINANCIAL ACCOUNTING
1 Personal Balance Sheet
2 Personal P&L
3 Basic accounting equation
4 Simple example of a new business
5 Game - Monopoly
At the end of the game, you will make your own Bal Sheet and P&L
By today evening

6 Corporate Bal Sheet

7 Corporate P&L
8 Understanding terminology around Corporate Financial Statements

Personal Balance Sheet

Two types of numbers in the world
1 Point of time numbers
2 Period of time numbers

How many cars do you have?

Five cars
What type of a number is this?
Point of time - as of when ? As of today - Aug 14, 2011 - he has five cars

1985 - zero cars

2025 - 25 cars
What is your salary?
Rs 15 lakhs
What type of a number is this?
As of today, his salary is Rs 15 lakhs ??
This is a "period of time" number
Rs 15 lakhs is a wrong answer, incomplete answer
Rs 15 lakhs per annum, per month, Harish Salve - Rs 15 lakhs per day, Rajnikant - Rs 15

1 Point of time numbers Balance Sheet

2 Period of time numbers Profit & Loss

The P&L starts afresh in every period - starts from zero all over again
The Bal Sheet continues forever

What is your salary for Aug 2011?

For this answer, your July salary is irrelevant
The Aug salary meter starts from zero on Aug 1

If you bott a house in 2001, will that house belong to you in 2011 also?
Yes

Your Personal Balance Sheet as of today - Aug 14, 2011

Liabilities - Owe
Sources of Funds
Where the Rupee came from
Own Capital / Net Worth
Own Funds / Accumulated past savings

Opening Balance 33.50

Profit during the year 2.50
Closing Balance 36.00

Home Loans
Personal Loans
Gold Loans
Car Loans
Auto Loans
Education Loans
Loans against Shares 12.00

Credit Card dues

All outstanding expenses 2.00

50.00

Salary ?? Will be accounted somewher

Education ?? Not an asset
Money spent for education ?? Will be accounted somewher
Wealthy friends ?? Not assets
Wealthy in laws ?? Not assets
Rich dad ?? Not assets

The most important asset that we have is our "Intellect"

The other important asset that we have is our "society - family, friends, relatives, boss
contacts"

Will they appear in our Bal Sheet?

Answer - No
Why?
Two challenges:
1 Monetization
I am very intelligent
We all agree
My intelligence is worth Rs 10 cr
We start fighting

2 Transferability (practical ownership)

Even if all of us agree that Rangarajan's intellgence is worth Rs 10 cr, can th
in a legally acceptable manner - sale, lease, licence, rent, etc

For accounting, we need a "transaction"

Transaction means a financial event
Unless transferability is possible, no event occurs
Rangarajan is very intelligent, but that is not a financial event
Property prices in Mahabalipuram have gone up
So what happens in the Bal Sheet?
You have a house in Mahabalipuram
Property prices going up is not a "transaction"
Nothing happens in the Bal Sheet

SHOW ME THE MONEY

Politicians are required to declare their assets

So should they declare at their cost (or at current market values)
I don’t know

In their Balance Sheets, these properties will appear at COST (not market values)

Anything that you sell, you will be satisfying both conditions

1 You will have to monetize it (bcoz without monetizing, you cant sell)
2 A transaction will occur (a transfer will happen)

If you buy a brand, we will show this as an Asset - bcoz it has a cost, it has a transactio
If you develop a brand, it will not appear as an Asset (it may be valuable), there is no
transaction
Development costs are not assets, they are "expenses"

COST VERSUS VALUE

Cost is what you paid, value is what you expect to fetch if the asset is sold off today
Accounting works on COST
Cost is a "fact", value is an "opinion"

If you bott your house for Rs 10 lakhs in 2004 and today it is worth Rs 65 lakhs, your Ba
show Rs 10 lakhs
Even this may have depreciated to Rs 8 lakhs

As a result, the Bal Sheet may not reflect current reality

It may be a very old ancient (and for some people - useless) financial statement
Accountants have preferred to go by the COST model instead of the VALUE model

Bcoz value is subjective, nobody knows the value, value keeps changing, each expert w
his own estimate of value, value is based on something which never happened
What is the loss to the Government due to the 2G Scam?
CAG - Rs 1.76 lakh crores
Jayalalitha - more than Rs 2.00 lakh crores
Raja - nothing
Kapil Sibal - nothing

In the Govt's accounting of 2G licences, the actual amount of money paid by each oper
would appear as a transaction
If we got Rs 2,000 cr as licence fees, we will record only Rs 2,000 cr - fact

Warren Buffet says that financial statements are the "starting point" for any financial a
value (not the end of the exercise)

Murugappa Group - wonderful building in Parrys called Parry House - 150 year old
Cost may have been Rs 1 lakh
Today, depreciated value will be zero
Value today - Rs 200 cr

If you take their Balance Sheet, that property appears at zero, but you will "estimate"
in your wisdom to be Rs 200 cr and value the share price accordingly

Accountants are criticized for knowing the cost of everything and the value of nothing

DEPRECIATION
All assets (other than land) have limited lives
If you bott a car today for Rs 8 lakhs and you estimate is has a ten year life with a salv
you should depreciate the car over the ten year period in such a manner that the car
car in the Bal Sheet becomes zero after ten years

Otherwise, the car will remain at Rs 8 lakhs

One fine day, the car will stop working
The entire asset will need to be written off on one day (this will become a loss)

You could depreciate the car at Rs 80,000 per annum

This depreciation becomes an expense in the P&L and the carrying value of the car red

Year Op Bal Depn Cl Bal

1 800,000 80,000 720,000
2 720,000 80,000 640,000
 3 640,000 80,000 560,000
4 560,000 80,000 480,000
5 480,000 80,000 400,000
6 400,000 80,000 320,000
7 320,000 80,000 240,000
8 240,000 80,000 160,000
9 160,000 80,000 80,000
10 80,000 80,000 -

Accountants are very simple people, they don’t understand complicated stuff like infla
US Debt, S&P rating, etc, etc
They record financial transactions
If the value of money drops due to passage of time, etc, that is not for the accountant

A Rs 10 note of 1980 is currently worth how much ?

In the Bal Sheet, the Rs 10 will appear at Rs 10 even today

Anesh has land, which has got polluted due to chemical effluents etc and the value of
as compared to the cost
What should he do now?
He bott the land for Rs 5 lakhs and the value is irreparably down to Rs 2 lakhs

The general principle is that we prefer cost over value

We don’t like valuation, etc, etc

But if there is damage to the asset (technically called IMPAIRMENT), then such damage

Same car example - the car got caught in an accident after 2 years
The value of the car is zero
The car book value after 2 years may be Rs 6.40 lakhs
The entire Rs 6.40 lakhs will be written off as Expenses on the day of the accident

On rare occasions, we may be forced to take the help of this VALUE animal, but we try
from the animal as we can
If depreciation is being recognized, why not appreciation?
The answer is depreciation is not being recognized in consequence of changes in marke

The car that you bott for Rs 8 lakhs today morning is worth how much in the evening?
Rs 7 lakhs
So what is the depreciation of day one?
If the car had a soul, when would it cry the most?
On the first day
Is the depreciation Rs 1 lakh? Answer No

Depreciation does not link up with market values

Depreciation is a result of "passage of time"

800,000 10 80,000 365 219

TIME WILL PASS - THAT IS THE ONLY TRUTH IN THIS WORLD

How long each asset will last - nobody knows

So some legal guidelines have been provided - so that corporates don’t come up with v
We do understand that the actual life may not be the same as the estimated life
As a result of that, depreciation may be partly correct and partly wrong

A ten year life of a car may turn out to be 8 or 12 years

Bank of England constructed its building 250 years ago in London and thought that the
for 100 years and depreciated accordingly
Since the last 150 years, it is appearing in the Bal Sheet at one pound

Accounting is a profession largely concerning HISTORY

Accountants are historians - financial historians
In the modern complex world, some elements of future are intricately linked with the
To this extent, some estimates are unavoidable - we will use estimates reluctantly and

Auditors are people who verify accountants and certify them to be true and fair

LIABILITIES
1 Insurance which does not return anything on maturity (only provides risk pro
 2 Family ??
3 Any bills payable ??
4 House rent ??
5 Income tax ??
6 Utility bills ?
7 Conveyance ?
8 School fees ?
9 Maintenance?

LIABILITIES VIS-À-VIS EXPENSES

What is the difference ?

You are living in a rented house from May 1, 2011 - monthly rent is Rs 9,000
For simplicity, assume today is Aug 31, 2011
Your financial year ending is March and the agreement is for three years
You have paid the landlord Rs 15,000 so far

What is your expense 36

What is your liability 21

An expense is an expense whether paid or not

If humanity understood this properly, credit card companies will go bankrupt

An expense happens when you "incur" the expense, not when you pay
You have dinner tonight for Rs 5,000 and you pay thro a credit card at the rate of Rs 50
plus interest of 36% plus late payment charges and service tax and etc etc

This payment happens over the next 10 months

When should the expense be recognized?

Today
Why today
You ate today

Don’t confuse or mix up payment with expense - these are very different events - two

1 Expense happens along with payment - simultaneous

You go to the railway station and have chai for Rs 5.00
 2 Advances given
Payment happens first, expense is incurred later

3 Stuff bought on credit (say 45 days)

Expense happens first, payment happens later

EXPENSE IS EXPENSE WHETHER PAID OR NOT - PRINCIPLE OF ACCRUAL

I am struggling, I have too many liabilities

I have a son who needs to go to college and a daughter to be married
How old are they
Son is 2 years old and daughter is 2 months old
I am struggling, I have too many liabilities

Son - I need Rs 45 lakhs

Daughter - I need Rs 75 lakhs

How much will appear as Liab in the Bal Sheet today

Zero
No historical liability as yet
Future liab are not liab - they are only tensions - psychological stuff

My daughter got married yday and the catering bill came to Rs 10 lakhs
I have paid only Rs 3 lakhs so far
Then, Rs 7 lakhs is a liability in an accounting sense

L&T Ltd
Share Capital / Shareholders Funds 2,000.00
Net Worth

Bank Loans 5,000.00

Vendors Payable 500.00
7,500.00

Assets are sold for Rs 10,000 cr

Vendors will be paid Rs 500 cr
Lenders will be paid Rs 5,000 cr
Balance Rs 4,500 cr goes to the shareholders

Reliance Industries is liable to pay Mukesh Ambani

On liquidation, what is the priority of settlement:

1 Labour chaps
PF, ESIC
2 Official liquidator of the High Court
3 Taxes
4 Secured lenders (bankers)
5 Unsecured lenders and vendors
6 Shareholders (Preference and Equity)

YOUR
PROFIT & LOSS ACCOUNT
for the period April 1, 2011 to Aug 14, 2011
Expenses
House Rent
Conveyance, Travel
Food, Provisions
Electricity, Water, Maintenance
Cell phones, Landline phones, Satellite phones, all Phones
Petrol, Diesel, Kerosene, LPG, LNG
Credit Card Expenses
Interest expense on loans taken
Depreciation
Income Tax
Salaries paid
Entertainment, Medical, Theft, Damages
Many expenses 9.50

Net Profit (savings during the period) 2.50

(taken to Capital in the Bal Sheet)
12.00

Insurance Claims will tend to reduce your expenses - Your car got damaged and you sp
This is your expense - but the company gave you Rs 18,000
So your net expense is Rs 7,000

You placed a Fixed Deposit (5 year cumulative) with Indian Bank for Rs 10 lakhs on Feb
Your financial year end is March, no taxes - special relief for Great Lakes participants
Today is Aug 14, 2011
The interest and the principal will come back after 5 years, 10% interest
What is the Income in the above P&L

Zero ?

INCOME IS INCOME WHETHER RECEIVED OR NOT

There should be reasonable assurance of receipt

We are assuming that Indian Bank will live for 5 years or more and they will be honoura

Principal 1,000,000
Interest 10%
Annual Interest 100,000
Period - April 1 to Aug 14 136
Interest for this period 37,260 simple calculation

Income tax goes by this principle and you are supposed to pay tax accordingly
Half of humanity is unaware and very few are questioned, so life goes on
TDS on Interest goes by this principle

Investment in National Savings Certificates - Section 80C

No interest ever declared

If you make profits year after year, your Capital / Net Worth will stand enhanced
If you suffer losses, Capital will be eroded

In cricket you can do only three things

1 Batting
2 Bowling
3 Fielding

In financial accounting, there are only four corners:

1 Assets
2 Liabilities
3 Incomes
4 Expenses

If you mis-classify through ignorance, that is an error

If you mis-classify deliberately, that is a fraud

It will change profits, capital

When you go to your banker, you tend to overstate

When you go the tax dept, you tend to understate

BASIC ACCOUNTING EQUATION

Every transaction will have two effects - Newton's laws of motion

Assets + Expenses = Liabilities + Incomes

You bought a Washing Machine for Rs 25,000 and you will pay the shop after 7 days (he

Assets Expenses Liabilities

Washing Machine Vendor Payable

25,000 - 25,000
You bought washing powder for Rs 25 for this machine and paid in cash
This is a short term item - consumable item
Washing machine is a long term item - not consumed immediately or short term

Cash Bal Washing Exps

(25) 25 -

You bought a Washing Machine for Rs 25,000 and paid in cash

Assets Expenses Liabilities

Washing Machine
25,000
Cash Bal
(25,000) - -

Pradeep starts a garments business - he has land of Rs 20 lakhs, bank balance of

Rs 15 lakhs
Company Name : Pradeep Garments Pvt Ltd (PGPL)

Assets Expenses
1. Pradeep will bring in capital and HDFC Bank
the company will issue shares 1,500,000 -

2. Pradeep withdraws Rs 20,000 HDFC Bank

cash from the bank (20,000)
Cash on hand
20,000 -

3. He identifies a shop and leases it HDFC Bank

for 5 years, rental per month is (100,000)
Rs 20,000 and he pays a deposit Shop Deposit
of Rs 1 lakh 100,000 -

4. He interviews 25 candidates and No transaction, no accounting

 recruits 10 people at a salary of These are mere commitments, plans
Rs 5,000 per month - they will
join next Monday

5. He buys some furniture, telephones, Furn, Comp, Tel

computers for Rs 2 lakhs and he 200,000 -
will pay after 15 days

6. He buys 100 shirts at Rs 200 per Inventories

shirt and he pays the vendor 20,000
Rs 5,000 on account HDFC Bank
(5,000) -

7. PGPL sells 60 shirts at Rs 450 per

shirt and collects Rs 20,000 today
7a ) Sales HDFC Bank
20,000
Receivables/ Debtors
7,000 -

7b ) Cost of Sales Inventories Cost of Sales

(12,000) 12,000

8. PGPL does aggressive marketing HDFC Bank Bal Sales Promotion

Approached potential customers (50,000) 50,000
through campaigning and spent
Rs 50,000

9. Month end accounting:

HDFC Bank Bal
Rent paid (20,000) 20,000
Salaries payable - 50,000
Electricity, Telephone (say Rs 2,000) - 2,000
Depreciation (say Rs 3,000) (3,000) 3,000
MONOPOLY GAME
1 Monopoly
2 Vyapar
3 Trade
4 Business

One table - 4 to 5 team

You reach Dehradun - Rs 2,300

You can buy Dehradun for this price
You will be given Rs 20,000 cash by your banker - you can treat this is a loan
You pay the cash and get the property document

Anybody else coming to Dehradun will pay you a rent

You can convert Dehradun into a premium property (your wish)

Office, Bungalow, Godown

For all unknowns, undefineds, pay Rs 500 to the banker (Jail, Tax, Rest Hou

You may run out of money

You can mortgage your property cand raise a loan
Banker will charge you 10% interest upfront

You can also sell your property to the other teams - on an auction basis
Banker will handle the proceedings

You play around 20 transactions each

Each team will have two players - front office (plays the game) and back office (accou
of cash balance and historian - record the transactions)

Don’t make the Bal Sheet and P&L after every entry
Make them finally

At least one loan taken and one sale of property - recommended

nheard and we would be traveling in

d a little bit of time

ial events)
sity, then you go ahead and explore
ce people

s decision and not Tata Motors CFOs decision

l Sheet and P&L

cial Statements

s five cars
er day, Rajnikant - Rs 15 lakhs per hour

nce Sheet Photograph Wealth Static

it & Loss Video film Income Flow

Assets - Own
Application of Funds
Where the Rupee went
House
Land, Ancestral Property
Car
Gold
Computers, Furniture, Appliances

Shares
Cash and Bank Balances
Insurance
Fixed Deposits
Bonds, Mutual Funds, Post Office Deposits
 Loans Given, Advances Given, Deposits Given

50.00

be accounted somewhere

be accounted somewhere

y, friends, relatives, bosses, network,

is worth Rs 10 cr, can this be transferred

e, rent, etc
not market values)

ing, you cant sell)

a cost, it has a transaction

e valuable), there is no cost, there is no

asset is sold off today

orth Rs 65 lakhs, your Bal Sheet will

nancial statement
of the VALUE model

changing, each expert will come up with

h never happened
 All estimates (all values, not costs)
All estimates (all values, not costs)
All estimates (all values, not costs)
All estimates (all values, not costs)

money paid by each operator (telecom company)

000 cr - fact

point" for any financial analysis of deriving

ouse - 150 year old

, but you will "estimate" the property value

and the value of nothing

ten year life with a salvage value of zero,

h a manner that the carrying value of the

ill become a loss)

ying value of the car reduces to this extent

10 Years
Given by Company Law
 You can depreciate faster if you
wish, but not slower

mplicated stuff like inflation, GDP, USD INR,

s not for the accountant to decipher

nts etc and the value of the land has dropped

wn to Rs 2 lakhs

ENT), then such damage should be recognized

day of the accident

ALUE animal, but we try to be as far away

ence of changes in market value

w much in the evening?

Depreciation per day

tes don’t come up with very silly estimates

the estimated life
tly wrong

on and thought that the building will last

ricately linked with the past

estimates reluctantly and rarely

o be true and fair

ty (only provides risk protection) ??

nt is Rs 9,000

hree years

ill go bankrupt

card at the rate of Rs 500 per month

x and etc etc

y different events - two distinct events

ACCRUAL

10 lakhs
 7,500.00

Incomes
Salaries, Bonus, Incentive
Interest on Bank Deposits/Loans given
House Rent Income
Dividends
Capital Gains on Shares
Gifts, Inheritances
 Scholarship (if more than expense)
Tax refunds
Royalty on books / other patents / IPR
Lotteries, Gambling, Horse Racing, Cock fighting

12.00

got damaged and you spent Rs 25,000

nk for Rs 10 lakhs on Feb 1, 2011

reat Lakes participants

% interest

and they will be honourable

tax accordingly
ife goes on
will stand enhanced

the shop after 7 days (he is your friend)

Incomes

dor Payable
-
d in cash

tely or short term

Incomes

s, bank balance of

Liabilities Incomes Balance Sheet at the end

Share Capital Share Capital
1,500,000 - Reserves (accumulated profits)

- -
FCT Vendor Payable
Shirt Vendor Payable
Salaries Payable
Elec Tel Payable
- -
Total
itments, plans Profit & Loss Account for the period
Cost of Sales
Sales Promotion
Rent
FCT Vendor Salaries
200,000 - Electricity, Telephones
Depreciation

Shirt Vendor
15,000

-
Net Profit

Sales Revenue
27,000

of Sales
- -

s Promotion
- -

- -
50,000 -
2,000 -
- -
ou can treat this is a loan

(your wish)

nker (Jail, Tax, Rest House, Club)

on an auction basis

) and back office (accountant, custodian

alance Sheet at the end of the 9th transaction
1,500,000 Furniture, Comp, Telephones 197,000
(110,000)

Shop Deposit 100,000

HDFC Bank Balance 1,325,000
200,000 Cash on Hand 20,000
15,000 Inventories 8,000
50,000 Receivables 7,000
2,000

1,657,000 Total 1,657,000

Account for the period during 1st to 9th transaction
12,000 Sales Revenue 27,000
50,000
20,000
50,000
2,000
3,000

(110,000)
27,000 27,000
Summary

1 Personal Balance Sheet

Assets, Liabilities
2 Personal P&L
Incomes, Expenses
3 Accounting Equation
Assets + Expenses = Liabilities + Incomes
4 Depreciation - assets will reduce in book value with passage of time, becaus
limited lives
At the end of their life, the asset should be brought down to zero (or to salv
5 Cost versus Value
We prefer Cost in accounting, we don’t understand Value
Value is merely an opinion, opinion keeps changing, value is not a FACT, it h
Cost is a historical fact, evidenced by various documents - bank statement,
6 Principle of Accrual
Expense is an Expense whether paid or not
Unpaid expenses are liabilities
Income is Income whether received or not

Profit & Loss Account

Incomes 100
Expenses 103
Profit -3 Loss is plus 3

A loss is nothing but a negative profit - life becomes simpler

In a T Form P&L, where should the loss appear is not a very big challenge

Expenses 103 Income

Profit -3
100

Expenses 103 Income

Loss
103
Presentation is the least of our problems, but the source of a lot of unnecessary confus

I am trading firm
I bott 100 units at Rs
I sold 80 units at Rs

What is my profit or loss?

Loss 40
Profit 20
Profit 25

The problem is that units are not matching

What you bott and what you sold are not the same
A comparison of Purchases with Sales will be wrong

We need to compare Sales with COST OF SALES (Cost of Goods Sold)

80 units of Sales Revenue should be MATCHED with Cost of 80 units

Sales Revenue 80 3.25

Cost of Sales/Cost of Goods Sold 80 3.00
Profit

In America, they call this as COGS

In manufacturing, three levels

1 What you bott (raw materials, consumables)
2 What you produced (finished goods)
3 What you sold (finished goods)

Profit is on what?
1 Purchases
2 Prodn
3 Sales

Only on SALES

Transaction One
I bott 100 units at Rs 3.00 each and paid by cheque
Assets Exps
 Inventories
300
Bank Bal
-300 0

I sold 80 units at Rs 3.25 each and recd cheque

Assets Exps
a) Sales Revenue Bank Bal
260 0

b) Cost of Sales/COGS Inventories COGS

-240 240

You bott Delhi for Rs 7,000

I sold Delhi for Rs 7,500

Assets Exps
Property
7000
Bank Bal
-7000 0

Assets Exps
Bank Bal
7500 0

Property COGS
-7000 7000

This can be done BUT it will the correct method of presentation if your business consis
and selling of properties

What do you mean by the term "inventories"

Your stock in trade - the item that you trade in, you manufacture and you keep selling
In the Monopoly game, you can argue that I am a property company
My business is to buy and sell property
Property is my Inventory

You say that I am an individual working in a software company

I bott a house for Rs 20 lakhs and after 5 years, I sold it for Rs 38 lakhs
How should I make my accounts

You are not a property company and therefore property is not your Inventory

Assets Exps
Same accounting when Property
you bott Property 7000
Bank Bal
-7000 0

Assets Exps
Sold Property Bank Bal
7500
Property
-7000 0

MONOPOLY GAME BALANCE SHEET

Properties (you own at the en
Profit during the year xxxx Delhi
Jaipur
Initial Loan Agra
Mathura
Additional Loans
Cash Balance/Bank Balance
Payables
Receivables

MONOPOLY P&L
Rental Expenses Rental Income
Other Expenses Other Incomes
 Interest Gift
Jail Lottery
Club Sale of Properties
Taxes Alternatively - Capital Gains
COGS of Properties Gross

Profit xxxx

CORPORATE BALANCE SHEET AND P&L

Concepts of Assets, Liab, Incomes, Exps are absolutely the same
Many more terms will emerge
Language is a major challenge

Share Capital
Equity Share Capital
Preference Share Capital
Capital Employed
Capital Gains
Working Capital

Economics - Capital Formation

Productivity of Capital

REVIEW OF INDIA CEMENTS BALANCE SHEET - 5 YEARS 2007 TO 2011

Net Worth = Total Share Capital + Reserves + Revaluation Reserves

Total Debt = Secured Loans + Unsecured Loans
Total Liab = Net Worth + Total Debt

Net Block = Gross Block - Accumulated Depreciation

Total Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances
Total CA, Loans & Advances = Total Current Assets + Loans & Adv + Fixed Deposits
Total CL & Provisions = Def Credit + Current Liab + Provisions
Net Current Assets = Total CA, Loans & Adv - Total CL & Provisions

Total Assets = Net Block + Capital WIP + Investments + Net Current Assets + Misc Exp
Various sub totals are useful for analysis (not for totalling)

Sources of Funds Application of Funds

Shareholders / Owners Money - take high Fixed Assets - long lived asset
risk These assets are bott for us
Slow moving, hardly changin

Lenders Money - some risk Investments

Current Liabilities Current Assets

Vendors Payable Assets which are held in the
They have supplied us goods and services and day running of the business
we have not yet paid them - very soon we will soon be converted to Cash
pay them (< 1 year) Fast moving, changing all th
Inventories, Sundry Debtors
Customers)

Fixed means long term

Current means short term - Current means quick, fast

SAME BALANCE SHEET IN A DIFFERENT FORM

Sources of Funds
Shareholders / Owners Money - take high
risk

Lenders Money - some risk

TOTAL LIABILITIES
Application of Funds
Fixed Assets - long lived assets (> 1 years)
These assets are bott for usage, not for resale
Slow moving, hardly changing

Investments

Current Assets
Assets which are held in the course of day to
 day running of the business - these assets will
soon be converted to Cash
Fast moving, changing all the time
Inventories, Sundry Debtors (Receivables from
Customers)

Less : Current Liabilities

Vendors Payable
They have supplied us goods and services and
we have not yet paid them - very soon we will
pay them (< 1 year)

TOTAL ASSETS

In this format, Total Share Capital = Equity Share Capital + Share Application Money +

What is Share Capital?

When you subscribe for shares in a company, you get allotted some shares
If you applied for Coal India Share in the IPO, you got those shares

There are two types of Shares

1 Equity Shares Common variety - comprises
2 Preference Shares Rare - hardly 0.001% falls her

Equity Shares is the risk taking instrument

If the company fails, then the shareholders loses tons of money

Pref Shares get a "preference" over Equity shareholders

If the company goes into liquidation, then Pref Shares are paid out before Equity share
It is slightly more safe (less risky) than Equity Shares

When the company pays out dividends (dividends are paid out of profits), there too the
get a Preference
The Pref Shares are paid dividends and then Equity Shares are entitled to dividends

Dividends are discretionary - there is no complusion by law

I made a profit of Rs 1,000 cr but paid zero dividends - you, as a shareholder, can do n
In India, Preference Shares, by law have to be "redeemed" - redeemed means paid bac
If a company issues Pref Shares of face value of Rs 100, the company will declare that
these Shares after 7 years for Rs 100

They may also tell you that these Shares will carry a dividend of 8% per annum

All the fun is gone - nobody is interested

Returns are stable, redemption price is known
Anything that is known loses attraction

In equity shares, there is no concept of redemption (company does not pay you back fo
The entire attraction is that a Rs 100 share today can becomes Rs 5,000 in 7 years (ma

In Indian dictionary, when someone says Shares, he means Equity Shares

SHARE APPLICATION MONEY

When the share issue process is in the pipeline
The company announces an issue of shares on March 25th and people apply for these sh
The allotment happens on April 11th
So, on March 31st, the funds have come in, but shares have not yet been allotted
So these funds will appear as Share Application Money

Once the shares are allotted, the amount will be transferred to Equity Share Capital

RESERVES
Reserves are primarily "accumulated profits"
Profits from the P&L are taken to Bal Sheet
In the Bal Sheet, such profits are called as RESERVES
If you are a 37 year old company, Reserves will have 37 years of profits

The second source of Reserves is "Share Premium"

You are Coal India - the IPO happened at a price of Rs 245 - face value per share is Rs 1
They are charging you a premium of Rs 235

Coal India's cash balance will increase by Rs 245

Share Capital will increase by Rs 10 (face value)
Reserves will increase by Rs 235 (share premium)
Balance Sheet
Equity Share Capital 10
Reserves 235 Cash Bal

Having high Reserves means a glorious past

Having high Reserves does not mean/imply having huge Cash Balance
If India Cements Reserves are Rs 3,700 cr and all of us decide to pay them a visit and m
and ask him to open the safe, we may expect to find tons of cash (Reserves)
But in reality, there may be hardly any Cash

What happened to the Reserves? Where have the Reserves gone?

Your first month at work - your salary was Rs 35,000, zero expenses, very simple lifesty
Balance Sheet

Reserves 35000 Bank Balance

All your Reserves are sitting in the Cash box

You worked like this for five years, simple life, did nothing with the cash

Balance Sheet after 5 years

Reserves 3500000 Bank Balance

All your Reserves are sitting in the Cash box

You got married

Wife said - buy me a house
She saw a house, costing Rs 1 cr
You had no choice

New Balance Sheet

House
Reserves 3,500,000 Bank Balance
Home Loan (Debt) 6,500,000

Where are the Reserves? You have Reserves but no Cash

The Reserves are in the house (maybe the kitchen was financed from Reserves)

You may sometimes hear the term "Cash Rich Companies"

These are companies which have tons of Cash and tons of Reserves
India Cement has tons of Reserves but not much Cash
Is it Cash Rich?
No

Sometimes, you may have Cash but not much Reserves - can that happen?
Yes can happen
Your Uncle gave you a loan of Rs 5 cr and so you have Rs 5 cr cash
Are you rich?
No - you have a rich Uncle

India Cement has used all its Reserves in building factories, in its Inventories, in its Sun

REVALUATION RESERVES
We will discuss this later (maybe tomorrow)
Adjunct area, not an important area
Revaluation is rare in India, it is disappearing

NET WORTH
is also called by various names
1 Shareholders Funds
2 Owners Funds
3 Shareholders Equity
4 Owners Equity
5 Just Equity (in the US, this is more common)

This represents the funds payable to Shareholders in the event of a Liquidation

The company is liable to pay back its Shareholders this much of money
This represents the amount belonging to Shareholders, brought in by Shareholders in th

Brought in by shareholders directly and indirectly

1 Directly means they gave cash to the company and company allotted shares
 2 Indirectly means past profits
If the company made a profit of Rs 100 cr and the company declared a divid
the balance Rs 95 cr also belong to the Shareholders
But the Shareholders have allowed the company to "retain" these earnings
Indirectly, they have contributed

DEBT
means Borrowings, Loans taken
Secured Debt means company has offered some security (collateral)
Mortgage of fixed assets
Hypothecation of current assets
Most bank loans, financial institutions are secured
SARFESI Act has substantially strengthened the power of the banking sector in recoveri
They can push off the corporate, sell the asset and recover their dues

Unsecured Debt means no security has been offered

Personal life - Credit Card dues, Personal Loans - horrible loans 30% cost
If you have a single paise of these loans, your finances are badly managed
Fortunately, in the Corporate Sector, having Unsecured Loans is not so bad

Public Deposits are unsecured

You, as an individual, can earn 9.25% in a SBI FD
You can earn 10.25% in a Tata Steel FD
HDFC FD earns you slightly more than SBI FD

Sales Tax Deferral Schemes - provided by the Govts of various States

You set up a new factory in Himachal Pradesh
Himachal Pradesh wants to encourage entrepreneurs
Any new factory - you can collect Sales Tax on your product from your custo
You are supposed to pay the State Govt next month
But we will allow you to keep these funds with yourself for 8 years
You pay us after 8 years

Such sales taxes collected but not yet paid will appear as Unsecured Loans i

If you feel like knowing the break up of Unsecured Loans of India Cement, what can yo
You can go to the India Cements website and you can download the Annual Report
One year Annual Report will be 50 to 250 pages
This Annual Report will give you lots and lots of information
APPLICATION OF FUNDS - ASSETS SIDE
Fixed Assets
Gross Block means the original cost of fixed costs
Accumulated depreciation means depreciation from date of acquisition of the fixed ass
Net Block means Gross Block minus Accumulated Depreciation

You bought a car for Rs 8 lakhs and are depreciating it at Rs 75,000 per annum

Year 1 2 3 4
Gross Block 8.00 8.00 8.00 8.00
Less : Accu Depn 0.75 1.50 2.25 3.00
Net Block 7.25 6.50 5.75 5.00

Gross Block and Acc Depn are merely for disclosure purposes
Only the Net Block goes into the total of the Bal Sheet

Year A B
Gross Block 500.00 2,000.00
Less : Accu Depn 65.00 1,565.00
Net Block 435.00 435.00

What is this telling you?

B is the older company - most probably
B is also a larger company - most probably

In the P&L you will find depreciation. How much will that be?

Year 1 2 3 4
Gross Block 8.00 8.00 8.00 8.00
Less : Accu Depn 0.75 1.50 2.25 3.00
Net Block 7.25 6.50 5.75 5.00
P&L Depreciation 0.75 0.75 0.75 0.75

Capital Work in Progress

Fixed assets which are under installation / under construction
Factory is being built, not yet complete
Machine is being installed, not yet ready
Pipeline is being constructed, not yet operational

The amount in the Bal Sheet reflects the amount spent so far on this project
When the asset is ready to be used, what will happen?

This Cap WIP will be transferred to Gross Block

From that day, depreciation will start

If the amount in CWIP is huge, what does this mean?

Huge expansion is happening - may be the fruits will be seen in coming years

Conversely, when a corporate says that our sales will grow 30% per annum for the next
you don’t find too much in CWIP, what does that mean?
They are lying ?

INVESTMENTS
Strategic Investments
1 Investments in subsidiaries
A company where you own more than 50%
L&T has set up a company called L&T IT Ltd, another company called L&T F
L&T has invested Rs 100 cr in L&T IT Ltd as subscription to share capital
So, in the Bal Sheet of L&T, this will appear under Investments
I am controlling the subsidiary - the subsidiary will listen to me

2 Investments in associates
Associate is a company where we hold 20% to 50%
The associate may or may not listen to me - I am not in control
I have "significant influence"

3 Investments in joint ventures

There is joint control (control shared with another party)

All these are long term investments and will generally have some strategic importance
They will not be entered into merely because L&T has surplus funds

TREASURY INVESTMENTS
Treasury means short term
I have Rs 25 cr available for the next 4 days
What should I do
I can buy a Liquid Mutual Fund which can generate 3.50% return (annualized)

Strategic Investments are managed by Board of Directors

Treasury is managed by the Finance Dept

CURRENT ASSETS
Assets which rotate, keep changing - purpose of these Assets is to generate Cash

Inventories in mfg and trading are tangible

Raw Mat, WIP, Finished Goods, Packing Materials, Consumables, Stores and
Masterbatches

In software and service sectors, you will have Unbilled Work

Work that is in progress and you have not been able to bill for them
Bcoz milestones are not reached as yet

Sundry Debtors (also called Receivables, Trade Receivables, Outstandings)

Invoices have been raised - product has been delivered, services have been rendered
But the customer has not yet paid us - we have the right to collect
If these are very high, what does it mean
You are in trouble
Or your customer is in trouble, which also means you are in trouble
You are lazy, slow
Your customer is really king

Cash and Bank Balances - very simple

Loans & Advances under Current Assets means Loans & Advances given by you
1 Staff Loans
2 Advances to Vendors
3 VAT Input Credit
4 Excise Duty Input Credit
5 Disputed taxes paid under protest
6 Any refunds due
7 Deposits for premises, Advance rent paid

Deferred Credit
Credit given by vendors over a long period of time
If you buy a machine from Germany, the vendor may say - pay me after 11 months

Current Liab
Your vendors payable, salaries payable, interest payable, expenses payable, electricity

Provisions
You know that some amount is payable but you are not sure of the amount
You have estimated the amount

Your power company has overbilled you and you are fighting with them
They are demanding Rs 50 lakhs and you think it should be Rs 20 lakhs
But that is only your opinion, you also don’t know the final amount at which it will be

In your Bal Sheet, you have shown a Provision of Rs 20 lakhs - you are not sure of this a
your MANAGEMENT ESTIMATE
The moment you start estimating, some element of discretion, politics, manipulation e

Estimate, judgement are very dangerous terms - they can mean anything

Rs 50 lakhs will not appear in the Bal Sheet

Rs 20 lakhs will appear under Provisions

Next year, I pay them Rs 22 lakhs and the matter is over

Provision becomes zero
Rs 2 lakhs goes into Expense (case of under provisioning)

Legal suits, claims, disputed taxes, warranties, retirement benefits - provision exampl

MISCELLANEOUS EXPENDITURE
Will discuss later

CONTINGENT LIABILITY
This is not in the Bal Sheet, this is outside the Bal Sheet, this is not forming part of the
This is only for disclosure
Off Bal Sheet item

Is not a liability as of today

But it can become a liability in the future, if some events occur in a certain manner
But such events may or may not occur - we don’t know
Your dear friend wants a loan of Rs 20 lakhs
He asked you and you said sorry - I am myself in need of a loan
He went to a bank
Bank wants a guarantor
So he comes to you and you reluctantly sign the papers

Today evening, in your Bal Sheet, should you show this Rs 20 lakhs as your Liability?
No

But But - it can become your liability in the future

When
If he does not pay and the bank comes after you

It is not in your Bal Sheet, but you must tell your wife - disclosure

Examples
Guarantees given
Legal suits, claims, disputed taxes

Somebody files a suit on you and demands Rs 100 lakhs

Your lawyer says the suit can be settled for Rs 5 lakhs

Provision in the Bal Sheet of Rs 5 lakhs

Contingent Liab off Bal Sheet of Rs 95 lakhs

If Cont Liab are too high, analysts can get a little frightened - whether these are Real
management has mis-classified

INDIA CEMENTS - P&L

You sell cement for Rs 220 per bag

Add : Excise duty of 16% 16%

What is your Revenue

You are a postman for the Govt of India
You collect from the customer and pay the Govt - free service that you are rendering f
In the P&L, we will show this as under:
Sales
Less : Excise Duty
Net Sales

Other Income
Other Income should mean other than cement (core activities)
But in reality, things can get mixed up
Sometimes, you may not be sure of how much is real Other and how much is half Other

If Other Income is very high (say more than 20% of Profit Before Tax), then Analysts ge
Bcoz the behaviour of Other Income in future is not known, unpredictable, may not be
be volatile, may disappear, may be fraudulent, bogus

Stock Adjustment
When your production is not equal to Sales, profits should be measured only on Sales
But costs may be incurred on production

Sales 100
Less : COGS
What is COGS - Cost of Goods Sold

Opening Stock + Production - Sales = Closing Stock

5 100 80 = 25

Diff between Sales and Production will be the same as Diff between Opening Stock and

20 = 20

Stock Adjustment means diff between Closing Stock and Opening Stock (Prodn and Sale

Sales Revenue - Income - based on Sales Quantity

Stock Adjustment (diff between Sales and Prodn)

Expense
Costs - based on Production Quantity

The P&L matches properly

I am trading firm
I bott 100 units at Rs 3.00 each
I sold 80 units at Rs 3.25 each
Profit
Real profit is Rs 20

Indian P&L
Sales 80 3.25 260.00
Stock Adjst 20 3.00 60.00
320.00

Expenses
Cost of purchases 100 3.00 300.00

Profit 20.00

American Presentation
Sales 260.00
COGS 80 3.00 240.00
Profit 20.00

PBDIT - Profit Before Depreciation, Interest and Taxes - UK dictionary

EBIDTA - Earnings Before Interest, Depreciation, Taxes and Amortization - US dictionar

Both mean the same

Amortization is depreciation on intangible assets

You depreciate a table and amortize a patent

EBIDTA is more popular in the world and in India

Sales 3400
Other Income
Total Income

Operating Costs
Raw Mat, Power, Employees, Mfg, Selling, Admin, Misc

EBIDTA 500
Depreciation & Amortization 250
EBIT
Interest
EBT / PBT
Tax
PAT / Net Profit 70
Dividends
Retained Earnings (goes to Reserves)

The business is responsible for EBIDTA

The finance side is responsible for the journey from EBIDTA to PAT

Your EBIDTA is very strong

But you have tons of Debt
Your PAT may not be that strong

Your EBIDTA is very mediocre

But you are a zero debt company
Your PAT may be okay

Cash Profit will be 70 + 250 = 320

The term Operating Profit can mean several things to different people
In this website format, Operating Profit is computed as EBIDTA excluding Other Income
EBIDTA from Core Activities

EBIDTA 475.63
Less : Other Income 125.59
Core EBIDTA (Operating Profit) 350.04

Other companies may define Operating Profit to be the same as EBIDTA

So don’t go by this one meaning
Some terms are loosely defined
Operating Profit, Gross Profit, EBIDTA itself (sometimes it includes Other Income, some
Other Income)
Finance is a social subject - depends on evolution of humanity, behaviour

EXTRA ORDINARY ITEMS

Personal life
Salary - Core Income
Interest - Other Income
Dowry - Extra Ordinary Income
Unusual, Non recurring, Material

What is your annual income

You say Rs 61 lakhs ?

VALUE ADDITION
A term used by economists more than finance professionals
It means your sale price minus your material costs

You buy fabric for Rs 200 and you convert it into a shirt and sell the shirt for Rs 450
You are adding Rs 250 value to the society

We don’t use this much in Finance

Website has calculated it differently
We will ignore this for our discussion

GROWTH
Everyone - management, shareholders, stock market, employees, vendors, customers a
in growth
How much are you growing
How fast are you growing
How fast is the industry growing
Are you faster than them

Long term growth is best represented by CAGR

CAGR - Compounded Annual Growth Rate (Compounded Average Growth Rate)

TO DO:
1 Work out the CAGR for many line items in the P&L and the Bal Sheet
Sometimes, the CAGR may be useless - you need to figure out which ones ar
and which are not
2 Some insight into our findings
ith passage of time, because they have

ght down to zero (or to salvage value)

nd Value
ng, value is not a FACT, it has not HAPPENED
cuments - bank statement, invoice

ss is plus 3

big challenge

100

100

100
3
103
 a lot of unnecessary confusion in the world

3.00 each 300.00

3.25 each 260.00
40.00 WRONG

ods Sold)

260.00
240.00
20.00

100 tons
65 tons
2 tons

Only on 2 tons

Liab Incomes
 0 0

Liab Incomes
Sales Rev
0 260

0 0

Liab Incomes

0 0

Liab Incomes
Sales Rev
0 7500

0 0

ation if your business consists of buying

acture and you keep selling day in and day out

company

Rs 38 lakhs

not your Inventory

Liab Incomes

0 0

Liab Incomes
Capital
Gains
500
0

operties (you own at the end of the game)

ash Balance/Bank Balance

eceivables

ental Income
ther Incomes
le of Properties Gross
ternatively - Capital Gains on Sale Net

07 TO 2011

and Bank Balances

& Adv + Fixed Deposits

Current Assets + Misc Exp

pplication of Funds
xed Assets - long lived assets (> 1 years)
These assets are bott for usage, not for resale
Slow moving, hardly changing

vestments

urrent Assets
Assets which are held in the course of day to
day running of the business - these assets will
oon be converted to Cash
Fast moving, changing all the time
nventories, Sundry Debtors (Receivables from
Customers)

1. One below the other

2. Curr Liab appear on the
assets side but as a negative

Owners Capital, Bank Loans,

Fixed Assets, Investments
are managed by top management
Top Half is managed by Top
Management

Bottom half
This area of Current Assets and
 Current Liab is generally
managed by middle management
in any company

Day to day stuff

What to buy, what to produce,
how much to produce, when to
sell, whom to sell, how many
days credit from the vendor,
how days credit to the customer

Share Application Money + Preference Sh Cap

ed some shares

ommon variety - comprises 99.999% of Shares in India

are - hardly 0.001% falls here

aid out before Equity shareholders

ut of profits), there too the Pref Shareholders

are entitled to dividends

as a shareholder, can do nothing

 redeemed means paid back, bott back
company will declare that they will redeem

nd of 8% per annum

ny does not pay you back for your shares ever)

mes Rs 5,000 in 7 years (may not)

Equity Shares

nd people apply for these shares

not yet been allotted

d to Equity Share Capital

rs of profits

face value per share is Rs 10

 245

ash Balance
de to pay them a visit and meet the Cashier
of cash (Reserves)

es gone?

xpenses, very simple lifestyle

ank Balance 35000

with the cash

ank Balance 3500000

10,000,000
ank Balance -

nced from Reserves)

n that happen?

in its Inventories, in its Sundry Debtors

ent of a Liquidation
h of money
ght in by Shareholders in the past

nd company allotted shares

e company declared a dividend of only Rs 5 cr,

to "retain" these earnings

ollateral)

e banking sector in recovering Secured Loans

their dues

horrible loans 30% cost

ances are badly managed
ecured Loans is not so bad

vts of various States

our product from your customers

ourself for 8 years

ppear as Unsecured Loans in the Bal Sheet

India Cement, what can you do?

load the Annual Report
 acquisition of the fixed asset till today

s 75,000 per annum

Bank of England
100.00
99.99
0.01

Balance Sheet
Balance Sheet
Balance Sheet
P&L is for a period of time (for that one year)
ar on this project

n in coming years

30% per annum for the next 5 years and

ther company called L&T Finance Ltd

ription to share capital
er Investments
ill listen to me

not in control

er party)

some strategic importance

us funds
turn (annualized)

ts is to generate Cash

, Consumables, Stores and Spares, Tools, Dies,

for them

es, Outstandings)
vices have been rendered

you are in trouble

dvances given by you

pay me after 11 months

xpenses payable, electricity payable

e of the amount

g with them
Rs 20 lakhs
amount at which it will be settled

- you are not sure of this amount but this is

on, politics, manipulation enters into the picture

mean anything

benefits - provision examples

is is not forming part of the total

ccur in a certain manner

0 lakhs as your Liability?

d - whether these are Real Liab which the

220.00
35.20
255.20

220.00

ce that you are rendering for the nation

 255.20
35.20
220.00

and how much is half Other

fore Tax), then Analysts get worried

unpredictable, may not be sustainable, may

e measured only on Sales

between Opening Stock and Closing Stock

ening Stock (Prodn and Sales)

 300.00
260.00
40.00 WRONG

dictionary
Amortization - US dictionary
 Controlled by Business people
People who know Cement

Controlled by Finance
Top Management Policies
These people need know Cement

ent people
DTA excluding Other Income (Core EBIDTA)

me as EBIDTA
ncludes Other Income, sometimes excludes

ity, behaviour

10
1
50
61

sell the shirt for Rs 450

oyees, vendors, customers are all interested

erage Growth Rate)

&L and the Bal Sheet
to figure out which ones are meaningful
Mortgage of Land, Property, Fact
Hypothecation of Inventories, Sun
Land, Property, Factories
on of Inventories, Sundry Debtors
INDIA CEMENTS - BALANCE SHEET

Mar '11 Mar '10 Mar '09

Sources Of Funds

Equity Share Capital 307.18 307.17 282.43

Reserves 3,782.58 3,221.09 2,683.03
Revaluation Reserves - 607.56 665.93

Networth 4,089.76 4,135.82 3,631.39

Secured Loans 1,177.86 866.64 1,036.25

Unsecured Loans 1,278.21 1,266.09 951.78

Total Debt 2,456.07 2,132.73 1,988.03

Total Liabilities 6,545.83 6,268.55 5,619.42

Application Of Funds
Fixed Assets
Gross Block 5,925.99 5,710.20 5,313.58
Less: Accum. Depreciation 2,091.51 1,791.59 1,505.33
Net Block 3,834.48 3,918.61 3,808.25
Capital Work in Progress 1,039.83 702.89 904.04

Investments 160.31 313.97 158.97

Current Assets
Inventories 517.73 468.19 390.92
Sundry Debtors 254.40 485.26 353.98
Cash and Bank Balance 33.09 2.62 5.40
Loans and Advances 2,116.78 1,889.82 1,331.88
Fixed Deposits - 51.19 79.80
Total CA, Loans & Advances 2,922.00 2,897.08 2,161.98

Current Liabilities 1,335.08 1,454.10 1,342.01

Provisions 75.71 109.91 85.37
Total CL & Provisions 1,410.79 1,564.01 1,427.38

Net Current Assets 1,511.21 1,333.07 734.60

Miscellaneous Expenses - - 13.55

Total Assets 6,545.83 6,268.54 5,619.41

Mar '08 Mar '07

281.87 220.37 8.7%

2,314.94 1,166.18 34.2%
724.30 781.98 -100.0%

3,321.11 2,208.53 16.7%

971.02 1,165.99 0.3%

840.49 892.77 9.4%

1,811.51 2,058.76 4.5%

5,132.62 4,267.29

4,708.69 3,856.04 11.3%

1,244.24 1,060.21
3,464.45 2,795.83 8.2%
574.91 142.75

129.28 55.07 30.6%

350.64 248.50 20.1%

311.07 260.21 -0.6%
7.84 216.15 -37.4%
1,062.06 995.90 20.7%
417.80 14.04
2,149.41 1,734.80 13.9%

1,143.36 463.82 30.3%

65.89 30.46 25.6%
1,209.25 494.28 30.0%

940.16 1,240.52 5.1%

23.79 33.12

5,132.59 4,267.29 11.3%

INDIA CEMENTS - PROFIT & LOSS ACCOUNT
Mar '11 Mar '10 Mar '09 Mar '08
12 mths 12 mths 12 mths 12 mths

Income
Sales Turnover 3,888.07 4,100.70 3,839.12 3,554.47
Excise Duty 474.78 413.64 480.78 510.22
Net Sales 3,413.29 3,687.06 3,358.34 3,044.25
Other Income 125.59 163.34 35.32 0.37
Stock Adjustments 11.40 15.24 13.41 30.32
Total Income 3,550.28 3,865.64 3,407.07 3,074.94

Expenditure
Raw Materials 565.84 540.62 406.38 340.90
Power & Fuel Cost 1,020.08 999.85 891.60 690.75
Employee Cost 265.44 276.81 218.74 186.61
Other Manufacturing Expenses 57.38 47.18 49.99 30.87
Selling and Admin Expenses - 953.30 769.93 664.35
Miscellaneous Expenses 1,165.91 127.07 96.50 68.50

Total Expenses 3,074.65 2,944.83 2,433.14 1,981.98

EBIDTA 475.63 920.81 973.93 1,092.96

Interest 141.72 142.64 112.15 109.95
PBDT 333.91 778.17 861.78 983.01
Depreciation 244.03 233.12 203.32 127.92
Other Written Off - 13.74 10.24 10.44
Profit Before Tax 89.88 531.31 648.22 844.65
Extra-ordinary items - - 0.09 -
PBT (Post Extra-ord Items) 89.88 531.31 648.31 844.65
Tax 21.77 176.98 216.13 207.10
Reported Net Profit 68.10 354.34 432.18 637.54

Equity Dividend 46.08 61.43 54.85 65.89

Corporate Dividend Tax 7.65 10.20 11.23 0.90
Mar '07 CAGR
12 mths

2,610.75 10.5%
355.54
2,255.21 10.9%
9.46
4.50
2,269.17

260.86 21.4%
549.00 16.8%
103.40 26.6%
25.14
541.66
34.34

1,514.40 19.4%

754.77 -10.9%
149.80 -1.4%
604.97 -13.8%
102.63 24.2%
10.38
491.96 -34.6%
-
491.96 -34.6%
13.13 13.5%
478.83 -38.6%

30.46 10.9%
19.65
FINANCIAL RATIOS
Balance Sheet
Shareholders Funds (Net Worth) Fixed Assets

Debt Long Term Strategic Investme

Current Assets
Less : Current Liabilities

The rules are different

For top management, the skills required are:
1 Vision, Foresight
2 Macro thinking - Globe, India, Tamil Nadu, Cement sector, India Cement
3 Guts
4 Financial wisdom, strategy
5 They need to be contemplative, meditative, slow (not hasty), deep thought
6 More of thinking and less of action - playing chess
7 Implications are long term - if you make a mistake, you will suffer for a long
8 Need the ability to live with lack of clarity

For middle management, the story is entirely different - what skills do you need?
1 Buy buy buy raw material
2 Produce produce produce
3 Sell sell sell
4 Collect collect collect
5 Buy buy buy raw material

No vision, no foresight, no macro thinking

Most important skill is simple solid hard work
Land up there at 900 and work work work

You need good rules to direct the middle management

You need good scorecards - to measure how they are performing - week by w

India, as a country, great vision - each Planning Commission is a fantastic piece of art
Implementation - middle management - is almost non-existent
Pakistan, bad vision
Great implementation - each terrorist attack is highly successful - operational excellen

1 Liquidity Cash comfort in the short run - can I pay my salaries,

Middle Mgt Will I have to beg, borrow or steal to make these pay
If you are uncomfortable, you are facing a liquidity ch

2 Efficiency How fast am I able to rotate my funds in the short ter

Middle Mgt Rolling of funds

3 Solvency Cash comfort in the long run - can I pay my 20 year ho

In a company, can I pay my long term loans comfortab
Insolvent means unable to pay these debts - bankrupt

4 Profitability Profits in relation to Sales - Margins

Profits in relation to Investment - Returns

5 Valuation Stock market ratios - EPS, PE, Dividend yield, Book Va

LIQUIDITY
CURRENT RATIO = Current Assets / Current Liabilities
Current Assets are items that will generate cash for you in the short term
Curr Liab are items that will take away cash from you in the short term

Current Assets will include Loans & Adv 1,734.80

Current Liab will include Provisions 494.28
Current Ratio 3.51

For every one rupee of Curr Liab, we have the support of Rs 3.51 of Curr Assets

In your personal life, lets assume there are no credit cards, debit cards, ATMs
Your daily exps are Rs 100
You have cash in your pocket of Rs 351
Are you comfortable?
Yes

What is the ideal Current Ratio?

Ideal ratios are quite difficult to define in a sociological science like finance
Any ideal ratio should be taken with a pinch of salt, should not be blindly applied

Banks will insist on a Current Ratio of at least 1.33:1 in most sectors

If your Current Ratio is less than 1.33, then banks will feel quite uncomfortable in lend
your short term requirements

Could vary between sectors

1.20 to 1.45 could be a reasonable range

That insistence by the bank on maintaining certain ratios is called as a COVENANT

Financial covenants are conditions that the corporate agrees and if the corporate fails
withdraw their facilities

If the current ratio of a company is say 0.95:1, 0.90:, 0.85:1 - what will you say
Liab are high, not enuf Curr Assets, liquidity challenge ??

If I tell you that these companies are Hind Lever, Glaxo, Pfizer - how will you react no
They are not doing well ??

As a supplier to these chaps, will you be frightened by looking at the Curr Ratio? Will y
Will you limit your exposure?

They are using suppliers funds as a major source of funds

Great idea?
Good idea
We also should do that
Every well managed company should have a Curr Ratio of less than 1.00
Banks are idiots

Working Capital = Current Assets - Current Liabilities

Some people argue that negative working capital is a fantastic thing

When Curr Liab are more, then Working Capital will be negative and Curr Ratio will be

We should use suppliers funds to run our business

We should not invest our own funds too much
You are making money on their money - great idea
Negative working capital is dangerous, bad idea
You have to return short term liabilities in the short term
You cannot convert short term liab to long term liab - if you do that, people will stop d
or will make life difficult for you

The Bal Sheet is wrong

There is a line item called "Investments"
Investments are of two types - Strategic and Treasury
Treasury Investments are really Cash in Hand (temporary cash parked in financial instr

Current Assets 5,000

Current Liab 5,500
Simple Current Ratio 0.91

Short Term Investments 2,000

Real Current Assets 7,000
Real Current Ratio 1.27

Some companies have a Curr Ratio of 10:1, 12:1, 15:1

What will you say about these chaps?
Not investing in long term stuff ?
Money not being utilized properly ?

Your daily expense is Rs 100

You keep Rs 50,000 in your pocket every day
I ask you why
I need for my expenses
Am I happy with that answer

They are afraid of something? Cant say much ? Waiting for the right opportunity?
Maybe inventory is building up?
Incompetence? Bad production planning? Bad marketing?
They don’t have too much of fixed assets? Service industries?

These companies are Infosys, Wipro, TCS, etc

Huge Current Assets
Within Current Assets, it is Cash - huge Cash
Infy - Rs 15,000 cr
You ask Infy why do you hold so much Cash - why don’t you use it somewhere - is this n

Infy has two answers:

1 We need money for acquisitions
If a good acquisition comes up, typically there are many competitors who al
If we can pay fast, we have a brighter chance of acquiring

2 We are not merely vendors for our customers - we are their lifeline
Infy has a customer - RBS
RBS runs on Infy systems
RBS gets into some trouble in Europe because of global problems
RBS does not pay Infy on time
So Infy is not able to pay salaries on time
So people leave
Is that a good idea?

Infy says that we should have a huge cash balance on hand so that even if our custome
we are able to pay our employees smoothly
Customers look at our financial strength before awarding contracts to us
We compete with Accenture, IBM
IBM Cash Balance - Rs 250,000 cr
Infy Cash Balance - Rs 15,000 cr

Provisions are Curr Liab, but the amount is not very clear - management estimate

LET ME KEEP A PROVISION FOR CONTINGENCIES - THIS IS SIMPLE ENGLISH

LET ME MAKE A PROVISION FOR LIABILIITES - THIS IS ACCOUNTING ENGLISH

In your personal life, I recommend that you should keep some cash at home - all the ti
What will happen when - you don’t know
Suddenly somebody needs to be hospitalized - 2 am in the morning
Hopsitals don’t entertain - unless you pay cash

This is keeping a provision for adverse possible events - simple English

An Accounting Provision means something is payable to someone - but you don’t know
terms - you are fuzzy about the amount
Before jumping to simplistic conclusions, a little bit of reading on the sector, its challe
will be helpful

BURN RATIO
Very useful for start ups
In a start up, revenues are uncertain or may be zero (not yet kicked off)
But exps are ongoing

How long can my current cash balance last?

Cash Balance is Rs 500

Exps per week are Rs 125
I can last only 4 weeks

Within 4 weeks, I need either Revenue or additional Equity Capital or additional Debt

India faced this problem in 1991 - year of liberalization

India's forex balance was equivalent to 2 weeks of Imports
At that time, we mortgaged gold and got some dollars
The IMF insisted that we should open up our economy to foreignors
FDI policy, FII policy - we invited foreignors
Stock market opened up
Info tech sector, Call centres - liberalized

Now we are v v v prosperous

All this liberalization was not our vision

We protested and protested, but the IMF compelled us, pushed us into prosperity
The heart of it was the Burn Ratio

1791 to 1991
1991 to 2011 - we have done better in 20 years

Cash Balance (in weeks) = Cash Balance

Exps per week
1,514.40 52

EFFICIENCY RATIOS
Working Capital Cycle

Cash

36

Rec'bles 138
Days

Fin Goods

We want to know how fast you are in this Cash to Cash Cycle
Why is speed important?

You are running an auto rickshaw

You work for 8 hours, but billable time is only 3 hours
Bal 5 hours you are waiting

Two people invest Rs 100 in their business

One rotates this money 3 times Annual Sales are Rs 300
One rotates 5 times Annual Sales are Rs 500

TIME IS MONEY

RECEIVABLES (DAYS) : How long are my customers taking to pay me

Receivables (Days) = Receivables (Sundry Debtors)
Gross Sales per Day

260.21 = 36
7.15

Annual Sales 2,610.75 In the P&L

Days per annum 365
Sales per day 7.15

INVENTORIES (DAYS) : How long do I take from raw material stage to prodn to sellin

Inventories (Days) = Inventories = 248.50

Mfg Cost per Day 2.43

Inventories 248.50
Mfg Cost for the year
Raw Mat 260.86
Power 549.00
Employees 51.70 103.4
Other Mfg Costs 25.14
Total Mfg Cost 886.70
Days per annum 365.00
Mfg Cost per Day 2.43

SOLVENCY RATIOS
Cash comfort in the long run
Can I repay my long term debt comfortably
In Indian context, we generally club the long term debt and short term debt
In the Indian Bal Sheet, we have something called Loans (Secured + Unsecured)

In reality, short term loans may be longer than long term loans
How come

Working capital facilities from the bank are generally renewed every year
Generally these are limits and not loans

In a loan, the bank gives you Rs 10 cr and you repay Rs 10 cr

In a limit, the bank tells you that you can draw upto Rs 10 cr
You may draw, then deposit cash, again draw, again deposit
In US they call this as Revolver

Savings Bank Account min balance is zero

In a Cash Credit Account, the min balance can be minus Rs 10 cr
Day 1 (1.00)
Day 2 3.00
Day 3 (8.00)
Day 4 5.00

The advantage is that you pay interest only for those days when the balance goes nega

Next year, my business grows

So I ask the bank for a limit of Rs 12 cr
Third year - Rs 18 cr

29th year - Limit Rs 1,000 cr

When did I repay this loan?

In reality, short term loans may be longer than long term loans

Ratios
1 Debt Equity Ratio
In your funding, how much is lenders funds and how much is owners funds
Debt is good bcoz it is cheap (cheaper than equity)

You start a new business, you need Rs 50 cr, you have Rs 25 cr

You have an option - either you get a loan for Rs 25 cr or you get a partner f

Which is better
Partner will demand 50% share of profit, share of ownership, share of office
share of foreign trips

Secondly, the interest that you pay the bank is tax deductible (it is an expen
However, share of profit that you pay your partner is not an expense (from

First I pay interest Interest is a tax deductible expense

Then I pay income tax
Then I pay dividend Dividend is not an expense, it is merely sh
Which profits? Post tax profits

If I pay the bank 13% interest and my tax rate is 30%, the effective cost of in
EBIT 500
Interest 60
PBT 440
Tax 30% 132
PAT 308

How much did my PAT fall due to interest 42

How much interest did I pay 60
How come?
I get a tax benefit by claiming interest as an expense
30% of the interest is borne by the Govt of India - Govt of India is my partne

You pay 11.5% housing loan interest

Home loan interest is tax deductible upto Rs 1.50 lakhs per annum
Your tax rate is 30%
By paying this interest, you have been able to reduce your tax expen

The effective cost of interest is = Rate of Interest x (1-t), where t is the tax

Rate of interest is 11.50%

Tax rate (t) 30%
1- t 70%
Interest x (1-t) 8.05%

So, the next thought could be why not borrow and borrow and borrow more
Why should you invest your own funds at all
Why not have 99% Debt and 1% Equity

High debt is high risk - ability to repay ??

High debt means - you will do very good if the going is good
Conversely, you will do very bad if the going is bad
Risk means volatility of returns

Debt - - -
Equity 100.00 100.00 100.00
Capital employed 100.00 100.00 100.00
Return on Capital 20% 30% 5%
PBIT 20.00 30.00 5.00
 Interest 14% - - -
PBT 20.00 30.00 5.00
Tax 30% 6.00 9.00 1.50
PAT 14.00 21.00 3.50
Return on Equity 14% 21.0% 3.5%

Debt 70.00 70.00 70.00

Equity 30.00 30.00 30.00
Capital employed 100.00 100.00 100.00
Return on Capital 20% 30% 5%
PBIT 20.00 30.00 5.00
Interest 14% 9.80 9.80 9.80
PBT 10.20 20.20 (4.80)
Tax 30% 3.06 6.06 (1.44)
PAT 7.14 14.14 (3.36)
Return on Equity 23.8% 47.1% -11.2%

Debt 99.00 99.00 99.00

Equity 1.00 1.00 1.00
Capital employed 100.00 100.00 100.00
Return on Capital 20% 30% 5%
PBIT 20.00 30.00 5.00
Interest 14% 13.86 13.86 13.86
PBT 6.14 16.14 (8.86)
Tax 30% 1.84 4.84 (2.66)
PAT 4.30 11.30 (6.20)
Return on Equity 429.8% 1129.8% -620.2%

Debt is good, but like amrut, it should be consumed in reasonable quantities

Debt Equity = Debt / Equity

Debt means Loans taken (Secured + Unsecured) (taken means amount drawn
Equity means Net Worth (Capital + Reserves)
Generally, we ignore Revaluation Reserves in the computation of Net Worth
 How much debt is good?
Sector dependent
Infra - 5:1 Capital intensive sectors tend to carry mo
Power - 4:1 Asset light sectors will have low debt / ze
Aluminum - 3.5:1
Cement - 2.5:1 You cannot compare Infosys with Tata Pow
Pharma - 1.5:1
Software - Zero:1
Consulting - Zero:1
Call Centers - 1:1

Wisdom demands that if your earnings are volatile, you should borrow less

If you are a stockbroker earning Rs 1 cr per annum and your friend is a lawy
per annum, you should borrow less than him

Colgate make a profit of Rs 1,000 cr

Sterlite also makes a similar profit of Rs 1,000 cr

Colgate can borrow more - steady income, people generally have teeth and
and will keep brushing for some more centuries - brand is established
Sterlite - copper, zinc, aluminum - prices - change everyday - demand - wha

Debt 2,058.76
Net Worth 2,208.53
Less : Reval Res 781.98
Revised Net Worth 1,426.55

Debt Equity Ratio 1.44 : 1

For every one rupee of own funds, India Cements has borrowed Rs 1.44

Interest Coverage Ratio = EBIDTA / Interest

EBIDTA 754.77
Interest 149.80
Interest Cover 5.04 times

If we need to pay the bank one rupee interest, we have Rs 5.04 of support of our earni
Will the bank be happy?
Quite happy

Generally banks look for 3 to 4 times cover

The next question that arises is - what do we need to pay the bank? Only interest?
What about the principal to be repaid?

Debt Service Coverage Ratio (DSCR) = EBIDTA - Tax

Interest + Annual Principal Repayment

EBIDTA 754.77
Tax 13.13 741.64

Interest 149.80
Annual Principal Repayment
Total Debt 2,058.76
Tenor (assumed) 8 257.35 407.15

DSCR 1.82

For every one rupee that I need to pay the bank (towards interest and princ
support of Rs 1.82 of earnings

Banks look for a DSCR of at least 1.60 times (for a great company they may be happy w

We are looking at repayment capability (not actual repayment)

If you go for a home loan, how much will the bank lend you?
1 80% of the cost of the house
2 60 months of salary - logic behind this limit is - if you are earning x rupees,
you devote towards EMI

40% of your salary can go towards EMI

More than that will be difficult bcoz you have to also live

EMI / Earnings is 40%

DSCR = Earnings / EMI = 2.5 times
 The home loan company imposes a DSCR of 2.5 times

DR L C GUPTA'S RESEARCH
Can financial ratios help me in predicting sickness?
Sickness can lead to corporate failure, bankruptcy, etc
Do ratios have predictive ability? If yes, which ones?

He picked up 200 sick companies and went back in time

Before they fell sick, how did the financial ratios look (3 years before, 5 years before)

Apollo - wellness - how well are you

You have a 15% prob of developing xyz illness in the next 10 years

Three types of ratios

1 P&L numbers / P&L numbers
2 Bal Sheet numbers / Bal Sheet numbers
3 P&L number / Bal Sheet number (or vice versa)

He found that the third category was more useful in prediction

In particular, he found the DSCR was excellent in predicting sickness
He assumed an 8 year tenor of loans for this purpose

Debt / EBIDTA
Debt 2,058.76
EBIDTA 754.77
Debt / EBIDTA 2.73 times

Crudely speaking, we can say that 2.73 years of EBIDTA can retire all the debt

PROFITABILITY RATIOS
Margins Profit in relation to Sales
Returns Profit in relation to Investment in Business
What does the owner want ? Margins or Returns ?

Returns is the objective of the owner

1 High margin high return strategy Fine
2 Low margin high return strategy Fine
3 High margin low return strategy Not interesting
4 Low margin low return strategy Go home
 Low margins may be accompanied by high volumes and faster time cycles

Sometimes low margin may be deliberate strategy

Sometimes, it may be market compulsions - you don’t have a choice

MARGINS
There are many variants of these formula - I am giving you the mainstream formula

Operating Profit Margin = EBIDTA or Core EBIDTA

Net Sales

754.77 33.5%
2,255.21

Net Profit Margin = PAT

Net Sales

478.83 21.2%
2,255.21

Margins are high in service sector, sectors driven by strong brands, technology, patents
sectors with a high entry barrier

In contrast, sectors with heavy competition will face low margins

Cyclical sectors will face cyclical margins

Boom

Recovery Recession

Depression

EBIDTA margins are generated by the "business people"

Net Profit margins are generated by business + finance put together
Great EBIDTA, bad NPM - you know whom to blame
Poor EBIDTA, poor NPM - bad times, you can blame God
Great EBIDTA, great NPM - good times, you can praise each other
Poor EBIDTA, great NPM - could be fraud??

RETURNS
RoCE = Return on Capital Employed = EBIT
Cap Emp

EBIT - Earnings Before Interest and Taxes

Cap Emp = Net Worth + Debt (funds deployed by business - including banker

How much is the business generating

EBIDTA 754.77
Depreciation 102.63
EBIT 652.14
Cap Emp 4,267.29 781.98 3,485.31 exclude Reval Res

RoCE 18.71% Return from the Business

RoE = Return on Equity = PAT

Net Worth

PAT 478.83
Net Worth (excl Reval Res) 1,426.55

RoE 33.57% Return for the Owner of the B

I earn 18.71% on the entire capital employed including funds provided by banks
But I pay the banks only 11% or 12% or something
I, as the owner, earn not only on my funds but also on the bankers funds

Reliance is in the business of what?

Oil & Gas, Petrochemicals, Refining, etc

Mukesh Ambani is in what business?

Mukesh Ambani is in the business of making money

Making money has two angles:

1 Making money from petrochemicals, Oil & Gas, Refining
2 Making money from money

Why is Finance Dept required in this world? What value do they bring to humanity?
The answer is - they convert the 18% RoCE to a 33% RoE

Mukesh Ambani earns 18% thro Engineering efforts and 15% thro Financial skills, thus ea

PERSONAL EXAMPLE
You buy a second house for Rs 50 lakhs
You let it out on rent and earn 8 lakhs Rs 4 lakhs per annum
After 2 years, you sell the house 70 lakhs

What is your rate of return

Earnings
Rent 8
Capital Gain 20
28

Rate of Return 56% in two years time

The same house, you bott using a loan of 40

Your own equity 10
You paid interest per annum of 11%
Two years interest 8.80

Your earnings
Rent 8.00
Capital Gains 20.00
Less : Interest (8.80)
19.20

Rate of Return 192% in two years time

Solvency
1 Debt Equity
2 Interest Cover
3 Debt Service Cover
4 Debt / EBIDTA

Profitability
1 OPM
2 NPM
3 RoCE
4 RoE
ed Assets Top Management

g Term Strategic Investments

rent Assets Middle Management

s : Current Liabilities

nt sector, India Cement

(not hasty), deep thought

e, you will suffer for a long long time

what skills do you need?

are performing - week by week, month by month

is a fantastic piece of art

ssful - operational excellent

un - can I pay my salaries, vendors, power bill

or steal to make these payments
you are facing a liquidity challenge / crisis

e my funds in the short term

un - can I pay my 20 year home loan comfortably

y long term loans comfortably
pay these debts - bankruptcy

- Margins
ment - Returns

PE, Dividend yield, Book Value, PBV

or you in the short term

you in the short term

:1

3.51 of Curr Assets

debit cards, ATMs

ence like finance
not be blindly applied

t sectors
uite uncomfortable in lending to you for

called as a COVENANT
s and if the corporate fails, then bankers can

- what will you say

zer - how will you react now?

ng at the Curr Ratio? Will you refuse to supply?

ss than 1.00

tic thing
tive and Curr Ratio will be < 1.00
 do that, people will stop dealing with you

sh parked in financial instruments)

he right opportunity?
 use it somewhere - is this not inefficient?

e many competitors who also want to buy

acquiring

e are their lifeline

global problems

o that even if our customers don’t pay us,

ntracts to us

management estimate

PLE ENGLISH
NTING ENGLISH

me cash at home - all the time

ple English
eone - but you don’t know the amount in certain
ng on the sector, its challenges, its practices

t kicked off)

Capital or additional Debt

hed us into prosperity

216.15 = 7.42 weeks

29.12
 Raw Mat

102
WIP

e Rs 300 Margin of 7%, Profit is Rs 21

e Rs 500 Margin of 7%, Profit is Rs 35

to pay me

days
al stage to prodn to selling the produced cement

102 Days

50% assume mfg is this much

short term debt

cured + Unsecured)

ed every year
when the balance goes negative

ow much is owners funds

have Rs 25 cr
25 cr or you get a partner for Rs 25 cr

ownership, share of office space, share of car,

x deductible (it is an expense in your P&L)

er is not an expense (from tax point of view)

x deductible expense

an expense, it is merely sharing of profits

Post tax profits

30%, the effective cost of interest is how much?

 500
0
500
150
350

Govt of India is my partner

11.50% 90000
lakhs per annum
30% 27000
duce your tax expen 3.45%
8.05% 63000

t x (1-t), where t is the tax rate

d borrow and borrow more

ing is good
 Too safe

High Risk

Reckless Risk

onable quantities

taken means amount drawn from the limits)

computation of Net Worth

ve sectors tend to carry more debt
ors will have low debt / zero debt

mpare Infosys with Tata Power

e, you should borrow less

m and your friend is a lawyer earning Rs 1 cr

e generally have teeth and generally do brush

- brand is established
e everyday - demand - what will China do

has borrowed Rs 1.44

5.04 of support of our earnings

 e bank? Only interest?

ual Principal Repayment

times

towards interest and principal), I have the

mpany they may be happy with 1.40 times)

you are earning x rupees, how much can

ars before, 5 years before)

ce versa)

sickness

retire all the debt

interesting
es and faster time cycles

a choice

he mainstream formula

This may be better for India Cement

9.46 745.31 33.0%

2,255.21

brands, technology, patents and IPR protection,

business - including bankers funds and owners funds)

lude Reval Res

urn from the Business

urn for the Owner of the Business

s provided by banks

ankers funds
l & Gas, Refining

hey bring to humanity?

hro Financial skills, thus earning 33% total

4 lakhs per annum

ROCE - the house generated 56% return

wo years time
ROE - financial skills generated 136% more
1 What do we read from the book
Read Chapters 1, 2 and 3 from the book given to you
That is good enough

2 Please note that the book is American style and we are using Indian financials
So terminology will vary slightly - try and get the broad message and don’t look

3 Further reading - what can you read

Try and start reading Research Reports on corporates written by brokerage hous
If you understand 50% or more of these Reports, that is a good starting point
What you don’t understand - you should network amongst yourselves, other tha
Google, Facebook, etc

4 What is our assignment, test, exam, homework

Assignment - will be - to analyze at least two companies from diff sectors - you
Auto, Chemicals, Engg, Pumps, Compressors, Trading - Retail, Airlines
Group of 4 people

5 Test - I don’t know

The course content will be based on our Excel files

Curr Ratio = Curr Assets/Curr Liab

If I give you the Cur Ratio and the Curr Assets, you should be able to find the C
using Indian financials
message and don’t look at nit picking

ritten by brokerage houses

a good starting point
st yourselves, other than your Group

from diff sectors - you choose

Retail, Airlines

uld be able to find the Curr Liab

OCTOBER 2011 EXAM
CALCULATORS ALLOWED
LAPTOPS, TEXT BOOK, NOTE BOOKS, NOT ALLOWED
60 MINUTES DURATION
100 MARKS
RAGHU IYER

QUESTION ONE
State whether true or false
1 Balance sheet captures point of time numbers
2 Accounting equation says : Assets + Expenses = Liabilities + Income
3 You bought a house in 1981 for Rs 25,000. Today it is worth Rs 25 lakhs. This ho
appear in your Balance Sheet at Rs 21,000.
4 Out of your salary income over the past ten years of hard work, you have built
Fixed Deposit of Rs 15 lakhs. This will appear as Capital in your Balance Sheet
5 Depreciation is charged in financial accounting because market prices of asset
fall after you have bought them
6 Your expense for the last six months on a particular line item was Rs 50,000. O
you have paid Rs 35,000 so far. Your liability on this account will be Rs 15,000.
7 You bought petrol for your car for Rs 1,400 today. Of this you paid Rs 500 by ca
Rs 900 through a credit card. Your expense for today is Rs 500.
8 You have placed a purchase order for some components for Rs 2 lakhs today. T
increase your assets and your liabilities in your Balance Sheet of today evening
9 Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your B
Sheet as of today evening, this amount will appear as a Liability
10 Your bank has been kind enough to sanction you a loan of Rs 50 lakhs. In your B
Sheet as of today evening, this amount will appear as an Asset

QUESTION TWO
In each of the transactions below, indicate which of the four items will increase / decrea
be affected at all:
Assets
1 You bought furniture on credit
2 You deposited cash into your bank account
3 You opened a bank locker and paid
 some bank charges
4 You appointed a Manager in your company
5 You bought inventories and paid cash
6 You paid an advance towards travelling expenses
to your sales person
7 You launched an advertising campaign and incurred
expenses towards an event, not yet paid for
8 You sold an old machine at book value and
got cash
9 Your month is over, but you have not yet paid
salaries of this month
10 Your customer paid you a cheque

QUESTION THREE
1 Your current assets are Rs 50 crores. Your working capital is Rs 20 crores.
Work out the Current Ratio

2 Inventories comprise 42% of your Current Assets. These are carried on

an average for 100 days. Work out the Mfg Cost of the year

3 Receivables comprise 34% of your Current Assets. These are carried on

an average for 61 days. Work out the Sales turnover for the year

QUESTION FOUR 19 Marks

Your equity is Rs 100 crores and debt is Rs 25 crores. You want to raise more
debt. Your EBIDTA is Rs 30 crores. Interest rates are approx 12.5%.

Bankers are insisting on a max debt equity ratio of 0.6:1 and a minimum
interest cover of 3 times.

How much incremental debt can this company now take on?

QUESTION FIVE 20 Marks

Rs cr
Sales 800
EBIDTA 125
Interest 35
Depreciation 10
Tax 24

Shareholders Funds 100

Debt 30

Work out the OPM, NPM, RoCE and RoE

 20 Marks

es + Income
orth Rs 25 lakhs. This house can

rd work, you have built up a

in your Balance Sheet
market prices of assets generally

e item was Rs 50,000. Of these,

count will be Rs 15,000.
is you paid Rs 500 by cash and

for Rs 2 lakhs today. This will

Sheet of today evening.
of Rs 50 lakhs. In your Balance
Liability
of Rs 50 lakhs. In your Balance

20 Marks
s will increase / decrease or not

Liabilities Incomes Expenses

 21 Marks
tal is Rs 20 crores.

are carried on

are carried on
the year

raise more
Text Book - Brigham and Houston - Financial Management

Ten Sessions of Two Hours each - Total Twenty Hours

1 Valuation Ratios, DuPont Analysis
2 Cash Flow Statement
3 Compounding and Discounting
4 Workshop on Compounding and Discounting
5 Payback period, NPV
6 IRR, Discounted Payback Period
7 Profitability Index, Pros and Cons of Various Methods
8 Business Examples and Workshop applying above methods
9 Derivation of Cash Flows for evaluating capex proposals
10 Workshop on Cash Flow Derivation
Methods
ove methods
x proposals
Financial Ratios
1 Liquidity Current Ratio, Burn Ratio
2 Solvency Interest Coverage, DSCR, etc
3 Efficiency Inventories (Days), Receivable (Days)
4 Profitability Margins - Operating, Net, Returns - RoCE, RoE

All these are management actions which will prompt these ratios to be good or lousy

If you as management work well, then you will be rewarded (the company will be reward
By who? How ?
By the markets
By pushing your company valuation upwards

5 Valuation Ratios Results of those actions

Partly your actions, partly the

STOCK MARKET RELATED STUFF

1 Earnings per Share EPS

EPS = Net Profit (PAT) / No of Shares
PAT 68.10
Equity Share Capital 307.18
Face value per Share 10.00
No of Shares 30.72
EPS 2.22

This is telling you how much the company is earning per Share
Per Share numbers are very popular in the stock market (not among manageme

In the stock market, you buy that one share for say Rs 75
You want to know what the company is earning on MY ONE LITTLE SHARE
The most important word it the world is ME, MY, MINE, AHAM

The investor community will correlate the price of Rs 75 to the earnings of Rs

with their own ideas
If you were Naresh Goyal and you were buying the entire Sahara Airlines, you w
worried about per Share numbers
Rather you would worried about the total EBIDTA, total PROFIT

You should be able to watch CNBC intelligently and understand 50% of what th

Forward EPS and Trailing EPS

Trailing EPS means the EPS of the latest four quarters

Today's date is Oct 29, 2011
What is Trailing EPS ?

If Sept 2011 results are out, then Trailing EPS will be

Profits of the period Oct 2010 to Sept 2011 / No of Shares

If Sept 2011 results are not out, then Trailing EPS will be
Profits of the period July 2010 to June 2011 / No of Shares

Forward EPS is a for a future period

It is not known, it is estimated - future is not known

CNBC says Sensex EPS for FY 12 is expected to be Rs 1,185

CNBC says Sensex EPS for FY 13 is expected to be Rs 1,301

Each brokerage house may have its own estimates of Forward EPS
Each brokerage house may change its estimates with passage of time

In EcoTimes, on page 4, you may read that India Cements EPS is Rs 2.22
In EcoTimes, on page 7, you may read that India Cements EPS is Rs 7.03

Which is right?
Both may be right - one may be Trailing and the other may be Forward

Forward EPS may refer to any period

FY 12 means what period ? April 2011 to March 2012
FY 13 means what period ? April 2012 to March 2013

One year forward means what period?

Today, bcoz today is Oct 29, 2011, one year forward will typically mean Oct 20
One year forward Sensex EPS is estimated to be Rs 1,243

Europe US is December
India is March

US - S&P 500 - FY 12 EPS is estimated to be say Rs 103.45

What do they mean?
They mean Jan 2012 to Dec 2012

You are a cement sector analyst working in Kotak

Last year India Cement profit was Rs 68 cr (fact)
Next year profit as per your estimate is likely to be Rs 125 cr
Projected PAT 125.00
No of Shares 30.72
Forward EPS comes to 4.07

Various analysts will come up with different Forward EPS estimates

An average of such estimates is called as CONSENSUS ESTIMATE
If consensus is say Rs 4.03 (India Cement EPS FY 12 forward) and your estimate
then you need to rethink

Analysts EPS Forw

1 3.53
2 1.01 Outlier - he needs to be careful, he should rec
3 8.09 Outlier - he needs to be careful, he should rec
4 4.05
5 4.51
6 3.85
7 4.23
Consensus 4.18 Simple Average - is generally not done
4.03 More correct average excludes outliers
 If you make a loss EPS will be negative, that’s fine

If Trailing EPS is negative and Consensus Forward is positive, those are great tu
and you could make big money on the stock market is you identify them in goo

2 PE Ratio or PE Multiple (Price Earnings Multiple)

This ratio compares the price per share to the earnings per share

PE Multiple = Price per Share / Earnings per Share

India Cements price per share is say Rs

Trailing EPS is
Trailing PE Mutliple will be

India Cements price per share is say Rs

Forward EPS Consensus is
Forward PE Multiple will be

For every one rupee that India Cements is likely to earn in the coming year, th
to pay Rs 18.59

The PE Multiple is an indicator of the cheapness or expensiveness of the stock

Price per Share

Which one is more expensive?
Infosys
Why?
One share of Infy is more expensive than two shares of TCS ??

Infy announces a stock split and one share is now split into ten shares
Revised prices are

Price per Share

Which one is more expensive?
TCS is more expensive ?

In a split what happens

You have one one hundred rupee currency note
They took it from you and gave you ten ten rupee notes

Price per Share is not an indication of CHEAPNESS or EXPENSIVENESS of a stock

Most people go by the price per share, which is a wrong metric

What are these companies earning?

If I pay Rs 2,823 for Infosys for one share, what is the support of earnings of th
justifies such a price?

Price per Share

EPS - 1 year forward consensus
PE Multiple

For one rupee of earnings, market is willing to pay Rs 21.63 for Infosys
For the same one rupee of earnings of TCS, market is willing to pay Rs 29.70

TCS is more expensive (in this situation)

A lower PE Multiple means a cheaper stock

A higher PE Multiple means an expensive stock

Whether cheaper stock is better stock is a difficult question - no simplistic

You want to buy apples

Rs 60 per kg, Rs 80 per kg, Rs 100 per kg, Rs 120 per kg
Which is the cheapest one?
Rs 60 per kg

Always buy Rs 60 apples

Never buy Rs 120 apples

A cheap stock may have cheap for the last 30 years

You saw it today

PE of 45 times - Nestle
PE of 3 times - Visa Steel

Post Office or the Bank Fixed Deposit

I invest Rs
I earn Rs
PE Multiple is

PE Multiple of a house
I buy a house for Rs
I earn rent of Rs
PE Multiple is

If stock market PE multiples become too high (say 25 times), then every invest
asking this basic question - why should I not buy Post Office deposits which mu
12.5 times
Warren Buffet says:
NEVER FORGET THE POST OFFICE

Expensiveness or cheapness should be measured in relation to the Post Office

If Post Office is 12.5 times and stock market is 15 times PE, may be that’s quit
If Post Office is 12.5 times and stock market is 35 times PE, may be that’s not

Today's PE Multiple on the Sensex is around 12 to 14 times (one year forward)

Historically, we have seen a high of 25 times
Historically we have seen lows of 7 to 8 times also - over the last 30 years

If you and me were rational (which we are not), we would buy at 7 to 8 PE and
at 25 PE
 When we say Sensex, we mean India

At 25 PE we will be too excited and experts will be telling us that Sensex from
go to 35000 etc etc - Jan 2008

At 8 PE we will be too exhausted and depressed (most of us would have lost hu

then, no energy left) and experts will be telling us that Sensex will become N
Sensex went to 7900 (Nifty at that time was 2700)

3 Dividend related ratios

Dividend per Share 46.08 30.72
Dividend % Dividend per Share / Face Value per Share
1.50 10.00
Dividend Payout Dividends / PAT
46.08 68.10
Dividend Yield Dividend per Share / Market Price per Share
1.50 75.00

Dividend yield on good companies is only 1 to 3% of their current prices

Investors don’t buy shares to earn dividends and they do not influence the sha
so much

However, if you are a very old investor (you bought the share in 1991 at very l
dividends can be substantial for you at your old cost

FINANCE
How is Finance different from Financial Accounting / Financial Analysis
Accounting Score keeping
Good score keeping does not make you a grea
Analysis Required run rate is xyz
Number of runs scored between midwicket an
runs scored
Extension of score keeping skills
Finance Playing the game itself
 Finance - future oriented - decision oriented - how to make him live
Accounting - past oriented - post mortem oriented - how did this fellow die

Past is clear, known, no uncertainty - Accounting

Future - vague, uncertain, subjective, you could go wrong

Accounting - right and wrong

Finance - no rights and no wrongs - your thought versus mine - your approach versus some

What was the EPS of Tata Steel last year

You have a clear answer

How do I fund the new acquisition of Corus Steel (in Tata Steel)
I need Rs 10,000 cr - how do I fund this
1,000 ways to fund it - you need to find YOUR WAY

As a finance person, you are a player (manager)

As an accounting person, you are an observer

TIME VALUE OF MONEY

Compounding and Discounting
Future Value and Present Value
Determines most long term financial decisions

Time is money
If I give you Rs 100 today and you return back Rs 100 after 2 years, that is not fair
Why?
The same Rs 100 in a bank would have generated some interest
That interest I should earn in other opportunities also

Why does interest exist in the world? What is interest?

Compensation for time

Nominal Interest
 Real Interest
3%

If Indian Bank offers you 10% interest on Fixed Deposits and inflation in the country is 7%,
really earning 3%

If you give your friend Rs 100, you would expect at least 10% yield on this loan
In economics, economists are quite thrilled to discuss real interest rates
In finance, we are more practical and we discuss nominal interest rates

Inflation is already factored in when you are dealing with Nominal Interest
In other words, having considered nominal interest, please don’t consider inflation again

German FD rates will be 2% Inflation is 1%

Japan FD rates will be 0.50% Inflation is zero percent
Botswana FD rates will be 3000% Inflation is 2500%

You friend wants Rs 100

He will return interest and principal after 2 years
How much will you get after 2 years?
Assume you are happy with 10%

When we say 10% what do we mean?

We mean 10% per annum
We mean 10% per annum compounded annually

Principal 100
Interest in year one 10% 10
End of year one Principal 110
Interest in year two 10% 11
End of year two Principal 121

r (rate of interest) 10%

1+r 110%
Year Value
0 100 This method is quicker
1 110 You simply multipy by (1+r)
2 121

Even more faster - Multiply by {(1+r)^n} (where n stands for number of years)

121
What if my friend returns back the funds after 200 years
18990527646

Most of the times, in corporate life, complex formula fail badly

The more intelligent you are, the more others run away from you
They don’t understand what you are saying

It is important to know, but it is more important to express in non-math language

This process is called compounding

Compounding means multiplying by (1+r)

Rs 100 is called as the PRESENT VALUE

Rs 121 is called as the FUTURE VALUE
Moving from Present Value to Future Value is "compounding"
Compounding means multiplying by (1+r)

DISCOUNTING
Opposite of compounding
Your friend wants a loan
He says he can repay you Rs 5 lakhs after 4 years
How much can you lend him today (lets assume that you are happy with 10% return)

Year Value
4 500,000 r (rate of interest)
3 454,545 1+r
2 413,223 In discounting, we DIVIDE BY 1
1 375,657
 0 341,507

In discounting, we start with FUTURE VALUE and we derive the PRESENT VALUE
What is the present value of Rs 5 lakhs receivable after 4 years at a discounting rate of 10
Answer - Rs 341,507

If you tell me that first year rate is 10%, second year rate is 10.50%, third year is 9.75% an
is 8.50%

Year Value
4 500,000 8.50% 108.50%
3 460,829 9.75% 109.75%
2 419,890 10.50% 110.50%
1 379,991 10.00% 110.00%
0 345,446

VARIANT OF THE ABOVE EXAMPLE

Your friend can return to you Rs 2 lakhs per annum at the end of years 5, 6, 7 and 8
You are happy to earn 10% per annum
How much should you lend him today?

476313 Standard practice in financial framework

433012 Present value factor of rupee one
373201 r= 10%
124000 1+r = 110%
93301
373201 Year PV Factor Nominal
CashFlow
373206 0 1.0000
1 0.9091 -
2 0.8264 -
 3 0.7513 -
4 0.6830 -
5 0.6209 200,000
6 0.5645 200,000
7 0.5132 200,000
8 0.4665 200,000
Present value, DCF value

If I give him Rs 433,012 today and he returns back Rs 2 lakhs each at end of years 5, 6, 7
dealt with him at 10% in this transaction

DENA BANK
You want to introduce a long term scheme for your depositors
The depositor will pay Rs 1 lakh per annum for 10 years
You will pay back Rs 3 lakhs per annum from the end of the 20th year onwards
Interest rate is 8%
How long can you pay him Rs 3 lakhs per annum 8%

Year Open Bal CashFlow Interest Clos Bal

year begin year begin year end year end
Calculated Manual Calculated Calculated
1 - 100,000 8,000 108,000
2 108,000 100,000 16,640 224,640
3 224,640 100,000 25,971 350,611
4 350,611 100,000 36,049 486,660
5 486,660 100,000 46,933 633,593
6 633,593 100,000 58,687 792,280
7 792,280 100,000 71,382 963,663
8 963,663 100,000 85,093 1,148,756
9 1,148,756 100,000 99,900 1,348,656
10 1,348,656 100,000 115,892 1,564,549
11 1,564,549 - 125,164 1,689,713
12 1,689,713 - 135,177 1,824,890
13 1,824,890 - 145,991 1,970,881
14 1,970,881 - 157,670 2,128,551
15 2,128,551 - 170,284 2,298,835
16 2,298,835 - 183,907 2,482,742
17 2,482,742 - 198,619 2,681,362
18 2,681,362 - 214,509 2,895,871
19 2,895,871 - 231,670 3,127,540
20 3,127,540 - 250,203 3,377,743
21 3,377,743 (300,000) 246,219 3,323,963
22 3,323,963 (300,000) 241,917 3,265,880
23 3,265,880 (300,000) 237,270 3,203,150
24 3,203,150 (300,000) 232,252 3,135,402
25 3,135,402 (300,000) 226,832 3,062,234
26 3,062,234 (300,000) 220,979 2,983,213
27 2,983,213 (300,000) 214,657 2,897,870
28 2,897,870 (300,000) 207,830 2,805,700
29 2,805,700 (300,000) 200,456 2,706,156
30 2,706,156 (300,000) 192,492 2,598,648
31 2,598,648 (300,000) 183,892 2,482,540
32 2,482,540 (300,000) 174,603 2,357,144
33 2,357,144 (300,000) 164,571 2,221,715
34 2,221,715 (300,000) 153,737 2,075,452
35 2,075,452 (300,000) 142,036 1,917,488
36 1,917,488 (300,000) 129,399 1,746,887
37 1,746,887 (300,000) 115,751 1,562,638
38 1,562,638 (300,000) 101,011 1,363,650
39 1,363,650 (300,000) 85,092 1,148,741
40 1,148,741 (300,000) 67,899 916,641
41 916,641 (300,000) 49,331 665,972
42 665,972 (300,000) 29,278 395,250
43 395,250 (300,000) 7,620 102,870
44 102,870 (300,000) (15,770) (212,901)

1 Time value of money

2 Compounding (multiply by 1+r)
3 Discounting (divide by 1+r)
4 Future value
 5 Present value
6 Present value factor tables (for one rupee)
7 Nominal cash flow
8 Discounted cash flow (nominal cash flow x PV factor)

Internal Rate of Return (IRR)

You give your friend Rs 5 lakhs today and he returns back Rs 9 lakhs after 3 years
What have you earned (% per annum)?

Future Value = Present Value x (1+r) ^ n

Four variables: Compounding Discounting

1 FV Determine Given
2 PV Given Determine
3r Given Given
4n Given Given

Year CashFlow
0 (500,000) 21.64%
1 -
2 - How do I know this is right?
3 900,000
500,000
608,220
739,864
900,000

"Internal" Rate of Return

What does this "Internal" mean?
The rate of return is being computed without referring to any external market or bank or
or anything
This rate of return is purely based on your own inflows and outflows of cash without rega
external factor
Internal to your own set of cash flows

You give your friend Rs 5 lakhs and he returns back to you Rs 2 lakhs each in years 3 to 10
What are you earning?

Year CashFlow
0 (500,000) 21.39%
1 -
2 -
3 200,000
4 200,000
5 200,000
6 200,000
7 200,000
8 200,000
9 200,000
10 200,000

HOME LOAN INDUSTRY

Every EMI that you pay comes straight off the IRR
Principal amount 2,000,000
Tenor 20 years
EMI 19,633
Solve for "r" Monthly IRR 0.85%
IRR will help us Annual IRR 10.25%

Month CashFlow Interest PrincRepaid PrincBal

0 (2,000,000) 2,000,000
1 19,633 17,083 2,550 1,997,450
2 19,633 17,062 2,571 1,994,879
3 19,633 17,040 2,593 1,992,286
4 19,633 17,018 2,615 1,989,671
5 19,633 16,995 2,638 1,987,033
6 19,633 16,973 2,660 1,984,373
7 19,633 16,950 2,683 1,981,690
8 19,633 16,927 2,706 1,978,984
9 19,633 16,904 2,729 1,976,255
10 19,633 16,881 2,752 1,973,502
11 19,633 16,857 2,776 1,970,727
12 19,633 16,833 2,800 1,967,927
13 19,633 16,810 2,823 1,965,104
14 19,633 16,785 2,848 1,962,256
15 19,633 16,761 2,872 1,959,384
16 19,633 16,737 2,896 1,956,488
17 19,633 16,712 2,921 1,953,566
18 19,633 16,687 2,946 1,950,620
19 19,633 16,662 2,971 1,947,649
20 19,633 16,636 2,997 1,944,652
21 19,633 16,611 3,022 1,941,630
22 19,633 16,585 3,048 1,938,582
23 19,633 16,559 3,074 1,935,508
24 19,633 16,533 3,100 1,932,407
25 19,633 16,506 3,127 1,929,281
26 19,633 16,479 3,154 1,926,127
27 19,633 16,452 3,181 1,922,947
28 19,633 16,425 3,208 1,919,739
29 19,633 16,398 3,235 1,916,504
30 19,633 16,370 3,263 1,913,241
31 19,633 16,342 3,291 1,909,951
32 19,633 16,314 3,319 1,906,632
33 19,633 16,286 3,347 1,903,285
34 19,633 16,257 3,376 1,899,909
35 19,633 16,229 3,404 1,896,505
36 19,633 16,199 3,434 1,893,071
37 19,633 16,170 3,463 1,889,608
38 19,633 16,141 3,492 1,886,116
39 19,633 16,111 3,522 1,882,594
40 19,633 16,081 3,552 1,879,041
41 19,633 16,050 3,583 1,875,459
42 19,633 16,020 3,613 1,871,845
43 19,633 15,989 3,644 1,868,201
44 19,633 15,958 3,675 1,864,526
45 19,633 15,926 3,707 1,860,819
46 19,633 15,895 3,738 1,857,081
47 19,633 15,863 3,770 1,853,311
48 19,633 15,831 3,802 1,849,508
49 19,633 15,798 3,835 1,845,673
50 19,633 15,765 3,868 1,841,805
51 19,633 15,732 3,901 1,837,905
52 19,633 15,699 3,934 1,833,970
53 19,633 15,665 3,968 1,830,003
54 19,633 15,631 4,002 1,826,001
55 19,633 15,597 4,036 1,821,965
56 19,633 15,563 4,070 1,817,895
57 19,633 15,528 4,105 1,813,790
58 19,633 15,493 4,140 1,809,650
59 19,633 15,458 4,175 1,805,475
60 19,633 15,422 4,211 1,801,264
61 19,633 15,386 4,247 1,797,017
62 19,633 15,350 4,283 1,792,733
63 19,633 15,313 4,320 1,788,413
64 19,633 15,276 4,357 1,784,057
65 19,633 15,239 4,394 1,779,663
66 19,633 15,201 4,432 1,775,231
67 19,633 15,164 4,469 1,770,762
68 19,633 15,125 4,508 1,766,254
69 19,633 15,087 4,546 1,761,708
70 19,633 15,048 4,585 1,757,123
71 19,633 15,009 4,624 1,752,499
72 19,633 14,969 4,664 1,747,835
73 19,633 14,930 4,703 1,743,132
74 19,633 14,889 4,744 1,738,388
75 19,633 14,849 4,784 1,733,604
76 19,633 14,808 4,825 1,728,779
77 19,633 14,767 4,866 1,723,913
78 19,633 14,725 4,908 1,719,005
79 19,633 14,683 4,950 1,714,055
80 19,633 14,641 4,992 1,709,063
81 19,633 14,598 5,035 1,704,029
 82 19,633 14,555 5,078 1,698,951
83 19,633 14,512 5,121 1,693,830
84 19,633 14,468 5,165 1,688,665
85 19,633 14,424 5,209 1,683,457
86 19,633 14,380 5,253 1,678,203
87 19,633 14,335 5,298 1,672,905
88 19,633 14,290 5,343 1,667,562
89 19,633 14,244 5,389 1,662,173
90 19,633 14,198 5,435 1,656,737
91 19,633 14,151 5,482 1,651,256
92 19,633 14,105 5,528 1,645,727
93 19,633 14,057 5,576 1,640,152
94 19,633 14,010 5,623 1,634,529
95 19,633 13,962 5,671 1,628,857
96 19,633 13,913 5,720 1,623,138
97 19,633 13,864 5,769 1,617,369
98 19,633 13,815 5,818 1,611,551
99 19,633 13,765 5,868 1,605,684
100 19,633 13,715 5,918 1,599,766
101 19,633 13,665 5,968 1,593,798
102 19,633 13,614 6,019 1,587,779
103 19,633 13,562 6,071 1,581,708
104 19,633 13,511 6,122 1,575,586
105 19,633 13,458 6,175 1,569,411
106 19,633 13,406 6,227 1,563,183
107 19,633 13,352 6,281 1,556,903
108 19,633 13,299 6,334 1,550,568
109 19,633 13,245 6,388 1,544,180
110 19,633 13,190 6,443 1,537,737
111 19,633 13,135 6,498 1,531,239
112 19,633 13,079 6,554 1,524,685
113 19,633 13,023 6,610 1,518,076
114 19,633 12,967 6,666 1,511,410
115 19,633 12,910 6,723 1,504,687
116 19,633 12,853 6,780 1,497,907
117 19,633 12,795 6,838 1,491,068
118 19,633 12,736 6,897 1,484,172
119 19,633 12,677 6,956 1,477,216
120 19,633 12,618 7,015 1,470,201
121 19,633 12,558 7,075 1,463,126
122 19,633 12,498 7,135 1,455,991
123 19,633 12,437 7,196 1,448,795
124 19,633 12,375 7,258 1,441,537
125 19,633 12,313 7,320 1,434,217
126 19,633 12,251 7,382 1,426,835
127 19,633 12,188 7,445 1,419,389
128 19,633 12,124 7,509 1,411,881
129 19,633 12,060 7,573 1,404,307
130 19,633 11,995 7,638 1,396,670
131 19,633 11,930 7,703 1,388,967
132 19,633 11,864 7,769 1,381,198
133 19,633 11,798 7,835 1,373,363
134 19,633 11,731 7,902 1,365,461
135 19,633 11,663 7,970 1,357,491
136 19,633 11,595 8,038 1,349,453
137 19,633 11,527 8,106 1,341,347
138 19,633 11,457 8,176 1,333,172
139 19,633 11,388 8,245 1,324,926
140 19,633 11,317 8,316 1,316,610
141 19,633 11,246 8,387 1,308,224
142 19,633 11,175 8,458 1,299,765
143 19,633 11,102 8,531 1,291,234
144 19,633 11,029 8,604 1,282,631
145 19,633 10,956 8,677 1,273,954
146 19,633 10,882 8,751 1,265,202
147 19,633 10,807 8,826 1,256,376
148 19,633 10,732 8,901 1,247,475
149 19,633 10,656 8,977 1,238,498
150 19,633 10,579 9,054 1,229,444
151 19,633 10,502 9,131 1,220,312
152 19,633 10,424 9,209 1,211,103
153 19,633 10,345 9,288 1,201,815
154 19,633 10,266 9,367 1,192,447
155 19,633 10,186 9,447 1,183,000
156 19,633 10,105 9,528 1,173,472
157 19,633 10,024 9,609 1,163,862
158 19,633 9,941 9,692 1,154,171
159 19,633 9,859 9,774 1,144,396
160 19,633 9,775 9,858 1,134,539
161 19,633 9,691 9,942 1,124,597
162 19,633 9,606 10,027 1,114,570
163 19,633 9,520 10,113 1,104,457
164 19,633 9,434 10,199 1,094,258
165 19,633 9,347 10,286 1,083,972
166 19,633 9,259 10,374 1,073,598
167 19,633 9,170 10,463 1,063,135
168 19,633 9,081 10,552 1,052,583
169 19,633 8,991 10,642 1,041,941
170 19,633 8,900 10,733 1,031,208
171 19,633 8,808 10,825 1,020,383
172 19,633 8,716 10,917 1,009,466
173 19,633 8,623 11,010 998,456
174 19,633 8,529 11,104 987,351
175 19,633 8,434 11,199 976,152
176 19,633 8,338 11,295 964,857
177 19,633 8,242 11,391 953,466
178 19,633 8,144 11,489 941,977
179 19,633 8,046 11,587 930,390
180 19,633 7,947 11,686 918,704
181 19,633 7,847 11,786 906,919
182 19,633 7,747 11,886 895,032
183 19,633 7,645 11,988 883,045
184 19,633 7,543 12,090 870,954
185 19,633 7,439 12,194 858,761
186 19,633 7,335 12,298 846,463
187 19,633 7,230 12,403 834,060
188 19,633 7,124 12,509 821,552
189 19,633 7,017 12,616 808,936
190 19,633 6,910 12,723 796,213
191 19,633 6,801 12,832 783,381
192 19,633 6,691 12,942 770,439
193 19,633 6,581 13,052 757,387
194 19,633 6,469 13,164 744,224
195 19,633 6,357 13,276 730,948
196 19,633 6,244 13,389 717,558
197 19,633 6,129 13,504 704,054
198 19,633 6,014 13,619 690,435
199 19,633 5,898 13,735 676,700
200 19,633 5,780 13,853 662,847
201 19,633 5,662 13,971 648,876
202 19,633 5,543 14,090 634,785
203 19,633 5,422 14,211 620,575
204 19,633 5,301 14,332 606,242
205 19,633 5,178 14,455 591,788
206 19,633 5,055 14,578 577,210
207 19,633 4,930 14,703 562,507
208 19,633 4,805 14,828 547,679
209 19,633 4,678 14,955 532,724
210 19,633 4,550 15,083 517,641
211 19,633 4,422 15,211 502,430
212 19,633 4,292 15,341 487,089
213 19,633 4,161 15,472 471,616
214 19,633 4,028 15,605 456,012
215 19,633 3,895 15,738 440,274
216 19,633 3,761 15,872 424,401
217 19,633 3,625 16,008 408,394
218 19,633 3,488 16,145 392,249
219 19,633 3,350 16,283 375,966
220 19,633 3,211 16,422 359,545
221 19,633 3,071 16,562 342,983
222 19,633 2,930 16,703 326,280
223 19,633 2,787 16,846 309,434
224 19,633 2,643 16,990 292,444
225 19,633 2,498 17,135 275,309
 226 19,633 2,352 17,281 258,027
227 19,633 2,204 17,429 240,598
228 19,633 2,055 17,578 223,021
229 19,633 1,905 17,728 205,293
230 19,633 1,754 17,879 187,413
231 19,633 1,601 18,032 169,381
232 19,633 1,447 18,186 151,195
233 19,633 1,291 18,342 132,853
234 19,633 1,135 18,498 114,355
235 19,633 977 18,656 95,699
236 19,633 817 18,816 76,883
237 19,633 657 18,976 57,907
238 19,633 495 19,138 38,769
239 19,633 331 19,302 19,467
240 19,633 166 19,467 (0)
4,711,920

IRR is an iterative calculation

Deterministic calculations 2+7 = 9
Probabilistic calculations
What will be your sales next year? I don’t know
If I force you, you may come up with sir, may be Rs 10 cr, may be Rs 15 cr
80% prob - Rs 10 cr, 20% prob - Rs 15 cr

Iterative calculations
The answer is not known
But we will try and try and try till we succeed

Excel starts with 10% as the default IRR

It tries to check if indeed the IRR is 10%
It guesses that the IRR is less than 10% (or more than 10%)
If less, it again tries with say 9.75% (illustrating)
It tries 32 times (Excel 2007 version)

FLAT INTEREST RATE EXAMPLE

The real rate of interest that you pay or receive is known only by IRR workings
If you borrow Rs 5 lakhs from a pathan and he charges you 8% flat interest rate and you re
Rs 1 lakh per annum for 5 years (year 1 to year 5), what does this flat interest rate mean
It means that you pay interest on Rs 5 lakhs throughout (not on reducing balance but on o

What is the real interest cost to you?

Year CashFlow
0 (5.00) 12.38%
1 1.40 8% is not 8%, 8% on flat rate basis is 12.38% in
2 1.40
3 1.40
4 1.40
5 1.40

ZERO PERCENT INTEREST

You go to retail store ABC in T Nagar, Chennai
You want to buy a LED TV
MRP Rs 70,000
They are offering zero percent interest instalment facility
12 instalments, 3 payable in advance (today)
4th to 12th instalment in month 4 to month 12
2% processing fees
If you were to buy the TV cash down, you get a discount of 4% - in the scheme that discou

What does zero percent really imply in reality?

There is no inflow for the consumer, so this can be slightly confusing to some people
When you buy the TV, there is simply outflow outflow

Options Buy cash down Use the loan Difference

Month
- (67,200) (18,900) 48,300
1 - - -
2 - - -
3 - - -
4 - (5,833) (5,833)
 5 - (5,833) (5,833)
6 - (5,833) (5,833)
7 - (5,833) (5,833)
8 - (5,833) (5,833)
9 - (5,833) (5,833)
10 - (5,833) (5,833)
11 - (5,833) (5,833)
12 - (5,833) (5,833)

1.05% 12

INSURANCE
Endowment Policies
Annual premium 111,000
Sum Assured 2,700,000
Tenor 15

Term Plan
You pay a premium (very low) and if you survive, then you get back nothing
Annual Premium 6,500
Sum Assured 2,700,000
Tenor 15

Let me assume that the amount of premium saved is invested in PPF earning 8.5%

Which plan is better?

Endowment versus (Term Plan + PPF)

Endowment
Year CashFlow
0 (111,000) IRR = 5.83%
1 (111,000)
2 (111,000)
 3 (111,000) Endowment is bundling
4 (111,000) Bundling of : Insurance Cover and Savings
5 (111,000)
6 (111,000)
7 (111,000)
8 (111,000)
9 (111,000)
10 (111,000)
11 (111,000)
12 (111,000)
13 (111,000)
14 (111,000)
15 2,700,000

When I buy the term plan, I will pay annual premium of Rs

The balance amount left in my hand is Rs
This balance amount will be invested in PPF

Year Open Bal Cash Inflow Interest Cl Bal

Beginning
1 - 104,500 8,883 113,383
2 113,383 104,500 18,520 236,403
3 236,403 104,500 28,977 369,879
4 369,879 104,500 40,322 514,701
5 514,701 104,500 52,632 671,834
6 671,834 104,500 65,988 842,322
7 842,322 104,500 80,480 1,027,302
8 1,027,302 104,500 96,203 1,228,005
9 1,228,005 104,500 113,263 1,445,768
10 1,445,768 104,500 131,773 1,682,041
11 1,682,041 104,500 151,856 1,938,397
12 1,938,397 104,500 173,646 2,216,543
13 2,216,543 104,500 197,289 2,518,331
14 2,518,331 104,500 222,941 2,845,772
15 2,845,772 104,500 250,773 3,201,045
Year CashFlow
0 (111,000) 7.81%
1 (111,000)
2 (111,000)
3 (111,000)
4 (111,000)
5 (111,000)
6 (111,000)
7 (111,000)
8 (111,000)
9 (111,000)
10 (111,000)
11 (111,000)
12 (111,000)
13 (111,000)
14 (111,000)
15 3,201,045

1 Don’t go for flat interest rate schemes - the real interest rate is much higher
2 Don’t go for zero EMI - pls recheck the IRR
3 Don’t go for endowment policies or ULIPs - if you wish to buy insurance, buy T
Cheapest value for money

In ULIPs, they take Rs 100 from you and carve out Rs 23 towards service charges of variou
What gets invested is only Rs 77
23
77
30% So long as market has not appreciated by 30% you are under water

How do use these concepts in business life

Most capex decisions are long term
Capex means capital expenditure (new factory, new product launch, new branch, new co
You invest today and you reap the harvest in future
Future is long term (at least more than one year)
If I spend Rs 500 cr and I get back Rs 600 cr after 3 years, is that interesting?
No - bcoz of time value of money

What should we discount?

What should be the discounting rate?
What if the future unfolds differently than what I thought?
 Actions

ceivable (Days)
Net, Returns - RoCE, RoE

to be good or lousy

company will be rewarded)

ts of those actions
y your actions, partly the environment, partly sentiment, etc

Rs cr
Rs cr
Rs
Cr
Rs per Share

et (not among management)

ONE LITTLE SHARE

75 to the earnings of Rs 2.22 and come up

ire Sahara Airlines, you will NOT BE

al PROFIT

derstand 50% of what they say

2011 / No of Shares

e 2011 / No of Shares

Forward EPS
passage of time

ents EPS is Rs 2.22

ents EPS is Rs 7.03

may be Forward
will typically mean Oct 2011 to Sept 2012

Rs cr
You think this will remain constant
Rs per Share

EPS estimates
ESTIMATE
ward) and your estimate is far away,

be careful, he should recheck his assumptions

be careful, he should recheck his assumptions

enerally not done

excludes outliers
sitive, those are great turn around cases
you identify them in good time

s per share

75.00 Rs per Share

2.22 Rs per Share
33.83 Times (x)

75.00 Rs per Share

4.03 Rs per Share
18.59 Times (x)

rn in the coming year, the market is willing

pensiveness of the stock

Infosys TCS
2,823.00 1,225.00

into ten shares

Infosys TCS
282.30 1,225.00
 XPENSIVENESS of a stock
ng metric

support of earnings of that one share which

Infosys TCS
2,823.00 1,225.00 These are not comparable
130.50 41.25
21.63 29.70
20 - 23 27 - 30

21.63 for Infosys

willing to pay Rs 29.70

question - no simplistic answers

 100 Price of the financial instrument
8
12.5 times

40 lakhs
2 lakhs
20 times

times), then every investor should keep

Office deposits which much cheaper at

ation to the Post Office

es PE, may be that’s quite okay
es PE, may be that’s not okay

mes (one year forward)

ver the last 30 years

ould buy at 7 to 8 PE and we would sell

ling us that Sensex from 21000 will soon

of us would have lost huge amounts by

at Sensex will become Nifty - Oct 2008

1.50 Rs per Share

Face Value per Share
15%

68%
Market Price per Share
2.00%

eir current prices

do not influence the share purchase decision

e share in 1991 at very low prices), then

oes not make you a great cricketer

d between midwicket and midon is 72% of the total

eping skills
make him live
ow did this fellow die

ur approach versus some one else

s, that is not fair

nal Interest
10%
 Inflation
7%

tion in the country is 7%, you are

d on this loan

al Interest
consider inflation again (double counting)

ion is 1%
ion is zero percent
ion is 2500%

121

Conventional terminologies
Conventional terminologies
ber of years)

200

n-math language

py with 10% return)

e of interest) 10%
110%
counting, we DIVIDE BY 1+r
RESENT VALUE
t a discounting rate of 10%?

0%, third year is 9.75% and fourth year

How do you know what rates will prevail when

Rs 5 cr software

years 5, 6, 7 and 8

Discounted
Cash Flow

- If I give you Rs 0.9091 today and you

- return back one rupee after one year,
 - then are we dealing at 10% with
- each other
124,184
112,895
102,632
93,301
433,012

h at end of years 5, 6, 7 and 8, I have

year onwards
khs after 3 years

IRR
Given
Given
Determine
Given

r= 21.64%
1+r= 121.64%

ternal market or bank or Govt Securities

ows of cash without regard to any

khs each in years 3 to 10

12
e Rs 15 cr

IRR workings
t interest rate and you repay principal
s flat interest rate mean
educing balance but on original loan)

at rate basis is 12.38% in reality

n the scheme that discount does not apply

sing to some people

MRP 70,000
Discount 4%
Cash Down 67,200
Tenor 12 months
EMI 5,833
Proc Fee 2%
1,400
 12.63%

ck nothing

PPF earning 8.5%

e Cover and Savings

6,500 Life Cover

104,500 Savings
8.50%
est rate is much higher

to buy insurance, buy Term Plans

service charges of various types

under water

nch, new branch, new company acquisition)

interesting?
 108%
PV Fact DCF CumuDCF

1.0000 100,000 100,000

0.9259 92,593 192,593
0.8573 85,734 278,326
0.7938 79,383 357,710
0.7350 73,503 431,213
0.6806 68,058 499,271
0.6302 63,017 562,288
0.5835 58,349 620,637
0.5403 54,027 674,664
0.5002 50,025 724,689
0.4632 - 724,689
0.4289 - 724,689
0.3971 - 724,689
0.3677 - 724,689
0.3405 - 724,689
0.3152 - 724,689
0.2919 - 724,689
0.2703 - 724,689
0.2502 - 724,689
0.2317 - 724,689
0.2145 (64,364) 660,324
0.1987 (59,597) 600,728
0.1839 (55,182) 545,545
0.1703 (51,095) 494,451
0.1577 (47,310) 447,141
0.1460 (43,805) 403,336
0.1352 (40,561) 362,775
0.1252 (37,556) 325,219
0.1159 (34,774) 290,445
0.1073 (32,198) 258,247
0.0994 (29,813) 228,434
0.0920 (27,605) 200,829
0.0852 (25,560) 175,269
0.0789 (23,667) 151,602
0.0730 (21,914) 129,688
0.0676 (20,290) 109,398
0.0626 (18,787) 90,611
0.0580 (17,396) 73,215
0.0537 (16,107) 57,108
0.0497 (14,914) 42,194
0.0460 (13,809) 28,385
0.0426 (12,786) 15,598
0.0395 (11,839) 3,759
0.0365 (10,962) (7,203)
Summary of yesterday
1 Valuation ratios
EPS
Forward and Trailing EPS
PE Multiples
Tells us what is cheap and what is expensive (share price itself does not conv
Dividend ratios - Div per Share, Div %, Div Payout, Div Yield

2 Time value of money

Compounding - Multiply by 1+r
Discounting - Divide by 1+r
Nominal cash flow
Present value factor
Discounted cash flow
IRR
Present value, future value

BUSINESS EXAMPLES
You are setting up a new project and this project will cost you Rs 100 cr
For simplicity, let us assume that the entire spending will happen on day zero
You will earn Rs 20 cr per annum for the first two years, then Rs 30 cr per annum for the
and then Rs 40 cr per annum for the next four years
End of this period, you will sell off the business for Rs 50 cr
You can borrow funds at 14%
Is this project a good idea?

SEVERAL FINANCIAL CRITERIA

1 Payback period
2 Net Present Value NPV
3 IRR
4 Discounted payback period
5 Profitability Index (PI) - this is used when you have multiple competing proje

Year Nominal Cumulative Present Discounted

 CashFlow Nom CF Value Factor Cash Flow
0 (100) (100) 1.0000 (100.00)
1 20 (80) 0.8772 17.54
2 20 (60) 0.7695 15.39
3 30 (30) 0.6750 20.25
4 30 - 0.5921 17.76
5 30 30 0.5194 15.58
6 40 70 0.4556 18.22
7 40 110 0.3996 15.99
8 40 150 0.3506 14.02
9 90 240 0.3075 27.68
240.00 NPV 62.43

Nominal cash outflows (100)

Nominal cash inflows 340
Nominal net cash flow 240 But this is a useless number
time value of money

Present value of cash outflows (100.00)

Present value of cash inflows 162.43
Net Present Value 62.43 This is a useful number bco
of money - even after consi
in time, then NPV is still po
interesting

If we shift to Planet Jupiter and on Jupiter, there is nothing like INTEREST, then Nominal
will be equal to Net Present Value - we will not require any discounting or compounding o

Payback period
Without getting into complicated arithmetic, how many years does it take to get my mon
We ignore interest, we ignore compounding, discounting
Our payback is exactly 4 years
If Project A payback is 4 years and Project B is 3 years, which is better?
B is better

But the fact may be that after the payback period, A generates huge earnings, while B do

Drawbacks:
1 Interest is ignored
2 Cash flows after the payback period are ignored

Merits:
In many sectors, the long term is simply unknown - I simply don’t know
So complex long term projections may be simply false

In such cases, I am quite nervous in spending on capex based on very shaky projections
I am more convinced that a simple measure like payback is important

If the payback is 7 years, I am simply not interested

Many SME who will reject any project with a payback of over 2 years

Large corporates may typically have hundreds of small projects

I want to buy this new software which will automate several processes and I can save on
This software will cost me Rs 2 cr and save wages of Rs 25 lakhs per annum for the next 1
That is a project

The large corporate also will look for a quick PAYBACK on its small projects

Tata Motors Nano project may well have a payback of ten years
This is a large project and who approves it - Ratan Tata himself

Within Tata Motors, there are 800 small projects each costing less than Rs 5 cr
Who approves them
Executive Committee
These people will not allow projects beyond 2 year payback, 3 year payback

Tooling Cost payback 1 year - Brakes India

Customer proposals - when calculating RoI, payback is computed - TCS - US customers loo
Glass - payback 2 years, 4 year payback products are tough to sell
Conventional glass consumes more electricity
High performance glass consumes less
Benefit - lower electricity costs
Cost - incremental cost of this glass

Family run company making kids shoes - machines with payback of 3 years get approved q
with 10 year payback take time - we may try one machine for testing, but bulk orders a

Large capital intensive projects will tend to have long paybacks - 7 years, 10 years, 15 ye
For projects of national importance, such paybacks are common
Delhi Airport - payback may well be 15 years
Konkan Railway - payback may be 25 years
Reliance Refinery - payback may be 7 years

If you are a middle level manager and you have some bright ideas, then please make sure
have short paybacks if you want them to be approved

RELATIONSHIP BETWEEN FINANCIAL RATIOS (RoI, RoE, etc) AND CAPEX PARAMETERS (N

Financial ratios work year on year

RoE
27%

RoE
24% RoE
Project Level 22%
Financial parameters
Cut across several years

2011 2012 2013

Company level numbers for one year at a time
 Company is nothing but a collection of projects
Accounting ratios

Project level RoI = Benefits of the Project / Costs of the Project

These RoI are very crude workings and most of the time are highly political workings

NET PRESENT VALUE

Present value means cash flows of future years discounted to today's value - divide by (1+
The term NET stands of present value of inflows minus present value of outflows

If the NET is a positive number, what does this mean?

PV of Inflows is more than PV of Outflows - the idea looks good

If the NET is a negative number, what does this mean?

PV of Inflows is less than PV of Outflows - the idea does not look so bright

INTERNAL RATE OF RETURN

The NPV is 62.43 when we are discounting at
At a very simple level, we have assumed that funds will be available at
What if interest rates start rising and funds are now available at
What do you think will happen to the NPV?
1 Goes up
2 Goes down
3 Indifferent

The NPV should fall - the project should become less attractive bcoz the banks will take
me, from my business

If Interest rates go up drastically, say to 45%, what may happen?

The project may become unattractive - the NPV may turn negative

In Chennai, if you are a vegetable vendor, your interest may be 3600% per annum also
He gives you Rs 900 in the morning and collects Rs 1,000 in the evening

The IRR is that rate of interest which makes the NPV zero
If you borrow funds at the IRR rate, the project will neither make losses nor profits - you

If your cost of borrowings is less than IRR, then the project is interesting
IRR in this case will be 26.08%

If you borrow at 14%, then NPV will be positive

If you borrow at any rate above 26.08%, the NPV will be negative

If you borrow at exactly 26.08%, NPV will be zero

Many corporates will have a certain minimum IRR which each project should satisfy
Any project with an IRR below this threshold will be rejected by management
IRR rate, min rate, threshold rate, hurdle rate

25% IRR - Brakes India - quite a high hurdle - may be difficult to beat
20% IRR in competitive segments
Most Indian corporates look at a min min 15% IRR

I want positive NPV projects - that’s where I make money

If my min IRR hurdle is 15% and my pet project is showing an IRR of 22%, what does this m
This project will show a positive NPV if discounted at 15%

IRR thinking - positive conclusion - 22% > 15%

NPV thinking - positive conclusion - NPV will be positive in this project

You will never have a conflict where IRR says No and NPV says Yes

Which one should you use - NPV or IRR

After the break

DISCOUNTED PAYBACK PERIOD

The criticism against the simple payback is that it ignores interest
So the discounted payback overcomes this challenge - it considers interest
It uses the discounted cash flows to compute the payback period and as we know, the dis
column considers interest

End of year 5 - cumulative DCF is negative (13.47)

End of year 6 - cumulative DCF is positive 4.75
DCF in year 6 18.22
How much do I need to make my Cum DCF zero 13.47
How much fraction of the 6th year 0.74

Disc Payback is 5.x years

Disc Payback is 5.74 years

PROFITABILITY INDEX (PI)

This criterion is used when we have limited funds and many competing project ideas
You have only Rs 200 cr and you have 300 ideas which need Rs 700 cr
You will have to pick and choose, you cant satisfy everybody
So, which ones to pick? On what criteria?

There can be conflicts between NPV and IRR

In a single project situation there is no conflict

Proj A Proj B
Project Cost 150 200
NPV Rs cr 100 120
IRR % 19% 17%

So, which one ?

The Profitability Index is the answer = PV of Inflows
PV of Outflows

PV of Outflows 150 200

PV of Inflows 250 320
Profitability Index 1.67 1.60

I don’t have money - so I need to conserve my funds - every rupee is important

If I invest one rupee in Project A, I am getting back Rs 1.67
If I invest one rupee in Project B, I am getting back Rs 1.60

So, I will go for Project A

BUSINESS CAPEX EXERCISE

Your company is in infrastructure and is bidding for a road project
The road will cost Rs 1,000 cr - assume that road building takes one day
In the first year, the toll revenue will be Rs 100 cr
This revenue will increase 10% every year
The licence to operate the road works for 30 years
At the end of 30 years, the company will walk away from the road (road belongs to the G
Assume that funds can be brought in at 14%

Work out the four project evaluation criteria and advise on the feasibility of this project

IRR should not be worked out on the DCF column bcoz the discounting process itself has a
inflows downwards by 14% and once again on this if you apply IRR (which is another form
then you are double counting

GOAL SEEK COMMAND

In the context of IRR, we discussed IRR is that rate of interest which makes the NPV zero
Can we automatically work out the IRR (not using the IRR formula) using the NPV table (w
trying and trying)

INPUT MODELING
A spreadsheet is useful because it can calculate
If a spreadsheet cannot calculate, then it is a word processor
Many of us use spreadsheets like word processors

What can be a formula should never be a hard number

Hard numbers should be minimal

100 100 100 is a hard number (unav

110 110 Second year should be a for
So 100 x 1.1 (or 100 x 110%)
RIGHT WRONG But is it really good?
OR NOT The 1.1 factor or the 110%
SO RIGHT ? Should a hard number be ha
Ideally No
Then what should I do?
The 10% should sit in a sepa
The 110% should be a formu
100.00 10%
110.00
121.00

MOST RIGHT

Whether a formula should contain a hard number - second question

If my toll revenue were to grow at 12% (not 10%), then what?

Then what, then what, then what? WHAT IF ANALYSIS

Having used a formula once, you should not be required to repeat the formula
If you are repeating the same formula again and again, recheck your logic

1 Use minimal hard numbers

2 Keep these hard numbers in clear cells (don’t mix them up with formula)
3 Don’t use the same formula again - if you need that number, refer to that ce
recalculating the number)
4 Always remember that your file should be amenable to good WHAT IF analysi

My revenues grow at:

8%
9%
10%
11%
 12%

My cost of capital is:

12%
13%
14%
15%
16%

How much can you simplify, automate?

Test the Goal Seek Command for IRR - NPV

Much faster way of WHAT IF ANALYSIS

There is a DATA TABLE function meant for such analysis - very powerful, very easy

For every change of inputs, it re-calculates your desired outputs

One Way Table

One input factor is being changed at a time
Dis Factor NPV IRR
62.43 26.08%
11% 86.94 26.08%
12% 78.21 26.08%
13% 70.06 26.08%
14% 62.43 26.08%
15% 55.30 26.08%
16% 48.61 26.08%
17% 42.35 26.08%

Two way Tables

Two factors are changing at the same time
What will be my NPV in the following 35 situations (7 discounting factors x 5 possible Proj

Dis Factor Project Cost

 62.43 (80.00) (90.00) (100.00) (110.00)
11% 106.94 96.94 86.94 76.94
12% 98.21 88.21 78.21 68.21
13% 90.06 80.06 70.06 60.06
14% 82.43 72.43 62.43 52.43
15% 75.30 65.30 55.30 45.30
16% 68.61 58.61 48.61 38.61
17% 62.35 52.35 42.35 32.35

Sensitivity to Revenue Growth

NPV IRR PI
8%
9%
10%
11%
12%

Two Way Tables

NPV Sensitivity
12% 13% 14% 15%
8%
9%
10%
11%
12%

IRR Sensitivity
12% 13% 14% 15%
8%
9%
10%
 11%
12%

PI Sensitivity
12% 13% 14% 15%
8%
9%
10%
11%
12%

We are reasonably familiar with Payback, NPV, IRR, Discounted Payback and PI
We are also familiar with Data Tables (1 way and 2 way)
We have some idea of good modeling and bad modeling

Business Case
We are going to integrate our earlier knowledge of Bal Sheet, P&L with the new knowledg

You are putting a new factory, cost of Rs 1

You will produce name plates
Cost of each name plate is Rs 100 Variable costs, Direct costs
Selling price is Rs 150
Annual fixed operating costs are Rs 20 lakhs
First year volume of business is 100,000 units

Volume will increase at 5% per annum

Selling prices will increase at 7% per annum
Costs will not increase, kept under control
Working capital (Current Assets - Inventories, Cash, Receivables minus Current Liab - Ven
Expense Payables, Provisions) is estimated to be 12%

This business will run for 10 years

At the end of ten year, I will quit the business and sell off the factory, which will fetch o
The working capital in the business (at that time) will be released (converted to Cash)

Assume cost of capital is 14% Will not affect your Bal She
Assume that appropriate depreciation has been provided for
Ignore interest, bank loans taken and repaid, income tax

Balance Sheet for each year Projections

P&L for each year Projections
We could assume for financial projections that the funds came from owners equity

Cost of Fixed Assets 10,000,000

Salvage value estimated 1,000,000
Depreciable value 9,000,000
Tenor 10
Depreciation per annum (SLM) 900,000

PROJECTED PROFIT & LOSS ACCOUNT

Year 1 2 3
Volume 100,000 105,000 110,250
Selling Price 150.00 160.50 171.74
Sales Revenue 15,000,000 16,852,500 18,933,784
Variable Cost per Unit 100.00 100.00 100.00
Variable Cost Rs 10,000,000 10,500,000 11,025,000
Fixed Costs 2,000,000 2,000,000 2,000,000
EBIDTA 3,000,000 4,352,500 5,908,784
Depreciation 900,000 900,000 900,000
EBIT 2,100,000 3,452,500 5,008,784

PROJECTED BALANCE SHEET

Liabilities 0 1 2 3
Sh Capital 11,800,000 11,800,000 11,800,000 11,800,000
Reserves - 2,100,000 5,552,500 10,561,284
Total Liab 11,800,000 13,900,000 17,352,500 22,361,284

Assets
Fixed Assets 10,000,000 9,100,000 8,200,000 7,300,000
Work Cap 1,800,000 2,022,300 2,272,054 2,552,653
Excess Cash - 2,777,700 6,880,446 12,508,631
Total Assets 11,800,000 13,900,000 17,352,500 22,361,284

Excess Cash is the balancing number in the Bal Sheet

CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZ
Sources of Funds (Inflows)
Owners Equi 11,800,000 - - -
Cash Profits - 3,000,000 4,352,500 5,908,784
Fixed Assets - - - -
Working Capi - - - -
Total 11,800,000 3,000,000 4,352,500 5,908,784

Application of Funds (Outflows)

Fixed Assets 10,000,000 - - -
WorkCap 1,800,000 222,300 249,754 280,599
Total 11,800,000 222,300 249,754 280,599

Surplus - 2,777,700 4,102,746 5,628,185

Open Bal - - 2,777,700 6,880,446
Cl Bal - 2,777,700 6,880,446 12,508,631

Difference in Cash Bal - - -

- Sum of the difference

Cash Profits = PAT + Depreciation added back

Capital expenditure evaluation is based on CASH FLOWS, not profits, not reserves, not EB
Year 0 1 2 3
Capex FA (10,000,000)
Work Cap (1,800,000) (222,300) (249,754) (280,599)
Cash Profits - 3,000,000 4,352,500 5,908,784
Sale of FA
Release of Work Cap
Total (11,800,000) 2,777,700 4,102,746 5,628,185

PV Factor 1.000 0.877 0.769 0.675

DCF (11,800,000) 2,436,579 3,156,930 3,798,865

NPV 38,806,441
ce itself does not convey)

n day zero
cr per annum for the next three years

tiple competing projects

Cumulative 14.00%
 Disc Cash Flo 114%
(100.00)
(82.46) PV Factor = last year PVF / 114%
(67.07)
(46.82)
(29.06) What does 0.5921 mean?
(13.47) If I give you 0.5921 rupees today
4.75 and you return me back one rupee
20.73 after 4 years, then we have
34.76 transacted with each other at 14%
62.43

is is a useless number, bcoz this does not consider

alue of money

a useful number bcoz it incorporates time value

ney - even after considering that inflows arrive later
e, then NPV is still positive - the project looks

EREST, then Nominal Net Cash Flows

ting or compounding on Planet Jupiter

t take to get my money back

e earnings, while B does not

y shaky projections

ses and I can save on people cost

annum for the next 10 years

han Rs 5 cr

payback
CS - US customers look at around 1 year

years get approved quickly and those

ng, but bulk orders are risky

years, 10 years, 15 years

hen please make sure that such ideas

APEX PARAMETERS (NPV, IRR)

RoE
26%

RoE Payback 7 years

20%
NPV Rs 15 cr
IRR 31%

2014 2015 Years

at a time
f projects

olitical workings

s value - divide by (1+r)

e of outflows

14%
14%
16%

z the banks will take away more from

0% per annum also

sses nor profits - you will be indifferent

t should satisfy
nagement

22%, what does this mean

in this project
d as we know, the discounted cash flow

ing project ideas

Outflows

Rs cr
Rs cr
times

important
road belongs to the Govt)

ibility of this project

ng process itself has adjusted cash

which is another form of discounting),

makes the NPV zero

using the NPV table (without manually

a hard number (unavoidable)

d year should be a formula
0 x 1.1 (or 100 x 110%) is good - formula
it really good?
 1 factor or the 110% factor is a hard number
d a hard number be hard coded onto a formula?

what should I do?

0% should sit in a separate cell (hard number)
10% should be a formula (second cell)
110%

he formula

up with formula)
mber, refer to that cell (instead of

good WHAT IF analysis

What happens to my:

Situations
Payback 10
NPV 10
IRR 10
Discounted Payback 10
 PI 10

rful, very easy

ctors x 5 possible Project Costs)

Best case
 (120.00)
66.94
58.21
50.06
42.43 Realistic case
35.30
28.61
22.35
Worst case

Sensitivity to Cost of Capital

NPV IRR PI
12%
13%
14%
15%
16%

25 situations
16%

16%
 16%

back and PI

with the new knowledge of NPV, IRR

cr 10,000,000

ble costs, Direct costs

100,000
us Current Liab - Vendor Payables,
of coming year Sales

ry, which will fetch only Rs 10 lakhs

converted to Cash)

ot affect your Bal Sheet, P&L - only for capex decision

114%

owners equity

4 5 6 7 8
115,763 121,551 127,628 134,010 140,710
183.76 196.62 210.38 225.11 240.87
21,272,106 23,899,211 26,850,764 30,166,833 33,892,437
100.00 100.00 100.00 100.00 100.00
11,576,250 12,155,063 12,762,816 13,400,956 14,071,004
2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
7,695,856 9,744,149 12,087,948 14,765,877 17,821,433
900,000 900,000 900,000 900,000 900,000
6,795,856 8,844,149 11,187,948 13,865,877 16,921,433
 4 5 6 7 8
11,800,000 11,800,000 11,800,000 11,800,000 11,800,000
17,357,140 26,201,288 37,389,237 51,255,113 68,176,546
29,157,140 38,001,288 49,189,237 63,055,113 79,976,546

6,400,000 5,500,000 4,600,000 3,700,000 2,800,000

2,867,905 3,222,092 3,620,020 4,067,092 4,569,378
19,889,234 29,279,197 40,969,217 55,288,021 72,607,167
29,157,140 38,001,288 49,189,237 63,055,113 79,976,546

ENDED XYZ

- - - - -
7,695,856 9,744,149 12,087,948 14,765,877 17,821,433
- - - - -
- - - - -
7,695,856 9,744,149 12,087,948 14,765,877 17,821,433

- - - - -
315,253 354,186 397,928 447,072 502,286
315,253 354,186 397,928 447,072 502,286

7,380,603 9,389,962 11,690,020 14,318,804 17,319,147

12,508,631 19,889,234 29,279,197 40,969,217 55,288,021
19,889,234 29,279,197 40,969,217 55,288,021 72,607,167

- - - - -

, not reserves, not EBIDTA, not EBIT

 4 5 6 7 8

(315,253) (354,186) (397,928) (447,072) (502,286)

7,695,856 9,744,149 12,087,948 14,765,877 17,821,433

7,380,603 9,389,962 11,690,020 14,318,804 17,319,147

0.592 0.519 0.456 0.400 0.351

4,369,910 4,876,852 5,325,816 5,722,329 6,071,384
 9 10 Growth 1+x
147,746 155,133 5% 105%
257.73 275.77 7% 107%
38,078,153 42,780,805
100.00 100.00 0% 100%
14,774,554 15,513,282
2,000,000 2,000,000 0% 100%
21,303,598 25,267,523
900,000 900,000
20,403,598 24,367,523
 9 10
11,800,000 11,800,000
88,580,144 112,947,667
100,380,144 124,747,667

1,900,000 - 1,000,000 Asset book value

5,133,697 - 1,000,000 Sold for the same amount and enh
93,346,448 124,747,667 - No profit no loss on sale
100,380,144 124,747,667

- -
21,303,598 25,267,523
- 1,000,000
- 5,133,697
21,303,598 31,401,219

- -
564,318 -
564,318 -

20,739,280 31,401,219
72,607,167 93,346,448
93,346,448 124,747,667

- -
 9 10

(564,318) -
21,303,598 25,267,523
1,000,000
5,133,697
20,739,280 31,401,219

0.308 0.270
6,377,493 8,470,284
same amount and enhanced cash
loss on sale
 1 Impact of Interest, Depreciation and Taxes on Capex decisions
2 Cost of Capital
3 Risk - Definition, Measurement, Implications

SHOULD WE PREPAY A HOME LOAN OR NOT

There is no answer to the question - at what point in time is advantageous to prepay
The home loan costs you say 10.00%
You get a tax benefit of 30% 3.00%
Post tax cost of home loan 7.00%
PPF earns 8.00%

Why should I prepay

Answer - financially appears to be never prepay
Psychologically, some may prefer to prepay - they don’t want tension
If they have surplus funds, their relatives will take it away
They don’t trust themselves (on not to spend)

INTEREST
We will recall that in our workings, we have ignored interest
For capex evaluation, we always ignore interest
Why?
Is interest not a real cost? How can we ignore interest?

Interest is compensation to the lender for passage of time

If I borrow at 10 am and return at 1001 am, then possibly most lenders will not charge int
I borrow in 2011 and I return in 2021, hence interest is charged

Discounting is nothing but considering passage of time (time value of money)

As we are already discounting cash flows, we should not consider interest - otherwise we
counting

The rate of interest is extremely important but all gets captured in the rate of discountin

Cash flows are pre-interest, but discounting takes care of this

DEPRECIATION
Depreciation is not a cash outflow, it is a mere book entry
So depreciation is ignored in the computation of cash flows
However, depreciation becomes important for another purpose, viz tax
Tax laws allow you depreciation as an expense
So, if you can claim high depreciation, what will happen?
Your tax burden will reduce
Tax is a cash outflow or a book entry?
If tax were a book entry, Planet Earth will become Heaven
We will compute tax after considering depreciation benefits
However, the basic depreciation amount itself will be either ignored (if you have not ded
added back (if you have deducted it earlier)

Reality
With Int
EBIDTA 150
Depreciation 50
EBIT 100
Interest 20
PBT 80
Tax 30% 24
PAT 56

Cash flow in the above situation

Two ways of presenting the cash flow - both mean the same thing but start from differen
EBIDTA 150
Less : Interest -20
Less : Tax -24
Cash Flow 106

Presentation Two
PAT 56
Add back Depreciation 50
Cash Flow 106
Presentation Three
We just discussed that Interest should be ignored for capex evaluation
If you ignore interest, then we need a number to help us with cash profits

EBIT x (1-t) + Depreciation

EBIT 100
t (tax rate) 30%
1-t 70%
EBIT x (1-t) 70
Add Depreciation 50
Cash flow for capex decisions 120

This Rs 120 cr is not the real cash profit of the year

The real cash profit is Rs 106 cr

In capex evaluation, we are trying to discount cash flows

If you discount, you should ignore interest
This Rs 120 cr is trying to tell you that if you had not paid any interest, then your cash flo
Rs 120 cr

SUMMARY
1 We ignore interest bcoz we are discounting cash flows
2 We ignore depreciation bcoz there is no cash flow
3 We will consider taxes as an outflow and also consider the impact of depreciat

P&L - first sessions

Sales

Business journey, Sectoral journey

EBIDTA

Finance journey
PAT

Business Case
In the last Business Case, we will introduce the following:
1 The project cost is funded partly by banks and partly by promoters
Banks 75%
Promoters 25%

2 Interest rate charged by banks is

3 The bank loan will be repaid equally in the first

4 Tax rate in the country

We are going to integrate our earlier knowledge of Bal Sheet, P&L with the new knowledg

You are putting a new factory, cost of Rs 1

You will produce name plates
Cost of each name plate is Rs 100 Variable costs, Direct costs
Selling price is Rs 150
Annual fixed operating costs are Rs 20 lakhs
First year volume of business is 100,000 units

Volume will increase at 5% per annum

Selling prices will increase at 7% per annum
Costs will not increase, kept under control

Working capital (Current Assets - Inventories, Cash, Receivables minus Current Liab - Ven
Expense Payables, Provisions) is estimated to be 12%

This business will run for 10 years

At the end of ten year, I will quit the business and sell off the factory, which will fetch o
The working capital in the business (at that time) will be released (converted to Cash)
Assume cost of capital is 14% Will not affect your Bal Sheet, P&
Assume that appropriate depreciation has been provided for
Ignore interest, bank loans taken and repaid, income tax

Balance Sheet for each year Projections

P&L for each year Projections
We could assume for financial projections that the funds came from owners equity

Cost of Fixed Assets 10,000,000

Salvage value estimated 1,000,000
Depreciable value 9,000,000
Tenor 10
Depreciation per annum (SLM) 900,000

PROJECTED PROFIT & LOSS ACCOUNT

Year 1 2 3
Volume 100,000 105,000 110,250
Selling Price 150.00 160.50 171.74
Sales Revenue 15,000,000 16,852,500 18,933,784
Variable Cost per Unit 100.00 100.00 100.00
Variable Cost Rs 10,000,000 10,500,000 11,025,000
Fixed Costs 2,000,000 2,000,000 2,000,000
EBIDTA 3,000,000 4,352,500 5,908,784
Depreciation 900,000 900,000 900,000
EBIT 2,100,000 3,452,500 5,008,784
Interest 1,062,000 849,600 637,200
PBT 1,038,000 2,602,900 4,371,584
Tax 30% 311,400 780,870 1,311,475
PAT 726,600 1,822,030 3,060,109

PROJECTED BALANCE SHEET

Liabilities 0 1 2 3
Sh Capital 2,950,000 2,950,000 2,950,000 2,950,000
Reserves - 726,600 2,548,630 5,608,739
Bank Loans 8,850,000 7,080,000 5,310,000 3,540,000
Total Liab 11,800,000 10,756,600 10,808,630 12,098,739

Assets
Fixed Asse 10,000,000 9,100,000 8,200,000 7,300,000
Work Cap 1,800,000 2,022,300 2,272,054 2,552,653
Excess Cas - (365,700) 336,576 2,246,086
Total Asset 11,800,000 10,756,600 10,808,630 12,098,739

Excess Cash is the balancing number in the Bal Sheet

CASH FLOW STATEMENT - PERIODIC STATEMENT - FOR THE YEAR ENDED XYZ
Sources of Funds (Inflows)
Owners Equ 2,950,000 - - -
Bank Loan 8,850,000
Cash Profit - 1,626,600 2,722,030 3,960,109
Fixed Asset - - - -
Working Ca - - - -
Total 11,800,000 1,626,600 2,722,030 3,960,109

Application of Funds (Outflows)

Fixed Asse 10,000,000 - - -
WorkCap 1,800,000 222,300 249,754 280,599
Bank Loan - 1,770,000 1,770,000 1,770,000

Total 11,800,000 1,992,300 2,019,754 2,050,599

Surplus - (365,700) 702,276 1,909,510

Open Bal - - (365,700) 336,576
Cl Bal - (365,700) 336,576 2,246,086

Difference in Cash Bal - - -

- Sum of the difference

Cash Profits = PAT + Depreciation added back

Bank Loan Amortization Schedule
Op Bal 8,850,000 8,850,000 7,080,000 5,310,000
Repay 0 1,770,000 1,770,000 1,770,000
Cl Bal 8,850,000 7,080,000 5,310,000 3,540,000
Tenor 5 years
Int Rate 12%
Interest 1,062,000 849,600 637,200

Capital expenditure evaluation is based on CASH FLOWS, not profits, not reserves, not EB
Cash Profit should be : EBIT x (1-t) Plus Depreciation

Year 0 1 2 3
Capex FA (10,000,000)
Work Cap (1,800,000) (222,300) (249,754) (280,599)
EBITx(1-t) 1,470,000 2,416,750 3,506,149
Add : Depn 900,000 900,000 900,000

Sale of FA
Release of Work Cap
Total (11,800,000) 2,147,700 3,066,996 4,125,550

PV Factor 1.000 0.877 0.769 0.675

DCF (11,800,000) 1,883,947 2,359,954 2,784,629

NPV 25,032,192

The reduction in the NPV is attributable to tax costs in this version (as compared to zero
version)
Cash means cash balance (cash on hand), bank balances, securities which are convertible
notice, cash equivalents (mutual funds, bonds, liquid instruments)

In the accounts, bank balances can go negative

You pay your vendors on Friday evening - best practice
Why Friday evening?
He will deposit on Saturday and Sunday is a holiday - 3 days you have extracted from the
If you have a positive balance, may be it can earn some interest for 3 days
If you have a negative balance, then you can deposit something on Monday morning
A negative bank balance in your books is sometimes called as a Book Overdraft

DEPRECIATION IN YOUR PERSONAL LIFE

Your salary income is Rs 15 lakhs
You bott a car for Rs 8 lakhs (life 5 years)
Depn per annum is Rs 1.60 lakhs
If depreciation were allowed as an expense for you (unfortunately not the case), what wo
income be?
Salary 15.00
Less : Depreciation 1.60
Taxable Income 13.40

This is not allowed as per tax law

However, if you are running your business and your profit is say Rs 15 lakhs (before depre
we will allow depn as a tax deductible expense

Business profits before depreciation 15.00

Less : Depreciation 1.60
Taxable Income 13.40

The businessman is using his car to further his business profits, while the salaried employ
earned the same salary even if he had no car

COST OF CAPITAL
If your business needs Rs 100, of which the bank is ready to fund Rs 75 and the bank will
what is your cost of capital?

One thought could be:

75 12% 9
25 0% 0
100 9% 9

Many new entrepreneurs think this way

But this is very wrong

Not a penny is free, every penny costs you something

Some times you pay in a tangible manner
Sometimes you don’t pay anything, but there is still a cost attached to it
Nothing is free

What is the cost of EQUITY? Is it zero?

Answer - No it is not zero
Had you not invested in this business venture and done something else with it, what woul
Opportunity cost

Capital

Debt
Banks, Fin Inst

COST OF DEBT
Primarily Interest 12.00%
Some bank charges
Stamp duties for executing documents
Mortgage deeds 0.50%
Bank processing charges, guarantees 0.50%
Pre tax cost of debt 13.00%

When you charge interest in your P&L as an expense, the profit will reduce
So your tax also redcues

If your tax rate is say 30%

Your tax benefit on interest is 3.90%

Your post tax cost of interest is 9.10%

As a businessman, all interest is tax deductible (on all business loans)

As an individual, only home loan interest is tax deductible (other loans are generally not
other education)

If you don’t pay any tax, then your cost of debt is 13.00%
How come you don’t pay tax
1 Loss making company
2 SEZ units
3 Infrastructure units
4 Mauritius

COST OF EQUITY
Cost of equity cannot be seen in the P&L - it is not tangible
We don’t pay our shareholders anything as an obligation - there is no obligation to pay
We may sometimes distribute dividends, but that is not a cost - that is sharing of profits,
discretionary, no compulsion, it may depend on various factors - even if I make fantastic
I need cash for expansion, I may declare zero dividend

What is the cost of equity

Many years and many decades passed before humanity could find an answer
Most people were looking at the P&L for this cost

Prof William Sharpe, Stanford University came up with an answer, for which he won the N
CAPM Model - Capital Asset Pricing Model

Don’t look at the P&L

Look at the psychology of the investor
Ask him - why are you investing in this company's equity
Why not elsewhere

First of all, every country has some risk free instruments and any investor can always inve
In India, we have the PPF, Post Office Deposits, Govt Securities - risk free
India current yield on Govt Securities is 8%

If I can buy G Securities why should I buy your shares

Bcoz I think that you can generate higher returns

Greed - the basic philosophy of all investing is greed

How much more do you want

So if you get 9% instead of 8%, are you okay to invest in this company's shares?

In every country, there will be a long term rate of return from the equity market and a lo
of return from the G Sec market (long term here means 25 years, 30 years)

Equity market means the index of the country - India - Sensex, Nifty

India
If your long term G Sec yield has been 8.00%
Long term Sensex returns have been 15.50%

This tells you that investors are happy with an incremental return of

Equity is high risk and higher risk requires a higher return to compensate for that higher r

All this is generic equity (Sensex)

But your company is not the Sensex
You company is XYZ
How much return should I expect for investing in your company?

Prof William Sharpe said - we should map the risk of your company vis-à-vis that of the Se
Let the Sensex risk be 1.000
Then what is your company risk
If that risk is say 1.570

Then, he said that investors will demand more return from you (as compared to Sensex)
HUL HUL DLF
Risk free rate 8.00%
Equity risk premium (Sense 7.50% 7.50%
Relative risk factor 0.85 6.38% 2.85
Cost of equity for your company 14.38%

What is risk?
Risk is variability of return
If you invest in the Post Office, you will get 8%, 8%, 8%, 8%, 8%, 8% and your Rs 100 back
What is the variability in your returns?
Zero variability
Zero variability means RISK FREE (zero risk)

Your friend comes back from Dubai after 17 years

He says I have a great project idea and why don’t you become my partner
What idea
Smuggling
What is your first question?
What is the rate of return?
9% Are you interested? No
He clarifies 9% per month
Are you interested?
Which product? Which port? Who will be caught if caught? Will my name appear in docum

What is the variability in your returns?

One year - fantastic 108%
Next year - caught - jail
Third year - 300%

If the relative risk factor is 3.00, that company or that sector would have enormous varia
year on year
DLF, Unitech, DB Realty - huge volatility of earnings

If your risk factor is 0.85, your earnings are very steady, maybe growing
Government employees at personal level
HUL, Nestle, Marico, Colgate

We are DLF

Capital

Debt
Banks, Fin Inst
9.10%

How much of my capital is coming from debt and how much from equity (mix)
Mix Cost WACC
Debt 40% 9.10% 3.64%
Equity 60% 29.38% 17.63%
100% 21.27%

WACC - Weighted Average Cost of Capital

I should take up only those projects that will beat the WACC of

This WACC becomes your discounting rate in your capex evaluation

Also called as Hurdle Rate, Threshold Rate, Min IRR Rate, Discounting Rate, WACC - you n
to beat this Rate
Only then will your NPV be positive and IRR be higher than the WACC

RELATIVE RISK FACTOR

Known as "beta" in the stock markets
Beta compares the daily return on your stock vis-à-vis the daily return on the Sensex

Sensex day 17624 Your company share price yday

Sensex today 17675 Today
Change in the Sensex 51
% change (daily return) 0.29%

If you draw up this daily return for the Sensex and your company for the past two years a
the line of least squares between them, the slope of that line is called as the "beta"

Beta is published by the exchanges and you can have free access

There are 10,035 problems with the beta, which we can spend time debating - but not m
of that discussion
Many experts have fought with the CAPM model and have criticized it so much over the la
But none of them have come with an alternative popular models
The alternatives are fraught with more controversy

There are 6,000 plus stocks in the country

But hardly 1,800 of them trade every day
The top 50 will contribute to 97% of the trading volumes of the country
So, the share prices of most small stocks are unreliable and so is their "beta"
Conceptually, beta assumes a liquid market
Absence of a liquid market will affect beta accuracy

17624 2.5
17675 2.5
17783 2.5
17501 2.5
No trade

WHAT TO DO IF BETA IS NOT AVAILABLE

Cost of Equity = Risk Free Rate + (Generic Equity Risk Premium x Beta)
In many cases, beta is not available
1 Unlisted entity
2 Listed but not actively traded

Beta was suggested by Prof William Sharpe as a measure of "risk"

He was trying to quantify something that was thought to be very difficult to quantify
If you are not listed, but your competitors, your industry is listed, then you use the indus
measure of your beta

You are ABC Real Estate Ltd, unlisted

But you have DLF, Sobha Developers and 20 others who are listed
It is quite likely that your risk profile is similar to theirs
Their average beta is your beta

Whom should you include in your definition of industry is difficult to answer - controversi

You could say DLF is not like me - DLF is 100 times larger
DB Realty is not me - my director is out of jail
South India Real Estate is very different from Western India - I will exclude Mumbai based
I build residential apartments and therefore will exclude heavy commercial builders

Sectoral beta becomes your starting point of beta

Adjustments to beta for specific factors
1 Debt
High debt means high risk means high beta
If the industry debt equity is 1:1 and your debt equity is 1.5:1
you should have a higher beta than industry beta

There is a clear methodology on how beta should be adjusted

Levered beta and unlevered beta

2 Size
A smaller company is a riskier entity
Infra is hit badly
But IVRCL is hit more badly than L&T
So if industry beta is 1.31 and your size is one tenth of the size
industry player, then experts will make your beta 1.81 instead

In India, we don’t have scientific adjustments for size

In the US, there are agencies which publish beta for various se
provide guidance for size related adjustments
 Ibbotsons is a leader in this business of computing beta and em
additions for size
Ibbotsons has been taken over by MorningStar

If you are in an industry where there is no other company, all other companies are all unl
stage entities, then what is your beta

Your company is planning to take people to the moon for their summer vacation
PE firms start from 40%, 35% as the Cost of Equity in such cases
The final number of Cost of Equity is heavily negotiated rather than computed

RISK
Risk is defined as variability of return
If return is defined as some form of profit (for this limited discussion) and we try and mea
variation in relation to variation in sales, that measurement provides some understanding
This is called impact of "leverage"

In engineer, the term "lever" stands for what?

For a small amount of effort, the movement is a multiplier impact

Original Revised Leverage

Volume growth 10.00%
Sales 100.00 110.00 10.00%
Variable Costs 52.00 57.20
Contribution 48.00 52.80
Fixed Costs 23.00 23.00
EBIT 25.00 29.80 19.20%
Interest 7.00 7.00
PBT 18.00 22.80
Tax 30% 5.40 6.84
PAT 12.60 15.96 26.67%

When can my entire profits be wiped out?

Operating Leverage = % Change in EBIT

% Change in Sales
 A 1% change in Sales will produce a 1.92% change in EBIT

Financial Leverage = % Change in PAT

% Change in EBIT

A 1% change in EBIT will produce a 1.39% change in PAT

Total Leverage = % Change in PAT

% Change in Sales

Total Leverage = Operating Leverage x Financial Leverage

A 1% change in Sales will produce a 2.67% change in PAT

1 Whether a higher leverage is good or bad

2 What makes the leverage high or low

Higher leverage means higher risk - in what sense - more volatility of your earnings and if
entity, this will lead to higher "beta" in the marketplace

A higher fixed cost will necessarily increase leverage

High fixed cost means high risk - you have to pay for fixed costs whether you make money
Fixed costs (both in personal and business life) is like a stone on your neck
Heavier the stone more difficult our life

What is the benefit of outsourcing?

I have 5,000 people working for me in California
Now I transfer them to Bangalore and I pay per hour, per call, per seat, per transaction, p
It that something does not happen (decrease in volume), I wont pay
What have I done?
I have converted my fixed costs into a variable cost

Nike has no factories

What is the benefit?
No fixed costs

If you set up a large factory, fixed costs will be high

If you set up a large office, call center types, fixed costs will be high
If you go for latest expensive technologies, fixed costs will be high
If you set up a call center in Chennai compared to Salem, fixed costs will be high

Financial Leverage
Interest is a fixed costs in most cases
Interest depends on what
Depends on how much debt you have in your capital structure
High debt - means high interest - means high financial fixed costs - means high financial l
- high beta if you are listed

Operating Leverage structuring and Financial Leverage structuring are independent decisi
theory)

If you have tons of your own money (equity), you may be able to afford a call center in C
somebody else who has very little of own equity

If you already are sitting or plan to sit on a high operating leverage, please don’t compou
by adding financial leverage to that entity

If you don’t have much of your own funds, then please please reduce your operating leve

Overall, we believe that a total levarage of more than 3 is dangerous

Very crude benchmark
3 times means your entire profits will be wiped out if sales drop by 33%

If your operating leverage is say 2, then how much financial leverage can you afford?
1.5 you are okay
x decisions

dvantageous to prepay

tax free

t lenders will not charge interest

alue of money)
der interest - otherwise we will be double

ed in the rate of discounting

e, viz tax

gnored (if you have not deducted it earlier) or

Hypothesis
W/o Int
150
50
100
0
100
30
70

hing but start from different points

150
0
-30 Text Book A page 156
120

70
50 Text B page 307
120
aluation
cash profits

This method of presentation is more

common in capex evaluation models

interest, then your cash flow would have been

der the impact of depreciation on taxes

ctoral journey

Depreciation, Interest and Taxes

ly by promoters

12%

5 years

30%

P&L with the new knowledge of NPV, IRR

cr 10,000,000

ble costs, Direct costs

100,000

es minus Current Liab - Vendor Payables,

of coming year Sales

factory, which will fetch only Rs 10 lakhs

ased (converted to Cash)
ot affect your Bal Sheet, P&L - only for capex decision

114%

e from owners equity

4 5 6 7 8
115,763 121,551 127,628 134,010 140,710
183.76 196.62 210.38 225.11 240.87
21,272,106 23,899,211 26,850,764 30,166,833 33,892,437
100.00 100.00 100.00 100.00 100.00
11,576,250 12,155,063 12,762,816 13,400,956 14,071,004
2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
7,695,856 9,744,149 12,087,948 14,765,877 17,821,433
900,000 900,000 900,000 900,000 900,000
6,795,856 8,844,149 11,187,948 13,865,877 16,921,433
424,800 212,400 - - -
6,371,056 8,631,749 11,187,948 13,865,877 16,921,433
1,911,317 2,589,525 3,356,384 4,159,763 5,076,430
4,459,739 6,042,224 7,831,564 9,706,114 11,845,003

4 5 6 7 8
2,950,000 2,950,000 2,950,000 2,950,000 2,950,000
10,068,478 16,110,702 23,942,266 33,648,379 45,493,382
 1,770,000 - - - -
14,788,478 19,060,702 26,892,266 36,598,379 48,443,382

6,400,000 5,500,000 4,600,000 3,700,000 2,800,000

2,867,905 3,222,092 3,620,020 4,067,092 4,569,378
5,520,573 10,338,610 18,672,246 28,831,287 41,074,004
14,788,478 19,060,702 26,892,266 36,598,379 48,443,382

YEAR ENDED XYZ

- - - - -

5,359,739 6,942,224 8,731,564 10,606,114 12,745,003

- - - - -
- - - - -
5,359,739 6,942,224 8,731,564 10,606,114 12,745,003

- - - - -
315,253 354,186 397,928 447,072 502,286
1,770,000 1,770,000 - - -

2,085,253 2,124,186 397,928 447,072 502,286

3,274,487 4,818,038 8,333,635 10,159,041 12,242,717

2,246,086 5,520,573 10,338,610 18,672,246 28,831,287
5,520,573 10,338,610 18,672,246 28,831,287 41,074,004

- - - - -
 3,540,000 1,770,000
1,770,000 1,770,000
1,770,000 -

424,800 212,400

profits, not reserves, not EBIDTA, not EBIT

4 5 6 7 8

(315,253) (354,186) (397,928) (447,072) (502,286)

4,757,099 6,190,904 7,831,564 9,706,114 11,845,003
900,000 900,000 900,000 900,000 900,000

5,341,847 6,736,718 8,333,635 10,159,041 12,242,717

0.592 0.519 0.456 0.400 0.351

3,162,802 3,498,840 3,796,692 4,059,932 4,291,795

rsion (as compared to zero tax in the earlier

rities which are convertible to cash at short

ou have extracted from the system

st for 3 days
ng on Monday morning
a Book Overdraft

tely not the case), what would your taxable

y Rs 15 lakhs (before depreciation), Govt says

, while the salaried employee would have

nd Rs 75 and the bank will charge 12% interest,

ached to it

hing else with it, what would you have earned?

Equity
Owners, Shareholders
 Before considering tax benefits of interest

it will reduce

Pre tax Interest x (1-t)

her loans are generally not tax deductible

re is no obligation to pay
- that is sharing of profits, that is
ors - even if I make fantastic profits but

ind an answer

wer, for which he won the Nobel Prize

any investor can always invest here
es - risk free
8.50%

ompany's shares?

the equity market and a long term rate

ars, 30 years)

7.50%

ompensate for that higher risk

pany vis-à-vis that of the Sensex (relative risk)

u (as compared to Sensex)
DLF Sensex Sensex
8.00% 8.00%
7.50%
21.38% 1.00 7.50%
29.38% 15.50%

%, 8% and your Rs 100 back

my partner

my name appear in documents?

would have enormous variation in earnings

e growing

Equity
Owners, Shareholders
29.38%

om equity (mix)

21.27%

ounting Rate, WACC - you need as a Manager,

y return on the Sensex

price yday 203.45

 204.65
1.2
0.59%

any for the past two years and work out

is called as the "beta"

d time debating - but not much will come out

cized it so much over the last 30 years

e country
is their "beta"

m x Beta)

ery difficult to quantify

ted, then you use the industry beta as the

cult to answer - controversial

will exclude Mumbai based companies

y commercial builders

nd your debt equity is 1.5:1, that means

industry beta

w beta should be adjusted for debt

size is one tenth of the size of the average

make your beta 1.81 instead of 1.31

djustments for size

h publish beta for various sectors and also
djustments
ss of computing beta and empirically suggesting

MorningStar

other companies are all unlisted and early

r summer vacation

r than computed

cussion) and we try and measure profit

rovides some understanding of risk

Operating Leverage

Financial Leverage

19.20% 1.92 times

10.00%
 1.92% change in EBIT

26.67% 1.39 times

19.20%

1.39% change in PAT

26.67% 2.67 times

10.00%

2.67 times

2.67% change in PAT

ility of your earnings and if you are a listed

ts whether you make money or not

on your neck

per seat, per transaction, per something

d costs will be high

osts - means high financial leverage - high risk

ring are independent decisions (in simplistic

to afford a call center in Chennai more than

erage, please don’t compound your problems

reduce your operating leverage

op by 33%

verage can you afford?

 9 10 Growth 1+x
147,746 155,133 5% 105%
257.73 275.77 7% 107%
38,078,153 42,780,805
100.00 100.00 0% 100%
14,774,554 15,513,282
2,000,000 2,000,000 0% 100%
21,303,598 25,267,523
900,000 900,000
20,403,598 24,367,523
- -
20,403,598 24,367,523
6,121,080 7,310,257
14,282,519 17,057,266

9 10
2,950,000 2,950,000
59,775,901 76,833,167
 - -
62,725,901 79,783,167

1,900,000 - ### Asset book value

5,133,697 - ### Sold for the same amount and enh
55,692,204 79,783,167 - No profit no loss on sale
62,725,901 79,783,167

- -

15,182,519 17,957,266
- 1,000,000
- 5,133,697
15,182,519 24,090,962

- -
564,318 -
- -

564,318 -

14,618,201 24,090,962
41,074,004 55,692,204
55,692,204 79,783,167

- -
 9 10

(564,318) -
14,282,519 17,057,266
900,000 900,000

1000000
5133696.5702755
14,618,201 24,090,962

0.308 0.270
4,495,213 6,498,388
same amount and enhanced cash
loss on sale
FINANCE - QUESTION PAPER - JAN 2012
TIME - ONE HOUR, LAPTOP ALLOWED

Question One
Company X Ltd figures are as under:
Year ending March 31 Mar-11 Dec-11 Mar-12
Rs cr
Profit After Tax 150 158 175
Share Capital 50 60 60
Face value per share (Rs) 10 10 10
Market price per Share as at Jan 7, 2012 - Rs 304

What is its trailing EPS

What is its forward EPS
What is the trailing PE
What is the forward PE

Question Two
Company Y relevant figures for the year ended March 31, 2011 are as under:
Rs cr
Profit After Tax 250
Share Capital 100
Face value per Share (Rs) 5
Market price per Share (Rs) 278

If it declares a dividend of Rs 12 per share, what are the following:

Dividend %
Dividend Payout
Dividend Yield

Question Three
Your friend has taken a loan of Rs xx from you. He will pay you back Rs 5 lakhs
after 3 years, Rs 2 lakhs after 4 years and Rs 2 lakhs after 5 years. Your rate
of interest on this deal is 12%.
What is the amount you have lent him today?

Question Four
In your insurance policy, you pay an annual premium of Rs 12,700 for 20 years
You get back Rs 4,50,000 after 20 years. What is your rate of return?

Question Five
You are setting up a new project and this project will cost you Rs 10 cr
You will lose Rs 1 cr in year one, earn Rs 2 cr per annum in year two and then Rs 4 cr per
for the next five years
End of this perid, you will exit the business and realize Rs 3 cr
Your cost of capital is 15%

Evaluate the project using payback period, NPV and IRR

Provide your recommendations on the project

Question Six

Your borrowing rate is 12.50%. You pay tax at 22% on your profits.
Risk free rate of interest in the economy is 8.50%. Incremental return on equity demande
by investors is 8%. Your company beta is 1.31.
Your debt equity mix is 40:60
What is your cost of debt
What is your cost of equity
What is the weighted average cost of capital
 12 marks

as under:

9 Marks

6 marks
ck Rs 5 lakhs
Your rate
 6 marks
for 20 years

15 marks

wo and then Rs 4 cr per annum

12 marks

urn on equity demanded

 1 Refresh of WACC
2 Refresh of the Cash Flow Statement

1 Incorporation of risk in the capital budgeting process

NPV, IRR, Payback
2 Equity versus Project
Is the project profitable? Is your child doing well?
Will the owners be happy? Are you happy about that ?
3 Bonds - what are bonds, how are they valued?
4 Very simple options on bonds

5 DuPont Analysis

WACC
Capital comes from two sources - Debt and Equity
Debt is cheaper (prima facie)
Why
He (the lender) does not demand a share of your profit
He is happy with a fixed return (interest)

In comparison our equity partner is very demanding

He says company earned Rs 1,000 cr - I am 50% partner, so give me Rs 500 cr
Of course, if the company makes losses, he keeps quiet

The second reason why debt is cheap is that interest is tax deductible
If I pay interest, it becomes an expense for tax purposes
So I save tax by having such an interest expense

WACC

Debt
Cost

Average

Cost of Debt
Your interest rate is say 11.00% Reliance Industries Deb
Your tax rate is say 28%
You are profitable
Tax benefit on interest 3.08%
Your post tax cost of debt 7.92%

If on your home loan you are paying 11% interest and your tax slab falls in the 30% rang
cost is not 11%
It is only 7.7%

Some people think that the home loan is very expensive and we should repay
Bcoz they look at 11%
They are wrong
They should look at 7.7%

Total Interest is Rs 225000 150000 75000

Tax benefit 30% 45000 45000 0
20%

Your HDFC rate is 11.00%

Tax benefit is 2.20%
Your post tax cost of debt 8.80%

Cost of debt = Pre tax cost x (1-t) where t is the tax rate

Company is loss making

Your interest rate is say 11.00%
Your tax rate is say 28%
You are not profitable
Tax benefit on interest 0.00%
Your post tax cost of debt 11.00%

Your company is an SEZ Unit where no tax is applicable

Your interest rate is say 11.00%
Your tax rate is say 28%
You are not profitable
Tax benefit on interest 0.00%
Your post tax cost of debt 11.00%

Cost of Equity
Your shareholders cannot demand anything (like a fixed rate of interest)
If you are profitable, they are happy - bcoz the share price will go up - even if you don
How will shareholders think about investing in your shares / equity ?
Why should a shareholder buy your shares ? What is his expectation from you ?

Thinking is very psychological - half finance, half psychology

What is the risk free interest in the country - he could have invested in those securitie
G Sec 10 year bond 8.52% lets say

But your equity carries tons of risk while that G Sec is risk free
So what?

He will demand a risk premium from you - he will expect a higher rate of return

Generic Equity Risk Premium - for any investment in a model portfolio (Sensex, Nifty, s

Sensex is made up of 30 leading stocks in the country

Nifty is made up of 50 leading stocks in the country

Let us suppose that this risk premium demanded by rational investors today is 8%

Rational investors will demand a total return of 16.52% return for investing in the Sens

If they don’t see a return of 16.52%, they will not be interested in equity

Sensex BSE Index

Nifty NSE Index
Both exchanges compete with each other
Out of the 30 in the Sensex most of the time 27 to 30 will also be part of the Nifty (ver

In reality, Sensex and Nifty move very very closely with other each other
If in a month, Nifty appreciates 10.31%, Sensex will appreciate 10.32%

The absolute numbers are very different

Today Sensex is at 16,000 and Nifty is at 5,000

Your company is not the Sensex / Nifty

Your company is XYZ company

The investor will ask : what is the risk in your company relative to Sensex

If we denominate Sensex risk as 1.00, then what is your risk?

Let us say your risk is seen to be 1.41 (beta)
You are more risky than the Sensex
Investor will demand a higher return from you
How much higher return?

G Sec + (Equity Risk Premium x Beta)

8.52% 8% 1.41

Cost of Equity 19.8%

He will expect a min return of 19.80% on his investment in equity in your company

If some other company beta was 0.81, what does that mean
It is less risky than the Sensex

Humanity needs benchmarks - for any relative discussion a benchmark is essential

In my SSC I got 81%
If the max marks that anyone could have got be assumed to be 100, then what I got is
What is the benchmark here?
100 is the benchmark

We use 100, we use "x", we use 1.00, we use "light years"

My age is 35 years
Why years
Convention understood by humanity

Investing in Sensex means investing in all 30 stocks in the same proportion in which the
Then you would be happy with 16.52% return

WACC

Debt
Cost
7.92%
Average
Weighted

WACC Mix Cost WACC

Debt 42% 7.92% 3.33%
Equity 58% 19.8% 11.48%
14.81%

If I don’t earn Rs 14.81 on every Rs 100 given to me by society (lenders + shareholders

then they will punish me
The min return, the IRR, the hurdle rate is 14.81%
If I don’t earn even 14.81% over the long run, then I don’t deserve to exist in business

World is changing every day

The WACC may keep changing - dynamic concept
In reality, we don’t change the hurdle every day - we build in a buffer

So, if the computed WACC is 14.81%, I will ask my units to bear a cost of 16% (buffer is

In my P&L, interest is an expense

Dividend that I pay to shareholders is not an expense - not tax deductible - no tax bene

In your own life, the interest you pay to HDFC is tax deductible
But the electricity bill is not tax deductible

DuPont Analysis
DuPont is one of those rare entities which has survived more than 100 years in this wor
P&G - 180 years, Dun & Bradstreet - 180 years
Financial analysis, costing, financial reporting - these disciplines got their shape in the
After the 1st world war, US was in great shape
1920s are called as the roaring twenties - huge wealth, sudden wealth, huge inequity i

In India, a cream of the population is enjoying a great time

Bulk of the people are still in poverty

DuPont said don’t calculate 100s of financial ratios for the mere purpose of calculation
Be clear - what are you going to do with these ratios
If you have too much info, that is misleading - have focussed information

Richard Collins - Built to Last, Good to Great

Lets look at the best performing companies over the last 30 years
Lets see if we can learn from them
He defined best performing as those which have generated maximum shareholder retu

Walgreens - pharma retail company

They focus on one single financial ratio - profit per store

Way back in the 1920s, DuPont did the same thing

They said - focus on one ratio - RoE - Return on Equity
The shareholder invests in you so that you earn for him a high return on his equity

RoE = PAT Net Worth means Share Capital + Reserves (Shareholde

RoNW = Net Worth

RoE = PAT = PAT x Sales x

Net Worth Sales Cap Emp
Margins Efficiency

Capital Employed = Net Worth + Debt

Sales 100
Capital Employed 40 Equity + Debt
Debt 15
Equity (Net Worth) 25
PAT 7
RoE = 7 = 7 x 100 x
25 100 40
Margins Efficiency

28% = 7% x 2.5 x
times

Shareholders are a very demanding community

They want higher RoE - 28% is good, but they want more
How do I increase my RoE
Can I make it 31% - how ? What to do ?

Some ideas will increase margins Will depress efficiency, solvency

Some ideas will increase efficiency Will depress margins
Some ideas will increase solvency number
So these will increase RoE - or will they?

A bright idea - lets increase selling prices which will improve margins, depress efficien
solvency unchanged - lets see what happens

27% = 8% x 2.1 x
times

Not a very bright idea - the RoE is being depressed

Another idea
Let us reduce selling prices, increase volumes, more movement, more efficiency

33% = 6.5% x 3.2 x

times

Fine, lets go ahead

DuPont insight into quality of earnings

How strong are the earnings
How vulnerable
How stable, how volatile
If some tsunami comes along, will you die or survive (compared to others)

RoE Margins EfficiencySolvency

A 30.0% 10% 3.00 1.00
B 30.0% 5% 4.50 1.33
C 30.0% 2% 4.00 3.75
D 30.0% 1% 5.00 6.00 Over ambitious entrepreneurs - ov
AKAI, AIWA

How would you rank them ?

A Margins are excellent, so they have some strength - great brand, great prici
technology, some people, locational advantage, Govt policy, vintage, age
A great strength on margins - has it made them a little slow, lazy, complace

Corporate aristocracy

Solvency - zero debt company

Very conservative in borrowing
Old rich

A great idea which can earn 16% return - he will propose we do this for USD
His boss will think and think - and allow him to do for USD 30 mio - 30 days

Reliance - same idea USD 300 mio

Senior most people - call him in 30 minutes
Are you convinced
Yes
So why not do this for USD 3,000 mio - why USD 300 mio

B What it loses on margins, it makes up on efficiency

Quite low debt
Bright boy on the horizon - running fast, enthusiastic - stiff competitor for C

C Very low margin compared to A

Not so efficent as B
Making money on money - by borrowing heavily
Making money on a business with thin margins is not a reliable source of ma
D Bad product - cant sell without heavy discounts - no strength in the business
Super efficient
Is super efficiency good or bad ??
Super efficiency to make up for margin deficiency - is highly dangerous
Super efficiency has a tendency to break down

I want my aircraft to run 6 times a day

Other airlines run 4 times a day
So I compromise on maintenance, checking, etc etc

Super efficiency means

1 My customer will pay me at 10 am in the morning
2 I will deposit high value cheque at 1015 am
3 This will be credited in my account at 1130 am (I know the bank)
4 I will pay my excise duty at 1145 am
5 My consignment will be cleared at 1230
6 It will reach the customer at 230
7 This customer pays on delivery at 245
8 I will deposit this cheque at 330 and get credit by 430
9 I need to pay wages at 530 today evening

Very dangerous
If one link breaks, then the whole wheel is jammed
Transport strike
Bank strike
Customs strike

Olympic runner - winner of the Gold medal 100 meter race

Great fellow

He wants to go to his office from his house

He starts running on the road as if it were the Olympics
What will happen
Very risky

Efficiency is like haemoglobin

Normal range 10 to 14
8 is a problem
18 is also a problem
 Very high efficiency with borrowed funds is very very high risk
Company is very vulnerable to macro factors and can collapse any moment

Suddenly, India is flooded by Chine

All companies are forced to reduce
margins by 2%
RoE Margins EfficiencySolvency RoE Margins
A 30.0% 10% 3.00 1.00 24.0% 8%
B 30.0% 5% 4.50 1.33 18.0% 3%
C 30.0% 2% 4.00 3.75 0.0% 0%
D 30.0% 1% 5.00 6.00 -30.0% -1%

If money is available easily, that is a major curse (not a blessing)

Outliers - Gladwell
One good book a month - must

Key Ratios
Banking sector - profit per branch, profit per employee
Hotel sector - Average Room Rent (per day)
Telecom sector - Average Revenue per User (ARPU)
Cement sector - EBIDTA per Ton
Hospital sector - Average Revenue per Bed (per day)
Walgreens - profit per store
Retail sector - Gross Margin Return on Inventory (GMROI), Gross Margin per Sq Ft

Bonds - what are bonds, how are they valued?

You are a mfg company and you avail of a loan from SBI of Rs 25 cr
This is a private transactions between you and SBI
When you return the loan you will return to SBI

Alternatively, you could issue bonds of Rs 25 cr to whosoever subscribes to these bonds

You got your Rs 25 cr and it is a loan (debt)
A bond is a debt instrument
But who is the lender? Not one bank - many entities (banks, financial institutions, reta
Govt companies, foreignors, mutual funds, insurance companies)

These bonds will thereafter be traded in the bond market

So, ICICI Prudential subscribed to Rs 2 cr of your bonds
Then they sold these bonds to Reliance Mutual Funds for Rs 2.01 cr after 7 days
Reliance is the holder of the bonds

The bonds have a tenor of 7 years

In 7 years, they were bott and sold 73 times
After 7 years, one market participant will come to you and ask for redemption and you

In bonds, a market develops

Issue Price 100

Redemption Price 100
Tenor 7 years
Coupon 8%
Payable frequency - once a year

On day one, Tata Power issues bonds of Rs 25 cr (25 lakh bonds of Rs 100 each)
Many entities subscribe to these bonds

The coupon is paid to the holder of the bond on the date of the coupon
If the bond issue happened on Jan 21, 2012, then the coupon will be paid to the holder

Bond market has not developed

There is a reasonable G Sec market but the only players are institutions
The Indian public is quite unaware of this instrument

Mutual funds are major players in the fixed income market

 Reliance
Dhirubhai Ambani

me Rs 500 cr

Equity
Cost
eliance Industries Debt Rs 74,000 cr

b falls in the 30% range, then your interest

hould repay
o up - even if you don’t pay them anything

on from you ?

ted in those securities

r rate of return

tfolio (Sensex, Nifty, some benchmark index)

stors today is 8%

r investing in the Sensex / Nifty

part of the Nifty (very high overlap)

o Sensex

in your company

mark is essential

00, then what I got is 81

roportion in which they form the Sensex

 Equity
Cost
19.8%

enders + shareholders together),

e to exist in business (Kingfisher)

cost of 16% (buffer is 1.19%)

ductible - no tax benefits

n 100 years in this world

got their shape in the 1920s

ealth, huge inequity in distribution

purpose of calculation

mum shareholder return over 30 years

urn on his equity

Reserves (Shareholders Funds)

Cap Emp
Net Worth
Solvency
 40
25
Solvency

1.6 = 28%
times

efficiency, solvency

gins, depress efficiency and leave

1.6
times

more efficiency

1.6
times
o others)

ous entrepreneurs - over greedy - Alexanders

eat brand, great pricing power, some

policy, vintage, age
slow, lazy, complacent ? Appears so

se we do this for USD 300 mio

USD 30 mio - 30 days

stiff competitor for Company A

reliable source of making money

rength in the business itself

highly dangerous

am (I know the bank)

dit by 430
collapse any moment

dia is flooded by Chinese products in this sector

s are forced to reduce their prices affecting

Efficiency Solvency
3.00 1.00 Most safe
4.50 1.33
4.00 3.75
5.00 6.00 Most risky

Margin per Sq Ft

scribes to these bonds

 cial institutions, retail, other corporates,

cr after 7 days

or redemption and you will happily pay him

f Rs 100 each)

be paid to the holders on Jan 20, 2013

BONDS
Tata Power issues bonds of Rs 25 cr
Rs Rs
Issue Price 100 100
Redemption Price 100 105
Tenor 7 years 7
Coupon 8% 8%
Payable frequency - once a year

If the bonds are issued on Jan 22, 2012, the interest coupons may be paid on each Jan
7 years
Whosoever holds these bonds on Jan 21st will get full year interest

So, if you bott these bonds on Jan 17, 2014, in all fairness, you should get interest for
will, in fact, get interest for one full year

Dividends are paid on a certain record date

As of that date, whosever is the owner of those shares gets the dividend

We know that Diwali comes sometime in Oct / Nov

We may forecast that this company pays dividends sometime in Sept / Oct
An AGM is a must once a year - dividends are declared at the AGM and paid within 42 d

Dividend of Rs 2 on a share
Price today is Rs 31 (cum-div)
On the day after record day, what will happen?
Price will be Rs 29 (ex-div)

Why is the term "coupon" used? What is wrong with the term "interest"? Why introduce

Accrued interest challenge

Interest accrues on the bond every day (at the rate of 8% per annum)

0 100.00 8%
1 0.022
2 0.044 If you buy the bond after 52 days, you will pay the sell
3 0.066 itself plus Rs 1.140 towards accrued inter
 4 0.088 Suppose for simplicity, the price of the bond itself is R
5 0.110 will pay a total of Rs 103.140
6 0.132
7 0.153 Clean price 102.000
8 0.175 Interest accrual 1.140
9 0.197 Dirty price 103.140
10 0.219
11 0.241 If you buy the bond on Jan 17, Tata Power will pay you
12 0.263 on Jan 21 (but you don’t deserve to get one year inter
13 0.285 only 4 days interest)
14 0.307
15 0.329 You will pay the counterparty 361 days interest
16 0.351 Tata Power will pay you 365 days intrerest
17 0.373 Net net you got 4 days interest
18 0.395
19 0.416
20 0.438
21 0.460
22 0.482
23 0.504
24 0.526
25 0.548
26 0.570
27 0.592
28 0.614
29 0.636
30 0.658
31 0.679
32 0.701
33 0.723
34 0.745
35 0.767
36 0.789
37 0.811
38 0.833
39 0.855
40 0.877
41 0.899
42 0.921
43 0.942
44 0.964
45 0.986
46 1.008
47 1.030
48 1.052
49 1.074
50 1.096
51 1.118
52 1.140
53 1.162
54 1.184
55 1.205
56 1.227
57 1.249
58 1.271
59 1.293
60 1.315
61 1.337
62 1.359
63 1.381
64 1.403
65 1.425
66 1.447
67 1.468
68 1.490
69 1.512
70 1.534
71 1.556
72 1.578
73 1.600
74 1.622
75 1.644
76 1.666
77 1.688
78 1.710
79 1.732
80 1.753
81 1.775
 82 1.797
83 1.819
84 1.841
85 1.863
86 1.885
87 1.907
88 1.929
89 1.951
90 1.973
91 1.995
92 2.016
93 2.038
94 2.060
95 2.082
96 2.104
97 2.126
98 2.148
99 2.170
100 2.192
101 2.214
102 2.236
103 2.258
104 2.279
105 2.301
106 2.323
107 2.345
108 2.367
109 2.389
110 2.411
111 2.433
112 2.455
113 2.477
114 2.499
115 2.521
116 2.542
117 2.564
118 2.586
119 2.608
120 2.630
121 2.652
122 2.674
123 2.696
124 2.718
125 2.740
126 2.762
127 2.784
128 2.805
129 2.827
130 2.849
131 2.871
132 2.893
133 2.915
134 2.937
135 2.959
136 2.981
137 3.003
138 3.025
139 3.047
140 3.068
141 3.090
142 3.112
143 3.134
144 3.156
145 3.178
146 3.200
147 3.222
148 3.244
149 3.266
150 3.288
151 3.310
152 3.332
153 3.353
154 3.375
155 3.397
156 3.419
157 3.441
158 3.463
159 3.485
160 3.507
161 3.529
162 3.551
163 3.573
164 3.595
165 3.616
166 3.638
167 3.660
168 3.682
169 3.704
170 3.726
171 3.748
172 3.770
173 3.792
174 3.814
175 3.836
176 3.858
177 3.879
178 3.901
179 3.923
180 3.945
181 3.967
182 3.989
183 4.011
184 4.033
185 4.055
186 4.077
187 4.099
188 4.121
189 4.142
190 4.164
191 4.186
192 4.208
193 4.230
194 4.252
195 4.274
196 4.296
197 4.318
198 4.340
199 4.362
200 4.384
201 4.405
202 4.427
203 4.449
204 4.471
205 4.493
206 4.515
207 4.537
208 4.559
209 4.581
210 4.603
211 4.625
212 4.647
213 4.668
214 4.690
215 4.712
216 4.734
217 4.756
218 4.778
219 4.800
220 4.822
221 4.844
222 4.866
223 4.888
224 4.910
225 4.932
226 4.953
227 4.975
228 4.997
229 5.019
230 5.041
231 5.063
232 5.085
233 5.107
234 5.129
235 5.151
236 5.173
237 5.195
238 5.216
239 5.238
240 5.260
241 5.282
242 5.304
243 5.326
244 5.348
245 5.370
246 5.392
247 5.414
248 5.436
249 5.458
250 5.479
251 5.501
252 5.523
253 5.545
254 5.567
255 5.589
256 5.611
257 5.633
258 5.655
259 5.677
260 5.699
261 5.721
262 5.742
263 5.764
264 5.786
265 5.808
266 5.830
267 5.852
268 5.874
269 5.896
270 5.918
271 5.940
272 5.962
273 5.984
274 6.005
275 6.027
276 6.049
277 6.071
278 6.093
279 6.115
280 6.137
281 6.159
282 6.181
283 6.203
284 6.225
285 6.247
286 6.268
287 6.290
288 6.312
289 6.334
290 6.356
291 6.378
292 6.400
293 6.422
294 6.444
295 6.466
296 6.488
297 6.510
298 6.532
299 6.553
300 6.575
301 6.597
302 6.619
303 6.641
304 6.663
305 6.685
306 6.707
307 6.729
308 6.751
309 6.773
310 6.795
311 6.816
312 6.838
313 6.860
314 6.882
315 6.904
316 6.926
317 6.948
318 6.970
319 6.992
320 7.014
321 7.036
322 7.058
323 7.079
324 7.101
325 7.123
326 7.145
327 7.167
328 7.189
329 7.211
330 7.233
331 7.255
332 7.277
333 7.299
334 7.321
335 7.342
336 7.364
337 7.386
338 7.408
339 7.430
340 7.452
341 7.474
342 7.496
343 7.518
344 7.540
345 7.562
346 7.584
347 7.605
348 7.627
349 7.649
350 7.671
351 7.693
352 7.715
353 7.737
354 7.759
 355 7.781
356 7.803
357 7.825
358 7.847
359 7.868
360 7.890
361 7.912
362 7.934
363 7.956
364 7.978
365 8.000

How is the bond priced?

How are interest rates moving in the economy
Interest rates are dynamic - they keep changing
Inflation, RBI policy on SLR, CRR, Government deficits, tax collections, elections, USD

Tata Power has issued this bond - 8% coupon, 7 year tenor, Rs 100 face value, redempt
On that day of issue, the coupon of 8% was very fair - it has to be fair
If they pay more than fair, they are stupid
If they pay less than fair, nobody will subscribe

Two months later, life has changed, interest rates have moved
Now the interest rate in the economy (and for Tata Power) has gone to 8.31%
If Tata Power were to issue a bond today, that bond would have to be issued at 8.31%

This bond however has a fixed coupon of 8% (you cant change the terms of the bond)
How will the market adjust?
The market will adjust by repricing the bond - the price of the bond may no longer be
Price will move

If the yield in the market nowadays is 8.31% and this bond generates a coupon of Rs 8.
the price of the bond will be 8 96.27 approx
8.31%

100.000 96.270
 8.310 8.000

BOND PRICES ARE INVERSELY CORRELATED TO INTEREST RATES

A more refined bond pricing mechanism will emerge from the following table

Year CashFlow
0
1 8
2 8
3 8
4 8
5 8
6 8
7 108

"One year" has passed and interest rates in the economy have risen to
The cash flows on this bond will be discounted at the current yield

Year CashFlow Disc Fact Pres Val r=

0 1.000 1+r=
1 8 0.923 7.39
2 8 0.852 6.82
3 8 0.787 6.30
4 8 0.727 5.81
5 8 0.671 5.37
6 108 0.619 66.90
98.58

Interest - generic term denoting what you can earn on a bond

Coupon - the rate of interest as per terms of issue of the bond
Yield to maturity (YTM) - a specific term indicating what you will earn over the life of

A 8% coupon translates into a 8.31% YTM

Bond markets are very complex and software programs costing crores of rupees are use
and derivatives on bonds
Fine pricing - if the buyer quotes 98.5812, the seller may quote 98.5813
Equity market - WABCO TVS - bid - 2412, ask - 2415 - bad pricing

How is your life connected to bonds

You may never buy bonds if deal size is min Rs 100 cr
Are we wasting our time on this topic ?
Many of us might be investing in mutual funds
There are two types of funds - equity funds and debt funds
Debt funds invest in bond markets
By investing in debt funds, you are investing in bond markets

The NAV of these funds will move up and down adversely in relation to interest rates
In the last two years, interest rates have been rising and therefore Debt Fund NAVs hav
Now, if you believe that RBI is at the end of its cycle and interest rates will fall
Debt Fund NAVs may tend to rise

Which fund to invest?

Debt funds or Equity funds - that’s the right choice
If you decide Equity funds, then within that - you may ask - HDFC or ICICI or Birla Sunli

Which train to catch?

Where do you want to go?

Equity funds - high risk, high return - substitute for direct equity
Instead of buying Infosys, TCS, SBI shares, you have decided to buy Equity Fu
Debt funds - low risk, low return - substitute for bank fixed deposits
Instead of going to Indian Bank and placing a FD, you have chosen Debt orie

FD - 9% Debt Fund - 8 to 10% - better tax benefits

The name of the fund itself, the objectives of the fund will be very clear - whether eq

In an FD, your interest income is taxable at 30% in most cases

In a Debt Fund, your income will be either dividends or capital gains
Rate of tax may vary from 10% to 15%

FD earns 9.00% Debt Fund 8.00%

Tax 30% 2.70% Tax 10% 0.80%
Post tax 6.30% Post Tax 7.20%
Open ended has no expiry date - it may remain open for decades
Close ended funds will end on a certain day
FMP - Fixed Maturity Plans - 180 days, 368 days

There are fixed rate bonds (the Tata Power bond above) and there are floating rate bo
In a floater, you will be paid LIBOR plus 100 basis points (1%)
If LIBOR today is 0.65%, you will be paid 1.65%
After one year LIBOR goes up to 0.85%, you will be paid 1.85%

What is LIBOR
London Inter Bank Offered Rate
It is the rate at which a panel of banks are ready to lend to each other today
So Bank of America has quoted a rate of 0.65% to Citi for a 1 year USD Loan (today)

This LIBOR changes every day

Banks are usually strong banks
If a bank becomes weak, that bank is pulled out of the panel

SBI will think - LIBOR plus 200 bps is fine Credit spread of 200 bps
Tata Power will think - LIBOR plus 250 bps is fine
Reliance - LIBOR plus 225 bps is fine
Visa Steel may be happy with LIBOR plus 700 bps

OPTIONS ON BONDS
Lakhpati Bond issued by IDBI once upon a time
Another Lakhpati Bond issued by SIDBI soon thereafter

IDBI said - give us Rs 2,800 and we will give you back Rs 1 lakh after 30 years
SIDBI said - give us Rs 2,500 and we will give you back Rs 1 lakh after 30 years
People went crazy in the desire to become a Lakhpati

But nobody became a lakhpati and are not going to become either
Why?

What is the yield on these bonds?

IDBI Bond 2800 12.66% 113% 30 35.71 100,000

On the date of issue, IDBI was quite prepared to be 12.66% per annum for the next 30 y
With passage of time, interest rates fell (in the economy)
IDBI suddenly felt a little stupid

But they had been smart in the terms of issuue

The terms of issue mentioned that IDBI can call back the bond after 5 years, 10 years,
25 years if they wanted to - this is a CALL OPTION

They can redeem the bond - they can force you to return the bond and they will pay yo

WHAT IS RISK
Risk is volatility of returns
Returns can even swing negative (volatility includes loss of principal also)

In any project there will be 5 to 10 key parameters which can make or break the proje
There may be 10,000 parameters - but 10,000 cannot be handled by humanity
Most of them may be not material
Wisdom is in detecting which are the major ones and focusing on them

In our projections, conduct a sensitivity on those 5 to 10 parameters

How much can they swing

If your sales is based on GDP growth in the economy, how much can GDP growth swing
Min 5%
Max 10%

What are those factors

How much can they swing

Volume 10.00 10.50 11.03 11.58 12.16

Price p Unit 5.00 5.40 5.83 6.30 6.80
Sales Revenue 50.00 56.70 64.30 72.91 82.68
Variable Costs p U 3.00 3.21 3.43 3.68 3.93
Variable Cost Amt 30.00 33.71 37.87 42.54 47.80
Contribution 20.00 23.00 26.43 30.37 34.89
Fixed Costs 10.00 10.80 11.66 12.60 13.60
Profit 10.00 12.20 14.77 17.77 21.28
PV Factor 14%
114%
1 0.88 0.77 0.67 0.59 0.52
PV of Future Profits 8.77 9.38 9.97 10.52 11.05

Total PV 49.70

If I sell this stream of profits today for Rs 49.70, it is the same as working hard for 5 ye
Rs 10 in the first year, Rs 12.20 in the second year and so on

Various assumptions
1 First year volume will be 10
2 Volume will grow at 5%
3 First year selling price will be Rs 5 per unit
4 Selling price will grow at 8%
5 First year VC per unit will be Rs 3
6 These VC will grow at 7%
7 First year FC will be Rs 10
8 They will grow at 8%
9 A realistic WACC for this project is 14%

Nobody knows the future and all 9 assumptions could be erroneous, over optimistic ???
How wrong is wrong?
If I very wrong, what will happen to me? What worst can happen?

What is the best situation? What is the worst situation? How far are these two situa
Sensitivity will help you in weeding out those factors which are not deal breakers
Is selling price more important than managing fixed costs?
Is volume more important than WACC ?

Selling PV Fixed
Price 49.70 Cost 49.70
4.50 28.00 56% 9.00 53.65 108%
4.75 38.85 78% 9.50 51.67 104%
5.00 49.70 100% 10.00 49.70 100%
 5.25 60.55 122% 10.50 47.72 96%
5.50 71.40 144% 11.00 45.75 92%

What do you mean by risk free?

No variation in return
In your PPF what is the return? 8%
8% in which situation?
All situations

Equity versus Project

Project is funded by two sources - Equity and Debt

If project earns 16% and the WACC is 14%, project is doing pretty well (beating the WA
How much will owners make? Owners cost is cost of equity
If cost of equity is say 17%, will owners make 19% ?

If project earns 11% and the WACC is 14%, project is pretty bad (below the WACC by 3%
How much will owners make? Owners cost is cost of equity
If cost of equity is say 17%, will owners make 14% ?

What is the Project IRR and how does it differ from Equity IRR ?
If the Project does well, the Owner will do very well
If the Project does badly, the Owner will do very badly

The Owner's fortunes will swing more than the Project's fortunes

If Commonwealth Games do well, Kalmadi will do very well

If Commonwealth Games do badly, Kalmadi will do very badly

Year Project Project is funded by

CashFlow Proj Cost 100
0 -100 Debt 35
1 40 Equity 65
2 40
3 40 Debt carries interest at
4 40 Debt is repaid in equal annual instalments o
Proj IRR 22% Annual debt repayment

In Project Cash Flows, we ignore interest

We ignore loans availed
We ignore loans repaid

If you want to look at this project through the Owner's eyes (completely new concept),
the cash flows?

Year Project Debt Interest Owner's

CashFlow 12% CashFlow
0 -100 35.00 (65.00)
1 40 (8.75) (4.20) 27.05
2 40 (8.75) (3.15) 28.10
3 40 (8.75) (2.10) 29.15
4 40 (8.75) (1.05) 30.20
Proj IRR 22% OwnerIRR 27%

Owner IRR in a good project is higher than Project IRR bcoz Owner makes money in tw
1 He makes money from the project 22%
2 He makes money from money 5%
27%

If I bring in more debt, what will be happen?

Owner IRR will shoot up - better and better

Debt 27% If annual cash flows are lower

20 24% 22% 27%
30 26% 20 Err:504 -20%
35 27% 25 Err:504 -6%
40 28% 30 Err:504 6%
50 30% 35 Err:504 16%
60 34% 40 Err:504 27%
70 41%
80 52%
 Premium on Redemption of Rs 5
years

paid on each Jan 21st for the next

d get interest for 4 days but you

d paid within 42 days

t"? Why introduce complexity to the world?

8.00 365

u will pay the seller Rs xx for the bond

ards accrued interest
he bond itself is Rs 102.00, then you

Power will pay you one year interest

get one year interest, you deserve

ys interest
ns, elections, USD INR rates, etc, etc

ce value, redemption value

to 8.31%
e issued at 8.31%

ms of the bond)

may no longer be Rs 100

a coupon of Rs 8.00, in crude terms,

ng table

8.31%

8.31%
108.31%

8%
n over the life of the bond 8.31%

s of rupees are used to value bonds

to interest rates
ebt Fund NAVs have been falling
es will fall

ICICI or Birla Sunlife ??

ed to buy Equity Funds of mutual funds

chosen Debt oriented mutual funds

lear - whether equity / debt

re floating rate bonds

her today
D Loan (today)

f 200 bps

30 years
m for the next 30 years

5 years, 10 years, 15 years, 20 years,

nd they will pay you a yield of 12.66%

or break the project

humanity

GDP growth swing

5% 105%
8% 108%

7% 107%
 8% 108%

rking hard for 5 years and earning

over optimistic ???

e these two situations?

eal breakers

Selling PPF Risk Free

Price Return
4.50 8% 100%
4.75 8% 100%
5.00 8% 100%
 5.25 8% 100%
5.50 8% 100%

l (beating the WACC by 2%)

w the WACC by 3%)

12%
nual instalments over 4 years
 4 8.75

ely new concept), then what are

Loan
Balance
35.00
26.25
17.50
8.75
-

akes money in two ways:

crudely
Valuation of Equity
1 PBV
2 DCF
Enterprise Value
EVA
Working Capital Management

Bonds - we don’t buy for sale - there is no market in India

PBV
Value of shares comes from two sources:
1 Assets Few sectors
2 Earnings Most sectors

If you have strong assets, the asset value becomes the share value in "some sectors"

You have a company which has only one asset - residential flat

Balance Sheet
Share Capital 2 Property

The value of the company is Rs 2 cr driven by the asset

You give this flat on rent and you earn Rs 10 lakhs over the next one year

Balance Sheet
Share Capital 2.00 Property
Reserves 0.10 Cash

Profit & Loss Account

Operating Expenses 0.03 Rental Income
Income Tax 0.02
Net Profit (Reserves) 0.10

Value of the company will be Rs 2.10 crores

This value is driven by its assets (property and cash)

At a deeper level, if the value of the flat has increased to say Rs 2.50 cr, then the value o
should have become Rs 2.60 cr

The assets can either be recognized at book value (Bal Sheet) or at market value
Stock markets would recognize market value if the asset can be easily detached and sold
this market value

Suppose you set up an IT company (software)

Balance Sheet
Share Capital 2.00 Cash

You have good people, but they don’t appear in the Bal Sheet

You earn a profit of Rs 5 cr, sales of Rs 15 cr, expenses of Rs 10 cr

Balance Sheet after one year

Balance Sheet
Share Capital 2.00 Cash
Reserves 5.00

What do you think will be the "value" of this company

Will you be okay to sell this companny for Rs 7 cr?
What is driving that value?

This company earns Rs 5 cr per annum as profits

Give me 10 times earnings as the value
I want a valuation of Rs 50 cr (actual assets are only Rs 7 cr)
ASSET BASED VALUATION
Share Capital (Face Value Rs 10 p share) 40 Assets
Reserves 160
Shareholders Funds (Net Worth) 200
Outside Liabilites 300
Total 500 Total

Net Assets means what?

1 Assets minus Outside Liabilities
500 300 200
2 Net Assets means Shareholders Funds
40 160 200

Book Value per Share = Shareholders Funds per Share (Net Worth per Share)
Share Capital 40 Rs cr
Face Value per Share 10 Rs
No of Shares issued 4 cr
Shareholders Funds 200 Rs cr
Book Value per Share 50 Rs

If this company's valuation was indeed driven by assets and the book value of the assets w
the market value of the assets, then the share price ought to hover around Rs 50

If the share price was say Rs 20, this might be a great buying opportunity
If the share price was say Rs 200, this might be a great selling opportunity

In the normal course of accounting, the Balance Sheet values of assets are based on "histo
In the case of long term assets, this cost is further reduced by "depreciation"

In long term asset heavy industries, the book value may not be very representative of the
Market values for real estate may be far higher than book value
Market values for plant and machinery and vehicles may be far lower than book value

BANKING SECTOR
Liabilities Assets
Share Capital Little bit - offices, furnit
Reserves
Net Worth Government Securities

Deposits - Fixed, Current, Savings Loans Given

Loans from Other Banks Cash on Hand
Current Liab - Salary Payable Deposits with RBI and Ot

Book Value per Share = Net Worth per Share = Net Assets per Share

If that Book Value for XYZ Bank is say Rs 95 per share and the market price is say
Rs 45 per share - the bank is undervalued signficantly and could be a good buy
Rs 395 per share - the bank could be seriously overvalued

Earnings are not very important (assets are more important than earnings)

1 www.moneycontrol.com
2 Data for various banks - public, private
3 Work out the Book Value per Share on March 31, 2011 - readily available
4 Work out the Book Value per Share on December 31, 2011 - not readily availab
5 Look up the price today
6 Work out the PBV - Price / Book Value
7 What do you think
8 Each person 3/4 banks State Bank of India
Punjab National Bank
Union Bank
Canara Bank
Indian Bank
Bank of India
Dena Bank
UCO Bank
Syndicate Bank
Corporation Bank
Bank March BV June Qtr Sept Qtr Dec Qtr Dec BV
EPS EPS EPS

HDFCBank 109 5 5 6 125

IndusInd 82 4 4 4 94
Yes Bank 109 6 7 7 129
Axis 463 25 23 22 533
SBI 1023 25 44 51 1143
ICICI 478 15 13 11 517
BoB 536 26 29 32 623
BoI 292 13 9 10 324
PNB
Union
Canara 405 16 19 19 459
Corporatio 482 27 27 24 560
Indian 184 9 11 12 216
Allahabad
Andhra
Federal
Syndicate 123 6 6 6 141
Dena 104 5 5 6 120

Pvt banks get higher PBV than public sector banks

The larger banks appear to get a higher PBV

If Indian Bank has assets of one rupee, the market is valuing them at 84 paise (16% discou
Market is of the belief that 16% of the assets will not be realized (will be lost) - bad loans

HDFC Bank is not a bank

A bank is supposed to borrow funds and lend funds and make the difference
In London, in the 1980s, they used to say banks are 3-6-3 businesses
You borrow at 3%, you lend at 6%, you go home at 3 pm (play golf with your customers)

A bank is supposed to borrow funds and lend funds and make the difference
This business is quite tough and competitive
Money knows no loyalty

If you are a depositor and X bank gives you 7% and Y bank gives you 7.25%, whom do you
Y Bank - your family has been with X bank for 73 years

If you having using Colgate toothpaste since birth and Colgate is more expensive than Pep
with Colgate

HDFC Bank is not a bank

HDFC Bank - a very huge share of profits and revenues come from non-banking activities
Fund based income and Non-fund based income
Fund based income means interest income
Non-fund based income means
Commission on selling insurance policies to you and me
Commission on mutual funds
Commission on foreign exchange
Treasury activities
Advisory to corporates on forex, treasury

More than 40% of their profits come from non-fund initiatives

Which poor Dena Bank and Syndicate Bank have not been able to develop

Are the PBV of smaller PSU Banks too much beaten down?
For example, the market is valuing Dena Bank as if 27% of its loans will not be returned
Syndicate Bank - 22% of their loans will not be paid back
Indian Bank - 16% will not be paid back

All these banks have already made some provisions for bad loans (as per RBI regulations)
Provide means reduce your profits, reduce your reserves, reduce your Book Value

Small Project
1 Take 4/5 banks from the above
2 Track their max PBV and min PBV over the last 5 years - PBV range
Annual PBV from moneycontrol
 Max / Min price range for each year
Max / Min PBV range
3 Compare today's PBV with the range and determine where it stands
Today's PBV is 1.28
Max PBV 2.01
Min PBV 0.77

Book Value
Book value represents the net assets and in sectors like banking provides a good benchma
itself

In other sectors which are driven by "earnings", the book value may act as a floor

Infy price is Rs 2,900

Infy book value is lets say Rs 500
Rs 2,900 is driven by earnings, but in a real read bad situation if the price falls, then Rs 5
floor for the price

SAIL - price fell below book value - Rs 80

GMR Infra - book value Rs 25 - it went to Rs 17, 18

Earnings Upside

Floor - Asset based Book

Earnings as the Driver

Earnings are the driver for most sectors (other than Banking, Real Estate)

EPS is say Rs 20 per Share

Price 250 Rs per Share
Price Earnings Multiple PE 12.5 times

If you track the history of the PE over several years, ten years, you will get the max / min
Comparing that to today, you will get a sense of expensive or cheapness of the security

Feb 3, 2012 5,326 This number by itself is meaningless

PE 18.97 All the meaning is here in the PE

If the Nifty companies were to earn one rupee, the market is valuing them at Rs 18.97
Nifty is an index of India's top 50 companies

Is this 18.97 times too high, too low, around the average?
Is the Nifty too expensive, too cheap, just about okay ?

You want to buy a flat in Chennai

You have a house, you are buying for earning some rental income

Price Rental PE Ratio

Anna Nagar 10,000,000 20,000 500
Mylapore 12,500,000 27,000 463

Which flat is more expensive?

A flat in Anna Nagar costs 500 times monthly rental income, while one at Mylapore costs
income
Anna Nagar is more expensive

The price does not matter in a financial asset, the PE matters

If Infy price is Rs 2,900 and Satyam price is Rs 72, which is more expensive?
Cant say - we need to track the earnings and only then we can comment
Infy is earning Rs 110 per share and Satyam is Re 1.05 per share

Infy 2900 110 26.36

Satyam 72 1.05 68.57 Very expensive

Many people immediately conclude that a low PE company is cheap and should be a good
And a high PE is expensive and should be sold off
But that may not be correct
How come ?

Low PE may have been low for 20 years, you saw it today
High PE may have been high for 20 years
So what does that mean?

Where does the PE come from ?

Why is the PE of Co X so high (and consistently high) and Co Y so low (and consistently low
Asian Paints and Berger Paints - Asian Paints PE 32 times, Berger Paints 21 times (today, y

Asian Berger Asian

Reputation
Size
Earnings 100 80 100
Price 1000 800 3200
PE 10 10 32

Reliance PE more than Cairn Energy

IOC should be more than HPCL, BPCL
Market share ? More market share more PE ?
Distribution strength ? More dist strength more PE ?
Consistent high RoI ?

The PE is an indicator of "respect"

The stock market quantifies everything, including reputation, respect, goodwill
The PE comes the following factors:
1 Consistency of financial performance
 2 Growth prospects in earnings

PEG Model - was proposed by Peter Lynch

Peter Lynch was a fund manager in Fidelity
In 1977, he managed a fund called Magellan Fund - the size of the funds was USD 20 mio
20 USD Mio
50 USD INR
100 Rs cr
By 1990, the fund size grew to USD 13 billion
13 USD Bio
50 USD INR
65000 Rs cr

He came up with a possible answer to the question - what drives the PE

PEG Model : Price Earnings to Growth

The optimium PEG is 1:1

If your growth in earnings (EPS) is expected to be 18% per annum, then your PE
18:18 = 1:1
If your growth in earnings (EPS) is expected to be 18% per annum, and your PE
PEG = 12:18 = 0.67:1
What does this mean ?
Stock is underpriced, could be a good buy

If your growth in earnings (EPS) is expected to be 18% per annum, and your PE
PEG = 22:18 = 1.22:1
Stock is overpriced, could be a good sell

Companies and sectors whose earnings are expected to grow rapidly will command a high
which are slow growth will command a low PE

Growth Stocks (High Priced, High PE)

Value Stocks (Reasonably Priced, Mid PE, Low PE)
This became a big theme, investing philosophy

What do you mean by size?

Who is large? Who is small ?

In the 1980s, if you read Business India, it would give you a listing of the largest Indian co
That list would be based on "assets"
More assets, more size
Top of the list would be : Tatas, Birlas, FERA Companies (MNC), Mahindras, Mafatlals

Late 1980s, early 1990, size came to be defined by Sales Turnover

Oil companies started appearing in the list

After mid 1995, when FIIs started investing in the market, size was again redefined
Size was now defined as "Market Cap"
Market Cap = Price per Share x No of Shares
Today, this definition is valid

If your read Business Today annual issue, you will find Top 500 listed in the order of Mark
Suddenly you find that Infosys and TCS which by asset size or sales turnover are nowhere,
the list
Market Cap Market Cap
Large cap stocks More than Rs 10,00 cr Top 200

Mid cap stocks Rs 5,000 - Rs 10,000 cr Next 300

Small cap stocks Less than Rs 5,000 cr Others

Why should Asian Paints command 32 PE

Asian Paints EPS is expected to grow faster than Berger Paints
Asian Paints has done better and has been more consistent than Berger in the past ten ye
Asian Paints share is more expensive but deservedly more - need not be a good sell
Berger may not be a good buy (inspite of a lower PE)

Don’t look merely at the PE, also look at the PEG

If the PEG is less than 0.70:1, then it could be a great buy
If the PEG is more than 1.30:1, then it could be a good sell
The investment world believes that in reasonably stable industries the PEG works well

Pharma, FMCG, IT - PEG would be reasonably good as an indicator

Guidance
Forecast earnings levels provided by management itself (not mandatory)
Forward earnings are estimates by analysts - analysts do consider guidance while estimat
earnings

The PEG has been terribly misused by Indian experts, which we need to know
Any good concept can be misused on TV and we need to be very careful - don’t believe an
You should be very cynical, very pessimistic, very question oriented

Infy in the 1998, 1999, 2000 used to grow at 160% earnings

Wipro 180%

Infy PE used to be 160 times

Wipro 180 times

Experts said this is fair

Why?
That is exactly what Peter Lynch has said in the PEG model

PEG 1:1 (180:180, 160:160) - life is fine, world is balanced

Infy went to 13,660 in its peak
If you had bott Infy at that time, for the next 8 years you would have been in losses
What went wrong?

Global recession ?
Growth of 160%, 180% is not sustainable
This growth was not what Peter Lynch meant
He meant sustainable medium term (say 5 years growth)
You grew 160% last year, that is not false, that is true

Infy Turnover In the next 12 years, if Infy were to

1998 800 260% Infy would be larger than India
2012 516,079,798 Rs cr Is that possible? Doable?
GDP 7,000,000 Rs cr

7373%

Any company PE of more than 50 times - is impossible to sustain

India PE has never crossed 28 times since 1994 (18 years)

Whenever it has touched 28 times, markets have crashed
If India PE goes to more than 24 times, then be very cautious, be nervous, look at Indian
At this time, everyone will be rushing to the stock market

India Today will have on its cover page the BSE Tower Building
That means you should get out

History of the PE of any company - PE band - where does it fall now

PE combined with earnings growth prospects

Past and future should be defined based on today (not report date)
If you buy the share, when you will buy? Do you have the ability to go back in time (to the

GSK - Sharekhan Report 2009 2010

EPS in the past years 55 71
Max Price in the past relevant years 1457 2524
Min Price in the past relevant years 451 1253
Max PE 26.49 35.55
Min PE 8.20 17.65
Average PE 17.35 26.60
Current PE
 Price Today 2,645
Earnings for the current year 2012 est 101
Current PE 26.19 Compared to history of last two year

PEG Model 2011 2012 2013

EPS estimate for the future years 86 101 120
Growth in this EPS (CAGR) 18%
One year forward PE 26
PEG (One year forward PE / CAGR) 1.44

Ideal PEG is 1:1

Here the PEG is 1.44:1
Overpriced
A company with earnings growth of 18% should ideally trade at 18 PE
But this is trading at 26 PE
So it is quoting at a premium of 44% over ideal PEG price

1 History PE Band - it is at an average PE - fairly priced

2 PEG - I find it overpriced by 44%

L&T JM Report 2010 2011

EPS in the past years 53 61
Max Price in the past relevant years 2213 2002
Min Price in the past relevant years 1390 969
Max PE 41.75 32.82
Min PE 26.23 15.89
Average PE 33.99 24.35
Current PE
Price Today 1,449
Earnings FY 13 71
One year Forward PE 20.41 Compared to history, the PE is reaso

PEG Model 2013 2014

EPS estimate for the future years 71 78
Growth in this EPS (CAGR) 7%
One year forward PE 20
PEG (One year forward PE / CAGR) 2.87

PEG of 2.87 is quite high (norm is 1:1)

The PEG in this example is quite misleading - a simple formula x/y will always have challe

If my earnings grow at 2%, will the share be available at 2 PE ?

If my earnings grow at 48%, should the share go to 48 PE ?
Will not happen and should not happen also

At very low EPS CAGR and very high EPS CAGR, the PEG will get smoothened
L&T will most likely never trade at 7 PE even if earnings grow at 7%

Suppose L&T makes a loss in the next years, so negative CAGR - how will PEG work
So share should be free
In fact for every share, you should be given an incentive to buy

Book value as per Bal Sheet is Rs 350

Very old company lot of Real Estate
Market value of assets will be far higher
Say adjusted book value may be Rs 500 or so
in "some sectors"

2.00
0.10

0.15
50 cr, then the value of the company

market value
sily detached and sold and would realize

2.00

7.00
 500

500

h per Share)

(10 + 40)

k value of the assets was more or less

er around Rs 50

depressed sentiment
exuberance

sets are based on "historical cost"

reciation"

y representative of their market values

er than book value

ttle bit - offices, furniture, comp

overnment Securities

ans Given
ash on Hand
eposits with RBI and Other Banks

et price is say
e a good buy

eadily available
1 - not readily available

HDFC Bank
Axis Bank
ICICI Bank
Yes Bank
Indus Ind Bank
 Price PBV

525 4.20 Private

303 3.22 Private
341 2.64 Private
1185 2.22 Private
2205 1.93 Public
932 1.80 Private
795 1.28 Public
373 1.15 Public

501 1.09 Public

477 0.85 Public Good buys ?
182 0.84 Public Good buys ?

110 0.78 Public Good buys ?

87 0.73 Public Good buys ?

at 84 paise (16% discount)

will be lost) - bad loans, NPAs

fference

with your customers)

fference
u 7.25%, whom do you go to?

ore expensive than Pepsodent, you are okay

non-banking activities

es to you and me

will not be returned

s per RBI regulations)

our Book Value

PBV range
re it stands
??? What percentile
100
0

ovides a good benchmark for the price

act as a floor

e price falls, then Rs 500 may be a good

rnings Upside

oor - Asset based Book Value

 will get the max / min of the PE
pness of the security

y itself is meaningless
ng is here in the PE

ng them at Rs 18.97

AnnPE
41.67 times
38.58 times

one at Mylapore costs 463 times monthly

pensive?
p and should be a good buy

w (and consistently low)

aints 21 times (today, yday, last year, 1983)

Berger

80
1680
21

ect, goodwill
 unds was USD 20 mio

er annum, then your PE should be 18

er annum, and your PE is 12 times?

er annum, and your PE is 22 times?

y will command a high PE and those

LargeCap MidCap SmallCap

Highest
Lowest
of the largest Indian corporates

hindras, Mafatlals

again redefined

d in the order of Market Cap

turnover are nowhere, are in the top of

Market Cap Relative

> 0.10% of India Low Risk

0.05% to 0.10% High Risk

Others V High

rger in the past ten years

ot be a good sell

the PEG works well

uidance while estimating forward

ed to know
reful - don’t believe anybody

ve been in losses
 years, if Infy were to grow at that rate
larger than India
e? Doable?

ervous, look at Indian Bank Fixed Deposits

go back in time (to the report date)?

2011 200911Gr
86 25%
2704
1921
31.44
22.34
26.89
history of last two years, it is fairly priced

times

2012 200911Gr
68 13%
1531
990
22.51
14.56
18.54

history, the PE is reasonable

will always have challenges

oothened

w will PEG work

 1 Equity valuation
Next steps
a PBV - Asset based valuation
b PE - Earnings based valuation
c DCF valuation - mother of all valuations - more complex - used by institutions
NPV, IRR - capex budgeting
d Enterprise Value EV

2 Working Capital Management

3 EVA - Economic Value Added

L&T, Murugappa, Godrej, HUL, Coca Cola

4 Bond examples

5 Shares - how does the market behave

Personal investing - what should you do - how can you make money - without r

Summarize yesterday's discussions

Valuation

Assets
Few sectors
Banking
Real Estate
PBV

Some banks - PBV Range - 4.20 HDFC Bank to

0.73 Dena Bank
Dena Bank is cheap (< 1)
HDFC Bank is expensive - non banking work
fee based revenue (not fund based)
HDFC Bank is not a bank, bank plus plus
PBV < 1 - could be a good opportunity

HDFC Non Banking Revenue - Other Income ? What should it be classified as ?

What is Other Income ? Other Income is other than core
What is core?
If I tell you that core is banking plus treasury plus forex advisory plus wealth managemen

GSK Pharma
PE band - average
PE - 26 times, Growth 18% PEG 1.44:1 - slightly
expensive
May not be a great buy
SATYAM CASE
Share price fell badly
Till what level it fall ? Rs 55 - two month range
What was the book value at that time?
What were contingent claims at that time ?
Class action suit in the US
Upaid case
SEC might take action against Satyam
Income tax case - currently on

EXAMPLE
You bott a flat yday - Mylapore for Rs 12,500,000
Rental Income per month 27,000
Annual escalation possible % 10%
Your debt component is say 80%
Interest rate 11%
On your equity component, you expect 12%

Assume a five year period is reasonable, what is the expected value of the flat after 5 ye
What is the capital appreciation the world expects in 5 years time in Mylapore
Ignore income tax

Cost of Capital - WACC

Debt 11% 80% 8.800%
Equity 12% 20% 2.400%
WACC 11.200%

PROJECT IRR LOGIC

Don’t map the loan availed, loan repaid and interest on loan
Dont worry about how the project was funded - flat does not know how it was funded
Consider the flat cost as Rs 1.25 cr

Year CashFlow Sale of Flat Total CashFlow

Derived number
0 (12,500,000) (12,500,000)
1 324,000 324,000
2 356,400 356,400
3 392,040 392,040
4 431,244 431,244
5 474,368 18,821,714 19,296,083

The financial world believes that your flat of Rs 1.25 cr will appreciate to Rs 1.88 cr in 5
That is why they are happy to accept a rent of Rs 27,000 per month
324,000 12,500,000 2.59%
18,821,714 12,500,000 5 8.53%

If capital appreciation appeared to be impossible, rentals would rise in Chennai (or flat p

We divorce the two actions - funding and operations

The funding dept will take care of funding - they will raise debt, equity, whatever
The ops dept will take care of ops - their job is to earn the rent
The flat does not know how it was funded and will generate the same rental income irres
how it was funded

EQUITY IRR THINKING

Here you are thinking like Dhirubhai Ambani (not like Reliance)

Year CashFlow Bank Payments Sale of Flat Total CashFlow

0 (2,500,000) (2,500,000)
1 324,000 (1,100,000) (776,000)
2 356,400 (1,100,000) (743,600)
3 392,040 (1,100,000) (707,960)
4 431,244 (1,100,000) (668,756)
5 474,368 (11,100,000) 18,934,758 8,309,127
DCF Valuation of Equity
Year 1 2
EBIT 200
Tax Rate t 20%
EBIT x (1-t) 160
Add back Depreciation 35
Incremental Working Capital -30
Capital Expenditure -15
Free Cash Flow to the Firm - FCFF 150

FCFF is your purpose in life Depreciation is not a cash outflow, it is only a bo

Why are you alive?
To generate FCFF

FCFF - what does this mean

This is the amount you can withdraw from the business and give it to the stakeholders
1 You could pay interest to your lenders
2 You could repay loans of your lenders
3 You could pay dividends to your equityholders
4 You could even return to your equityholders - you could buy back shares

If you generate fantastic FCFF, then your valuation in the market will also be fantastic

The value of the company is nothing but the present value of future FCFF (discounted pre

Year FCFF Sale of firm TotalCash PV Factor

1.000
1 100 100 0.877
2 150 150 0.769
3 225 225 0.675
4 300 300 0.592
5 500 5000 5500 0.519
Value of the Firm
 1 Value in the stock market - every day, every moment
Retail investors buy 10 shares and 20 shares - PE, PBV
Institutional investors buying 100,000 shares, 1 million shares - FCFF, DCF

Citi has sold a huge stake in HDFC and other large institutions are buying
Citi sold at Rs 657/658

2 Equity placement - private placement of equity

3 Investment by Venture Capital Companies, Private Equity Companies

4 Mergers and Acquisitions

5 Joint Ventures

PROJECT THINKING, CORPORATE THINKING

The CEO is worried about generating FCFF
This FCFF will be used to pay both debtholders and equityholders
The discounting is done at WACC
WACC includes cost of both debt and equity

If you consider interest as an expense in this thinking, then you are moving to Equity thin

The machine does not know how it was funded - it works the same way regardless of fund
The operational cash flow is not dependent on debt equity mix

LIQUIGAS FALLACY
There was a company Liquigas - they used to work in the following manner:

Year One
Board Meeting - many new ideas for expansion, new projects
100 ideas with varying IRRs
Best IRR - 21%, Last IRR - 3%
The CEO asks the CFO - what is our cost of capital for this year
From where are we raising funds this year
CFO says - we are raising debt and cost of debt is 4%
All projects which generate more than 4% IRR are accepted and those with less than 4% IR
85 new projects sanctioned
New debt is raised and projects are implemented

Year Two
Board Meeting - many new ideas for expansion, new projects
100 ideas with varying IRRs
Best IRR - 21%, Last IRR - 3%
The CEO asks the CFO - what is our cost of capital for this year
From where are we raising funds this year
CFO says - this year we will raise equity because debt is too high now
Cost of equity - say 10%
All projects with IRR more than 10% are accepted, less than 10% are rejected

Year Three
Board Meeting - many new ideas for expansion, new projects
100 ideas with varying IRRs
Best IRR - 21%, Last IRR - 3%
The CEO asks the CFO - what is our cost of capital for this year
From where are we raising funds this year
CFO says - we can raise debt this year - cost 3.8%
All projects with IRR more than 3.8% are accepted, less than 3.8% are rejected

Right way of thinking

Don’t correlate funding with projects
Have one common WACC for the company for all years
WACC in all the three years is say 7.8%

Businessman wants what? You will work for 40 years in your life and you w
1 Profits
 2 Revenues
3 Assets
4 Capital
5 Returns
6 Margins
7 Cash, Wealth, Shareholder Wealth, Money
8 Reserves

Free Cash Flow is the objective Margins 8%

Not profit Cash 100 CR
Profit is a bookish number Revenues 200 cr

Profit is like CTC

Cash is like Take Home

ENTERPRISE VALUE - EV
If we were to buy the entire company today, what would it cost us
1 We would buy the entire equity
This would cost us the Market Cap
2 We would become responsible for its debt
If Mukesh Ambani takes over Kingfisher Airlines today and buys all the equity, f
will SBI call for recovery of its debt?
Whom does the income tax dept call for its Satyam tax demands ?
Mahindras
3 Whatever cash the company has will become your cash

Balance Sheet - Rs cr
Share Capital (Face value Rs 5) 100 Fixed Assets
Reserves 600 Cash
Loans 525 Net Current Assets

1,225
Market price of the share is Rs 71
What is its Enterprise Value

1 Market Cap
100 5 20 71
2 Add Debt

3 Less : Cash
Enterprise Value

Why are Reserves being ignored in this Computation

EBIDTA is lets say

EV/EBIDTA Multiple

For one rupee earning (ebidta), I am required to pay Rs 6.42

Poor man's earnings multiple is the PE Cost of one share / Earnings from
Rich man's earnings multiple is the EV/EBIDTA Cost of the company / Earnings fr

Sales As a small shareholder, you have

Ops Whatever PAT the company make

EBIDTA
As a controlling shareholder, you
Finance Especially in financial issues
PAT Given an EBIDTA, you can regener

L&T JM REPORT

Enterprise Value = 9 times Forward EBIDTA

Enterprise Value = Market Cap + Debt - Cash
Debt - Cash = Net Debt
Enterprise Value = Market Cap + Net Debt
Market Cap = Enterprise Value - Net Debt

Sum of the parts valuation (SOTP)

EV/EBIDTA
PE
Cost
Market Cap
Multiple Revenue
More complex multiples

Good examples where SOTP is a must

GMR
GE
Reliance - Oil exploration, Refining, Petrochem, Retail
Kotak - Banking, Securities, Insurance, Investment Banking, Mutual Fund, Reit
HDFC - Home Lending, Banking, Insurance, Mutual Fund, Securities, Property V
ICICI
SBI - Cards
Grasim
Essar
Raymonds - Textiles, Engg, Automotive, Real Estate
Marg - Infra, Real Estate, Port
Amalgamations - Tractors, Retail Dealerships, Various other small businesses
M&M - Auto, Leisure, Real Estate, Components, IT, Tractors
Conglomerates valuation becomes complex

L&T Ltd
Has invested in L&T Finance, L&T Infotech and L&T X and L&T Y
L&T holds shares in these other entities
So when you buy one share of L&T Ltd you are automatically getting a little bit L&T Finan
So the value of L&T should be inclusive of the value of its children
Tata Group should not be treated on par
So when you buy Tata Motors, you don’t get TCS along with it (unless Tata Motors holds a
TCS shares)

When I buy HDFC, I get a bit of HDFC Bank automatically and HDFC Standard Life automa
When I buy HDFC Bank, I don’t get HDFC or HDFC Insurance

www.motilaloswal.com
www.sharehkhan.com
www.jmfinancial.com
You will get access to Research Reports
You need not trade here

INVESTING
Indian equity has done brilliantly over the past 33 years
Sensex 1979 100
Today 2012 18,000
33 17.04% 180

Bank Fixed Deposit 9% 100 109%

1,718

At 9% your Rs 100 would have grown from Rs 100 to Rs 1,718 in 33 years

At 17% your Rs 100 would have grown from Rs 100 to Rs 18,000 in 33 years

So where is the catch?

1000 buy start getting into

start getting into add, accumulate

 600 panic, run away
unaware
100

18,000 will go to 5,00,000 or more in the coming three decades

But the common man will be repeating his behaviour - so he will not become wealthy

A lot of intellect is generally spent in when to buy, when to sell, how to make millions
Only God knows when to buy and when to sell and he does not disclose

Then there are "experts" who advise you what to do

But they don’t share in losses

All of them in Dec Sensex will go to 14,000 Nifty will go to 4200, 4300 and dollar will go t
January is the weakest in the history of the stock market over the last 12 years
What happened - complete the reverse

In Jan 2008, Sensex went to 22,000 and experts said it will go to 35,000
In Oct 2008, Sensex crashed to 7,900 and experts said Sensex will become Nifty (2,500)
So experts are pretty useless

So timing the market is not possible - don’t waste your energy in this pursuit

The best way to make money is to invest in SIP - Systematic Investing Plans
Just invest Rs 10,000 per month, Rs 5,000 per week, etc
Don’t look at the market
Don’t watch CNBC
Don’t read EcoTimes
Don’t ask people where is the market going to go

You pay a heavy price for a cheery consensus

While SIP might look dull, unintelligent, it is more effective than all intellectual theories
The quality of your returns is a direct result of the quantum of time you spend in creating
After 8 years, you cannot make losses

Which SIP, which mutual fund, which direct equity

Large mutual fund which has strong people

HDFC Mutual Fund HDFC Top 200, Equity
DSP Blackrock Tiger
Franklin Templeton Blue Chip
Birla SunLife
Pru ICICI

Large diversified mutual fund schemes represent India

Nifty, Sensex represent India
If India does well, these schemes will do well

EV - COMPUTATION
Why are Reserves ignored ?
Share Capital and Reserves are relevant for book value of the enterprise
We are not using book value in EV working
We are using market price
Market Cap of a company is "Share Price" x "No of Shares"
Share price is wherever it is bcoz of what? Bcoz of the Reserves that any company has

PE AND PBV RATIOS - KEEP REDUCING IN ANY RESEARCH REPORT - WHY

Current Market Price 2544

EPS of 5 years 55 71 85
PE 46.3 35.8 29.9
Useless Useless Useless
Wrong Wrong
NM/NMF NM/NMF
BOND RELATED QUESTIONS
Question 7-11
14 % coupon - paid semi-annual frequency
Face value USD 1,000
Tenor 30 years
Callable 5 years from now
Callable price is USD 1,050
Current price USD 1,353.54
Yield curve is flat
What is the best estimate of nominal interest rate on new bonds

Yield curve is flat - the rate of interest is the same, irrespective of tenor
If I issue new bonds with a tenor of 2 years, the rate of interest is say x%
The same rate of interest x% will be valid even if the tenor were to be 3 years, 5 years, 1

Solution
Yield to Call - if I call the bond in 5 years, what is the effective rate of interest that I wil

HalfYear CashFlow
0 (1,353.54) 3.24% 1000
1 70 2 1050
2 70 6.47% Annual IRR, YTC
3 70
4 70
5 70 Half of the challenge is not Finance, it is English
6 70
7 70
8 70
9 70
10 1120

Question 7-10
1 Get the coupon rate
2 Current yield = Coupon / Current market price
Question 7-13
Tenor 20 years
Par Value USD 1,000
Annual coupon 9%
Tenor for you - 5 years
Required rate of return for you - 10%
After 5 years, YTM is expected to be 8.5% on this bond
What can you pay for this bond today?

After you sell the bond, it will have a balance tenor of 15 years
At that time, when you sell it, it will have a YTM of 8.50% (6th year to 20th year)
So with this information, what can you get?
You can work out the price of the bond that will prevail at the end of 5 years from today

For the first five years

1 Coupons
2 End value
3 Required rate of return
You can get the price on day one

Question 7-16
Heekin USD 140 mio of bonds, average cost is 7.50%
Interest expense USD 10.50 mio
Times interest earned (TIE) is 3.2 times
Interest Coverage Ratio is 3.2 times
This info will give you EBIDTA
TIE cannot fall below 2.5 times
This info will give you the max interest you can e
Other loan details
You can easily work out which loans, what rate of interest, how much can you

Question 7-17
Known - Face value, coupon, tenor, YTM
From here you can get the purchase price
Sell price is given
So return you can get
WORKING CAPITAL MANAGEMENT

Retail industry has huge working capital, huge inventory

So their focus on this area is very high
Their Receivables are zero

Which product lines are good, bad, excellent, hopeless

How do you determine
What can you do about the bad and hopeless ones

Product Line Gross Contribn Sales

Margins Margins estimates
for a year

% % Rs cr
Mens garments 25% 22% 100
Shoes 30% 28% 30
Cosmetics 40% 35% 150
Jewelry 38% 31% 85

Sales minus Variable Costs = Contribution

Contribution minus Fixed Costs = Profit

Gross Margin is Sales minus Cost of Goods Sold (in COGS we will include purchase price, ta
freight)
Gross Margin minus Other Variable Costs (sales commissions, incentives) = Contribution M

Sales 100
COGS
Admin
Selling
Distribution
Misc
Opex 92 Both fixed and variable (exclude Int, Depn, Inc T
Operating Margin 8 EBIDTA

Product Line Gross Contribn Sales

Margins Margins estimates
for a year

% % Rs cr
Mens garments 25% 22% 100
Shoes 30% 28% 30
Cosmetics 40% 35% 150
Jewelry 38% 31% 85

Gross Margin Return on Investment/Inventory - GMRoI/I

We want to earn max Gross Margin but on min investment in inventory

1 Gross Margin Return on Inventory

2 Contribution Return on Inventory
3 Gross Margin Return on Net Inventory (after deducting supplier credit)
4 Contribution Return on Net Inventory

What is the Gross Margin / Contribution per square foot of space ?

What is the Gross Margin / Contribution per rupee of salary cost ?

Read the Shoppers Stop Annual Report

1 Concept of Consignment of Inventory

Vendor comes and places his inventory in your store
You don’t really buy this inventory
Your investment is zero
If it sells, then you pay
If it does not sell, he will take it back

But generally vendors also need to live

So they may not give you all inventory on consignment

Asset to Memo ratio

J C Penny - give me 50:50
Vendor will say 80:20

2 Store within Store

Economic Value Added - EVA Rs cr

Net Worth 100
Debt 200
Capital Employed 300

WACC 14%
Min you should earn 42
What are you really earning
This earning as : EBIT x (1-t) 51
EVA 9

EVA = EBIT x (1-t) minus the Minimum WACC

EVA is a Rs cr number
Positive EVA means you are beating the WACC

Stern Stewart & Co - research shows - if your EVA is positive and growing, then Sharehold
indeed attractive
If your EVA, then you don’t deserve to live
mplex - used by institutions

you make money - without risking too much

Earnings
Most sectors

PE

Right PE - PEG Model - PE should be driven

by expected growth in EPS
Ideal PEG level 1:1
If your EPS is expected to grow at 20%, then
your PE may well be 20 times
PE band in history
 Nifty PE band - 10 to 28 times
Today Nifty PE - 18 times
Average 18, Std Dev 3.6
Below 14, Nifty is very attractive
Above 22, it may be too expensive

e classified as ?

ory plus wealth management plus insurance

L&T
PE history - was okay
PEG was uninteresting
Growth in earnings 7%, PE - 20 times
PEG 2.87 times - which is quite quite high

Growth of 7% appears to be rather muted

Could be over a short period of 2 years
Long term growth may be much better
Historically, this company has grown well
Market will not price at very low PE just because
EPS is growing very low
If growth is 2%, will you get it 2 PE ? No
If growth is negative, will the share be free ? No

The book value will act as a floor

Earnings upside
 Book value floor

Book value Rs 100 lets say

Prob on these contingent claims

Ok - these may be Rs 45
Share price is rightly Rs 55

d value of the flat after 5 years

time in Mylapore

10,000,000 11% 1,100,000

know how it was funded

 11.19% Goal Seek

12,500,000 324,000 39 times

ppreciate to Rs 1.88 cr in 5 years time

Poor yield on rent

Capital appreciation expected

uld rise in Chennai (or flat prices would fall)

bt, equity, whatever

he same rental income irrespective of

CashFlow 12.00% Cost of Equity

 3 4 5

cash outflow, it is only a book entry

ive it to the stakeholders

could buy back shares

rket will also be fantastic

future FCFF (discounted present value)

WACC 14% 114%

DCF

87.72
115.42
151.87
177.62
2,856.53
3,389.16
lion shares - FCFF, DCF

institutions are buying

Equity Companies

ou are moving to Equity thinking

same way regardless of funding pattern

owing manner:
nd those with less than 4% IRR are rejected

5% - accepted

9% - rejected
0% are rejected

4% - accepted
3.8% are rejected

years in your life and you will get one of these

 9%
10 CR
500 CR

cost us

ay and buys all the equity, from tom whom

tax demands ?

1,155
20
urrent Assets 50

1,225
 Rs cr
1420 Market value of equity (Capital + Reserves) covers
Capital and Reserves here
525 We believe that market value
1945 of debt is the same as book value of debt
20
1925

300

6.42 times

of one share / Earnings from one share

of the company / Earnings from the company

mall shareholder, you have no control

ever PAT the company makes, you accept

ontrolling shareholder, you have tons of control

ially in financial issues
an EBIDTA, you can regenerate the PAT
Banking, Mutual Fund, Reit
Fund, Securities, Property Ventures

ous other small businesses

Tractors

getting a little bit L&T Finance, L&T Infotech

(unless Tata Motors holds a big chunk of

HDFC Standard Life automatically

n 33 years
0 in 33 years

buy
2000

getting into add, accumulate

800 panic, run away

, run away

will not become wealthy

ell, how to make millions

t disclose

00, 4300 and dollar will go to 59/60

r the last 12 years

to 35,000
will become Nifty (2,500)

y in this pursuit

nvesting Plans

han all intellectual theories about the market

f time you spend in creating the SIP
enterprise

es that any company has

PORT - WHY

101 120
25.2 21.2
Useful Partly Useful
 on new bonds

ive of tenor
st is say x%
ere to be 3 years, 5 years, 100 years

ve rate of interest that I will pay

14% 7% 70

e is not Finance, it is English

h year to 20th year)

e end of 5 years from today

u EBIDTA

u the max interest you can ever pay

nterest, how much can you borrow

Inventory Supplier Gross COGS COGS Inventory
Credit Margin per Day

365
Days Days Rs cr Rs cr Rs cr Rs cr
90 30
100 45
60 21
180 60
ill include purchase price, taxes on purchase,

ncentives) = Contribution Margin

ble (exclude Int, Depn, Inc Tax)

Inventory Supplier Gross COGS Inventory GMRoI

Credit Margin

365
Days Days Rs cr Rs cr Rs cr %
90 60 25.00 75.00 18.49 1.35
100 45 9.00 21.00 5.75 1.56
60 21 60.00 90.00 14.79 4.06
180 60 32.30 52.70 25.99 1.24

nventory

ting supplier credit)

and growing, then Shareholder Wealth is
GMROI Gross Mark up GMROI Net Net GMRONI
Gross Mgn Cycles Cycles x Cycle Cycles Gross Mgn
Return on per Mark-up time per Return on
Inventory annum annum Net Invn
Rs Number % Rs Days Number Rs
Cont CRoI Ranking Net GMRoNI CRoNI
Inventory
Paid
Inventory
Rs cr % Rs cr % %
22.00 1.19 3 6.16 406% 357%
8.40 1.46 2 3.16 284% 265%
52.50 3.55 1 9.62 624% 546%
26.35 1.01 4 17.33 186% 152%
eturn on