Corporate Finance Structure

Amity Business School

The Objective – Maximize The Value of The Firm

Basic Corporate Financial Decisions

• How to allocate resources and which projects to select?
• How to raise funds to finance these projects?
• How much to payout and how much to reinvest?

Analysis of Risk & Options &

Present
Financial Return Valuation
Value
Statements Models Models

The Corporate Financial Toolbox

 Return Amity Business School

• Return is the future monetary gain or loss

which an individual will get from any
investment.
• Return can either be real or opportunistic.
• What is the return of the share purchased for
Rs 125 one year ago and the current price is
Rs 165 and the dividend received during the
year is Rs 15.
 Risk Amity Business School

The notion of the risk involves two concepts

– likelihood and impact of future events.

So the risk can be defined as a function of

the two as:
Risk = f (likelihood, impact)

Total Risk = Unique (or Unsystematic or

Diversifiable) Risk + Market (or Systematic
or Non-diversifiable) Risk
 Measuring Risk Amity Business School

• Average Return
µ = (∑ Xi)/n
• Standard Deviation
δ = [{∑( Xi – µ)2}/(n-1)]1/2
• Covariance
δxy = {∑( Xi – µx)*( Yi – µy)}/(n-2)
• Correlation
rxy = δxy /(δx δy)
 Numerical Amity Business School

Calculate the measures of risk for the

following two stocks:
• A: – 8.19%; 36.95%; 14.38%; 24.96%; –
0.80%
• B: 58.92%; 161.72%; 50.62%; – 21.77%;
16.84%
 Returns on Portfolio Amity Business School

• Average Return = waµx + (1-wa)µy

• Variance = (waδx)2 + {(1-wa)δy}2 + 2wa(1-

wa)* δxy

• Find the measures of risk for the portfolio

of the two stocks having equal allocation.
 Measuring Risk with P.D. Amity Business School

• Average Return
µ = ∑ (pi* Xi)
• Standard Deviation
δ = [∑{( Xi – µ)2 * pi}]1/2
• Calculate the return and SD for the given
stock with the following p.d.f.
-15% - 0.3; 10% - 0.45; 20% - 0.2; 35% -
0.05
 Corporate Finance Structure
Amity Business School

The Objective – Maximize The Value of The Firm

Basic Corporate Financial Decisions

• How to allocate resources and which projects to select?
• How to raise funds to finance these projects?
• How much to payout and how much to reinvest?

Analysis of Risk & Options &

Present
Financial Return Valuation
Value
Statements Models Models

The Corporate Financial Toolbox

 Financial Decisions
Amity Business School

• Investment Decisions

• Financing Decisions

• Dividend Decisions
 Investment Decisions Amity Business School

• Short-term Investments

• Long-term Investments
 Long-term Investment or Amity Business School

Capital Expenditure
• Refers to as “Strategic” Investments
• Characteristics of CapEx
– Involves a huge amount of investment
– Have a long-term impact
– Irreversible and if reversible, incur huge cost
• Types
– Capacity Expansion
– Replacement or Modernization
– Concentric or Conglomerate Diversification
– Mergers & Acquisitions
 Stages in CapEx Amity Business School

Evaluation
• Identification of Strategic Investment
Opportunity
• Preparation of Pro Forma Financial
Statements
• Deciding the Appraisal Method to be used
• Deciding the Discounting Rate
• Calculation of the Appraisal Value
• Acceptance or Rejection based on
Appraisal Criteria
 Principles of CFs Amity Business School

Estimation

• Incremental Basis

• After-Tax

• Accounting vs. Finance

– Tax Treatment

– Opportunity Cost
 Steps in Preparing Amity Business School

Financials
• Estimation of the Cost of Project

• Financing Mix Details

• Estimation of Revenues and Operating

Costs

• Preparation of Pro forma Financial

Statements
 Cost of Project Amity Business School

• New Investment Basis: Cost of Project =

Capital Cost + Increased Working Capital
Requirements – Other Benefits
• Replacement Investment Basis: Cost of
Project = Capital Cost – Salvage Value –
Tax Benefit (or + Tax Paid) + Net Increase
in Working Capital Requirements (or – Net
Decrease) – Other Benefits
 Numerical 1 Amity Business School

• Find the cost of the project with following

characteristics
• Price of machine = 50 lakh
• Installation Charges = 5 lakh
• Investment Allowance from state
government = 15%
• Tax rate = 35%
 Numerical 2
Amity Business School

• Price of new machine = 50 lakh

• Installation Charges = 5 lakh
• The old machine was purchased five years ago for
Rs 30 lakh and has a current book value of Rs. 10
lakh
• Tax rate = 35%
• Capital Gain Tax rate = 50%
• Find the cost of the project if the old machine is sold
for
– Rs 3 lakh
– Rs 10 lakh
– Rs 15 lakh
– Rs 35 lakh
 Cash Flow Calculation
Amity Business School

• CFAT = (Cash Sales Revenue – Cash Operating

Cost – Depreciation and Other Deductible Non-
cash charges)*(1-t) + Depreciation and Other
Deductible Non-cash charges
• CFAT for last year = (Cash Sales Revenue –
Cash Operating Cost – Depreciation and Other
Deductible Non-cash charges)*(1-t) +
Depreciation and Other Deductible Non-cash
charges + Net Salvage Value + Recovery of
Working Capital
 Numerical 3
Amity Business School

• Cost of the machine = Rs 15 lakh

• Additional WC requirement = Rs 3 lakh
• Life of machine = 5 years
• Salvage Value: Fixed asset = 10%; Current
Asset = 100%
• Annual Sales Rs 10 lakh
• Annual Variable Cost Rs 3 lakh
• Annual Fixed Cost = Rs 4 lakh
• Annual growth rate in revenue and cost = 10%
• Depreciation = 15% WDV
• Tax rate = 35%
 Numerical 4 Amity Business School

• Initial Investment = Rs. 1.25 crore in CapEx and

Rs. 30 lakh in WC
• Expected Life = 10 year
• Salvage Value = Rs. 55 lakh for CapEx and
100% for WC
• Fixed Annual Production = 1 lakh units
• Expected Sales Revenue = Rs. 300 per unit
• Growth rate in Sales Revenue = 5%
• Pre-tax Operating Margin = 10%
• Annual WC requirement = 12% of revenue
• Depreciation rate = 5% on WDV; Tax rate = 36%
 CFAT vs. FCF Amity Business School

• CFAT = PAT + Depreciation and Other

Deductible Non-cash charges

• Free Cash Flow (FCF) = PAT + Depreciation

and Other Deductible Non-cash charges –
Additional Investment Requirements in CapEx
or NWC (or + Decrease)
 Stages in CapEx Amity Business School

Evaluation
• Identification of Strategic Investment
Opportunity
• Preparation of Pro Forma Financial
Statements
• Deciding the Appraisal Method to be used
• Deciding the Discounting Rate
• Calculation of the Appraisal Value
• Acceptance or Rejection based on
Appraisal Criteria
 CapEx Appraisal Amity Business School

• Selection of Methods

– Traditional

– DCF

• Identification of Discounting Rate

 Discounting Rate Amity Business School

• Cost of Financing Component

• Weighted Average Cost of Capital

• Discounting Rate
 Appraisal Methods Amity Business School

• Average Rate of Return

ARR = Average Income/Average Investment

• Payback Period
• Net Present Value
NPV = ∑PV of Cash Inflows – ∑PV of Cash Outflows or NPV =
∑PV of FCF

• Internal Rate of Return

IRR = LR + {(NPV@LR)/(NPV@LR-NPV@HR)}*(HR-LR)

• Profitability Index
PI = ∑PV of Cash Inflows/∑PV of Cash Outflows
 Numerical Amity Business School

• Cost of new machine = Rs 50,000

• Life = 5 years and no salvage value
• Depreciation = SLM Basis
• Tax Rate = 35%
• EBITDA = 10,000; 10,692; 12,769; 13,462;
20,385
• Discounting Rate = 10%
• Find PBP, ARR, NPV, IRR, PI
 Amity Business School

Particulars I II III IV V

EBITDA 10,000 10,692 12,769 13,462 20,385

Depreciation 10,000 10,000 10,000 10,000 10,000

Operating
0 692 2,769 3,462 10,385
Profit

Tax (35%) 0 242 969 1,212 3,635

Net Income 0 450 1,800 2,250 6,750

CFAT 10,000 10,450 11,800 12,250 16,750

27
Stages in CapEx Amity Business School

Planning
Valuing the
Investment

Managing Risk
 Risk Management Amity Business School

• Risk Identification

• Risk Analysis & Assessment

• Risk Response Planning, Mitigation &

Allocation
 Stages for Risk Amity Business School

Identification

• Development Stage

• Construction Stage

• Operational Stage
 Development Stage RisksAmity Business School

• Development or Bid Risk

– Project Related

– Country Specific

• Equity Partners Related Risk

• Financing Risk
– Over or Under Financing

– Timely Availability
 Construction Stage Risks
Amity Business School

• Time Overrun Risk

• Cost Overrun Risk

 Operational Stage Risks Amity Business School

• Input Related Risk

• Performance Related Risk
• Economic Off-take Risk
• Currency Risk
• Political Risk
– Sovereign Risk
– Expropriation Risk

• Refinancing or Equity Resale Risk

 Risk Management Amity Business School

• Risk Identification

• Risk Analysis & Assessment

• Risk Response Planning, Mitigation &

Allocation
 Risk Assessment & Amity Business School

Analysis
• Breakeven Analysis
– Accounting Breakeven

– Financial or NPV Breakeven

• Scenario Analysis

• Sensitivity Analysis

• Monte Carlo Simulation