Finance

Compendium
Part-II: Corporate Finance

Department of Management Studies

Indian Institute Technology, Delhi

1
Table of Contents
Corporate Finance
Introduction to Corporate Finance 3
Tools of Corporate Finance 4
Capital Structure 5
Cost of Debt 6
Cost of Preferred Stock 7
Cost of Equity 8
Optimal Capital Structure 11
Leverage 12
Breakeven Point 16
Working Capital Management 16
Capital Budgeting
Introduction 22
Metrics 22
NPV 23
IRR 26
Payback Period 28

2
Introduction to Corporate Finance
Corporate Finance In basic terms refers to any action taken by a business that involves
money. Since every business decision has financial implications, this definition would
include essentially everything. This broad view of the world in corporate finance has some
merits. From this lens, we can apply the principles of corporate finance to every business
decision. Should the business choose investment A or investment B? How much debt
should the business raise, and of which duration? What should the business do with excess
cash? All these decisions are at the core of corporate finance: we will learn a simple
framework to go about these decisions. What do we aim to achieve as the managers of an
organization? The aim of corporate finance is to maximize shareholder wealth. This
objective has increasingly come under fire for being too narrow minded, and there is a
debate about the maximization of stakeholder value (which includes employees,
customers, governments, lenders, and society at large) versus shareholder value. While it
sounds good to consider everyone and work for their benefit, interests often conflict: what
might be good for employees may not always be good for lenders or shareholders, what
might be good for society may not always be good for lenders or shareholders, and so on.
We do encourage you to explore this idea further, but for now, we will stick to our stated
objective: maximizing shareholder wealth. We will realize later from the Modigliani-
Miller propositions that maximizing shareholder wealth is the same as maximizing the
value of the business; these are interchangeable goals.
We can summarize the entirety of corporate finance in one diagram:

3
In the financing decision, you consider the right way to finance the company (which
proportion through shares, bonds, loans, and so on). Each financing instrument has some
characteristics in cost, terms, duration that must be coherent with the cash flows that will
generate the investments. In the investment decision, you look at the risk and profitability
profile of the projects you want to tackle.

Corporate finance involves analyzing investment projects. An investment project is any

business unit or specific endeavor (new product, process improvement, new plant) that
requires an investment and the can generate returns and requires capital. The idea is to set
up an optimal portfolio of investment projects in your firm considering your objectives-
that is supported by an appropriate capital structure. In the end, most of corporate finance
relates to balancing the cash flow profile of your sources of capital and your projects. If
they are imbalanced, you are going to run into problems.

The idea is simple: the firm raises money (from shareholders and creditors), invests in
projects to get returns, pays back the money to its providers (dividends, interests, debt
service) and pockets the difference (company value).

In corporate finance you use certain tools:

Financial Accounting: To prepare reports about the impact in the past of the financial
decisions on the company stakeholders (creditors, shareholders, and the government). It
is the one that prepares the balance (what the company owns and owes), Profit and Loss
(if it earns money) and Cash Flow (how much money goes in and out the company)
statements. These statements are prepared following certain standards (the Generally
Accepted Accounting Principles).

Managerial Accounting: It is used by the managers of the company to analyze and

control decisions with the goal of estimating the costs or performance (of products,
services, processes, Departments, projects).

Financial Modelling: To analyze the impact of different financing and investment

decisions. It is a future oriented use of the statements from financial accounting so that
different scenarios are considered.

Valuation: It is usually the main outcome of financial modeling. It provides the impact
on the company value of diverse decisions. In coming up with an estimated valuation it
4
considers the issues of revenue growth, margins, tax rates, financing mix and the weighted
average cost of capital, capital investment and project duration.

Financial Planning and Control: It refers to the establishment of targets for some
financial metrics and the reporting of progress towards them, so that corrective action can
be taken to assure proper accomplishment. It is commonly considered part of managerial
accounting. Financial control not only is about the effective use of the company assets but
also considers some organizational procedures so that financial information is reliable,
and money is used with integrity. Here you find auditing, budgeting (including capital
budgeting, that is the one of specific new projects), risk management, and other
techniques.

Financial Instruments: To raise capital and make certain investments – whether short
or long term, companies must consider the full range of financial instruments (shares,
bonds, loans, cash and its equivalents, derivatives (such as options, futures, forwards,
swaps, etc.) and the possibilities in terms of risk, flexibility, cash flows and terms. All
these tools are interrelated. A certain knowledge of corporate finance and, mostly, its
principles is important for any senior executive that is involved in making key strategic
decisions such as:
• Set objectives that improve company’s valuation, make investors happy
• Make strategic growth or restructuring decisions that impact a mix of
geographies, business units, products/services of the company in order to improve
its valuation.
• Raise capital for expansion or restructuring projects and deal with investors.
• Merge with or acquire other businesses or negotiate the best price and terms for
your company if you are the acquired one.
• Avoid or manage risks for your company, whether they come from your project
mix or your selected financing mix.

Capital Structure
Both debt and equity can be found on the balance sheet. Company assets, also listed on
the balance sheet, are purchased with this debt and equity. Capital structure can be a
mixture of a company's long-term debt, short-term debt, common stock, and preferred
stock. A company's proportion of short-term debt versus long-term debt is considered
when analyzing its capital structure.

5
When analysts refer to capital structure, they are most likely referring to a firm's debt-to-
equity (D/E) ratio, which provides insight into how risky a company's borrowing practices
are. Usually, a company that is heavily financed by debt has a more aggressive capital
structure and therefore poses a greater risk to investors. This risk, however, may be the
primary source of the firm's growth.
• Debt is one of the two main ways a company can raise money in the capital markets.
Companies benefit from debt because of its tax advantages; interest payments made
as a result of borrowing funds may be tax-deductible. Debt also allows a company
or business to retain ownership, unlike equity. Additionally, in times of low interest
rates, debt is abundant and easy to access.
• Equity allows outside investors to take partial ownership in the company. Equity is
more expensive than debt, especially when interest rates are low. However, unlike
debt, equity does not need to be paid back. This is a benefit to the company in the
case of declining earnings. On the other hand, equity represents a claim by the
owner on the future earnings of the company.

Capital structure refers to the proportion of equity vs. debt financing that a firm utilizes
to carry out its operations and growth. Managers need to weigh the costs and benefits of
raising each type of capital along with their ability to raise either. Equity capital involves
diluting some of the company ownership and voting rights but comes with fewer
obligations to investors in terms of repayment. Debt tends to be cheaper capital (plus it
has tax advantages) but comes with serious responsibilities in terms of repaying interest
and principal, which can lead to default or bankruptcy if not carried through. Firms in
different industries will use capital structures better suited to their type of business.
Capital Intensive industries like auto manufacturing may utilize more debt, while labor-
intensive or service-oriented firms like software companies may prioritize equity.

Cost of Debt:
The cost of debt is the rate of return the firm’s lenders demand when they loan money to
the firm. Put simply, the cost of debt is the effective interest rate or the total amount of
interest that a company or individual owes on any liabilities, such as bonds and loans.
This expense can refer to either the before-tax or after-tax cost of debt. The degree of the
cost of debt depends entirely on the borrower's creditworthiness, so higher costs mean the
borrower is considered risky.

𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) ∗ 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒

6
The cost of debt helps understand the overall rate being paid by a company to use different
types of debt financing. This can also give investors an idea of the company's risk level
when compared to the others because riskier companies tend to have a higher cost of debt.

Impact of Taxes on Cost of Debt

Since the interest paid on debts is often treated favorably by tax codes, the tax deductions
due to outstanding debts can lower the effective cost of debt paid by a borrower.

The after-tax cost of debt is the interest paid on debt less any income tax savings due to
deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s
effective tax rate from one, and multiply the difference by its cost of debt. The company’s
marginal tax rate is not used. Instead, the company’s state and federal tax rates are added
together to ascertain its effective tax rate.

For example, if a company’s only debt is a bond that it issued with a 5% rate, then its
pretax cost of debt is 5%. If its effective tax rate is 30%, then the difference between
100% and 30% is 70%, and 70% of the 5% is 3.5%. The after-tax cost of debt is 3.5%.
The rationale behind this calculation is based on the tax savings that the company receives
from claiming its interest as a business expense.

Cost of Preferred Stock

The cost of preferred stock is the rate of return, which is required by the holders of a
company's preferred stock. It can be calculated by dividing the annual preferred dividend
payment by the preferred stock's current market price. Management often uses this metric
to determine what way of raising capital is most effective and cost-efficient. Corporations
can issue debt, common shares, preferred shares, and a number of different instruments
in order to raise funds for expansions or continuing operations.
𝐾𝑝 = 𝐷𝑝 /𝑃𝑝s
Dp - Dividend
Pps- Price of the stock

Preferred stock is a form of equity that may be used to fund expansion projects or
developments that firms seek to engage in. Like other equity capital, selling preferred
stock enables companies to raise funds. Preferred stock has the benefit of not diluting the

7
ownership stake of common shareholders, as preferred shares do not hold the same voting
rights that common shares do.

Preferred stock lies in between common equity and debt instruments in terms of
flexibility. It shares most of the characteristics that equity has and is commonly known as
equity. However, preferred stock also shares a few characteristics of bonds, such as
having a par value. Common equity does not have a par value.

Cost of Equity
The cost of equity is the return that a company requires to decide if an investment meets
capital return requirements. Firms often use it as a capital budgeting threshold for the
required rate of return. A firm’s cost of equity represents the compensation that the market
demands in exchange for owning the asset and bearing the risk of ownership.

What the Cost of Equity Can Tell You?

The cost of equity refers to two separate concepts, depending on the party involved. If
you are the investor, the cost of equity is the rate of return required on an investment in
equity. If you are the company, the cost of equity determines the required rate of return
on a particular project or investment.

There are two ways that a company can raise capital: debt or equity. Debt is cheaper, but
the company must pay it back. Equity does not need to be repaid, but it generally costs
more than debt capital due to the tax advantages of interest payments. Since the cost of
equity is higher than debt, it generally provides a higher rate of return.

Methods of calculating cost of equity:

1. Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) gives the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout
finance to price risky securities and generate the expected returns for the assets given the
risk of those assets and the cost of capital.
KE = E(Ri) = RF + βi [E(RM) − RF]

KE = Cost of Equity

E(Ri) = Expected return on Equity

8
βi = The return sensitivity of stock i to changes in the market return

E(RM) = the expected return on the market

RF = Risk free rate

E(RM) − RF = the expected market risk premium

A risk-free asset is defined as an asset that has no default risk. An example can be a
default-free government debt instrument.

E(RM − RF) is the expected market risk premium, is the premium that investors demand
for investing in a market portfolio relative to the risk-free rate.

βi (beta) of a potential investment is a measure of how much risk the investment will add
to a portfolio that looks like the market. If a stock is riskier than the market, it will have
a beta greater than one. If a stock has a beta of less than one, it will reduce the risk of a
portfolio.

2. Dividend Discount Model

The dividend discount model (DDM) is a quantitative method used for predicting the
price of a company's stock based on the theory that its present-day price is worth the sum
of all of its future dividend payments when discounted back to their present value.

It attempts to calculate the fair value of a stock irrespective of the prevailing market
conditions and takes into consideration the dividend payout factors and the market
expected returns. If the value obtained from the DDM is higher than the current trading
price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.

Assuming that dividends are expected to grow at a constant rate (g) and that price reflects
intrinsic value we can write the value of a stock as:

P0 = 𝐷1/𝑟𝑒 − 𝑔

9
Rearranging for expected return on equity:

𝑘𝑒 = 𝑟𝑒 = 𝐷1/𝑃0 + 𝑔

𝐷1 = Expected dividend per share

P0 = Current share price
g = Dividend growth rate
ke = cost of equity

Shortcomings of DDM:
While the GGM method of the DDM is widely used, it has two well-known shortcomings.
The model assumes a constant dividend growth rate in perpetuity. This assumption is
generally safe for very mature companies that have an established history of regular
dividend payments.

However, DDM may not be the best model to value newer companies that have
fluctuating dividend growth rates or no dividends at all. One can still use the DDM on
such companies, but with more and more assumptions, the precision decreases.

The second issue with the DDM is that the output is very sensitive to the inputs. For
example, in the Company X example above, if the dividend growth rate is lowered by
10% to 4.5%, the resulting stock price is $75.24, which is more than a 20% decrease from
the earlier calculated price of $94.50.

The model also fails when companies may have a lower rate of return (r) compared to the
dividend growth rate (g). This may happen when a company continues to pay dividends
even if it is incurring loss or relatively lower earnings.

Using the DDM for Investments:

All DDM variants, especially the GGM, allow valuing a share exclusive of the current
market conditions. It also aids in making direct comparisons among companies, even if
they belong to different industrial sectors.

Investors who believe in the underlying principle that the present-day intrinsic value of a
stock is a representation of their discounted value of future dividend payments can use it
for identifying overbought or oversold stocks. If the calculated value comes to be higher
10
than the current market price of a share, it indicates a buying opportunity as the stock is
trading below its fair value as per the DDM.

However, one should note that the DDM is another quantitative tool available in the big
universe of stock valuation tools. Like any other valuation method used to determine the
intrinsic value of a stock, one can use the DDM in addition to the several other commonly
followed stock valuation methods. Since it requires lots of assumptions and predictions,
it may not be the sole best way to base investment decisions.

Optimal Capital Structure

The optimal capital structure is the optimal mix of the debt and equity financing that
maximizes a company’s market value and simultaneously decreases its cost of capital.

Decreasing the weighted average cost of capital (WACC) is one of the ways to optimize
for the lowest cost mix of financing.

The optimal capital structure can be estimated by calculating the mix of debt and equity
that will be able to minimize the weighted average cost of capital (WACC) of a company
while simultaneously maximizing its market value. The lower the cost of capital, the
higher is the present value of the firm’s future cash flows, discounted by the WACC.

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

In order to optimize the structure, a firm can issue either more debt or equity. The new
capital that’s acquired may be used to invest in new assets or may be used to repurchase
debt/equity that’s currently outstanding, as a form of recapitalization.

11
Debt investors take less risk because they have the first claim on the assets of the business
in the event of bankruptcy. For this reason, they accept a lower rate of return and, thus,
the firm has a lower cost of capital when it issues debt compared to equity.

Equity investors take more risk, as they only receive the residual value after debt investors
have been repaid. In exchange for this risk, investors expect a higher rate of return and,
therefore, the implied cost of equity is greater than that of debt.

Leverages
Leverage refers to borrowing funds for a particular purpose with an obligation to repay
these funds, with interest, at an agreed-to schedule. The idea behind leverage is to help
borrowers achieve a higher return with a smaller investment.

You’ll want to forecast your expenditures and determine your funding requirements
before deciding what kind of leverage to use. Instruments like derivatives, where the
investment is a small fraction of the underlying position, can be used as leverage.
However, in this article, we focus on debt.

How does leverage work?

If and when your business is ready to increase its scale of operations, expand into new
markets, or update existing infrastructure, you’re going to need funds. However, if you
don’t have enough equity or cash upfront, you’ll have to borrow funds.
Two ways to borrow capital are to issue bonds (equity financing) or borrow directly from
lenders (debt financing).
Equity financing involves selling your equity in exchange for funding. One of the biggest
benefits of equity financing is that it doesn’t lead to the company having to make interest
payments or any principal repayment. Some of the most common examples of equity
financing are initial public offerings (IPOs) and crowdfunding.

12
Debt financing involves a company borrowing money to fund working capital
requirements. When a company borrows money, it needs to make interest payments as
well as repay the principal. Taking a loan is a common debt financing example.

Main types of Leverages:

The three basic types of leverage can best be defined with reference to the firm’s
income statement:

1) Operating leverage is concerned with the relationship between the firm’s sales revenue
and its earnings before interest and taxes, or EBIT.
Operating leverage accounts for the fixed operating costs and variable costs of providing
goods and services. As fixed assets don’t change with the level of output produced, their
costs are constant and must be paid regardless of whether your business is making a profit
or experiencing losses. On the other hand, variable costs change depending on the output
produced.
You can determine operating leverage by finding the ratio of fixed costs to variable costs.
If your business has more fixed expenses than variable expenses, it has high operating
leverage. You can use a high degree of operating leverage to magnify your returns, but
too much of it can increase your financial risk.
The degree of operating leverage (DOL) is defined as the percentage change in operating
income (EBIT) that results from a given percentage change in sales:

DOL = percentage change in EBIT/ percentage change in sales

13
To calculate a firm's DOL for a particular level of unit sales:

DOL = Contribution/ EBIT

2) Financial leverage is concerned with the relationship between the firm’s EBIT and its
common stock earnings per share (EPS). Financial leverage refers to the amount of debt
a business has acquired. On a balance sheet, financial leverage is represented by the
liabilities listed on the right-hand side of the sheet.
Financial leverage lets your business continue to make investments even if you're short
on cash. It’s usually preferred to equity financing, as it lets you raise funds without
diluting your ownership.
The degree of financial leverage (DFL) is interpreted as the ratio of the percentage change
in net income (or EPS) to the percentage change in EBIT:

DFL = percentage change in EPS/ percentage change in EBIT

For a particular level of operating earnings, DFL is calculated as:

DFL = EBIT/ EBIT - Interest

3) Total leverage is concerned with the relationship between the firm’s sales revenue and
EPS. The degree of total leverage (DTL) combines the degree of operating leverage and
financial leverage. DTL measures the sensitivity of EPS to change in sales.

DTL is computed as:

DTL = DOL x DFL

= percentage change in EPS/ percentage change in sales

Or

Contribution/ EBT

14
Degree of Operating Leverage
Operating leverage results from the existence of fixed operating costs in the firm’s income
stream. We can define operating leverage as the potential use of fixed operating costs to
magnify the effects of changes in sales on the firm’s earnings before interest and taxes.

The degree of operating leverage (DOL) is the numerical measure of the firm’s operating
leverage.

DOL = Percentage change in EBIT/ Percentage change in Sales

DOL at base level sales = 𝑄∗(𝑃−𝑉𝐶)/𝑄∗(𝑃−𝑉𝐶)−𝐹𝐶

Changes in fixed operating costs affect operating leverage significantly. Firms sometimes
can incur fixed operating costs rather than variable operating costs and at other times may
be able to substitute one type of cost for the other.

For example, a firm could make fixed-dollar lease payments rather than payments equal
to a specified percentage of sales. Or it could compensate sales representatives with a
fixed salary and bonus rather than on a percent-of-sales commission basis.

Degree of Financial Leverage

Financial leverage results from the presence of fixed financial costs in the firm’s income
stream. We can define financial leverage as the potential use of fixed financial costs to
magnify the effects of changes in earnings before interest and taxes on the firm’s earnings
per share.

The two fixed financial costs that may be found on the firm’s income statement are (1)
interest on debt and (2) preferred stock dividends. These charges must be paid regardless
of the amount of EBIT available to pay them.

The degree of financial leverage (DFL) is the numerical measure of the firm’s financial
leverage.

DFL = Percentage change in EPS / Percentage change in EBIT

DFL at base level EBIT = 𝐸𝐵𝐼𝑇/𝐸𝐵𝐼𝑇−𝐼− 𝑃𝐷 (1−𝑇)

15
Where,
I = Interest paid on debt
PD = Preferred Dividend paid
T = Tax rate

Breakeven Quantity of Sales

Break Even Point
The breakeven point, QBE, is the number of units produced and sold at which the
company’s net income is zero or that is the revenues are equal to costs.
At this number of units, the company goes from being unprofitable to being profitable.

𝑄𝐵𝐸 = 𝐹 + 𝐶 / 𝑃 − 𝑉

QBE = Breakeven number of units

F = Fixed operating cost
V = Variable operating cost
C = Fixed financial cost
P = Price per unit

Operating Break Even Point

At the operating breakeven point revenues are set equal to operating costs.

𝑄𝑂𝐵𝐸 = 𝐹/𝑃 − 𝑉

QOBE = Operating breakeven number of units

F = Fixed operating cost
V = Variable operating cost
P = Price per unit

Working Capital Management

Working capital management refers to the set of activities performed by a company to
make sure it has enough resources for day-to-day operating expenses while keeping
resources invested in a productive way.

16
What is Working Capital?
Working capital is the difference between a company’s current assets and its current
liabilities.
• Current assets include cash, accounts receivable, and inventories.
• Current liabilities include accounts payable, short-term borrowings, and accrued
liabilities.
Some approaches may subtract cash from current assets and financial debt from current
liabilities.

Why is working capital management important?

• Ensuring that the company possesses appropriate resources for its daily activities
means protecting the company’s existence and ensuring it can keep operating as a
going concern.
• Scarce availability of cash, uncontrolled commercial credit policies, or limited
access to short-term financing can lead to the need for restructuring, asset sales,
and even liquidation of the company.

Managing Liquidity
• Properly managing liquidity ensures that the company possesses enough cash
resources for its ordinary business needs and unexpected needs of a reasonable
amount. It’s also important because it affects a company’s creditworthiness, which
can contribute to determining a business’s success or failure.
• The lower a company’s liquidity, the more likely it is going to face financial
distress, other conditions being equal. However, too much cash parked in low- or
non-earning assets may reflect a poor allocation of resources.
• Proper liquidity management is manifested at an appropriate level of cash and/or
in the ability of an organization to quickly and efficiently generate cash resources
to finance its business needs.

Managing Accounts Receivables

• A company should grant its customers the proper flexibility or level of commercial
credit while making sure that the right amounts of cash flow in via operations.
• A company will determine the credit terms to offer based on the financial strength
of the customer, the industry’s policies, and the competitors’ actual policies.
• Credit terms can be ordinary, which means the customer generally is given a set
number of days to pay the invoice (generally between 30 and 90). The company’s
17
 policies and manager’s discretion can determine whether different terms are
necessary, such as cash before delivery, cash on delivery, bill-to-bill, or periodic
billing.

Managing Inventory
• Inventory management aims to make sure that the company keeps an adequate level
of inventory to deal with ordinary operations and fluctuations in demand without
investing too much capital in the asset.
• An excessive level of inventory means that an excessive amount of capital is tied
to it. It also increases the risk of unsold inventory and potential obsolescence
eroding the value of inventory.
• A shortage of inventory should also be avoided, as it would determine lost sales for
the company.

Managing Short Term Debt

• Like liquidity management, managing short-term financing should also focus on
making sure that the company possesses enough liquidity to finance short-term
operations without taking on excessive risk.
• The proper management of short-term financing involves the selection of the right
financing instruments and the sizing of the funds accessed via each instrument.
• Popular sources of financing include regular credit lines, uncommitted lines,
revolving credit agreements, collateralized loans, discounted receivables, and
factoring.
• A company should ensure there will be enough access to liquidity to deal with peak
cash needs. For example, a company can set up a revolving credit agreement well
above ordinary needs to deal with unexpected cash needs.

Managing Accounts Payable

• Accounts payable arise from trade credit granted by a company’s suppliers, mostly
as part of the normal operations. The right balance between early payments and
commercial debt should be achieved.
• Early payments may unnecessarily reduce the liquidity available, which can be
used in more productive ways.
• Late payments may erode the company’s reputation and commercial relationships,
while a high level of commercial debt could reduce its creditworthiness.

18
Is Negative working capital a bad sign?
• Most of the time, this is not considered as a good sign, but there are cases where
negative working capital is good for the organization.
• Sometimes it means that the company can generate the cash so quickly that it gets
time in between to pay off its suppliers and creditors. So basically, the company is
using the suppliers’ money to run its day-to-day operations. Generally, firms who
are dealing with cash-only business enjoy high turnover with negative working
capital. Such firms don’t supply goods on credit and constantly increase their sales.
Online retailers, discount retailers, grocery stores, restaurants and telecom
companies are expected to have negative working capital.
• Though this means a good idea, having the negative working capital to its
advantage is not everyone’s cup of tea. The companies which deal with cash only
businesses or where the receivables time is too short often have negative working
capital.

Types of Working Capital Management Ratios:

Three ratios are important in working capital management:
1) The working capital ratio or current ratio
2) The collection ratio
3) The inventory turnover ratio

Current Ratio
Current Ratio = Current Assets / Current Liabilities

The working capital ratio or current ratio is the ratio of current assets to current liabilities.
It is a key indicator of a company's financial health as it demonstrates its ability to meet
the short-term financial obligations of the company.

A working capital ratio < 1.0 generally indicates that a company is having trouble meeting
its short term obligations. Such a scenario implies that the company’s liquid assets would
not cover the company’s debts due in the upcoming year. In this case, the company may
have to resort to selling off assets, securing long-term debt, or using other financing
options to cover its short-term debt obligations.

Working capital ratios of 1.2 to 2.0 are considered desirable.

19
A working capital ratio > 2.0 suggests that the company is not effectively using its assets
to increase revenues. A high ratio may indicate that the company is not securing financing
appropriately or managing its working capital efficiently.

Collection Ratio
Collection Ratio = No. of days * Average Accounts Receivable / Net Credit Sales

The collection ratio is a measure of how efficiently a company manages its accounts
receivable. The collection ratio is calculated as the product of the number of days in an
accounting period and the average amount of outstanding accounts receivables and
divided by the total amount of net credit sales during the accounting period.

The collection ratio calculation provides the average number of days it takes a company
to receive payment after a sales transaction on credit. If a company's billing department
is effective at collections attempts and customers pay their bills on time, the collection
ratio will be lower. Therefore, the lower the company's collection ratio, the more efficient
its cash flow.

Inventory Turnover Ratio

Inventory Turnover Ratio = Revenue / Inventory Cost

To operate with maximum efficiency and maintain a comfortably high level of working
capital, a company must keep sufficient inventory on hand to meet customers' needs while
avoiding unnecessary inventory that ties up working capital.

Companies typically measure how efficiently that balance is maintained by monitoring

the inventory turnover ratio. The inventory turnover ratio, calculated as the ratio of
revenues to inventory cost, reveals how rapidly a company's inventory is being sold and
replenished.

A relatively low ratio compared to industry peers indicates inventory levels are
excessively high, while a relatively high ratio may indicate inadequate inventory levels.
Also known as the stock turnover ratio, this ratio monitors the time a company takes to
convert its goods into cash. The lower the time taken, the higher is the company’s stock
efficiency.
20
Cash Conversion Cycle (CCC)
The cash conversion cycle (CCC) expresses the time (measured in days) it takes for a
company to convert its investments in inventory and other resources into cash flows from
sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to
measure how long each net input currency is tied up in the production and sales process
before converting it into cash received.

It considers how much time the company needs to sell its inventory, how much time it
takes to collect receivables, and how much time it must pay its bills without incurring
penalties.

Cash Conversion Cycle = DIO + DSO – DPO

where,
DIO = Days of inventory outstanding.
DSO = Days sales outstanding.
DPO = Days payables outstanding

DIO and DSO are associated with the company’s cash inflows, while DPO is linked to
cash outflow. Hence, DPO is the only negative figure in the calculation. Another way to
look at the formula construction is that DIO and DSO are linked to inventory and accounts
receivable, respectively, which are considered as short-term assets and are taken to be
positive. DPO is linked to accounts payable, which is a liability and thus assumed to be
negative.

21
Capital Budgeting
Capital budgeting involves choosing projects that add value to a company. The capital
budgeting process can involve almost anything including acquiring land or purchasing
fixed assets like a new truck or machinery. Companies use different metrics to track the
performance of a potential project, and there are various methods to capital budgeting.

Process:

1. Forecast Earnings
2. Determine Free Cash Flows (FCFs)
3. Choose from various available alternatives.
4. Analyze the project

Metrics:
When a firm is presented with a capital budgeting decision, one of its first tasks is to
determine whether the project will prove to be profitable. The payback period (PB),
internal rate of return (IRR) and net present value (NPV) methods are the most common
approaches to project selection.
Although an ideal capital budgeting solution is such that all three metrics will indicate
the same decision, these approaches will often produce contradictory results.

22
Thus, Investment Decisions can be made based on three metrics -
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Payback Period

Net Present Value

This is the value of all future cash flows (positive and negative) over the entire life of an
investment discounted to the present.

NPV = Present Value (Benefits) - Present Value (Costs)

If it is an/a
A. Investment Decision - Choose the alternative with highest NPV
B. Standalone project - Choose between accepting or rejecting the project

Years 2019 2020 2021 2022 2023

Future Cash Flows $100 $100 $100 $100 $100

Now if the discount rate is 10%, the Present value of the Future Cash Flow would be
PV = FCF / (1 + i)^n
where,
i = Discount rate
n = Number of years

NPV of Perpetual Cash Flows = Free Cash Flows / r

23
Terminal Value:
Value of the free cash flow beyond the forecast period

Growing Perpetuity Formula:

Terminal Value = FCF ( 1 + g)

r-g
Where,
FCF = Free Cash Flow
g = Growth rate
r = cost of capital

Example for calculating NPV:

Imagine a company can invest in equipment that would cost $1 million and is expected to
generate $25,000 a month in revenue for five years. Alternatively, the company could
invest that money in securities with an expected annual return of 8%. What should the
company go ahead with?

Step 1: NPV of the Initial Investment

Because the equipment is paid for up front, this is the first cash flow included in the
calculation. No elapsed time needs to be accounted for, so the immediate expenditure of
$1 million doesn’t need to be discounted.

Step 2: NPV of Future Cash Flows

Identify the number of periods (t): The equipment is expected to generate monthly cash
flow for five years, which means that there will be 60 periods included in the calculation
after multiplying the number of years of cash flows by the number of months in a year.

Identify the discount rate (i): The discount rate is 8% for alternative investment. We need
a monthly discount rate for this investment. For ease, leaving the calculations, taking the
monthly rate to be 0.64% which is equivalent to the 8% annual rate.

24
Now, this goes on for n = 60.

= 25000
(1 + 0.64) ^ 60

= 1,242,323

Now, Calculating the Net Present Value

= PV(Benefits) - PV(Costs)
= −$1,000,000+$1,242,323
= $242,323

Interpretation: In this case, the NPV is positive; the equipment should be purchased. If
the present value of these cash flows had been negative because the discount rate was
larger or the net cash flows were smaller, then the investment would not have made sense.

(Source - https://www.investopedia.com/terms/n/npv.asp#toc-example-of-
calculating-npv)

25
Internal Rate of Return
IRR, or internal rate of return, is a metric used in financial analysis to estimate the
profitability of potential investments. IRR is a discount rate that makes the net present
value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

Manually Calculating IRR

1. Using the formula, one would set NPV equal to zero and solve for the discount rate,
which is the IRR.
2. Note that the initial investment is always negative because it represents an outflow.
3. Each subsequent cash flow could be positive or negative, depending on the
estimates of what the project delivers or requires as a capital injection in the future.

The ultimate goal of IRR is to identify the rate of discount, which makes the present value
of the sum of annual nominal cash inflows equal to the initial net cash outlay for the
investment. In capital planning, one popular scenario for IRR is comparing the
profitability of establishing new operations with that of expanding existing operations.
For example, an energy company may use IRR in deciding whether to open a new power
plant or to renovate and expand an existing power plant.

26
Interpretation:
If IRR > Cost of Capital - Accept the Project
If IRR < Cost of Capital - Reject the Project

Example:
Let's assume that a company is reviewing two projects in which to invest its money.
Management must decide whether to move forward with one, both, or neither of the
projects. Its cost of capital is 10%. The cash flow patterns for each project are
highlighted in the following table:

Project A Project B

Initial Outlay $5,000 $2,000

Year One $1,700 $400

Year Two $1,900 $700

Year Three $1,600 $500

Year Four $1,500 $400

Year Five $700 $300

27
$0 = Σ [ CFt ÷ (1 + IRR)t ] - C0

Where:
CF = Net Cash flow
IRR = Internal rate of return
t = Period (from 0 to last period)
C0 = The initial outlay

IRR Project A: $0 = [ (-$5,000) + $1,700 ] ÷ [ (1 + r)1 + $1,900 ] ÷ [ (1 + r)2 + $1,600 ]

÷ [ (1 + r)3 + $1,500 ] ÷ [ (1 + r)4 + $700 ] ÷ [ (1 + r)5 ]
IRR Project B: $0 = (-$2,000) + $400 ÷ (1 + r)1 + $700 ÷ (1 +r)2 + $500 ÷ (1 + r)3 +
$400 ÷ (1 + r)4 + $300 ÷ (1 + r)5
Thus this way we get a discount rate which makes NPV 0. If this rate is greater than r
(Cost of Capital), we accept the project else we reject it.

Payback Period:

• The term payback period refers to the amount of time it takes to recover the cost of
an investment. Simply put, it is the length of time an investment reaches a
breakeven point.
• Shorter paybacks mean more attractive investments, while longer payback periods
are less desirable.
• The payback period is calculated by dividing the amount of the investment by the
annual cash flow.
• Account and fund managers use the payback period to determine whether to go
through with an investment.
28
 • One of the downsides of the payback period is that it disregards the time value of
money.

Example
Assume Company A invests $1 million in a project that is expected to save the company
$250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period
of four years for this investment.

Consider another project that costs $200,000 with no associated cash savings that will
make the company an incremental $100,000 each year for the next 20 years at $2 million.
Clearly, the second project can make the company twice as much money, but how long
will it take to pay the investment back?

The answer is found by dividing $200,000 by $100,000, which is two years. The second
project will take less time to pay back, and the company's earnings potential is greater.
Based solely on the payback period method, the second project is a better investment if
the company wants to prioritize recapturing its capital investment as quickly as possible.

29