Financial Management Sem2

Financial Management
MBA ZG 521
Session 1
(Contact Hours 1, 2)
Foundations of Financial Management
Krishnamurthy Bindumadhavan, Fellow (IIM),

CFA, FRM
Professor, Management - Finance
Email: k.bindumadhavan@pilani.bits-pilani.ac.in
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Agenda
• Introductions
• Course objectives/ outcomes
• Textbooks/ Resources
• Evaluation scheme
• Overview of Financial Management
• Interface between Finance and other Functions
• Shareholder wealth maximization
• Basic Principles of Financial Management
• Understanding Indian Financial System

Introductions – Lead Instructor
Krishnamurthy Bindumadhavan, CFA, FRM
• Bachelor of Engineering, MBA
• Received the CFA charter in 2002
• Awarded FRM title in 2008
• Worked for over 7 years as Senior Analyst/ Consultant to leading Corporations,
Banks; preparing candidates for CFA/ FRM exams
• Worked for 8 years at Capital One, a top 10 US bank and one of the World’s
largest diversified financial services firms
• Worked in both strategic roles as well as operational roles including credit
strategy, product strategy and risk operations
• Drove innovation in risk management to add value of over $50 Million
• Last assignment with Capital One was General Manager, Risk Operations, Asia
• 5+ years of prior experience in Banking technology, primarily with TCS/ TUL
Course Objectives
No. Objectives
CO1 Gain basic understanding of the underlying concepts and building blocks related to financial
management. Develop understanding of the tools relevant to financial management
including time value of money and financial statements analysis.
CO2 Understand business risk, financial risk, break even analysis, and impact of leverage on risk.
Understand the relationship between risk and return and the drivers of risk.
CO3 Understand the application of cost of capital and do the necessary calculations of the
components of cost of capital and WACC; Basic principles of capital budgeting, categories
of capital budgeting projects, discounted and non-discounted cash flow evaluation
methods and their limitations, analysis of risks involved in capital budgeting projects.
CO4 Definition of working capital; Composition and determination of working capital; Financing
and management of current assets; Cash management.
CO5 Understanding the major theories of capital structure and their implications; How to set
target capital structure; Dividend policy and its impact on firm value.

Learning Outcome Statements
No. Learning Outcomes
LO1 Able to analyze and interpret the three key Financial Statements so as to assess the health of a firm/
business.
LO2 Apply Time Value of Money concepts for valuation.
LO3 Distinguish between the different types of risk faced by a firm and express the relationship between
risk and return.
LO4 Able to calculate all the components of cost of capital as well as the overall WACC for a firm.
LO5 Able to evaluate Capital Budgeting projects and make Accept/ Reject decisions based on NPV/ other
business rules.
LO6 Able to formulate corporate Financial Policies in the areas of Working Capital/ Cash Management,
Capital Structure, and Dividend Policy so as to maximize firm value.
LO7 Demonstrate solutions to "real" business/ financial problems by employing excel/ financial modeling in
a optimal/ effective manner.
LO8 Analyze/ Evaluate real life business/ financial situations and identify/ apply the appropriate
framework/ concepts to solve it in a optimal/ effective manner.

Textbook/ Resources
T1 Fundamentals of Financial Management, 6th Edition

(2014), by Prasanna Chandra, published by McGraw Hill
Education (India) Private Limited
R1 Financial Management Theory and Practice, 8th Edition
R2 Financial Management and Policy, 13th Edition (2009), by
Van Horne J.C., published by PHI Learning
R3 In addition (for some sessions) we will be referring to
selected articles from top journals relevant to the topics at
hand; links and/ or references to the same will be
provided later by the instructor
Evaluation Scheme
Name Type Duration Weight Day, Date, Session, Time
Quiz-I Online - 5% Before Mid Semester
Quiz-II Online - 5% After Mid Semester
Experiential Home - 15% TBD

Learning
Assignments
Mid-Semester Closed 2 hours 30% TBD

Test Book
Comprehensive Open Book 2 hours 45% TBD
Exam
Finance
• Finance is the study of how people and

businesses evaluate investments and raise capital
to fund them

Finance vs. Accounting
Accounting Finance
Definition Preparation of accounting records and Efficient and productive
financial statements management of financial
resources (assets and
liabilities )
Purpose Measuring, preparing, analyzing, and Analysis of financial
interpreting financial statements. To statements to make
collect and present financial information. decisions on working capital
issues such as level of
inventory, cash holding,
credit levels, financial
strategy, managing and
controlling cash flow.
Goal To see how the company is performing, To forecast and model the
to monitor day to day accounting future performance of the
operations, and for taxation purposes. business. Financial
Planning.
5 year forecast, etc.
Tools Balance sheet, profit and loss Performance reports, ratio
statement, and cash flow statements. analysis, risk analysis,
estimating break evens,
returns on investment, etc.
Accounting is about looking at the past whereas Finance is about looking at the future
Basic areas of Finance
• Corporate Finance
• Decisions relating to the efficient management of a firm
• Investment analysis and management

• Analysis and valuation of financial assets (stocks, bonds, etc.),
risk versus return, and asset allocation
• Financial institutions management

• Management of banks, insurance companies, brokerage
houses, etc.
• International or Multinational Finance

• International perspective; becoming more and more
important in the context of globalization
Why Study Financial Management?
(What’s in it for me?)
• Knowledge of finance is critical for making good decisions (professional/ personal )
• Finance is an integral part of corporate world

• Marketing
• Budgets, marketing financial products (or marketing research)
• Management
• Strategic thinking, job performance, profitability
• Financial Goals and Metrics Help Firms Implement Strategy and Track Success
• Example: Few years back, GM made the strategic decision to invest $740 million to
produce the Chevy Volt (electric+ car)
•Such decisions require the expertise of various management disciplines including

marketing, accounting, operations management, and finance and not just technology!
• Most key personal decisions require financial knowledge/understanding
• Example: buying a house or car, planning for retirement, children’s education, etc.
Function of Financial Manager
1a.Raising funds
2.Investments
Financial Financial
Operations Manager 1b.Obligations
(plant, (stocks, debt Markets
equipment, securities) (investors,
3.Cash from i.e. people
projects) operational
activities
with
4.Reinvesting 5.Dividends or surplus
interest funds)
payments
Key role of Finance function is to manage the cash flow

Major Financial Decisions
1) Investment Decision 2) Financing Decision*
Financial Financial
Operations Manager Markets
How much to invest? Source of funds?

What assets/ projects Debt?
to invest in? Equity?
(Capital Budgeting) (Capital Structure)
3) Working Capital Management Decision
How best to manage the cash flows from day to day operations?
* Another related decision is the Dividend decision
Business Organizational Forms
Business Forms
Sole Partnerships
Corporations Hybrids
Proprietorships

Summary of Organization Forms:


Goal of financial management
• The goal of the financial manager must be consistent with
the mission of the corporation
• What should be the goal of a modern corporation?
1. Maximize revenues?
2. Minimize costs?
3. Maximize profits?
4. Maximize shareholder wealth?
• “To achieve sustainable growth, we have established a
vision with clear goals: Maximizing return to shareholders
while being mindful of our overall responsibilities” (part of
Coca-Cola’s mission statement)
• Google?

Corporate Mission
•While managers have to cater to all the stakeholders (such as

consumers, employees, suppliers etc.), they need to pay
particular attention to the owners of the corporation i.e.
shareholders.
•If managers fail to pursue shareholder wealth maximization,

they will lose the support of investors and lenders. The
business may cease to exist and ultimately, the managers will
lose their jobs!

Ethics in Finance
o What do we mean by Ethics?
o Examples of recent financial scandals
o J.P. Morgan Chase $7 Billion Trading Mishap
o Libor Rate Rigging Scandal
o Satyam Scandal

Agency Problem
•Agency relationship
•Principal hires an agent to represent its interests

•Stockholders (principals) hire managers (agents) to run the
company
•Agency problem
•Conflict of interest between principal and agent

•Example: Not pursuing risky project for fear of losing jobs, expensive
perks, expanding the business for increasing scope/ scale of power
• All else equal, agency problems will reduce the firm value.

How to Reduce Agency
Problems?
1. Monitoring
(Examples: Reports, Meetings, Auditors, board of
directors, financial markets, bankers, credit agencies)
2. Compensation plans
(Examples: Performance based bonus, salary, stock
options, benefits)
3. Others
(Examples: Threat of being fired, Threat of takeovers,
Stock market, regulations such as SOX)

Key financial principles
1. Time value of Money
2. Risk return trade-off
3. Cash flows are the key source of value (After tax, Incremental)
4. Efficient Capital Markets
5. Competitive Markets
6. All risks are not equal (diversifiable vs. undiversifiable)
7. Principal Agent issue
8. Ethics

Financial markets
• The main goal of financial markets is to

take the savings from those who do not
wish to consume (savings surplus units)
and to channel them to those who wish to
invest more than what they presently have
(saving deficit units)

Financial markets and
financial system
Financial system
Return on
Return on
investments
Financial investments
markets
money money
Saving surplus Saving deficit

units (savers) units (investors)
money money
Ф Financial
intermediaries
Return on Return on
investments investments

Financing decisions
Financing
decisions
Internal corporate External sources

financing of funds
Direct financing Indirect financing

Retained earnings (financial markets (financial
Instruments) Intermediaries)
Stocks Loans
Debt instruments
(bonds, CPs etc.)

Financial markets
Financial markets
Organized exchanges
Primary markets Money market
Over-the-counter
Secondary markets Capital market

Primary and secondary
markets
• Primary market – primary issues of
securities are sold, allows governments,
banks, corporations to raise money by
directly selling financial instruments to the
public. Such issues are referred as IPO’s
• Secondary market – allows investors to

trade financial securities among
themselves. Examples: BSE, NSE, etc.

Money and capital markets
Money market instruments – short-term assets

(typically maturity less than 1 year):
• Certificates of deposits (CDs)
• Commercial papers (CPs)
• Treasury bills
Capital markets – long-term assets (maturity longer

than 1 year) are traded:
• Stocks
• Corporate bonds
• Long-term government bonds

Organized exchanges and
over-the-counter
• Organized exchanges – most stocks, bonds and
derivatives are traded on organized exchanges. It has a
trading floor where floor traders execute transactions in
the secondary market for their clients.
• Stocks not listed on the organized exchanges are traded

in the over-the-counter (OTC) market. OTC market
facilitates secondary market transactions and unlike an
organized exchange, the OTC market doesn’t have a
trading floor. The buy and sell orders are typically
completed through a telecommunications/ computer
network.

Recent Developments
• Digital Disruption!
• Peer to Peer Lending (P2P) – Online platform that

eliminates the middle man.
• Instead of the bank acting as a intermediary, the

platform brings lenders and borrowers together so
that both can benefit
• Lending Club

Indian Financial System
•Banking - RBI, Commercial banks, Co-operative banks, Post

office savings banks
•Non-banking - LIC, GIC, UTI, Housing development finance

companies-HDFC, HUDCO
•Developmental - ICICI, IDBI, IFCI, NABARD, SIDBI, Tourism

finance corporation SFCs
•Regulatory Institutions - SEBI, RBI, IRDA- Insurance Regulatory

and Development Authority, etc.

Homework
• Review the relevant chapters from textbook
• Look at mission statement of Google, your organization,

others that you are interested in
• Make sure you have access to laptop/ computer with Excel;

we will need it for experiential learning components in
subsequent classes. (Excel 2010 or later versions required.)
• Email me your expectations from this course:

• k.bindumadhavan@pilani.bits-pilani.ac.in

By:
Dr. Vaishali Pagaria
BITS Pilani
Pilani Campus
Bhamidipati.vaishali@pilani.bits-pilani.ac.in
BITS Pilani
1.2 &1.3 Financial Statement

Analysis
Faculty Introduction
Name: Prof (Dr.) Vaishali Pagaria

Qualifications: PhD (Management), MBA (Finance)
Work Experience: 22+ years
Universities/Institutes worked with: NMIMS, Liverpool John Moores
University, Middlesex University, NALSAR
Domain Area: Finance, Accounting, Economics, Business Research, and
Entrepreneurship
Students Handled and Guided: 7000+
Research Publications: 48
Patents: 2
Awards: "International Inspirational Women Award for Best Women Change
Marker", and “Academic Excellence Award” in the year 2020, and “Excellency
in Teaching and Social Services” in the year 2012
BITS Pilani, Deemed to be University under Section 3, UGC Act

Reference from Handout
Type Content Ref. Topic Title Study/HW Resource Reference
Pre CH 1.2 Review previous week's topics. Chapter 3, 4, 5, and 6 of text (T1)
Replay appropriate prerecorded

content/ courseware (module
wise)
During CH 1.2 Introduction to FS; Key components of Chapter 3, 4, 5, and 6 of text (T1)
financial statements;
Understanding the Balance Sheet
Understanding the Income Statement
Understanding the Cash Flow Statement
Post CH 1.2 Review reference chapters from textbook; Chapter 3, 4, 5, and 6 of text (T1)
replay videos as needed to clarify
understanding; do the assigned homework
BITS Pilani, Deemed to be University under Section 3, UGC Act

Reference for Pre-recorded
Videos
• Recorded Lecture 1.2 – Key Financial

Statements
• Recorded Lecture 1.3 – Financial
Statement Analysis
11/17/2023 BITS Pilani, Deemed to be University under Section 3, UGC Act

1.2 Key Financial Statements
Managers, shareholders, lenders, suppliers, customers, tax

authorities, and other interested groups seek answers to
the following important questions about a firm:
• What is the financial position of the firm at a given point

of time?
• How has the firm performed financially over a given
period of time?
• What have been the sources and uses of cash over a
given period of time?

Key Financial Statements
To answer the above questions, Financial Accounting

prepared the following three key statements
• Balance Sheet: Shows the financial position of the firm

at a given point of time
• Profit and Loss A/C: Reflects the performance of the
firm over a period of time
• Cash Flow Statement: Displays the sources and uses
of cash during the period.

Financial Statements
• Provide information on how the firm has performed in the

past and what is its current financial position.
• Serve as a convenient device for the stakeholders to set

performance norms and impose restrictions on the
management of the firm.
• Provide convenient templates for financial forecasting

and planning.

Balance Sheet
Total Assets = Total Liabilities + Owner’s Equity

TA = TL + OE
Total Assets = Total Fixed Assets + Total Current Assets
Total Liabilities = Total Long-term Liabilities + Total Current

Liabilities
Owner’s Equity = Shareholders’ Funds + Reserves and
Surplus

Balance Sheet Format
Liabilities Amt Amt Assets Amt Amt
Capital Fixed Assets (less Depreciation)
Share capital Land and Buildings
Retained earnings Plant and Machinery
Equipments
Long-term Liabilities Current Assets

Debentures Cash
Bonds Bank
Long-term loans Marketable securities
Note Accounts receivables (Debtors)
Inventories
Prepaid expenses
Current Liabilities Other Assets
Accounts payables (creditors) Investments
Taxes payables Intangible assets
Accrued expenses
Deferred revenues
Current portion of long-term
debt
Profit and Loss A/C
Profit After Tax (PAT) = Revenue – Expenses
Based on the two important principles of Accounting
• Realization Principle: Revenue is recognized when the

transaction generating the revenue takes place
• Matching Principle: The expenses associated with a
product/service are recognized when the product/service
is sold

Profit and Loss A/C Format
Particulars Amount Amount
Sales XXX
(less) Cost of Goods Sold XXX
Gross Profit XXX
(less) R & D Expenses XXX
Sales & Distribution Expenses XXX
Administration and General Expenses XXX XXX
Operating Income (EBDIT) XXX
(less) Depreciation XXX
EBIT XXX
(less) Interest XXX
EBT XXX
(less) Tax XXX
EAT or PAT XXX
Cash Flow Statement
The Cash Flow Statement reflects an enterprise’s major sources
of
• Cash Receipts, and
• Cash Payments.
It reports the cash effects during a period of an enterprise’s

• Operations,
• Investing transactions, and
• Financing transactions
It focuses on
• Aggregate of cash and
• Cash equivalents

Cash Flow Statement Format
SN Particulars Amount Amount

(a) Cash Flow from Operating Activities
List of individual inflows and outflows XXXX
Net cash provided by/used in Operating Activities XXXX
(b) Cash Flow from Investing Activities
Net cash provided by/used in Investing Activities XXXX
(c) Cash Flow from Financing Activities
Net cash provided by/used in Financing Activities XXXX
(d) Net increase/decrease in cash (a+b+c) XXXX
(e) Cash and cash equivalents, beginning of period XXXX
(f) Cash and cash equivalents, end of period (d+e) XXXX
Schedule of non-cash investing and financing activities
List of individual transactions

Financial Statement Analysis
Framework
Source: www.ift.world

1.3 Financial Statement
Analysis Techniques
• Financial Ratio Analysis (including Dupont analysis)
• Time Series of Financial Ratio (Trend Analysis)
• Percentage Format Financial Statement (Common-

size financial analysis)
• Industry benchmarking Analysis
• Cost-volume-profit analysis

Financial Ratio Analysis
1. Liquidity Ratio
2. Solvency or Leverage Ratio
3. Turn over Ratio or Efficiency Ratio
4. Profitability Ratio
5. Valuation Ratio

Ratio Formula
Liquidity Ratio
• Current Ratio Current Assets/ Current Liabilities
• Acid-test Ratio Quick Assets/Current Liabilities
Leverage Ratio
• Debt-equity Ratio Total Liabilities/Shareholders Funds
• Interest Coverage Ratio EBIT/Interest
Turn Over Ratio
• Inventory Turnover Ratio Sales/Inventory OR COGS/Inventory
• Debtors’ Turnover Ratio Net Credit Sales/Trade Receivables
• Fixed Assets Turnover Ratio Sales/Net Fixed Assets
• Total Assets Turnover Ratio Sales/Total Assets

Ratio Formula
Profitability Ratio
• Gross Profit Margin Ratio Gross Profit/Sales
• Net Profit Margin Ratio Net Profit/Sales
• Return on Assets (ROA) PAT/Total Assets OR
[PAT + Interest (1-Tax rate)]/Total Assets
• Earning Power EBIT/Total Assets
• Return on Capital Employed EBIT (1-T)/Total Assets
• Return on Equity (ROE) Equity Earnings/Equity or PAT/Equity
Valuation Ratio
• Price-Earning Ratio (PE) Market Price per Share/Earning per Share
• Yield (Dividend + Price Change)/Initial Price
• Market Value to Book Value Market price per share ratio/book value per
share
Exercise Problem

Exercise Problem

DU PONT Analysis
Sales
Net Profit
-
Net Profit
Margin ÷
Expenses
Sales
Return on
Assets X
Sales Fixed
Assets
Total Assets ÷
Turnover +
Total Assets Current
Assets

Time Series of Financial Ratio
• Besides looking at the ratios for one year, look at the

ratios for several years
• Helps to detect secular changes and avoid the bias
introduced by transitory forces.

Percentage Format Financial
Statements
• To understand better a firm’s changing financial position
and performance over time
• To compare one firm with another
In two forms
• Horizontal : Percentage of previous year
• Vertical also known as Common Size Statement Analysis
➢ Balance Sheet: Each asset and liability amount is expressed as percentage of
total assets
➢ Profit and Loss A/C: Each item is expresses as a percentage of total revenues.

Industry Benchmarking
Analysis
• Technique to use to compare your business to a
competitor business or to businesses in the industry at
large.
• It can help answer questions like:
• Does your business have a competitive advantage?
• Are there weaknesses or inefficiencies that we can
address and close the gap between your company
and competitors?”

Cost-volume-profit Analysis
• Set relationship between sales, production volume and

business profit
• Helps to set break-even point, target sales, production
and profit
• Analyse change in fixed cost, variable cost with the
change in target sales

Limitations in Financial
Statement Analysis
• Heuristic and intuitive characters
• Development of benchmarks
• Window dressing
• Price level changes
• Variation in accounting polices
• Interpretation of results

Widely used software for FSA
• Microsoft Excel – VBA Macro tool

• MATLAB
• SAS
• Quilkview
• ORACLE
• Python, R

Ratio Analysis: Practice
Exercise
ABC Ltd. has made plan for the next year. It is estimated
that the company will employ total assets of Rs. 800000,
50% of the assets being financed by borrowed capital at an
interest rate of 16% per year. The direct costs for the year
are estimated at Rs. 480000 and all other operating
expenses are estimated at Rs. 80000. The goods will be
sold to customers at 150% of the direct costs. Income-tax
rate is assumed to be 50%. You are required to calculate
1. Net profit margin
2. Return on assets
3. Assets turnover and
4. Return on owner’s equity

BITS Pilani
Case Discussion : The Hindustan

Manufacturing Company
11/17/2023
Hindustan Manufacturing Company:
Financial Statement Analysis
The Hindustan Manufacturing Company is a leading

producer and exporter of engineering items such as
steel, pipes, ingots, billets, etc. it has also recently added
a chemical plant and a paper plant as part of its
diversification strategy. The company started with a
share capital of Rs.25 lakh in the early sixties, which has
now increased to Rs.225 lakh. The number of shares
outstanding is 22.50 lakh. The average market price
(AMP) of the company’s share during 2019-2021 has
been: RS.26.38 in 2019, Rs.34.50 in 2020 and Rs.29.25
in 2021. The financial data for the company are given in
the following tables. Analysis the financial position of the
company.

Hindustan Manufacturing Company
Profit and Loss Account for the year ending on 31 March
(Rs. In lakh)
Particulars 2019 2020 2021
Net sales 2338.90 2825.69 3717.23
(-)COGS (Depreciation included) 1929.04 2322.80 3053.66
Gross Profit 409.86 502.89 663.57
(-) Selling and Admin Exp 239.72 262.10 357.87
Operating Income 170.14 240.79 305.70
(+) Other Income 15.24 25.38 36.91
EBIT 185.38 266.17 342.61
(-) Interest 59.84 124.98 143.46
PBT 125.54 141.19 199.15
Tax 41.79 30.00 64.29
PAT 83.75 111.19 134.86
Dividend Distributed 33.75 39.38 45.00
Retained earnings 50.00 71.81 89.86

Statement of Cost of Goods Sold for the year ending on 31
March (Rs. In lakh)

Raw Material 1587.34 2019.54 2751.52
Direct labour 138.13 170.86 228.94
Depreciation 23.07 38.64 41.59
Other manufacturing exp 205.34 255.72 329.44
Total direct manufacturing exp. 1953.88 2484.76 3351.49
(+) Opening stock in process 57.09 85.74 150.55
2010.97 2570.50 3502.04
(-) closing stock in process 85.74 150.55 23.083
Cost of production 1925.23 2419.95 3271.21
(+) opening stock of finished goods 150.93 147.12 244.26
2076.16 2567.07 3515.47
(-) closing stock of finished goods 147.12 244.26 461.81
Cost of Goods Sold 1929.04 2322.81 3053.66

Balance Sheet as on 31 March (Rs. In lakh)

A Net Worth
Share capital 225.00 225.00 225.00
Reserve 286.13 357.95 447.81
Total Net Worth 511.13 582.95 672.81
B Borrowings
Long-term: Debentures - 75.75 76.46
FDs 199.87 285.90 312.73
Long-term loan 199.87 361.65 389.19
Short-term loan 442.92 641.39 838.87
Total Borrowings 642.79 1003.04 1229.06
C Capital Employed (A+B) 1153.92 1585.99 1901.87
D Fixed Assets
Gross block 653.49 841.64 921.55
(-) Depreciation 159.55 194.46 235.44
Other non-current assets 52.76 16.44 60.72
Net Fixed Assets 546.70 663.62 746.83
Balance Sheet as on 31 March (Rs. In lakh)

E Current Assets
Inventories:
Raw material 243.42 384.06 457.74
Stock in process 85.74 150.55 230.84
Finished goods 147.12 244.28 461.81
Inventories 476.28 778.89 1150.39
Debtors 253.16 340.61 483.18
Cash and bank balance 8.37 98.84 26.08
Others 128.27 186.21 211.27
Total Current Assets 866.08 1404.55 1870.92
F Current Liabilities*
Trade Payables 35.99 211.21 339.35
Provisions and others 222.87 270.97 376.53
Total current liabilities 258.86 482.18 715.88
G Net Current Assets (E-F) 607.22 922.37 1155.04
H Net Assets (D+G) 1153.92 1585.99 1901.87
MM ZG 521
BITS Pilani Krishnamurthy Bindumadhavan, CFA, FRM

Associate Professor, Management - Finance
Pilani Campus
BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Introduction - Part 1
Agenda
• Introductions
• Flipped classroom
• Course objectives/ outcomes
• Textbooks/ Resources
• Evaluation scheme
• Overview of Financial Management
• Interface between Finance and other Functions
• Shareholder wealth maximization
• Basic Principles of Financial Management
• Understanding Indian Financial System

Introductions – Lead Instructor
Krishnamurthy Bindumadhavan, CFA, FRM
• Bachelor of Engineering, MBA
• Received the CFA charter in 2002
• Awarded FRM title in 2008
• Worked for over 7 years as Senior Analyst/ Consultant to leading Corporations,
Banks; preparing candidates for CFA/ FRM exams
• Worked for 8 years at Capital One, a top 10 US bank and one of the World’s
largest diversified financial services firms
• Worked in both strategic roles as well as operational roles including credit
strategy, product strategy and risk operations
• Drove innovation in risk management to add value of over $50 Million
• Last assignment with Capital One was General Manager, Risk Operations, Asia
• 5+ years of prior experience in Banking technology, primarily with TCS/ TUL
Flipped Classroom
• Replay recorded lectures

• Review relevant study materials/ pre-class assignments
Week before • Case study (if applicable)
class
• Review important and advanced/ difficult concepts

• Active Learning - Application/ Problem solving
In “Live” • Experiential learning – Excel modelling, Case study discussion,
Class Simulation
• Active learning - problem solving

• Discussion forums
After Class • Peer learning

Course Objectives
No. Objectives
CO1 Gain basic understanding of the underlying concepts and building blocks related to financial
management. Develop understanding of the tools relevant to financial management
including time value of money and financial statements analysis.
CO2 Understand business risk, financial risk, break even analysis, and impact of leverage on risk.
Understand the relationship between risk and return and the drivers of risk.
CO3 Understand the application of cost of capital and do the necessary calculations of the
components of cost of capital and WACC; Basic principles of capital budgeting, categories
of capital budgeting projects, discounted and non-discounted cash flow evaluation
methods and their limitations, analysis of risks involved in capital budgeting projects.
CO4 Definition of working capital; Composition and determination of working capital; Financing
and management of current assets; Cash management.
CO5 Understanding the major theories of capital structure and their implications; How to set
target capital structure; Dividend policy and its impact on firm value.

Learning Outcome Statements
No. Learning Outcomes
LO1 Able to analyze and interpret the three key Financial Statements so as to assess the health of a firm/
business.
LO2 Apply Time Value of Money concepts for valuation.
LO3 Distinguish between the different types of risk faced by a firm and express the relationship between
risk and return.
LO4 Able to calculate all the components of cost of capital as well as the overall WACC for a firm.
LO5 Able to evaluate Capital Budgeting projects and make Accept/ Reject decisions based on NPV/ other
business rules.
LO6 Able to formulate corporate Financial Policies in the areas of Working Capital/ Cash Management,
Capital Structure, and Dividend Policy so as to maximize firm value.
LO7 Demonstrate solutions to "real" business/ financial problems by employing excel/ financial modeling in
a optimal/ effective manner.
LO8 Analyze/ Evaluate real life business/ financial situations and identify/ apply the appropriate
framework/ concepts to solve it in a optimal/ effective manner.

Textbook/ Resources
T1 Fundamentals of Financial Management, 6th Edition

R1 Financial Management Theory and Practice, 8th Edition
R2 Financial Management and Policy, 13th Edition (2009), by
Van Horne J.C., published by PHI Learning
R3 In addition (for some sessions) we will be referring to
selected articles from top journals, selected case studies,
and simulations. Links and/ or references to the same will
be provided during the course.
Evaluation Scheme
No Name Type Duration Weight
EC-1 Quiz-I Online - 5%

Quiz-II Online - 5%
Quiz-III Online - 5%
EC-2 Mid-Semester Test Closed Book 2 hours 35%
EC-3 Comprehensive Exam Open Book 3 hours 50%

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Finance
• Finance is the study of how people and

businesses evaluate investments and raise capital
to fund them

Finance vs. Accounting
Accounting Finance
Definition Preparation of accounting records and Efficient and productive
financial statements management of financial
resources (assets and
liabilities )
Purpose Measuring, preparing, analyzing, and Analysis of financial
interpreting financial statements. To statements to make
collect and present financial information. decisions on working capital
issues such as level of
inventory, cash holding,
credit levels, financial
strategy, managing and
controlling cash flow.
Goal To see how the company is performing, To forecast and model the
to monitor day to day accounting future performance of the
operations, and for taxation purposes. business. Financial
Planning.
5 year forecast, etc.
Tools Balance sheet, profit and loss Performance reports, ratio
statement, and cash flow statements. analysis, risk analysis,
estimating break evens,
returns on investment, etc.
Accounting is about looking at the past whereas Finance is about looking at the future
Basic areas of Finance
• Corporate Finance
• Decisions relating to the efficient management of a firm
• Investment analysis and management

• Analysis and valuation of financial assets (stocks, bonds, etc.),
risk versus return, and asset allocation
• Financial institutions management

• Management of banks, insurance companies, brokerage
houses, etc.
• International or Multinational Finance

• International perspective; becoming more and more
important in the context of globalization
• Knowledge of finance is critical for making good decisions (professional/ personal )
• Finance is an integral part of corporate world

• Marketing
• Budgets, marketing financial products (or marketing research)
• Management
• Strategic thinking, job performance, profitability
• Financial Goals and Metrics Help Firms Implement Strategy and Track Success
• Example: Few years back, GM made the strategic decision to invest $740 million to
produce the Chevy Volt (electric+ car)
•Such decisions require the expertise of various management disciplines including

marketing, accounting, operations management, and finance and not just technology!
• Most key personal decisions require financial knowledge/understanding
• Example: buying a house or car, planning for retirement, children’s education, etc.
Function of Financial Manager
1a.Raising funds
2.Investments
Financial Financial
Operations Manager 1b.Obligations
(plant, (stocks, debt Markets
equipment, securities) (investors,
3.Cash from i.e. people
projects) operational
activities
with
4.Reinvesting 5.Dividends or surplus
interest funds)
payments
Key role of Finance function is to manage the cash flow

Major Financial Decisions
1) Investment Decision 2) Financing Decision*
Financial Financial
Operations Manager Markets
How much to invest? Source of funds?

What assets/ projects Debt?
to invest in? Equity?
(Capital Budgeting) (Capital Structure)
3) Working Capital Management Decision
How best to manage the cash flows from day to day operations?
* Another related decision is the Dividend decision
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BITS Pilani

Business Organizational Forms
Business Forms
Sole Partnerships
Corporations Hybrids
Proprietorships

Summary of Organization Forms:


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Goal of financial management
• The goal of the financial manager must be consistent with
the mission of the corporation
• What should be the goal of a modern corporation?
1. Maximize revenues?
2. Minimize costs?
3. Maximize profits?
4. Maximize shareholder wealth?
• “To achieve sustainable growth, we have established a
vision with clear goals: Maximizing return to shareholders
while being mindful of our overall responsibilities” (part of
Coca-Cola’s mission statement)
• Google?

Corporate Mission
•While managers have to cater to all the stakeholders (such as

consumers, employees, suppliers etc.), they need to pay
particular attention to the owners of the corporation i.e.
shareholders.
•If managers fail to pursue shareholder wealth maximization,

they will lose the support of investors and lenders. The
business may cease to exist and ultimately, the managers will
lose their jobs!

Ethics in Finance
o What do we mean by Ethics?
o Examples of recent financial scandals
o J.P. Morgan Chase $7 Billion Trading Mishap
o Libor Rate Rigging Scandal
o Satyam Scandal

Agency Problem
•Agency relationship
•Principal hires an agent to represent its interests

•Stockholders (principals) hire managers (agents) to run the
company
•Agency problem
•Conflict of interest between principal and agent

•Example: Not pursuing risky project for fear of losing jobs, expensive
perks, expanding the business for increasing scope/ scale of power
• All else equal, agency problems will reduce the firm value.

How to Reduce Agency
Problems?
1. Monitoring
(Examples: Reports, Meetings, Auditors, board of
directors, financial markets, bankers, credit agencies)
2. Compensation plans
(Examples: Performance based bonus, salary, stock
options, benefits)
3. Others
(Examples: Threat of being fired, Threat of takeovers,
Stock market, regulations such as SOX)

Key financial principles
1. Time value of Money
2. Risk return trade-off
3. Cash flows are the key source of value (After tax, Incremental)
4. Efficient Capital Markets
5. Competitive Markets
6. All risks are not equal (diversifiable vs. undiversifiable)
7. Principal Agent issue
8. Ethics

MBA ZG 521

Pilani Campus
BITS Pilani

Financial markets
• The main goal of financial markets is to

take the savings from those who do not
wish to consume (savings surplus units)
and to channel them to those who wish to
invest more than what they presently have
(saving deficit units)

Financial markets and
financial system
Financial system
Return on
Return on
investments
Financial investments
markets
money money
Saving surplus Saving deficit

units (savers) units (investors)
money money
Ф Financial
intermediaries
Return on Return on
investments investments

102
Financing decisions
Financing
decisions
Internal corporate External sources

financing of funds
Direct financing Indirect financing

Retained
(financial markets (financial
earnings
Instruments) Intermediaries)
Stocks Loans
Debt instruments
(bonds, CPs etc.)

Financial markets
Financial markets
Organized
Primary markets Money market exchanges
Secondary markets Capital market Over-the-counter

Primary and secondary
markets
• Primary market – primary issues of
securities are sold, allows governments,
banks, corporations to raise money by
directly selling financial instruments to the
public. Such issues are referred as IPO’s
• Secondary market – allows investors to

trade financial securities among
themselves. Examples: BSE, NSE, etc.

Money and capital markets
Money market instruments – short-term assets

(typically maturity less than 1 year):
• Certificates of deposits (CDs)
• Commercial papers (CPs)
• Treasury bills
Capital markets – long-term assets (maturity longer

than 1 year) are traded:
• Stocks
• Corporate bonds
• Long-term government bonds

Organized exchanges and
over-the-counter
• Organized exchanges – most stocks, bonds and
derivatives are traded on organized exchanges. It has a
trading floor where floor traders execute transactions in
the secondary market for their clients.
• Stocks not listed on the organized exchanges are traded

in the over-the-counter (OTC) market. OTC market
facilitates secondary market transactions and unlike an
organized exchange, the OTC market doesn’t have a
trading floor. The buy and sell orders are typically
completed through a telecommunications/ computer
network.

Recent Developments
• Digital Disruption!
• Peer to Peer Lending (P2P) – Online platform that

eliminates the middle man.
• Instead of the bank acting as a intermediary, the

platform brings lenders and borrowers together so
that both can benefit
• Lending Club

Indian Financial System
•Banking - RBI, Commercial banks, Co-operative banks, Post

office savings banks
•Non-banking - LIC, GIC, UTI, Housing development finance

companies-HDFC, HUDCO
•Developmental - ICICI, IDBI, IFCI, NABARD, SIDBI, Tourism

finance corporation SFCs
•Regulatory Institutions - SEBI, RBI, IRDA- Insurance Regulatory

and Development Authority, etc.

Pre-class assignment
• Review the relevant chapters from textbook
• Look at mission statement of Google, your organization,

others that you are interested in and note down your
observations
• Make sure you have access to laptop/ computer with Excel;

we will need it for experiential learning components in
subsequent classes. (Excel 2007 or later versions preferred.)
• Email me your expectations from this course:

• k.bindumadhavan@pilani.bits-pilani.ac.in

MM ZG 521

Pilani Campus
BITS Pilani

- Part 1
Agenda
• Session overview/ objectives
• Key components of financial statements
• Understanding the Balance Sheet
• Understanding the Income Statement
• Statement of Retained Earnings
• Understanding the Cash flow Statement
• Notes to the financial statements

Session overview/ objectives
Topic Title Reference
Key components of financial statements Chapter 3, 4, 5, and 6 of text (T1)
Understanding the Balance Sheet Chapter 3, 4, 5, and 6 of text (T1)
Understanding the Income Statement Chapter 3, 4, 5, and 6 of text (T1)
Understanding the Cash Flow Statement Chapter 3, 4, 5, and 6 of text (T1)

Key Financial Statements
1. Balance Sheet
2. Income Statement
3. Statement of Retained Earnings
4. Cash flow Statement

Purpose of Financial Statements
Financial Statements helps investors/ stakeholders to understand the

performance of the company in the most recent period and answers basic
questions such as:
• What is the company’s current financial status?
•What was the company’s operating results for the period?
• How did the company obtain and use cash during the period?
Key points:
• Only public source of financial data (regulatory and voluntary)

• Main external communication tool (to all stake holders)
• Subject to verification by external experts – auditors, etc.
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- Part 2
Balance Sheet
The Balance Sheet provides a summary of the financial position of a company as of a

particular date.
It lists the following details:
Assets: cash, accounts receivable, inventory, land, buildings, equipment and intangible
items
Liabilities: accounts payable, notes payable and mortgages payable
Owners’ Equity: net assets after all obligations have been satisfied
It helps answer the following questions:

What are the resources of the company?
What are the company’s existing obligations?
What are the company’s net assets?

Basic Accounting Entity
Assets = Liabilities + Owners’ Equity

Resources Sources of Funding
Resources Creditors’ Owners’

used to claims claims
generate = against + against
revenues resources resources

Sample Balance Sheet
Assets Liabilities
Cash $ 50 Accounts payable $ 100
Accounts receivable 100 Notes payable 200
Land 300 $ 300
Owners’ Equity
Total assets $450
Capital stock $ 100
Must Retained earnings 50
Equal $ 150
Total liabilities
and owners’ equity $ 450
This form of presentation is also
referred to as Horizontal BS

Classified and Comparative
Balance Sheets
Classified Balance Sheet:
A classified balance sheet arranges the balance sheet into a format that is useful for
investors and stakeholders.
•A typical arrangement distinguishes between:

•Current and long-term assets
•Current and long-term liabilities
•They are listed in decreasing order of liquidity
Comparative Balance Sheet:

• A comparative balance sheet presents side by side information about a firm’s assets,
liabilities and equity across multiple points of time.
•Such a statement helps stakeholders to identify significant changes over time.

Limitations of Balance Sheet
• Assets recorded at historical value
• Assets depreciated using accounting rules
• Above two features leads to BV not reflecting MV
• Additionally, estimations are required for valuing certain assets and liabilities (example:
net realizable value of accounts receivable, cost of warranty, etc.)
• Only recognizes assets that can be expressed in monetary terms
• In some organizations (consulting, etc.) Human Resources may be the most critical
assets but may not be reflected on the BS!
• Does not include off balance sheet liabilities

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BITS Pilani

- Part 3
Income Statement
The Income Statement shows the results of a company’s operations over a period of
time, and answers questions such as:
• What goods were sold or services performed that provided revenue for the
company?
• What costs were incurred in normal operations to generate these revenues?
• What are the earnings or company profit?

Balance Sheet Vs. Income Statement
Snapshot
Balance sheet Balance sheet Balance sheet Balance sheet
31/12/2011 31/12/2012 31/12/2013 31/12/2014
Income Income Income

statement 2012 statement 2013 statement 2014
“Flow” data

Income Statement - Components
Revenues
Assets (cash or AR) created through business operations
Expenses
Assets (cash or AP) consumed through business operations
Net Income or (Net Loss)

Revenues - Expenses

Sample Income Statement
2014 2013
Revenue:
Sales $150 $ 125
Other revenue 50 25
Total revenues $200 $150
Expenses:
Cost of goods sold $ 100 $ 90
Operating & admin. 40 30
Income tax 20 15
Total expenses $ 160 $ 135
Net Income $ 40 $ 15

Typical Income Statement
Income statement for period 2014

$ ’000
Sales 5,356
Cost of sales (2,601)
2,755
1
Distribution costs 382
Administrative expenses 874 (1256)
Profit before interest and tax 1,499
Interest (362)
2 Profit before taxation 1,137
Taxation (384)
Profit available for shareholders 753
Note: 1) Operating result 2) Return to other stakeholders (other than owners)

Statement of Retained
Earnings
• This financial statement outlines the changes in retained earnings from one
accounting period to the next
Beginning retained earnings

+ Net income
– Dividends paid
= Ending retained earnings

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- Part 4
Cash Flow Statement
The cash flow statement reports the amount of cash collected

and paid out by a company during a particular period of time
and is usually classified into three buckets, namely: operating,
investing and financing activities.
It helps answer two important questions:
• How did the company receive cash?
• How did the company use its cash?
• The cash flow statement complements the income statement

and gives an indication of the ability of a company to continue
in business and generate income in the future.

Cash flow Statement
Cash inflows:
• Sell goods or services

• Sell other assets or by borrowing
• Receive cash from investments by owners
Cash outflows:
• Pay operating expenses

• Expand operations, repay loans
• Pay owners a return on investment

Classification of Cash Flows
Operating activities – Transactions and events that factor into

the determination of net income.
Investing activities – Transactions and events that involve the
purchase and sale of securities, property, plant, equipment,
and other assets not generally held for resale, and cash
advances and collections on loans made to other entities.
Financing activities – Transactions and events where resources
are obtained from (or repaid to) owners and creditors.

Operating Activities
Cash Inflow Cash Outflow

• Sale of goods or • Inventory payments
services • Interest payments
• Sale of investments • Wages
in trading securities • Utilities, rent
• Interest revenue • Taxes
• Dividend revenue
Note that interest income, interest expense and dividends received from
investments in other firms form part of operating activities

Investing Activities

• Sale of plant assets • Purchase of plant assets
• Sale of securities, other • Purchase of securities,
than trading securities other than trading
• Collection of principal securities
on loans (made to other • Making of loans to other
entities)
entities

Financing Activities

• Issuance of own stock • Dividend payments
• Borrowing • Repayment of debt (i.e.
principal borrowed)
• Equity repurchases
(Treasury stock)

Cash Flow Statement
Operating Investing Financing

Activities Activities Activities
CASH
INFLOWS Inv
Ops
CASH ON
Fin HAND
CASH
OUTFLOWS
Operating Investing Financing
Activities Activities Activities
Sample Cash Flow Statement
Best Consultants Ltd.

Statement of Cash Flow
December 31, 2014
Cash Flows From Operating Activities:

Receipts 50
Payments (45) 5
Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)
Cash Flows Used By Financing Activities:

Receipts 12
Payments (6) 6
Net Cash Flow 7

Cash Flow - Interpretation
Operating Investing Financing Interpretation

Building up a pile of cash; possibly looking to
1 + + + make an acquisition
Operating cash flow being used to buy fixed

2 + ─ ─ assets and pay down debt
3 Operating cash flow and sale of fixed assets

being used to pay down debt
+ + ─
Operating cash flow and borrowed

4 + ─ + money being used to expand the business

Cash Flow - Interpretation
Operating Investing Financing Interpretation

Operating cash flow problems covered by
5 ─ + + sale of fixed assets, borrowing and owner
contributions.
Rapid growth, short falls in operating cash

6 ─ ─ + flow; purchase of fixed assets.
7 Sale of fixed assets is financing operating

cash flow shortages.
─ + ─
Company is using reserves to finance cash

8 ─ ─ ─ flow short falls.

Notes to Financial Statements
• Notes are used to convey information required by GAAP or to provide
more detailed explanations
• The notes help investors to better understand and interpret the

numbers presented in the main financial statements
Four general types of notes:
• Summary of significant accounting policies such as key assumptions and

estimates
• Additional information about the summary totals
• Disclosure of important information that is not recognized in the financial

statements
• Supplementary information required by accounting rules or investment or other

regulations

Thank You
145
MBA ZG 521

Pilani Campus
BITS Pilani
Financial Statements Analysis

- Part 1
FSA - Agenda
• Session overview/ objectives
• Principles of Financial Statements Analysis
• Tools and Techniques used in financial statements analysis
• Horizontal Analysis
• Vertical Analysis
• Ratio Analysis
• Introduction to Ratio Analysis
• Calculation of all key ratios (and their interpretation)
• Activity
• Liquidity
• Solvency
• Profitability
• Valuation ratios
• Basic Dupont Analysis - Application and interpretation
• Limitations of financial statements analysis

References
Module Title: Foundations of Financial Management
Principles of Financial Statements Analysis Chapter 3, 4, 5, and 6 of text (T1)
Tools and Techniques used in financial statements Chapter 3, 4, 5, and 6 of text (T1)
analysis
Limitations of financial statements analysis Chapter 3, 4, 5, and 6 of text (T1)

Introduction to Ratio Analysis Chapter 3, 4, 5, and 6 of text (T1)
Calculation of all key ratios including Activity, Liquidity, Chapter 3, 4, 5, and 6 of text (T1)
Solvency, Profitability and Valuation ratios and their
interpretation
Application of Dupont Analysis and its interpretation Chapter 3, 4, 5, and 6 of text (T1)

Objective of Financial Statements
Analysis
Financial statement analysis helps various stakeholders (such as investors,
lenders, etc.) to make better decisions by assessing the present condition of
the firm and comparing it to past periods or to industry peers.
Internal Stakeholders:
• Managers
• Officers
• Internal Auditors
External Stakeholders:
•Shareholders
•Lenders
•Customers

Internal Financial Analysis
• To evaluate the performance of employees and determine their pay raises

and bonuses
• To compare the financial performance of the firm’s different divisions
• To prepare financial projections, such as those associated with the launch

of a new product
• To evaluate the firm’s financial performance in light of its competitors and

determine how the firm might improve its operations

External Financial Analysis
• Banks and other lenders deciding whether to lend money to the firm.
• Suppliers who are considering whether to grant credit to the firm.
• Credit-rating agencies trying to determine the firm’s creditworthiness.
• Investment analysts who work for investment companies considering investing in

the firm or advising others about investing in the firm.
• Individual investors deciding whether to invest in the firm.

Basic Accounting Principles
The following three fundamental principles are adhered to by

accountants when preparing financial statements:
• The revenue recognition principle

• The matching principle
• The historical cost principle
An understanding of these basic principles allows us to be a more

informed user of financial statements and thereby be more
effective in our analysis

Revenue recognition principle
• According to this principle, revenue should be included in the

firm’s income statement for the period in which:
• Goods and services were exchanged for cash or

accounts receivable (OR)
• The firm has completed what it needs to do to be

entitled to the cash

Matching principle
• The matching principle determines whether specific costs or

expenses can be attributed to this period’s revenues
• The expenses are matched with the revenues they helped

produce:
•For example, employees’ salaries are recognized when the
product produced as a result of their work is sold, and not
when the wages were paid

Historical cost principle
• This principle is the basis for determining the dollar amounts

the firm reports in its balance sheet.
• Most assets and liabilities are reported in the firm’s financial

statements at historical cost i.e. the price the firm paid to
acquire them.
• The historical cost generally does not equal the current

market value of the assets or liabilities.

Tools and Techniques
1) Common size/ Vertical financial statements analysis:
• This is a standardized version of a financial statement in which all entries are
converted into percentages of a key financial statement component
• A common size financial statement helps to compare entries in a firm’s financial
statements, even if the firms are not of equal size.
2) Horizontal financial statements analysis:
• Here also all entries are presented in percentages
• However the focus is on trends over time
• Horizontal financial statements analysis helps a financial statement user to see
relative changes over time and identify both positive and negative trends
3) Ratio Analysis
• Ratio Analysis is another method for standardizing the financial information on
the income statement and balance sheet.
• A ratio is typically compared to:
• Ratios from previous years
• Ratios of peers (other firms in the same industry)
• If differences are significant a more in-depth analysis will help uncover the drivers

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BITS Pilani

- Part 2
Common size analysis
• For common size income statement analysis, we divide each entry in the income
statement by the company’s sales
• For common size balance sheet analysis, we divide each entry in the balance
sheet by the firm’s total assets

Common Size Income
Statement Analysis

Common Size Income
Statement Analysis
Key take-away’s:
• Cost of goods sold make up 75% of the firm’s sales resulting in a gross
profit of 25%
• Selling expenses account for about 3% of sales. Income taxes account for
4.1% of the firm’s sales
• After accounting for all expenses, the firm generates net income of 7.6%
of the firm’s sales
Essentially this type of analysis helps answer questions such as:
• What percentage of revenues is the cost of goods sold?

• What is the gross profit percentage?
• What is the mix of expenses (in terms of percentages) that the company has
incurred in this period?
• What is the net profit percentage?

Common Size Balance Sheet

Common Size Balance Sheet
Analysis
Key take-away’s:
• Total current assets account for 32.6% of firm’s assets in 2010, showing an
increase of 5.6%
• Similarly total current liabilities account for 14.6% of firm’s total liabilities and
equity (which is equal to assets) in 2010, showing a decline of 2%
• Long-term debt account for 39.2% of firm’s assets in 2010, showing a decline
of 1.7%
• What percentage of total assets (or liabilities + equity) is classified as current
assets (or current liabilities)?
• What percentage of total assets is classified as inventory? Is this changing
over time? If it is increasing does this mean the firm is facing difficulty in selling
its inventory? If yes, is that because of competition or obsolescence?
• What percentage of total assets is classified as accounts receivable? If it is
increasing does this mean the firm is having difficulty in collections? If it is
decreasing, is it because of a tighter credit policy? Is this leading to lost sales?
• What is the composition of the capital structure?

Horizontal Analysis
• In horizontal analysis, typically a base year is selected and the dollar amount of
each financial statement item in subsequent years is converted to a percentage of
the base year dollar amount
Fraud detection analysis: In this scenario we would select the last year in which we
believe there was no fraud as the base year so as to estimate the extent of the fraud
in subsequent years
Investment analysis (after introduction of new product/ management/ etc.): In this

scenario we would select the last year before the change as the base year so that
we may estimate the impact of the change, i.e. new product/ management/ etc.
Example in Excel!

MBA ZG 521

Pilani Campus
BITS Pilani

- Part 3
Ratio Analysis - Introduction
• Financial ratios provide an alternative method for

standardizing the financial information on the income
statement and balance sheet
• A ratio by itself may not be very informative
• Typically a ratio is compared to

• Ratios from prior years
• Ratios of peers (other firms in the same industry)
• If the differences are significant then more detailed analysis is

done to identify the underlying drivers and the implications

Financial Ratio Analysis – Key
Building Blocks
Ability to meet Ability to

short-term generate future
Liquidity and
obligations and to Activity/ revenues and
Solvency
efficiently generate Efficiency meet long-term
revenues obligations
Ability to provide
financial rewards Ability to
sufficient to attract Profitability Valuation generate
and retain positive market
financing expectations

Liquidity Ratios
• Liquidity ratios help answer the question:

• How liquid is the firm?
• A firm is financially liquid if it is able to pay its bills on time
• We typically analyze a firm’s liquidity from two perspectives:

• Overall or general firm liquidity
•Liquidity of specific current asset accounts

(these are sometimes also classified as turnover ratios or
activity ratios or efficiency ratios)

Overall Liquidity
• Overall liquidity is analyzed by comparing the firm’s current assets to the
firm’s current liabilities
• The two key ratios used in this analysis are:
• Current ratio (sometimes referred to as working capital ratio)
• Acid-test ratio
Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current
(short-term) liabilities
• Acid-Test (Quick) Ratio: This ratio excludes the inventory from current assets since
inventory is usually not as liquid as cash or other current assets

Turnover ratios
Accounts Receivable Turnover Ratio measures how many times

accounts receivable are “turned over or rolled over” during a year
Inventory turnover ratio measures how many times the company

turns over its inventory during the year. Shorter inventory cycles
lead to greater liquidity since the items in inventory are converted
to cash more quickly.
Inventory turnover ratio: HP vs. Dell

Ratios (Con’t)
Average Collection Period measures the number of days it takes

the firm to collect its receivables.
= 365 ÷ Accounts Receivable turnover ratio
• Inventory Processing Period: We can express the inventory

turnover ratio in terms of the number of days the inventory sits
unsold on the firm’s shelves
• This is also called Days’ Sales in Inventory
Inventory Processing Period = 365 ÷ inventory turnover ratio

Liquidity guidelines
• A high investment in liquid assets will enable the firm to repay its
current liabilities in a timely manner.
• However, too much investment in liquid assets may not be a

good thing as it can be very costly for the firm since liquid assets
(such as cash) generate minimal return

Solvency ratios
• Solvency ratios speak to the risk and leverage of a firm

• Creditors are especially interested in these ratios.
• A rising debt-to-equity ratio means higher interest expenses
and beyond a certain point it will impact the company’s credit
rating, making it expensive to raise additional debt
• Debt to Equity ratio = Debt ÷ Equity
• Debt to assets = Total debt ÷ Total assets

Profitability ratios
Profitability ratios address a very fundamental question: Has the firm earned adequate
returns on its investments?
Typically we answer this question by looking at two types of ratios:
Profit margin: which predicts the ability of the firm to control its expenses
Rate of return on investments: which tells us the return on the investment
• Gross Profit margin = Gross Profit ÷ Sales
• Net Profit margin = Net Profit ÷ Sales
• Return on Equity = Net Income ÷ Common Equity

Return on Equity ratio measures the accounting return on the
common stockholders’ investment.

MBA ZG 521

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BITS Pilani

- Part 4
Dupont Analysis
DuPont method analyzes the firm’s ROE by decomposing it into

three parts: profitability, efficiency and an equity multiplier.
ROE = Profitability × Efficiency × Equity Multiplier
• Equity multiplier captures the effect of the firm’s use of debt

financing on its return on equity. The equity multiplier increases in
value as the firm uses more debt.

Valuation or Market Value ratios
Market value ratios address the question, how are the firm’s shares valued in the stock
market?
Two market value ratios are:

Price-Earnings Ratio
Market-to-Book Ratio
Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1
of reported earnings.

Market Value ratios
Market-to-Book Ratio measures the relationship between the market value and the
accumulated investment in the firm’s equity.

Limitations of Financial Ratio
Analysis
• Picking an industry benchmark can sometimes be difficult.
• Published peer-group or industry averages are not always representative of the

firm being analyzed.
• An industry average is not necessarily a desirable target or norm.
• Accounting practices differ widely among firms.
• Many firms experience seasonal changes in their operations.
• Financial ratios offer only clues. We need to analyze the numbers in order to fully
understand the ratios.
• The results of financial analysis are dependent on the quality of the financial
statements.

MBA ZG 521

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BITS Pilani
Time Value of Money

- Part 1
Agenda
• Time Value of Money – Basic Principles
• Future Value
• Present Value
• Effective Interest Rate
• Ordinary Annuity
• Annuity Due
• Perpetuity
• Applications
• Calculations using Excel/ Financial Calculator

Time value of money
• How much it costs to rent money A dollar today

– Keeping the money at home creates an opportunity cost
is worth more
– Interest rate is a measure of this opportunity cost
– Price of impatience and the value of waiting than a dollar
tomorrow
• Example: Assume you have $100 and interest rate is 10%
– PV = $100
• At the end of year 1, FV = PV + r(PV) = PV(1+r) = $110; Where:

– FV = Future Value
– PV = Present Value
– r = interest rate (or discount rate)
• At the end of year 2, FV = $110 x 1.1 = $121
– Interest on interest = $1 = Compound Interest
• In general, FV = PV(1+r)^n; where n = number of time periods
• Reversing the logic: PV = FV/ (1+r)^n

189
Time lines show timing of cash flows.
Interest Rate
0 1 2 3
i%
CF0 CF1 CF2 CF3

Cash Flows
Tick marks at ends of periods.
• Time 0 is today; Time 1 is the end of Period 1; or the beginning of
Period 2.
90% of getting a Time Value problem correct is setting up the

timeline correctly!!!

Future Values
What’s the FV of an initial $100 after 3 years
if i = 10%?
0 1 2 3
10%
100 FV = ?
Finding FVs (moving to the right on a time line) is called

compounding.
• Compounding involves earning interest on interest for
investments of more than one period.

Single Sum - Future & Present
Value
FV3 = (1+i)3PV
FV2 = (1+i)2PV
FV1 = (1+i)PV
PV
0 1 2 3
• Assume one can invest the PV at interest rate i to receive future sum, FV
• Similar reasoning leads to Present Value of a Future sum today.
FV1 FV2 FV3
0 1 2 3
PV = FV1/(1+i)
PV = FV2/(1+i)2
PV = FV3/(1+i)3
Single Sum – FV & PV Formulas
FVn = PV(1 + i )n for given PV

n
FVn  1 
PV = n = FVn  
 1+ i
(1+ i)
PV Calculation for $100 received in 3 years
if interest rate is 10%
 1 3
PV = $100  
 1.10 
= $100 (0.7513 ) = $75.13.
Single Sum – FV & PV Formulas
FVn = PV(1 + i )n for given PV

n
FVn  1 
PV = n = FVn  
 1+ i
(1+ i)
PV Calculation for $100 received in 3 years
if interest rate is 10%
 1 3
PV = $100  
 1.10 
= $100 (0.7513 ) = $75.13.
Question on PV of a given FV
Ex 1. An investor wants to have

$1 million when she retires in
20 years. If she can earn a 10
percent annual return,
compounded annually, on her
investments, the lump-sum
amount she would need to
invest today to reach her goal
is closest to:
A. $100,000.
B. $117,459.
C. $148,644.
D. $161,506.

Question on PV of a given FV
Ex 1. An investor wants to have

$1 million when she retires in • This is a single payment to be
20 years. If she can earn a 10 turned into a set future value
percent annual return, FV=$1,000,000 in N=20 years
compounded annually, on her time invested at r=10% interest
investments, the lump-sum
rate.
amount she would need to
invest today to reach her goal PV =[ 1/(1+r) ]N FV
is closest to: PV = [ 1/(1.10) ]20 $1,000,000
A. $100,000.
PV10 = [0.14864]($1,000,000)
B. $117,459.
C. $148,644. PV10 = $148,644
D. $161,506.

There are 3 ways of looking at Interest rates
• Returns required by investors to induce them to postpone consumption

– Rate of interest that can convert consumers into investors or lenders
• Discount rate
– Generic term that measures the rate of return reflecting the time value of money
• Opportunity cost: value of next best option that investors forgo by choosing what they
do

Opportunity cost is a basic economics concept
• Opportunity Cost
– Difference between a particular action and the value of the best alternative
– Explicit recognition of the reality that taking an action eliminates other avenues/
options
– Indication of the relative importance of a decision
• If opportunity cost is small => cost of incorrect choice is small

• If opportunity cost is large => cost is large
• Examples
– buying your groceries (likely small)
– buying a car (potentially large)
• However, it is not always obvious or easy to calculate

In calculating PV, choice of discount rate is fairly
critical
$120
PV Factor
$100
$80
$60
$40
Discount rate 0%
Discount rate 5%
$20 Discount rate 10%
Discount rate 15%
Discount rate 20%
Discount rate 25%
Discount rate 30%
$-
1 2 3 4 5 6 7 8 9 10 11
Time Period

Inflation and risk impact interest rates
• In a certain world interest rate is the risk free rate

– Closest is government short term debt like US T-bills
• In real world however two factors come into play

– 1) Inflation: lenders charge an inflation premium to account for expected increase in prices
– 2) Risk: Compared to governments there is risk inherent in lending to private companies,

driven primarily by business dynamics such as industry climate, competition, economy, etc.
• This is typically referred to as default risk
• Interest rates are also affected by the forces of demand and supply

202
Frequency of compounding
• Certain investment products pay interest more than once a year
• In these cases, by convention the stated or quoted annual interest rate is (periodic
rate x # of periods in a year)
• FVN = PV(1 + r s/m)(m x n)
• Where: r s is the stated interest rate; m is the # of compounding periods in a year and
N is the # of years
• Continuous compounding: when number of compounding periods in a year

approaches infinity
• FVN = PV x e(r s x n); where e ~ 2.7183
• Effective interest rate = (1 + r s/m)(m ) - 1
• And in the case of continuous compounding, effective interest rate = er s - 1

204
MBA ZG 521

Pilani Campus
BITS Pilani
Time Value of Money

- Part 2
Annuity
• Annuity: finite set of sequential CF’s, all of the same value
• Two types of annuities:

– Ordinary annuity
– Annuity due:

Annuities
• Regular or ordinary annuity is a finite set of

sequential cash flows, all with the same value A,
which has a first cash flow that occurs one period
from now.
• An annuity due is a finite set of sequential cash
flows, all with the same value A, which has a first
cash flow that is paid immediately.

Ordinary Annuity Timeline
Time line for an ordinary annuity of $100 for 3 years.
0 1 2 3
i%
$100 $100 $100

Ordinary Annuity vs. Annuity Due
Difference between an ordinary annuity and an annuity
due?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT

Annuity Due
0 1 2 3
i%
PMT PMT PMT

PV FV
Annuity calculations
• Ordinary Annuity - Equal CF’s
▪ FV = A [ (1+r)^N -1]/ r
▪ PV = A[(1 – 1/(1+r)^N]/ r
• Annuity Due: treat the 1st CF as one component of PV and for the
remaining CF’s use the above formula and sum the two components

212
213
Perpetuities
Perpetuity is a series of constant payments, A, each period forever.
A A A A A A A
0 1 2 3 4 5 6 7
PV1 = A/(1+r)
PV2 = A/(1+r)2
PV3 = A/(1+r)3
PV4 = A/(1+r)4
etc. etc.
PVperpetuity = [A/(1+i)t] = A [1/(1+i)t] = A/i
Intuition:
Present Value of a perpetuity is the amount that must invested today at the
interest rate i to yield a payment of A each year without affecting the value
of the initial investment.

Annuity can be viewed as a combination
of two perpetuities
1. We can view an annuity as the difference between 2 perpetuities with

different starting dates
2. PV of a series of unequal CF’s = Sum of the PV’s of the individual

CF’s
3. Use the appropriate formula (PV/ FV) to solve for other unknowns
including: rates, # of periods or size of annuity payments

216
Annuity Formula and Perpetuities
1. Perpetuity of A per period in Period 0 -- PV1 = A/i
A A A A A A A A A A A A A A
0 2 4 6 8 10 12 14
2. Perpetuity of A per period in Period 8 -- PV8 = [1/(1+i)]8 x (A/i)

A A A A A A
0 2 4 6 8 10 12 14
3. Annuity of A for 8 periods -- PV = PV1 – PV8 = (A/i) x { 1 – [1/(1+i)]8 }
A A A A A A A A
0 2 4 6 8 10 12 14
Intuition: Formula for a N-period annuity of A is:

PV of a Perpetuity of A today minus PV of a Perpetuity of A in period N
Annuities & Perpetuities Again
• Rather than memorize the • Calculating the PV of an

annuity formula it may be annuity has 3 steps:
easier to calculate it as 1. Calculate (A/i)
the difference between – PV of a Perpetuity with
payments of $A per
two perpetuities with the period.
same payment. 2. Calculate [1/(1+i)]N
– Discount factor
• PV of an N-period annuity associated with end of the
of $A per period is: annuity.
3. Calculate PVN =
PVN =
(A/i) x { 1 - [1/(1 + i)]N }
(A/i) x { 1 – [1/(1+i)]N} – I think this is easier under
pressure than memorizing
the formula.

Question on FV of Annuity Due
Ex 2.An individual deposits

$10,000 at the beginning of
each of the next 10 years,
starting today, into an
account paying 9 percent
interest compounded
annually. The amount of
money in the account at the
end of 10 years will be
closest to:
A. $109,000.
B. $143,200.
C. $151,900.
D. $165,600.

Question on FV of Annuity Due
Ex 2.An individual deposits • This is an annuity due of

$10,000 at the beginning of A=$10,000 for N=10 years at
each of the next 10 years, i=9% interest rate.
starting today, into an • Annuity due must be adjusted by
account paying 9 percent (1+i) to reflect payment is made at
interest compounded beginning rather than end of
annually. The amount of period.
money in the account at the • Also must adjust PV formula by
(1+i) N for FV of annuity.
end of 10 years will be
closest to:
PV = (1+i) (1+i)[(A/i) { 1 – [1/(1+i)] }]
N N N
A. $109,000.
PV10 = (1.09)11 ($10K/.09) {1 – [1/1.09]10}
B. $143,200.
C. $151,900. PV10 = (2.58)($111,111){1 – [0.42]}
D. $165,600. PV10 = $165,601

Application of Annuities
• Loan or lease payments
• Calculating EMI’s

MBA ZG 521

Pilani Campus
BITS Pilani
Time Value of Money

- Part 3
Applications of TVM
• NPV – to be discussed in a subsequent session
• IRR – to be discussed in a subsequent session
• Basic Bond Valuation
• Basic Equity valuation

Principles of bond valuation
C C C, Face
t=0 t= T
• Fundamental principles of valuation

- Dollar today is higher than dollar received in the future
- The value of any financial asset equals the PV of its expected
cash flows
• Three steps in valuation

- We must estimate the size/ timing of future cash flows
- We must determine the appropriate discount rate
- We must calculate the PV’s of the estimated cash flows using
the discount rate in step 2
225
Basics of Bond Valuation
• The value of the bond is equal to the present value of the cash flows generated by the
bond ...

T Ct Face
PO = +
(1 + r)t (1 + r)T
t= 1
Where:
Ct = coupon payment at time t
r = yield to maturity required by the market
Face = face value of the bond to be repaid at the maturity date T
226
Bond Valuation Example
What’s the value of a 10-year, 10% coupon bond if

kd = 10%?
0 1 2 10
10%
...
VB = ? $100 $100 ($100 + $1,000)

Bond Valuation Example
What’s the value of a 10-year, 10% coupon bond if

kd = 10%?
0 1 2 10
10%
...
VB = ? $100 $100 $100 + $1,000
$100 $100 $1,000

VB = 1 + . . . + 10 + 10
(1+ k d ) (1+ k d ) (1+ k d )
= $90.91 + . . . + $38.55 + $385.54

= $1,000.
Valuing preferred Stock
• Valuation of preferred stock
- Relatively easy because dividend is fixed and the preferred life’s is infinite
(perpetuity)
V = Dividend/Kp, where Kp = required return on preferred stock
• Assume a preferred stock A has a$100 par value and a dividend of $8 a
year. Because of inflation, uncertainties and tax advantage, the required
rate of return is 9%. Thus, the value of this preferred stock A is……
V = 8/0.09 = $88.89
• If the market price of preferred stock A is $95, would you buy it?
How about if it’s $80?

Valuing common stock using dividend
discount models
• Valuation of common stock
- More difficult than bonds and preferred stock because the size and timing
of future cash flows are highly uncertain and the required rate of return or
discount rate is also unknown
- The basic model used to value common stock is called the dividend
discount model (DDM)
• DDM determines value of a stock by calculating the PV of the future
stream of dividends
V= 
Dt / (1 + K), where Dt = dividend during period t
K = required return
• If an investor sells the stock, the purchaser is buying the remaining
dividend streams

DDM for a one-year holding period:
• Valuation of common stock (one-year holding period)

- Value = PV of all any dividends + PV of the selling price
V = D1 / (1 + K) + SP / (1 + K),
Where: SP = selling price; D1 = dividend to be received at end of year 1
• What is the value of a stock that last year paid a $1 dividend. You think next
year’s dividend will be 10% higher and the stock will be selling for $25 at year-
end. The required return or the discount rate is 11%.
- Solve for D1 = $1 (1.10) = 1.10
- Substitute all given variables to the equation
V = 1.10 / (1 + 0.11) + 25 / (1 + 0.11)
V = 0.99 + 22.52 = $23.51
- Will you buy the stock if the market price is $25? How about $20?

DDM for a multiple-year holding period:
• Valuation of common stock (multi-year holding period)

V = D1 / (1 + K) + D2 / (1 + K)2 + SP / (1 + K)2 … 2-period
V = D1 / (1 + K) + D2 / (1 + K)2 + D3 / (1 + K)3 + SP / (1 + K)3 … 3-period
• Assuming a holding period of three years with the following estimated
dividend payments: Year 1 = $1.10; Year 2 = 1.25 and Year 3 = 1.50. Assume
an estimated sale price of $57, three years from now. Required rate of return
is 15%.
V = 1.10 / (1 + .15) + 1.25 / (1 + .15)2 + 1.50 / (1 + .5)3 + 57 / (1 + .15)3
V = $40.37
• Will you buy the stock if the market price is more than $40.37? How
about if it is less than?

DDM for infinite period returns
• Valuation of common stock (infinite period DDM)

- This is also called the constant growth DDM
- Assumes an estimation of future dividend payment for an infinite period
V = D1 / (k - g) … g = growth rate
• What is the value of the stock that paid $2 dividend last year if dividends are
expected to grow at 5% forever? The required rate of return is 12%
- Solve for D1 = $2 (1.05) = 2.10, then …
V = 2.10 / (.12 - .05) = $30
- The relationship between k and g is critical. What happens to the stock if the
difference widens? How about if it narrows?

MBA ZG 521

Pilani Campus
BITS Pilani
Risk Management
- Part 1
Agenda
• Return – Basic Concepts
• Geometric vs. Arithmetic mean
• Risk – Basic Concepts
• Calculations – Returns, Standard Deviation, etc.
• Risk Return Relationship
• Probability distributions
• Risk attitudes
• Portfolio diversification
• Systematic vs. Unsystematic Risk
• CAPM - Basics

Defining Return
Income received on an investment plus any

change in market price, usually expressed
as a percent of the beginning market price
of the investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
Return Example
The stock price for Stock A was $10 per share

1 year ago. The stock is currently trading at
$9.50 per share and shareholders just received
a $1 dividend. What return was earned over
the past year?

Return Example
The stock price for Stock A was $10 per share

1 year ago. The stock is currently trading at
$9.50 per share and shareholders just received
a $1 dividend. What return was earned over
the past year?
$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
Geometric vs. Arithmetic
Average Rates of Return
• There are two commonly used ways to

calculate the average returns:
– Arithmetic
– Geometric
• Arithmetic average may not always
capture the true rate of return realized on
an investment. In some cases, geometric
or compound average may be a more
appropriate measure of return.

Geometric vs. Arithmetic
Average Rates of Return (cont.)
• The geometric average rate of return

answers the question, “What was the
growth rate of your investment?”
• The arithmetic average rate of return

answers the question, “what was the
average of the yearly rates of return?

MBA ZG 521

Pilani Campus
BITS Pilani
Risk Management
- Part 2
Defining Risk
The variability of returns from those

that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank deposit or a share
of stock?

Determining Expected
Return (Discrete Dist.)
n
R = S ( Ri )( Pi )
i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.

How to Determine the Expected
Return and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09 or
9%
.33 .10 .033
Sum 1.00 .090
Determining Standard Deviation
(Risk Measure)
n
s= S ( Ri - R )2( Pi )
i=1
Standard Deviation, s, is a statistical measure
of the variability of a distribution around its
mean.
It is the square root of variance.
Note, this is for a discrete distribution.

How to Determine the Expected
Return and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
(Risk Measure)
n
s= S
i=1
( Ri - R ) 2( P )
i
s= .01728
s= .1315 or 13.15%

Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0
13%
22%
31%
40%
49%
58%
67%
4%
-50%
-41%
-32%
-23%
-14%
-5%
-15% -3% 9% 21% 33%

Statistics : Normal distribution
• Bell shaped Symmetrical curve
• Area under curve gives the total

probability

Common Probability Distributions :
Standard Normal Distribution
• The Standard Normal Distribution is a normal distribution with (mean),

 = 0 and (std. devn.)s = 1.
• Symmetrical
• Total area under curve = 1
Also Note:
1) area within + or - 2
standard deviations
is 95.4%
2) Area within + or - 1
standard deviation
is 68.3%
99.7%
Wide ranging applications in Modern Portfolio Theory and Risk Management

Determining Expected
Return (Continuous Dist.)
n
R = S ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.

(Risk Measure)
n
s= S
i=1
( R i - R )2
(n)
Note, this is for a continuous distribution

where the distribution is for a population. R
represents the population mean in this
example.
Continuous Distribution
Problem
• Assume that the following list represents the

continuous distribution of population returns for
a particular investment (even though there are
only 10 returns).
• 9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
• Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.

How to solve using
Calculator
Enter “Data” first. Press:

2nd Data
2nd CLR Work
9.6 ENTER ↓ ↓
-15.4 ENTER ↓ ↓
26.7 ENTER ↓ ↓
• Note, we are inputting data
only for the “X” variable and
ignoring entries for the “Y”
variable in this case.

How to solve using
Calculator
Enter “Data” first. Press:

-0.2 ENTER ↓ ↓
20.9 ENTER ↓ ↓
28.3 ENTER ↓ ↓
-5.9 ENTER ↓ ↓
3.3 ENTER ↓ ↓
12.2 ENTER ↓ ↓
10.5 ENTER ↓ ↓

How to solve using
Calculator
Examine Results! Press:
2nd Stat
• ↓ through the results.
• Expected return is 9% for the
10 observations. Population
standard deviation is 13.32%.
• This can be much quicker than
calculating by hand, but slower
than using a spreadsheet.

MBA ZG 521

Pilani Campus
BITS Pilani
Risk Management
- Part 3
264
Risk Attitudes
Certainty Equivalent (CE) is the amount of

cash someone would require with certainty
at a point in time to make the individual
indifferent between that certain amount and
an amount expected to be received with risk
at the same point in time.

Risk Attitudes
Certainty equivalent > Expected value

Risk Preference
Certainty equivalent = Expected value
Risk Neutral
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Risk Attitude - Example
You have the choice between (1) a guaranteed

dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance).
The expected value of the gamble is $50,000.
– Ankita requires a guaranteed $25,000, or more, to call
off the gamble.
– Ram is just as happy to take $50,000 or take the risky
gamble.
– Raju requires at least $52,000 to call off the gamble.

Risk Attitude - Example
What are the Risk Attitude tendencies of each?
Ankita shows “risk aversion” because her “certainty

equivalent” < the expected value of the gamble.
Ram exhibits “risk neutral” behavior because his
“certainty equivalent” equals the expected value of the
gamble.
Raju reveals a “risk preference” because his “certainty
equivalent” > the expected value of the gamble.

U.S. Financial Markets —
Investment Returns
• We observe a clear relationship between
risk and return. Small stocks have the
highest annual return but higher returns
are associated with much greater risk.
Annual Small Large Governme Treasur

Stocks Stocks nt Bonds y Bills
Return 11.7% 9.6% 5.7% 3.7%
S.D. 34.1% 21.4% 8.5% 0.9%

Lessons Learned from Historical
Returns in the Financial Market
Lesson #1: The riskier investments have

historically realized higher returns.
– The difference between the return on riskier

stock investments and government securities
is called the equity risk premium. For
example, the equity risk premium is 6% for
small stocks over government bonds.

Lessons Learned from Historical Returns
in the Financial Market (cont.)
Lesson #2: The historical returns of the

higher-risk investment classes have
higher standard deviations.
For example, small stocks had a standard

deviation of 34.1% while the standard
deviation of treasury bill was only 0.9%.

Determining Portfolio Expected
Return
m
S ( Wj )( Rj )
RP = j=1
RP is the expected return for the portfolio,

Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the portfolio.
Determining Portfolio Standard
Deviation
m m
sP = S
j=1
S Wj Wk sjk
k=1
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Wk is the weight (investment proportion) for
the kth asset in the portfolio,
sjk is the covariance between returns for the jth
and kth assets in the portfolio.
MBA ZG 521

Pilani Campus
BITS Pilani
Risk Management
Agenda
• Term Structure of Interest Rates
• Background
• Theories of the Term Structure of Interest Rates
• Implications

Term Structure of Interest Rates
• Interest rates provide a summary measure of a loan to lenders and

act in a similar manner to prices (with regards to allocating
resources) for goods and services
• Just like high prices for a particular good/ industry tends to attract
investors/ resources into production, similarly high interest rates
tend to attract lenders
• Hence identifying factors that determine high interest rates is an
area of interest to economists/ finance professionals
• Economic theory suggests that one important factor that helps in
explaining differences in interest rates is differences in their terms,
i.e. the time to maturity of the loan or security
• The relationship between the term of the security and the market
interest rate is known as the term structure of interest rates or Yield
Curve

Typical yield curve shapes observed in
practice
• A normal yield curve is one in which long-term rates are greater

than short-term rates, so the curve has a positive slope.
• A flat yield curve represents the situation where the yield on all
maturities is essentially the same.
• An inverted yield curve reflects the condition where long-term

rates are less than short-term rates, giving the yield curve a
negative slope.
• With a "humped" yield curve, rates in the middle of the maturity

spectrum are higher or lower than those for both short and long
maturity bonds.

Pictorial representation of typical yield
curves
Yield Yield
Normal
Flat
Term to Term to
Maturity Maturity
Yield Yield
Humped
Inverted
Term to Term to
Maturity Maturity

Theories of the term structure of interest
rates
• The pure expectations hypothesis suggests that forward rates are

solely a function of expected future spot rates.
– This theory implies that an investor could earn the same return by investing in
a one-year bond or by sequentially investing in two six-month bonds.
• The liquidity preference theory proposes that forward rates reflect

investors’ expectations of future rates plus a liquidity premium to
compensate them for exposure to interest rate risk.
– This theory suggests that the liquidity premium is positively related to
maturity.
• The market segmentation theory proposes that lenders and borrowers

have preferred maturity ranges.
– This theory relies on the idea that some investors have restrictions (either
legal or practical) on their maturity structure.

282
Implications of the theories of term
structure
• The implications for the shape of the yield curve under the pure
expectations theory are:
– If the yield curve is upward sloping, short-term rates are expected to rise.
– If the curve is downward sloping, short-term rates are expected to fall.
– A flat yield curve implies that the market expects short-term rates to remain
constant.
• According to the liquidity preference theory, the yield curve will have
a definite upward bias because investors show a preference for short-
term securities.
• Under the market segmentation theory, the yield curve can be just
about any shape, depending on the supply and demand conditions.

Term Structure of Interest Rates
- Applications
• Knowledge of the Term Structure and the theories are useful for
predicting future interest rates and future bond prices.
• This knowledge is useful for individuals and financial managers

when deciding whether to take long-term or short-term loans for
financing a purchase/ project.

MBA ZG 521

Pilani Campus
BITS Pilani
Risk Management
- Part 5
Agenda
• Risk – Basic Concepts
• Market Risk, Credit Risk, Operational Risk – Definitions
• Example of Market Risk - Interest Rate Risk

Risk - Definition
• Risk may be defined as “ exposure

to uncertainty”
• Favourable or unfavourable
outcomes
• Risk management aims at
mitigating the loss
• Focus is on managing the risk
rather than on eliminating it

Risk management is a four step
process
• Identifying the risk

• Measuring the risk (i.e. quantifying)
• Managing the risk
• Controlling, monitoring and reviewing
the risk exposures on a periodic basis

Risk can be broken out into
three broad categories
• Credit risk
• Market risk
• Operational risk

Credit Risk
• Credit risk arises in the context of

lending
• Credit risk refers to default (on

interest or principal payments) by the
borrower or deterioration of
borrower’s credit quality

Market Risk
Market risk arises from the movement in

market prices
• Interest Rate Risk

• Exchange Rate Risk
• Commodities Price risk
• Equity Price Risk

Operational Risk
Operational risk is the loss arising from

inadequate or failed:
– Internal processes
– People
– Systems or
– External events

Interest Rate Risk
Same yield change
Price
Option-free
Larger impact
Bond
Smaller
impact
Yield
• Sensitivity of bond prices to changes in interest rates is known as Interest Rate Risk
• The yield level affects straight bond price volatility inversely
• As yields increase, the bond prices fall but at a decreasing rate since the price
curve gets flatter
• As yields fall, the price curve gets steeper and small changes in yield have a big
impact on bond prices. This is know as convexity.
• Duration (various flavors) is a measure of interest rate risk (Advanced topic)

MBA ZG 521

Pilani Campus
BITS Pilani
Risk Management
- Part 6
Agenda
• Business Risk
• Operating Leverage
• Break even analysis
• Financial Risk
• Financial Leverage
• Total Leverage

Business risk
• Uncertainty about future operating income (EBIT),

i.e., how well can we predict operating income?
Probability Low risk
High risk
0 E(EBIT) EBIT
• Note that business risk does not include effect of
financial leverage.

Drivers of business risk
• Uncertainty about demand (sales).

• Uncertainty about output prices.
• Uncertainty about costs.
• Product, other types of liability.
• Competition.
• Operating leverage.

Operating leverage
Operating Leverage refers to the use

of fixed operating costs by the firm.
– One potential “effect” caused by the

presence of operating leverage is that
a change in the volume of sales
results in a “more than proportional”
change in operating profit (or loss).

Operating leverage
• OL is defined as (%change in
EBIT)/(%change in sales)
• Operating leverage is high if the

production requires higher fixed costs and
low variable costs.
• Key point: High fixed costs translate small

increases in sales into large increases in
EBIT

Effect of operating leverage
• Large operating leverage leads to higher
business risk because a small sales decline
causes a huge decline in profits
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales

Operating leverage
Low operating leverage

Probability
High operating leverage
EBITL EBITH
• Higher operating leverage leads to higher

E(EBIT), but risk also increases.
Break-Even Analysis
Break-Even Analysis – A technique for studying

the relationship among fixed costs, variable costs,
sales volume, and profits. Also called
cost/volume/profit analysis (C/V/P) analysis.
– When studying operating leverage,

“profits” refers to operating profits before
taxes (i.e., EBIT) and excludes debt
interest and dividend payments.
Break-Even Chart
Total Revenues
Profits
REVENUES AND COSTS
250
($ thousands)
Total Costs
175
100 Fixed Costs

Losses
Variable Costs
50
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD

Break-Even Point
(Quantity)
Break-Even Point – The sales volume required so

that total revenues and total costs are equal; may
be in units or in sales dollars.
How to find the quantity break-even point:
EBIT = P(Q) – V(Q) – FC
EBIT = Q(P – V) – FC
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units)
produced and sold

Break-Even Point
(Quantity)
Breakeven occurs when EBIT = 0

Q (P – V) – FC = EBIT
QBE (P – V) – FC = 0
QBE (P – V) = FC
QBE = FC / (P – V)
a.k.a. Unit Contribution Margin

Break-Even Point
(Sales)
How to find the sales break-even point:
EBIT = P(Q) – V(Q) – FC

= Sales – V(Q) – FC
For break-even, EBIT =0
➔ Sales – V(Q) – FC = 0
➔ SBE = FC + (QBE )(V)

Break-Even Point- Example
India Handicrafts wants to determine both

the quantity and sales break-even points
when:
• Fixed costs are $100,000
• Baskets are sold for $43.75 each
• Variable costs are $18.75 per basket

Break-Even Point- Example
Breakeven occurs when:
QBE = FC / (P – V)
QBE = $100,000 / ($43.75 – $18.75)
QBE = 4,000 Units
SBE = (QBE )(V) + FC

SBE = (4,000 )($18.75) + $100,000
SBE = $175,000

Break-Even Chart
Total Revenues
Profits
REVENUES AND COSTS
250
($ thousands)
Total Costs
175
Fixed Costs
100
Losses
Variable Costs
50
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD
Financial leverage and
Financial risk
• Financial leverage is defined as

(%change in NI) / (% change in
EBIT)
• High usage of debt can cause
small increases in EBIT to lead to
large increases in net income.
• Financial leverage increases with
increasing levels of debt

Financial risk?
• Financial risk is the additional risk

concentrated on common stockholders as a
result of financial leverage.
– More debt, more financial leverage, more financial
risk.
– More debt will concentrate business risk on
stockholders because debt holders do not bear
business risk (in case of no bankruptcy).

Summary
Operating Financial Business Financial

Leverage Leverage Risk Risk
%change in %change in Variability in Additional
EBIT/%change in NI/%change in EBIT the firm’s variability in net
sales expected EBIT. income to
common
shareholders.
Increases with Increases with Increases with Increases with
higher fixed cost higher debt high OL. high FL.
If a firm already has high business risk, then it may be advisable to use less debt
to lower the financial risk. If a firm has less business risk, then it may be able to
afford higher financial risk.

Total leverage
Degree of Total Leverage – The percentage

change in a firm’s earnings per share (EPS)
resulting from a 1 percent change in output
(sales).
DTL at Q units Percentage change in
(or S dollars) of earnings per share (EPS)
output (or = Percentage change in
sales) output (or sales)
DTL Q units (or S dollars) = ( DOL Q units (or S dollars) ) x ( DFL EBIT of X dollars )

By:
Dr. Vaishali Pagaria
BITS Pilani
Pilani Campus
vaishali.pagaria@wilp.bits-pilani.ac.in
BITS Pilani
4: Working Capital Management

4.1: Basic Concepts
4.2: Cash Management
Textbook Reference
Type Content Ref. Topic Title Study/HW Resource Reference
Pre CH 4.1 Review previous week's topics. Chapter 22 - 26 of text (T1)
Replay appropriate pre-recorded

content/ courseware (module
wise)
During CH 4.1 Objective of working capital management Chapter 22 - 26 of text (T1)
Static and dynamic view of working capital
Factors affecting the composition of working

capital
Determination of working capital - operating

cycle and simulation approaches
Evaluation of working capital management
Post CH 4.1 Review reference chapters from textbook; Chapter 22 - 26 of text (T1)
replay videos as needed to clarify
understanding; do the assigned homework
11/17/2023 Dr. Vaishali Pagaria BITS Pilani, Deemed to be University 318

under Section 3, UGC Act
Pre-recorded lectures
Pre-recorded sessions on Working capital management 4.3

What is Working Capital?
• The capital of a business which is used in its day-by-day

trading operations.
• It’s a short-erm financial decisions typically involve cash
flows within a year or within the operating cycle of the
firm.
• There are two views of working capital
1. Static view
2. Dynamic view

Static and Dynamic View of
WC
Static View of WC Dynamic View of WC
Working capital can be
• Gross Working Capital
viewed as the amount of
(GWC) refers as total capital required for the
investment in the current smooth and uninterrupted
assets of the firm. functioning of the normal
• Net Working Capital business operations of a
(NWC) is the net company ranging from the
difference between CA procurement of raw
materials, converting the
and CL of the firm. It can
same into finished products
be positive or negative for sale and realizing cash
along with profit from the
accounts receivables that
arise from the sale of finished
goods on credit.

Factors Affecting the
Composition of WC
• Nature of Business: Service firm vs.
Manufacturing firm
• Seasonality of operations: seasonal
business
• Production policy: constant production
• Market conditions: market structure
• Conditions of supply: supply of production
inputs

Proportion of CA and FA
Current Fixed Assets Industries

Assets (%) (%)
10-20 80-90 Hotel and Restaurants
20-30 70-80 Electricity Generation and Distribution
30-40 60-70 Aluminium, Shipping
40-50 50-60 Iron and Steel, Basic Industrial
Chemicals
50-60 40-50 Tea Plantation
60-70 30-40 Cotton Textiles, Sugar
70-80 20-30 Edible Oils, Tobacco
80-90 10-20 Trading, Construction
Working Capital Management
• Management of working capital refers to the

management of CA and CL
Objective of Working Capital Management

1. Liquidity Vs. Profitability
2. Choosing the pattern of financing: the maturity
of the sources of finance should match the
maturity of the assets being financed.

Inter-dependency Among the
Components of WC: CA Cycle

Financing of WC
Short-term Financing
• Bank credit
• Transaction credit
• Advances from customers
• Bank advances
• Loans
• Overdraft
• Bills purchase and discounted
• Advance against documents of title of goods
• Term loans by bank
• Commercial paper
• Bank deposits, etc.

Need for WC
• Inventory management
• Receivable management
• Cash management

Inventory Management
• Inventory represents by the largest portion

of current assets.
• Effective and efficient management of

inventories helps in
• minimising cost of holding inventories,
• minimising risks and losses due to stockout, and
• keeping the investment in inventories at a reasonable level.

Benefits of Carrying
Inventories
To ensure uninterrupted A firm with sufficient
production and to avoid stock of materials in hand
catastrophe of is also relieved of the
breakdown of whole dangers of breakdowns in
operation, the firm must the productive process
carry an inventory of raw further minimises cost of
materials. production.
Purchase of materials in
huge quantity will be
economical because that
would result in
substantial savings in the
cost of goods sold.

Costs of Carrying Inventories
• Storage
Carrying • Handling, loss in value due to
obsolescence and physical
Cost deterioration,
• Taxes, insurance, financing
• Cost of placing orders for new

Ordering inventory (fixed cost)
• Cost of shipping and receiving new
Cost inventory (variable cost)

Economic Oder Quantity
(EOQ) Approach
• According to EOQ approach optimal level of investment
in inventory is one where total cost of inventory
comprising carrying and ordering costs will be minimum.
2𝐴𝑂
EOQ =
𝐶𝐶
Where,
A = Annual usage
O = Ordering cost per order
CC = Annual carrying cost per unit
(price per unit X carrying cost per unit in percentage)

Illustration
1. The demand for a certain item is random. It has been

estimated that monthly demand of the item has a normal
distribution with a mean of 780 units. The unit price of the
item is Rs.25. ordering cost is Rs.28 and the inventory
carrying cost is estimated to be 35 per cent year. Determine
(a) EOQ, (b) Total inventory cost with EOQ
2. Hindustan Engineering Factory consumes 75000 units of a
component per year. The ordering, receiving and handling
costs are Rs.6 per order while transportation cost is Rs.24
per order. Depreciation and obsolescence cost is Rs.0.008
per unit per year, interest cost Rs.0.12 per unit per year,
storage cost Rs.2000 per year for 75000 units. Calculate (a)
EOQ, (b) Total inventory cost with EOQ

Receivable Management
Receivable is defined as “debt owed to the firm by

customers arising form sale of goods or services in the
ordinary course of business.”
Account receivables…..
• risk involvement
• based on economic values
• implies futurity
Objective of receivable management
• Maximising the value of the firm
• Optimum investment in sundry debtors
• Control and managing the cost of trade credit

5 C’s of the Credit Assessment
Behavioral Analysis
1. Character – The applicant’s intrinsic desire to honor terms and conditions of the
credit obligation
2. Capacity – The applicant’s capacity to pay interest and principal as per the
agreement
3. Capital – Quantum of equity capital and extent of ‘Leverage”
4. Collateral – The availability of assess available as security against the loan
5. Condition – The economic trends and development in the industry and the
macro economic context of the county

5 C’s of Credit Analysis
Usage
• The five C's are typically used, explicitly or implicitly, in the construction of
credit Scorecards, with the significance of each "C" being assigned either
subjectively (in Expert Based Models) or quantitatively in quantitative /
statistical models.
Quantification / Automation Tools

Some aspects of establishing the 5 C's profile may be facilitated or even
automated using programmatic procedures and algorithms
• Capacity information can be extracted from documentation (Financial
Statements) but may be insufficiently forward looking
• Capital information extracted from documentation (financial statements)
• Character information extracted from credit history (credit reports) and
(more speculatively) from other behavioral evidence (social media)
• Collateral quality (volatility) may be assessed from market data but the
assessment may suffer for illiquid assets
• Economic Conditions (volatility) assessed from market and economic data
but may be insufficiently forward looking and lack idiosyncratic aspects
11/17/2023 Dr. Vaishali Pagaria BITS Pilani, Deemed to be University under Section 3, UGC Act
Cost of Receivable
Management
➢ Capital cost
➢ Collection cost
➢ Bad debts

Determination of WC
1. Operating Cycle Approach

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

Operating and Cash Cycle

Operating Cycle Approach
The length of Operating Cycle of a manufacturing firm can

be calculated….
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
• Inventory turnover period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑂𝐺𝑆/365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑏𝑡𝑜𝑟𝑠
• Debtors (Receivable) turnover period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑆𝑎𝑙𝑒𝑠/365
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
• Creditors (Payables) deferral period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑂𝐺𝑆/365
• Operating Cycle = Inventory turnover period + debtors
turnover period
• Cash cycle = Operating cycle – Creditors deferral period

Illustration
From the following information of Horizon Ltd. Calculate

operating cycle and cash cycle and comments on
company’s WC position.
Sales : 800
COGS: 720
Inventory : Beginning of the year 2010 is 96 and end of the
year it is 102
Accounts Receivable(Debtors): Beginning of the year 2010
is 86 and end of the year it is 90
Accounts Payable (Creditors): Beginning of the year 2010
is 56 and end of the year it is 60

Evaluation of WC
Management
• Liquidity
• Availability of Cash
• Inventory turnover
• Credit extended to customers
• Credit obtained from suppliers

Practice Problems
1. The relevant financial information for Xavier Ltd. For the

year ended 2011 is given below:
Profit & Loss A/C Data Balance Sheet Data
(Rs. Million)
Particulars Beginning End of the
of the year year 2011
2011
Sales 80 Inventory 9 12
COGS 56 Debtors 12 16
Creditors 7 10
What is the length of the operating cycle? The cash cycle?
Assume 365 days to a year.

Practice Problems
2. The relevant financial information for Zenith Ltd. For the

year ended 2011 is given below:
Profit & Loss A/C Data Balance Sheet Data
(Rs. Million)
Particulars Beginning End of the
of the year year 2011
2011
Sales 500 Inventory 60 64
COGS 360 Debtors 80 88
Creditors 40 46
What is the length of the operating cycle? The cash cycle?

Assume 365 days to a year.

BITS Pilani
4.2 Cash Management
11/17/2023 Dr. Vaishali Pagaria

344
Introduction
• Cash is a Current Assets of the business

• Cash is in the form of hard cash or cash at bank
• Cash itself does not produce good or services. It is used
as a medium to acquire other assets.
• The idle cash can be deposited in bank to earn interest
• A firm will have to maintain a critical level of cash. If at a
time it does not have sufficient cash with it, it will have to
borrow from the market for reaching the required level.

Motives for Holding Cash
• Transaction Motive : To meet firm’s transaction needs

• Precautionary Motive: To meet uncertainty about the
magnitude and timing of cash inflows
• Speculative Motive: To tap profit making opportunities
arising from fluctuations in commodity prices, security
prices, interest rates and foreign exchanges.

Cash Management
• The liquidity provided by the cash holding is at the

expense of profits sacrificed by foregoing alternative
investment opportunities.
Hence, the financial manager should

1. Establish reliable forecasting and reporting systems
2. Improve cash collection and disbursements
3. Achieve optimal conservation and utilization of funds.

Financing of Current/Cash
Assets
Long-term Financing Short-term Financing

• Share capital • Bank credit
a. Equity share capital • Transaction credit
b. Preference share capital • Advances from customers
• Debentures • Bank advances
a. Convertible debentures • Loans
b. Non-convertible debentures • Overdraft
c. Redeemable debentures • Bills purchase and discounted
d. Non-Redeemable debentures • Advance against documents of title of
• Bonds goods
• Loans from banks & financial institutions • Term loans by bank
• Retained earnings • Commercial paper
• Venture capital fund for innovative • Bank deposits, etc.
projects

Cash Budgeting
• Cash budgeting or short-term cash forecasting is the

principal tool of cash management. This is helpful in
Estimating cash requirements
Planning short-term financing
Scheduling payments in connection with capital expenditure projects
Planning purchases of materials
Developing credit policies
Checking the accuracy of long-erm forecasts

Receipts and Payment Method
• Cash budget prepared under this method

shows the timing and magnitude of
expected cash receipts and payments
over the forecast period.
• It includes all expected receipts and
payments irrespective of how they are
classified in accounting.

Cash Receipts & Payments:
Basis of Estimation
Items Basis of Estimation
Cash Sales Estimated sales and its division between cash
and credit sales
Collection of dividend receivable Estimated sales, its division between cash

and credit sales, and collection pattern
Interest and dividend receipts Firm’s portfolio of securities and return

expected from the portfolio
Increase in loans/deposits and issue of Financing plan

securities
Sale of assets Proposed deposal of assets

Cash purchases Estimated purchases, and its division
between cash and credit purchases

Cash Receipts & Payments:
Basis of Estimation
Items Basis of Estimation
Payment for purchases Estimated purchases, its division between
cash and credit purchases, and payment
terms
Wages and salaries Manpower employed, wages and salaries

structure
Manufacturing expenses Production plan
General, admin and selling exp. Admin and sales personnel and proposed
sales promotion and distribution exp.
Capital equipment purchases Capital expenditure budget and payment
pattern associated with capital
equipment purchases
Repayment of loans and retirement of Financing plan

securities

Practice Problem 1
From the following information, prepare cash budget for the month of January to
April
Expected Sales (Rs.) Expected Purchases (Rs.)

Jan 60000 Jan 48000
Feb 40000 Feb 80000
March 45000 March 81000
April 40000 April 90000
Wages to be paid to workers Rs. 5,000 each month. Balance at the bank on 1st
Jan. Rs.8,000. It has been decided by the Management that:
(i) In case of deficit fund within the limit of Rs.10,000 arrangements can be made
with bank.
(ii) In case of deficit fund exceeding Rs. 10,000 but within the limits of Rs. 42,000
issue of debentures is to be preferred.
(iii) In case of deficit fund exceeding Rs. 42,000, issue of shares is preferred

Practice Problem 2
Prepare Cash Budget of a Company for April, May and June 2019 in a columnar
form using the following information
Month Sales Purchase Wages Exps.
Jan 80,000 45,000 20,000 5,000
Feb 80,000 40,000 18,000 6,000
March 75,000 42,000 22,000 6,000
April 90,000 50,000 24,000 6,000
May 85,000 45,000 20,000 6,000
June 80,000 35,000 18,000 5,000
You are further informed that:

(a) 10% of purchase and 20% of Sale are for cash
(b) The average collection period of the Co. is 1/2 month and credit purchase is paid off
regularly after one month
(c) Wages are paid half monthly and the rent of Rs.500 excluded in expense is paid
monthly
(d) Cash and Bank Balance on April 1, was Rs.15,000 and the company wants to keep it
on end of every month below this figure, the excess cash being put in fixed deposits.

Practice Problem 3
From the following information prepare a monthly cash budget for the three months
ending 31st Dec.2019.
Admin.
Production
Sales Materials Wages Selling,
Month O/H
(Rs.) (Rs.) (Rs.) etc.
(Rs.)
(Rs.)
June 3,000 1,800 650 225 160
July 3,250 2,000 750 225 160
Aug. 3,500 2,400 750 250 175
Sep. 3,750 2,250 750 300 175
Oct. 4,000 2,300 800 300 200
Nov. 4,250 2,500 900 350 200
Dec. 4,500 2,600 1,000 350 225

Practice Problem 3
(i) Credit terms are:

(a) Sales — 3 months to debtors. 10% of sales are on cash. On an average, 50%
of credit sales are paid on the due dates while the other 50% are paid in the month
following
(b) Creditors for material — 2 months.
(ii) Lag in payment: Wages. 1/4 month, overheads — 1/2 month.
(iii) Cash and Bank Balance on 1st Oct. expected Rs.1,500.
(iv) Other information
(a) Plant and Machinery to be installed in Aug. at a cost of Rs.24,000. It will be paid
for by monthly installments of Rs.500 each from 1st Oct.;
(b) Preference share dividend @ 5% on Rs.50,000 are to be paid on 1st Dec.
(c) Calls on 250 equity shares @ Rs.2 per share expected on 1st November;
(d) Dividends from investments amounting to Rs.250 are expected on 31st Dec.;
(e) Income tax (advance) to be paid in December Rs. 500

Practice Problem 4
From the following forecast of income and expenditure, prepare cash

budget for the months January to April, 2015.
Months Sales Purchases Wages Mfg. exp Admin Exp Selling

Exp
2014
Nov 30,000 15,000 3,000 1,150 1,060 500
Dec 35,000 20,000 3,200 1,225 1,040 550
2015
Jan 25,000 15,000 2,500 990 1,100 600
Feb 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570
April 40,000 25,000 2,600 1,200 1,180 710

Practice Problem 4
Additional Information
1. The customers are allowed a credit period of 2 months.

2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on
15th January for Rs. 5,000; a Building has been purchased on
1stMarch and the payments are to be made in monthly installments
of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 2015 is Rs. 15,000

MBA ZG 521

Pilani Campus
BITS Pilani
Cost of Capital and Capital Budgeting

-Part 1
Agenda
• Cost of Capital
• Cost of Debt
• Cost of Preferred
• Cost of Equity
• WACC
• Floatation Costs

Cost of Capital
• The cost of capital represents the overall cost of

financing to the firm
• The cost of capital is normally the relevant
discount rate to use in analyzing an investment
• The overall cost of capital is a weighted average of
the various sources, including debt, preferred
stock, and common equity:
WACC = Weighted Average Cost of Capital
WACC = After-tax costs x weights

Sources of long-term
capital
Long-Term
Capital
Long-Term Preferred Common

Debt Stock Stock
Retained New Common

Earnings Stock

Calculating the weighted average
cost of capital
WACC = wd(pretax rd)(1-Tax rate) + wprp +

were
• The w’s refer to the firm’s capital structure
weights.
• The r’s refer to the cost of each
component.

Should we use before-tax or
after-tax costs?
• Stockholders are interested in After-Tax

CFs. Therefore, we should focus on After-
Tax capital costs.
• Only cost of debt needs adjustment,
because interest is tax deductible.

Should we use historical costs or
new (marginal) costs?
• The cost of capital is used primarily to

make decisions that involve raising new
capital for funding new projects.
• So we should focus on today’s marginal
costs (for WACC).

WACC Formula
WACC = rD (1 − T ) + rP + rE
D P E
V V V
• It is important to understand the inputs to the

WACC formula

WACC Inputs 1
• D = market value of all debt

• P = market value of preferred stock
• E = market value of common stock
• V = D + P + E = Market value of the entire firm
• D/V, P/V, and E/V are the capital structure

weights – the proportion of the firm financed by
debt, preferred and common stock

WACC Inputs 2
• rD = cost of debt
• rP = cost of preferred stock
• rE = cost of common stock
• T = marginal corporate tax rate
• We will learn how to estimate all of these

Weighting example
Bonds 40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400
What is weight of each component?

Weighting example
Bonds 40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400
Bonds = 40/400 = 10%

Pref. Stock = 100/400 = 25%
Cost of debt
WACC = wd(pretax rd)(1-T) + wprp + were
• rd is the marginal cost of debt capital.

• The yield to maturity on outstanding L-T
debt is often used as a measure of rd.
• Why should we make the tax adjustment,
i.e. why rd(1-Tax rate)?

Logic for tax adjustment
Before After
Sales 1,000 1,000
Interest 100* 0
EBT 900 1,000

Tax 40% 360 400
EAT 540 600 60 difference
If tax rate is 40% then 10% before tax = 6% after tax

Cost of debt
• Interest is tax deductible, so

aftertax rd = pretax rd (1-T)
= 10% (1 - 0.40) = 6%
T = tax rate = 40%

Cost of debt
• What is the current cost of debt for a firm

that has a 9% coupon bond with 5 years to
maturity and a current price of $962?
• What is the after tax cost if it is in the 40%
tax bracket?

Cost of preferred stock
WACC = wdrd(1-T) + wprp + were
• rp is the marginal cost of preferred

stock.
• The rate of return investors require on
the firm’s preferred stock.

Cost of Preferred (rP)
D
rP =
P0
• Use perpetuity formula:
– D is the annual dividend on preferred stock

– P0 is the latest preferred stock price

Example rP
• The company has 1 million shares of 8%

preferred stock selling for $120 today.
What is rP?
• rP = _____ / _____ = ______
• Note: 8% preferred means the company

pays a preferred dividend of 8% of its par
value which is always $100

Cost of preferred stock
• Preferred dividends are not

tax-deductible, so no tax adjustments
necessary.

MBA ZG 521

Pilani Campus
BITS Pilani

-Part 2
Cost of equity
WACC = wd(pretax wd)(1-T) + wprp + were
• re is the marginal cost of common equity

Why is there a cost for retained
earnings?
• Earnings can be reinvested or paid out as

dividends.
• Investors could buy other securities, earn a
return.
• If earnings are retained, there is an
opportunity cost (the return that stockholders
could earn on alternative investments of
equal risk).
– Investors could buy similar stocks and earn re.
– Firm could repurchase its own stock and earn re.
– Therefore, re is the cost of retained earnings.

Two ways to determine the
cost of common equity, re
1. CAPM: re = RRF + β x (Mkt. risk premium

[E(RM)– RRF])
• RRF = Risk Free Rate (now around 2.7%)

• RM = Return on the market
• β = Beta - the relation of its returns with that of
the stock market e.g.
– 0 – not correlated
– 1 - moves with the market
– 2 – twice as volatile

Two ways to determine the
cost of common equity, re
2. DCF: P0 = (D1 / r - g)
(this is the Gordon constant growth model)
where r = re
re = (D1 / P0)+ g

Example
If the market premium is 6%, risk-

free rate is 2.7% and the firm’s
beta is 1.48, what’s the cost of
common equity based upon the
CAPM?
re = RRF + β(mkt premium)

= 2.7% + 1.48(6.0%) = 11.58%

Example
If D0 = $1.72, P0 = $43, and g = 5%, what’s the cost

of common equity based upon the DCF approach?
D1 = D0 (1+g)
D1 = $1.72 (1 + .05)
D1 = $1.81
re = (D1 / P0)+ g
= ($1.81 / $43) + 0.05
= 9.2%
What is a reasonable final
estimate of re?
Method Estimate
CAPM 11.58%
DCF 9.2%
1) One option is to take the Average

10.4%
2) Be conservative and choose higher
3) Put more weight to CAPM vs. DCF

Calculate WACC
• If 40% of your financing is from debt at an

after tax cost of 8% and 60% is from pref.
stock at 10%, what is the WACC?
• It will be between what two numbers?

Solution
• 40% (.08) + 60% (.10)

• .032 + .06 = .092
• 9.2%
• It will be between the two components of
costs of capital

Example - Balance Sheet
(using the costs calculated earlier)
Market values
Cash 5,000 LT Debt 3,000
Equipment 5,000 Pref. Stock 1,000
Stock 6,000
Tot. Assets 10,000 Tot. Debt & Eq. 10,000

Ignoring issuance costs,
what is the firm’s WACC?
WACC = wd(pretax rd)(1-Tax) + wprp + were
= .3(10%)(0.6) + .1(7.2%) + .6(10.4%)
= 1.8% + 0.72% + 6.2%
= 8.7%

WACC
• You are analyzing the cost of capital for a

firm that is financed with 60 percent equity
and 40 percent debt. The after-tax cost of
debt capital is 10 percent, while the cost of
equity capital is 20 percent for the firm.
What is the overall cost of capital for the
firm?
• (.6 x .2) + (.4 x .1) = 16%
Equity + Debt

Another example
• A company has bonds outstanding with 15

years to maturity and are currently priced
at $800. If the bonds have a coupon rate
of 8.5 percent, then what is the after-tax
cost of debt if the marginal tax rate is
30%?
• 7.9%

Homework
• Independence Mining Corporation (IMC) has 7 million

shares of common stock outstanding, 1 million shares of
6 percent preferred outstanding, and 100,000 $1,000
par, 9 percent semiannual coupon bonds outstanding.
The stock sells for $35 per share and has a beta of 1.2,
the preferred stock sells for $60 per share, and the
bonds have 15 years to maturity and sell for 89 percent
of par. The market risk premium is 5.5 percent, T-bills are
yielding 6 percent, and the firm’s tax rate is 34 percent.
• Compute IMC’s WACC

Flotation Costs
• Flotation costs represent the expenses incurred for
the issue (or float) of new stocks or bonds.
• Floatation costs comprise of items like:
– Underwriting costs
– Brokerage expenses
– Fees of merchant bankers
– Advertising expenses, etc.
• Two approaches to incorporate floatation
costs:
1. Adjust the WACC (inferior method)
2. Include as part of project cost, i.e. CF0 (preferred
method)

1st Method: Adjust WACC
• In this method the WACC is adjusted to reflect

the floatation cost
• Simple example to illustrate this method
• If suppose for a particular company the WACC is
12% and the average floatation costs are 6%, the
WACC can be adjusted as follows to reflect the
floatation costs:
Adjusted WACC = WACC/(1 – Floatation cost)
= 12%/ (1 – 0.06) = 12.77%

2nd Method: Adjust project cost
• This is the superior and preferred method

• In this method we do not change the WACC (denominator) but
instead include the floatation costs as part of the project cost
(numerator)
• In other words the floatation costs are considered to be incremental
cash flows of the project, which typically reduce the NPV since they
increase the initial project cost (i.e., CF0).
• So amount to be raised (including floatation costs) is calculated as
follows:
– Amount Raised = Necessary Proceeds/(1-% flotation cost)
• The % flotation cost is a weighted average based on the average

cost of issuance for each funding source and the firm’s target capital
structure:
– f(A) = (E/V)* f(E) + (D/V)* f(D)

Illustration: Flotation Costs
• The Wichita Manufacturing company has a

target capital structure of 80% equity and 20%
debt.
• The floatation costs for equity issues are 20% of
the amount raised; the floatation costs for debt
issues are 6%.
• If company needs $65 million for a new
manufacturing facility, what is the true cost
including floatation costs?
• Note: this example focuses on the second
method only

Solution
• The % flotation cost is a weighted average based on the

average cost of issuance for each funding source and
the firm’s target capital structure:
% f(A) = (E/V)* f(E) + (D/V)* f(D)

= (80%) x (0.2) + (20%) x (0.06) = 17.2%
Therefore the true cost of setting up the new
manufacturing facility (including floatation costs)
= $65 / (1 - 17.2%) = $78.5 million
Hence floatation costs = $78.5 - $65 = $13.5 Million

MBA ZG 521

Pilani Campus
BITS Pilani

Agenda
• Capital Budgeting
• NPV
• IRR
• Payback Period
• Discounted Payback Period
• Ranking Problems
• Capital Rationing
• Project Risk
• Note: Please thoroughly review the relevant chapters from the two Prasanna
Chandra books that are mentioned in the course handout. I am not explicitly
covering 2 or 3 inferior methods that are outlined in these books.
404
Capital Budgeting: Introduction
• Capital budgeting is the process of selecting the most profitable (or rather
value adding) long term projects
• Key responsibility of a financial manager since:
– Lock in period for long term asset reduces flexibility
– Forecasting of revenues and related modeling
• Post audits are important in ensure rigor around forecasting
– Inform the firm’s strategic plan
• Capital Budgeting projects may be categorized as:
– Mutually exclusive: only one of a given family of projects can be accepted
– Independent projects: project decisions are unrelated to one another; this is not
usually the case in practice since there are always resource constraints

Capital budgeting process
1. Idea Generation or Search for investment opportunities. This

process will vary among firms and industries but aims to
identify candidate projects.
2. Analyze project proposals:

– Estimate all cash flows for each project.
– Evaluate the cash flows. a) Payback period b) Discounted Payback

c) Net Present Value. d) Internal Rate of Return.
– Make the accept/reject decision.

• Independent projects: Accept/reject decision for a project is not
affected by the accept/reject decisions of other projects.
• Mutually exclusive projects: Selection of one alternative
precludes another alternative.
3. Periodically reevaluate past investment decisions.

Capital Budgeting : Categories
• Categories of the capital budgeting process :

– Replacement projects
• Two types:
1. To maintain the business at its current level
2. For cost reduction
– Ex. Should we replace a machine that is obsolete but usable or not?
– Expansion Projects
• These are undertaken to expand the business
– New product or market developments
• This involves complex decision making process as it has a lot of uncertainty
– Mandatory projects
• These are typically mandated by governmental agencies, regulators or
insurance companies
– Other projects
• These include pet projects of senior management or a high risk endeavor
that is difficult to analyze with typical capital budgeting assessment methods

Capital Budgeting : Key considerations
• Key principles of Capital Budgeting

– Decisions are based on cash flows, not accounting Income
• Incremental cash flows are only considered here
• And it is after tax cash flows that we are interested in
– Cash flows are based on opportunity cost
• Opportunity cost is the cash flow generated by the asset , the company
already owns and which will be forgone if the project is undertaken
• Corollary is that Sunk costs are not relevant
• Cannibalization needs to be considered (externalities)
– Financing costs are part of the project’s required rate of return (in the
denominator, not in the numerator)
• The discount rate used here is the firm’s cost of capital (since we are
analyzing at firm level)
– Timing of cash flow is important
• Time value of money is crucial as cash flow earned earlier is more important
than cash flow to be received later

MBA ZG 521

Pilani Campus
BITS Pilani
Working Capital and Liquidity Management

-Part 1
Agenda
• Working Capital Management
• Basic Concepts
• Inventory Management
• Credit/ Accounts receivable management
• Management of Cash and Marketable securities
• Short term borrowing/ financing

Working Capital Basics
• Working Capital
– Assets/liabilities required to operate business
on day-to-day basis
• Cash
• Accounts Receivable
• Inventory
• Accounts Payable
• Accruals
– Short-term in nature—turn over regularly

Working Capital and the
Current Accounts
• Gross working capital = Current assets

– Gross Working Capital (GWC) represents
investment in current assets
• (Net) working capital =

Current assets – Current liabilities
413
Working Capital and
Funding Requirements
• Working Capital Requires Funds

– Maintaining working capital balance requires
permanent commitment of funds
• Example: Firm will always have minimum level of
Inventory, Accounts Receivable, and Cash—this
requires funding
414
Working Capital and
Funding Requirements
• Net working capital is Gross Working Capital –

Current Liabilities (including spontaneous
financing)
– Reflects net amount of funds needed to support

routine operations
415
Objective of Working Capital
Management
• To run firm efficiently with as little money
as possible tied up in Working Capital
– Involves trade-offs between easier operation
and cost of carrying short-term assets
• Benefit of low working capital
– Money otherwise tied up in current assets can be
invested in activities that generate higher payoff
– Reduces need for costly financing
• Cost of low working capital

– Risk of shortages in cash, inventory

Working Capital Trade-offs
Inventory
High Levels Low Levels
Benefit: Cost:
• Happy customers • Shortages
• Few production delays (always have needed • Dissatisfied customers
parts on hand) Benefit:
Cost: • Low storage costs
• Expensive • Less risk of obsolescence
• High storage costs
• Risk of obsolescence
Cash
Benefit: Benefit:
• Reduces risk • Reduces financing costs
Cost: Cost:
• Increases financing costs • Increases risk

Accounts Receivable
High Levels (favourable credit terms) Low Levels (unfavourable
terms)
Benefit: Cost:
• Happy customers • Dissatisfied customers
• High sales • Lower Sales
Cost: Benefit:
• Expensive • Less expensive
• High collection costs
• Increases financing costs
Accounts Payable and Accruals

Benefit: Benefit:
• Reduces need for external finance--using a • Happy suppliers/employees
spontaneous financing source Cost:
Cost: • Not using a spontaneous
• Unhappy suppliers financing source

Current Assets High Level Low Level
Profitability Lower Higher

Risk Lower Higher
Liquidity Higher Lower
419
MBA ZG 521

Pilani Campus
BITS Pilani

-Part 2
• Inventory management— establishes a balance
between carrying enough inventory to meet
sales or production requirements while
minimizing inventory costs
• Inventory usually managed by manufacturing or

operations
– However, finance department has an oversight
responsibility
• Monitor level of lost or obsolete inventory
• Supervise periodic physical inventories

• Cost of maintaining inventory:
1. Carrying costs: all costs associated with carrying
inventory
• Storage, handling, loss in value due to obsolescence and
physical deterioration, taxes, insurance, financing
2. Ordering costs:
• Cost of placing orders for new inventory (fixed cost: same
dollar amount regardless of quantity ordered)
• Cost of shipping and receiving new inventory (variable
cost: increase with increases in quantity ordered)

• Total inventory maintenance costs (carrying
costs plus ordering costs) vary inversely.
– Carrying costs increase with increases in average
inventory levels and therefore argue in favor of low
levels of inventory in order to hold these costs down.
– Ordering costs decrease with increases in average
inventory levels and therefore firm wants to carry high
levels of inventory so that it does not have to reorder
inventory as often as it would if it carried low levels of
inventory.

• Economic order quantity (EOQ) model:
mathematical model designed to
determine optimal level of average
inventory that firm should maintain to
minimize sum of carrying costs and
ordering costs (total cost inventory
maintenance cost)

Inventory Costs and the
EOQ
Cost ($)
Total
Cost
Carrying
Cost
Ordering
Cost
EOQ Q (Order Size)

Economic Order Quantity
(EOQ) Model
• EOQ model is: Q=  

2FD
c
½
where
Q= order size in units
D= annual quantity used in units
F= cost of placing one order
C= annual cost of carrying one unit in stock
½ denotes square root

EOQ - Example
Q: The Richond Corp. buys a part that costs $5. The carrying
cost of inventory is approximately 20% of the part’s dollar value
per year. It costs $50 to place, process and receive an order.
The firm uses 900 of the $5 parts per year.
What ordering quantity minimizes inventory costs?

How many orders will be placed each year if that order quantity
is used?
What inventory costs are incurred for the part with this ordering
quantity?

EOQ - Example
A: Annual carrying cost per unit is 20% x $5 = $1
Q =  2 ( 50 )( 900 )
1

½
EOQ = 300 units

The annual number of reorders is 900 300 = 3
Ordering costs are $50 x 3 = $150 per year
Average inventory is 300  2 = 150 units
Carrying costs are 150 x $1 = $150 a year
Total inventory cost of the part is $300

MBA ZG 521

Pilani Campus
BITS Pilani

-Part 3
Accounts Receivable
Management
• Accounts receivable management requires
balance between cost of extending credit
and benefit received from extending credit.
• No universal optimization model to determine
credit policy for all firms since each firm has
unique operating characteristics that affect its
credit policy.
• However, there are numerous general
techniques for credit management.

Accounts Receivable
Management
• Industry conditions
– Manufacturing firms and wholesalers
generally extend credit terms
– Retailers commonly extend consumer credit,
either through store-sponsored charge plan or
acceptance of external credits cards
– Small retailers cannot afford cost of
maintaining credit department and thus do not
offer store-sponsored charge plans

Accounts Receivable
Management
• “Five Cs” of credit analysis” used to decide
whether or not to extend credit to particular customer:
1. Character: moral integrity of credit applicant and whether
borrower is likely to give his/her best efforts to honoring credit
obligation
2. Capacity: whether borrowing form has financial capacity to
meet required account payments
3. Capital: general financial condition of firm as judged by
analysis of financial statements
4. Collateral: existence of assets (i.e. inventory, accounts
receivable) that may be pledged by borrowing firm as security
for credit extended
5. Conditions: operating and financial condition of firm

Accounts Receivable
Management
• Commercial credit services
– National credit services provide credit reports
on potential new accounts that summarize
firm’s financial condition, past history, and
other key business information
– Local credit associations

Accounts Receivable
Management
• Three types of cost:
1.Financing accounts receivable
2.Offering discounts
3.Bad-debt losses
– Must analyze relationship of these costs to
profitability
– Marginal cost of credit must be compared to
expected marginal profit resulting from credit
terms

Management of Cash and
Marketable Securities
• Firms hold cash balances in checking
accounts. Why?
1. Transaction motive: Firms maintain cash
balances to conduct normal business
transactions. For example,
• Payroll must be met
• Supplies and inventory purchases must be paid
• Trade discounts should be taken if financially
attractive
• Other day-to-day expenses of being in business
must be met

2. Precautionary motive: Firms maintain

cash balances to meet precautionary
liquidity needs.
• Two major categories of liquidity needs:
1. To bridge the gaps between cash inflow and cash
outflow
• In order to predict these gaps we need to construct a
detailed cash budget
2. To meet unexpected emergencies

3. Speculative motive: Firms maintain

cash balances in order to “speculate” –
that is, to take advantage of
unanticipated business opportunities that
may come along from time to time.
• The nature of these opportunities may vary.

4. Firms using bank debt are required to
maintain a compensating balance with the
bank from which they have borrowed the
money.
• Compensating balance: when a bank makes a
loan to a firm, the bank requires this minimum
balance in a non-interest-earning checking account
equal to a specified percentage of the amount
borrowed
• Common arrangement is a compensating balance equal to
5-10% of amount of loan
• Bankers maintain that existence of compensating balance
prevents firms from overextending cash flow position
because it forces them to maintain a reasonable minimum
cash balance.

• Marketable securities: short-term, high-quality
debt instruments that can be easily converted
into cash.
• In order of priority, three primary criteria for
selecting appropriate marketable securities to
meet firm’s anticipated short-term cash needs
(particularly those arising from precautionary
and speculative motives):
1. Safety
2. Liquidity
3. Yield

1. Safety
• Implies that there is negligible risk of default
of securities purchases
• Implies that marketable securities will not be
subject to excessive market fluctuations due
to fluctuations in interest rates

2. Liquidity
• Requires that marketable securities can be sold
quickly and easily with no loss in principal value due
to inability to readily locate purchaser for securities
3. Yield
• Requires that the highest possible yield be earned
and is consistent with safety and liquidity criteria
• Least important of three in structuring marketable
securities portfolio

• Safety, liquidity, and yield criteria severely restricts range
of securities acceptable as marketable securities.
• Most major corporations meet marketable securities
needs with U.S. Treasury bills or with corporate
commercial paper carrying highest credit rating.
– These securities are short-term, highly liquid, and have
reasonably high yields.
– Treasury bills are default-risk free.
– High-quality commercial paper carries miniscule default risk.
• Firms that have sought to achieve higher potential yields
via money market funds invested in asset-backed
securities have learned that those higher potential
yields carried higher risk.

Improving Cash Flow

• Actions firm may take to improve
cash flow pattern:
1. Attempt to synchronize cash inflows and
cash outflows
– Common among large corporations
– E.g. Firm bills customers on regular schedule
throughout month and also pays its own bills
according to a regular monthly schedule. This
enables firm to match cash receipts with cash
disbursements.

Improving Cash Flow
2. Expedite check-clearing process,
slow disbursements of cash, and
maximize use of “float” in corporate
checking accounts
• But new developments in financial services
industry such as electronic funds clearing
(NEFT, etc.) have reduced the value of this
approach

MBA ZG 521

Pilani Campus
BITS Pilani

-Part 4
Sources of Short-term
Financing
• Three major sources of short-term

financing:
1. Trade credit (accounts payable)
2. Commercial bank loans
3. Commercial paper

Sources of Short-term Financing
1. Trade credit (“spontaneous financing”): form of “free”
financing in the sense that no explicit interest rate is
charged on outstanding accounts payable
– Accounts payable arise spontaneously during normal
course of business
– Commercial firms buy inventory and supplies in open
account from their suppliers on whatever credit terms are
available rather than cash payments.
– Two costs associated with trade credit:
1. Cost of missed discounts
2. Cost of financing outstanding accounts receivable (firm
offers trade credit) increases cost of doing business over
what it would be if firm sold on cash terms only.

2. Commercial bank loans
– Employed to finance inventory and accounts
receivable
– Used as source of funds to enable firm to take
discounts on accounts payable when cost of missed
discounts exceeds interest cost of bank debt

2. Commercial bank loans (continued)
– Two possible structures:
1. Note for a fixed period of time
– At end of note term (maturity date), face amount of note must be repaid
or note must be renewed (“rolled over”).
– Bank and borrower may enter into formal/informal agreement to renew
note at maturity at specified rate, which is tied to prime interest rate (rate
charged to bank’s best corporate customers).
o Ex. Interest rate at prime plus some percentage over prime: “prime
plus 2%”
– Size of premium above interest rate is determined by bank’s assessment
of risk involved in making loan
o Higher risk, higher premium
– As prime rate changes, bank’s cost of obtaining funds changes, so
requiring firm to roll over its notes allows bank to change interest rate on
note.

– Two possible structures
2. Line of credit (“revolver”)
– Bank establishes upper limit on amount firm may
borrow and firm draws whatever money it needs
against credit line up to maximum.
– Interest rate may be fixed or float with prime or LIBOR
rate.
– Interest is charged only on amount actually borrowed,
not total amount available.

• Unsecured loan: “full faith and credit” obligation of
borrowing firm
– No specific assets are pledged as collateral for loan, but bank
has general claim against firm’s assets if firm defaults on loan
• Secured loan: firm pledges specific asset as collateral
for loan (i.e. accounts receivable, inventory)
– If firm defaults on loan, asset may be seized by bank and
liquidated to satisfy loan balance
– Any excess bank receives above amount of principal and
interest due on loan must be returned to borrower

• 3. Commercial paper: short-term
corporate IOU that is sold in large dollar
amounts through commercial paper
dealers
– Sold by large corporations
– Usually purchased by other corporations (as an outlet
for marketable securities) or by financial institutions
(i.e. banks, money market mutual funds)
– Not available means of financing for small business
organizations

Financing Accounts Receivable
• Accounts receivable: used as collateral
for short-term loans
• Three methods of accounts receivable
financing:
1. Pledging
2. Assigning
3. Factoring

1. Pledging
– Bank or other lender makes loan of some percentage of value of
receivables but does not take possession of them
– Receivables merely serve as collateral in the event of default
– If loan is not paid on time, bank has right to take possession of
receivables and collect amount necessary to satisfy loan principal and
interest due
– Any excess money collected above amount owed must be returned to
borrower
– Banks commonly loan 50-80% of face amount of receivables
– Amount loaned depends mainly on credit reputation of borrower and
quality of receivables pledged
– Quality of receivables is a function of credit rating of customer
accounts and age of receivables

2. Assigning
– Borrowing firm signs over its right to collect account to lender
– Lender advances money to borrower up to some
predetermined percentage of accounts receivable and then
collects directly from customer account
– Payments received in excess of amount loaned are property of
borrower (treated as part of “circulating pot” of money from
which borrower may draw funds as needed)
– Lenders commonly lend 75-90% of face value of receivables
assigned
– Percentage loaned is a function of credit rating of borrower and
quality of accounts receivable

• Pledging/Assigning (continued)
– Lender has recourse to borrower if account
fails to pay
– Lender only acts as supplier of funds so if
borrower defaults, borrower suffers bad-debt
loss, not lender
– Cost of pledging and assigning are about
equal

3.Factoring
– Lender buys accounts receivable outright
from borrower at discount from face value
and assumes burden of collecting
receivables
• Burden includes assumption of bad-debt losses
• If account does not pay, lender has no recourse
on borrowing firm

3.Factoring (continued)
• Lenders provides three services
1. Provide financing of accounts receivable for
borrowing firms
2. Act as borrowing firm’s credit department
3. Assumes risk of bad-debt losses
• Transfers risk from borrowing firms to factor
• Most expensive form of accounts receivable financing

MBA ZG 521

Pilani Campus
BITS Pilani
Dividend Policy and Capital Structure

-Part 1
Agenda
• Introduction
• Evolution This relates to chapters 15 and 16 of
• Miller Modigliani Hypothesis the prescribed textbook by Prasanna Chandra.
• Tax benefits of debt
• Financial Distress
• Agency Cost You may also wish to refer to Chapters 19 to
• Trade-off theory 22 of the Book on “Theory and Practice” by
• Asymmetric Information the same author
• Pecking Order Theory
• Target Capital Structure
• Dividend policy – Introduction
• Dividend Policy – theories
• Alternatives to Dividends

Introduction
• The capital structure decision affects financial

risk and, hence, the value of the company.
• The capital structure theories helps us to

understand the factors that are most important in
the inter-relationship between capital structure
and value (of the firm)
• Is it possible for firms to create value by altering

their capital structure?
Capital structure
• Does the size of a pizza have nothing to

do with how it is sliced?
• Is the value of a firm also independent of

how the firm mixes debt and equity?

Does capital structure affect the
firm value?
Debt Equity Debt
Equity Debt Equity

Wastage Govt.
Govt.
Slicing the pie doesn’t Slicing the pie can Slicing the pie can
affect the total amount affect the size of the slice affect the size of the
available to debt going to government Wastage slice
holders and equity holders (in the form of taxes)

Evolution of the theories
Evolution of theory from Miller and Modigliani to today:
Costs of
Asymmetric
Agency Information
Costs
Costs of
Financial
Benefit from Distress
Tax
Capital Deductibility
Structure of Interest
Irrelevance
1958 Today

Modigliani and Miller (MM)
• Basic theory: Modigliani and

Miller (MM) in 1958 and 1963
• Are they relevant today?
– Before MM, there was no formal
framework for analyzing Capital
Structure
– First to study capital structure and
WACC together
– Won the Nobel prize in 1990

Modigliani and Miller (MM)
• These are the most influential papers ever

published in finance (citations)
• However they make certain restrictive
assumptions (which are unrealistic)
• It is the first “no arbitrage” proof in finance
• Foundation for the development of several
other important theories in finance

MM Proposition I without Taxes:
Capital Structure Irrelevance
• Franco Modigliani and Merton Miller (MM) developed a

theory that was the first step towards enhancing our
understanding around how taxes and financial distress
affect a company’s capital structure decision.
• Assumptions:
1. Investors have homogeneous expectations regarding future
cash flows.
2. Bonds and stocks trade in perfect markets.
3. Investors can borrow and lend at the same rate.
4. There are no agency costs.
5. Investment and financing decisions are independent of one
another.

Proposition I without Taxes:
Capital Structure Irrelevance
MM Proposition I
The market value of a company is not affected by the capital structure of the
company.
• This is based on the assumption that there are no taxes, no

costs to financial distress, and no agency costs. Therefore
investors would value firms with the same cash flows in equal
terms, regardless of how the firms are financed.
• If a company has a given set of assets, changing debt to
equity will change the way net operating income is divided
between lenders and shareholders but will not change the
value of the company.

Proposition 1: Proof
• Two companies that have the same assets but
different capital structures are, under the
assumptions, perfect substitutes. As such, perfect
substitutes should have the same value.
• There is no reason for investors to pay a
premium for shares of levered companies
because investors can borrow to create home-
made leverage.
• The assumption being that home-made
leverage — is a perfect substitute for corporate
leverage.
• The central mechanism in MM’s proof is the
substitutability between corporate debt and
personal debt.

Proposition II without Taxes:
Higher Financial Leverage
MM Proposition II:
The cost of equity is a linear function of the company’s debt/equity ratio.
• Because creditors have a claim to income and assets that has

preference over equity, the cost of debt will be less than the cost of
equity.
• As the company uses more debt in its capital structure, the cost of
equity increases because of the seniority of debt:
𝐷
𝑟𝑒 = 𝑟0 + (𝑟0 −𝑟𝑑 )
𝐸
where r0 is the cost of equity if there is no debt financing.
• The WACC is constant because as more of the cheaper source of
capital is used (that is, debt), the cost of equity increases.
Note: In the formula above, RA is the cost of equity if there is no debt financing.

MM Proposition II

Introducing Taxes into the MM
Theory
When taxes are introduced (specifically, the tax
deductibility of interest by the firm), the value of the firm
is enhanced by the tax shield provided by this interest
deduction. The tax shield:
– Lowers the cost of debt.
– Lowers the WACC as more debt is used.
– Increases the value of the firm by tD (that is, marginal tax
rate times debt)
Without Taxes With Taxes
Value of the Firm VL = VU VL = VU + tD
WACC
Cost of Equity
Bottom line: The optimal capital structure is 99.99% debt.

Introducing costs of
financial distress
• Costs of financial distress are costs associated with a
company that is having difficulty meeting its obligations.
• Costs of financial distress include the following:
– Opportunity cost of not making optimal decisions
– Inability to negotiate long-term supply contracts.
– Loss of customers.
• The expected cost of financial distress increases as the
relative use of debt financing increases.
– This expected cost reduces the value of the firm, offsetting, in
part, the benefit from interest deductibility.
– The expected cost of distress affects the cost of debt and equity.
Bottom line: There is an optimal capital structure at which the value

of the firm is maximized and the cost of capital is minimized.

Introducing costs of
financial distress

MBA ZG 521

Pilani Campus
BITS Pilani
Dividend Policy and Capital Structure

-Part 2
Agency Costs
• Agency costs are the costs associated with the

separation of owners and management.
• Types of agency costs:
– Monitoring costs
– Bonding costs
– Residual loss
• The better the corporate governance, the lower the
agency costs.
• Agency costs increase the cost of equity and reduce
the value of the firm.
• The higher the use of debt relative to equity, the
greater the monitoring of the firm and, therefore, the
lower the cost of equity.

Trade-off Theory: Value of the
Firm
• According to this theory every firm has an optimal debt to equity ratio that maximizes value
• The implication being that there is a trade-off between the benefits of debt (interest tax
shield) and the costs of debt (financial distress, agency costs)
Market
Value
of the
Firm
Debt/Equity
Value of the unlevered firm
Value of the levered firm without costs of financial distress
Value of the firm: with taxes and costs of financial distress
The Optimal Capital Structure
Costs to
Financial
Taxes Distress Optimal Capital Structure?
No No No
Yes No Yes, 99.99% debt
Yes Yes Yes, benefits of interest deductibility are offset by the
expected costs of financial distress
While we may not always be able to determine the optimal capital structure for a
given company, we do know for sure that it depends on the following:
• The business risk of the company.
• The tax situation of the company.
• The degree to which the company’s assets are tangible.
• The company’s corporate governance.
• The transparency of the financial information.

Costs of Asymmetric
Information
• Asymmetric information is the situation
in which different parties have varying
levels of information.
– For example in a corporation, managers will
have a better information set than investors.
– The degree of asymmetric information varies
among companies and industries

Capital Structure with Information
Asymmetry
• Pecking order theory:
– In raising finance, managers follow a pecking order in
which internal funds are preferred, followed by debt, hybrid
securities and then, as a last resort, a new issue
of ordinary shares.
• Myers explains this pecking order based on information
asymmetry.
– Information asymmetry is a situation where all relevant
information is not known by all interested parties. Typically,
this involves company insiders (managers) having more
information about the company’s prospects than outsiders
(shareholders and lenders).

Deviating from Target
A company’s capital structure may be different from its

target (i.e. optimal) capital structure because of the
following reasons:
– Share market constantly fluctuates and hence the market
value of equity will change constantly, leading to deviations
– Some times, market conditions may favor one type of
security over another (Ex: debt over equity, etc.)
– Sometimes the market conditions are such that it is
inadvisable or too expensive to raise fresh capital.
– Since investment banking fees are typically very high they
encourage companies to come out with large equity issues
(on a less frequent basis), leading to temporary
imbalances

Dividend Policy - Introduction
Three major schools of thought:

– Dividends do not matter, and dividend policy does not
affect value
• No taxes on dividends
• Companies can raise equity whenever needed
– Dividends are bad, and increasing dividends will lead
to less firm value
• Dividends are taxed unfavorably (as compared to capital
gains)
– Dividends are good, and increasing dividends will
lead to higher firm value
• Stockholders like dividends
• Dividends are a signal of the future prospects of the firm

Dividend Policy - Theories
• Dividend irrelevance theory of Miller and Modigliani
– In a no tax/ no fee world, dividend policy is irrelevant since it has no impact on stock price
or cost of capital
– Investors could create their own dividend patterns by selling the stock, etc.
• Clientele Effect: certain stockholders may prefer more dividends because of
constant income and/ or lower taxes; or vice-versa ➔ stable dividend policy
• Bird in hand theory says certainty of current CF is preferred to future capital gains
• Tax preference theory suggests that differences between income and capital gains
taxes make dividends less attractive
• Signaling theory suggests that dividend changes convey management expectations
about future earnings
Stock price
Bird in hand theory
Dividend irrelevance theory
Tax preference
Payout ratio

Alternatives to Dividend
Several alternatives exist:

– Bonus stocks
– Stock options
– Stock repurchase/ share buyback

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Financial Management

Krishnamurthy Bindumadhavan, Fellow (IIM),

• Course objectives/ outcomes

• Overview of Financial Management

• Interface between Finance and other Functions

• Shareholder wealth maximization

• Basic Principles of Financial Management

• Understanding Indian Financial System

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

LO2 Apply Time Value of Money concepts for valuation.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

T1 Fundamentals of Financial Management, 6th Edition

Quiz-I Online - 5% Before Mid Semester

Quiz-II Online - 5% After Mid Semester

Experiential Home - 15% TBD

Mid-Semester Closed 2 hours 30% TBD

• Finance is the study of how people and

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• Investment analysis and management

• Financial institutions management

• International or Multinational Finance

• Knowledge of finance is critical for making good decisions (professional/ personal )

• Finance is an integral part of corporate world

•Such decisions require the expertise of various management disciplines including

• Most key personal decisions require financial knowledge/understanding

Key role of Finance function is to manage the cash flow

How much to invest? Source of funds?

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

•While managers have to cater to all the stakeholders (such as

•If managers fail to pursue shareholder wealth maximization,

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

o What do we mean by Ethics?

o Examples of recent financial scandals

o J.P. Morgan Chase $7 Billion Trading Mishap

o Libor Rate Rigging Scandal

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

•Principal hires an agent to represent its interests

•Conflict of interest between principal and agent

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

1. Time value of Money

2. Risk return trade-off

4. Efficient Capital Markets

6. All risks are not equal (diversifiable vs. undiversifiable)

7. Principal Agent issue

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• The main goal of financial markets is to

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Saving surplus Saving deficit

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Internal corporate External sources

Direct financing Indirect financing

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

• Secondary market – allows investors to

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956